On October 28, 2020, the SEC adopted a new regulatory framework for derivatives use by registered investment companies. New Rule 18f-4 applies to mutual funds other than money market funds, exchange-traded funds (ETFs), closed-end funds, and business development companies (BDCs). The new rule permits such funds to enter into derivative transactions and certain other transactions notwithstanding statutory restrictions on the use of “senior securities” contained in Section 18 of the Investment Company Act of 1940 (the “1940 Act”). The new rule replaces prior guidance included in SEC releases and SEC staff no-action letters.
New Rule 18f-4 will be effective as of the date 60 days after publication of the adopting release in the Federal Register. Compliance with the new rule will be required 18 months after the effective date.
A fund that relies on Rule 18f-4 must comply with VaR-based limits on fund leverage risk, adopt a derivatives risk management program (including an appointed derivatives risk manager), and comply with specific board oversight and reporting requirements, as set forth in more detail below.
Limit on Fund Leverage Risk. The rule requires funds to comply with a VaR‑based outer limit on fund leverage risk. Generally, this outer limit is based on a relative VaR test that compares the fund’s VaR to the VaR of a DRP. Under the rule, a DRP is either a designated unleveraged index that reflects the markets or asset classes in which the fund invests or, in the case of an actively managed fund, the fund’s securities portfolio excluding any derivatives transactions. In general, a fund may not use a designated index as its DRP if the designated index was “created at the request of the fund or its investment adviser.”
If a fund’s derivatives risk manager reasonably determines that a DRP would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund must comply with an absolute VaR test. The VaR of a fund relying on the relative VaR test may not exceed 200% of the VaR of its DRP. A fund relying on the absolute VaR test cannot have a portfolio VaR of more than 20% of the value of the fund’s net assets.
While there has been much focus on this component of the rule, the VaR tests in rule 18f-4 are a single metric within the overall derivatives risk management program (described in detail below). Comparing a fund’s VaR to that of an unleveraged reference portfolio that reflects the markets or asset classes in which the fund invests can help the derivatives risk manager determine whether a fund is using derivatives transactions to leverage the fund’s portfolio, which can magnify its potential for losses and significant payment obligations to derivatives counterparties. A VaR test can also demonstrate whether a fund is using derivatives for reasons other than leveraging the fund’s portfolio, which may be less likely to raise the concerns underlying Section 18 of the 1940 Act. For example, a fund that uses derivatives extensively, but has a VaR that does not substantially exceed the VaR of an appropriate benchmark, would not be substantially leveraging its portfolio.
The SEC acknowledged that the relative VaR test differs from the asset coverage requirements included in Section 18. However, the SEC takes the view that section18, “like the relative VaR test, limits a fund’s potential leverage on a relative basis rather than an absolute basis.” According to the adopting release, the relative VaR test is likewise designed “to limit the extent to which a fund increases its market risk by leveraging its portfolio through derivatives, while not restricting a fund’s ability to use derivatives for other purposes.”
The rule requires that any VaR model used by a fund for purposes of either the relative or absolute VaR test take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments. Funds must also provide parameters for the VaR calculation’s confidence level, time horizon, and historical market data. The final rule does not require a fund to use the same VaR model for calculating its portfolio’s VaR and the VaR of its DRP.
The rule does not prescribe the modeling methodology that must be followed by a fund in calculating its VaR. However, it includes a non-exhaustive list of market risk factors that a fund must account for in its VaR model (if applicable). These include: (i) equity price risk, interest rate risk, credit spread risk, foreign currency risk, and commodity price risk; (ii) material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (iii) the sensitivity of the market value of the fund’s investments to changes in volatility. Additionally, the rule prescribes that a fund’s VaR model use a 99% confidence level and a time horizon of 20 trading days. Moreover, a fund’s chosen VaR model must be based on at least three years of historical market data.
