United States: Special Update On Proposed Derivatives Rules For Registered Funds And BDCs

At an open meeting on December 11, 2015, the Securities and Exchange Commission ("SEC") proposed a new "exemptive" rule, Rule 18f-4, which addresses investment company use of derivatives and other leveraging arrangements. It would require most funds that use derivatives to implement a derivative risk management program (including appointing a derivatives management officer). The proposed rule applies to mutual funds, ETFs, closed-end funds and BDCs.

The rule is intended to modernize and harmonize funds' treatment of derivatives under Section 18 of the Investment Company Act of 1940, as amended (the "1940 Act"), by updating and modifying previous guidance issued in 1979 in Investment Company Act Release 10666 and more than 30 no-action letters in which SEC staff permitted fund practices involving specific types of derivatives.1

According to the SEC, Section 18, which restricts funds' capital structures, was designed to address abuses that existed before the enactment of the 1940 Act: excessive borrowing and levered securities issuances. The SEC views a fund's obligation to pay money or deliver assets to a counterparty as implicating Section 18. Proposed Rule 18f-4 would clarify that the limitations of Section 18 apply to most derivatives (forwards, futures, swaps and written options) and financial commitments (reverse repurchase agreements, short sale borrowings, firm or standby commitments, and other similar agreements) and would provide that funds could enter into derivative transactions only if their portfolios satisfy certain conditions, including a portfolio-level limit on derivative investments and asset segregation requirements developed from the Release 10666 model.

Asset Segregation

Following the model described in Release 10666, most funds that use derivatives or financial commitment transactions in their portfolios would be required to abide by asset segregation requirements. A fund that uses derivatives would have to segregate by maintaining "qualifying coverage assets" (identified on the books and records of the fund at least once daily) in an amount equal to the sum of:

The Market Coverage Amount: The amount the fund would pay if the fund exited the derivative transaction; and
The Risk-Based Coverage Amount: A reasonable estimate of the amount the fund would pay if it exited the transaction under stressed conditions.

The sum of these two amounts would reflect the overall exposure of the fund to the ongoing risk incurred in holding a particular derivative investment. It covers both the "mark-to-market" exposure, as well as potential future losses. The Market Coverage Amount would be reduced by the value of assets posted as variation margin (but not initial margin or the "independent amount") or collateral with respect to a transaction, because the variation margin or collateral is a security for the mark-to-market exposure of a particular transaction. The Risk-Based Coverage Amount would be reduced by the value of assets representing initial margin or the "independent amount" because those amounts are posted to cover potential future amounts payable in a specific transaction. Thus, a fund using derivatives would receive "credit" for security posted in relation to the transaction when calculating the amount of coverage needed.

Unlike under existing practice, segregation requirements for derivative transactions would have to be satisfied exclusively in cash and cash equivalents, or, if the fund can satisfy its obligation by delivering a specific asset, the specific asset. Currently, many funds use "any liquid asset" to meet segregation requirements.

Cash equivalents include:

  • U.S. Treasury and agency securities
  • Bank deposits
  • Commercial paper
  • Shares of money market funds

If the fund enters into "financial commitment transactions," it would be required to segregate assets that equal the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver. Generally, "financial commitment transactions" include reverse repurchase agreements, short sale borrowings, firm or standby commitment agreements and comparable agreements, and can include uncalled capital commitments to private funds. For financial commitment transactions, a fund could meet the segregation requirement by identifying cash or cash equivalents, specific assets, or assets that are convertible to cash or will generate cash equal to the amount of the financial commitment obligation before the date on which the fund would be expected to pay.

A fund's board of directors, including a majority of the independent directors, would be required to approve a fund's policies and procedures for asset segregation.

Overall Limit — Two Alternatives

Funds would have to limit overall exposure to derivatives and other senior securities, tested immediately after their acquisition, by applying one of two alternative limitations.

