United States: SEC Proposes Requirements For Funds' Use Of Derivatives And Other Financial Transactions

If adopted, the proposed requirements would significantly alter funds' ability to enter into derivatives and other financial transactions, present new operational challenges, expand reporting requirements, and impose new and enhanced oversight responsibilities on funds' boards of directors.

On December 11, the US Securities and Exchange Commission (SEC) voted three-to-one in favor of proposing a new rule—Rule 18f-4 under the Investment Company Act of 1940 (1940 Act)—that would significantly change the way the SEC regulates the use of derivatives and other financial transactions by registered investment companies (i.e., mutual funds, exchange-traded funds, and closed-end funds) and business development companies.1

This is the third significant proposed rulemaking for the registered fund industry this year2—as first outlined by SEC Chair Mary Jo White in December 2014—which together represent a significant departure from the SEC's traditional approach to the regulation of not just derivatives, but funds generally.3 This proposal comes more than four years after the SEC issued a Concept Release on funds' investments in derivative instruments, and would effectively replace a patchwork of SEC Staff positions that has evolved over the last 35-plus years with a comprehensive approach of proactive oversight that is intended (among other things) to limit funds' economic exposures that result from derivatives investments and other financial transactions.4

In support of its proposal, the SEC cited the need to protect investors and a concern for potential losses in funds that make extensive use of derivatives, as well as the desire to implement a more comprehensive approach to the regulation of funds' use of derivative transactions. Comments on the proposal will be due sometime in March 2016—90 days after the proposal is published in the Federal Register.

Under the proposal, "derivatives transactions" would be broadly defined to include swaps, security-based swaps, futures contracts, forward contracts, and options, as well as any combination of those instruments and any similar instrument under which a fund is or may be required to make any payment or delivery of cash or other assets. In addition, the proposal would regulate funds' "financial commitment transactions," which would include reverse repurchase agreements, short sales, and any firm or standby commitment agreements or similar agreements (including promises to make a loan or capital commitments).

The proposal would regulate fund investments in derivatives in three ways: (i) by imposing certain portfolio limitations on leverage, which would act to limit the exposure a fund may obtain through derivatives, (ii) by requiring assets to be segregated and significantly limiting the types of assets that can be used for segregation, and (iii) by requiring certain funds to adopt a formal derivatives risk management program. Funds would also face new recordkeeping and reporting requirements.

Portfolio Limitations for Derivative Transactions

As proposed, funds would be required to comply with one of two alternative portfolio limitation tests that would limit the amount of leverage a fund can obtain through derivative transactions. A fund's board of directors would have to approve the portfolio limitation test the fund would use. Compliance requirements and board oversight would be based on the test selected by the fund.

Exposure-Based Portfolio Limitation Test

The first test would be an exposure-based portfolio limitation, under which a fund would be required to limit its aggregate exposure to derivatives to 150% of its net assets, calculated immediately after entering into any senior securities transaction. Under this test, a fund's exposure to derivatives would be calculated as the sum of (i) the aggregate notional amount of its derivative transactions (after netting any directly offsetting positions with the same type of instrument and same underlying reference assets, maturity, and other material terms),5 (ii) the aggregate amount of cash or other assets that the fund is obligated to pay or deliver under its financial commitment transactions, and (iii) the aggregate indebtedness with respect to any senior securities transactions entered into by the fund pursuant to Section 18 of the 1940 Act (including involuntary liquidation preferences in the case of closed-end funds and business development companies).

Risk-Based Portfolio Limitation Test

The second test would be a risk-based portfolio limitation, under which a fund would be permitted to obtain derivatives exposure up to 300% of its net assets, provided that the fund satisfies a risk-based test that would be calculated using a value-at-risk (VaR) methodology. This second test would also be calculated immediately after entering into any senior securities transaction. VaR is a risk metric that would be defined under the proposed rule as an estimate of potential losses (of either a particular instrument or an entire portfolio) over a specified time horizon and at a given confidence interval, expressed in US dollars.

