Use of Derivatives by Registered Investment Companies and Business Development Companies: SEC Proposes Significant Modifications to Existing Regulatory Framework for Derivatives; New Rule Would Require Registered Investment Companies and Business Development Companies to Comply with Portfolio Limitations on Their Use of Derivatives, Establish Stricter Asset Coverage Requirements, and Require Funds That Utilize Derivatives to Establish a Derivatives Risk Management Program; Rule Would Mandate Board Oversight and Require Various Board Approvals

Sullivan & Cromwell LLP - December 18, 2015

On December 11, 2015, the Securities and Exchange Commission, by a vote of three to one, proposed new rule 18f-4 under the Investment Company Act of 1940.  The proposed rule would provide registered investment companies and business development companies that comply with certain requirements with an exemption that would permit them to enter into derivatives transactions and financial commitment transactions (as those terms are defined in the proposed rule) notwithstanding the Investment Company Act’s prohibitions and restrictions on the issuance of senior securities.  Compared to existing SEC and SEC staff guidance on which funds have historically relied to engage in such transactions, which would be superseded and rescinded, the new rule would impose significant new restrictions and requirements.  In particular, a fund seeking to rely on the new rule would be required to:

  • comply with one of two alternative portfolio limitations designed to impose a limit on the total amount of leverage the fund can obtain through derivatives and financial commitment transactions;
  • maintain an amount of “qualifying coverage assets” (which must generally be cash or cash equivalents) with respect to each derivative or financial commitment transaction designed to enable it to meet its obligations under such transaction;
  • if the fund engages in derivatives transactions with a combined notional value of at least 50% of a fund’s net assets, or transacts in complex derivatives, establish a formalized derivatives risk management program;
  • obtain various board approvals, including of the fund’s choice of portfolio limitation, its asset coverage policies and procedures, and its derivatives risk management program, and conduct periodic board reviews of various aspects of the fund’s compliance with the proposed rule; and
  • comply with new recordkeeping, disclosure and reporting requirements related to a fund’s use of derivatives.

The SEC acknowledged in the proposing release that certain alternative strategy funds, particularly so-called leveraged ETFs, could not continue operating as registered funds under the proposed rule’s restrictions, and stated that such funds may wish to consider de-registering under the Investment Company Act, with the funds’ sponsors offering such strategies via private funds or other vehicles not subject to statutory limitations on the use of leverage.
The SEC also proposed amendments to proposed Forms N-PORT and N-CEN that would require registered investment companies to report additional information regarding their derivatives and financial commitment transactions. 

The SEC has requested comments regarding the proposed rule and the proposed amendments to Form N-PORT and N-CEN generally and on numerous specific matters discussed in the release.  Comments must be submitted no later than 90 days following the release’s publication in the Federal Register.