The SEC has proposed new Rule 18f-4, which is meant to address investor protection purposes and concerns underlying section 18 of the Investment Company Act and to provide a modernized approach to the regulation of the use of derivatives transactions and other section 18 transactions by funds. Rule 18f-4 would allow funds to enter into derivatives transactions as long as certain conditions (which impose a limit on the leverage a fund may obtain through the use of derivatives and financial commitment transactions and other senior securities transactions, and which require the fund to have assets available to meet its obligations arising from those transactions) are met.

Under the proposed rule, a fund would be required to comply with a portfolio limitation that would limit the amount of leverage the fund may obtain through the use of derivatives. There are two options within the proposed rule that would satisfy this limitation.

The Exposure-Based Portfolio Limit

Under the exposure-based portfolio limit, a fund would be required to limit its aggregate exposure to 150% of the fund’s net assets. A fund’s “exposure” would be calculated as the aggregate notional amount of its derivatives transactions with its obligations under financial commitment transactions and certain other transactions.

The Risk-Based Portfolio Limit

Under the risk-based portfolio limit, a fund would be permitted to obtain exposure up to 300% of the fund’s net assets, provided that the fund satisfies a risk-based test that is based on value-at-risk. The test would be designed to determine whether the fund’s aggregate derivatives transactions result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives.

Additionally, the fund would be required to have assets available (generally cash and cash equivalents) equal to the sum of two amounts:

The Mark-to-Market Coverage Amount – the amount that the fund would pay if the fund exited the derivatives transaction at the time of the determination.

The Risk-Based Coverage Amount – a risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the derivatives transaction under stressed conditions.

If a fund engaged in more than limited derivatives transactions or used complex derivatives, the fund would be required to establish a formalized derivatives risk management program. This program would need to consist of certain components administered by a derivatives risk manager designated by the fund and approved by the fund’s board of directors. The fund’s board of directors would be required to approve and review the derivatives risk management program as well.

With this proposed rule, the SEC is also proposing amendments to the previously proposed Form N-CEN and Form N-PORT. These amendments would alter the forms to allow for funds to report additional risk metrics for certain derivatives and to disclose whether it relied on Rule 18f-4 during the reporting period. Funds that are required to have a derivatives risk management program would disclose additional risk metrics associated with the fund’s use of derivatives on Form N-PORT. Funds would disclose whether they relied on Rule 18f-4, as well as the portfolio limitation that is applicable to the fund, on Form N-CEN.

The SEC is seeking comment on this proposed rule and the amendments to proposed Forms N-PORT and N-CEN. Comments are due on or before March 28, 2016. Comments that have been received by the SEC already are available here.

Sources:

https://www.sec.gov/news/pressrelease/2015-276.html

https://www.sec.gov/rules/proposed/2015/ic-31933.pdf