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Proposed Rule Conformed to Federal Register version SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 239, 240, 249, 270, 274 and 275 Release No. 34-87607; IA-5413; IC-33704; File No. S7-24-15 RIN: 3235-AL60 Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. SUMMARY: The Securities and Exchange Commission (the “Commission”) is re-proposing rule 18f-4, a new exemptive rule under the Investment Company Act of 1940 (the “Investment Company Act”) designed to address the investor protection purposes and concerns underlying section 18 of the Act and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives and the other transactions addressed in the proposed rule. The Commission is also proposing new rule 15l-2 under the Securities Exchange Act of 1934 (the “Exchange Act”) and new rule 211(h)-1 under the Investment Advisers Act of 1940 (“Advisers Act”) (collectively, the “sales practices rules”). In addition, the Commission is proposing new reporting requirements and amendments to Form N-PORT, Form N-LIQUID (which we propose to be re-titled as “Form N-RN”), and Form N-CEN, which are designed to enhance the Commission’s ability to effectively oversee funds’ use of and compliance with the proposed rules, and for the Commission and the public to have greater insight into the impact that funds’ use of derivatives would have on their portfolios. Finally, the Commission is proposing to amend rule 6c-11 under the Investment Company Act to allow certain 1 leveraged/inverse ETFs that satisfy the rule’s conditions to operate without the expense and delay of obtaining an exemptive order. DATES: Comments should be submitted on or before March 24, 2020. ADDRESSES: Comments may be submitted by any of the following methods: Electronic comments: • Use the Commission’s internet comment form (http://www.sec.gov/rules/proposed.shtml); or • Send an email to [email protected]. Please include File No. S7-24-15 on the subject line. Paper comments: • Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090. All submissions should refer to File Number S7-24-15. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method of submission. The Commission will post all comments on the Commission’s website (http://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and printing in the Commission’s Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make publicly available. Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of 2 any such materials will be made available on the Commission’s website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at www.sec.gov to receive notifications by email. FOR FURTHER INFORMATION CONTACT: Asaf Barouk, Attorney-Adviser; Joel Cavanaugh, Senior Counsel; John Lee, Senior Counsel; Sirimal Mukerjee, Senior Counsel; Amanda Hollander Wagner, Branch Chief; Thoreau Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management; and with respect to proposed rule 15l-2, Kelly Shoop, Senior Counsel; or Lourdes Gonzalez, Assistant Chief Counsel; Office of Chief Counsel, Division of Trading and Markets; Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. SUPPLEMENTARY INFORMATION: Proposed rule 18f-4 would apply to mutual funds (other than money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, and companies that have elected to be treated as business development companies (“BDCs”) under the Investment Company Act (collectively, “funds”). It would permit these funds to enter into derivatives transactions and certain other transactions, notwithstanding the restrictions under sections 18 and 61 of the Investment Company Act, provided that the funds comply with the conditions of the rule. The proposed sales practices rules would require a broker, dealer, or investment adviser that is registered with (or required to be registered with) the Commission to exercise due diligence in approving a retail customer’s or client’s account to buy or sell shares of certain “leveraged/inverse investment vehicles” before accepting an order from, or placing an order for, the customer or client to engage in these transactions. 3 The Commission is proposing for public comment 17 CFR 270.18f-4 (new rule 18f-4) under the Investment Company Act, 17 CFR 240.15l-2 (new rule 15l-2) under the Exchange Act, 17 CFR 275.211(h)-1 (new rule 211(h)-1) under the Advisers Act; amendments to 17 CFR 270.6c-11 (rule 6c-11) under the Investment Company Act; amendments to Form N-PORT [referenced in 17 CFR 274.150], Form N-LIQUID (which we propose to re-title as “Form N- RN”) [referenced in 17 CFR 274.223], Form N-CEN [referenced in 17 CFR 274.101], and Form N-2 [referenced in 17 CFR 274.11a-1] under the Investment Company Act. 4 TABLE OF CONTENTS I. Introduction .................................................................................................................. 9 A. Overview of Funds’ Use of Derivatives ................................................................13 B. Derivatives and the Senior Securities Restrictions of the Investment Company Act .........................................................................................................17 1. Requirements of Section 18 ............................................................................ 17 2. Evolution of Commission and Staff Consideration of Section 18 Restrictions as Applied to Funds’ Use of Derivatives .................................... 19 3. Need for Updated Regulatory Framework ...................................................... 28 C. Overview of the Proposal.......................................................................................30 II. Discussion ................................................................................................................... 36 A. Scope of Proposed Rule 18f-4 ...............................................................................36 1. Funds Permitted to Rely on Proposed Rule 18f-4 .......................................... 36 2. Derivatives Transactions Permitted Under Proposed Rule 18f-4 ................... 39 B. Derivatives Risk Management Program ................................................................45 1. Summary ......................................................................................................... 45 2. Program Administration.................................................................................. 48 3. Required Elements of the Program ................................................................. 55 C. Board Oversight and Reporting .............................................................................79 1. Board Approval of the Derivatives Risk Manager ......................................... 81 2. Board Reporting .............................................................................................. 84 D. Proposed Limit on Fund Leverage Risk ................................................................90 1. Use of VaR ...................................................................................................... 91 2. Relative VaR Test ........................................................................................... 97 3. Absolute VaR Test ........................................................................................ 113 4. Choice of Model and Parameters for VaR Test ............................................ 117 5. Implementation ............................................................................................. 126 6. Other Regulatory Approaches to Limiting Fund Leverage Risk .................. 133 E. Limited Derivatives Users ...................................................................................148 1. Exposure-Based Exception ........................................................................... 149 2. Currency Hedging Exception ........................................................................ 164 3. Risk Management ......................................................................................... 167 F. Asset Segregation.................................................................................................171 G. Alternative Requirements for Certain Leveraged/Inverse Funds and Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment Vehicles .............................................................................................176 1. Background on Proposed Approach to Certain Leveraged/Inverse Funds
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