This test would be an alternative to the exposure-based test and would permit a fund to obtain exposure in excess of the limitations set forth in the exposure-based test, provided the fund complies with the VaR-based limitations. The SEC recognized that it may be appropriate for a fund to be able to obtain exposure in excess of what would be permitted under the exposure-based portfolio limitations if the fund's derivatives transactions have the effect of reducing the fund's exposure to market risk. VaR models will vary from fund to fund, but must incorporate all identifiable market risks, including equity price risk, interest rate risk, credit spread risk, foreign currency risk, and commodity price risk. VaR models also need to address sensitivity to changes in volatility and non-linear price characteristics. To satisfy the VaR test, a fund's full portfolio VaR (i.e., the VaR of the fund's entire portfolio, including securities, derivatives transactions, and other transactions) would have to be less than the fund's securities VaR (i.e., the VaR of the fund's securities and other investments, excluding any derivatives transactions) immediately after the fund enters into any senior security transaction.   

Asset Segregation for Derivatives Transactions

The proposed rule would also require a fund to manage the risks associated with its derivatives transactions by, among other things, segregating assets to ensure that the fund has sufficient assets to meet its obligations under those transactions. Funds would be required to implement board-approved policies and procedures through which they would maintain a required amount of qualifying coverage assets. The amount of qualifying coverage assets would be determined by a two-part test. The first amount would be a "marked-to-market coverage amount," equal to the amount that would be payable by the fund if it were to exit the derivatives transaction as of the time of determination. The second amount would be a "risk-based coverage amount," equal to a reasonable estimate of the potential amount payable by the fund if it were to exit under stressed conditions. This risk-based coverage amount, if applicable, would be in addition to the marked-to-market amount, and not an alternative.

"Qualifying coverage assets" generally would be limited to cash and cash equivalents, with certain exceptions. For derivative transactions and financial commitment transactions under which a fund is required to deliver a particular asset, then that particular asset would be a qualifying coverage asset for that position. Funds would need to identify qualifying coverage assets on their books and records at least once each business day, and the timing of the marked-to-market and risk-based amounts would be required to be consistent with one another so as to provide the fund with a reasonably current estimate of the potential amounts payable.

Derivatives Risk Management Program

In most cases, a fund would also be required to adopt and implement a written derivatives risk management program that is reasonably designed to assess and manage the risks associated with its derivatives transactions.

The written risk management program would be required to

  1. assess the risks associated with the fund's investments (including an evaluation of the potential leverage, market, counterparty, liquidity, and operational risks);
  2. manage associated risks by monitoring whether investments are consistent with the fund's investment guidelines, disclosures to investors, and communications with the fund's portfolio managers and board of directors;
  3. be segregated from the portfolio management of the fund; and
  4. be reviewed and updated at least once annually, including updating models or risk measurement tools used as part of the program (such as VaR models).

A fund's board of directors (including a majority of the independent directors) would be required to initially approve the written risk management program and to approve any material changes to the program. The fund would be required to designate an employee or officer of the fund (or the fund's adviser) as a "derivatives risk manager" who would be responsible for administering the policies and procedures set forth in the written derivatives risk management program. The derivatives risk manager would not be permitted to be a portfolio manager and would have to be approved by the board of directors (including a majority of the independent directors). The board would also be required to review, at least quarterly, a written report prepared by the derivatives risk manager that assesses the adequacy and effectiveness of the fund's program.

A fund that has aggregate exposure to derivatives transactions of less than 50% of the value of the fund's net assets and that does not use complex derivatives transactions would not be required to adopt a written risk management program. As proposed, a "complex derivative transaction" would be any instrument where the amount payable (i) depends on the value of an underlying reference asset at multiple points in time, or (ii) is a non-linear function of the value of the underlying reference asset.6

Financial Commitment Transactions

As noted above, the proposal would also regulate funds' "financial commitment transactions," which would include reverse repurchase agreements, short sales, and any firm or standby commitment agreements or similar agreements (including promises to make a loan or capital commitments). Funds that enter into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund would be obligated to pay or deliver under those transactions. These coverage assets would have to be identified on the books of the fund at least once each business day. A fund's board (including a majority of its independent directors) would also have to approve policies and procedures reasonably designed to comply with these coverage requirements.

Recordkeeping, Disclosure, and Reporting

Funds would be required to maintain numerous records under the proposed rule, including a written record of certain determinations made by the board, copies of the policies and procedures, materials provided to the board in connection with the approval of the written derivatives risk management program, records documenting periodic reviews of the program, and portfolio records evidencing compliance with applicable portfolio limitations and coverage requirements, including records that must be created on a per-transaction basis.