Derivatives Risk Management Program. A fund’s derivatives risk management program must be reasonably designed to ensure that the fund’s use of derivatives aligns with the fund’s investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements. The derivatives risk management program should complement, but not replace, a fund’s other risk management activities, including its liquidity risk management program under Rule 22e-4. The derivatives risk management program should take into account the way a fund uses derivatives, e.g., whether to increase investment exposures and increase portfolio risks, or to reduce portfolio risks or facilitate efficient portfolio management. The program must include, at a minimum, the following elements:
Derivatives risk manager. The program must be administered by an officer or officers of a fund’s investment adviser who serves as a fund’s derivatives risk manager. The derivatives risk manager may not be the fund’s portfolio manager, and the fund must reasonably segregate the functions of the program from its portfolio management functions.
The derivatives risk manager must have relevant experience such that she can carry out her responsibilities under the rule, including not only administering the program and the related policies and procedures, but also making necessary internal and board reports. The person(s) serving in this role must have sufficient authority within the investment adviser to carry out these responsibilities. Additionally, although she is responsible for administration of the program, the derivatives risk manager may hire and rely on others, including third-party service providers, to carry out the activities associated with the program. The rule also does not preclude a derivatives risk manager from delegating to a sub-adviser specific derivatives risk management activities that are not specifically assigned to the derivatives risk manager in the rule, subject to appropriate oversight.
The SEC acknowledged that many commenters raised the concern that an individual appointed as the derivatives risk manager could be subjected to increased potential liability based on her administration of the program. The rule does not change the standards that the SEC will apply in determining whether a person is liable for aiding, abetting, or causing a violation of the federal securities laws. The SEC said, however, that is “recognize[s] that risk management necessarily involves judgment. That a fund suffers losses does not, itself, mean that a fund’s derivatives risk manager acted inappropriately.”
Risk identification and assessment. The program must include procedures to identify and assess a fund’s derivatives risk in the context of its derivatives transactions and other investments. Moreover, the SEC said that an appropriate assessment of derivatives risks “generally involves assessing how a fund’s derivatives may interact with the fund’s other investments or whether the fund’s derivatives have the effect of helping the fund manage risks.” Under the rule, the following derivatives risks must be identified, assessed, and managed:
Importantly, however, the rule does not limit a fund’s identification and assessment of derivatives risks to only those specified in the rule but specifically includes any other risks a fund’s derivatives risk manager deems material.
Stress testing. The program will have to provide for stress testing of derivatives risks to evaluate potential losses to a fund’s portfolio under stressed conditions. Stress tests must “evaluate potential losses in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund’s portfolio.” Additionally, stress tests must take into account correlations of market risk factors and resulting payments to derivatives counterparties and address the frequency with which stress testing will occur in light of the fund’s strategy and investments and current market conditions, provided that stress tests must be conducted no less frequently than weekly.
Although not required by the rule itself, the SEC identified six factors—liquidity, volatility, yield curve shifts, sector movements, or changes in the price of the underlying reference security or asset—that could be considered for stress testing. Importantly, however, the SEC acknowledged that there are factors other than these that should be considered for stress testing, and the specific factors will vary from fund to fund based on the judgment of fund risk professionals designing the stress tests.
As noted above, stress testing must occur at least weekly. However, the scope of stress testing may vary. For example, a fund may conduct more-detailed scenario analyses monthly and conduct more-focused weekly stress tests. In short, hypothetical scenarios involved in stress testing should be tailored to the particular fund.
Internal reporting and escalation. The program must provide for the reporting of certain matters relating to a fund’s derivatives use to the fund’s portfolio management and board of directors. The internal reporting and escalation components of the program must identify the circumstances under which persons responsible for portfolio management will be informed regarding the operation of the program (for example, when identified risk guidelines are exceeded) and the results of the fund’s stress testing. The program should also clarify when the derivatives risk manager must inform the fund’s board of material risks arising from the fund’s derivatives use. While the rule requires the derivatives risk manager to “timely” inform portfolio managers of material risks arising from the fund’s derivatives transactions, the derivatives risk manager has flexibility to inform the board about such material risks “as appropriate.” Moreover, a fund’s escalation requirements should be tailored based on its size, sophistication, and needs.
