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, 4446-4567 [2020-00040]

Download as PDF 4446 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 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 Securities and Exchange Commission. AGENCY: ACTION: Proposed rule. The Securities and Exchange Commission (the ‘‘Commission’’) is reproposing 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 leveraged/inverse ETFs that satisfy the rule’s conditions to operate without the expense and delay of obtaining an exemptive order. lotter on DSKBCFDHB2PROD with PROPOSALS2 SUMMARY: Comments should be submitted on or before March 24, 2020. DATES: Comments may be submitted by any of the following methods: ADDRESSES: VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 Electronic Comments • Use the Commission’s internet comment form (https://www.sec.gov/ rules/proposed.shtml); or • Send an email to rule-comments@ sec.gov. 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 (https:// 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 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 PO 00000 Frm 00002 Fmt 4701 Sfmt 4702 (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. 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. Table of Contents I. Introduction A. Overview of Funds’ Use of Derivatives B. Derivatives and the Senior Securities Restrictions of the Investment Company Act 1. Requirements of Section 18 2. Evolution of Commission and Staff Consideration of Section 18 Restrictions as Applied to Funds’ Use of Derivatives 3. Need for Updated Regulatory Framework C. Overview of the Proposal II. Discussion A. Scope of Proposed Rule 18f–4 1. Funds Permitted To Rely on Proposed Rule 18f–4 2. Derivatives Transactions Permitted Under Proposed Rule 18f–4 B. Derivatives Risk Management Program 1. Summary 2. Program Administration 3. Required Elements of the Program C. Board Oversight and Reporting 1. Board Approval of the Derivatives Risk Manager 2. Board Reporting D. Proposed Limit on Fund Leverage Risk E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 1. Use of VaR 2. Relative VaR Test 3. Absolute VaR Test 4. Choice of Model and Parameters for VaR Test 5. Implementation 6. Other Regulatory Approaches to Limiting Fund Leverage Risk E. Limited Derivatives Users 1. Exposure-Based Exception 2. Currency Hedging Exception 3. Risk Management F. Asset Segregation G. Alternative Requirements for Certain Leveraged/Inverse Funds and Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment Vehicles 1. Background on Proposed Approach to Certain Leveraged/Inverse Funds 2. Proposed Sales Practices Rules for Leveraged/Inverse Investment Vehicles 3. Alternative Provision for Leveraged/ Inverse Funds Under Proposed Rule 18f– 4 4. Proposed Amendments to Rule 6c–11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs H. Amendments to Fund Reporting Requirements 1. Amendments to Form N–PORT 2. Amendments to Current Reporting Requirements 3. Amendments to Form N–CEN 4. BDC Reporting I. Reverse Repurchase Agreements J. Unfunded Commitment Agreements K. Recordkeeping Provisions L. Transition Periods M. Conforming Amendments III. Economic Analysis A. Introduction B. Economic Baseline 1. Fund Industry Overview 2. Funds’ Use of Derivatives 3. Current Regulatory Framework for Derivatives 4. Funds’ Derivatives Risk Management Practices and Use of VaR Models 5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse Funds C. Benefits and Costs of the Proposed Rules and Amendments 1. Derivatives Risk Management Program and Board Oversight and Reporting 2. VaR-Based Limit on Fund Leverage Risk 3. Limited Derivatives Users 4. Reverse Repurchase Agreements and Similar Financing Transactions 5. Alternative Requirements for Certain Leveraged/Inverse Funds and Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment Vehicles 6. Proposed Amendments to Rule 6c–11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs 7. Unfunded Commitment Agreements 8. Recordkeeping 9. Amendments to Fund Reporting Requirements 10. Money Market Funds D. Effects on Efficiency, Competition, and Capital Formation 1. Efficiency 2. Competition VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 3. Capital Formation E. Reasonable Alternatives 1. Alternative Implementations of the VaR Tests 2. Alternatives to the VaR Tests 3. Stress Testing Frequency 4. Alternative Exposure Limits for Leveraged/Inverse Funds 5. No Sales Practices Rules and No Separate Exposure Limit for Leveraged/ Inverse Funds 6. Enhanced Disclosure F. Request for Comments IV. Paperwork Reduction Act Analysis A. Introduction B. Proposed Rule 18f–4 1. Derivatives Risk Management Program 2. Board Oversight and Reporting 3. Disclosure Requirement Associated With Limit on Fund Leverage Risk 4. Disclosure Requirement for Leveraged/ Inverse Funds 5. Disclosure Changes for Money Market Funds 6. Policies and Procedures for Limited Derivatives Users 7. Recordkeeping Requirements 8. Proposed Rule 18f–4 Total Estimated Burden C. Proposed Rule 15l–2: Sales Practices Rule for Broker-Dealers 1. Due Diligence and Account Approval 2. Policies and Procedures 3. Recordkeeping 4. Proposed Rule 15l–2 Total Estimated Burden D. Proposed Rule 211(h)–1: Sales Practices for Registered Investment Advisers 1. Due Diligence and Account Approval 2. Policies and Procedures 3. Recordkeeping 4. Proposed Rule 211(h)–1 Total Estimated Burden E. Rule 6c–11 F. Form N–PORT G. Form N–RN H. Form N–CEN I. Request for Comments V. Initial Regulatory Flexbility Analysis A. Reasons for and Objectives of the Proposed Actions B. Legal Basis C. Small Entities Subject to Proposed Rules D. Projected Reporting, Recordkeeping, and Other Compliance Requirements 1. Proposed Rule 18f–4 2. Proposed Amendments to Forms N– PORT, N–LIQUID, and N–CEN 3. Proposed Sales Practices Rules 4. Proposed Amendments to Rule 6c–11 E. Duplicative, Overlapping, or Conflicting Federal Rules F. Significant Alternatives 1. Proposed Rule 18f–4 2. Proposed Sales Practices Rules 3. Proposed Amendments to Forms N– PORT, N–LIQUID, and N–CEN 4. Rule 6c–11 G. Request for Comment VI. Consideration of Impact on the Economy VII. Statutory Authority VIII. Appendix A IX. Appendix B I. Introduction The fund industry has grown and evolved substantially in past decades in PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 4447 response to various factors, including investor demand, technological developments, and an increase in domestic and international investment opportunities, both retail and institutional.1 Funds today follow a broad variety of investment strategies and provide diverse investment opportunities for fund investors, including retail investors. As funds’ strategies have become increasingly diverse, funds’ use of derivatives has grown in both volume and complexity over the past several decades.2 Derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, some other asset or metric.3 Funds use derivatives for a variety of purposes. For example, funds use derivatives to seek higher returns through increased investment exposure, to hedge risks in their investment portfolios, or to obtain exposure to particular investments or markets more efficiently than may be 1 For example, the investment company industry consisted of more than 3,500 investment companies, and held over $1.3 trillion in assets, as of the end of 1991. See SEC Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation (1992), available at https://www.sec.gov/divisions/ investment/guidance/icreg50-92.pdf. The assets held by U.S.-registered investment companies grew to approximately $7.1 trillion as of the end of 1999, and from then until the end of 2018 grew over 200%, to approximately $21.4 trillion. See Investment Company Institute, 2018 Investment Company Fact Book at 32, available at https:// www.icifactbook.org/deployedfiles/FactBook/ Site%20Properties/pdf/2019/2019_factbook.pdf . Similarly, the number of mutual funds, registered closed-end funds, and ETFs grew from 7,970, 512, and 30 (respectively) as of the end of 1999, to 9,599, 506, and 2,057 (respectively) as of the end of 2018. See id. at 50. The diversity of fund strategies has also increased over time, including, more recently, the introduction of funds pursuing so-called ‘‘alternative strategies’’ (which tend to use derivatives more than other fund types). See Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang & William Yost, Use of Derivatives by Registered Investment Companies, Division of Economic and Risk Analysis (2015), available at https:// www.sec.gov/dera/staffpapers/white-papers/ derivatives12-2015.pdf (‘‘DERA White Paper’’). 2 See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 28, 2015)], at n.6 and accompanying text (‘‘2015 Proposing Release’’). 3 The asset or metric on which the derivative’s value is based, or from which its value is derived, is commonly referred to as the ‘‘reference asset,’’ ‘‘underlying asset,’’ or ‘‘underlier.’’ See id. at n.3 and accompanying text (citing Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR 55237 (Sept. 7, 2011)], at n.3 (‘‘2011 Concept Release’’)). The comment letters on the 2011 Concept Release (File No. S7–33–11) are available at https:// www.sec.gov/comments/s7-33-11/s73311.shtml. E:\FR\FM\24JAP2.SGM 24JAP2 4448 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 possible through direct investments.4 At the same time, derivatives can introduce certain new risks and heighten certain risks to a fund and its investors. These risks can arise from, for example, leverage, liquidity, markets, operations, legal matters (e.g., contract enforceability), and counterparties. Funds using derivatives must consider requirements under the Investment Company Act of 1940.5 These include sections 18 and 61 of the Investment Company Act, which limit a fund’s ability to obtain leverage or incur obligations to persons other than the fund’s common shareholders through the issuance of ‘‘senior securities.’’ 6 As we discuss more fully in this release, as derivatives markets have expanded and funds have increased their use of derivatives, the Commission and its staff have issued guidance addressing the use of specific derivatives instruments and practices, and other financial instruments, under section 18. In determining how they will comply with section 18, we understand that funds consider this Commission and staff guidance, as well as staff no-action letters and the practices that other funds disclose in their registration statements.7 In the absence of Commission rules and guidance that address the current 4 See, e.g., My Nguyen, Using Financial Derivatives to Hedge Against Currency Risk, Arcada University of Applied Sciences (2012). 5 15 U.S.C. 80a (the ‘‘Investment Company Act,’’ or the ‘‘Act’’). Except in connection with our discussion of proposed rule 15l–2 under the Securities Exchange Act of 1934 and proposed rule 211(h)–1 under the Advisers Act or as otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act, including proposed rule 18f–4, will be to title 17, part 270 of the Code of Federal Regulations, 17 CFR part 270. 6 See infra section I.B.1. Funds using derivatives must also comply with all other applicable statutory and regulatory requirements, such as other federal securities law provisions, the Internal Revenue Code, Regulation T of the Federal Reserve Board, and the rules and regulations of the Commodity Futures Trading Commission (the ‘‘CFTC’’). See also Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, 124 Stat. 1376 (2010) (the ‘‘Dodd-Frank Act’’), available at https://www.sec.gov/about/laws/ wallstreetreform-cpa.pdf. Section 61 of the Investment Company Act makes section 18 of the Act applicable to BDCs, with certain modifications. See infra note 32 and accompanying text. Except as otherwise noted, or unless the context dictates otherwise, references in this release to section 18 of the Act should be read to refer also to section 61 with respect to BDCs. 7 Any staff guidance or no-action letters discussed in this release represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Commission. Furthermore, the Commission has neither approved nor disapproved their content. Staff guidance has no legal force or effect; it does not alter or amend applicable law; and it creates no new or additional obligations for any person. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 broad range of funds’ derivatives use, inconsistent industry practices have developed.8 We are concerned that certain of these practices may not address investor protection concerns that underlie section 18’s limitations on funds’ issuance of senior securities. Specifically, certain fund practices can heighten leverage-related risks, such as the risk of potentially significant losses and increased fund volatility, that section 18 is designed to address. We are also concerned that funds’ disparate practices could create an un-level competitive landscape and make it difficult for funds and our staff to evaluate funds’ compliance with section 18.9 To address these concerns, in 2015 the Commission proposed new rule 18f– 4 under the Investment Company Act, which would have permitted a fund to enter into derivatives transactions and ‘‘financial commitment transactions,’’ subject to certain conditions.10 We received approximately 200 comment letters in response to the 2015 8 See infra section I.B.2.b (discussing the asset segregation practices funds have developed to ‘‘cover’’ their derivatives positions, which vary based on the type of derivatives transaction and with respect to the types of assets that funds segregate to cover their derivatives positions). 9 See, e.g., Comment Letter of the Investment Company Institute on the 2011 Concept Release (Nov. 7, 2011) (File No. S7–33–11) at n.19 (‘‘ICI Concept Release Comment Letter’’) (noting that funds segregate the notional amount of physicallysettled futures contracts, while some funds disclose that they segregate only the marked-to-marked obligation in respect of cash-settled futures and agreeing with the concern reflected in the 2011 Concept Release that this ‘‘results in differing treatment of arguably equivalent products’’). 10 For purposes of this release, we will refer to the version of rule 18f–4 that the Commission proposed in the 2015 Proposing Release as the ‘‘2015 proposed rule.’’ We will generally refer to rule 18f– 4 as we propose it here as the ‘‘proposed rule.’’ The 2015 proposed rule included four principal elements for funds entering into derivatives transactions: (1) A requirement to comply with one of two alternative portfolio limitations designed to limit the amount of leverage a fund may obtain through derivatives and other senior securities transactions; (2) asset segregation for derivatives transactions, designed to enable a fund to meet its derivatives-related obligations; (3) a derivatives risk management program requirement for funds that engage in more than limited derivatives transactions or that use complex derivatives; and (4) reporting requirements regarding a fund’s derivatives usage. The 2015 proposed rule included different requirements for derivatives transactions and ‘‘financial commitment transactions’’ (collectively, reverse repurchase agreements, short sale borrowings, or any firm or standby commitment agreement or similar agreement). Rule 18f–4 as we propose it here does not separately define ‘‘financial commitment transactions,’’ although the proposed rule does address—either directly or indirectly—all of the types of transactions that composed that defined term in the 2015 proposed rule. See infra section II. PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 proposal.11 In developing this reproposal we considered those comment letters, as well as subsequent staff engagement with large and small fund complexes and investor groups.12 We are re-proposing rule 18f–4, which is designed to address the investor protection purposes and concerns underlying section 18 and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives transactions and certain other transactions. The proposed rule would permit funds to enter into these transactions, notwithstanding the restrictions under section 18 of the Investment Company Act, provided that they comply with the conditions of the rule. The proposed rule’s conditions are designed to require funds to manage the risks associated with their use of derivatives and to limit fund leverage risk consistent with the investor protection purposes underlying section 18. Our proposal also includes requirements designed to address specific risks posed by certain registered investment companies and exchangelisted commodity- or currency-based trusts or funds that obtain leveraged or inverse exposure to an underlying index, generally on a daily basis.13 The proposal also addresses funds’ use of reverse repurchase agreements and similar transactions and certain socalled ‘‘unfunded commitments.’’ Finally, we propose to amend rule 6c– 11 under the Investment Company Act to allow certain leveraged/inverse ETFs that satisfy that rule’s conditions to operate without the expense and delay of obtaining an exemptive order. Together, the rules we are proposing are designed to promote funds’ ability to continue to use derivatives in a broad variety of ways that serve investors, while responding to the concerns underlying section 18 of the Investment Company Act and promoting a more 11 The comment letters on the 2015 proposed rule (File No. S7–24–15) are available at https:// www.sec.gov/comments/s7-24-15/s72415.shtml. 12 See also Division of Economic and Risk Analysis, Memorandum re: Risk Adjustment and Haircut Schedules (Nov. 1, 2016), available at https://www.sec.gov/comments/s7-24-15/s72415260.pdf (‘‘2016 DERA Memo’’). 13 As discussed in more detail in section II.G, the proposed sales practices rules would cover transactions in ‘‘leveraged/inverse investment vehicles,’’ which include registered investment companies and certain exchange-listed commodityor currency-based trusts or funds that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time. For purposes of this release, we refer to leveraged, inverse, and leveraged inverse investment vehicles collectively as ‘‘leveraged/inverse.’’ E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules modern and comprehensive framework for regulating funds’ use of derivatives and the other transactions addressed in the proposed rule. A. Overview of Funds’ Use of Derivatives lotter on DSKBCFDHB2PROD with PROPOSALS2 Funds today use a variety of derivatives. These derivatives can reference a range of assets or metrics, such as: Stocks, bonds, currencies, interest rates, market indexes, currency exchange rates, or other assets or interests. Examples of derivatives that funds commonly use include forwards, futures, swaps, and options. Derivatives are often characterized as either exchange-traded or over-the-counter (‘‘OTC’’).14 A common characteristic of most derivatives is that they involve leverage or the potential for leverage. The Commission has stated that ‘‘[l]everage exists when an investor achieves the right to a return on a capital base that exceeds the investment which he has personally contributed to the entity or instrument achieving a return.’’ 15 Many fund derivatives transactions, such as futures, swaps, and written options, involve leverage or the potential for leverage because they enable the fund to magnify its gains and losses compared to the fund’s investment, while also obligating the fund to make a payment or deliver assets to a counterparty under specified conditions.16 Other derivatives transactions, such as purchased call options, provide the economic equivalent of leverage because they can magnify the fund’s exposure beyond its investment but do not impose a payment obligation on the fund beyond its investment.17 14 Exchange-traded derivatives—such as futures, certain options, and options on futures—are standardized contracts traded on regulated exchanges. See 2015 Proposing Release, supra note 2, at nn.10–13 and accompanying text. OTC derivatives—such as certain swaps, non-exchangetraded options, and combination products such as swaptions and forward swaps—are contracts that parties negotiate and enter into outside of an organized exchange. See id. at nn.14–16 and accompanying text. Unlike exchange-traded derivatives, OTC derivatives may be significantly customized and may not be cleared by a central clearing organization. Title VII of the Dodd-Frank Act provides a comprehensive framework for the regulation of the OTC swaps market. See supra note 6. 15 See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)], at n.5 (‘‘Release 10666’’). 16 The leverage created by such an arrangement is sometimes referred to as ‘‘indebtedness leverage.’’ See 2015 Proposing Release, supra note 2, at n.21 (citing 2011 Concept Release, supra note 3, at n.31). 17 This type of leverage is sometimes referred to as ‘‘economic leverage.’’ See id. at n.22 (citing 2011 Concept Release, supra note 3, at n.32). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 Funds use derivatives both to obtain investment exposures as part of their investment strategies and to manage risk. A fund may use derivatives to gain, maintain, or reduce exposure to a market, sector, or security more quickly, and with lower transaction costs and portfolio disruption, than investing directly in the underlying securities.18 A fund also may use derivatives to obtain exposure to reference assets for which it may be difficult or impractical for the fund to make a direct investment, such as commodities.19 With respect to risk management, funds may employ derivatives to hedge interest rate, currency, credit, and other risks, as well as to hedge portfolio exposures.20 At the same time, a fund’s derivatives use may entail risks relating to, for example, leverage, markets, operations, liquidity (particularly with respect to complex OTC derivatives), and counterparties, as well as legal risks.21 A fund’s investment adviser, therefore, must manage (and the board of directors oversee) the fund’s derivatives use, consistent with the fund’s investment objectives, policies, restrictions, and risk profile. Furthermore, a fund’s investment adviser and board of directors must bear in mind the requirements of section 18 of the Investment Company Act, as well as the Act’s other requirements, when considering the use of derivatives. Section 18 is designed to limit the leverage a fund can obtain or incur through the issuance of senior securities. Although the leverage limitations in section 18 apply regardless of whether the relevant fund actually experiences significant losses, several recent examples involving significant losses illustrate how a fund’s use of derivatives may raise the investor protection concerns underlying section 18. The 2015 proposal discussed several circumstances in which substantial and rapid losses resulted from a fund’s 18 See, e.g., id. at n.24 and accompanying text (citing 2011 Concept Release, supra note 3, at section I). 19 See, e.g., Comment Letter of Stone Ridge Asset Management LLC (Mar. 28, 2016) (‘‘[I]t is not possible for AVRPX [a Stone Ridge fund] to trade many of the physical assets underlying the derivatives included in our portfolio—Stone Ridge does not maintain facilities to store oil or live hogs, for example.’’); Comment Letter of Vanguard (Mar. 28, 2016) (‘‘Vanguard Comment Letter’’) (stating that a fund may use a derivative, such as commodity futures, when it is impractical to take delivery of physical commodities). 20 See 2015 Proposing Release, supra note 2, at n.25 and accompanying text; see also 2011 Concept Release, supra note 3, at section I.B. 21 See 2015 Proposing Release, supra note 2, at n.26 and accompanying text (citing 2011 Concept Release, supra note 3, at n.34). PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 4449 investment in derivatives.22 For example, one of these cases shows that further losses can result when a fund’s portfolio securities decline in value at the same time that the fund is required to make additional payments under its derivatives contracts.23 Similarly, last year the LJM Preservation and Growth Fund liquidated after sustaining considerable losses (with its net asset value declining approximately 80% in two days) when market volatility spiked. The fund’s principal investment strategy involved purchasing and selling call and put options on the Standard & Poor’s (‘‘S&P’’) 500 Futures Index.24 S&P 500 options prices are determined in part by market volatility, and a volatility spike in early February 2018 caused the fund to incur significant losses. The fund closed to new investments on February 7, 2018 and announced on February 27, 22 See 2015 Proposing Release, supra note 2, at section II.D.1.d. (discussing, among other things, the following settled actions: In the Matter of OppenheimerFunds, Inc. and OppenheimerFunds Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action) (‘‘OppenheimerFunds Settled Action’’) (involving two mutual funds that suffered losses driven primarily by their exposure to certain commercial mortgage-backed securities, obtained mainly through total return swaps); In the Matter of Claymore Advisors, LLC, Investment Company Act Release No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset Management, LLC, Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled actions) (involving a registered closed-end fund that pursued an investment strategy involving written out-of-the-money put options and short variance swaps, which led to substantial losses for the fund); In the Matter of UBS Willow Management L.L.C. and UBS Fund Advisor L.L.C., Investment Company Act Release No. 31869 (Oct. 16, 2015) (settled action) (involving a registered closed-end fund that incurred significant losses due in part to large losses on the fund’s credit default swap portfolio)). See also In the Matter of Team Financial Asset Management, LLC, Team Financial Managers, Inc., and James L. Dailey, Investment Company Act Release No. 32951 (Dec. 22, 2017) (settled action) (involving a mutual fund incurring substantial losses arising out of speculative derivatives instruments, including losing $34.67 million in 2013 from trading in derivatives such as futures, options, and currency contracts); In the Matter of Mohammed Riad and Kevin Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21, 2018) (settled action) (involving a registered closed-end fund incurring substantial losses resulting from the implementation of a new derivatives trading strategy); In the Matter of Top Fund Management, Inc. and Barry C. Ziskin, Investment Company Act Release No. 30315 (Dec. 21, 2012) (settled action) (involving a mutual fund engaged in a strategy of buying options for speculative purposes contrary to its stated investment policy, which permitted options trading for hedging purposes, losing about 69% of its assets as a result of this activity before liquidating). 23 See OppenheimerFunds Settled Action, supra note 22. 24 See Prospectus, LJM Preservation and Growth Fund (Feb. 28, 2017), available at https:// www.sec.gov/Archives/edgar/data/1552947/ 000158064217001225/ljm485b.htm. E:\FR\FM\24JAP2.SGM 24JAP2 4450 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 2018 that it would liquidate its assets and dissolve on March 29, 2018.25 The losses suffered by this fund and in the other examples we discuss above are extreme. Funds rarely suffer such large and rapid losses. We note these examples to illustrate the rapid and extensive losses that can result from a fund’s investments in derivatives absent effective derivatives risk management. In contrast, there are many other instances in which funds, by employing derivatives, have avoided losses, increased returns, and lowered risk. B. Derivatives and the Senior Securities Restrictions of the Investment Company Act 1. Requirements of Section 18 lotter on DSKBCFDHB2PROD with PROPOSALS2 Section 18 of the Investment Company Act imposes various limits on the capital structure of funds, including, in part, by restricting the ability of funds to issue ‘‘senior securities.’’ Protecting investors against the potentially adverse effects of a fund’s issuance of senior securities, and in particular the risks associated with excessive leverage of investment companies, is a core purpose of the Investment Company Act.26 ‘‘Senior security’’ is defined, in part, as ‘‘any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.’’ 27 Congress’ concerns underlying the limits in section 18 focused on: (1) Excessive borrowing and the issuance of excessive amounts of senior securities by funds when these activities increase unduly the speculative character of funds’ junior securities; (2) funds operating without adequate assets and reserves; and (3) potential abuse of the 25 See Supplement to the Prospectus dated Feb. 28, 2017, LJM Preservation and Growth Fund (Feb. 27, 2018), available at https://www.sec.gov/ Archives/edgar/data/1552947/ 000158064218001068/ljm497.htm. 26 See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of the Investment Company Act; see also Provisions Of The Proposed Bill Related To Capital Structure (Sections 18, 19(B), And 21(C)), Introduced by L.M.C Smith, Associate Counsel, Investment Trust Study, Securities and Exchange Commission, Hearings on S.3580 Before a Subcommittee of the Senate Committee on Banking and Currency, 76th Congress, 3rd session (1940), at 1028 (‘‘Senate Hearings’’) (‘‘Because of the leverage influence, a substantial swing of the securities market is likely to deprive the common stock of a leverage investment company of both its asset and market value. . . . [H]ad investment companies been simple structure companies exclusively, a very substantial part of the losses sustained by investors in the common stock would have been avoided.’’). 27 See section 18(g) of the Investment Company Act. The definition of ‘‘senior security’’ in section 18(g) also includes ‘‘any stock of a class having priority over any other class as to the distribution of assets or payment of dividends’’ and excludes certain limited temporary borrowings. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 purchasers of senior securities.28 To address these concerns, section 18 prohibits an open-end fund from issuing or selling any ‘‘senior security,’’ other than borrowing from a bank (subject to a requirement to maintain 300% ‘‘asset coverage’’).29 Section 18 similarly prohibits a closed-end fund from issuing or selling any ‘‘senior security [that] represents an indebtedness’’ unless it has at least 300% ‘‘asset coverage,’’ although closed-end funds’ ability to issue senior securities representing indebtedness is not limited to bank borrowings.30 Closed-end funds also may issue senior securities that are a stock, subject to the limitations of section 18.31 The Investment Company Act also subjects BDCs to the limitations of section 18 to the same extent as registered closed-end funds, except the applicable asset coverage amount for any senior security representing indebtedness is 200% (and can be decreased to 150% under certain circumstances).32 28 For discussion of the excessive borrowing concern, see section 1(b)(7) of the Investment Company Act; Release 10666, supra note 15, at n.8; see also Senate Hearings, supra note 26, at 1028 (‘‘The Commission believes that it has been clearly shown that it is the leverage aspect of the seniorjunior capital structure in investment companies . . . which may be held accountable for a large part of the losses which have been suffered by the investor who purchases the common stock of a leverage company.’’). For discussion of concerns regarding funds operating without adequate assets and reserves, see section 1(b)(8) of the Investment Company Act; Release 10666, supra note 15, at n.8. For discussion of, among other things, potential abuse of the purchasers of senior securities, see Senate Hearings, supra note 26, at 265–78; see also Mutual Funds and Derivative Instruments, Division of Investment Management Memorandum transmitted by Chairman Levitt to Representatives Markey and Fields (Sept. 26, 1994), at 23, available at https://www.sec.gov/news/studies/deriv.txt (‘‘1994 Letter to Congress’’) (describing practices in the 1920s and 1930s that gave rise to section 18’s limits on leverage). 29 See section 18(f)(1) of the Investment Company Act. ‘‘Asset coverage’’ of a class of senior securities representing indebtedness of an issuer generally is defined in section 18(h) of the Investment Company Act as ‘‘the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of senior securities representing indebtedness of such issuer.’’ Take, for example, an open-end fund with $100 in assets and with no liabilities or senior securities outstanding. The fund could, while maintaining the required coverage of 300% of the value of its assets, borrow an additional $50 from a bank. The $50 in borrowings would represent one-third of the fund’s $150 in total assets, measured after the borrowing (or 50% of the fund’s $100 net assets). 30 See section 18(a)(1) of the Investment Company Act. 31 See section 18(a)(2) of the Investment Company Act. If a closed-end fund issues or sells a class of senior securities that is a stock, it must have an asset coverage of at least 200% immediately after such issuance or sale. Id. 32 See section 61(a)(1) of the Investment Company Act. BDCs, like registered closed-end funds, also PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 2. Evolution of Commission and Staff Consideration of Section 18 Restrictions as Applied to Funds’ Use of Derivatives a. Investment Company Act Release 10666 In a 1979 General Statement of Policy (Release 10666), the Commission considered the application of section 18’s restrictions on the issuance of senior securities to reverse repurchase agreements, firm commitment agreements, and standby commitment agreements.33 The Commission concluded that these agreements fall within the ‘‘functional meaning of the term ‘evidence of indebtedness’ for purposes of Section 18 of the Investment Company Act,’’ noting ‘‘the unique legislative purposes and policies underlying Section 18 of the Act.’’ 34 The Commission stated in Release 10666 that, for purposes of section 18, ‘‘evidence of indebtedness’’ would include ‘‘all contractual obligations to pay in the future for consideration presently received.’’ The Commission recognized that, while section 18 would generally prohibit open-end funds’ use of reverse repurchase agreements, firm commitment agreements, and standby commitment agreements, the Commission nonetheless permitted funds to use these and similar arrangements subject to the constraints that Release 10666 describes. These constraints relied on funds’ use of ‘‘segregated accounts’’ to ‘‘cover’’ senior securities, which ‘‘if properly created and maintained, would limit the investment company’s risk of loss.’’ 35 The Commission also stated that the segregated account functions as ‘‘a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock’’ and that it ‘‘[would] assure the availability of adequate funds to meet the obligations arising from such activities.’’ 36 The may issue a senior security that is a stock (e.g., preferred stock), subject to limitations in section 18. See sections 18(a)(2) and 61(a)(1) of the Investment Company Act. In 2018, Congress passed the Small Business Credit Availability Act, which, among other things, modified the statutory asset coverage requirements applicable to BDCs (permitting BDCs that meet certain specified conditions to elect to decrease their effective asset coverage requirement from 200% to 150%). See section 802 of the Small Business Credit Availability Act, Public Law 115– 141, 132 Stat. 348 (2018). 33 See Release 10666, supra note 15. 34 See id. 35 See 2015 Proposing Release, supra note 2, at nn.45–47 and accompanying text (discussing Release 10666’s discussion of segregated accounts). 36 See Release 10666, supra note 15, at 25132; see also 2015 Proposing Release, supra note 2, at n.48 and accompanying text. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 Commission stated that its expressed views were not limited to the particular trading practices discussed, but that the Commission sought to address the implications of comparable trading practices that could similarly affect funds’ capital structures.37 We continue to view the transactions described in Release 10666 as falling within the functional meaning of the term ‘‘evidence of indebtedness,’’ for purposes of section 18.38 The trading practices that Release 10666 describes, as well as short sales of securities for which the staff initially developed the segregated account approach that the Commission applied in Release 10666, all impose on a fund a contractual obligation under which the fund is or may be required to pay or deliver assets in the future to a counterparty. These transactions therefore involve the issuance of a senior security for purposes of section 18.39 37 See 2015 Proposing Release, supra note 2, at nn.49–50 and accompanying text. 38 See Release 10666, supra note 15, at ‘‘The Agreements as Securities’’ discussion. The Investment Company Act’s definition of the term ‘‘security’’ is broader than the term’s definition in other federal securities laws. See 2015 Proposing Release, supra note 2, at n.61. Compare section 2(a)(36) of the Investment Company Act with sections 2(a)(1) and 2A of the Securities Act of 1933 (15 U.S.C. 77a et seq.) (‘‘Securities Act’’) and sections 3(a)(10) and 3A of the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) (‘‘Exchange Act’’). See also 2011 Concept Release, supra note 3, at n.57 and accompanying text (explaining that the Commission has interpreted the term ‘‘security’’ in light of the policies and purposes underlying the Investment Company Act). 39 See Release 10666, supra note 15, at ‘‘The Agreements as Securities’’ discussion; see also section 18(g) (defining the term ‘‘senior security,’’ in part, as ‘‘any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness’’). The Commission received several comments on the 2015 proposal that objected to the Commission treating derivatives and financial commitment transactions as involving senior securities where a fund has ‘‘appropriately’’ covered its obligations under those transactions. These comments generally argued that this approach is not consistent with the Commission’s views in Release 10666 and that funds have for many years addressed senior security concerns raised by these transactions by segregating assets or engaging in offsetting, or ‘‘cover,’’ transactions that take into account Release 10666 and staff guidance. See, e.g., Comment Letter of the American Action Forum (Mar. 25, 2016) (‘‘AAF Comment Letter’’); Comment Letter of Financial Services Roundtable (Mar. 28, 2016) (‘‘FSR Comment Letter’’); Comment Letter of Franklin Resources, Inc. (Mar. 28, 2016) (‘‘Franklin Resources Comment Letter’’); Comment Letter of Dechert LLP (Mar. 28, 2016) (‘‘Dechert Comment Letter’’). Whether a transaction involves the issuance of a senior security will depend on whether that transaction involves a senior security within the meaning of section 18(g). A fund’s segregation of assets, although one way to address policy concerns underlying section 18 as the Commission described in Release 10666, does not, itself, affect the legal question of whether a fund has issued a senior security. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 We apply the same analysis to all derivatives transactions that create future payment obligations. This is the case where the fund has a contractual obligation to pay or deliver cash or other assets to a counterparty in the future, either during the life of the instrument or at maturity or early termination.40 As was the case for trading practices that Release 10666 describes, where the fund has entered into a derivatives transaction and has such a future payment obligation, we believe that such a transaction involves an evidence of indebtedness that is a senior security for purposes of section 18.41 The express scope of section 18 supports this interpretation. Section 18 defines the term ‘‘senior security’’ broadly to include instruments and transactions that other provisions of the federal securities laws might not otherwise consider to be securities.42 For example, section 18(f)(1) generally prohibits an open-end fund from issuing or selling any senior security ‘‘except [that the fund] shall be permitted to borrow from any bank.’’ 43 This statutory permission to engage in a specific borrowing makes clear that such borrowings are senior securities, which otherwise section 18 would 40 These payments—which may include payments of cash, or delivery of other assets—may occur as margin, as settlement payments, or otherwise. 41 As the Commission explained in Release 10666, we believe that an evidence of indebtedness, for purposes of section 18, includes not only a firm and un-contingent obligation, but also a contingent obligation, such as a standby commitment or a ‘‘put’’ (or call) option sold by a fund. See Release 10666, supra note 15, at ‘‘Standby Commitment Agreements’’ discussion. We understand it has been asserted that a contingent obligation that a standby commitment or similar agreement creates does not involve a senior security under section 18, unless and until generally accepted accounting principles (‘‘GAAP’’) would require the fund to recognize the contingent obligation as a liability on the fund’s financial statements. The treatment of derivatives transactions under GAAP, including whether the derivatives transaction constitutes a liability for financial statement purposes at any given time or the extent of the liability for that purpose, is not determinative with respect to whether the derivatives transaction involves the issuance of a senior security under section 18. This is consistent with the Commission’s analysis of a fund’s obligation, and the corresponding segregated asset amounts, under the trading practices that Release 10666 describes. See id. 42 Consistent with Release 10666, and as the Commission stated in the 2015 Proposing Release, we are only expressing our views in this release concerning the scope of the term ‘‘senior security’’ in section 18 of the Investment Company Act. See also section 12(a) of the Investment Company Act (prohibiting funds from engaging in short sales in contravention of Commission rules or orders). 43 Section 18(c)(2) similarly treats all promissory notes or evidences of indebtedness issued in consideration of any loan as senior securities except as section 18 otherwise specifically provides. PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 4451 prohibit absent this specific permission.44 This interpretation also is consistent with the fundamental policy and purposes underlying the Investment Company Act expressed in sections 1(b)(7) and 1(b)(8) of the Act.45 These respectively declare that ‘‘the national public interest and the interest of investors are adversely affected’’ when funds ‘‘by excessive borrowing and the issuance of excessive amounts of senior securities increase unduly the speculative character’’ of securities issued to common shareholders and when funds ‘‘operate without adequate assets or reserves.’’ The Commission emphasized these concerns in Release 10666, and we continue to believe that the prohibitions and restrictions under the senior security provisions of section 18 should ‘‘function as a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock’’ and that funds should not ‘‘operate without adequate assets or reserves.’’ 46 Funds’ use of derivatives, like the trading practices the Commission addressed in Release 10666, may raise the undue speculation and asset sufficiency concerns in section 1(b).47 First, funds’ obtaining 44 The Commission similarly observed in Release 10666 that section 18(f)(1), ‘‘by implication, treats all borrowings as senior securities,’’ and that ‘‘[s]ection 18(f)(1) of the Act prohibits such borrowings unless entered into with banks and only if there is 300% asset coverage on all borrowings of the investment company.’’ See Release 10666, supra note 15, at ‘‘Reverse Repurchase Agreements’’ discussion. 45 The Commission received several comments on the 2015 proposal asserting that the provisions in section 1(b) of the Investment Company Act do not, themselves, provide us authority to regulate senior securities transactions. See, e.g., AAF Comment Letter; Franklin Resources Comment Letter; Comment Letter of the Securities Industry and Financial Markets Association (Mar. 28, 2016) (‘‘SIFMA Comment Letter’’). The fundamental statutory policy and purposes underlying the Investment Company Act, as expressed in section 1(b) of the Act, inform our interpretation of the scope of the term ‘‘senior security’’ in section 18, as we discuss in the paragraph accompanying this note (and separately inform our consideration of appropriate conditions for the exemption that proposed rule 18f–4 provides, as we discuss in sections II.B–II.G infra). The authority under which we are proposing rules today is set forth in section VII of this release and includes, among other provisions, section 6(c) of the Act. 46 See Release 10666, supra note 15, at ‘‘Segregated Account’’ discussion. 47 As the Commission stated in Release 10666, leveraging an investment company’s portfolio through the issuance of senior securities ‘‘magnifies the potential for gain or loss on monies invested and therefore results in an increase in the speculative character of the investment company’s outstanding securities’’ and ‘‘leveraging without E:\FR\FM\24JAP2.SGM Continued 24JAP2 4452 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 leverage (or potential for leverage) through derivatives may raise the Investment Company Act’s undue speculation concern because a fund may experience gains and losses that substantially exceed the fund’s investment, and also may incur a conditional or unconditional obligation to make a payment or deliver assets to a counterparty.48 Not viewing derivatives that impose a future payment obligation on the fund as involving senior securities, subject to appropriate limits under section 18, would frustrate the concerns underlying section 18.49 Second, with respect to the Investment Company Act’s asset sufficiency concern, a fund’s use of derivatives with future payment obligations also may raise concerns regarding the fund’s ability to meet those obligations. Many fund derivatives investments, such as futures contracts, swaps, and written options, pose a risk of loss that can result in payment obligations owed to the fund’s counterparties.50 Losses on derivatives any significant limitation’’ was identified ‘‘as one of the major abuses of investment companies prior to the passage of the Act by Congress.’’ Id. 48 See, e.g., The Report of the Task Force on Investment Company Use of Derivatives and Leverage, Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6, 2010), at 8 (‘‘2010 ABA Derivatives Report’’) (stating that ‘‘[f]utures contracts, forward contracts, written options and swaps can produce a leveraging effect on a fund’s portfolio’’ because ‘‘for a relatively small up-front payment made by a fund (or no upfront payment, in the case with many swaps and written options), the fund contractually obligates itself to one or more potential future payments until the contract terminates or expires’’; noting, for example, that an ‘‘[interest rate] swap presents the possibility that the fund will be required to make payments out of its assets’’ and that ‘‘[t]he same possibility exists when a fund writes puts and calls, purchases short and long futures and forwards, and buys or sells credit protection through [credit default swaps]’’). 49 One commenter on the 2011 Concept Release made this point directly. See Comment Letter of Stephen A. Keen on the 2011 Concept Release (Nov. 8, 2011) (File No. S7–33–11), at 3 (‘‘Keen Concept Release Comment Letter’’) (‘‘If permitted without limitation, derivative contracts can pose all of the concerns that section 18 was intended to address with respect to borrowings and the issuance of senior securities by investment companies.’’); see also, e.g., ICI Concept Release Comment Letter, at 8 (‘‘The Act is thus designed to regulate the degree to which a fund issues any form of debt—including contractual obligations that could require a fund to make payments in the future.’’). The Commission similarly noted in Release 10666 that, given the potential for reverse repurchase agreements to be used for leveraging and their ability to magnify the risk of investing in a fund, ‘‘one of the important policies underlying section 18 would be rendered substantially nugatory’’ if funds’ use of reverse repurchase agreements were not subject to limitation. See 2015 Proposing Release, supra note 2, at text preceding n.76. 50 Some derivatives transactions, like physicallysettled futures and forwards, can require the fund to deliver the underlying reference assets regardless VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 therefore can result in counterparty payment obligations that directly affect the capital structure of a fund and the relative rights of the fund’s counterparties and shareholders. These losses and payment obligations also can force a fund’s adviser to sell the fund’s investments to meet its obligations. When a fund uses derivatives to leverage its portfolio, this can amplify the risk of a fund having to sell its investments, potentially generating additional losses for the fund.51 In an extreme situation, a fund could default on its payment obligations.52 b. Market and Industry Developments Following Release 10666 Following the issuance of Release 10666, Commission staff issued more than thirty no-action letters to funds concerning the maintenance of segregated accounts or otherwise ‘‘covering’’ their obligations in connection with various transactions otherwise restricted by section 18.53 In these letters (issued primarily in the 1970s through 1990s) and through other staff guidance, Commission staff has addressed questions—generally on an instrument-by-instrument basis— regarding the application of the Commission’s statements in Release 10666 to various types of derivatives and other transactions. Funds have developed certain general asset segregation practices to cover their derivatives positions, based at least in part on the staff’s no-action letters and guidance. Practices vary based on the type of derivatives transaction. For certain derivatives, funds generally segregate an amount equal to the full amount of the fund’s potential obligation under the contract, or the full market value of the underlying reference asset for the derivative (‘‘notional amount segregation’’).54 For certain cash-settled derivatives, funds often segregate an amount equal to the fund’s of whether the fund experiences losses on the transaction. 51 See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen, Market Liquidity and Funding Liquidity, 22 The Review of Financial Studies 6, 2201–2238 (June 2009), available at https:// www.princeton.edu/∼markus/research/papers/ liquidity.pdf (providing both empirical support as well as a theoretical foundation for how short-term leverage obtained through borrowings or derivative positions can result in funds and other financial intermediaries becoming vulnerable to tighter funding conditions and increased margins, specifically during economic downturns (as in the recent financial crisis), thus potentially increasing the need for the fund or intermediary to de-lever and sell portfolio assets at a loss). 52 See 2015 Proposing Release, supra note 2, at n.80. 53 See id. at n.51 and accompanying text (citing 2011 Concept Release, supra note 3, at section I). 54 See id. at nn.54–55 and accompanying text. PO 00000 Frm 00008 Fmt 4701 Sfmt 4702 daily mark-to-market liability, if any (‘‘mark-to-market segregation’’).55 Similarly, funds use different practices regarding the types of assets that they segregate to cover their derivatives positions. Release 10666 states that the assets eligible to be included in segregated accounts should be ‘‘liquid assets’’ such as cash, U.S. government securities, or other appropriate high-grade debt obligations.56 However, a subsequent staff no-action letter stated that the staff would not recommend enforcement action if a fund were to segregate any liquid asset, including equity securities and non-investment grade debt securities, to cover its senior securitiesrelated obligations.57 As a result of these asset segregation practices, funds’ derivatives use—and thus funds’ potential leverage through derivatives transactions—does not appear to be subject to a practical limit as the Commission contemplated in Release 10666. Funds’ mark-to-market liability often does not reflect the full investment exposure associated with their derivatives positions.58 As a result, a fund that segregates only the mark-tomarket liability could theoretically incur virtually unlimited investment leverage.59 These current asset segregation practices also may not assure the 55 See id. at nn.56–58, 96–98 and accompanying text (stating that funds initially applied the markto-market approach to segregation to specific types of transactions addressed through guidance by our staff (interest rate swaps, cash-settled futures, nondeliverable forwards), but that funds now apply mark-to-market segregation to a wider range of cashsettled instruments, with our staff observing that some funds appear to apply the mark-to-market approach to any derivative that is cash settled). 56 See id. at n.47 and accompanying text. 57 See id. at n.59 and accompanying text (citing Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996), available at https:// www.sec.gov/divisions/investment/ imseniorsecurities/merrilllynch070196.pdf). 58 For example, for derivatives where there is no loss in a given day, a fund applying the mark-tomarket approach might not segregate any assets. This may be the case, for example, because the derivative is currently in a gain position, or because the derivative has a market value of zero (as will generally be the case at the inception of a transaction). The fund may, however, still be required to post collateral to comply with other regulatory or contractual requirements. 59 See, e.g., Comment Letter of Ropes & Gray LLC on the Concept Release (Nov. 7, 2011) (File No. S7– 33–11), at 4 (stating that ‘‘[o]f course, in many cases [a fund’s daily mark-to-market liability, if any] will not fully reflect the ultimate investment exposure associated with the swap position’’ and that, ‘‘[a]s a result, a fund that segregates only the market-tomarket liability could theoretically incur virtually unlimited investment leverage using cash-settled swaps’’); Keen Concept Release Comment Letter, at 20 (stating that the mark-to-market approach, as applied to cash settled swaps, ‘‘imposes no effective control over the amount of investment leverage created by these swaps, and leaves it to the market to limit the amount of leverage a fund may use’’). E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules availability of adequate assets to meet funds’ derivatives obligations, as the Commission contemplated in Release 10666. A fund using the mark-to-market approach could segregate assets that only reflect the losses (and corresponding potential payment obligations) that the fund would then incur as a result of transaction termination. This practice provides no assurances that future losses will not exceed the value of the segregated assets or the value of all assets then available to meet the payment obligations resulting from such losses.60 We also recognize that when a fund segregates any liquid asset, rather than the more narrow range of high-quality assets the Commission described in Release 10666, the segregated assets may be more likely to decline in value at the same time as the fund experiences losses on its derivatives.61 In this case, or when a fund’s derivatives payment obligations are substantial relative to the fund’s liquid assets, the fund may be forced to sell portfolio securities to meet its derivatives payment obligations. These forced sales could occur during stressed market conditions, including at times when prudent management could advise against such liquidation.62 3. Need for Updated Regulatory Framework lotter on DSKBCFDHB2PROD with PROPOSALS2 As the Commission observed in the 2015 proposal and for the reasons discussed above, we continue to be concerned that funds’ current practices regarding derivatives use may not address the undue speculation and asset sufficiency concerns underlying section 18.63 Additionally, as recent events demonstrate, a fund’s derivatives use may involve risks that can result in significant losses to a fund.64 Accordingly, we continue to believe that it is appropriate for funds to address these risks and considerations relating to their derivatives use. Nevertheless, 60 A fund’s mark-to-market liability on any particular day, if any, could be substantially smaller than the fund’s ultimate obligations under a derivative. See 2015 Proposing Release, supra note 2, at n.113. 61 See id. at n.115. 62 The Commission noted in Release 10666 that ‘‘in an extreme case an investment company which has segregated all its liquid assets might be forced to sell non-segregated portfolio securities to meet its obligations upon shareholder requests for redemption. Such forced sales could cause an investment company to sell securities which it wanted to retain or to realize gains or losses which it did not originally intend.’’ See Release 10666, supra note 15, at ‘‘Segregated Account’’ discussion. 63 See 2015 Proposing Release, supra note 2, at sections II.D.1.b and II.D.1.c; see also supra paragraphs accompanying notes 58–62. 64 See supra paragraph accompanying notes 22– 25. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 we also recognize the valuable role derivatives can play in helping funds to achieve their objectives efficiently or manage their investment risks. We therefore believe funds that significantly use derivatives should adopt and implement formalized programs to manage the risks derivatives may pose. In addition, a more modern framework for regulating funds’ derivatives use would respond to our concern that funds today are not subject to a practical limit on potential leverage that they may obtain through derivatives transactions. The risk management program requirement and limit on fund leverage risk we are proposing are designed to address these considerations, in turn. A comprehensive approach to regulating funds’ derivatives use also would help address potential adverse results from funds’ current, disparate asset segregation practices. The development of staff guidance and industry practice on an instrument-byinstrument basis, together with growth in the volume and complexity of derivatives markets over past decades, has resulted in situations in which different funds may treat the same kind of derivative differently, based on their own view of our staff’s guidance or observation of industry practice. This may unfairly disadvantage some funds.65 The lack of comprehensive guidance also makes it difficult for funds and our staff to evaluate and inspect for funds’ compliance with section 18 of the Investment Company Act. Moreover, where there is no specific guidance, or where the application of existing guidance is unclear or applied inconsistently, funds may take approaches that involve an extensive use of derivatives and may not address the purposes and concerns underlying section 18. C. Overview of the Proposal Our proposal consists of three parts. Proposed rule 18f–4 is designed to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives and the other transactions that the proposed rule addresses. The proposed sales practices rules are designed to address investor protection concerns with respect to leveraged/ inverse funds by requiring broker65 See, e.g., Comment Letter of Davis Polk on the 2011 Concept Release (Nov. 11, 2011), at 1–2 (stating that ‘‘funds and their sponsors may interpret the available guidance differently, even when applying it to the same instruments, which may unfairly disadvantage some funds’’); see also Comment Letter of Federated Investors, Inc. (Mar. 23, 2016) (‘‘Federated Comment Letter’’); Comment Letter of Salient Partners, L.P. (Mar. 25, 2016) (‘‘Salient Comment Letter). PO 00000 Frm 00009 Fmt 4701 Sfmt 4702 4453 dealers and investment advisers to exercise due diligence on retail investors before approving retail investor accounts to invest in leveraged/ inverse funds. The proposed amendments to Forms N–PORT, N– LIQUID (which we propose to re-title as ‘‘Form N–RN’’), and N–CEN are designed to enhance the Commission’s ability to 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. Proposed rule 18f–4 would permit a fund to enter into derivatives transactions, notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Investment Company Act, subject to the following conditions: 66 • Derivatives risk management program.67 The proposed rule would generally require a fund to adopt a written derivatives risk management program with risk guidelines that must cover certain elements, but that otherwise would be tailored based on how the fund’s use of derivatives may affect its investment portfolio and overall risk profile. The program also would have to include stress testing, backtesting, internal reporting and escalation, and program review elements. The program would institute a standardized risk management framework for funds that engage in more than a limited amount of derivatives transactions, while allowing principlesbased tailoring to the fund’s particular risks. We believe that a formalized derivatives risk management program is critical to appropriate derivatives risk management and is foundational to providing exemptive relief under section 18. • Limit on fund leverage risk.68 The proposed rule would generally require funds when engaging in derivatives 66 See proposed rule 18f–4(b) and (d). Proposed rule 18f–4(b) would provide an exemption for funds’ derivatives transactions from sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act. See supra section I.B.1 of this release (providing an overview of the requirements of section 18). Because the proposed conditions are designed to provide a tailored set of requirements for derivatives transactions, the proposed rule would also provide that a fund’s derivatives transactions would not be considered for purposes of computing asset coverage under section 18(h). Applying section 18(h) asset coverage to a fund’s derivatives transactions appears unnecessary in light of the tailored restrictions we are proposing. See also infra section II.M. 67 See proposed rule 18f–4(c)(1); infra section II.A.2. 68 See proposed rule 18f–4(c)(2); infra section II.D. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4454 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules transactions to comply with an outer limit on fund leverage risk based on value at risk, or ‘‘VaR.’’ This outer limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a ‘‘designated reference index’’ for that fund. If the fund’s derivatives risk manager is unable to identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test. These proposed requirements are designed to limit fund leverage risk consistent with the investor protection purposes underlying section 18 and to complement the proposed risk management program. Because VaR is a commonly-known and broadly-used industry metric that enables risk to be measured in a reasonably comparable and consistent manner across the diverse instruments that may be included in a fund’s portfolio, the proposed VaR-based limit is designed to address leverage risk for a variety of fund strategies. • Board oversight and reporting.69 The proposed rule would require a fund’s board of directors to approve the fund’s designation of a derivatives risk manager, who would be responsible for administering the fund’s derivatives risk management program. The fund’s derivatives risk manager would have to report to the fund’s board on the derivatives risk management program’s implementation and effectiveness and the results of the fund’s stress testing. The derivatives risk manager would have a direct reporting line to the fund’s board. We believe requiring a fund’s derivatives risk manager to be responsible for the day-to-day administration of the fund’s program, subject to board oversight, is consistent with the way we understand many funds currently manage derivatives risks and is key to appropriately managing these risks. • Exception for limited derivatives users.70 The proposed rule would except limited derivatives users from the derivatives risk management program requirement and the VaR-based limit on fund leverage risk. This proposed exception would be available to a fund that either limits its derivatives exposure to 10% of its net assets or uses derivatives transactions solely to hedge certain currency risks and, in either case, that also adopts and implements policies and procedures reasonably designed to manage the fund’s derivatives risks. Requiring a derivatives risk management program that includes all of the program 69 See 70 See proposed rule 18f–4(c)(5); infra section II.C. proposed rule 18f–4(c)(3); infra section II.E. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 elements specified in the rule for funds that use derivatives only in a limited way could potentially require these funds to incur costs and bear compliance burdens that are disproportionate to the resulting benefits. • Alternative requirements for certain leveraged/inverse funds.71 The proposed rule would provide an exception from the limit on fund leverage risk for certain leveraged/ inverse funds in light of the additional safeguards provided by the proposed requirements under the sales practices rules that broker-dealers and investment advisers exercise due diligence on retail investors before approving the investors’ accounts to invest in these funds.72 The conditions of this exception are designed to address the investor protection concerns that underlie section 18 of the Investment Company Act, while preserving choice for investors the investment adviser or broker-dealer reasonably believes have such financial knowledge and experience that they may reasonably be expected to be capable of evaluating the risk of these funds. • Recordkeeping.73 The proposed rule would require a fund to adhere to recordkeeping requirements that are designed to provide the Commission’s staff, and the fund’s board of directors and compliance personnel, the ability to evaluate the fund’s compliance with the proposed rule’s requirements. Proposed rule 18f–4 would also permit funds to enter into reverse repurchase agreements and similar financing transactions, as well as ‘‘unfunded commitments’’ to make certain loans or investments, subject to conditions tailored to these transactions.74 A fund would be permitted to engage in reverse repurchase agreements and similar financing transactions so long as they meet the asset coverage requirements under section 18. If the fund also borrows from a bank or issues bonds, for example, these senior securities as well as the reverse repurchase agreement would be required to comply with the asset coverage requirements under the 71 See proposed rule 18f–4(c)(4); infra section II.G. 72 In our discussion in this release of the entities subject to the proposed sales practices rules, we use ‘‘broker-dealer’’ to refer to a broker-dealer that is registered with, or required to register with, the Commission. Similarly, we use ‘‘investment adviser’’ to refer to an investment adviser that is registered with, or required to register with, the Commission. 73 See proposed rule 18f–4(c)(6); infra section II.K. 74 See proposed rule 18f–4(d) and (e); infra sections II.I and II.J. PO 00000 Frm 00010 Fmt 4701 Sfmt 4702 Investment Company Act. This approach would provide the same asset coverage requirements under section 18 for reverse repurchase agreements and similar financing transactions, bank borrowings, and other borrowings permitted under the Investment Company Act. A fund would be permitted to enter into unfunded commitment agreements if the fund reasonably believes that its assets will allow the fund to meet its obligations under these agreements. This approach recognizes that, while unfunded commitment agreements do raise the risk that a fund may be unable to meet its obligations under these transactions, such unfunded commitments do not generally involve the leverage and other risks associated with derivatives transactions. The proposed sales practices rules are designed to address certain specific considerations raised by certain leveraged/inverse funds and listed commodity pools that obtain leveraged or inverse exposure to an underlying index, on a periodic (generally, daily) basis.75 These rules would require broker-dealers and investment advisers to exercise due diligence in determining whether to approve a retail customer or client’s account to buy or sell these products. A broker-dealer or adviser could only approve the account if it had a reasonable basis to believe that the customer or client is capable of evaluating the risk associated with these products. In this regard, the proposed sales practices rules would complement the leveraged/inverse funds exception from proposed rule 18f–4’s limit on leverage risk by subjecting brokerdealers or advisers to the proposed sales practices rules’ due diligence and approval requirements. In connection with proposed rules 15l–2, 211(h)–1, and 18f–4, we are proposing amendments to rule 6c–11 under the Investment Company Act. Rule 6c–11 generally permits ETFs to operate without obtaining a Commission exemptive order, subject to certain conditions.76 The rule currently excludes leveraged/inverse ETFs from relying on the rule, however, to allow the Commission to consider the section 18 issues raised by these funds’ investment strategies as part of a broader consideration of derivatives use by registered funds and BDCs.77 As part of this further consideration, we are 75 See infra note 327 and accompanying text (defining ‘‘listed commodity pools’’). 76 See generally Exchange-Traded Funds, Investment Company Act Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24, 2019)] (‘‘ETFs Adopting Release’’). 77 See id. at nn.72–74 and accompanying text. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules proposing to remove this provision and permit leveraged/inverse ETFs to rely on rule 6c–11 because the proposed sales practices rules and rule 18f–4 are designed to address these issues. In this regard, we are also proposing to rescind the exemptive orders previously issued to the sponsors of leveraged/inverse ETFs. Amending rule 6c–11 and rescinding these exemptive orders would promote a level playing field by allowing any sponsor (in addition to the sponsors currently granted exemptive orders) to form and launch a leveraged/ inverse ETF subject to the conditions in rule 6c–11 and proposed rule 18f–4, with transactions in the fund subject to the proposed sales practices rules. The proposed amendments to Forms N–PORT, N–LIQUID, and N–CEN would require a fund to provide information regarding: (1) The fund’s exposure to derivatives; (2) the fund’s VaR (and, if applicable, the fund’s designated reference index) and backtesting results; (3) VaR test breaches, to be reported to the Commission in a non-public current report; and (4) certain identifying information about the fund (e.g., whether the fund is a limited derivatives user that is excepted from certain of the proposed requirements, or whether the fund is a ‘‘leveraged/ inverse fund’’). Finally, in view of our proposal for an updated, comprehensive approach to the regulation of funds’ derivative use, we are proposing to rescind Release 10666. In addition, staff in the Division of Investment Management is reviewing certain of its no-action letters and other guidance addressing derivatives transactions and other transactions covered by proposed rule 18f–4 to determine which letters and other staff guidance, or portions thereof, should be withdrawn in connection with any adoption of this proposal. Upon the adoption of any final rule, some of these letters and other staff guidance, or portions thereof, would be moot, superseded, or otherwise inconsistent with the final rule and, therefore, would be withdrawn. We would expect to provide funds a one-year transition period while they prepare to come into compliance with rule 18f–4 before Release 10666 is withdrawn. lotter on DSKBCFDHB2PROD with PROPOSALS2 II. Discussion A. Scope of Proposed Rule 18f–4 1. Funds Permitted To Rely on Proposed Rule 18f–4 The proposed rule would apply to a ‘‘fund,’’ defined as a registered openend or closed-end company or a BDC, including any separate series thereof. The rule would therefore apply to VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 mutual funds, ETFs, registered closedend funds, and BDCs. The proposed rule’s definition of a ‘‘fund’’ would, however, exclude money market funds regulated under rule 2a–7 under the Investment Company Act (‘‘money market funds’’). Under rule 2a–7, money market funds seek to maintain a stable share price or limit principal volatility by limiting their investments to shortterm, high-quality debt securities that fluctuate very little in value under normal market conditions. As a result of these and other requirements in rule 2a– 7, we believe that money market funds currently do not typically engage in derivatives transactions or the other transactions permitted by rule 18f–4.78 We believe that these transactions would generally be inconsistent with a money market fund maintaining a stable share price or limiting principal volatility, and especially if used to leverage the fund’s portfolio.79 We therefore believe that excluding money market funds from the scope of the proposed rule is appropriate. Section 18 applies only to open-end or closed-end companies, i.e., to management investment companies. Proposed rule 18f–4 therefore also would not apply to unit investment trusts (‘‘UITs’’) because they are not management investment companies. In addition, as the Commission has noted, derivatives transactions generally require a significant degree of management, and a UIT engaging in derivatives transactions therefore may not meet the Investment Company Act requirements applicable to UITs.80 We request comment on all aspects of the proposed rule’s definition of the term ‘‘fund,’’ including the following items. 1. The proposed definition excludes money market funds. Should we include money market funds in the definition? Why or why not? 2. Do money market funds currently engage in any transactions that might 78 See infra note 583. Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) [79 FR 47735 (Aug. 14, 2014)] (discussing (1) retail and government money market funds, which seek to maintain a stable net asset value per share and (2) institutional nongovernment money market funds whose net asset value fluctuates, but still must stress test their ability to minimize principal volatility given that ‘‘commenters pointed out investors in floating NAV funds will continue to expect a relatively stable NAV’’). 80 See section 4(2) of the Investment Company Act; see also Custody Of Investment Company Assets with Futures Commission Merchants And Commodity Clearing Organizations, Investment Company Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT portfolios are generally unmanaged). See also ETFs Adopting Release, supra note 76, at n.42. 79 See PO 00000 Frm 00011 Fmt 4701 Sfmt 4702 4455 qualify as derivatives transactions under the rule or any of the other transactions permitted by the rule? For example, do money market funds engage in reverse repurchase agreements, ‘‘to be announced’’ dollar rolls, or ‘‘when issued’’ transactions? If so, which transactions, to what extent, and for what purpose? For example, do money market funds engage in reverse repurchase agreements for liquidity management purposes but not to leverage the fund’s portfolio? If so, what effects would the proposed rule have on money market funds’ liquidity management if they are excluded from the rule’s scope as proposed? To the extent money market funds engage in any of the transactions that the proposed rule would permit, how do money market funds analyze them under rule 2a–7? 3. Should we permit money market funds to engage in some of the transactions that the rule would permit? If so, which transactions and why, and how would the transactions be consistent with rule 2a–7? If we were to include money market funds in the rule, or permit them to engage in specific types of transactions, should the rule provide specific conditions tailored to money market funds entering into those transactions? What kinds of conditions and why? Should they be permitted to engage in all (or certain types) of derivatives transactions, or reverse repurchase or similar financing transactions, for liquidity management or other purposes that do not leverage the fund’s portfolio? If money market funds were permitted to rely on the rule for any transactions, should those transactions be limited in scale? For example, should that limit be the same as the proposed approach for limited derivatives users that limit the extent of their derivatives exposure, as discussed below in section II.E.1? Would even such limited use be consistent with funds that seek to maintain a stable share price or limit principal volatility? 4. If we were to include money market funds in the scope of rule 18f–4, should we revise Form N–MFP so that money market funds filing reports on the form could select among the list of investment categories set forth in Item C.6 of Form N–MFP derivatives and the other transactions addressed in the proposed rule 18f–4? 81 Why or why not? 2. Derivatives Transactions Permitted Under Proposed Rule 18f–4 The proposed rule would permit funds to enter into derivatives 81 See E:\FR\FM\24JAP2.SGM infra note 583. 24JAP2 4456 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 transactions, subject to the rule’s conditions. The proposed rule would define the term ‘‘derivatives transaction’’ to mean: (1) Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (‘‘derivatives instrument’’), under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payment or otherwise; and (2) any short sale borrowing.82 The first prong of this proposed definition is designed to describe those derivatives transactions that involve the issuance of a senior security, because they involve a contractual future payment obligation.83 When a fund engages in these transactions, the fund will have an obligation (or potential obligation) to make payments or deliver assets to the fund’s counterparty. This prong of the definition incorporates a list of derivatives instruments that, together with the proposed inclusion in the definition of ‘‘any similar instrument,’’ covers the types of derivatives that funds currently use and that the requirements of section 18 would restrict. This list is designed to be sufficiently comprehensive to include derivatives that may be developed in the future. We believe that this approach is clearer than a more principles-based definition of the term ‘‘derivatives transaction,’’ such as 82 Proposed rule 18f–4(a). The 2015 proposal similarly defined a derivatives transaction as including enumerated derivatives instruments ‘‘under which the fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as a margin or settlement payment or otherwise.’’ 2015 proposed rule 18f–4(c)(2). Most commenters did not address the proposed definition of the term ‘‘derivatives transaction,’’ although those commenters who did address the definition generally supported it. Some commenters more generally supported the view, or sought confirmation, that a derivative does not involve the issuance of a senior security if it does not impose an obligation under which the fund is or may be required to make a future payment (e.g., a standard purchased option). See, e.g., Comment Letter of The Options Clearing Corporation (Mar. 25, 2016); Comment Letter of Investment Adviser Association (Mar. 28, 2016) (‘‘IAA Comment Letter’’); FSR Comment Letter. 83 See supra note 27 and accompanying text, and text following note 34 (together, noting that ‘‘senior security’’ is defined in part as ‘‘any . . . similar obligation or instrument constituting a security and evidencing indebtedness,’’ and that the Commission has previously stated that, for purposes of section 18, ‘‘evidence of indebtedness’’ would include ‘‘all contractual obligations to pay in the future for consideration presently received’’); see also infra notes 85–87 (recognizing that not every derivative instrument will involve the issuance of a senior security). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 defining this term as an instrument or contract whose value is based upon, or derived from, some other asset or metric. This prong of the definition also provides that a derivatives instrument, for purposes of the proposed rule, must involve a future payment obligation.84 This aspect of the definition recognizes that not every derivatives instrument imposes an obligation that may require the fund to make a future payment, and therefore not every derivatives instrument will involve the issuance of a senior security.85 A derivative that does not impose any future payment obligation on a fund generally resembles a securities investment that is not a senior security, in that it may lose value but will not require the fund to make any payments in the future.86 Whether a transaction involves the issuance of a senior security will depend on the nature of the transaction. The label that a fund or its counterparty assigns to the transaction is not determinative.87 84 Under the proposed rule, a derivatives instrument is one where the fund ‘‘is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payment or otherwise.’’ 85 See 2015 Proposing Release, supra note 2, at paragraph accompanying nn.82–83. A fund that purchases a standard option traded on an exchange, for example, generally will make a non-refundable premium payment to obtain the right to acquire (or sell) securities under the option. However, the option purchaser generally will not have any subsequent obligation to deliver cash or assets to the counterparty unless the fund chooses to exercise the option. 86 See id. at n.82. 87 For example, the Commission received a comment on the 2015 proposal addressing a type of total return swap, asserting that ‘‘[t]he Swap operates in a manner similar to a purchased option or structure, in that the fund’s losses under the Swap cannot exceed the amount posted to its triparty custodian agreement for purposes of entering into the Swap,’’ and that, in the commenter’s view, the swap should be ‘‘afforded the same treatment as a purchased option or structured note’’ because ‘‘[a]lthough the Swap involves interim payments through the potential posting of margin from the custodial account, the payment obligations cannot exceed the [amount posted for purposes of entering into the Swap].’’ See Comment Letter of Dearborn Capital Management (Mar. 24, 2016) (‘‘Dearborn Comment Letter’’). Unlike a fund’s payment of a one-time non-refundable premium in connection with a standard purchased option or a fund’s purchase of a structured note, this transaction appears to involve a fund obligation to make interim payments of fund assets posted as margin or collateral to the fund’s counterparty during the life of the transaction in response to market value changes of the underlying reference asset, as this commenter described. The fund also must deposit additional margin or collateral to maintain the position if the fund’s losses deplete the assets that the fund posted to initiate the transaction; if a fund effectively pursues its strategy through such a swap, or a small number of these swaps, the fund may as a practical matter be required to continue reestablishing the trade or refunding the collateral account in order to continue to offer the fund’s PO 00000 Frm 00012 Fmt 4701 Sfmt 4702 Unlike the 2015 proposal, this proposal does not include references to, or a definition of, ‘‘financial commitment transaction’’ in addition to the proposed definition of ‘‘derivatives transaction.’’ The 2015 proposal defined a ‘‘financial commitment transaction’’ as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement.88 Because our proposal addresses funds’ use of reverse repurchase agreements and unfunded commitment agreements separately from funds’ use of derivatives, the proposed definition of ‘‘derivatives transaction’’ does not include reverse repurchase agreements and unfunded commitment agreements.89 Short sale borrowings, however, are included in the second prong of the proposed definition of ‘‘derivatives transaction.’’ We appreciate that short sales of securities do not involve derivatives instruments such as swaps, futures, and options. The value of a short position is, however, derived from the price of another asset, i.e., the asset sold short. A short sale of a security provides the same economic exposure as a derivatives instrument, like a future or swap, that provides short exposure to the same security. The proposed rule therefore treats short sale borrowings and derivatives instruments identically for purposes of funds’ reliance on the rule’s exemption.90 While this proposal does not specifically list firm or standby commitment agreements in the definition of ‘‘derivatives transaction,’’ we interpret the definitional phrase ‘‘or any similar instrument’’ to include these agreements. A firm commitment agreement has the same economic characteristics as a forward contract.91 Similarly, a standby commitment agreement has the same economic characteristics as an option contract, and the Commission has previously stated that such an agreement is economically equivalent to the issuance strategy. The transaction therefore appears to involve the issuance of a senior security as the fund may be required to make future payments. See also infra section II.J (discussing the characterization of ‘‘unfunded commitment’’ agreements for purposes of the proposed rule, and as senior securities). 88 See 2015 Proposing Release, supra note 2, at section III.A.2; 2015 proposed rule 18f–4(c)(4); see also supra note 10. 89 See infra section II.I. 90 See proposed rule 18f–4(b). 91 Indeed, the Commission noted in Release 10666 that a firm commitment is known by other names such as a ‘‘forward contract.’’ See Release 10666, supra note 15, at nn.10–12 and accompanying text. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 of a put option.92 To the extent that a fund engages in transactions similar to firm or standby commitment agreements, they may fall within the ‘‘any similar instrument’’ definitional language, depending on the facts and circumstances.93 We request comment on all aspects of the proposed rule’s definition of the term ‘‘derivatives transaction,’’ including the following items. 5. Is the definition of ‘‘derivatives transaction’’ sufficiently clear? Are there additional types of derivatives instruments, or other transactions, that we should include or exclude? Adding additional transactions to the definition would permit a fund to engage in those transactions by complying with the proposed rule, rather than section 18. Are there transactions that we should exclude from the definition so that funds must comply with the limits of section 18 (to the extent permitted under section 18) with respect to these transactions, rather than the proposed rule’s conditions? 6. The proposed rule’s definition of the term ‘‘derivatives transaction’’ is designed to describe those derivatives transactions that would involve the issuance of a senior security. Do commenters agree that derivatives transactions that involve obligations to make a payment or deliver assets involve the issuance of a senior security under section 18 of the Act? Does the rule effectively describe all of the types of derivatives transactions that would involve the issuance of a senior security? Conversely, are there any types of transactions that are included in the proposed definition of ‘‘derivatives transaction’’ that should not be considered to involve the issuance of a senior security? If so, which types of transactions and why? 7. Is it appropriate that the proposed rule’s definition of ‘‘derivatives transaction’’ incorporates a list of derivatives instruments plus ‘‘any similar instrument,’’ rather than a principles-based definition, such as an instrument or contract whose value is based upon, or derived from, some other 92 See id. at ‘‘Standby Commitment Agreements’’ (‘‘The standby commitment agreement is a delayed delivery agreement in which the investment company contractually binds itself to accept delivery of a Ginnie Mae with a stated price and fixed yield upon the exercise of an option held by the other party to the agreement at a stated future date. . . . The Commission believes that the standby commitment agreement involves, in economic reality, the issuance and sale by the investment company of a ‘put.’ ’’). 93 See, e.g., infra paragraph accompanying notes 419–420 (discussing agreements that would not qualify for the proposed rule’s treatment of unfunded commitment agreements because they are functionally similar to derivatives transactions). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 asset or metric? Why or why not? Is the reference to ‘‘any similar instrument’’ in the proposed definition sufficiently clear to address transactions that may be developed in the future? If not, how should we modify the rule to provide additional clarity? 8. Should the proposed definition of ‘‘derivatives transaction’’ include short sale borrowings? Would this approach cause any confusion because short sales are not typically understood as derivatives instruments? If the latter, what alternative approach would be preferable? 9. Should we specifically list firm or standby commitments in the proposed definition of ‘‘derivatives transaction’’? Would funds understand the phrase ‘‘or any similar instrument’’ in the proposed definition to include these agreements? Do funds currently use the terms ‘‘firm commitment agreement’’ or ‘‘standby commitment agreement’’ to describe any of their transactions? 10. Are there any transactions similar to firm or standby commitments that we should specifically address, either in the proposed definition of ‘‘derivatives transaction’’ or otherwise as guidance? Are there any other types of transactions that the Commission should address— either in the proposed definition or as guidance—as transactions that fall within the ‘‘any similar instrument’’ definitional language? B. Derivatives Risk Management Program 1. Summary Fund investments in derivatives transactions can pose a variety of risks, and poor risk management can cause significant harm to funds and their investors. Derivatives can raise potential risks such as market, counterparty, leverage, liquidity, and operational risk. Although many of these risks are not limited to derivatives, the complexity and character of certain derivatives— such as their multiple contingencies and optionality, path dependency, and nonlinearity—may heighten these risks.94 Even simple derivatives without multiple contingencies and optionality, for example, can present additional risks beyond a fund’s investment in the underlying reference assets, such as the risk that a fund must have margineligible assets on hand to meet margin or collateral calls. We also recognize the 94 See European Securities and Markets Authority (formerly Committee of European Securities Regulators), Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, CESR/10–788 (July 28, 2010), at 12, available at https:// www.esma.europa.eu/sites/default/files/library/ 2015/11/10_788.pdf (‘‘CESR Global Guidelines’’). PO 00000 Frm 00013 Fmt 4701 Sfmt 4702 4457 valuable role derivatives can play in helping funds to achieve their objectives efficiently or manage their investment risks. An investment adviser of a fund that uses derivatives therefore should manage this use to ensure alignment with the fund’s investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements. In addition, a fund’s board of directors is responsible for overseeing the fund’s activities and the adviser’s management of risks, including any derivatives risks.95 Given the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds and their related risks, we believe that requiring funds that are users of derivatives (other than limited derivatives users) to have a formalized risk management program with certain specified elements (a ‘‘program’’) supports exempting these transactions from section 18. Under the proposed program requirement, a fund would have to adopt and implement a written derivatives risk management program, which would include policies and procedures reasonably designed to manage the fund’s derivatives risks.96 A fund’s risk management program should take into the account the way the fund uses derivatives, whether to increase investment exposures in ways that increase portfolio risks or, conversely, to reduce portfolio risks or facilitate efficient portfolio management.97 The program requirement is designed to result in a program with elements that are tailored to the particular types of derivatives that the fund uses and their related risks, as well as how those derivatives impact the fund’s investment portfolio and strategy. The proposal would require a fund’s program to include the following elements: • Risk identification and assessment.98 The program would have to provide for the identification and assessment of a fund’s derivatives risks, 95 See, e.g., Interpretive Matters Concerning Independent Directors of Investment Companies, Investment Company Act Release No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 (Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)]; Independent Directors Council, Fund Board Oversight of Risk Management (Sept. 2011), available at https:// www.ici.org/pdf/pub_11_oversight_risk.pdf (‘‘2011 IDC Report’’). 96 Proposed rule 18f–4(c)(1). 97 See supra note 4 and accompanying text; infra section II.B.3.a. 98 Proposed rule 18f–4(c)(1)(i); see also infra section II.B.3.a. E:\FR\FM\24JAP2.SGM 24JAP2 4458 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 which would take into account the fund’s derivatives transactions and other investments. • Risk guidelines.99 The program would have to provide for the establishment, maintenance, and enforcement of investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to a fund’s derivatives risks. • Stress testing.100 The program would have to provide for stress testing of derivatives risks to evaluate potential losses to a fund’s portfolio under stressed conditions. • Backtesting.101 The program would have to provide for backtesting of the VaR calculation model that the fund uses under the proposed rule. • Internal reporting and escalation.102 The program would have to provide for the reporting of certain matters relating to a fund’s derivatives use to the fund’s portfolio management and board of directors. • Periodic review of the program.103 A fund’s derivatives risk manager would be required to periodically review the program, at least annually, to evaluate the program’s effectiveness and to reflect changes in risk over time. The proposed program requirement is drawn from existing fund best practices. We believe it would enhance practices for funds that have not already implemented a derivatives risk management program, while building off practices of funds that already have one in place.104 Most commenters generally supported the 2015 proposal’s derivatives risk management program requirement, which had many similar foundational elements to those of the program we are proposing here. These commenters stated that the use of derivatives transactions by a fund should be subject to a comprehensive and appropriate written risk management program, which would benefit investors.105 Our 99 Proposed rule 18f–4(c)(1)(ii); see also infra section II.B.3.b. 100 Proposed rule 18f–4(c)(1)(iii); see also infra section II.B.3.c. 101 Proposed rule 18f–4(c)(1)(iv); see also infra section II.B.3.d. 102 Proposed rule 18f–4(c)(1)(v); see also infra section II.B.3.e. 103 Proposed rule 18f–4(c)(1)(vi); see also infra section II.B.3.f. 104 See, e.g., Aviva Comment Letter (discussing the implementation of formalized derivatives risk management programs); Vanguard Comment Letter. 105 See, e.g., Comment Letter of AFG-French Asset Management Association (Mar. 25, 2016) (‘‘AFG Comment Letter’’); Comment Letter of American Beacon Advisors (Mar. 28, 2016) (‘‘American Beacon Comment Letter’’); Comment Letter of AQR VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 proposal includes elements from the 2015 proposal’s derivatives risk management program framework, and adds elements that take into account our analysis of the comments we received. 2. Program Administration The proposed rule would require a fund adviser’s officer or officers to serve as the fund’s derivatives risk manager.106 This requirement is designed to centralize derivatives risk management and to promote accountability. The designation of the derivatives risk manager must be approved by the fund’s board of directors, and the derivatives risk manager must have direct communication with the fund’s board of directors. Allowing multiple officers of the fund’s adviser (including any subadvisers) to serve as the fund’s derivatives risk manager is designed to allow funds with differing sizes, organizational structures, or investment strategies to more effectively tailor the programs to their operations.107 We understand that many advisers today involve committees or groups of officers in the vetting and analysis of portfolio risk and other types of risk.108 Although the proposed rule would not permit a third party to serve as a fund’s derivatives risk manager, the derivatives risk manager could obtain assistance from third parties in administering the program. For example, third parties could provide data relevant to the administration of a fund’s program or other analysis that may inform the fund’s derivatives risk management. The proposed rule would also require that the fund’s derivatives risk manager have relevant experience regarding derivatives risk management.109 This requirement is designed to reflect the potential complex and unique risks that derivatives can pose to funds and promote the selection of a derivatives risk manager who is well-positioned to Capital Management (Mar. 28, 2016) (‘‘AQR Comment Letter’’); Federated Comment Letter; Comment Letter of Fidelity (Mar. 28, 2016) (‘‘Fidelity Comment Letter’’); Comment Letter of AFL–CIO (Mar. 28, 2016); Comment Letter of Alternative Investment Management Association (Mar. 28, 2016) (‘‘AIMA Comment Letter’’); Comment Letter of Aviva (Mar. 28, 2016) (‘‘Aviva Comment Letter’’); Comment Letter of BlackRock (Mar. 28, 2016) (‘‘BlackRock Comment Letter’’); Comment Letter of Capital Research and Management Company (Mar. 28, 2016) (‘‘CRMC Comment Letter’’). 106 Proposed rule 18f–4(a). 107 The term ‘‘adviser’’ as used in this release and rule 18f–4 generally refers to any person, including a sub-adviser, that is an ‘‘investment adviser’’ of an investment company as that term is defined in section 2(a)(20) of the Investment Company Act. 108 See, e.g., IAA Comment Letter. 109 Proposed rule 18f–4(a). PO 00000 Frm 00014 Fmt 4701 Sfmt 4702 manage these risks. As discussed below, under the proposed rule, a fund’s board must approve the designation of the fund’s derivatives risk manager, taking into account the derivatives risk manager’s relevant experience regarding derivatives risk management.110 The proposed rule would require a fund to reasonably segregate the functions of the program from its portfolio management.111 Segregating derivatives risk management from portfolio management is designed to promote objective and independent identification, assessment, and management of the risks associated with derivatives use. Accordingly, this element is designed to enhance the accountability of the derivatives risk manager and other risk management personnel and, therefore, to enhance the program’s effectiveness.112 We understand that funds today often segregate risk management from portfolio management. Many have observed that independent oversight of derivatives activities by compliance and internal audit functions is valuable.113 Because a fund may compensate its portfolio management personnel in part based on the returns of the fund, the incentives of portfolio managers may not always be consistent with the restrictions that a risk management program would impose. Keeping the functions separate in the context of derivatives risk management should help mitigate the possibility that these competing incentives diminish the program’s effectiveness. Separation of functions creates important checks and balances, and funds could institute this proposed requirement through a variety of methods, such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel. The proposed rule would require reasonable segregation of functions, rather than taking a more prescriptive approach, such as requiring funds to implement strict protocols regarding communications between specific fund personnel, to allow funds to structure their risk management and portfolio management functions in ways that are tailored to each fund’s facts and circumstances, including the size and 110 See infra section II.C.1. rule 18f–4(c)(1). 112 See, e.g., Comptroller of the Currency Administrator of National Banks, Risk Management of Financial Derivatives: Comptroller’s Handbook (Jan. 1997), at 9 (discussing the importance of independent risk management functions in the banking context). 113 See, e.g., Kenneth K. Marshall, Internal Control and Derivatives, The CPA Journal (Oct. 1995), available at https://archives.cpajournal.com/ 1995/OCT95/f461095.htm. 111 Proposed E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules resources of the fund’s adviser. In this regard, the reasonable segregation requirement is not meant to indicate that the derivatives risk manager and portfolio management must be subject to a communications ‘‘firewall.’’ We recognize the important perspective and insight regarding the fund’s use of derivatives that the portfolio manager can provide and generally understand that the fund’s derivatives risk manager would work with the fund’s portfolio management in implementing the program requirement. For similar reasons, the proposed rule would also prohibit the derivatives risk manager position from being filled solely by the fund’s portfolio manager, if a single fund officer serves in the position.114 The proposed rule also would prohibit a majority of the officers who compose the derivatives risk manager position from being portfolio managers, if multiple fund officers serve in the position. Commenters generally supported the 2015 proposal’s requirement that a fund’s derivatives risk management program be administered by a derivatives risk manager and that the fund’s derivatives risk management be segregated from the fund’s portfolio management.115 Commenters did, however, express concern about the 2015 proposal’s requirement that there be a single derivatives risk manager and urged that the Commission permit a fund’s portfolio managers to provide some input into the fund’s derivatives risk management function.116 This reproposal addresses these concerns by permitting a group or committee to serve as a fund’s derivatives risk manager, a portion of whom could be portfolio managers. We request comment on the proposed requirements that a fund’s derivatives risk manager administer the fund’s program, and that the derivatives risk management function be reasonably segregated from the fund’s portfolio management. 11. Is the proposed definition of ‘‘derivatives risk manager’’ sufficiently clear? Why or why not? Should the rule, as proposed, require that a fund’s derivatives risk manager be an officer or officers of the fund’s adviser, and would this requirement further the goals of centralizing derivatives risk management and promoting 114 Proposed rule 18f–4(a). e.g., BlackRock Comment Letter. 116 See, e.g., BlackRock Comment Letter; Comment Letter of Morningstar (Mar. 28, 2016) (‘‘Morningstar Comment Letter’’); Comment Letter of the Investment Company Institute (Mar. 28, 2016) (‘‘ICI Comment Letter I’’); Comment Letter of WisdomTree (Mar. 28, 2016). 115 See, VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 accountability? Why or why not? Should the rule, as proposed, permit a fund’s derivatives risk manager to be an officer or officers of the fund’s subadvisers? Why or why not? If so, should the rule require that at least one of the officers be an officer of the adviser or otherwise limit the number of subadviser officers? Why or why not? Would a fund’s program be more effective if we required the derivatives risk manager to be a single individual? Why or why not? If so, should this individual be required to be an officer of a fund’s adviser? 12. Should the rule, as proposed, require that a fund’s derivatives risk manager have relevant experience regarding derivatives risk management? Why or why not? Is the proposed requirement that the derivatives risk manager have ‘‘relevant experience regarding the management of derivatives risk’’ sufficiently clear? Would this raise questions about whether portfolio management experience, or experience outside of formal derivatives risk management, would suffice for purposes of the rule? Should the rule, instead, require that a fund’s derivatives risk manager simply have ‘‘relevant experience’’? Should the rule specify that the derivatives risk manager must have relevant experience as determined by the fund’s board, to allow a board to determine the experience that would be appropriate? Or should the rule identify specific qualifications, training, or experience of a fund’s derivatives risk manager? Why or why not? If so, what should they be and why? 13. Should the rule, as proposed, require a fund to segregate derivatives risk management functions from portfolio management? Why or why not? If we were not to require independence between a fund’s derivatives risk manager and the fund’s portfolio managers, how could we ensure that a fund’s portfolio management personnel, who may have conflicting incentives, do not unduly influence the fund’s program management? 14. Should we provide any additional clarification regarding the proposed reasonable segregation requirement? If so, what changes should we make? Should we add any specific requirements? For example, should we limit the extent to which fund risk management personnel can be compensated in part based on fund performance? 15. Is our understanding that many funds already segregate functions correct? If so, how and why do current approaches differ from the proposed PO 00000 Frm 00015 Fmt 4701 Sfmt 4702 4459 rule’s requirement to segregate functions? 16. Are there other ways to facilitate objective and independent risk assessment of portfolio strategies that we should consider? If so, what are they and how would these alternatives be more effective than the proposed rule’s requirement to reasonably segregate functions? 17. Rule 22e–4 under the Investment Company Act, similar to the proposed rule, requires certain funds to implement a risk management program. In particular, rule 22e–4 requires person(s) designated to administer a fund’s liquidity risk management program to be the fund’s investment adviser, officer, or officers (which may not be solely portfolio managers of the fund) (the ‘‘liquidity risk manager’’). Should we amend rule 22e–4 to more closely align the definition of ‘‘liquidity risk manager’’ with the proposed definition of ‘‘derivatives risk manager’’ by prohibiting a fund’s adviser from serving as a liquidity risk manager? Why or why not? Conversely, should we align the standard for derivatives risk manager with the liquidity risk manager standard under rule 22e–4? 18. Would the proposed derivatives risk manager requirement raise any particular challenges for funds with smaller advisers and, if so, what could we do to help mitigate these challenges? For example, should we modify the rule to permit funds to authorize the use of third parties not employed by the adviser to administer the program and, if so, under what conditions? Why or why not? Would allowing third parties to act as derivatives risk managers enhance the program by allowing specialized personnel to administer the program or detract from it by allowing for a derivatives risk manager who may not be as focused on the specific risks of the particular fund or as accountable to its board? Would the proposed requirement that a fund reasonably segregate derivatives risk management from portfolio management pose particular challenges for funds with smaller advisers? If so, how and why, and would additional guidance on this proposed requirement or changes to the proposed rule be useful? Conversely, would this proposed requirement (which does not prescribe how funds must segregate functions) provide appropriate flexibility for funds with smaller advisers? 19. Rule 38a–1(c) under the Investment Company Act prohibits officers, directors, and employees of the fund and its adviser from, among other things, coercing or unduly influencing a fund’s chief compliance officer in the E:\FR\FM\24JAP2.SGM 24JAP2 4460 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules performance of his or her duties. Should we include such a prohibition on unduly influencing a fund’s derivatives risk manager in the proposed rule? Why or why not? 20. Should we include any other program administration requirements? If so, what? For example, should we include a requirement for training staff responsible for day-to-day management of the program, or for portfolio managers, senior management, and any personnel whose functions may include engaging in, or managing the risk of, derivatives transactions? If we require such training, should that involve setting minimum qualifications for staff responsible for carrying out the requirements of the program? Why or why not? Should we require training and education with respect to any new derivatives instruments that a fund may trade? Why or why not? Should we require a new instrument review committee? 3. Required Elements of the Program lotter on DSKBCFDHB2PROD with PROPOSALS2 a. Risk Identification and Assessment The proposed program requirement would require a fund to identify and assess its derivatives risks in order to manage these risks.117 It would require that the fund’s identification and assessment take into account the fund’s other investments as well as its derivatives transactions. 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. For example, the risks associated with a currency forward would differ if a fund is using the forward to hedge the fund’s exposure to currency risk associated with a fund investment denominated in a foreign currency or, conversely, to take a speculative position on the relative price movements of two currencies. We believe that by assessing its derivatives use holistically, a fund will be better positioned to implement a derivatives risk management program that does not over- or understate the risks its derivatives use may pose. Accordingly, we believe that this approach would result in a more-tailored derivatives risk management program. The proposed rule would define the derivatives risks that must be identified and managed to include leverage, market, counterparty, liquidity, operational, and legal risks, as well as any other risks the derivatives risk 117 Proposed VerDate Sep<11>2014 rule 18f–4(c)(1)(i). 18:37 Jan 23, 2020 Jkt 250001 manager deems material.118 In the context of a fund’s derivatives transactions: • Leverage risk generally refers to the risk that derivatives transactions can magnify the fund’s gains and losses; 119 • Market risk generally refers to risk from potential adverse market movements in relation to the fund’s derivatives positions, or the risk that markets could experience a change in volatility that adversely impacts fund returns and the fund’s obligations and exposures; 120 • Counterparty risk generally refers to the risk that a counterparty on a derivatives transaction may not be willing or able to perform its obligations under the derivatives contract, and the related risks of having concentrated exposure to such a counterparty; 121 • Liquidity risk generally refers to risk involving the liquidity demands that derivatives can create to make payments of margin, collateral, or settlement payments to counterparties; • Operational risk generally refers to risk related to potential operational issues, including documentation issues, settlement issues, systems failures, inadequate controls, and human error; 122 and • Legal risk generally refers to insufficient documentation, insufficient capacity or authority of counterparty, or legality or enforceability of a contract.123 118 Proposed rule 18f–4(a). In the case of funds that are limited derivatives users under the proposed rule, the definition would include any other risks that the fund’s investment adviser (as opposed to the fund’s derivatives risk manager) deems material, because a fund that is a limited derivatives user would be exempt from the requirement to adopt a derivatives risk management program (and therefore also exempt from the requirement to have a derivatives risk manager). See infra section II.E. 119 See, e.g., Independent Directors Council, Board Oversight of Derivatives Task Force Report (July 2008), at 12 (‘‘2008 IDC Report’’). 120 Funds should consider market risk together with leverage risk because leveraged exposures can magnify such impacts. See, e.g., NAPF, Derivatives and Risk Management Made Simple (Dec. 2013), available at https://www.jpmorgan.com/cm/ BlobServer/is_napfms2013.pdf?blobkey=id &blobwhere=1320663533358 &blobheader=application/pdf&blob headername1=Cache-Control& blobheadervalue1=private&blobcol=urldata& blobtable=MungoBlobs. 121 See, e.g., Nils Beier, et al., Getting to Grips with Counterparty Risk, McKinsey Working Papers on Risk, Number 20 (June 2010). 122 See, e.g., 2008 IDC Report, supra note 119; RMA, Statement on best practices for managing risk in derivatives transactions (2004) (‘‘Statement on best practices for managing risk in derivatives transactions’’), available at https://www.rmahq.org/ securities-lending/best-practices. 123 See, e.g., Raimonda Martinkute ˙ -Kauliene˙, Risk Factors in Derivatives Markets, 2 Entrepreneurial Business and Economics Review 4 (2014); Capital, PO 00000 Frm 00016 Fmt 4701 Sfmt 4702 We believe these risks are common to most derivatives transactions.124 The proposed rule would not limit a fund’s identification and assessment of derivatives risks to only those specified in the rule. The proposed definition of the term ‘‘derivatives risks’’ includes any other risks a fund’s derivatives risk manager deems material.125 Some derivatives transactions could pose certain idiosyncratic risks. For example, Margin, and Segregation Requirements for SecurityBased Swap Dealers and Major Security-Based Swap Participants and Capital and Segregation Requirements for Broker-Dealers, Exchange Act Release No. 86175 (June 21, 2019), 84 FR 43872 (Aug. 22, 2019), n.1055 (‘‘Capital Margin Release’’) (‘‘Market participants face risks associated with the financial and legal ability of counterparties to perform under the terms of specific transactions’’); see also Office of the Comptroller of the Currency, Risk Management of Financial Derivatives, Comptroller’s Handbook (Jan. 1997) (narrative), (Feb. 1998) (procedures). Because derivatives contracts that are traded over the counter are not standardized, they bear a certain amount of legal risk in that poor draftsmanship, changes in laws, or other reasons may cause the contract to not be legally enforceable against the counterparty. See, e.g., Comprehensive Risk Management of OTC Derivatives, supra note 124. For example, some netting agreements or qualified financial contracts contain so-called ‘‘walkaway’’ clauses, such as provisions that, under certain circumstances, suspend, condition, or extinguish a party’s payment obligation under the contract. These provisions would not be enforceable where the Federal Deposit Insurance Act is applicable. See 12 U.S.C 1821(e)(8)(G). As another example, many derivatives contracts and prime brokerage agreements that hedge funds and other counterparties had entered into with Lehman Brothers included cross-netting that allowed for payments owed to and from different Lehman affiliates to be offset against each other, and crossliens that granted security interests to all Lehman affiliates (rather than only the specific Lehman entity entering into a particular transaction). In 2011, the U.S. Bankruptcy Court for the Southern District of New York held that cross-affiliate netting provisions in an ISDA swap agreement were unenforceable against a debtor in bankruptcy. In the Matter of Lehman Brothers Inc., Bankr. Case No. 08–01420 (JPM) (SIPA), 458 B.R. 134, 1135–137 (Bankr. S.D.N.Y. Oct. 4, 2011). 124 See Numerix, Comprehensive Risk Management of OTC Derivatives; A Tricky Endeavor (July 16, 2013), available at https:// www.numerix.com/comprehensive-riskmanagement-otc-derivatives-tricky-endeavor (‘‘Comprehensive Risk Management of OTC Derivatives’’); Statement on best practices for managing risk in derivatives transactions, supra note 122; 2008 IDC Report, supra note 119; Lawrence Metzger, Derivatives Danger: internal auditors can play a role in reigning in the complex risks associated with financial instruments, FSA Times (2011), available at https://www.theiia.org/ fsa/2011-features/derivatives-danger (‘‘FSA Times Derivatives Dangers’’). See also 17 CFR 240.15c3– 4(a) (‘‘An OTC derivatives dealer shall establish, document, and maintain a system of internal risk management controls to assist it in managing the risks associated with its business activities, including market, credit, leverage, liquidity, legal, and operational risks.’’). Nonbank security-based swap dealers and broker-dealers authorized to use internal models to compute net capital also are subject to rule 15c3–4. See Capital Margin Release, supra note 123. 125 See supra note 118. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules some derivatives transactions could pose a risk that a complex OTC derivative could fail to produce the expected result (e.g., because historical correlations change or unexpected merger events occur) or pose a political risk (e.g., events that affect currencies). Commenters to the 2015 proposal generally supported its requirement that a fund engage in a process of identifying and evaluating the potential risks posed by its derivatives transactions.126 We request comment on all aspects of the proposed requirement to identify and assess a fund’s derivatives risks, as well as the proposed definition of the term ‘‘derivatives risks.’’ 21. Is the proposed definition of ‘‘derivatives risks’’ sufficiently clear? Why or why not? 22. Are the categories of risks that we have identified in the proposed rule appropriate? Why or why not? Should we remove any of the identified risk categories? If so, what categories should be removed, and why? Should we add any other specified categories of risks that should be addressed? If so, what additional categories and why? Should we provide further guidance regarding the assessment of any of these risks? If so, what should the guidance be, and why? 23. Do commenters believe the proposed approach with respect to risk identification and assessment is appropriate? Why or why not? 24. Do funds currently assess the risks associated with their derivatives transactions by taking into account both their derivatives transactions and other investments? If so, how do they perform this assessment? Are there certain derivatives transactions whose risks do not involve an assessment of other investments in a fund’s portfolio? If so, which derivatives transactions, and why? 25. Should we require policies and procedures to include an assessment of particular risks based on an evaluation of certain identified risk categories as proposed? If not, why? lotter on DSKBCFDHB2PROD with PROPOSALS2 b. Risk Guidelines The proposed rule would require a fund’s program to provide for the establishment, maintenance, and enforcement of investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s derivatives risks (the ‘‘guidelines’’).127 The guidelines 126 See, e.g., ICI Comment Letter I; Comment Letter of the Consumer Federation of America (Mar. 28, 2016) (‘‘CFA Comment Letter’’). 127 Proposed rule 18f–4(c)(1)(ii). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 would be required to specify levels of the given criterion, metric, or threshold that a fund does not normally expect to exceed and the measures to be taken if they are exceeded. The proposed guidelines requirement is designed to address the derivatives risks that a fund would be required to monitor routinely as part of its program, and to help the fund identify when it should respond to changes in those risks. We understand that many funds today have established risk management guidelines, with varying degrees of specificity. The proposed rule would not impose specific risk limits for these guidelines. It would, however, require a fund to adopt guidelines that provide for quantitative thresholds that the fund determines to be appropriate and that are most pertinent to its investment portfolio, and that the fund reasonably determines are consistent with its risk disclosure.128 Requiring a fund to establish discrete metrics to monitor its derivatives risks would require the fund and its derivatives risk manager to measure changes in its risks regularly, and this in turn is designed to lead to more timely steps to manage these risks. Moreover, requiring a fund to identify its response when these metrics have been exceeded would provide the fund’s derivatives risk manager with a clear basis from which to determine whether to involve other persons, such as the fund’s portfolio management or board of directors, in addressing derivatives risks appropriately.129 Funds may use a variety of approaches in developing guidelines that comply with the proposed rule.130 This would draw on the risk identification element of the program and the scope and objectives of the fund’s use of derivatives. A fund could use quantitative metrics that it determines would allow it to monitor and manage its particular derivatives risks most appropriately. We understand that today funds use a variety of quantitative models or methodologies to measure the risks associated with the derivatives transactions. With respect to market risk, we understand that funds commonly use VaR, stress testing, or 128 See, e.g., Mutual Fund Directors Forum, Risk Principles for Fund Directors: Practical Guidance for Fund Directors on Effective Risk Management Oversight (Apr. 2010), available at https:// www.mfdf.org/images/Newsroom/Risk_Principles_ 6.pdf (‘‘MFDF Guidance’’). 129 See proposed rule 18f–4(c)(1)(v); see also infra section II.B.3.e. 130 See, e.g., Comprehensive Risk Management of OTC Derivatives, supra note 124; Statement on best practices for managing risk in derivatives transactions, supra note 122; 2008 IDC Report, supra note 119. PO 00000 Frm 00017 Fmt 4701 Sfmt 4702 4461 horizon analysis. Concentration risk metrics are also being used in connection with monitoring counterparty risk (e.g., requiring specific credit committee approval for transactions with a notional exposure in excess of a specified amount, aggregated with other outstanding positions with the same of affiliated counterparties). In addition, liquidity models have been designed to address liquidity risks over specified periods (e.g., models identifying margin outlay requirements over a specified period under specified volatility scenarios). In developing the guidelines, a fund generally should consider how to implement them in view of its investment portfolio and the fund’s disclosure to investors. For example, a fund may wish to consider establishing corresponding investment size controls or lists of approved transactions across the fund.131 A fund generally should consider whether to implement appropriate monitoring mechanisms designed to allow the fund to abide by the guidelines, including their quantitative metrics. While the 2015 proposal did not require funds to adopt risk guidelines, commenters on the 2015 proposal generally supported the concept of a requirement that a fund adopt and implement policies and procedures reasonably designed to manage the risks of its derivatives transactions, including by monitoring whether those risks continue to be consistent with any investment guidelines established by the fund or the fund’s investment adviser.132 We request comment on the proposed rule’s guidelines requirement. 26. Should we require, as proposed, a fund’s program to provide for the establishment, maintenance, and enforcement of investment, risk management, or related guidelines? Why or why not? Should we require, as proposed, that the guidelines provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s derivatives risks? Why or why not? If not, is there an alternative program element that would be more appropriate in promoting effective derivatives risk management? Should we prescribe particular tools or 131 A fund could also consider establishing an ‘‘approved list’’ of specific derivatives instruments or strategies that may be used, as well as a list of persons authorized to engage in the transactions on behalf of the fund. A fund may wish to provide new instruments (or instruments newly used by the fund) additional scrutiny. See, e.g., MFDF Guidance, supra note 128, at 8. 132 See, e.g., BlackRock Comment Letter; CRMC Comment Letter; ICI Comment Letter I. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4462 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules approaches that funds must use to manage specific risks related to their use of derivatives? For example, should we require funds to manage derivatives’ liquidity risks by maintaining highly liquid assets to cover potential future losses and other liquidity demands? 27. Should we require a specific number or range of numbers of guidelines that a fund should establish? For example, should we require a fund to establish a minimum of 2, 3, 4, or more different guidelines to cover a range of different risks? Why or why not? 28. Do funds currently adopt, and monitor compliance with, such guidelines? If so, do these guidelines provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the funds’ derivatives risks? If so, what criteria, metrics, or thresholds are provided for? Should we require that funds use specific risk management tools? If so, what tools should we require? 29. Should we specify a menu of guideline categories that all funds should use to promote consistency in risk management among funds? For example, should we identify certain commonly-used types of guidelines such as VaR, notional amounts, and duration, and require funds to choose among those commonly-used types? If we were to do so, which metrics should we allow funds to use? Would such a menu become stale as new risk measurement tools are developed? 30. Should we require, as proposed, that the guidelines specify set levels of a given criterion, metric, or threshold that the fund does not generally expect to exceed? Why or why not? If so, how would these levels be set or calculated? Should we instead set maximum levels for certain guidelines a fund would not exceed? 31. Should we require that a fund publicly disclose the guidelines it uses and the quantitative levels selected? If so, where (for example, in the fund’s prospectus, website, or on Form N– PORT or N–CEN)? Should we instead require that funds confidentially report to us the guidelines they use and the quantitative levels selected? If so, on what form should they report this information? 32. Should we require, as proposed, that the guidelines identify measures to be taken when the fund exceeds a criterion, metric, or threshold in the fund’s guidelines? Why or why not? 33. Should we require any form of public disclosure or confidential reporting to us if a fund were to exceed its risk guidelines? Would such reporting or disclosure result in funds VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 setting guidelines that are so restrictive or lax that they would be unlikely to be useful as a monitoring and risk management tool? 34. Should the rule require the guidelines to provide for other elements? If so, what elements and why? c. Stress Testing The proposed rule would require a fund’s program to provide for stress testing to evaluate potential losses to the fund’s portfolio.133 We understand that, as a derivatives risk management tool, stress testing is effective at measuring different drivers of derivatives risks, including non-linear derivatives risks that may be understated by metrics or analyses that do not focus on periods of stress. Stress testing is an important tool routinely used in other areas of the financial markets and in other regulatory regimes, and we understand that funds engaging in derivatives transactions have increasingly used stress testing as a risk management tool over the past decade.134 The Commission has also required certain types of funds to conduct stress tests or otherwise consider the effect of stressed market conditions on their portfolios.135 We believe that requiring a fund to stress test its portfolio would help the fund better manage its derivatives risks and facilitate board oversight. We also believe that stress testing would serve as an important complement to the proposed VaR-based limit on fund leverage risk, as well as any VaR testing under the fund’s risk guidelines.136 During periods of stress, returns, correlations, and volatilities tend to change dramatically over a very short period of time. Losses under stressed conditions—or ‘‘tail risks’’— would not be reflected in VaR analyses that are not calibrated to a period of 133 Proposed rule 18f–4(c)(1)(iii); see also infra section II.D.6.a (discussing an alternative to the proposed limit on fund leverage risk that would rely on a stress testing framework). The proposed rule would require a fund that is required to establish a derivatives risk mangement program to stress test its portfolio, that is, all of the fund’s investments, and not just the fund’s derivatives transactions. 134 See, e.g., Comment Letter of Investment Company Institute (Oct. 8, 2019) (‘‘ICI Comment Letter III’’) (stating that, based on a survey of member firms, many funds perform ex ante stress testing). 135 See rule 2a–7 under the Investment Company Act [17 CFR 270.2a–7]; see also rule 22e–4 under the Investment Company Act [17 CFR 270.22e–4] (requiring a fund subject to the rule to assess its liquidity risk by considering, for example, its investment strategy and portfolio investment liquidity under reasonably foreseeable stressed conditions). 136 See proposed rule 18f–4(c)(2); infra section II.D. PO 00000 Frm 00018 Fmt 4701 Sfmt 4702 market stress and that do not estimate losses that occur on the trading days with the highest losses.137 Requiring funds to stress test their portfolios would provide information regarding these ‘‘tail risks’’ that VaR and other analyses may miss. Under the proposed rule, the fund’s stress tests would be required to evaluate potential losses to the fund’s portfolio 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.138 The stress tests also would have to take into account correlations of market risk factors and resulting payments to derivatives counterparties.139 We believe that these requirements would promote stress tests that produce results that are valuable in appropriately managing derivatives risks by focusing the testing on extreme events that may provide actionable information to inform a fund’s derivatives risk management.140 We understand that funds commonly consider the following market risk factors: liquidity, volatility, yield curve shifts, sector movements, or changes in the price of the underlying reference security or asset.141 In addition, we believe it is important for a fund’s stress testing to take into account payments to counterparties, as losses can result when the fund’s portfolio securities decline in value at the same time that the fund is required to make additional payments under its derivatives contracts.142 To inform a fund’s derivatives risk management effectively, a fund should stress test its portfolio with a frequency that would best position the derivative risk manager to appropriately administer, and the board to appropriately oversee, a fund’s derivatives risk management, taking into account the frequency of change in the fund’s investments and market conditions. The proposed rule, therefore, would permit a fund to determine the frequency of stress tests, provided that the fund must conduct stress testing at least weekly. In establishing such frequency, a fund 137 The proposed rule would not require a fund to implement a stressed VaR test. See infra section II.D.1. 138 Proposed rule 18f–4(c)(1)(iii). 139 Id. 140 Krishan Mohan Nagpal, Designing Stress Scenarios for Portfolios, 19 Risk Management 323 (2017). 141 See, e.g., ICI Comment Letter I; Thomas Breuer, et al., How to Find Plausible, Severe, and Useful Stress Scenarios, International Journal of Central Banking 205 (Sept. 2009). 142 See OppenheimerFunds Settled Action, supra note 22. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 must take into account the fund’s strategy and investments and current market conditions. For example, a fund whose strategy involves a high portfolio turnover might determine to conduct stress testing more frequently than a fund with a more static portfolio. A fund similarly might conduct more frequent stress tests in response to increases in market stress. The minimum weekly stress testing frequency is designed to balance the potential benefits of relatively frequent stress testing with the burdens of administering stress testing.143 We also considered a less frequent requirement, such as monthly stress testing. A less frequent requirement, however, may fail to provide a fund’s derivatives risk manager adequate and timely insight into the fund’s derivatives risk, particularly where the fund has a high portfolio turnover. In determining this minimum frequency, we also took into account that this requirement would only apply to funds that do not qualify for the limited derivatives user exception because they use derivatives in more than a limited way. In addition, in view of the proposed rule’s internal reporting and periodic review requirements, the weekly stress testing minimum would provide a fund’s derivatives risk manager and board with multiple sets of stress testing results, which would allow them to observe trends and how the results may change over time.144 Although the 2015 proposal’s risk management program did not include a stress testing requirement, some commenters stated that stress testing would serve as an important component of derivatives risk management and recommended that the Commission require a fund’s designated risk manager to perform stress testing and report the results to the fund’s board.145 We request comment on the proposed rule’s stress testing requirement. 35. Should we require, as proposed, that funds conduct stress testing as part of the program requirement? Why or why not? How, if at all, would stress testing serve as a complement for other risk measurement tools, such as VaR? What does stress testing capture as part 143 We recognize that the costs associated with stress testing may increase with the frequency of conducting such tests. We understand, however, that once a fund initially implements a stress testing framework, subsequent stress tests could be automated and, as a result, be less costly. 144 See infra sections II.B.3.e and II.C. 145 See, e.g., Comment Letter of Blackstone Alternative Investment Advisors LLC (Mar. 28, 2016) (‘‘Blackstone Comment Letter’’); Comment Letter of Invesco Management Group, Inc. (Mar. 28, 2016) (‘‘Invesco Comment Letter’’); see also ICI Comment Letter III. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 of derivatives risk management that other tools do not, and why? 36. Should the rule require funds to conduct a particular type of stress testing? If so, what type, and what should the required elements be? For example, should the rule require funds to conduct scenario analysis? 37. Should the rule identify specific stress events to be applied? Should any required stress events vary based on the primary risks of particular funds? 38. Do funds currently conduct stress testing? If so, what types of stress testing, for what purposes, and how does the stress testing that funds currently conduct differ from the proposed rule’s requirement? 39. For funds that currently conduct stress testing, how frequently do they conduct it? Daily, weekly, or monthly? Why? Does it depend on the type of stress testing? On the investment objective or strategy of a fund? With what minimum frequency should the rule require stress testing be conducted? For example, instead of weekly tests should we require daily tests? Conversely should we allow longer periods of time between tests, such as monthly, or quarterly? Why? Should we require more frequent testing for funds with some investment objectives or strategies than other funds? If so, for which objectives or strategies should we require more frequent testing? 40. Is the proposed rule’s reference to ‘‘extreme but plausible market changes or changes in market risk factors’’ sufficiently clear? Should we identify more quantitative changes, such as the worst change in a specific risk factor seen in the last 10, 20, or 50 years? Is the proposed rule’s reference to ‘‘significant adverse effect’’ sufficiently clear? Should we instead identify quantitative levels of NAV change, such as a drop of 20, 30, or 50% of the fund’s NAV? 41. Should we require stress tests to include certain identified market risk factors such as changes in interest rates or spreads, market volatility, market liquidity, or other market factors? If so, which market risk factors should we identify, and why? If we were to identify certain market risk factors to be tested, should we require a fund to take action (such as reporting to its board or to the Commission, or reducing its derivatives usage) if a stress test were to show that one of these factors would result in the fund losing a certain percentage of its NAV? If so, what level of NAV, what types of risk factors, and what types of action should we consider? 42. Should we require, as proposed, that funds take into account their PO 00000 Frm 00019 Fmt 4701 Sfmt 4702 4463 strategy, investments, and current market conditions in considering the appropriate frequency for a fund’s stress tests? Why or why not? Should we require, as proposed, that funds to take into account correlations of market risk factors and payments to derivatives counterparties as part of the fund’s stress tests? Why or why not? Would any additional guidance help funds to better understand, and more consistently conduct, the stress tests that the proposed rule would require? 43. We discuss and request comment below on the proposed rule’s requirements to provide information to a fund’s board of directors, including the derivatives risk manager’s analysis of a fund’s stress testing. In addition to providing this information to the board, should we require funds to disclose stress test results to investors or report them confidentially to us? If so, what information should be disclosed or reported? d. Backtesting The proposed rule would require a fund to backtest the results of the VaR calculation model used by the fund in connection with the relative VaR or absolute VaR test, as applicable, as part of the program.146 This proposed requirement is designed to require a fund to monitor the effectiveness of its VaR model. It would assist a fund in confirming the appropriateness of its model and related assumptions and help identify when funds should consider model adjustments.147 We are proposing this requirement in light of the central role that VaR plays in the proposed VaR-based limit on leverage risk. This also is consistent with the comments we received on the 2015 proposal suggesting that we require backtesting, which we had not included in that proposal.148 Specifically, the proposed backtesting requirement provides that, each business day, the fund must compare its actual gain or loss for that business day with the VaR the fund had calculated for that day. For purposes of the backtesting requirement, the VaR would be estimated over a one-trading day time horizon. For example, on Monday at the 146 See proposed rule 18f–4(c)(1)(iv). commenters on the 2015 proposal suggested that the Commission require backtesting of a fund’s VaR calculation models. See, e.g., Blackstone Comment Letter; Comment Letter of Investment Company Institute (Sept. 27, 2016) (‘‘ICI Comment Letter II’’); Aviva Comment Letter; Comment Letter of the Global Association of Risk Professionals (Mar. 21, 2016) (‘‘GARP Comment Letter’’). 148 See, e.g., Blackstone Comment Letter; ICI Comment Letter II; Aviva Comment Letter; GARP Comment Letter. 147 Some E:\FR\FM\24JAP2.SGM 24JAP2 4464 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 end of the trading day, a fund would analyze whether the gain or loss it experienced that day exceeds the VaR calculated for that day. In this backtesting example, the fund could calculate the VaR for Monday on Friday evening (after Friday trading closes) or Monday morning (before Monday trading begins). The fund would have to identify as an exception any instance in which the fund experiences a loss exceeding the corresponding VaR calculation’s estimated loss. This approach is generally consistent with the practice of firms that use internal models to compute regulatory capital and other regulatory approaches.149 Because the proposed rule would require that the fund’s backtest be conducted using a 99% confidence level and over a one-day time horizon, and assuming 250 trading days in a year, a fund would be expected to experience a backtesting exception approximately 2.5 times a year, or 1% of the 250 trading days.150 If the fund were consistently to experience backtesting exceptions more (or less) frequently, this could suggest that the fund’s VaR model may not be effectively taking into account and incorporating all significant, identifiable market risk factors associated with a fund’s investments, as required by the proposed rule.151 The proposed rule would require funds to conduct a backtest each day so that a fund and its derivatives risk 149 See, e.g., rule 15c3–1e under the Exchange Act [17 CFR 240.15c3–1e] (Appendix E to 17 CFR 240.15c3–1) (‘‘On the last business day of each quarter, the broker or dealer must identify the number of backtesting exceptions of the VaR model, that is, the number of business days in the past 250 business days, or other period as may be appropriate for the first year of its use, for which the actual net trading loss, if any, exceeds the corresponding VaR measure.’’); CESR Global Guidelines, supra note 94 (‘‘The UCITS should carry out the back testing program at least on a monthly basis, subject to always performing retroactively the comparison for each business day,’’ i.e., ‘‘provid[ing] for each business day a comparison of the one-day value-at-risk measure generated by the UCITS model for the UCITS’ endof-day positions to the one-day change of the UCITS’ portfolio value by the end of the subsequent business day’’); see also infra note 152 (discussing frequency variations for backtesting requirements). 150 The proposed backtesting requirement would be based on a one-day time horizon. See infra section II.D.4 (discussing the proposed VaR model requirements that would be based on a twenty-day time horizon). 151 If 10 or more exceptions are generated in a year from backtesting that is conducted using a 99% confidence level and over a one-day time horizon, and assuming 250 trading days in a year, it is statistically likely that such exceptions are a result of a VaR model that is not accurately estimating VaR. See, e.g., Philippe Jorion, Value at Risk: The New Benchmark for Managing Financial Risk (3d ed. 2006), at 149–150 (‘‘Jorion’’). See also rule 15c3– 1e under the Exchange Act (requiring backtesting of VaR models and the use of a multiplication factor based on the number of backtesting exceptions). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 manager could more readily and efficiently adjust or calibrate its VaR calculation model and, therefore, could more effectively manage the risks associated with its derivatives use. We understand that some funds perform these calculations less frequently than daily.152 We are proposing a daily backtesting requirement because market risk factors and fund investments are dynamic, which might result in frequent changes to the accuracy and effectiveness of a VaR model and calculations using the model. Some commenters on the 2015 proposal supported a backtesting requirement with a daily frequency.153 We also believe that the additional costs associated with a daily backtesting requirement would be limited because a fund would be required to calculate its portfolio VaR each business day to satisfy the proposed limits on fund leverage discussed in section II.D of this release. We request comment on the proposed backtesting requirement. 44. Is the proposed requirement that a fund backtest its VaR model each business day appropriate? Why or why not? Would less-frequent backtesting be sufficient? Is backtesting an effective tool to promote derivatives risk management and VaR model accuracy? Why or why not? 45. Should the rule specify the number of exceedances, or the number of consecutive days without an exceedance, that would require VaR model calibration? Why or why not? 46. How often do funds that currently use VaR backtest their VaR models and why? Should the backtesting requirement be less frequent? For example, should we require a fund to perform backtests weekly, monthly, or quarterly, in each case considering the 152 See, e.g., CESR Global Guidelines, supra note 94 (‘‘The UCITS should carry out the back testing program at least on a monthly basis, subject to always performing retroactively the comparison for each business day,’’ i.e., ‘‘provid[ing] for each business day a comparison of the one-day value-atrisk measure generated by the UCITS model for the UCITS’ end-of-day positions to the one-day change of the UCITS’ portfolio value by the end of the subsequent business day’’); Blackstone Comment Letter (suggesting monthly backtests); Aviva Comment Letter (recommending reporting to the Commission on a semi-annual basis if a fund experienced a certain number of backtest exceptions). Cf. rule 15c3–1e under the Exchange Act [17 CFR 240.15c3–1e] (Appendix E to 17 CFR 240.15c3–1) (‘‘On the last business day of each quarter, the broker or dealer must identify the number of backtesting exceptions of the VaR model, that is, the number of business days in the past 250 business days, or other period as may be appropriate for the first year of its use, for which the actual net trading loss, if any, exceeds the corresponding VaR measure.’’). 153 See, e.g., GARP Comment Letter; Aviva Comment Letter; ICI Comment Letter II. PO 00000 Frm 00020 Fmt 4701 Sfmt 4702 one-day value change for each trading day in the period? Please explain. 47. For funds that currently backtest their VaR models, how often and for what reasons do funds recalibrate their VaR models? Are certain market risk factors or investment types particularly prone to requiring VaR model recalibrations (as well as backtesting)? e. Internal Reporting and Escalation The proposed rule would require communication between a fund’s risk management and portfolio management regarding the operation of the program.154 We believe these lines of communication are a key part of derivatives risk management.155 Providing 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. The proposed rule also would require communication between a fund’s derivatives risk manager and its board, as appropriate. We understand that funds today often have a dialogue between risk professionals and fund boards. Requiring a dialogue between a fund’s derivatives risk manager and the fund’s board would provide the fund’s board with key information to facilitate its oversight function. To provide flexibility for funds to communicate among these groups as they deem appropriate and taking into account funds’ own facts and circumstances, the proposed rule would require a fund’s program to identify the circumstances under which a fund must communicate with its portfolio management about the fund’s derivatives risk management, including its program’s operation.156 A fund’s program, in addition, could require that the fund’s derivatives risk manager inform the fund’s portfolio management, for example, by meeting with the fund’s portfolio management on a regular and frequent basis, or require that the fund’s portfolio management is notified of the fund’s exceedances or stress tests through software designed to provide automated updates. The proposed rule would also require a fund’s derivatives risk manager to communicate material risks to the fund’s portfolio management and, as appropriate, its board of directors.157 Specifically, the rule would require the 154 Proposed rule 18f–4(c)(1)(v). 