SEC proposes exemptive rule to regulate fund derivatives

SEC exemption ruleAt its Dec. 11, 2015, open meeting, the SEC proposed to limit the amount of leverage that mutual funds can gain via derivatives. New Rule 18f-4 would be added under the Investment Company Act of 1940 (the 1940 Act). This rule would also amend the previously proposed Form N-PORT and Form N-CEN, which relate to registered investment companies.

In her opening remarks at the Dec. 11 meeting, SEC Chair Mary Jo White said, “The current regulatory framework no longer achieves the statutory objectives of [the 1940 Act], which seeks to protect investors from the risks of excessive leverage and from funds being unable to meet payment obligations that can result from derivatives and other instruments,” and also provides a “modernized, comprehensive regulatory framework” for funds’ use of derivatives. She feels that the current framework must be revised because investment companies “can experience substantial and rapid losses from investments in derivatives,” which could harm investors.1

To modernize the process, the SEC proposed three categories of regulatory requirements for derivative use by funds under new Rule 18f-4:
  • Portfolio limitations on derivatives transactions
  • Asset segregation requirements
  • Derivatives risk management program requirements

Portfolio limitations on derivatives transactions
Proposed Rule 18f-4 outlines two alternative portfolio limitations that would limit a fund’s ability to obtain leverage through investments in derivatives and certain other instruments. White said these portfolio limitations will address risks related to leverage and “provide funds the ability to use various types of derivatives in different ways, while curbing a fund’s ability to engage in undue speculation, a principal concern underlying the [1940 Act].2” The alternatives are:

  • Exposure-based portfolio limitation. In this scenario, a fund would limit its aggregate exposure to 150% of net assets. Exposure can be defined as the aggregate notional amount of the fund’s derivatives transactions, along with the fund’s obligations under financial commitment transactions such as reverse repurchase agreements and other similar transactions.
  • Risk-based portfolio limitation. As an alternative, a fund could obtain exposure through the use of derivatives in an aggregate notional amount up to 300% of the fund’s net assets, provided that the fund satisfies a risk-based test based on valueat- risk (VaR).3 This would determine whether a fund’s aggregated derivatives transactions result in less market risk for the portfolio than if the fund did not use derivatives.

Asset segregation requirements
White stated that proposed asset segregation requirements “are designed to address concerns relating to a fund’s ability to meet its obligation under a derivatives transaction.4

In derivatives transactions, the SEC would require funds to manage risks by segregating qualifying coverage assets (cash and cash equivalents) equal to the sum of the mark-to-market coverage amount plus a risk-based coverage amount.

  • The mark-to-market coverage amount: A fund would be required to segregate assets at any time equal to the amount that the fund would pay if it exited the derivatives transaction at the time of the calculation of the coverage amount.
  • The risk-based coverage amount: A fund also would be required to segregate an additional riskbased coverage amount. This amount would be a reasonable estimate of how much the fund would pay if the fund exited the derivatives transaction under stressed conditions.

Note that the rule does not permit funds to use offsetting transactions to avoid senior security concerns.

In financial commitment transactions (e.g., short sales, reverse repurchase agreements and firm commitments), funds would be required to segregate an amount equal to the full notional amount of the instrument.

Derivatives risk management program requirements
Funds that have derivatives transactions that make up more than 50% of net assets or those that use complex derivatives would be required to establish and maintain a formalized derivatives risk management program and designate a derivatives risk manager. Both of these must be segregated from the fund’s portfolio management and must be approved by the fund’s board of directors.

The risk management program must be reasonably designed to assess the risks of derivatives transactions, manage and monitor risks, and require periodic updates and reviews, among other things. In addition, the rule would require fund boards to review written reports prepared by the derivatives risk manager, at least quarterly, and review the adequacy and effectiveness of the derivatives risk
management program.

Form N-PORT and Form N-CEN
The SEC proposed further amendments to the two reporting forms that it proposed in May 2015:

  • Form N-PORT amendments would require enhanced reporting on portfolio-wide and positionlevel investments in derivatives. Funds that are required to adopt derivatives risk management programs would be required to disclose additional risk metrics related to derivatives. The SEC believes that VaR is the most appropriate metric for purposes of the proposed rule.
  • Form N-CEN amendments would require funds to disclose whether they relied on Rule 18f-4 during the reporting period and, if so, the applicable portfolio limitation.

For more information on proposed Forms N-CEN and N-PORT, please see Grant Thornton LLP’s July 20, 2015, article SEC Seeks to Modernize Investment Reporting and Disclosures.

The proposals continue the SEC’s focus on funds’ use of derivatives, which has been necessitated by innovations in portfolio management techniques and wider derivatives use. The proposed rules both limit the use of leverage while also providing some flexibility for using derivatives (with added compliance requirements).

We can expect to see the SEC continue to focus on funds and derivatives in the future, since the proposal only addresses Section 18 of the 1940 Act without addressing provisions regarding such issues as governing issuer diversification, industry concentration and investments in securities-related issuers.

The comment period for the proposals is 90 days. For more information, please see the SEC’s fact sheet5 and the proposing release.6

Download the PDF.

Michael Patanella
Audit Services Partner
U.S. Asset Management Sector Leader
T +1 212 624 5258

John Stomper
Audit Services Partner
Mutual Funds Practice Leader
T +1 312 602 8080

1 White, Mary Jo. “Statement at Open Meeting,”, Dec. 11, 2015.
2 White, Mary Jo. “Statement at Open Meeting,”, Dec. 11, 2015.
3 Generally, VaR attempts to quantify the amount an investor is likely to lose over a period of time, based on historical probability levels.
4 White, Mary Jo. “Statement at Open Meeting,”, Dec. 11, 2015.
5 SEC. “SEC Proposes New Derivatives Rules for Registered Funds and Business Development Companies” (press release),, Dec. 11, 2015.
6 SEC. Release No. IC-31933, “Use of Derivatives by Registered Investment Companies and Business Development Companies,”, Dec. 11, 2015.