Although the rule specifies that a fund’s portfolio manager may not be the fund’s derivatives risk manager, the internal reporting and escalation requirements of the rule contemplate communication between a fund’s risk management and portfolio management regarding the operation of the program. According to the SEC, “[p]roviding portfolio managers with the insight of a fund’s derivatives risk manager is designed to inform portfolio managers’ execution of the fund’s strategy and recognize that portfolio managers will generally be responsible for transactions that could mitigate or address derivatives risks as they arise.”
Board Oversight and Reporting. Under Rule 18f-4, the board is required to approve the designation of a fund’s derivatives risk manager with relevant experience in the management of derivatives risk. The board is not required to approve the derivatives risk management program itself. The SEC said that it anticipates that a fund’s adviser will, at the request of the board, carry out due diligence on appropriate candidates and articulate the qualifications of the candidate(s) that it puts forward to the board. However, “requiring the board to designate the derivatives risk manager is important to establish the foundation for an effective relationship and line of communication between a fund’s board and its derivatives risk manager.”
The rule requires the derivatives risk manager to provide a fund’s board with a written report at or before the implementation of the fund’s derivatives risk management program and at least annually thereafter. Among other things, such report must provide the board with information about the effectiveness and implementation of the program so that the board may appropriately exercise its oversight responsibilities, including its role under rule 38a-1. The derivatives risk manager should include in such report her representation that the program is reasonably designed to manage the fund’s derivatives risks and to incorporate the required elements of the program. The report must include the basis for such representation, which may be the derivatives risk manager’s reasonable belief after due inquiry.
The written report must also include, as applicable, the fund’s derivatives risk manager’s basis for the approval of the DRP (or any change in the DRP) used under the relative VaR test or, alternatively, explain why the derivatives risk manager determined it was not appropriate to use a DRP for purposes of the relative VaR test such that the fund relied on the absolute VaR test instead. In addition to the required annual report, the derivatives risk manager should provide the board (at a frequency determined by the board) with reports that analyze circumstances when the fund exceeded its risk guidelines and the results of the fund’s stress testing and backtesting.
Although it is the derivatives risk manager who must have relevant experience regarding the management of derivatives risk, the SEC said in the adopting release that the board should “understand the program and the derivatives risks it is designed to manage. They also should ask questions and seek relevant information regarding the adequacy of the program[.]” Among other things, this means that a board should inquire about material risks arising from a fund’s derivatives transactions and follow up regarding the steps the fund takes to address such risks and any change in those risks over time. Finally, the board is expected to take reasonable steps to see that matters identified through the derivatives risk management program are appropriately addressed.
Notwithstanding the level of expected involvement of the board, the SEC confirmed that the board’s role is one of “general oversight.” Consistent with that obligation, the SEC clarified that directors should “exercise their reasonable business judgment in overseeing the program on behalf of [a] fund’s investors.” The SEC also clarified its characterization of the process as “iterative,” meaning that the board’s oversight role requires regular engagement with the derivatives risk management program rather than a one-time assessment.
As noted above, a fund that limits its derivatives exposure to 10% of its net assets will be excepted from the rule’s requirements to adopt a derivatives risk management program, comply with the VaR-based limit on fund leverage risk, and comply with the related board oversight and reporting provisions. For purposes of this calculation, “derivatives exposure” means the sum of: (1) the gross notional amounts of a fund’s derivatives transactions such as futures, swaps, and options; and (2) in the case of short sale borrowings, the value of any asset sold short. A fund may exclude from the 10% threshold derivatives transactions that are used to hedge certain currency and/or interest rate risks and positions closed out with the same counterparty, but may not exclude offset positions across different counterparties.