Option 1: Exposure-Based Limit Option 2: Risk-Based Portfolio Limit
150 percent of Net Assets

A fund could limit aggregate exposure to 150 percent of the fund's net assets. A fund's exposure is the aggregate notional amount of its derivatives transactions (as opposed to mark-to-market exposure) together with its obligations under financial commitment transactions and certain other transactions. There would be a "look-through" to obligations underlying separately managed accounts, Cayman blockers, index funds and similar investments.
300 percent of Net Assets and VaR Test

A fund could obtain exposure to up to 300 percent of the fund's net assets, so long as the fund satisfies a risk-based test based on value-at-risk ("VaR"), which is an amount expressed in U.S. dollars representing the estimate of potential losses on an instrument or portfolio, over a specified time horizon and at a given confidence interval based on a fund's VaR model. The risk-based test is designed to determine whether the fund's derivative or senior securities transactions, in aggregate, have effectively reduced the fund's market risk (in other words, the portfolio would have less market risk after a derivatives transaction than if the fund did not use derivatives). Under this risk-based limit, the fund's full portfolio VaR would have to be less than the fund's securities VaR (which is the VaR of the fund's holdings in securities and other investments but not derivatives).

A fund's particular limit would have to be approved by its board of directors, including a majority of its independent directors. This requirement suggests that in order to adopt the risk-based model, a board would have to gain a basic understanding of value-at-risk and the specific models used by the adviser to evaluate value-at-risk.

Derivatives Risk Management Program

Funds that have portfolio-level derivatives with notional exposure of more than 50 percent of their assets, or funds using any complex derivatives, would be required to implement a Derivatives Risk Management Program (DRMP) designed to identify and assess the risks associated with the fund's derivative transactions, and manage and monitor these risks. The DRMP would need to address the potential risks posed by the investments, and monitor derivatives investing activity to ensure that it is consistent with a fund's investment guidelines, relevant portfolio limitations and relevant disclosure to investors. The DRMP would be composed of policies and procedures including models (such as VaR calculation models), as well as other measurement tools that address potential leverage, market, counterparty, liquidity and operational risks. The DRMP would be reviewed periodically and updated at least annually to reflect changes in risk over time, and changes in policies, measurement tools or models. A fund would also need to segregate personnel involved in derivative risk management from personnel involved in portfolio management and appoint a derivatives risk manager. The proposal does not discuss whether the risk manager function can be outsourced in the same way that some funds use chief compliance officers who are employed by separate compliance organizations.

The fund's board of directors, including a majority of the fund's independent directors, would have to review and approve the DRMP and any material changes to the DRMP, and the appointment of the risk manager. The fund's board would also have to receive regular reports from the risk manager, at least quarterly, and review the adequacy and efficacy of the program. In the adopting release, the SEC specifically suggested that boards should consider the adequacy of a fund's DRMP in light of past experience (of the fund and markets in general) and recent compliance experience.

Reporting Changes

The Commission is also proposing amendments to its recently proposed reporting forms, Form N-PORT and Form N-CEN. As we have previously reported to you, these new forms, proposed in May 2015, are part of the Commission's effort to modernize investment company regulation and reporting.

Form N-PORT Form N-CEN
Form N-PORT would require funds to provide information about the fund's investment portfolio on a monthly basis. The SEC now proposes to add to Form N-PORT additional risk metrics relating to some derivatives, but only for funds that are required to adopt a DRMP. Form N-CEN would replace current Form N-SAR and would be filed annually to reflect certain census information about funds. The SEC proposes to add to Form N-CEN additional disclosures about whether a fund relied on the new Rule 18f-4 during a period, and the particular limitations that applied to the fund's use of derivatives.

The comment period for the proposed rule is 90 days from publication in the Federal Register.


1. The proposal developed after the director of the Division of Investment Management in 2009 challenged the Subcommittee on Investment Companies and Investment Advisers of the American Bar Association Section of Business Law's Committee on Federal Regulation of Securities to suggest enhancements to the SEC's approaches to derivatives, resulting in the formation of the Task Force on Investment Company Use of Derivatives and Leverage (the "ABA Task Force"), on which Kramer Levin participated, and a July 2010 report by the ABA Task Force seeking enhanced regulation or guidance on certain outstanding issues and concerns. In response, the SEC issued a concept release in August 2011 seeking further comment. Kramer Levin continues to participate on the ABA Task Force and will participate in its drafting of a comment letter on the current proposal.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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.

In association with
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
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). 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 & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd 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 or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.