2011 IDC Report, supra note 95. 156 Proposed rule 18f–4(c)(1)(v)(A). 157 Proposed rule 18f–4(c)(1)(v)(B). 155 See E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules derivatives risk manager to inform, in a timely manner, persons responsible for the fund’s portfolio management—and the fund’s board of directors, as appropriate—of material risks arising from the fund’s derivatives transactions.158 The proposed rule would not require a fund’s derivatives risk manager to escalate these risks to the fund’s board automatically, but would require that the derivatives risk manager directly inform the fund’s board of directors regarding these material risks if the manager determines board escalation to be appropriate. A fund’s derivatives risk manager, for example, could determine to inform the fund’s adviser’s senior officers of material derivatives risks after informing the fund’s portfolio management, and before informing the fund’s board. As another example, a fund’s derivatives risk manager could determine that it would be appropriate to communicate certain material derivatives risks (for example, those that put more than a certain percentage of the fund’s assets at imminent risk) to the board at the same time it informs the fund’s portfolio management. We believe that a fund’s derivatives risk manager is best positioned to determine when to appropriately inform the fund’s portfolio management and board of material risks. The proposed rule would require that these material risks include any material risks identified by the fund’s guideline exceedances or stress testing. For example, an unexpected risk may arise due to a sudden market event, such as a downgrade of a large investment bank that is a substantial derivatives counterparty to the fund. This requirement is designed to inform portfolio managers of material risks identified by a fund’s derivatives risk management function so that portfolio managers can take them into account in managing the fund’s portfolio and address or mitigate them as appropriate. It also would facilitate board oversight by empowering the derivatives risk manager to escalate a material risk directly to the fund’s board where appropriate. Requiring that a fund’s derivatives risk manager have this direct line of communication with the board regarding material risks arising from the fund’s derivatives transactions is designed to foster an open and effective dialogue among the derivatives risk manager and the board. We request comment on the internal reporting and escalation elements of the proposed program requirement. 158 Id. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 48. Are the proposed internal reporting and escalation requirements appropriate? Why or why not? Should the rule describe the circumstances under which a fund must inform its portfolio management regarding the operation of the program, including any exceedances of its guidelines and the results of its stress tests? Why or why not? If so, what should the circumstances be and why? Should the rule require a fund to report to others at the fund or its adviser (e.g., the fund’s chief compliance officer)? If so, who should a fund report to and why? 49. Should we prescribe the types of internal reporting information that persons responsible for a fund’s portfolio management or the fund’s board should receive, and the means by which these persons receive such information? Why or why not? If so, what should we prescribe and why? 50. Are the proposed requirements to escalate material risks to the fund’s portfolio management (and, as appropriate, the fund’s board of directors) appropriate? Why or why not? Should these material risks include risks identified by the fund’s guideline exceedances or stress testing? Why or why not? Should a fund’s derivatives risk manager be required to report all material derivatives risks to the fund’s board, as well as to its portfolio management? Why or why not? 51. Should the rule, as proposed, permit a fund to determine what risks arising from its derivatives transactions are material to the fund, for purposes of the proposed escalation requirement? Why or why not? If so, should the rule specifically require a fund’s derivatives risk manager to make this determination? 52. Should the rule require the means by which internal reporting and/or material risk escalation occur? For example, should the rule specify that certain communications must be in writing? Why or why not? 53. Should the rule require a fund’s derivatives risk manager to inform the fund’s portfolio management regarding the operation of the program on a regular basis? Why or why not? If so, what should the frequency be and why? 54. Should the rule require a fund to report material risks to us? Why or why not? If so, what should a fund report and how should it be reported? For example, should a fund be required to report material exceedances to its guidelines? Why or why not? Should such a report be confidential? 55. Should the rule permit a fund to determine whether the material risk warrants informing the fund’s board? Why or why not? If so, which person or PO 00000 Frm 00021 Fmt 4701 Sfmt 4702 4465 persons at the fund or its adviser should be responsible for that determination? Should a fund’s board always be informed of material risks regarding the fund’s derivatives use? Why or why not? If so, under what circumstances and frequency should the board be informed, and why? 56. Should we require that a fund’s derivatives risk manager be permitted to communicate directly with the fund’s board of directors? If not, how should we otherwise address the concern that a board may not receive the derivatives risk manager’s independent risk assessments if the derivatives risk manager is not empowered to communicate directly with the board? f. Periodic Review of the Program The proposed rule would require a fund’s derivatives risk manager to review the program at least annually to evaluate the program’s effectiveness and to reflect changes in the fund’s derivatives risks over time.159 The review would apply to the overall program, including each of the specific program elements discussed above. The periodic review would also cover the VaR model a fund uses to comply with the proposed VaR-based limit on fund leverage risk and related matters. As discussed below, the proposed rule would require a fund to comply with a relative or absolute VaR test.160 For the relative VaR test, the fund would compare its VaR to a ‘‘designated reference index,’’ as defined in the rule and selected by the fund’s derivatives risk manager. The proposed periodic review would therefore include the VaR calculation model that the fund used in connection with either of the proposed VaR tests (including the fund’s backtesting of the model) and any designated reference index that the derivatives risk manager selected, to evaluate whether the calculation model and designated reference index remain appropriate. We believe that the periodic review of a fund’s program and VaR calculation model is necessary to determine whether the fund is appropriately addressing its derivatives risks. A fund’s derivatives risk manager, as a result of the review, could determine whether the fund should update its program, its VaR calculation model, or any designated reference index. Commenters on the 2015 proposal generally supported a similar proposed requirement that a fund review and 159 Proposed 160 See rule 18f–4(c)(1)(vi). proposed rule 18f–4(c)(2); infra section II.D. E:\FR\FM\24JAP2.SGM 24JAP2 4466 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 update its derivatives risk management program at least annually.161 The proposed rule would not prescribe review procedures or incorporate specific developments that a derivatives risk manager must consider as part of its review. We believe a derivatives risk manager generally should implement periodic review procedures for evaluating regulatory, market-wide, and fund-specific developments affecting the fund’s program so that it is well positioned to evaluate the program’s effectiveness. We believe that a fund should review its program, VaR calculation model, and designated reference index on at least an annual basis, because derivatives and fund leverage risks, and the means by which funds evaluate such risks, can change. The proposed rule would require at least an annual review so that there would be a recurring dialogue between a fund’s derivatives risk manager and its board regarding the implementation of the program and its effectiveness. This frequency also mirrors the minimum period in which the fund’s derivatives risk manager would be required to provide a written report on the effectiveness of the program to the board.162 A fund’s derivatives risk manager could, however, determine that more frequent reviews are appropriate based on the fund’s particular derivatives risks, the fund’s policies and procedures implementing the program, market conditions, or other facts and circumstances.163 We request comment on the proposed rule’s periodic review requirement. 57. Should the rule, as proposed, specifically require that a fund’s derivatives risk manager periodically review the program’s effectiveness, including the program’s VaR calculation model and any designated reference index? Why or why not? 58. Should the rule, as proposed, require this review to take place at least annually, or should it require a more frequent review, such as quarterly? Should we, instead, not prescribe a minimum frequency for the periodic review? Why or why not? 59. Are there certain review procedures that the proposed rule should require and/or on which the 161 See, e.g., Vanguard Comment Letter. 162 See infra section II.C.2. 163 See also proposed rule 18f–4(c)(2)(iii)(A) (requiring, for a fund that is not in compliance with the applicable VaR test within three business days, the derivatives risk manager to report to the fund’s board of directors and explain how and by when (i.e., number of business days) the derivatives risk manager reasonably expects that the fund will come back into compliance). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 Commission should provide guidance? If so, what are they? For example, should the periodic review involve board input? Should the Commission provide any additional guidance on regulatory, market-wide, and fundspecific developments that a fund’s review procedures might cover? Why or why not? If so, how? 60. Should the rule, as proposed, specifically require that other program elements be periodically reviewed? Why or why not? If so, which elements and why, and should they be reviewed with the same frequency? should ask questions and seek relevant information regarding the adequacy of the program and the effectiveness of its implementation. The board should view oversight as an iterative process. Therefore, the board should inquire about material risks arising from the fund’s derivatives transactions and follow up regarding the steps the fund has taken to address such risks, including as those risks may change over time. To facilitate the board’s oversight, the proposed rule, as discussed below, would require the fund’s derivatives risk manager to provide reports to the board. C. Board Oversight and Reporting A fund’s board would also be responsible for overseeing a fund’s The proposed rule would require: (1) compliance with proposed rule 18f–4. A fund’s board of directors to approve the designation of the fund’s derivatives Rule 38a–1 under the Investment risk manager and (2) the derivatives risk Company Act requires a fund’s board, including a majority of its independent manager to provide regular written directors, to approve policies and reports to the board regarding the procedures reasonably designed to program’s implementation and prevent violation of the federal effectiveness, and describing any securities laws by the fund and its exceedances of the fund’s guidelines service providers.167 Rule 38a–1 and the results of the fund’s stress testing.164 Requiring a fund’s derivatives provides for oversight of compliance by the fund’s adviser and other service risk manager approved by the fund’s providers through which the fund board and with relevant experience as conducts its activities. Rule 38a–1 determined by the fund’s board to be would encompass a fund’s compliance responsible for the day-to-day obligations with respect to proposed administration of the fund’s program, rule 18f–4. subject to board oversight, is consistent with the way we believe many funds 1. Board Approval of the Derivatives currently manage derivatives risks.165 It Risk Manager is also consistent with a board’s duty to The proposed rule would require a oversee other aspects of the fund’s board to approve the designation management and operations of a fund. of the fund’s derivatives risk manager, The proposed rule’s requirements taking into account the derivatives risk regarding board oversight and reporting manager’s relevant experience regarding are designed to further facilitate the the management of derivatives risk.168 board’s oversight of the fund’s This requirement is designed to derivatives risk management.166 Board establish the foundation for an effective oversight should not be a passive relationship and line of communication activity. Consistent with that view, we between a fund’s board and its believe that directors should understand derivatives risk manager, and to ensure the program and the derivatives risks it that the board receives information it is designed to manage as well as needs to approve the designation.169 participate in determining who should The requirement that the board consider administer the program. They also the derivatives risk manager’s relevant experience is designed to provide 164 Proposed rule 18f–4(c)(5). The board could flexibility for a fund’s board to take into designate a committee of directors to receive the account a derivatives risk manager’s report. 165 See, e.g., Comment Letter of the Independent specific experience, rather than the rule Directors Council (June 22, 2016) (providing views taking a more prescriptive approach in regarding the appropriate oversight role of fund identifying a specific amount or type of directors). experience that a derivatives risk 166 Many commenters to the 2015 proposal expressed the view that the appropriate role of the board in the context of funds’ derivatives risk management is one of oversight. See, e.g., Comment Letter of Mutual Fund Directors Forum (Mar. 28, 2016) (stating it has long taken the position that boards and independent trustees have an important role to play in overseeing the risks associated with funds’ use of derivatives, including the manner in which those risks are managed); see also Comment Letter of the Independent Directors Council (Mar. 28, 2016) (‘‘IDC Comment Letter’’); Morningstar Comment Letter. PO 00000 Frm 00022 Fmt 4701 Sfmt 4702 167 See rule 38a–1 under the Investment Company Act; Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)] (discussing the adoption and implementation of policies and procedures required under rule 38–1) (‘‘Compliance Program Release’’). 168 Proposed rule 18f–4(c)(5)(i). 169 Cf. rules 22e–4 and 38a–1 under the Investment Company Act. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules manager must have. Detailing a derivatives risk manager’s required experience in the rule would not be practical, given the numerous ways in which a person could obtain experience with derivatives or risk management. Any specification in the rule of the specific experience required to serve as a derivatives risk manager likely would be over- or under-inclusive and would not take into account the way that any particular fund uses derivatives. We believe that a fund’s board, in its oversight role, is best-positioned to consider a prospective derivatives risk manager’s experience based on all the facts and circumstances relevant to the fund in considering whether to approve the derivatives risk manager’s designation. Commenters on the 2015 proposal generally supported a requirement that the board approve a fund’s derivatives risk manager, although some of these commenters objected to the proposed requirement that only a single individual could serve in that role. These commenters asserted that requiring the board to approve a single individual as the derivatives risk manager would have required the board to participate too closely in the management function of the fund.170 This re-proposal, in contrast, would permit a fund’s board to approve the designation of a single individual or group of individuals, subject to the other proposed requirements about who may serve as a derivatives risk manager. We request comment on the proposed requirement that a fund’s board approve the designation of the fund’s derivatives risk manager. 61. Should we require, as proposed, that a fund’s board approve the designation of the fund’s derivatives risk manager? Why or why not? Are there any specific requirements we should include with respect to the derivatives risk manager’s relationship with the board? For example, should we require the board to meet with the derivatives risk manager in executive session? Should we also require the derivatives risk manager to be removable only by the fund’s board? Should we require the derivatives risk manager’s compensation be approved by the board, like a fund’s chief compliance officer? If so, why? Would such a requirement pose undue burdens on fund boards or place the board in an inappropriate role? If so, why? 170 See, e.g., Comment Letter of Guggenheim (Mar. 28, 2016) (‘‘Guggenheim Comment Letter’’); Dechert Comment Letter; IDC Comment Letter; American Beacon Comment Letter; Fidelity Comment Letter; IAA Comment Letter; ICI Comment Letter I; Invesco Comment Letter. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 62. Should the rule permit a board committee to approve the designation of the derivatives risk manager, rather than the full board (and a majority of directors who are not interested persons of the fund) as proposed? Why or why not? If so, should there be any requirements or guidance with respect to such a board committee (e.g., composition or responsibilities)? 63. Should the rule, as proposed, require that a fund’s board in approving the fund’s derivatives risk manager, take into account the derivatives risk manager’s relevant experience regarding the management of derivatives risk? Why or why not? Would a fund’s board, in approving the designation of the fund’s derivatives risk manager, only approve individuals with relevant experience even without this express requirement? Is the proposed requirement that a fund’s board must take into account the derivatives risk manager’s ‘‘relevant experience regarding the management of derivatives risk’’ sufficiently clear? Would this raise questions for a fund’s board about whether portfolio management experience, or experience outside of formal derivatives risk management, would suffice for purposes of the rule? Should the rule, instead, require that a fund’s board take into account the derivatives risk manager’s ‘‘relevant experience’’? Or should the rule identify specific qualifications or experience of a fund’s derivatives risk manager that the fund’s board must consider? Why or why not? If so, what should they be and why? 64. Should we require a fund’s board, or a committee thereof, to approve the derivatives risk management program or any material changes to the program? Why or why not? If so, should we require that the committee have a majority that are disinterested? Would such an approval requirement promote greater board engagement and oversight? Do a fund’s derivatives use and related derivatives risks present matters for which it would be appropriate to require the fund’s board, or committee thereof, to approve the program or any material changes to the program? Why or why not? 2. Board Reporting The proposed rule would require the derivatives risk manager to provide a written report on the effectiveness of the program to the board at least annually and also to provide regular written reports at a frequency determined by the board. This requirement is designed to PO 00000 Frm 00023 Fmt 4701 Sfmt 4702 4467 facilitate the board’s oversight role, including its role under rule 38a–1.171 Many commenters to the 2015 proposal did not support the proposal’s requirement that the board approve material changes to the program. Many commenters did state, however, that a fund’s board of directors should be provided with notices of changes to the policies and procedures implementing the derivatives risk management program and that the fund’s derivatives risk manager should provide the board with a written report describing the adequacy of the derivatives risk management program and the effectiveness of its implementation and the results of the fund’s stress testing.172 Reporting on Program Implementation and Effectiveness The proposed rule would require a fund’s derivatives risk manager to provide to the fund’s board, on or before the implementation of the program and at least annually thereafter, a written report providing a representation that the program is reasonably designed to manage the fund’s derivatives risks and to incorporate the required elements of the program as well as the basis for the representation.173 This requirement, as discussed below, is designed to provide a fund’s 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. To facilitate the board’s oversight, the proposed rule would require the written report to include the basis for the derivatives risk manager’s representation along with such information as may be reasonably necessary to evaluate the adequacy of the fund’s program and the effectiveness of its implementation. In addition, the representation may be based on the derivatives risk manager’s reasonable belief after due inquiry. A derivatives risk manager, for example, could form its reasonable belief based on an assessment of the program and taking into account input from fund personnel, including the fund’s portfolio management, or from third parties. We propose to require that the derivatives risk manager include this representation and its basis, because we believe the derivatives risk manager—rather than the board—is best positioned to make this determination. Requiring the 171 See Compliance Program Release, supra note 166, at n.33 and accompanying text. 172 See, e.g., BlackRock Comment Letter; Vanguard Comment Letter. 173 Proposed rule 18f–4(c)(5)(ii). E:\FR\FM\24JAP2.SGM 24JAP2 4468 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 derivatives risk manager to include the information in a board report would also reinforce that the fund and its adviser are responsible for derivatives risk management while the board’s responsibility is to oversee this activity. Reports following the initial implementation of the program must also address the effectiveness of the program. This requirement is designed to provide the board with appropriate and useful information so it can exercise its judgment in overseeing the program, and in light of its role under rule 38a– 1. The proposed rule would also require the written report to include a fund’s derivatives risk manager’s basis for the selection of the designated reference index used under the proposed relative VaR test or, if applicable, an explanation of why the derivatives risk manager was unable to identify a designated reference index appropriate for the fund such that the fund relied on the proposed absolute VaR test instead. The derivatives risk manager’s selection of a particular designated reference index, or conclusion that one is not available, can affect the amount of leverage risk a fund may obtain under the proposed rule.174 We therefore believe it is important that a fund’s board have sufficient information to oversee this activity. Regular Board Reporting The proposed rule would require a fund’s derivatives risk manager to provide to the fund’s board, at a frequency determined by the board, a written report analyzing any exceedances of the fund’s risk guidelines and the results of the fund’s stress tests and backtesting.175 Requiring the derivatives risk manager to provide information about how the fund performed relative to these measures and at a board-determined frequency is designed to provide the board with timely information to facilitate its oversight of the fund and the operation of the program. The program’s guidelines and stress testing requirements are designed to address a fund’s particular derivatives risks and are areas the fund should routinely monitor. The program’s backtesting requirement is designed to require a fund to monitor the effectiveness of the fund’s VaR model, which plays a central role in the proposed VaR-based limit on 174 See infra section II.D.2.b. The proposed rule would not limit a derivatives risk manager from receiving input from the fund’s portfolio managers or others regarding the fund’s designated reference index. 175 Proposed rule 18f–4(c)(5)(iii); see also proposed rule 18f–4(c)(1)(ii)–(iv); see also supra sections II.B.3.b, II.B.3.c, and II.B.3.d. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 fund leverage risk. Therefore, we believe that a board overseeing a fund’s derivatives risk management should receive regular reporting regarding the derivatives risk manager’s analysis of guideline exceedances and the results of stress testing and backtesting. We also understand that many fund advisers today provide regular reports to fund boards, often in connection with quarterly board meetings, regarding a fund’s use of derivatives and their effects on a fund’s portfolio, among other information. Accordingly, the proposed rule would require that the report include the derivatives risk manager’s analysis of any exceedances and stress testing and backtesting results, and to include such information as may be reasonably necessary for the board to evaluate the fund’s response to any exceedances and the stress testing and backtesting results. This requirement is designed to provide the board with information in a format, and with appropriate context, that would facilitate the board’s understanding of the information. A simple listing of exceedances and stress testing and backtesting results without context, in contrast, would provide less useful information for a fund’s board and would not satisfy this proposed requirement. Under the proposed regular board reporting requirement, a fund’s board would determine the frequency of this written report. Boards should be allowed flexibility in determining the frequency of reporting so that they can tailor their oversight to their funds’ particular facts and circumstances. We request comment on the proposed board reporting requirements. 65. Are the proposed requirements for the fund’s derivatives risk manager to provide written reports to the fund’s board on the program’s implementation and effectiveness appropriate? Why or why not? Should the board receive a written report on or before the implementation of the program? Why or why not? Should we modify the proposed rule to require funds to provide boards reports with greater frequency than annually? Why or why not? 66. Is the proposed representation that the derivatives risk manager would have to make in the report appropriate? Why or why not? What should the representation entail, and why? Should we provide guidance as to what the representation should look like? Why or why not? Would the representation be helpful for a fund’s board in exercising its oversight responsibilities? Why or why not? What effect, if any, would the representation have on a fund’s PO 00000 Frm 00024 Fmt 4701 Sfmt 4702 derivatives risk management apart from the board’s oversight of such risk management? 67. Would the responsibilities the proposed rule allocates to a fund’s derivatives risk manager affect a fund’s ability to hire or retain a derivatives risk manager? If so, how? 68. Is the proposed requirement for the written report to include the basis for the derivatives risk manager’s representation along with information to evaluate the program’s adequacy and effectiveness, appropriate? Why or why not? Should the rule require specific information in the written report? Why or why not? If so, what information and why? Should the rule, as proposed, permit the representation to be based on the derivatives risk manager’s reasonable belief after due inquiry? Why or why not? Should we provide more guidance regarding the basis for the representation? If so, what should we provide? For example, should we provide guidance regarding the types of information on which a fund’s derivatives risk manager may base this representation? Why or why not? Is the reference to due inquiry appropriate in this context? Is the reference sufficiently clear? 69. Should the rule require the written report to include a fund’s derivatives risk manager’s basis for the selection of the designated reference index or, if applicable, an explanation of why the derivatives risk manager was unable to identify a designated reference index appropriate for the fund? Why or why not? Should the rule require the written report to identify and explain any difference between the selected index and any indices that are used for performance comparisons in the fund’s registration statement and shareholder reports? Why or why not? 70. Should the rule require a fund’s derivatives risk manager to provide a written report regarding any exceedances to thresholds provided for in the fund’s guidelines? Why or why not? Should the rule require a fund’s derivatives risk manager to provide a written report regarding the results of the stress tests and backtests? Why or why not? 71. Should the rule require that a fund’s derivatives risk manager report to the board? Why or why not? If not, should the fund determine who should report to the board, and why? Should the rule permit the derivatives risk manager to delegate its reporting obligations under the rule to other officers or employees of the adviser? Why or why not? If so, to whom should they be able to delegate these obligations? E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 72. Should the rule permit a fund’s board to determine the frequency with which it receives the written report? Why or why not? Or should the rule require that the derivatives risk manager provide the written report with a certain frequency? Why or why not? If so, what frequency should the rule require, and why? Should the rule permit a fund’s derivatives risk manager to determine to report to the board sooner than the frequency determined by the board if appropriate? Why or why not? 73. Should the rule require that the written report include such information as may be reasonably necessary for the board to evaluate a fund’s response to any exceedances and the results of the fund’s stress testing? Why or why not? What information may be reasonably necessary for the board’s evaluation? Should the rule require certain information to be provided in the written report? Why or why not? If so, what information should be required to be provided? 74. Should the rule require the report to be written? Why or why not? Should the rule require that the derivatives risk manager prepare the written report? Why or why not? 75. Would the approach provided by the proposed rule’s board oversight provisions appropriately provide the board the ability to oversee a fund’s derivatives risk management? Why or why not? Does the proposed rule provide an appropriate balance between the board’s role of general oversight and the fund’s roles of day-to-day risk management and portfolio management? Why or why not? 76. Should the board be required to approve the program, including initially, and any material changes to the program? Why or why not? What is current industry practice with respect to the board’s oversight of a fund’s derivatives risk management? lotter on DSKBCFDHB2PROD with PROPOSALS2 D. Proposed Limit on Fund Leverage Risk The proposed rule would also generally require funds relying on the rule when engaging in derivatives transactions to comply with a VaRbased limit on fund leverage risk. This outer limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a ‘‘designated reference index.’’ If the fund’s derivatives risk manager is unable to identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test.176 176 A fund that is a leveraged/inverse investment vehicle, as defined in the proposed sales practices rules, would not be required to comply with the VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 1. Use of VaR VaR is an estimate of an instrument or portfolio’s potential losses over a given time horizon and at a specified confidence level. VaR will not provide, and is not intended to provide, an estimate of an instrument or portfolio’s maximum loss amount. For example, if a fund’s VaR calculated at a 99% confidence level was $100, this means the fund’s VaR model estimates that, 99% of the time, the fund would not be expected to lose more than $100. However, 1% of the time, the fund would be expected to lose more than $100, and VaR does not estimate the extent of this loss. We propose to use VaR tests to limit fund leverage risk associated with derivatives because VaR generally enables risk to be measured in a reasonably comparable and consistent manner across diverse types of instruments that may be included in a fund’s portfolio. One benefit of the proposed VaR-based approach is that different funds could, and would be required to, tailor their VaR models to incorporate and reflect the risk characteristics of their fund’s particular investments.177 VaR is a commonlyknown and broadly-used industry metric that integrates the market risk associated with different instruments into a single number that provides an overall indication of market risk, including the market risk associated with the fund’s derivatives transactions.178 We recognize that funds use many other risk analytic metrics suited to particular financial instrument categories.179 Given the diverse proposed VaR-based limit on fund leverage risk. Broker-dealers and investment advisers would be required to approve retail investors’ accounts to purchase or sell shares in these funds. See infra section II.G (discussing leveraged/inverse investment vehicles). The proposed rule also would provide an exception from the proposed VaR tests for funds that use derivatives to a limited extent or only to hedge currency risks. See infra sections II.E and II.G (discussing the proposed rule’s provisions regarding limited derivatives users and leveraged/ inverse funds covered by the sales practices rules). 177 See infra section II.D.4 (discussing the choice of model and parameters for the VaR test). 178 See Kevin Dowd, An Introduction to Market Risk Measurement (Oct. 2002), at 10 (‘‘Dowd’’) (VaR ‘‘provides a common consistent measure of risk across different positions and risk factors. It enables us to measure the risk associated with a fixedincome position, say, in a way that is comparable to and consistent with a measure of the risk associated with equity positions’’); see also Jorion, supra note 151, at 159 (stating that VaR ‘‘explicitly accounts for leverage and portfolio diversification and provides a simple, single measure of risk based on current positions’’). 179 See Jorion, supra note 151. For example, risk measures for government bonds can include duration, convexity and term-structure models; for corporate bonds, ratings and default models; for stocks, volatility, correlations and beta; for options, PO 00000 Frm 00025 Fmt 4701 Sfmt 4702 4469 portfolios of many funds, these more category-specific risk metrics may be less suitable for establishing a proposed limit on fund leverage risk that is applied more generally. We recognize that VaR is not itself a leverage measure. But a VaR test, and especially one that compares a fund’s VaR to an unleveraged index that reflects the markets or asset classes in which the fund invests, can be used to analyze whether a fund is using derivatives transactions to leverage the fund’s portfolio, magnifying its potential for losses and significant payment obligations of fund assets to derivatives counterparties. At the same time, VaR tests can also be used to analyze whether a fund is using derivatives with effects other than leveraging the fund’s portfolio that may be less likely to raise the concerns underlying section 18. For example, fixed-income funds use a range of derivatives instruments, including credit default swaps, interest rate swaps, swaptions, futures, and currency forwards. These funds often use these derivatives in part to seek to mitigate the risks associated with a fund’s bond investments or to achieve particular risk targets, such as a specified duration. If a fund were using derivatives extensively, but had either a low VaR or a VaR that did not substantially exceed the VaR of an appropriate benchmark, this would indicate that the fund’s derivatives were not substantially leveraging the fund’s portfolio. We also understand that VaR calculation tools are widely available, and many advisers that enter into derivatives transactions already use risk management or portfolio management platforms that include VaR capability.180 Advisers to the funds that delta, gamma and vega; and for foreign exchange, target zones and spreads. Certain funds are required to report on Form N–PORT some of these metrics, such as portfolio-level duration (DV01 and SDV01) and position-level delta. See Investment Company Reporting Modernization, Investment Company Act Release No. 32314 (Oct. 13, 2016) [81 FR 81870 (Nov. 18, 2016)] (‘‘Investment Company Reporting Modernization Adopting Release’’). 180 See, e.g., ICI Comment Letter III (‘‘73 percent of respondents [to an Investment Company Institute survey of its member firms] use both some form of VaR and stress testing as derivatives risk management tools.)’’; Comment Letter of OppenheimerFunds (Mar. 28, 2016) (‘‘Oppenheimer Comment Letter’’); Federated Comment Letter; Franklin Resources Comment Letter; see also Christopher L. Culp, Merton H. Miller & Andres M. P. Neves, Value at Risk: Uses and Abuses, 10 Journal of Applied Corporate Finance 26 (Jan. 1998) (VaR is ‘‘used regularly by nonfinancial corporations, pension plans and mutual funds, clearing organizations, brokers and futures commission merchants, and insurers.’’). Moreover, the proposed relative VaR test is similar to a relative VaR approach that applies to UCITS under E:\FR\FM\24JAP2.SGM Continued 24JAP2 4470 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 use derivatives transactions more extensively may be particularly likely to already use risk management or portfolio management platforms that include VaR capability, as compared to advisers to the funds that are within the scope of the proposed provision for limited derivatives users and that would not be subject to the proposed VaR tests.181 While we believe there are significant benefits to using the proposed VaRbased limit on fund leverage risk, we recognize risk literature critiques of VaR (especially since the 2007–2009 financial crisis). One common critique of VaR is that it does not reflect the size of losses that may occur on the trading days during which the greatest losses occur—sometimes referred to as ‘‘tail risks.’’ 182 A related critique is that VaR calculations may underestimate the risk of loss under stressed market conditions.183 These critiques often arise in the context of discussing risk managers’ use of additional risk tools to address VaR’s shortcomings. Our proposed VaR tests are designed to provide a metric that can help assess the extent to which a fund’s derivatives transactions raise concerns underlying section 18, but we do not believe they should be the sole component of a derivatives risk management program.184 We do not intend to encourage risk managers to over-rely on VaR as a stand-alone risk management tool.185 Instead, as discussed above, the European guidelines. See infra section II.D.6.c (discussing the UCITS approach). 181 See, e.g., ICI Comment Letter III. 182 See Chris Downing, Ananth Madhavan, Alex Ulitsky & Ajit Singh, Portfolio Construction and Tail Risk, 42 The Journal of Portfolio Management 1, 85–102 (Fall 2015), available at https:// jpm.iijournals.com/content/42/1/85 (‘‘for especially fat-tailed return distributions the VaR threshold value might appear to be low, but the actual amount of value at risk is high because VaR does not measure the mass of distribution beyond the threshold value’’). With respect to VaR, the ‘‘tail’’ refers to the observations in a probability distribution curve that are outside the specified confidence level. ‘‘Tail risk’’ describes the concern that losses outside the confidence level may be extreme. 183 See Jorion, supra note 151, at 357 (VaR ‘‘quantif[ies] potential losses under ‘normal’ market conditions, where normal is defined by the confidence level, typically 99 percent. . . . In practice, [VaR] measures based on recent historical data can fail to identify extreme unusual situations that could cause severe losses.’’). 184 See supra section II.B.3. 185 See, e.g., James O’Brien & Pawel J. Szerszen, An Evaluation of Bank VaR Measures for Market Risk During and Before the Financial Crisis, Federal Reserve Board Staff Working Paper 2014–21 (Mar. 7, 2014), available at https:// www.federalreserve.gov/pubs/feds/2014/201421/ 201421pap.pdf (‘‘Criticism of banks’ VaR measures became vociferous during the financial crisis as the banks’ risk measures appeared to give little forewarning of the loss potential and the high VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 proposed rule would require a fund to establish risk guidelines and to stress test its portfolio as part of its risk management program in part because of concerns that VaR as a risk management tool may not adequately reflect tail risks.186 We also recognize that a fund’s use of derivatives transactions may pose other risks (such as counterparty risk and liquidity risk) that VaR does not capture. A fund that adopts a derivatives risk management program under the proposed rule would have to consider these risks as part of its derivatives risk management program.187 We also considered proposing tests based on stressed VaR, expected shortfall, or both. Stressed VaR refers to a VaR model that is calibrated to a period of market stress. A stressed VaR approach would address some of the VaR test critiques related to tail risk and underestimating expected losses during stressed conditions. Calibrating VaR to a period of market stress, however, can pose quantitative challenges by requiring funds to identify a stress period with a full set of risk factors for which historical data is available. Expected shortfall analysis is similar to VaR, but accounts for tail risk by taking the average of the potential losses beyond the specified confidence level. For example, if a fund’s VaR at a 99% confidence level is $100, the fund’s expected shortfall would be the average of the potential losses in the 1% ‘‘tail.’’ Because there are fewer observations in the tail, however, there is an inherent difficulty in estimating the expected value of larger losses. Expected shortfall analysis also could involve potentially greater sensitivity to extreme outlier losses because it is based on an average of a smaller number of observations that are in the tail. Taking these considerations into account, we are proposing tests based on VaR, which is commonly used and does not present all of the quantitative challenges associated with stressed VaR and expected shortfall, complemented by elements in the proposed risk management program designed to address VaR’s limitations. We request comment on the proposed definition of VaR, the proposed use of VaR as a means to limit funds’ leverage frequency and level of realized losses during the crisis period.’’); see also Pablo Triana, VaR: The Number That Killed Us, Futures Magazine (Dec. 1, 2010), available at https://www.futuresmag.com/ 2010/11/30/var-number-killed-us (stating that ‘‘in mid-2007, the VaR of the big Wall Street firms was relatively quite low, reflecting the fact that the immediate past had been dominated by uninterrupted good times and negligible volatility’’). 186 See supra section II.B.3.b. 187 See supra section II.B.3.a. PO 00000 Frm 00026 Fmt 4701 Sfmt 4702 risk, as well as alternative VaR-based methodologies (stressed VaR and expected shortfall). We also request comment and discuss alternatives to VaR and VaR-based methodologies in section II.D.6 below. 77. Is the proposed definition of the term ‘‘VaR’’ appropriate? Why or why not? If not, how should we define it? 78. Is a VaR-based test an appropriate way to limit funds’ leverage risk? Why or why not? Do commenters agree with our observations regarding VaR’s characteristics and its critiques? Do commenters believe that the proposed derivatives risk management program requirement would help to address VaR’s limitations? Please explain. 79. Should we change the rule to require stressed VaR, either as part of the program’s stress testing requirement or as part of the limit on fund leverage risk? If so, how should we implement a stressed VaR requirement? Should the rule provide, for example, that the historical data used to calculate VaR must include a period of market stress? What VaR model requirements should we include if the rule required stressed VaR? Please describe in detail. Are there any other corresponding changes we should make to the proposed VaR model requirements or proposed VaR tests if we used stressed VaR? Why or why not? 80. Should we change the rule to require expected shortfall or stressed expected shortfall, either as part of the program’s stress testing requirement or as part of the limit on fund leverage risk? If so, how should we implement this element? What VaR model requirements should we include if the rule required expected shortfall or stressed expected shortfall? Please describe in detail. Are there any other corresponding changes we should make to the proposed VaR model requirements or proposed VaR tests if we were to require expected shortfall or stressed expected shortfall? Why or why not? 81. Are there risk metrics or measurements other than VaR that similarly can be applied to a wide breadth of fund strategy types and investments and used to limit fund leverage risk? Please explain. 82. Should we use VaR as the only methodology to establish an outside limit on funds’ leverage risk in rule 18f– 4? We discuss below additional alternatives to VaR for this purpose. Should we include in rule 18f–4 some combination of the proposed VaR tests and the alternatives discussed in that section, and provide flexibility to funds to comply with the approach that they believe is most appropriate based on their strategies and investments? If so, E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 which approaches should we include in the rule and why? 2. Relative VaR Test The proposed relative VaR test would require a fund to calculate the VaR of the fund’s portfolio and compare it to the VaR of a ‘‘designated reference index.’’ As discussed in more detail below, a fund’s designated reference index must be unleveraged and reflect the markets or asset classes in which the fund invests, among other requirements. This index is designed to create a baseline VaR that approximates the VaR of a fund’s unleveraged portfolio. To the extent a fund entered into derivatives to leverage its portfolio, the relative VaR test is designed to identify this leveraging effect. If a fund is using derivatives and its VaR exceeds that of the designated reference index, this difference may be attributable to leverage risk. A fund would be required to comply with the relative VaR test unless a designated reference index is unavailable. We propose a relative VaR test as the default means of limiting fund leverage risk because it resembles the way that section 18 limits a fund’s leverage risk. Section 18 limits the extent to which a fund can potentially increase its market exposure through leveraging by issuing senior securities, but it does not directly limit a fund’s level of risk or volatility. For example, a fund that invests in less-volatile securities and leverages itself to the maximum extent may not be as volatile as a completely unleveraged fund that invests in more-volatile securities. The proposed relative VaR test likewise is 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. For example, if a derivatives transaction reduces (or does not substantially increase) a fund’s VaR relative to the VaR of the designated reference index, the transaction would not be restricted by the relative VaR test. In addition, allowing funds to rely on the proposed absolute VaR test may be inconsistent with investors’ expectations where a designated reference index is available. For example, a fund that invests in shortterm fixed income securities would have a relatively low level of volatility. The fund’s investors could reasonably expect that the fund might exhibit a degree of volatility that is broadly consistent with the volatility of the markets or asset classes in which the fund invests, as represented by the fund’s designated reference index. This VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 fund’s designated reference index would be composed of short-term fixed income securities, and could, for example, have a VaR of 4%. If the fund were permitted to rely on the absolute VaR test, however, the fund could substantially leverage its portfolio almost four times its designated reference index’s VaR to achieve a level of volatility that substantially exceeds the volatility associated with fixedincome securities. a. Designated Reference Index A fund would satisfy the proposed relative VaR test if the VaR of its entire portfolio does not exceed 150% of the VaR of its designated reference index.188 The proposed rule would define a ‘‘designated reference index’’ as an unleveraged index that is selected by the derivatives risk manager, and that reflects the markets or asset classes in which the fund invests.189 The proposed definition also would require that the designated reference index not be administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used.190 Additionally, the designated reference index must either be an ‘‘appropriate broad-based securities market index’’ or an ‘‘additional index’’ as defined in Item 27 of Form N–1A.191 A fund would have to disclose its designated reference index in the annual report, together with a presentation of the fund’s performance relative to the designated reference index.192 The requirement that the designated reference index reflect the markets or asset classes in which the fund invests is designed to provide an appropriate baseline for the relative VaR test. Because of this requirement, differences between the fund’s VaR and the VaR of the designated reference index are more likely to represent leverage than other 188 See proposed rule 18f–4(a) (defining the term ‘‘relative VaR test’’); proposed rule 18f–4(c)(2)(i); infra section II.D.2.b (discussing the 150% limit under the relative VaR test). 189 See proposed rule 18f–4(a) (defining the term ‘‘designated reference index’’). 190 Furthermore, for a blended index, none of the indexes that compose the blended index may be administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used. See id. 191 See proposed rule 18f–4(a) (defining the term ‘‘designated reference index’’); see also Instructions 5 and 6 to Item 27(b)(7)(ii) of Form N–1A (discussing the terms ‘‘appropriate broad-based securities market index’’ and ‘‘additional index’’). 192 See proposed rule 18f–4(c)(2)(iv). PO 00000 Frm 00027 Fmt 4701 Sfmt 4702 4471 factors, like differences between the securities in the fund’s portfolio and those in the index, as compared to a relative VaR test that compares the fund’s VaR to an index that does not reflect the markets or asset classes in which the fund invests.193 Take, for example, a fund that invests primarily in S&P 500 index options and uses that index as its designated reference index. Differences between the fund’s VaR and the VaR of the S&P 500 would be more likely attributable to the leverage risk associated with the options than, for example, if the fund were permitted to use an index that did not reflect the markets or assets classes in which the fund invests, such as an index of small capitalization stocks in this example. The derivatives risk manager could select a designated reference index that is a blended index under the proposed rule (assuming that the blended index meets the proposed requirements for a designated reference index), which would give some flexibility in identifying or constructing a designated reference index that provides an appropriate baseline for the relative VaR test.194 For example, the derivatives risk manager of a balanced fund may determine that a blended index of an unleveraged equity index and an unleveraged fixed income index would be an appropriate designated reference index. The requirement that the designated reference index be an unleveraged index also is designed to provide an appropriate baseline against which to measure a fund’s portfolio VaR for 193 To the extent a fund discloses in its annual report an ‘‘appropriate broad-based securities market index’’ that does not reflect the markets or asset classes in which the fund invests, such a fund may satisfy the performance disclosure requirements of Form N–1A, but it would not satisfy the proposed designated reference index requirement. For example, a fund that pursues its strategy primarily through commodity futures contracts could select the S&P 500 to satisfy its performance disclosure requirement under Form N– 1A, but such an index would not satisfy the proposed designated reference index requirement because a commodity fund would not invest in stocks included in the S&P 500 or large cap stocks generally. 194 If the derivatives risk manager selects a designated reference index that is a blended index, the designated reference index would have to be disclosed as an ‘‘additional index’’ (as opposed to an ‘‘appropriate broad-based securities market index’’) as defined in the instruction to Item 27 in Form N–1A. Form N–1A defines the term ‘‘appropriate broad-based securities market index’’ to mean an index ‘‘that is administered by an organization that is not an affiliated person of the [f]und, its investment adviser, or principal underwriter, unless the index is widely recognized and used.’’ See Instruction 5 to Item 27(b)(7)(ii) of Form N–1A. A blended index that is administered by the fund’s investment adviser, for example, would therefore not qualify as an ‘‘appropriate broad-based securities market index.’’ E:\FR\FM\24JAP2.SGM 24JAP2 4472 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 purposes of assessing the fund’s leverage risk. Conducting a VaR test on a designated reference index that itself is leveraged would distort the leveragelimiting purpose of the VaR comparison by inflating the volatility of the index that serves as the reference portfolio for the relative VaR test. For example, an equity fund might select as its designated reference index an index that tracks a basket of large-cap U.S. listed equity securities such as the S&P 500. But the fund could not select an index that is leveraged, such as an index that tracks 200% of the performance of the S&P 500. A relative VaR test based on this index would effectively permit additional leveraging inconsistent with the Investment Company Act.195 Our proposal would prohibit the designated reference index from being an index administered by an organization that is an affiliated person of the fund, its investment adviser, or its principal underwriter, or created at the request of the fund or its investment adviser. This proposed prohibition would not, however, extend to indexes that are ‘‘widely recognized and used.’’ 196 We believe that the indexes permissible under the proposed rule would be less likely to be designed with the intent of permitting a fund to incur additional leverage-related risk. The proposed rule would require that a fund publicly disclose to its investors in its annual reports the designated reference index. An open-end fund would have to disclose its designated reference index in the fund’s annual report as the fund’s ‘‘appropriate broadbased securities market index’’ or an ‘‘additional index’’ that Form N–1A describes in the context of the annual report performance presentation requirements.197 Form N–2, on the other 195 See supra section I.B.1. But see infra section II.G (discussing leveraged/inverse funds covered by the proposed sales practices rules). 196 See proposed rule 18f–4(a) (defining the term ‘‘designated reference index’’). This ‘‘widely recognized and used’’ standard has historically been used to permit a fund to employ affiliatedadministered indexes for disclosure purposes, when the use of such indexes otherwise would not be permitted. See supra note 193. 197 See proposed rule 18f–4(c)(2)(iv); Item 27(b)(7)(ii) of Form N–1A. See also Instructions to Items 4 and 27(b)(7)(ii) of Form N–1A. Form N–1A provides that ‘‘New Funds,’’ as defined in the form, are not required to disclose an appropriate broad-based securities market index and the fund’s performance in the annual report because of the fund’s limited operating history. See Instruction 6 to Item 3 of Form N–1A (defining a ‘‘New Fund’’ to mean a ‘‘Fund that does not include in Form N–1A financial statements reporting operating results or that includes financial statements for the Fund’s initial fiscal year reporting operating results for a period of 6 months or less’’). For the same reason, the proposed rule would provide that a fund would VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 hand, does not require closed-end funds to disclose a benchmark index for comparing a fund’s performance. Nevertheless, some closed-end funds choose to disclose a benchmark index in their annual reports to shareholders. Under the proposed rule, a closed-end fund seeking to satisfy the relative VaR test would have to disclose the fund’s designated reference index in its annual report together with a presentation of the fund’s performance.198 In proposing this approach, we considered the role of investor expectations in selecting funds that correspond to investors’ desired level of investment risk.199 We believe that investors could reasonably expect that their fund might exhibit a degree of volatility that is broadly consistent with the volatility of the markets or asset classes in which the fund invests, as represented by the fund’s designated reference index. Requiring a fund to select a designated reference index that it publicly discloses would promote the fund’s selection of an appropriate index that reflects the fund’s portfolio risks and its investor expectations. Some registered closed-end funds currently elect to provide a Management’s Discussion of Fund Performance (‘‘MDFP’’) in their annual reports.200 These registered closed-end funds could disclose their performance relative to the performance of the designated reference index in the fund’s MDFP. BDCs that are publicly traded must disclose, in their annual reports filed on Form 10–K, a line graph comparing the yearly percentage change in fund share price with the return of a broad equity market index.201 A publicly-traded BDC could choose to include its designated reference index in this line graph disclosure. We recognize the concern that funds could have the incentive to select an inappropriate designated reference index composed of more volatile securities to allow the fund to obtain more leverage risk under the relative not be required to disclose its designated reference index in the fund’s annual report if the fund is a ‘‘New Fund,’’ or would meet that definition if it were filing on Form N–1A, at the time the fund files its annual report. See proposed rule 18f–4(c)(2)(iv). 198 See proposed rule 18f–4(c)(2)(iv). 199 To the extent a fund’s use of derivatives transactions is part of its principal investment strategy or is a principal risk, it is required to be disclosed as such in the fund’s prospectus. See Item 4 of Form N–1A; Item 8 of Form N–2. 200 The Commission recently proposed to amend Form N–2 to require registered closed-end funds to include MDFP disclosure in their annual reports. See Securities Offering Reform for Closed-End Investment Companies, Investment Company Act Release No. 33427 (Mar. 20, 2019) [84 FR 14448 (Apr. 10, 2019)], at 14471–72 (‘‘Securities Offering Reform Proposing Release’’). 201 17 CFR 229.201(e)(1)(i). PO 00000 Frm 00028 Fmt 4701 Sfmt 4702 VaR test. The proposed rule includes three provisions designed to address this concern. In addition to requiring that the designated reference index reflect the markets or asset classes in which the fund invests, and that the index not be administered by certain affiliated persons or created at the request of the fund or its investment adviser, as described above, the proposed rule would require: (1) The derivatives risk manager to select the designated reference index and to periodically review it; (2) the fund to disclose the designated reference index, relative to its performance, in its annual report, creating the disincentive for a fund to present performance that may be significantly lower than, or not related to, the disclosed index; and (3) the board of directors to receive a written report providing the derivatives risk manager’s basis for selecting the designated reference index.202 These requirements, collectively, are designed to require funds to use designated reference indexes that provide an appropriate baseline for the relative VaR test and to prohibit funds from, instead, selecting indexes solely for the purpose of maximizing the fund’s permissible leverage risk under the proposed rule. We recognize that some (but not all) popular benchmark indexes charge funds a licensing fee for their inclusion in fund prospectuses and annual reports. Funds could incur licensing fees if their derivatives risk managers select a designated reference index whose provider charges such a fee and the fund is not already using the index. We are nevertheless proposing this disclosure requirement because the relative VaR test’s ability to limit a fund’s leverage risk is directly tied to the appropriateness of its designated reference index. This disclosure requirement is designed to address concerns about inappropriate indexes, as discussed above, by creating the disincentive for a fund to select an inappropriate index because the fund would have to disclose its performance against that index in its annual report and likely would not want to present performance that is significantly lower than, or not related to, the disclosed index.203 At the same time, the proposed rule provides funds flexibility to use any index that meets the proposed requirements. The proposed rule would provide this flexibility in light of the conditions discussed above 202 See proposed rule 18f–4(a), (c)(1)(vi), (c)(2)(iii), (c)(5)(ii)–(iii); see also supra sections II.B.3.f, II.C.2. 203 See supra note 201 and accompanying paragraph. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules designed to require that a fund use a designated reference index that is appropriate for the relative VaR test. The 2015 Proposing Release also included a risk-based portfolio limit based on VaR.204 The 2015 proposal provided that a fund would satisfy its risk-based portfolio limit condition if a fund’s full portfolio VaR was less than the fund’s ‘‘securities VaR’’ (i.e., the VaR of the fund’s portfolio of securities and other investments, but excluding any derivatives transactions).205 Our proposal, however, differs from the 2015 proposal in that the proposed relative VaR test compares the fund’s VaR to the VaR of the fund’s designated reference index, rather than the fund’s ‘‘securities VaR.’’ This is because some funds that use derivatives extensively hold primarily cash, cash equivalents, and derivatives. These funds’ ‘‘securities VaRs’’ would be based primarily on the fund’s cash and cash equivalents. As some commenters on the 2015 proposal noted, this would not provide an appropriate comparison for a relative VaR test because the VaR of the cash and cash equivalents would be very low and would not provide a reference level of risk associated with the fund’s strategy.206 We request comment on the proposed requirements regarding the selection and disclosure of a designated reference index for purposes of compliance with the proposed relative VaR test. 83. Is the proposed definition of the term ‘‘designated reference index’’ appropriate? Why or why not? Should the Commission provide additional guidance, or requirements in the proposed rule, addressing when an index reflects the markets or asset classes in which a fund invests? Are there particular types of indexes that would not be appropriate as a designated reference index? Why or why not? If so, what types of indexes and why would they be inappropriate for this purpose? 84. Should the rule require that the designated reference index be an unleveraged index? Should the rule specify with greater particularity what constitutes an unleveraged index? Please explain. Alternatively, should the Commission provide guidance on when an index will be ‘‘leveraged’’? 85. Are there other considerations that would present challenges for funds in 204 See 2015 Proposing Release, supra note 2, at section III.B.2. 205 Under that proposal, a fund that satisfied this VaR test was also required to limit its aggregate exposure—including derivatives exposure—to 300% of the fund’s net assets. See id. 206 See, e.g., AlphaSimplex Comment Letter; AQR Comment Letter; ICI Comment Letter I. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 light of the proposed requirement to select a designated reference index for purposes of the proposed relative VaR test requirement? If so, what? 86. To what extent do funds expect that the requirement to disclose the designated reference index would result in additional licensing fees? Please explain. What consequences would such charges create? 87. Should we change the proposed definition of the term ‘‘designated reference index’’ to no longer track in part the definition of an ‘‘appropriate broad-based securities market index’’ in Form N–1A (Instruction 5 of Item 27(b)(7)) and allow a derivatives risk manager to select an index administered by an affiliated person of the fund, its investment adviser, or principal underwriter? Should we change the proposed definition to allow a derivatives risk manager to select an index created at the request of the fund or its investment adviser? Is it appropriate to exclude such indexes from the definition of ‘‘designated reference index,’’ and is it appropriate that widely recognized and used indexes be carved out from this exclusion, as proposed? Would the proposed exclusion help ensure the selection of indexes that are appropriately designed to create a baseline VaR that approximates the VaR of a fund’s unleveraged portfolio? Please explain. Would allowing funds to use indexes that would fall within the proposed exclusion raise concerns that the indexes would not be appropriate, or—if the Commission were to permit the use of such indexes—would the rule’s other proposed conditions designed to address this concern work equally well for all indexes? If the Commission were to permit the use of indexes that would fall within the proposed exclusion, would any additional limits on the use of these indexes be appropriate? If so, what limits and why? 88. If we were to further limit or restrict the types of indexes that a fund could select as its designated reference index under the proposed rule, what additional limits would be appropriate? Should we, for example, provide that a fund’s designated reference index must meet the definition of an ‘‘appropriate broad-based securities market index’’ as defined in Form N–1A? Should we require that the index be widely recognized and used? 89. Similar to UCITS guidelines, should the proposed definition specifically require that the risk profile of the designated reference index be consistent with the fund’s investment PO 00000 Frm 00029 Fmt 4701 Sfmt 4702 4473 objectives and policies, as well as investment limits? 207 Why or why not? 90. Should the rule require funds to disclose their designated reference indexes in their annual reports to shareholders, as proposed? Should such disclosure also appear in the fund’s prospectus? What reasons, if any, should the designated reference index not be an index a fund includes as part of its performance disclosure? Please explain. Should a fund be required to specify that the index it includes in its performance disclosure is the fund’s designated reference index, which has been selected for purposes of the fund’s compliance with rule 18f–4? If so, what other information or explanations should a fund also have to include (if any), in order to best promote investor understanding of how the fund’s designated reference index affects the fund’s ability to use leverage, and how this in turn affects the risks associated with an investment in the fund? For example, should a fund also be required to disclose the index’s historical (e.g., 1year) average VaR? What accompanying narrative disclosure would help investors best understand the significance of this information? Would this disclosure be useful to supplement the VaR information that a fund would be required to disclose on Form N– PORT under the proposal? 91. Should the rule permit a fund to compare its portfolio VaR to its ‘‘securities VaR’’ for purposes of the rule’s relative VaR test, as provided for in the 2015 proposed rule, in addition to its designated reference index? 208 Why or why not? If the relative VaR test permitted a fund to compare its porfolio’s VaR against its designated reference index or its ‘‘securities VaR,’’ would funds prefer to use their ‘‘securities VaRs’’? If so, why? In what circumstances or what fund strategies would ‘‘securities VaR’’ be a more or equally appropriate baseline for funds calculating their relative VaR? What benefits or drawbacks are there with respect to this approach? Please explain. 92. For a registered closed-end fund, is the proposed requirement that it must disclose its designated reference index in its annual report together with a presentation of the fund’s performance appropriate? Why or why not? What challenges, if any, would the proposed disclosure requirement have for closedend funds that do not currently disclose their performance relative to a benchmark index in their annual reports? Please explain. 207 See infra section II.D.6.c (discussing the UCITS framework). 208 See supra note 204 and accompanying text. E:\FR\FM\24JAP2.SGM 24JAP2 4474 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 93. For a registered closed-end fund, should we prescribe in rule 18f–4 or Form N–2 where in the fund’s annual report it must disclose its designated reference index? Why or why not? 94. What challenges, if any, would a BDC have in disclosing its designated reference index together with its performance in the BDC’s annual report? Please explain. 95. Should we also amend Forms N– 1A and/or N–2 to require a fund relying on rule 18f–4 and subject to the relative VaR test to disclose its performance relative to the performance of its designated reference index? Would it be helpful to have this requirement both in rule 18f–4 and in the registration forms? 96. What changes should we make to the rule in light of the concern that a fund could have an incentive to select an inappropriate designated reference index to obtain more leverage risk? Is the proposed requirement that the derivatives risk manager select the designated reference index useful for this purpose? Is the proposed requirement that the designated reference index be an appropriate broadbased securities index or an additional index effective for this purpose? Is the proposed requirement that the fund disclose the designated reference index relative to its performance in the annual report useful for this purpose? Is the proposed requirement that the board of directors receive a written report from the derivatives risk manager about the basis for the designated reference index subject to periodic review useful for this purpose? Please explain. b. 150% Limit Under Proposed Relative VaR Test We are proposing that a fund’s VaR must not exceed 150% of the VaR of the fund’s designated reference index.209 In proposing a 150% limit, we first considered the extent to which a fund could borrow in compliance with the requirements of section 18. For example, a mutual fund with $100 in assets and no liabilities or senior securities outstanding could borrow an additional $50 from a bank. With the additional $50 in bank borrowings, the mutual fund could invest $150 in securities based on $100 of net assets. This fund’s VaR would be approximately 150% of the VaR of the fund’s designated reference index. The proposed 150% limit would therefore effectively limit a fund’s leverage risk related to derivatives transactions similar to the way that section 18 limits a registered open- or closed-end fund’s 209 See proposed rule 18f–4(a) (defining the term ‘‘relative VaR test’’). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 ability to borrow from a bank (or issue other senior securities representing indebtedness for registered closed-end funds) subject to section 18’s 300% asset coverage requirement. We recognize that while a fund could achieve certain levels of market exposure through borrowings permitted under section 18, it may be more efficient to obtain those exposures through derivatives transactions. Allowing a fund to have a VaR that is 150% of its designated reference index, rather than a higher or lower relative VaR, is designed to provide what we believe is an appropriate degree of flexibility for funds to use derivatives. We considered proposing different relative VaR tests for different types of investment companies, tied to the asset coverage requirements applicable to registered open-end funds, registered closed-end funds, and BDCs.210 Registered closed-end funds, like openend funds, are only permitted to issue senior securities representing indebtedness under section 18 subject to a 300% asset coverage requirement, although closed-end funds’ indebtedness is not limited to bank borrowings.211 Using the example above, a registered closed-end fund with $100 in assets likewise could only borrow $50. Although registered closedend funds also are permitted to issue senior securities that are stocks,212 proposed rule 18f–4 is focused on the indebtedness leverage that derivatives transactions create. We do not believe that a registered closed-end fund’s ability to issue preferred stock, for example, suggests that registered closedend funds should be permitted to obtain additional indebtedness leverage through derivatives transactions. The Investment Company Act also provides greater flexibility for BDCs to issue senior securities. BDCs, however, generally do not use derivatives or do so only to a limited extent. To help evaluate the extent to which BDCs use derivatives, our staff sampled 48 of the current 99 BDCs by reviewing their most recent financial statements filed with the Commission. The staff’s sample included both BDCs with shares listed on an exchange and BDCs whose shares are not listed. The sampled BDCs’ net assets ranged from $32 million to $7.4 billion. Of the 48 sampled, 54% did not report any derivatives holdings, and a further 29% reported using derivatives with gross notional amounts below 10% 210 See supra notes 29–32 and accompanying paragraph (discussing asset coverage requirements for different investment company types). 211 See supra note 30 and accompanying text. 212 See supra note 31 and accompanying text. PO 00000 Frm 00030 Fmt 4701 Sfmt 4702 of net assets. A few BDCs used derivatives more extensively, when measured on a gross notional basis, mainly due to interest rate swaps— which likely would have lower adjusted notional amounts if they were converted to ten-year bond equivalents, as the proposed rule would permit.213 Finally, two of the sampled BDCs used total return swaps to gain a substantial portion of their exposure. We therefore believe that most BDCs either would not use derivatives or would rely on the exception for limited derivatives users.214 In addition, the greater flexibility for BDCs to issue senior securities allows them to provide additional equity or debt financing to the ‘‘eligible portfolio companies’’ in which BDCs are required to invest at least 70% of their total assets. Derivatives transactions, in contrast, generally will not have similar capital formation benefits for portfolio companies unless the fund’s counterparty makes an investment in the underlying reference assets equal to the notional amount of the derivatives transaction. Allowing BDCs to leverage their portfolios with derivatives to a greater extent than other funds therefore would not appear to further the capital formation benefits that underlie BDCs’ ability to obtain additional leverage under the Investment Company Act. We also understand that, even when BDCs do use derivatives more extensively, derivatives generally do not play as significant of a role in implementing the BDC’s strategy, as compared to many other types of funds that use derivatives extensively. BDCs are required under the Investment Company Act to invest at least 70% of their total assets in ‘‘eligible portfolio companies,’’ which may limit the role that derivatives can play in a BDC’s portfolio relative to other kinds of funds that would generally execute their strategies primarily through derivatives transactions (e.g., a managed futures fund). For these reasons, and to provide a consistent framework regarding funds’ use of derivatives, we believe that it is appropriate to set a single limit on fund leverage risk under the proposed rule for derivatives transactions. The proposed rule would not restrict a fund from issuing senior securities subject to the limits in section 18 to the full extent 213 Our staff did not have access to sufficient information to adjust the notional amounts of the BDCs’ interest rate derivatives or options. Some of the 17% of the sampled BDCs with gross notional amounts exceeding 10% of net assets likely would have lower notional amounts after applying these adjustments. 214 See infra section II.E (discussing the proposed exception for limited derivatives users). E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 permitted by the Investment Company Act.215 We request comment on the following aspects of the proposed relative VaR test. 97. Is the proposed relative VaR test requirement appropriate? Why or why not? As proposed, should funds be required to comply with a relative VaR test, rather than an absolute VaR test, except where a designated reference index is unavailable? 98. Should the limit in the proposed relative VaR test be lower or higher than 150% of the VaR of the designated reference index, and if so why? For example, the relative VaR test applicable to UCITS funds allows a UCITS fund to have a relative VaR up to 200% of the VaR of the relevant index.216 Should rule 18f–4 similarly permit a fund to have a VaR up to 200% of the VaR of its designated reference index? If so, how should the rule incorporate investor protection provisions consistent with section 18? Conversely, should the relative VaR test be set at a lower level, such as 125% of the VaR of the designated reference index? If so, why? 99. Should the proposed relative VaR test incorporate different leverage limit levels according to fund type and corresponding to the asset coverage requirements under the Investment Company Act? Why or why not and how? 100. Are there any challenges in calculating the VaR of the designated reference index? If so, would certain types of funds particularly encounter these challenges, and if so which ones? How should we address any challenges? 101. Are there any fund-type specific challenges to open-end funds, registered closed-end funds, or BDCs complying with the VaR-based limit on fund leverage risk? For example, would registered closed-end funds or BDCs encounter any unique challenges in 215 For purposes of calculating asset coverage, as defined in section 18(h), BDCs have used derivatives transactions’ notional amounts, less any posted cash collateral, as the ‘‘amount of senior securities representing indebtedness’’ associated with the transactions. We believe this approach— and not the transactions’ market values—represents the ‘‘amount of senior securities representing indebtedness’’ for purposes of this calculation. Open-end funds cannot enter into derivatives transactions under section 18, absent relief from that section’s requirements, because section 18 limits open-end funds’ senior securities to bank borrowings. Section 18(c) also limits a registered closed-end fund’s ability to enter into derivatives transactions absent such relief. 216 See infra section II.D.6.c (discussing the UCITS framework); see also ICI Comment Letter III (suggesting that a Commission rule limiting the use of derivatives by registered investment companies allow funds to use either ex ante stress testing or UCITS VaR for that purpose). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 calculating VaR because of the nature of their investments? If so, what kinds of challenges and how should we address them? Please also explain specifically the nature of any challenges given that a number of financial institutions such as banks and UCITS funds calculate VaR for regulatory purposes, and these institutions’ portfolios hold a wide range of assets. 3. Absolute VaR Test We recognize that, for some funds, the derivatives risk manager may be unable to identify an appropriate designated reference index. For example, some multi-strategy funds manage their portfolios based on target volatilities but implement a variety of investment strategies, making it difficult to identify a single index (even a blended index) that would be appropriate. If a derivatives risk manager is unable to identify an appropriate designated reference index, a fund relying on the proposed rule would be required to comply with the absolute VaR test.217 To comply with the proposed absolute VaR test, the VaR of the fund’s portfolio must not exceed 15% of the value of the fund’s net assets. In proposing an absolute VaR test of 15% of a fund’s net assets, we considered the comparison of a fund complying with the absolute VaR test and a fund complying with the relative VaR test. A fund that uses the S&P 500 as its benchmark index, as many funds do, would be permitted to have a VaR equal to 150% of the VaR of the S&P 500 if the fund also used that index as its designated reference index. The Division of Economic and Risk Analysis (‘‘DERA’’) staff calculated the VaR of the S&P 500, using the parameters specified in this proposed rule over various time periods. DERA staff’s calculation of the S&P 500’s VaR since inception, for example, produced a mean VaR of approximately 10.4%, although the VaR of the S&P 500 varied over time.218 Setting the level of loss in the proposed 217 See supra note 173 and accompanying text (discussing the proposed requirement for the fund’s derivatives risk manager to provide written reports to the fund’s board of directors that must include, among other things, the derivatives risk manager’s basis for the selection of the designated reference index or, if applicable, an explanation of why the derivatives risk manager was unable to identify a designated reference index appropriate for the fund); infra notes 425–426 and accompanying text (discussing proposed recordkeeping requirements for such written reports provided to the fund’s board). 218 DERA staff calculated descriptive statistics for the VaR of the S&P 500 using Morningstar data from March 4, 1957 to June 28, 2019, based on daily VaR calculations, each using three years of prior return data and calculated using historical simulation at a 99% confidence level for a 20-day horizon using overlapping observations. PO 00000 Frm 00031 Fmt 4701 Sfmt 4702 4475 absolute VaR test at 15% of a fund’s net assets would therefore provide approximately comparable treatment for funds that rely on the absolute VaR test and funds that rely on the relative VaR test and use the S&P 500 as their designated reference index during periods where the S&P 500’s VaR is approximately equal to the historical mean. DERA staff analyzed the S&P 500 because funds often select broad-based large capitalization equities indexes such as the S&P 500 for performance comparison purposes, including funds that are not broad-based large capitalization equity funds.219 Many investors may therefore understand the risk inherent in these indexes as the level of risk inherent in the markets generally.220 An absolute VaR test set to approximate, or not substantially exceed, this level of risk would therefore often approximate the level of risk that investors may understand, and frequently choose to undertake, through investments in funds. We are proposing a single absolute VaR limit that would apply to open-end funds and registered closed-end funds and BDCs for the same reasons we are proposing that all funds relying on the relative VaR test must limit their VaR to 150% of the VaR of their designated reference index.221 The proposed absolute VaR test is also broadly consistent with the European Union regulatory framework that that applies to UCITS funds.222 Advisers that manage (or have affiliates that manage) UCITS funds may derive some efficiencies from reasonably comparable requirements across jurisdictions.223 Commenters to the 2015 proposal also generally supported an absolute VaR test.224 219 This is based on staff experience and analysis of data obtained from Morningstar. 220 Some commenters to the 2015 proposal also expressed the view that the S&P 500 Index is an appropriate risk-based reference point because it is widely used with a risk profile that is well understood and commonly acceptable to investors. See, e.g., AQR Comment Letter; Comment Letter of Millburn Ridgefield Corporation (Mar. 28, 2016). 221 See supra section II.D.2.b. 222 See CESR Global Guidelines, supra note 94, at 26. The absolute VaR test for UCITS funds is similar to the proposed absolute VaR test in rule 18f–4, although it sets a 20% limit for UCITS funds, rather than 15% as we propose in rule 18f–4. 223 See, e.g., ICI Comment Letter III (stating that, in response to the Investment Company Institute’s survey, ‘‘45 percent of respondents indicated that it would be only slightly burdensome to implement a UCITS VaR test that used the same parameters as prescribed for UCITS. An additional 34 percent reported that it would be moderately burdensome.’’). 224 See, e.g., ICI Comment Letter I; Franklin Resources Comment Letter; SIFMA Comment Letter; Comment Letter of T. Rowe Price Associates, E:\FR\FM\24JAP2.SGM Continued 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4476 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules We request comment on the proposed absolute VaR test requirement. 102. Is the proposed absolute VaR test requirement appropriate? Are we correct that in some cases a fund’s derivatives risk manager may be unable to identify an appropriate designated reference index? Why or why not? What are examples of funds that would likely use the absolute VaR test because a derivatives risk manager would be unable to identify an appropriate designated reference index? Is it appropriate for these funds to use an absolute VaR test? Why or why not? 103. Should we provide additional guidance on the circumstances under which a fund’s derivatives risk manager would be ‘‘unable’’ to identify an appropriate index? If so, what guidance should we provide? Should the rule include a different standard than the inability to identify a designated reference index for funds to be able to use the absolute VaR test instead of the relative VaR test? If so, what standard and why? For example, should we identify certain types of fund strategies that may not typically have appropriate reference indexes or for which absolute VaR would otherwise be appropriate? If so, which fund strategies, and how would we keep any list of fund strategies current over time? 104. Should the proposed absolute VaR test include a limit other than 15% of the fund’s net assets? Please explain. For example, should it be 12, 18, 20, or 25%? If so, which limit, and why? Would funds using the absolute VaR test manage their VaRs to a certain amount below the limit the Commission sets? If so, to what extent and should we take this into account in determining the appropriate limit under this test? Should we look to different market data in determining an appropriate level of absolute VaR? Which other sources, and why would they be appropriate? 105. For funds that use an absolute VaR test as part of their risk management practices, do risk managers set internal absolute VaR limits, and if so, at what level and why? For funds that currently use both absolute VaR and relative VaR, are the internal limits set at comparable levels? Why or why not? Please describe each internal level set with respect to these two VaR tests. Do certain fund types or strategies more commonly use either absolute VaR or relative VaR for risk management purposes? If so, why? 106. Should the rule include both a relative and absolute VaR test, as proposed, or should it include only a Inc. (Mar. 28, 2016) (‘‘T. Rowe Price Comment Letter’’). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 relative VaR test or an absolute VaR test? Why, and which test should the rule include? Should it use a different VaR-based test? If so, which one? 107. Should the rule permit funds to choose which VaR test to comply with regardless of the derivatives risk manager’s ability or inability to identify a designated reference index? If so, would this be consistent with investor expectations and section 18? 4. Choice of Model and Parameters for VaR Test The proposed rule would require that any VaR model a fund uses for purposes of the relative or absolute VaR test take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments.225 The proposed rule includes a non-exhaustive list of common market risk factors that a fund must account for in its VaR model, if applicable. These market risk factors are: (1) Equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk; (2) material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (3) the sensitivity of the market value of the fund’s investments to changes in volatility.226 VaR models are often categorized according to three modeling methods—historical simulation, Monte Carlo simulation, or parametric models.227 Each method has 225 See proposed rule 18f–4(a) (defining the term ‘‘value-at-risk’’ or ‘‘VaR’’). 226 See id. 227 Historical simulation models rely on past observed historical returns to estimate VaR. Historical VaR involves taking a fund’s current portfolio, subjecting it to changes in the relevant market risk factors observed over a prior historical period, and constructing a distribution of hypothetical profits and losses. The resulting VaR is then determined by looking at the largest (100 minus the confidence level) percent of losses in the resulting distribution. Monte Carlo simulation uses a random number generator to produce a large number (often tens of thousands) of hypothetical changes in market values that simulate changes in market factors. These outputs are then used to construct a distribution of hypothetical profits and losses on the fund’s current portfolio, from which the resulting VaR is ascertained by looking at the largest (100 minus the confidence level) percent of losses in the resulting distribution. Parametric methods for calculating VaR rely on estimates of key parameters (such as the mean returns, standard deviations of returns, and correlations among the returns of the instruments in a fund’s portfolio) to create a hypothetical statistical distribution of returns for a fund, and use statistical methods to calculate VaR at a given confidence level. See, e.g., Dowd, supra note 177; see also Thomas J. Linsmeier & Neil D. Pearson, Value at Risk, 56 Journal of Financial Analysts 2 (Mar.–Apr. 2000) (‘‘Linsmeier & Pearson’’). PO 00000 Frm 00032 Fmt 4701 Sfmt 4702 certain benefits and drawbacks, which may make a particular method more or less suitable, depending on a fund’s strategy, investments and other factors. In particular, some VaR methodologies may not adequately incorporate all of the material risks inherent in particular investments, or all material risks arising from the nonlinear price characteristics of certain derivatives.228 We believe it should be the responsibility of the derivatives risk manager to choose the appropriate VaR model for the fund’s portfolio, and the proposed requirement is designed to allow funds to use a VaR model that is appropriate for the fund’s investments. Commenters that addressed the same proposed requirement for VaR models in the 2015 proposal generally supported it.229 The proposed rule also requires that a fund’s VaR model use a 99% confidence level and a time horizon of 20 trading days.230 We understand that market participants currently using VaR most commonly use 95% or 99% confidence levels and often use time horizons of 10 or 20 days. The proposed confidence level and time horizon requirements also are similar to those in other VaR-based regulatory schemes.231 228 For example, some parametric methodologies may be more likely to yield misleading VaR estimates for assets or portfolios that exhibit nonlinear returns, due, for example, to the presence of options or instruments that have embedded optionality (such as callable or convertible bonds). See, e.g., Linsmeier & Pearson, supra note 226 (stating that historical and Monte Carlo simulation ‘‘work well regardless of the presence of options and option-like instruments in the portfolio. In contrast, the standard [parametric] delta-normal method works well for instruments and portfolios with little option content but not as well as the two simulation methods when options and option-like instruments are significant in the portfolio.’’). 229 See, e.g., Oppenheimer Comment Letter; CFA Comment Letter. 230 See proposed rule 18f–4(a) (defining the term ‘‘value-at-risk’’ or ‘‘VaR’’). We recognize that many market participants today also may calculate VaR over a one-day time horizon. See also supra section II.B.3.d (the proposed rule would require calculating a fund’s one-day VaR as part of the proposed backtesting requirement). A VaR calculation based on a one-day time horizon can be scaled to a 20-day time horizon. For example, a common VaR model timescaling technique is to multiply the one-day VaR by the square root of the designated time period (i.e., for the proposed rule it would be the square root of 20). But for funds with returns that are not identically and independently normally distributed, simple time-scaling techniques may be inaccurate. If this inaccuracy results in meaningful underestimation of VaR, this simple time-scaling technique would be inappropriate. 231 See, e.g., CESR Global Guidelines, supra note 94 (providing default VaR calculation standards that require funds that use the relative VaR or absolute VaR approach to calculate VaR using a ‘‘one-tailed confidence interval of 99%’’); rule 15c3–1e under the Exchange Act [17 CFR 240.15c3– 1e] (Appendix E to 17 CFR 240.15c3–1) (requiring VaR models to use ‘‘a 99 percent, one-tailed confidence level with price changes equivalent to E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 VaR models that use relatively high confidence levels and longer time horizons—as the proposed rule parameters reflect—result in a focus on more-‘‘extreme’’ but less-frequent losses. We propose relatively high confidence level and longer time horizon requirements so that the VaR model is designed to measure, and seek to limit the severity of, these less-frequent but larger losses. This is because a fund’s VaR model would be based on a distribution of returns, where a higher confidence level would go further into the tail of the distribution (i.e., more‘‘extreme’’ but less-frequent losses) and a longer time horizon would result in larger losses in the distribution (i.e., losses have the potential to be larger over twenty days when compared, for example, to over one day). In proposing a higher confidence level and longer time horizon, we considered whether this would result in a VaR model based on fewer data points in comparison to lower confidence levels and shorter time horizons. However, we understand that a longer trading day horizon only results in reduced data points if the fund uses historical simulation and measures historical losses using non-overlapping periods, which our proposal would not require. For example, a fund measuring nonoverlapping twenty-day periods, assuming 250 trading days in a year, would expect approximately 12 or 13 data points (250 trading days/20-day time horizons). But if the fund measured the twenty-day periods on a rolling and overlapping basis, it could expect as many as 250 data points where each data point captures the return over the trailing 20 trading days. A fund could use either a non-overlapping or overlapping approach under the proposed rule. The 2015 proposal similarly specified the particular confidence level and time horizon parameters that funds would use in their VaR models for purposes of the proposed risk-based portfolio limit. These parameters were a 99% confidence level and a time horizon range of not less than 10 and not more than 20 trading days.232 Comments were a ten business-day movement in rates and prices’’). See also the Basel Committee on Banking Supervision, Amendment To The Capital Accord To Incorporate Market Risks (Jan. 1996), available at https://www.bis.org/publ/bcbs24.pdf (contemplating banks’ use of internal models for measuring market risk based on a 10-day time horizon); CESR Global Guidelines, supra note 94 (specifying generally a 20-day time horizon as a quantitative requirement when calculating VaR for risk measurement and the calculation of global exposure and counterparty risk for UCITS). 232 2015 Proposing Release, supra note 2, at section III.B.2.b. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 mixed but generally supported a confidence level in the range of 95% to 99%.233 Rather than a time horizon range providing funds discretion to select the number of trading days for which to compute their VaR models, some commenters suggested that the rule should specify a particular number of days.234 Because our proposal, unlike the 2015 proposal, includes an absolute VaR test, our proposed VaR model parameters reflect commenter suggestions by proposing a confidence level within the generally supported range and proposing a specific VaR model time horizon rather than a range of permissible time horizons. In addition to specifying the confidence level and time horizon that a fund’s VaR model would use, we are also proposing that the fund’s chosen VaR model must be based on at least three years of historical market data. We understand that the availability of data is a key consideration when calculating VaR, and that the length of the data observation period may significantly influence the results of a VaR calculation. For example, a shorter observation period means that each observation will have a greater influence on the result of the VaR calculation (as compared to a longer observation period), such that periods of unusually high or low volatility could result in unusually high or low VaR estimates.235 Longer observation periods, however, can lead to data collection problems, if sufficient historical data is not available.236 We believe requiring a fund’s chosen VaR model to be based on at least three years of historical market data strikes an appropriate balance. The proposed historical market data requirement would permit a fund to base its VaR estimates on a meaningful number of observations, while also recognizing the concern that requiring a longer historical period could make it difficult for a fund to obtain sufficient historical data to estimate VaR for the 233 See, e.g., AQR Comment Letter; ICI Comment Letter II. 234 See, e.g., Morningstar Comment Letter; AIMA Comment Letter; AQR Comment Letter; ICI Comment Letter II. 235 See Linsmeier & Pearson, supra note 226 (stating that, because historical simulation relies directly on historical data, a danger is that the price and rate changes in the last 100 (or 500 or 1,000) days might not be typical. For example, if by chance the last 100 days were a period of low volatility in market rates and prices, the VAR computed through historical simulation would understate the risk in the portfolio). 236 See Dowd, supra note 177 (stating that ‘‘[a] long sample period can lead to data collection problems. This is a particular concern with new or emerging market instruments, where long runs of historical data don’t exist and are not necessarily easy to proxy’’). PO 00000 Frm 00033 Fmt 4701 Sfmt 4702 4477 instruments in its portfolio.237 The 2015 proposal would have required three years of market data for funds using historical simulation (but did not require three years of market data for VaR models based on Monte Carlo simulation or parametric methods).238 A number of commenters supported our approach in the 2015 proposal to require three years of market data for funds using historical simulation.239 However, some commenters suggested that the rule should require a longer period of historical market data.240 As discussed above, we believe that three years strikes an appropriate balance. We also are proposing to require funds to use three years of market data for all VaR calculations under the proposed rule—rather than only historical simulation as in the 2015 proposal. We believe this is appropriate because all methods for calculating VaR—not just historical simulation—rely on historical data. Unlike the 2015 proposal, the proposed rule does not require a fund to apply its VaR model consistently (i.e., the same VaR model applied in the same way) when calculating the VaR of its portfolio and the VaR of its designated reference index.241 The proposed rule would, however, require that VaR calculations comply with the same proposed VaR definition and its specified model requirements.242 Our proposal does not include the 2015 237 See Michael Minnich, Perspectives On Interest Rate Risk Management For Money Managers And Traders (Frank Fabozzi, ed.) (1998) (stating that for historical simulation, ‘‘[l]onger periods of data have a richer return distribution while shorter periods allow the VAR to react more quickly to changing market events’’ and that ‘‘[t]hree to five years of historical data are typical’’); see also Darryll Hendricks, Evaluation of Value-at-Risk Models Using Historical Data, FRBNY Economic Policy Review (Apr. 1996) (finding that, when using historical VaR, ‘‘[e]xtreme [confidence level] percentiles such as the 95th and particularly the 99th are very difficult to estimate accurately with small samples’’ and that the complete dependence of historical VaR models on historical observation data ‘‘to estimate these percentiles directly is one rationale for using long observation periods’’). 238 See 2015 Proposing Release, supra note 2, at section III.B.2.b; see also supra note 177 (discussing historical simulation, Monte Carlo simulation, and parametric methods). 239 See, e.g., Comment Letter of Abbey Capital (Mar. 28, 2016); AIMA Comment Letter; Comment Letter of Aspect Capital Limited (Mar. 28, 2016); Comment Letter of Intercontinental Exchange (Apr. 15, 2016). 240 See, e.g., materials attached to the memorandum included in the comment file concerning a meeting between representatives of AlphaSimplex Group LLC and members of the staff of the Division of Investment Management (July 8, 2016); AQR Comment Letter. 241 See 2015 Proposing Release, supra note 2, at section III.B.2.b. 242 See infra section II.D.4 (discussing the proposed VaR model requirements). E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4478 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules proposal’s model consistency requirement because if the proposed rule required funds to apply the same VaR model to its portfolio and the designated reference index, it could prevent funds from using less-costly approaches. For example, under the proposed approach, in many cases a fund could calculate the VaR of a designated reference index based on the index levels over time without having to obtain access to more-detailed information about the index constituents. A fund also would have the flexibility to obtain the VaR from a third-party vendor instead of analyzing it in-house. A model consistency requirement could preclude these approaches, however, because a fund might not be able apply the same approach to its portfolio. For example, if a fund invested significantly in options, it generally would not be appropriate to use certain parametric VaR models.243 The fund might instead use Monte Carlo simulation, which is more computationally intensive and takes more time to perform. A model consistency requirement would require the fund to apply the same Monte Carlo simulation model to its unleveraged designated reference index, for which a parametric or other simpler and less costly VaR model might be appropriate. Although requiring a fund to apply the same VaR model to its portfolio and the designated reference index could result in a more precise comparison of the two values, we do not believe that the additional precision is necessary for the relative VaR test to identify where funds’ use of derivatives is more likely to raise the concerns underlying section 18 because the proposed rule would provide certain common parameters for all VaR calculations under the rule. Because a fund’s designated reference index must be unleveraged, we believe it is generally unlikely that different VaR models calibrated to these common parameters would produce substantially different results for a fund’s designated reference index. Additionally, the derivatives risk manager would be responsible for administering and maintaining the derivatives risk management program, which includes the integrity of the VaR test. On balance, we believe the proposed approach would not materially diminish the efficacy of the proposed relative VaR test while permitting less-costly approaches for funds. 243 See supra note 227 (explaining that some parametric methodologies may be more likely to yield misleading VaR estimates for assets or portfolios that exhibit non-linear returns, due, for example, to the presence of options or instruments that have embedded optionality). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 We request comment on the proposed requirements regarding a fund’s choice of VaR model, and the required parameters for a VaR model that funds would use under the proposed rule. 108. Should the rule specify a particular VaR model(s) that funds must use (i.e., a historical simulation, Monte Carlo simulation, or parametric methodology)? If so, which methodology (or methodologies) and why? 109. Is the proposed requirement that a fund’s VaR model incorporate all significant, identifiable market risk factors associated with a fund’s investments appropriate? Why or why not? 110. The proposed rule would provide a non-exhaustive list of risk factors that may be relevant in light of a fund’s strategy and investments. Should the final rule include this nonexhaustive list of risk factors? Are risk factors included in the proposed list appropriate? Should we include any additional risk factors to this list? If so, which ones and why? 111. The proposed rule would require a fund to use a 99% confidence level for its VaR model. Is the proposed confidence level appropriate? Should the rule include a different confidence level? If so, which level and why, and if not, why not? 112. The proposed rule would require a fund to use a time horizon of 20 trading days for its VaR model. Is the proposed time horizon appropriate? Should the rule include a different time horizon? If so, which time horizon and why, and if not, why not? 113. The proposed rule would require a fund to use at least three years of historical market data for its VaR model. Is the historical market data requirement appropriate? Should the rule set forth a different length of time for requiring historical market data? Should the requirement be limited to funds using historical simulation? Would funds experience challenges in identifying sufficient data for particular types of investments? If so, which types of investments and how should the rule address these challenges? Please explain. 114. The proposed rule does not include any requirement for third-party validation of a fund’s chosen VaR model, either at inception or upon material changes, to confirm that the model is structurally sound and adequately captures all material risks.244 244 The Global Exposure Guidelines applicable to UCITS’ requires such validation. See CESR Global Guidelines, supra note 94. PO 00000 Frm 00034 Fmt 4701 Sfmt 4702 Should we require third-party validation? Why or why not? 115. Should the rule require a fund’s board to approve the VaR model and any material changes to the model? Why or why not? 116. Should the final rule also include a requirement that a fund that uses the relative VaR test apply the same VaR model when calculating the fund’s portfolio and the VaR of the designated reference portfolio? Would the requirement to apply the same VaR model to the fund’s portfolio and the designated reference portfolio address any concerns that funds could inappropriately manipulate the results of VaR testing under the proposed rule’s requirements? What additional cost, if any, would such a requirement impose on funds? Are there other ways that we could prevent such manipulations? To what extent would this requirement promote additional precision in the relative VaR test and would any additional precision increase the efficacy of the test in limiting fund leverage risk? Please explain. 5. Implementation a. Testing Frequency The proposed rule would require a fund to determine its compliance with the applicable VaR test at least once each business day.245 Although we believe that funds would calculate their VaRs at a consistent time each day, which would generally be either in the mornings before markets open or in the evenings after markets close, we do not propose to require one at the exclusion of the other, to allow funds to conduct their VaR tests at the time that is most efficient based on each fund’s facts and circumstances. We considered proposing that funds determine compliance with the proposed VaR test at the time of, or immediately after, entering into a derivatives transaction. We recognize, however, that conducting a VaR test on a trade-by-trade basis could present operational challenges for some funds and could limit the fund’s choice of VaR modeling. For example, we believe that most funds would be unable to perform computationallyintensive Monte Carlo simulations so frequently based on computing resources and compliance costs. Requiring this VaR calculation each day, in contrast, would provide funds flexibility to use VaR models they believe to be appropriate while also providing for fairly frequent calculations. The 2015 proposal included a testing frequency of 245 Proposed E:\FR\FM\24JAP2.SGM 24JAP2 rule 18f–4(c)(2)(ii). Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 immediately after entering into any senior securities transactions, but many commenters raised concerns about operational complexity related to transaction-by-transaction testing, and instead generally suggested a daily testing frequency.246 We believe that determining compliance with the VaR test less frequently than each business day would not be consistent with the purpose of a condition to limit fund leverage risk. Section 18 sets forth certain fund leverage risk protections that are fundamental to protecting investors. If this testing requirement were less frequent than each business day, then a fund could satisfy the condition only on business days requiring a VaR test and modify its trading strategy to circumvent the purpose of the test on other business days. Additionally, we believe that testing each business day is appropriate in light of the potential for market risk factors associated with a fund’s investments to change quickly. We request comment on the proposed frequency of conducting the relative or absolute VaR test. 117. Is the proposed required frequency for conducting the VaR test appropriate? Should the rule require a fund to conduct the required VaR test more frequently or less frequently, such as—respectively—either before or after each transaction, multiple times throughout the day, or on a weekly basis? Why or why not? Should the required frequency vary depending on fund type or whether the fund is conducting an absolute VaR test or relative VaR test? Please explain. 118. Should the rule require funds to conduct the test at the same time each day? If so, why? What compliance or operational challenges, if any, would funds have to conduct the test at the same time each day? Would the absence of such a requirement allow funds to ‘‘game’’ the test? b. Remediation If a fund determines that it is not in compliance with the applicable proposed VaR test, then under our proposal a fund must come back into compliance promptly and within no more than three business days after such determination.247 If the fund is not in compliance within three business days, then: (1) The derivatives risk manager must report to the fund’s board of directors and explain how and by when 246 See, e.g., ICI Comment Letter I; Franklin Resources Comment Letter; SIFMA Comment Letter; AIMA Comment Letter; BlackRock Comment Letter. 247 See proposed rule 18f–4(c)(2)(ii). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 (i.e., the number of business days) the derivatives risk manager reasonably expects that the fund will come back into compliance; (2) the derivatives risk manager must analyze the circumstances that caused the fund to be out of compliance for more than three business days and update any program elements as appropriate to address those circumstances; and (3) the fund may not enter into derivatives transactions (other than derivatives transactions that, individually or in the aggregate, are designed to reduce the fund’s VaR) until the fund has been back in compliance with the applicable VaR test for three consecutive business days and satisfied the board reporting requirement and program analysis and update requirements.248 The proposed three-business-day remediation provision is designed to provide funds with some flexibility in coming back into compliance with the applicable proposed VaR tests. It reflects our view that it would be inappropriate for a fund to purposefully exceed the VaR-based limit on fund leverage risk, but allows funds to take reasonable steps to come back into compliance without harming fund investors. The three-business-day period is designed to provide an appropriate time period to permit remediation efforts because it balances investor protections related to fund leverage risk and potential harm to a fund if it were required to sell assets or unwind transactions even more quickly. This remediation approach is similar to the remediation approach that section 18 of the Investment Company Act provides for asset coverage compliance with respect to bank borrowings, which also includes a threeday period to come back into compliance.249 If the fund does not come back into compliance within three business days, the proposed rule would not require the fund to exit its derivatives transactions or make other portfolio adjustments.250 Although a fund remaining out of compliance with the applicable VaR test raises investor protection concerns related to fund leverage risk, if the proposed rule were to force a fund to exit derivatives transactions 248 See proposed rule 18f–4(c)(2)(iii); see also infra section II.H.2 (discussing the proposed requirement to submit a confidential report to the Commission if the fund is out of compliance with the applicable proposed VaR test for three business days). 249 Section 18(f)(1) of the Investment Company Act. 250 Under the proposed rule, a fund that is not in compliance within three business days also would be required to file a report to the Commission on proposed Form N–RN. See proposed rule 18f– 4(c)(7); infra section II.H.2. PO 00000 Frm 00035 Fmt 4701 Sfmt 4702 4479 immediately at the end of the three-day period, this could harm investors, for example, by requiring the fund to realize trading losses that could have been avoided under a more-flexible approach. The proposed remediation provision reflects the balancing of these multiple investor protection concerns. Instead of requiring a fund to come back into compliance under these circumstances immediately, the fund must satisfy three requirements before it can enter into derivatives transactions other than those designed to reduce the fund’s VaR. First, the derivatives risk manager must report to the fund’s board of directors and explain how and by when (i.e., the number of business days) the derivatives risk manager reasonably expects that the fund will come back into compliance.251 This requirement is designed to facilitate the fund coming back into compliance promptly by requiring the derivatives risk manager to develop a specific course of action to come back into compliance and to facilitate the board’s oversight by requiring the derivatives risk manager to report this information to the board. Second, the derivatives risk manager must analyze the circumstances that caused the fund to be out of compliance for more than three business days and update any program elements as appropriate to address those circumstances.252 That the fund was unable to come back into compliance with the applicable VaR test within three business days may suggest there are deficiencies in the fund’s program. This requires the derivatives risk manager to analyze and update any program elements as appropriate before the fund is able to enter into derivatives transactions other than those designed to reduce VaR. Finally, a fund may not enter into derivatives transactions (other than those designed to reduce the fund’s VaR) until the fund has been back in compliance with the applicable VaR test for at least three consecutive business days and has satisfied the applicable board reporting and program analysis and update requirements.253 If the proposed rule were to permit a fund that is out of compliance with the limit on fund leverage risk to comply for just one day before entering into derivatives transactions that would increase the fund’s market risk, this could potentially lead to some funds having persistently high levels of leverage risk 251 Proposed rule 18f–4(c)(2)(iii)(A). rule 18f–4(c)(2)(iii)(B). 253 Proposed rule 18f–4(c)(2)(iii)(C). 252 Proposed E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4480 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules beyond that permitted by the applicable VaR test. We request comment on the proposed remediation requirement for a fund that is out of compliance with the applicable VaR test. 119. Is the proposed three-businessday remediation provision appropriate? Could such a limited remediation period exacerbate fund or market instability and harm investors? Should the rule require a longer or shorter period, such as one or seven days? Why or why not, and if so, what should the alternative remediation period be? In light of the balancing of investor protection concerns (fund compliance with the VaR-based limit on fund leverage risk and not forcing asset sales or unwinding transactions to comply), is there a more-effective means to structure a remediation provision that balances these concerns? If so, how? 120. Should we change the rule’s remediation provision to include an escalating provision that requires longer periods of compliance based on the number of three-day (or more) periods that a fund has been out of compliance? If so, how should we structure such a provision? 121. Should we change the rule to factor in the aggregate number of days in a trailing year that a fund has been out of compliance? What additional remediation consequences should a fund address before entering into derivatives transactions (other than those designed to reduce the fund’s VaR)? Please explain. 122. Should the remediation provision provide further or different limitations for a fund that continuously goes in and out of compliance with its VaR test? For example, should the rule provide that such a fund is not permitted to rely on the proposed rule indefinitely or for a set period of time? How should a rule define ‘‘continuously going in and out of compliance’’? Should such a fund be subject to a lower VaR requirement? If so, what level of VaR and why? How long should the fund remain subject to any lower VaR requirement? Should the fund be subject to limits on its derivatives exposure? 123. Should the remediation provision, as proposed, require the derivatives risk manager to report to the fund’s board of directors that the fund has been out of compliance with the VaR-based limit for more than three consecutive business days? Why or why not? Should the derivatives risk manager be required to explain how the fund will come back into compliance promptly and by when? Should we change the rule to require such a fund to take certain specific actions? Should VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 we change the rule to require fund compliance within a specific time period? If so, how should we change the rule and why? 124. Should the remediation provision, as proposed, require the derivatives risk manager to analyze the circumstances for the fund being out of compliance for more than three business days? Should we change the rule to require specific program updates? Should we change the rule to require a complete program review and update? What challenges would such a remediation requirement impose on funds? What are the benefits of specifying program updates? Under what circumstances, if any, would a fund be out of compliance for more than three business days and not have risk management program elements to update? Please explain. 6. Other Regulatory Approaches To Limiting Fund Leverage Risk a. Stress Testing In addition to our proposal to require stress testing as a derivatives risk management program element, we considered a stress testing requirement as a means to limit fund leverage risk in lieu of, or in addition to, the proposed VaR tests. We understand that many funds that use derivatives transactions already conduct stress tests for purposes of risk management.254 For example, we considered proposing a single-factor stress test requirement that would enumerate a limited number of shocks, corresponding to different asset classes in which funds commonly invest, and specify the required shock levels for each asset class. Similar to Form PF, the rule could categorize stress testing shocks based on market factors such as equity prices, risk-free interest rates, credit spreads, currency rates, commodity prices, option implied volatilities, default rates for assetbacked securities, and default rates for corporate bonds and credit-default swaps.255 The rule could also include an ‘‘other,’’ general category for which the corresponding shock level would be a specific or otherwise determinable factor based on extreme but plausible market conditions determined by the derivatives risk manager. A fund would 254 See, e.g., ICI Comment Letter III. While we do not propose to require stress testing as a means for limiting a fund’s leverage risk, as discussed above, one element of the proposed program requires stress testing for risk management purposes. See supra section II.B.3.c. 255 Question 42 on Form PF requires some private fund advisers to report the impact on the fund’s portfolio from specified changes to the identified market factors. PO 00000 Frm 00036 Fmt 4701 Sfmt 4702 ‘‘fail’’ this stress test if one of the prescribed shocks would cause the fund to experience a level of loss that we would specify. We could, for example, specify the shock levels for each market factor based on a certain number of standard deviations from the mean of historical distributions of returns for that factor, such as three or four standard deviations, as a means of establishing standardized shock levels.256 We could then specify that a fund fails the stress test if any such shock leads to a loss of a certain percentage of the fund’s net assets over a single trading day or series of trading days, such as 20% over one trading day. We could determine these metrics based on how funds that do not engage in derivatives, but that have borrowed up to and in compliance with the requirements of section 18, would perform against the stress test. For example, the stress test outer limit could be based on a fund that is not using derivatives but has invested $150 in securities based on $100 of net assets and $50 in bank borrowings. To be consistent with section 18, a fund that uses derivatives and conducts a stress test resulting in losses greater than the stress test losses of this hypothetical bank-borrowing-leveraged fund would fail the single-factor stress test. This approach would have the benefit of setting forth a comparatively simpleto-conduct test that a broad variety of funds could apply. The challenges of a single-factor stress testing requirement, however, include identifying an appropriate universe of market risk factors for the broad universe of derivatives in which funds invest and strategies they follow, setting the appropriate level of each shock for each factor, and determining the level of losses that would result in a fund ‘‘failing’’ the test. Making these determinations would be particularly challenging in a rule that would apply to all funds. Any prescribed shocks and related values could become stale over time and necessarily would not include all of the relevant risk factors for each fund. As funds continue to innovate, there could be funds for which no prescribed shock would be relevant. An approach that looks at a fund’s losses in response to changes in a single market risk factor also may not effectively take into account correlations among market risk factors under stressed market conditions. Stress testing is useful as a risk management tool because it 256 If normally distributed, shock levels based on historical returns of a market factor that is three standard deviations from the mean of that market factor would correspond to approximately a 99.7% confidence level. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules provides a framework for advisers to consider a range of potential scenarios tailored to each fund and refined over time. Its benefits as a limit of fund leverage risk may not be fully realized, however, by single-factor stress testing that includes static values that a rule specifies.257 We also considered requiring a multifactor stress test based on scenario analysis. Rather than a fund applying a single-factor shock to each relevant asset class, this approach would require funds to create a stress test model that takes into account multiple asset classes simultaneously, which a fund would have to identify to tailor the stress test to its fund. The fund would then run numerous scenarios against the model, shocking the multiple asset classes identified, based on a high number of iterations and permutations akin to a Monte Carlo simulation. A multi-factor stress test would result in a matrix or range of estimated potential losses during stressed market conditions because each scenario permutation would create one estimated potential loss calculation. The benefits of multifactor stress testing include tailoring the stress test to the investment and risk characteristics of a fund’s portfolio, which may result in more meaningful derivatives risk management. But in considering a multi-factor stress testing requirement, we would have to consider whether such a framework, if highly particularized, would permit enough long-term flexibility as an applicable regulatory limit on fund leverage risk. For example, the multi-factor stress test could identify specific correlations and assumptions that funds should reflect in their stress tests based on their strategies and investments, or identify specific historical market events to run as scenarios against their stress test model. In addition, if we were to propose a principles-based multi-factor stress testing requirement that would rely on funds to tailor their stress tests, it would present regulatory challenges in determining whether funds were adhering to a limit on fund leverage risk consistent with section 18. Finally, our proposed VaR-based limit on fund leverage risk, as opposed to stress testing, may better align with section 18’s investor protection goals concerning the level of risk in a registered fund. This is because the 257 We recognize that these concerns do not apply to all uses of single-factor stress testing. For example, money market fund stress testing does not raise similar concerns in part because of money market funds’ common strategies and limited universe of investment holdings. See rule 2a–7(g)(8) under the Investment Company Act (requiring periodic stress testing). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 limitations in section 18 apply under both normal and stressed market conditions.258 For these reasons, as well as the regulatory design challenges of specifying the universe of asset class shocks and setting their corresponding levels, we are proposing a VaR-based limit on fund leverage risk instead of a stress testing approach to limiting fund leverage risk. We request comment on stress testing as a means to limit funds’ leverage risk. 125. In addition to our proposed stress testing requirement as part of the derivatives risk management program, should the rule require stress testing as a means to limit fund leverage risk in lieu of or in addition to the VaR-based limit on fund leverage risk? Why or why not? Is a stress test an effective means to limit a fund’s leverage risk? Please explain. If we were to include a stress testing requirement in addition to a VaR-based limit on fund leverage risk, should we require a fund to comply with both requirements, or should we allow a fund to choose one or the other? If we were to allow funds to comply with either approach, would that result in inconsistent limits across funds and would that be appropriate if so? 126. To measure and/or limit fund leverage risk, do funds currently use VaR tests, stress tests or both? If a fund uses VaR tests but not stress tests (or vice versa), did the fund consider using the other approach as a means to measure and limit its leverage risk? Why or why not? 127. If funds use both VaR tests and stress tests to measure and/or limit fund leverage risk, why do they use both tests? Are there certain fund types or strategies that are better suited for VaR or for stress testing? If so, which ones and why? 128. Should the limit of fund leverage risk focus on normal market conditions, stressed market conditions, or both? Please explain. 129. Should the rule require a singlefactor stress test as an alternative to the proposed VaR-based limit on fund leverage risk? If so, what single-factor shocks should the test require? What would the corresponding shock levels be for each factor? Are the example single-factor shocks discussed above appropriate? Please explain. How frequently and on what basis, if at all, do commenters anticipate that the Commission would need to amend a rule that incorporated the enumerated shocks and their corresponding levels? 130. What number of standard deviations from the mean of historical distributions of returns should the 258 See PO 00000 supra section I.B.1. Frm 00037 Fmt 4701 Sfmt 4702 4481 single-factor shock levels for each market risk factor be? Would three standard deviations or four standard deviations be appropriate? How should the rule define a failed stress test? Would a loss expressed as a percentage of the fund’s net assets over a single trading day or series of trading days be appropriate? What percentage and over what period would be appropriate? Would 20% over one trading day be appropriate? How frequently, if at all, do commenters anticipate that the Commission would need to amend the rule to revise the specified loss level? 131. Should the rule require a multifactor stress test as an alternative to the proposed VaR-based limit on fund leverage risk? If so, how might the rule include a multi-factor stress testing requirement that permits adequate flexibility and tailoring but could also promote comparability and regulatory consistency in setting a leverage risk limit? 132. Should the single-factor or multifactor stress testing methods be required as part of the proposed program’s stress testing requirement? If so, which one and why? b. Asset Segregation We considered applying an asset segregation approach to derivatives transactions, similar to asset segregation under Release 10666, as a tool to limit funds’ leverage-related risks.259 Under this approach, we could require a fund engaging in derivatives transactions to segregate cash and cash equivalents equal in value to the full amount of the conditional and unconditional obligations incurred by the fund (also referred to as ‘‘notional amount segregation’’). We could allow funds to segregate additional types of assets beyond cash and cash equivalents subject to prescribed haircuts based on the assets’ volatilities. The 2016 DERA Memo, for example, analyzed different risk-based ‘‘haircuts’’ that could apply to a broader range of assets.260 Allowing a broader range of segregated assets would have the effect of allowing funds to take on additional leverage because it would increase a fund’s ability to obtain market exposure through a combination of cash, market securities investments, and derivatives transactions. Allowing funds to segregate a broader range of assets, even if subject to haircuts, also may not effectively address all of the section 18 concerns underlying an asset segregation requirement. For example, if 259 We separately discuss below our consideration of asset segregation as a complement to the proposed limitations on fund leverage risk. See infra section II.F. 260 See, e.g., 2016 DERA Memo, supra note 12. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4482 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules a fund must raise cash to pay a derivatives counterparty by selling a segregated security with unrealized trading losses, then the fund still would realize trading losses on the sale of the security regardless of whether the fund applied haircuts to the value of the security when determining the amount of its segregated assets. The haircuts therefore could help to prevent a fund from defaulting on its derivatives transactions obligations, but may not prevent a fund from realizing trading losses to meet those obligations. Notional amount segregation, although generally an effective way to limit leverage risk, is a non-risksensitive and often more restrictive approach to limiting potential leverage risk as compared to the proposed VaR tests. Notional amount segregation could limit funds’ ability to engage in derivatives transactions that may not raise the concerns underlying section 18. For example, if a fund had segregated all available qualifying assets, it would not be permitted to enter into a derivatives transaction that would reduce portfolio risk. The proposed VaR tests would not constrain such a transaction because it would reduce the fund’s VaR. We also considered proposing an approach that would require funds to segregate liquid assets in an amount equal to the fund’s daily mark-to-market liability plus a ‘‘cushion amount’’ designed to address potential future losses. Requiring funds to segregate liquid assets would indirectly limit a fund’s leverage risk because each derivatives transaction and segregation of liquid assets would limit the net assets available for segregation to support additional derivatives. This approach would require segregating a smaller amount of liquid assets than the notional amount segregation approach.261 In light of the smaller amount of segregated assets, we could provide that only a specified percentage of a fund’s assets can be segregated. We could provide, for example, that a fund’s segregated amount cannot exceed one-third of its total assets or one-half of its net assets because this is the maximum amount that an open-end fund can owe a bank under section 18. This approach, however, would raise compliance complexities and may not be as effective as the proposed VaR tests in limiting fund leverage risk. For example, under this approach we would 261 See 2010 ABA Derivatives Report (recommending a risk-adjusted segregated amounts approach); 2011 Concept Release, supra note 3, at sections II.B.2, II.C.2 (citing and requesting comment on the 2010 ABA Derivatives Report approach). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 have to define the risk-based ‘‘cushion amount’’ funds would segregate. We could define this amount as we proposed in 2015: A reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions.262 Some commenters suggested determining these amounts could raise compliance challenges.263 Another approach would be to use the amount of required initial margin, for transactions subject to regulatory initial margin requirements. Not all derivatives transactions are subject to initial margin requirements, however, and these requirements generally vary based on the type of derivatives instrument. An approach that were to allow a fund to have more leverage when trading futures as compared to swaps, for example, would not seem consistent with the concerns underlying section 18. Requiring funds to segregate liquid assets in an amount equal to the fund’s daily mark-to-market liability plus a ‘‘cushion amount’’ therefore could introduce unnecessary complexity and compliance costs and may not result in an effective limit on fund leverage. We believe that the proposed VaR-based tests would be a more direct and effective method of limiting fund leverage risk consistent with section 18. We request comment on asset segregation as an alternative or complement to VaR. 133. Should the rule require asset segregation in lieu of or in addition to the proposed VaR-based limit on fund leverage risk? Is asset segregation equally effective or more effective than the proposed VaR tests in limiting a fund’s leverage risk? Why or why not? 134. Are there certain fund types or strategies for which an asset segregation approach would be more effective or appropriate for limiting a fund’s leverage risk? Which ones and why? 135. Should the proposed rule require notional amount segregation? What challenges, if any, would funds have with complying with notional amount segregation? Would this be an effective means to limit a fund’s leverage risk? If so, how? Please describe. 136. Should the proposed rule require an asset segregation risk-based approach based on the fund’s daily mark-tomarket liability and ‘‘cushion amount’’? Please explain why or why not. If so, how should funds calculate the risk262 See 2015 proposed rule 18f–4(c)(9). discuss these challenges in more detail below in section II.F. See also, e.g., AAF Comment Letter; Angel; Comment Letter of James J. Angel, Ph.D., CFA (Mar. 28, 2016). 263 We PO 00000 Frm 00038 Fmt 4701 Sfmt 4702 based cushions? Should we use the approach in the 2015 proposal for riskbased coverage amounts? Would funds encounter challenges in determining stressed conditions for purposes of that analysis? Would that approach lead to consistent segregated amounts across funds for the same or similar investments? Why or why not? Could we provide for greater consistency by prescribing a standardized schedule for computing these amounts based on the volatility of the underlying reference assets? What values should we prescribe? Rather than the approach in the 2015 proposal, should we use the amounts posted to satisfy regulatory margin requirements? Would it be appropriate for different instruments that provide the same economic exposure (e.g., futures and swaps that reference the same index) to have different segregated amounts? Under this approach, how should funds calculate risk-based cushions for transactions that are not subject to regulatory initial margin requirements? 137. Should we use the risk-based cushion amount approach to indirectly limit leverage risk? If so, should we provide that a fund’s segregated amount cannot exceed one-third of its total assets, one-half of its net assets, or some other percentage of a fund’s total or net assets? Would such an approach be sufficiently risk-sensitive and dynamic? If we were to use such an approach, how should we address derivatives transactions that may require little or no margin or collateral to be posted? 138. Are there other reasons that the proposed rule should include asset segregation? Should the derivatives risk management program specify asset segregation requirements? Would market practices adequately address asset coverage concerns? If not, why? 139. We included an asset segregation requirement as part of the 2015 proposal designed in part to address the asset sufficiency related concerns underlying section 18. Would an asset segregation requirement help to address fund leverage risk and complement the proposed VaR tests? If so, what type of asset sufficiency test? c. Exposure-Based Test We considered an exposure-based approach for limiting fund leverage risk. For example, we could design an exposure-based approach that permits a fund to enter into derivatives transactions so long as its derivatives exposure does not exceed a specified percentage of the fund’s net assets, such as 50%. This would be similar to an exposure-based test under the European E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 Union guidelines that apply to UCITS funds.264 A fund’s ‘‘derivatives exposure’’ could be defined as in proposed rule 18f–4.265 A similar approach would be to provide that the sum of a fund’s derivatives exposure and the value of its other investments cannot exceed 150% of the fund’s net asset value. This latter approach, and particularly if cash and cash equivalents were not included in the calculation, would allow a fund to achieve the level of market exposure permitted for an open-end fund under section 18 using any combination of derivatives and other investments.266 This alternative approach would recognize that for most types of derivatives, the notional amount generally serves as a measure of the fund’s economic exposure to the underlying reference asset or metric. It also would provide a simple approach because a fund would just add the relevant values rather than having to perform VaR tests. An exposure-based test does have certain limitations. One drawback to this alternative approach is that a derivative’s notional amount does not reflect the way in which the fund uses the derivative and is not a risk measurement. For this reason, an exposure-based approach may be viewed as a relatively blunt measurement. It would not differentiate between derivatives transactions having the same notional amount but different underlying reference assets with potentially very different risks. There are adjustments to notional amounts available that may better reflect the risk associated with derivatives 264 CESR (now known as the European Securities and Markets Authority (‘‘ESMA’’)) issued its Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (‘‘Global Exposure Guidelines’’) in 2010, addressing the implementation of the European Commission’s 2009 revised UCITS Directive (‘‘2009 Directive’’). See CESR Global Guidelines, supra note 94, at 9. A UCITS fund may, instead of complying with the European Union’s VaR-based test, satisfy a ‘‘commitment approach.’’ The commitment approach provides that a UCITS fund is in compliance with the leverage limits under the guidelines if its derivatives notional amounts (taking into account netting and hedging) do not exceed 100% of the fund’s net asset value. See 2009 Directive. 265 Proposed rule 18f–4(a) (defining derivatives exposure to mean the sum of the notional amounts of the fund’s derivatives instruments and, in the case of short sale borrowings, the value of the asset sold short. In determining derivatives exposure a fund may convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts). 266 This approach would exclude cash and cash equivalents because they do not meaningfully contribute to a fund’s market exposure. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 transactions. One way to attempt to address these drawbacks would be to define the circumstances under which funds could subtract the exposure associated with ‘‘hedging’’ and ‘‘netting’’ transactions from a fund’s derivatives exposure. This would be similar to the ‘‘commitment method’’ applicable to UCITS funds.267 Defining these kinds of transactions can be challenging. For example, determining whether transactions are ‘‘hedges’’ can involve an analysis of historical correlations and predicting future price movements of related instruments or underlying reference assets, among other things. Historical correlations also can break down in times of market stress.268 Another potential way to modify an exposure-based test would be to adjust the notional amounts that contribute to a fund’s derivatives exposure based on the volatility of their underlying reference assets. Some commenters on the 2015 proposal suggested we take this approach, and DERA staff prepared 267 See, e.g., CESR Global Guidelines, supra note 94, at 13–14 (defining netting as ‘‘combinations of trades on financial derivative instruments and/or security positions which refer to the same underlying asset, irrespective—in the case of financial derivative instruments—of the contracts’ due date; and where the trades on financial derivative instruments and/or security positions are concluded with the sole aim of eliminating the risks linked to positions taken through the other financial derivative instruments and/or security positions’’ and hedging as ‘‘combinations of trades on financial derivative instruments and/or security positions which do not necessarily refer to the same underlying asset and where the trades on financial derivative instruments and/or security positions are concluded with the sole aim of offsetting risks linked to positions taken through the other financial derivative instruments and/or security positions’’). 268 In times of extreme market stress, price correlations between asset classes frequently break down. See Mico Loretan & William B. English, Evaluating ‘‘Correlation Breakdowns’’ During Periods of Market Volatility, Federal Reserve System International Finance Working Paper No. 658 (Feb. 2000), available at https:// papers.ssrn.com/sol3/papers.cfm?abstract_ id=231857 (‘‘[I]n periods of heightened market volatility correlations between asset returns can differ substantially from those seen in quieter markets. The problem of ‘correlation breakdown’ during periods of greater volatility is well known.’’). During periods of stressed conditions, correlations between asset classes with historically weak or inverse correlations may change significantly. See Whitney Kisling, Greed Beats Fear With Stock-Bond Correlation Falling, Bloomberg (Nov. 22, 2010) (stating that the 30-day correlation between S&P 500 prices and 10-year Treasury yields showed equity and bond markets, typically inversely correlated markets, moving in lockstep after the 2008 financial crisis); see also A Review of Financial Market Events in Autumn 1998, Bank for International Settlements, Committee on the Global Financial System (1999), available at https:// www.bis.org/publ/cgfs12.htm (during the Russian financial crisis in August 1998 the average correlation between five-day changes in yield spreads for 26 instruments in 10 economies rose from 11% in the first half of 1998 to 37% during the height of the crisis). PO 00000 Frm 00039 Fmt 4701 Sfmt 4702 4483 an analysis of commenters’ suggestions.269 This would make an exposure-based test more risk-sensitive, but would not provide the morecomprehensive analysis of portfolio risk that VaR provides. An exposure-based test, even with these various adjustments to notional amounts for purposes of calculating a fund’s derivatives exposure, still would be a relatively blunt measurement. For example, this approach could limit certain fund strategies that rely on derivatives more extensively but that do not seek to take on significant leverage risk. While we do not propose an exposure-based test element as a means for limiting all funds’ leverage risk, we are proposing an exposure-based test for limited derivatives users (as discussed below).270 We request comment on an exposurebased test as a means to limit funds’ leverage risk. 140. Should the rule incorporate an exposure-based approach in addition to, or in lieu of, the proposed VaR-based limit on fund leverage risk? If so, what derivatives exposure amount should this approach permit? For example, should we modify the proposed rule so that a fund would not be required to satisfy either VaR test if the fund limited its derivatives exposure, as defined for purposes of the limited derivatives user exception discussed below, to 50% of a fund’s net assets? Should an exposurebased approach focus on a fund’s overall gross market exposure and be based on the sum of the fund’s derivatives exposure and the value of its other investments, less any cash and cash equivalents? If so, should a fund’s gross market exposure be limited to 150% of net assets to allow a fund to achieve the level of market exposure permitted for an open-end fund under section 18 using any combination of derivatives and other investments? Would any of these approaches to implementing an exposure-based limit on fund leverage risk effectively address the potential leverage associated with a fund’s derivatives transactions? If so, would funds find it more cost effective or otherwise preferable to have the option to comply with an exposurebased test in lieu of the proposed VaR tests? Please explain. 141. If the rule were to incorporate an exposure-based approach, should we permit funds to make netting and hedging adjustments when calculating their derivatives exposures? If so, why? How should we define permissible 269 See 270 See E:\FR\FM\24JAP2.SGM 2016 DERA Memo, supra note 12. proposed rule 18f–4(c)(3). 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4484 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules netting and hedging transactions? If we permit netting and hedging to be incorporated into the exposure calculation, should the rule include third-party verification to test whether a fund’s netting and hedging calculations were reasonable and appropriate? What other provisions could achieve these concerns with netting and hedging? Please describe. 142. If the rule were to incorporate an exposure-based approach, should we permit funds to make risk-sensitive adjustments as discussed in the 2016 DERA Memo? If so, why? How should we define the permissible risk-adjusted notional amounts? If we permit these adjustments to be incorporated into the exposure calculation, should the rule include third-party verification to test whether a fund’s adjustments were reasonable and appropriate? What other provisions could achieve these concerns with risk-adjusted notional amounts? Please describe. 143. Are there certain fund types or strategies where an exposure-based test would be more appropriate? If so, which ones and why? Would these fund types or strategies have difficulty conducting either a relative VaR test or absolute VaR test? If so, why would an exposurebased test be less challenging to conduct than a VaR-based test? 144. What challenges, if any, would funds have in conducting an exposurebased test? How could an exposurebased test rule account for these challenges? 145. Do funds currently conduct exposure-based tests as a means of measuring and limiting a fund’s leverage risk? If so, which ones and why? Are these exposure-based tests in place of or in addition to VaR-based tests or other risk measurements? Should the rule be modified to require both, and what benefits do funds find when running an exposure-based test and VaR-based test and comparing results? Would these additional compliance burdens result in a moreaccurate limit on fund leverage risk? If so, how much so, and what would the additional compliance burdens be? 146. In what ways is the proposed approach to limiting leverage risk superior or inferior to the current regulatory approach or alternative approaches, including the stress testing, asset segregation and exposure-based alternatives discussed herein? E. Limited Derivatives Users We are proposing an exception from the proposed rule’s risk management program requirement and VaR-based limit on fund leverage risk for funds that use derivatives in a limited manner. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 Requiring funds that use derivatives only in a limited way to adopt a derivatives risk management program that includes all of the proposed program elements could potentially require funds (and therefore their shareholders) to incur costs and bear compliance burdens that may be disproportionate to the resulting benefits.271 We recognize that the risks and potential impact of derivatives transactions on a fund’s portfolio generally increase as the fund’s level of derivatives usage increases and when funds use derivatives for speculative purposes. The proposed exception would cover two alternative types of limited derivatives use. It would be available to a fund that either limits its derivatives exposure to 10% of its net assets, or that uses derivatives transactions solely to hedge certain currency risks.272 A fund that relies on the proposed exception would also be required to adopt policies and procedures that are reasonably designed to manage its derivatives risks.273 We believe that the risks and potential impact of these funds’ derivatives use may not be as significant, compared to those of funds that do not qualify for the exception, and that a principles-based policies and procedures requirement would appropriately address these risks. We discuss and request comment on each of the elements of this proposed exception below. 1. Exposure-Based Exception Under one alternative set of conditions, a fund would be permitted to rely on the limited derivatives user exception if its derivatives exposure does not exceed 10% of its net assets. The proposed rule would generally define the term ‘‘derivatives exposure’’ to mean the sum of the notional amounts of the fund’s derivatives instruments and, for short sale borrowings, the value of any asset sold short.274 This definition is designed to provide a measure of the market exposure associated with a fund’s derivatives transactions entered into in reliance on proposed rule 18f–4.275 We recognize that using notional amounts as a measure of market 271 The cost burden concern extends to smaller funds as well, which could experience an even more disproportionate cost than larger funds. See infra sections III.C.3and V.D.1.c. 272 See proposed rule 18f–4(c)(3)(i)–(ii); see also infra sections II.E.1 and II.E.2 (discussing the specific requirements for funds relying on either alternative of the proposed exception). 273 See proposed rule 18f–4(c)(3). 274 See proposed rule 18f–4(a) (defining the term ‘‘derivatives exposure’’). 275 Id. PO 00000 Frm 00040 Fmt 4701 Sfmt 4702 exposure could be viewed as a relatively blunt measurement in that different derivatives transactions having the same notional amount but different underlying reference assets—for example, an interest rate swap and a credit default swap having the same notional amount—may expose a fund to very different potential investment risks and potential payment obligations. The derivatives exposure threshold in the limited derivatives user exception, however, is not designed to provide a precise measure of a fund’s market exposure or to serve as a risk measure, but rather to serve as an efficient way to identify funds that use derivatives in a limited way. The proposed definition of ‘‘derivatives exposure’’ would, however, include two adjustments designed to address certain limitations associated with measures of market exposure that use derivatives’ notional amounts without adjustments. Specifically, the proposed rule would permit a fund to convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts.276 Converting interest rate derivatives to 10-year bond equivalents would provide for greater comparability of the notional amounts of different interest rate derivatives that provide similar exposure to changes in interest rates but that have different unadjusted notional amount. In addition, absent this adjustment, short-term interest rate derivatives in particular can produce large unadjusted notional amounts that may not correspond to large exposures to interest rate changes.277 Permitting funds to convert these and other interest rate derivatives to 10-year bond equivalents is designed to result in adjusted notional amounts that better represent a fund’s exposure to interest rate changes. Similarly, permitting delta adjusting of options is designed to provide for a more tailored notional amount that better reflects the exposure that an option creates to the underlying reference asset. These adjustments are therefore designed to provide for more tailored notional amounts that better reflect the exposure that a derivative creates to the underlying reference asset. Providing these adjustments also would be efficient for funds because the adjustments are consistent with the 276 Id. Delta refers to the ratio of change in the value of an option to the change in value of the asset into which the option is convertible. A fund would delta adjust an option by multiplying the option’s unadjusted notional amount by the option’s delta. 277 Id. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules reporting requirements in Form PF and Form ADV.278 We do not believe additional adjustments are necessary for purposes of identifying limited derivatives users. For example, commenters on the 2015 proposal suggested an approach to adjusting notional amounts based on the volatility of the underlying reference assets, and DERA staff analyzed these suggestions.279 We believe, however, that whether a fund is using derivatives in a limited way for purposes of the limited derivatives user exception should not depend on the volatility of the underlying reference assets, but rather on the extent to which a fund uses derivatives to implement its investment strategy. The proposed 10% derivatives exposure condition represents a threshold that is designed to exclude funds from the program requirement and the VaR-based limit on fund leverage risk when their derivatives exposure is relatively limited. This proposed threshold is based in part on staff analysis of funds’ practices regarding derivatives use. Specifically, DERA staff analyzed funds’ use of derivatives based on Form N–PORT filings as of September 2019. As discussed in more detail in section III, these filings covered mutual funds, ETFs, registered closed-end funds, and variable annuity separate accounts registered as management investment companies. Based on this analysis, 59% of funds report no derivatives holdings and 14% of funds report derivatives holdings with gross notional amounts above 50% of NAV. DERA staff also analyzed the levels of these funds’ derivatives exposure after adjusting interest rate derivatives and options, as permitted under the proposed rule. Taking these adjustments into account, DERA staff’s analysis showed that 78% of funds have adjusted notional amounts below 10% of NAV; 80% of funds have adjusted notional amounts below 15% of NAV; 81% of funds have adjusted notional amounts below 20% of NAV; and 82% of funds have adjusted notional amounts below 25% of NAV. Although BDCs are not required to file reports on Form N– PORT, our staff separately analyzed a sampling of BDCs, finding that of the sampled BDCs, 54% did not report any derivatives holdings and a further 29% reported using derivatives with gross 278 See, e.g., General Instruction 15 to Form PF; Item B.30 of Section 2b of Form PF; Glossary of Terms, Gross Notional Value of Form ADV; Schedule D of Part 1A of Form ADV. 279 See 2016 DERA Memo, supra note 12. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 notional amounts below 10% of net assets.280 We recognize that not all funds are currently required to file reports on Form N–PORT.281 It appears, however, that funds’ use of derivatives reflected in the Form N–PORT data is generally consistent with that in the representative sample studied in the White Paper prepared in connection with the 2015 proposal, entitled ‘‘Use of Derivatives by Investment Companies.’’ 282 For example, DERA staff compared the percentages of funds in both data sets that reported no derivatives and the percentage with gross notional amounts less than 50% of net assets. These figures were comparable, suggesting that the Form N–PORT data provides a representative sample of current funds, and not just the set of funds currently required to file reports on Form N–PORT.283 Taking these results into account, we are proposing to permit a fund to operate as a limited derivatives user if its derivatives exposure is below 10% of net assets. DERA staff analysis suggests that most funds either do not use derivatives or do so to a more limited extent, and that setting the derivatives exposure threshold for the limited user exception at 10%, 15%, 20%, or 25%, for example, would result in nearly the same percentages of funds qualifying for the exception. We therefore are proposing a lower threshold of 10% because the lower threshold would 280 See infra section III.B.2. As noted above, our staff did not have sufficient information to adjust the notional amounts of the BDCs’ interest rate derivatives or options. Some of the 17% of the sampled BDCs with gross notional amounts exceeding 10% of net assets likely would have lower notional amounts after applying these adjustments. 281 Larger fund groups—funds that together with other investment companies in the same ‘‘group of related investment companies’’ have net assets of $1 billion or more as of the end of the most recent fiscal year of the fund—currently are required to file reports on N–PORT. Smaller fund groups must begin to file reports on Form N–PORT by April 30, 2020. While only larger fund groups are currently required to file reports on Form N–PORT, existing filings nevertheless covered 89% of funds representing 94% of assets. See infra note 457 and accompanying text. 282 DERA White Paper, supra note 1; see also ICI Comment Letter III (regarding a survey related to funds’ use of derivatives sent to its member firms, the Investment Company Institute stated ‘‘The survey was distributed to smaller fund complex members, yet relatively few responses were received from these smaller fund members. Based on anecdotal conversations with staff at these member complexes, the smaller fund firms described no to minimal use of derivatives.’’). 283 Specifically, the DERA White Paper observes that 68% of funds held no derivatives and 89% of funds had gross notional amounts less than 50% of net assets. See DERA White Paper, supra note 1. The respective figures from the N–PORT data were 59% and 86% of funds. PO 00000 Frm 00041 Fmt 4701 Sfmt 4702 4485 result in nearly the same percentage of funds qualifying for the exception based on current practices while potentially providing greater investor protections in the future by requiring funds that exceed the lower 10% threshold to establish a program and comply with the VaR-based limit on fund leverage risk. The 2015 proposal also included an exception from that proposal’s risk management program requirement for funds: (1) Whose notional derivatives exposure does not exceed 50% of net assets; and (2) that do not enter into ‘‘complex derivatives transactions,’’ defined in that proposal to include certain path-dependent and non-linear transactions.284 The 2015 proposal permitted funds to use delta-adjusted notional amounts for options but did not provide an adjustment for interest rate derivatives. We are proposing a 10% derivatives exposure threshold that takes into account certain adjustments rather than a higher figure, like the 50% threshold we proposed in 2015 that did not include adjustments for interest rate derivatives, because we believe this approach would more effectively identify funds whose derivatives may be effectively managed without a fund needing to establish a derivatives risk management program that includes all of the proposed program elements. A fund with derivatives exposure equal to 50% of net assets, for example, would be at risk of substantial losses, notwithstanding that an open-end fund could borrow an amount equal to 50% of its net assets from a bank.285 Conversely, if a fund were entering into interest rate derivatives—and especially short-term interest rate derivatives— those transactions’ unadjusted notional amounts could cause a fund to exceed the threshold we proposed in 2015 even though the fund’s derivatives risks could be less significant than those of 284 Specifically, the 2015 proposal defined the term ‘‘complex derivatives transaction’’ to mean any derivatives transaction for which the amount payable by either party upon settlement date, maturity or exercise: (1) Is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction; or (2) is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price. 2015 proposed rule 18f– 4(c)(1). 285 See, e.g., CFA Comment Letter (stating that the commenter did not believe it was ‘‘appropriate that a fund with 40 or 45 percent notional exposure should be viewed as having a limited amount of exposure obviating the requirement for that fund to implement a formal risk management program’’ and that ‘‘Section 18’s limit reflects a congressional determination on the level of exposure funds may not exceed; it does not reflect the level of exposure at which funds should begin to establish formal risk management practices’’). E:\FR\FM\24JAP2.SGM 24JAP2 4486 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 other funds that would qualify for the exception. The approach the Commission proposed in 2015 therefore could have permitted some funds to rely on the exception while still taking on significant derivatives risks, while disqualifying other funds whose derivatives transactions may have posed less-significant risks but that had high unadjusted notional amounts. Here, our proposal is designed to address these concerns by proposing a lower derivatives exposure threshold while also allowing funds to adjust interest rate derivatives’ notional amounts because the unadjusted values may be more likely to overstate a fund’s market exposure. We also are not proposing to prohibit funds relying on the exception from entering into complex derivatives transactions as we proposed in 2015 because, as discussed in more detail below, we are proposing to require that limited derivatives users manage all of the risks associated with their derivatives transactions, including any complex derivatives transactions. In addition, if these or other complex or exotic derivatives were to embed multiple forms of optionality or other non-linearities such that the fund could not reliably compute the transaction’s notional amount, the fund would not be able to confirm that its derivatives exposure is below 10% of the fund’s net assets and therefore would not be able to rely on the limited derivatives user exception. Finally, if these complex derivatives transactions were to cause a fund’s derivatives exposure to exceed 10% of the fund’s net assets—or the fund were to exceed the limit for any other reason—the fund would have to reduce its derivatives exposure promptly or establish a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as reasonably practicable. We also considered an alternative approach to identifying funds that use derivatives in a limited way based on a fund’s disclosure. Specifically, we considered providing that a fund would be a limited derivatives user if its principal investment strategies disclosed in its prospectus do not involve the use of derivatives.286 A fund 286 See, e.g., ICI Comment Letter III (stating that an appropriate threshold for limited derivatives users could be whether a fund listed derivatives in its prospectus as a principal investment strategy). Form N–1A requires an open-end fund to disclose its principal investment strategies, including the particular type or types of securities in which the fund principally invests or will invest. See Item 9 of Form N–1A. Form N–1A also provides, in part, that ‘‘[i]n determining what is a principal investment strategy, consider, among other things, the amount of the Fund’s assets expected to be VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 that does not identify the use of derivatives in its principal investment strategies should generally be using derivatives less extensively than a fund that does include the use of derivatives as a principal investment strategy. This approach would provide some efficiencies for funds because they already are required to make this disclosure.287 This approach would, however, have certain drawbacks. For example, whether a fund’s use of derivatives is a principal investment strategy is a factsand-circumstances-based analysis. Funds that may appear broadly similar could provide different disclosures, leading to less consistency in the application of the derivatives risk management program requirement and in the application of the VaR-based limit on leverage risk. Taking these considerations into account, we are proposing to look at a uniform metric of a fund’s derivatives exposure, rather than at the more factspecific question of whether a fund views the use of derivatives as a principal investment strategy. We believe the proposed approach should result in more-consistent determinations by funds and would be more appropriate in determining whether a fund should qualify for the limited derivatives user exception. We request comment on the proposed exposure-based exception. 147. Is it appropriate to permit funds to rely on the limited derivatives user exception if their derivatives exposure does not exceed 10% of their net assets? Why or why not? Should we lower or raise the proposed derivatives exposure threshold, for example to 5% or to 15%? Why or why not? Should we lower it to a de minimis amount, such as 1% or 3%, and provide that a fund with derivatives exposure below these levels is not required to adopt policies and procedures designed to manage derivatives risk? Should the threshold vary based on whether a fund is an committed to the strategy, the amount of the Fund’s assets expected to be placed at risk by the strategy, and the likelihood of the Fund’s losing some or all of those assets from implementing the strategy.’’ See Instruction 2 to Item 9 of Form N–1A. Form N–2 requires a closed-end fund to concisely describe the fund’s investment objectives and policies that will constitute its principal portfolio emphasis, including the types of securities in which the fund invests or will invest principally. See Item 8 of Form N–2. The instructions to this item direct the fund to briefly describe the significant investment practices or techniques that the fund employs or intends to employ with several examples, including examples related to derivatives transactions. 287 See ICI Comment Letter III (stating that 92% of the firms surveyed indicated that their firms have funds that list derivatives as a principal investment strategy in their prospectus). PO 00000 Frm 00042 Fmt 4701 Sfmt 4702 open-end fund, registered closed-end fund, or BDC? If so, why, and which levels would be appropriate for each kind of fund? 148. The derivatives exposure of certain types of transactions may be difficult to calculate or may change rapidly, which may make it difficult for a fund to consistently comply with the limited derivatives user exception. Should we provide that a fund relying on the limited derivatives user exception may not enter into complex or exotic derivatives transactions, whose risks may not be fully reflected in their notional amounts? If so, what kinds of complex or exotic transactions? For example, should we provide that a fund relying on the exception may not enter into complex derivatives transactions, as defined in the 2015 proposal? Should we only permit a fund to have a morelimited amount of derivatives exposure associated with these transactions, such as 1% or 5% of net assets? Why or why not? 149. Should we prescribe how a fund must calculate its notional amounts, or is that term in the proposed rule sufficiently clear? If we should prescribe the calculation, what should we prescribe? For example, in 2015 the Commission proposed to define a derivatives transaction’s notional amount to mean, among other things: (1) The market value of an equivalent position in the underlying reference asset for the derivatives transaction (expressed as a positive amount for both long and short positions); or (2) the principal amount on which payment obligations under the derivatives transaction are calculated. Should we include this definition in rule 18f–4? The 2015 proposal also included specific provisions for calculating a derivatives transaction’s notional amount for: (1) Derivatives that provide a return based on the leveraged performance of a reference asset; and (2) derivatives transactions for which the reference asset is a managed account or entity formed or operated primarily for the purpose of investing in or trading derivatives transactions, or an index that reflects the performance of such a managed account or entity.288 Should we include either or both of these provisions in rule 18f–4? Why or why not? Would funds calculate their notional amounts consistently with these provisions even if they were not included in the rule text because the calculations would be consistent with the way market participants determine 288 See 2015 Proposing Release, supra 2, at n.158 and accompanying text. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules derivatives transactions’ notional amounts? 150. Would funds be able to calculate notional amounts for complex derivatives and, if so, would they reflect the market risk in the transactions? Why or why? If we permit funds to enter into complex derivatives transactions as defined in the 2015 proposal while relying on the limited derivatives user exception, should we require that funds calculate these transactions’ notional amounts as the Commission proposed in 2015? That proposal would have provided that the notional amount of a complex derivatives transaction would be the aggregate notional amounts of derivatives transactions (excluding complex derivatives transactions) reasonably estimated to offset substantially all of the market risk of the complex derivatives transaction. 151. For purposes of determining a fund’s derivatives exposure, should the proposed rule treat differently derivatives that create synthetic positions where the fund holds cash and cash equivalents with a value equal to the derivative’s notional amount less any posted margin? These transactions may not leverage the fund’s portfolio because of the fund’s holding cash and cash equivalents equal to the notional amount of the derivatives transaction less any posted margin, rather than investing in additional securities or making other investments. Take, for example, a fund with $100 that posts $20 of initial margin to initiate a long position in a swap contract referencing a market index. If the fund posted cash and cash equivalents as initial margin and maintains the remaining $80 in cash and cash equivalents as well, the fund would have a market exposure that would be similar to having invested the fund’s $100 in the stocks composing the index. Such a transaction could, however, present other risks, such as counterparty risk. Because these synthetic transactions may not leverage a fund’s portfolio, should we permit a fund to exclude these transactions from its derivatives exposure? Conversely, because they can raise other risks, such as counterparty risks, should they be included in derivatives exposure as proposed? 152. Should the rule define limited derivatives users using an alternative methodology other than the proposed threshold tied to derivatives exposure (or, as discussed below, for funds that use derivatives to hedge currency risks)? Why or why not? For example, should the limited derivatives user exception be defined to include funds that do not disclose the use of derivatives as a principal investment strategy in their VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 prospectuses? Would this disclosurebased exception threshold be over- or under-inclusive? Would it lead to less consistency in the requirement to establish a derivatives risk management program and comply with a VaR-based limit on leverage risk and potentially create uncertainty for funds as to when they would qualify for the limited user exception? Why or why not? If this could lead to less consistency, would any additional instructions in funds’ registration forms, regarding what a fund should disclose as a principal investment strategy in its prospectus, help mitigate this concern, and if so, what should those instructions be? Is it appropriate to tie an exception to the derivatives risk management program requirement and VaR-based limit on fund leverage risk to a prospectus disclosure requirement? Why or why not? 153. Should the condition that a limited derivatives user’s derivatives exposure not exceed 10% of the fund’s net assets address exceedances and remediation? Why or why not? For example, as noted above, if a fund’s derivatives exposure were to exceed 10% of the fund’s net assets, the fund would have to promptly reduce its derivatives exposure or establish a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as reasonably practicable. Should we provide in rule 18f–4 specific time periods for these actions and, if so, which time periods would be appropriate? As an alternative way to address temporary exceedances, should the rule provide that a fund will be a limited derivatives user if it adopts a policy providing that, under normal circumstances, the fund’s derivatives exposure will not exceed 10% of the fund’s net assets? If so, what should be considered ‘‘normal circumstances’’? Would this standard be too subjective such that funds would have substantial derivatives exposures while still qualifying as limited derivatives users? Rather than a policy referring to ‘‘normal circumstances,’’ should we require a fund to disclose in its prospectus that it does not expect its derivatives exposure to exceed 10% of the fund’s net assets? Should this disclosure also appear in the fund’s annual report? 154. Should we prohibit a fund whose derivatives exposure repeatedly exceeds 10% of net assets from relying on the exception again for a period of time? For example, if a fund were to exceed this limit more than two or three times in a year, should we provide that the fund cannot rely on the limited derivatives user exception for one or two years? PO 00000 Frm 00043 Fmt 4701 Sfmt 4702 4487 155. In calculating derivatives exposure, should we permit a fund to convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts, as proposed? Would delta adjusting options raise the concern that a fund’s delta-adjusted options exposure would be small, allowing a fund to avoid establishing a program, but could quickly grow in response to large price changes in the option’s reference asset? How should we address this concern? Should we permit additional adjustments? Why or why not? If so, what additional adjustments should we permit? For example, should we permit funds to adjust notional amounts based on the volatility of the underlying reference assets? Why or why not? 156. The proposed rule provides that, for a fund to operate as a limited derivatives user under the exposurebased prong, the fund’s derivatives exposure must not exceed 10% of net assets. The rule does not, however, prescribe the frequency with which funds must calculate their derivatives exposure to evaluate their compliance. Should we require that a fund calculate its notional amounts daily, or at some other specified frequency? Are there other requirements we should specify regarding a fund’s calculation of its derivatives exposure? If so, what are they, and why would these other requirements more accurately address a fund’s derivatives exposure? 157. Should we permit a fund to adjust its derivatives exposure for purposes of the proposed exception to account for certain netting and hedging transactions? 289 Why or why not? If so, how should we define netting and hedging transactions for this purpose? How should we prescribe in rule 18f–4 the circumstances under which different derivatives—and particularly derivatives with different reference assets—should be treated as hedged or offsetting? If the rule were to permit funds to exclude hedging or netting transactions from their derivatives exposure, should we require funds to maintain records concerning these transactions to help our staff and fund compliance personnel evaluate if the transactions reasonably could be viewed as hedging or netting? If so, what information should those records reflect? For example, the regulations under section 13 of the Bank Holding Company Act, commonly known as the Volcker Rule, require certain banking entities to maintain certain 289 See paragraph accompanying supra notes 266– 267. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4488 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules documentation relating to hedging strategies, including positions and techniques.290 Should the proposed rule take this or a similar approach? As another example, should we require funds to identify both the asset being hedged or netted and the derivatives transaction used to hedge or net that asset? How should we consider the risk that the historical correlations underlying an adviser’s view that assets will have inverse price correlations can break down in times of market stress? How could a standard in the rule be reasonably objective such that funds and our staff could confirm a fund’s compliance? Should we permit funds to account for netting but not hedging or vice versa? Why or why not? Would the compliance burden to calculate netting and hedging transactions for purposes of such adjustments justify the benefits of permitting these adjustments? Why or why not? What other challenges could funds face in accounting for netting and hedging transactions that could increase the costs associated with this exercise, or that could negatively affect a fund’s ability to assess its derivatives exposure accurately? Could these challenges be mitigated in any way? If so, how? 158. Should we specify in the rule that a fund calculating its derivatives exposure may net any directly-offsetting derivatives transactions that are the same type of instrument and have the same underlying reference asset, maturity and other material terms, as we proposed in 2015? Why or why not? 159. In determining a fund’s derivatives exposure, or the level of derivatives exposure a fund may obtain while remaining a limited derivatives user, should we consider other types of investments, like structured notes, that have return profiles that are similar to many derivatives instruments? Take, for example, a fund with derivatives exposure exceeding the proposed 10% threshold by 2% that reallocates that 2% of its net asset value from a derivatives instrument to a structured note with a similar return profile. The fund would be a limited derivatives user on the basis that its derivatives exposure was below the threshold, but would present a similar risk profile to its prior portfolio that exceeded the threshold. Are there circumstances where we should require the fund in this example to include the value of the structured note (or similar investment) in determining its derivatives exposure? If so, which circumstances and what kinds of instruments should be included? As another alternative, should we provide that, when funds that invest in 290 See 17 CFR 255.5(c). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 derivatives also invest in structured notes or similar investments, they should be subject to a lower threshold of derivatives exposure to remain a limited derivatives user? If so, what lower level would be appropriate? 2. Currency Hedging Exception Under the second alternative set of conditions, a fund could rely on the limited derivatives user exception if it limits its use of derivatives transactions to currency derivatives for hedging purposes as specified in the proposed rule.291 Under this exception, a fund could only use currency derivatives to hedge currency risk associated with specific foreign-currency-denominated equity or fixed-income investments in the fund’s portfolio. In addition, the notional amount of the currency derivatives the fund holds could not exceed the value of the instruments denominated in the foreign currency by more than a negligible amount.292 The proposed currency hedging exception reflects our view that using currency derivatives solely to hedge currency risk does not raise the policy concerns underlying section 18. While distinguishing most hedging transactions from leveraged or speculative transactions is challenging, we believe that the currency hedging described in the proposed rule is definable because it involves a single risk factor (currency risk) and requires that the derivatives instrument must be tied to specific hedged investments (foreign-currency-denominated securities held by the fund).293 Although we recognize that most funds that use derivatives do not use them solely to hedge currency risks, these currency hedges are not intended to leverage the fund’s portfolio, and conversely could mitigate potential losses.294 We also recognize that certain funds hedge all of the foreign currency risk associated with their foreign securities investments. A fund that invests all or substantially all of its assets in foreign securities and currency derivatives to hedge currency risks associated with the foreign securities necessarily would have derivatives exposure exceeding 10% of net asset value. This is because such a fund could have derivatives 291 See proposed rule 18f-4(c)(3)(ii). 292 Id. 293 Many hedges are imperfect, which makes it difficult to distinguish purported hedges from leveraged or speculative exposures. See 2015 Proposing Release, supra 2, at n.238 and accompanying text. 294 See infra section III.C.3 (discussing the number of funds whose current derivatives transactions practices would qualify them for the currency hedging exception). PO 00000 Frm 00044 Fmt 4701 Sfmt 4702 exposure up to approximately 100% of the fund’s net assets to hedge the risks associated with all of its foreign security investments. We therefore are proposing a separate basis for the limited derivatives user exception for currency hedging because certain funds that hedge currency risks would be unable to qualify for the exposure-based limited derivatives user exception discussed above. Rather than proposing two alternative bases to qualify for the limited derivatives user exception, we considered permitting a fund to qualify as a limited derivatives user if its derivatives exposure does not exceed 10% of net assets, excluding any currency hedges as discussed above. We are not taking this combined approach, however, to preclude a fund that is operating as a limited derivatives user from engaging in a broad range of derivatives transactions that may raise risks that we believe should be managed through a derivatives management program and subject to the proposed VaR-based limit on fund leverage risk. We request comment on the proposed currency hedging exception. 160. Is the proposed currency risk hedging exception appropriate? Why or why not? Should we modify the proposed exception in any way? Why or why not? For example, should we limit the derivatives exposure of a fund that relies on the currency hedging exception, and if so, what should be that exposure threshold? Should we prescribe the kinds of currency derivatives that a fund may use while relying on the exception? If so, which derivatives should be permitted and which should be prohibited and why? Should the rule refer to other foreigncurrency-denominated assets in addition to equity or fixed-income investments? For example, do funds hedge holdings of foreign currencies themselves in addition to foreigncurrency-denominated investments? 161. Are there other types of derivatives that funds use that are less likely to raise the policy concerns underlying section 18? If so, which derivatives, and how do funds use them? For instance, we are aware that funds use interest rate derivatives to hedge interest rate risk arising from fixed income investments in their portfolios. Should we modify the proposed hedging-based exception to also include interest rate derivatives that funds use for hedging purposes? Why or why not? If so, what challenges could funds encounter in identifying interest rate derivatives that are used for hedging purposes (instead of for speculation or to accomplish E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules leveraging)? How could we define interest rate hedging in rule 18f–4 in a way that would allow hedging transactions while not permitting transactions that simply are speculating on the direction of interest rates? How could conditions in the rule help identify interest rate derivatives that funds use for ‘‘true’’ hedging? For example, should we require that any interest rate derivative that is treated as a hedge be tied to specific fixed-income securities or groups of specific fixedincome securities in the fund’s portfolio? This would be analogous to the proposed nexus between a fund’s currency derivatives and the fund’s hedged foreign-currency-denominated investments. Should we similarly allow a fund to treat as a hedging transaction an interest rate derivative that converts a fund’s fixed rate borrowings to floating rate borrowings or vice versa? To what extent do funds engage in these transactions? For funds that do engage in these transactions, how large are the notional amounts of these transactions, in ten-year bond equivalents, as a percentage of the fund’s net assets? 162. Should the rule address what happens if a fund using currency derivatives exceeds the notional amount of the value of the instruments denominated in a foreign currency by more than a negligible amount? If so, how should we address exceedances? Should we provide further guidance on what a negligible amount would be? For example, should we provide guidance or provide in rule 18f–4 that exceedances of 1% or 2%, for example, would be negligible? 163. Should we permit funds that rely on the first alternative set of limited derivatives user conditions (limiting their derivatives exposure to 10% of net assets) to deduct the notional amounts of their currency derivatives used for hedging purposes when calculating their derivatives exposure for purposes of the proposed exception? Why or why not? Should we allow funds to rely on both exceptions at the same time, instead of the exceptions being alternatives? If the exceptions were combined, could that result in funds relying on the limited derivatives user exception developing larger and potentially more complex derivatives portfolios that that may raise risks more appropriately managed through a derivatives management program and subject to the proposed VaR-based limit on fund leverage risk? Why or why not? with its derivatives transactions by adopting and implementing policies and procedures that are reasonably designed to manage the fund’s derivatives risks.295 The requirement that funds relying on the exception manage their derivatives risks recognizes that even a limited use of derivatives can present risks that should be managed. For example, a fund that uses derivatives solely to hedge currency risks would not be introducing leverage risk, but could still introduce other risks, including counterparty risk and the risk that a fund could be required to sell its investments to meet margin calls. As another example, certain derivatives, and particularly derivatives with nonlinear or path-dependent returns, may pose risks that require monitoring even when the derivatives represent a small portion of net asset value. For example, because of the non-linear payout profiles associated with put and call options, changes in the value of the option’s underlying reference asset can increase the option’s delta, and thus the extent of the fund’s derivatives exposure from the option. An options transaction that represented a small percentage of a fund’s net asset value can rapidly increase to a larger percentage. The proposed rule would require funds relying on the limited derivatives user exception to adopt and implement policies and procedures reasonably designed to manage the funds’ derivatives risks. Because they would be reasonably designed to address each fund’s derivatives risks, these policies and procedures would reflect the extent and nature of a fund’s use of derivatives within the parameters provided in the exception. For example, a fund that uses derivatives only occasionally and for a limited purpose, such as to equitize cash, could have limited policies and procedures commensurate with this limited use. A fund that uses more complex derivatives with derivatives exposure approaching 10% of net asset value, in contrast, would need to have policies and procedures tailored to the risks these derivatives could present. These policies and procedures could be more extensive and could include elements similar to those required under the proposed derivatives risk management program. The 2015 proposal would have required funds relying on that proposal’s exception to the derivatives risk management program requirement to manage derivatives risks by 3. Risk Management A fund relying on the limited derivatives user exception would be required to manage the risks associated 295 See proposed rule 18f–4(c)(3); see also proposed rule 18f–4(a) (definition of ‘‘derivatives risks’’) and supra note 118 and accompanying text (discussing the proposed definition of ‘‘derivatives risks’’). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 PO 00000 Frm 00045 Fmt 4701 Sfmt 4702 4489 determining (and maintaining certain assets to cover) a ‘‘risk-based coverage amount’’ associated with the fund’s derivatives. This amount represented an estimate of the amount the fund would expect to pay to exit the derivatives transaction under stressed conditions. The approach we are proposing here is designed to require a fund relying on the limited derivatives user exception to manage all of the risks associated with its derivatives transactions, and not just the risks that an asset segregation requirement could address.296 Moreover, our proposal is designed to limit derivatives risks by limiting the extent to which a fund can use derivatives while relying on the exception. As discussed above, the 2015 proposal would have permitted funds to obtain substantially greater derivatives exposure—up to 50% of net assets— without establishing a derivatives risk management program. On balance, we believe that the proposed bases for the limited derivatives user exception, together with the requirement that a fund manage any risks its limited use of derivatives presents, would provide both important investor protections and flexibility for funds to use derivatives in a way that is consistent with the policy concerns underlying section 18. We request comment on the proposed requirement that a fund relying on the limited derivatives user exception manage the risks associated with its derivatives transactions by adopting policies and procedures that are reasonably designed to manage its derivatives risks. 164. Is it appropriate to require funds relying on the limited derivatives user exception to adopt policies and procedures that are reasonably designed to manage their derivatives risks, in lieu of requiring such a fund to adopt a derivatives risk management program that includes all of the proposed program elements and comply with the proposed VaR-based limit on fund leverage risk? Would this requirement effectively address the risks entailed by the levels and types of derivatives use in which a fund that qualifies for the proposed exception might engage? 165. Alternatively, should funds eligible for the proposed limited derivatives user exception be subject to a tailored version of the proposed program requirement (e.g., a program requirement that would specify only certain elements, such as risk identification and assessment, establishing risk guidelines, stress 296 We discuss the limitations of an asset segregation requirement in section II.F below. E:\FR\FM\24JAP2.SGM 24JAP2 4490 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 testing, etc.)? If so, if so what should this entail? 166. Either in addition to or in lieu of policies and procedures reasonably designed to manage a fund’s derivatives risk, should we require funds relying on the limited derivatives user exception to comply with an asset segregation requirement? Should we use the same approach we proposed in 2015? Should we use that approach but allow funds to segregate a broader range of assets, such as the assets with corresponding haircuts analyzed in the 2016 DERA Memo? 167. Should we require limited derivatives users to publicly disclose that they are limited derivatives users in their prospectus, annual report, or on their website? If so, should we require any particular disclosure to enhance investors’ understanding of, for example: (1) The risks of investing in a fund that qualifies as a limited derivatives user under the proposed rule, or (2) such a fund’s derivatives risk management practices? F. Asset Segregation The Commission and staff have historically taken the position that a fund may appropriately manage the risks that section 18 is designed to address if the fund ‘‘covers’’ its obligations in connection with various transactions by maintaining ‘‘segregated accounts.’’ 297 Funds’ practices regarding the amount of ‘‘cover’’ they segregate, and the assets available for segregation, have evolved over time. In addition, different funds have applied those practices in varying ways to derivatives transactions with comparable economic exposures. Moreover, regulatory and contractual margin requirements have developed significantly since the adoption of Release 10666. The 2015 proposal drew on the Commission’s historical approach—and sought to primarily address the Investment Company Act’s asset sufficiency concern—by including an asset segregation requirement as part of the 2015 proposed rule.298 Under the Commission’s 2015 proposed approach, a fund relying on the proposed rule, in addition to complying with one of two portfolio limitations, would have had to maintain an amount of ‘‘qualifying coverage assets’’ designed to enable a fund to meet its derivatives-related obligations. Under the 2015 proposed rule, a fund would not have been required to segregate a derivative’s full 297 See supra section I.B.2. 2015 Proposing Release supra note 2, at section III.C. 298 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 notional amount, but instead would have had to segregate qualifying coverage assets (generally cash and cash equivalents) equal to the sum of two amounts: (1) The amount that would be payable by the fund if the fund were to exit the derivatives transaction at the time of determination (the ‘‘mark-tomarket coverage amount’’), and (2) a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions (the ‘‘riskbased coverage amount’’).299 Although commenters generally supported the overarching framework of the 2015 proposed rule’s asset segregation requirement, they identified several operational complexities. For example, commenters stated that additional clarity was necessary for funds to determine risk-based coverage amounts, including how funds should determine stressed conditions for this purpose.300 Commenters also raised questions about how funds could reduce segregated amounts to account for posted initial or variation margin and, more generally, how rule provisions governing coverage amounts would apply to cleared transactions (as opposed to OTC transactions covered by netting agreements).301 A number of commenters also expressed concerns about the proposed requirement that funds generally segregate cash and cash equivalents.302 Commenters suggested alternatives to this proposed requirement, including allowing funds to segregate a broader range of assets 299 See id. at section III.C.2 (discussing the composition of qualifying coverage assets as either: (1) Cash and cash equivalents, or (2) with respect to any derivatives transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset). 300 See, e.g., ICI Comment Letter I; BlackRock Comment Letter; Dechert Comment Letter; FSR Comment Letter; Guggenheim Comment Letter. 301 See, e.g., SIFMA Comment Letter (stating that ‘‘[i]n practice, variation margin and initial margin are often calculated in the aggregate, on a net basis, rather than separately’’ and recommending that funds ‘‘be able to get credit for both initial and variation margin posted on a net basis . . .’’ rather than limiting the type of coverage amount against which initial or variation margin may be credited); BlackRock Comment Letter (stating that initial and variation margin are used for cleared and OTC derivatives transactions by the clearinghouse and counterparties, respectively, when a derivatives transaction is exited and that distinguishing between the uses of the two types of margin will introduce complexity given that both forms of margin are available to cover potential obligations under derivatives in the event of a party’s default). 302 See, e.g., AIMA Comment Letter; AQR Comment Letter; BlackRock Comment Letter; Dechert Comment Letter; Comment Letter of Eaton Vance Management (Mar. 28, 2016) (‘‘Eaton Vance Comment Letter’’); Guggenheim Comment Letter; Comment Letter of JPMorgan (Mar. 28, 2016); Oppenheimer Comment Letter; PIMCO Comment Letter. PO 00000 Frm 00046 Fmt 4701 Sfmt 4702 subject to ‘‘haircuts’’ prescribed by the Commission based on the relative volatility of different asset classes.303 Our proposal does not include a specific asset segregation requirement because we do not believe that an asset segregation requirement is necessary in light of the proposed rule’s requirements, including the requirements that funds establish risk management programs and comply with the proposed VaR-based limit on fund leverage risk. As discussed in more detail above, a fund relying on proposed rule 18f–4 would be required to adopt and implement a written derivatives risk management program that, among other things, would require the fund to: Identify and assess its derivatives risks; put in place guidelines to manage these risks; stress test the fund’s portfolio at least weekly; and escalate material risks to the fund’s portfolio managers and, as appropriate, the board of directors.304 These proposed requirements are designed to require a fund to manage all of the risks associated with its derivatives transactions. These include—but are not limited to—the risk that a fund may be required to sell its investments to generate cash to pay derivatives counterparties, which the 2015 proposal’s asset segregation was designed to address. Moreover, the proposed rule would require that a fund’s stress testing for purposes of its derivatives management program specifically take into account the fund’s payments to derivatives counterparties that could result from losses in stressed conditions. Rather than require a fund to evaluate the amounts it would pay to exit derivatives transactions under stressed conditions on a transaction-by-transaction basis as in the 2015 proposal,305 our proposal would require funds to conduct portfolio-wide stress tests, taking into account potential payments to counterparties. Although counterparties often require funds to post margin or collateral for individual transactions (or groups of transactions) in order to cover potential loss exposure, the proposed 303 See, e.g., Dechert Comment Letter; Eaton Vance Comment Letter; IAA Comment Letter; SIFMA Comment Letter, Guggenheim Comment Letter. 304 Proposed rule 18f–4(c)(1). Funds that rely on the limited derivatives user exception also would be required to manage the risks associated with their more limited use of derivatives. See supra section II.E. 305 In the 2015 proposal, funds were required to determine qualifying coverage assets on a transaction-by-transaction basis, with the exception that funds could determine the amount of qualifying coverage assets on a net basis for derivatives transactions covered by netting agreements. See 2015 proposed rule 18f–4(c)(6) and (9). E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules rule’s stress testing requirement is designed to provide a portfolio-wide assessment of how the fund may respond to stressed conditions and any resulting payment obligations. This portfolio-wide assessment also would be buttressed by the other provisions in the risk management program and the proposed VaR-based limit on fund leverage risk, which are designed to limit a fund’s leverage risk and therefore the potential for payments to derivatives counterparties. The 2015 proposal’s derivatives risk management program, in contrast, did not include such a portfolio-wide assessment. We believe that the proposed rule’s requirements, in their totality, would appropriately address the asset sufficiency risks underlying section 18. A separate asset segregation requirement, in contrast, may be less effective. As derivatives markets evolve, questions may arise about the amount (and composition) of assets that funds must segregate for novel types of transactions. Although the Commission in 2015 sought to take a principlesbased approach to the amount of assets that funds would segregate, many commenters asserted that additional clarity would be necessary to administer this approach. It would be difficult in this context for the Commission to specify the amount of assets that funds should segregate on a transaction-bytransaction basis and to keep any specific requirements current as markets develop. And a principles-based approach to asset segregation, if it does not provide sufficient clarity, may contribute to the kinds of divergent asset segregation practices that exist today, which in turn have led to situations in which funds are not subject to a practical limit on potential leverage that they may obtain through derivatives transactions.306 By building on current risk management practices and techniques, including VaR and stress testing, the proposed rule is designed to provide a framework that we believe funds can apply to a broad variety of fund types and derivatives uses without our having to specify the operational details that an asset segregation requirement would entail. We request comment on our proposal not to include a specific asset segregation requirement. 168. Do commenters believe that the proposed rule’s requirements discussed above, in their totality, would appropriately address the asset sufficiency risks underlying section 18? If not and commenters believe rule 18f– 4 should include an asset segregation 306 See supra sections I.B.2 and I.B.3. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 requirement, what should that requirement entail? What added benefits would an asset segregation requirement provide that the current proposed rule requirements would not? 169. Should we require funds relying on the limited derivatives user exposure-based exception to segregate assets for purposes of the exception? Why or why not? Would an asset segregation requirement for such limited derivatives users obviate any need for a policies and procedures requirement? Why or why not? 170. Commenters in the 2015 release requested further clarity about the Commission’s 2015 proposal to require a principles-based asset segregation regime. What aspect of that proposal required further clarity and why? G. Alternative Requirements for Certain Leveraged/Inverse Funds and Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment Vehicles 1. Background on Proposed Approach to Certain Leveraged/Inverse Funds Proposed rule 18f–4 would include an alternative approach for certain funds that seek to provide leveraged or inverse exposure to an underlying index, generally on a daily basis. This alternative approach would be available for a registered investment company that is a ‘‘leveraged/inverse investment vehicle,’’ as that term is defined in proposed Exchange Act rule 15l–2 and proposed Advisers Act rule 211(h)–1 (which we refer to collectively as the proposed ‘‘sales practices rules,’’ as noted above). As discussed below, the proposed sales practices rules would require broker-dealers and investment advisers to engage in due diligence before accepting or placing an order for a customer or client that is a natural person (‘‘retail investor’’) to trade a leveraged/inverse investment vehicle, or approving a retail investor’s account for such trading. The definition of the term ‘‘leveraged/inverse investment vehicle’’ in the proposed sales practices rules would include certain entities that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time.307 The entities included in the proposed scope of the sales practices rules would include registered 307 See proposed rules 15l–2(d) and 211(h)–1(d) (defining the term ‘‘leveraged/inverse investment vehicle’’); see also, e.g., ETFs Adopting Release, supra note 76, at section II.A.3; rule 6c–11(c)(3) under the Investment Company Act. PO 00000 Frm 00047 Fmt 4701 Sfmt 4702 4491 investment companies and certain exchange-listed commodity- or currency-based trusts or funds. In this release, we refer to the registered investment companies covered by the proposed sales practices rules as ‘‘leveraged/inverse funds’’ (which in turn would be subject to the proposed alternative approach under rule 18f–4). We use the proposed sales practices rules’ defined term ‘‘leveraged/inverse investment vehicle’’ to refer to both such leveraged/inverse funds and to the exchange-listed commodity- or currency-based trusts or funds covered by those rules. Leveraged/inverse funds, which today are structured primarily as leveraged/ inverse ETFs, seek to amplify the returns of an underlying index by a specified multiple or to profit from a decline in the value of their underlying index over a predetermined period of time using financial derivatives.308 These funds reset periodically and are designed to hedge against or profit from short-term market movements without using margin, and, as such, are generally intended as short-term trading tools.309 To achieve their targeted returns, leveraged/inverse funds use derivatives extensively. In contrast to other funds that use derivatives as part of their broader investment strategy, leveraged/ inverse funds’ strategies (and use of derivatives) are predicated on leverage. Accordingly, leveraged/inverse funds raise the issues that section 18 of the 308 See infra section III.B for baseline statistics regarding leveraged/inverse ETFs and mutual funds. Leveraged/inverse ETFs operate under Commission orders providing exemptive relief from certain provisions of the Investment Company Act. These orders, however, do not provide exemptive relief from section 18 of the Investment Company Act. Rather, like other funds that use derivative investments, leveraged/inverse ETFs rely upon Release 10666 and operate consistent with the conditions in staff no-action letters and other staff guidance on derivatives transactions. See infra section II.L (discussing our proposal to rescind Release 10666, and stating that staff in the Division of Investment Management is reviewing certain of its no-action letters and other guidance to determine which letters and other staff guidance should be withdrawn in connection with any adoption of this proposal). The Commission recently adopted rule 6c–11 under the Investment Company Act to permit ETFs that satisfy certain conditions to operate without obtaining an exemptive order from the Commission. Rule 6c–11 includes a provision excluding leveraged/inverse ETFs from the scope of that rule. See infra section II.G.4 (discussing proposed amendments to rule 6c–11 and proposed rescission of exemptive orders issued to leveraged/inverse ETFs). 309 See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at text preceding n.39 (‘‘Fiduciary Interpretation’’). E:\FR\FM\24JAP2.SGM 24JAP2 4492 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 Investment Company Act is designed to address. Leveraged/inverse funds and certain commodity pools following the same strategy also present unique considerations because they rebalance their portfolios on a daily (or other predetermined) basis in order to maintain a constant leverage ratio. This reset, and the effects of compounding, can result in performance over longer holding periods that differs significantly from the leveraged or inverse performance of the underlying reference index over those longer holding periods.310 This effect can be more pronounced in volatile markets.311 As a result, buy-and-hold investors in a leveraged/inverse fund who have an intermediate or long-term time horizon—and who may not evaluate their portfolios frequently—may experience large and unexpected losses or otherwise experience returns that are different from what they anticipated.312 The Commission’s Office of Investor Education and Advocacy and FINRA have issued alerts in the past decade to highlight issues investors should consider when investing in leveraged/ 310 For example, as a result of compounding, a leveraged/inverse fund can outperform a simple multiple of its index’s returns over several days of consistently positive returns, or underperform a simple multiple of its index’s returns over several days of volatile returns. 311 See FINRA Regulatory Notice 09–31, NonTraditional ETFs—FINRA Reminds Firms of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds (June 2009) (‘‘FINRA Regulatory Notice 09–31’’) (‘‘Using a twoday example, if the index goes from 100 to close at 101 on the first day and back down to close at 100 on the next day, the two-day return of an inverse ETF will be different than if the index had moved up to close at 110 the first day but then back down to close at 100 on the next day. In the first case with low volatility, the inverse ETF loses 0.02 percent; but in the more volatile scenario the inverse ETF loses 1.82 percent. The effects of mathematical compounding can grow significantly over time, leading to scenarios such as those noted above.’’). 312 See id. (reminding member firms of their sales practice obligations relating to leveraged/inverse ETFs and stating that leveraged/inverse ETFs are typically not suitable for retail investors who plan to hold these products for more than one trading session). See also Fiduciary Interpretation, supra note 308 (stating that ‘‘leveraged exchange-traded products are designed primarily as short-term trading tools for sophisticated investors . . . [and] require daily monitoring . . . .’’); Securities Litigation and Consulting Group, Leveraged ETFs, Holding Periods and Investment Shortfalls, (2010), at 13 (‘‘The percentage of investors that we estimate hold [leveraged/inverse ETFs] longer than a month is quite striking.’’); ETFs Adopting Release, supra note 76, at n.78 (discussing comment letters submitted by Consumer Federation of America (urging the Commission to consider additional investor protection requirements for leveraged/ inverse ETFs) and by Nasdaq (stating that ‘‘there is significant investor confusion regarding existing leveraged/inverse ETFs’ daily investment horizon’’)). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 inverse funds.313 In addition, some commenters to the 2015 proposal indicated that at least some segment of investors may hold leveraged/inverse funds for long periods of time, which can lead to significant losses under certain circumstances.314 FINRA has sanctioned a number of brokerage firms for making unsuitable sales of leveraged/inverse ETFs.315 More 313 SEC Investor Alert and Bulletins, Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors (Aug. 1, 2009), available at https://www.sec.gov/investor/pubs/ leveragedetfs-alert.htm. This investor alert, jointly issued by SEC staff and FINRA, followed FINRA’s June 2009 alert, which raised concerns about retail investors holding leveraged/inverse ETFs over periods of time longer than one day. See FINRA Regulatory Notice 9–31, supra note 310. 314 See, e.g., CFA Comment Letter (‘‘There is evidence that suggests investors are incorrectly using certain alternative investments that use derivatives extensively. For example, despite the fact that double and triple leveraged ETFs are shortterm trading vehicles that are not meant to be held longer than one day, a significant number of shares are held for several days, if not weeks.’’). But cf. Comment Letter of Rafferty Asset Management (Mar. 28, 2016) (asserting that there is no evidence that investors do not understand the leveraged/ inverse ETF product, citing, for example, an analysis of eight of its leveraged/inverse ETFs between May 1, 2009 and July 31, 2015, and finding an average implied holding period ranging from 1.18 days to 4.03 days and suggesting, therefore, that investors understand the products are designed for active trading). We note, however, that the analysis relied upon in the Comment Letter of Rafferty Asset Management did not analyze shareholder-level trading activity or provide any information on the distribution of shareholder holding periods. 315 See FINRA News Release, FINRA Sanctions Four Firms $9.1 Million for Sales of Leveraged and Inverse Exchange-Traded Funds (May 1, 2012), available at https://www.finra.org/newsroom/2012/ finra-sanctions-four-firms-91-million-salesleveraged-and-inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus and Century Securities to Pay Fines and Restitution Totaling More Than $1 Million for Unsuitable Sales of Leveraged and Inverse ETFs, and Related Supervisory Deficiencies (Jan. 9, 2014), available at https://www.finra.org/newsroom/2014/finra-ordersstifel-nicolaus-and-century-securities-pay-finesand-restitution-totaling; FINRA News Release, FINRA Sanctions Oppenheimer & Co. $2.9 Million for Unsuitable Sales of Non-Traditional ETFs and Related Supervisory Failures (June 8, 2016), available at https://www.finra.org/newsroom/2016/ finra-sanctions-oppenheimer-co-29-millionunsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of Acceptance, Waiver and Consent (‘‘AWC’’) No. 2014039418801 (Aug. 8, 2016), available at https:// disciplinaryactions.finra.org/Search/ ViewDocument/66461; Citigroup Global Markets Inc., FINRA Letter of AWC No. 20090191134 (May, 1, 2012), available at https:// disciplinaryactions.finra.org/Search/ ViewDocument/31714. See also Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12, 2019)], at paragraph accompanying nn.593–98 (‘‘Regulation Best Interest: The Broker-Dealer Standard of Conduct’’). See also, e.g., SEC. v. Hallas, No 1:17–cv–2999 (S.D.N.Y. Sept. 27, 2017) (default judgement); In the Matter of Demetrios Hallas, SEC. Release No. 1358 (Feb. 22, 2019) (initial decision), Exchange Act Release No 85926 (May 23, 2019) (final decision) PO 00000 Frm 00048 Fmt 4701 Sfmt 4702 recently, the Commission has brought enforcement actions against investment advisers for, among other things, soliciting advisory clients to purchase leveraged/inverse ETFs for their retirement accounts with long-term time horizons, and holding those securities in the client accounts for months or years.316 Most leveraged/inverse funds could not satisfy the limit on fund leverage risk in proposed rule 18f–4 because they provide leveraged or inverse market exposure exceeding 150% of the return or inverse return of the relevant index.317 These funds therefore would fail the relative VaR test and would not be eligible to use the absolute VaR test.318 Requiring these funds to comply with the proposed VaR tests therefore effectively would preclude sponsors from offering the funds in their current form. Investors who are capable of evaluating these funds’ characteristics and their unique risks, however, may want to use them to meet specific shortterm or other investment goals. We therefore are proposing a set of alternative requirements for leveraged/ inverse funds designed to address the investor protection concerns that underlie section 18 of the Investment Company Act, while preserving choice for these investors. These requirements, discussed below, are designed to help ensure that retail investors in leveraged/ inverse investment vehicles are limited to those who are capable of evaluating the risks these products present. They also would limit the amount of leverage that leveraged/inverse funds subject to rule 18f–4 can obtain to their current levels. 2. Proposed Sales Practices Rules for Leveraged/Inverse Investment Vehicles As a complement to proposed rule 18f–4, we are proposing sales practices rules under the rulemaking authority provided in Exchange Act section 15(l)(2) and Advisers Act section (involving a former registered representative of registered broker-dealers purchasing and selling leveraged ETFs and exchange-traded notes for customer accounts while knowingly or recklessly disregarding that they were unsuitable for these customers, in violation of section 17(a) of the Securities Act and section 10(b) and rule 10b–5 thereunder of the Exchange Act). 316 See, e.g., In the Matter of Morgan Stanley Smith Barney, LLC, Investment Advisers Act Release No. 4649 (Feb. 14, 2017) (settled action). 317 See supra section II.D (discussing the proposed VaR-based limit on fund leverage risk). 318 See supra section II.D (discussing relative and absolute VaR tests under proposed rule 18f–4). In addition, we understand that even if leveraged/ inverse funds were to apply the proposed absolute VaR test, many of those funds also would fail that test. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 211(h).319 The proposed sales practices rules would require broker-dealers and investment advisers to exercise due diligence on retail investors before approving retail investor accounts to invest in leveraged/inverse investment vehicles. Specifically, proposed rule 15l–2 under the Exchange Act would require a broker-dealer (or any associated person of the broker-dealer) to exercise due diligence to ascertain certain essential facts about a customer who is a retail investor before accepting the customer’s order to buy or sell shares of a leveraged/inverse investment vehicle, or approving the customer’s account to engage in those transactions.320 Similarly, proposed rule 211(h)–1 under the Advisers Act would require an investment adviser (or any supervised person of the investment adviser) to exercise due diligence to ascertain the same set of essential facts about a client who is a retail investor before placing an order for that client’s account to buy or sell shares of a leveraged/inverse investment vehicle, or approving the client’s account to engage in those transactions.321 Under both of the proposed sales practices rules, a firm could approve the retail investor’s account to buy or sell shares of leveraged/inverse investment vehicles only if the firm had a reasonable basis to believe that the investor is capable of evaluating the risks associated with these products. The proposed sales practices rules are designed to establish a single, uniform set of enhanced due diligence and approval requirements for brokerdealers and investment advisers with respect to retail investors that engage in leveraged/inverse investment vehicle transactions, including transactions where no recommendation or investment advice is provided by a firm. These rules therefore would apply the same due diligence requirements to both broker-dealers and investment advisers.322 They are designed to help 319 These provisions provide the Commission with authority to ‘‘where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.’’ 320 Proposed rule 15l–2(a). In this release, the term ‘‘firm,’’ which collectively refers to Commission-registered broker-dealers and investment advisers, also includes associated persons of such broker-dealers. 321 Proposed rule 211(h)–1(a). In this release, the term ‘‘firm,’’ which collectively refers to Commission-registered broker-dealers and investment advisers, also includes supervised persons of such investment advisers. 322 Although we expect that the proposed sales practices rules would cover a significant percentage of the retail investors who invest in leveraged/ VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 ensure that investors in these funds are limited to those who are capable of evaluating their characteristics— including that the funds would not be subject to all of the leverage-related requirements applicable to registered investment companies generally—and the unique risks they present. Compliance with the proposed rules would not supplant or by itself satisfy other broker-dealer or investment adviser obligations, such as a brokerdealer’s obligations under Regulation Best Interest or an investment adviser’s fiduciary duty under the Advisers Act.323 The approval and due diligence requirements under the proposed rules are modeled after current FINRA options account approval requirements for broker-dealers.324 Under the FINRA rules governing options, a broker-dealer may not accept a customer’s options order unless the broker-dealer has approved the customer’s account for options trading.325 Similarly, the proposed sales practices rules would require that a firm approve a retail investor’s account before the retail investor may invest in leveraged/inverse investment vehicles. As such, the proposed sales practices rules, like the FINRA rule, would not require firms to evaluate retail investors’ eligibility to transact in these products on a transaction-by-transaction basis. We have generally modeled the proposed rules after the FINRA options account framework in part because leveraged/ inverse investment vehicles, when held over longer periods of time, may have certain similarities to options.326 The inverse investment vehicles, we recognize that not every purchase or sale of a leveraged/inverse investment vehicle will involve a customer or client of a Commission-registered broker-dealer or investment adviser that would be subject to the proposed sales practices rules. 323 See Regulation Best Interest: The BrokerDealer Standard of Conduct, supra note 314 (discussing broker-dealer obligations when providing a recommendation to a retail customer of any securities transaction or investment strategy involving securities based on the customer’s investment profile); Fiduciary Interpretation, supra note 308 (discussing an investment adviser’s fiduciary duty to its client, and stating that as fiduciaries, investment advisers owe their clients duties of care and loyalty). 324 See, e.g., FINRA rule 2360(b)(16), (17) (requiring for options accounts, firm approval, diligence and recordkeeping). 325 FINRA rule 2360(b)(16). The same requirements apply for transactions in index warrants, currency index warrants, and currency warrants. See FINRA rules 2352 and 2353. Similar requirements apply for transactions in security futures. See FINRA rule 2370(b)(16) (requiring broker-dealer approval and diligence regarding the opening of accounts to trade security futures). 326 For example, both leveraged/inverse investment vehicles and options provide exposure that is economically equivalent to a dynamically PO 00000 Frm 00049 Fmt 4701 Sfmt 4702 4493 options account approval requirements also represent a current framework that can be used in connection with complex products generally.327 This approach may provide some efficiencies and reduced compliance costs for brokerdealers that already have compliance procedures in place for approving options accounts, although we recognize that these efficiencies and reduced compliance costs would not apply to investment advisers that are not dually registered as, or affiliated with, brokerdealers subject to FINRA rules. a. Definition of Leveraged/Inverse Investment Vehicle The proposed sales practices rules would define a ‘‘leveraged/inverse investment vehicle’’ to mean a registered investment company or an exchange-listed commodity- or currency-based trust or fund (a ‘‘listed commodity pool’’), that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time.328 Although the scope of this definition extends beyond just ETFs (as defined in rule 6c–11), this definition otherwise is substantively identical to the provision in rule 6c–11 excluding leveraged/inverse ETFs from the scope of that rule. The substantive requirements in the proposed definition in the sales practices rules have the same meaning as the provision in rule 6c–11.329 We believe it is appropriate for the scope of the proposed sales practices rules to include leveraged/inverse funds as well as listed commodity pools that follow a similar leveraged or inverse rebalanced inverse or leveraged position in an underlying asset. As a result, both have return characteristics that are more complex than those of the underlying asset, particularly as a leveraged/ inverse investment vehicle’s leverage multiple and/ or holding period increase. See infra section III.B.5. 327 See FINRA Regulatory Notice 12–03 (providing, among other things, that FINRA members ‘‘should consider prohibiting their sales force from recommending the purchase of some complex products to retail investors whose accounts have not been approved for options trading’’). 328 See proposed rule 15l–2(d) and proposed rule 211(h)–1(d). 329 See rule 6c–11(c)(4) (providing that scope of rule 6c–11 does not include ETFs that ‘‘seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time.’’). See also ETFs Adopting Release, supra note 76, at section II.A.3 (discussing rule 6c–11(c)(4)). E:\FR\FM\24JAP2.SGM 24JAP2 4494 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 strategy. The same investor protection concerns regarding aligning firms’ transaction practices with investors’ capability of evaluating the risks of these trading tools apply to this broader category of leveraged/inverse investment vehicles, and not just leveraged/inverse funds specifically.330 Indeed, we understand that leveraged/ inverse funds and listed commodity pools following the same strategy can have virtually identical investment portfolios. Applying the proposed rule to all leveraged/inverse investment vehicles, as defined in the proposed rules, would avoid potential regulatory arbitrage that could result if we were to place different requirements on these products. We request comment on the definition of the term ‘‘leveraged/inverse investment vehicle’’ in the proposed sales practices rules. 171. Is the scope of the proposed definition of the term ‘‘leveraged/ inverse investment vehicle’’ appropriate? The definition includes a fund that seeks to provide investment returns that have an inverse relationship to the performance of a market index. Do commenters agree that this is appropriate? Should the definition instead only include an inverse fund that seeks investment returns that exceed the inverse performance of a market index by a specified multiple (e.g., ¥1.5 or lower)? Why or why not? The definition also includes a fund that seeks to provide performance results ‘‘over a predetermined period of time.’’ Do commenters agree that this is appropriate? Generally, the extent to which a fund’s performance can be expected to deviate from the multiple or inverse multiple of the performance of its index when held over longer periods is larger for funds that track a multiple or inverse multiple of the performance of an index over shorter time intervals, as those funds typically rebalance their portfolios more frequently. Should we specify a time period in the definition 330 The definition of commodity- or currencybased trusts or funds that we propose to include in the leveraged/inverse investment vehicle definition tracks a definition recently provided by Congress in the Fair Access to Investment Research Act of 2017, Public Law 115–66, 131 Stat. 1196 (2017) (the ‘‘FAIR Act’’), which we understand includes the kinds of commodity pools that generally pursue leveraged or inverse investment strategies. Our proposed definition differs from the FAIR Act definition because it would not include a trust or fund that holds only commodities or currencies and does not hold derivatives. Because we believe that trusts or funds that seek to provide a leveraged or inverse return of an index generally would use derivatives to do so, we do not believe it is necessary to include trusts or funds that do not hold derivatives in the proposed definition in the sales practices rules. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 and, if so, what time period would be appropriate? For example, should the definition only include a fund that seeks investment returns that correspond to a multiple or inverse multiple of an index over a fixed period of time that is less than a year, a quarter, or a month? Please explain. 172. Do commenters agree with our proposal to include listed commodity pools within the definition? Are we correct that the similarities between the investment strategies and return profiles of listed commodity pools and other leveraged/inverse investment vehicles, such as leveraged/inverse ETFs, warrant including listed commodity pools within the scope of this definition? 173. Are there other types of investments or products that we should include in the leveraged/inverse investment vehicle definition? For example, should we include exchangetraded notes within the scope of the proposed sales practices rules if they have the same or similar return profile as the leveraged/inverse funds and listed commodity pools included in the proposed definition? 331 Are there additional complex financial products, such as those discussed in FINRA Regulatory Notice 12–03 (including, among others, certain structured or asset-backed notes, unlisted REITs, securitized products, and products that offer exposure to stock market volatility), that commenters believe should be subject to the due diligence and account approval requirements that we are proposing for leveraged/inverse investment vehicles? 332 b. Required Approval and Due Diligence in Opening Accounts Under the proposed sales practices rules, no firm may accept an order from or place an order for a retail investor to buy or sell shares of a leveraged/inverse investment vehicle, or approve such a retail investor’s account to engage in 331 The Commission also recently brought and settled an enforcement action against a duallyregistered broker-dealer/investment adviser, certain of its supervisory personnel, and one of its registered representatives arising out of that representative’s recommending that his customers buy and hold leveraged and inverse exchangetraded funds and exchange traded notes (including allegations that the registered representative recommended that his customers hold a tripleleveraged exchange-traded note for longer than the one-day holding period set forth in the product’s prospectus). See In the Matter of Cadaret Grant, et al., Exchange Act Release No. 84074 (Sept. 11, 2018) (alleging, among other things, a violation of section 206(4) of the Advisers Act and rule 206(4)– 7 thereunder and failure to supervise) (settled action). See In the Matter of Cadaret Grant, et al., Exchange Act Release No. 84074 (Sept. 11, 2018) (settled action). 332 See FINRA Regulatory Notice 12–03, supra note 326. PO 00000 Frm 00050 Fmt 4701 Sfmt 4702 those transactions, unless the firm has complied with certain conditions. Specifically, the proposed rules would require the firm to (1) approve the retail investor’s account for buying and selling shares of leveraged/inverse investment vehicles pursuant to a due diligence requirement; and (2) adopt and implement policies and procedures reasonably designed to achieve compliance with the proposed rules. The proposed due diligence requirement provides that a firm must exercise due diligence to ascertain the essential facts relative to the retail investor, his or her financial situation, and investment objectives. A firm must seek to obtain, at a minimum, certain information about its retail investor’s: • Investment objectives (e.g., safety of principal, income, growth, trading profits, speculation) and time horizon; • employment status (name of employer, self-employed or retired); • estimated annual income from all sources; • estimated net worth (exclusive of family residence); • estimated liquid net worth (cash, liquid securities, other); • percentage of the retail investor’s liquid net worth that he or she intends to invest in leveraged/inverse investment vehicles; and • investment experience and knowledge (e.g., number of years, size, frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, stocks and bonds, commodities, and other financial instruments.333 Based on its evaluation of this information, the firm would be required specifically to approve or disapprove the retail investor’s account for buying or selling shares of leveraged/inverse investment vehicles. If the firm approves the account, the approval must be in writing. Under the proposed rules, to provide this approval a firm must have a reasonable basis for believing that the retail investor has the financial knowledge and experience to be reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. We are not proposing a brightline test for this determination. Rather, the determination would be based on all of the relevant facts and circumstances. The information that a firm would collect includes information about the retail investor’s financial status (e.g., 333 See proposed rule 15l–2(b)(2). For joint accounts, the firm must seek to obtain the information for all participants in joint retail investor accounts. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules employment status, income, and net worth (including liquid net worth)); and information about his or her investment objectives generally and his or her anticipated investments in, and experience with, leveraged/inverse investment vehicles (e.g., general investment objectives, percentage of liquid net worth intended for investment in leveraged/inverse investment vehicles, and investment experience and knowledge). This information is designed to provide a comprehensive picture of the retail investor to allow a firm to evaluate whether the retail investor has the financial knowledge and experience to be reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. While not required under the proposed rules, firms could consider establishing multiple levels of account approvals for a retail investor seeking to trade leveraged/inverse investment vehicles. We understand that brokerdealers set different levels of options account approval depending on the customer’s trading experience and financial sophistication.334 Similarly, a firm may determine that certain leveraged/inverse investment vehicles (e.g., those with lower leverage multiples or that invest in less-volatile asset classes) are more appropriate for a lower level of account approval, while other types of leveraged/inverse investment vehicles may be more appropriate for a higher level of account approval. Any such approaches generally should be addressed in the policies and procedures that the proposed sales practices rules would require a firm to adopt and implement.335 The proposed rules’ scope with respect to a firm’s customer or client is limited to ‘‘a natural person’’ or ‘‘the legal representative of a natural person.’’ 336 The rules include all natural persons—including high-net worth individuals—to provide the related investor protections to all natural persons. The proposed rules require firms to seek to obtain and to consider information related to a retail investor’s net worth as part of their consideration of whether to approve the investor’s account for trading in leveraged/inverse investment vehicles. 334 These increasing levels generally track the riskiness of the product or trading strategy; for example, the initial option account approval may permit covered call writing of equity options but higher account approvals would be needed for writing uncovered index options. 335 See proposed rules 15l–2(a) and 211(h)–1(a). 336 See proposed rules 15l–2(a) and 211(h)–1(a). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 We interpret ‘‘legal representative’’ of a natural person to mean non-professional legal representatives of a natural person.337 This interpretation would exclude institutions and certain professional fiduciaries, but it would include certain legal entities such as trusts that represent the assets of a natural person.338 This interpretation is designed to provide the protections of the sales practices rules where nonprofessional persons are acting on behalf of natural persons, but where such professional persons are not regulated financial services industry professionals retained by natural persons to exercise independent professional judgment.339 In addition, we are proposing to specify in the sales practices rules that, although the rules would apply to transactions by broker-dealers and investment advisers for retail investors—including those investors who have existing accounts before the rules’ compliance date—the sales practices rules would not apply to a position in a leveraged/inverse investment vehicle established before the rules’ compliance date. This provision is designed to allow existing investors in leveraged/inverse investment vehicles with open investments as of the rules’ compliance date to sell their holdings (or to purchase leveraged/inverse investment vehicles to close out short positions in the leveraged/inverse investment vehicle) without the additional steps we propose to require for their brokerdealer or investment adviser to determine whether to approve the retail investor’s account to trade in these products.340 Absent this provision, the sales practices rules could prevent or delay a retail investor’s ability to close or reduce a position in a leveraged/ inverse investment vehicle that he or 337 See, e.g., Form CRS Relationship Summary, Exchange Act Release No. 34–86032 (June 5, 2019) [84 FR 33492 (July 12, 2019)] (‘‘Form CRS Release’’), at n.629 and accompanying text. 338 See Form CRS Release, supra note 336, at nn.645–647 and accompanying text (clarifying interpretation of ‘‘legal representative’’ of a natural person to cover only non-professional legal representatives (e.g., a non-professional trustee that represents the assets of a natural person and similar representatives such as executors, conservators, and persons holding a power of attorney for a natural person)); Regulation Best Interest: The BrokerDealer Standard of Conduct, supra note 314, at n.237 and accompanying text (defining ‘‘retail customer’’). 339 See Form CRS Release, supra note 336, at nn.645–647 and accompanying text. 340 This provision is designed to allow a retail investor to exit a legacy position in a leveraged/ inverse investment vehicle, as discussed above, and does not reflect any view on whether any recommendation for these legacy positions was suitable when made. PO 00000 Frm 00051 Fmt 4701 Sfmt 4702 4495 she entered into before firms were required to comply with the rules. We also do not believe it would be appropriate to apply the sales practices rules only to retail accounts established after the rules’ compliance date, because the investor protection concerns underlying the rules would apply equally to pre-existing retail investor accounts. Accordingly, the proposed rules would make clear that, even if a retail investor had already been trading leveraged/inverse investment vehicles, a firm would have to satisfy the due diligence and account approval requirements for that investor’s account before the investor could make additional investments in leveraged/ inverse investment vehicles.341 The proposed sales practices rules also would require firms to adopt and implement written policies and procedures addressing compliance with the applicable sales practices rule.342 We are not proposing to impose specific requirements for these policies and procedures, provided that they are reasonably designed to achieve compliance with the applicable sales practices rule, including the due diligence and account approval requirements. This requirement, together with the proposed recordkeeping requirements discussed below, is designed to provide comparable policies and procedures and recordkeeping requirements for both broker-dealers and investment advisers. We request comment on the proposed approval and due diligence requirements for approving retail investors’ accounts to trade in shares of leveraged/inverse investment vehicles. 174. Is modeling these rules on FINRA’s options rule the appropriate approach? Why or why not? 175. Should the proposed sales practices rules apply to Commissionregistered broker-dealers and investment advisers? Why or why not? What challenges, if any, would brokerdealers or investment advisers face complying with the proposed rules, and what compliance burdens would the proposed rules create for broker-dealers and investment advisers? Would compliance burdens be substantially different for investment advisers than for broker-dealers (for example, because of any compliance efficiencies that might result to the extent broker-dealers are already complying with FINRA’s 341 As discussed above, this evaluation would take into account, among other things, the investor’s experience with leveraged/inverse investment vehicles. See, e.g., proposed rules 211(h)–1(b)(2) and 15l–2(b)(2). 342 See proposed rule 15l–2(a); proposed rule 211(h)–1(a). E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4496 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules rules for approving options accounts), or vice versa? Should we apply proposed Advisers Act rule 211(h)–1 to investment advisers that are registered with one or more states but not registered with the Commission? Why or why not? Should the proposed rule for investment advisers apply equally to advisers with discretionary authority and with non-discretionary authority over client accounts? If the sales practices rule for investment advisers applies to both discretionary and nondiscretionary advisory accounts, should we apply different due diligence and account approval requirements based on whether an account is discretionary or non-discretionary? Should the proposed sales practices rules apply to investment advisers, in light of their fiduciary duties to their clients? Why or why not? Should the sales practices rules apply to a broker-dealer if the broker-dealer does not effect transactions in leveraged investment vehicles for retail investors other than transactions resulting from recommendations that are subject to Regulation Best Interest? Why or why not? 176. Should the proposed rules apply to transactions in leveraged/inverse investment vehicles that are directed by a retail investor without any recommendation or advice from a broker-dealer or investment adviser? Why or why not? 177. Should the proposed rules apply on a transaction-by-transaction basis rather than requiring an initial account approval to transact in leveraged/ inverse investment vehicles? Why or why not? 178. As proposed, the sales practices rules would require that a firm could provide account approval only if the firm has a reasonable basis for believing that the investor has such knowledge and experience in financial matters that he or she may reasonably be expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. Is this account approval standard appropriate? Why or why not? If not, what should the account approval standard be? Should it be tied instead, for example, to an investor’s ability to absorb losses, and if so how should a firm assess this? 179. Is the investor information that the proposed rules would require firms to seek to obtain under the rules’ due diligence requirements appropriate, and would this information effectively assist in forming a reasonable basis for assessing the investor’s knowledge and experience in financial matters as required under the proposed account approval standard? Why or why not? What modifications, if any, should we VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 make to the information items that the proposed rules would require a firm to seek to obtain? Are there any information items that we should remove from the proposed list, or any additional information items that we should include? For example, instead of tracking generally the information elements set forth under FINRA’s option rule, should the proposed rules track generally the information set forth in the definition of ‘‘retail customer investment profile’’ under Regulation Best Interest (i.e., ‘‘age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the retail customer may disclose to the broker, dealer, or a natural person who is an associated person of a broker or dealer’’)? As proposed, should the rules require firms to seek to obtain the percentage of the investments that the retail investor intends to invest in leveraged/inverse investment vehicles? Why or why not? 180. Should the sales practices rules require firms to obtain the specified information, rather than to seek to obtain it? Would a firm be able to form a reasonable basis for believing that a retail investor has such knowledge and experience in financial matters that he or she may reasonably be expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles if the retail investor provides some, but not all, of the information specified in the sales practices rules? 181. What special procedures, if any, do firms currently undertake in permitting or not permitting retail investors to trade in leveraged/inverse investment vehicles? At account opening? With respect to specific transactions? With respect to concentration limits? Do firms already have approval processes in place designed to evaluate whether their retail investors are reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles? If so, do firms distinguish between types of vehicles or trading strategies? Do these practices differ between broker-dealers and investment advisers? If so, please explain the differences. 182. What special procedures, if any, do firms currently undertake in permitting or not permitting retail investors to trade in other types of complex products? Please explain in detail, including products to which such procedures apply and what the approval process entails. PO 00000 Frm 00052 Fmt 4701 Sfmt 4702 183. The proposed sales practices rules would require that firms’ approvals of retail investors’ accounts for buying or selling shares of leveraged/ inverse investment vehicles be in writing. The proposed rules would not require account disapprovals to be in writing. Should we require account disapprovals also to be in writing? Would such a requirement raise any practical concerns, or other concerns, for firms? In other investor approval contexts, do firms currently put both their approvals and disapprovals in writing? 184. How do broker-dealers apply the options eligibility requirement with respect to clients of investment advisers, if at all, when those advisers submit orders on behalf of their clients? Do broker-dealer practices differ with respect to orders submitted by other types of intermediaries? Please explain. 185. How do broker-dealers currently analyze the information they collect under FINRA rule 2360? Which data elements do broker-dealers find most important and which elements are less important? What standards do brokerdealers apply in determining whether to approve a customer’s account on the basis of the information collected? 186. Should the proposed rules require firms to provide specific disclosure as part of the approval process, similar to the options disclosure document that must be provided under FINRA rule 2360? If so, what information should it contain? Should the rules require that receipt of such disclosure be acknowledged? 187. Should the rules require firms to provide retail investors a short, plainEnglish disclosure generally describing the risks associated with leveraged/ inverse investment vehicles as part of the proposed account approval process? For example, before a firm approves a retail investor’s account for buying and selling shares of a leveraged/inverse investment vehicle, should the rules require a firm to incorporate and distill into a short disclosure the specific risk factors associated with leveraged/ inverse investment vehicles (such as the risks related to compounding and other risks that leveraged/inverse funds disclose in their prospectuses)? 188. Should the rules apply to all customers or clients, and not just natural persons? Should they apply to a different subset of customers or clients and, if so, which ones and why? If the rule were to apply to all customers or clients, including institutional accounts, what changes should we make to the information that firms must collect or to the basis upon which a firm would approve or disapprove the account? Are E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules there distinctions between institutional investors and natural persons that invest in leveraged/inverse investment vehicles that we should consider? For example, do commenters have data or information on the percentage of leveraged investment vehicles’ investors who are natural persons, and how natural persons use these investment products (e.g., how long do these investors hold the products)? 189. As discussed above, we understand that certain purchases or sales of leveraged/inverse investment vehicles do not involve a customer or client of a broker-dealer or investment adviser that would be subject to the proposed sales practices rules.343 Should the proposed rules apply to these transactions? For example, should the proposed sales practices rule for broker-dealers apply to a mutual fund principal underwriter’s transactions with any retail investor who is purchasing fund shares directly from the fund? 190. Should the sales practices rules include different account-approval conditions for different types of leveraged/inverse investment vehicles? For example, should the rules include different conditions for investment vehicles that seek to exceed the performance of a market index by a specified multiple, versus those that provide returns that have an inverse relationship to the performance of a market index? Should the rules include different levels of account approval, such as heightened requirements for investors to transact in leveraged/ inverse investment vehicles with higher leverage multiples or that invest in more volatile asset classes? Similarly, should the rules include different levels of account-approval conditions based on a retail investor’s trading experience and financial sophistication? 191. Do commenters agree that we should apply the sales practices rules to all retail investors, including those who have opened accounts with an investment adviser or broker-dealer before the rules’ compliance date? Should the sales practices rules include exceptions from the due diligence and account approval requirements for retail investors that have already traded in leveraged/inverse investment vehicles as of the rules’ compliance date? Should the sales practices rules provide exceptions for retail investors who meet established criteria, such as retail investors who are accredited investors? Why or why not? 192. The proposed rules also would not apply to, and therefore would not 343 See supra note 321. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 restrict a retail investor’s ability to close or reduce, a position in a leveraged/ inverse investment vehicle established before the rules’ compliance date. Do commenters agree that this is appropriate? Are there modifications we should make to the rules so that they would not impede an investor’s ability to close or reduce an existing position in a leveraged/inverse investment vehicle? Which modifications and why? Alternatively, should the sales practices rules apply to retail investors with positions in leveraged/inverse investment vehicles established before the rules’ compliance date even if they do not seek to make additional purchases or sales of leveraged investment vehicles? If so, how would firms comply, in practice, with the due diligence and account approval requirements for these investors? 193. Do commenters agree with the proposed policies and procedures requirement? Should the rule provide specific requirements for firms’ policies and procedures relating to compliance with the sales practices rules? c. Recordkeeping Under the proposed sales practices rules, a firm would have to maintain a written record of the investor information that it obtained under the rules’ due diligence requirements, the firm’s written approval of the retail investor’s account for buying and selling shares of leveraged/inverse investment vehicles, and the versions of the firm’s policies and procedures that it adopted under the proposed rules that were in place when it approved or disapproved the account. We propose that firms be required to retain these records for a period of not less than six years (the first two years in an easily accessible place) after the date of the closing of the investor’s account.344 We believe that it is appropriate for the proposed rules to include a recordkeeping provision to facilitate compliance, and regulatory oversight of a firm’s compliance, with the rules. Also, because an investor account that was approved to trade in leveraged/inverse investment vehicles could remain open with a firm for more than six years, we believe it is appropriate to require that records be preserved for a minimum of six years after the closing of the account, rather than six years after the creation of the records.345 We believe that this 344 See proposed rules 15l–2(c) and 211(h)–1(c). is consistent with other Commission recordkeeping requirements relating to investor account documentation. See, e.g., rule 17a–4(c) under the Exchange Act (requiring broker-dealers to preserve for a period of not less than six years after the closing of any customer’s account any account 345 This PO 00000 Frm 00053 Fmt 4701 Sfmt 4702 4497 recordkeeping requirement would provide sufficient investor protection and, because it is generally consistent with recordkeeping requirements for broker-dealers and investment advisers, would not impose overly burdensome recordkeeping costs.346 We request comment on the recordkeeping requirement in the proposed sales practices rules: 194. Is the proposed recordkeeping requirement appropriate? Why or why not? 195. What changes, if any, should we make to this proposed requirement (e.g., by modifying the types of records that a firm would have to keep)? 196. Does our proposal to apply the same recordkeeping requirement to both broker-dealers and investment advisers raise any specific recordkeeping concerns for either broker-dealers or investment advisers (e.g., do investment advisers believe it would be particularly burdensome to comply with a six-year recordkeeping period)? Should the proposed rules include different requirements for broker-dealers and investment advisers? 197. Is the proposed duration of the recordkeeping provision, including the proposed requirement that the records be maintained for a minimum of six years after the closing of the investor’s account, appropriate? Does using the closing of the investor’s account as the starting point for the recordkeeping period raise any practical difficulties for firms? Should we lengthen or shorten the required recordkeeping periods? Why or why not? 3. Alternative Provision for Leveraged/ Inverse Funds Under Proposed Rule 18f–4 Under proposed rule 18f–4, a fund would not have to comply with the proposed VaR-based leverage risk limit if it: (1) Meets the definition of a ‘‘leveraged/inverse investment vehicle’’ in the proposed sales practices rules; (2) limits the investment results it seeks to cards or records relating to the terms and conditions with respect to the opening and maintenance of the account). 346 See, e.g., id.; see also rule 204–2(e)(1) under the Investment Advisers Act (requiring investment advisers to preserve certain records in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years in an appropriate office of the investment adviser). While we recognize that our existing recordkeeping requirements generally require broker-dealers to preserve records for six years and investment advisers for five years, we believe it would be appropriate for the recordkeeping requirements under the proposed sales practices rule to be consistent, in part because many brokerdealers and investment advisers are dual-registered, and thus are proposing a six-year period for both rules. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4498 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 300% of the return (or inverse of the return) of the underlying index; and (3) discloses in its prospectus that it is not subject to proposed rule 18f–4’s limit on fund leverage risk. We refer to this set of proposed conditions collectively as the ‘‘alternative provision for leveraged/ inverse funds.’’ A leveraged/inverse fund that satisfies these conditions still would be required to satisfy all of the additional conditions in proposed rule 18f–4 other than the VaR tests, including the proposed conditions requiring a derivatives risk management program, board oversight and reporting, and recordkeeping.347 First, the alternative provision for leveraged/inverse funds requires that a leveraged/inverse fund be a ‘‘leveraged/ inverse investment vehicle’’ as defined in the proposed sales practices rules.348 As discussed above, the proposed sales practices rules are designed to help ensure that investors in leveraged/ inverse investment vehicles are limited to those who are capable of evaluating their general characteristics and the unique risks they present. Second, the alternative provision for leveraged/inverse funds would limit a leveraged/inverse fund’s market exposure by providing that the fund must not seek or obtain, directly or indirectly, investment results exceeding 300% of the return (or inverse of the return) of the underlying index.349 This limitation reflects the highest leverage level currently permitted by our exemptive orders for leveraged/inverse ETFs.350 It therefore reflects the maximum amount of leverage in these funds with which investors and other market participants are familiar. To permit leveraged/inverse funds to use a higher level of leverage would heighten the investor protection concerns these funds present, notwithstanding their more limited investor base.351 Moreover, allowing leveraged/inverse funds to increase their leverage beyond current levels would result in a nonlinear increase in the extent of leveraged/inverse funds’ rebalancing activity, which may have adverse effects on the markets for the constituent securities as discussed in more detail in sections III.D.1 and III.E.4. For these reasons, and because the Commission does not have experience with leveraged/inverse funds that seek returns above 300% of the return (or 347 See proposed rule 18f–4(c)(1), (5)–(6). proposed rule 18f–4(c)(4)(i); proposed rules 15l–2(d) and 211(h)–1(d) (defining the term ‘‘leveraged/inverse investment vehicle’’). 349 See proposed rule 18f–4(c)(4)(iii). 350 See ETFs Adopting Release, supra note 76, at n.75 and accompanying text. 351 See also section III.C.5. 348 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 inverse of the return) of the underlying index, we are not proposing to permit higher levels of leveraged market exposure for leveraged/inverse funds in this rule. Third, the alternative provision for leveraged/inverse funds would require a leveraged/inverse fund to disclose in its prospectus that it is not subject to the condition of proposed rule 18f–4 limiting fund leverage risk.352 This requirement is designed to provide investors and the market with information to clarify that leveraged/ inverse funds—which as discussed above, use derivatives extensively—are not subject to rule 18f–4’s limit on fund leverage risk. We request comment on the proposed alternative provision for leveraged/ inverse funds. 198. Should the rule include an alternative set of requirements for leveraged/inverse funds? Should leveraged/inverse funds instead be required to meet the proposed requirements for all funds that use derivatives, including the VaR-based limit on fund leverage risk? If commenters agree that we should permit leveraged/inverse ETFs to rely on rule 18f–4 based on an alternative set of requirements, are there additional conditions—either relating to these funds’ derivatives risk management or otherwise—that we should consider requiring those funds to satisfy? To what extent would additional limitations or restrictions on leveraged investment vehicles’ advertising or marketing materials help to address the investor protection concerns discussed above? 199. Does our proposal to include within the scope of the rule only leveraged/inverse funds that are covered by the proposed sales practices rules, along with the conditions comprising the alternative provision for leveraged/ inverse funds, address the investor protection concerns related to leveraged/inverse funds? 200. If leveraged/inverse funds operate pursuant to the proposed alternative provision, should they nonetheless be subject to other requirements in the proposed rule (e.g., the proposed risk management program requirement, board oversight and reporting requirement, and recordkeeping requirement)? 201. Should leveraged/inverse funds relying on the alternative provision be required to disclose in their prospectuses that the fund is not subject to the proposed VaR-based limit on fund leverage risk, as proposed? If so, what 352 See PO 00000 proposed rule 18f–4(c)(4)(ii). Frm 00054 Fmt 4701 Sfmt 4702 would be the most appropriate method of disclosure? In addition to requiring this disclosure under rule 18f–4, should we also include this requirement in Form N–1A? Would it aid practitioners for a leveraged/inverse fund’s registration form to specify this requirement? 202. Should a leveraged/inverse fund relying on rule 18f–4 be required to limit the investment results it seeks or obtains to 300% of the return (or inverse of the return) of the underlying index? Would some other threshold be more appropriate? Should the threshold be higher, such as 400%, or lower, such as 150% or 200%? 203. Any registered investment company that operates as a leveraged/ inverse fund would be eligible to comply with the proposed alternative provision for leveraged/inverse funds in rule 18f–4. Should we limit the scope of leveraged/inverse funds eligible for this provision to open-end funds, including ETFs? 4. Proposed Amendments to Rule 6c–11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs Earlier this year, the Commission adopted rule 6c–11, which permits ETFs that satisfy certain conditions to operate without obtaining an exemptive order from the Commission.353 Rule 6c–11 includes a provision excluding leveraged/inverse ETFs from the scope of ETFs that may rely on that rule.354 Leveraged/inverse ETFs, therefore, continue to rely on their Commission exemptive orders. In adopting rule 6c– 11, the Commission stated that the particular section 18 concerns raised by leveraged/inverse ETFs’ use of derivatives distinguish those funds from the other ETFs permitted to rely on that rule, and that those section 18 concerns would be more appropriately addressed in a rulemaking addressing the use of derivatives by funds more broadly.355 The Commission further stated that leveraged/inverse ETFs are similar in structure and operation to the other types of ETFs that are within the scope of rule 6c–11.356 The rules we are proposing, rule 18f–4 under the 353 See ETFs Adopting Release, supra note 76. rule 6c–11(c)(4). 355 See ETFs Adopting Release, supra note 76, at nn.72–75 and accompanying text. 356 See id. at text following n.86. In addition, one sponsor of leveraged/inverse ETFs has stated that its ETFs would prefer to rely on rule 6c–11 over their exemptive orders and that leveraged/inverse ETFs would be able to comply with rule 6c–11 because they are structured and operated in the same manner as other ETFs that fall within the scope of that rule. See id. at n.83 and accompanying text. 354 See E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 Investment Company Act and the sales practices rules under the Exchange Act and the Advisers Act, would create an updated and more comprehensive regulatory framework for the use of derivatives by funds, including provisions specifically applicable to leveraged/inverse ETFs. Accordingly, we propose to amend rule 6c–11 to remove the provision excluding leveraged/inverse ETFs from the scope of that rule one year following the publication of the final amendments in the Federal Register. In addition, because the proposed amendments to rule 6c–11 would permit leveraged/inverse ETFs to rely on that rule rather than their exemptive orders, we are proposing to rescind the exemptive orders we have previously issued to leveraged/inverse ETFs. The exemptive relief granted to leveraged/ inverse ETFs has resulted in an uneven playing field among market participants because the Commission has permitted only three ETF sponsors to operate leveraged/inverse ETFs and has not granted any exemptive relief for leveraged/inverse ETFs since 2009.357 We believe that amending rule 6c–11 and rescinding these exemptive orders would promote a more level playing field and greater competition by allowing any sponsor to form and launch a leveraged/inverse ETF subject to the conditions in rules 6c–11 and proposed rule 18f–4, with transactions in the funds subject to the proposed sales practices rules. We propose to rescind these exemptive orders on the effective date of the proposed amendments to rule 6c–11 (one year following the publication of the final rule amendments in the Federal Register), to coincide with the compliance date for the sales practices rules and to allow time for brokerdealers and investment advisers to make any adjustments necessary to comply with the proposed sales practices rules. Providing a one-year period for existing leveraged/inverse ETFs also would provide time for them to prepare to comply with rule 6c–11 rather than their exemptive orders.358 357 There are currently two ETF sponsors that rely upon this exemptive relief today. See supra note 307 and accompanying text; infra note 473 and accompanying text. We also discuss below in section III.E alternative approaches for leveraged/ inverse funds, including an approach under which the Commission would rescind the exemptive orders issued to leveraged/inverse ETF sponsors, permit leveraged/inverse funds to operate under rule 6c–11, but require leveraged/inverse funds to comply with rule 18f–4’s VaR-based limit on fund leverage risk in lieu of adopting the proposed sales practices rules. 358 See ETFs Adopting Release, supra note 76, at text following n.451. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 We request comment on the proposed amendments to rule 6c–11 and rescission of leveraged/inverse ETF exemptive orders. 204. If leveraged/inverse funds are permitted to rely on rule 18f–4, should the Commission amend rule 6c–11 to permit leveraged/inverse funds to operate under that rule, as proposed? Do the requirements of proposed rule 18f– 4, together with the proposed sales practices rules, adequately address the section 18 concerns relating to leveraged/inverse funds? Are there are other concerns regarding leveraged/ inverse funds that we should consider in determining whether to allow such funds to rely on rule 6c–11? 205. In addition, do commenters agree with our proposal to rescind the existing leveraged/inverse ETF exemptive relief in view of our proposed treatment of leveraged/inverse funds under rule 18f– 4 and proposed amendments to rule 6c– 11? Are there other approaches to the existing leveraged/inverse ETF exemptive relief that we should consider in view of proposed rule 18f– 4 and the proposed sales practices rules? H. Amendments to Fund Reporting Requirements We are proposing amendments to the reporting requirements for funds that would rely on proposed rule 18f–4—in particular, amendments to Forms N– PORT, N–LIQUID (which we propose to re-title as ‘‘Form N–RN’’), and N– CEN.359 These proposed amendments are designed to enhance the Commission’s ability to oversee funds’ use of and compliance with the proposed rules effectively, and for the Commission and the public to have greater insight into the impact that funds’ use of derivatives would have on their portfolios.360 They would allow 359 17 CFR 274.150; 17 CFR 274.223; and 17 CFR 249.330 and 17 CFR 274.101. 360 The funds that would rely on proposed rule 18f–4 other than BDCs generally are subject to reporting requirements on Form N–PORT. All registered management investment companies, other than registered money market funds and small business investment companies, are (or will be) required to electronically file with the Commission, on a quarterly basis, monthly portfolio investment information on Form N–PORT, as of the end of each month. See Investment Company Reporting Modernization Adopting Release, supra note 178. As of April 30, 2019, larger fund groups (defined as having $1 billion or more in net assets) have begun submitting reports on Form N–PORT for the period ending March 31, 2019. Smaller fund groups (less than $1 billion in net assets) will begin submitting reports on Form N–PORT by April 30, 2020. See Investment Company Reporting Modernization, Investment Company Act Release No. 32936 (Dec. 8, 2017) [82 FR 58731 (Dec. 14, 2017)]. Only information reported for the third month of each fund’s fiscal quarter on Form N– PO 00000 Frm 00055 Fmt 4701 Sfmt 4702 4499 the Commission and others to identify and monitor industry trends, as well as risks associated with funds’ investments in derivatives (including by requiring current, non-public reporting to the Commission when certain significant events related to a fund’s leverage risk occur). The proposed amendments also would aid the Commission in evaluating the activities of investment companies in order to better carry out its regulatory functions. 1. Amendments to Form N–PORT We are proposing to amend Form N– PORT to add new items to Part B (‘‘Information About the Fund’’), as well as to make certain amendments to the form’s General Instructions. a. Derivatives Exposure We are proposing to amend Form N– PORT to include a new reporting item on funds’ derivatives exposure.361 A fund would be required to provide its derivatives exposure as of the end of the reporting period.362 This information PORT will be publicly available (60 days after the end of the fiscal quarter). See Amendments to the Timing Requirements for Filing Reports on Form N–PORT, Investment Company Act Release No. 33384 (Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)]. Currently, only open-end funds that are not regulated as money market funds under rule 2a–7 under the Investment Company Act are required to file current reports on Form N–LIQUID, under section 30(b) of the Investment Company Act and rule 30b1–10 under the Act. See Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016) [81 FR 82142 (Nov. 18, 2016)], at section III.L.2 (‘‘Liquidity Adopting Release’’). Our proposal, including proposed amendments to Form N–LIQUID, rule 30b1–10 and proposed rule 18f– 4(c)(7), would add new VaR-related items to the form, and would extend the requirement to file current reports with respect to these new items to any fund (including registered open-end funds, registered closed-end funds, and BDCs) that relies on rule 18f–4 and that is subject to the rule’s limit on leverage risk. The funds that would rely on proposed rule 18f– 4 other than BDCs generally are subject to reporting requirements on Form N–CEN. Specifically, all registered investment companies, including money market funds but excluding face amount certificate companies, are currently required to file annual reports on Form N–CEN. See Investment Company Reporting Modernization Adopting Release, supra note 178. Form N–CEN requires these funds to report census-type information including reports on whether a fund relied upon certain enumerated rules under the Investment Company Act during the reporting period. See, e.g., Item C.7 of Form N–CEN. 361 See proposed Item B.9 of Form N–PORT; see also proposed amendments to General Instruction E to Form N–PORT (adding a new definition for ‘‘derivatives exposure,’’ as defined in proposed rule 18f–4(a),which would permit a fund to convert the notional amounts of interest rate derivatives to 10year bond equivalents and delta adjust the notional amounts of options contracts). 362 See proposed Item B.9 of Form N–PORT. Just as the proposed definition of ‘‘derivatives transaction’’ in rule 18f–4 includes derivatives instruments as well as short sale borrowings, Form E:\FR\FM\24JAP2.SGM Continued 24JAP2 4500 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 would be publicly available for the third month of each fund’s quarter and would provide market-wide insight into the levels of funds’ derivatives exposure to the Commission, its staff, and market participants.363 It also would allow the Commission and its staff to oversee and monitor compliance with the proposed rule’s exception for limited derivatives users.364 We seek comment on the Commission’s proposed amendments to Form N–PORT requiring reporting of derivatives exposure: 206. Is the proposed requirement that funds report their derivatives exposure on Form N–PORT appropriate? Why or why not? Should we modify the proposed derivatives exposure reporting item in any way? If so, how should we modify this reporting item? 207. Our proposal would make public the information that a fund would report in response to the new derivatives exposure Form N–PORT item. Is there any reason why this information should not be publicly available? 208. Should we require this reporting only from certain funds—for example, those that qualify either as limited derivatives users or leveraged/inverse funds under proposed rule 18f–4— during the reporting period? 209. Should we require funds to report metrics tied to their daily notional amount calculation on Form N–PORT (for example, a fund’s highest daily derivatives exposure during the reporting period and the date of its highest exposure, and its median daily derivatives exposure during the reporting period)? Should we only require funds to report these types of N–PORT would require a fund to report exposure associated with derivatives instruments and short sales. The proposed requirement to report derivatives exposure at the end of the reporting period reflects the form’s requirement to report information about funds’ portfolio holdings as of the last business day, or last calendar day, of each month. See General Instruction A to Form N–PORT. While we are proposing that funds report their highest daily VaR and median daily VaR during the reporting period (see infra section II.H.1.b), we are not also proposing that funds report their highest daily derivatives exposure (or median daily derivatives exposure) during the reporting period. This is because proposed rule 18f–4 requires daily calculation of a fund’s VaR but does not require a fund to calculate its derivatives exposure daily. 363 We are not proposing to amend General Instruction F to Form N–PORT, which specifies the information that funds report on Form N–PORT that the Commission does not make publicly available. While the information for the first two months of a fund’s quarter would be non-public, the information for the third month of a fund’s quarter would be publicly available. See supra note 359. 364 Under this proposal, a fund would have to indicate whether it is a limited derivatives user on Form N–CEN. See infra section II.H.3. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 metrics if we were also to modify proposed rule 18f–4 to require funds to calculate their notional amounts daily? Would this type of reporting requirement help to mitigate any potential ‘‘window dressing’’ concerns about funds’ reporting of their derivatives exposure, and/or provide additional beneficial transparency with respect to any particular type of funds (for example, leveraged/inverse funds)? If so, would these benefits outweigh related costs? b. VaR Information We are also proposing to amend Form N–PORT to include a new reporting item related to the proposed VaR tests.365 Information that a fund would report under this new reporting item would be made public for the third month of each fund’s quarter.366 The proposed item would apply to funds that were subject to the proposed VaRbased limit on fund leverage risk during the reporting period. Funds that are subject to the new VaR-related N–PORT item would have to report their highest daily VaR during the reporting period and its corresponding date, as well as their median daily VaR for the monthly reporting period.367 Funds subject to the relative VaR test during the reporting period would report the name of the fund’s designated reference index, and index identifier.368 These funds also would have to report the fund’s highest daily VaR ratio (that is, the value of the fund’s portfolio VaR divided by the VaR of the designated reference index) during the reporting period and its corresponding date, as well as the fund’s median daily VaR ratio for the reporting period.369 The proposed requirement for a fund to report highest daily VaR (and, for a fund that is subject to the relative VaR test, information about the fund’s VaR 365 See proposed Item B.10 of Form N–PORT. Proposed item B.10 would require that a fund provide the applicable VaR information in accordance with proposed rule 18f–4(c)(2)(ii), which requires a fund to determine compliance with its applicable VaR test at least once each business day. 366 See supra note 362. While the information for the first two months of a fund’s quarter would be non-public, the information for the third month of a fund’s quarter would be publicly available. See supra note 359. 367 See proposed Items B.10.a.–c of Form N– PORT. The proposed form amendments would require each of the reported metrics to be determined in accordance with the requirement under proposed rule 18f–4 to determine the fund’s compliance with the applicable VaR test at least once each business day. 368 See proposed Item B.10.d.i.–ii of Form N– PORT. 369 See proposed Item B.10.d.iii.–v of Form N– PORT. PO 00000 Frm 00056 Fmt 4701 Sfmt 4702 ratio) is designed to help assess compliance with the proposed rule. These requirements, and the proposed requirement for a fund to report its median daily VaR (and, for a fund that is subject to the relative VaR test, the median VaR ratio) are designed to help identify changes in a fund’s VaR over time, and to help identify trends involving a single fund or group of funds regarding their VaRs. The proposed requirement that a fund report information about its designated reference index is designed to help analyze whether funds are using designated reference indexes that meet the rule’s requirements, and also to assess any trends in the designated reference indexes that funds select. A fund also would have to report the number of exceptions the fund identified during the reporting period arising from backtesting the fund’s VaR calculation model.370 This proposed requirement is designed to help analyze whether a fund’s VaR model is effectively taking into account and incorporating all significant, identifiable market risk factors associated with a fund’s investments, as required by the proposed rule.371 This information would assist in monitoring for compliance with the proposed VaR tests and also would provide high-level information to market participants, as well as researchers and analysts, to help evaluate the extent to which funds’ VaR models, used as part of the proposed VaR tests, are operating effectively. Because this information would be made publicly available on a delayed basis, and would not provide details about backtesting exceptions other than the number of exceptions, we do not believe that this proposed reporting requirement would produce adverse effects such that the reported information should be made nonpublic.372 We seek comment on the Commission’s proposed amendments to 370 See proposed Item B.10.e of Form N–PORT; see also supra section II.B.3.d (discussing proposed backtesting requirement); ICI Comment Letter II (discussing UCITS funds being similarly required to report to their primary regulator, on a semi-annual basis, the number of VaR breaks that exceed a specified threshold (a VaR break occurs when the actual one-day loss exceeds that day’s VaR), and recommending the Commission require funds to report the number of VaR breaks and the dates on which they occurred). 371 See supra note 151. 372 See supra notes 362, 365. But see infra section II.H.2 (discussing adverse effects that might arise from the real-time public reporting of a fund’s VaR test breaches under the proposed amendments to Form N–LIQUID). Information reported for the third month of each fund’s fiscal quarter on Form N–PORT will be made publicly available 60 days after the end of the fiscal quarter. See supra note 359. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 Form N–PORT requiring reporting of VaR information: 210. Are the proposed requirements that funds report VaR information on Form N–PORT, and each of the elements that a fund would have to report under this requirement, appropriate? Why or why not? Should we modify the proposed VaR information reporting item in any way? If so, how should we modify this reporting item? 211. Our proposal would make public all of the information that a fund would report in response to the new VaR information item on Form N–PORT. Is there any reason why this information should not be publicly available? For example, would making this information public lead to harm arising from investor confusion, adverse competitive effects, or for any other reason? If we require that this reported information be made public, is there additional information we should require funds to report to provide contextualization or mitigate any adverse effects that could arise from public disclosure? Should we make non-public some of these disclosures (e.g., portfolio VaR or a fund’s designated reference index, or information about backtesting results) but not others? If so, which ones should we make non-public and why? 212. Would any of the proposed N– PORT reporting requirements be more appropriately structured as Form N– CEN reporting requirements, or items to be reported on a current basis on Form N–RN? 213. Is there any additional information related to funds’ derivatives exposure or derivatives risk management that we should require funds to report on Form N–PORT? What information and why, and should this reported information be made public? 2. Amendments to Current Reporting Requirements We are also proposing current reporting requirements for funds that are relying on proposed rule 18f–4. We are proposing to re-title Form N–LIQUID as Form N–RN and to amend this form to include new reporting events for funds that are subject to the proposed VaR-based limit on fund leverage risk.373 These funds would be required to determine their compliance with the applicable VaR test on at least a daily basis.374 We are proposing to require these funds to file Form N–RN to report information about VaR test breaches 373 See proposed Parts E–G of Form N–RN. supra section II.D; see also proposed rule 18f–4(c)(2). 374 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 under certain circumstances. Proposed rule 18f–4 would require a fund that has determined that it is not in compliance with the applicable VaR test to come back into compliance promptly and within no more than three business days after such determination.375 We are therefore proposing that a fund that determines that it is out of compliance with the VaR test and has not come back into compliance within three business days after such determination would file a report on Form N–RN providing certain information regarding its VaR test breaches.376 If the portfolio VaR of a fund subject to the relative VaR test were to exceed 150% of the VaR of its designated reference index for three business days, we are proposing to require that such a fund report: (1) The dates on which the fund portfolio’s VaR exceeded 150% of the VaR of its designated reference index; (2) the VaR of its portfolio for each of these days; (3) the VaR of its designated reference index for each of these days; (4) the name of the designated reference index; and (5) the index identifier.377 A fund would have to report this information within one business day following the third business day after the fund has determined that its portfolio VaR exceeds 150% of its designated reference index VaR.378 Such a fund also would have to file a report on Form N–RN when it is back in compliance with the relative VaR test.379 If the portfolio VaR of a fund subject to the absolute VaR test were to exceed 15% of the value of the fund’s net assets for three business days, we are proposing to require that such a fund report: (1) The dates the on which the fund portfolio’s VaR exceeded 15% of the value of its net assets; (2) the VaR of its portfolio for each of these days; and (3) the value of the fund’s net assets 375 See supra section II.D.5.b. proposed Parts E and F of Form N–RN. 377 See proposed Part E of Form N–RN. 378 For example, if the fund were to determine, on the evening of Monday, June 1, that its portfolio VaR exceeded 150% of the fund’s designated reference index VaR, and this exceedance were to persist through Tuesday (June 2), Wednesday (June 3), and Thursday (June 4), the fund would file Form N–RN on Friday, June 5 (because 3 business days following the determination on June 1 is June 4, and 1 business day following June 4 is June 5). If the exceedance were to still persist on June 5 (the date that the fund would file Form N–RN), the fund’s report on Form N–RN would provide the required information elements for June 1, 2, 3, 4, and 5. 379 See proposed Part G of Form N–RN. The report would include the dates on which the fund was not in compliance with the VaR test, and the current VaR of the fund’s portfolio on the date the fund files the report. See also proposed rule 18f– 4(c)(2)(iii) (providing that a fund must meet specific requirements to be back in compliance). 376 See PO 00000 Frm 00057 Fmt 4701 Sfmt 4702 4501 for each of these days.380 A fund would have to report this information within one business day following the third business day that the fund determined that its portfolio VaR exceeds 15% of the value of its net assets. Such a fund also would have to file a report on Form N–RN when it is back in compliance with the absolute VaR test.381 The data points, collectively, would aid the Commission in assessing funds’ compliance with the VaR tests. In addition, the information would provide staff the ability to assess how long a fund is precluded from entering into derivatives transactions as a consequence of its lack of compliance with its VaR test. Currently, only registered open-end funds (excluding money market funds) are required to file reports on Form N– LIQUID.382 We are proposing to amend this form, as well as rule 30b1–10 under the Investment Company Act, to reflect the proposed 18f–4 requirement that all funds that are subject to the relative VaR test or absolute VaR test file current reports regarding VaR test breaches under the circumstances that Form N– RN specifies.383 The scope of funds that would be subject to the new VaR test breach current reporting requirements would thus include registered open-end funds as well as registered closed-end funds and BDCs. In addition to extending the scope of funds required to respond to Form N–LIQUID, we are proposing to amend the general instructions to the form to reflect the expanded scope and application.384 380 See proposed Part F of Form N–RN. supra note 378. 382 See General Instruction A.(1) to Form N– LIQUID; see also rule 30b1–10 [17 CFR 270.30b1– 10]. 383 See proposed Form N–RN; see also proposed amendments to rule 30b1–10 under the Investment Company Act, and proposed rule 18f–4(c)(7) (requiring a fund that experiences an event specified in the parts of Form N–RN titled ‘‘Relative VaR Test Breaches,’’ ‘‘Absolute VaR Test Breaches,’’ or ‘‘Compliance with VaR Test’’ to file with the Commission a report on Form N–RN within the period and according to the instructions specified in that form). 384 See, e.g., proposed General Instruction A.(1) to Form N–RN (amending the defined term ‘‘registrant’’); proposed General Instruction A.(2) to Form N–RN (amending the submission requirement to clarify application to the new VaR-test-breachrelated items); proposed General Instruction A.(3) to Form N–RN (clarifying that only open-end funds required to comply with rule 22e–4 under the Investment Company Act would be required to respond to events occurring in Parts B–D, as applicable, while funds required to comply with the limit on fund leverage risk in proposed rule 18f– 4 would be required to respond to events specified in proposed Parts E–G, as applicable); and proposed General Instruction F to Form N–RN (clarifying that the terms used in proposed Parts E–G, unless otherwise specified, would have the same meaning as the terms in proposed rule 18f–4). 381 See E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4502 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules We are proposing to require funds to provide this information in a current report because we believe that the Commission should be notified promptly when a fund is out of compliance with the proposed VaRbased limit on fund leverage risk, which in turn we believe could indicate that a fund is experiencing heightened risks as a result of the fund’s use of derivatives transactions. VaR test breaches could indicate that a fund is using derivatives transactions to leverage the fund’s portfolio, magnifying its potential for losses and significant payments of fund assets to derivatives counterparties. Such breaches also could indicate market events that are drivers of potential derivatives risks or other risks across the fund industry. Either of these scenarios—increased fund-specific risks, or market events that affect funds’ risks broadly—may, depending on the facts and circumstances, require attention by the Commission. The proposed current reporting requirement is designed to provide the Commission current information regarding potential increased risks and stress events (as opposed to a requirement to report the same or similar information later, for example on Form N–PORT).385 The onebusiness-day time-frame for submitting a report on Form N–RN regarding a fund’s VaR test breaches is designed to provide an appropriately early notification to the Commission of potential heightened risks, while at the same time providing sufficient time for a fund to compile and file its report on Form N–RN. This time-frame is also consistent with the current required timing for reporting other events on Form N–LIQUID.386 We are cognizant that certain adverse effects might arise from real-time public reporting of a fund’s VaR test breaches. For example, publicly disclosing this information could lead to investor confusion. Investors might mistakenly assume that a fund that breached the applicable VaR test actually had suffered substantial losses or that substantial losses necessarily were imminent. Investors might also believe that a fund’s failing the VaR test suggests a sudden increase in fund risk when, in some cases, a fund can fail a VaR test—and especially an absolute VaR test—due to changes in market volatility generally. Investors also might believe that a fund’s real-time reporting of a VaR test breach necessarily meant that the fund was not complying with applicable regulations. Information about VaR breaches would therefore 385 See 386 See supra section II.H.1.b. General Instruction A of Form N–LIQUID. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 provide important information to the Commission and its staff for regulatory purposes but could confuse investors and lead them and other market participants to make incorrect assumptions about a fund’s relative riskiness. This could have potential adverse effects for funds if investors redeem or sell fund shares as a result. Other market participants also could react to real-time reporting of VaR breaches in ways that could adversely affect funds. For example, if market participants knew on a real-time basis that a fund had breached the applicable VaR test, market participants might seek to anticipate the trading activity the fund might undertake to come back into compliance and engage in predatory trading that could adversely affect the fund. Accordingly, we are proposing to make funds’ reports on Form N–RN regarding VaR test breaches (like their reports on this form regarding liquidityrelated items) non-public, because we preliminarily believe that public disclosure of this information is neither necessary nor appropriate in the public interest or for the protection of investors.387 We seek comment on the Commission’s proposed amendments to Form N–LIQUID requiring reporting of certain information regarding a fund’s VaR test breaches: 214. Is the proposed new current reporting requirement for funds that are subject to the VaR-based limit on fund leverage risk appropriate? Why or why not? If not, how should the scope of the proposed current reporting requirement be modified? Should we require additional current reporting requirements for funds to report other derivatives-risk-related information? For example, should funds that are limited derivatives users pursuant to the proposed exposure-based exception be required to file current reports if their derivatives exposure were to exceed 10% of their net assets? 388 Should we require a fund to file a current report if it identifies a certain number of exceptions as a result of backtesting its VaR calculation model, and if so, what circumstances should trigger the requirement to file a current report? 389 387 See proposed General Instruction A.(1) to Form N–RN; see also section 45(a) of the Investment Company Act (requiring information in reports filed with the Commission pursuant to the Investment Company Act to be made available to the public, unless we find that public disclosure is neither necessary nor appropriate in the public interest or for the protection of investors). 388 See supra section II.E.1. 389 See supra section II.B.3.d (discussing backtesting requirements in proposed rule 18f–4); see also supra section II.H.1.b (discussing proposed PO 00000 Frm 00058 Fmt 4701 Sfmt 4702 215. Is each of the pieces of information that we propose a fund would include in a report about a VaR test breach on proposed Form N–RN appropriate? Why or why not? Should we modify the required information in any way? 216. For a fund that is out of compliance with the VaR test, and is unable to come back into compliance within three business days after its initial determination, the proposed current reporting requirement would require that fund to file a report on Form N–RN providing certain information regarding its VaR test breaches. Is the proposed threebusiness-day current reporting requirement appropriate? Why or why not? Should the rule require a shorter or longer period, such as one or seven days, before prompting a current reporting requirement? Which time period would be appropriate and why? 217. We are proposing that a fund’s reports regarding VaR test breaches on Form N–RN would not be made public. Would there be a benefit to publicly reporting this information, and would it be appropriate to make these disclosures public? Why or why not? Should we make public some of these disclosures but not others? If so, which ones should we make public and why? 218. As an alternative or an addition to the proposed current reporting requirement, should we require funds to report information regarding VaR test breaches on Form N–PORT? Why or why not? If so, should we make public this information reported on Form N– PORT? 219. Should we modify the proposed current reporting requirement to require reporting by certain types of funds and not others? If so which types of funds, and why? For example, should we require BDCs also to report the information that we are proposing them to report on Form N–RN on Form 8–K? Why or why not? 220. As an alternative to amending Form N–LIQUID to require current reporting on VaR test breaches, should we provide a new, separate current reporting form for funds to use to report VaR test breaches (and/or any other current reporting items relating to their derivatives risk management programs under proposed rule 18f–4)? Why or why not? 3. Amendments to Form N–CEN Form N–CEN currently includes an item that requires a fund to indicate— in a manner similar to ‘‘checking a requirement to report backtesting results on Form N–PORT). E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules box’’—whether the fund has relied on certain Investment Company Act rules during the reporting period.390 We are proposing amendments to this item to require a fund to identify whether it relied on proposed rule 18f–4 during the reporting period.391 We are also proposing amendments to require a fund to identify whether it relied on any of the exceptions from various requirements under the proposed rule, specifically: • Whether the fund is a limited derivatives user excepted from the proposed rule’s program requirement, under either the proposed exception for funds that limit their derivatives exposure to 10% of their net assets or under the exception for funds that limit their derivatives use to certain currency hedging; 392 or • Whether the fund is a leveraged/ inverse fund covered by the proposed sales practices rules that, under proposed rule 18f–4, would be excepted from the proposed limit on fund leverage risk.393 Finally, a fund would have to identify whether it has entered into reverse repurchase agreements or similar financing transactions, or unfunded commitment agreements, as provided under the proposed rule.394 This information would assist the Commission and staff with our oversight functions by allowing us to identify which funds were excepted from certain of the proposed rule’s provisions or relied on the rule’s provisions regarding reverse repurchase agreements and unfunded commitment agreements. We seek comment on the Commission’s proposed amendments to Form N–CEN: 221. Should we require, as proposed, that funds identify that they relied on rule 18f–4, including whether they are limited derivatives users that are excepted from the proposed program requirement? Why or why not? 222. Should we require, as proposed, that funds identify that they are leveraged/inverse funds that are excepted from the proposed limit on fund leverage risk? Why or why not? 223. Should we require, as proposed, that funds identify that they entered into reverse repurchase agreements or similar financing transactions, or unfunded commitment agreements? Why or why not? 390 See Item C.7 of Form N–CEN. proposed Item C.7.l of Form N–CEN. 392 See proposed Item C.7.l.i.–ii of Form N–CEN; see also supra section II.E. 393 See proposed Item C.7.l.iii of Form N–CEN; see also supra section II.G. 394 See proposed Item C.7.l.iv–v of Form N–CEN; see also infra sections II.I and II.J. 391 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 224. Are there other means that funds use to disclose or report information (e.g., prospectus or annual report disclosure in addition to the other disclosure requirements in this proposal) that would be more appropriate for reporting any of the information that the proposed amendments to Form N–CEN would require? Should any of the disclosures required in the proposed amendments to Form N–PORT above be made on Form N–CEN? Why or why not? 4. BDC Reporting BDCs do not file reports on Form N– CEN or Form N–PORT. We considered proposing to require that BDCs provide the new information that we propose registered funds report on Form N–CEN, and the new information regarding derivatives exposure and VaR that we propose to require funds to report on Form N–PORT, in their annual reports on Form 10–K. BDCs, however, generally do not enter into derivatives transactions or do so to a limited extent.395 We therefore believe that most BDCs that enter into derivatives transactions would qualify for the limited derivatives user exception (which would make the proposed VaR reporting items on Form N–PORT inapplicable to BDCs). In addition, and as noted above, we understand that even when BDCs do use derivatives more extensively, derivatives generally do not play as significant of a role in implementing the BDC’s strategy, as compared to many other types of funds that use derivatives extensively. BDCs are required under the Investment Company Act to invest at least 70% of their total assets in ‘‘eligible portfolio companies,’’ which may limit the role that derivatives can play in a BDC’s portfolio relative to other kinds of funds that would generally execute their strategies primarily through derivatives transactions (e.g., a managed futures fund). BDCs that would not qualify as limited derivatives users under the proposed rule also would be subject to the proposed new requirement to file current reports regarding VaR test breaches on Form N–RN.396 Taking these factors into account, we are not proposing additional reporting requirements for BDCs because we believe that the reporting framework we are proposing for BDCs adequately addresses the Commission’s ability to monitor BDCs’ compliance with the proposed rules, as well as any competitive disparities that could result from disparate reporting requirements 395 See 396 See PO 00000 supra section II.D.2.b. supra section II.H.2. Frm 00059 Fmt 4701 Sfmt 4702 4503 among funds that rely on proposed rule 18f–4.397 We seek comment on the Commission’s proposal to not require BDCs to report on Forms N–PORT or N– CEN: 225. Should we require BDCs to report any of the same information on Form 10–K (or elsewhere, such as in a BDC’s prospectus) that we are proposing to require registered investment companies to report on Forms N–CEN and N–PORT? Why or why not? Should we require, for example, that a BDC report its derivatives exposure, whether it is a limited derivatives user, and/or its designated reference index (if applicable)? If so, where? If a BDC uses derivatives and does not qualify as a limited derivatives user, should it have to report information about its derivatives exposure and portfolio VaR on Form N–PORT (or elsewhere)? 226. Should we require BDCs to report on Form 10–K or elsewhere whether they have relied on the rule’s provision regarding reverse repurchase agreements and similar financing transactions or unfunded commitment agreements? I. Reverse Repurchase Agreements Funds may engage in certain transactions that may involve senior securities primarily as a means of obtaining financing. For example, openend funds are permitted to borrow money from a bank, provided they maintain a 300% asset coverage ratio.398 Another common method of obtaining financing is through the use of reverse repurchase agreements. In a reverse repurchase agreement, a fund transfers a security to another party in return for a percentage of the value of the security. At an agreed-upon future date, the fund repurchases the transferred security by paying an amount equal to the proceeds of the initial sale transaction plus interest.399 A reverse repurchase 397 We have separately proposed to require BDCs to tag their financial statements using Inline XBRL, a structured, machine-readable format, which would provide structured data about BDCs’ derivatives and other investments. See Securities Offering Reform Proposing Release, supra note 199, at section II.H.1. In addition, BDCs are currently required to disclose certain information about their exposures to market risks, including risks that may arise as a result of their derivatives-related activity. See, e.g., Items 303 and 305 of Regulation S–K [17 CFR 229.303 and 229.305]. See also infra section III.D.2 (discussing, among other things, potential competitive effects resulting from BDCs not being subject to the proposed additional reporting requirements on Form N– PORT and Form N–CEN). 398 See section 18(f)(1) of the Investment Company Act. 399 See Release 10666, supra note 15, at ‘‘Reverse Repurchase Agreements’’ discussion (stating that a Continued E:\FR\FM\24JAP2.SGM 24JAP2 4504 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 agreement is economically equivalent to a secured borrowing.400 We believe that reverse repurchase agreements and other similar financing transactions that have the effect of allowing a fund to obtain additional cash that can be used for investment purposes or to finance fund assets should be treated for section 18 purposes like a bank borrowing or other borrowing, as they achieve effectively identical results. Accordingly, we are proposing that a fund may engage in reverse repurchase agreements and other similar financing transactions so long as they are subject to the relevant asset coverage requirements of section 18.401 For example, this would have the effect of permitting an open-end fund to obtain financing by borrowing from a bank, engaging in a reverse repurchase agreement, or any combination thereof, so long as all sources of financing are included when calculating the fund’s asset coverage ratio.402 Reverse repurchase agreements and similar financing transactions are not treated as derivatives transactions under the proposed rule because they have the economic effects of a secured borrowing, and thus more closely resemble bank borrowings with a known repayment obligation rather than the more-uncertain payment obligations of many derivatives. However, such reverse repurchase agreement may not have an agreed-upon repurchase date, and in that case the agreement would be treated as if it were reestablished each day). 400 See, e.g., Office of Financial Research, Reference Guide to U.S. Repo and Securities Lending Markets (Sept. 9, 2015), available at https://www.financialresearch.gov/working-papers/ files/OFRwp-2015-17_Reference-Guide-to-U.S.Repo-and-Securities-Lending-Markets.pdf. 401 Proposed rule 18f–4(d). Among other things, section 18 prescribes the required amount of asset coverage for a fund’s senior securities and provides certain consequences for a fund that fails to maintain this amount. See, e.g., section 18(a) (restrictions on dividend issuance). This provision in rule 18f–4 would not provide any exemptions from the requirements of section 61 for BDCs because that section does not limit a BDC’s ability to engage in reverse repurchase or similar transactions in parity with other senior security transactions permitted under that section. 402 Section 18 states that certain borrowings that are made for temporary purposes (less than 60 days) and that do not exceed 5% of the total assets of the issuer at the time when the loan is made (temporary loans) are not senior securities for purposes of certain paragraphs in section 18. As we noted in Release 10666, reverse repurchase agreements and similar financing transactions could be designed to appear to fall within the temporary loans exception, and then could be ‘‘rolled-over,’’ perhaps indefinitely, with such short-term transactions being entered into, closed out, and later re-entered. If substantially similar financing arrangements were being ‘‘rolled over’’ in any manner for a total period of 60 days or more, we would treat the later transactions as renewals of the earlier ones, and all such transactions would fall outside the exclusion for temporary loans. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 transactions can have the effect of introducing leverage into a fund’s portfolio if the fund were to use the proceeds of the financing transaction to purchase additional investments. In addition, such transactions impose a requirement to return assets at the termination of the agreement, which can raise section 18 asset sufficiency concerns to the extent the fund needs to sell less-liquid securities at a loss to obtain the necessary assets. Reverse repurchase agreements and similar financing transactions would not be included in calculating a fund’s derivatives exposure under the limited derivatives user provisions of the proposed rule. However, if a fund did not qualify as a limited derivatives user due to its other investment activity, any portfolio leveraging effect of reverse repurchase agreements or similar financing transactions would be included and restricted through the proposed VaR-based limit on fund leverage risk. This is because the proposed VaR tests estimate a fund’s risk of loss taking into account all of its investments, including the proceeds of reverse repurchase agreements and similar investments the fund purchased with those proceeds. Securities lending arrangements are structurally similar to reverse repurchase agreements in that, in both cases, a fund transfers a portfolio security to a counterparty in exchange for cash (or other assets). Although these arrangements are structurally similar, under our proposal we would not view a fund’s obligation to return securities lending collateral as a ‘‘similar financing transaction’’ in the circumstances discussed below. In the 2015 Proposing Release, we sought comment on whether rule 18f–4 should address funds’ compliance with section 18 in connection with securities lending.403 Commenters stated that the staff’s current guidance on securities lending forms the basis for funds’ securities lending practices and effectively addresses the senior securities implications of securities lending, and thus securities lending practices need not be addressed in the final rule.404 403 2015 Proposing Release, supra note 2, at paragraph accompanying n.149. 404 See, e.g., ICI Comment Letter I; Guggenheim Comment Letter; SIFMA Comment Letter; Comment Letter of the Risk Management Association (Mar. 28, 2016). Staff guidance on Securities Lending by U.S. Open-End and Closed-End Investment Companies (Feb. 27, 2014), available at https:// www.sec.gov/divisions/investment/securitieslending-open-closed-end-investmentcompanies.htm (providing guidance on certain noaction letters that funds consider when engaging in securities lending and summarizing areas those PO 00000 Frm 00060 Fmt 4701 Sfmt 4702 Currently, funds that engage in securities lending typically reinvest cash collateral in highly liquid, shortterm investments, such as money market funds or other cash or cash equivalents, and funds generally do not sell or otherwise use non-cash collateral to leverage the fund’s portfolio.405 We believe a fund that engages in securities lending under these circumstances is limited in its ability to use securities lending transactions to increase leverage in its portfolio. Accordingly, the proposed rule does not treat a fund’s obligation to return securities lending collateral as a financing transaction similar to a reverse repurchase agreement, so long as the obligation relates to an agreement under which a fund engages in securities lending, the fund does not sell or otherwise use noncash collateral received for loaned securities to leverage the fund’s portfolio, and the fund invests cash collateral solely in cash or cash equivalents. If a fund were to engage in securities lending and to invest the cash collateral in securities other than cash or cash equivalents, this may result in leveraging of the fund’s portfolio, and we believe this activity would be a ‘‘similar financing transaction’’ and should thus be included when calculating a funds asset coverage ratio. We believe that a fund’s obligation with respect to a ‘‘tender option bond’’ (‘‘TOB’’) financing may be similar to a reverse repurchase agreement in some circumstances. One commenter on the 2015 proposal explained that TOB financings are economically similar to reverse repurchase agreements because a fund employing a TOB trust has in effect used the underlying bond as collateral to secure a borrowing analogous to a fund’s use of a security to secure a reverse repurchase agreement.406 We believe that determining whether a TOB is a similar financing transaction as a reverse repurchase agreement would depend on the facts and circumstances. To the letters address, including limitations on the amount that may be lent and collateralization for such loans). 405 See ICI, Securities Lending by Mutual Funds, ETFs, and Closed-End Funds: The Basics (Sept. 14, 2014), available at https://www.ici.org/viewpoints/ view_14_sec_lending_01 (‘‘[T]he collateral that funds can accept from borrowers must be highly liquid, such as cash, government securities, or bank letters of credit. U.S. regulated funds typically demand cash collateral. . . . In practice, U.S. regulated funds most often invest cash collateral in money market funds.’’); SIFMA, Master Securities Lending Agreement, section 4.2 (2000), available at https://www.sifma.org/wp-content/uploads/2017/ 08/MSLA_Master-Securities-Loan-Agreement-2000Version.pdf (generally limiting lenders from rehypothecating non-cash collateral). 406 See SIFMA Comment Letter. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules extent a fund concludes that there are economic similarities between a TOB financing and a reverse repurchase agreement, the fund should treat obligations with respect to the TOB financing as a similar financing transaction under the proposed rule. We request comment on our proposed approach to reverse repurchase agreements and similar financing transactions under the proposed rule. 227. As proposed, should we treat reverse repurchase agreements and similar financing transactions as economically equivalent to bank borrowings under section 18, and subject them to the same asset coverage requirements? Why or why not? 228. Should we not combine reverse repurchase agreements with bank borrowing and other senior securities under the provision, and instead treat them separately but with the same limit? For example, should we allow a fund to borrow from a bank subject to the 300% asset coverage limit and also separately use reverse repurchase agreements up to a 300% asset coverage limit? 229. Should we instead treat such reverse repurchase agreements and similar financing transactions as derivatives transactions under the proposed rule? Would this have any disparate effects on certain types of funds? 230. Is there a way to distinguish reverse repurchase agreements and similar financing transactions that funds use to leverage their portfolios from instances in which funds use those transactions for other purposes? If so, should we treat such transactions engaged in for leveraging purposes differently than transactions engaged in for other purposes? 231. Should we include securities lending transactions as a similar financing transaction (regardless of how the proceeds are invested) under the proposed provision? Why or why not? Should we define in rule 18f–4 the circumstances under which securities lending would not be treated as a similar financing transaction? 232. Are there other types of transactions that we should identify and treat as similar financing transactions to reverse repurchase agreements that we have not identified above? What are they and why should they be treated accordingly? J. Unfunded Commitment Agreements Under unfunded commitment agreements, a fund commits, conditionally or unconditionally, to make a loan to a company or to invest VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 equity in a company in the future.407 They include capital commitments to a private fund requiring investors to fund capital contributions or to purchase shares upon delivery of a drawdown notice. The proposed rule would therefore define an unfunded commitment agreement to mean a contract that is not a derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a loan to a company or to invest equity in a company in the future, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner.408 The Commission’s 2015 proposal would have treated these agreements as ‘‘financial commitment transactions.’’ As a result, a fund’s obligations under the agreements could not exceed the fund’s net asset value.409 Commenters on the 2015 proposal identified characteristics of these agreements that they believed distinguished unfunded commitments from the derivatives transactions and financial commitment transactions covered by that proposal, which are also covered by re-proposed rule 18f–4.410 First, commenters stated that a fund often does not expect to lend or invest up to the full amount committed. Second, commenters stated that a fund’s obligation to lend is commonly subject to conditions, such as a borrower’s obligation to meet certain financial metrics and performance 407 We understand that the types of funds that enter into unfunded commitment agreements typically include BDCs and registered closed-end funds. 408 Proposed rule 18f–4(a). 409 See 2015 proposed rule 18f–4(c)(4) (defining ‘‘financial commitment transactions’’); 2015 proposed rule 18f–4(b) (permitting funds to engage in financial commitment transactions if the fund maintains qualifying coverage assets with a value equal to at least the fund’s aggregate financial commitment obligations); 2015 proposed rule 18f– 4(c)(5) (defining a fund’s ‘‘financial commitment obligations,’’ in part, to mean ‘‘the amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under a financial commitment transaction). 410 Specifically, these commenters generally compared unfunded commitment agreements to firm and standby commitment agreements (which we would in turn interpret the phrase ‘‘or any similar instrument’’ in proposed rule 18f–4’s definition of ‘‘derivatives transaction’’ to include, see supra note 91 and accompanying paragraph). See, e.g., Letter of Ares Capital Corporation (Mar. 28, 2016) (‘‘Ares Comment Letter’’); Comment Letter of the Small Business Investor Alliance (Mar. 28, 2016) (‘‘SBIA Comment Letter’’); Comment Letter of the Center for Capital Markets Competitiveness, U.S. Chamber of Commerce (Mar. 28, 2016); Comment Letter of Skadden, Arps, Slate, Meagher & Flom LLP (Mar. 28, 2016) (‘‘Skadden Comment Letter’’); Dechert Comment Letter; Private Equity Growth Capital Council (Mar. 28, 2016) (‘‘PEGCC Comment Letter’’). PO 00000 Frm 00061 Fmt 4701 Sfmt 4702 4505 benchmarks, which are not typically present under the types of agreements that the Commission described in Release 10666.411 Commenters also asserted that unfunded commitment agreements do not give rise to the risks that Release 10666 identified and do not have a leveraging effect on the fund’s portfolio because they do not present an opportunity for the fund to realize gains or losses between the date of the fund’s commitment and its subsequent investment when the other party to the agreement calls the commitment.412 These commenters contrasted firm and standby commitment agreements, under which a fund commits itself to purchase a security with a stated price and fixed yield without condition or upon the counterparty’s demand.413 They argued that the firm and standby commitment agreements that Release 10666 describes expose the fund to investment risk during the life of the transaction, because the value of the fund’s commitment agreement will change as interest rates change. We agree that these factors distinguish unfunded commitment agreements from the derivatives transactions covered by proposed rule 18f–4. The derivatives transactions covered by proposed rule 18f–4—including the firm and standby commitment agreements the Commission described in Release 10666—expose the fund to investment risk during the life of the transaction. Derivatives transactions therefore can be used to leverage a fund’s portfolio by enabling a fund to magnify its gains and 411 See, e.g., SBIA Comment Letter; Comment Letter of Hercules Capital (Mar. 29, 2016); see also, e.g., Skadden Comment Letter (contingent loan commitments typically have ‘‘funding conditions that excuse the BDC from funding if the borrower does not continue to satisfy various representations, financial and non-financial metrics and performance conditions . . . [and] cannot result in substantial risk of loss prior to funding because the BDC is not required to fund the loan if the borrower’s credit or financial position degenerates meaningfully.’’). 412 See, e.g., PEGCC Comment Letter (distinguishing the agreements that Release 10666 discusses because, while the value of the fund’s limited partnership interest may fluctuate based on the amount of capital it invests in the private fund, the fund has no profit or loss on the unfunded commitment); Ares Comment Letter (stating that, in general, unfunded loan commitments do not reflect a bet on interest rate movements because the yields for unfunded loan commitments are determined as a spread over a prevailing market interest rate); see also Altegris Comment Letter (explaining that unfunded commitment agreements do not have a potential for ‘‘pyramiding’’ because—in contrast to a reverse repurchase agreement—a fund ‘‘receives nothing from the underlying private equity funds in return for its capital commitments and, as a result, its gross assets remain unchanged.’’). 413 See, e.g., SBIA Comment Letter; see also Altegris Comment Letter; Ares Comment Letter; Comment Letter of Dechert (Feb. 7, 2016); Skadden Comment Letter. E:\FR\FM\24JAP2.SGM 24JAP2 4506 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 losses compared to the fund’s investment, while also obligating the fund to make a payment to a counterparty. Based on the characteristics of unfunded commitment agreements commenters described, which we understand are typical of these agreements, we do not believe that such unfunded commitment agreements are undertaken to leverage a fund’s portfolio. For example, if the yield for an unfunded loan commitment is determined as a spread over a prevailing market interest rate, the agreement creates a risk that the fund would not have liquid assets to fund the loan, but the agreement would not reflect a speculative position on the direction of interest rates.414 We therefore do not believe that such unfunded commitment agreements generally raise the Investment Company Act’s concerns regarding the risks of undue speculation.415 Depending on the facts and circumstances, however, an unfunded commitment agreement could raise the asset sufficiency concerns underlying the Investment Company Act.416 A fund could be required to liquidate other assets to obtain the cash needed to satisfy its obligation under an unfunded commitment agreement if the fund did not have cash on hand to meet its obligation to provide a committed loan or make a committed equity investment. If the fund is unable to meet its obligations, the fund would be subject to default remedies available to its counterparty. For example, if a fund fails to fulfill its commitments to invest in a private fund when called to do so, the fund could be subject to the remedies specified in the limited partnership agreement (or similar document) relating to that private fund. These remedies can have the practical effect of forfeiture of some or all of the fund’s investment in the private fund.417 In these and other 414 Cf. Release 10666, supra note 15, at n.12 (‘‘Commitments to purchase securities whose yields are determined on the date of delivery with reference to prevailing market interest rates are not intended to be included in this general statement of policy. Such commitments neither create nor shift the risk associated with interest rate changes in the marketplace, and in economic reality have no discernible potential for leverage.’’). 415 See supra notes 45–47 and accompanying text. 416 See id. 417 See, e.g., Phyllis A. Schwartz & Stephanie R. Breslow, Private Equity Funds: Formation and Operation (June 2015 ed.), at 2–34 (remedies private equity funds may apply in event of investor default include, among other things, the right to charge high interest on late payments, the right to force a sale of the defaulting investor’s interest, the right to continue to charge losses and expenses to defaulting investors while cutting off their interest in future profits, and the right to take any other action permitted at law or in equity). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 circumstances a fund’s investors could be harmed if the fund is unable to meet its obligations under an unfunded commitment agreement. Because unfunded commitment agreements can raise the asset sufficiency concern underlying section 18, but generally do not raise the undue speculation concern associated with derivatives transactions (and reverse repurchase agreements and similar financing transactions), we are proposing to permit a fund to enter into unfunded commitment agreements if it reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as they come due.418 While a fund should consider its unique facts and circumstances to have such a reasonable belief, the proposed rule would prescribe certain specific factors that a fund must take into account.419 First, the proposed rule would require a fund to take into account its reasonable expectations with respect to other obligations (including any obligation with respect to senior securities or redemptions). This is because other obligations can place competing demands on cash a fund otherwise might intend to use to fund an unfunded commitment agreement. Second, the proposed rule would provide that a fund may not take into account cash that may become available from the sale or disposition of any investment at a price that deviates significantly from the market value of those investments. This provision is designed to address the risk that a fund could suffer losses by selling assets to raise cash to fund an unfunded commitment agreement, ultimately having an adverse impact on the fund’s investors. Finally, the proposed rule would provide that a fund may not consider cash that may become available from issuing additional equity. Whether a fund would be able to raise capital in the future and the amount of any additional capital would depend on 418 See proposed rule 18f–4(e)(1). Because this proposed condition is designed to provide an approach tailored to unfunded commitment agreements, the proposed rule would also provide that these transactions would not be considered for purposes of computing asset coverage under section 18(h). As with our approach to derivatives transactions, applying section 18(h) asset coverage to these transactions appears unnecessary in light of the tailored requirement we are proposing. See supra note 66. 419 The proposed rule would also require the fund to make and maintain records documenting the basis for this belief. See proposed rule 18f–4(e)(2); see also infra section II.K. PO 00000 Frm 00062 Fmt 4701 Sfmt 4702 a variety of factors, including future market conditions, that we believe are too speculative to support a fund’s reasonable belief that it could fund an unfunded commitment with the proceeds from future sales of the fund’s securities. The proposed rule would not preclude a fund from considering the issuance of debt to support a reasonable belief that it could fund an unfunded commitment, as we understand that funds often satisfy their obligations under unfunded commitments through borrowings. Moreover, such borrowings by funds would be limited by section 18’s asset coverage requirements, which would limit the extent to which a fund’s belief regarding its ability to borrow would allow the fund to enter into unfunded commitment agreements. To have a reasonable belief, a fund therefore could consider, for example, its strategy, its assets’ liquidity, its borrowing capacity under existing committed lines of credit, and the contractual provisions of its unfunded commitment agreements. A fund with unfunded loan commitments, for instance, could evaluate the likelihood that different potential borrowers would meet contractual ‘‘milestones’’ that the borrowers would have to satisfy as a condition to the obligation to fund a loan, as well as the amount of the anticipated borrowing. The fund’s historical experience with comparable obligations should inform this analysis. Whether a fund has a reasonable belief also could be informed by a fund’s assessment of the likeliness that subsequent developments could impair the fund’s ability to have sufficient cash and cash equivalents to meet its unfunded commitment obligations. This proposed approach for unfunded commitment agreements reflects the staff’s experience in reviewing and commenting on fund registration statements, which have disclosure regarding the funds’ unfunded commitments. These funds have generally represented, in substance, that they reasonably believe that their assets will provide adequate cover to allow them to satisfy all of their unfunded investment commitments, without taking into account any projected securities offerings. In their responses to staff comments, funds also have provided a general explanation as to the process by which they reached this reasonable belief. Finally, the proposed rule would provide that an agreement that meets the rule’s definition of a derivatives transaction is not an unfunded E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules commitment.420 This is because the proposed rule’s treatment of unfunded commitments is predicated on these agreements having characteristics that distinguish them from the derivatives transactions covered by the proposed rule, as discussed above. Because the proposed definition of the term ‘‘derivatives transaction’’ includes any instrument that is similar to certain listed derivatives instruments, a contract that is functionally similar to a listed derivatives instrument would be a derivatives transaction and therefore would not qualify for the proposed rule’s treatment of unfunded commitment agreements.421 For example, a fund that enters into a binding commitment to make a loan or purchase a note upon demand by the borrower, with stated principal and term and a fixed interest rate, would appear to have entered into an agreement that is similar to a standby commitment agreement or a written put option.422 This transaction would expose the fund to investment risk during the life of the transaction because the value of the fund’s commitment agreement will change as interest rates change. Such an agreement thus would fall within the proposed rule’s definition of ‘‘derivatives transaction’’ and would not be an unfunded commitment agreement under the proposed rule. We request comment on our proposed approach to unfunded commitment agreements. 233. Are unfunded commitment agreements distinguishable from derivatives transactions? Can funds use unfunded commitment agreements for speculation or to accomplish leveraging? If so, how? What types of funds enter into unfunded commitment agreements, and for what purposes? 234. Does funds’ use of unfunded commitment agreements raise the undue speculation and/or the assets sufficiency concerns underlying section 18 of the Investment Company Act? Why or why not? 235. Is the proposed approach to unfunded commitment agreements appropriate? Would the proposed approach appropriately address any asset sufficiency concerns that funds’ use of unfunded commitment agreements might entail? Why or why not? 420 See proposed rule 18f–4(a) (defining the term ‘‘unfunded commitment agreement’’). 421 See supra section II.A (discussing proposed definition of ‘‘derivatives transaction’’). 422 See supra paragraph accompanying notes 408– 412 (discussing factors distinguishing unfunded commitment agreements from the derivatives transactions covered by proposed rule 18f–4). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 236. Is the proposed requirement that a fund must have a ‘‘reasonable belief’’ regarding its ability to meet its unfunded commitment obligations, at the time it enters into an unfunded commitment agreement, appropriate? Should the rule instead, or also, require a fund to reassess whether this belief remains reasonable at various points during the period of the unfunded commitment agreement? 237. Are the rule’s provisions regarding the factors that a fund must consider in determining whether it has the required ‘‘reasonable belief’’ appropriate? Why or why not? Are they sufficiently clear? Should we specify other factors that a fund could consider? Should the rule provide, for example, that a fund may consider potential borrowings only to the extent the fund has committed lines of credit or other committed borrowing capacity? If so, how should we define ‘‘committed’’ for this purpose? 238. Under the proposed rule, a fund’s reasonable belief that it has sufficient cash to satisfy its unfunded commitments may not be based on cash that may become available from issuing additional equity. Do commenters agree that a fund’s ability to raise capital in the future, and the amount of any such additional capital, are based on factors that are too speculative to support a fund’s reasonable belief that it could use that capital to fund an unfunded commitment? Are there circumstances in which a fund can expect to raise capital in the future, such as expected inflows from retirement plan platforms, that would not raise the same concerns about supporting a reasonable belief under the proposed rule? Should the rule permit a fund to consider such additional capital as a basis for forming a reasonable belief? 239. Should the rule otherwise limit funds’ use of unfunded commitment agreements? If so, how? For example, should the rule specify that funds’ unfunded commitment agreements, in the aggregate, may not exceed the fund’s net asset value? Or should we adopt different requirements for unfunded commitment agreements for different types of funds, based on their ability to borrow money under the Investment Company Act? 423 Should the rule limit the agreements’ counterparties or otherwise restrict the agreements’ terms in any way? If so, how? Should we adopt different requirements for unfunded loan commitments, which generally will be contingent upon a borrower meeting certain ‘‘milestones,’’ as compared to commitments to invest 423 See PO 00000 supra notes 29–32 and accompanying text. Frm 00063 Fmt 4701 Sfmt 4702 4507 in a private fund due upon demand by the fund’s adviser? If so, which requirements should apply to each type of transaction and why? 240. Should the rule instead treat all—or a specified subset of—unfunded commitment agreements in the same way that it treats derivatives transactions? If a subset of these agreements, should the rule specify that certain characteristics of these agreements are indicative that these agreements are ‘‘similar instruments’’ in the proposed rule’s definition of ‘‘derivatives transaction’’? Should a fund that enters into unfunded commitment agreements, but that otherwise does not use derivatives (or that limits its derivatives exposure, either as the proposed rule specifies in the limited derivative user provisions or otherwise) be subject to the proposed VaR-based limit on fund leverage risk? Should such a fund be exempt from any of the proposed rule’s other requirements, and if so, which ones and why? 241. Is the proposed definition of ‘‘unfunded commitment agreement’’ clear and appropriate? If not, how should the Commission modify it? Should the Commission clarify any aspect of the definition (e.g., should the Commission further define or provide guidance regarding agreements that involve a commitment to ‘‘make a loan to a company’’ or to ‘‘invest equity in a company in the future’’)? Would funds experience any challenges in practice differentiating between unfunded commitments, on the one hand, and firm or standby commitment agreements or other transactions included in the definition of ‘‘derivatives transaction,’’ on the other? If so, how should the Commission provide additional clarity? 242. Are there other types of transactions that we should identify and treat as similar to unfunded commitment agreements? What are they and why should they be treated accordingly? Are there any transactions that may be viewed as firm or standby commitment agreements, but that commenters believe should be given the same treatment as unfunded commitments under the proposed rule? What kinds of transactions and why? 243. Would any adverse market effects result from the proposed treatment of unfunded commitment agreements? For example, would the proposal lead funds to restructure transactions as unfunded commitment agreements, and if so would this adversely affect investor protection? Would any modifications to the proposed rule, or additional E:\FR\FM\24JAP2.SGM 24JAP2 4508 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules Commission guidance, help mitigate potential adverse market effects? lotter on DSKBCFDHB2PROD with PROPOSALS2 K. Recordkeeping Provisions Proposed rule 18f–4 also includes certain recordkeeping requirements. These proposed requirements are designed to provide our staff, and a fund’s compliance personnel, the ability to evaluate the fund’s compliance with the proposed rule’s requirements. First, the proposed rule would require the fund to maintain certain records documenting the fund’s derivatives risk management program. Specifically, for a fund subject to the proposed rule’s program requirements, the proposed rule would require the fund to maintain a written record of its policies and procedures that are designed to manage the fund’s derivatives risks.424 The proposed rule would also require a fund to maintain a written record of the results of any stress testing of its portfolio, results of any VaR test backtesting it conducts, records documenting any internal reporting or escalation of material risks under the program, and records documenting any periodic reviews of the program.425 These records would allow our staff to understand a fund’s derivatives risk management program and how the fund administered it. Second, the proposed rule would require funds to keep records of any materials provided to the fund’s board of directors in connection with approving the designation of the derivatives risk manager.426 The proposed rule would also require a fund to keep records of any written reports provided to the board of directors relating to the program, and any written reports provided to the board that the rule would require regarding the fund’s non-compliance with the applicable VaR test.427 These records would help our staff to understand what was provided to the fund’s board while overseeing the fund’s program. Third, for a fund that is required to comply with the proposed VaR-based limit on fund leverage risk, the fund would have to maintain records documenting the fund’s determination of: The VaR of its portfolio; the VaR of the fund’s designated reference index, 424 Proposed rule 18f–4(c)(6)(i)(A); see also supra section II.B.3. Under proposed rule 18f–4(c)(4), leveraged/ inverse funds would be subject to the proposed rule’s derivatives risk management program requirement. Such funds would therefore also be subject to the program-related recordkeeping provisions of the proposed rule. 425 Proposed rule 18f–4(c)(6)(i)(A). 426 Proposed rule 18f–4(c)(6)(i)(B); see also supra section II.C. 427 Id.; see also supra section II.D.5.b. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 as applicable; the fund’s VaR ratio (the value of the VaR of the fund’s portfolio divided by the VaR of the designated reference index), as applicable; and any updates to any VaR calculation models used by the fund, as well as the basis for any material changes made to those models.428 These records would provide information on the operation of a fund’s VaR test and, for example, would allow our staff to better understand how a fund (and funds generally) implement the proposed VaR tests. Fourth, the proposed rule would require a fund that is a limited derivatives user to maintain a written record of its policies and procedures that are reasonably designed to manage its derivatives risk.429 These records would help our staff to understand what policies and procedures that a limited derivatives user has adopted and implemented to address the risks associated with its use of derivatives. Fifth, the proposed rule would require a fund that enters into unfunded commitment agreements to maintain a record documenting the basis for the fund’s belief regarding the sufficiency of its cash and cash equivalents to meet its obligations with respect to its unfunded commitment agreements.430 A fund must make such a record each time it enters into such an agreement.431 These records would allow our staff to understand and evaluate funds’ determinations regarding their ability to meet their obligations under their unfunded commitment agreements. Finally, the proposed rule would require funds to maintain the required records for a period of five years.432 In particular, a fund must retain a copy of its written policies and procedures under the rule that are currently in effect, or were in effect at any time within the past five years, in an easily accessible place.433 In addition, a fund would have to maintain all other records and materials that the rule would require the fund to keep for at least five years (the first two years in an easily accessible place).434 The 428 Proposed rule 18f–4(c)(6)(i)(C); see also supra section II.K. 429 Proposed rule 18f–4(c)(6)(i)(D); see also supra section II.K. 430 Proposed rule 18f–4(e)(2); see also supra section II.K. 431 Id. 432 Proposed rule 18f–4(c)(6)(ii); proposed rule 18f–4(e)(2). 433 Proposed rule 18f–4(c)(6)(ii)(A); see also supra notes 423 and 428 and accompanying text. The retention requirement would apply to both funds that are required to implement a derivatives risk management program and funds that are limited derivatives users under proposed rule 18f–4(c)(3). 434 Proposed rule 18f–4(c)(6)(ii)(B); proposed rule 18f–4(e)(2). PO 00000 Frm 00064 Fmt 4701 Sfmt 4702 proposed five-year retention period is consistent with the period provided in rule 38a–1(d) and rule 22e–4 under the Investment Company Act. We believe consistency in these retention periods is appropriate because funds currently have compliance-program-related recordkeeping procedures in place incorporating a five-year retention period, which we believe would lessen the proposed new recordkeeping compliance burden to funds, compared to choosing a different, longer retention period. We request comment on the proposed rule’s recordkeeping requirements. 244. Are the proposed recordkeeping provisions appropriate? Are there any other records relating to a fund’s derivatives transactions that a fund should be required to maintain? For example, should we also require a fund to maintain written records relating to any action the fund took after exceeding a risk guideline (or any internal reporting that occurred following the exceedance of a risk guideline)? 435 Or, as another example, should we include a provision in the proposed rule that would require a fund that enters into reverse repurchase agreements under proposed rule 18f–4(d) to maintain records documenting the fund’s compliance with the applicable asset coverage requirement of section 18? Why or why not? The proposed rule would require a fund to maintain records of the VaR of its portfolio, the VaR of its designated reference index (as applicable), and its VaR ratio. To what extent would the requirement to maintain records of the fund’s VaR ratio involve burdens in addition to the requirement to maintain the fund’s VaR and the VaR of the designated reference index? 245. Are there feasible alternatives to the proposed recordkeeping requirements that would minimize recordkeeping burdens, including the costs of maintaining the required records, while promoting the goals of providing the Commission and its staff, and a fund’s compliance personnel, sufficient information to understand: (1) A fund’s derivatives risk management program and how the fund had administered it, (2) how a fund’s board oversees the program, (3) the administration and effectiveness of a fund’s VaR test, (4) how a limited derivatives user’s policies and procedures are designed to address the risks associated with its use of derivatives, and (5) the basis for a fund’s determination regarding the sufficiency 435 See, e.g., proposed rule 18f–4(c)(1)(ii), proposed rule 18f–4(c)(1)(v)(A). E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 of its cash to meet its obligations with respect to unfunded commitment agreements? 246. Are the record retention time periods that we have proposed appropriate? Should we require records to be maintained for a longer or shorter period? If so, for how long? L. Transition Periods In view of our proposal for an updated, comprehensive approach to the regulation of funds’ derivatives use, we are proposing to rescind Release 10666.436 In addition, staff in the Division of Investment Management is reviewing its no-action letters and other guidance addressing derivatives transactions and other transactions covered by proposed rule 18f–4 to determine which letters and other staff guidance, or portions thereof, should be withdrawn in connection with any adoption of this proposal. Upon the adoption of any final rule, some of these letters and other staff guidance, or portions thereof, would be moot, superseded, or otherwise inconsistent with the final rule and, therefore, would be withdrawn. If interested parties believe that additional letters or other staff guidance, or portions thereof, should be withdrawn, they should identify the letter or guidance, state why it is relevant to the proposed rule, how it or any specific portion thereof should be treated, and the reason therefor. The staff review would include, but would not necessarily be limited to, all of the staff no-action letters and other staff guidance listed below, including our staff’s position regarding TOBs.437 • Dreyfus Strategic Investing & Dreyfus Strategic Income (pub. avail. June 22, 1987) • Merrill Lynch Asset Management, L.P. (pub. avail. July 2, 1996) • Robertson Stephens Investment Trust (pub. avail. Aug. 24, 1995) • Claremont Capital Corp (pub. avail. Sept. 16, 1979) • Emerald Mgt. Co. (pub. avail. Jan. 21, 1978) • Sanford C. Bernstein (pub. avail. June 25, 1990) • Hutton Options Trading, L.P. (pub. avail. Feb. 2, 1989) • Prudential-Bache IncomeVertible Plus Fund (pub. avail. Nov. 20, 1985) • State Street Income Fund, State Street Balanced Fund (pub. avail. Oct. 21, 1985) 436 See supra section I.C. Investment Management Staff Issues of Interest, available at https://www.sec.gov/divisions/ investment/issues-of-interest.shtml#tobfinancing; see also Registered Investment Company Use of Senior Securities—Select Bibliography, available at https://www.sec.gov/divisions/investment/ seniorsecurities-bibliography.htm. 437 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 • New England Life Government Securities Trust (pub. avail. Sept. 26, 1985) • Putnam Option Income Trust II (pub. avail. Sept. 23, 1985) • Thomson McKinnon Government Securities Fund (pub. avail. Sept. 23, 1985) • GMO Core Trust (pub. avail. Aug. 19, 1985) • Bartlett Capital Trust (pub. avail. Aug. 19, 1985) • Continental Option Income Plus Fund (pub. avail. Aug. 12, 1985) • Colonial High Yield Securities Trust, Colonial Enhanced Mortgage Trust (pub. avail. July 25, 1985) • Putnam High Income Government Trust (pub. avail. June 3, 1985) • Bartlett Management Trust (pub. avail. May 17, 1985) • Drexel Series Trust—Government Securities Series (pub. avail. Apr. 25, 1985) • Koenig Tax Advantaged Liquidity Fund (pub. avail. Mar. 27, 1985) • Colonial Tax-Managed Trust (pub. avail. Dec. 31, 1984) • Monitrend Fund (pub. avail. Nov. 14, 1984) • Pilot Fund (pub. avail. Sept. 14, 1984) • Colonial Government Securities Plus Trust (pub. avail. June 15, 1984) • Z-Seven Fund (pub. avail. May 21, 1984) • Pension Hedge Fund (pub. avail. Jan. 20, 1984) • Steinroe Bond Fund (pub. avail. Jan. 17, 1984) • IDS Bond Fund (pub. avail. Apr. 11, 1983) • Safeco Municipal Bond, Inc (pub. avail. Nov. 26, 1982) • ‘‘Dear Chief Financial Officer’’ Letter, from Lawrence A. Friend, Chief Accountant, Division of Investment Management (pub. avail. Nov. 7, 1997) Accordingly, following a one-year transition period to provide time for funds to prepare to come into compliance with the new rule, funds could only enter into derivatives transactions, reverse repurchase agreements and similar financing transactions, and unfunded commitments to the extent permitted by, and consistent with the requirements of, proposed rule 18f–4 or section 18. At that time, Release 10666 would be rescinded and, as determined appropriate in connection with the staff’s review of no-action letters and other staff guidance described in this release, staff no-action letters and other staff guidance, or portions thereof, would be withdrawn. We similarly propose to provide a one-year compliance period for the sales PO 00000 Frm 00065 Fmt 4701 Sfmt 4702 4509 practices rules to provide time for broker-dealers and investment advisers to bring their operations into conformity with the new rule. We also propose a one-year delay to the effective date of the amendments to rule 6c–11, which would permit leveraged/inverse ETFs to rely on that rule, and to rescind the exemptive orders we have provided to leveraged/inverse ETF sponsors on the effective date of the amendments to rule 6c–11. We propose that each of the transition periods discussed in this section would run from the date of the publication of any final rule in the Federal Register. Accordingly, one year after that date: (1) Any fund that enters into the transactions permitted by rule 18f–4 would do so relying on that rule; (2) broker-dealers and investment advisers would be required to comply with the sales practices rules; and (3) leveraged/ inverse ETFs could operate under rule 6c–11 and the current leveraged/inverse ETF sponsors’ orders would be rescinded. We request comment on these transition periods. 247. Do commenters agree that a oneyear transition period to provide time for funds to prepare to come into compliance with proposed rule 18f–4 is appropriate? Should the period be shorter or longer? 248. Should we adopt tiered transition periods for smaller entities? For example, should we provide an additional 6 months for smaller entities (or some other shorter or longer period) in any transition period that we provide? Should the transition period be the same for all funds that rely on proposed rule 18f–4 (for example 12 months after any adoption of proposed rule 18f–4, or any shorter or longer period)? 249. Is the proposed one-year compliance period for the sales practices rules appropriate? Why or why not? Is a longer or shorter compliance period necessary to allow investment advisers and broker-dealers to comply with the proposed sales practices rules? Why or why not? If we provide small and large funds a tiered transition period to comply with proposed rule 18f–4, should we similarly implement a tiered compliance period for investment advisers and broker-dealers to comply with the proposed sales practices rules? Why or why not? 250. Would our proposal to rescind the current leveraged/inverse ETF sponsors’ exemptive orders on the delayed effective date of the amendments to rule 6c–11 provide sufficient time for the leveraged/inverse E:\FR\FM\24JAP2.SGM 24JAP2 4510 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 ETF sponsors to transition to rule 6c– 11? M. Conforming Amendments Form N–2 requires a closed-end fund to disclose a senior securities table with certain information about any senior securities it has issued.438 Outstanding senior securities may bear on the likelihood, frequency, and size of distributions from the fund to its investors because section 18 prohibits distributions when a closed-end fund does not have the asset coverage required under that section. Proposed rule 18f–4 would provide that a fund’s derivatives transactions and unfunded commitments entered into under the proposed rule would not be considered for purposes of computing section 18 asset coverage.439 These transactions therefore would not affect a fund’s ability under section 18 to make distributions to investors. Registered closed-end funds are already required to disclose extensive information about their derivatives transactions on Form N–PORT. In light of this treatment under proposed rule 18f–4 and the information that is already available regarding registered closed-end funds’ derivatives transactions, we are proposing to amend Form N–2 to provide that funds relying on proposed rule 18f–4 would not be required to include their derivatives transactions and unfunded commitment agreements in the senior securities table on Form N–2.440 Commenters on the 2015 proposal that addressed this topic supported such a conforming amendment with respect to asset coverage calculations and disclosure.441 We request comment on the proposed conforming amendment to Form N–2, and other conforming amendments that commenters suggest would be necessary or appropriate. 251. Is the proposed conforming amendment appropriate? We have not proposed to exclude reverse repurchase agreements and similar financing transactions from the senior securities table in Form N–2 because these transactions may bear on the likelihood, frequency, and size of distributions from a fund to its investors. Do commenters agree that this is appropriate? Why or why not? If commenters do not believe that these transactions should be included in the senior securities table, what other disclosure would be appropriate? Item 4.3 of Form N–2. proposed rule 18f–4(b). 440 See proposed amendment to Instruction 2 of Item 4.3 of Form N–2. 441 See, e.g., Ares Comment Letter; ICI Comment Letter I. 252. Rule 22e–4 requires funds subject to the rule, in classifying the liquidity of their portfolios and in determining whether a fund primarily holds highly liquid investments, to take into account the fund’s highly liquid investments that it has ‘‘segregated’’ to cover certain less liquid investments.442 Proposed rule 18f–4, however, does not include an asset segregation requirement, and would supersede Release 10666 and related staff guidance. Should we remove any references in rule 22e–4 to ‘‘segregated’’ assets (while retaining rule 22e–4’s references to assets pledged to satisfy margin requirements)? Is there any other basis on which funds ‘‘segregate’’ assets that would warrant our retaining these references? 253. Are there other conforming amendments to any of our other rules or forms that we should make? If so, what rules or forms should be amended and why? III. Economic Analysis We are mindful of the costs imposed by, and the benefits obtained from, our rules. Section 3(f) of the Exchange Act and section 2(c) of the Investment Company Act state that when the Commission is engaging in rulemaking under such titles and is required to consider or determine whether the action is necessary or appropriate in (or, with respect to the Investment Company Act, consistent with) the public interest, the Commission shall consider whether the action will promote efficiency, competition, and capital formation, in addition to the protection of investors. Further, section 23(a)(2) of the Exchange Act requires the Commission to consider, among other matters, the impact such rules would have on competition and states that the Commission shall not adopt any rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. The following analysis considers, in detail, the potential economic effects that may result from the proposed rule, including the benefits and costs to investors and other market participants as well as the broader implications of the proposal for efficiency, competition, and capital formation. A. Introduction Funds today use a variety of derivatives, referencing a range of assets or metrics. Funds use derivatives both to obtain investment exposure as part of their investment strategies and to manage risks. A fund may use derivatives to gain, maintain, or reduce exposure to a market, sector, or security more quickly, or to obtain exposure to a reference asset for which it may be difficult or impractical for the fund to make a direct investment. A fund may use derivatives to hedge interest rate, currency, credit, and other risks, as well as to hedge portfolio exposures.443 As funds’ strategies have become increasingly diverse, funds’ use of derivatives has grown in both volume and complexity over the past several decades. At the same time, a fund’s derivatives use may entail risks relating to, for example, leverage, markets, operations, liquidity, and counterparties, as well as legal risks.444 Section 18 of the Investment Company Act is designed to limit the leverage a fund can obtain through the issuance of senior securities.445 As discussed above, a fund’s derivatives use may raise the investor protections concerns underlying section 18. In addition, funds’ asset segregation practices have developed such that funds’ derivatives use—and thus funds’ potential leverage through derivatives transactions—does not appear to be subject to a practical limit as the Commission contemplated in Release 10666. Accordingly, we continue to be concerned that certain fund asset segregation practices may not address the concerns underlying section 18.446 Proposed rule 18f–4 is designed to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives and certain other transactions. The proposed rule would permit a fund, subject to certain conditions, to enter into derivatives or other transactions, notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Investment Company Act. We believe that the proposed rule’s requirements, including the derivatives risk management program requirement and VaR-based limit on fund leverage risk, would benefit investors by mitigating derivatives-related risks, including those that may lead to unanticipated and potentially significant losses for investors. Certain funds use derivatives in a limited manner, which we believe presents a lower degree of risk or 438 See 439 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 442 See rule 22e–4(b)(1)(ii)(C); rule 22e– 4(b)(1)(iii)(B). A fund would also have to take into account the percentage of its highly liquid investments that it has pledged to satisfy margin requirements. See id. PO 00000 Frm 00066 Fmt 4701 Sfmt 4702 443 See supra section I.A. e.g., supra notes 16–17 and accompanying text. 445 See supra section I.B.1. 446 See supra sections I.B.3. 444 See, E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules potential impact and generally a lower degree of leverage than permitted under section 18. The proposed rule would provide an exception from the proposed derivative risk management program requirement and VaR-based limit on fund leverage risk for these limited derivatives users. Instead, the proposed rule would require a fund relying on this exception to adopt policies and procedures that are reasonably designed to manage its derivatives risks. Funds with limited derivatives exposure and funds that use derivatives transactions solely to hedge certain currency risk would therefore not be required to incur costs and bear compliance burdens that may be disproportionate to the resulting benefits, while still being required to manage the risks their limited use of derivatives may present.447 The proposed rule would also provide an exception from the VaR-based limit on fund leverage risk for certain leveraged/inverse funds in light of the requirements under the proposed sales practices rules that broker-dealers and investment advisers exercise due diligence in approving the accounts of retail investors to invest in these funds, and other conditions for these funds that proposed rule 18f–4 includes.448 This would allow these funds, which generally could not currently satisfy the proposed VaR-based limit on fund leverage risk, to continue offering their current strategies. The proposed sales practices rules’ due diligence and account approval requirements also would apply to accounts of investors in certain exchange-listed commodity- or currency-based trusts or funds, which are not investment companies subject to section 18 but present similar investor protection concerns. We believe the proposed sales practices rules would enhance investor protection by helping to ensure that investors in these funds are limited to those who are capable of evaluating their characteristics— including that the funds would not be subject to all of the leverage-related requirements applicable to registered investment companies generally—and the unique risks they present. Proposed rule 18f–4 also contains requirements for funds’ use of certain senior securities that are not derivatives. Specifically, the proposed rule would permit reverse repurchase agreements and other similar financing transactions if they comply with the asset coverage requirements of section 18; this approach would align the treatment of reverse repurchase agreements and similar financing transactions, for 447 See 448 See supra sections I.C and II.E. supra section II.G. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 section 18 purposes, with the treatment of bank borrowings and other senior securities transactions subject to section 18’s asset coverage requirements.449 In addition, the proposed rule would permit a fund to enter into unfunded commitment agreements if it reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements.450 This requirement is designed to address the concern that a fund may experience losses as a result of having insufficient assets to meet its obligations with respect to these transactions, and we believe that the requirement would benefit investors by mitigating such losses or other adverse effects if a fund is unable to satisfy an unfunded commitment agreement.451 This proposal also includes certain recordkeeping requirements and reporting requirements for funds that use derivatives.452 We expect that the proposed recordkeeping requirements would benefit investors by facilitating fund compliance with the proposed rule and our staff’s review of funds’ compliance. In addition, we expect that the proposed amendments to Forms N– PORT, N–CEN, and N–RN would further benefit investors by enhancing the Commission’s and the public’s understanding of the impact of funds’ use of derivatives on fund portfolios, and by facilitating the Commission’s ability to oversee funds’ use of derivatives and compliance with the proposed rules.453 B. Economic Baseline 449 Similar financing transactions may include securities lending arrangements and TOBs, depending on the particular facts and circumstances of the individual transaction. See supra section II.I. 450 See supra section II.J. 451 We believe that the proposed treatment of unfunded commitment transactions is consistent with general market practices. Therefore, we believe that the proposed requirements for both types of senior securities would not have significant economic effects when measured against this baseline. 452 See supra sections II.C and II.H. 453 Because leveraged/inverse funds would not be subject to the proposed VaR-based limit on fund leverage risk, these funds would not be subject to the related proposed reporting requirements on Forms N–PORT and N–RN. Leveraged/inverse funds would, however, be subject to the proposed new reporting requirements on funds’ derivatives exposure on form N–PORT as well as to the proposed new requirements on Form N–CEN. PO 00000 Frm 00067 Fmt 4701 Sfmt 4702 developments, and an increase in domestic and international investment opportunities, both retail and institutional.454 As of September 2019, there were 9,788 mutual funds (excluding money market funds) with $21,333 billion in total net assets, 1,910 ETFs organized as an open-end fund or as a share-class of an open-end fund with $3,081 billion in total net assets, 664 registered closed-end funds with 294 billion in total net assets, and 13 variable annuity separate accounts registered as management investment companies on Form N–3 with $224 billion in total net assets. There also were 413 money market funds with $3,392 billion in total net assets.455 Finally, as of June 2019, there were 99 BDCs with $63 billion in total net assets.456 2. Funds’ Use of Derivatives DERA staff analyzed funds’ use of derivatives based on Form N–PORT filings as of September 2019. The filings covered 9,074 mutual funds with $19,590 billion in total net assets, 1,711 ETFs with $3,317 billion in total net assets, 565 registered closed-end funds with $327 billion in net assets, and 13 variable annuity separate accounts registered as management investment companies with $219 billion in total net assets.457 While only larger fund groups are currently required to file reports on Form N–PORT, existing filings nevertheless covered 89% of funds representing 94% of assets.458 454 See supra note 1. of the number of registered investment companies and their total net assets are based on a staff analysis of Form N–CEN filings as of September 5, 2019. For open-end funds that have mutual fund and ETF share classes, we count each type of share class as a separate fund and use data from Morningstar to determine the amount of total net assets reported on Form N–CEN attributable to the ETF share class. Money market funds are excluded from the scope of proposed rule 18f–4 but may experience economic effects as a result of being excluded from the rule’s scope. We therefore report their number and net assets separately from those of other mutual funds. 456 Estimates of the number of BDCs and their net assets are based on a staff analysis of Form 10–K and Form 10–Q filings as of June 30, 2019. Our estimate includes BDCs that may be delinquent or have filed extensions for their filings, and it excludes 6 wholly-owned subsidiaries of other BDCs. 457 The analysis is based on each registrant’s latest Form N–PORT filing as of September 23, 2019. Money market funds are excluded from the analysis; they do not file monthly reports on Form N–PORT and are excluded from the scope of proposed rule 18f–4. For open-end funds that have mutual fund and ETF share classes, we count each type of share class as a separate fund and use data from Morningstar to determine the amount of total net assets reported on Form N–PORT attributable to the ETF share class. 458 See supra note 280. 455 Estimates 1. Fund Industry Overview The fund industry has grown and evolved substantially in past decades in response to various factors, including investor demand, technological 4511 E:\FR\FM\24JAP2.SGM 24JAP2 4512 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules Based on this analysis, 59% of funds reported no derivatives holdings, and a further 27% of funds reported using derivatives with gross notional amounts below 50% of net assets. These results are comparable to and consistent with the findings of the DERA White Paper, which studied a random sample of 10% of funds in 2014.459 BDCs do not file Form N–PORT. To help evaluate the extent to which BDCs use derivatives, our staff reviewed the most recent financial statements of 48 of the current 99 BDCs as of September 2019.460 Based on this analysis, we observe that most BDCs do not use derivatives extensively. Of the sampled BDCs, 54% did not report any derivatives holdings, and a further 29% reported using derivatives with gross notional amounts below 10% of net assets. lotter on DSKBCFDHB2PROD with PROPOSALS2 3. Current Regulatory Framework for Derivatives Funds have developed certain general asset segregation practices to ‘‘cover’’ their derivatives positions, consistent with the conditions in staff no-action letters and guidance.461 However, staff has observed that practices vary based on the type of derivatives transaction, and that funds use different practices regarding the types of assets that they segregate to cover their derivatives positions. For purposes of establishing the baseline, we assume that funds generally segregate sufficient assets to at least cover any mark-to-market liabilities on the funds’ derivatives transactions, with some funds segregating more assets for certain types of derivatives transactions (sufficient to cover the full notional amount of the transaction or an amount between the transaction’s full notional amount and any mark-to-market liability).462 As the mark-to-market liability of a derivative can be much smaller than the full investment exposure associated with the position, funds’ current use of the markto-market asset segregation approach, and funds’ segregation of any liquid asset, do not appear to place a practical limit on their use of derivatives.463 4. Funds’ Derivatives Risk Management Practices and Use of VaR Models There is currently no requirement for funds that use derivatives to have a formalized derivatives risk management program. However, we understand that advisers to many funds whose 459 See DERA White Paper, supra note 1. supra note 279 and accompanying text. 461 See supra section II.B.2.b. 462 See supra notes 54–55 and accompanying text. 463 See supra section I.B.2.b. 460 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 investment strategies entail the use of derivatives, including leveraged/inverse funds, already assess and manage risks associated with their derivatives transactions to varying extents. In addition, we understand that funds engaging in derivatives transactions have increasingly used stress testing as a risk management tool over the past decade.464 We also understand that VaR calculation tools are widely available, and many advisers that enter into derivatives transactions already use risk management or portfolio management platforms that include VaR tools.465 Advisers to funds that use derivatives more extensively may be particularly likely to currently use risk management or portfolio management platforms that include VaR capability. Moreover, advisers that manage (or that have affiliates that manage) UCITS funds may already be familiar with using VaR models in connection with European guidelines.466 One commenter submitted the results of a survey based on responses from 24 fund complexes with $13.8 trillion in assets.467 The results of this survey indicate that 73% of respondents used some form of both VaR and stress testing as derivatives risk management tools. 5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse Funds Leveraged/inverse investment vehicles, as defined in the proposed sales practices rules, include leveraged/ inverse funds and certain exchangelisted commodity- or currency-based trusts or funds. Currently, there are 164 leveraged/inverse ETFs with $33.9 billion in total net assets; 105 leveraged/ inverse mutual funds with $4.9 billion in total net assets; and 17 exchangelisted commodity- or currency-based trusts or funds with $1.2 billion in total net assets.468 464 See also supra note 145 and accompanying text. 465 See also supra note 179. supra note 221 and accompanying text. 467 See ICI Comment Letter III. The commenter also indicated that the surveyed ICI member firms accounted for 67% of mutual fund and ETF assets as of June 2019 and that survey responses were submitted by firms ‘‘whose assets under management spanned the spectrum from small to very large.’’ However, these representations alone do not provide sufficient information about whether the surveyed firms were representative of all mutual funds and ETFs in terms of the exact distribution of specific characteristics, such as firm size or type of investment strategy. 468 Estimates of the number of leveraged/inverse mutual funds and leveraged/inverse ETFs and their total net assets are based on a staff analysis of Form N–CEN filings as of September 5, 2019. Estimates of the number of exchange-listed commodity- or currency-based trusts or funds and their total net 466 See PO 00000 Frm 00068 Fmt 4701 Sfmt 4702 Leveraged/inverse investment vehicles generally target a daily return (or a return over another predetermined time period) that is a multiple, inverse, or inverse multiple of the return of an underlying index; however over longer holding periods, the realized leverage multiple of the returns of an investment in a leveraged/inverse investment vehicle relative to the returns of its underlying index can vary substantially from the vehicle’s daily leverage multiple. In addition, the returns of leveraged/ inverse investment vehicles over longer holding periods share certain features with the returns of holding an option.469 For example, a call option on an index with a strike price that is much higher than the current index price (i.e., the option is significantly ‘‘out of the money’’) is likely to expire worthless. If the option expires worthless, an investor that holds the option until expiry receives no payoff in exchange for their initial investment (the option premium) and therefore experiences a return of ¥100%. Holding all other factors fixed, the likelihood of this outcome increases with the strike price of the option, and the option is priced accordingly—options that are further out of the money, all else equal, will have lower premiums. At the same time, on the rare occasions when the index price exceeds the strike price at expiration, the investor will earn a high return on his or her initial investment because the initial price paid for a call option is lower when the strike price is higher. While the payoff to holding a leveraged/inverse investment vehicle over long periods generally lacks this strict discontinuous nature (expiring either in the money or out of the money), it is nevertheless similar to that of an option in the sense that, as the vehicle’s leverage multiple or investor’s holding period increases, the likelihood of experiencing a loss increases (analogous to the option expiring out of the money) while gains, when they do occur, tend to be larger (analogous to the option expiring in the money).470 assets are based on Bloomberg data as of September 20, 2019. 469 For a technical analysis of the similarities between the returns of leveraged/inverse ETFs over longer holding periods and the returns of holding an option, see Division of Economic and Risk Analysis, Economics Note: The Distribution of Leveraged ETF Returns (Nov. 2019), available at https://www.sec.gov/files/DERA_LETF_Economics_ Note_Nov2019.pdf. The results of that analysis also apply more generally to other types of leveraged/ inverse investment vehicles. 470 In statistical terms, the option returns and returns of holding leveraged/inverse investment vehicles over longer holding periods both exhibit positive skewness. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 To achieve the stated leverage multiple, most leveraged/inverse investment vehicles rebalance their exposure to the underlying index daily.471 This is also similar to options, whose payoffs can be replicated by trading dynamically in the underlying asset and a low-risk bond. For example, call options are economically equivalent to holding a long position in the underlying asset and a short position in a low-risk bond.472 Both leveraged/ inverse investment vehicles and options are therefore economically equivalent to a dynamically rebalanced leveraged/ inverse or inverse leveraged/inverse position in the underlying asset or reference index.473 The majority of assets held in leveraged/inverse funds are held in leveraged/inverse ETFs. There are currently two ETF sponsors that rely upon exemptive relief from the Commission that permits them to operate leveraged/inverse ETFs.474 Since 2009, the Commission has not granted leveraged/inverse exemptive relief to any additional sponsors. In addition, leveraged/inverse ETFs are currently excluded from the scope of rule 6c–11, which the Commission adopted earlier this year and which allows ETFs satisfying certain conditions to operate without obtaining an exemptive order from the Commission.475 Retail investors predominantly purchase and sell shares of leveraged/ inverse investment vehicles through broker-dealers and investment advisers.476 To the extent that brokerdealers or investment advisers recommend leveraged/inverse investment vehicles to their customers or clients, they should have processes in 471 Leveraged/inverse investment vehicles that track the returns of an underlying index over time periods that are longer than one day rebalance their portfolios at the end of each such period. Leveraged/inverse investment vehicles use derivatives to achieve their targeted returns. 472 Conversely, put options are economically equivalent to holding a short position in the underlying and a long position in a low-risk bond— their replicating portfolio consists of an inverse leveraged position in the underlying. 473 Option replication portfolios need to be rebalanced continuously throughout the day as the price of the underlying asset changes. While the implied rebalancing happens continuously during the trading day for options, leveraged/inverse investment vehicles perform rebalancing trades in the underlying less frequently (daily for most leveraged/inverse investment vehicles). 474 See supra notes 307 and 356. The exemptive orders of the two sponsors that operate leveraged/ inverse ETFs permit these sponsors to launch additional funds under the terms and conditions of those orders. 475 See supra notes 352–353 and accompanying text. 476 See supra note 321. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 place to satisfy their obligations to make only suitable recommendations or provide best interest advice, respectively.477 For example, the basis for an investment adviser’s reasonable understanding generally would include, for retail clients of investment advisers, a reasonable inquiry into the client’s financial situation, level of financial sophistication, investment experience, and financial goals.478 When an adviser is assessing whether complex or highrisk products—such as leveraged/ inverse funds—are in a retail client’s best interest, the adviser should generally apply heightened scrutiny to whether such investments fall within the retail client’s risk tolerance and objectives.479 Broker-dealers also will be required to comply with Regulation Best Interest beginning on June 30, 2020.480 Broker-dealers complying with Regulation Best Interest will have to exercise reasonable diligence, care, and skill when making a recommendation to a retail customer, including by understanding potential risks, rewards, and costs associated with a recommendation in light of the customer’s investment profile.481 C. Benefits and Costs of the Proposed Rules and Amendments The Commission is sensitive to the economic effects that may result from the proposed rules and rule and form amendments, including benefits and costs. Where possible, we have attempted to quantify the likely economic effects; however, we are unable to quantify certain economic effects because we lack the information necessary to provide reasonable estimates. In some cases, it is difficult to predict how market participants would act under the conditions of the proposed rules. For example, we are unable to predict whether the proposed derivatives risk management program requirement and VaR-based limit on fund leverage risk may make investors 477 Following the June 30, 2020 compliance date for Regulation Best Interest, broker-dealers will have to provide recommendations in the best interest of their retail customers. See Regulation Best Interest: The Broker-Dealer Standard of Conduct, supra note 308. 478 See, e.g., Fiduciary Interpretation, supra note 308, at text preceding n.36. 479 See id. at text preceding n.39. The Commission further stated in the Fiduciary Interpretation that leveraged/inverse funds and other complex products ‘‘may not be in the best interest of a retail client absent an identified, shortterm, client-specific trading objective and, to the extent that such products are in the best interest of a retail client initially, they would require daily monitoring by the adviser.’’ See id. 480 See Regulation Best Interest: The BrokerDealer Standard of Conduct, supra note 305. 481 See id. at section II.C.2. PO 00000 Frm 00069 Fmt 4701 Sfmt 4702 4513 more or less likely to invest in funds that would be subject to these requirements or the degree to which these requirements may affect the use of derivatives by these funds. Nevertheless, as described more fully below, we are providing both a qualitative assessment and quantified estimate of the economic effects, including the initial and ongoing costs of the additional reporting requirements, where feasible. Direct costs incurred by funds discussed below may, to some extent, be absorbed by the fund’s investment adviser or be passed on to investors in the form of increased management fees. The share of these costs borne by funds, their advisers, and investors depends on multiple factors, including the nature of competition between advisers, and investors’ relative sensitivity to changes in fund fees, the joint effects of which are particularly challenging to predict due to the number of assumptions that the Commission would need to make. 1. Derivatives Risk Management Program and Board Oversight and Reporting Proposed rule 18f–4 would require funds that enter into derivatives transactions and are not limited derivatives users to adopt and implement a derivatives risk management program. The program would provide for the establishment of risk guidelines that must include certain elements, but that are otherwise tailored based on how the fund’s use of derivatives may affect its investment portfolio and overall risk profile. The program also would have to include stress testing, backtesting, internal reporting and escalation, and program review elements. The proposed rule would require a fund’s board of directors to approve the fund’s designation of a derivatives risk manager, who would be responsible for administering the derivatives risk management program. The fund’s derivatives risk manager would have to report to the fund’s board on the derivatives risk management program’s implementation and effectiveness and the results of the fund’s stress testing and backtesting. We understand that advisers to many funds whose investment strategies entail the use of derivatives already assess and manage risks associated with their derivatives transactions.482 However, proposed rule 18f–4’s requirement that funds establish written derivatives risk management programs would create a standardized framework for funds’ 482 See E:\FR\FM\24JAP2.SGM supra section III.B.4. 24JAP2 4514 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 derivatives risk management by requiring each fund’s program to include all of the proposed program elements. To the extent that the resulting risk management activities are more comprehensive than funds’ current practices, this may result in more-effective risk management across funds. While the adoption of a derivatives risk management program requirement may not eliminate all derivatives-related risks, including that investors could experience large, unexpected losses from funds’ use of derivatives, we expect that investors would benefit from a decrease in leverage-related risks. Some funds may reduce or otherwise alter their use of derivatives transactions to respond to risks identified after adopting and implementing their risk management programs. In particular, we expect that funds currently utilizing risk management practices that are not tailored to their use of derivatives may decide to make such changes to their portfolios.483 The proposed rule would require a fund to reasonably segregate the functions of its derivatives risk management program from those of its portfolio management.484 This segregation requirement is designed to enhance the program’s effectiveness by promoting the objective and independent identification and assessment of derivatives risk.485 Segregating the functions of a fund’s derivatives risk management program from those of its portfolio management may also mitigate the risks of competing incentives between a fund’s portfolio managers and its investors.486 483 As a consequence of reducing risk, such funds may earn reduced returns. 484 See supra section II.B.2. 485 See supra note 112 and accompanying text. While some portfolio managers may find it burdensome to collaborate with a derivatives risk manager, to the extent that portfolio managers already consider the impact of trades on the fund’s portfolio risk, we believe that having the involvement of a derivatives risk manager may typically make a portfolio manager’s tasks more rather than less efficient. 486 For example, portfolio managers of activelymanaged funds that are underperforming competing funds may have an incentive to increase risk exposures through use of derivatives in an effort to increase returns. This behavior may result in a fund also increasing risk beyond investor expectations. (For theoretical motivation of such behaviors see, e.g., Keith C. Brown, W.V. Harlow, & Laura T. Starks, Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry, 51 Journal of Finance 85 (1996), available at https://www.onlinelibrary.wiley.com/ doi/abs/10.1111/j.1540-6261.1996.tb05203.x; Judith Chevalier & Glenn Ellison, Risk-Taking by Mutual Funds as a Response to Incentives, 105 Journal of Political Economy 1167 (1997), available at https:// www.jstor.org/stable/10.1086/516389?seq=1# metadata_info_tab_contents). VerDate Sep<11>2014 18:55 Jan 23, 2020 Jkt 250001 Finally, to the extent that the periodic stress testing and backtesting requirements of the proposed derivatives risk management program result in fund managers developing a more complete understanding of the risks associated with their use of derivatives, we expect that funds and their investors will benefit from improved risk management.487 Such benefits would be in addition to benefits derived from the proposed VaR-based limit on fund leverage risk discussed below.488 VaR analysis, while yielding a simple yet general measure of a fund’s portfolio risk, does not provide a complete picture of a fund’s financial risk exposures.489 Complementing VaR analysis with stress testing would provide a more complete understanding of the fund’s potential losses under different sets of market conditions. For example, simulating potential stressed market conditions not reflected in historical correlations between fund returns and asset prices observed in normal markets may provide derivatives risk managers with important information pertaining to derivatives risks in stressed environments.490 By incorporating the potential impact of future economic outcomes and market volatility in its stress test analysis, a fund may be able to analyze future potential swings in its portfolio that may impact the fund’s long-term performance. This forward-looking aspect of stress testing would supplement the proposed rule’s VaR analysis requirement, which would rely on historical data. In addition, requiring that a fund backtest the results of its VaR analysis each business day would assist funds in examining the effectiveness of the fund’s VaR model. The proposed rule 487 See supra sections II.B.3.c and II.B.3.d; see also supra section II.C.2 (discussing the proposed requirements that a fund’s derivatives risk manager provide to the fund’s board: (1) A written report, at least annually, providing a representation that the program is reasonably designed to manage the fund’s derivatives risks and to incorporate the required elements of the program (including a review of the VaR calculation model used by the fund under proposed rule 18f–4(c)(2), and the backtesting required by proposed rule 18f– 4(c)(1)(iv)); and (2) a written report, at the frequency determined by the board, regarding any exceedances of the fund’s risk guidelines and the results of the fund’s stress tests). 488 See infra section III.C.2. 489 See id. 490 See supra section II.B.3.c (proposed rule 18f– 4 would require the program to provide for stress testing to ‘‘evaluate potential losses to the fund’s portfolio 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, taking into account correlations of market risk factors as appropriate and resulting payments to derivatives counterparties’’). PO 00000 Frm 00070 Fmt 4701 Sfmt 4702 would require that, each business day, the fund compare its actual gain or loss for that business day with the fund’s VaR calculated for that day.491 This comparison would help identify days where the fund’s portfolio losses exceed the VaR calculated for that day, as well as systematic over- or under-estimation of VaR suggesting that the fund may not be accurately measuring all significant, identifiable market risk factors.492 Proposed rule 18f–4 would also require that a fund’s board of directors approve the designation of the fund’s derivatives risk manager, taking into account the derivatives risk manager’s relevant experience.493 We anticipate that this requirement, along with the derivatives risk manager’s direct reporting line to the board, would result in effective communication between the board and the derivatives risk manager that would enhance oversight of the program to the benefit of the fund and its investors. Proposed rule 18f–4 would require that the derivatives risk manager provide the fund’s board a written report at least once a year on the program’s effectiveness as well as regular written reports at a frequency determined by the board that analyze exceedances of the fund’s risk guidelines and present the results of the fund’s stress tests and backtests.494 The proposed board reporting requirements may facilitate the board’s oversight of the fund and the operation of the derivatives risk management program, to the extent the fund does not have such regular reporting mechanisms already in place. In the event the derivatives risk manager encounters material risks that need to be escalated to the fund’s board, the proposed provision that the derivatives risk manager may directly inform the board of these risks in a timely manner as appropriate may help prevent delays in resolving such risks. Funds today employ a range of different practices, with varying levels of comprehensiveness and sophistication, for managing the risks associated with their use of derivatives.495 We expect that compliance costs associated with the proposed derivatives risk management program requirement would vary based on the fund’s current risk management practices, as well as the fund’s characteristics, including in particular 491 See 492 See supra section II.B.3.d. supra notes 150–151 and accompanying text. 493 See supra section II.C.1. supra section II.C.2. 495 See supra section III.B.4. 494 See E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 the fund’s investment strategy, and the nature and type of derivatives transactions used by the fund. We understand that VaR models are widely used in the industry and that backtesting is commonly performed in conjunction with VaR analyses. As a result, we believe that many funds that would be required to establish derivatives risk management programs already have VaR models with backtesting in place. Moreover, the proposed rule’s derivatives risk management program requirements, including stress testing and backtesting requirements are, generally, high-level and principles-based. As a result, it is likely that many funds’ current risk management practices may already be in line with many of the proposed rule’s derivatives risk management program requirements or could be readily conformed without material change. Thus, the costs of adjusting funds current’ practices and procedures to comply with the parallel requirements of proposed rule 18f–4 may be minimal for such funds. Certain costs of the proposed derivatives risk management program may be fixed, while other costs may vary with the size and complexity of the fund and its portfolio allocation. For instance, costs associated with purchasing certain third-party data used in the program’s stress tests may not vary much across funds. On the other hand, certain third-party services may vary in terms of costs based on the portfolio positions to be analyzed. Further, the extent to which a cost corresponding to the program is fixed or variable may also depend on the thirdparty service provider. Larger funds or funds that are part of a large fund complex may incur higher costs in absolute terms but find it less costly, per dollar managed, to establish and administer a derivatives risk management program relative to a smaller fund or a fund that is part of a smaller fund complex. For example, larger funds may have to allocate a smaller portion of existing resources for the program, and fund complexes may realize economies of scale in developing and implementing derivatives risk management programs for several funds.496 496 Although we believe that many funds have existing risk officers whose role extends to managing derivatives risks, we note that some funds, and in particular smaller funds or those that are part of a smaller fund complex, may not have existing personnel capable of fulfilling the responsibilities of the derivatives risk manager, or may choose to hire a new employee or employees to fulfill this role, rather than assigning that responsibility to a current employee or officer of the fund or the fund’s investment adviser. We expect VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 For funds that do not already have a derivatives risk management program in place that could be readily adapted to meet the proposed rule’s requirements without significant additional cost, we estimate that the one-time costs to establish and implement a derivatives risk management program would range from $70,000 to $500,000 per fund, depending on the particular facts and circumstances, including whether a fund is part of a larger fund complex and therefore may benefit from economies of scale. These estimated costs are attributable to the following activities: (1) Developing risk guidelines and processes for stress testing, backtesting, internal reporting and escalation, and program review; (2) integrating and implementing the guidelines and processes described above; and (3) preparing training materials and administering training sessions for staff in affected areas. For funds that do not already have a derivatives risk management program in place that could be readily adapted to meet the proposed rule’s requirements without significant additional cost, based on our understanding, we estimate that the ongoing annual program-related costs that a fund would incur range from 65% to 75% of the one-time costs to establish and implement a derivatives risk management program. Thus, a fund would incur ongoing annual costs that range from $45,500 to $375,000.497 These estimated costs are attributable to the following activities: (1) Assessing, monitoring, and managing the risks associated with the fund’s derivatives transactions; (2) periodically reviewing and updating (A) the program including any models or measurement tools (including any VaR calculation models) to evaluate the program’s effectiveness and to reflect changes in risk over time, and (B) any designated reference index to evaluate its appropriateness; (3) providing written reports to the fund’s board on the derivatives risk management program’s implementation and effectiveness and the results of the fund’s stress testing; and (4) additional staff training. Under the proposed rule, a fund that is a limited derivatives user would not be required to establish a derivatives risk management program.498 Based on that a fund that would hire new employees would likely incur larger costs compared to a fund that has existing employees that could serve as a fund’s derivatives risk manager. 497 This estimate is based on the following calculations: 0.65 × $70,000 = $45,500; 0.75 × $500,000 = $375,000. 498 The estimates of the one-time and ongoing costs described in this section include the costs PO 00000 Frm 00071 Fmt 4701 Sfmt 4702 4515 an analysis of Form N–PORT filings, as well as financial statements filed with the Commission by BDCs, we estimate that about 22% of funds that would be subject to the proposed rule, or 2,693 funds total, would be required to implement a risk management program.499 As many funds belong to a fund complex and are likely to experience economies of scale, we expect that the lower end of the estimated range of costs ($70,000 in onetime costs; $45,500 in annual costs) better reflects the total costs likely to be incurred by those funds.500 In addition, we believe that many funds already have a derivatives risk management program in place that could be readily adapted to meet the proposed rule’s requirements without significant additional cost.501 However, as we do not have data to determine how many funds already have a program in place that would substantially satisfy the proposed rule’s requirements, we overinclusively assume that all funds would incur a cost associated with this requirement. Based on these assumptions, we provide an upper-end estimate for total industry cost in the first year of $311,041,500.502 2. VaR-Based Limit on Fund Leverage Risk The proposed rule would generally impose a VaR-based limit on fund leverage risk on funds relying on the rule to engage in derivatives transactions.503 This outer limit would be based on a relative VaR test or, if the fund’s derivatives risk manager is unable to identify an appropriate designated reference index, an absolute VaR test. In either case a fund would apply the test at least once each business day. The proposed rule would include an exception from the limit on associated with determining whether a fund is a limited derivatives user. 499 We estimate that about 22% of all funds that would be subject to the proposed rule hold some derivatives and would not qualify as a limited derivatives user under the proposed rule. 500 A fund that uses derivatives in a complex manner, has existing risk management practices that are not commensurate with such use of derivatives, and may have to hire additional personnel to fulfill the role of derivatives risk manager would be particularly likely to experience costs at the upper end of this range. 501 One commenter indicated that implementing stress testing, which would be one of the required elements of the proposed derivatives risk management program, would be only slightly burdensome for 27% of respondents to a survey of ICI member firms and would be moderately burdensome for an additional 50% of respondents. See ICI Comment Letter III; see also supra note 466. 502 This estimate is based on the following calculation: 2,693 funds × ($70,000 + $45,500) = $311,041,500. 503 See supra section II.D. E:\FR\FM\24JAP2.SGM 24JAP2 4516 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules fund leverage risk for limited derivatives users and also certain funds that are ‘‘leveraged/inverse investment vehicles,’’ as defined in the proposed sales practices rules.504 The proposed relative VaR test would limit a fund’s VaR to 150% of the VaR of the fund’s designated reference index.505 The designated reference index would have to be unleveraged and reflect the markets or asset classes in which the fund invests.506 Therefore, the relative VaR test restricts the incremental risk associated with a fund’s portfolio relative to a similar but unleveraged investment strategy. In this sense, the relative VaR test restricts the degree to which a fund can use derivatives to leverage its portfolio. We recognize that the derivatives risk managers of some funds may not be able to identify an appropriate designated reference index.507 As these funds would not be able to comply with the proposed relative VaR test, the proposed rule would require these funds to comply with the proposed absolute VaR test instead.508 To comply with the absolute VaR test, the VaR of the fund’s portfolio must not exceed 15% of the value of the fund’s net assets. The level of loss in the proposed absolute VaR test would provide approximately comparable treatment for funds that rely on the absolute VaR test and funds that rely on the relative VaR test and use the S&P 500 as their designated reference index during periods where the S&P 500’s VaR is approximately equal to the historical mean.509 One common critique of VaR is that it does not reflect the conditional distribution of losses beyond the specified confidence level.510 In other words, the proposed VaR tests would not capture the size and relative frequency of losses in the ‘‘tail’’ of the distribution of losses beyond the measured confidence level.511 As a result, two funds with the same VaR level could differ significantly in the magnitude and relative frequency of extreme losses, even though the probability of a VaR breach would be the same for the two funds. To demonstrate this limitation of VaR, we construct a simplified portfolio with an equity investment that also achieves leverage through derivatives. By varying the type of derivatives included in the portfolio, we illustrate that the tail risk varies significantly across portfolios with equal VaR. The details of the strategy are as follows. Assume a fund has initial assets of $100 in cash. On day t, the manager of the portfolio achieves the additional leverage by writing $ X worth of put options, and then invests the proceeds from the sale of the options and the initial cash balance, i.e., $(100 + X), into the S&P 500 index.512 For simplicity, we further assume that the underlying asset of the shorted put options is also the S&P 500 index, so that the fund’s designated reference index is the S&P 500. The maturity of the put option is assumed to be one month, and the price of the S&P on day t is normalized to $100. On day t + 1, the manager buys back the put options and realizes the returns of the strategy. The one-day gross return of the fund can be described mathematically as RFund = 100 +X X 100 RM - 100 Rput, where RM is the gross one-day return of the S&P 500 index, and Rput = P(t + 1)/ P(t) is the gross one-day return of the put option, with the price of the put option at time t denoted by P(t). The return of the put option depends on the return of the underlying sset, and the money-ness of the put—the lower the strike price, the more out-of-the-money is the put. In our exercise, we look at three options with three different strike prices, ranging from more out-of-themoney to at-the-money. The strike prices, denoted by K, are equal to K = 92%, K = 96%, and K = 100%, of the current level of the S&P 500 index respectively.513 Assuming the portfolio manager wants to achieve as much leverage as possible with each of the three options, while still abiding by the proposed limit set by the relative VaR level of 150% at a 99% confidence level, we calculate the amount of puts she would short, the expected returns of the three portfolios, and the relative VaR for confidence levels of 95%, 99%, and 99.9%. In our calculation, the model is calibrated to approximately match the historical return distribution of the S&P 500. Returns are assumed to be normally distributed (for simplicity) with an annualized mean return of 6% and an annual standard deviation of roughly 16%. The latter implies a daily standard deviation of 1%. For simplicity, the risk-free rate is assumed to be zero. The results are in Table 1. TABLE 1—PORTFOLIO COMPOSITION, RETURNS AND VAR LEVELS Portfolio Weight ........................................................................................................................... Number of Contracts ................................................................................................................... Fund Expected Return ................................................................................................................. Fund Relative VaR (99%) ............................................................................................................ Fund Relative VaR (99.9%) ......................................................................................................... 504 See supra sections II.E and II.G.3. supra section II.D.2. 506 See supra section II.D.2.a. The proposed definition of ‘‘designated reference index’’ also includes other requirements, as discussed above. See id. For example, a designated reference index could not be administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used. 507 See supra section II.D.3. 508 Whether a fund complies with the proposed relative or absolute VaR test would depend on whether the fund’s derivatives risk manager would lotter on DSKBCFDHB2PROD with PROPOSALS2 505 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 be able to identify a designated reference index that is appropriate for the fund taking into account the fund’s investments, investment objectives, and strategy. See id. We therefore anticipate that industry norms that reflect the availability of an appropriate designated reference index would develop under which funds with similar strategies would generally comply with the same type of VaR test (that is, either the proposed relative VaR test or the proposed absolute VaR test). 509 See supra section II.D.3. 510 See supra note 181 and accompanying text. 511 The term ‘‘relative frequency’’ here refers to the frequency of loss outcomes in the tail of the distribution relative to other loss outcomes that are also in the tail of the distribution. This relative PO 00000 Frm 00072 Fmt 4701 Sfmt 4702 ¥0.58% ¥9.92 6.68% 1.49 2.14 K = 96% Portfolio ¥0.93% ¥2.05 7.00% 1.49 2.07 K = 100% Portfolio ¥1.54% ¥0.84 7.30% 1.49 2.03 frequency of the loss outcomes together with the magnitude of the associated losses describe the conditional distribution of losses in the tail of the distribution. 512 This strategy could be implemented by either investing in the constituent securities of the S&P 500 directly or, for example, by investing in an ETF that tracks the S&P 500 index. 513 Given the historical volatility of the S&P 500— approximately 16% annually, or 1% daily—an 8% daily drop in the price is an 8 standard deviation event. Therefore, an option with a strike price of 92% of the current value of the S&P 500 index could be considered a deep out-of-the-money option. E:\FR\FM\24JAP2.SGM 24JAP2 EP24JA20.000</GPH> K = 92% Portfolio Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 Relative VaR levels are identical and no greater than 150% for all three portfolios at the 99% confidence level and, as expected, for each portfolio relative VaR is higher for higher confidence levels. However, this example illustrates that relative VaR varies across these portfolio for confidence levels above 99%. The fund writing the more out-of-the-money option (K = 92%) is riskier in the tail of the S&P 500 return distribution (when VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 the S&P 500 drops over the one-day period) than the fund writing the at-themoney option (K = 100%), but the relative VaR level at the 99% confidence level does not reflect this difference. Figure 1 shows the daily return profile of the three portfolios as a function of daily returns to the S&P 500 index. Along the x-axis are daily returns to the S&P 500 index, ranging from ¥8% to +8%. The dotted line represents the daily return profile of a PO 00000 Frm 00073 Fmt 4701 Sfmt 4702 4517 portfolio that tracks 1.5 times the returns of the S&P 500 index. The figure shows that the degree of tail risk differs across portfolios. While the returns to all portfolios are equal at the 150% relative VaR limit at a 99% confidence level, returns beyond the 150% relative VaR limit are lower for portfolios that write puts that are further out-of-themoney. BILLING CODE 8011–01–P E:\FR\FM\24JAP2.SGM 24JAP2 4518 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules FIGURE 1: DAILY PORTFOLIO RETURNS -K=9296 - - K.c=96~ -·-' K=lOG:llli{ATM) -25%~-~----~-~--~-~---~ .~~~~~a a Market Return a• FIGURE 2: THREE-DAY RETURNS WITH DAILY REBALANCING CJ%· -Three-day Return ---- Firshda.v Ret1,1rn -1% -6% ~5% .,.41,\i; ~3% -2% Market Return BILLING CODE 8011–01–C We also considered the effect that a decline in the S&P 500 over three consecutive days would have on the VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 fund that is short the put options with a K = 92% strike price considered above. The proposed rule requires that a fund determine its compliance with PO 00000 Frm 00074 Fmt 4701 Sfmt 4702 the applicable VaR test at least once each business day. In computing threeday returns for the fund, we assume that, as the fund exceeds the relative E:\FR\FM\24JAP2.SGM 24JAP2 EP24JA20.001</GPH> lotter on DSKBCFDHB2PROD with PROPOSALS2 .,.,, Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules VaR test each business day, the fund rebalances its portfolio, at the beginning of each day, to bring the fund back into compliance with the 150% relative VaR limit. The solid line in Figure 2 shows the three-day cumulative return of the fund as a function of the per-day returns of the S&P 500 on the x-axis, which is assumed to be the same for three consecutive days. The dashed curve in Figure 2 shows the corresponding firstday returns of the portfolio for comparison, which are the same as those denoted by the solid line in Figure 1. The figure shows that the three-day cumulative returns shown by the solid curve (in Figure 2) are less than three times the single-day losses shown by the dashed curve. This is a result of the daily rebalancing of the portfolio, which, in this example, reduces the incremental downside risk over time. As discussed in more detail above, the proposed VaR tests are designed to address the concerns underlying section 18, but they are not a substitute for a fully-developed derivatives risk management program.514 Recognizing VaR’s limitations, the proposed rule also would require the fund to adopt and implement a derivatives risk management program that, among other things, would require the fund to establish risk guidelines and to stress test its portfolio in part because of concerns that VaR as a risk management tool may not adequately reflect tail risks. DERA staff analyzed the VaR levels of the portfolios of all funds that would be subject to the proposed rule and of certain benchmark indexes as of December 2018 in order to estimate how many of the funds that would be subject to the proposed VaR-based limit on fund leverage risk currently operate in exceedance of that limit.515 This analysis identified only six funds that would be subject to the proposed limit that DERA staff estimated may fail the relative VaR test. In the case of these six funds, DERA staff calculated the relative VaR test using the primary benchmark disclosed in the funds’ prospectuses. To the extent that these funds’ derivatives 514 See supra note 183 and accompanying text. analysis is based on Morningstar data as of December 31, 2018. DERA staff computed the VaR of each fund and that of a reference index using historical simulation from three years of prior daily return data. Staff generally computed the relative VaR test based on a fund’s primary prospectus benchmark. In cases where historical return data for the primary prospectus benchmark was not available or where the primary prospectus benchmark did not appear to capture the markets or asset classes in which a fund invests, DERA staff instead used a broad-based unleveraged index that captures a fund’s markets or asset classes or a broad-based U.S. equity index. lotter on DSKBCFDHB2PROD with PROPOSALS2 515 This VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 risk managers were to determine that a different index would be more appropriate for purposes of computing the relative VaR test or that no appropriate designated reference index were available, some or all of these funds could be compliant with the VaRbased limit on fund leverage risk either under the relative VaR test with a more appropriate index or under the absolute VaR test.516 As a result, we estimate that there would only be a very small number of funds, if any, that would have to adjust their portfolios in order to comply with the VaR-based limit on fund leverage risk. This is consistent with the VaR-based limit on fund leverage risk functioning as an outer bound on fund leverage risk. To the extent that there are funds that would have to adjust their portfolios to comply with the VaR-based limit on fund leverage risk, these funds would incur associated trading costs. If there were a fund that would have to adjust its portfolio so significantly that it could no longer pursue its investment strategy, such a fund may also lose investors or, if it chooses to cease operating, incur costs associated with unwinding the fund. In addition, funds could be required to adjust their portfolios to comply in the future and, if so, would incur associated trading costs. For example, as market conditions change, a fund’s VaR could exceed the proposed limits, especially if a fund relies on the absolute VaR test. The proposed VaR tests also would eliminate the flexibility that funds currently have to leverage their portfolios to a greater extent than the proposed VaR tests would permit. Although funds currently may not be exercising this flexibility, they may nevertheless value the ability to so increase leverage in the future. While, on the one hand, the proposed VaR tests impose costs on funds by restricting the strategies they may employ, the proposed limit on fund leverage risk would benefit fund investors, to the extent that it would prevent these investors from experiencing unexpected losses from a fund’s increased risk exposure that are prevented by the proposed VaR-based limit on fund leverage risk. By establishing a bright-line limit on the amount of leverage risk that a fund can take on using derivatives, the proposed rule may make some funds and their advisers more comfortable with using derivatives. As a result, some 516 Based on our analysis, we estimate that only one of the six funds that we identified may fail the proposed relative VaR test would also fail the proposed absolute VaR test. PO 00000 Frm 00075 Fmt 4701 Sfmt 4702 4519 funds that currently invest in derivatives to an extent that would result in the fund’s VaR being below the proposed limit may react by increasing the extent of their derivatives usage. The proposed requirement could also indirectly result in changing the amount of investments in funds. On the one hand, the proposed rule could attract additional investment, if investors become more comfortable with funds’ general level of riskiness as a result of funds’ compliance with an outside limit on fund leverage risk. On the other hand, to the extent that investors currently expect funds to limit their risk to levels below those which the proposed limits would produce (which investors could observe from the required VaR reporting requirements on form N–PORT for funds other than limited derivatives users and leveraged/ inverse funds), or investors see funds’ general level of riskiness increasing after funds come into compliance with the proposed limits, the proposed limits may result in investors re-evaluating how much risk they are willing to take and reducing their investments in funds. Due to a lack of data regarding current investor expectations about fund risk, however, we are unable to predict which of the two effects would more likely dominate the other. As the proposed requirements would prevent funds from offering investment strategies that exceed the proposed outer limit on fund leverage risk, those investors who prefer to invest in such funds because they value the increased potential for gains that is generally associated with riskier investment strategies may see their investment opportunities restricted by the proposed rules. As a result, such investors may instead invest in alternative investment vehicles, exchange-traded notes, or structured products, which can provide leveraged market exposure but would not be subject to the VaR-based limit on fund leverage risk of rule 18f–4.517 Alternatively, such investors, particularly institutional ones, may instead borrow themselves or trade on margin to achieve leverage. Funds that would be subject to the proposed VaR-based limit on fund leverage risk would incur the cost of determining their compliance with the applicable VaR test at least once each business day. Part of these costs would be associated with obtaining the necessary data required for the VaR calculation. Funds implementing the relative VaR test would likely incur larger data costs compared to funds implementing the absolute VaR test, as 517 See E:\FR\FM\24JAP2.SGM supra section III.C.5. 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4520 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules the absolute VaR test would require funds to obtain data only for the VaR calculation for the fund’s portfolio, whereas the relative VaR test also would require funds to obtain data for the VaR calculation for their designated reference index. In addition, some index providers may charge licensing fees to funds for including indexes in their disclosure documents or for access to information about the index’s constituent securities and weightings.518 Funds that do not already have systems to perform the proposed VaR calculations in place would also incur the costs associated with setting up these systems or updating existing systems.519 Both the data costs and the systems costs would likely be larger for funds that use multiple types of derivatives, use derivatives more extensively, or otherwise have more complicated derivatives portfolios, compared to funds with less complicated derivatives portfolios. Larger funds or funds that are part of a large fund complex may incur higher costs in absolute terms but find it less costly, per dollar managed, to perform VaR tests relative to a smaller fund or a fund that is part of a smaller fund complex. For example, larger funds may have to allocate a smaller portion of existing resources for the VaR test and fund complexes may realize economies of scale in implementing systems to compute VaR. In particular, the costs associated with implementing or updating systems to calculate VaR would likely only be incurred once at the level of a fund complex, as such systems can be used to perform VaR tests for all funds in the complex that are subject to the VaR test requirement. Similarly, larger fund complexes may incur lower costs associated with purchasing data per fund, to the extent that the VaR calculations for multiple funds in the complex partially or completely require the same data. Under the proposed rule, a fund that holds derivatives that is either a limited derivatives user or a leveraged/inverse fund that complies with the alternative requirements for leveraged/inverse investment vehicles would not be subject to the proposed VaR-based limit on fund leverage risk. Based on an analysis of Form N–PORT filings and financial statements filed with the Commission by BDCs, we estimate that about 19% of funds that would be subject to the proposed rule, or 2,424 funds total, would be required to implement VaR tests.520 We estimate that the incremental annual cost associated with the VaR test would range from $5,000 to $100,000 per fund, depending on the particular facts and circumstances, including whether the fund currently computes VaR; whether the fund is implementing the relative or absolute VaR test; and whether a fund that is part of a larger complex may be able to realize economies of scale. Funds that currently already compute VaR would be particularly likely to experience costs at the very low end of this range. Assuming that the midpoint of this range reflects the cost to the average fund subject to the VaR requirement, we estimate a total additional annual industry cost of $127,260,000.521 In addition, a fund that today or in the future may operate in a manner that would result in the fund’s portfolio VaR being just under the proposed limit on fund leverage risk may need to alter its portfolio during periods of increased market volatility in order to avoid falling out of compliance with the proposed limit. We would expect such a scenario to be more likely for a fund that would rely on the absolute VaR test, because the relative VaR test would allow a fund to operate with a higher portfolio VaR when the VaR of its designated reference index increases. A fund that were to eliminate some of its leverage risk associated with 518 We understand that industry practices around licensing indexes for regulatory purposes vary widely, with some providers not charging any fees and others charging fees in excess of $10,000 per year. 519 One commenter indicated that implementing a UCITS VaR test would be only slightly burdensome for 45% of respondents to a survey of ICI member firms and would be moderately burdensome for an additional 34% of respondents. The commenter also indicated that respondents commonly reported that the burden would increase, in some cases very substantially, if a VaR test has different parameters or is more prescriptive than UCITS VaR. See ICI Comment Letter III; see also supra note 451. As the requirements of the proposed VaR test are generally consistent with existing market practice, including that of UCITs funds, the results of this survey therefore support our view that many funds would likely experience efficiencies in implementing the proposed VaR test. 520 We estimate that about 19% of all funds that would be subject to the proposed rule hold some derivatives, would not qualify as a limited derivatives user, and are not a leveraged/inverse fund that could comply with the alternative requirements for leveraged/inverse investment vehicles. 521 This estimate is based on the following calculation: 2,424 funds × 0.5 × ($5,000 + $100,000) = $127,260,000. Some funds may find it more cost effective to restrict their use of derivatives in order to be able to rely on the proposed rule’s exception for limited derivatives users compared to complying with the proposed VaR-based limit on fund leverage risk. See supra section II.E; infra section III.C.3. As we do not have data that would allow us to quantify the costs and benefits that define the tradeoff for any particular fund of changing its use of derivatives in order to qualify for the limited user exception, we are unable to quantify how many funds would make this choice. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 PO 00000 Frm 00076 Fmt 4701 Sfmt 4702 derivatives in order to comply with the proposed VaR-based limit on leverage risk might do so through unwinding or hedging its derivatives transactions or through some other means. These portfolio adjustments may be costly, particularly in conditions of market stress and reduced liquidity. The proposed rule would, however, give a fund the flexibility to mitigate these potential costs by not requiring the fund to exit positions or change its portfolio if it is out of compliance with the VaR test. Instead, the rule would provide that, if a fund has been out of compliance with the applicable VaR test for more than three business days, then: (1) The derivatives risk manager must report to the fund’s board of directors and explain how and by when (i.e., the number of business days) the derivatives risk manager reasonably expects that the fund will come back into compliance; 522 (2) the derivatives risk manager must analyze the circumstances that caused the fund to be out of compliance for more than three business days and update any program elements as appropriate to address those circumstances; and (3) the fund may not enter into derivatives transactions other than derivatives transactions that, individually or in the aggregate, are designed to reduce the fund’s VaR, until the fund has been back in compliance with the applicable VaR test for three consecutive business days and satisfied the board reporting requirement and program analysis and update requirements.523 These provisions of the proposed rule collectively would provide some flexibility for a fund that is out of compliance with the VaR test to make any portfolio adjustments, which may allow funds to avoid some of the costs that otherwise could result from forced changes in the fund’s portfolio. 3. Limited Derivatives Users Proposed rule 18f–4 includes an exception from the proposed risk management program requirement and VaR-based limit on fund leverage risk for limited derivatives users.524 The proposed exception would be available for a fund that either limits its derivatives exposure to 10% of its net assets or uses derivatives transactions solely to hedge certain currency risks and that also adopts and implements policies and procedures reasonably 522 Proposed rule 18f–4(c)(2)(iii)(A). See also infra section II.H.2 (discussing a report to the Commission regarding the fund being out of compliance with the applicable proposed VaR test for three business days). 523 See proposed rule 18f–4(c)(2)(iii). 524 See supra section II.E. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules designed to manage the fund’s derivative risks. We expect that the risks and potential impact of these funds’ derivatives use may not be as significant, compared to those of funds that do not qualify for the exception.525 Therefore, we believe that a principlesbased policies and procedures requirement would appropriately address these risks. We believe that investors in funds that use derivatives in a limited manner would benefit from the proposed requirement, which we anticipate would reduce, but not eliminate, the frequency and severity of derivativesrelated losses for such funds. In addition, to the extent that the proposed framework is more comprehensive than funds’ current practices, the proposed requirement may result in more effective risk management across funds and increased fund industry stability. For funds that do not already have policies and procedures in place that could be readily adapted to meet the proposed rule’s requirements without significant additional cost, we estimate that the one-time costs would range from $1,000 to $100,000 per fund, depending on the particular facts and circumstances, including whether a fund is part of a larger fund complex; the extent to which the fund uses derivatives within the parameters of the limited user exception, including whether the fund uses more complex derivatives; and the fund’s current derivatives risk management practices. These estimated costs are attributable to the following activities: (1) Assessing whether a fund is a limited derivatives user; (2) developing policies and procedures reasonably designed to manage a fund’s derivatives risks; (3) integrating and implementing the policies and procedures; and (4) preparing training materials and administering training sessions for staff in affected areas. For funds that do not already have policies and procedures in place that could be readily adapted to meet the proposed rule’s requirements without significant additional cost, we estimate that the ongoing annual costs that a fund that is a limited derivatives user would incur range from 65% to 75% of the one-time costs to establish and implement the policies and procedures. Thus, a fund would incur ongoing annual costs that range from $650 to $75,000.526 These estimated costs are 525 See supra note 270 and accompanying and immediately-following text. 526 This estimate is based on the following calculations: 0.65 × $1,000 = $650; 0.75 × $100,000 = $75,000. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 attributable to the following activities: (1) Assessing, monitoring, and managing the risks associated with the fund’s derivatives transactions; (2) periodically reviewing and updating a fund’s policies and procedures; and (3) additional staff training. Based on an analysis of Form N– PORT filings, as well as financial statements filed with the Commission by BDCs, we estimate that about 19% of funds that would be subject to the proposed rule, or 2,398 funds total, would qualify as limited derivatives users. Almost all of these funds would be able to rely on the exposure-based exception. While some funds, about 1%, could rely on both the exposure-based exception and the currency hedging exception, only a fraction of 1% of funds would qualify as limited derivatives users solely based on the currency hedging exception. As many funds belong to a fund complex and are likely to experience economies of scale, we expect that the lower end of the estimated range of costs ($1,000 in one-time costs; $650 in annual costs) better reflects the total costs likely to be incurred by many funds. In addition, we believe that many funds already have policies and procedures in place that could be readily adapted to meet the proposed rule’s requirements without significant additional cost. However, as we do not have data to determine how many funds already have such policies and procedures in place that would substantially satisfy the proposed rule’s requirements, we assume that all funds would incur a cost associated with this requirement. Based on these assumptions, we over-inclusively estimate a lower bound for the total industry cost in the first year of $751,773.527 Some funds may change how they use derivatives in order to qualify for the limited derivatives user exception and thereby avoid the potentially increased compliance cost associated with the proposed derivatives risk management program and VaR-based limit on fund leverage risk. Specifically, a fund with derivatives exposure just below 10% of 527 This estimate is based on the following calculation: 2,398 funds × 0.19 × ($1,000 + $650) = $751,773. This cost estimate assumes that none of the funds that currently do not hold any derivatives would choose to establish and implement policies and procedures reasonably designed to manage the fund’s derivatives risks in anticipation of a future limited use of derivatives. Notwithstanding this assumption, we acknowledge some funds that currently do not use derivatives may still choose to establish and implement such policies and procedures prophylactically in order to preserve the flexibility to engage in a limited use of derivatives on short notice. PO 00000 Frm 00077 Fmt 4701 Sfmt 4702 4521 its net assets may forego taking on additional derivatives positions, or a fund with derivatives exposure just above 10% of its net assets may close out some existing derivatives positions. Similarly, a fund that uses derivatives to hedge certain currency risks may forego or eliminate its use of derivatives for other purposes. As a result, the proposed exception for limited derivatives users may reduce the extent to which some funds use derivatives.528 4. Reverse Repurchase Agreements and Similar Financing Transactions The proposed rule would allow funds to engage in reverse repurchase agreements and other similar financing transactions. However, as these transactions achieve economically identical results to other secured loans, the proposed rule would require that they be treated the same as bank borrowings and other borrowings under section 18. The proposal would therefore require a fund to combine any bank borrowings or other borrowings and reverse repurchase agreements when assessing compliance with the relevant asset coverage requirements of section 18.529 Today, funds rely on the asset segregation approach that Release 10666 describes with respect to reverse repurchase agreements, which funds may view as separate from the limitations established on bank borrowings (and other senior securities that are evidence of indebtedness) by the asset coverage requirements of section 18.530 As a result, the degree to which funds could engage in reverse repurchase agreements may differ under the proposed rule from the baseline. A fund that engages solely in reverse repurchase agreements, or solely in bank borrowings (for example), would be unaffected by the proposed requirement.531 However, to the extent that a fund engages in both reverse repurchase agreements and bank borrowings (or similar transactions), because we believe these transactions are economically equivalent, they would be combined for purposes of analyzing whether a fund is in compliance with section 18’s asset 528 As we do not have data that would allow us to quantify the costs and benefits that define the tradeoff for any particular fund of changing its use of derivatives in order to qualify for the limited user exception, we are unable to quantify how many funds would make this choice. 529 See supra section II.I. 530 See supra section I.B.2.a. 531 For example, an open-end fund with no other senior securities outstanding could borrow an amount equivalent to 50% of its net assets using reverse repurchase agreements or bank borrowings under the baseline. E:\FR\FM\24JAP2.SGM 24JAP2 4522 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules coverage requirement. This may have the effect of limiting the overall scale of these transactions under the proposed requirement compared to the baseline, to the extent that funds today separately analyze their asset coverage requirements with respect to reverse repurchase agreements under Release 10666 and bank borrowings and similar senior securities under section 18. DERA staff analyzed funds’ use of reverse repurchase agreements and borrowings using Form N–PORT filings as well as financial statements filed with the Commission by BDCs. Based on our analysis of Form N–PORT filings, we estimate that about 0.36% of funds that would be subject to the proposed rule, or 45 funds total, used these transactions in combined amounts that exceeded the asset coverage requirement.532 These funds would have to adjust their use of reverse repurchase agreements, similar financing transactions, or borrowings in order to comply with the proposed rule and may incur associated transactions costs. In addition, under the proposed rule, if a fund did not qualify as a limited derivatives user due to its other investment activity, any portfolio leveraging effect of reverse repurchase agreements, similar financing transactions, and borrowings would also be restricted indirectly through the VaRbased limit on fund leverage risk. As a result, a fund could be restricted through the VaR-based limit on fund leverage risk from investing the proceeds of borrowings through reverse repurchase agreements to the full extent otherwise permitted by the asset coverage requirements in section 18 if the fund did not qualify as a limited derivatives user. lotter on DSKBCFDHB2PROD with PROPOSALS2 5. Alternative Requirements for Certain Leveraged/Inverse Funds and Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment Vehicles The proposed sales practices rules would require a broker-dealer or investment adviser to (1) exercise due diligence in approving a retail investor’s account to buy or sell shares of leveraged/inverse investment vehicles before accepting an order from, or 532 In our review of form N–PORT filings, we observed that several of the funds that used reverse repurchase agreements and similar financing transactions (bank borrowings and similar securities) in combined amounts that exceeded 50% of net assets already exceeded the 50% limit for either repurchase agreements, similar financing transactions (bank borrowings and similar securities, or both, when considered separately. In our review of financial statements filed by the Commission by BDCs, we observed that no BDCs exceeded the asset coverage requirement. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 placing an order for, such an investor to engage in these transactions; and (2) adopt and implement policies and procedures reasonably designed to achieve compliance with the proposed rules.533 Additionally, a leveraged/ inverse fund that meets the definition of a ‘‘leveraged/inverse investment vehicle’’ in the proposed sales practices rules would not have to comply with the VaR-based leverage risk limit under proposed rule 18f–4, provided the fund limits the investment results it seeks to 300% of the return (or inverse of the return) of the underlying index and discloses in its prospectus that it is not subject to the proposed VaR-based limit on fund leverage risk.534 These due diligence and approval requirements are designed to address potential investor protection concerns with respect to leveraged/inverse investment vehicles by subjecting retail investors to specific due diligence and account approval requirements by broker-dealers and investment advisers. The proposed rules also are designed to help to ensure that investors in these funds are limited to those who are capable of evaluating their characteristics—including that the funds would not be subject to all of the leverage-related requirements applicable to registered investment companies generally—and the unique risks they present. There is a body of academic literature providing empirical evidence that retail investors may not fully understand the risks inherent in their investment decisions and not fully understand the effects of compounding returns over time.535 Retail investors 533 See supra section II.G.2. The proposed sales practices rules define ‘‘leveraged/inverse investment vehicle’’ to mean a registered investment company or an exchange-listed commodity- or currency-based trust or fund that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time. See proposed rules 15l–2(d) and 211(h)–1(d). 534 See supra section II.G.3. A leveraged/inverse fund that meets these requirements still would be required to satisfy all of the conditions in proposed rule 18f–4 other than the proposed VaR-based limit on fund leverage risk, including the proposed conditions requiring a derivatives risk management program, board oversight and reporting, and recordkeeping. 535 See, e.g., Annamaria Lusardi & Olivia S. Mitchell, The Economic Importance of Financial Literacy: Theory and Evidence, 52 Journal of Economic Literature 5 (2014), available athttps:// www.aeaweb.org/articles?id=10.1257/jel.52.1.5, which provides a literature review of recent surveybased work indicating that many retail investors have limited financial literacy and, for example, do not always understand the compounding of returns, which may directly apply in the context of the daily compounding feature of leveraged/inverse ETFs. The literature does not address retail investor’s PO 00000 Frm 00078 Fmt 4701 Sfmt 4702 could face additional burdens in investing in leveraged/inverse investment vehicles, to the extent that they do not currently possess the requisite capability of evaluating the risks of these products to satisfy the approval requirements implemented by broker-dealers and investment advisers in connection with the proposed rules’ due diligence and account approval obligations. However, we expect such retail investors would benefit from the proposed requirement, which we believe would help to ensure that investors in these funds are limited to those who are capable of evaluating the characteristics and unique risks of these products.536 We acknowledge that these benefits may be reduced, to the extent that they overlap with the effects of investment advisers’ or broker-dealers’ existing requirements or practices related to a retail investors’ suitability for investments in these produces as discussed in section III.B.5 above. Since the alternative provision for leveraged/inverse funds under proposed rule 18f–4 includes a requirement that a leveraged/inverse fund disclose in its prospectus that it is not subject to the proposed limit on fund leverage risk, both investors and the market would benefit from transparency regarding which funds are exempt from rule 18f– 4’s limit on fund leverage fund risk. Some investors may value this information to the extent that it helps them make better-informed choices between funds. The costs that broker-dealers and investment advisers may incur as a result of the proposed sales practices rules would vary depending on the firm. For example, as the proposed requirements are generally modeled after the options account requirements, broker-dealers that already have compliance procedures in place for approving options accounts would likely have reduced compliance costs.537 In addition, some brokerdealers and investment advisers may incur costs associated with training inattention to investment risk or the unique dynamics of compounding of daily returns in the context of leveraged/inverse ETFs or other leveraged/inverse investment vehicles specifically, but studies investor inattention to financial products more generally. 536 The sales practices rules would not apply to a position in a leveraged/inverse investment vehicle established before the rules’ compliance date. See supra note 339 and associated text. As a result, investors with such existing positions would only be affected by the proposed sales practices rules if they seek to increase an existing or add a new position in a leveraged/inverse investment vehicle. 537 These efficiencies and the resulting reduced compliance costs would not apply to investment advisers that are not also registered broker-dealers because they are not subject to FINRA rules. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules customer-facing personnel and supervisory review of account approval decisions. Investment advisers’ and broker-dealers’ existing processes, as discussed above in section III.B.5, may reduce the costs that the proposed sales practices rules otherwise would involve to the extent that investment advisers or broker-dealers can build on existing processes in complying with the proposed sales practices rules. Broker-dealers and investment advisers would incur costs associated with the proposed sales practices rules. We estimate that one-time costs for a broker-dealer or investment adviser related to the due diligence and account approval requirements would range from $7,749 to $12,915 538 and that onetime costs related to drafting the associated policies and procedures would range from $1,367 to $2,278.539 Thus, we estimate total one-time costs for a broker-dealer or investment adviser would range from $9,116 to $15,193.540 In addition, we estimate that ongoing costs for a broker-dealer or investment adviser related to the due diligence and account approval requirements would range from $1,211 to $2,018 per year,541 that ongoing costs related to the associated policies and procedures requirement would range from $903 to $1,505 per year,542 and that ongoing lotter on DSKBCFDHB2PROD with PROPOSALS2 538 This estimated range is based on the following calculations: (6 hours × $365 (compliance attorney) + 9 hours × $284 (senior systems analyst) + 12 hours × $331 (senior programmer)) = ($2,190 + $2,556 + $3,972) = $8,718 for development and implementation of online client questionnaire; (3 hours × $365 (compliance attorney) + 3 hour × $70 (compliance clerk)) = $1,305 for customer due diligence; and 1 hour × $309 (compliance manager) = $309 for evaluation of client information for account approval/disapproval for a total of $10,332. Assuming a range of +/¥25% around the average total of $10,332 gives a range for one-time costs from $10,332 × 75% = $7,749 to $10,332 × 125% = $12,915. 539 This estimated range is based on the following calculations: (3 hours × $309 (senior manager) + 1 hour × $365 (compliance attorney) + 1 hour × $530 (chief compliance officer)) = ($927 + $365 + $530) = $1,822 for establishing and implementing rule 15l–2 policies and procedures. Assuming a range of +/¥25% around the average total of $1,822 gives a range for one-time costs from $1,822 × 75% = $1,366.50 to $1,822 × 125% = $2,277.50. 540 This estimated range is based on the following calculations: $7,749 + $1,366.50 = $9,115.50 for the minimum of the cost range and $12,915 + $2,277.50 = $15,192.50 for the maximum of the cost range. 