In conjunction with proposed Rule 18f-4, the SEC also proposed amendments to two reporting forms that were first proposed in May 2015. First, Form N-PORT (which was proposed in May to be a monthly filing of portfolio-wide and position-level data and would replace current Form N-Q) would now also require funds to disclose, on a monthly basis, certain risk metrics about their use of certain derivatives. Second, Form N-CEN (which was proposed in May to be an annual filing that would replace Form N-SAR) would now also require disclosure of whether a fund relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund (i.e., exposure-based or risk-based). This requirement is designed to prevent funds from selectively changing between the portfolio limitations as one becomes preferable to the other.

Comments on the Proposal and Effect on Existing Guidance

Comments on the proposed reforms are due 90 days after the Proposing Release is published in the Federal Register. This publication process typically takes less than two weeks, so we expect comments will be due during the second half of March 2016.

The SEC noted that if proposed Rule 18f-4 is adopted, then the SEC would rescind its release on Securities Trading Practices of Registered Investment Companies from April 1979,7 as well as the SEC Staff's no-action letters addressing derivatives and financial commitment transactions. If the proposed reforms are adopted, then funds would only be permitted to enter into derivatives transactions and financial commitment transactions to the extent permitted by Rule 18f-4, or Section 18 or 61 of the 1940 Act.

The SEC noted that until the proposed changes are adopted, its current guidance, including all related no-action letters, will remain in place. A fund would be able to rely on the proposed rule after its effective date as soon as the fund can comply with the rule's conditions. The SEC also noted that it would expect to provide a transition period during which funds would move from the current regulatory framework to the effective rule. The SEC has requested comment on whether a transition period would be appropriate and, if so, how long such a period should be.

Upcoming Information from Morgan Lewis

These proposed changes would substantially affect how registered investment companies and business development companies use derivatives and other financial transactions, particularly those funds that rely on such instruments as a primary component of their investment strategies. Financial entities that provide derivatives and other financial transactions to the marketplace likely will be indirectly affected by these changes as well. Fund compliance professionals and boards of directors would also face new challenges as a result of the reforms.

Morgan Lewis is committed to staying on top of these developments as they evolve. In the near future, we expect to publish a White Paper discussing this proposal as well as the background on the regulation of fund investments in derivatives. We also plan to host a webinar with members of our derivatives and investment funds teams to discuss these proposed amendments. We will distribute more information about the White Paper and webinar soon.


1 See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Rel. No. 31,933 (Dec. 11, 2015) (hereinafter, Proposing Release). The proposal relies significantly on a white paper from the SEC's Division of Economic and Risk Analysis titled " Use of Derivatives by Registered Investment Companies," which was released in tandem. A draft copy of Rule 18f-4 is based on the text set forth in the Proposing Release.

2 See Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Rel. No. 31,835 (Sep. 22, 2015); See also Investment Company Reporting Modernization, Investment Company Act Rel. No. 31,610 (May 20, 2015); See also Morgan Lewis's September 2015 LawFlash " SEC Proposes Liquidity Risk Management Rules for Open-End Funds." For more information on the Reporting Modernization proposal, see our May 2015 LawFlash " SEC Proposes Rules Affecting Funds and Advisers."

3 See Speech by SEC Chair Mary Jo White, Enhancing Risk Monitoring and Regulatory Safeguards for the Asset Management Industry (Dec. 11, 2014). 

4 See Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Rel. No. 29,776 (Aug. 31, 2011).

5 The SEC noted in the Proposing Release that a fund would be able to net directly offsetting derivatives transactions even if those transactions are entered into with different counterparties and without regard to whether those transactions are subject to a netting agreement.  See Proposing Release, supra note 1 at n. 374.

6 In the Proposing Release, the SEC notes that a variance swap would be an example of a complex derivative transaction where the amount payable is a non-linear function based on the value of the underlying reference asset. In a variance swap, investors profit from the current implied volatility and future realized volatility of an asset, but payments based on variance are the square of volatility.

7 See Investment Company Act Rel. No. 10,666 (Apr. 18, 1979).

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
Kramer Levin Naftalis & Frankel LLP
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Kramer Levin Naftalis & Frankel LLP
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions