SEC Adopts Derivatives Rule and Related Amendments
A divided SEC adopted rule 18f-4 under the 1940 Act to enhance the regulatory framework for derivatives use by registered investment companies, including mutual funds (other than money market funds), ETFs, closed-end funds, and BDCs. The new rule and rule amendments will provide a modernized, comprehensive approach to the regulation of these funds’ derivatives use that addresses investor protection concerns and reflects developments over the past decades, the SEC said. The new rule permits funds to enter into certain derivatives transactions that previously required an exemptive order from the Commission, provided funds comply with certain conditions designed to protect investors. These conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain based on value-at-risk, or “VaR.” A streamlined set of requirements will apply for funds that use derivatives in a limited way. Fund boards must approve the designation of a derivatives risk manager, who must report to the board at least annually on the derivatives risk management program’s implementation and effectiveness. A summary of the rule from lawyers at Sidley provides key highlights of the rule. The new requirements will also apply to leveraged or inverse investment products launched after the rule becomes effective. The SEC said it directed the staff to review the effectiveness of existing regulatory requirements in protecting investors, particularly those with self-directed accounts, who invest in leveraged or inverse products and whether the Commission’s promulgation of any additional requirements for these products may be appropriate. A report in the Financial Times noted that regulators have historically warned investors away from leveraged and inverse ETF products because of the potential for large losses. The SEC last year proposed sales restrictions involving such products but failed to adopt the sales restrictions along with rule 18f-4. Commissioners Allison Herren Lee and Caroline Crenshaw criticized the SEC’s decision, with Lee stating that investors holding shares of these funds over a longer period of time may suffer large and unexpected losses or returns that otherwise substantially deviate from what they reasonably anticipated. The rule and related rule and form amendments will become effective 60 days after publication in the Federal Register. The Commission has provided for an eighteen-month transition period for funds to comply with the rule and related reporting requirements.