541 This estimated range is based on the following calculations: (3 hours × $365 (compliance attorney) + 3 hour × $70 (compliance clerk)) = $1,305 per year for customer due diligence; and 1 hour × $309 (compliance manager) = $309 per year for evaluation of client information for account approval/disapproval for a total of $1,614 per year. Assuming a range of +/¥25% around the average total of $1,614 per year gives a range for ongoing costs from $1,614 × 75% = $1,210.50 per year to $1,614 × 125% = $2,017.50 per year. 542 This estimated range is based on the following calculations: (1 hour × $309 (senior manager) + 1 VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 costs related to the associated recordkeeping requirements would range from $157 to $393 per year.543 Thus, we estimate that total ongoing costs for a broker-dealer or investment adviser would range from $2,271 to $3,915 per year.544 As of December 2018, there were 2,766 broker-dealers that reported some sales to retail customer investors.545 We estimate that 700 of these broker dealers with retail customer accounts (approximately 25%) have retail customer accounts that invest in leveraged/inverse investment vehicles. Our staff further estimates that 715,000 existing customer accounts with such broker-dealers would require account approval for trading in leveraged/ inverse investment vehicles and that 10,000 new customer accounts opened each year would require such approval.546 In addition, as of December 2018, there were 8,235 investment advisers registered with the Commission having some portion of their business dedicated to retail investors, including either individual high net worth clients or individual non-high net worth clients.547 We estimate that 2,000 of these investment advisers with retail client accounts (approximately 25%) have retail client accounts that invest in leveraged/inverse investment vehicles. Wefurther estimate that 715,000 existing customer accounts with such investment advisers would require hour × $365 (compliance attorney) + 1 hour × $530 (chief compliance officer)) = $1,204 per year for reviewing and updating rule 15l¥2 policies and procedures. Assuming a range of +/–25% around the average total of $1,204 per year gives a range for ongoing costs from $1,204 × 75% = $903 per year to $1,204 × 125% = $1,505 per year. 543 This estimated range is based on the following calculations: (1 hour × $62 (general clerk) + 1 hour × $95 (senior computer operator)) = $157 per year for the minimum of the cost range and (2.5 hours × $62 (general clerk) + 2.5 hours × $95 (senior computer operator) = ($155 + $237.50)) = $392.50 per year for the maximum of the cost range. 544 This estimated range is based on the following calculations: ($1,210.50 + $903 + $157) = $2,270.50 per year for the minimum of the cost range and ($2,017.50 + $1,505 + $392.50) = $3,915 per year for the maximum of the cost range. 545 Our estimate of the number of broker-dealers with retail customers are based on data obtained from Form BD and Form BR as of December 31, 2018. 546 The number of broker-dealers that have retail client accounts that invest in leveraged/inverse investment vehicles as well as the numbers of existing and new customer accounts with these broker-dealers that would require approval for trading in these products are based on staff experience, as we do not have data that would allow us to determine these numbers more precisely. 547 Our estimate of the number of investment advisers with retail accounts are based on data obtained from responses to Item 5.D of Form ADV as of December 31, 2018. PO 00000 Frm 00079 Fmt 4701 Sfmt 4702 4523 account approval for trading in leveraged/inverse investment vehicles, and that 10,000 new customer accounts opened each year would require such approval.548 To the extent that many brokerdealers already have compliance procedures in place for approving options accounts, which is a common industry practice, these broker-dealers would likely have reduced costs associated with the proposed requirements of the sales practices rules. Thus, we estimate that many brokerdealers would incur one-time and ongoing costs that are closer to the low end of the provided ranges, while broker-dealers that cannot take advantage of such efficiencies and many investment advisors would likely experience costs closer to the high end of the provided ranges.549 We estimate that the total industry cost for the proposed requirements of the sales practice rule in the first year for both broker-dealers and investment advisers would equal $2,377,503,800, which is based on the midpoint of the sum of the ranges for both one-time and ongoing costs.550 Some broker-dealers and investment advisers may decide to pass 548 The number of investment advisors that have retail client accounts that invest in leveraged/ inverse investment vehicles as well as the numbers of existing and new customer accounts with these investment advisers that would require approval for trading in these products are based on staff experience, as we do not have data that would allow us to determine these numbers more precisely. 549 See supra notes 514 and 518. 550 This estimate is based on the following calculations: (700 broker-dealers + 2,000 registered investment advisers having retail customer accounts that invest in leveraged/inverse investment vehicles) × ($8,718 + $1,822)) = $28,458,000 + ((2 × 715,000) existing customer accounts with broker-dealers and registered investment advisers requiring account approval for trading in leveraged/inverse investment vehicles) × ($1,305 + $309) = $2,308,020,000 for total one-time industry costs to broker-dealers and investment advisers of $2,336,478,000; and ((2 × 10,000) new customer accounts requiring account approval for trading in leveraged/inverse investment vehicles) × ($1,305 + $309) = $32,280,000 + (700 broker-dealers + 2,000 registered investment advisers having retail customer accounts that invest in leveraged/inverse investment vehicles) × $1,204) = $3,250,800 + (10,000 new customer accounts requiring account approval for trading in leveraged/inverse investment vehicles) × ($157 (broker-dealer recordkeeping costs) + $392.50 (investment adviser recordkeeping costs)) = $5,495,000 for total ongoing annual industry costs to broker-dealers and investment advisers of $41,025,800 per year. Total industry cost for proposed requirements of sales practice rule in the first year is $2,336,478,000 + $41,025,800 = $2,377,503,800, which is consistent with being the midpoint of the sum of the ranges for both one-time and ongoing costs discussed in preceding calculations. E:\FR\FM\24JAP2.SGM 24JAP2 4524 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 these compliance costs on to their customers.551 In addition, some leveraged/inverse investment vehicles may lose existing or potential investors as a result of some retail investors not being approved by their broker-dealer or investment adviser to transact in leveraged/inverse investment vehicles or some retail investors being deterred by the time costs and delay introduced by the account-opening procedures. Brokerdealers or investment advisers with a larger fraction of retail customers or clients that can no longer transact in leveraged/inverse investment vehicles as a result of the proposed sales practices rules may experience larger declines in their customer or client base and associated reductions in profits.552 It is our understanding that no funds that would meet the definition of a ‘‘leveraged/inverse investment vehicle,’’ and that seek returns above 300% of the return (or inverse of the return) of the underlying index, currently exist. Therefore we do not expect any costs associated with existing funds having to alter their investment strategies or business practices to comply with proposed rule 18f–4’s alternative requirements for leveraged/inverse funds. Requiring a leveraged/inverse fund covered by the proposed sales practices rules to limit its exposure to 300% of the return (or inverse of the return) of the underlying index while preventing a fund that does not qualify as a leveraged/inverse investment vehicle from offering investment strategies that exceed the proposed outer limit on fund leverage risk may also have competitive effects, which we discuss in section III.B.5 below. As an alternative to the proposed exposure limit for leveraged/ inverse funds, we also discuss the effects of conditioning the exemption for leveraged/inverse funds on compliance with a higher or lower exposure limit in section III.D.1 below. 551 The share of these costs passed on to investors by investment advisers or broker-dealers would depend on multiple factors, including the nature of competition between investment advisers and broker-dealers as well as investors’ relative sensitivity to changes in fees, the joint effects of which are inherently impossible to predict. Some broker-dealers offer transactions in certain leveraged/inverse investment vehicles, such as some leveraged/inverse ETFs, without charging commissions. In these cases, broker-dealers may pass on some of the compliance costs associated with the proposed requirements by charging some amount of commission on these trades. 552 Any such reduction in a broker-dealer’s or investment adviser’s customer base may be offset to the extent that clients transact in other products with the same broker dealer or investment adviser instead. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 6. Proposed Amendments to Rule 6c–11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs Existing leveraged/inverse ETFs rely on exemptive relief, which the Commission has not granted to a leveraged/inverse ETF sponsor since 2009. We are proposing to amend rule 6c-11 to remove the provision excluding leveraged/inverse ETFs from its scope, which would permit fund sponsors to operate a leveraged/inverse ETF under that rule and without obtaining an exemptive order. The proposed amendments to rule 6c– 11 would benefit any fund sponsors seeking to launch leveraged/inverse ETFs that did not obtain the required exemptive relief due to the Commission’s moratorium on granting such relief as well as fund sponsors seeking to launch leveraged/inverse ETFs in the future. A fund sponsor planning to seek exemptive relief from the Commission to form and operate a leveraged/inverse ETF would also no longer incur the cost associated with applying for an exemptive order.553 To the extent that the amendments result in new leveraged/inverse ETFs coming to market, the industry-wide assets under management of leveraged/inverse ETFs could increase and investors that would be eligible under the proposed sales practices rules to invest in leveraged/ inverse ETFs could benefit from an increase in investment choices.554 Because our proposed amendments to rule 6c–11 would permit leveraged/ inverse ETFs to rely on that rule, we also are proposing to rescind the exemptive orders the Commission has previously granted to leveraged/inverse ETFs. As a result, existing and future leveraged/inverse ETFs would operate under a consistent regulatory framework. We believe that the costs to leveraged/inverse ETFs associated with rescinding their existing exemptive relief would be minimal, as we anticipate that all existing leveraged/ inverse ETFs would be able to continue 553 In the ETFs Adopting Release, we estimated that the direct cost of a typical fund’s application for ETF relief (associated with, for example, legal fees) is approximately $100,000. As exemptive applications for leveraged/inverse ETFs are significantly more complex than those of the average fund, we estimate that the direct costs of an application for leveraged/inverse ETF relief would amount to approximately $250,000. See ETFs Adopting Release, supra note 76, at nn.537– 539 and accompanying text. 554 The increase in assets under management among leveraged/inverse ETFs could be attenuated, to the extent that proposed rule 15l–2’s and 211(h)– 1’s due diligence requirements would lead to a reduction in the number of investors that invest in these funds. See infra section III.C.5. PO 00000 Frm 00080 Fmt 4701 Sfmt 4702 operating with only minor adjustments, other than being required to comply with the requirements in rule 6c–11 for additional website disclosures and basket asset policies and procedures.555 Additional economic considerations that the proposed treatment of leveraged/inverse ETFs presents with regards to efficiency and competition are discussed below in section III.D. 7. Unfunded Commitment Agreements The proposed rule would permit a fund to enter into unfunded commitment agreements if it reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as they come due.556 While a fund should consider its unique facts and circumstances, the proposed rule would prescribe certain specific factors that a fund must take into account in having such a reasonable belief. We believe that the proposed requirements are consistent with current market practices, based on the staff’s experience in reviewing and commenting on fund registration statements, which have disclosure regarding their unfunded commitments, as well as representations funds have made to the staff.557 As a result, we do not believe that the rule’s treatment of unfunded commitment agreements represents a change from the baseline, although we acknowledge that there may be some variation in the specific factors that funds consider today, as well as the potential for some variation between those factors and those prescribed in the proposed rule. Because we believe that the proposed approach is consistent with general market practices and we do not have specific granular information to identify differences in funds’ current practices relative to the proposed rule, we believe this proposed requirement would not lead to significant economic effects. 8. Recordkeeping Proposed rule 18f–4 includes certain recordkeeping requirements.558 Specifically, the proposed rule would 555 In this section as well as in section III.D below, we have accounted for the costs and benefits to leveraged/inverse ETFs as a result of the removal of the current exclusion of these funds from rule 6c–11. We believe that the additional considerations the Commission analyzed in the ETFs Adopting Release for ETFs other than leveraged/inverse ETFs that were included in the scope of rule 6c–11 at adoption would apply substantially similarly to leveraged/inverse ETFs. See ETFs Adopting Release, supra note 76. 556 See supra section II.J. 557 See supra discussion in paragraph preceding note 419. 558 See supra section II.K. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules require a fund to maintain certain records documenting its derivatives risk management program’s written policies and procedures, along with its stress test results, VaR backtesting results, internal reporting or escalation of material risks under the program, and reviews of the program.559 It would also require a fund to maintain records of any materials provided to the fund’s board of directors in connection with approving the designation of the derivatives risk manager and any written reports relating to the derivatives risk management program.560 A fund that would be required to comply with the proposed VaR test would also have to maintain records documenting the determination of: Its portfolio’s VaR; its designated reference index VaR, as applicable; its VaR ratio (the value of the VaR of the Fund’s portfolio divided by the VaR of the designated reference index), as applicable; and any updates to any of its VaR calculation models and the basis for any material changes to its VaR models.561 A fund that would be a limited derivatives user under the proposed rule would have to maintain a written record of its policies and procedures that are reasonably designed to manage derivatives risks.562 Finally, a fund engaging in unfunded commitment agreements would be required to maintain records documenting the sufficiency of its funds to meet its obligations with respect to all unfunded commitment agreements.563 We believe that these proposed requirements would increase the effectiveness of the Commission’s oversight of the fund industry, which will, in turn, benefit investors. Further, the requirement to keep records documenting the derivatives risk management program, including records documenting periodic review of the program and reports provided to the board of directors relating to the program, would help our staff evaluate a fund’s compliance with the proposed derivatives risk management program requirements. We anticipate that these recordkeeping requirements would generally not impose a large additional burden on funds, as most funds would likely choose to keep such records, even absent the proposed requirement to do so, in order to support their ongoing administration of the proposed derivatives risk management program and their compliance with the associated requirements. 559 See proposed rule 18f–4(c)(i)(A). proposed rule 18f–4(c)(6)(i)(B). 561 See proposed rule 18f–4(c)(6)(i)(C). 562 See proposed rule 18f–4(c)(6)(i)(D). 563 See proposed rule 18f–4(c)(6)(i)(E). 560 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 As discussed below in section IV.B.7, our estimated average one-time and ongoing annual costs associated with the recordkeeping requirements take into account the fact that certain funds can rely on the proposed rule’s limited derivatives user exception and may incur less extensive recordkeeping costs relative to those funds which may not rely on this exception. Of the estimated 5,091 funds that would be subject to the recordkeeping requirements, we estimate that 2,398 funds would be limited derivatives users. Assuming that both one-time and ongoing annual recordkeeping costs for limited derivatives users are 90% of those for funds that would not qualify as limited derivatives users, we estimate that, on average, each fund that could not rely on the limited user exception would incur a one-time cost of $2,047 564 and an ongoing cost of $330 per year 565 and each fund that could rely on the exception would incur, a one-time cost of $1,842 566 and an ongoing cost of $297 per year.567 We thus estimate that the total industry cost for this requirement in the first year would equal $11,529,656.568 9. Amendments to Fund Reporting Requirements a. Form N–PORT and Form N–CEN We are proposing to amend Form N– PORT to include a new reporting item on funds’ derivatives exposure, which would be publicly available for the third month of each fund’s quarter.569 In 564 This estimate is based on the following derivations and calculations: 1.5 hours × $62 (general clerk)/((2,398/5,091) × 90% + ((5,091¥2,398)/5,091)) = $97.60; and 1.5 hours × $95 (senior computer operator)/((2,398/5,091) × 90% + ((5,091¥2,398)/5,091)) = $149.54 for a total of $97.60 + $149.54 + ($1,800 for initial external cost burden) = $2,047.14, where (2,398/5,091) is the share of funds that are limited derivatives users and (5,091¥2,398)/5,091) is the share of funds that are not limited derivatives users. 565 This estimate is based on the following derivations and calculations: 2 hours × $62 (general clerk)/((2,398/5,091) × 90% + ((5,091¥2,398)/ 5,091)) = $130.13; and 2 hours × $95 (senior computer operator)/((2,398/5,091) × 90% + ((5,091¥2,398)/5,091)) = $199.39 for a total of $130.13 + $199.39 = $329.52, where (2,398/5,091) is the share of funds that are limited derivatives users and (5,091¥2,398)/5,091) is the share of funds that are not limited derivatives users. 566 This estimate is based on the following calculations: $2,047.14 × 90% = $1,842.43. 567 This estimate is based on the following calculations: $329.52 × 90% = $296.57. 568 This estimate is based on the following calculations: (5,091¥2,398 = 2,693 funds which cannot rely on the limited derivatives user exception) × ($2,047.14 + $329.52) = $6,400,347.32; and (2,398 funds which can rely on the limited derivatives user exception) × ($1,842.43 + $296.57) = $5,129,309.17 for a total of $11,529,656.48. 569 See supra section II.H.1. While the information for the first two months of a fund’s quarter would be non-public, the information for PO 00000 Frm 00081 Fmt 4701 Sfmt 4702 4525 addition, we are proposing amendments that would require funds that are subject to the proposed VaR-based limit on fund leverage risk to report certain information related to their VaR.570 We are also proposing to amend Form N– CEN to require a fund to identify (1) whether it is a limited derivatives user (either under the proposed exception for funds that limit their derivatives exposure to 10% of their net assets or under the exception for funds that limit their derivatives use to certain currency hedging); (2) whether it is a leveraged/ inverse investment vehicle as defined in proposed sales practices rules; and (3) whether it has entered into reverse repurchase agreements or similar financing transactions, or unfunded commitment agreements.571 These additional reporting requirements would not apply to BDCs, which do not file reports on Form N–CEN or Form N– PORT.572 To the extent that measures of derivatives exposure, and the other information that we would require funds to report on Forms N–PORT and N–CEN, are not currently available, the proposed requirements that funds make such information available periodically on these forms would improve the ability of the Commission to oversee reporting funds. It also would allow the Commission and its staff to oversee and monitor reporting funds’ compliance with the proposed rule and help identify trends in reporting funds’ use of derivatives, portfolio VaRs, and their choice of designated reference indexes. The expanded reporting also would increase the ability of the Commission staff to identify trends in investment strategies and fund products in reporting funds as well as industry outliers.573 the third month of a fund’s quarter would be publicly available. See supra note 359. 570 Specifically, this information would include: (1) The fund’s highest daily VaR during the reporting period and its corresponding date; and (2) the fund’s median daily VaR for the reporting period. Funds subject to the relative VaR test during the reporting period also would have to report: (1) The name of the fund’s designated reference index; (2) the index identifier; (3) the fund’s highest daily VaR ratio during the reporting period and its corresponding date; and (4) the fund’s median daily VaR ratio for the reporting period. Finally, all funds that are subject to the proposed limit on fund leverage risk also would have to report the number of exceptions that the fund identified as a result of the backtesting of its VaR calculation model. See id. 571 We believe that many of these proposed new reporting items would be inapplicable to most BDCs. See supra section II.H.3. 572 See supra section II.H.4. 573 The structuring of the information in Form N– PORT would improve the ability of Commission staff to compile and aggregate information across all reporting funds, and to analyze individual funds or E:\FR\FM\24JAP2.SGM Continued 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4526 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules Investors, third-party information providers, and other potential users would also experience benefits from the proposed amendments to Forms N– PORT and N–CEN. Investors and other potential users would have disclosure of additional information that is not currently available in any filings. We believe that the structured data format of this information in Forms N–PORT and N–CEN would allow investors and other potential users to more efficiently analyze portfolio investment information. The additional information, as well as the structure of that information, would increase the transparency of a fund’s investment strategies and allow more efficient assessment of reporting funds’ potential leverage-related risks. The amendments to Forms N–PORT and N–CEN would also benefit investors, to the extent that they use the information, to better differentiate funds that are not limited derivatives users or leveraged/inverse funds based on their derivatives usage. For example, investors would be able to more efficiently identify the extent to which such funds use derivatives as part of their investment strategies. Investors, and in particular individual investors, could also indirectly benefit from the additional information in amended Forms N–PORT and N–CEN to the extent that third-party information providers and other interested parties obtain, aggregate, provide, analyze and report on the information. Investors could also indirectly benefit from the additional information in amended Forms N–PORT and N–CEN to the extent that other entities, including investment advisers and broker-dealers, utilize the information to help investors make more informed investment decisions related to funds that provide this information. As discussed below in section IV.F, our estimated average one-time and ongoing annual costs associated with the amendments to Forms N–PORT take into account the fact that certain funds that are not subject to the proposed VaRbased limit on fund leverage risk in proposed rule 18f–4 would not have to report certain VaR-related information and may incur less extensive reporting costs relative to those funds subject to the limit, which are required to report such VaR-related disclosure information. Of the estimated 5,091 funds that would be subject to the exposure-related disclosure requirement, we estimate that 2,424 funds would also be subject to the VaRa group of funds, and would increase the overall efficiency of staff in analyzing the information. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 related disclosure requirements. We estimate that, on average, each fund that is not subject to the VaR-related disclosure requirement would incur a one-time cost of $6,982 574 and an ongoing cost of $2,088 per year 575 and each fund that is subject to the VaRrelated disclosure requirement would incur a one-time cost of $8,374 576 and an ongoing cost of $4,176 per year.577 We thus estimate that the total industry cost for this reporting requirement in the first year would equal $54,610,890.578 As discussed below in section IV.H, we estimate that the average ongoing annual cost for a registered fund to prepare amendments to Form N–CEN is $6.96 per year.579 We thus estimate that the total industry cost for all registered funds associated with this reporting requirement in the first year is $86,130.580 b. Amendments to Current Reporting Requirements We are also proposing current reporting requirements for funds that are relying on proposed rule 18f–4 and subject to the proposed VaR-based limit on fund leverage risk. Specifically, a 574 This estimate is based on the following derivations and calculations: (2 hours × $365 (compliance attorney) + 2 hours × $331 (senior programmer) + ($5,590 for initial external cost burden)) = $6,982 to comply with the new N–PORT requirements of derivatives exposure information in the first reporting quarter of the fiscal year. 575 This estimate is based on the following derivations and calculations: (3 hours × $365 (compliance attorney) + 3 hours × $331 (senior programmer)) = $2,088 per year to comply with the new N–PORT requirements of derivatives exposure information in the final three reporting quarters of the fiscal year. 576 This estimate is based on the following derivations and calculations: (4 hours × $365 (compliance attorney) + 4 hours × $331 (senior programmer) + ($5,590 for initial external cost burden)) = $8,374 to comply with the new N–PORT requirements of derivatives exposure and VaRrelated information in the first reporting quarter of the fiscal year. 577 This estimate is based on the following derivations and calculations: (6 hours × $365 (compliance attorney) + 6 hours × $331 (senior programmer)) = $4,176 to comply with the new N– PORT requirements of derivatives exposure and VaR-related information in the final three reporting quarters of the fiscal year. 578 This estimate is based on the following calculations: (5,091¥2,424 = 2,667 funds which are not subject to the VaR-related disclosure agreements) × ($6,982 + $2,088) = $24,189,690; and (2,424 funds which are subject to the VaR-related disclosure agreements) × ($8,374 + $4,176) = $30,421,200 for a total of ($24,189,690 + $30,421,200) = $54,610,890. 579 This estimate is based on the following derivations and calculations: 0.01 hour × $365 (compliance attorney) + 0.01 hour × $331 (senior programmer) = $3.65 + $3.31 = $6.96 per year. 580 This estimate is based on the following derivations and calculations: (12,375 registered funds required to prepare a report on Form N–CEN as amended) × $6.96 = $86,130. PO 00000 Frm 00082 Fmt 4701 Sfmt 4702 fund that is out of compliance with the VaR test for more than three business days would be required to file a nonpublic report on Form N–RN providing certain information regarding its VaR test breaches and a fund will also be required to file a report when it is back in compliance with its applicable VaR test.581 We anticipate that the enhanced current reporting requirements could produce significant benefits. For example, when a fund is out of compliance with the proposed VaRbased limit on fund leverage risk, this may indicate that a fund is experiencing heightened risks as a result of a fund’s use of derivatives transactions. Such breaches also could indicate market events that are drivers of potential derivatives risks across the fund industry and therefore complement other sources of information related to such market events for the Commission. As a result, we believe that the proposed current reporting requirement would increase the effectiveness of the Commission’s oversight of the fund industry by providing the Commission and staff with current information regarding potential increased risks and stress events, which in turn would benefit investors. As discussed below in section IV.G, our estimated average cost burdens associated with the amendments to Form N–RN are based on the assumption that, of the estimated 2,424 funds that would be required to comply with either of the VaR tests, the Commission would receive approximately 30 filings per year in response to each of the new VaR-related items proposed to be included in Form N–RN, as amended. We estimate such funds would incur an average cost of $3.49 per year on a per-fund basis 582 to prepare amended Form N–RN. Thus, the estimated total industry cost for this reporting requirement in the first year for funds required to comply with either of the VaR tests is $8,460.583 We do not believe there would be any potential indirect costs associated with filing Form N–RN, such as spillover effects or the potential for investor flight due to a VaR test breach (to the extent that investors would leave a fund if they believed a fund’s VaR test breaches 581 See supra section II.H.2. estimate is based on the following derivations and calculations: 0.005 hour × $365 (compliance attorney) + 0.005 hour × $331 (senior programmer) = $1.83 + $1.66 = $3.49 per year on a per-fund basis. 583 This estimate is based on the following derivations and calculations: (30 filings per year fractionalized across the 2,424 funds per year required to comply with either of the VaR tests) × $3.49 = $8,460. 582 This E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules indicate that a fund has a risk profile that is inconsistent with their investment goals and risk tolerance), because Form N–RN filings would not be publicly disclosed. Because the Form N–RN filing requirements would be triggered by events that are part of a fund’s proposed requirement to determine compliance with the applicable VaR test at least daily, any monitoring costs associated with Form N–RN are included in our estimates of the compliance costs for rule 18f–4 above. 10. Money Market Funds Money market funds are excluded from the scope of proposed rule 18f–4. As we are proposing to rescind Release 10666, however, money market funds would not be able to enter into transactions covered by proposed rule 18f–4, including derivatives transactions and reverse repurchase agreements. As discussed above in section II.A.1, we believe that money market funds currently do not typically engage in derivatives transactions or the other transactions permitted by rule 18f–4.584 However, to the extent that there are money market funds that do engage in such transactions to increase the efficiency of their portfolio management, these funds would bear the costs associated with losing any such efficiencies. However, we believe any costs to money market funds that may currently enter into transactions covered by proposed rule 18f–4 would likely be small. Specifically, as discussed above in section II.A.1, we believe that these transactions would generally be inconsistent with a money market fund maintaining a stable share price or limiting principal volatility, and especially if used to leverage the fund’s portfolio. Therefore, we do not believe that any fund that may currently engage in these transactions would use them as an integral part of its investment strategy. lotter on DSKBCFDHB2PROD with PROPOSALS2 D. Effects on Efficiency, Competition, and Capital Formation This section evaluates the impact of the proposed rules and amendments on 584 Money market funds file monthly reports on Form N–MFP and disclose schedules of portfolio securities held on the form. For each security held, Form N–MFP requires money market funds to disclose the investment category most closely identifying the instrument held from a list of investment categories. See Item C.6 of Form N– MFP. However, the form does not contemplate nor include data element categories for transactions covered by proposed rule 18f–4, including derivatives transactions and reverse repurchase agreements. We therefore do not estimate the extent to which money market funds currently rely on these transactions. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 efficiency, competition, and capital formation. However, we are unable to quantify the effects on efficiency, competition, and capital formation because we lack the information necessary to provide a reasonable estimate. For example, we are unable to predict how the proposed rules, amendments, and form amendments would change investors’ propensity to invest in funds and ultimately affect capital formation. Therefore, much of the discussion below is qualitative in nature, although where possible we attempt to describe the direction of the economic effects. 1. Efficiency Proposed rule 18f–4 in conjunction with the proposed rescission of Release 10666 may make derivatives use more efficient for certain funds, particularly for those funds that would qualify as limited derivatives users. Specifically, funds’ current asset segregation practices may provide a disincentive to use derivatives for which notional amount segregation is the practice, even if such derivatives would otherwise provide a lower-cost method of achieving desired exposures than purchasing the underlying reference asset directly. For example, a fund seeking to sell credit default swaps to take a position in an issuer’s credit risk may currently choose not to do so because of the large notional amounts that the fund would segregate for that specific derivatives position. The proposed rule therefore could increase efficiency by mitigating current incentives for funds to avoid use of certain derivatives (even if foregoing the use of those derivatives would entail cost and operational efficiencies). In addition, the proposed rules and amendments may change the degree to which some funds choose to use derivatives generally or the degree to which funds use certain derivatives over others.585 Changes in the degree to which certain derivatives are used by 585 Specifically, (1) as discussed in the previous paragraph, funds may transact in more notionalvalue based derivatives as a result of removing the incentive distortion of notional- vs. market-value asset segregation under funds’ current asset segregation practices; (2) new potential funds may reduce their use of derivatives transactions to satisfy the proposed VaR-based limit on fund leverage risk (see supra section III.C.2); (3) existing funds may change their use of derivatives transactions to respond to risks identified after adopting and implementing their risk management programs (see supra section III.C.1); and (4) both existing and new potential funds may increase their use of derivatives transactions as a result of the exemptive rule’s bright-line limits on leverage risk (see supra section III.C.2). Overall, the effect of the proposed rules and amendments on funds use of derivatives transactions is ambiguous and depends on the type of derivatives transaction. PO 00000 Frm 00083 Fmt 4701 Sfmt 4702 4527 funds could affect the liquidity and price efficiency of these derivatives. Although unaddressed in the academic literature, we expect an increase in the use of derivatives to correspond to an increase in derivatives market liquidity as more derivatives contracts may be easily bought or sold in markets in a given period, as well as an increase in price efficiency since information regarding underlying securities (and other factors that affect derivatives prices) may be better reflected in the prices of derivative contracts. Changes in the degree to which certain derivatives are used could also affect the pricing efficiency and liquidity of securities underlying these derivatives and those of related securities. For example, one paper provides evidence that the introduction of credit default swap contracts decreases the liquidity and price efficiency of the equity security of the issuer referenced in the swap.586 Conversely, the paper also observes that the introduction of exchange-traded stock option contracts improves the liquidity and price efficiency of the underlying stocks. The proposed VaR-based limit on fund leverage risk would also establish a bright-line limit on the amount of leverage that a fund can take on using derivatives.587 To the extent that funds are more comfortable with managing their derivatives exposures to a clear outside limit, the proposed rule could improve the efficiency of fund’s portfolio risk management practices. In addition, the recordkeeping elements of proposed rule 18f–4 would facilitate more efficient evaluation of 586 This paper analyzed NYSE-listed firms and observed that, all else equal, equity markets become less liquid and equity prices become less efficient when single-name credit default swap contracts are introduced, while the opposite results hold when equity options are listed on exchanges. Ekkehart Boehmer, Sudheer Chava, & Heather E. Tookes, Related Securities and Equity Market Quality: The Case of CDS, 50 Journal of Financial and Quantitative Analysis 509 (2015), available at https://www.cambridge.org/core/journals/journalof-financial-and-quantitative-analysis/article/ related-securities-and-equity-market-quality-thecase-of-cds/ 08DE66A250F9950FA486AE818D5E0341. The latter result, that traded equity options are associated with more liquid and efficient equity prices, is consistent with several other academic papers. See, e.g., Charles Cao, Zhiwu Chen, & John M. Griffin, Informational Content of Option Volume Prior to Takeovers, 78 Journal of Business 1073 (2005), as well as Jun Pan & Allen M. Poteshman, The Information in Option Volume for Future Stock Prices, 19 Review of Financial Studies 871 (2006). The effects described in the literature are based on studies of the introduction of derivative securities and may therefore apply differently to changes in the trading volume of derivatives securities that may occur as a result of the proposed rule. 587 See supra section III.C.2. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4528 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules compliance with the rule while also providing the Commission with information that may be useful in assessing market risks associated with derivative products. Moreover, the proposed amendments to fund’s current reporting requirements could facilitate the Commission’s oversight of funds subject to proposed rule 18f–4 with fewer resources, thus making its supervision more efficient.588 The amendments to Forms N–PORT and N–CEN would allow investors, to the extent that they use the information, to better differentiate funds that are not limited derivatives users or leveraged/ inverse funds based on their derivatives usage.589 As a result, investors would be able to more efficiently identify the extent to which such funds use derivatives as part of their investment strategies, allowing them to make betterinformed investment decisions. The proposed sales practices rules could also reduce investments in leveraged/inverse investment vehicles, to the extent that some retail investors would not be approved by their brokerdealer or investment adviser to transact in leveraged/inverse investment vehicles or to the extent that some retail investors would be deterred by the time costs and delay introduced by the account-opening procedures.590 The proposed amendments to rule 6c–11, however, would likely outweigh these effects in the case of leveraged/inverse ETFs and lead to an overall increase in the number and assets under management for these types of funds. To the extent that the proposed rules would lead to a reduction in investment in leveraged/inverse commodity- or currency-based trusts or funds, the liquidity of these products may decline as a result. Conversely, to the extent that the proposed rules would lead to an overall increase in investments in leveraged/inverse ETFs, the liquidity of these funds may increase as a result. The likely increase in the number, and assets under management, of leveraged/ inverse ETFs as a result of the proposed amendments to rule 6c–11 may affect the quality of the markets for underlying securities and derivatives. Specifically, the academic literature to date provides some evidence, albeit inconclusive, that leveraged/inverse ETFs’ rebalancing activity may have an impact on the price and volatility of the constituent assets that make up the ETFs. For example, one paper empirically tests whether the rebalancing activity of leveraged/inverse ETFs impacts the 588 See supra section III.C.8. supra section III.C.9.a. 590 See supra section III.B.5. 589 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 price and price volatility of underlying stocks.591 The authors find a positive association, suggesting that rebalancing demand may affect the price and price volatility of component stocks, and may reduce the degree to which prices reflect fundamental value of the component stocks. As leveraged/inverse ETFs commonly use derivatives to rebalance their portfolios, similar effects could also extend to underlying derivatives, although we are not aware of any academic literature that has examined the effects of leveraged/inverse ETFs’ rebalancing activity on derivatives markets. Conversely, another paper argues that the existing literature that studies the effect of leveraged/inverse ETFs’ rebalancing activity on the constituent asset prices does not control for the effect of the creation and redemption transactions (i.e., fund flows) by authorized participants.592 The paper presents evidence that positively leveraged/inverse ETFs tend to have capital flows in the opposite direction of the underlying index, and inverse leveraged/inverse ETFs tend to have capital flows in the same direction as the underlying index, suggesting that investor behavior may attenuate the effect of leveraged/inverse ETFs’ rebalancing activity on the prices of underlying securities and derivatives.593 2. Competition Certain aspects of the proposed rules and amendments may have an impact on competition. Certain of these potential competitive effects result from the proposed rule imposing differential costs on different funds. Specifically, (1) large fund complexes may find it less costly to comply per fund with the new requirements of proposed rule 18f–4; 594 (2) funds that would qualify as limited derivatives users would generally incur lower compliance costs associated with the rule than funds that would not qualify for this exception; 595 (3) funds that would comply with the relative 591 See Qing Bai, Shaun A. Bond & Brian Hatch, The Impact of Leveraged and Inverse ETFs on Underlying Real Estate Returns, 43 Real Estate Economics 37 (2015). 592 See Ivan T. Ivanov & Stephen Lenkey, Are Concerns About Leveraged ETFs Overblown?, FEDS Working Paper No. 2014–106 (2014). 593 The literature we are aware of focuses on leveraged/inverse ETFs and does not study similar effects of leveraged/inverse mutual funds, although both types of funds generally engage in similar rebalancing activity. To the extent that similar effects may be attributable to leveraged/inverse mutual funds and that any increase in leveraged/ inverse ETF assets would be (at least partially) offset by a decrease in leveraged/inverse mutual fund assets, this may ameliorate the overall effect on the price and volatility of constituent assets. 594 See supra section III.C.2. 595 See supra section III.C.3. PO 00000 Frm 00084 Fmt 4701 Sfmt 4702 VaR test would generally incur higher compliance costs than those that would comply with the absolute VaR test; (4) BDCs are not subject to the additional reporting requirements on Forms N– CEN or N–PORT and would therefore not incur the increased compliance costs that would be imposed on filers of these forms; and (5) leveraged/inverse funds are not subject to several of the additional reporting requirements on Forms N–CEN or N–PORT and would therefore incur a reduced additional burden compared to other funds that are not limited users of derivatives.596 To the extent that investors believe that the funds that would incur lower compliance burdens and the funds that would incur a higher compliance burden under the rule are substitutes, the rule would result in a competitive advantage for funds with the lower compliance burden to the extent that a lower burden makes such funds materially less costly to operate. To the extent that the proposed sales practices rules’ due diligence and account approval requirements limit certain customers or clients from buying or selling shares of certain leveraged/ inverse investment vehicles, such investors may instead opt to invest in another product with a similar risk profile that is not subject to those requirements.597 Thus, the proposed sales practices rules may generate substitution spillover effects that increase competition between leveraged/inverse investment vehicles within the scope of the rule and other products outside the scope of the rule that provide similar exposures. Similarly, broker-dealers and investment advisers with a larger fraction of retail customers or clients that can no longer transact in leveraged/ inverse investment vehicles as a result of the proposed sales practices rules’ due diligence and account approval requirements may experience larger declines in their customer or client base.598 As a result, broker-dealers and investment advisers that would see a larger reduction in customers or clients may be at a competitive disadvantage 596 See supra section III.C.2. investors that are not approved to buy or sell leveraged/inverse investment vehicles may opt to move their capital into exchange-traded notes or other products with a similar risk profile. Conversely, some investors may transact in leveraged/inverse investment vehicles without involving a broker-dealer or investment adviser that would be subject to the proposed sales practices rules, although this is uncommon. See supra note 321. 598 Any such reduction in a broker-dealer’s or investment adviser’s customer base may be offset to the extent that clients transact in other products with the same broker dealer or investment adviser instead. See supra section III.C.5. 597 Some E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules compared to broker-dealers and investment advisers that would see only a smaller reduction in customers or clients or no reduction at all. The Commission has not provided exemptive relief to new prospective sponsors of leveraged/inverse ETFs since 2009.599 The proposed amendments to rule 6c–11 would allow other leveraged/inverse ETFs to enter the leveraged/inverse ETF market, likely leading to more competition among leveraged/inverse ETFs and between leveraged/inverse ETFs and other products that investors may perceive as substitutes, such as leveraged/inverse mutual funds. This increase in competition could be significant, as the leveraged/inverse ETF market is very concentrated; currently, only two fund sponsors operate leveraged/inverse ETFs.600 In addition, fees for leveraged/ inverse ETFs and substitute products, such as leveraged/inverse mutual funds, could fall as a result of any such increase in competition. reverse repurchase agreements.602 To the extent that this restricts a fund’s ability to obtain financing to invest in debt or equity securities, capital formation may be reduced. In addition, the proposed sales practices rules may reduce capital formation in asset markets directly connected with covered leveraged/ inverse investment vehicles. By restricting the accounts of customers or clients seeking to buy or sell shares of a leveraged/inverse investment vehicle, the proposed rules may produce net capital outflows from retail investors. However, the size of this effect would depend on the number of retail investors that would no longer be approved to buy or sell shares of leveraged/inverse investment vehicles and any other investments these retail investors would make in lieu of investing in leveraged/inverse investment vehicles. 3. Capital Formation 1. Alternative Implementations of the VaR Tests Certain aspects of the proposed rules and amendments may have an impact on capital formation. Certain of these effects may arise from a change in investors’ propensity to invest in funds. On the one hand, investors may be more inclined to invest in funds as a result of increased investor protection arising from any decrease in leverage-related risks. On the other hand, some investors may reduce their investments in certain funds that may increase their use of derivatives in light of the bright-line VaR-based limit on fund leverage risk.601 Additionally, some investors may re-evaluate their desire to invest in funds generally as a result of the increased disclosure requirements, with some investors deciding to invest more and other investors deciding to invest less. While we are unable to determine whether the proposed rules and amendments would lead to an overall increase or decrease in fund assets, to the extent the overall fund assets change, this may have an effect on capital formation. The proposed rule may also decrease the use of reverse repurchase agreements, similar financing transactions, or borrowings by some funds, or reduce some funds’ ability to invest the borrowings obtained through 599 See supra text following note 473. increase in competition among leveraged/ inverse ETFs could be attenuated, to the extent that proposed rule 15l–2’s and 211(h)–1’s due diligence requirements would limit the number of investors that invest in these funds. See supra section III.C.5. 601 See supra section III.C.2. 600 The VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 E. Reasonable Alternatives a. Different Confidence Level or Time Horizon Proposed rule 18f–4 would require that a fund’s VaR model use a 99% confidence level and a time horizon of 20 trading days.603 We could alternatively require a different confidence level and/or a different time horizon for the VaR test. As discussed above in section II.D.4, market participants calculating VaR most commonly use 95% or 99% confidence levels and often use time horizons of 10 or 20 days. The proposed VaR parameters therefore represent a confidence level and time horizon at the high end of what is commonly used. Compared to requiring a lower confidence level and a shorter time horizon, the proposed parameters result in a VaR test that is designed to measure, and therefore limit the severity of, less frequent but larger losses. The cost of calculating VaR does not vary based on how the model is parametrized, meaning the proposed confidence level and time horizon would not lead to larger compliance costs for funds compared to the alternatives we considered. A lower confidence level or shorter time horizon may be less effective at placing a VaRbased outer limit on fund leverage risk associated with larger losses and would not result in cost savings for funds. 602 See 603 See PO 00000 supra section III.C.4. supra section II.D.4. Frm 00085 Fmt 4701 Sfmt 4702 4529 b. Absolute VaR Test Only To establish an outer limit for a fund’s leverage risk, the proposed rule would generally require a fund engaging in derivatives transactions to comply with a relative VaR test; the fund could instead comply with an absolute VaR test only if the derivatives risk manager is unable to identify an appropriate designated reference index for the fund. As an alternative, we could require all funds that would be subject to the proposed VaR-based limit on fund leverage risk to comply with an absolute VaR test. Use of an absolute VaR test would be less costly for some funds that would be required to comply with the relative VaR test under the proposed rule, including because the relative VaR test may require some funds to pay licensing costs associated with the use of the reference index.604 In addition, use of an absolute VaR test would reduce the compliance challenge for fund risk managers who have difficulty identifying a designated reference index; however, this benefit would be limited for funds that have an existing or easy-to-identify benchmark. On the other hand, the absolute VaR test is a static measure of fund risk in the sense that the implied limit on a fund’s VaR will not change with the VaR of its designated reference index. The absolute VaR test is therefore less suited for measuring leverage risk and limiting the degree to which a fund can use derivatives to leverage its portfolio, as measuring leverage inherently requires comparing a fund’s risk exposure to that of an unleveraged point of reference.605 An additional implication of this aspect of an absolute VaR test is that a fund may fall out of compliance with an absolute VaR test just because the market it invest in becomes more volatile even though the degree of leverage in the fund’s portfolio may not have changed. Overall, we believe that permitting funds to rely on an absolute VaR test only in those instances when a designated reference index is unavailable is justified. c. Choice of Absolute or Relative VaR Tests As another alternative, we could allow derivatives risk managers to choose between an absolute and a relative VaR limit, depending on their preferences and without regard to whether a designated reference index is available. Such an alternative would offer derivatives risk managers more flexibility than the proposed rule and 604 See supra section III.C.2. 605 Id. E:\FR\FM\24JAP2.SGM 24JAP2 4530 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules could reduce compliance costs for funds, to the extent that derivatives risk managers would choose the VaR test that is cheaper to implement for their particular fund. However, this alternative may result in less uniformity in the outer limit on funds’ leverage risk across the industry, as individual derivatives risk managers would have the ability to choose between VaR-based tests that could provide for different limits on fund leverage risk. Funds that invest in assets with a low VaR, for example, could obtain significantly more leverage under an absolute VaR test because the VaR of the fund’s designated reference index would be low; as a result, investors in these funds would be less protected from leveragerelated risks compared to the proposed rule. lotter on DSKBCFDHB2PROD with PROPOSALS2 d. Optional Relative VaR Test Using a Fund’s ‘‘Securities VaR’’ As another alternative, we could allow funds relying on the relative VaR test to compare the fund’s VaR to its ‘‘securities VaR’’ (i.e., the VaR of the fund’s portfolio of securities and other investments, but excluding any derivatives transactions), rather than the VaR of the fund’s designated reference index, depending on the derivatives risk manager’s preferences and without regard to whether a designated reference index is available.606 While such an alternative would offer derivatives risk managers more flexibility than the proposed rule, we believe that it would not be easier to implement or lead to cost savings for a significant number of funds. Conversely, the alternative VaR test based on a fund’s ‘‘securities VaR’’ would provide an incentive for some funds to invest in volatile, riskier securities that would increase the fund’s ‘‘securities VaR,’’ thereby reducing the test’s effectiveness at limiting fund leverage risk. As a result, investors in these funds would be less protected from leverage-related risks compared to the proposed rule. e. Third-Party Validation of a Fund’s VaR Model The proposed rule does not require third-party validation of a fund’s chosen VaR model. As an alternative, we could require that a fund obtain third-party validation of its VaR model, either at inception or in connection with any material changes to the model, to 606 The 2015 Proposing Release also included a risk-based portfolio limit based on VaR, which provided that a fund would satisfy its risk-based portfolio limit condition if a fund’s full portfolio VaR was less than the fund’s ‘‘securities VaR.’’ See 2015 Proposing Release, supra note 2, at section III.B.2. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 independently confirm that the model is structurally sound and adequately captures all material risks.607 While such a requirement could help ensure funds’ compliance with the proposed VaR-based limit on fund leverage risk, this incremental benefit may not justify the potentially significant additional costs to funds associated with thirdparty validation of the fund’s VaR model.608 2. Alternatives to the VaR Tests a. Stress Testing As an alternative to the proposed VaR-based limit on fund leverage risk, we could require a stress testing approach. As discussed above in section II.D.6.a, we understand that many funds that use derivatives transactions already conduct stress testing for purposes of risk management. However, we do not believe that a stress testing approach would impose significantly lower costs on funds compared to a VaR-based approach, with the exception of those funds that already conduct stress testing but not VaR testing.609 In addition, as also discussed in section II.D.6.a above, it would be challenging for the Commission to specify a set of asset class shocks, their corresponding shock levels, and, in the case of multi-factor stress testing, assumptions about the correlations of the shocks, in a manner that applies to all funds and does not become stale over time. While we could also prescribe a principles-based stress testing requirement, we believe that the flexibility such an approach would give to individual funds over how to implement the test would render it less effective than the proposed VaR test at establishing an outer limit on fund leverage risk. Finally, stress testing generally focuses on a narrower and more remote range of extreme loss events compared to VaR analysis. As a result, a limit on fund leverage risk based on stress testing would likely be less effective at limiting fund leverage risk during more normal conditions and protecting investors from unexpected losses resulting from less extreme scenarios. 607 See also supra note 243. note that the UCITS regime requires thirdparty validation of funds’ VaR models; as a result, these additional costs could be mitigated for fund that are part of a complex that also includes UCITS funds. See supra note 243. 609 See also ICI Comment Letter III (stating that, ‘‘depending on the type of fund managed and whether the fund currently employs the test for risk management purposes, some respondents viewed a stress loss test as being more burdensome to implement, while others viewed a VaR test as being more burdensome to implement.’’). 608 We PO 00000 Frm 00086 Fmt 4701 Sfmt 4702 b. Asset Segregation As another alternative, we could require an asset segregation approach in lieu of the proposed VaR-based limit on fund leverage risk. For example, we could consider an approach similar to the Commission’s position in Release 10666, under which a fund engaging in derivatives transactions would segregate cash and cash equivalents equal in value to the full amount of the conditional and unconditional obligations incurred by the fund (also referred to as ‘‘notional amount segregation’’). Such an approach could also permit a fund to segregate a broader range of assets, subject to haircuts.610 Alternatively, we could require funds to segregate liquid assets in an amount equal to the fund’s daily mark-to-market liability plus a ‘‘cushion amount’’ designed to address potential future losses. As discussed above in section II.D.6.b, we believe that asset segregation approaches have several drawbacks as a means for limiting fund leverage risk, compared to the proposed VaR tests. For example, notional amount segregation is not risk-sensitive and could restrict derivatives transactions that would reduce portfolio risk. Similarly, segregation of liquid assets in an amount equal to the fund’s daily markto-market liability plus a ‘‘cushion amount’’ would be difficult to implement in a manner that is applied uniformly across all funds and types of derivatives. In addition, asset segregation approaches raise certain compliance complexities that may not make them significantly less costly to implement for funds than the proposed VaR tests.611 In conjunction with the proposed VaR-based limit, we could also require a fund relying on the proposed rule to maintain an amount of ‘‘qualifying coverage assets’’ designed to enable a fund to meet its derivatives-related obligations. As discussed above, we believe that the proposed rule’s requirements, including the requirements that funds establish risk management programs and comply with the proposed VaR-based limit on fund leverage risk, would address the risk that a fund may be required to realize trading losses by selling its investments to generate cash to pay derivatives counterparties. 610 The 2016 DERA Memo, for example, analyzed different risk-based ‘‘haircuts’’ that could apply to a broader range of assets. See, e.g., 2016 DERA Memo, supra note 12. 611 See supra section II.D.6.b. E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules c. Exposure-Based Test We alternatively considered proposing an exposure-based approach for limiting fund leverage risk in lieu of the proposed VaR test. An exposurebased test could limit a fund’s derivatives exposure, as defined in the proposed rule, to a specified percentage of the fund’s net assets. For example, we considered proposing that a fund limit its derivatives exposure to 50% of net assets. This would allow a fund to add to its portfolio an amount of derivatives exposure equal to the amount that an open-end fund could borrow from a bank. A similar approach would be to provide that the sum of a fund’s derivatives exposure and the value of its other investments cannot exceed 150% of its net asset value. This latter approach, and particularly if cash and cash equivalents were not included in the calculation, would allow a fund to achieve the level of market exposure permitted for an open-end fund under section 18 using any combination of derivatives and other investments. While an exposure-based test may be simpler and therefore less costly to implement for the typical fund than the proposed VaR tests, an exposure-based test has certain limitations compared to VaR tests, as discussed in detail in section above. One limitation is that measuring derivatives exposure based on notional amounts would not reflect how derivatives are used in a portfolio, whether to hedge or gain leverage, nor would it differentiate derivatives with different risk profiles. Various adjustments to the notional amount are available that may better reflect the risk associated with the derivatives transactions, although even with these adjustments the measure would remain relatively blunt. For example, an exposure-based limit could significantly limit certain strategies that rely on derivatives more extensively but that do not seek to take on significant leverage risk. Some of the limitations of an exposure-based approach could be addressed, however, if rule 18f–4 were to provide an exposure-based test as an optional alternative to the proposed VaR tests, rather than as the sole means of limiting fund leverage risk. Under this second alternative, funds with less complex portfolios might choose to rely on an exposure-based test because it would be simpler and impose lower compliance costs than the proposed VaR tests. Furthermore, if we provided that the sum of a fund’s derivatives exposure and the value of its other investments cannot exceed 150% of its net asset value, funds below this threshold would VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 generally also pass the proposed relative VaR test.612 Conversely, funds with more complex portfolios that rely on derivatives more extensively but that do not seek to take on significant leverage risk might choose to rely on the proposed VaR test. As the proposed rule would already except limited derivatives users from the VaR-based limit on fund leverage risk, however, we do not believe that also giving funds the option of relying on an exposure-based limit on fund leverage risk would be necessary or that it would significantly reduce the compliance burden associated with the rule. 3. Stress Testing Frequency Proposed rule 18f–4 would require funds that enter into derivatives transactions and are not limited derivatives users to adopt and implement a derivatives risk management program that includes stress testing, among other elements. The proposed rule would permit a fund to determine the frequency of stress tests, provided that the fund must conduct stress testing at least weekly. As an alternative to the weekly requirement, we considered both shorter and longer minimum stress testing frequencies. On the one hand, more frequent stress testing would reflect changes in risk for fund strategies that involve frequent and significant portfolio turnover. In addition, more frequent stress testing may reflect increases in market stress in a timelier manner. On the other hand, given the forward-looking nature of stress testing, we expect that most funds would take foreseeable changes in market conditions and portfolio composition into account when conducting stress testing. In addition, more frequent stress testing may impose an increased cost burden on funds, although we would expect any additional cost burden to be small, to the extent that funds perform stress testing in an automated manner. Overall, we preliminarily believe that the proposed minimum weekly stress testing appropriately balances the anticipated benefits of relatively frequent stress testing against the burdens of administering stress testing. Another alternative would be to permit a fund to determine its own stress testing frequency without the proposed rule prescribing a minimum stress testing frequency. This approach would provide maximum flexibility to 612 A fund that limited the sum of its derivatives exposure and the value of its other investments to 150% of its net asset value would generally also pass the proposed relative VaR test, provided that derivatives notionals are either not adjusted or only adjusted for delta in the case of options. PO 00000 Frm 00087 Fmt 4701 Sfmt 4702 4531 funds regarding the frequency of their stress tests, and would reduce compliance costs for funds that determine that stress testing less frequently than weekly is warranted in light of their own particular facts and circumstances. However, allowing funds to individually determine the frequency with which stress tests are conducted could result in some funds stress testing their portfolios too infrequently to provide timely information to the fund’s derivatives risk manager and board. Taking these considerations into account, we are proposing to require weekly stress tests, rather than less frequent testing, to provide for consistent and reasonably frequent stress testing by all funds that would be required to establish a derivatives risk management program. 4. Alternative Exposure Limits for Leveraged/Inverse Funds A fund that meets the definition of a ‘‘leveraged/inverse investment vehicle’’ in the proposed sales practices rules would not have to comply with the VaRbased leverage risk limit under proposed rule 18f–4, provided the fund limits the investment results it seeks to 300% of the return (or inverse of the return) of the underlying index and discloses in its prospectus that it is not subject to the proposed limit on fund leverage risk.613 Alternatively, we could condition the exemption on compliance with a higher or lower exposure limit. Over longer holding periods, the realized leverage multiple of the returns of an investment in a leveraged/inverse fund relative to the returns of its underlying index can vary substantially from the fund’s daily leverage multiple.614 All else equal, this effect becomes stronger as the fund’s leverage multiple increases. The extent of a leveraged/inverse fund’s rebalancing activity likewise increases as the fund’s leverage multiple increases.615 Therefore, the effects of leveraged/ inverse funds’ rebalancing activity on the constituent asset prices may be heightened if a significant number of leveraged/inverse funds were to increase their leverage beyond the levels currently observed in markets and, 613 See supra section II.G.3. supra section III.B.5. 615 The rebalancing demand of a leveraged/ inverse fund is a function of the fund’s assets, the realized return of its reference index, and is proportional to the term , where denotes the fund’s leverage multiple. (See, e.g., Minder Cheng & Ananth Madhavan, The dynamics of leveraged/ inverse and inverse exchange-traded funds, 7 Journal of Investment Management 4 (2009).) As a result, increasing a fund’s leverage multiple increases its rebalancing demand more than linearly. 614 See E:\FR\FM\24JAP2.SGM 24JAP2 4532 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules conversely, could be diminished if a significant number of leveraged/inverse funds were to reduce their leverage below current levels. While permitting a higher exposure limit may benefit fund sponsors to the extent that some sponsors would bring funds with higher leverage multiples to market, we are concerned that a higher exposure limit would heighten the investor protection concerns these funds present. Conversely, limiting leveraged/ inverse funds’ exposure could reduce the concerns these funds present, but could reduce investor choice relative to the baseline given that leveraged/ inverse funds today operate with levels of leverage up to the exposure limit we propose. Allowing funds to continue to obtain this level of leverage, subject to the additional requirements in proposed rule 18f–4 and in light of the proposed sales practices rules, is designed to address the investor protection concerns that underlie section 18, while preserving choice for retail investors who are capable of evaluating their characteristics and unique risks. For these reasons, and because the Commission does not have experience with leveraged/inverse funds that seek returns above 300% of the return (or inverse of the return) of the underlying index, we are not proposing to permit higher levels of leveraged/inverse market exposure for leveraged/inverse funds in this rule. We also are not proposing a lower exposure limit for these funds in light of the investor protections that we believe proposed rule 18f–4 and the sales practices rules would provide.616 lotter on DSKBCFDHB2PROD with PROPOSALS2 5. No Sales Practices Rules and No Separate Exposure Limit for Leveraged/ Inverse Funds The proposed rules would require a leveraged/inverse fund that meets the definition of a ‘‘leveraged/inverse investment vehicle’’ to limit its investment results to 300% of the return (or inverse of the return) of the underlying index and would require a broker-dealer or investment adviser to exercise due diligence in approving a retail investor’s account to buy or sell shares of leveraged/inverse investment vehicles, as well as implement policies and procedures reasonably designed to achieve compliance with the proposed rules.617 In lieu of the proposed sales practices rules and associated exception from the VaR-based limit on fund leverage risk, we could alternatively require leveraged/inverse funds to 616 See 617 See supra section II.G.3. supra sections II.G.3 and II.G.2. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 comply with the proposed relative VaR test. Existing leveraged/inverse ETFs and mutual funds generally could comply with the proposed relative VaR test only if they restricted the investment results they seek to 150% of the return (or inverse of the return) of the underlying index. Therefore, under this alternative, leveraged/inverse funds that seek investment results in excess of this limit would either have to significantly change their investment strategy or liquidate. Given that existing fund sponsors frequently offer leveraged/ inverse funds with various target multiples referencing the same index, we would expect that this alternative would reduce the number of leveraged/ inverse funds. Compared to the proposal, this alternative would also restrict choice for investors that prefer to invest in leveraged/inverse funds that pursue investment results in excess of 150% of the return (or inverse of the return) of the underlying index and who would satisfy the due diligence and approval requirements adopted by their brokerdealer or investment adviser in connection with the proposed rule. At the same time, the alternative could result in increased investor protection for investors in these funds compared to the proposal. While investors’ access to leveraged/inverse funds would not be subject to the proposed sales practice rules under this alternative (and investment advisers and broker-dealers would not incur the associated compliance costs), these funds would be required to limit their exposure to 150% of the return (or inverse of the return) of the underlying index, thereby reducing the potential consequences for leveraged/inverse fund investors who are not capable of evaluating their return characteristics and ameliorating the associated investor protection concerns. Conversely, the alternative would reduce protection for investors in leveraged/inverse commodity- and currency-based trusts or funds, as those funds would be subject to neither the 150% exposure limit nor the proposed sales practices rules. Finally, because leveraged/inverse funds would no longer be able to offer exposures above 150% of the return (or inverse of the return) of the underlying index, the alternative may ameliorate the concerns associated with the rebalancing activity of leveraged/inverse ETFs, which decreases with the targeted leverage multiple of these funds.618 As 618 See supra sections III.D.1 and III.E.4. While the literature focuses on leveraged/inverse ETFs, PO 00000 Frm 00088 Fmt 4701 Sfmt 4702 discussed above in section D.1, however, while the literature observes that leveraged/inverse ETFs’ rebalancing activity may have an adverse impact on the prices and volatility of the constituent assets that make up leveraged/inverse ETFs, the literature, overall, is not definitive. Overall, we believe that preserving investor choice justifies providing leveraged/inverse funds an exemption from the proposed VaR-based limit on fund leverage risk, particularly in light of the proposed sales practices rules, which we believe would help to ensure that investors in these funds are limited to those who are capable of evaluating the characteristics and risks of these products.619 6. Enhanced Disclosure As an alternative to the requirements in rule 18f–4, such as the proposed derivatives risk management program and the VaR-based limit on fund leverage risk, we could consider addressing the risks associated with funds’ use of derivatives through enhanced disclosures to investors with respect to a fund’s use of derivatives and the resulting derivatives-related risks.620 While an approach focused on enhanced disclosures could result in greater fund investment flexibility, such an approach may be less effective than the proposed rule in addressing the purposes and concerns underlying section 18 of the Investment Company Act. Section 18 itself imposes a specific limit on the amount of senior securities that a fund may issue, regardless of the level of risk introduced or the disclosure that a fund provides regarding those risks. Absent additional requirements to limit leverage or potential leverage, requiring enhancement to derivatives disclosure alone would not appear to provide any limit on the amount of leverage a fund may obtain. Indeed, the degree to which funds use derivatives varies widely between funds. As a result, an approach focused solely on enhanced disclosure requirements may not provide a sufficient basis for an exemption from the requirements of section 18 of the Investment Company Act. the results may apply similarly to leveraged/inverse mutual funds. 619 See also supra note 535. 620 See, e.g., Comment Letter of the Fixed Income Market Structure Advisory Committee on proposed rule 6c–11 under the Investment Company Act (Oct. 29, 2018) (recommending that the Commission consider future rulemaking regarding ‘‘leveraged ETP’’ investor disclosure requirements). E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 F. Request for Comments The Commission requests comment on all aspects of this initial economic analysis, including whether the analysis has: (1) Identified all benefits and costs, including all effects on efficiency, competition, and capital formation; (2) given due consideration to each benefit and cost, including each effect on efficiency, competition, and capital formation; and (3) identified and considered reasonable alternatives to the proposed new rules and rule amendments. We request and encourage any interested person to submit comments regarding the proposed rules, our analysis of the potential effects of the proposed rules and proposed amendments, and other matters that may have an effect on the proposed rules. We request that commenters identify sources of data and information as well as provide data and information to assist us in analyzing the economic consequences of the proposed rules and proposed amendments. We also are interested in comments on the qualitative benefits and costs we have identified and any benefits and costs we may have overlooked. In addition to our general request for comments on the economic analysis associated with the proposed rules and proposed amendments, we request specific comment on certain aspects of the proposal: 254. Are we correct that many funds already have a derivatives risk management program in place that could be readily adapted to meet the proposed rule’s requirements without significant additional cost? If so, for how many funds would this be true? 255. The proposed rule does not include any requirement for third-party validation of a fund’s chosen VaR model, either at inception or upon material changes, to confirm that the model is structurally sound and adequately captures all material risks.621 How costly would such a requirement be to funds? What would the benefits of such a requirement be? 256. Are we correct that many funds that use derivatives in a limited manner already have in place policies and procedures that are reasonably designed to address their derivatives that could be readily adapted to meet the proposed rule’s requirements without significant additional cost? If so, for how many funds would this be true? 257. How many broker-dealers provide customers the ability to buy or sell interests in leveraged/inverse investment vehicles? How many 621 See also supra note 243. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 investment advisers place orders to buy or sell leveraged/inverse investment vehicles for their advisory clients? How many retail investor accounts with broker-dealers and investment advisers trade leveraged/inverse investment vehicles? 258. How many current investors in leveraged/inverse investment vehicles would likely not be approved to buy or sell these products under the proposed sales practices rules’ due diligence and account approval requirements? 259. If we provided that the sum of a fund’s derivatives exposure and the value of its other investments cannot exceed 150% of its net asset value, funds below this threshold would generally also pass the proposed relative VaR test. How many funds would be likely to rely on such an exposure-based test if exempted funds that satisfied this limit from the proposed VaR tests? IV. Paperwork Reduction Act Analysis A. Introduction Proposed rule 18f–4, proposed rule 15l–2, and proposed rule 211(h)–1 would result in new ‘‘collection of information’’ requirements within the meaning of the Paperwork Reduction Act of 1995 (‘‘PRA’’).622 In addition, the proposed amendments to rule 6c–11 under the Investment Company Act, as well as to Forms N–PORT, Form N– LIQUID (which would be renamed Form N–RN), and N–CEN would affect the collection of information burden under those rules and forms.623 The titles for the existing collections of information are: ‘‘Form N–PORT’’ (OMB Control No. 3235–0731); ‘‘Form N–LIQUID’’ (OMB Control No. 3235– 0754); ‘‘Form N–CEN’’ (OMB Control No. 3235–0730); and ‘‘Rule 6c–11 under the Investment Company Act of 1940, Exchange-traded funds’’ (OMB Control No. xxxx–xxxx). The titles for the new collections of information would be: ‘‘Rule 18f–4 under the Investment Company Act of 1940, Use of Derivatives by Registered Investment Companies and Business Development Companies,’’ ‘‘Rule 15l–2 under the Securities Exchange Act of 1934, Broker and Dealer Sales Practices for Leveraged/Inverse Investment 622 44 U.S.C. 3501–3520. do not believe that the proposed conforming amendment to Form N–2, to reflect a clarification that funds do not have to disclose in their senior securities table the derivatives transactions and unfunded commitment agreements entered into in reliance on proposed rule 18f–4, makes any new substantive recordkeeping or information collection within the meaning of the PRA. Accordingly, we do not revise any burden and cost estimates in connection with this proposed amendment. 623 We PO 00000 Frm 00089 Fmt 4701 Sfmt 4702 4533 Vehicles,’’ and ‘‘Rule 211(h)–1 under the Investment Advisers Act of 1940, Investment Adviser Sales Practices for Leveraged/Inverse Investment Vehicles.’’ The Commission is submitting these collections of information to the Office of Management and Budget (‘‘OMB’’) for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently-valid control number. The Commission published notice soliciting comments on the collection of information requirements in the 2015 Proposing Release and submitted the proposed collections of information to OMB for review and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11.624 The Commission received comments on the 2015 proposal’s collection of information burden regarding the 2015 proposal’s trade-by-trade determination of compliance with portfolio limits.625 These comments were considered but did not form the basis of our burden estimates because we do not propose a trade-by-trade determination of compliance with the proposed VaRbased tests. We discuss below the collection of information burdens associated with proposed rule 18f–4, proposed rule 15l– 2, proposed rule 211(h)–1, as well as proposed amendments to rule 6c–11 and Forms N–PORT, N–LIQUID, and N– CEN. B. Proposed Rule 18f–4 Proposed rule 18f–4 would permit a fund to enter into derivatives transactions, notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Investment Company Act. Proposed rule 18f–4 would generally require a fund that relies on the rule to enter into derivatives transactions to: Adopt a derivatives risk management program; have its board of directors approve the fund’s designation of a derivatives risk manager and receive direct reports from the derivatives risk manager about the derivatives risk management program; and require a fund to comply with a VaR-based test designed to limit a fund’s leverage risk consistent with the investor protection purposes underlying section 18. 624 See 2015 Proposing Release, supra note 2. e.g., Vanguard Comment Letter; Invesco Comment Letter; see also supra note 245 and accompanying text. 625 See, E:\FR\FM\24JAP2.SGM 24JAP2 4534 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules Proposed rule 18f–4 includes an exception from the risk management program requirement and limit on fund leverage risk if a fund is a ‘‘limited derivatives user’’ that either limits its derivatives exposure to 10% of its net assets or it uses derivatives transactions solely to hedge certain currency risks. A fund relying on the proposed exception would be required to adopt policies and procedures that are reasonably designed to manage its derivatives risks. Proposed rule 18f–4 also includes alternative requirements for a leveraged/inverse fund not subject to the proposed VaRbased leverage risk limit, if such a fund: (1) Meets the definition of a ‘‘leveraged/ inverse investment vehicle’’ in the proposed sales practices rules; (2) limits the investment results it seeks to 300% of the return (or inverse of the return) of the underlying index; and (3) discloses in its prospectus that it is not subject to proposed rule 18f–4’s limit on fund leverage risk.626 Proposed rule 18f–4 also would require a fund to adhere to certain recordkeeping requirements that are designed to provide the Commission’s staff, and the fund’s board of directors and compliance personnel, the ability to evaluate the fund’s compliance with the proposed rule’s requirements. The respondents to proposed rule 18f4 would be registered open- and closedend management investment companies and BDCs.627 We estimate that 5,091 funds would likely rely on rule 18f– 4.628 Compliance with proposed rule 18f–4 would be mandatory for all funds that seek to engage in derivatives transactions in reliance on the rule, which would otherwise be subject to the restrictions of section 18. To the extent that records required to be created and maintained by funds under the rule are provided to the Commission in connection with examinations or investigations, such information would be kept confidential subject to the provisions of applicable law. 1. Derivatives Risk Management Program Proposed rule 18f–4 would require certain funds relying on the rule to adopt and implement a written derivatives risk management program, which would include policies and procedures reasonably designed to manage the fund’s derivatives risks. The proposal would require a fund’s program to include the following elements: (1) Risk identification and assessment; (2) risk guidelines; (3) stress testing; (4) backtesting; (5) internal reporting and escalation; and (6) periodic review of the program.629 Under the proposed rule, the derivatives risk manager is responsible for administering the derivatives risk management program and its policies and procedures. Certain funds relying on the proposed rule would not be subject to the program requirement.630 We estimate that 2,693 funds would likely be subject to the program requirement.631 Below we estimate the initial and annual ongoing burdens associated with initial documentation of the program, and any revision (and related documentation) of the derivatives risk management program arising from the periodic review of the program. In addition to the initial burden to document the program, including policies and procedures reasonably designed to manage the fund’s derivatives risks, we estimate that a fund relying on the proposed rule would have an ongoing burden associated with the proposed periodic review requirements to evaluate the program’s effectiveness and to reflect changes in the fund’s derivatives risks over time. Below we estimate the initial and annual ongoing burdens associated with documentation and any review and revision of funds’ programs including their policies and procedures. Table 2 below summarizes the proposed PRA initial and ongoing annual burden estimates associated with the derivatives risk management program requirement under proposed rule 18f–4. We do not estimate that there will be any initial or ongoing external costs associated with the derivatives risk management program requirement. TABLE 2—DERIVATIVES RISK MANAGEMENT PROGRAM PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Wage rate 2 Internal time costs Proposed Estimates 12 4 × $357 (derivatives risk manager) ................. $1,428 12 12 0 4 4 2 × × × $466 (assistant general counsel) ............... $365 (compliance attorney) ........................ $357 (derivatives risk manager) ................. 1,864 1,460 714 0 0 2 2 × × $466 (assistant general counsel) ................ $365 (compliance attorney) ........................ 932 730 ........................ ........................ 18 × 2,693 ..................................................................... ..................................................................... 7,128 × 2,693 Written derivatives risk management program development. Periodic review and revisions of the program. lotter on DSKBCFDHB2PROD with PROPOSALS2 Total annual burden per fund .............. Number of funds ........................... 626 See proposed rule 18f–4(c)(4); supra section II.G.3. 627 See proposed rule 18f–4(a) (defining ‘‘fund’’). 628 See supra notes 467, 498 and accompanying text, and paragraph following note 525 (2,693 funds that would be subject to the proposed derivatives risk management program and limit on fund leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and complying with the related limited derivatives user requirements). The Commission’s estimates of the relevant wage rates in the tables below are based on salary VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 information for the securities industry compiled by the Securities Industry and Financial Markets Association’s Office Salaries in the Securities Industry 2013. The estimated wage figures are modified by Commission staff to account for an 1,800-hour work-year and multiplied by 2.93 to account for bonuses, firm size, employee benefits, overhead, and adjusted to account for the effects of inflation. See Securities Industry and Financial Markets Association, Report on Management & Professional Earnings in the Securities Industry 2013 (‘‘SIFMA Report’’). PO 00000 Frm 00090 Fmt 4701 Sfmt 4702 629 See proposed rule 18f–4(c)(1)(i)–(vi); supra section II.A.2 (discussing the proposed derivatives risk management program requirement). 630 A fund that is a limited derivatives user would not be required to comply with the proposed program requirement. Funds that are limited derivatives users would be required to adopt policies and procedures that are reasonably designed to manage its derivatives risks. See proposed rule 18f–4(c)(3); infra section IV.B.6 (discussing limited derivatives users). 631 See supra notes 498, 627 and accompanying text. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 4535 TABLE 2—DERIVATIVES RISK MANAGEMENT PROGRAM PRA ESTIMATES—Continued Internal initial burden hours Total annual burden ............................. Internal annual burden hours 1 ........................ Wage rate 2 48,474 ..................................................................... Internal time costs 19,195,704 Notes: 1. For ‘‘Written Derivatives Risk Management Program Development,’’ these estimates include initial burden estimates annualized over a three-year period. 2. See supra note 627. and (3) the derivatives risk manager to provide written reports describing any exceedances of the fund’s guidelines and the results of the fund’s stress testing and backtesting.634 We estimate that 2,693 funds would be subject to these requirements.635 Table 3 below summarizes the proposed PRA initial and ongoing 2. Board Oversight and Reporting The proposed rule would require: (1) A fund’s board of directors to approve the designation of the fund’s derivatives risk manager,632 (2) the derivatives risk manager to provide written reports to the board regarding the program’s implementation and effectiveness,633 annual burden estimates associated with the board oversight and reporting requirements under proposed rule 18f– 4. We do not estimate that there will be any initial or ongoing external costs associated with the board oversight and reporting requirements. TABLE 3—BOARD OVERSIGHT AND REPORTING PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Wage rate 2 Internal time costs Proposed Estimates 3 1 × $17,860 (combined rate for 4 directors) 2 ... $17,860 ........................ ........................ 8 1 × × $357 (derivatives risk manager) ................. $17,860 (combined rate for 4 directors) ..... 2,856 17,860 Total annual burden per fund .............. Number of funds ........................... ........................ ........................ 10 × 2,693 ..................................................................... ..................................................................... 11,786 × 2,693 Total annual burden ............................. ........................ 26,930 ..................................................................... 31,739,698 Approving the designation of the derivatives risk manager. Derivatives risk manager written reports 3 .. Notes: 1. For ‘‘Approving the Designation of the Derivatives Risk Manager,’’ this estimate includes initial burden estimates annualized over a three– year period. 2. See supra notes 627. 3. See supra notes 631–632 and accompanying text. lotter on DSKBCFDHB2PROD with PROPOSALS2 3. Disclosure Requirement Associated With Limit on Fund Leverage Risk The proposed rule would also generally require funds relying on the rule to comply with an outer limit on fund leverage risk based on VaR. This outer limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a ‘‘designated reference index.’’ If the fund’s derivatives risk manager is unable to identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test.636 Under the proposed rule, a fund must disclose its designated reference index in its annual report.637 We estimate that 2,424 funds would be subject to this disclosure requirement.638 Table 4 below summarizes the proposed PRA initial and ongoing annual burden estimates associated with the disclosure requirement associated with the proposed limit on fund leverage risk. We do not estimate that there will be any paperwork-related initial or ongoing external costs associated with this proposed disclosure requirement. 632 See proposed rule 18f–4(c)(5)(i); supra section II.C (discussing the proposed board oversight and reporting requirements). 633 See proposed rule 18f–4(c)(5)(ii); supra section II.C. 634 See proposed rule 18f–4(c)(5)(iii); supra section II.C. Burdens associated with reports to the fund’s board of directors of material risks arising from the fund’s derivatives transactions, as described in proposed rule 18f–4(c)(1)(v), are discussed above in supra section IV.B.1. 635 See supra notes 498, 627 and accompanying text. 636 The collections of information burdens for disclosure requirements associated with the proposed limit on fund leverage risk are reflected in the PRA for proposed rule 18f–4 and not in the funds’ applicable disclosure forms because the burden arises from the proposed rule. The Paperwork Reduction Act analysis for the funds’ applicable disclosure forms will not reflect the collections of information burdens for disclosure requirements associated with the proposed limit on fund leverage risk. A fund that is a leveraged/inverse investment vehicle, as defined in the proposed sales practices rules, would not be required to comply with the proposed VaR-based limit on fund leverage risk. Broker–dealers and investment advisers would be required to approve retail investors’ accounts to purchase or sell shares in these funds. See infra sections IV.C and IV.D (discussing leveraged/ inverse investment vehicles and leveraged/inverse funds covered by the sales practices rules). The proposed rule also would provide an exception from the proposed VaR tests for funds that use derivatives to a limited extent or only to hedge currency risks. See infra sections IV.B.5 (discussing the proposed rule’s provisions regarding limited derivatives users). VaR test burdens related to recordkeeping and reporting are reflected in the recordkeeping section below, and also in the Forms N–PORT, N– CURRENT, and N–CEN burdens discussed below. See infra sections IV.F, IV.G, and IV.H. 637 See proposed rule 18f–4(c)(2)(iv). 638 See supra notes 519–520 and accompanying text. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 PO 00000 Frm 00091 Fmt 4701 Sfmt 4702 E:\FR\FM\24JAP2.SGM 24JAP2 4536 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules TABLE 4—DISCLOSURE REQUIREMENT ASSOCIATED WITH LIMIT ON FUND LEVERAGE RISK PRA ESTIMATES Internal initial burden hours Internal annual burden hours Wage rate 1 Internal time costs Proposed Estimates Disclosure of designated reference index .. 0 0 .5 .5 Total annual burden per fund .............. Number of funds ........................... ........................ ........................ Total annual burden ............................. ........................ × × $309 (compliance manager) ....................... 365 (compliance attorney) .......................... $154.50 182.50 1 hour × 2,424 ..................................................................... ..................................................................... 337 × 2,424 2,424 ..................................................................... 816,888 Notes: 1. See supra note 627. 4. Disclosure Requirement for Leveraged/Inverse Funds Under the proposed rule, a fund would not have to comply with the proposed VaR-based leverage risk limit if it: (1) Meets the definition of a ‘‘leveraged/inverse investment vehicle’’ in the proposed sales practices rules; (2) limits the investment results it seeks to 300% of the return (or inverse of the return) of the underlying index; and (3) discloses in its prospectus that it is not subject to proposed rule 18f–4’s limit on fund leverage risk.639 We estimate that 269 funds would be subject to the proposed prospectus disclosure requirement for leveraged/inverse funds.640 Table 5 below summarizes the proposed PRA initial and ongoing annual burden estimates associated with the disclosure requirement in the proposed rule’s alternative provision for leveraged/inverse funds. We do not estimate that there will be any initial or ongoing external costs associated with this proposed disclosure requirement. TABLE 5—DISCLOSURE REQUIREMENT ASSOCIATED WITH LEVERAGED/INVERSE FUNDS PRA ESTIMATES Internal initial burden hours Internal annual burden hours Wage rate 1 Internal time costs Proposed Estimates 0 .25 × $309 (compliance manager) ....................... $77 0 .25 × 365 (compliance attorney) .......................... 91 Total annual burden per fund .............. Number of funds ........................... ........................ ........................ 1 × 269 ..................................................................... ..................................................................... 168 × 269 Total annual burden ............................. ........................ 269 ..................................................................... 45,192 Leveraged/inverse fund prospectus disclosure. lotter on DSKBCFDHB2PROD with PROPOSALS2 Notes: 1. See supra note 627. 5. Disclosure Changes for Money Market Funds Money market funds are excluded from the scope of the rule and could not rely on proposed rule 18f–4 to enter into derivatives transactions or other transactions addressed in the proposed rule.641 To the extent a money market fund currently discloses in its prospectus that it may use any of these transactions—even if it is not currently entering into these transactions—money market funds would be subject to the burdens associated with making disclosure changes to their prospectuses. We estimate that 413 funds could be subject to such disclosure changes on account of money market funds’ exclusion from the proposed rule.642 Table 6 below summarizes the proposed PRA initial and ongoing annual burden estimates associated with disclosure changes that money market funds could make because of their exclusion from proposed rule 18f–4.643 We do not estimate that there will be any initial or ongoing external costs associated with this disclosure change requirement. 639 See proposed rule 18f–4(c)(4); supra section II.G (discussing the alternative requirements for leveraged/inverse funds). 640 See supra note 467 and accompanying text (164 leveraged/inverse ETFs + 105 leveraged mutual funds). 641 See proposed rule 18f–4(a) (defining the term ‘‘Fund’’ to ‘‘. . . not include a registered open-end company that is regulated as a money market fund’’); supra section II.A.1 (discussing the exclusion of money market funds from the scope of the proposed rule). 642 See supra note 454 and accompanying text. This likely overestimates the total number of funds subject to these disclosure changes, because we believe that money market funds currently do not typically engage in derivatives transactions or the other transactions addressed by proposed rule 18f– 4. See supra section II.A.1. 643 These per-fund burden estimates likely overestimate the total burden associated with these disclosure changes. See supra note 641. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 PO 00000 Frm 00092 Fmt 4701 Sfmt 4702 E:\FR\FM\24JAP2.SGM 24JAP2 4537 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules TABLE 6—DISCLOSURE CHANGES FOR MONEY MARKET FUNDS PRA ESTIMATES Internal initial burden hours Internal annual burden hours Wage rate 1 Internal time costs Proposed Estimates .75 .25 × $309 (compliance manager) ....................... $77 .75 .25 × $365 (compliance attorney) ........................ 91 Total annual burden per fund .............. Number of funds ........................... ........................ ........................ .5 × 413 ..................................................................... ..................................................................... 168 × 413 Total annual burden ............................. ........................ 207 ..................................................................... 69,384 Money market changes. prospectus disclosure Notes: 1. See supra note 627. We estimate that 2,398 funds would be subject to the limited derivatives users requirements.645 In addition to the initial burden to document the policies and procedures, we estimate that limited derivatives users would have an ongoing burden associated with any review and revisions to its policies and procedures to ensure that they are ‘‘reasonably designed’’ to manage the fund’s derivatives risks. Below we estimate the initial and annual ongoing burdens associated with documentation 6. Policies and Procedures for Limited Derivatives Users Proposed rule 18f–4 would require funds relying on the limited derivatives user provisions to adopt and implement written policies and procedures reasonably designed to manage the fund’s derivatives risks.644 Only funds that limit their derivatives exposure to 10% of their net assets or that use derivatives transactions solely to hedge certain currency risks would be permitted to rely on these provisions. and any review and revision of the limited derivatives users’ policies and procedures. Table 7 below summarizes the proposed PRA initial and ongoing annual burden estimates associated with the policies and procedures requirement for limited derivatives users under proposed rule 18f–4. We do not estimate that there will be any initial or ongoing external costs associated with the policies and procedures requirement for limited derivatives users. TABLE 7—POLICIES AND PROCEDURES FOR LIMITED DERIVATIVES USERS PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Wage rate 2 Internal time costs Proposed Estimates Written policies and procedures ................. $329 365 82.25 91.25 2.5 × 2,398 ..................................................................... ..................................................................... 867.50 × 2,398 5,995 ..................................................................... 2,080,265 1 1 .25 .25 Total annual burden per fund .............. Number of funds ........................... ........................ ........................ Total annual burden ............................. ........................ Review of policies and procedures ............. × × (senior manager) 4 ....................... (compliance attorney) 4 ................ (senior manager) 4 ............................. (compliance attorney) 4 ...................... 3 3 0 0 $329 $365 $329 $365 Notes: 1. For ‘‘Written Policies and Procedures,’’ these estimates include initial burden estimates annualized over a three-year period. 2. See supra note 627. 7. Recordkeeping Requirements lotter on DSKBCFDHB2PROD with PROPOSALS2 Proposed rule 18f–4 would require a fund to maintain certain records documenting its derivatives risk management program’s written policies and procedures, along with its stress test results, VaR backtesting results, internal 644 See proposed rule 18f–4(c)(3); supra section II.E (discussing the proposed policies and procedures requirement for limited derivatives users). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 reporting or escalation of material risks under the program, and reviews of the program.646 The proposed rule would also require a fund to maintain records of any materials provided to the fund’s board of directors in connection with approving the designation of the derivatives risk manager and any 645 See supra paragraph following note 525. proposed rule 18f–4(c)(6)(i)(A); supra section II.K (discussing the proposed recordkeeping requirements). written reports relating to the derivatives risk management program.647 A fund that is required to comply with the proposed VaR test would also have to maintain records documenting the determination of: Its portfolio VaR; the VaR of its designated 647 See proposed rule 18f–4(c)(6)(i)(B). 646 See PO 00000 Frm 00093 Fmt 4701 Sfmt 4702 E:\FR\FM\24JAP2.SGM 24JAP2 4538 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules reference indexes, as applicable; its VaR ratio (the value of the VaR of the Fund’s portfolio divided by the VaR of the designated reference index), as applicable; and any updates to any of its VaR calculation model and the basis for any material changes to its VaR model.648 A fund that is a limited derivatives users under the proposed rule would have to maintain a written record of its policies and procedures that are reasonably designed to manage derivatives risks.649 A fund engaging in unfunded commitment agreements would be required to maintain records documenting the sufficiency of its funds to meet its obligations with respect to all unfunded commitment agreements.650 We estimate that 5,091 funds would be subject to the recordkeeping requirements.651 Below we estimate the average initial and ongoing annual burdens associated with the recordkeeping requirements. This average takes into account that some funds such as limited derivatives users may have less extensive recordkeeping burdens than other funds that use derivatives more substantially. Table 8 below summarizes the proposed PRA estimates associated with the recordkeeping requirements in rule 18f–4. TABLE 8—RECORDKEEPING PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Initial external cost burden Internal time costs Wage rate 2 Annual external cost burden Proposed Estimates Establishing recordkeeping policies and procedures. 1.5 .5 $62 (general clerk) .......................... $31 $1,800 $600 Recordkeeping ................................. 1.5 0 0 .5 2 2 $95 (senior computer operator) ...... 62 (general clerk) ............................ $95 (senior computer operator) ...... 47.50 31 47.50 ........................ 0 ........................ ........................ 0 ........................ Total annual burden per fund ... Number of funds ................ ........................ ........................ 5 × 5,091 .......................................................... .......................................................... 157 × 5,091 ........................ ........................ 600 5,091 Total annual burden .................. ........................ 25,455 .......................................................... 799,287 ........................ 3,054,600 × × Notes: 1. For ‘‘Establishing Recordkeeping Policies and Procedures,’’ these estimates include initial burden estimates annualized over a three-year period. 2. See supra note 627. 8. Proposed Rule 18f–4 Total Estimated Burden As summarized in Table 9 below, we estimate that the total hour burdens and time costs associated with proposed rule 18f–4, including the burden associated with documenting the derivatives risk management program, board oversight and reporting, disclosure requirements associated with the proposed VaR tests, disclosure requirements associated with the alternative requirements for leveraged/inverse funds, policies and procedures development for limited derivatives users, and recordkeeping, amortized over three years, would result in an average aggregate annual burden of 109,754 hours and an average aggregate annual monetized time cost of $54,761,797. We also estimate that, amortized over three years, there would be external costs of $3,054,600 associated with this collection of information. Therefore, each fund that relies on the rule would incur an average annual burden of approximately 20.56 hours, at an average annual monetized time cost of approximately $10,757, and an external cost of $600 to comply with proposed rule 18f–4.652 TABLE 9—PROPOSED RULE 18f–4 TOTAL PRA ESTIMATES lotter on DSKBCFDHB2PROD with PROPOSALS2 Internal hour burden Internal burden time cost External cost burden Derivatives risk management program ........................................................................................ Board oversight and reporting ..................................................................................................... Disclosure requirement associated with limit on fund leverage risk ........................................... Disclosure requirement associated with alternative requirements for leveraged/inverse funds Disclosure changes for money market funds .............................................................................. Policies and procedures for limited derivatives users ................................................................. Recordkeeping requirements ....................................................................................................... 48,474 26,930 2,424 269 207 5,995 25,455 $19,195,704 31,739,698 816,888 45,192 69,384 2,080,265 799,287 $0 0 0 0 0 0 3,054,600 Total annual burden ............................................................................................................. Number of funds ............................................................................................................ 109,754 ÷ 5,091 54,746,418 ÷ 5,091 3,054,600 ÷ 5,091 Average annual burden per fund ......................................................................................... 20.56 10,754 600 648 See proposed rule 18f–4(c)(6)(i)(C). proposed rule 18f–4(c)(6)(i)(D). 650 See proposed rule 18f–4(e)(2). 651 See supra notes 467, 498 and accompanying text, and paragraph following note 525 (2,693 funds 649 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 that would be subject to the proposed derivatives risk management program and limit on fund leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and complying with the related limited derivatives user requirements). PO 00000 Frm 00094 Fmt 4701 Sfmt 4702 652 These per-fund burden estimates likely overestimate the total burden of proposed rule 18f– 4 because not all funds (e.g., limited derivatives users) would incur the various burdens set forth in the table. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 1. Due Diligence and Account Approval C. Proposed Rule 15l–2: Sales Practices Rule for Broker-Dealers Proposed rule 15l–2 would impose burdens on registered broker-dealers relating to investments in leveraged/ inverse investment vehicles by their retail customers.653 The proposed rule is designed to address investor protection concerns relating to leveraged/inverse investment vehicles by helping to ensure that retail investors in these products are capable of evaluating their characteristics and the unique risks they present. The collections of information under proposed rule 15l–2, discussed below, would assist the Commission with its accounting, auditing and oversight functions. The respondents to the proposed rule would be brokerdealers registered under the Exchange Act with retail customers that transact in leveraged/inverse investment vehicles. Compliance with proposed rule 15l–2 would be mandatory for all such broker-dealers. To the extent that records required to be created and maintained by broker-dealers under the proposed rule are provided to the Commission in connection with examinations or investigations, such information would be kept confidential subject to the provisions of applicable law. We estimate that, as of December 31, 2018, there were approximately 2,766 broker-dealers registered with the Commission that reported some sales to retail customer investors.654 We further estimate that 700 of those broker dealers with retail customer accounts (approximately 25%) have retail customer accounts that invest in leveraged/inverse investment vehicles. Under proposed rule 15l–2, before accepting an order from a customer that is a natural person (or the legal representative of a natural person) to buy or sell shares of a leveraged/inverse investment vehicle, or approve such a customer’s account to engage in those transactions, the broker-dealer must approve the customer’s account to engage in those transactions in accordance with the proposed rule.655 To make this determination, the brokerdealer must exercise due diligence to ascertain certain facts about the customer, his or her financial situation, and investment objectives. To comply with this due diligence requirement, the broker-dealer must seek to obtain certain information described in the proposed rule. This proposed rule is modeled, in large part, after the FINRA rule requiring due diligence and account approval for retail investors to trade in options. Based on our understanding of how broker-dealers comply with the FINRA options account requirements, we believe that a common way for broker-dealers to comply with this due diligence obligation would be to utilize in-house legal and compliance counsel, as well as in-house computer and website specialists, to create an online form for customers to provide the required information for approval of their accounts to trade in leveraged/ inverse investment vehicles. We also believe that a portion of the due diligence would be performed by individuals associated with a brokerdealer or by telephone or in-person meetings with investors. Based on our understanding of current broker-dealer 4539 practices, we do not believe there would be any initial or ongoing external costs associated with the proposed brokerdealer due diligence requirement. Currently, there are 105 leveraged/ inverse mutual funds, 164 leveraged/ inverse ETFs, and 17 exchange-listed commodity- or currency-based trusts or funds that meet the definition of ‘‘leveraged/inverse investment vehicle’’ under the proposed rule.656 Accordingly, there are 286 leveraged/ inverse investment vehicles in total for which a broker-dealer would be required to approve a retail customer’s account before the customer could transact in the shares of those vehicles. Based on our experience with brokerdealers and leveraged/inverse investment vehicles, we estimate that each of these leveraged/inverse investment vehicles is held by approximately 2,500 separate retail investor accounts held by registered broker dealers, for a total of 715,000 existing accounts requiring approval to trade in leveraged/inverse investment vehicles. We further estimate that approximately 10,000 new retail accounts will be opened each year requiring approval to trade in leveraged/ inverse investment vehicles.657 Table 10 below summarizes our initial and ongoing PRA burden estimates associated with the due diligence and account approval requirements in proposed rule 15l–2. Based on our understanding of current broker-dealer practices, we do not estimate that there will be any initial or ongoing external costs associated with the proposed due diligence and account approval requirements. TABLE 10—PROPOSED RULE 15l–2 DUE DILIGENCE AND ACCOUNT APPROVAL PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Internal time costs Wage rate 2 Initial external cost burden Annual external cost burden Proposed Estimates 6 2 × $365 (compliance attorney) ............ $730 ........................ ........................ 9 12 ........................ ........................ 3 4 9 700 × × 284 (senior systems analyst) .......... 331 (senior programmer) ................ .......................................................... .......................................................... 852 1,324 2,906 700 ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ Total burden (I) ......................... ........................ 6,300 .......................................................... 2,034,200 ........................ ........................ Customer due diligence ................... 3 3 1 1 1 hour .33 365 (compliance attorney) .............. 70 (compliance clerk) ...................... $309 (compliance manager) ........... 365 70 101.97 ........................ ........................ ........................ ........................ ........................ ........................ Development and implementation of customer due diligence. lotter on DSKBCFDHB2PROD with PROPOSALS2 Annual burden per broker-dealer ..... Estimated number of affected broker-dealers. Evaluation of customer information for account approval/disapproval. 653 Specifically, the proposed sales practices rules (proposed rule 15l–2, as well as proposed rule 211(h)–1 under the Advisers Act), would require broker-dealers and investment advisers to engage in due diligence before accepting or placing an order VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 × × × for a retail investor to trade a leveraged/inverse investment vehicle or approving an investor’s account for such trading. See supra section II.G.2. 654 Our estimates relating to retail sales by brokerdealers are based on data obtained from Form BD PO 00000 Frm 00095 Fmt 4701 Sfmt 4702 and Form BR. See also supra note 543 and accompanying text. 655 See supra section II.G.2.b. 656 See supra note 467 and accompanying text. 657 See supra note 545 and accompanying text. E:\FR\FM\24JAP2.SGM 24JAP2 4540 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules TABLE 10—PROPOSED RULE 15l–2 DUE DILIGENCE AND ACCOUNT APPROVAL PRA ESTIMATES—Continued Internal initial burden hours Total annual burden per customer account. Estimated number of affected customer accounts. Internal annual burden hours 1 7 ........................ 3× Internal time costs Wage rate 2 Initial external cost burden Annual external cost burden 2.33 .......................................................... 536.97 ........................ ........................ 248,333.33 .......................................................... × 248,333.33 × 248,333.33 × 248,333.33 Total burden (II) ........................ ........................ 578,616.66 .......................................................... $133,347,548 ........................ ........................ Total annual burden (I + II) ....... ........................ 584,916.66 .......................................................... 135,381,748 $0 $0 Notes: 1. Includes initial burden estimates annualized over a three-year period. 2. See supra note 627. 3. We estimate that 715,000 existing customer accounts with broker-dealers would require the proposed rule 15l–2 account approval for trading in leveraged/inverse investment vehicles, and that 10,000 new customer accounts opened each year would require such approval. Accordingly, we believe that over a three-year period, a total of 745,000 accounts will require approval, which when annualized over a three-year period, equals 248,333.33 accounts per year. 2. Policies and Procedures Proposed rule 15l–2 requires brokerdealers to adopt and implement policies and procedures reasonably designed to achieve compliance with the proposed rule’s provisions.658 We believe that broker-dealers likely would establish these policies and procedures by adjusting their current systems for implementing and enforcing compliance policies and procedures. While brokerdealers already have policies and procedures in place to address compliance with other Commission rules (among other obligations), they would need to update their existing policies and procedures to account for rule 15l–2. To comply with this obligation, we believe that brokerdealers would use in-house legal and compliance counsel to update their existing policies and procedures to account for the requirements of rule 15l–2. For purposes of these PRA estimates, we assume that brokerdealers would review the policies and procedures that they would adopt under proposed rule 15l–2 annually (for example, to assess whether the policies and procedures continue to be ‘‘reasonably designed’’ to achieve compliance with the proposed rule). We therefore have estimated initial and ongoing burdens associated with the proposed policies and procedures requirement. As discussed above, we estimate that approximately 700 broker dealers have retail customer accounts that invest in leveraged/inverse investment vehicles. We do not estimate that there will be any initial or ongoing external costs associated with the proposed policies and procedures requirement. Table 11 below summarizes our initial and ongoing annual PRA burden estimates associated with the policies and procedures requirement in proposed rule 15l–2. TABLE 11—PROPOSED RULE 15l–2 POLICIES AND PROCEDURES PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Wage rate 2 Internal time costs Proposed Estimates 3 1 × $309 (compliance manager) ....................... $309.00 1 1 ........................ 0.33 0.33 1 × × × 365 (compliance attorney) .......................... 530 (chief compliance officer) ..................... 309 (compliance manager) ......................... $20.45 174.90 309.00 1 1 4.66 × 700 × × Total annual burden per broker-dealer ....... Number of affected broker-dealers ............. ........................ ........................ ........................ ........................ 365 (compliance attorney) .......................... 530 (chief compliance officer) ..................... ..................................................................... ..................................................................... 365.00 530.00 1,808.35 × 700 Total annual burden ............................. ........................ 3,262 ..................................................................... 1,265,845 Establishing and implementing rule 15l–2 policies and procedures. Reviewing and updating rule 15l–2 policies and procedures. lotter on DSKBCFDHB2PROD with PROPOSALS2 Notes: 1. Includes initial burden estimates annualized over a three-year period. 2. See supra note 627. 3. Recordkeeping Under proposed rule 15l–2, a brokerdealer would have to maintain a written record of the information that it obtained under the rule 15l–2 due diligence requirement and its written approval of the customer’s account, as well as the firm’s policies and 658 See supra section II.G.2.b. VerDate Sep<11>2014 18:37 Jan 23, 2020 procedures, for a period of not less than six years (the first two years in an easily accessible place) after the date of the closing of the client’s account.659 To comply with this obligation, we believe that broker-dealers would use in-house personnel to compile and maintain the relevant records. We do not estimate 659 See Jkt 250001 PO 00000 that there will be any initial or ongoing external costs associated with this requirement. Table 12 below summarizes our PRA initial and onging annual burden estimates associated with the recordkeeping requirement in proposed rule 15l–2. supra section II.G.2.c. Frm 00096 Fmt 4701 Sfmt 4702 E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules 4541 TABLE 12—PROPOSED RULE 15l–2 RECORDKEEPING PRA ESTIMATES Internal initial burden hours Internal annual burden hours Internal time costs Wage rate 1 Proposed Estimates Recordkeeping ............................................ 0 1 × $62 (general clerk) ...................................... $62 0 0 × 700 1 2 × 700 × Total annual burden per broker-dealer ....... Number of affected broker-dealers ............. $95 (senior computer operator) .................. ..................................................................... ..................................................................... 95 157 × 700 Total annual burden ............................. 0 1,400 ..................................................................... 109,900 Notes: 1. See supra note 627. 4. Proposed Rule 15l–2 Total Estimated Burden As summarized in Table 13 below, we estimate that the total hour burdens and time costs associated with proposed rule 15l–2, including the burden associated with the due diligence and account approval requirement, the policies and procedures requirement, and the recordkeeping requirement, would result in an average aggregate annual burden of 589,578.66 hours and an average aggregate time cost of $136,757,493. Therefore, each brokerdealer would incur an annual burden of approximately 842.26 hours, at an average time cost of approximately $195,367.85, to comply with proposed rule 15l–2. TABLE 13—PROPOSED RULE 15l–2 TOTAL PRA ESTIMATES Internal initial burden hours External cost burden Due diligence and account approval ........................................................................................... Policies and procedures .............................................................................................................. Recordkeeping ............................................................................................................................. Total annual burden ............................................................................................................. 584,916.66 3,262 1,400 589,578.66 $135,381,748 1,265,845 109,900 136,757,493 $0 0 0 0 Number of affected broker-dealers ............................................................................... ÷ 700 ÷ 700 ÷ 700 Average annual burden per affected broker-dealer ............................................................. 842.26 195,367.85 0 D. Proposed Rule 211(h)–1: Sales Practices for Registered Investment Advisers lotter on DSKBCFDHB2PROD with PROPOSALS2 Internal burden time cost Proposed 211(h)–1 would impose burdens on registered investment advisers relating to investments in leveraged/inverse investment vehicles by their retail clients.660 Proposed rule 211(h)–1 is designed to address investor protection concerns relating to leveraged/inverse investment vehicles by helping to ensure that retail investors in these products are capable of evaluating their characteristics and the unique risks they present. The Commission also believes that the collections of information under proposed rule 211(h)–1, discussed below, would assist the Commission with its accounting, auditing and oversight functions. The respondents to the proposed rule would be investment advisers registered under the Advisers Act that place orders for retail clients to invest in leveraged/ 660 See supra note 652. VerDate Sep<11>2014 18:37 Jan 23, 2020 inverse investment vehicles. Compliance with proposed rule 211(h)– 1 would be mandatory for all such investment advisers. To the extent that records required to be created and maintained by investment advisers under the proposed rule are provided to the Commission in connection with examinations or investigations, such information would be kept confidential subject to the provisions of applicable law. We estimate that, as of December 31, 2018, approximately 8,235 investment advisers registered with the Commission have some portion of their business dedicated to retail investors, including either individual high net worth clients or individual non-high net worth clients.661 Based on our experience with registered investment advisers, we further estimate that 2,000 of these investment advisers with retail client accounts (approximately 25%) have retail client accounts that invest in 661 Based Jkt 250001 PO 00000 on responses to Item 5.D of Form ADV. Frm 00097 Fmt 4701 Sfmt 4702 leveraged/inverse investment vehicles. As such, the investment advisers for those client accounts would be subject to the requirements of proposed rule 211(h)–1.662 1. Due Diligence and Account Approval Under proposed rule 211(h)–1, before placing an order for the account of a client that is a natural person (or the legal representative of a natural person) to buy or sell shares of a leveraged/ inverse investment vehicle, or approving such a client’s account to engage in those transactions, the investment adviser must approve the client’s account to engage in those transactions in accordance with the proposed rule.663 To make this determination, the adviser must exercise due diligence to ascertain certain facts about the client, his or her financial situation, and investment objectives. To 662 See supra note 547 and accompanying paragraph. 663 See proposed rule 211(h)–1; supra section II.G.2. E:\FR\FM\24JAP2.SGM 24JAP2 4542 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules comply with this due diligence requirement, the investment adviser must seek to obtain certain information described in the proposed rule. Based on our understanding of how brokerdealers comply with the FINRA options account requirements, as discussed above (which we assume, for purposes of this PRA estimate, that investment advisers could model their compliance programs after), we believe that investment advisers likely would comply with this due diligence obligation by utilizing in-house legal and compliance counsel, as well as inhouse computer and website specialists, to create an online form for clients to complete with the required information for approval of their accounts to trade in leveraged/inverse investment vehicles.664 We also believe that a portion of the due diligence would be performed by individuals associated with an investment adviser by telephone or in-person meetings with investors. Currently, there are 105 leveraged/ inverse mutual funds, 164 leveraged/ inverse ETFs, and 17 exchange-listed commodity- or currency-based trusts or funds that meet the definition of ‘‘leveraged/inverse investment vehicle’’ under the proposed rule.665 Accordingly, there are 286 leveraged/ inverse investment vehicles in total for which an investment adviser would be required to approve a retail client’s account before the client could transact in the shares those vehicles. Based on our experience with registered investment advisers, we estimate that each of these leveraged/inverse investment vehicles is held by approximately 2,500 separate retail investor accounts held by investment advisers, for a total of 715,000 existing accounts requiring approval to trade in leveraged/inverse investment vehicles. Based on our experience, we further estimate that approximately 10,000 new retail accounts will be opened each year requiring approval to trade in leveraged/ inverse investment vehicles.666 Table 14 below summarizes our initial and ongoing PRA burden estimates associated with the due diligence requirement in proposed rule 211(h)–1. We do not estimate that there will be any initial or ongoing external costs associated with the proposed due diligence and approval requirements. TABLE 14—PROPOSED RULE 211(h)–1 DUE DILIGENCE AND ACCOUNT APPROVAL PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Internal time costs Wage rate 2 Initial external cost burden Annual external cost burden Proposed Estimates 6 2 × $365 (compliance attorney) ............ $730 $0 $0 9 12 ........................ 3 4 9 × × $284 (senior systems analyst) ........ $331 (senior programmer) .............. .......................................................... 852 1,324 2,906 ........................ ........................ ........................ ........................ ........................ ........................ ........................ 2,000 .......................................................... 2,000 ........................ ........................ ........................ 3 3 1 18,000 1 1 .33 .......................................................... $365 (compliance attorney) ............ $70 (compliance clerk) .................... $309 (compliance manager) ........... 5,812,000 365 70 101.97 ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ 7 2.33 .......................................................... 536.97 ........................ ........................ × 248,333.33 ........................ ........................ Development and implementation of client due diligence. Annual burden per investment adviser. Estimated number of affected investment advisers. Total burden (I) ......................... Client due diligence .......................... Evaluation of client information for account approval/disapproval. Total annual burden per client account. Estimated number of affected client accounts. 3× × × 248,333.33 Total burden (II) ........................ ........................ 578,616.66 .......................................................... 133,347,548 ........................ ........................ Total annual burden (I + II) ....... ........................ 596,616.66 .......................................................... 139,159,548 0 0 Notes: 1. Includes initial burden estimates annualized over a three-year period. 2. See supra note 627. 3. We estimate that 715,000 existing client accounts with registered investment advisers would require the proposed rule 211(h)–1 account approval for trading in leveraged/inverse investment vehicles, and that 10,000 new client accounts opened each year would require such approval. Accordingly, we believe that over a threeyear period, a total of 745,000 client accounts would require approval, which when annualized over a three-year period, is 248,333.33 accounts per year. lotter on DSKBCFDHB2PROD with PROPOSALS2 2. Policies and Procedures Proposed rule 211(h)–1 requires investment advisers to adopt and implement policies and procedures reasonably designed to achieve compliance with the proposed rule’s provisions.667 We believe that investment advisers likely would establish these policies and procedures by adjusting their current systems for implementing and enforcing compliance policies and procedures. While investment advisers already have 664 See 665 See supra paragraph accompanying note 654. supra note 467 and accompanying text. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 policies and procedures in place to address compliance with other Commission rules (among other obligations), they would need to update their existing policies and procedures to account for rule 211(h)–1. To comply with this obligation, we believe that investment advisers would use in-house legal and compliance counsel to update their existing policies and procedures to account for the requirements of rule 211(h)–1. For purposes of these PRA estimates, we assume that investment 666 See 667 See PO 00000 advisers would review the policies and procedures that they would adopt under proposed rule 211(h)–1 annually (for example, to assess whether the policies and procedures continue to be ‘‘reasonably designed’’ to achieve compliance with the proposed rule, and in compliance with Advisers Act rule 206(4)–7(b)). We therefore have estimated initial and ongoing burdens associated with the proposed policies and procedures requirement. We do not estimate that there will be any initial or supra note 547 and accompanying text. supra section II.G.2.b. Frm 00098 Fmt 4701 Sfmt 4702 E:\FR\FM\24JAP2.SGM 24JAP2 4543 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules ongoing external costs associated with the proposed policies and procedures requirement. Table 15 below summarizes our PRA estimates associated with the policies and procedures requirement in proposed rule 211(h)–1. TABLE 15—PROPOSED RULE 211(h)–1 POLICIES AND PROCEDURES PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Wage rate 2 Internal time costs Proposed Estimates 3 1 hour × $309 (compliance manager) ....................... $309 1 1 ........................ 0.33 0.33 1 × × $365 (compliance attorney) ........................ $530 (chief compliance officer) ................... $309 (compliance manager) ....................... 120.45 174.90 309 Total annual burden per investment adviser. Number of affected investment advisers .... ........................ 1 1 4.66 $365 (compliance attorney) ........................ $530 (chief compliance officer) ................... ..................................................................... 365 530 1,808.35 ........................ × 2,000 ..................................................................... × 2,000 Total annual burden ............................. ........................ 9,320 ..................................................................... 3,616,700 Establishing and implementing 211(h)–1 policies and procedures. rule Reviewing and updating rule 211(h)–1 policies and procedures. Notes: 1. Includes initial burden estimates annualized over a three-year period. 2. See supra note 627. 3. Recordkeeping leveraged/inverse investment vehicles, as well as the firm’s policies and procedures, for a period of not less than six years (the first two years in an easily accessible place) after the date of the closing of the client’s account.668 To comply with this obligation, we believe that investment advisers would use inhouse personnel to compile and Under the proposed rule, a registered investment adviser would have to maintain a written record of the information that it obtained under the rule 211(h)–1 due diligence requirement and its written approval of the client’s account for buying or selling shares of maintain the relevant records. We do not estimate that there will be any initial or ongoing external costs associated with this requirement. Table 16 below summarizes our PRA estimates associated with the recordkeeping requirement in proposed rule 211(h)–1. TABLE 16—PROPOSED RULE 211(h)–1 RECORDKEEPING PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Wage rate 2 Internal time costs Proposed Estimates Recordkeeping ............................................ ................................................................ Total annual burden per investment adviser. Number of affected investment advisers .... 0 0 0 2.5 2.5 5 × 2,000 Total annual burden ............................. 0 × × $62 (general clerk) ...................................... $95 (senior computer operator) .................. ..................................................................... $155 237.50 392.50 × 2,000 ..................................................................... × 2,000 10,000 ..................................................................... 785,000 Notes: 1. Includes initial burden estimates annualized over a three-year period. 2. See supra note 627. lotter on DSKBCFDHB2PROD with PROPOSALS2 4. Proposed Rule 211(h)–1 Total Estimated Burden As summarized in Table 17 below, we estimate that the total hour burdens and time costs associated with proposed rule 211(h)–1, including the burden 668 See associated with the due diligence and account approval requirement, the policies and procedures requirement, and the recordkeeping requirement, would result in an average aggregate annual burden of 615,936.66 hours and an average aggregate time cost of $143,561,248. Therefore, each investment adviser would incur an annual burden of approximately 307.97 hours, at an average time cost of approximately $71,780.62 to comply with proposed rule 211(h)–1. supra section II.G.2.c. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 PO 00000 Frm 00099 Fmt 4701 Sfmt 4702 E:\FR\FM\24JAP2.SGM 24JAP2 4544 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules TABLE 17—PROPOSED RULE 211(h)–1 TOTAL ESTIMATED PRA BURDEN Internal initial burden hours Internal burden time cost External cost burden Due diligence and account approval ........................................................................................... Policies and procedures .............................................................................................................. Recordkeeping ............................................................................................................................. 596,616.66 9,320 10,000 $139,159,548 3,616,700 785,000 $0 0 0 Total annual burden ............................................................................................................. Number of affected investment advisers ...................................................................... 615,936.66 ÷ 2,000 143,561,248 ÷ 2,000 0 ÷ 2,000 Average annual burden per investment adviser .................................................................. 307.97 71,780.62 0 E. Rule 6c–11 We recently adopted rule 6c–11, which permits ETFs that satisfy certain conditions to operate without first obtaining an exemptive order from the Commission.669 The rule is designed to create a consistent, transparent, and efficient regulatory framework for such ETFs and facilitate greater competition and innovation among ETFs. Rule 6c–11 includes a provision excluding leveraged/inverse ETFs from the scope of ETFs that may rely on that rule. To promote a level playing field among ETFs, and in view of the other conditions we are proposing to place on leveraged/inverse ETFs under proposed rule 18f–4 and on transactions in leveraged/inverse ETFs’ securities under proposed rule 15l–2 and 211(h)–1, we are proposing to amend rule 6c–11 to permit leveraged/inverse ETFs to rely on that rule. Because we believe this proposed amendment would increase the number of funds relying on rule 6c– 11, we are updating the PRA analysis for rule 6c–11 to account for any burden Information provided to the Commission in connection with staff examinations or investigations will be kept confidential subject to the provisions of applicable law. Under current PRA estimates, 1,735 ETFs would be subject to these requirements. The current PRA estimates for rule 6c–11 include 74,466.2 total internal burden hours, $24,771,740.10 in internal time costs, and $1,735,000 in external time costs. We continue to believe that the current annual burden and cost estimates for rule 6c–11 are appropriate, but estimate that the proposed amendment to rule 6c–11 would result in an increase in the number of respondents. Specifically, we estimate that an additional 164 ETFs (all leveraged/inverse ETFs) would rely on rule 6c–11, resulting in an increase in the number of respondents to 1,899 ETFs.670 Table 18 below summarizes these revisions to the estimated annual responses, burden hours, and burdenhour costs based on the proposed amendment to rule 6c–11. increases that would result from this increase in respondents to that rule. We are not updating the rule 6c–11 PRA analysis in any other respect. Rule 6c–11 requires an ETF to disclose certain information on its website, to maintain certain records, and to adopt and implement certain written policies and procedures. The purpose of these collections of information is to provide useful information to investors who purchase and sell ETF shares in secondary markets and to allow the Commission to better monitor reliance on rule 6c–11 and will assist the Commission with its accounting, auditing and oversight functions. The respondents to rule 6c–11 will be ETFs registered as open-end management investment companies other than share class ETFs and nontransparent ETFs. This collection will not be mandatory, but will be necessary for those ETFs seeking to operate without individual exemptive orders, including all ETFs whose existing exemptive orders will be rescinded. TABLE 18—RULE 6c–11 PRA ESTIMATES lotter on DSKBCFDHB2PROD with PROPOSALS2 Updated estimated annual internal time burden cost Updated estimated annual external cost burden Updated estimated annual internal hour burden 2 Website disclosure ....................... Recordkeeping ............................. Policies and procedures .............. 33,398.75 8,675 32,392.45 36,555.75 9,495 35,454.33 $10,717,945.15 680,987.50 13,372,807.45 $11,731,053.51 745,357.50 14,636,865.33 $1,735,000 0 0 $1,899,000 0 0 Total annual burden .............. Number of affected ETFs ........................... 74,466.2 81,505.08 24,771,740.10 27,113,276.34 1,735,000 1,899,000 ÷ 1,735 ÷ 1,899 ÷ 1,735 ÷ 1,899 ÷ 1,735 ÷ 1,899 42.92 42.92 14,277.66 14,277.66 1,000 1,000 Average annual burden per ETF .................................... Previously estimated annual internal burden time cost Previously estimated annual external cost burden Previously estimated annual internal hour burden 1 Notes: 1. The previously estimated burdens and costs in this table are based on an estimate of 1,735 ETFs relying on rule 6c–11. 2. The updated estimated burdens and costs in this table are based on an estimate of 164 leveraged/inverse ETFs that would rely on rule 6c– 11 pursuant to the proposed amendment to that rule, for a total estimate of 1,899 ETFs that would rely on rule 6c–11. 669 See supra notes 352–355 and accompanying 670 See supra note 467 and accompanying text. text. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 PO 00000 Frm 00100 Fmt 4701 Sfmt 4702 E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules F. Form N–PORT We are proposing to amend Form N– PORT to add new items to Part B (‘‘Information About the Fund’’), as well as to make certain amendments to the form’s General Instructions. Form N–PORT, as amended, would require funds to provide information about their derivatives exposure.671 We estimate that 5,091 funds would be subject to this exposure-related disclosure requirement.672 In addition, funds that are subject to the limit on fund leverage risk in proposed rule 18f–4 would have to report certain VaR-related information, including: (1) The fund’s highest daily VaR during the reporting period and its corresponding date; and (2) the fund’s median daily VaR for the reporting period. Funds subject to the relative VaR test during the reporting period also would have to report: (1) The name of the fund’s designated reference index, (2) the index identifier, (3) the fund’s highest daily VaR ratio during the reporting period and its corresponding date; and (4) the fund’s median daily VaR ratio for the reporting period.673 Finally, all funds that are subject to the proposed limit on fund leverage risk also would have to report the number of exceptions that the fund identified as a result of the backtesting of its VaR calculation model.674 We estimate that 2,424 funds would be subject to these VaR-related disclosure requirements.675 Preparing reports on Form N–Port is mandatory for all management investment companies (other than money market funds and small business investment companies) and UITs that operate as ETFs and is a collection of information under the PRA. The information required by Form N–Port must be data-tagged in XML format. Responses to the reporting requirements will be kept confidential, subject to the provisions of applicable law, for reports filed with respect to the first two months of each quarter; the third month of the quarter will not be kept confidential, but made public sixty days after the quarter end. Form N–Port is 4545 designed to assist the Commission its regulatory, disclosure review, inspection, and policymaking roles, and to help investors and other market participants better assess different fund products.676 Based on current PRA estimates, we estimate that funds prepare and file their reports on Form N–Port either by (1) licensing a software solution and preparing and filing the reports in house, or (2) retaining a service provider to provide data aggregation, validation and/or filing services as part of the preparation and filing of reports on behalf of the fund. We estimate that 35% of funds subject to the proposed N–Port filing requirements would license a software solution and file reports on Form N–Port in house, and the remainder would retain a service provider to file reports on behalf of the fund. Table 19 below summarizes our PRA initial and ongoing annual burden estimates associated with the proposed amendments to Form N–Port. TABLE 19—FORM N–PORT PRA ESTIMATES Internal initial burden hours Internal annual burden hours 1 Initial external cost burden Annual external cost burden $1,580 ........................ ........................ 1,433 ........................ ........................ 3,013 ........................ ........................ 15,339,183 ........................ ........................ $365 (compliance attorney). $331 (senior programmer). 1,580 $5,490 $4,210 1,433 ........................ ........................ ......................................... 3,013 ........................ ........................ Wage rate 2 Internal time costs Proposed Estimates 2 3 4.33 × 2 4.33 × ........................ 8.66 Report derivatives exposure information. Total new burden for derivatives exposure information. Number of funds for derivatives exposure information. lotter on DSKBCFDHB2PROD with PROPOSALS2 ......................................... × 5,091 × 5,091 Total new annual burden for derivatives exposure information (I). ........................ 44,088 Report VaR-related information. 2 4.33 × 2 4.33 × ........................ 8.66 Total new burden for VaR-related information. Number of funds for VaRrelated information. 19:20 Jan 23, 2020 ......................................... × 2,424 671 See proposed Item B.9 of Form N–PORT; supra section II.H.1.a. 672 See supra notes 467, 498 and accompanying text, and paragraph following note 525 (2,693 funds that would be subject to the proposed derivatives risk management program and limit on fund VerDate Sep<11>2014 $365 (compliance attorney). $331 (senior programmer). Jkt 250001 × 2,424 leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and complying with the related limited derivatives user requirements). 673 See proposed Item B.10 of Form N–Port; supra section II.H.1.b. PO 00000 Frm 00101 Fmt 4701 Sfmt 4702 674 See id. supra paragraph following note 525. 676 The specific purposes for each of the new proposed reporting items are discussed in section II.H.1 supra. 675 See E:\FR\FM\24JAP2.SGM 24JAP2 4546 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules TABLE 19—FORM N–PORT PRA ESTIMATES—Continued Internal initial burden hours Internal annual burden hours 1 Wage rate 2 Internal time costs Initial external cost burden Annual external cost burden Total new annual burden for VaR-related information (II). ........................ 20,992 ......................................... 7,303,512 ........................ ........................ Total new annual burden (I + II). Current burden estimates ........................ 65,080 ......................................... 22,642,695 ........................ 4 21,433,110 ........................ 1,803,826 ......................................... ........................ ........................ 103,776,240 Revised burden estimates. ........................ 1,868,906 ......................................... ........................ ........................ 125,209,350 Notes: 1. Includes initial burden estimates annualized over a three-year period. 2. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the proposed reporting requirements that we believe otherwise would be involved in preparing and filing reports on Form N–PORT. 3. This estimate assumes that, annually after the initial 2 hours to comply with the new N–PORT requirements, each of a compliance attorney and a senior programmer would incur 1 burden hours per filing associated with the new reporting requirements. The estimate of 4.33 hours is based on the following calculation: ((2 hours for the first filing × 1 = 2) + (3 additional filings in year 1 × 1 hour for each of the additional 3 filings in year 1 = 3) + (4 filings in years 2 and 3 × 1 hour per filing × 2 years) = 8)/3 = 4.33. 4. This estimate is based on the following calculation: $4,210 (average costs for funds reporting the proposed information on Form N–PORT) * 5,091 funds (which includes funds reporting derivative exposure information and VaR-related information). lotter on DSKBCFDHB2PROD with PROPOSALS2 G. Form N–RN We are proposing to amend Form N– LIQUID (which we propose to re-title as ‘‘Form N–RN’’) to add new current reporting requirements for funds subject to the proposed VaR-based limit on fund leverage risk pursuant to proposed rule 18f–4.677 Specifically, a fund that determines that it is out of compliance with the VaR test and has not come back into compliance within three business days after such determination would have to file a non-public report on Form N–RN providing certain information regarding its VaR test breaches.678 If the portfolio VaR of a fund subject to the relative VaR test were to exceed 150% of the VaR of its designated reference index for three business days, a fund would have to report: (1) The dates on which the fund portfolio’s VaR exceeded 150% of the VaR of its designated reference index; (2) the VaR of its portfolio for each of these days; (3) the VaR of its designated reference index for each of these days; (4) the name of the designated reference index; and (5) the index identifier. If the portfolio VaR of a fund subject to the absolute VaR test were to exceed 10% of the value of the fund’s net assets for three business days, a fund would have to report: (1) The dates on which the fund portfolio’s VaR exceeded 10% of 677 See supra section II.H.2. requirement would be implemented through the proposed amendments to rule 30b1–10 under the Investment Company Act, and proposed rule 18f–4(c)(7). For purposes of this PRA analysis, the burden associated with the proposed amendments to rule 30b1–10 and proposed rule 18f–4(c)(7) is included in the collection of information requirements for Form N–RN. 678 This VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 the value of its net assets; (2) the VaR of its portfolio for each of these days; and (3) the value of the fund’s net assets for each of these days. In addition, if a fund that has filed Part E or Part F of Form N–RN to report it has breached its applicable VaR test, has come back into compliance with either the relative VaR test or the absolute VaR test, as applicable, it must file a report on Form N–RN to indicate that.679 Specifically, a fund must report the dates on which its portfolio VaR exceeded, as applicable, 150% of the VaR of its designated reference index (if the fund is subject to the relative VaR test under proposed rule 18f–4(c)(2)(i)) or exceeded 15% of the value of its net assets (if the fund is subject to the absolute VaR test under proposed rule 18f–4(c)(2)(ii)).680 Furthermore, a fund must also report the current VaR of its portfolio.681 A fund would have to report information for either VaR test breach, within one business day following the third business day after the fund has determined that its portfolio VaR exceeds either of the VaR test thresholds, as applicable. Similarly, a fund that has come back into compliance with its applicable VaR test would have to file such a report within one business day. We estimate that 2,424 funds per year would be required to comply with either of the VaR tests, and the Commission would receive approximately 30 filing(s) per year in response to each of the new VaR-related 679 See proposed Part G of Form N–RN. 680 Id. 681 Id. PO 00000 Frm 00102 Fmt 4701 Sfmt 4702 items that we proposed to include on Form N–RN, as amended.682 Under the proposed amendments to Form N–RN, preparing a report on this form would be mandatory for any fund that is out of compliance with its applicable VaR test for more than three business days, as described above, and for any fund that has come back into compliance with its applicable VaR test. A report on Form N–RN is a collection of information under the PRA. The VaR test breach information provided on Form N–RN, as well as the information a fund provides when it has come back into compliance, would enable the Commission to receive information on events that could impact funds’ leverage-related risk more uniformly and efficiently and would enhance the Commission’s oversight of funds when significant fund and/or market events occur. The Commission would be able to use the newly required information that funds would provide on Form N– RN in its regulatory, disclosure review, inspection, and policymaking roles. Responses to the reporting requirements and this collection of information would be kept confidential, subject to provisions of applicable law. Table 20 below summarizes our PRA initial and ongoing annual burden estimates associated with the proposed amendments to funds’ current reporting requirement. Staff estimates there will 682 This estimate is similar to the Commission’s estimates of the number of reports that funds, in the aggregate, would submit annually in response to the liquidity-related items of Form N–LIQUID. See Liquidity Adopting Release, supra note 359, at nn.1281–1283 and accompanying paragraph. See also supra paragraph following note 525. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules be no external costs associated with this collection of information. We further assume similar hourly and cost burdens, as well as similar response rates, for responses to either a breach of the 4547 absolute VaR test or the relative VaR test. TABLE 20—FORM N–RN PRA ESTIMATES Internal initial burden hours Internal annual burden hours Wage rate 1 Internal time costs Proposed Estimates 0 2 0.005 × 0 0.005 × Total new annual burden per fund .................................................... Number of funds ........................................................................ ........................ Total new annual burden .................................................................. Current burden estimates ......................................................................... Revised burden estimates ................................................................. Relative or absolute VaR test breach reports .......................................... $365 (compliance attorney) $331 (senior programmer) $1.83 0.01 × 2,424 ........................ 3.49 × 2,424 ........................ ........................ 24 941 ........................ ........................ 8,460 ........................ ........................ 965 ........................ ........................ 1.66 Notes: 1. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the proposed reporting requirements that we believe otherwise would be involved in preparing and filing reports on Form N–LIQUID. 2. This estimate is based on the assumption that, of the 2,424 funds that would be required to comply with either of the VaR tests, on average the Commission would receive 30 reports regarding a relative or absolute VaR test breach and that compliance attorney and senior programmer would each spend 30 minutes as part of preparing and submitting this report. H. Form N–CEN We are proposing to amend Form N– CEN to require a fund to identify whether it relied on proposed rule 18f– 4 during the reporting period.683 Form N–CEN is a structured form that requires registered funds to provide census-type information to the Commission on an annual basis. The proposed amendments also would require a fund to identify whether it relied on any of the exemptions from various requirements under the proposed rule, specifically: (1) Whether the fund is a limited derivatives user excepted from the proposed rule’s program requirement, under either of the proposed exception’s alternatives (either a funds that limits its derivatives exposure to 10% of its net assets, or a fund that uses derivatives transactions solely to hedge certain currency risks); or (2) whether it is a leveraged/inverse investment fund covered by the proposed sales practices rules that, under proposed rule 18f–4, would be excepted from the proposed limit on fund leverage risk. Finally, a fund would have to identify whether it has entered into reverse repurchase agreements or similar financing transactions, or unfunded commitment agreements, as provided under the proposed rule. Preparing a report on Form N–CEN, as amended, would be mandatory for all registered funds. Responses would not be kept confidential. We estimate that 12,375 funds would be subject to these disclosure requirements.684 The purpose of Form N–CEN is to satisfy the filing and disclosure requirements of section 30 of the Investment Company Act, and of amended rule 30a–1 thereunder. The information required to be filed with the Commission assures the public availability of the information and is designed to facilitate the Commission’s oversight of registered funds and its ability to monitor trends and risks. Table 21 below summarizes our PRA initial and ongoing annual burden estimates associated with the proposed amendments to Form N–CEN based on current Form N–CEN practices and burdens associated with minor amendments to the form. Staff estimates there will be no external costs associated with this collection of information. TABLE 21—FORM N–CEN PRA ESTIMATES Internal initial burden hours Internal annual burden hours Wage rate 1 Internal time costs Proposed Estimates 0 0.01 × $365 (compliance attorney) ........................ $3.7 0 0.01 × $331 (senior programmer) .......................... 3.3 ........................ 0.02 × 12,375 ..................................................................... 7 × 12,375 lotter on DSKBCFDHB2PROD with PROPOSALS2 Reporting derivatives-related fund census information. Total new annual burden per fund ...... Number of funds ......................................... 683 See supra section II.H.3. supra section III.B.1 (9,788 mutual funds + 1,910 ETFs organized as an open-end fund or as 684 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 a share-class of an open-end fund + 664 registered closed-end funds + 13 variable annuity separate PO 00000 Frm 00103 Fmt 4701 Sfmt 4702 accounts registered as management investment companies on Form N–3). E:\FR\FM\24JAP2.SGM 24JAP2 4548 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules TABLE 21—FORM N–CEN PRA ESTIMATES—Continued Internal initial burden hours Internal annual burden hours Wage rate 1 Internal time costs Total new annual burden ..................... Current burden estimates ........................... ........................ ........................ 248 74,425 ..................................................................... ..................................................................... 86,625 ........................ Revised burden estimates ................... ........................ 74,673 ..................................................................... ........................ lotter on DSKBCFDHB2PROD with PROPOSALS2 Notes: 1. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the proposed reporting requirements that we believe otherwise would be involved in preparing and filing reports on Form N–CEN. 2. This estimate assumes each fund reporting on Form N–CEN would spend 1 to 2 minutes reporting these new data elements. I. Request for Comments V. Initial Regulatory Flexbility Analysis We request comment on whether these estimates are reasonable. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (1) Evaluate whether the proposed collections of information are necessary for the proper performance of the functions of the Commission, including whether the information will have practical utility; (2) evaluate the accuracy of the Commission’s estimate of the burden of the proposed collections of information; (3) determine whether there are ways to enhance the quality, utility, and clarity of the information to be collected; and (4) determine whether there are ways to minimize the burden of the collections of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology. Persons wishing to submit comments on the collection of information requirements of the proposed rules and amendments should direct them to the OMB, Attention Desk Officer for the Securities and Exchange Commission, Office of Information and Regulatory Affairs, Washington, DC 20503, and should send a copy to, Vanessa Countryman, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090, with reference to File No. S7–24–15. OMB is required to make a decision concerning the collections of information between 30 and 60 days after publication of this release; therefore a comment to OMB is best assured of having its full effect if OMB receives it within 30 days after publication of this release. Requests for materials submitted to OMB by the Commission with regard to these collections of information should be in writing, refer to File No. S7–24–15, and be submitted to the Securities and Exchange Commission, Office of FOIA Services, 100 F Street NE, Washington, DC 20549–2736. This Initial Regulatory Flexibility Analysis has been prepared in accordance with section 3 of the Regulatory Flexibility Act.685 It relates to proposed rules 18f–4, 15l–2, 211(h)– 1, and proposed amendments to Forms N–PORT, N–LIQUID (which we propose to re-title as ‘‘Form N–RN’’), and N– CEN.686 VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 A. Reasons for and Objectives of the Proposed Actions The Commission is proposing new rules 18f–4, 211(h)–1, and 15l–2, amendments to rule 6c–11, as well as amendments to Forms N–PORT, N– LIQUID, and N–CEN. These proposed rules, and proposed rule and form amendments, are designed to address the investor protection purposes and concerns underlying section 18 of the Investment Company Act and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives and the other transactions covered by proposed rule 18f–4.687 Proposed rule 18f–4 is designed to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives and certain other transactions, generally through the implementation of a derivatives risk management program, limits on fund leverage risk, board oversight and reporting, and related recordkeeping requirements.688 The proposed sales practices rules are designed to address certain specific considerations raised by certain leveraged/inverse investment vehicles by requiring registered brokerdealers and investment advisers to satisfy due diligence and account 685 5 U.S.C. 603. discussed above, the proposed conforming amendment to Form N–2 does not change the Form N–2 collection of information. See supra note 622. We also do not believe there to be any reporting, recordkeeping, or compliance burden associated with this proposed conforming amendment. 687 See supra section I.B (discussing the requirements of section 18, and as well as Congress’ concerns underlying the limits of section 18). 688 See supra section II.A.2. 686 As PO 00000 Frm 00104 Fmt 4701 Sfmt 4702 approval requirements.689 Finally, the proposed amendments to Forms N– PORT, N–LIQUID, and N–CEN are designed to enhance the Commission’s ability to effectively oversee the use by funds, broker-dealers and investment advisers of the proposed rules and to provide the Commission and the public with greater insight into the impact that funds’ use of derivatives may have on their portfolios.690 All of these requirements are discussed in detail in section II of this release. The costs and burdens of these requirements on small funds, investment advisers, and broker-dealers are discussed below as well as above in our Economic Analysis and Paperwork Reduction Act Analysis, which discuss the applicable costs and burdens on all funds, investment advisers, and brokerdealers.691 B. Legal Basis The Commission is proposing new rule 18f–4 under the authority set forth in sections 6(c), 12(a), 18, 31(a), 38(a), and 61 of the Investment Company Act of 1940 [15 U.S.C. 80a–6(c), 80a–12(a), 80a–18, 80a–30(a), 80a–37(a), and 80a– 60]. The Commission is proposing amendments to rule 6c–11 under the authority set forth in sections 6(c), 22(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a–6(c), 22(c), and 80a– 37(a)]. The Commission is proposing new rule 15l–2 under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 17, 23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C. 78c, 78c(b), 78c–5, 78j, 78o(l), 78o–10, 78q, 78w(a), and 78mm]. The Commission is proposing new rule 211(h)–1 under the authority set forth in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment Advisers Act of 1940 [15 U.S.C. 80b–6, 80b–6a, 80b–8, 80b–11(a), and 80b–11(h)]. The Commission is 689 See supra section II.G. supra section II.H. 691 See supra sections III and IV. These sections also discuss the professional skills that we believe compliance with the proposed rules, and proposed rule and form amendments would entail. 690 See E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules proposing amendments to Form N– PORT, Form N–LIQUID (which we propose to re–title as ‘‘Form N–RN’’), Form N–CEN, and Form N–2 under the authority set forth in sections 8, 18, 30, and 38 of the Investment Company Act of 1940 [15 U.S.C. 80a–8, 80a–18, 80a– 29, 80a–37, 80a–63], sections 6, 7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C. 77f, 77g(a), 77j, 77s(a)], and sections 10, 13, 15, 23, and 35A of the Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and 78ll]. C. Small Entities Subject to Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 For purposes of Commission rulemaking in connection with the Regulatory Flexibility Act, an investment company is a small entity if, together with other investment companies in the same group of related investment companies, it has net assets of $50 million or less as of the end of its most recent fiscal year (a ‘‘small fund’’).692 Commission staff estimates that, as of June 2019, approximately 42 registered open-end mutual funds, 8 registered ETFs, 33 registered closedend funds, and 16 BDCs (collectively, 99 funds) are small entities.693 For purposes of Commission rulemaking in connection with the Regulatory Flexibility Act, a brokerdealer is a small entity if it: (1) Had total capital (net worth plus subordinated liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared pursuant to rule 17a–5(d) under the Exchange Act, or, if not required to file such statements, had total capital (net worth plus subordinated liabilities) of less than $500,000 on the last business day of the preceding fiscal year (or in the time that it has been in business, if shorter); and (2) it is not affiliated with any person (other than a natural person) that is not a small business or small organization.694 Commission staff estimates that, as of June 30, 2019, there are approximately 942 broker-dealers that may be considered small entities.695 692 See rule 0–10(a) under the Investment Company Act [17 CFR 270.0–10(a)]. 693 This estimate is derived an analysis of data obtained from Morningstar Direct as well as data reported to the Commission for the period ending June 2019. 694 See rule 0–10(c)(1)–(2) under the Exchange Act [17 CFR 240.0–10(c)(1)(2)]. 695 This estimate is derived from an analysis of data for the period ending June 30, 2019 obtained from Financial and Operational Combined Uniform Single (FOCUS) Reports that broker-dealers generally are required to file with the Commission and/or SROs pursuant to rule 17a–5 under the Exchange Act [17 CFR 240.17a–5]. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 Under Commission rules, and for the purposes of the Advisers Act and the Regulatory Flexibility Act, a registered investment adviser generally is a small entity if it: (1) Has assets under management having a total value of less than $25 million; (2) did not have total assets of $5 million or more on the last day of the most recent fiscal year; and (3) does not control, is not controlled by, and is not under common control with another investment adviser that has assets under management of $25 million or more, or any person (other than a natural person) that had total assets of $5 million or more on the last day of its most recent fiscal year.696 We believe that proposed rule 211(h)–1 would not affect most investment advisers that are small entities (‘‘small advisers’’). Many small advisers would not be affected because they are registered with one or more state securities authorities and not with the Commission. Under section 203A of the Advisers Act, many small advisers are prohibited from registering with the Commission and are regulated by state regulators.697 Of those advisers that are registered with the Commission, we estimate based on IARD data that as of June 30, 2019, approximately 470 SECregistered investment advisers are small entities under the RFA.698 Of these, we estimate that 171 registered investment advisers are small entities that provide advice to individual clients.699 D. Projected Reporting, Recordkeeping, and Other Compliance Requirements 1. Proposed Rule 18f–4 a. Derivatives Risk Management Program, and Board Oversight and Reporting Proposed rule 18f–4 would generally require a fund relying on the rule— including small entities, but not 696 See rule 0–7(a) under the Advisers Act [17 CFR 275.0–7(a)]. 697 15 U.S.C. 80b–3a. 698 Based on SEC registered investment adviser responses to Item 12 of Form ADV. 699 Based on SEC-registered investment adviser responses to Items 5.D.(1)(a)–(b), 5.D.(3)(a)–(b), 5.F and 12 of Form ADV. These responses indicate that: The investment adviser has clients that are high net worth individuals and/or individuals other than high net worth individuals; the investment adviser has regulatory assets under management attributable to clients that are high net worth individuals and/or individuals other than high net worth individuals; and that the investment adviser is a small entity. Firms that are registered as a broker-dealer and an investment adviser are counted in both the total number of small investment advisers and small broker-dealers that would be subject to the new requirements. We believe that counting these firms twice is appropriate because of any additional burdens of complying with the rules with respect to both their advisory and brokerage businesses. PO 00000 Frm 00105 Fmt 4701 Sfmt 4702 4549 including funds that are limited derivatives users—to adopt and implement a derivatives risk management program.700 This risk management program would include policies and procedures reasonably designed to assess and manage the risks of the fund’s derivatives transactions.701 The program requirement is designed to permit a fund to tailor the program’s elements to the particular types of derivatives that the fund uses and related risks, as well as how those derivatives impact the fund’s investment portfolio and strategy. The proposal would require a fund’s program to include the following elements: (1) Risk identification and assessment; (2) risk guidelines; (3) stress testing; (4) backtesting; (5) internal reporting and escalation; and (6) periodic review of the program. The proposed rule also would require: (1) A fund’s board of directors to approve the designation of the fund’s derivatives risk manager and (2) the derivatives risk manager to provide written reports to the board regarding the program’s implementation and effectiveness, including describing any exceedances of the fund’s guidelines and the results of the fund’s stress testing and backtesting.702 As discussed above, we estimate that the one-time operational costs necessary to establish and implement a derivatives risk management program would range from $70,000 to $500,000 per fund, depending on the particular facts and circumstances and current derivatives risk management practices of the fund.703 We also estimate that each fund would incur ongoing program-related costs that range from 65% to 75% of the one-time costs necessary to establish and implement a derivatives risk management program.704 Thus, we estimate that a fund would incur ongoing annual costs associated with proposed rule 18f–4 that would range from $45,500 to $375,000.705 We estimate that approximately 22% of funds would be required to implement a derivatives risk management program, including board oversight.706 We 700 See supra section II.A.2; proposed rule 18f– 4(c)(1). 701 See proposed rule 18f–4(a). 702 See supra sections II.C and III.C.1. 703 See supra section III.C.1. This section, along with sections IV.B.1 and IV.B.2, also discusses the professional skills that we believe compliance with this aspect of the proposal would entail. 704 Id. 705 Id. 706 These are funds that would not be considered limited derivatives users under the proposed rule. See supra sections II.E, III.C.1, IV.B.1 and IV.B.2; infra section V.D.1.c. E:\FR\FM\24JAP2.SGM 24JAP2 4550 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules similarly estimate—applying to small funds the same estimated percentage of funds that would implement a derivatives risk management program— that approximately 22% of small funds (approximately 22 small funds) would establish a derivatives risk management program.707 There are different factors that would affect whether a smaller fund incurs program-related costs that are on the higher or lower end of the estimated range. For example, we would expect that smaller funds—and more specifically, smaller funds that are not part of a fund complex—may not have existing personnel capable of fulfilling the responsibilities of the proposed derivatives risk manager, or may choose to hire a derivatives risk manager rather than assigning that responsibility to a current officer (or officers) of the fund’s investment adviser who is not a portfolio manager. Also, while we would expect larger funds or funds that are part of a large fund complex to incur higher program-related costs in absolute terms relative to a smaller fund or a fund that is part of a smaller fund complex, we would expect a smaller fund to find it more costly, per dollar managed, to comply with the proposed program requirement because it would not be able to benefit from a larger fund complex’s economies of scale.708 b. Limit on Fund Leverage Risk lotter on DSKBCFDHB2PROD with PROPOSALS2 Proposed rule 18f–4 would also generally require a fund relying on the rule—including small entities, but not including funds that are limited derivatives users or that are certain leveraged/inverse funds that the rule describes—to comply with an outer limit on fund leverage risk based on VaR.709 This outer limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a designated reference index. If the fund’s derivatives risk manager is unable to identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test.710 Under the proposed rule, a fund must disclose its designated reference index in its annual report.711 This proposed requirement is designed to limit fund leverage risk consistent with the investor protection purposes underlying section 18. 707 See supra sections III.C.1 and V.C. We estimate that there are 99 small funds that meet the small entity definition. See supra note 692 and accompanying text. 99 small funds × 22% = approximately 22 funds that are small entities. 708 See supra section III.C.1. 709 See supra sections II.D, II.E, and II.G. 710 See supra sections II.D.2, II.D.3. 711 Proposed rule 18f–4(c)(2)(iv). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 As discussed above, we estimate that the one-time operational costs necessary to establish and implement a VaR calculation model consistent with the proposed limit on fund leverage risk would range from $5,000 to $100,000 per fund, depending on the particular facts and circumstances and current derivatives risk management practices of the fund.712 We estimate that approximately 19% of funds would be required to comply with the proposed limit on fund leverage risk.713 We similarly estimate—applying to small funds the same estimated percentage of funds overall that would comply with this requirement—that approximately 19% of small funds (approximately 19 small funds) would be required to comply with the proposed limit on fund leverage risk.714 There are multiple factors that could affect whether the costs that smaller funds would incur in complying with the proposed limit on fund leverage risk would be on the lower versus higher end of this estimated range. To the extent that funds (including smaller funds) have already established and implemented portfolio VaR testing practices and procedures, these funds would incur fewer costs relative to those funds that have not already established and implemented VaR-based analysis in their risk management. If as a result of fewer resources, a smaller fund, and more specifically a smaller fund not part of a fund complex, hired a third-party vendor to comply with the VaR-based limit on fund leverage risk, this could increase costs of complying with the proposed limit for those funds. Finally, costs would vary based on factors such as whether the fund uses multiple types of derivatives or uses derivatives more extensively, whether the fund would be implementing the absolute VaR test versus the relative VaR test, and whether (for a fund that uses the relative VaR test) the fund uses a designated reference index for which the index provider charges a licensing fee.715 712 See supra section III.C.2. This section, along with section IV.B.3, also discusses the professional skills that we believe compliance with this aspect of the proposal would entail. 713 See supra section III.C.2. This estimate excludes both: (1) Limited derivatives users, and (2) funds that are leveraged/inverse investment vehicles under the proposed sales practices rules. Id.; see also supra sections II.E, II.G, III.C.2, III.C.3, III.C.5, and IV.B.3; infra section V.D.1.c. 714 See supra sections III.C.2 and V.C. We estimate that there are 99 small funds that meet the small entity definition. See supra note 692 and accompanying text. 99 small entities × 19% = approximately 19 funds that are small entities. 715 See supra note 202 and accompanying paragraph; note 517 and accompanying sentence. PO 00000 Frm 00106 Fmt 4701 Sfmt 4702 c. Requirements for Limited Derivatives Users Proposed rule 18f–4 includes an exception from the proposed rule’s risk management program requirement and limit on fund leverage risk for ‘‘limited derivatives users.’’ 716 The proposed exception would be available to a fund that either limits its derivatives exposure to 10% of its net assets, or that uses derivatives transactions solely to hedge certain currency risks. Any fund that relies on the proposed exception— small funds as well as large funds— would also be required to adopt policies and procedures that are reasonably designed to manage its derivatives risks. We expect that the risks and potential impact of these funds’ derivatives use may not be as significant, compared to those of funds that do not qualify for the exception, and that a principles-based policies and procedures requirement would appropriately address these risks. These ‘‘reasonably designed’’ policies and procedures would have a scope that that reflects the extent and nature of a fund’s use of derivatives within the parameters that the proposed exception provides. As discussed above, we estimate that the one-time costs to establish and implement policies and procedures reasonably designed to manage a fund’s derivative risks would range from $1,000 to $100,000 per fund, depending on the particular facts and circumstances and current derivatives risk management practices of the fund.717 We also estimate that the ongoing annual costs that a fund that is a limited derivatives user would incur range from 65% to 75% of the one-time costs to establish and implement the policies and procedures. Thus, we estimate that a fund would incur ongoing annual costs associated with the proposed limited derivatives user exception that would range from $650 to $75,000.718 We anticipate that larger funds that are limited derivatives users—or limited derivatives user funds that are part of a large fund complex— would likely experience economies of scale in complying with the proposed requirements for limited derivatives users that smaller funds would not 716 See supra section II.E; proposed rule 18f– 4(c)(3)(i)–(ii). 717 See supra section III.C.3 (discussing the onetime range of costs for implementing the limited derivatives user requirements under proposed rule18f–4 and the variables impacting a fund incurring costs at the lower or higher end of the estimated cost range). This section, along with section IV.B.6, also discusses the professional skills that we believe compliance with this aspect of the proposal would entail. 718 Id. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules necessarily experience.719 Thus, smaller funds that are limited derivatives users could incur costs on the higher end of the estimated range. However, a smaller fund whose derivatives use is limited could benefit from the proposed limited derivatives user exception, because it would not be required to adopt a derivatives risk management program (including all of the proposed program elements), and therefore such a fund could potentially avoid incurring costs and bearing compliance burdens that may be disproportionate to any benefits.720 We estimate that approximately 19% of funds that use derivatives would qualify for the limited derivatives user exception.721 We would expect some small funds to fall within the proposed limited derivatives user exception.722 However, not all small funds that use derivatives would necessarily qualify as limited derivatives users. We estimate— applying to small funds the same estimated percentage of funds overall that would qualify as limited derivatives users—that approximately 19% of small funds that use derivatives (approximately 19 small funds) would comply with the proposed requirements for limited derivatives users under the proposed rule.723 d. Reverse Repurchase Agreements and Unfunded Commitment Agreements Proposed rule 18f–4 would permit a fund to engage in reverse repurchase agreements and other similar financing transactions so long as they are subject to the relevant asset coverage requirements of section 18.724 Because funds are required to rely on the asset segregation approach in Release 10666, the degree to which funds could engage in reverse repurchase agreements under the proposal would generally be the same as under current practice. Therefore we do not estimate a significant compliance burden—either for small funds that engage in reverse repurchase agreements or for larger funds—associated with the proposed provisions regarding reverse repurchase 719 See supra note 707 and accompanying text. supra section II.E. 721 Id. This estimate excludes both: (1) Funds that would comply with the derivatives risk management program, and (2) funds that would be leveraged/inverse investment vehicles under proposed rule 15l–2. See also supra sections II.A.2, II.E, II.G, III.C.1, III.C.3, III.C.5, IV.B.4, and V.D.1.a. 722 Id.; see also supra section III.C.3. 723 Id.; see also supra sections III.C.3 and V.C. We estimate that there are 99 small funds that meet the small entity definition. See supra note 692 and accompanying text. 99 small entities × 19% = approximately 19 funds that are small entities. 724 See supra section II.I. lotter on DSKBCFDHB2PROD with PROPOSALS2 720 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 agreements in rule 18f–4.725 For large and small funds subject to the proposed limit on fund leverage risk, any portfolio leveraging effect of reverse repurchase agreements or similar financing transactions would be included and restricted through the proposed VaRbased limits, and therefore would incrementally affect the costs associated with complying with these limits.726 The proposed rule also includes a provision that codifies an approach for funds’ participation in unfunded commitment agreements in light of the concerns underlying section 18.727 Proposed rule 18f–4 would permit a fund to enter into unfunded commitment agreements if it reasonably believes, at the time it enters into such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as they come due. The proposed rule would prescribe factors that a fund must consider in forming such a reasonable belief. If a fund enters into unfunded comment agreements in compliance with this requirement, the proposed rule specifies that unfunded commitment agreements will not be considered for purposes of computing asset coverage, as defined in section 18(h) of the Investment Company Act. This proposed approach for unfunded commitment agreements reflects the staff’s experience in reviewing and commenting on fund registration statements, as discussed above.728 We therefore do not expect that the proposed approach would result in significant costs to small or large funds because we believe the proposed approach is generally consistent with the current practices of funds that enter into unfunded commitment agreements. e. Recordkeeping Proposed rule 18f–4 includes certain recordkeeping provisions that are designed to provide the Commission’s staff, and the fund’s board of directors and compliance personnel, the ability to evaluate the fund’s compliance with the proposed rule’s requirements.729 The proposed rule would require a fund to maintain certain records documenting its derivatives risk management program, including a written record of: (1) Its policies and procedures designed to manage the fund’s derivatives risks, (2) the results of any stress testing of its portfolio, (3) the results of any VaR test 725 See supra section III.C.4. supra section II.I. 727 See supra section II.J. 728 See id. 729 See supra section II.K. 726 See PO 00000 Frm 00107 Fmt 4701 Sfmt 4702 4551 backtesting it conducts, (4) records documenting any internal reporting or escalation of material risks under the program, and (5) records documenting any periodic reviews of the program.730 Second, the proposed rule would also require a fund to maintain a written record of any materials provided to the fund’s board of directors in connection with approving the designation of the derivatives risk manager. The proposed rule would also require a fund to keep records of any written reports provided to the board of directors relating to the program, and any written reports provided to the board that the rule would require regarding the fund’s noncompliance with the applicable VaR test.731 Third, a fund that is required to comply with the proposed VaR test would also have to maintain written records documenting the determination of: Its portfolio VaR; the VaR of its designated reference index, as applicable; its VaR ratio (the value of the VaR of the Fund’s portfolio divided by the VaR of the designated reference index), as applicable; and any updates to the VaR calculation models used by the fund, as well as the basis for any material changes made to those models.732 Fourth, the proposed rule would require a fund that is a limited derivatives user to maintain a written record of its policies and procedures that are reasonably designed to manage its derivatives risks.733 Finally, a fund that enters into unfunded commitment agreements would be required to maintain a records documenting the basis for the fund’s belief regarding the sufficiency of its cash and cash equivalents to meet its obligations with respect to its unfunded commitment agreements.734 A record must be made each time a fund enters into such an agreement.735 As discussed above, we estimate that the average one-time recordkeeping costs for funds that would not qualify as limited derivatives users would be $2,047 per fund, depending on the particular facts and circumstances and current derivatives risk management practices of the fund.736 We also 730 See proposed rule 18f–4(c)(6)(i)(A). proposed rule 18f–4(c)(6)(i)(B). 732 See proposed rule 18f–4(c)(6)(i)(C). 733 See proposed rule 18f–4(c)(6)(i)(D). 734 See proposed rule 18f–4e)(2); see also supra note 429 and accompanying text. 735 Id.; see also supra note 430 and accompanying text. 736 See supra section III.C.8. This section, along with section IV.B.7, also discusses the professional skills that we believe compliance with this aspect of the proposal would entail. 731 See E:\FR\FM\24JAP2.SGM 24JAP2 4552 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules estimate that such a fund would incur an average ongoing annual recordkeeping costs of $330.737 We further estimate that the one-time and ongoing annual recordkeeping costs for a limited derivatives user to be 90% of those for funds that do not qualify as limited derivatives users.738 Thus, for each fund that could rely on the limited derivatives user exception, we estimate a one-time cost of $1,842 and an ongoing cost of $297 per year.739 To the extent that we estimate that small funds would be subject to the various provisions of the proposed rule that would necessitate recordkeeping requirements, as discussed above, these small funds also would be subject to the associated proposed recordkeeping requirements. Therefore, we estimate that: 22% of small funds (approximately 22 small funds) would have to comply with the program-related recordkeeping requirements and requirements regarding materials provided to the fund’s board; 19% of small funds (approximately 19 small funds) would have to comply with requirements to maintain records of compliance with the proposed VaR test; and 19% of small funds (approximately 19 funds) would have to comply with the recordkeeping requirements for limited derivatives users.740 A fund’s recordkeeping-related costs will vary, depending on the provisions of proposed rule 18f–4 that the fund relies on. For example, funds that are required to adopt derivatives risk management programs, versus funds that are limited derivatives users under the proposed rule, would be subject to different recordkeeping requirements. However, while small funds’ recordkeeping burdens would vary based on the provisions of the proposed rule that a fund relies on, their recordkeeping burdens would not vary solely because they are small funds. We do not anticipate that larger funds, or funds that are part of a large fund complex, would experience any significant economies of scale related to the proposed recordkeeping requirements. lotter on DSKBCFDHB2PROD with PROPOSALS2 2. Proposed Amendments to Forms N– PORT, N–LIQUID, and N–CEN a. Proposed Amendments to Form N– PORT The proposed amendments to Form N–PORT would require funds to report information about their derivatives 737 Id. 738 Id. 739 Id. 740 See supra sections III.C.1, III.C.2, III.C.3, V.D.1.a, V.D.1.b, and V.D.1.c. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 exposure, and also—as applicable for funds that are subject to the proposed rule 18f–4 VaR-based limit on fund leverage risk—to report certain VaRrelated information.741 These proposed amendments would provide marketwide insight into the levels of reporting funds’ derivatives exposure to the Commission, its staff, and market participants at the specific points in time covered by the reporting. They also would help the Commission and its staff assess compliance with proposed rule 18f–4. All funds that file Form N–PORT would have to provide information regarding their derivatives exposure on this form. We estimate that 41% of small funds that file Form N–PORT (approximately 34 small funds) use derivatives, and thus only these funds would have substantive information to report in response to this new exposurerelated disclosure requirement.742 In addition, funds that are subject to the proposed limit on fund leverage risk would have to report: (1) The fund’s highest daily VaR during the reporting period and its corresponding date; and (2) the fund’s median daily VaR for the reporting period. Funds subject to the relative VaR test during the reporting period also would have to report: (1) The name of the fund’s designated reference index, (2) the index identifier, (3) the fund’s highest daily VaR ratio during the reporting period and its corresponding date; and (4) the fund’s median daily VaR ratio for the reporting period. A fund would be required to determine its compliance with its applicable VaR test once each business day.743 741 See supra section II.H.1; see also proposed Items B.9 and B.10 of Form N–PORT. 742 See supra sections V.C, V.D.1.a, and V.D.1.c. Because BDCs do not file reports on Form N–PORT, we deduct the number of BDCs from the total number of small funds that we estimate (99 small funds¥16 BDCs that are small entities = 83 small funds that file reports on Form N–PORT). See supra note 692 and accompanying text. We estimate that approximately 22% of funds would be subject to the proposed rule’s derivatives risk management program requirements and approximately 19% of funds would be subject to either of the limited derivatives user exceptions, with funds from both groups subject to reporting requirements on Form N–PORT. See supra notes 706, 720, and accompanying text. Although both of these estimated percentages include BDCs, we note that the total number of BDCs relative to the number of registered open- and closed-end funds is small, and therefore our estimates do not adjust these percentages to reflect the fact that BDCs do not file Forms N–PORT. See supra section III.B.1. Therefore, we estimate the total number of small funds subject to the proposed Form N–PORT requirements as follows: 83 small funds that file reports on Form N–PORT × (22% + 19% = 41%) = 34 small funds. 743 See supra note 364. PO 00000 Frm 00108 Fmt 4701 Sfmt 4702 All funds that are subject to the proposed limit on fund leverage risk also would have to report the number of exceptions that the fund identified as a result of the backtesting of its VaR calculation model. We estimate that 19% of small funds (approximately 16 small funds) would be subject to these VaR-related disclosure requirements.744 We estimate that each fund that reports information in response to the proposed VaR-related disclosure requirements on Form N–PORT would incur a one-time cost of $2,784 and an ongoing cost of $4,176 per year, and each fund that is not subject to the VaRrelated disclosure requirement would incur a one-time cost of $1,392 and an ongoing cost of $2,088 per year.745 Notwithstanding the economies of scale experienced by large versus small funds, we would not expect the costs of compliance associated with the new Form N–PORT requirements to be meaningfully different for small versus large funds. The costs of compliance would vary only based on fund characteristics tied to their derivatives use. For example, a fund that uses derivatives extensively would incur more costs to calculate its derivatives exposure than a fund that does not use derivatives extensively.746 And a fund that is a limited derivatives user, or that otherwise is not subject to the proposed VaR test, would not incur any costs to comply with the proposed new VaRrelated N–PORT items.747 b. Proposed Amendments to Form N– LIQUID We are proposing to re-title Form N– LIQUID as Form N–RN, and amend this form to include new reporting events for funds that are subject to proposed rule 18f–4’s limit on fund leverage risk.748 The proposed amendments would require funds subject to the limit on fund leverage risk to report information 744 We estimate 83 small funds that file reports on Form N–PORT. See supra note 741. We estimate that approximately 19% of funds would be subject to the proposed limit on fund leverage risk. See supra note 712 and accompanying text. Although this estimated percentage include BDCs, we note that the total number of BDCs relative to the number of registered open- and closed-end funds is small, and therefore our estimate does not adjust this percentage to reflect the fact that BDCs do not file Forms N–PORT. See supra section III.B.1. Therefore, we estimate the total number of small funds that would make VaRrelated disclosures on Form N–PORT as follows: 83 small funds that file reports on Form N–PORT × 19% = approximately 16 small funds. 745 See supra section III.C.9.a.; see also supra section IV.F (discussing the professional skills that we believe compliance with this aspect of the proposal would entail). 746 See supra note 714. 747 See proposed Item B.10 to Form N–PORT. 748 See supra section II.H.2. E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules about VaR test breaches under certain circumstances. These proposed current reporting requirements are designed to aid the Commission in assessing funds’ compliance with the VaR tests, and to provide staff the ability to assess how long a fund is precluded from entering into derivatives transactions as a consequence of its lack of compliance with its VaR test. We are proposing to require funds to provide this information in a current report because we believe that the Commission should be notified promptly when a fund is out of compliance with the proposed VaRbased limit on fund leverage risk (and also when it has come back into compliance with its applicable VaR test). We believe this information could indicate that a fund is experiencing heightened risks as a result of a fund’s use of derivatives transactions, as well as provide the Commission insight about the duration and severity of those risks, and whether those heightened risks are fund-specific or industry-wide. As discussed above, we estimate that each fund subject to the proposed new current reporting requirements would incur an average cost of $10 per year to prepare amended Form N–RN.749 We estimate that approximately 19 registered open- and closed-end funds, and BDCs, are small entities that would be required to report VaR test related information on Form N–RN.750 Because the proposed amendments to Form N– RN would require both large and small funds to report VaR test breaches, the burden to report is not associated with fund size, and consequently, we would not expect the costs of compliance with the new Form N–RN requirements to be meaningfully different for small versus large funds. lotter on DSKBCFDHB2PROD with PROPOSALS2 c. Proposed Amendments to Form N– CEN The proposed amendments to Form N–CEN would require a fund to identify whether it relied on proposed rule 18f– 4 during the reporting period.751 The proposed amendments also would require a fund to identify whether it relied on any of the exemptions from 749 See supra section III.C.9.b; see also supra section IV.G (discussing the professional skills that we believe compliance with this aspect of the proposal would entail). 750 This estimate is based on an estimate that 16 small registered open- and closed-end funds would make VaR-related disclosures on Form N–PORT (see supra note 743 and accompanying text), plus 3 BDCs (16 total small BDCs (see supra note 692 and accompanying text) × 19% (our estimate of the percentage of funds subject to a VaR-based limit on fund leverage risk, see supra note 712 and accompanying text) = approximately 3 BDCs). Thus, 16 small registered open- and closed-end funds + 3 BDCs = 19 funds. 751 See supra section II.H.3. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 various requirements under the proposed rule, specifically: (1) Whether the fund is a limited derivatives user excepted from the proposed rule’s program requirement, under either of the proposed exception’s alternatives (either a funds that limits its derivatives exposure to 10% of its net assets, or a fund that uses derivatives transactions solely to hedge certain currency risks); or (2) whether it is a leveraged/inverse fund covered by the proposed sales practices rules that, under proposed rule 18f–4, would be excepted from the proposed limit on fund leverage risk. Finally, a fund would have to identify whether it has entered into reverse repurchase agreements or similar financing transactions, or unfunded commitment agreements, as provided under the proposed rule.752 The proposed amendments to Form N–CEN are designed to assist the Commission and staff with our oversight functions by allowing us to identify which funds were excepted from certain of the proposed rule’s provisions or relied on the rule’s provisions regarding reverse repurchase agreements and unfunded commitment agreements. As discussed above, we estimate that each fund subject to the proposed new Form N–CEN reporting requirements would incur on average an ongoing annual cost of $6.96 per year.753 We estimate that approximately 34 registered open- and closed-end funds are small entities that would be subject to the proposed new Form N–CEN reporting requirements.754 752 See proposed Item C.7.l.iv–v of Form N–CEN; see also supra section II.I and II.J; proposed rule 18f–4(d); and proposed rule 18f–4(e). 753 See supra section III.C.9.a; see also supra section IV.H (discussing the professional skills that we believe compliance with this aspect of the proposal would entail). 754 Because BDCs do not file reports on Form N– CEN, we deduct the number of BDCs from the total number of small funds that we estimate (99 small funds ¥ 16 BDCs that are small entities = 83 small funds that file reports on Form N–CEN). See supra note 692 and accompanying text. The estimate of 34 funds is based on the percentage of funds we believe would be subject to the proposed derivatives risk management program requirement (22% of funds, see supra note 498 and accompanying text) plus the percentage of funds we believe would qualify as limited derivatives users (19% of funds, see supra note 720 and accompanying text). We estimate that 83 small funds that file reports on Form N–CEN (99 total small funds less 16 small BDCs) × 41% (22% + 19%) = 34 small funds subject to the proposed Form N–CEN reporting requirements. To the extent that there are funds that either (1) would not adopt a derivatives risk management program or (2) would not qualify as limited derivatives user, but that would rely on the rule’s provisions with respect to reverse repurchase agreements or unfunded commitment agreements, this analysis might underestimate the number of funds that would be subject to the new Form N–CEN reporting requirements. PO 00000 Frm 00109 Fmt 4701 Sfmt 4702 4553 Notwithstanding any economies of scale experienced by large versus small funds, we would not expect the costs of compliance with the new Form N–CEN requirements to be meaningfully different for small versus large funds. 3. Proposed Sales Practices Rules The proposed sales practices rules under the Exchange Act and the Advisers Act would require a firm to exercise due diligence in determining whether to approve the account of a retail investor to buy or sell shares of a leveraged/inverse investment vehicle before accepting an order from, or placing an order for, the retail investor to engage in these transactions.755 Under the proposed sales practices rules, no firm may accept an order from or place an order for a retail investor to buy or sell shares of a leveraged/inverse investment vehicle, or approve such an investor’s account to engage in those transactions, unless the firm has complied with certain conditions. Specifically, the proposed sales practices rules would require the firm to: (1) Approve the retail investor’s account for buying and selling shares of leveraged/inverse investment vehicles pursuant to a due diligence requirement; and (2) adopt and implement policies and procedures reasonably designed to achieve compliance with the proposed rules.756 The proposed sales practices rules’ due diligence requirements provide that a firm must exercise due diligence to ascertain the essential facts relative to the retail investor, his or her financial situation, and investment objectives. A firm must seek to obtain, at a minimum, certain specified information about the retail investor. The proposed sales practices rules also include recordkeeping requirements relating to the information that the firm obtained through its due diligence, the firm’s approval or disapproval of the retail investor’s account for buying and selling shares of leveraged/inverse investment vehicles (account approvals must be in writing), and the firm’s policies and procedures that it adopted pursuant to those rules.757 The proposed sales practices rules are designed to establish a uniform set of enhanced due diligence and account approval requirements for all leveraged/ inverse investment vehicle transactions, including transactions where no recommendation or investment advice is provided by a firm. They also are designed in part to help to ensure that 755 See supra section II.G.1. supra section II.G.2.b. 757 See supra section II.G.2.c. 756 See E:\FR\FM\24JAP2.SGM 24JAP2 4554 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules lotter on DSKBCFDHB2PROD with PROPOSALS2 investors in these funds are limited to those who understand their characteristics—including that these funds would not be subject to all of the leverage-related requirements applicable to registered investment companies generally—and the unique risks they present. As discussed above, we estimate that each broker-dealer subject to proposed rule 15l–2, and each investment adviser subject to proposed rule 211(h)–1, would incur total one-time costs that would range from $9,115.50 to $15,192.50 to comply with the proposed rules, and total ongoing costs that would range from $2,270.50 to $3,915 per year to comply with the proposed rules.758 We estimate that approximately 236 broker-dealers and 43 registered investment advisers are small entities that would be subject to the proposed sales practices rules.759 The costs that broker-dealers and investment advisers may incur as a result of the proposed sales practices rules would vary depending on the firm and the due diligence requirements that the firm adopts as a result of the proposed rules’ requirements.760 We expect that economies of scale among larger firms could result in cost reductions for larger firms. Compliance costs could, however, be different across firms with relatively smaller or larger 758 See supra notes 539 and 543 and accompanying text. This discussion, along with sections IV.C and IV.D supra, also discusses the professional skills that we believe compliance with this aspect of the proposal would entail. 759 We estimate there are currently 942 small broker-dealers. See supra note 694 and accompanying text. We further estimate that 700 broker-dealers (or 25% of all 2,766 broker-dealers registered with the Commission) have retail customer accounts that invest in leveraged/inverse investment vehicles. See supra section III.C.5. Our estimate of 236 broker-dealers is based on the following calculation: 942 small broker dealers × 25% = approximately 236 small broker-dealers that have retail customer accounts that invest in leveraged/inverse investment vehicles. We estimate that there are currently 470 SECregistered investment advisers that are small entities. See supra note 697 and accompanying text. Of these, we estimate that 171 provide advice to individual clients, and could therefore be subject to the proposed new sales practices rules under the Advisers Act. See supra note 698 and accompanying text. We further estimate that 2,000 investment advisers (or approximately 25% of the 8,235 investment advisers that are registered with the Commission and offer some part of their business to retail investors) have retail client accounts that invest in leveraged/inverse investment vehicles. See supra sections III.C.5 and IV.D. Our estimate of 43 investment advisers is based on the following calculation: 171 small investment advisers that provide advice to individual clients × 25% = approximately 43 small investment advisers that have retail client accounts that invest in leveraged/inverse investment vehicles. 760 See supra section III.C.5 (discussing costs and benefits of proposed sales practices rules). VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 numbers of retail investors as customers or clients.761 4. Proposed Amendments to Rule 6c–11 We are proposing to amend rule 6c– 11 to remove the provision excluding leveraged/inverse ETFs from the scope of that rule and to newly permit leveraged/inverse ETFs to rely on that rule.762 Rule 6c–11 permits ETFs that satisfy certain conditions to operate without obtaining an exemptive order from the Commission.763 The rule is designed to create a consistent, transparent, and efficient regulatory framework for such ETFs and facilitate greater competition and innovation among ETFs. As a consequence of our proposed amendment to rule 6c–11, and proposal to rescind the exemptive orders we have previously issued to leveraged/inverse ETFs, these proposed amendments would newly permit leveraged/inverse ETFs to come within scope of the rule’s exemptive relief. Currently, there are 73 leveraged/ inverse ETFs.764 As a result of the proposed amendments, we would expect the number of funds relying on rule 6c–11 to increase, and we estimate that all 73 leveraged/inverse ETFs would newly seek to use rule 6c–11. We also estimate, for purposes of this Regulatory Flexibility Act analysis, that approximately 1 of these leveraged/ inverse ETFs would be a small leveraged/inverse ETF that would seek to rely on rule 6c–11.765 We do not estimate our amendments to rule 6c–11 would change the estimated per-fund cost burden associated with rule 6c–11, but we do believe the number of funds using the rule, as a result of our amendment, would now increase.766 The costs associated with complying with rule 6c–11 are discussed in the ETFs Adopting Release.767 E. Duplicative, Overlapping, or Conflicting Federal Rules Commission staff has not identified any federal rules that duplicate, overlap, or conflict with proposed Investment Company Act rule 18f–4, proposed 761 See supra section II.G.2.b (discussing required approval and due diligence for retail investors’ accounts to trade shares of leveraged/inverse investment vehicles under the proposed sales practices rules). 762 See supra section II.G.4. 763 Id. 764 See supra note 467. 765 This estimate is based on the following calculation: 8 small ETFs/1,190 total ETFs = approximately 0.67% of ETFs that are small ETFs. See supra sections III.B.1 and V.C. 0.67% of 73 leveraged/inverse ETFs = approximately 1 leveraged/inverse ETF. 766 See supra section IV.E. 767 See ETFs Adopting Release, supra note 76, at section IV. PO 00000 Frm 00110 Fmt 4701 Sfmt 4702 Exchange Act rule 15l–2, proposed Advisers Act rule 211(h)–1, or the proposed amendments to Form N– PORT, Form N–LIQUID, and Form N– CEN. We recognize that other broker-dealer or investment adviser obligations require these entities to engage in due diligence with respect to transactions they recommend to customers or clients. The proposed sales practices rules, in contrast, would apply regardless of whether a broker-dealer or investment adviser recommends that a customer or client buy or sell leveraged/inverse investment vehicles. We therefore do not believe that the sales practices rules would conflict with existing brokerdealer or investment adviser obligations, and believe that any overlap or duplication should be limited because a broker-dealer or investment adviser could consider the information it collects in connection with the sales practices rules in connection with the due diligence the broker-dealer or investment adviser conducts in connection with other, existing obligations for recommended transactions. F. Significant Alternatives The Regulatory Flexibility Act directs the Commission to consider significant alternatives that would accomplish our stated objectives, while minimizing any significant economic impact on small entities. We considered the following alternatives for small entities in relation to our proposal: (1) Exempting funds, broker-dealers, and registered investment advisers that are small entities from the proposed reporting, recordkeeping, and other compliance requirements, to account for resources available to small entities; (2) establishing different reporting, recordkeeping, and other compliance requirements or frequency, to account for resources available to small entities; (3) clarifying, consolidating, or simplifying the compliance requirements under the proposal for small entities; and (4) using performance rather than design standards. 1. Proposed Rule 18f–4 We do not believe that exempting small funds from the provisions in proposed rule 18f–4 would permit us to achieve our stated objectives. Because proposed rule 18f–4 is an exemptive rule, it would require funds to comply with new requirements only if they wish to enter into derivatives or certain other transactions.768 Therefore, if a 768 See E:\FR\FM\24JAP2.SGM supra sections II.D.6 and III.E. 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules small entity does not enter into derivatives or such other transactions as part of its investment strategy, then the small entity would not be subject to the provisions of proposed rule 18f–4. In addition, a small fund whose derivatives use is limited could benefit from the proposed limited derivatives user exception, because it would not be required to adopt a derivatives risk management program (including all of the proposed program elements). We estimate that 59% of all funds do not have any exposure to derivatives or such other transactions.769 This estimate indicates that many funds, including many small funds, would be unaffected by the proposed rule. However, for small funds that would be affected by our proposed rule, providing an exemption for them could subject investors in small funds that invest in derivatives or engage in such other transactions to a higher degree of risk than investors to large funds that would be required to comply with the proposed elements of the rule. The undue speculation concern expressed in section 1(b)(7) of the Investment Company Act, and the asset sufficiency concern reflected in section 1(b)(8) of the Act—both of which the proposed rule is designed to address— apply to both small as well as large funds. As discussed throughout this release, we believe that the proposed rule would result in investor protection benefits, and these benefits should apply to investors in smaller funds as well as investors in larger funds. We therefore do not believe it would be appropriate to exempt small funds from the proposed rule’s program requirement or VaR-based limit on fund leverage risk, or to establish different requirements applicable to funds of different sizes under these provisions to account for resources available to small entities. We believe that all of the proposed elements of rule 18f–4 should work together to produce the anticipated investor protection benefits, and therefore do not believe it is appropriate to except smaller funds because we believe this would limit the benefits to investors in such funds. We also do not believe that it would be appropriate to subject small funds to different reporting, recordkeeping, and other compliance requirements or frequency. Similar to the concerns discussed above, if the proposal included different requirements for small funds, it could raise investor protection concerns for investors in small funds including subjecting small 769 See supra note 458 and accompanying paragraph. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 fund investors to a higher degree of risk if the small fund uses derivatives transactions. We also believe that all fund investors will benefit from enhanced Commission monitoring and oversight of the fund industry, which we anticipate will result from the disclosure and reporting requirements. We do not believe that clarifying, consolidating, or simplifying the compliance requirements under the proposal for small funds would permit us to achieve our stated objectives. Again, this approach would raise investor protection concerns for investors in small funds using derivatives transactions. However, as discussed above, the proposed rule contains an exception for limited derivatives users that we anticipate would subject funds that qualify for this exception to fewer compliance burdens. We recognize that the risks and potential impact of derivatives transactions on a fund’s portfolio generally increase as the fund’s level of derivatives usage increases and when funds use derivatives for speculative purposes. Therefore the proposed rule would entail a less significant compliance burden for funds— including small funds—that choose to limit their derivatives usage in the manner that the proposed exception specifies. The proposal, therefore, does include provisions designed to consider the requirement burdens based on the fund’s use of derivatives (rather than the size of the fund). The costs associated with proposed rule 18f–4 would vary depending on the fund’s particular circumstances, and thus the proposed rule could result in different burdens on funds’ resources. In particular, we expect that a fund that pursues an investment strategy that involves greater derivatives risk may have greater costs associated with its derivatives risk management program. For example, a fund that qualifies as a limited derivatives user under the proposed rule would be exempt from the proposed requirements to adopt and implement a derivatives risk management program, and to adhere to the proposed rule’s VaR-based limit on fund leverage risk. The costs of compliance with the proposed rule would vary even for limited derivatives users, as these funds would be required to adopt policies and procedures that are ‘‘reasonably designed’’ to manage their derivatives risks. Thus, to the extent a fund that is a small entity faces relatively little derivatives risk, we believe it would incur relatively low costs to comply with the proposed rule. However, we believe that it is appropriate to correlate the costs PO 00000 Frm 00111 Fmt 4701 Sfmt 4702 4555 associated with the proposed rule with the level of derivatives risk facing a fund, and not necessarily with the fund’s size in light of our investor protection objectives. Finally, with respect to the use of performance rather than design standards, the proposed rule generally uses performance standards for all funds relying on the proposed rule, regardless of size. We believe that providing funds with the flexibility with respect to investment strategies and use of derivatives transactions is appropriate, as well as the derivatives risk management program design. However, the proposed rule also uses design standards with respect to certain requirements such as complying with the VaR-based limit on fund leverage risk and the specified program elements in the derivatives risk management program. For the reasons discussed above, we believe that this use of design standards is appropriate to address investor protection concerns, particularly the concerns expressed in sections 1(b)(7), 1(b)(8), and 18 of the Investment Company Act. 2. Proposed Sales Practices Rules Similarly, we do not believe that exempting any subset of broker-dealers or registered investment advisers, including those firms that are small entities, from the provisions in the proposed sales practices rules would permit us to achieve our stated investor protection objectives. We also do not believe that it would be desirable to establish different requirements applicable to firms of different sizes under the proposed sales practices rules to account for resources available to small entities, to consolidate or simplify the compliance requirements under the proposal for small entities, or to use performance standards rather than design standards for small entities. We do not believe exempting small broker-dealers and investment advisers from the proposed sales practices rules would serve the interest of investors. As we discussed above, leveraged/inverse investment vehicles present unique considerations, and the proposed sales practices rules are designed in part to address the investor protection concerns leveraged/inverse funds present.770 The proposed sales practices rules would permit broker-dealers and investment advisers to accept or place orders to buy or sell shares of a ‘‘leveraged/inverse investment vehicle’’ only for investors that they have approved for those transactions, based on certain required 770 See E:\FR\FM\24JAP2.SGM supra section II.G. 24JAP2 4556 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules criteria.771 Exempting smaller brokerdealer and investment adviser firms would create a regulatory gap, whereby larger funds would be required to comply with the proposed sales practices rules’ due diligence requirements to determine whether to approve the account of retail investor to buy or sell shares of a leveraged/inverse investment vehicle, and small entities would not need to conduct this same diligence. As discussed above, we believe that this limitation on leveraged/inverse investment vehicles’ investor base would help provide that investors in these vehicles understand the characteristics of these vehicles and the unique risks they present.772 Providing different requirements or simplifying the requirements for small entities would dilute these investor protection benefits for customers or clients of small entities. We do not believe that the investor protection benefits of the proposed sales practices rules should depend on whether an investor is transacting through a small or a large firm. Furthermore, a broker-dealer or investment adviser would have to comply with the applicable proposed rule’s requirements only if it transacts with retail investors in the shares of leveraged/inverse investment vehicles.773 Finally, we are not proposing performance standards rather than design standards for smaller entities. We believe that subjecting smaller entities to different standards under the proposed rules could lead to inconsistency in how investors would transact in leveraged/inverse investment vehicles, depending on whether the investor has a relationship with a large or small broker-dealer or investment adviser. This would be inconsistent with the regulatory and investor protections purposes of the proposed rules and could subject investors who interact with small firms to a higher degree of risk than investors who interact with larger firms. It could also circumvent the proposed rules’ ability to establish a uniform set of enhanced due diligence and approval requirements for all leveraged/inverse 771 See proposed rule 15l–2(b). supra section II.G. 773 We estimate that approximately 236 brokerdealers and 43 registered investment advisers are small entities that would be subject to the proposed sales practices rules. See supra note 758 and accompanying text. Broker-dealers and investment advisers that would have to comply with the proposed sales practices rules also might currently have processes in place that would provide efficiencies in complying with the proposed rules. See supra note 536 and accompanying text. lotter on DSKBCFDHB2PROD with PROPOSALS2 772 See VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 investment vehicle transactions, and to address the investor protection concerns underlying section 18 for leveraged/ inverse funds by limiting their investor base. 3. Proposed Amendments to Forms N– PORT, N–LIQUID, and N–CEN We do not believe that the interests of investors would be served by exempting funds that are small entities from the proposed disclosure and reporting requirements. We believe that the form amendments are necessary to help identify and provide the Commission, staff, investors, and other market participants timely information about funds that comply with proposed rule 18f–4, and to realize the anticipated benefits of the proposed reporting requirements.774 Exempting small funds from coverage under all or any part of the proposed form amendments could compromise the effectiveness of the required disclosures, which the Commission believes would not be consistent with its goals of industry oversight and investor protection. We believe that all fund investors, including investors in small funds, would benefit from disclosure and reporting requirements that would permit them to make investment choices that better match their risk tolerances. We also believe that all fund investors would benefit from enhanced Commission monitoring and oversight of the fund industry, which we anticipate would result from the proposed disclosure and reporting requirements. For similar reasons, we do not believe that the interests of investors would be served by establishing different reporting, recordkeeping, or other compliance requirements for small funds. We considered providing small funds simplified compliance or disclosure requirements. However, we believe this too would subject investors in small funds that invest in derivatives to a higher degree of risk and information asymmetry than investors to large funds that would be required to comply with the proposed disclosure requirements. We also note that registered open- and closed-end management investment companies, including those that are small entities, have already updated their systems and have established internal processes to prepare, validate, and file reports on Forms N–PORT and N–CEN (or will do so shortly).775 For funds that will be 774 See supra section III.C.9. supra note 359 (discussing, among other things, Form N–PORT compliance dates and noting that the funds that would rely on proposed rule 18f–4 (if adopted) other than BDCs generally are subject to reporting requirements on Form N–CEN); 775 See PO 00000 Frm 00112 Fmt 4701 Sfmt 4702 required to file reports on Form N–RN, the vast majority of them are open-end funds, which already are required to submit the form upon specified events. With respect to the additional registered closed-end funds and BDCs newly required to file reports on Form N–RN, we do not believe they would need more time to comply with the new reporting requirements, given the limited set of reporting requirements they would be subject to and the relatively low burden we estimate of filing reports on Form N–RN. We also do not believe that the interests of investors would be served by clarifying, consolidating, or simplifying the compliance requirements under the proposal for small funds. Small funds are as vulnerable to the same potential risks associated with their derivatives use as larger funds are, and therefore we believe that simplifying or consolidating the proposed reporting requirements for small funds would not allow us to meet our stated objectives. Moreover, we believe many of the proposed disclosure requirements involve minimal burden. For example, the Form N–CEN ‘‘checking a box’’ reporting requirement is completed on an annual basis. Finally, we did not prescribe performance standards rather than design standards for small funds because we believe this too could diminish the ability of the proposed rules to achieve their intended regulatory purpose by creating inconsistent reporting requirements between small and large funds, and weakening the benefits of the proposed reporting requirement for investors in small funds. 4. Rule 6c–11 Rule 6c–11 is designed to modernize the regulatory framework for ETFs and to create a consistent, transparent, and efficient regulatory framework.776 The Commission’s full Regulatory Flexibility Act Analysis regarding rule 6c–11, including analysis of significant alternatives, appears in the 2019 ETFs Adopting Release and the 2018 ETFs Proposing Release.777 Our analysis of alternatives for small leveraged/inverse ETFs here is consistent with the Commission’s analysis of alternatives for small ETFs in those releases. see also Investment Report Modernization Adopting Release supra note 178, at section II.H. 776 See ETFs Adopting Release, supra note 76, at section I. 777 See id. at section VI; see also Exchange-Traded Funds, Investment Company Act Release No. 10515 (June 28, 2018) [83 FR 37332 (July 31, 2018)] (‘‘ETFs Proposing Release’’), at section V. E:\FR\FM\24JAP2.SGM 24JAP2 4557 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules We do not believe that permitting or requiring different treatment for any subset of leveraged/inverse ETFs, including small leveraged/inverse ETFs, under the proposed amendments to rule 6c–11, and the rule’s related recordkeeping, disclosure and reporting requirements, would permit us to achieve our stated objectives. Similarly, we do not believe that we can establish simplified or consolidated compliance requirements for small leveraged/ inverse ETFs under the proposed amendments to rule 6c–11 without compromising our objectives. The Commission discussed the bases for this determination (with respect to ETFs other than leveraged/inverse ETFs) in more detail in the ETFs Proposing Release and the ETFs Adopting Release, and we are extending that analysis to leveraged/inverse ETFs in this Initial Regulatory Flexibility Act Analysis. In addition, we do not believe it would be appropriate to exempt small leveraged/ inverse ETFs from the proposed amendments to rule 6c–11 (or to establish different disclosure, reporting, or recordkeeping requirements, or simplified or consolidated compliance requirements under rule 6c–11 for these entities) because of the particular risks that leveraged/inverse ETFs may present.778 We also do not think it would be appropriate to establish different requirements under rule 6c–11 for small leveraged/inverse ETFs, which could produce a competitive advantage for these funds compared to larger leveraged/inverse ETFs (and compared to other ETFs that rely on the rule). This would conflict with our goals of creating a consistent, transparent, and efficient regulatory framework for ETFs and to facilitate greater competition and innovation among ETFs. lotter on DSKBCFDHB2PROD with PROPOSALS2 G. Request for Comment The Commission requests comments regarding this analysis. We request comment on the number of small entities that would be subject to our proposal and whether our proposal would have any effects that have not been discussed. We request that commenters describe the nature of any effects on small entities subject to our proposal and provide empirical data to support the nature and extent of such effects. We also request comment on the estimated compliance burdens of our proposal and how they would affect small entities. 778 See supra section II.G.1. VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 VI. Consideration of Impact on the Economy Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and 78ll]. For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996 (‘‘SBREFA’’), the Commission must advise OMB whether a proposed regulation constitutes a ‘‘major’’ rule. Under SBREFA, a rule is considered ‘‘major’’ where, if adopted, it results in or is likely to result in: • An annual effect on the economy of $100 million or more; • A major increase in costs or prices for consumers or individual industries; or • Significant adverse effects on competition, investment, or innovation. We request comment on whether our proposal would be a ‘‘major rule’’ for purposes of SBREFA. We solicit comment and empirical data on: • The potential effect on the U.S. economy on an annual basis; • Any potential increase in costs or prices for consumers or individual industries; and • Any potential effect on competition, investment, or innovation. Commenters are requested to provide empirical data and other factual support for their views to the extent possible. Text of Rules and Forms VII. Statutory Authority The Commission is proposing new rule 18f–4 under the authority set forth in sections 6(c), 12(a), 18, 31(a), 38(a), and 61 of the Investment Company Act of 1940 [15 U.S.C. 80a–6(c), 80a–12(a), 80a–18, 80a–30(a), 80a–37(a), and 80a– 60]. The Commission is proposing amendments to rule 6c–11 under the authority set forth in sections 6(c), 22(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a–6(c), 22(c), and 80a– 37(a)]. The Commission is proposing new rule 15l–2 under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 17, 23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C. 78c, 78c(b), 78c–5, 78j, 78o(l), 78o–10, 78q, 78w(a), and 78mm]. The Commission is proposing new rule 211(h)–1 under the authority set forth in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment Advisers Act of 1940 [15 U.S.C. 80b–6, 80b–6a, 80b–8, 80b–11(a), and 80b–11(h)]. The Commission is proposing amendments to Form N– PORT, Form N–LIQUID (which we propose to re-title as ‘‘Form N–RN’’), Form N–CEN, and Form N–2 under the authority set forth in sections 8, 18, 30, and 38 of the Investment Company Act of 1940 [15 U.S.C. 80a–8, 80a–18, 80a– 29, 80a–37, 80a–63], sections 6, 7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C. 77f, 77g(a), 77j, 77s(a)], and sections 10, 13, 15, 23, and 35A of the PO 00000 Frm 00113 Fmt 4701 Sfmt 4702 List of Subjects 17 CFR Parts 240 and 249 Brokers, Fraud, Reporting and recordkeeping requirements, Securities. 17 CFR Parts 270 and 274 Investment companies, Reporting and recordkeeping requirements, Securities. 17 CFR Part 275 Reporting and recordkeeping requirements, Securities. For the reasons set out in the preamble, title 17, chapter II of the Code of Federal Regulations is proposed to be amended as follows: * * * * * PART 240—GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 1. The authority citation for part 240 is amended by adding a subauthority for Section 240.15l–2 to read as follows: ■ Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c–3, 78c–5, 78d, 78e, 78f, 78g, 78i, 78j, 78j–1, 78k, 78k–1, 78l, 78m, 78n, 78n–1, 78o, 78o–4, 78o–10, 78p, 78q, 78q–1, 78s, 78u–5, 78w, 78x, 78dd, 78ll, 78mm, 80a–20, 80a–23, 80a–29, 80a–37, 80b– 3, 80b–4, 80b–11, and 7201 et seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; Pub. L. 111–203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112–106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted. * * * * * Section 240.15l–2 is also issued under Pub. L. 111–203, sec. 913, 124 Stat. 1376, 1827 (2010). * * * * * 2. Section 240–15l–2 is added to read as follows: ■ § 240.15l–2 Broker and dealer sales practices for leveraged/inverse investment vehicles. (a) Required approval of customer account. No broker or dealer registered or required to be registered under the Securities Exchange Act of 1934, or any associated person of the broker or dealer, may accept an order from a customer that is a natural person (or the legal representative of a natural person) to buy or sell shares of a leveraged/ inverse investment vehicle unless the broker or dealer has approved such a customer’s account to engage in those transactions and has adopted and implemented policies and procedures reasonably designed to achieve compliance with this section. Any E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4558 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules approval of a customer’s account for buying or selling leveraged/inverse investment vehicles must be effected as provided in paragraph (b). (b) Diligence in approving accounts. (1) In determining whether to approve a customer’s account to buy or sell leveraged/inverse investment vehicles, the broker or dealer must exercise due diligence to ascertain the essential facts relative to the customer, his or her financial situation, and investment objectives, including, at a minimum, the information specified in paragraph (b)(2) of this section (and must seek to obtain information for all participants in a joint account). Based upon this information, the broker or dealer must specifically approve or disapprove the customer’s account for buying and selling shares of leveraged/inverse investment vehicles. An approval of a customer account must be in writing. A broker or dealer may provide this approval if the broker or dealer has a reasonable basis for believing that the customer has such knowledge and experience in financial matters that he or she may reasonably be expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. (2) A broker or dealer must seek to obtain the following information at a minimum regarding the customer: (i) Investment objectives (e.g., safety of principal, income, growth, trading profits, speculation) and time horizon; (ii) Employment status (name of employer, self-employed or retired); (iii) Estimated annual income from all sources; (iv) Estimated net worth (exclusive of family residence); (v) Estimated liquid net worth (cash, liquid securities, other); (vi) Percentage of the customer’s estimated liquid net worth that he or she intends to invest in leveraged/ inverse investment vehicles; and (vii) Investment experience and knowledge (e.g., number of years, size, frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, stocks and bonds, commodities, and other financial instruments. (c) Recordkeeping. A broker or dealer must maintain a written record of the information that it obtained under paragraph (b) of this section and, if applicable, its written approval of the customer’s account, as well as the versions of the firm’s policies and procedures required under paragraph (a) that were in place when it approved or disapproved the customer’s account, for a period of not less than six years (the first two years in an easily accessible VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 place) after the date of the closing of the customer’s account. (d) Definitions. For purposes of this section: Associated person of the broker dealer means any partner, officer, director, or branch manager of such broker or dealer (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling, controlled by, or under common control with such broker or dealer, or any employee of such broker or dealer, except that any person associated with a broker or dealer whose functions are solely clerical or ministerial shall not be included in the meaning of such term for purposes of section 15(b) of the Exchange Act (other than paragraph (6) thereof). Commodity- or Currency-Based Trust or Fund means a trust or other person: (1) Issuing securities in an offering registered under the Securities Act of 1933 (15 U.S.C. 77a et seq.) and which class of securities is listed for trading on a national securities exchange; (2) The assets of which consist primarily of derivative instruments that reference commodities or currencies, or interests in the foregoing; and (3) That provides in its registration statement under the Securities Act of 1933 (15 U.S.C. 77a et seq.) that a class of its securities are purchased or redeemed, subject to conditions or limitations, for a ratable share of its assets. Leveraged/inverse investment vehicle means a registered investment company (including any separate series thereof), or commodity- or currency-based trust or fund, that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time. (e) Transition. This section applies to all customers of the broker or dealer, including customers who have opened accounts with the broker or dealer before the compliance date for this section, provided that this section does not apply to, and therefore will not restrict a customer’s ability to close or reduce, a position in a leveraged/inverse investment vehicle that a customer established before the compliance date of this section. PART 270—RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940 3. The authority citation for part 270 continues to read, in part, as follows: ■ PO 00000 Frm 00114 Fmt 4701 Sfmt 4702 Authority: 15 U.S.C. 80a–1 et seq., 80a– 34(d), 80a–37, 80a–39, and Pub. L. 111–203, sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted. * * * * * Section 270.6c–11 is also issued under 15 U.S.C. 80a–6(c) and 80a–37(a). * * * § 270.6c–11 * * [Amended] 4. Amend § 270.6c–11 by removing paragraph (c)(4). ■ 5. Section 270.18f–4 is added to read as follows: ■ § 270.18f–4 Exemption from the requirements of section 18 and section 61 for certain senior securities transactions. (a) Definitions. For purposes of this section: Absolute VaR test means that the VaR of the fund’s portfolio does not exceed 15% of the value of the fund’s net assets. Derivatives exposure means the sum of the notional amounts of the fund’s derivatives instruments and, in the case of short sale borrowings, the value of the asset sold short. In determining derivatives exposure a fund may convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts. Derivatives risks means the risks associated with a fund’s derivatives transactions or its use of derivatives transactions, including leverage, market, counterparty, liquidity, operational, and legal risks and any other risks the derivatives risk manager (or, in the case of a fund that is a limited derivatives user as described in paragraph (c)(3) of this section, the fund’s investment adviser) deems material. Derivatives risk manager means an officer or officers of the fund’s investment adviser responsible for administering the program and policies and procedures required by paragraph (c)(1) of this section, provided that the derivatives risk manager: (1) May not be a portfolio manager of the fund, or if multiple officers serve as derivatives risk manager, may not have a majority composed of portfolio managers of the fund; and (2) Must have relevant experience regarding the management of derivatives risk. Derivatives transaction means: (1) Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (‘‘derivatives instrument’’), under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules or at maturity or early termination, whether as margin or settlement payment or otherwise; and (2) Any short sale borrowing. Designated reference index means an unleveraged index that: (1) Is selected by the derivatives risk manager and that reflects the markets or asset classes in which the fund invests; (2) is not administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used; and (3) is an ‘‘appropriate broad-based securities market index’’ or an ‘‘additional index,’’ as defined in the instruction to Item 27 in Form N–1A [17 CFR 274.11A]. In the case of a blended index, none of the indexes that compose the blended index may be administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used. Fund means a registered open-end or closed-end company or a business development company, including any separate series thereof, but does not include a registered open-end company that is regulated as a money market fund under § 270.2a–7. Relative VaR test means that the VaR of the fund’s portfolio does not exceed 150% of the VaR of the designated reference index. Unfunded commitment agreement means a contract that is not a derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a loan to a company or to invest equity in a company in the future, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner. Value-at-risk or VaR means an estimate of potential losses on an instrument or portfolio, expressed as a percentage of the value of the portfolio’s net assets, over a specified time horizon and at a given confidence level, provided that any VaR model used by a fund for purposes of determining the fund’s compliance with the relative VaR test or the absolute VaR test must: (1) Take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments, including, as applicable: (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 VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 and positions with embedded optionality; and (iii) The sensitivity of the market value of the fund’s investments to changes in volatility; (2) Use a 99% confidence level and a time horizon of 20 trading days; and (3) Be based on at least three years of historical market data. (b) Derivatives transactions. If a fund satisfies the conditions of paragraph (c) of this section, the fund may enter into derivatives transactions, notwithstanding the requirements of sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a–18(a)(1), 80a–18(c), 80a– 18(f)(1), and 80a–60), and derivatives transactions entered into by the fund in compliance with this section will not be considered for purposes of computing asset coverage, as defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a–18(h)). (c) Conditions. (1) Derivatives risk management program. The fund adopts and implements a written derivatives risk management program (‘‘program’’), which must include policies and procedures that are reasonably designed to manage the fund’s derivatives risks and to reasonably segregate the functions associated with the program from the portfolio management of the fund. The program must include the following elements: (i) Risk identification and assessment. The program must provide for the identification and assessment of the fund’s derivatives risks. This assessment must take into account the fund’s derivatives transactions and other investments. (ii) Risk guidelines. The program must provide for the establishment, maintenance, and enforcement of investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s derivatives risks. These guidelines must specify levels of the given criterion, metric, or threshold that the fund does not normally expect to exceed, and measures to be taken if they are exceeded. (iii) Stress testing. The program must provide for stress testing to evaluate potential losses to the fund’s portfolio 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, taking into account correlations of market risk factors and resulting payments to derivatives counterparties. The frequency with which the stress testing under this paragraph is conducted must take into account the PO 00000 Frm 00115 Fmt 4701 Sfmt 4702 4559 fund’s strategy and investments and current market conditions, provided that these stress tests must be conducted no less frequently than weekly. (iv) Backtesting. The program must provide for backtesting of the results of the VaR calculation model used by the fund in connection with the relative VaR test or the absolute VaR test by, each business day, comparing the fund’s gain or loss with the corresponding VaR calculation for that day, estimated over a one-trading day time horizon, and identifying as an exception any instance in which the fund experiences a loss exceeding the corresponding VaR calculation’s estimated loss. (v) Internal reporting and escalation. (A) Internal reporting. The program must identify the circumstances under which persons responsible for portfolio management will be informed regarding the operation of the program, including exceedances of the guidelines specified in paragraph (c)(1)(ii) of this section and the results of the stress tests specified in paragraph (c)(1)(iii) of this section. (B) Escalation of material risks. The derivatives risk manager must inform in a timely manner persons responsible for portfolio management of the fund, and also directly inform the fund’s board of directors as appropriate, of material risks arising from the fund’s derivatives transactions, including risks identified by the fund’s exceedance of a criterion, metric, or threshold provided for in the fund’s risk guidelines established under paragraph (c)(1)(ii) of this section or by the stress testing described in paragraph (c)(1)(iii) of this section. (vi) Periodic review of the program. The derivatives risk manager must review the program at least annually to evaluate the program’s effectiveness and to reflect changes in risk over time. The periodic review must include a review of the VaR calculation model used by the fund under paragraph (c)(2) of this section (including the backtesting required by paragraph (c)(1)(iv) of this section) and any designated reference index to evaluate whether it remains appropriate. (2) Limit on fund leverage risk. (i) The fund must comply with the relative VaR test or, if the derivatives risk manager is unable to identify a designated reference index that is appropriate for the fund taking into account the fund’s investments, investment objectives, and strategy, the absolute VaR test. (ii) The fund must determine its compliance with the applicable VaR test at least once each business day. If the fund determines that it is not in compliance with the applicable VaR test, the fund must come back into compliance promptly and within no E:\FR\FM\24JAP2.SGM 24JAP2 lotter on DSKBCFDHB2PROD with PROPOSALS2 4560 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules more than three business days after such determination. (iii) If the fund is not in compliance with the applicable VaR test within three business days: (A) The derivatives risk manager must report to the fund’s board of directors and explain how and by when (i.e., number of business days) the derivatives risk manager reasonably expects that the fund will come back into compliance; (B) The derivatives risk manager must analyze the circumstances that caused the fund to be out of compliance for more than three business days and update any program elements as appropriate to address those circumstances; and (C) The fund may not enter into any derivatives transactions (other than derivatives transactions that, individually or in the aggregate, are designed to reduce the fund’s VaR) until the fund has been back in compliance with the applicable VaR test for three consecutive business days and has satisfied the requirements set forth in paragraphs (c)(2)(iii)(A) and (B) of this section. (iv) If the fund is complying with the relative VaR test, an open-end fund must disclose in its annual report the fund’s designated reference index as the fund’s ‘‘appropriate broad-based securities market index’’ or an ‘‘additional index,’’ as defined in the instruction to Item 27 in Form N–1A [17 CFR 274.11A], and a registered closedend fund or business development company must disclose its designated reference index in the annual report, together with a presentation of the fund’s performance relative to the designated reference index. A fund is not required to include this disclosure in an annual report if the fund is a ‘‘New Fund,’’ as defined in Form N–1A [17 CFR 274.11A], or would meet that definition if it were filing on Form N– 1A [17 CFR 274.11A], at the time the fund files the annual report. (3) Limited derivatives users. A fund is not required to adopt a program as prescribed in paragraph (c)(1) of this section, or comply with the limit on fund leverage risk in paragraph (c)(2) of this section, if the fund adopts and implements policies and procedures reasonably designed to manage the fund’s derivatives risks and: (i) The fund’s derivatives exposure does not exceed 10 percent of the fund’s net assets; or (ii) The fund limits its use of derivatives transactions to currency derivatives that hedge the currency risks associated with specific foreigncurrency-denominated equity or fixed- VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 income investments held by the fund, provided that the currency derivatives are entered into and maintained by the fund for hedging purposes and that the notional amounts of such derivatives do not exceed the value of the hedged instruments denominated in the foreign currency (or the par value thereof, in the case of fixed-income investments) by more than a negligible amount. (4) Leveraged/inverse funds. A fund is not required to comply with the limit on fund leverage risk in paragraph (c)(2) of this section if: (i) The fund is a leveraged/inverse investment vehicle as defined in § 240.15l–2 and § 275.211(h)–1; (ii) The fund discloses in its prospectus that it is not subject to the limit on fund leverage risk in paragraph (c)(2) of this section; and (iii) The fund does not seek or obtain, directly or indirectly, investment results exceeding 300% of the return (or inverse of the return) of the underlying index. (5) Board oversight and reporting. (i) Approval of the derivatives risk manager. A fund’s board of directors, including a majority of directors who are not interested persons of the fund, must approve the designation of the derivatives risk manager, taking into account the derivatives risk manager’s relevant experience regarding the management of derivatives risk. (ii) Reporting on program implementation and effectiveness. On or before the implementation of the program, and at least annually thereafter, the derivatives risk manager must provide to the board of directors a written report providing a representation that the program is reasonably designed to manage the fund’s derivatives risks and to incorporate the elements provided in paragraphs (c)(1)(i) through (vi) of this section. The representation may be based on the derivatives risk manager’s reasonable belief after due inquiry. The written report must include the basis for the representation along with such information as may be reasonably necessary to evaluate the adequacy of the fund’s program and, for reports following the program’s initial implementation, the effectiveness of its implementation. The written report also must include the derivatives risk manager’s basis for the selection of the designated reference index or, if applicable, an explanation of why the derivatives risk manager was unable to identify a designated reference index appropriate for the fund. (iii) Regular board reporting. The derivatives risk manager must provide to the board of directors, at a frequency PO 00000 Frm 00116 Fmt 4701 Sfmt 4702 determined by the board, a written report regarding the derivatives risk manager’s analysis of any exceedances described in paragraph (c)(1)(ii) of this section, the results of the stress testing conducted under paragraph (c)(1)(iii) of this section, and the results of the backtesting conducted under paragraph (c)(1)(iv) of this section since the last report to the board. Each report under this paragraph must include such information as may be reasonably necessary for the board of directors to evaluate the fund’s response to any exceedances and the results of the fund’s stress testing. (6) Recordkeeping. (i) Records to be maintained. A fund must maintain a written record documenting, as applicable: (A) The fund’s written policies and procedures required by paragraph (c)(1) of this section, along with: (1) The results of the fund’s stress tests under paragraph (c)(1)(iii) of this section; (2) The results of the backtesting conducted under paragraph (c)(1)(iv) of this section; (3) Records documenting any internal reporting or escalation of material risks under paragraph (c)(1)(v)(B) of this section; and (4) Records documenting the reviews conducted under paragraph (c)(1)(vi) of this section. (B) Copies of any materials provided to the board of directors in connection with its approval of the designation of the derivatives risk manager, any written reports provided to the board of directors relating to the program, and any written reports provided to the board of directors under paragraph (c)(2)(iii)(A) of this section. (C) Any determination and/or action the fund made under paragraphs (c)(2)(i)–(ii) of this section, including a fund’s determination of: The VaR of its portfolio; the VaR of the fund’s designated reference index, as applicable; the fund’s VaR ratio (the value of the VaR of the Fund’s portfolio divided by the VaR of the designated reference index), as applicable; and any updates to any VaR calculation models used by the fund and the basis for any material changes thereto. (D) If applicable, the fund’s written policies and procedures required by paragraph (c)(3) of this section. (ii) Retention periods. (A) A fund must maintain a copy of the written policies and procedures that the fund adopted under paragraphs (c)(1) or (c)(3) of this section that are in effect, or at any time within the past five years were in effect, in an easily accessible place. E:\FR\FM\24JAP2.SGM 24JAP2 4561 lotter on DSKBCFDHB2PROD with PROPOSALS2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules (B) A fund must maintain all records and materials that paragraphs (c)(6)(i)(A)(1)–(4) and (c)(6)(i)(B)–(D) of this section describe for a period of not less than five years (the first two years in an easily accessible place) following each determination, action, or review that these paragraphs describe. (7) Current reports. A fund that experiences an event specified in the parts of Form N–RN [referenced in 17 CFR 274.223] titled ‘‘Relative VaR Test Breaches,’’ ‘‘Absolute VaR Test Breaches,’’ or ‘‘Compliance with VaR Test’’ must file with the Commission a report on Form N–RN within the period and according to the instructions specified in that form. (d) Reverse repurchase agreements. A fund may enter into reverse repurchase agreements or similar financing transactions, notwithstanding the requirements of sections 18(c), and 18(f)(1) of the Investment Company Act, if the fund complies with the asset coverage requirements of section 18 and combines the aggregate amount of indebtedness associated with the reverse repurchase agreement or similar financing transaction with the aggregate amount of any other senior securities representing indebtedness when calculating the asset coverage ratio. (e) Unfunded commitment agreements. (1) A fund may enter into an unfunded commitment agreement, notwithstanding the requirements of sections 18(a), 18(c), 18(f)(1), and 61 of the Investment Company Act, if the fund reasonably believes, at the time it enters into such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as they come due. In forming a reasonable belief, the fund must take into account its reasonable expectations with respect to other obligations (including any obligation with respect to senior securities or redemptions), and may not take into account cash that may become available from the sale or disposition of any investment at a price that deviates significantly from the market value of those investments, or from issuing additional equity. Unfunded commitment agreements entered into by the fund in compliance with this section will not be considered for purposes of computing asset coverage, as defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a–18(h)). (2) For each unfunded commitment agreement that a fund enters into under paragraph (e)(1) of this section, a fund must document the basis for its reasonable belief regarding the sufficiency of its cash and cash VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 equivalents to meet its unfunded commitment agreement obligations, and maintain a record of this documentation for a period of not less than five years (the first two years in an easily accessible place) following the date that the fund entered into the agreement. ■ 6. Revise § 270.30b1–10 to read as follows: § 270.30b1–10 Current report for open-end and closed-end management investment companies. Every registered open-end management investment company, or series thereof, and every registered closed-end management investment company, but not a fund that is regulated as a money market fund under § 270.2a–7, that experiences an event specified on Form N–RN, must file with the Commission a current report on Form N–RN within the period and according to the instructions specified in that form. PART 274—FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940 7. The general authority for part 274 continues to read as follows: ■ Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 78n, 78o(d), 80a–8, 80a–24, 80a–26, 80a–29, and Pub. L. 111– 203, sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted. * * * * * 8. Amend Form N–2 (referenced in §§ 239.14 and 274.11a–1) by revising instruction 2. to sub-item ‘‘3. Senior Securities’’ of ‘‘Item 4. Financial Highlights’’ to read as follows: ■ Note: The text of Form N–2 does not, and this amendment will not, appear in the Code of Federal Regulations. Form N–2 * * * * * Item 4. Financial Highlights * * * * * 3. Senior Securities * * * * * Instructions * * * * * 2. Use the method described in section 18(h) of the 1940 Act [15 U.S.C. 80a–18(h)] to calculate the asset coverage to be set forth in column (3). However, in lieu of expressing asset coverage in terms of a ratio, as described in section 18(h), express it for each class of senior securities in terms of dollar amounts per share (in the case of preferred stock) or per $1,000 of indebtedness (in the case of senior PO 00000 Frm 00117 Fmt 4701 Sfmt 4702 indebtedness). A fund should not consider any derivatives transactions, or any unfunded commitment agreements, that it enters into in compliance with rule 18f–4 under the Investment Company Act [17 CFR 270.18f–4] for purposes of computing asset coverage. * * * * * ■ 9. Amend Form N–CEN (referenced in §§ 249.330 and 274.101) by adding new Item C.7.l. to read as follows: Note: The text of Form N–CEN does not, and this amendment will not, appear in the Code of Federal Regulations. FORM N–CEN ANNUAL REPORT FOR REGISTERED INVESTMENT COMPANIES * * * * * Item C.7. * * * l. Rule 18f–4 (17 CFR 270.18f–4): l i. Is the Fund excepted from the rule 18f–4 (17 CFR 270.18f–4) program requirement under rule 18f– 4(c)(3)(i) (17 CFR 270.18f– 4(c)(3)(i))? ll ii. Is the Fund excepted from the rule 18f–4 (17 CFR 270.18f–4) program requirement under rule 18f– 4(c)(3)(ii) (17 CFR 270.18f– 4(c)(3)(ii))? ll iii. Is the Fund a leveraged/inverse fund covered by rule 15l–2 under the Exchange Act (17 CFR 240.15l– 2) or rule 211(h)–1 under the Investment Advisers Act of 1940 (17 CFR 275.211(h)–1) that, under rule 18f–4(c)(4) (17 CFR 270.18f– 4(c)(4)), is excepted from the requirement to comply with the limit on leverage risk described in rule 18f–4(c)(2) (17 CFR 270.18f– 4(c)(2))? ll iv. Has the Fund entered into any reverse repurchase agreements or similar financing transactions under rule 18f–4(d) (17 CFR 270.18f– 4(d))? ll v. Has the Fund entered into any unfunded commitment agreements under rule 18f–4(e) (17 CFR 270.18f–4(e))? ll * * * * * ■ 10. Amend Form N–PORT (referenced in § 274.150) by: ■ a. Adding to General Instruction E. ‘‘Definitions’’ in alphabetical order, the following definitions: ■ i. ‘‘Absolute VaR Test’’; ■ ii. ‘‘Designated Reference Index’’; ■ iii. ‘‘Derivatives Exposure’’; ■ iv. ‘‘Relative VaR Test’’; ■ v. ‘‘Value-at-risk’’; ■ vi. ‘‘VaR Ratio’’; and ■ b. Adding Items B.9 and B.10. The additions read as follows: E:\FR\FM\24JAP2.SGM 24JAP2 4562 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules Note: The text of Form N–PORT does not, and this amendment will not, appear in the Code of Federal Regulations. Form N–PORT MONTHLY PORTFOLIO INVESTMENTS REPORT * * * * * GENERAL INSTRUCTIONS * * * * * E. Definitions lotter on DSKBCFDHB2PROD with PROPOSALS2 * * * * * ‘‘Absolute VaR Test’’ has the meaning defined in rule 18f–4(a) [17 CFR 270.18f–4(a)]. * * * * * ‘‘Derivatives Exposure’’ has the meaning defined in rule 18f–4(a) [17 CFR 270.18f–4(a)]. * * * * * ‘‘Designated Reference Index’’ has the meaning defined in rule 18f–4(a) [17 CFR 270.18f–4(a)]. * * * * * ‘‘Relative VaR Test’’ has the meaning defined in rule 18f–4(a) [17 CFR 270.18f–4(a)]. * * * * * ‘‘Value-at-risk’’ or VaR has the meaning defined in rule 18f–4(a) [17 CFR 270.18f–4(a)]. * * * * * ‘‘VaR Ratio’’ means the value of the Fund’s portfolio VaR divided by the VaR of the Designated Reference Index. * * * * * ii. Index Identifier for the Fund’s Designated Reference Index. iii. Highest VaR Ratio during the reporting period. iv. Date of highest VaR Ratio during the reporting period. v. Median VaR Ratio during the reporting period. e. Backtesting Results. Number of exceptions that the Fund identified as a result of its backtesting of its VaR calculation model (as described in rule 18f–4(c)(1)(iv) [17 CFR 270.18f–4(c)(1)(iv)] during the reporting period. * * * * * ■ 11. Revise § 274.223, its sectional heading, and Form N–LIQUID (referenced in § 274.223) and its title to read as follows: § 274.223 Form N–RN, Current report, open- and closed-end investment company reporting. This form shall be used by registered open-end management investment companies, or series thereof, and closedend management investment companies, or series thereof, to file reports pursuant to § 270.18f–4(c)(7) and § 270.30b1–10 of this chapter. Note: The text of Form N–RN does not, and this amendment will not, appear in the Code of Federal Regulations. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 PART B. * * * FORM N–RN Item B.9 Derivatives Exposure. Report as a percentage of the Fund’s net asset value: a. Derivatives Exposure. i. Exposure from derivatives instruments. ii. Exposure from short sales. Item B.10 VaR Information. For Funds subject to the limit on fund leverage risk in rule 18f–4(c)(2) [17 CFR 270.18f– 4(c)(2)], provide the following information, as determined in accordance with the requirement under rule 18f–4(c)(2)(ii) to determine the fund’s compliance with the applicable VaR test at least once each business day: a. Highest daily VaR during the reporting period. b. Date of highest daily VaR during the reporting period. c. Median daily VaR during the reporting period. d. For Funds that were subject to the Relative VaR Test during the reporting period, provide: i. Name of the Fund’s Designated Reference Index. CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND BUSINESS DEVELOPMENT COMPANIES VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 Form N–RN is to be used by a registered open-end management investment company or series thereof, but not including a fund that is regulated as a money market fund under rule 2a–7 under the Act (17 CFR 270.2A–7) (a ‘‘registered open-end fund’’), a registered closed-end management investment company (a ‘‘registered closed-end fund’’), or a closed-end management investment company that has elected to be regulated as a business development company (a ‘‘business development company’’), to file current reports with the Commission pursuant to rule 18f–4 and rule 30b1–10 under the Investment Company of 1940 Act [15 U.S.C. 80a] (‘‘Act’’) (17 CFR 270.18f–4; 17 CFR 270.30b1–10). The Commission may use the information provided on Form N– RN in its regulatory, disclosure review, inspection, and policymaking roles. PO 00000 Frm 00118 Fmt 4701 Sfmt 4702 GENERAL INSTRUCTIONS A. Rules as to Use of Form N–RN (1) Form N–RN is the reporting form that is to be used for current reports of registered open-end funds (not including funds that are regulated as money market funds under rule 2a–7 under the Act), registered closed-end funds, and business development companies (together, ‘‘registrants’’) required by, as applicable, section 30(b) of the Act and rule 30b1–10 under the Act, as well as rule 18f–4 under the Act. The Commission does not intend to make public information reported on Form N–RN that is identifiable to any particular registrant, although the Commission may use Form N–RN information in an enforcement action. (2) Unless otherwise specified, a report on this Form N–RN is required to be filed, as applicable, within one business day of the occurrence of the event specified in Parts B–G of this form. If the event occurs on a Saturday, Sunday, or holiday on which the Commission is not open for business, then the one business day period shall begin to run on, and include, the first business day thereafter. (3) For registered open-end funds required to comply with rule 22e–4 under the Investment Company Act [17 CFR 270.22e–4], complete Parts B–D of this form, as applicable. For registrants that rely on rule 18f–4 of the Act [17 CFR 270.18f–4], complete Parts E–G of this form, as applicable. B. Application of General Rules and Regulations The General Rules and Regulations under the Act contain certain general requirements that are applicable to reporting on any form under the Act. These general requirements should be carefully read and observed in the preparation and filing of reports on this form, except that any provision in the form or in these instructions shall be controlling. C. Information To Be Included in Report Filed on Form N–RN Upon the occurrence of the event specified in Parts B–G of Form N–RN, as applicable, a registrant must file a report on Form N–RN that includes information in response to each of the items in Part A of the form, as well as each of the items in the applicable Parts B–G of the Form. D. Filing of Form N–RN A registrant must file Form N–RN in accordance with rule 232.13 of Regulation S–T (17 CFR part 232). Form N–RN must be filed electronically using E:\FR\FM\24JAP2.SGM 24JAP2 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules the Commission’s Electronic Data Gathering, Analysis and Retrieval System (‘‘EDGAR’’). E. Paperwork Reduction Act Information A registrant is not required to respond to the collection of information contained in Form N–RN unless the form displays a currently valid Office of Management and Budget (‘‘OMB’’) control number. Please direct comments concerning the accuracy of the information collection burden estimate and any suggestions for reducing the burden to the Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090. The OMB has reviewed this collection of information under the clearance requirements of 44 U.S.C. 3507. F. Definitions (1) References to sections and rules in this Form N–RN are to the Investment Company Act (15 U.S.C. 80a), unless otherwise indicated. Terms used in this Form N–RN have the same meaning as in the Investment Company Act, rule 22e–4 under the Investment Company Act (for Parts B–D of the Form), or rule 18f–4 under the Investment Company Act (for Part E–G of the Form), unless otherwise indicated. In addition, as used in this Form N–RN, the term registrant means the registrant or a separate series of the registrant, as applicable. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND BUSINESS DEVELOPMENT COMPANIES lotter on DSKBCFDHB2PROD with PROPOSALS2 PART A. General Information Item A.1. Report for [mm/dd/yyyy]. Item A.2. CIK Number of registrant. Item A.3. EDGAR Series Identifier. Item A.4. Securities Act File Number, if applicable. Item A.5. Provide the name, email address, and telephone number of the person authorized to receive information and respond to questions about this Form N–RN. If more than 15 percent of the registrant’s net assets are, or become, illiquid investments that are assets as defined in rule 22e–4, then report the following information: VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 PART C. At or Below 15% Illiquid Investments If a registrant that has filed Part B of Form N–RN determines that its holdings in illiquid investments that are assets have changed to be less than or equal to 15 percent of the registrant’s net assets, then report the following information: Item C.1. Date(s) on which the registrant’s illiquid investments that are assets fell to or below 15 percent of net assets. Item C.2. The current percentage of the registrant’s net assets that are illiquid investments that are assets. PART D. Assets That Are Highly Liquid Investments Below the Highly Liquid Investment Minimum FORM N–RN PART B. Above 15% Illiquid Investments Item B.1. Date(s) on which the registrant’s illiquid investments that are assets exceeded 15 percent of its net assets. Item B.2. The current percentage of the registrant’s net assets that are illiquid investments that are assets. Item B.3. Identification of illiquid investments. For each investment that is an asset that is held by the registrant that is considered illiquid, disclose (1) the name of the issuer, the title of the issue or description of the investment, the CUSIP (if any), and at least one other identifier, if available (e.g., ISIN, Ticker, or other unique identifier (if ticker and ISIN are not available)) (indicate the type of identifier used), and (2) the percentage of the fund’s net assets attributable to that investment. If a registrant’s holdings in assets that are highly liquid investments fall below its highly liquid investment minimum for more than 7 consecutive calendar days, then report the following information: Item D.1. Date(s) on which the registrant’s holdings of assets that are highly liquid investments fell below the fund’s highly liquid investment minimum. PART E. Relative VaR Test Breaches If a registrant is subject to the relative VaR test under rule 18f–4(c)(2)(i) [17 CFR 270.18f–4(c)(2)(i)], and the fund determines that it is not in compliance with the relative VaR test and has not come back into compliance within 3 business days after such determination, provide: Item E.1. The dates on which the VaR of the registrant’s portfolio exceeded 150% of the VaR of its designated reference index. PO 00000 Frm 00119 Fmt 4701 Sfmt 4702 4563 Item E.2. The VaR of the registrant’s portfolio on the dates each exceedance occurred. Item E.3. The VaR of the registrant’s designated reference index on the dates each exceedance occurred. Item E.4. The name of the registrant’s designated reference index. Item E.5. The index identifier for the registrant’s designated reference index. PART F. Absolute VaR Test Breaches If a registrant is subject to the absolute VaR test under rule 18f–4(c)(2)(i) [17 CFR 270.18f–4(c)(2)(i)], and the fund determines that it is not in compliance with the absolute VaR test and has not come back into compliance within 3 business days after such determination, provide: Item F.1. The dates on which the VaR of the registrant’s portfolio exceeded 15% of the value of the registrant’s net assets. Item F.2. The VaR of the registrant’s portfolio on the dates each exceedance occurred. Item F.3. The value of the registrant’s net assets on the dates each exceedance occurred. PART G. Compliance with VaR Test If a registrant that has filed Part E or Part F of Form N–RN has come back into compliance with either the relative VaR test or the absolute VaR test, as applicable, then report the following information: Item G.1. Dates on which the VaR of the registrant’s portfolio exceeded, as applicable, 150% of the VaR of its designated reference index (if the registrant is subject to the relative VaR test under rule 18f–4(c)(2)(i) [17 CFR 270.18f–4(c)(2)(i)]) or 15% of the value of the registrant’s net assets (if the registrant is subject to the absolute VaR test under rule 18f–4(c)(2)(i) [17 CFR 270.18f– 4(c)(2)(i)]). Item G.2. The current VaR of the registrant’s portfolio. PART H. Explanatory Notes (if any) A registrant may provide any information it believes would be helpful in understanding the information reported in response to any Item of this Form. SIGNATURES Pursuant to the requirements of the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. lllllllllllllllllll E:\FR\FM\24JAP2.SGM 24JAP2 4564 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules (Registrant) Date llllllllllllllll lllllllllllllllllll (Signature) * * Print name and title of the signing officer under his/her signature. * * * * * PART 275—RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940 12. The authority citation for part 275 continues to read, in part, and the subauthority for Section 275.211h–1 is added to read as follows: ■ Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b– 2(a)(11)(H), 80b–2(a)(17), 80b–3, 80b–4, 80b– 4a, 80b–6(4), 80b–6a, and 80b–11, unless otherwise noted. * * * * * Section 275.211(h)–1 is also issued under sec. 913, Pub. L. 111–203, 124 Stat. 1827–28 (2010). * * * * * 13. Section 275.211(h)–1 is added to read as follows: ■ lotter on DSKBCFDHB2PROD with PROPOSALS2 § 275.211(h)–1 Investment adviser sales practices for leveraged/inverse investment vehicles. (a) Required approval of client account. No investment adviser registered or required to be registered under the Advisers Act, or any supervised person of the investment adviser, may place an order for the account of an advisory client that is a natural person (or the legal representative of a natural person) to buy or sell shares of a leveraged/inverse investment vehicle unless the investment adviser has approved such a client’s account to engage in those transactions and has adopted and implemented policies and procedures reasonably designed to achieve compliance with this section. Any approval of a client’s account for buying or selling leveraged/inverse investment vehicles must be effected as provided in paragraph (b). (b) Diligence in approving accounts. (1) In determining whether to approve a client’s account to buy or sell leveraged/ inverse investment vehicles, the investment adviser must exercise due diligence to ascertain the essential facts relative to the client, his or her financial situation, and investment objectives, including, at a minimum, the information specified in paragraph (b)(2) of this section (and must seek to obtain information for all participants in a joint account). Based upon this information, the investment adviser must specifically approve or disapprove the client’s account for buying and selling shares of leveraged/inverse VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 investment vehicles. An approval of a client account must be in writing. An investment adviser may provide this approval if the investment adviser has a reasonable basis for believing that the client has such knowledge and experience in financial matters that he or she may reasonably be expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. (2) An investment adviser must seek to obtain the following information at a minimum regarding the client: (i) Investment objectives (e.g., safety of principal, income, growth, trading profits, speculation) and time horizon; (ii) Employment status (name of employer, self-employed or retired); (iii) Estimated annual income from all sources; (iv) Estimated net worth (exclusive of family residence); (v) Estimated liquid net worth (cash, liquid securities, other); (vi) Percentage of the client’s estimated liquid net worth that he or she intends to invest in leveraged/ inverse investment vehicles; and (vii) Investment experience and knowledge (e.g., number of years, size, frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, stocks and bonds, commodities, and other financial instruments. (c) Recordkeeping. An investment adviser must maintain a written record of the information that it obtained under paragraph (b) of this section and, if applicable, its written approval of the client’s account, as well as the versions of the firm’s policies and procedures required under paragraph (a) that were in place when it approved or disapproved the client’s account, for a period of not less than six years (the first two years in an easily accessible place) after the date of the closing of the client’s account. (d) Definitions. For purposes of this section: Commodity- or currency-based trust or fund means a trust or other person: (1) Issuing securities in an offering registered under the Securities Act of 1933 (15 U.S.C. 77a et seq.) and which class of securities is listed for trading on a national securities exchange; (2) The assets of which consist primarily of derivative instruments that reference commodities or currencies, or interests in the foregoing; and (3) That provides in its registration statement under the Securities Act of 1933 (15 U.S.C. 77a et seq.) that a class of its securities are purchased or redeemed, subject to conditions or PO 00000 Frm 00120 Fmt 4701 Sfmt 4702 limitations, for a ratable share of its assets. Leveraged/inverse investment vehicle means a registered investment company (including any separate series thereof), or commodity- or currency-based trust or fund, that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time. Supervised person means any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment adviser, or other person who provides investment advice on behalf of the investment adviser. (e) Transition. This section applies to all clients of the investment adviser, including clients who have opened accounts with the investment adviser before the compliance date for this section, provided that this section does not apply to, and therefore will not restrict the ability to close or reduce, a client’s position in a leveraged/inverse investment vehicle that a client established before the compliance date of this section. By the Commission. Dated: November 25, 2019. Eduardo A. Aleman, Deputy Secretary. VIII. APPENDIX A Note: Appendix A will not appear in the Code of Federal Regulations. Feedback Flier: Funds’ Use of Derivatives We are proposing a new regulatory approach for funds’ use of derivatives. This includes proposed rule 18f–4 under the Investment Company Act of 1940, a new exemptive rule 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. The proposal also includes certain new proposed reporting requirements relating to funds’ derivatives use. More information about our proposal is available at https://www.sec.gov/rules/proposed/2019/3487607.pdf. We are particularly interested in learning what small funds think about the requirements of proposed new rule 18f–4 and the proposed new reporting requirements. Hearing from small funds could help us learn how the proposed rule and new reporting requirements would affect these entities, and evaluate how we could address any unintended consequences resulting from the cost and effort of regulatory compliance while still promoting investor protection. We would appreciate your feedback on any or all of the following questions. E:\FR\FM\24JAP2.SGM 24JAP2 4565 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules All of the following questions are optional, including any questions that ask about identifying information. Please note that responses to these questions—including any other general identifying information you provide—will be made public. Item 1: General Identifying Information Instructions: At your option, you may include general identifying information that would help us contextualize your other feedback on the proposal. This information could include responses to the following questions, as well as any other general identifying information you would like to provide. Responses to these items—like responses to the other items on this Feedback Flier—will be made public. a. How big is the fund in terms of net asset value? (This may be expressed in a range, for example, $40 million–$50 million.) b. What is/are the principal investment strategy/strategies of the fund? c. Does the fund use derivatives transactions (as defined in the proposed rule) to pursue the fund’s principal investment strategy/strategies? [Y/N] d. Is the fund part of a fund complex? [Y/N] e. Please include any additional general identifying information that you wish to provide, that could add context for your other feedback on the proposal. Item 2: Derivatives Risk Management Program Instructions: If you believe the fund would be required to adopt and implement a derivatives risk management program under the proposed rules, please answer the following questions. If you do not believe so, please proceed to Item 4. a. The proposed derivatives risk management program requirement would include the following seven elements. In the following chart, please indicate which of the proposed program elements you think would be the most expensive for the fund to implement and which would be least expensive to implement, by ranking the following elements from one (1)—most expensive—through seven (7)—least expensive—using each number only once. If you have any comments about the factors informing your analysis, please include. Rank by cost (1—most expensive; 7—least expensive) Use each number once Derivatives risk management program elements Comments (a) Risk identification and assessment (b) Risk guidelines (c) Stress testing (d) Backtesting (e) Internal reporting and escalation (f) Periodic review of the program (g) Board reporting and oversight b. Implementation timing. (1.) How many months do you think it would take the fund to adopt and 6 months–12 months [ implement a derivatives risk management program (check one box)? 12 months–18 months ] [ (2.) If the response above is more than 12 months, what would help to shorten that time period? (3.) Please provide any explanatory notes that you would like to include. 18 months–24 months ] [ >24 months ] [ ] combined internal and external costs) (check one box)? c. Implementation cost. (1.) Approximately how much do you think it would cost the fund to implement a derivatives risk management program (in terms of Estimated cost ($) $0–$150,000 lotter on DSKBCFDHB2PROD with PROPOSALS2 [ $150,001–$350,000 ] [ (2.) Please include any explanatory notes that you would like to provide. These could describe, for example, how a fund that is part of a fund complex might share these costs, any particular cost considerations for a fund that uses subadvisers, or the extent to which the estimated costs would arise from internal versus external costs (such as those associated with third-party service providers). d. To the extent that the fund is a subadvised fund, would any of the proposed VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 $350,001–$500,000 ] [ ] program elements present any particular challenges for the fund to implement in light of its advisory structure? If so please explain. Item 3: Limit on Fund Leverage Risk Instructions: The proposed rule would require certain funds to comply with a limit on fund leverage risk based on value at risk (‘‘VaR’’). The following questions relate to this proposed requirement. a. Does the fund currently use VaR testing? [Y/N] PO 00000 Frm 00121 Fmt 4701 Sfmt 4702 >$500,000 [ ] b. Implementation cost. (1.) If you anticipate that, if the proposed rules were adopted, the fund would have to comply with the VaR testing requirement, approximately how much do you think it would cost the fund to implement the proposed VaR test requirements (in terms of combined internal and external costs) (check one box)? E:\FR\FM\24JAP2.SGM 24JAP2 4566 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules Estimated cost ($) $0–$25,000 [ $25,001–$50,000 ] [ (2.) Please include any explanatory notes that you would like to provide. These could describe, for example, how a fund that is part of a fund complex might share these costs, any particular cost considerations for a fund that uses sub- $50,001–$75,000 ] [ ] advisers, or the extent to which the estimated costs would arise from internal versus external costs (such as those associated with third-party service providers). Relative VaR test [ [ Absolute VaR test [ on fund leverage risk present any particular challenges for the fund to implement in light of its advisory structure? If so please explain. Item 4: Limited Derivatives Users Instructions: If you believe the fund would qualify as a limited derivatives user under the proposed rule, please answer the Exposure-based test (The fund’s derivatives exposure does not exceed 10% of the fund’s net asset value) ] following questions. If you do not believe so, please proceed to question 5. a. Please state which basis for the proposed limited derivatives user exception you think the fund would seek to rely on (check one box): Currency hedging exception (The fund only uses derivatives for currency hedging purposes as specified in the proposed rule) ] [ b. Should the rule include any other bases for a fund to qualify as a limited derivatives user? What alternative approach and why? ] c. Use of relative VaR test and absolute VaR test. (1.) Would the fund anticipate that it would use the proposed relative VaR test or the proposed absolute VaR test (check one box)? ] (2.) If you anticipate that you would use the proposed relative VaR test, and you already disclose a benchmark index for performance disclosure, do you anticipate that the index would also qualify as a designated reference index under the proposed rule? [Y/N] d. To the extent that the fund is a subadvised fund, would the proposed limit [ >$75,000 c. Implementation cost. (1.) Approximately how much do you think it would cost the fund to adopt and implement policies and procedures ] reasonably designed to manage its derivatives risks (in terms of combined internal and external costs) (check one box)? Estimated cost ($) $0–$25,000 [ $25,001–$50,000 ] [ ] [ (2.) Please include any explanatory notes that you would like to provide. Item 5: Recordkeeping a. Approximately how much would it cost the fund to comply with the proposed recordkeeping requirements associated with rule 18f–4 (in terms of combined internal and external costs)? b. Should we modify any of the proposed recordkeeping requirements, and if so, how? lotter on DSKBCFDHB2PROD with PROPOSALS2 Item 6: Reporting Requirements a. Approximately how much would it cost the fund to comply with the proposed new requirements for reporting on Form N–PORT, Form N–CEN, and Form N–RN (in terms of combined internal and external costs)? b. Should we modify any of the proposed reporting requirements, and if so, how? VerDate Sep<11>2014 18:37 Jan 23, 2020 $50,001–$75,000 Jkt 250001 $75,001–$100,000 ] [ Item 7: Other Feedback on Proposed Rule 18f–4 and Proposed New Reporting Requirements Instructions: Please include any other additional suggestions or comments about proposed rule 18f–4, and/or the proposed new reporting requirements, that you would like to provide. We will post your feedback on our website. Your submission will be posted without change; we do not redact or edit personal identifying information from submissions. You should only make submissions that you wish to make available publicly. If you are interested in more information on the proposal, or want to provide feedback on additional questions, click here. Comments should be received on or before March 24, 2020 Thank You! Other Ways to Submit Your Feedback You also can send us feedback in the following ways (include the file number S7– 24–15 in your response): Print Your Responses and Mail PO 00000 Frm 00122 Fmt 4701 Sfmt 4702 ] >$100,000 [ ] Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090 Print a PDF of Your Responses and Email Use the printer friendly page and select a PDF printer to create a file you can email to: rule-comments@sec.gov Print a Blank Copy of This Flier, Fill it Out, and Mail Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090 IX. APPENDIX B Note: Appendix B will not appear in the Code of Federal Regulations. Feedback Flier: Sales Practices Rules for Transacting in Shares of Leveraged/Inverse Investment Vehicles We are proposing two new sales practices rules—rule 15l–2 under the Securities Exchange Act of 1934, and Rule 211(h)–1 under the Investment Advisers Act of 1940— that would require a broker, dealer, or E:\FR\FM\24JAP2.SGM 24JAP2 4567 Federal Register / Vol. 85, No. 16 / Friday, January 24, 2020 / Proposed Rules registered investment adviser 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.’’ More information about our proposal is available at https://www.sec.gov/ rules/proposed/2019/34-87607.pdf. We are particularly interested in learning what small broker-dealers and investment advisers think about the proposed new sales practices rules’ requirements. Hearing from these smaller firms could help us learn how our proposed rules would affect them, and evaluate how we could address any unintended consequences resulting from the cost and effort of regulatory compliance while still promoting investor protection. We would appreciate your feedback on any or all of the following questions. All of the following questions are optional, including any questions that ask about identifying information. Please note that responses to these questions—including any other general identifying information you provide—will be made public. Item 1: General Identifying Information Instructions: At your option, you may include general identifying information that would help us contextualize your other feedback on the proposal. This information could include responses to the following questions, as well as any other general identifying information you would like to provide. Responses to these items—like responses to the other items on this Feedback Flier—will be made public. a. Is the firm a Commission-registered investment adviser or a broker-dealer? b. What is the size of the firm in terms of: (1.) The number of retail investors (as defined in the release)? (2.) For Investment Advisers, regulatory assets under management? (3.) For broker-dealers, regulatory net capital? (4.) Other (please specify)? c. Please include any additional general identifying information that you wish to provide, that could add context to your other feedback on the proposal. d. Does the firm accept orders from or place orders for the accounts of retail investors to buy or sell shares of leveraged/inverse investment vehicles (as defined in the proposed sales practices rules)? Item 2: Cost To Comply With the Proposed Due Diligence and Account Approval Requirements a. What do you expect the cost to your firm would be in order to comply with these proposed requirements (in terms of combined internal and external costs)? (1.) For an investment adviser (check one box): Estimated cost ($) $0–$5,000 $5,001–$10,000 [ ] [ >$10,000 ] [ ] (2.) For a broker-dealer (check one box): Estimated cost ($) $0–$25,000 $25,001–$50,000 [ ] [ b. Are there any less expensive alternatives to the proposed requirements you can suggest that would still preserve the proposed rules’ intended investor protection safeguards? lotter on DSKBCFDHB2PROD with PROPOSALS2 Item 3: Other Feedback on Proposed Sales Practices Rules Instructions: Please include any other additional suggestions or comments about the proposed sales practices rules that you would like to provide. We will post your feedback on our website. Your submission will be posted without change; we do not redact or edit personal VerDate Sep<11>2014 18:37 Jan 23, 2020 Jkt 250001 >$50,000 ] [ identifying information from submissions. You should only make submissions that you wish to make available publicly. If you are interested in more information on the proposal, or want to provide feedback on additional questions, click here. Comments should be received on or before March 24, 2020. Thank You! Other Ways to Submit Your Feedback You also can send us feedback in the following ways (include the file number S7– 24–15 in your response): Print Your Responses and Mail PO 00000 Frm 00123 Fmt 4701 Sfmt 9990 ] Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090 Print a PDF of Your Responses and Email Use the printer friendly page and select a PDF printer to create a file you can email to: rule-comments@sec.gov Print a Blank Copy of This Flier, Fill it Out, and Mail Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090 [FR Doc. 2020–00040 Filed 1–23–20; 8:45 am] BILLING CODE 8011–01–P E:\FR\FM\24JAP2.SGM 24JAP2

