On December 11, 2015, the SEC proposed Rule 18f-4 (the “Proposed Rule”) under the 1940 Act. If adopted, the Proposed Rule represents a comprehensive overhaul of the current regulatory framework governing the use of derivatives and other trading practices that create leverage by registered investment companies. The Proposed Rule would supersede historical guidance provided by the SEC and its staff. 

The principal elements of the Proposed Rule include the following requirements:

• Portfolio Limits. A fund must limit its exposure to underlying reference assets through derivatives and other senior securities to either (i) 150% of net assets (“Exposure-Based Portfolio Limit”), or (2) 300% of net assets for funds that satisfy a “value-at-risk” (“VaR”) test (“Risk-Based Portfolio Limit”).

• Asset Coverage. A fund must maintain “qualifying coverage assets” in an amount equal to its current obligation (i.e., typically, a mark-to-market amount) plus a cushion, which represents a reasonable estimate of the potential obligations of the fund under stressed conditions. 

• Risk Management Program. Except for funds that use derivatives to a limited extent, the Proposed Rule requires funds to adopt a formalized risk management program and appoint a board-approved derivatives risk manager. 

Portfolio Limits

Exposure-Based Portfolio Limit

A fund relying on this limitation generally would be required to limit its aggregate exposure (as defined below), measured immediately after entering into a covered transaction, to 150% of the fund’s net assets. Under this test, the Proposed Rule does not include any provision to permit a fund to reduce its aggregate exposure for particular derivatives transactions that may be entered into for hedging (or riskmitigating) purposes or that may be “cover transactions.”

Risk-Based Portfolio Limit

A fund relying on this limitation would be required to limit its aggregate exposure to 300% of the fund’s net assets, measured immediately after entering into a covered transaction, if the fund can satisfy a risk-based test based on VaR. To satisfy this test, a fund’s full portfolio VaR (i.e., the VaR of its portfolio including derivatives transactions) must be less than that fund’s VaR excluding derivatives transactions. The Proposed Rule gives funds some flexibility in the selection of a VaR model for use in the riskbased
test for purposes of the risk-based portfolio limit, but the VaR model must meet certain minimum requirements explained in more detail in the Proposed Rule.

Aggregate Exposure

For the purposes of both portfolio limits described above, aggregate exposure is the sum of: (1) the aggregate notional amount of the fund’s derivatives transactions, subject to certain adjustments discussed below; (2) the amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under any financial commitment transactions; and (3) the aggregate indebtedness (and with respect to any closed-end fund or business development company, involuntary liquidation preference of preferred shares) with respect to any other senior securities transactions entered into by the fund pursuant to Section 18 or 61 of the 1940 Act.

Additionally, the Proposed Rule requires an adjustment to the notional amount in three circumstances:

(1) derivatives that provide a return based on the leveraged performance of an underlying reference asset; (2) derivatives transactions for which the underlying reference asset is a managed account or entity formed or operated primarily for the purpose of investing in or trading derivatives transactions, or an index that reflects the performance of such a managed account or entity; and (3) certain defined “complex derivatives transactions.”

Asset Coverage Requirements

Derivatives Transactions

The Proposed Rule would require a fund to manage the risks associated with its “derivatives transactions,” which include any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing or any similar instrument that may require payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination. A fund would be required to do so by maintaining a certain amount of “qualifying coverage assets” for each derivatives transaction, determined pursuant to policies and procedures approved by the fund’s board of directors.

Under the Proposed Rule, “qualifying coverage assets” in respect of a derivatives transaction would be fund assets that either: (1) are cash and cash equivalents; or (2) are, with respect to any derivatives transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset. Notably, qualifying coverage assets do not include other types of liquid assets such as equities or investment grade bonds.

For each derivatives transaction, the Proposed Rule requires a fund to maintain qualifying coverage assets with a value equal to the sum of: (1) the amount that would be payable by the fund if the fund were to exit the derivatives transaction as of the time of determination (the “mark-to-market coverage amount”); and (2) an additional amount that represents a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions (the “risk-based coverage amount”). Under the Proposed Rule, the fund must determine the risk-based coverage amount for each derivatives transaction in accordance with policies and procedures approved by the fund’s board of directors.

Financial Commitment Transactions

The Proposed Rule would require a fund that engages in “financial commitment transactions” (which include any short sale, reverse repurchase agreement, firm or standby commitment agreement or similar agreement) to maintain qualifying coverage assets equal in value to the amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under each of its financial commitment transactions. Under the Proposed Rule, “qualifying coverage assets” in respect of a financial commitment transaction would be fund assets that: (1) are cash and cash equivalents; (2) are, with respect to any financial commitment transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset; or (3) are assets that are convertible to cash or that will generate cash equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to be required to pay such obligation or that have been pledged with respect to the financial commitment obligation and can be expected to satisfy such obligation, determined in accordance with policies and procedures approved by the fund’s board of directors.

Risk Management Program

Funds Subject to the Risk Management Program Condition

Funds that have aggregate exposure to derivatives transactions exceeding 50% of its net asset value, or that use complex derivatives, must adopt and implement a formalized written risk management program. The 50% exposure condition would include exposures from derivatives transactions entered into by a fund, but would not include exposure from financial commitment transactions or other senior securities transactions entered into by the fund pursuant to Section 18 or 61 of the 1940 Act.

Administration of the Program

The Proposed Rule would require a fund to designate an employee or officer of the fund or the fund’s investment adviser responsible for administering the policies and procedures of the derivatives risk management program, whose designation must be approved by the fund’s board of directors. Board Approval and Oversight Under the Proposed Rule, the fund’s derivatives risk management program would be administered by the derivatives risk manager, with oversight provided by the fund’s board of directors. In addition, the Proposed Rule would require each fund to obtain initial approval of its written derivatives risk management program, and any material changes to the program thereafter, from the fund’s board of directors.

Comments on the Proposed Rule are due on or before March 28, 2016. The proposing release is available at: http://www.sec.gov/rules/proposed/2015/ic-31933.pdf.