A fund relying on the limited derivatives user exception will nonetheless be expected to manage the risks associated with its derivatives transactions by adopting and implementing written policies and procedures that are reasonably designed to manage such risks. The rule also contains remediation provisions to address instances in which a fund exceeds the 10% threshold. Thus, if a fund’s derivatives exposure exceeds the 10% derivatives exposure threshold for five business days, the fund’s investment adviser must provide a written report to the fund’s board of directors informing it whether the investment adviser intends either to: (i) promptly, but within no more than 30 calendar days, reduce the fund’s derivatives exposure to be in compliance with the 10% threshold; or (ii) adopt the requirements of Rule 18f-4, including establishing a derivatives risk management program, complying with the VaR-based limit on fund leverage risk, and complying with the related board oversight and reporting requirements as soon as reasonably practicable. In either case, the fund’s next filing on Form N-PORT must specify the number of business days, in excess of five business days, that the fund’s derivatives exposure exceeded 10% of its net assets during the applicable reporting period.
The SEC adopted certain amendments to the reporting requirements for funds that rely on Rule 18f-4, as set forth below.
Form N-PORT. Form N-PORT is amended to add new items to Part B (“Information about the Fund”). A fund that relies on the exception to the rule available to limited users of derivatives must report its aggregate derivatives exposure as of the end of each reporting period. Such a fund will also be required to break out certain aspects of its derivatives exposure, including exposure from currency and interest rate derivatives that hedge related risks, and report the number of business days (in excess of the five-business-day remediation period provided in Rule 18f-4) that derivatives exposure exceeded 10% of its net assets. The derivatives exposure information reported by funds that rely on exception for limited derivatives users will be confidentially reported and not publicly disclosed.
Funds that rely on Rule 18f-4 will be required to report their median daily VaR for the monthly reporting period. Funds subject to the relative VaR test will report, as applicable, the name of the fund’s designated index or a statement that the fund’s DRP is the fund’s securities portfolio, as well as their median VaR during the reporting. Funds subject to the absolute VaR test will report their median daily VaR during the reporting period. A fund’s median VaR information will not be publicly available.
A fund also must report the number of identified exceptions during the reporting period arising from backtesting the fund’s VaR calculation model, but this information will not be made publicly available.
New Rule 18f-4 creates a level playing field for registered funds that use more than a limited amount of derivatives. It recognizes that a fund may appropriately use derivatives for the benefit of a fund and its shareholders, provided that any resulting risks are understood and managed. Moreover, it facilitates the ability of fund sponsors to bring new leveraged/inverse funds to market.
For any fund that seeks to rely on Rule 18f-4, however, the rule creates another required risk-management program and meaningfully increases the oversight obligations of the board. Commenters on the proposal also argued that the rule unnecessarily inserts the board more firmly into management of a fund’s adviser by requiring that the derivatives risk manager, who must be an officer of the adviser, have a direct reporting relationship with the fund’s board. In recognition of this concern, the Commission clarified that a fund’s board will not be responsible for the day-to-day management of the fund’s derivatives risk.
Nonetheless, the Commission anticipates that the board of a fund relying on Rule 18f-4 will regularly engage with the derivatives risk management program (presumably through interactions with the derivatives risk manager) and actively inquire into material risks arising from the fund’s derivatives transactions and the steps the fund takes to address such risks. Boards should therefore expect to spend significant time over the next 18 months to come up to speed on a fund’s use of derivatives and their related risks. Boards should also expect to spend a meaningful amount of time reviewing derivatives and their associated risks on a going forward basis.
 Section 18 of the 1940 Act imposes limits on a fund’s capital structure. Among other things, Section 18 restricts a fund’s ability to issue “senior securities.” A senior security is defined, in part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.”
 A fund with the investment objective to track the performance (including a leveraged multiple or inverse multiple) of an unleveraged index must use the unleveraged index it is tracking as its DRP. Additionally, an actively managed fund may use a blended index as its designated index, provided that each constituent index meets the rule’s requirements.
 Under the final rule, closed-end funds that have issued to investors and have outstanding shares of a senior security that is a stock are subject to relative and absolute VaR limits of 250% and 25%, respectively. A closed-end fund that does not obtain equity-based structural leverage would, however, be subject to the same 200% relative VaR limit as other funds.
 A fund also may obtain the VaR of its DRP from a third-party vendor instead of analyzing it in-house.