Agencies

SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 85, Number 16 (Friday, January 24, 2020)]
[Proposed Rules]
[Pages 4446-4567]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-00040]



[[Page 4445]]

Vol. 85

Friday,

No. 16

January 24, 2020

Part III





Securities and Exchange Commission





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17 CFR Parts 239, 240, 249, et al.





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; Proposed Rule

Federal Register / Vol. 85 , No. 16 / Friday, January 24, 2020 / 
Proposed Rules

[[Page 4446]]


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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.

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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 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 (https://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 (https://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 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.
    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.

Table of Contents

I. Introduction
    A. Overview of Funds' Use of Derivatives
    B. Derivatives and the Senior Securities Restrictions of the 
Investment Company Act
    1. Requirements of Section 18
    2. Evolution of Commission and Staff Consideration of Section 18 
Restrictions as Applied to Funds' Use of Derivatives
    3. Need for Updated Regulatory Framework
    C. Overview of the Proposal
II. Discussion
    A. Scope of Proposed Rule 18f-4
    1. Funds Permitted To Rely on Proposed Rule 18f-4
    2. Derivatives Transactions Permitted Under Proposed Rule 18f-4
    B. Derivatives Risk Management Program
    1. Summary
    2. Program Administration
    3. Required Elements of the Program
    C. Board Oversight and Reporting
    1. Board Approval of the Derivatives Risk Manager
    2. Board Reporting
    D. Proposed Limit on Fund Leverage Risk

[[Page 4447]]

    1. Use of VaR
    2. Relative VaR Test
    3. Absolute VaR Test
    4. Choice of Model and Parameters for VaR Test
    5. Implementation
    6. Other Regulatory Approaches to Limiting Fund Leverage Risk
    E. Limited Derivatives Users
    1. Exposure-Based Exception
    2. Currency Hedging Exception
    3. Risk Management
    F. Asset Segregation
    G. Alternative Requirements for Certain Leveraged/Inverse Funds 
and Proposed Sales Practices Rules for Certain Leveraged/Inverse 
Investment Vehicles
    1. Background on Proposed Approach to Certain Leveraged/Inverse 
Funds
    2. Proposed Sales Practices Rules for Leveraged/Inverse 
Investment Vehicles
    3. Alternative Provision for Leveraged/Inverse Funds Under 
Proposed Rule 18f-4
    4. Proposed Amendments to Rule 6c-11 Under the Investment 
Company Act and Proposed Rescission of Exemptive Relief for 
Leveraged/Inverse ETFs
    H. Amendments to Fund Reporting Requirements
    1. Amendments to Form N-PORT
    2. Amendments to Current Reporting Requirements
    3. Amendments to Form N-CEN
    4. BDC Reporting
    I. Reverse Repurchase Agreements
    J. Unfunded Commitment Agreements
    K. Recordkeeping Provisions
    L. Transition Periods
    M. Conforming Amendments
III. Economic Analysis
    A. Introduction
    B. Economic Baseline
    1. Fund Industry Overview
    2. Funds' Use of Derivatives
    3. Current Regulatory Framework for Derivatives
    4. Funds' Derivatives Risk Management Practices and Use of VaR 
Models
    5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse 
Funds
    C. Benefits and Costs of the Proposed Rules and Amendments
    1. Derivatives Risk Management Program and Board Oversight and 
Reporting
    2. VaR-Based Limit on Fund Leverage Risk
    3. Limited Derivatives Users
    4. Reverse Repurchase Agreements and Similar Financing 
Transactions
    5. Alternative Requirements for Certain Leveraged/Inverse Funds 
and Proposed Sales Practices Rules for Certain Leveraged/Inverse 
Investment Vehicles
    6. Proposed Amendments to Rule 6c-11 Under the Investment 
Company Act and Proposed Rescission of Exemptive Relief for 
Leveraged/Inverse ETFs
    7. Unfunded Commitment Agreements
    8. Recordkeeping
    9. Amendments to Fund Reporting Requirements
    10. Money Market Funds
    D. Effects on Efficiency, Competition, and Capital Formation
    1. Efficiency
    2. Competition
    3. Capital Formation
    E. Reasonable Alternatives
    1. Alternative Implementations of the VaR Tests
    2. Alternatives to the VaR Tests
    3. Stress Testing Frequency
    4. Alternative Exposure Limits for Leveraged/Inverse Funds
    5. No Sales Practices Rules and No Separate Exposure Limit for 
Leveraged/Inverse Funds
    6. Enhanced Disclosure
    F. Request for Comments
IV. Paperwork Reduction Act Analysis
    A. Introduction
    B. Proposed Rule 18f-4
    1. Derivatives Risk Management Program
    2. Board Oversight and Reporting
    3. Disclosure Requirement Associated With Limit on Fund Leverage 
Risk
    4. Disclosure Requirement for Leveraged/Inverse Funds
    5. Disclosure Changes for Money Market Funds
    6. Policies and Procedures for Limited Derivatives Users
    7. Recordkeeping Requirements
    8. Proposed Rule 18f-4 Total Estimated Burden
    C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers
    1. Due Diligence and Account Approval
    2. Policies and Procedures
    3. Recordkeeping
    4. Proposed Rule 15l-2 Total Estimated Burden
    D. Proposed Rule 211(h)-1: Sales Practices for Registered 
Investment Advisers
    1. Due Diligence and Account Approval
    2. Policies and Procedures
    3. Recordkeeping
    4. Proposed Rule 211(h)-1 Total Estimated Burden
    E. Rule 6c-11
    F. Form N-PORT
    G. Form N-RN
    H. Form N-CEN
    I. Request for Comments
V. Initial Regulatory Flexbility Analysis
    A. Reasons for and Objectives of the Proposed Actions
    B. Legal Basis
    C. Small Entities Subject to Proposed Rules
    D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    1. Proposed Rule 18f-4
    2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
    3. Proposed Sales Practices Rules
    4. Proposed Amendments to Rule 6c-11
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    1. Proposed Rule 18f-4
    2. Proposed Sales Practices Rules
    3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
    4. Rule 6c-11
    G. Request for Comment
VI. Consideration of Impact on the Economy
VII. Statutory Authority
VIII. Appendix A
IX. Appendix B

I. Introduction

    The fund industry has grown and evolved substantially in past 
decades in response to various factors, including investor demand, 
technological developments, and an increase in domestic and 
international investment opportunities, both retail and 
institutional.\1\ Funds today follow a broad variety of investment 
strategies and provide diverse investment opportunities for fund 
investors, including retail investors. As funds' strategies have become 
increasingly diverse, funds' use of derivatives has grown in both 
volume and complexity over the past several decades.\2\ Derivatives may 
be broadly described as instruments or contracts whose value is based 
upon, or derived from, some other asset or metric.\3\ Funds use 
derivatives for a variety of purposes. For example, funds use 
derivatives to seek higher returns through increased investment 
exposure, to hedge risks in their investment portfolios, or to obtain 
exposure to particular investments or markets more efficiently than may 
be

[[Page 4448]]

possible through direct investments.\4\ At the same time, derivatives 
can introduce certain new risks and heighten certain risks to a fund 
and its investors. These risks can arise from, for example, leverage, 
liquidity, markets, operations, legal matters (e.g., contract 
enforceability), and counterparties.
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    \1\ For example, the investment company industry consisted of 
more than 3,500 investment companies, and held over $1.3 trillion in 
assets, as of the end of 1991. See SEC Division of Investment 
Management, Protecting Investors: A Half Century of Investment 
Company Regulation (1992), available at https://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf. The assets held by 
U.S.-registered investment companies grew to approximately $7.1 
trillion as of the end of 1999, and from then until the end of 2018 
grew over 200%, to approximately $21.4 trillion. See Investment 
Company Institute, 2018 Investment Company Fact Book at 32, 
available at https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf . Similarly, the number 
of mutual funds, registered closed-end funds, and ETFs grew from 
7,970, 512, and 30 (respectively) as of the end of 1999, to 9,599, 
506, and 2,057 (respectively) as of the end of 2018. See id. at 50.
     The diversity of fund strategies has also increased over time, 
including, more recently, the introduction of funds pursuing so-
called ``alternative strategies'' (which tend to use derivatives 
more than other fund types). See Daniel Deli, Paul Hanouna, Christof 
Stahel, Yue Tang & William Yost, Use of Derivatives by Registered 
Investment Companies, Division of Economic and Risk Analysis (2015), 
available at https://www.sec.gov/dera/staffpapers/white-papers/derivatives12-2015.pdf (``DERA White Paper'').
    \2\ See Use of Derivatives by Registered Investment Companies 
and Business Development Companies, Investment Company Act Release 
No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 28, 2015)], at n.6 and 
accompanying text (``2015 Proposing Release'').
    \3\ The asset or metric on which the derivative's value is 
based, or from which its value is derived, is commonly referred to 
as the ``reference asset,'' ``underlying asset,'' or ``underlier.'' 
See id. at n.3 and accompanying text (citing Use of Derivatives by 
Investment Companies under the Investment Company Act of 1940, 
Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR 
55237 (Sept. 7, 2011)], at n.3 (``2011 Concept Release'')). The 
comment letters on the 2011 Concept Release (File No. S7-33-11) are 
available at https://www.sec.gov/comments/s7-33-11/s73311.shtml.
    \4\ See, e.g., My Nguyen, Using Financial Derivatives to Hedge 
Against Currency Risk, Arcada University of Applied Sciences (2012).
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    Funds using derivatives must consider requirements under the 
Investment Company Act of 1940.\5\ These include sections 18 and 61 of 
the Investment Company Act, which limit a fund's ability to obtain 
leverage or incur obligations to persons other than the fund's common 
shareholders through the issuance of ``senior securities.'' \6\ As we 
discuss more fully in this release, as derivatives markets have 
expanded and funds have increased their use of derivatives, the 
Commission and its staff have issued guidance addressing the use of 
specific derivatives instruments and practices, and other financial 
instruments, under section 18. In determining how they will comply with 
section 18, we understand that funds consider this Commission and staff 
guidance, as well as staff no-action letters and the practices that 
other funds disclose in their registration statements.\7\
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    \5\ 15 U.S.C. 80a (the ``Investment Company Act,'' or the 
``Act''). Except in connection with our discussion of proposed rule 
15l-2 under the Securities Exchange Act of 1934 and proposed rule 
211(h)-1 under the Advisers Act or as otherwise noted, all 
references to statutory sections are to the Investment Company Act, 
and all references to rules under the Investment Company Act, 
including proposed rule 18f-4, will be to title 17, part 270 of the 
Code of Federal Regulations, 17 CFR part 270.
    \6\ See infra section I.B.1. Funds using derivatives must also 
comply with all other applicable statutory and regulatory 
requirements, such as other federal securities law provisions, the 
Internal Revenue Code, Regulation T of the Federal Reserve Board, 
and the rules and regulations of the Commodity Futures Trading 
Commission (the ``CFTC''). See also Title VII of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act, Public Law 111-203, 124 
Stat. 1376 (2010) (the ``Dodd-Frank Act''), available at https://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.
    Section 61 of the Investment Company Act makes section 18 of the 
Act applicable to BDCs, with certain modifications. See infra note 
32 and accompanying text. Except as otherwise noted, or unless the 
context dictates otherwise, references in this release to section 18 
of the Act should be read to refer also to section 61 with respect 
to BDCs.
    \7\ Any staff guidance or no-action letters discussed in this 
release represent the views of the staff of the Division of 
Investment Management. They are not a rule, regulation, or statement 
of the Commission. Furthermore, the Commission has neither approved 
nor disapproved their content. Staff guidance has no legal force or 
effect; it does not alter or amend applicable law; and it creates no 
new or additional obligations for any person.
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    In the absence of Commission rules and guidance that address the 
current broad range of funds' derivatives use, inconsistent industry 
practices have developed.\8\ We are concerned that certain of these 
practices may not address investor protection concerns that underlie 
section 18's limitations on funds' issuance of senior securities. 
Specifically, certain fund practices can heighten leverage-related 
risks, such as the risk of potentially significant losses and increased 
fund volatility, that section 18 is designed to address. We are also 
concerned that funds' disparate practices could create an un-level 
competitive landscape and make it difficult for funds and our staff to 
evaluate funds' compliance with section 18.\9\
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    \8\ See infra section I.B.2.b (discussing the asset segregation 
practices funds have developed to ``cover'' their derivatives 
positions, which vary based on the type of derivatives transaction 
and with respect to the types of assets that funds segregate to 
cover their derivatives positions).
    \9\ See, e.g., Comment Letter of the Investment Company 
Institute on the 2011 Concept Release (Nov. 7, 2011) (File No. S7-
33-11) at n.19 (``ICI Concept Release Comment Letter'') (noting that 
funds segregate the notional amount of physically-settled futures 
contracts, while some funds disclose that they segregate only the 
marked-to-marked obligation in respect of cash-settled futures and 
agreeing with the concern reflected in the 2011 Concept Release that 
this ``results in differing treatment of arguably equivalent 
products'').
---------------------------------------------------------------------------

    To address these concerns, in 2015 the Commission proposed new rule 
18f-4 under the Investment Company Act, which would have permitted a 
fund to enter into derivatives transactions and ``financial commitment 
transactions,'' subject to certain conditions.\10\ We received 
approximately 200 comment letters in response to the 2015 proposal.\11\ 
In developing this re-proposal we considered those comment letters, as 
well as subsequent staff engagement with large and small fund complexes 
and investor groups.\12\
---------------------------------------------------------------------------

    \10\ For purposes of this release, we will refer to the version 
of rule 18f-4 that the Commission proposed in the 2015 Proposing 
Release as the ``2015 proposed rule.'' We will generally refer to 
rule 18f-4 as we propose it here as the ``proposed rule.''
    The 2015 proposed rule included four principal elements for 
funds entering into derivatives transactions: (1) A requirement to 
comply with one of two alternative portfolio limitations designed to 
limit the amount of leverage a fund may obtain through derivatives 
and other senior securities transactions; (2) asset segregation for 
derivatives transactions, designed to enable a fund to meet its 
derivatives-related obligations; (3) a derivatives risk management 
program requirement for funds that engage in more than limited 
derivatives transactions or that use complex derivatives; and (4) 
reporting requirements regarding a fund's derivatives usage.
    The 2015 proposed rule included different requirements for 
derivatives transactions and ``financial commitment transactions'' 
(collectively, reverse repurchase agreements, short sale borrowings, 
or any firm or standby commitment agreement or similar agreement). 
Rule 18f-4 as we propose it here does not separately define 
``financial commitment transactions,'' although the proposed rule 
does address--either directly or indirectly--all of the types of 
transactions that composed that defined term in the 2015 proposed 
rule. See infra section II.
    \11\ The comment letters on the 2015 proposed rule (File No. S7-
24-15) are available at https://www.sec.gov/comments/s7-24-15/s72415.shtml.
    \12\ See also Division of Economic and Risk Analysis, Memorandum 
re: Risk Adjustment and Haircut Schedules (Nov. 1, 2016), available 
at https://www.sec.gov/comments/s7-24-15/s72415-260.pdf (``2016 DERA 
Memo'').
---------------------------------------------------------------------------

    We are re-proposing rule 18f-4, which is designed to address the 
investor protection purposes and concerns underlying section 18 and to 
provide an updated and more comprehensive approach to the regulation of 
funds' use of derivatives transactions and certain other transactions. 
The proposed rule would permit funds to enter into these transactions, 
notwithstanding the restrictions under section 18 of the Investment 
Company Act, provided that they comply with the conditions of the rule. 
The proposed rule's conditions are designed to require funds to manage 
the risks associated with their use of derivatives and to limit fund 
leverage risk consistent with the investor protection purposes 
underlying section 18. Our proposal also includes requirements designed 
to address specific risks posed by certain registered investment 
companies and exchange-listed commodity- or currency-based trusts or 
funds that obtain leveraged or inverse exposure to an underlying index, 
generally on a daily basis.\13\ The proposal also addresses funds' use 
of reverse repurchase agreements and similar transactions and certain 
so-called ``unfunded commitments.'' Finally, we propose to amend rule 
6c-11 under the Investment Company Act to allow certain leveraged/
inverse ETFs that satisfy that rule's conditions to operate without the 
expense and delay of obtaining an exemptive order. Together, the rules 
we are proposing are designed to promote funds' ability to continue to 
use derivatives in a broad variety of ways that serve investors, while 
responding to the concerns underlying section 18 of the Investment 
Company Act and promoting a more

[[Page 4449]]

modern and comprehensive framework for regulating funds' use of 
derivatives and the other transactions addressed in the proposed rule.
---------------------------------------------------------------------------

    \13\ As discussed in more detail in section II.G, the proposed 
sales practices rules would cover transactions in ``leveraged/
inverse investment vehicles,'' which include registered investment 
companies and certain exchange-listed commodity- or currency-based 
trusts or funds that seek, directly or indirectly, to provide 
investment returns that correspond to the performance of a market 
index by a specified multiple, or to provide investment returns that 
have an inverse relationship to the performance of a market index, 
over a predetermined period of time. For purposes of this release, 
we refer to leveraged, inverse, and leveraged inverse investment 
vehicles collectively as ``leveraged/inverse.''
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A. Overview of Funds' Use of Derivatives

    Funds today use a variety of derivatives. These derivatives can 
reference a range of assets or metrics, such as: Stocks, bonds, 
currencies, interest rates, market indexes, currency exchange rates, or 
other assets or interests. Examples of derivatives that funds commonly 
use include forwards, futures, swaps, and options. Derivatives are 
often characterized as either exchange-traded or over-the-counter 
(``OTC'').\14\
---------------------------------------------------------------------------

    \14\ Exchange-traded derivatives--such as futures, certain 
options, and options on futures--are standardized contracts traded 
on regulated exchanges. See 2015 Proposing Release, supra note 2, at 
nn.10-13 and accompanying text. OTC derivatives--such as certain 
swaps, non-exchange-traded options, and combination products such as 
swaptions and forward swaps--are contracts that parties negotiate 
and enter into outside of an organized exchange. See id. at nn.14-16 
and accompanying text. Unlike exchange-traded derivatives, OTC 
derivatives may be significantly customized and may not be cleared 
by a central clearing organization. Title VII of the Dodd-Frank Act 
provides a comprehensive framework for the regulation of the OTC 
swaps market. See supra note 6.
---------------------------------------------------------------------------

    A common characteristic of most derivatives is that they involve 
leverage or the potential for leverage. The Commission has stated that 
``[l]everage exists when an investor achieves the right to a return on 
a capital base that exceeds the investment which he has personally 
contributed to the entity or instrument achieving a return.'' \15\ Many 
fund derivatives transactions, such as futures, swaps, and written 
options, involve leverage or the potential for leverage because they 
enable the fund to magnify its gains and losses compared to the fund's 
investment, while also obligating the fund to make a payment or deliver 
assets to a counterparty under specified conditions.\16\ Other 
derivatives transactions, such as purchased call options, provide the 
economic equivalent of leverage because they can magnify the fund's 
exposure beyond its investment but do not impose a payment obligation 
on the fund beyond its investment.\17\
---------------------------------------------------------------------------

    \15\ See Securities Trading Practices of Registered Investment 
Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) 
[44 FR 25128 (Apr. 27, 1979)], at n.5 (``Release 10666'').
    \16\ The leverage created by such an arrangement is sometimes 
referred to as ``indebtedness leverage.'' See 2015 Proposing 
Release, supra note 2, at n.21 (citing 2011 Concept Release, supra 
note 3, at n.31).
    \17\ This type of leverage is sometimes referred to as 
``economic leverage.'' See id. at n.22 (citing 2011 Concept Release, 
supra note 3, at n.32).
---------------------------------------------------------------------------

    Funds use derivatives both to obtain investment exposures as part 
of their investment strategies and to manage risk. A fund may use 
derivatives to gain, maintain, or reduce exposure to a market, sector, 
or security more quickly, and with lower transaction costs and 
portfolio disruption, than investing directly in the underlying 
securities.\18\ A fund also may use derivatives to obtain exposure to 
reference assets for which it may be difficult or impractical for the 
fund to make a direct investment, such as commodities.\19\ With respect 
to risk management, funds may employ derivatives to hedge interest 
rate, currency, credit, and other risks, as well as to hedge portfolio 
exposures.\20\
---------------------------------------------------------------------------

    \18\ See, e.g., id. at n.24 and accompanying text (citing 2011 
Concept Release, supra note 3, at section I).
    \19\ See, e.g., Comment Letter of Stone Ridge Asset Management 
LLC (Mar. 28, 2016) (``[I]t is not possible for AVRPX [a Stone Ridge 
fund] to trade many of the physical assets underlying the 
derivatives included in our portfolio--Stone Ridge does not maintain 
facilities to store oil or live hogs, for example.''); Comment 
Letter of Vanguard (Mar. 28, 2016) (``Vanguard Comment Letter'') 
(stating that a fund may use a derivative, such as commodity 
futures, when it is impractical to take delivery of physical 
commodities).
    \20\ See 2015 Proposing Release, supra note 2, at n.25 and 
accompanying text; see also 2011 Concept Release, supra note 3, at 
section I.B.
---------------------------------------------------------------------------

    At the same time, a fund's derivatives use may entail risks 
relating to, for example, leverage, markets, operations, liquidity 
(particularly with respect to complex OTC derivatives), and 
counterparties, as well as legal risks.\21\ A fund's investment 
adviser, therefore, must manage (and the board of directors oversee) 
the fund's derivatives use, consistent with the fund's investment 
objectives, policies, restrictions, and risk profile. Furthermore, a 
fund's investment adviser and board of directors must bear in mind the 
requirements of section 18 of the Investment Company Act, as well as 
the Act's other requirements, when considering the use of derivatives.
---------------------------------------------------------------------------

    \21\ See 2015 Proposing Release, supra note 2, at n.26 and 
accompanying text (citing 2011 Concept Release, supra note 3, at 
n.34).
---------------------------------------------------------------------------

    Section 18 is designed to limit the leverage a fund can obtain or 
incur through the issuance of senior securities. Although the leverage 
limitations in section 18 apply regardless of whether the relevant fund 
actually experiences significant losses, several recent examples 
involving significant losses illustrate how a fund's use of derivatives 
may raise the investor protection concerns underlying section 18. The 
2015 proposal discussed several circumstances in which substantial and 
rapid losses resulted from a fund's investment in derivatives.\22\ For 
example, one of these cases shows that further losses can result when a 
fund's portfolio securities decline in value at the same time that the 
fund is required to make additional payments under its derivatives 
contracts.\23\
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    \22\ See 2015 Proposing Release, supra note 2, at section 
II.D.1.d. (discussing, among other things, the following settled 
actions: In the Matter of OppenheimerFunds, Inc. and 
OppenheimerFunds Distributor, Inc., Investment Company Act Release 
No. 30099 (June 6, 2012) (settled action) (``OppenheimerFunds 
Settled Action'') (involving two mutual funds that suffered losses 
driven primarily by their exposure to certain commercial mortgage-
backed securities, obtained mainly through total return swaps); In 
the Matter of Claymore Advisors, LLC, Investment Company Act Release 
No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset 
Management, LLC, Investment Company Act Release No. 30309 (Dec. 19, 
2012) (settled actions) (involving a registered closed-end fund that 
pursued an investment strategy involving written out-of-the-money 
put options and short variance swaps, which led to substantial 
losses for the fund); In the Matter of UBS Willow Management L.L.C. 
and UBS Fund Advisor L.L.C., Investment Company Act Release No. 
31869 (Oct. 16, 2015) (settled action) (involving a registered 
closed-end fund that incurred significant losses due in part to 
large losses on the fund's credit default swap portfolio)).
    See also In the Matter of Team Financial Asset Management, LLC, 
Team Financial Managers, Inc., and James L. Dailey, Investment 
Company Act Release No. 32951 (Dec. 22, 2017) (settled action) 
(involving a mutual fund incurring substantial losses arising out of 
speculative derivatives instruments, including losing $34.67 million 
in 2013 from trading in derivatives such as futures, options, and 
currency contracts); In the Matter of Mohammed Riad and Kevin 
Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21, 
2018) (settled action) (involving a registered closed-end fund 
incurring substantial losses resulting from the implementation of a 
new derivatives trading strategy); In the Matter of Top Fund 
Management, Inc. and Barry C. Ziskin, Investment Company Act Release 
No. 30315 (Dec. 21, 2012) (settled action) (involving a mutual fund 
engaged in a strategy of buying options for speculative purposes 
contrary to its stated investment policy, which permitted options 
trading for hedging purposes, losing about 69% of its assets as a 
result of this activity before liquidating).
    \23\ See OppenheimerFunds Settled Action, supra note 22.
---------------------------------------------------------------------------

    Similarly, last year the LJM Preservation and Growth Fund 
liquidated after sustaining considerable losses (with its net asset 
value declining approximately 80% in two days) when market volatility 
spiked. The fund's principal investment strategy involved purchasing 
and selling call and put options on the Standard & Poor's (``S&P'') 500 
Futures Index.\24\ S&P 500 options prices are determined in part by 
market volatility, and a volatility spike in early February 2018 caused 
the fund to incur significant losses. The fund closed to new 
investments on February 7, 2018 and announced on February 27,

[[Page 4450]]

2018 that it would liquidate its assets and dissolve on March 29, 
2018.\25\
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    \24\ See Prospectus, LJM Preservation and Growth Fund (Feb. 28, 
2017), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm.
    \25\ See Supplement to the Prospectus dated Feb. 28, 2017, LJM 
Preservation and Growth Fund (Feb. 27, 2018), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064218001068/ljm497.htm.
---------------------------------------------------------------------------

    The losses suffered by this fund and in the other examples we 
discuss above are extreme. Funds rarely suffer such large and rapid 
losses. We note these examples to illustrate the rapid and extensive 
losses that can result from a fund's investments in derivatives absent 
effective derivatives risk management. In contrast, there are many 
other instances in which funds, by employing derivatives, have avoided 
losses, increased returns, and lowered risk.

B. Derivatives and the Senior Securities Restrictions of the Investment 
Company Act

1. Requirements of Section 18
    Section 18 of the Investment Company Act imposes various limits on 
the capital structure of funds, including, in part, by restricting the 
ability of funds to issue ``senior securities.'' Protecting investors 
against the potentially adverse effects of a fund's issuance of senior 
securities, and in particular the risks associated with excessive 
leverage of investment companies, is a core purpose of the Investment 
Company Act.\26\ ``Senior security'' is defined, in part, as ``any 
bond, debenture, note, or similar obligation or instrument constituting 
a security and evidencing indebtedness.'' \27\
---------------------------------------------------------------------------

    \26\ See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of 
the Investment Company Act; see also Provisions Of The Proposed Bill 
Related To Capital Structure (Sections 18, 19(B), And 21(C)), 
Introduced by L.M.C Smith, Associate Counsel, Investment Trust 
Study, Securities and Exchange Commission, Hearings on S.3580 Before 
a Subcommittee of the Senate Committee on Banking and Currency, 76th 
Congress, 3rd session (1940), at 1028 (``Senate Hearings'') 
(``Because of the leverage influence, a substantial swing of the 
securities market is likely to deprive the common stock of a 
leverage investment company of both its asset and market value. . . 
. [H]ad investment companies been simple structure companies 
exclusively, a very substantial part of the losses sustained by 
investors in the common stock would have been avoided.'').
    \27\ See section 18(g) of the Investment Company Act. The 
definition of ``senior security'' in section 18(g) also includes 
``any stock of a class having priority over any other class as to 
the distribution of assets or payment of dividends'' and excludes 
certain limited temporary borrowings.
---------------------------------------------------------------------------

    Congress' concerns underlying the limits in section 18 focused on: 
(1) Excessive borrowing and the issuance of excessive amounts of senior 
securities by funds when these activities increase unduly the 
speculative character of funds' junior securities; (2) funds operating 
without adequate assets and reserves; and (3) potential abuse of the 
purchasers of senior securities.\28\ To address these concerns, section 
18 prohibits an open-end fund from issuing or selling any ``senior 
security,'' other than borrowing from a bank (subject to a requirement 
to maintain 300% ``asset coverage'').\29\ Section 18 similarly 
prohibits a closed-end fund from issuing or selling any ``senior 
security [that] represents an indebtedness'' unless it has at least 
300% ``asset coverage,'' although closed-end funds' ability to issue 
senior securities representing indebtedness is not limited to bank 
borrowings.\30\ Closed-end funds also may issue senior securities that 
are a stock, subject to the limitations of section 18.\31\ The 
Investment Company Act also subjects BDCs to the limitations of section 
18 to the same extent as registered closed-end funds, except the 
applicable asset coverage amount for any senior security representing 
indebtedness is 200% (and can be decreased to 150% under certain 
circumstances).\32\
---------------------------------------------------------------------------

    \28\ For discussion of the excessive borrowing concern, see 
section 1(b)(7) of the Investment Company Act; Release 10666, supra 
note 15, at n.8; see also Senate Hearings, supra note 26, at 1028 
(``The Commission believes that it has been clearly shown that it is 
the leverage aspect of the senior-junior capital structure in 
investment companies . . . which may be held accountable for a large 
part of the losses which have been suffered by the investor who 
purchases the common stock of a leverage company.'').
    For discussion of concerns regarding funds operating without 
adequate assets and reserves, see section 1(b)(8) of the Investment 
Company Act; Release 10666, supra note 15, at n.8.
    For discussion of, among other things, potential abuse of the 
purchasers of senior securities, see Senate Hearings, supra note 26, 
at 265-78; see also Mutual Funds and Derivative Instruments, 
Division of Investment Management Memorandum transmitted by Chairman 
Levitt to Representatives Markey and Fields (Sept. 26, 1994), at 23, 
available at https://www.sec.gov/news/studies/deriv.txt (``1994 
Letter to Congress'') (describing practices in the 1920s and 1930s 
that gave rise to section 18's limits on leverage).
    \29\ See section 18(f)(1) of the Investment Company Act. ``Asset 
coverage'' of a class of senior securities representing indebtedness 
of an issuer generally is defined in section 18(h) of the Investment 
Company Act as ``the ratio which the value of the total assets of 
such issuer, less all liabilities and indebtedness not represented 
by senior securities, bears to the aggregate amount of senior 
securities representing indebtedness of such issuer.'' Take, for 
example, an open-end fund with $100 in assets and with no 
liabilities or senior securities outstanding. The fund could, while 
maintaining the required coverage of 300% of the value of its 
assets, borrow an additional $50 from a bank. The $50 in borrowings 
would represent one-third of the fund's $150 in total assets, 
measured after the borrowing (or 50% of the fund's $100 net assets).
    \30\ See section 18(a)(1) of the Investment Company Act.
    \31\ See section 18(a)(2) of the Investment Company Act. If a 
closed-end fund issues or sells a class of senior securities that is 
a stock, it must have an asset coverage of at least 200% immediately 
after such issuance or sale. Id.
    \32\ See section 61(a)(1) of the Investment Company Act. BDCs, 
like registered closed-end funds, also may issue a senior security 
that is a stock (e.g., preferred stock), subject to limitations in 
section 18. See sections 18(a)(2) and 61(a)(1) of the Investment 
Company Act. In 2018, Congress passed the Small Business Credit 
Availability Act, which, among other things, modified the statutory 
asset coverage requirements applicable to BDCs (permitting BDCs that 
meet certain specified conditions to elect to decrease their 
effective asset coverage requirement from 200% to 150%). See section 
802 of the Small Business Credit Availability Act, Public Law 115-
141, 132 Stat. 348 (2018).
---------------------------------------------------------------------------

2. Evolution of Commission and Staff Consideration of Section 18 
Restrictions as Applied to Funds' Use of Derivatives
a. Investment Company Act Release 10666
    In a 1979 General Statement of Policy (Release 10666), the 
Commission considered the application of section 18's restrictions on 
the issuance of senior securities to reverse repurchase agreements, 
firm commitment agreements, and standby commitment agreements.\33\ The 
Commission concluded that these agreements fall within the ``functional 
meaning of the term `evidence of indebtedness' for purposes of Section 
18 of the Investment Company Act,'' noting ``the unique legislative 
purposes and policies underlying Section 18 of the Act.'' \34\ The 
Commission stated in Release 10666 that, for purposes of section 18, 
``evidence of indebtedness'' would include ``all contractual 
obligations to pay in the future for consideration presently 
received.'' The Commission recognized that, while section 18 would 
generally prohibit open-end funds' use of reverse repurchase 
agreements, firm commitment agreements, and standby commitment 
agreements, the Commission nonetheless permitted funds to use these and 
similar arrangements subject to the constraints that Release 10666 
describes.
---------------------------------------------------------------------------

    \33\ See Release 10666, supra note 15.
    \34\ See id.
---------------------------------------------------------------------------

    These constraints relied on funds' use of ``segregated accounts'' 
to ``cover'' senior securities, which ``if properly created and 
maintained, would limit the investment company's risk of loss.'' \35\ 
The Commission also stated that the segregated account functions as ``a 
practical limit on the amount of leverage which the investment company 
may undertake and on the potential increase in the speculative 
character of its outstanding common stock'' and that it ``[would] 
assure the availability of adequate funds to meet the obligations 
arising from such activities.'' \36\ The

[[Page 4451]]

Commission stated that its expressed views were not limited to the 
particular trading practices discussed, but that the Commission sought 
to address the implications of comparable trading practices that could 
similarly affect funds' capital structures.\37\
---------------------------------------------------------------------------

    \35\ See 2015 Proposing Release, supra note 2, at nn.45-47 and 
accompanying text (discussing Release 10666's discussion of 
segregated accounts).
    \36\ See Release 10666, supra note 15, at 25132; see also 2015 
Proposing Release, supra note 2, at n.48 and accompanying text.
    \37\ See 2015 Proposing Release, supra note 2, at nn.49-50 and 
accompanying text.
---------------------------------------------------------------------------

    We continue to view the transactions described in Release 10666 as 
falling within the functional meaning of the term ``evidence of 
indebtedness,'' for purposes of section 18.\38\ The trading practices 
that Release 10666 describes, as well as short sales of securities for 
which the staff initially developed the segregated account approach 
that the Commission applied in Release 10666, all impose on a fund a 
contractual obligation under which the fund is or may be required to 
pay or deliver assets in the future to a counterparty. These 
transactions therefore involve the issuance of a senior security for 
purposes of section 18.\39\
---------------------------------------------------------------------------

    \38\ See Release 10666, supra note 15, at ``The Agreements as 
Securities'' discussion. The Investment Company Act's definition of 
the term ``security'' is broader than the term's definition in other 
federal securities laws. See 2015 Proposing Release, supra note 2, 
at n.61. Compare section 2(a)(36) of the Investment Company Act with 
sections 2(a)(1) and 2A of the Securities Act of 1933 (15 U.S.C. 77a 
et seq.) (``Securities Act'') and sections 3(a)(10) and 3A of the 
Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) (``Exchange 
Act''). See also 2011 Concept Release, supra note 3, at n.57 and 
accompanying text (explaining that the Commission has interpreted 
the term ``security'' in light of the policies and purposes 
underlying the Investment Company Act).
    \39\ See Release 10666, supra note 15, at ``The Agreements as 
Securities'' discussion; see also section 18(g) (defining the term 
``senior security,'' in part, as ``any bond, debenture, note, or 
similar obligation or instrument constituting a security and 
evidencing indebtedness'').
    The Commission received several comments on the 2015 proposal 
that objected to the Commission treating derivatives and financial 
commitment transactions as involving senior securities where a fund 
has ``appropriately'' covered its obligations under those 
transactions. These comments generally argued that this approach is 
not consistent with the Commission's views in Release 10666 and that 
funds have for many years addressed senior security concerns raised 
by these transactions by segregating assets or engaging in 
offsetting, or ``cover,'' transactions that take into account 
Release 10666 and staff guidance. See, e.g., Comment Letter of the 
American Action Forum (Mar. 25, 2016) (``AAF Comment Letter''); 
Comment Letter of Financial Services Roundtable (Mar. 28, 2016) 
(``FSR Comment Letter''); Comment Letter of Franklin Resources, Inc. 
(Mar. 28, 2016) (``Franklin Resources Comment Letter''); Comment 
Letter of Dechert LLP (Mar. 28, 2016) (``Dechert Comment Letter''). 
Whether a transaction involves the issuance of a senior security 
will depend on whether that transaction involves a senior security 
within the meaning of section 18(g). A fund's segregation of assets, 
although one way to address policy concerns underlying section 18 as 
the Commission described in Release 10666, does not, itself, affect 
the legal question of whether a fund has issued a senior security.
---------------------------------------------------------------------------

    We apply the same analysis to all derivatives transactions that 
create future payment obligations. This is the case where the fund has 
a contractual obligation to pay or deliver cash or other assets to a 
counterparty in the future, either during the life of the instrument or 
at maturity or early termination.\40\ As was the case for trading 
practices that Release 10666 describes, where the fund has entered into 
a derivatives transaction and has such a future payment obligation, we 
believe that such a transaction involves an evidence of indebtedness 
that is a senior security for purposes of section 18.\41\
---------------------------------------------------------------------------

    \40\ These payments--which may include payments of cash, or 
delivery of other assets--may occur as margin, as settlement 
payments, or otherwise.
    \41\ As the Commission explained in Release 10666, we believe 
that an evidence of indebtedness, for purposes of section 18, 
includes not only a firm and un-contingent obligation, but also a 
contingent obligation, such as a standby commitment or a ``put'' (or 
call) option sold by a fund. See Release 10666, supra note 15, at 
``Standby Commitment Agreements'' discussion. We understand it has 
been asserted that a contingent obligation that a standby commitment 
or similar agreement creates does not involve a senior security 
under section 18, unless and until generally accepted accounting 
principles (``GAAP'') would require the fund to recognize the 
contingent obligation as a liability on the fund's financial 
statements. The treatment of derivatives transactions under GAAP, 
including whether the derivatives transaction constitutes a 
liability for financial statement purposes at any given time or the 
extent of the liability for that purpose, is not determinative with 
respect to whether the derivatives transaction involves the issuance 
of a senior security under section 18. This is consistent with the 
Commission's analysis of a fund's obligation, and the corresponding 
segregated asset amounts, under the trading practices that Release 
10666 describes. See id.
---------------------------------------------------------------------------

    The express scope of section 18 supports this interpretation. 
Section 18 defines the term ``senior security'' broadly to include 
instruments and transactions that other provisions of the federal 
securities laws might not otherwise consider to be securities.\42\ For 
example, section 18(f)(1) generally prohibits an open-end fund from 
issuing or selling any senior security ``except [that the fund] shall 
be permitted to borrow from any bank.'' \43\ This statutory permission 
to engage in a specific borrowing makes clear that such borrowings are 
senior securities, which otherwise section 18 would prohibit absent 
this specific permission.\44\
---------------------------------------------------------------------------

    \42\ Consistent with Release 10666, and as the Commission stated 
in the 2015 Proposing Release, we are only expressing our views in 
this release concerning the scope of the term ``senior security'' in 
section 18 of the Investment Company Act. See also section 12(a) of 
the Investment Company Act (prohibiting funds from engaging in short 
sales in contravention of Commission rules or orders).
    \43\ Section 18(c)(2) similarly treats all promissory notes or 
evidences of indebtedness issued in consideration of any loan as 
senior securities except as section 18 otherwise specifically 
provides.
    \44\ The Commission similarly observed in Release 10666 that 
section 18(f)(1), ``by implication, treats all borrowings as senior 
securities,'' and that ``[s]ection 18(f)(1) of the Act prohibits 
such borrowings unless entered into with banks and only if there is 
300% asset coverage on all borrowings of the investment company.'' 
See Release 10666, supra note 15, at ``Reverse Repurchase 
Agreements'' discussion.
---------------------------------------------------------------------------

    This interpretation also is consistent with the fundamental policy 
and purposes underlying the Investment Company Act expressed in 
sections 1(b)(7) and 1(b)(8) of the Act.\45\ These respectively declare 
that ``the national public interest and the interest of investors are 
adversely affected'' when funds ``by excessive borrowing and the 
issuance of excessive amounts of senior securities increase unduly the 
speculative character'' of securities issued to common shareholders and 
when funds ``operate without adequate assets or reserves.'' The 
Commission emphasized these concerns in Release 10666, and we continue 
to believe that the prohibitions and restrictions under the senior 
security provisions of section 18 should ``function as a practical 
limit on the amount of leverage which the investment company may 
undertake and on the potential increase in the speculative character of 
its outstanding common stock'' and that funds should not ``operate 
without adequate assets or reserves.'' \46\ Funds' use of derivatives, 
like the trading practices the Commission addressed in Release 10666, 
may raise the undue speculation and asset sufficiency concerns in 
section 1(b).\47\ First, funds' obtaining

[[Page 4452]]

leverage (or potential for leverage) through derivatives may raise the 
Investment Company Act's undue speculation concern because a fund may 
experience gains and losses that substantially exceed the fund's 
investment, and also may incur a conditional or unconditional 
obligation to make a payment or deliver assets to a counterparty.\48\ 
Not viewing derivatives that impose a future payment obligation on the 
fund as involving senior securities, subject to appropriate limits 
under section 18, would frustrate the concerns underlying section 
18.\49\
---------------------------------------------------------------------------

    \45\ The Commission received several comments on the 2015 
proposal asserting that the provisions in section 1(b) of the 
Investment Company Act do not, themselves, provide us authority to 
regulate senior securities transactions. See, e.g., AAF Comment 
Letter; Franklin Resources Comment Letter; Comment Letter of the 
Securities Industry and Financial Markets Association (Mar. 28, 
2016) (``SIFMA Comment Letter'').
    The fundamental statutory policy and purposes underlying the 
Investment Company Act, as expressed in section 1(b) of the Act, 
inform our interpretation of the scope of the term ``senior 
security'' in section 18, as we discuss in the paragraph 
accompanying this note (and separately inform our consideration of 
appropriate conditions for the exemption that proposed rule 18f-4 
provides, as we discuss in sections II.B-II.G infra). The authority 
under which we are proposing rules today is set forth in section VII 
of this release and includes, among other provisions, section 6(c) 
of the Act.
    \46\ See Release 10666, supra note 15, at ``Segregated Account'' 
discussion.
    \47\ As the Commission stated in Release 10666, leveraging an 
investment company's portfolio through the issuance of senior 
securities ``magnifies the potential for gain or loss on monies 
invested and therefore results in an increase in the speculative 
character of the investment company's outstanding securities'' and 
``leveraging without any significant limitation'' was identified 
``as one of the major abuses of investment companies prior to the 
passage of the Act by Congress.'' Id.
    \48\ See, e.g., The Report of the Task Force on Investment 
Company Use of Derivatives and Leverage, Committee on Federal 
Regulation of Securities, ABA Section of Business Law (July 6, 
2010), at 8 (``2010 ABA Derivatives Report'') (stating that 
``[f]utures contracts, forward contracts, written options and swaps 
can produce a leveraging effect on a fund's portfolio'' because 
``for a relatively small up-front payment made by a fund (or no up-
front payment, in the case with many swaps and written options), the 
fund contractually obligates itself to one or more potential future 
payments until the contract terminates or expires''; noting, for 
example, that an ``[interest rate] swap presents the possibility 
that the fund will be required to make payments out of its assets'' 
and that ``[t]he same possibility exists when a fund writes puts and 
calls, purchases short and long futures and forwards, and buys or 
sells credit protection through [credit default swaps]'').
    \49\ One commenter on the 2011 Concept Release made this point 
directly. See Comment Letter of Stephen A. Keen on the 2011 Concept 
Release (Nov. 8, 2011) (File No. S7-33-11), at 3 (``Keen Concept 
Release Comment Letter'') (``If permitted without limitation, 
derivative contracts can pose all of the concerns that section 18 
was intended to address with respect to borrowings and the issuance 
of senior securities by investment companies.''); see also, e.g., 
ICI Concept Release Comment Letter, at 8 (``The Act is thus designed 
to regulate the degree to which a fund issues any form of debt--
including contractual obligations that could require a fund to make 
payments in the future.''). The Commission similarly noted in 
Release 10666 that, given the potential for reverse repurchase 
agreements to be used for leveraging and their ability to magnify 
the risk of investing in a fund, ``one of the important policies 
underlying section 18 would be rendered substantially nugatory'' if 
funds' use of reverse repurchase agreements were not subject to 
limitation. See 2015 Proposing Release, supra note 2, at text 
preceding n.76.
---------------------------------------------------------------------------

    Second, with respect to the Investment Company Act's asset 
sufficiency concern, a fund's use of derivatives with future payment 
obligations also may raise concerns regarding the fund's ability to 
meet those obligations. Many fund derivatives investments, such as 
futures contracts, swaps, and written options, pose a risk of loss that 
can result in payment obligations owed to the fund's 
counterparties.\50\ Losses on derivatives therefore can result in 
counterparty payment obligations that directly affect the capital 
structure of a fund and the relative rights of the fund's 
counterparties and shareholders. These losses and payment obligations 
also can force a fund's adviser to sell the fund's investments to meet 
its obligations. When a fund uses derivatives to leverage its 
portfolio, this can amplify the risk of a fund having to sell its 
investments, potentially generating additional losses for the fund.\51\ 
In an extreme situation, a fund could default on its payment 
obligations.\52\
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    \50\ Some derivatives transactions, like physically-settled 
futures and forwards, can require the fund to deliver the underlying 
reference assets regardless of whether the fund experiences losses 
on the transaction.
    \51\ See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen, 
Market Liquidity and Funding Liquidity, 22 The Review of Financial 
Studies 6, 2201-2238 (June 2009), available at https://
www.princeton.edu/~markus/research/papers/liquidity.pdf (providing 
both empirical support as well as a theoretical foundation for how 
short-term leverage obtained through borrowings or derivative 
positions can result in funds and other financial intermediaries 
becoming vulnerable to tighter funding conditions and increased 
margins, specifically during economic downturns (as in the recent 
financial crisis), thus potentially increasing the need for the fund 
or intermediary to de-lever and sell portfolio assets at a loss).
    \52\ See 2015 Proposing Release, supra note 2, at n.80.
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b. Market and Industry Developments Following Release 10666
    Following the issuance of Release 10666, Commission staff issued 
more than thirty no-action letters to funds concerning the maintenance 
of segregated accounts or otherwise ``covering'' their obligations in 
connection with various transactions otherwise restricted by section 
18.\53\ In these letters (issued primarily in the 1970s through 1990s) 
and through other staff guidance, Commission staff has addressed 
questions--generally on an instrument-by-instrument basis--regarding 
the application of the Commission's statements in Release 10666 to 
various types of derivatives and other transactions.
---------------------------------------------------------------------------

    \53\ See id. at n.51 and accompanying text (citing 2011 Concept 
Release, supra note 3, at section I).
---------------------------------------------------------------------------

    Funds have developed certain general asset segregation practices to 
cover their derivatives positions, based at least in part on the 
staff's no-action letters and guidance. Practices vary based on the 
type of derivatives transaction. For certain derivatives, funds 
generally segregate an amount equal to the full amount of the fund's 
potential obligation under the contract, or the full market value of 
the underlying reference asset for the derivative (``notional amount 
segregation'').\54\ For certain cash-settled derivatives, funds often 
segregate an amount equal to the fund's daily mark-to-market liability, 
if any (``mark-to-market segregation'').\55\
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    \54\ See id. at nn.54-55 and accompanying text.
    \55\ See id. at nn.56-58, 96-98 and accompanying text (stating 
that funds initially applied the mark-to-market approach to 
segregation to specific types of transactions addressed through 
guidance by our staff (interest rate swaps, cash-settled futures, 
non-deliverable forwards), but that funds now apply mark-to-market 
segregation to a wider range of cash-settled instruments, with our 
staff observing that some funds appear to apply the mark-to-market 
approach to any derivative that is cash settled).
---------------------------------------------------------------------------

    Similarly, funds use different practices regarding the types of 
assets that they segregate to cover their derivatives positions. 
Release 10666 states that the assets eligible to be included in 
segregated accounts should be ``liquid assets'' such as cash, U.S. 
government securities, or other appropriate high-grade debt 
obligations.\56\ However, a subsequent staff no-action letter stated 
that the staff would not recommend enforcement action if a fund were to 
segregate any liquid asset, including equity securities and non-
investment grade debt securities, to cover its senior securities-
related obligations.\57\
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    \56\ See id. at n.47 and accompanying text.
    \57\ See id. at n.59 and accompanying text (citing Merrill Lynch 
Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996), 
available at https://www.sec.gov/divisions/investment/imseniorsecurities/merrilllynch070196.pdf).
---------------------------------------------------------------------------

    As a result of these asset segregation practices, funds' 
derivatives use--and thus funds' potential leverage through derivatives 
transactions--does not appear to be subject to a practical limit as the 
Commission contemplated in Release 10666. Funds' mark-to-market 
liability often does not reflect the full investment exposure 
associated with their derivatives positions.\58\ As a result, a fund 
that segregates only the mark-to-market liability could theoretically 
incur virtually unlimited investment leverage.\59\
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    \58\ For example, for derivatives where there is no loss in a 
given day, a fund applying the mark-to-market approach might not 
segregate any assets. This may be the case, for example, because the 
derivative is currently in a gain position, or because the 
derivative has a market value of zero (as will generally be the case 
at the inception of a transaction). The fund may, however, still be 
required to post collateral to comply with other regulatory or 
contractual requirements.
    \59\ See, e.g., Comment Letter of Ropes & Gray LLC on the 
Concept Release (Nov. 7, 2011) (File No. S7-33-11), at 4 (stating 
that ``[o]f course, in many cases [a fund's daily mark-to-market 
liability, if any] will not fully reflect the ultimate investment 
exposure associated with the swap position'' and that, ``[a]s a 
result, a fund that segregates only the market-to-market liability 
could theoretically incur virtually unlimited investment leverage 
using cash-settled swaps''); Keen Concept Release Comment Letter, at 
20 (stating that the mark-to-market approach, as applied to cash 
settled swaps, ``imposes no effective control over the amount of 
investment leverage created by these swaps, and leaves it to the 
market to limit the amount of leverage a fund may use'').
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    These current asset segregation practices also may not assure the

[[Page 4453]]

availability of adequate assets to meet funds' derivatives obligations, 
as the Commission contemplated in Release 10666. A fund using the mark-
to-market approach could segregate assets that only reflect the losses 
(and corresponding potential payment obligations) that the fund would 
then incur as a result of transaction termination. This practice 
provides no assurances that future losses will not exceed the value of 
the segregated assets or the value of all assets then available to meet 
the payment obligations resulting from such losses.\60\ We also 
recognize that when a fund segregates any liquid asset, rather than the 
more narrow range of high-quality assets the Commission described in 
Release 10666, the segregated assets may be more likely to decline in 
value at the same time as the fund experiences losses on its 
derivatives.\61\ In this case, or when a fund's derivatives payment 
obligations are substantial relative to the fund's liquid assets, the 
fund may be forced to sell portfolio securities to meet its derivatives 
payment obligations. These forced sales could occur during stressed 
market conditions, including at times when prudent management could 
advise against such liquidation.\62\
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    \60\ A fund's mark-to-market liability on any particular day, if 
any, could be substantially smaller than the fund's ultimate 
obligations under a derivative. See 2015 Proposing Release, supra 
note 2, at n.113.
    \61\ See id. at n.115.
    \62\ The Commission noted in Release 10666 that ``in an extreme 
case an investment company which has segregated all its liquid 
assets might be forced to sell non-segregated portfolio securities 
to meet its obligations upon shareholder requests for redemption. 
Such forced sales could cause an investment company to sell 
securities which it wanted to retain or to realize gains or losses 
which it did not originally intend.'' See Release 10666, supra note 
15, at ``Segregated Account'' discussion.
---------------------------------------------------------------------------

3. Need for Updated Regulatory Framework
    As the Commission observed in the 2015 proposal and for the reasons 
discussed above, we continue to be concerned that funds' current 
practices regarding derivatives use may not address the undue 
speculation and asset sufficiency concerns underlying section 18.\63\ 
Additionally, as recent events demonstrate, a fund's derivatives use 
may involve risks that can result in significant losses to a fund.\64\ 
Accordingly, we continue to believe that it is appropriate for funds to 
address these risks and considerations relating to their derivatives 
use. Nevertheless, we also recognize the valuable role derivatives can 
play in helping funds to achieve their objectives efficiently or manage 
their investment risks.
---------------------------------------------------------------------------

    \63\ See 2015 Proposing Release, supra note 2, at sections 
II.D.1.b and II.D.1.c; see also supra paragraphs accompanying notes 
58-62.
    \64\ See supra paragraph accompanying notes 22-25.
---------------------------------------------------------------------------

    We therefore believe funds that significantly use derivatives 
should adopt and implement formalized programs to manage the risks 
derivatives may pose. In addition, a more modern framework for 
regulating funds' derivatives use would respond to our concern that 
funds today are not subject to a practical limit on potential leverage 
that they may obtain through derivatives transactions. The risk 
management program requirement and limit on fund leverage risk we are 
proposing are designed to address these considerations, in turn.
    A comprehensive approach to regulating funds' derivatives use also 
would help address potential adverse results from funds' current, 
disparate asset segregation practices. The development of staff 
guidance and industry practice on an instrument-by-instrument basis, 
together with growth in the volume and complexity of derivatives 
markets over past decades, has resulted in situations in which 
different funds may treat the same kind of derivative differently, 
based on their own view of our staff's guidance or observation of 
industry practice. This may unfairly disadvantage some funds.\65\ The 
lack of comprehensive guidance also makes it difficult for funds and 
our staff to evaluate and inspect for funds' compliance with section 18 
of the Investment Company Act. Moreover, where there is no specific 
guidance, or where the application of existing guidance is unclear or 
applied inconsistently, funds may take approaches that involve an 
extensive use of derivatives and may not address the purposes and 
concerns underlying section 18.
---------------------------------------------------------------------------

    \65\ See, e.g., Comment Letter of Davis Polk on the 2011 Concept 
Release (Nov. 11, 2011), at 1-2 (stating that ``funds and their 
sponsors may interpret the available guidance differently, even when 
applying it to the same instruments, which may unfairly disadvantage 
some funds''); see also Comment Letter of Federated Investors, Inc. 
(Mar. 23, 2016) (``Federated Comment Letter''); Comment Letter of 
Salient Partners, L.P. (Mar. 25, 2016) (``Salient Comment Letter).
---------------------------------------------------------------------------

C. Overview of the Proposal

    Our proposal consists of three parts. Proposed rule 18f-4 is 
designed to provide an updated, comprehensive approach to the 
regulation of funds' use of derivatives and the other transactions that 
the proposed rule addresses. The proposed sales practices rules are 
designed to address investor protection concerns with respect to 
leveraged/inverse funds by requiring broker-dealers and investment 
advisers to exercise due diligence on retail investors before approving 
retail investor accounts to invest in leveraged/inverse funds. The 
proposed amendments to Forms N-PORT, N-LIQUID (which we propose to re-
title as ``Form N-RN''), and N-CEN are designed to enhance the 
Commission's ability to 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.
    Proposed rule 18f-4 would permit a fund to enter into derivatives 
transactions, notwithstanding the prohibitions and restrictions on the 
issuance of senior securities under section 18 of the Investment 
Company Act, subject to the following conditions: \66\
---------------------------------------------------------------------------

    \66\ See proposed rule 18f-4(b) and (d). Proposed rule 18f-4(b) 
would provide an exemption for funds' derivatives transactions from 
sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company 
Act. See supra section I.B.1 of this release (providing an overview 
of the requirements of section 18). Because the proposed conditions 
are designed to provide a tailored set of requirements for 
derivatives transactions, the proposed rule would also provide that 
a fund's derivatives transactions would not be considered for 
purposes of computing asset coverage under section 18(h). Applying 
section 18(h) asset coverage to a fund's derivatives transactions 
appears unnecessary in light of the tailored restrictions we are 
proposing. See also infra section II.M.
---------------------------------------------------------------------------

     Derivatives risk management program.\67\ The proposed rule 
would generally require a fund to adopt a written derivatives risk 
management program with risk guidelines that must cover certain 
elements, but that otherwise would be tailored based on how the fund's 
use of derivatives may affect its investment portfolio and overall risk 
profile. The program also would have to include stress testing, 
backtesting, internal reporting and escalation, and program review 
elements. The program would institute a standardized risk management 
framework for funds that engage in more than a limited amount of 
derivatives transactions, while allowing principles-based tailoring to 
the fund's particular risks. We believe that a formalized derivatives 
risk management program is critical to appropriate derivatives risk 
management and is foundational to providing exemptive relief under 
section 18.
---------------------------------------------------------------------------

    \67\ See proposed rule 18f-4(c)(1); infra section II.A.2.
---------------------------------------------------------------------------

     Limit on fund leverage risk.\68\ The proposed rule would 
generally require funds when engaging in derivatives

[[Page 4454]]

transactions to comply with an outer limit on fund leverage risk based 
on value at risk, or ``VaR.'' This outer limit would be based on a 
relative VaR test that compares the fund's VaR to the VaR of a 
``designated reference index'' for that fund. If the fund's derivatives 
risk manager is unable to identify an appropriate designated reference 
index, the fund would be required to comply with an absolute VaR test. 
These proposed requirements are designed to limit fund leverage risk 
consistent with the investor protection purposes underlying section 18 
and to complement the proposed risk management program. Because VaR is 
a commonly-known and broadly-used industry metric that enables risk to 
be measured in a reasonably comparable and consistent manner across the 
diverse instruments that may be included in a fund's portfolio, the 
proposed VaR-based limit is designed to address leverage risk for a 
variety of fund strategies.
---------------------------------------------------------------------------

    \68\ See proposed rule 18f-4(c)(2); infra section II.D.
---------------------------------------------------------------------------

     Board oversight and reporting.\69\ The proposed rule would 
require a fund's board of directors to approve the fund's designation 
of a derivatives risk manager, who would be responsible for 
administering the fund's derivatives risk management program. The 
fund's derivatives risk manager would have to report to the fund's 
board on the derivatives risk management program's implementation and 
effectiveness and the results of the fund's stress testing. The 
derivatives risk manager would have a direct reporting line to the 
fund's board. We believe requiring a fund's derivatives risk manager to 
be responsible for the day-to-day administration of the fund's program, 
subject to board oversight, is consistent with the way we understand 
many funds currently manage derivatives risks and is key to 
appropriately managing these risks.
---------------------------------------------------------------------------

    \69\ See proposed rule 18f-4(c)(5); infra section II.C.
---------------------------------------------------------------------------

     Exception for limited derivatives users.\70\ The proposed 
rule would except limited derivatives users from the derivatives risk 
management program requirement and the VaR-based limit on fund leverage 
risk. This proposed exception would be available to a fund that either 
limits its derivatives exposure to 10% of its net assets or uses 
derivatives transactions solely to hedge certain currency risks and, in 
either case, that also adopts and implements policies and procedures 
reasonably designed to manage the fund's derivatives risks. Requiring a 
derivatives risk management program that includes all of the program 
elements specified in the rule for funds that use derivatives only in a 
limited way could potentially require these funds to incur costs and 
bear compliance burdens that are disproportionate to the resulting 
benefits.
---------------------------------------------------------------------------

    \70\ See proposed rule 18f-4(c)(3); infra section II.E.
---------------------------------------------------------------------------

     Alternative requirements for certain leveraged/inverse 
funds.\71\ The proposed rule would provide an exception from the limit 
on fund leverage risk for certain leveraged/inverse funds in light of 
the additional safeguards provided by the proposed requirements under 
the sales practices rules that broker-dealers and investment advisers 
exercise due diligence on retail investors before approving the 
investors' accounts to invest in these funds.\72\ The conditions of 
this exception are designed to address the investor protection concerns 
that underlie section 18 of the Investment Company Act, while 
preserving choice for investors the investment adviser or broker-dealer 
reasonably believes have such financial knowledge and experience that 
they may reasonably be expected to be capable of evaluating the risk of 
these funds.
---------------------------------------------------------------------------

    \71\ See proposed rule 18f-4(c)(4); infra section II.G.
    \72\ In our discussion in this release of the entities subject 
to the proposed sales practices rules, we use ``broker-dealer'' to 
refer to a broker-dealer that is registered with, or required to 
register with, the Commission. Similarly, we use ``investment 
adviser'' to refer to an investment adviser that is registered with, 
or required to register with, the Commission.
---------------------------------------------------------------------------

     Recordkeeping.\73\ The proposed rule would require a fund 
to adhere to recordkeeping requirements that are designed to provide 
the Commission's staff, and the fund's board of directors and 
compliance personnel, the ability to evaluate the fund's compliance 
with the proposed rule's requirements.
---------------------------------------------------------------------------

    \73\ See proposed rule 18f-4(c)(6); infra section II.K.
---------------------------------------------------------------------------

    Proposed rule 18f-4 would also permit funds to enter into reverse 
repurchase agreements and similar financing transactions, as well as 
``unfunded commitments'' to make certain loans or investments, subject 
to conditions tailored to these transactions.\74\ A fund would be 
permitted to engage in reverse repurchase agreements and similar 
financing transactions so long as they meet the asset coverage 
requirements under section 18. If the fund also borrows from a bank or 
issues bonds, for example, these senior securities as well as the 
reverse repurchase agreement would be required to comply with the asset 
coverage requirements under the Investment Company Act. This approach 
would provide the same asset coverage requirements under section 18 for 
reverse repurchase agreements and similar financing transactions, bank 
borrowings, and other borrowings permitted under the Investment Company 
Act. A fund would be permitted to enter into unfunded commitment 
agreements if the fund reasonably believes that its assets will allow 
the fund to meet its obligations under these agreements. This approach 
recognizes that, while unfunded commitment agreements do raise the risk 
that a fund may be unable to meet its obligations under these 
transactions, such unfunded commitments do not generally involve the 
leverage and other risks associated with derivatives transactions.
---------------------------------------------------------------------------

    \74\ See proposed rule 18f-4(d) and (e); infra sections II.I and 
II.J.
---------------------------------------------------------------------------

    The proposed sales practices rules are designed to address certain 
specific considerations raised by certain leveraged/inverse funds and 
listed commodity pools that obtain leveraged or inverse exposure to an 
underlying index, on a periodic (generally, daily) basis.\75\ These 
rules would require broker-dealers and investment advisers to exercise 
due diligence in determining whether to approve a retail customer or 
client's account to buy or sell these products. A broker-dealer or 
adviser could only approve the account if it had a reasonable basis to 
believe that the customer or client is capable of evaluating the risk 
associated with these products. In this regard, the proposed sales 
practices rules would complement the leveraged/inverse funds exception 
from proposed rule 18f-4's limit on leverage risk by subjecting broker-
dealers or advisers to the proposed sales practices rules' due 
diligence and approval requirements.
---------------------------------------------------------------------------

    \75\ See infra note 327 and accompanying text (defining ``listed 
commodity pools'').
---------------------------------------------------------------------------

    In connection with proposed rules 15l-2, 211(h)-1, and 18f-4, we 
are proposing amendments to rule 6c-11 under the Investment Company 
Act. Rule 6c-11 generally permits ETFs to operate without obtaining a 
Commission exemptive order, subject to certain conditions.\76\ The rule 
currently excludes leveraged/inverse ETFs from relying on the rule, 
however, to allow the Commission to consider the section 18 issues 
raised by these funds' investment strategies as part of a broader 
consideration of derivatives use by registered funds and BDCs.\77\ As 
part of this further consideration, we are

[[Page 4455]]

proposing to remove this provision and permit leveraged/inverse ETFs to 
rely on rule 6c-11 because the proposed sales practices rules and rule 
18f-4 are designed to address these issues. In this regard, we are also 
proposing to rescind the exemptive orders previously issued to the 
sponsors of leveraged/inverse ETFs. Amending rule 6c-11 and rescinding 
these exemptive orders would promote a level playing field by allowing 
any sponsor (in addition to the sponsors currently granted exemptive 
orders) to form and launch a leveraged/inverse ETF subject to the 
conditions in rule 6c-11 and proposed rule 18f-4, with transactions in 
the fund subject to the proposed sales practices rules.
---------------------------------------------------------------------------

    \76\ See generally Exchange-Traded Funds, Investment Company Act 
Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24, 2019)] 
(``ETFs Adopting Release'').
    \77\ See id. at nn.72-74 and accompanying text.
---------------------------------------------------------------------------

    The proposed amendments to Forms N-PORT, N-LIQUID, and N-CEN would 
require a fund to provide information regarding: (1) The fund's 
exposure to derivatives; (2) the fund's VaR (and, if applicable, the 
fund's designated reference index) and backtesting results; (3) VaR 
test breaches, to be reported to the Commission in a non-public current 
report; and (4) certain identifying information about the fund (e.g., 
whether the fund is a limited derivatives user that is excepted from 
certain of the proposed requirements, or whether the fund is a 
``leveraged/inverse fund'').
    Finally, in view of our proposal for an updated, comprehensive 
approach to the regulation of funds' derivative use, we are proposing 
to rescind Release 10666. In addition, staff in the Division of 
Investment Management is reviewing certain of its no-action letters and 
other guidance addressing derivatives transactions and other 
transactions covered by proposed rule 18f-4 to determine which letters 
and other staff guidance, or portions thereof, should be withdrawn in 
connection with any adoption of this proposal. Upon the adoption of any 
final rule, some of these letters and other staff guidance, or portions 
thereof, would be moot, superseded, or otherwise inconsistent with the 
final rule and, therefore, would be withdrawn. We would expect to 
provide funds a one-year transition period while they prepare to come 
into compliance with rule 18f-4 before Release 10666 is withdrawn.

II. Discussion

A. Scope of Proposed Rule 18f-4

1. Funds Permitted To Rely on Proposed Rule 18f-4
    The proposed rule would apply to a ``fund,'' defined as a 
registered open-end or closed-end company or a BDC, including any 
separate series thereof. The rule would therefore apply to mutual 
funds, ETFs, registered closed-end funds, and BDCs. The proposed rule's 
definition of a ``fund'' would, however, exclude money market funds 
regulated under rule 2a-7 under the Investment Company Act (``money 
market funds''). Under rule 2a-7, money market funds seek to maintain a 
stable share price or limit principal volatility by limiting their 
investments to short-term, high-quality debt securities that fluctuate 
very little in value under normal market conditions. As a result of 
these and other requirements in rule 2a-7, we believe that money market 
funds currently do not typically engage in derivatives transactions or 
the other transactions permitted by rule 18f-4.\78\ We believe that 
these transactions would generally be inconsistent with a money market 
fund maintaining a stable share price or limiting principal volatility, 
and especially if used to leverage the fund's portfolio.\79\ We 
therefore believe that excluding money market funds from the scope of 
the proposed rule is appropriate.
---------------------------------------------------------------------------

    \78\ See infra note 583.
    \79\ See Money Market Fund Reform; Amendments to Form PF, 
Investment Company Act Release No. 31166 (July 23, 2014) [79 FR 
47735 (Aug. 14, 2014)] (discussing (1) retail and government money 
market funds, which seek to maintain a stable net asset value per 
share and (2) institutional non-government money market funds whose 
net asset value fluctuates, but still must stress test their ability 
to minimize principal volatility given that ``commenters pointed out 
investors in floating NAV funds will continue to expect a relatively 
stable NAV'').
---------------------------------------------------------------------------

    Section 18 applies only to open-end or closed-end companies, i.e., 
to management investment companies. Proposed rule 18f-4 therefore also 
would not apply to unit investment trusts (``UITs'') because they are 
not management investment companies. In addition, as the Commission has 
noted, derivatives transactions generally require a significant degree 
of management, and a UIT engaging in derivatives transactions therefore 
may not meet the Investment Company Act requirements applicable to 
UITs.\80\
---------------------------------------------------------------------------

    \80\ See section 4(2) of the Investment Company Act; see also 
Custody Of Investment Company Assets with Futures Commission 
Merchants And Commodity Clearing Organizations, Investment Company 
Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT 
portfolios are generally unmanaged). See also ETFs Adopting Release, 
supra note 76, at n.42.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's definition 
of the term ``fund,'' including the following items.
    1. The proposed definition excludes money market funds. Should we 
include money market funds in the definition? Why or why not?
    2. Do money market funds currently engage in any transactions that 
might qualify as derivatives transactions under the rule or any of the 
other transactions permitted by the rule? For example, do money market 
funds engage in reverse repurchase agreements, ``to be announced'' 
dollar rolls, or ``when issued'' transactions? If so, which 
transactions, to what extent, and for what purpose? For example, do 
money market funds engage in reverse repurchase agreements for 
liquidity management purposes but not to leverage the fund's portfolio? 
If so, what effects would the proposed rule have on money market funds' 
liquidity management if they are excluded from the rule's scope as 
proposed? To the extent money market funds engage in any of the 
transactions that the proposed rule would permit, how do money market 
funds analyze them under rule 2a-7?
    3. Should we permit money market funds to engage in some of the 
transactions that the rule would permit? If so, which transactions and 
why, and how would the transactions be consistent with rule 2a-7? If we 
were to include money market funds in the rule, or permit them to 
engage in specific types of transactions, should the rule provide 
specific conditions tailored to money market funds entering into those 
transactions? What kinds of conditions and why? Should they be 
permitted to engage in all (or certain types) of derivatives 
transactions, or reverse repurchase or similar financing transactions, 
for liquidity management or other purposes that do not leverage the 
fund's portfolio? If money market funds were permitted to rely on the 
rule for any transactions, should those transactions be limited in 
scale? For example, should that limit be the same as the proposed 
approach for limited derivatives users that limit the extent of their 
derivatives exposure, as discussed below in section II.E.1? Would even 
such limited use be consistent with funds that seek to maintain a 
stable share price or limit principal volatility?
    4. If we were to include money market funds in the scope of rule 
18f-4, should we revise Form N-MFP so that money market funds filing 
reports on the form could select among the list of investment 
categories set forth in Item C.6 of Form N-MFP derivatives and the 
other transactions addressed in the proposed rule 18f-4? \81\ Why or 
why not?
---------------------------------------------------------------------------

    \81\ See infra note 583.
---------------------------------------------------------------------------

2. Derivatives Transactions Permitted Under Proposed Rule 18f-4
    The proposed rule would permit funds to enter into derivatives

[[Page 4456]]

transactions, subject to the rule's conditions. The proposed rule would 
define the term ``derivatives transaction'' to mean: (1) Any swap, 
security-based swap, futures contract, forward contract, option, any 
combination of the foregoing, or any similar instrument (``derivatives 
instrument''), under which a fund is or may be required to make any 
payment or delivery of cash or other assets during the life of the 
instrument or at maturity or early termination, whether as margin or 
settlement payment or otherwise; and (2) any short sale borrowing.\82\
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    \82\ Proposed rule 18f-4(a). The 2015 proposal similarly defined 
a derivatives transaction as including enumerated derivatives 
instruments ``under which the fund is or may be required to make any 
payment or delivery of cash or other assets during the life of the 
instrument or at maturity or early termination, whether as a margin 
or settlement payment or otherwise.'' 2015 proposed rule 18f-
4(c)(2). Most commenters did not address the proposed definition of 
the term ``derivatives transaction,'' although those commenters who 
did address the definition generally supported it. Some commenters 
more generally supported the view, or sought confirmation, that a 
derivative does not involve the issuance of a senior security if it 
does not impose an obligation under which the fund is or may be 
required to make a future payment (e.g., a standard purchased 
option). See, e.g., Comment Letter of The Options Clearing 
Corporation (Mar. 25, 2016); Comment Letter of Investment Adviser 
Association (Mar. 28, 2016) (``IAA Comment Letter''); FSR Comment 
Letter.
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    The first prong of this proposed definition is designed to describe 
those derivatives transactions that involve the issuance of a senior 
security, because they involve a contractual future payment 
obligation.\83\ When a fund engages in these transactions, the fund 
will have an obligation (or potential obligation) to make payments or 
deliver assets to the fund's counterparty. This prong of the definition 
incorporates a list of derivatives instruments that, together with the 
proposed inclusion in the definition of ``any similar instrument,'' 
covers the types of derivatives that funds currently use and that the 
requirements of section 18 would restrict. This list is designed to be 
sufficiently comprehensive to include derivatives that may be developed 
in the future. We believe that this approach is clearer than a more 
principles-based definition of the term ``derivatives transaction,'' 
such as defining this term as an instrument or contract whose value is 
based upon, or derived from, some other asset or metric.
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    \83\ See supra note 27 and accompanying text, and text following 
note 34 (together, noting that ``senior security'' is defined in 
part as ``any . . . similar obligation or instrument constituting a 
security and evidencing indebtedness,'' and that the Commission has 
previously stated that, for purposes of section 18, ``evidence of 
indebtedness'' would include ``all contractual obligations to pay in 
the future for consideration presently received''); see also infra 
notes 85-87 (recognizing that not every derivative instrument will 
involve the issuance of a senior security).
---------------------------------------------------------------------------

    This prong of the definition also provides that a derivatives 
instrument, for purposes of the proposed rule, must involve a future 
payment obligation.\84\ This aspect of the definition recognizes that 
not every derivatives instrument imposes an obligation that may require 
the fund to make a future payment, and therefore not every derivatives 
instrument will involve the issuance of a senior security.\85\ A 
derivative that does not impose any future payment obligation on a fund 
generally resembles a securities investment that is not a senior 
security, in that it may lose value but will not require the fund to 
make any payments in the future.\86\ Whether a transaction involves the 
issuance of a senior security will depend on the nature of the 
transaction. The label that a fund or its counterparty assigns to the 
transaction is not determinative.\87\
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    \84\ Under the proposed rule, a derivatives instrument is one 
where the fund ``is or may be required to make any payment or 
delivery of cash or other assets during the life of the instrument 
or at maturity or early termination, whether as margin or settlement 
payment or otherwise.''
    \85\ See 2015 Proposing Release, supra note 2, at paragraph 
accompanying nn.82-83. A fund that purchases a standard option 
traded on an exchange, for example, generally will make a non-
refundable premium payment to obtain the right to acquire (or sell) 
securities under the option. However, the option purchaser generally 
will not have any subsequent obligation to deliver cash or assets to 
the counterparty unless the fund chooses to exercise the option.
    \86\ See id. at n.82.
    \87\ For example, the Commission received a comment on the 2015 
proposal addressing a type of total return swap, asserting that 
``[t]he Swap operates in a manner similar to a purchased option or 
structure, in that the fund's losses under the Swap cannot exceed 
the amount posted to its tri-party custodian agreement for purposes 
of entering into the Swap,'' and that, in the commenter's view, the 
swap should be ``afforded the same treatment as a purchased option 
or structured note'' because ``[a]lthough the Swap involves interim 
payments through the potential posting of margin from the custodial 
account, the payment obligations cannot exceed the [amount posted 
for purposes of entering into the Swap].'' See Comment Letter of 
Dearborn Capital Management (Mar. 24, 2016) (``Dearborn Comment 
Letter''). Unlike a fund's payment of a one-time non-refundable 
premium in connection with a standard purchased option or a fund's 
purchase of a structured note, this transaction appears to involve a 
fund obligation to make interim payments of fund assets posted as 
margin or collateral to the fund's counterparty during the life of 
the transaction in response to market value changes of the 
underlying reference asset, as this commenter described. The fund 
also must deposit additional margin or collateral to maintain the 
position if the fund's losses deplete the assets that the fund 
posted to initiate the transaction; if a fund effectively pursues 
its strategy through such a swap, or a small number of these swaps, 
the fund may as a practical matter be required to continue 
reestablishing the trade or refunding the collateral account in 
order to continue to offer the fund's strategy. The transaction 
therefore appears to involve the issuance of a senior security as 
the fund may be required to make future payments.
    See also infra section II.J (discussing the characterization of 
``unfunded commitment'' agreements for purposes of the proposed 
rule, and as senior securities).
---------------------------------------------------------------------------

    Unlike the 2015 proposal, this proposal does not include references 
to, or a definition of, ``financial commitment transaction'' in 
addition to the proposed definition of ``derivatives transaction.'' The 
2015 proposal defined a ``financial commitment transaction'' as any 
reverse repurchase agreement, short sale borrowing, or any firm or 
standby commitment agreement or similar agreement.\88\ Because our 
proposal addresses funds' use of reverse repurchase agreements and 
unfunded commitment agreements separately from funds' use of 
derivatives, the proposed definition of ``derivatives transaction'' 
does not include reverse repurchase agreements and unfunded commitment 
agreements.\89\
---------------------------------------------------------------------------

    \88\ See 2015 Proposing Release, supra note 2, at section 
III.A.2; 2015 proposed rule 18f-4(c)(4); see also supra note 10.
    \89\ See infra section II.I.
---------------------------------------------------------------------------

    Short sale borrowings, however, are included in the second prong of 
the proposed definition of ``derivatives transaction.'' We appreciate 
that short sales of securities do not involve derivatives instruments 
such as swaps, futures, and options. The value of a short position is, 
however, derived from the price of another asset, i.e., the asset sold 
short. A short sale of a security provides the same economic exposure 
as a derivatives instrument, like a future or swap, that provides short 
exposure to the same security. The proposed rule therefore treats short 
sale borrowings and derivatives instruments identically for purposes of 
funds' reliance on the rule's exemption.\90\
---------------------------------------------------------------------------

    \90\ See proposed rule 18f-4(b).
---------------------------------------------------------------------------

    While this proposal does not specifically list firm or standby 
commitment agreements in the definition of ``derivatives transaction,'' 
we interpret the definitional phrase ``or any similar instrument'' to 
include these agreements. A firm commitment agreement has the same 
economic characteristics as a forward contract.\91\ Similarly, a 
standby commitment agreement has the same economic characteristics as 
an option contract, and the Commission has previously stated that such 
an agreement is economically equivalent to the issuance

[[Page 4457]]

of a put option.\92\ To the extent that a fund engages in transactions 
similar to firm or standby commitment agreements, they may fall within 
the ``any similar instrument'' definitional language, depending on the 
facts and circumstances.\93\
---------------------------------------------------------------------------

    \91\ Indeed, the Commission noted in Release 10666 that a firm 
commitment is known by other names such as a ``forward contract.'' 
See Release 10666, supra note 15, at nn.10-12 and accompanying text.
    \92\ See id. at ``Standby Commitment Agreements'' (``The standby 
commitment agreement is a delayed delivery agreement in which the 
investment company contractually binds itself to accept delivery of 
a Ginnie Mae with a stated price and fixed yield upon the exercise 
of an option held by the other party to the agreement at a stated 
future date. . . . The Commission believes that the standby 
commitment agreement involves, in economic reality, the issuance and 
sale by the investment company of a `put.' '').
    \93\ See, e.g., infra paragraph accompanying notes 419-420 
(discussing agreements that would not qualify for the proposed 
rule's treatment of unfunded commitment agreements because they are 
functionally similar to derivatives transactions).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's definition 
of the term ``derivatives transaction,'' including the following items.
    5. Is the definition of ``derivatives transaction'' sufficiently 
clear? Are there additional types of derivatives instruments, or other 
transactions, that we should include or exclude? Adding additional 
transactions to the definition would permit a fund to engage in those 
transactions by complying with the proposed rule, rather than section 
18. Are there transactions that we should exclude from the definition 
so that funds must comply with the limits of section 18 (to the extent 
permitted under section 18) with respect to these transactions, rather 
than the proposed rule's conditions?
    6. The proposed rule's definition of the term ``derivatives 
transaction'' is designed to describe those derivatives transactions 
that would involve the issuance of a senior security. Do commenters 
agree that derivatives transactions that involve obligations to make a 
payment or deliver assets involve the issuance of a senior security 
under section 18 of the Act? Does the rule effectively describe all of 
the types of derivatives transactions that would involve the issuance 
of a senior security? Conversely, are there any types of transactions 
that are included in the proposed definition of ``derivatives 
transaction'' that should not be considered to involve the issuance of 
a senior security? If so, which types of transactions and why?
    7. Is it appropriate that the proposed rule's definition of 
``derivatives transaction'' incorporates a list of derivatives 
instruments plus ``any similar instrument,'' rather than a principles-
based definition, such as an instrument or contract whose value is 
based upon, or derived from, some other asset or metric? Why or why 
not? Is the reference to ``any similar instrument'' in the proposed 
definition sufficiently clear to address transactions that may be 
developed in the future? If not, how should we modify the rule to 
provide additional clarity?
    8. Should the proposed definition of ``derivatives transaction'' 
include short sale borrowings? Would this approach cause any confusion 
because short sales are not typically understood as derivatives 
instruments? If the latter, what alternative approach would be 
preferable?
    9. Should we specifically list firm or standby commitments in the 
proposed definition of ``derivatives transaction''? Would funds 
understand the phrase ``or any similar instrument'' in the proposed 
definition to include these agreements? Do funds currently use the 
terms ``firm commitment agreement'' or ``standby commitment agreement'' 
to describe any of their transactions?
    10. Are there any transactions similar to firm or standby 
commitments that we should specifically address, either in the proposed 
definition of ``derivatives transaction'' or otherwise as guidance? Are 
there any other types of transactions that the Commission should 
address--either in the proposed definition or as guidance--as 
transactions that fall within the ``any similar instrument'' 
definitional language?

B. Derivatives Risk Management Program

1. Summary
    Fund investments in derivatives transactions can pose a variety of 
risks, and poor risk management can cause significant harm to funds and 
their investors. Derivatives can raise potential risks such as market, 
counterparty, leverage, liquidity, and operational risk. Although many 
of these risks are not limited to derivatives, the complexity and 
character of certain derivatives--such as their multiple contingencies 
and optionality, path dependency, and non-linearity--may heighten these 
risks.\94\ Even simple derivatives without multiple contingencies and 
optionality, for example, can present additional risks beyond a fund's 
investment in the underlying reference assets, such as the risk that a 
fund must have margin-eligible assets on hand to meet margin or 
collateral calls. We also recognize the valuable role derivatives can 
play in helping funds to achieve their objectives efficiently or manage 
their investment risks.
---------------------------------------------------------------------------

    \94\ See European Securities and Markets Authority (formerly 
Committee of European Securities Regulators), Guidelines on Risk 
Measurement and the Calculation of Global Exposure and Counterparty 
Risk for UCITS, CESR/10-788 (July 28, 2010), at 12, available at 
https://www.esma.europa.eu/sites/default/files/library/2015/11/10_788.pdf (``CESR Global Guidelines'').
---------------------------------------------------------------------------

    An investment adviser of a fund that uses derivatives therefore 
should manage this use to ensure alignment with the fund's investment 
objectives, policies, and restrictions, its risk profile, and relevant 
regulatory requirements. In addition, a fund's board of directors is 
responsible for overseeing the fund's activities and the adviser's 
management of risks, including any derivatives risks.\95\ Given the 
dramatic growth in the volume and complexity of the derivatives markets 
over the past two decades, and the increased use of derivatives by 
certain funds and their related risks, we believe that requiring funds 
that are users of derivatives (other than limited derivatives users) to 
have a formalized risk management program with certain specified 
elements (a ``program'') supports exempting these transactions from 
section 18.
---------------------------------------------------------------------------

    \95\ See, e.g., Interpretive Matters Concerning Independent 
Directors of Investment Companies, Investment Company Act Release 
No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role of 
Independent Directors of Investment Companies, Investment Company 
Act Release No. 24816 (Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)]; 
Independent Directors Council, Fund Board Oversight of Risk 
Management (Sept. 2011), available at https://www.ici.org/pdf/pub_11_oversight_risk.pdf (``2011 IDC Report'').
---------------------------------------------------------------------------

    Under the proposed program requirement, a fund would have to adopt 
and implement a written derivatives risk management program, which 
would include policies and procedures reasonably designed to manage the 
fund's derivatives risks.\96\ A fund's risk management program should 
take into the account the way the fund uses derivatives, whether to 
increase investment exposures in ways that increase portfolio risks or, 
conversely, to reduce portfolio risks or facilitate efficient portfolio 
management.\97\
---------------------------------------------------------------------------

    \96\ Proposed rule 18f-4(c)(1).
    \97\ See supra note 4 and accompanying text; infra section 
II.B.3.a.
---------------------------------------------------------------------------

    The program requirement is designed to result in a program with 
elements that are tailored to the particular types of derivatives that 
the fund uses and their related risks, as well as how those derivatives 
impact the fund's investment portfolio and strategy. The proposal would 
require a fund's program to include the following elements:
     Risk identification and assessment.\98\ The program would 
have to provide for the identification and assessment of a fund's 
derivatives risks,

[[Page 4458]]

which would take into account the fund's derivatives transactions and 
other investments.
---------------------------------------------------------------------------

    \98\ Proposed rule 18f-4(c)(1)(i); see also infra section 
II.B.3.a.
---------------------------------------------------------------------------

     Risk guidelines.\99\ The program would have to provide for 
the establishment, maintenance, and enforcement of investment, risk 
management, or related guidelines that provide for quantitative or 
otherwise measurable criteria, metrics, or thresholds related to a 
fund's derivatives risks.
---------------------------------------------------------------------------

    \99\ Proposed rule 18f-4(c)(1)(ii); see also infra section 
II.B.3.b.
---------------------------------------------------------------------------

     Stress testing.\100\ The program would have to provide for 
stress testing of derivatives risks to evaluate potential losses to a 
fund's portfolio under stressed conditions.
---------------------------------------------------------------------------

    \100\ Proposed rule 18f-4(c)(1)(iii); see also infra section 
II.B.3.c.
---------------------------------------------------------------------------

     Backtesting.\101\ The program would have to provide for 
backtesting of the VaR calculation model that the fund uses under the 
proposed rule.
---------------------------------------------------------------------------

    \101\ Proposed rule 18f-4(c)(1)(iv); see also infra section 
II.B.3.d.
---------------------------------------------------------------------------

     Internal reporting and escalation.\102\ The program would 
have to provide for the reporting of certain matters relating to a 
fund's derivatives use to the fund's portfolio management and board of 
directors.
---------------------------------------------------------------------------

    \102\ Proposed rule 18f-4(c)(1)(v); see also infra section 
II.B.3.e.
---------------------------------------------------------------------------

     Periodic review of the program.\103\ A fund's derivatives 
risk manager would be required to periodically review the program, at 
least annually, to evaluate the program's effectiveness and to reflect 
changes in risk over time.
---------------------------------------------------------------------------

    \103\ Proposed rule 18f-4(c)(1)(vi); see also infra section 
II.B.3.f.

The proposed program requirement is drawn from existing fund best 
practices. We believe it would enhance practices for funds that have 
not already implemented a derivatives risk management program, while 
building off practices of funds that already have one in place.\104\
---------------------------------------------------------------------------

    \104\ See, e.g., Aviva Comment Letter (discussing the 
implementation of formalized derivatives risk management programs); 
Vanguard Comment Letter.
---------------------------------------------------------------------------

    Most commenters generally supported the 2015 proposal's derivatives 
risk management program requirement, which had many similar 
foundational elements to those of the program we are proposing here. 
These commenters stated that the use of derivatives transactions by a 
fund should be subject to a comprehensive and appropriate written risk 
management program, which would benefit investors.\105\ Our proposal 
includes elements from the 2015 proposal's derivatives risk management 
program framework, and adds elements that take into account our 
analysis of the comments we received.
---------------------------------------------------------------------------

    \105\ See, e.g., Comment Letter of AFG-French Asset Management 
Association (Mar. 25, 2016) (``AFG Comment Letter''); Comment Letter 
of American Beacon Advisors (Mar. 28, 2016) (``American Beacon 
Comment Letter''); Comment Letter of AQR Capital Management (Mar. 
28, 2016) (``AQR Comment Letter''); Federated Comment Letter; 
Comment Letter of Fidelity (Mar. 28, 2016) (``Fidelity Comment 
Letter''); Comment Letter of AFL-CIO (Mar. 28, 2016); Comment Letter 
of Alternative Investment Management Association (Mar. 28, 2016) 
(``AIMA Comment Letter''); Comment Letter of Aviva (Mar. 28, 2016) 
(``Aviva Comment Letter''); Comment Letter of BlackRock (Mar. 28, 
2016) (``BlackRock Comment Letter''); Comment Letter of Capital 
Research and Management Company (Mar. 28, 2016) (``CRMC Comment 
Letter'').
---------------------------------------------------------------------------

2. Program Administration
    The proposed rule would require a fund adviser's officer or 
officers to serve as the fund's derivatives risk manager.\106\ This 
requirement is designed to centralize derivatives risk management and 
to promote accountability. The designation of the derivatives risk 
manager must be approved by the fund's board of directors, and the 
derivatives risk manager must have direct communication with the fund's 
board of directors. Allowing multiple officers of the fund's adviser 
(including any sub-advisers) to serve as the fund's derivatives risk 
manager is designed to allow funds with differing sizes, organizational 
structures, or investment strategies to more effectively tailor the 
programs to their operations.\107\ We understand that many advisers 
today involve committees or groups of officers in the vetting and 
analysis of portfolio risk and other types of risk.\108\ Although the 
proposed rule would not permit a third party to serve as a fund's 
derivatives risk manager, the derivatives risk manager could obtain 
assistance from third parties in administering the program. For 
example, third parties could provide data relevant to the 
administration of a fund's program or other analysis that may inform 
the fund's derivatives risk management.
---------------------------------------------------------------------------

    \106\ Proposed rule 18f-4(a).
    \107\ The term ``adviser'' as used in this release and rule 18f-
4 generally refers to any person, including a sub-adviser, that is 
an ``investment adviser'' of an investment company as that term is 
defined in section 2(a)(20) of the Investment Company Act.
    \108\ See, e.g., IAA Comment Letter.
---------------------------------------------------------------------------

    The proposed rule would also require that the fund's derivatives 
risk manager have relevant experience regarding derivatives risk 
management.\109\ This requirement is designed to reflect the potential 
complex and unique risks that derivatives can pose to funds and promote 
the selection of a derivatives risk manager who is well-positioned to 
manage these risks. As discussed below, under the proposed rule, a 
fund's board must approve the designation of the fund's derivatives 
risk manager, taking into account the derivatives risk manager's 
relevant experience regarding derivatives risk management.\110\
---------------------------------------------------------------------------

    \109\ Proposed rule 18f-4(a).
    \110\ See infra section II.C.1.
---------------------------------------------------------------------------

    The proposed rule would require a fund to reasonably segregate the 
functions of the program from its portfolio management.\111\ 
Segregating derivatives risk management from portfolio management is 
designed to promote objective and independent identification, 
assessment, and management of the risks associated with derivatives 
use. Accordingly, this element is designed to enhance the 
accountability of the derivatives risk manager and other risk 
management personnel and, therefore, to enhance the program's 
effectiveness.\112\ We understand that funds today often segregate risk 
management from portfolio management. Many have observed that 
independent oversight of derivatives activities by compliance and 
internal audit functions is valuable.\113\ Because a fund may 
compensate its portfolio management personnel in part based on the 
returns of the fund, the incentives of portfolio managers may not 
always be consistent with the restrictions that a risk management 
program would impose. Keeping the functions separate in the context of 
derivatives risk management should help mitigate the possibility that 
these competing incentives diminish the program's effectiveness.
---------------------------------------------------------------------------

    \111\ Proposed rule 18f-4(c)(1).
    \112\ See, e.g., Comptroller of the Currency Administrator of 
National Banks, Risk Management of Financial Derivatives: 
Comptroller's Handbook (Jan. 1997), at 9 (discussing the importance 
of independent risk management functions in the banking context).
    \113\ See, e.g., Kenneth K. Marshall, Internal Control and 
Derivatives, The CPA Journal (Oct. 1995), available at https://archives.cpajournal.com/1995/OCT95/f461095.htm.
---------------------------------------------------------------------------

    Separation of functions creates important checks and balances, and 
funds could institute this proposed requirement through a variety of 
methods, such as independent reporting chains, oversight arrangements, 
or separate monitoring systems and personnel. The proposed rule would 
require reasonable segregation of functions, rather than taking a more 
prescriptive approach, such as requiring funds to implement strict 
protocols regarding communications between specific fund personnel, to 
allow funds to structure their risk management and portfolio management 
functions in ways that are tailored to each fund's facts and 
circumstances, including the size and

[[Page 4459]]

resources of the fund's adviser. In this regard, the reasonable 
segregation requirement is not meant to indicate that the derivatives 
risk manager and portfolio management must be subject to a 
communications ``firewall.'' We recognize the important perspective and 
insight regarding the fund's use of derivatives that the portfolio 
manager can provide and generally understand that the fund's 
derivatives risk manager would work with the fund's portfolio 
management in implementing the program requirement.
    For similar reasons, the proposed rule would also prohibit the 
derivatives risk manager position from being filled solely by the 
fund's portfolio manager, if a single fund officer serves in the 
position.\114\ The proposed rule also would prohibit a majority of the 
officers who compose the derivatives risk manager position from being 
portfolio managers, if multiple fund officers serve in the position.
---------------------------------------------------------------------------

    \114\ Proposed rule 18f-4(a).
---------------------------------------------------------------------------

    Commenters generally supported the 2015 proposal's requirement that 
a fund's derivatives risk management program be administered by a 
derivatives risk manager and that the fund's derivatives risk 
management be segregated from the fund's portfolio management.\115\ 
Commenters did, however, express concern about the 2015 proposal's 
requirement that there be a single derivatives risk manager and urged 
that the Commission permit a fund's portfolio managers to provide some 
input into the fund's derivatives risk management function.\116\ This 
re-proposal addresses these concerns by permitting a group or committee 
to serve as a fund's derivatives risk manager, a portion of whom could 
be portfolio managers.
---------------------------------------------------------------------------

    \115\ See, e.g., BlackRock Comment Letter.
    \116\ See, e.g., BlackRock Comment Letter; Comment Letter of 
Morningstar (Mar. 28, 2016) (``Morningstar Comment Letter''); 
Comment Letter of the Investment Company Institute (Mar. 28, 2016) 
(``ICI Comment Letter I''); Comment Letter of WisdomTree (Mar. 28, 
2016).
---------------------------------------------------------------------------

    We request comment on the proposed requirements that a fund's 
derivatives risk manager administer the fund's program, and that the 
derivatives risk management function be reasonably segregated from the 
fund's portfolio management.
    11. Is the proposed definition of ``derivatives risk manager'' 
sufficiently clear? Why or why not? Should the rule, as proposed, 
require that a fund's derivatives risk manager be an officer or 
officers of the fund's adviser, and would this requirement further the 
goals of centralizing derivatives risk management and promoting 
accountability? Why or why not? Should the rule, as proposed, permit a 
fund's derivatives risk manager to be an officer or officers of the 
fund's sub-advisers? Why or why not? If so, should the rule require 
that at least one of the officers be an officer of the adviser or 
otherwise limit the number of sub-adviser officers? Why or why not? 
Would a fund's program be more effective if we required the derivatives 
risk manager to be a single individual? Why or why not? If so, should 
this individual be required to be an officer of a fund's adviser?
    12. Should the rule, as proposed, require that a fund's derivatives 
risk manager have relevant experience regarding derivatives risk 
management? Why or why not? Is the proposed requirement that the 
derivatives risk manager have ``relevant experience regarding the 
management of derivatives risk'' sufficiently clear? Would this raise 
questions about whether portfolio management experience, or experience 
outside of formal derivatives risk management, would suffice for 
purposes of the rule? Should the rule, instead, require that a fund's 
derivatives risk manager simply have ``relevant experience''? Should 
the rule specify that the derivatives risk manager must have relevant 
experience as determined by the fund's board, to allow a board to 
determine the experience that would be appropriate? Or should the rule 
identify specific qualifications, training, or experience of a fund's 
derivatives risk manager? Why or why not? If so, what should they be 
and why?
    13. Should the rule, as proposed, require a fund to segregate 
derivatives risk management functions from portfolio management? Why or 
why not? If we were not to require independence between a fund's 
derivatives risk manager and the fund's portfolio managers, how could 
we ensure that a fund's portfolio management personnel, who may have 
conflicting incentives, do not unduly influence the fund's program 
management?
    14. Should we provide any additional clarification regarding the 
proposed reasonable segregation requirement? If so, what changes should 
we make? Should we add any specific requirements? For example, should 
we limit the extent to which fund risk management personnel can be 
compensated in part based on fund performance?
    15. Is our understanding that many funds already segregate 
functions correct? If so, how and why do current approaches differ from 
the proposed rule's requirement to segregate functions?
    16. Are there other ways to facilitate objective and independent 
risk assessment of portfolio strategies that we should consider? If so, 
what are they and how would these alternatives be more effective than 
the proposed rule's requirement to reasonably segregate functions?
    17. Rule 22e-4 under the Investment Company Act, similar to the 
proposed rule, requires certain funds to implement a risk management 
program. In particular, rule 22e-4 requires person(s) designated to 
administer a fund's liquidity risk management program to be the fund's 
investment adviser, officer, or officers (which may not be solely 
portfolio managers of the fund) (the ``liquidity risk manager''). 
Should we amend rule 22e-4 to more closely align the definition of 
``liquidity risk manager'' with the proposed definition of 
``derivatives risk manager'' by prohibiting a fund's adviser from 
serving as a liquidity risk manager? Why or why not? Conversely, should 
we align the standard for derivatives risk manager with the liquidity 
risk manager standard under rule 22e-4?
    18. Would the proposed derivatives risk manager requirement raise 
any particular challenges for funds with smaller advisers and, if so, 
what could we do to help mitigate these challenges? For example, should 
we modify the rule to permit funds to authorize the use of third 
parties not employed by the adviser to administer the program and, if 
so, under what conditions? Why or why not? Would allowing third parties 
to act as derivatives risk managers enhance the program by allowing 
specialized personnel to administer the program or detract from it by 
allowing for a derivatives risk manager who may not be as focused on 
the specific risks of the particular fund or as accountable to its 
board? Would the proposed requirement that a fund reasonably segregate 
derivatives risk management from portfolio management pose particular 
challenges for funds with smaller advisers? If so, how and why, and 
would additional guidance on this proposed requirement or changes to 
the proposed rule be useful? Conversely, would this proposed 
requirement (which does not prescribe how funds must segregate 
functions) provide appropriate flexibility for funds with smaller 
advisers?
    19. Rule 38a-1(c) under the Investment Company Act prohibits 
officers, directors, and employees of the fund and its adviser from, 
among other things, coercing or unduly influencing a fund's chief 
compliance officer in the

[[Page 4460]]

performance of his or her duties. Should we include such a prohibition 
on unduly influencing a fund's derivatives risk manager in the proposed 
rule? Why or why not?
    20. Should we include any other program administration 
requirements? If so, what? For example, should we include a requirement 
for training staff responsible for day-to-day management of the 
program, or for portfolio managers, senior management, and any 
personnel whose functions may include engaging in, or managing the risk 
of, derivatives transactions? If we require such training, should that 
involve setting minimum qualifications for staff responsible for 
carrying out the requirements of the program? Why or why not? Should we 
require training and education with respect to any new derivatives 
instruments that a fund may trade? Why or why not? Should we require a 
new instrument review committee?
3. Required Elements of the Program
a. Risk Identification and Assessment
    The proposed program requirement would require a fund to identify 
and assess its derivatives risks in order to manage these risks.\117\ 
It would require that the fund's identification and assessment take 
into account the fund's other investments as well as its derivatives 
transactions. 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. For example, the risks 
associated with a currency forward would differ if a fund is using the 
forward to hedge the fund's exposure to currency risk associated with a 
fund investment denominated in a foreign currency or, conversely, to 
take a speculative position on the relative price movements of two 
currencies. We believe that by assessing its derivatives use 
holistically, a fund will be better positioned to implement a 
derivatives risk management program that does not over- or understate 
the risks its derivatives use may pose. Accordingly, we believe that 
this approach would result in a more-tailored derivatives risk 
management program.
---------------------------------------------------------------------------

    \117\ Proposed rule 18f-4(c)(1)(i).
---------------------------------------------------------------------------

    The proposed rule would define the derivatives risks that must be 
identified and managed to include leverage, market, counterparty, 
liquidity, operational, and legal risks, as well as any other risks the 
derivatives risk manager deems material.\118\ In the context of a 
fund's derivatives transactions:
---------------------------------------------------------------------------

    \118\ Proposed rule 18f-4(a). In the case of funds that are 
limited derivatives users under the proposed rule, the definition 
would include any other risks that the fund's investment adviser (as 
opposed to the fund's derivatives risk manager) deems material, 
because a fund that is a limited derivatives user would be exempt 
from the requirement to adopt a derivatives risk management program 
(and therefore also exempt from the requirement to have a 
derivatives risk manager). See infra section II.E.
---------------------------------------------------------------------------

     Leverage risk generally refers to the risk that 
derivatives transactions can magnify the fund's gains and losses; \119\
---------------------------------------------------------------------------

    \119\ See, e.g., Independent Directors Council, Board Oversight 
of Derivatives Task Force Report (July 2008), at 12 (``2008 IDC 
Report'').
---------------------------------------------------------------------------

     Market risk generally refers to risk from potential 
adverse market movements in relation to the fund's derivatives 
positions, or the risk that markets could experience a change in 
volatility that adversely impacts fund returns and the fund's 
obligations and exposures; \120\
---------------------------------------------------------------------------

    \120\ Funds should consider market risk together with leverage 
risk because leveraged exposures can magnify such impacts. See, 
e.g., NAPF, Derivatives and Risk Management Made Simple (Dec. 2013), 
available at https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=1320663533358&blobheader=application/pdf&blobheadername1=Cache-Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs
.
---------------------------------------------------------------------------

     Counterparty risk generally refers to the risk that a 
counterparty on a derivatives transaction may not be willing or able to 
perform its obligations under the derivatives contract, and the related 
risks of having concentrated exposure to such a counterparty; \121\
---------------------------------------------------------------------------

    \121\ See, e.g., Nils Beier, et al., Getting to Grips with 
Counterparty Risk, McKinsey Working Papers on Risk, Number 20 (June 
2010).
---------------------------------------------------------------------------

     Liquidity risk generally refers to risk involving the 
liquidity demands that derivatives can create to make payments of 
margin, collateral, or settlement payments to counterparties;
     Operational risk generally refers to risk related to 
potential operational issues, including documentation issues, 
settlement issues, systems failures, inadequate controls, and human 
error; \122\ and
---------------------------------------------------------------------------

    \122\ See, e.g., 2008 IDC Report, supra note 119; RMA, Statement 
on best practices for managing risk in derivatives transactions 
(2004) (``Statement on best practices for managing risk in 
derivatives transactions''), available at https://www.rmahq.org/securities-lending/best-practices.
---------------------------------------------------------------------------

     Legal risk generally refers to insufficient documentation, 
insufficient capacity or authority of counterparty, or legality or 
enforceability of a contract.\123\
---------------------------------------------------------------------------

    \123\ See, e.g., Raimonda Martinkut[edot]-Kaulien[edot], Risk 
Factors in Derivatives Markets, 2 Entrepreneurial Business and 
Economics Review 4 (2014); Capital, Margin, and Segregation 
Requirements for Security-Based Swap Dealers and Major Security-
Based Swap Participants and Capital and Segregation Requirements for 
Broker-Dealers, Exchange Act Release No. 86175 (June 21, 2019), 84 
FR 43872 (Aug. 22, 2019), n.1055 (``Capital Margin Release'') 
(``Market participants face risks associated with the financial and 
legal ability of counterparties to perform under the terms of 
specific transactions''); see also Office of the Comptroller of the 
Currency, Risk Management of Financial Derivatives, Comptroller's 
Handbook (Jan. 1997) (narrative), (Feb. 1998) (procedures).
    Because derivatives contracts that are traded over the counter 
are not standardized, they bear a certain amount of legal risk in 
that poor draftsmanship, changes in laws, or other reasons may cause 
the contract to not be legally enforceable against the counterparty. 
See, e.g., Comprehensive Risk Management of OTC Derivatives, supra 
note 124. For example, some netting agreements or qualified 
financial contracts contain so-called ``walkaway'' clauses, such as 
provisions that, under certain circumstances, suspend, condition, or 
extinguish a party's payment obligation under the contract. These 
provisions would not be enforceable where the Federal Deposit 
Insurance Act is applicable. See 12 U.S.C 1821(e)(8)(G). As another 
example, many derivatives contracts and prime brokerage agreements 
that hedge funds and other counterparties had entered into with 
Lehman Brothers included cross-netting that allowed for payments 
owed to and from different Lehman affiliates to be offset against 
each other, and cross-liens that granted security interests to all 
Lehman affiliates (rather than only the specific Lehman entity 
entering into a particular transaction). In 2011, the U.S. 
Bankruptcy Court for the Southern District of New York held that 
cross-affiliate netting provisions in an ISDA swap agreement were 
unenforceable against a debtor in bankruptcy. In the Matter of 
Lehman Brothers Inc., Bankr. Case No. 08-01420 (JPM) (SIPA), 458 
B.R. 134, 1135-137 (Bankr. S.D.N.Y. Oct. 4, 2011).

We believe these risks are common to most derivatives 
transactions.\124\
---------------------------------------------------------------------------

    \124\ See Numerix, Comprehensive Risk Management of OTC 
Derivatives; A Tricky Endeavor (July 16, 2013), available at https://www.numerix.com/comprehensive-risk-management-otc-derivatives-tricky-endeavor (``Comprehensive Risk Management of OTC 
Derivatives''); Statement on best practices for managing risk in 
derivatives transactions, supra note 122; 2008 IDC Report, supra 
note 119; Lawrence Metzger, Derivatives Danger: internal auditors 
can play a role in reigning in the complex risks associated with 
financial instruments, FSA Times (2011), available at https://www.theiia.org/fsa/2011-features/derivatives-danger (``FSA Times 
Derivatives Dangers''). See also 17 CFR 240.15c3-4(a) (``An OTC 
derivatives dealer shall establish, document, and maintain a system 
of internal risk management controls to assist it in managing the 
risks associated with its business activities, including market, 
credit, leverage, liquidity, legal, and operational risks.''). 
Nonbank security-based swap dealers and broker-dealers authorized to 
use internal models to compute net capital also are subject to rule 
15c3-4. See Capital Margin Release, supra note 123.
---------------------------------------------------------------------------

    The proposed rule would not limit a fund's identification and 
assessment of derivatives risks to only those specified in the rule. 
The proposed definition of the term ``derivatives risks'' includes any 
other risks a fund's derivatives risk manager deems material.\125\ Some 
derivatives transactions could pose certain idiosyncratic risks. For 
example,

[[Page 4461]]

some derivatives transactions could pose a risk that a complex OTC 
derivative could fail to produce the expected result (e.g., because 
historical correlations change or unexpected merger events occur) or 
pose a political risk (e.g., events that affect currencies).
---------------------------------------------------------------------------

    \125\ See supra note 118.
---------------------------------------------------------------------------

    Commenters to the 2015 proposal generally supported its requirement 
that a fund engage in a process of identifying and evaluating the 
potential risks posed by its derivatives transactions.\126\
---------------------------------------------------------------------------

    \126\ See, e.g., ICI Comment Letter I; Comment Letter of the 
Consumer Federation of America (Mar. 28, 2016) (``CFA Comment 
Letter'').
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed requirement to 
identify and assess a fund's derivatives risks, as well as the proposed 
definition of the term ``derivatives risks.''
    21. Is the proposed definition of ``derivatives risks'' 
sufficiently clear? Why or why not?
    22. Are the categories of risks that we have identified in the 
proposed rule appropriate? Why or why not? Should we remove any of the 
identified risk categories? If so, what categories should be removed, 
and why? Should we add any other specified categories of risks that 
should be addressed? If so, what additional categories and why? Should 
we provide further guidance regarding the assessment of any of these 
risks? If so, what should the guidance be, and why?
    23. Do commenters believe the proposed approach with respect to 
risk identification and assessment is appropriate? Why or why not?
    24. Do funds currently assess the risks associated with their 
derivatives transactions by taking into account both their derivatives 
transactions and other investments? If so, how do they perform this 
assessment? Are there certain derivatives transactions whose risks do 
not involve an assessment of other investments in a fund's portfolio? 
If so, which derivatives transactions, and why?
    25. Should we require policies and procedures to include an 
assessment of particular risks based on an evaluation of certain 
identified risk categories as proposed? If not, why?
b. Risk Guidelines
    The proposed rule would require a fund's program to provide for the 
establishment, maintenance, and enforcement of investment, risk 
management, or related guidelines that provide for quantitative or 
otherwise measurable criteria, metrics, or thresholds of the fund's 
derivatives risks (the ``guidelines'').\127\ The guidelines would be 
required to specify levels of the given criterion, metric, or threshold 
that a fund does not normally expect to exceed and the measures to be 
taken if they are exceeded. The proposed guidelines requirement is 
designed to address the derivatives risks that a fund would be required 
to monitor routinely as part of its program, and to help the fund 
identify when it should respond to changes in those risks. We 
understand that many funds today have established risk management 
guidelines, with varying degrees of specificity.
---------------------------------------------------------------------------

    \127\ Proposed rule 18f-4(c)(1)(ii).
---------------------------------------------------------------------------

    The proposed rule would not impose specific risk limits for these 
guidelines. It would, however, require a fund to adopt guidelines that 
provide for quantitative thresholds that the fund determines to be 
appropriate and that are most pertinent to its investment portfolio, 
and that the fund reasonably determines are consistent with its risk 
disclosure.\128\ Requiring a fund to establish discrete metrics to 
monitor its derivatives risks would require the fund and its 
derivatives risk manager to measure changes in its risks regularly, and 
this in turn is designed to lead to more timely steps to manage these 
risks. Moreover, requiring a fund to identify its response when these 
metrics have been exceeded would provide the fund's derivatives risk 
manager with a clear basis from which to determine whether to involve 
other persons, such as the fund's portfolio management or board of 
directors, in addressing derivatives risks appropriately.\129\
---------------------------------------------------------------------------

    \128\ See, e.g., Mutual Fund Directors Forum, Risk Principles 
for Fund Directors: Practical Guidance for Fund Directors on 
Effective Risk Management Oversight (Apr. 2010), available at https://www.mfdf.org/images/Newsroom/Risk_Principles_6.pdf (``MFDF 
Guidance'').
    \129\ See proposed rule 18f-4(c)(1)(v); see also infra section 
II.B.3.e.
---------------------------------------------------------------------------

    Funds may use a variety of approaches in developing guidelines that 
comply with the proposed rule.\130\ This would draw on the risk 
identification element of the program and the scope and objectives of 
the fund's use of derivatives. A fund could use quantitative metrics 
that it determines would allow it to monitor and manage its particular 
derivatives risks most appropriately. We understand that today funds 
use a variety of quantitative models or methodologies to measure the 
risks associated with the derivatives transactions. With respect to 
market risk, we understand that funds commonly use VaR, stress testing, 
or horizon analysis. Concentration risk metrics are also being used in 
connection with monitoring counterparty risk (e.g., requiring specific 
credit committee approval for transactions with a notional exposure in 
excess of a specified amount, aggregated with other outstanding 
positions with the same of affiliated counterparties). In addition, 
liquidity models have been designed to address liquidity risks over 
specified periods (e.g., models identifying margin outlay requirements 
over a specified period under specified volatility scenarios).
---------------------------------------------------------------------------

    \130\ See, e.g., Comprehensive Risk Management of OTC 
Derivatives, supra note 124; Statement on best practices for 
managing risk in derivatives transactions, supra note 122; 2008 IDC 
Report, supra note 119.
---------------------------------------------------------------------------

    In developing the guidelines, a fund generally should consider how 
to implement them in view of its investment portfolio and the fund's 
disclosure to investors. For example, a fund may wish to consider 
establishing corresponding investment size controls or lists of 
approved transactions across the fund.\131\ A fund generally should 
consider whether to implement appropriate monitoring mechanisms 
designed to allow the fund to abide by the guidelines, including their 
quantitative metrics.
---------------------------------------------------------------------------

    \131\ A fund could also consider establishing an ``approved 
list'' of specific derivatives instruments or strategies that may be 
used, as well as a list of persons authorized to engage in the 
transactions on behalf of the fund. A fund may wish to provide new 
instruments (or instruments newly used by the fund) additional 
scrutiny. See, e.g., MFDF Guidance, supra note 128, at 8.
---------------------------------------------------------------------------

    While the 2015 proposal did not require funds to adopt risk 
guidelines, commenters on the 2015 proposal generally supported the 
concept of a requirement that a fund adopt and implement policies and 
procedures reasonably designed to manage the risks of its derivatives 
transactions, including by monitoring whether those risks continue to 
be consistent with any investment guidelines established by the fund or 
the fund's investment adviser.\132\
---------------------------------------------------------------------------

    \132\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter; 
ICI Comment Letter I.
---------------------------------------------------------------------------

    We request comment on the proposed rule's guidelines requirement.
    26. Should we require, as proposed, a fund's program to provide for 
the establishment, maintenance, and enforcement of investment, risk 
management, or related guidelines? Why or why not? Should we require, 
as proposed, that the guidelines provide for quantitative or otherwise 
measurable criteria, metrics, or thresholds of the fund's derivatives 
risks? Why or why not? If not, is there an alternative program element 
that would be more appropriate in promoting effective derivatives risk 
management? Should we prescribe particular tools or

[[Page 4462]]

approaches that funds must use to manage specific risks related to 
their use of derivatives? For example, should we require funds to 
manage derivatives' liquidity risks by maintaining highly liquid assets 
to cover potential future losses and other liquidity demands?
    27. Should we require a specific number or range of numbers of 
guidelines that a fund should establish? For example, should we require 
a fund to establish a minimum of 2, 3, 4, or more different guidelines 
to cover a range of different risks? Why or why not?
    28. Do funds currently adopt, and monitor compliance with, such 
guidelines? If so, do these guidelines provide for quantitative or 
otherwise measurable criteria, metrics, or thresholds of the funds' 
derivatives risks? If so, what criteria, metrics, or thresholds are 
provided for? Should we require that funds use specific risk management 
tools? If so, what tools should we require?
    29. Should we specify a menu of guideline categories that all funds 
should use to promote consistency in risk management among funds? For 
example, should we identify certain commonly-used types of guidelines 
such as VaR, notional amounts, and duration, and require funds to 
choose among those commonly-used types? If we were to do so, which 
metrics should we allow funds to use? Would such a menu become stale as 
new risk measurement tools are developed?
    30. Should we require, as proposed, that the guidelines specify set 
levels of a given criterion, metric, or threshold that the fund does 
not generally expect to exceed? Why or why not? If so, how would these 
levels be set or calculated? Should we instead set maximum levels for 
certain guidelines a fund would not exceed?
    31. Should we require that a fund publicly disclose the guidelines 
it uses and the quantitative levels selected? If so, where (for 
example, in the fund's prospectus, website, or on Form N-PORT or N-
CEN)? Should we instead require that funds confidentially report to us 
the guidelines they use and the quantitative levels selected? If so, on 
what form should they report this information?
    32. Should we require, as proposed, that the guidelines identify 
measures to be taken when the fund exceeds a criterion, metric, or 
threshold in the fund's guidelines? Why or why not?
    33. Should we require any form of public disclosure or confidential 
reporting to us if a fund were to exceed its risk guidelines? Would 
such reporting or disclosure result in funds setting guidelines that 
are so restrictive or lax that they would be unlikely to be useful as a 
monitoring and risk management tool?
    34. Should the rule require the guidelines to provide for other 
elements? If so, what elements and why?
c. Stress Testing
    The proposed rule would require a fund's program to provide for 
stress testing to evaluate potential losses to the fund's 
portfolio.\133\ We understand that, as a derivatives risk management 
tool, stress testing is effective at measuring different drivers of 
derivatives risks, including non-linear derivatives risks that may be 
understated by metrics or analyses that do not focus on periods of 
stress. Stress testing is an important tool routinely used in other 
areas of the financial markets and in other regulatory regimes, and we 
understand that funds engaging in derivatives transactions have 
increasingly used stress testing as a risk management tool over the 
past decade.\134\ The Commission has also required certain types of 
funds to conduct stress tests or otherwise consider the effect of 
stressed market conditions on their portfolios.\135\ We believe that 
requiring a fund to stress test its portfolio would help the fund 
better manage its derivatives risks and facilitate board oversight.
---------------------------------------------------------------------------

    \133\ Proposed rule 18f-4(c)(1)(iii); see also infra section 
II.D.6.a (discussing an alternative to the proposed limit on fund 
leverage risk that would rely on a stress testing framework). The 
proposed rule would require a fund that is required to establish a 
derivatives risk mangement program to stress test its portfolio, 
that is, all of the fund's investments, and not just the fund's 
derivatives transactions.
    \134\ See, e.g., Comment Letter of Investment Company Institute 
(Oct. 8, 2019) (``ICI Comment Letter III'') (stating that, based on 
a survey of member firms, many funds perform ex ante stress 
testing).
    \135\ See rule 2a-7 under the Investment Company Act [17 CFR 
270.2a-7]; see also rule 22e-4 under the Investment Company Act [17 
CFR 270.22e-4] (requiring a fund subject to the rule to assess its 
liquidity risk by considering, for example, its investment strategy 
and portfolio investment liquidity under reasonably foreseeable 
stressed conditions).
---------------------------------------------------------------------------

    We also believe that stress testing would serve as an important 
complement to the proposed VaR-based limit on fund leverage risk, as 
well as any VaR testing under the fund's risk guidelines.\136\ During 
periods of stress, returns, correlations, and volatilities tend to 
change dramatically over a very short period of time. Losses under 
stressed conditions--or ``tail risks''--would not be reflected in VaR 
analyses that are not calibrated to a period of market stress and that 
do not estimate losses that occur on the trading days with the highest 
losses.\137\ Requiring funds to stress test their portfolios would 
provide information regarding these ``tail risks'' that VaR and other 
analyses may miss.
---------------------------------------------------------------------------

    \136\ See proposed rule 18f-4(c)(2); infra section II.D.
    \137\ The proposed rule would not require a fund to implement a 
stressed VaR test. See infra section II.D.1.
---------------------------------------------------------------------------

    Under the proposed rule, the fund's stress tests would be required 
to evaluate potential losses to the fund's portfolio 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.\138\ The stress tests also would have to take into account 
correlations of market risk factors and resulting payments to 
derivatives counterparties.\139\ We believe that these requirements 
would promote stress tests that produce results that are valuable in 
appropriately managing derivatives risks by focusing the testing on 
extreme events that may provide actionable information to inform a 
fund's derivatives risk management.\140\ We understand that funds 
commonly consider the following market risk factors: liquidity, 
volatility, yield curve shifts, sector movements, or changes in the 
price of the underlying reference security or asset.\141\ In addition, 
we believe it is important for a fund's stress testing to take into 
account payments to counterparties, as losses can result when the 
fund's portfolio securities decline in value at the same time that the 
fund is required to make additional payments under its derivatives 
contracts.\142\
---------------------------------------------------------------------------

    \138\ Proposed rule 18f-4(c)(1)(iii).
    \139\ Id.
    \140\ Krishan Mohan Nagpal, Designing Stress Scenarios for 
Portfolios, 19 Risk Management 323 (2017).
    \141\ See, e.g., ICI Comment Letter I; Thomas Breuer, et al., 
How to Find Plausible, Severe, and Useful Stress Scenarios, 
International Journal of Central Banking 205 (Sept. 2009).
    \142\ See OppenheimerFunds Settled Action, supra note 22.
---------------------------------------------------------------------------

    To inform a fund's derivatives risk management effectively, a fund 
should stress test its portfolio with a frequency that would best 
position the derivative risk manager to appropriately administer, and 
the board to appropriately oversee, a fund's derivatives risk 
management, taking into account the frequency of change in the fund's 
investments and market conditions. The proposed rule, therefore, would 
permit a fund to determine the frequency of stress tests, provided that 
the fund must conduct stress testing at least weekly. In establishing 
such frequency, a fund

[[Page 4463]]

must take into account the fund's strategy and investments and current 
market conditions. For example, a fund whose strategy involves a high 
portfolio turnover might determine to conduct stress testing more 
frequently than a fund with a more static portfolio. A fund similarly 
might conduct more frequent stress tests in response to increases in 
market stress. The minimum weekly stress testing frequency is designed 
to balance the potential benefits of relatively frequent stress testing 
with the burdens of administering stress testing.\143\ We also 
considered a less frequent requirement, such as monthly stress testing. 
A less frequent requirement, however, may fail to provide a fund's 
derivatives risk manager adequate and timely insight into the fund's 
derivatives risk, particularly where the fund has a high portfolio 
turnover. In determining this minimum frequency, we also took into 
account that this requirement would only apply to funds that do not 
qualify for the limited derivatives user exception because they use 
derivatives in more than a limited way. In addition, in view of the 
proposed rule's internal reporting and periodic review requirements, 
the weekly stress testing minimum would provide a fund's derivatives 
risk manager and board with multiple sets of stress testing results, 
which would allow them to observe trends and how the results may change 
over time.\144\
---------------------------------------------------------------------------

    \143\ We recognize that the costs associated with stress testing 
may increase with the frequency of conducting such tests. We 
understand, however, that once a fund initially implements a stress 
testing framework, subsequent stress tests could be automated and, 
as a result, be less costly.
    \144\ See infra sections II.B.3.e and II.C.
---------------------------------------------------------------------------

    Although the 2015 proposal's risk management program did not 
include a stress testing requirement, some commenters stated that 
stress testing would serve as an important component of derivatives 
risk management and recommended that the Commission require a fund's 
designated risk manager to perform stress testing and report the 
results to the fund's board.\145\
---------------------------------------------------------------------------

    \145\ See, e.g., Comment Letter of Blackstone Alternative 
Investment Advisors LLC (Mar. 28, 2016) (``Blackstone Comment 
Letter''); Comment Letter of Invesco Management Group, Inc. (Mar. 
28, 2016) (``Invesco Comment Letter''); see also ICI Comment Letter 
III.
---------------------------------------------------------------------------

    We request comment on the proposed rule's stress testing 
requirement.
    35. Should we require, as proposed, that funds conduct stress 
testing as part of the program requirement? Why or why not? How, if at 
all, would stress testing serve as a complement for other risk 
measurement tools, such as VaR? What does stress testing capture as 
part of derivatives risk management that other tools do not, and why?
    36. Should the rule require funds to conduct a particular type of 
stress testing? If so, what type, and what should the required elements 
be? For example, should the rule require funds to conduct scenario 
analysis?
    37. Should the rule identify specific stress events to be applied? 
Should any required stress events vary based on the primary risks of 
particular funds?
    38. Do funds currently conduct stress testing? If so, what types of 
stress testing, for what purposes, and how does the stress testing that 
funds currently conduct differ from the proposed rule's requirement?
    39. For funds that currently conduct stress testing, how frequently 
do they conduct it? Daily, weekly, or monthly? Why? Does it depend on 
the type of stress testing? On the investment objective or strategy of 
a fund? With what minimum frequency should the rule require stress 
testing be conducted? For example, instead of weekly tests should we 
require daily tests? Conversely should we allow longer periods of time 
between tests, such as monthly, or quarterly? Why? Should we require 
more frequent testing for funds with some investment objectives or 
strategies than other funds? If so, for which objectives or strategies 
should we require more frequent testing?
    40. Is the proposed rule's reference to ``extreme but plausible 
market changes or changes in market risk factors'' sufficiently clear? 
Should we identify more quantitative changes, such as the worst change 
in a specific risk factor seen in the last 10, 20, or 50 years? Is the 
proposed rule's reference to ``significant adverse effect'' 
sufficiently clear? Should we instead identify quantitative levels of 
NAV change, such as a drop of 20, 30, or 50% of the fund's NAV?
    41. Should we require stress tests to include certain identified 
market risk factors such as changes in interest rates or spreads, 
market volatility, market liquidity, or other market factors? If so, 
which market risk factors should we identify, and why? If we were to 
identify certain market risk factors to be tested, should we require a 
fund to take action (such as reporting to its board or to the 
Commission, or reducing its derivatives usage) if a stress test were to 
show that one of these factors would result in the fund losing a 
certain percentage of its NAV? If so, what level of NAV, what types of 
risk factors, and what types of action should we consider?
    42. Should we require, as proposed, that funds take into account 
their strategy, investments, and current market conditions in 
considering the appropriate frequency for a fund's stress tests? Why or 
why not? Should we require, as proposed, that funds to take into 
account correlations of market risk factors and payments to derivatives 
counterparties as part of the fund's stress tests? Why or why not? 
Would any additional guidance help funds to better understand, and more 
consistently conduct, the stress tests that the proposed rule would 
require?
    43. We discuss and request comment below on the proposed rule's 
requirements to provide information to a fund's board of directors, 
including the derivatives risk manager's analysis of a fund's stress 
testing. In addition to providing this information to the board, should 
we require funds to disclose stress test results to investors or report 
them confidentially to us? If so, what information should be disclosed 
or reported?
d. Backtesting
    The proposed rule would require a fund to backtest the results of 
the VaR calculation model used by the fund in connection with the 
relative VaR or absolute VaR test, as applicable, as part of the 
program.\146\ This proposed requirement is designed to require a fund 
to monitor the effectiveness of its VaR model. It would assist a fund 
in confirming the appropriateness of its model and related assumptions 
and help identify when funds should consider model adjustments.\147\ We 
are proposing this requirement in light of the central role that VaR 
plays in the proposed VaR-based limit on leverage risk. This also is 
consistent with the comments we received on the 2015 proposal 
suggesting that we require backtesting, which we had not included in 
that proposal.\148\
---------------------------------------------------------------------------

    \146\ See proposed rule 18f-4(c)(1)(iv).
    \147\ Some commenters on the 2015 proposal suggested that the 
Commission require backtesting of a fund's VaR calculation models. 
See, e.g., Blackstone Comment Letter; Comment Letter of Investment 
Company Institute (Sept. 27, 2016) (``ICI Comment Letter II''); 
Aviva Comment Letter; Comment Letter of the Global Association of 
Risk Professionals (Mar. 21, 2016) (``GARP Comment Letter'').
    \148\ See, e.g., Blackstone Comment Letter; ICI Comment Letter 
II; Aviva Comment Letter; GARP Comment Letter.
---------------------------------------------------------------------------

    Specifically, the proposed backtesting requirement provides that, 
each business day, the fund must compare its actual gain or loss for 
that business day with the VaR the fund had calculated for that day. 
For purposes of the backtesting requirement, the VaR would be estimated 
over a one-trading day time horizon. For example, on Monday at the

[[Page 4464]]

end of the trading day, a fund would analyze whether the gain or loss 
it experienced that day exceeds the VaR calculated for that day. In 
this backtesting example, the fund could calculate the VaR for Monday 
on Friday evening (after Friday trading closes) or Monday morning 
(before Monday trading begins). The fund would have to identify as an 
exception any instance in which the fund experiences a loss exceeding 
the corresponding VaR calculation's estimated loss. This approach is 
generally consistent with the practice of firms that use internal 
models to compute regulatory capital and other regulatory 
approaches.\149\ Because the proposed rule would require that the 
fund's backtest be conducted using a 99% confidence level and over a 
one-day time horizon, and assuming 250 trading days in a year, a fund 
would be expected to experience a backtesting exception approximately 
2.5 times a year, or 1% of the 250 trading days.\150\ If the fund were 
consistently to experience backtesting exceptions more (or less) 
frequently, this could suggest that the fund's VaR model may not be 
effectively taking into account and incorporating all significant, 
identifiable market risk factors associated with a fund's investments, 
as required by the proposed rule.\151\
---------------------------------------------------------------------------

    \149\ See, e.g., rule 15c3-1e under the Exchange Act [17 CFR 
240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) (``On the last 
business day of each quarter, the broker or dealer must identify the 
number of backtesting exceptions of the VaR model, that is, the 
number of business days in the past 250 business days, or other 
period as may be appropriate for the first year of its use, for 
which the actual net trading loss, if any, exceeds the corresponding 
VaR measure.''); CESR Global Guidelines, supra note 94 (``The UCITS 
should carry out the back testing program at least on a monthly 
basis, subject to always performing retroactively the comparison for 
each business day,'' i.e., ``provid[ing] for each business day a 
comparison of the one-day value-at-risk measure generated by the 
UCITS model for the UCITS' end-of-day positions to the one-day 
change of the UCITS' portfolio value by the end of the subsequent 
business day''); see also infra note 152 (discussing frequency 
variations for backtesting requirements).
    \150\ The proposed backtesting requirement would be based on a 
one-day time horizon. See infra section II.D.4 (discussing the 
proposed VaR model requirements that would be based on a twenty-day 
time horizon).
    \151\ If 10 or more exceptions are generated in a year from 
backtesting that is conducted using a 99% confidence level and over 
a one-day time horizon, and assuming 250 trading days in a year, it 
is statistically likely that such exceptions are a result of a VaR 
model that is not accurately estimating VaR. See, e.g., Philippe 
Jorion, Value at Risk: The New Benchmark for Managing Financial Risk 
(3d ed. 2006), at 149-150 (``Jorion''). See also rule 15c3-1e under 
the Exchange Act (requiring backtesting of VaR models and the use of 
a multiplication factor based on the number of backtesting 
exceptions).
---------------------------------------------------------------------------

    The proposed rule would require funds to conduct a backtest each 
day so that a fund and its derivatives risk manager could more readily 
and efficiently adjust or calibrate its VaR calculation model and, 
therefore, could more effectively manage the risks associated with its 
derivatives use. We understand that some funds perform these 
calculations less frequently than daily.\152\ We are proposing a daily 
backtesting requirement because market risk factors and fund 
investments are dynamic, which might result in frequent changes to the 
accuracy and effectiveness of a VaR model and calculations using the 
model. Some commenters on the 2015 proposal supported a backtesting 
requirement with a daily frequency.\153\ We also believe that the 
additional costs associated with a daily backtesting requirement would 
be limited because a fund would be required to calculate its portfolio 
VaR each business day to satisfy the proposed limits on fund leverage 
discussed in section II.D of this release.
---------------------------------------------------------------------------

    \152\ See, e.g., CESR Global Guidelines, supra note 94 (``The 
UCITS should carry out the back testing program at least on a 
monthly basis, subject to always performing retroactively the 
comparison for each business day,'' i.e., ``provid[ing] for each 
business day a comparison of the one-day value-at-risk measure 
generated by the UCITS model for the UCITS' end-of-day positions to 
the one-day change of the UCITS' portfolio value by the end of the 
subsequent business day''); Blackstone Comment Letter (suggesting 
monthly backtests); Aviva Comment Letter (recommending reporting to 
the Commission on a semi-annual basis if a fund experienced a 
certain number of backtest exceptions). Cf. rule 15c3-1e under the 
Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) 
(``On the last business day of each quarter, the broker or dealer 
must identify the number of backtesting exceptions of the VaR model, 
that is, the number of business days in the past 250 business days, 
or other period as may be appropriate for the first year of its use, 
for which the actual net trading loss, if any, exceeds the 
corresponding VaR measure.'').
    \153\ See, e.g., GARP Comment Letter; Aviva Comment Letter; ICI 
Comment Letter II.
---------------------------------------------------------------------------

    We request comment on the proposed backtesting requirement.
    44. Is the proposed requirement that a fund backtest its VaR model 
each business day appropriate? Why or why not? Would less-frequent 
backtesting be sufficient? Is backtesting an effective tool to promote 
derivatives risk management and VaR model accuracy? Why or why not?
    45. Should the rule specify the number of exceedances, or the 
number of consecutive days without an exceedance, that would require 
VaR model calibration? Why or why not?
    46. How often do funds that currently use VaR backtest their VaR 
models and why? Should the backtesting requirement be less frequent? 
For example, should we require a fund to perform backtests weekly, 
monthly, or quarterly, in each case considering the one-day value 
change for each trading day in the period? Please explain.
    47. For funds that currently backtest their VaR models, how often 
and for what reasons do funds recalibrate their VaR models? Are certain 
market risk factors or investment types particularly prone to requiring 
VaR model recalibrations (as well as backtesting)?
e. Internal Reporting and Escalation
    The proposed rule would require communication between a fund's risk 
management and portfolio management regarding the operation of the 
program.\154\ We believe these lines of communication are a key part of 
derivatives risk management.\155\ Providing 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. The proposed 
rule also would require communication between a fund's derivatives risk 
manager and its board, as appropriate. We understand that funds today 
often have a dialogue between risk professionals and fund boards. 
Requiring a dialogue between a fund's derivatives risk manager and the 
fund's board would provide the fund's board with key information to 
facilitate its oversight function.
---------------------------------------------------------------------------

    \154\ Proposed rule 18f-4(c)(1)(v).
    \155\ See 2011 IDC Report, supra note 95.
---------------------------------------------------------------------------

    To provide flexibility for funds to communicate among these groups 
as they deem appropriate and taking into account funds' own facts and 
circumstances, the proposed rule would require a fund's program to 
identify the circumstances under which a fund must communicate with its 
portfolio management about the fund's derivatives risk management, 
including its program's operation.\156\ A fund's program, in addition, 
could require that the fund's derivatives risk manager inform the 
fund's portfolio management, for example, by meeting with the fund's 
portfolio management on a regular and frequent basis, or require that 
the fund's portfolio management is notified of the fund's exceedances 
or stress tests through software designed to provide automated updates.
---------------------------------------------------------------------------

    \156\ Proposed rule 18f-4(c)(1)(v)(A).
---------------------------------------------------------------------------

    The proposed rule would also require a fund's derivatives risk 
manager to communicate material risks to the fund's portfolio 
management and, as appropriate, its board of directors.\157\ 
Specifically, the rule would require the

[[Page 4465]]

derivatives risk manager to inform, in a timely manner, persons 
responsible for the fund's portfolio management--and the fund's board 
of directors, as appropriate--of material risks arising from the fund's 
derivatives transactions.\158\ The proposed rule would not require a 
fund's derivatives risk manager to escalate these risks to the fund's 
board automatically, but would require that the derivatives risk 
manager directly inform the fund's board of directors regarding these 
material risks if the manager determines board escalation to be 
appropriate. A fund's derivatives risk manager, for example, could 
determine to inform the fund's adviser's senior officers of material 
derivatives risks after informing the fund's portfolio management, and 
before informing the fund's board. As another example, a fund's 
derivatives risk manager could determine that it would be appropriate 
to communicate certain material derivatives risks (for example, those 
that put more than a certain percentage of the fund's assets at 
imminent risk) to the board at the same time it informs the fund's 
portfolio management. We believe that a fund's derivatives risk manager 
is best positioned to determine when to appropriately inform the fund's 
portfolio management and board of material risks.
---------------------------------------------------------------------------

    \157\ Proposed rule 18f-4(c)(1)(v)(B).
    \158\ Id.
---------------------------------------------------------------------------

    The proposed rule would require that these material risks include 
any material risks identified by the fund's guideline exceedances or 
stress testing. For example, an unexpected risk may arise due to a 
sudden market event, such as a downgrade of a large investment bank 
that is a substantial derivatives counterparty to the fund. This 
requirement is designed to inform portfolio managers of material risks 
identified by a fund's derivatives risk management function so that 
portfolio managers can take them into account in managing the fund's 
portfolio and address or mitigate them as appropriate. It also would 
facilitate board oversight by empowering the derivatives risk manager 
to escalate a material risk directly to the fund's board where 
appropriate. Requiring that a fund's derivatives risk manager have this 
direct line of communication with the board regarding material risks 
arising from the fund's derivatives transactions is designed to foster 
an open and effective dialogue among the derivatives risk manager and 
the board.
    We request comment on the internal reporting and escalation 
elements of the proposed program requirement.
    48. Are the proposed internal reporting and escalation requirements 
appropriate? Why or why not? Should the rule describe the circumstances 
under which a fund must inform its portfolio management regarding the 
operation of the program, including any exceedances of its guidelines 
and the results of its stress tests? Why or why not? If so, what should 
the circumstances be and why? Should the rule require a fund to report 
to others at the fund or its adviser (e.g., the fund's chief compliance 
officer)? If so, who should a fund report to and why?
    49. Should we prescribe the types of internal reporting information 
that persons responsible for a fund's portfolio management or the 
fund's board should receive, and the means by which these persons 
receive such information? Why or why not? If so, what should we 
prescribe and why?
    50. Are the proposed requirements to escalate material risks to the 
fund's portfolio management (and, as appropriate, the fund's board of 
directors) appropriate? Why or why not? Should these material risks 
include risks identified by the fund's guideline exceedances or stress 
testing? Why or why not? Should a fund's derivatives risk manager be 
required to report all material derivatives risks to the fund's board, 
as well as to its portfolio management? Why or why not?
    51. Should the rule, as proposed, permit a fund to determine what 
risks arising from its derivatives transactions are material to the 
fund, for purposes of the proposed escalation requirement? Why or why 
not? If so, should the rule specifically require a fund's derivatives 
risk manager to make this determination?
    52. Should the rule require the means by which internal reporting 
and/or material risk escalation occur? For example, should the rule 
specify that certain communications must be in writing? Why or why not?
    53. Should the rule require a fund's derivatives risk manager to 
inform the fund's portfolio management regarding the operation of the 
program on a regular basis? Why or why not? If so, what should the 
frequency be and why?
    54. Should the rule require a fund to report material risks to us? 
Why or why not? If so, what should a fund report and how should it be 
reported? For example, should a fund be required to report material 
exceedances to its guidelines? Why or why not? Should such a report be 
confidential?
    55. Should the rule permit a fund to determine whether the material 
risk warrants informing the fund's board? Why or why not? If so, which 
person or persons at the fund or its adviser should be responsible for 
that determination? Should a fund's board always be informed of 
material risks regarding the fund's derivatives use? Why or why not? If 
so, under what circumstances and frequency should the board be 
informed, and why?
    56. Should we require that a fund's derivatives risk manager be 
permitted to communicate directly with the fund's board of directors? 
If not, how should we otherwise address the concern that a board may 
not receive the derivatives risk manager's independent risk assessments 
if the derivatives risk manager is not empowered to communicate 
directly with the board?
f. Periodic Review of the Program
    The proposed rule would require a fund's derivatives risk manager 
to review the program at least annually to evaluate the program's 
effectiveness and to reflect changes in the fund's derivatives risks 
over time.\159\ The review would apply to the overall program, 
including each of the specific program elements discussed above.
---------------------------------------------------------------------------

    \159\ Proposed rule 18f-4(c)(1)(vi).
---------------------------------------------------------------------------

    The periodic review would also cover the VaR model a fund uses to 
comply with the proposed VaR-based limit on fund leverage risk and 
related matters. As discussed below, the proposed rule would require a 
fund to comply with a relative or absolute VaR test.\160\ For the 
relative VaR test, the fund would compare its VaR to a ``designated 
reference index,'' as defined in the rule and selected by the fund's 
derivatives risk manager. The proposed periodic review would therefore 
include the VaR calculation model that the fund used in connection with 
either of the proposed VaR tests (including the fund's backtesting of 
the model) and any designated reference index that the derivatives risk 
manager selected, to evaluate whether the calculation model and 
designated reference index remain appropriate.
---------------------------------------------------------------------------

    \160\ See proposed rule 18f-4(c)(2); infra section II.D.
---------------------------------------------------------------------------

    We believe that the periodic review of a fund's program and VaR 
calculation model is necessary to determine whether the fund is 
appropriately addressing its derivatives risks. A fund's derivatives 
risk manager, as a result of the review, could determine whether the 
fund should update its program, its VaR calculation model, or any 
designated reference index. Commenters on the 2015 proposal generally 
supported a similar proposed requirement that a fund review and

[[Page 4466]]

update its derivatives risk management program at least annually.\161\
---------------------------------------------------------------------------

    \161\ See, e.g., Vanguard Comment Letter.
---------------------------------------------------------------------------

    The proposed rule would not prescribe review procedures or 
incorporate specific developments that a derivatives risk manager must 
consider as part of its review. We believe a derivatives risk manager 
generally should implement periodic review procedures for evaluating 
regulatory, market-wide, and fund-specific developments affecting the 
fund's program so that it is well positioned to evaluate the program's 
effectiveness.
    We believe that a fund should review its program, VaR calculation 
model, and designated reference index on at least an annual basis, 
because derivatives and fund leverage risks, and the means by which 
funds evaluate such risks, can change. The proposed rule would require 
at least an annual review so that there would be a recurring dialogue 
between a fund's derivatives risk manager and its board regarding the 
implementation of the program and its effectiveness. This frequency 
also mirrors the minimum period in which the fund's derivatives risk 
manager would be required to provide a written report on the 
effectiveness of the program to the board.\162\ A fund's derivatives 
risk manager could, however, determine that more frequent reviews are 
appropriate based on the fund's particular derivatives risks, the 
fund's policies and procedures implementing the program, market 
conditions, or other facts and circumstances.\163\
---------------------------------------------------------------------------

    \162\ See infra section II.C.2.
    \163\ See also proposed rule 18f-4(c)(2)(iii)(A) (requiring, for 
a fund that is not in compliance with the applicable VaR test within 
three business days, the derivatives risk manager to report to the 
fund's board of directors and explain how and by when (i.e., number 
of business days) the derivatives risk manager reasonably expects 
that the fund will come back into compliance).
---------------------------------------------------------------------------

    We request comment on the proposed rule's periodic review 
requirement.
    57. Should the rule, as proposed, specifically require that a 
fund's derivatives risk manager periodically review the program's 
effectiveness, including the program's VaR calculation model and any 
designated reference index? Why or why not?
    58. Should the rule, as proposed, require this review to take place 
at least annually, or should it require a more frequent review, such as 
quarterly? Should we, instead, not prescribe a minimum frequency for 
the periodic review? Why or why not?
    59. Are there certain review procedures that the proposed rule 
should require and/or on which the Commission should provide guidance? 
If so, what are they? For example, should the periodic review involve 
board input? Should the Commission provide any additional guidance on 
regulatory, market-wide, and fund-specific developments that a fund's 
review procedures might cover? Why or why not? If so, how?
    60. Should the rule, as proposed, specifically require that other 
program elements be periodically reviewed? Why or why not? If so, which 
elements and why, and should they be reviewed with the same frequency?

C. Board Oversight and Reporting

    The proposed rule would require: (1) A fund's board of directors to 
approve the designation of the fund's derivatives risk manager and (2) 
the derivatives risk manager to provide regular written reports to the 
board regarding the program's implementation and effectiveness, and 
describing any exceedances of the fund's guidelines and the results of 
the fund's stress testing.\164\ Requiring a fund's derivatives risk 
manager approved by the fund's board and with relevant experience as 
determined by the fund's board to be responsible for the day-to-day 
administration of the fund's program, subject to board oversight, is 
consistent with the way we believe many funds currently manage 
derivatives risks.\165\ It is also consistent with a board's duty to 
oversee other aspects of the management and operations of a fund.
---------------------------------------------------------------------------

    \164\ Proposed rule 18f-4(c)(5). The board could designate a 
committee of directors to receive the report.
    \165\ See, e.g., Comment Letter of the Independent Directors 
Council (June 22, 2016) (providing views regarding the appropriate 
oversight role of fund directors).
---------------------------------------------------------------------------

    The proposed rule's requirements regarding board oversight and 
reporting are designed to further facilitate the board's oversight of 
the fund's derivatives risk management.\166\ Board oversight should not 
be a passive activity. Consistent with that view, we believe that 
directors should understand the program and the derivatives risks it is 
designed to manage as well as participate in determining who should 
administer the program. They also should ask questions and seek 
relevant information regarding the adequacy of the program and the 
effectiveness of its implementation. The board should view oversight as 
an iterative process. Therefore, the board should inquire about 
material risks arising from the fund's derivatives transactions and 
follow up regarding the steps the fund has taken to address such risks, 
including as those risks may change over time. To facilitate the 
board's oversight, the proposed rule, as discussed below, would require 
the fund's derivatives risk manager to provide reports to the board.
---------------------------------------------------------------------------

    \166\ Many commenters to the 2015 proposal expressed the view 
that the appropriate role of the board in the context of funds' 
derivatives risk management is one of oversight. See, e.g., Comment 
Letter of Mutual Fund Directors Forum (Mar. 28, 2016) (stating it 
has long taken the position that boards and independent trustees 
have an important role to play in overseeing the risks associated 
with funds' use of derivatives, including the manner in which those 
risks are managed); see also Comment Letter of the Independent 
Directors Council (Mar. 28, 2016) (``IDC Comment Letter''); 
Morningstar Comment Letter.
---------------------------------------------------------------------------

    A fund's board would also be responsible for overseeing a fund's 
compliance with proposed rule 18f-4. Rule 38a-1 under the Investment 
Company Act requires a fund's board, including a majority of its 
independent directors, to approve policies and procedures reasonably 
designed to prevent violation of the federal securities laws by the 
fund and its service providers.\167\ Rule 38a-1 provides for oversight 
of compliance by the fund's adviser and other service providers through 
which the fund conducts its activities. Rule 38a-1 would encompass a 
fund's compliance obligations with respect to proposed rule 18f-4.
---------------------------------------------------------------------------

    \167\ See rule 38a-1 under the Investment Company Act; 
Compliance Programs of Investment Companies and Investment Advisers, 
Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR 
74714 (Dec. 24, 2003)] (discussing the adoption and implementation 
of policies and procedures required under rule 38-1) (``Compliance 
Program Release'').
---------------------------------------------------------------------------

1. Board Approval of the Derivatives Risk Manager
    The proposed rule would require a fund's board to approve the 
designation of the fund's derivatives risk manager, taking into account 
the derivatives risk manager's relevant experience regarding the 
management of derivatives risk.\168\ This requirement is designed to 
establish the foundation for an effective relationship and line of 
communication between a fund's board and its derivatives risk manager, 
and to ensure that the board receives information it needs to approve 
the designation.\169\ The requirement that the board consider the 
derivatives risk manager's relevant experience is designed to provide 
flexibility for a fund's board to take into account a derivatives risk 
manager's specific experience, rather than the rule taking a more 
prescriptive approach in identifying a specific amount or type of 
experience that a derivatives risk

[[Page 4467]]

manager must have. Detailing a derivatives risk manager's required 
experience in the rule would not be practical, given the numerous ways 
in which a person could obtain experience with derivatives or risk 
management. Any specification in the rule of the specific experience 
required to serve as a derivatives risk manager likely would be over- 
or under-inclusive and would not take into account the way that any 
particular fund uses derivatives. We believe that a fund's board, in 
its oversight role, is best-positioned to consider a prospective 
derivatives risk manager's experience based on all the facts and 
circumstances relevant to the fund in considering whether to approve 
the derivatives risk manager's designation.
---------------------------------------------------------------------------

    \168\ Proposed rule 18f-4(c)(5)(i).
    \169\ Cf. rules 22e-4 and 38a-1 under the Investment Company 
Act.
---------------------------------------------------------------------------

    Commenters on the 2015 proposal generally supported a requirement 
that the board approve a fund's derivatives risk manager, although some 
of these commenters objected to the proposed requirement that only a 
single individual could serve in that role. These commenters asserted 
that requiring the board to approve a single individual as the 
derivatives risk manager would have required the board to participate 
too closely in the management function of the fund.\170\ This re-
proposal, in contrast, would permit a fund's board to approve the 
designation of a single individual or group of individuals, subject to 
the other proposed requirements about who may serve as a derivatives 
risk manager.
---------------------------------------------------------------------------

    \170\ See, e.g., Comment Letter of Guggenheim (Mar. 28, 2016) 
(``Guggenheim Comment Letter''); Dechert Comment Letter; IDC Comment 
Letter; American Beacon Comment Letter; Fidelity Comment Letter; IAA 
Comment Letter; ICI Comment Letter I; Invesco Comment Letter.
---------------------------------------------------------------------------

    We request comment on the proposed requirement that a fund's board 
approve the designation of the fund's derivatives risk manager.
    61. Should we require, as proposed, that a fund's board approve the 
designation of the fund's derivatives risk manager? Why or why not? Are 
there any specific requirements we should include with respect to the 
derivatives risk manager's relationship with the board? For example, 
should we require the board to meet with the derivatives risk manager 
in executive session? Should we also require the derivatives risk 
manager to be removable only by the fund's board? Should we require the 
derivatives risk manager's compensation be approved by the board, like 
a fund's chief compliance officer? If so, why? Would such a requirement 
pose undue burdens on fund boards or place the board in an 
inappropriate role? If so, why?
    62. Should the rule permit a board committee to approve the 
designation of the derivatives risk manager, rather than the full board 
(and a majority of directors who are not interested persons of the 
fund) as proposed? Why or why not? If so, should there be any 
requirements or guidance with respect to such a board committee (e.g., 
composition or responsibilities)?
    63. Should the rule, as proposed, require that a fund's board in 
approving the fund's derivatives risk manager, take into account the 
derivatives risk manager's relevant experience regarding the management 
of derivatives risk? Why or why not? Would a fund's board, in approving 
the designation of the fund's derivatives risk manager, only approve 
individuals with relevant experience even without this express 
requirement? Is the proposed requirement that a fund's board must take 
into account the derivatives risk manager's ``relevant experience 
regarding the management of derivatives risk'' sufficiently clear? 
Would this raise questions for a fund's board about whether portfolio 
management experience, or experience outside of formal derivatives risk 
management, would suffice for purposes of the rule? Should the rule, 
instead, require that a fund's board take into account the derivatives 
risk manager's ``relevant experience''? Or should the rule identify 
specific qualifications or experience of a fund's derivatives risk 
manager that the fund's board must consider? Why or why not? If so, 
what should they be and why?
    64. Should we require a fund's board, or a committee thereof, to 
approve the derivatives risk management program or any material changes 
to the program? Why or why not? If so, should we require that the 
committee have a majority that are disinterested? Would such an 
approval requirement promote greater board engagement and oversight? Do 
a fund's derivatives use and related derivatives risks present matters 
for which it would be appropriate to require the fund's board, or 
committee thereof, to approve the program or any material changes to 
the program? Why or why not?
2. Board Reporting
    The proposed rule would require the derivatives risk manager to 
provide a written report on the effectiveness of the program to the 
board at least annually and also to provide regular written reports at 
a frequency determined by the board. This requirement is designed to 
facilitate the board's oversight role, including its role under rule 
38a-1.\171\
---------------------------------------------------------------------------

    \171\ See Compliance Program Release, supra note 166, at n.33 
and accompanying text.
---------------------------------------------------------------------------

    Many commenters to the 2015 proposal did not support the proposal's 
requirement that the board approve material changes to the program. 
Many commenters did state, however, that a fund's board of directors 
should be provided with notices of changes to the policies and 
procedures implementing the derivatives risk management program and 
that the fund's derivatives risk manager should provide the board with 
a written report describing the adequacy of the derivatives risk 
management program and the effectiveness of its implementation and the 
results of the fund's stress testing.\172\
---------------------------------------------------------------------------

    \172\ See, e.g., BlackRock Comment Letter; Vanguard Comment 
Letter.
---------------------------------------------------------------------------

Reporting on Program Implementation and Effectiveness
    The proposed rule would require a fund's derivatives risk manager 
to provide to the fund's board, on or before the implementation of the 
program and at least annually thereafter, a written report providing a 
representation that the program is reasonably designed to manage the 
fund's derivatives risks and to incorporate the required elements of 
the program as well as the basis for the representation.\173\ This 
requirement, as discussed below, is designed to provide a fund's 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.
---------------------------------------------------------------------------

    \173\ Proposed rule 18f-4(c)(5)(ii).
---------------------------------------------------------------------------

    To facilitate the board's oversight, the proposed rule would 
require the written report to include the basis for the derivatives 
risk manager's representation along with such information as may be 
reasonably necessary to evaluate the adequacy of the fund's program and 
the effectiveness of its implementation. In addition, the 
representation may be based on the derivatives risk manager's 
reasonable belief after due inquiry. A derivatives risk manager, for 
example, could form its reasonable belief based on an assessment of the 
program and taking into account input from fund personnel, including 
the fund's portfolio management, or from third parties. We propose to 
require that the derivatives risk manager include this representation 
and its basis, because we believe the derivatives risk manager--rather 
than the board--is best positioned to make this determination. 
Requiring the

[[Page 4468]]

derivatives risk manager to include the information in a board report 
would also reinforce that the fund and its adviser are responsible for 
derivatives risk management while the board's responsibility is to 
oversee this activity. Reports following the initial implementation of 
the program must also address the effectiveness of the program. This 
requirement is designed to provide the board with appropriate and 
useful information so it can exercise its judgment in overseeing the 
program, and in light of its role under rule 38a-1.
    The proposed rule would also require the written report to include 
a fund's derivatives risk manager's basis for the selection of the 
designated reference index used under the proposed relative VaR test 
or, if applicable, an explanation of why the derivatives risk manager 
was unable to identify a designated reference index appropriate for the 
fund such that the fund relied on the proposed absolute VaR test 
instead. The derivatives risk manager's selection of a particular 
designated reference index, or conclusion that one is not available, 
can affect the amount of leverage risk a fund may obtain under the 
proposed rule.\174\ We therefore believe it is important that a fund's 
board have sufficient information to oversee this activity.
---------------------------------------------------------------------------

    \174\ See infra section II.D.2.b. The proposed rule would not 
limit a derivatives risk manager from receiving input from the 
fund's portfolio managers or others regarding the fund's designated 
reference index.
---------------------------------------------------------------------------

Regular Board Reporting
    The proposed rule would require a fund's derivatives risk manager 
to provide to the fund's board, at a frequency determined by the board, 
a written report analyzing any exceedances of the fund's risk 
guidelines and the results of the fund's stress tests and 
backtesting.\175\ Requiring the derivatives risk manager to provide 
information about how the fund performed relative to these measures and 
at a board-determined frequency is designed to provide the board with 
timely information to facilitate its oversight of the fund and the 
operation of the program. The program's guidelines and stress testing 
requirements are designed to address a fund's particular derivatives 
risks and are areas the fund should routinely monitor. The program's 
backtesting requirement is designed to require a fund to monitor the 
effectiveness of the fund's VaR model, which plays a central role in 
the proposed VaR-based limit on fund leverage risk. Therefore, we 
believe that a board overseeing a fund's derivatives risk management 
should receive regular reporting regarding the derivatives risk 
manager's analysis of guideline exceedances and the results of stress 
testing and backtesting. We also understand that many fund advisers 
today provide regular reports to fund boards, often in connection with 
quarterly board meetings, regarding a fund's use of derivatives and 
their effects on a fund's portfolio, among other information.
---------------------------------------------------------------------------

    \175\ Proposed rule 18f-4(c)(5)(iii); see also proposed rule 
18f-4(c)(1)(ii)-(iv); see also supra sections II.B.3.b, II.B.3.c, 
and II.B.3.d.
---------------------------------------------------------------------------

    Accordingly, the proposed rule would require that the report 
include the derivatives risk manager's analysis of any exceedances and 
stress testing and backtesting results, and to include such information 
as may be reasonably necessary for the board to evaluate the fund's 
response to any exceedances and the stress testing and backtesting 
results. This requirement is designed to provide the board with 
information in a format, and with appropriate context, that would 
facilitate the board's understanding of the information. A simple 
listing of exceedances and stress testing and backtesting results 
without context, in contrast, would provide less useful information for 
a fund's board and would not satisfy this proposed requirement.
    Under the proposed regular board reporting requirement, a fund's 
board would determine the frequency of this written report. Boards 
should be allowed flexibility in determining the frequency of reporting 
so that they can tailor their oversight to their funds' particular 
facts and circumstances.
    We request comment on the proposed board reporting requirements.
    65. Are the proposed requirements for the fund's derivatives risk 
manager to provide written reports to the fund's board on the program's 
implementation and effectiveness appropriate? Why or why not? Should 
the board receive a written report on or before the implementation of 
the program? Why or why not? Should we modify the proposed rule to 
require funds to provide boards reports with greater frequency than 
annually? Why or why not?
    66. Is the proposed representation that the derivatives risk 
manager would have to make in the report appropriate? Why or why not? 
What should the representation entail, and why? Should we provide 
guidance as to what the representation should look like? Why or why 
not? Would the representation be helpful for a fund's board in 
exercising its oversight responsibilities? Why or why not? What effect, 
if any, would the representation have on a fund's derivatives risk 
management apart from the board's oversight of such risk management?
    67. Would the responsibilities the proposed rule allocates to a 
fund's derivatives risk manager affect a fund's ability to hire or 
retain a derivatives risk manager? If so, how?
    68. Is the proposed requirement for the written report to include 
the basis for the derivatives risk manager's representation along with 
information to evaluate the program's adequacy and effectiveness, 
appropriate? Why or why not? Should the rule require specific 
information in the written report? Why or why not? If so, what 
information and why? Should the rule, as proposed, permit the 
representation to be based on the derivatives risk manager's reasonable 
belief after due inquiry? Why or why not? Should we provide more 
guidance regarding the basis for the representation? If so, what should 
we provide? For example, should we provide guidance regarding the types 
of information on which a fund's derivatives risk manager may base this 
representation? Why or why not? Is the reference to due inquiry 
appropriate in this context? Is the reference sufficiently clear?
    69. Should the rule require the written report to include a fund's 
derivatives risk manager's basis for the selection of the designated 
reference index or, if applicable, an explanation of why the 
derivatives risk manager was unable to identify a designated reference 
index appropriate for the fund? Why or why not? Should the rule require 
the written report to identify and explain any difference between the 
selected index and any indices that are used for performance 
comparisons in the fund's registration statement and shareholder 
reports? Why or why not?
    70. Should the rule require a fund's derivatives risk manager to 
provide a written report regarding any exceedances to thresholds 
provided for in the fund's guidelines? Why or why not? Should the rule 
require a fund's derivatives risk manager to provide a written report 
regarding the results of the stress tests and backtests? Why or why 
not?
    71. Should the rule require that a fund's derivatives risk manager 
report to the board? Why or why not? If not, should the fund determine 
who should report to the board, and why? Should the rule permit the 
derivatives risk manager to delegate its reporting obligations under 
the rule to other officers or employees of the adviser? Why or why not? 
If so, to whom should they be able to delegate these obligations?

[[Page 4469]]

    72. Should the rule permit a fund's board to determine the 
frequency with which it receives the written report? Why or why not? Or 
should the rule require that the derivatives risk manager provide the 
written report with a certain frequency? Why or why not? If so, what 
frequency should the rule require, and why? Should the rule permit a 
fund's derivatives risk manager to determine to report to the board 
sooner than the frequency determined by the board if appropriate? Why 
or why not?
    73. Should the rule require that the written report include such 
information as may be reasonably necessary for the board to evaluate a 
fund's response to any exceedances and the results of the fund's stress 
testing? Why or why not? What information may be reasonably necessary 
for the board's evaluation? Should the rule require certain information 
to be provided in the written report? Why or why not? If so, what 
information should be required to be provided?
    74. Should the rule require the report to be written? Why or why 
not? Should the rule require that the derivatives risk manager prepare 
the written report? Why or why not?
    75. Would the approach provided by the proposed rule's board 
oversight provisions appropriately provide the board the ability to 
oversee a fund's derivatives risk management? Why or why not? Does the 
proposed rule provide an appropriate balance between the board's role 
of general oversight and the fund's roles of day-to-day risk management 
and portfolio management? Why or why not?
    76. Should the board be required to approve the program, including 
initially, and any material changes to the program? Why or why not? 
What is current industry practice with respect to the board's oversight 
of a fund's derivatives risk management?

D. Proposed Limit on Fund Leverage Risk

    The proposed rule would also generally require funds relying on the 
rule when engaging in derivatives transactions to comply with a VaR-
based limit on fund leverage risk. This outer limit would be based on a 
relative VaR test that compares the fund's VaR to the VaR of a 
``designated reference index.'' If the fund's derivatives risk manager 
is unable to identify an appropriate designated reference index, the 
fund would be required to comply with an absolute VaR test.\176\
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    \176\ A fund that is a leveraged/inverse investment vehicle, as 
defined in the proposed sales practices rules, would not be required 
to comply with the proposed VaR-based limit on fund leverage risk. 
Broker-dealers and investment advisers would be required to approve 
retail investors' accounts to purchase or sell shares in these 
funds. See infra section II.G (discussing leveraged/inverse 
investment vehicles). The proposed rule also would provide an 
exception from the proposed VaR tests for funds that use derivatives 
to a limited extent or only to hedge currency risks. See infra 
sections II.E and II.G (discussing the proposed rule's provisions 
regarding limited derivatives users and leveraged/inverse funds 
covered by the sales practices rules).
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1. Use of VaR
    VaR is an estimate of an instrument or portfolio's potential losses 
over a given time horizon and at a specified confidence level. VaR will 
not provide, and is not intended to provide, an estimate of an 
instrument or portfolio's maximum loss amount. For example, if a fund's 
VaR calculated at a 99% confidence level was $100, this means the 
fund's VaR model estimates that, 99% of the time, the fund would not be 
expected to lose more than $100. However, 1% of the time, the fund 
would be expected to lose more than $100, and VaR does not estimate the 
extent of this loss.
    We propose to use VaR tests to limit fund leverage risk associated 
with derivatives because VaR generally enables risk to be measured in a 
reasonably comparable and consistent manner across diverse types of 
instruments that may be included in a fund's portfolio. One benefit of 
the proposed VaR-based approach is that different funds could, and 
would be required to, tailor their VaR models to incorporate and 
reflect the risk characteristics of their fund's particular 
investments.\177\ VaR is a commonly-known and broadly-used industry 
metric that integrates the market risk associated with different 
instruments into a single number that provides an overall indication of 
market risk, including the market risk associated with the fund's 
derivatives transactions.\178\ We recognize that funds use many other 
risk analytic metrics suited to particular financial instrument 
categories.\179\ Given the diverse portfolios of many funds, these more 
category-specific risk metrics may be less suitable for establishing a 
proposed limit on fund leverage risk that is applied more generally.
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    \177\ See infra section II.D.4 (discussing the choice of model 
and parameters for the VaR test).
    \178\ See Kevin Dowd, An Introduction to Market Risk Measurement 
(Oct. 2002), at 10 (``Dowd'') (VaR ``provides a common consistent 
measure of risk across different positions and risk factors. It 
enables us to measure the risk associated with a fixed-income 
position, say, in a way that is comparable to and consistent with a 
measure of the risk associated with equity positions''); see also 
Jorion, supra note 151, at 159 (stating that VaR ``explicitly 
accounts for leverage and portfolio diversification and provides a 
simple, single measure of risk based on current positions'').
    \179\ See Jorion, supra note 151. For example, risk measures for 
government bonds can include duration, convexity and term-structure 
models; for corporate bonds, ratings and default models; for stocks, 
volatility, correlations and beta; for options, delta, gamma and 
vega; and for foreign exchange, target zones and spreads. Certain 
funds are required to report on Form N-PORT some of these metrics, 
such as portfolio-level duration (DV01 and SDV01) and position-level 
delta. See Investment Company Reporting Modernization, Investment 
Company Act Release No. 32314 (Oct. 13, 2016) [81 FR 81870 (Nov. 18, 
2016)] (``Investment Company Reporting Modernization Adopting 
Release'').
---------------------------------------------------------------------------

    We recognize that VaR is not itself a leverage measure. But a VaR 
test, and especially one that compares a fund's VaR to an unleveraged 
index that reflects the markets or asset classes in which the fund 
invests, can be used to analyze whether a fund is using derivatives 
transactions to leverage the fund's portfolio, magnifying its potential 
for losses and significant payment obligations of fund assets to 
derivatives counterparties. At the same time, VaR tests can also be 
used to analyze whether a fund is using derivatives with effects other 
than leveraging the fund's portfolio that may be less likely to raise 
the concerns underlying section 18. For example, fixed-income funds use 
a range of derivatives instruments, including credit default swaps, 
interest rate swaps, swaptions, futures, and currency forwards. These 
funds often use these derivatives in part to seek to mitigate the risks 
associated with a fund's bond investments or to achieve particular risk 
targets, such as a specified duration. If a fund were using derivatives 
extensively, but had either a low VaR or a VaR that did not 
substantially exceed the VaR of an appropriate benchmark, this would 
indicate that the fund's derivatives were not substantially leveraging 
the fund's portfolio.
    We also understand that VaR calculation tools are widely available, 
and many advisers that enter into derivatives transactions already use 
risk management or portfolio management platforms that include VaR 
capability.\180\ Advisers to the funds that

[[Page 4470]]

use derivatives transactions more extensively may be particularly 
likely to already use risk management or portfolio management platforms 
that include VaR capability, as compared to advisers to the funds that 
are within the scope of the proposed provision for limited derivatives 
users and that would not be subject to the proposed VaR tests.\181\
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    \180\ See, e.g., ICI Comment Letter III (``73 percent of 
respondents [to an Investment Company Institute survey of its member 
firms] use both some form of VaR and stress testing as derivatives 
risk management tools.)''; Comment Letter of OppenheimerFunds (Mar. 
28, 2016) (``Oppenheimer Comment Letter''); Federated Comment 
Letter; Franklin Resources Comment Letter; see also Christopher L. 
Culp, Merton H. Miller & Andres M. P. Neves, Value at Risk: Uses and 
Abuses, 10 Journal of Applied Corporate Finance 26 (Jan. 1998) (VaR 
is ``used regularly by nonfinancial corporations, pension plans and 
mutual funds, clearing organizations, brokers and futures commission 
merchants, and insurers.''). Moreover, the proposed relative VaR 
test is similar to a relative VaR approach that applies to UCITS 
under European guidelines. See infra section II.D.6.c (discussing 
the UCITS approach).
    \181\ See, e.g., ICI Comment Letter III.
---------------------------------------------------------------------------

    While we believe there are significant benefits to using the 
proposed VaR-based limit on fund leverage risk, we recognize risk 
literature critiques of VaR (especially since the 2007-2009 financial 
crisis). One common critique of VaR is that it does not reflect the 
size of losses that may occur on the trading days during which the 
greatest losses occur--sometimes referred to as ``tail risks.'' \182\ A 
related critique is that VaR calculations may underestimate the risk of 
loss under stressed market conditions.\183\ These critiques often arise 
in the context of discussing risk managers' use of additional risk 
tools to address VaR's shortcomings. Our proposed VaR tests are 
designed to provide a metric that can help assess the extent to which a 
fund's derivatives transactions raise concerns underlying section 18, 
but we do not believe they should be the sole component of a 
derivatives risk management program.\184\ We do not intend to encourage 
risk managers to over-rely on VaR as a stand-alone risk management 
tool.\185\ Instead, as discussed above, the proposed rule would require 
a fund to establish risk guidelines and to stress test its portfolio as 
part of its risk management program in part because of concerns that 
VaR as a risk management tool may not adequately reflect tail 
risks.\186\ We also recognize that a fund's use of derivatives 
transactions may pose other risks (such as counterparty risk and 
liquidity risk) that VaR does not capture. A fund that adopts a 
derivatives risk management program under the proposed rule would have 
to consider these risks as part of its derivatives risk management 
program.\187\
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    \182\ See Chris Downing, Ananth Madhavan, Alex Ulitsky & Ajit 
Singh, Portfolio Construction and Tail Risk, 42 The Journal of 
Portfolio Management 1, 85-102 (Fall 2015), available at https://jpm.iijournals.com/content/42/1/85 (``for especially fat-tailed 
return distributions the VaR threshold value might appear to be low, 
but the actual amount of value at risk is high because VaR does not 
measure the mass of distribution beyond the threshold value'').
    With respect to VaR, the ``tail'' refers to the observations in 
a probability distribution curve that are outside the specified 
confidence level. ``Tail risk'' describes the concern that losses 
outside the confidence level may be extreme.
    \183\ See Jorion, supra note 151, at 357 (VaR ``quantif[ies] 
potential losses under `normal' market conditions, where normal is 
defined by the confidence level, typically 99 percent. . . . In 
practice, [VaR] measures based on recent historical data can fail to 
identify extreme unusual situations that could cause severe 
losses.'').
    \184\ See supra section II.B.3.
    \185\ See, e.g., James O'Brien & Pawel J. Szerszen, An 
Evaluation of Bank VaR Measures for Market Risk During and Before 
the Financial Crisis, Federal Reserve Board Staff Working Paper 
2014-21 (Mar. 7, 2014), available at https://www.federalreserve.gov/pubs/feds/2014/201421/201421pap.pdf (``Criticism of banks' VaR 
measures became vociferous during the financial crisis as the banks' 
risk measures appeared to give little forewarning of the loss 
potential and the high frequency and level of realized losses during 
the crisis period.''); see also Pablo Triana, VaR: The Number That 
Killed Us, Futures Magazine (Dec. 1, 2010), available at https://www.futuresmag.com/2010/11/30/var-number-killed-us (stating that 
``in mid-2007, the VaR of the big Wall Street firms was relatively 
quite low, reflecting the fact that the immediate past had been 
dominated by uninterrupted good times and negligible volatility'').
    \186\ See supra section II.B.3.b.
    \187\ See supra section II.B.3.a.
---------------------------------------------------------------------------

    We also considered proposing tests based on stressed VaR, expected 
shortfall, or both. Stressed VaR refers to a VaR model that is 
calibrated to a period of market stress. A stressed VaR approach would 
address some of the VaR test critiques related to tail risk and 
underestimating expected losses during stressed conditions. Calibrating 
VaR to a period of market stress, however, can pose quantitative 
challenges by requiring funds to identify a stress period with a full 
set of risk factors for which historical data is available. Expected 
shortfall analysis is similar to VaR, but accounts for tail risk by 
taking the average of the potential losses beyond the specified 
confidence level. For example, if a fund's VaR at a 99% confidence 
level is $100, the fund's expected shortfall would be the average of 
the potential losses in the 1% ``tail.'' Because there are fewer 
observations in the tail, however, there is an inherent difficulty in 
estimating the expected value of larger losses. Expected shortfall 
analysis also could involve potentially greater sensitivity to extreme 
outlier losses because it is based on an average of a smaller number of 
observations that are in the tail. Taking these considerations into 
account, we are proposing tests based on VaR, which is commonly used 
and does not present all of the quantitative challenges associated with 
stressed VaR and expected shortfall, complemented by elements in the 
proposed risk management program designed to address VaR's limitations.
    We request comment on the proposed definition of VaR, the proposed 
use of VaR as a means to limit funds' leverage risk, as well as 
alternative VaR-based methodologies (stressed VaR and expected 
shortfall). We also request comment and discuss alternatives to VaR and 
VaR-based methodologies in section II.D.6 below.
    77. Is the proposed definition of the term ``VaR'' appropriate? Why 
or why not? If not, how should we define it?
    78. Is a VaR-based test an appropriate way to limit funds' leverage 
risk? Why or why not? Do commenters agree with our observations 
regarding VaR's characteristics and its critiques? Do commenters 
believe that the proposed derivatives risk management program 
requirement would help to address VaR's limitations? Please explain.
    79. Should we change the rule to require stressed VaR, either as 
part of the program's stress testing requirement or as part of the 
limit on fund leverage risk? If so, how should we implement a stressed 
VaR requirement? Should the rule provide, for example, that the 
historical data used to calculate VaR must include a period of market 
stress? What VaR model requirements should we include if the rule 
required stressed VaR? Please describe in detail. Are there any other 
corresponding changes we should make to the proposed VaR model 
requirements or proposed VaR tests if we used stressed VaR? Why or why 
not?
    80. Should we change the rule to require expected shortfall or 
stressed expected shortfall, either as part of the program's stress 
testing requirement or as part of the limit on fund leverage risk? If 
so, how should we implement this element? What VaR model requirements 
should we include if the rule required expected shortfall or stressed 
expected shortfall? Please describe in detail. Are there any other 
corresponding changes we should make to the proposed VaR model 
requirements or proposed VaR tests if we were to require expected 
shortfall or stressed expected shortfall? Why or why not?
    81. Are there risk metrics or measurements other than VaR that 
similarly can be applied to a wide breadth of fund strategy types and 
investments and used to limit fund leverage risk? Please explain.
    82. Should we use VaR as the only methodology to establish an 
outside limit on funds' leverage risk in rule 18f-4? We discuss below 
additional alternatives to VaR for this purpose. Should we include in 
rule 18f-4 some combination of the proposed VaR tests and the 
alternatives discussed in that section, and provide flexibility to 
funds to comply with the approach that they believe is most appropriate 
based on their strategies and investments? If so,

[[Page 4471]]

which approaches should we include in the rule and why?
2. Relative VaR Test
    The proposed relative VaR test would require a fund to calculate 
the VaR of the fund's portfolio and compare it to the VaR of a 
``designated reference index.'' As discussed in more detail below, a 
fund's designated reference index must be unleveraged and reflect the 
markets or asset classes in which the fund invests, among other 
requirements. This index is designed to create a baseline VaR that 
approximates the VaR of a fund's unleveraged portfolio. To the extent a 
fund entered into derivatives to leverage its portfolio, the relative 
VaR test is designed to identify this leveraging effect. If a fund is 
using derivatives and its VaR exceeds that of the designated reference 
index, this difference may be attributable to leverage risk.
    A fund would be required to comply with the relative VaR test 
unless a designated reference index is unavailable. We propose a 
relative VaR test as the default means of limiting fund leverage risk 
because it resembles the way that section 18 limits a fund's leverage 
risk. Section 18 limits the extent to which a fund can potentially 
increase its market exposure through leveraging by issuing senior 
securities, but it does not directly limit a fund's level of risk or 
volatility. For example, a fund that invests in less-volatile 
securities and leverages itself to the maximum extent may not be as 
volatile as a completely unleveraged fund that invests in more-volatile 
securities. The proposed relative VaR test likewise is 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. For example, if a 
derivatives transaction reduces (or does not substantially increase) a 
fund's VaR relative to the VaR of the designated reference index, the 
transaction would not be restricted by the relative VaR test.
    In addition, allowing funds to rely on the proposed absolute VaR 
test may be inconsistent with investors' expectations where a 
designated reference index is available. For example, a fund that 
invests in short-term fixed income securities would have a relatively 
low level of volatility. The fund's investors could reasonably expect 
that the fund might exhibit a degree of volatility that is broadly 
consistent with the volatility of the markets or asset classes in which 
the fund invests, as represented by the fund's designated reference 
index. This fund's designated reference index would be composed of 
short-term fixed income securities, and could, for example, have a VaR 
of 4%. If the fund were permitted to rely on the absolute VaR test, 
however, the fund could substantially leverage its portfolio almost 
four times its designated reference index's VaR to achieve a level of 
volatility that substantially exceeds the volatility associated with 
fixed-income securities.
a. Designated Reference Index
    A fund would satisfy the proposed relative VaR test if the VaR of 
its entire portfolio does not exceed 150% of the VaR of its designated 
reference index.\188\ The proposed rule would define a ``designated 
reference index'' as an unleveraged index that is selected by the 
derivatives risk manager, and that reflects the markets or asset 
classes in which the fund invests.\189\ The proposed definition also 
would require that the designated reference index not be administered 
by an organization that is an affiliated person of the fund, its 
investment adviser, or principal underwriter, or created at the request 
of the fund or its investment adviser, unless the index is widely 
recognized and used.\190\ Additionally, the designated reference index 
must either be an ``appropriate broad-based securities market index'' 
or an ``additional index'' as defined in Item 27 of Form N-1A.\191\ A 
fund would have to disclose its designated reference index in the 
annual report, together with a presentation of the fund's performance 
relative to the designated reference index.\192\
---------------------------------------------------------------------------

    \188\ See proposed rule 18f-4(a) (defining the term ``relative 
VaR test''); proposed rule 18f-4(c)(2)(i); infra section II.D.2.b 
(discussing the 150% limit under the relative VaR test).
    \189\ See proposed rule 18f-4(a) (defining the term ``designated 
reference index'').
    \190\ Furthermore, for a blended index, none of the indexes that 
compose the blended index may be administered by an organization 
that is an affiliated person of the fund, its investment adviser, or 
principal underwriter, or created at the request of the fund or its 
investment adviser, unless the index is widely recognized and used. 
See id.
    \191\ See proposed rule 18f-4(a) (defining the term ``designated 
reference index''); see also Instructions 5 and 6 to Item 
27(b)(7)(ii) of Form N-1A (discussing the terms ``appropriate broad-
based securities market index'' and ``additional index'').
    \192\ See proposed rule 18f-4(c)(2)(iv).
---------------------------------------------------------------------------

    The requirement that the designated reference index reflect the 
markets or asset classes in which the fund invests is designed to 
provide an appropriate baseline for the relative VaR test. Because of 
this requirement, differences between the fund's VaR and the VaR of the 
designated reference index are more likely to represent leverage than 
other factors, like differences between the securities in the fund's 
portfolio and those in the index, as compared to a relative VaR test 
that compares the fund's VaR to an index that does not reflect the 
markets or asset classes in which the fund invests.\193\ Take, for 
example, a fund that invests primarily in S&P 500 index options and 
uses that index as its designated reference index. Differences between 
the fund's VaR and the VaR of the S&P 500 would be more likely 
attributable to the leverage risk associated with the options than, for 
example, if the fund were permitted to use an index that did not 
reflect the markets or assets classes in which the fund invests, such 
as an index of small capitalization stocks in this example. The 
derivatives risk manager could select a designated reference index that 
is a blended index under the proposed rule (assuming that the blended 
index meets the proposed requirements for a designated reference 
index), which would give some flexibility in identifying or 
constructing a designated reference index that provides an appropriate 
baseline for the relative VaR test.\194\ For example, the derivatives 
risk manager of a balanced fund may determine that a blended index of 
an unleveraged equity index and an unleveraged fixed income index would 
be an appropriate designated reference index.
---------------------------------------------------------------------------

    \193\ To the extent a fund discloses in its annual report an 
``appropriate broad-based securities market index'' that does not 
reflect the markets or asset classes in which the fund invests, such 
a fund may satisfy the performance disclosure requirements of Form 
N-1A, but it would not satisfy the proposed designated reference 
index requirement. For example, a fund that pursues its strategy 
primarily through commodity futures contracts could select the S&P 
500 to satisfy its performance disclosure requirement under Form N-
1A, but such an index would not satisfy the proposed designated 
reference index requirement because a commodity fund would not 
invest in stocks included in the S&P 500 or large cap stocks 
generally.
    \194\ If the derivatives risk manager selects a designated 
reference index that is a blended index, the designated reference 
index would have to be disclosed as an ``additional index'' (as 
opposed to an ``appropriate broad-based securities market index'') 
as defined in the instruction to Item 27 in Form N-1A. Form N-1A 
defines the term ``appropriate broad-based securities market index'' 
to mean an index ``that is administered by an organization that is 
not an affiliated person of the [f]und, its investment adviser, or 
principal underwriter, unless the index is widely recognized and 
used.'' See Instruction 5 to Item 27(b)(7)(ii) of Form N-1A. A 
blended index that is administered by the fund's investment adviser, 
for example, would therefore not qualify as an ``appropriate broad-
based securities market index.''
---------------------------------------------------------------------------

    The requirement that the designated reference index be an 
unleveraged index also is designed to provide an appropriate baseline 
against which to measure a fund's portfolio VaR for

[[Page 4472]]

purposes of assessing the fund's leverage risk. Conducting a VaR test 
on a designated reference index that itself is leveraged would distort 
the leverage-limiting purpose of the VaR comparison by inflating the 
volatility of the index that serves as the reference portfolio for the 
relative VaR test. For example, an equity fund might select as its 
designated reference index an index that tracks a basket of large-cap 
U.S. listed equity securities such as the S&P 500. But the fund could 
not select an index that is leveraged, such as an index that tracks 
200% of the performance of the S&P 500. A relative VaR test based on 
this index would effectively permit additional leveraging inconsistent 
with the Investment Company Act.\195\
---------------------------------------------------------------------------

    \195\ See supra section I.B.1. But see infra section II.G 
(discussing leveraged/inverse funds covered by the proposed sales 
practices rules).
---------------------------------------------------------------------------

    Our proposal would prohibit the designated reference index from 
being an index administered by an organization that is an affiliated 
person of the fund, its investment adviser, or its principal 
underwriter, or created at the request of the fund or its investment 
adviser. This proposed prohibition would not, however, extend to 
indexes that are ``widely recognized and used.'' \196\ We believe that 
the indexes permissible under the proposed rule would be less likely to 
be designed with the intent of permitting a fund to incur additional 
leverage-related risk.
---------------------------------------------------------------------------

    \196\ See proposed rule 18f-4(a) (defining the term ``designated 
reference index''). This ``widely recognized and used'' standard has 
historically been used to permit a fund to employ affiliated-
administered indexes for disclosure purposes, when the use of such 
indexes otherwise would not be permitted. See supra note 193.
---------------------------------------------------------------------------

    The proposed rule would require that a fund publicly disclose to 
its investors in its annual reports the designated reference index. An 
open-end fund would have to disclose its designated reference index in 
the fund's annual report as the fund's ``appropriate broad-based 
securities market index'' or an ``additional index'' that Form N-1A 
describes in the context of the annual report performance presentation 
requirements.\197\ Form N-2, on the other hand, does not require 
closed-end funds to disclose a benchmark index for comparing a fund's 
performance. Nevertheless, some closed-end funds choose to disclose a 
benchmark index in their annual reports to shareholders. Under the 
proposed rule, a closed-end fund seeking to satisfy the relative VaR 
test would have to disclose the fund's designated reference index in 
its annual report together with a presentation of the fund's 
performance.\198\ In proposing this approach, we considered the role of 
investor expectations in selecting funds that correspond to investors' 
desired level of investment risk.\199\ We believe that investors could 
reasonably expect that their fund might exhibit a degree of volatility 
that is broadly consistent with the volatility of the markets or asset 
classes in which the fund invests, as represented by the fund's 
designated reference index. Requiring a fund to select a designated 
reference index that it publicly discloses would promote the fund's 
selection of an appropriate index that reflects the fund's portfolio 
risks and its investor expectations.
---------------------------------------------------------------------------

    \197\ See proposed rule 18f-4(c)(2)(iv); Item 27(b)(7)(ii) of 
Form N-1A.
    See also Instructions to Items 4 and 27(b)(7)(ii) of Form N-1A. 
Form N-1A provides that ``New Funds,'' as defined in the form, are 
not required to disclose an appropriate broad-based securities 
market index and the fund's performance in the annual report because 
of the fund's limited operating history. See Instruction 6 to Item 3 
of Form N-1A (defining a ``New Fund'' to mean a ``Fund that does not 
include in Form N-1A financial statements reporting operating 
results or that includes financial statements for the Fund's initial 
fiscal year reporting operating results for a period of 6 months or 
less''). For the same reason, the proposed rule would provide that a 
fund would not be required to disclose its designated reference 
index in the fund's annual report if the fund is a ``New Fund,'' or 
would meet that definition if it were filing on Form N-1A, at the 
time the fund files its annual report. See proposed rule 18f-
4(c)(2)(iv).
    \198\ See proposed rule 18f-4(c)(2)(iv).
    \199\ To the extent a fund's use of derivatives transactions is 
part of its principal investment strategy or is a principal risk, it 
is required to be disclosed as such in the fund's prospectus. See 
Item 4 of Form N-1A; Item 8 of Form N-2.
---------------------------------------------------------------------------

    Some registered closed-end funds currently elect to provide a 
Management's Discussion of Fund Performance (``MDFP'') in their annual 
reports.\200\ These registered closed-end funds could disclose their 
performance relative to the performance of the designated reference 
index in the fund's MDFP. BDCs that are publicly traded must disclose, 
in their annual reports filed on Form 10-K, a line graph comparing the 
yearly percentage change in fund share price with the return of a broad 
equity market index.\201\ A publicly-traded BDC could choose to include 
its designated reference index in this line graph disclosure.
---------------------------------------------------------------------------

    \200\ The Commission recently proposed to amend Form N-2 to 
require registered closed-end funds to include MDFP disclosure in 
their annual reports. See Securities Offering Reform for Closed-End 
Investment Companies, Investment Company Act Release No. 33427 (Mar. 
20, 2019) [84 FR 14448 (Apr. 10, 2019)], at 14471-72 (``Securities 
Offering Reform Proposing Release'').
    \201\ 17 CFR 229.201(e)(1)(i).
---------------------------------------------------------------------------

    We recognize the concern that funds could have the incentive to 
select an inappropriate designated reference index composed of more 
volatile securities to allow the fund to obtain more leverage risk 
under the relative VaR test. The proposed rule includes three 
provisions designed to address this concern. In addition to requiring 
that the designated reference index reflect the markets or asset 
classes in which the fund invests, and that the index not be 
administered by certain affiliated persons or created at the request of 
the fund or its investment adviser, as described above, the proposed 
rule would require: (1) The derivatives risk manager to select the 
designated reference index and to periodically review it; (2) the fund 
to disclose the designated reference index, relative to its 
performance, in its annual report, creating the disincentive for a fund 
to present performance that may be significantly lower than, or not 
related to, the disclosed index; and (3) the board of directors to 
receive a written report providing the derivatives risk manager's basis 
for selecting the designated reference index.\202\ These requirements, 
collectively, are designed to require funds to use designated reference 
indexes that provide an appropriate baseline for the relative VaR test 
and to prohibit funds from, instead, selecting indexes solely for the 
purpose of maximizing the fund's permissible leverage risk under the 
proposed rule.
---------------------------------------------------------------------------

    \202\ See proposed rule 18f-4(a), (c)(1)(vi), (c)(2)(iii), 
(c)(5)(ii)-(iii); see also supra sections II.B.3.f, II.C.2.
---------------------------------------------------------------------------

    We recognize that some (but not all) popular benchmark indexes 
charge funds a licensing fee for their inclusion in fund prospectuses 
and annual reports. Funds could incur licensing fees if their 
derivatives risk managers select a designated reference index whose 
provider charges such a fee and the fund is not already using the 
index. We are nevertheless proposing this disclosure requirement 
because the relative VaR test's ability to limit a fund's leverage risk 
is directly tied to the appropriateness of its designated reference 
index. This disclosure requirement is designed to address concerns 
about inappropriate indexes, as discussed above, by creating the 
disincentive for a fund to select an inappropriate index because the 
fund would have to disclose its performance against that index in its 
annual report and likely would not want to present performance that is 
significantly lower than, or not related to, the disclosed index.\203\ 
At the same time, the proposed rule provides funds flexibility to use 
any index that meets the proposed requirements. The proposed rule would 
provide this flexibility in light of the conditions discussed above

[[Page 4473]]

designed to require that a fund use a designated reference index that 
is appropriate for the relative VaR test.
---------------------------------------------------------------------------

    \203\ See supra note 201 and accompanying paragraph.
---------------------------------------------------------------------------

    The 2015 Proposing Release also included a risk-based portfolio 
limit based on VaR.\204\ The 2015 proposal provided that a fund would 
satisfy its risk-based portfolio limit condition if a fund's full 
portfolio VaR was less than the fund's ``securities VaR'' (i.e., the 
VaR of the fund's portfolio of securities and other investments, but 
excluding any derivatives transactions).\205\ Our proposal, however, 
differs from the 2015 proposal in that the proposed relative VaR test 
compares the fund's VaR to the VaR of the fund's designated reference 
index, rather than the fund's ``securities VaR.'' This is because some 
funds that use derivatives extensively hold primarily cash, cash 
equivalents, and derivatives. These funds' ``securities VaRs'' would be 
based primarily on the fund's cash and cash equivalents. As some 
commenters on the 2015 proposal noted, this would not provide an 
appropriate comparison for a relative VaR test because the VaR of the 
cash and cash equivalents would be very low and would not provide a 
reference level of risk associated with the fund's strategy.\206\
---------------------------------------------------------------------------

    \204\ See 2015 Proposing Release, supra note 2, at section 
III.B.2.
    \205\ Under that proposal, a fund that satisfied this VaR test 
was also required to limit its aggregate exposure--including 
derivatives exposure--to 300% of the fund's net assets. See id.
    \206\ See, e.g., AlphaSimplex Comment Letter; AQR Comment 
Letter; ICI Comment Letter I.
---------------------------------------------------------------------------

    We request comment on the proposed requirements regarding the 
selection and disclosure of a designated reference index for purposes 
of compliance with the proposed relative VaR test.
    83. Is the proposed definition of the term ``designated reference 
index'' appropriate? Why or why not? Should the Commission provide 
additional guidance, or requirements in the proposed rule, addressing 
when an index reflects the markets or asset classes in which a fund 
invests? Are there particular types of indexes that would not be 
appropriate as a designated reference index? Why or why not? If so, 
what types of indexes and why would they be inappropriate for this 
purpose?
    84. Should the rule require that the designated reference index be 
an unleveraged index? Should the rule specify with greater 
particularity what constitutes an unleveraged index? Please explain. 
Alternatively, should the Commission provide guidance on when an index 
will be ``leveraged''?
    85. Are there other considerations that would present challenges 
for funds in light of the proposed requirement to select a designated 
reference index for purposes of the proposed relative VaR test 
requirement? If so, what?
    86. To what extent do funds expect that the requirement to disclose 
the designated reference index would result in additional licensing 
fees? Please explain. What consequences would such charges create?
    87. Should we change the proposed definition of the term 
``designated reference index'' to no longer track in part the 
definition of an ``appropriate broad-based securities market index'' in 
Form N-1A (Instruction 5 of Item 27(b)(7)) and allow a derivatives risk 
manager to select an index administered by an affiliated person of the 
fund, its investment adviser, or principal underwriter? Should we 
change the proposed definition to allow a derivatives risk manager to 
select an index created at the request of the fund or its investment 
adviser? Is it appropriate to exclude such indexes from the definition 
of ``designated reference index,'' and is it appropriate that widely 
recognized and used indexes be carved out from this exclusion, as 
proposed? Would the proposed exclusion help ensure the selection of 
indexes that are appropriately designed to create a baseline VaR that 
approximates the VaR of a fund's unleveraged portfolio? Please explain. 
Would allowing funds to use indexes that would fall within the proposed 
exclusion raise concerns that the indexes would not be appropriate, 
or--if the Commission were to permit the use of such indexes--would the 
rule's other proposed conditions designed to address this concern work 
equally well for all indexes? If the Commission were to permit the use 
of indexes that would fall within the proposed exclusion, would any 
additional limits on the use of these indexes be appropriate? If so, 
what limits and why?
    88. If we were to further limit or restrict the types of indexes 
that a fund could select as its designated reference index under the 
proposed rule, what additional limits would be appropriate? Should we, 
for example, provide that a fund's designated reference index must meet 
the definition of an ``appropriate broad-based securities market 
index'' as defined in Form N-1A? Should we require that the index be 
widely recognized and used?
    89. Similar to UCITS guidelines, should the proposed definition 
specifically require that the risk profile of the designated reference 
index be consistent with the fund's investment objectives and policies, 
as well as investment limits? \207\ Why or why not?
---------------------------------------------------------------------------

    \207\ See infra section II.D.6.c (discussing the UCITS 
framework).
---------------------------------------------------------------------------

    90. Should the rule require funds to disclose their designated 
reference indexes in their annual reports to shareholders, as proposed? 
Should such disclosure also appear in the fund's prospectus? What 
reasons, if any, should the designated reference index not be an index 
a fund includes as part of its performance disclosure? Please explain. 
Should a fund be required to specify that the index it includes in its 
performance disclosure is the fund's designated reference index, which 
has been selected for purposes of the fund's compliance with rule 18f-
4? If so, what other information or explanations should a fund also 
have to include (if any), in order to best promote investor 
understanding of how the fund's designated reference index affects the 
fund's ability to use leverage, and how this in turn affects the risks 
associated with an investment in the fund? For example, should a fund 
also be required to disclose the index's historical (e.g., 1-year) 
average VaR? What accompanying narrative disclosure would help 
investors best understand the significance of this information? Would 
this disclosure be useful to supplement the VaR information that a fund 
would be required to disclose on Form N-PORT under the proposal?
    91. Should the rule permit a fund to compare its portfolio VaR to 
its ``securities VaR'' for purposes of the rule's relative VaR test, as 
provided for in the 2015 proposed rule, in addition to its designated 
reference index? \208\ Why or why not? If the relative VaR test 
permitted a fund to compare its porfolio's VaR against its designated 
reference index or its ``securities VaR,'' would funds prefer to use 
their ``securities VaRs''? If so, why? In what circumstances or what 
fund strategies would ``securities VaR'' be a more or equally 
appropriate baseline for funds calculating their relative VaR? What 
benefits or drawbacks are there with respect to this approach? Please 
explain.
---------------------------------------------------------------------------

    \208\ See supra note 204 and accompanying text.
---------------------------------------------------------------------------

    92. For a registered closed-end fund, is the proposed requirement 
that it must disclose its designated reference index in its annual 
report together with a presentation of the fund's performance 
appropriate? Why or why not? What challenges, if any, would the 
proposed disclosure requirement have for closed-end funds that do not 
currently disclose their performance relative to a benchmark index in 
their annual reports? Please explain.

[[Page 4474]]

    93. For a registered closed-end fund, should we prescribe in rule 
18f-4 or Form N-2 where in the fund's annual report it must disclose 
its designated reference index? Why or why not?
    94. What challenges, if any, would a BDC have in disclosing its 
designated reference index together with its performance in the BDC's 
annual report? Please explain.
    95. Should we also amend Forms N-1A and/or N-2 to require a fund 
relying on rule 18f-4 and subject to the relative VaR test to disclose 
its performance relative to the performance of its designated reference 
index? Would it be helpful to have this requirement both in rule 18f-4 
and in the registration forms?
    96. What changes should we make to the rule in light of the concern 
that a fund could have an incentive to select an inappropriate 
designated reference index to obtain more leverage risk? Is the 
proposed requirement that the derivatives risk manager select the 
designated reference index useful for this purpose? Is the proposed 
requirement that the designated reference index be an appropriate 
broad-based securities index or an additional index effective for this 
purpose? Is the proposed requirement that the fund disclose the 
designated reference index relative to its performance in the annual 
report useful for this purpose? Is the proposed requirement that the 
board of directors receive a written report from the derivatives risk 
manager about the basis for the designated reference index subject to 
periodic review useful for this purpose? Please explain.
b. 150% Limit Under Proposed Relative VaR Test
    We are proposing that a fund's VaR must not exceed 150% of the VaR 
of the fund's designated reference index.\209\ In proposing a 150% 
limit, we first considered the extent to which a fund could borrow in 
compliance with the requirements of section 18. For example, a mutual 
fund with $100 in assets and no liabilities or senior securities 
outstanding could borrow an additional $50 from a bank. With the 
additional $50 in bank borrowings, the mutual fund could invest $150 in 
securities based on $100 of net assets. This fund's VaR would be 
approximately 150% of the VaR of the fund's designated reference index. 
The proposed 150% limit would therefore effectively limit a fund's 
leverage risk related to derivatives transactions similar to the way 
that section 18 limits a registered open- or closed-end fund's ability 
to borrow from a bank (or issue other senior securities representing 
indebtedness for registered closed-end funds) subject to section 18's 
300% asset coverage requirement. We recognize that while a fund could 
achieve certain levels of market exposure through borrowings permitted 
under section 18, it may be more efficient to obtain those exposures 
through derivatives transactions. Allowing a fund to have a VaR that is 
150% of its designated reference index, rather than a higher or lower 
relative VaR, is designed to provide what we believe is an appropriate 
degree of flexibility for funds to use derivatives.
---------------------------------------------------------------------------

    \209\ See proposed rule 18f-4(a) (defining the term ``relative 
VaR test'').
---------------------------------------------------------------------------

    We considered proposing different relative VaR tests for different 
types of investment companies, tied to the asset coverage requirements 
applicable to registered open-end funds, registered closed-end funds, 
and BDCs.\210\ Registered closed-end funds, like open-end funds, are 
only permitted to issue senior securities representing indebtedness 
under section 18 subject to a 300% asset coverage requirement, although 
closed-end funds' indebtedness is not limited to bank borrowings.\211\ 
Using the example above, a registered closed-end fund with $100 in 
assets likewise could only borrow $50. Although registered closed-end 
funds also are permitted to issue senior securities that are 
stocks,\212\ proposed rule 18f-4 is focused on the indebtedness 
leverage that derivatives transactions create. We do not believe that a 
registered closed-end fund's ability to issue preferred stock, for 
example, suggests that registered closed-end funds should be permitted 
to obtain additional indebtedness leverage through derivatives 
transactions.
---------------------------------------------------------------------------

    \210\ See supra notes 29-32 and accompanying paragraph 
(discussing asset coverage requirements for different investment 
company types).
    \211\ See supra note 30 and accompanying text.
    \212\ See supra note 31 and accompanying text.
---------------------------------------------------------------------------

    The Investment Company Act also provides greater flexibility for 
BDCs to issue senior securities. BDCs, however, generally do not use 
derivatives or do so only to a limited extent. To help evaluate the 
extent to which BDCs use derivatives, our staff sampled 48 of the 
current 99 BDCs by reviewing their most recent financial statements 
filed with the Commission. The staff's sample included both BDCs with 
shares listed on an exchange and BDCs whose shares are not listed. The 
sampled BDCs' net assets ranged from $32 million to $7.4 billion. Of 
the 48 sampled, 54% did not report any derivatives holdings, and a 
further 29% reported using derivatives with gross notional amounts 
below 10% of net assets. A few BDCs used derivatives more extensively, 
when measured on a gross notional basis, mainly due to interest rate 
swaps--which likely would have lower adjusted notional amounts if they 
were converted to ten-year bond equivalents, as the proposed rule would 
permit.\213\ Finally, two of the sampled BDCs used total return swaps 
to gain a substantial portion of their exposure. We therefore believe 
that most BDCs either would not use derivatives or would rely on the 
exception for limited derivatives users.\214\
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    \213\ Our staff did not have access to sufficient information to 
adjust the notional amounts of the BDCs' interest rate derivatives 
or options. Some of the 17% of the sampled BDCs with gross notional 
amounts exceeding 10% of net assets likely would have lower notional 
amounts after applying these adjustments.
    \214\ See infra section II.E (discussing the proposed exception 
for limited derivatives users).
---------------------------------------------------------------------------

    In addition, the greater flexibility for BDCs to issue senior 
securities allows them to provide additional equity or debt financing 
to the ``eligible portfolio companies'' in which BDCs are required to 
invest at least 70% of their total assets. Derivatives transactions, in 
contrast, generally will not have similar capital formation benefits 
for portfolio companies unless the fund's counterparty makes an 
investment in the underlying reference assets equal to the notional 
amount of the derivatives transaction. Allowing BDCs to leverage their 
portfolios with derivatives to a greater extent than other funds 
therefore would not appear to further the capital formation benefits 
that underlie BDCs' ability to obtain additional leverage under the 
Investment Company Act. We also understand that, even when BDCs do use 
derivatives more extensively, derivatives generally do not play as 
significant of a role in implementing the BDC's strategy, as compared 
to many other types of funds that use derivatives extensively. BDCs are 
required under the Investment Company Act to invest at least 70% of 
their total assets in ``eligible portfolio companies,'' which may limit 
the role that derivatives can play in a BDC's portfolio relative to 
other kinds of funds that would generally execute their strategies 
primarily through derivatives transactions (e.g., a managed futures 
fund). For these reasons, and to provide a consistent framework 
regarding funds' use of derivatives, we believe that it is appropriate 
to set a single limit on fund leverage risk under the proposed rule for 
derivatives transactions. The proposed rule would not restrict a fund 
from issuing senior securities subject to the limits in section 18 to 
the full extent

[[Page 4475]]

permitted by the Investment Company Act.\215\
---------------------------------------------------------------------------

    \215\ For purposes of calculating asset coverage, as defined in 
section 18(h), BDCs have used derivatives transactions' notional 
amounts, less any posted cash collateral, as the ``amount of senior 
securities representing indebtedness'' associated with the 
transactions. We believe this approach--and not the transactions' 
market values--represents the ``amount of senior securities 
representing indebtedness'' for purposes of this calculation. Open-
end funds cannot enter into derivatives transactions under section 
18, absent relief from that section's requirements, because section 
18 limits open-end funds' senior securities to bank borrowings. 
Section 18(c) also limits a registered closed-end fund's ability to 
enter into derivatives transactions absent such relief.
---------------------------------------------------------------------------

    We request comment on the following aspects of the proposed 
relative VaR test.
    97. Is the proposed relative VaR test requirement appropriate? Why 
or why not? As proposed, should funds be required to comply with a 
relative VaR test, rather than an absolute VaR test, except where a 
designated reference index is unavailable?
    98. Should the limit in the proposed relative VaR test be lower or 
higher than 150% of the VaR of the designated reference index, and if 
so why? For example, the relative VaR test applicable to UCITS funds 
allows a UCITS fund to have a relative VaR up to 200% of the VaR of the 
relevant index.\216\ Should rule 18f-4 similarly permit a fund to have 
a VaR up to 200% of the VaR of its designated reference index? If so, 
how should the rule incorporate investor protection provisions 
consistent with section 18? Conversely, should the relative VaR test be 
set at a lower level, such as 125% of the VaR of the designated 
reference index? If so, why?
---------------------------------------------------------------------------

    \216\ See infra section II.D.6.c (discussing the UCITS 
framework); see also ICI Comment Letter III (suggesting that a 
Commission rule limiting the use of derivatives by registered 
investment companies allow funds to use either ex ante stress 
testing or UCITS VaR for that purpose).
---------------------------------------------------------------------------

    99. Should the proposed relative VaR test incorporate different 
leverage limit levels according to fund type and corresponding to the 
asset coverage requirements under the Investment Company Act? Why or 
why not and how?
    100. Are there any challenges in calculating the VaR of the 
designated reference index? If so, would certain types of funds 
particularly encounter these challenges, and if so which ones? How 
should we address any challenges?
    101. Are there any fund-type specific challenges to open-end funds, 
registered closed-end funds, or BDCs complying with the VaR-based limit 
on fund leverage risk? For example, would registered closed-end funds 
or BDCs encounter any unique challenges in calculating VaR because of 
the nature of their investments? If so, what kinds of challenges and 
how should we address them? Please also explain specifically the nature 
of any challenges given that a number of financial institutions such as 
banks and UCITS funds calculate VaR for regulatory purposes, and these 
institutions' portfolios hold a wide range of assets.
3. Absolute VaR Test
    We recognize that, for some funds, the derivatives risk manager may 
be unable to identify an appropriate designated reference index. For 
example, some multi-strategy funds manage their portfolios based on 
target volatilities but implement a variety of investment strategies, 
making it difficult to identify a single index (even a blended index) 
that would be appropriate. If a derivatives risk manager is unable to 
identify an appropriate designated reference index, a fund relying on 
the proposed rule would be required to comply with the absolute VaR 
test.\217\
---------------------------------------------------------------------------

    \217\ See supra note 173 and accompanying text (discussing the 
proposed requirement for the fund's derivatives risk manager to 
provide written reports to the fund's board of directors that must 
include, among other things, the derivatives risk manager's basis 
for the selection of the designated reference index or, if 
applicable, an explanation of why the derivatives risk manager was 
unable to identify a designated reference index appropriate for the 
fund); infra notes 425-426 and accompanying text (discussing 
proposed recordkeeping requirements for such written reports 
provided to the fund's board).
---------------------------------------------------------------------------

    To comply with the proposed absolute VaR test, the VaR of the 
fund's portfolio must not exceed 15% of the value of the fund's net 
assets. In proposing an absolute VaR test of 15% of a fund's net 
assets, we considered the comparison of a fund complying with the 
absolute VaR test and a fund complying with the relative VaR test. A 
fund that uses the S&P 500 as its benchmark index, as many funds do, 
would be permitted to have a VaR equal to 150% of the VaR of the S&P 
500 if the fund also used that index as its designated reference index. 
The Division of Economic and Risk Analysis (``DERA'') staff calculated 
the VaR of the S&P 500, using the parameters specified in this proposed 
rule over various time periods. DERA staff's calculation of the S&P 
500's VaR since inception, for example, produced a mean VaR of 
approximately 10.4%, although the VaR of the S&P 500 varied over 
time.\218\ Setting the level of loss in the proposed absolute VaR test 
at 15% of a fund's net assets would therefore provide approximately 
comparable treatment for funds that rely on the absolute VaR test and 
funds that rely on the relative VaR test and use the S&P 500 as their 
designated reference index during periods where the S&P 500's VaR is 
approximately equal to the historical mean.
---------------------------------------------------------------------------

    \218\ DERA staff calculated descriptive statistics for the VaR 
of the S&P 500 using Morningstar data from March 4, 1957 to June 28, 
2019, based on daily VaR calculations, each using three years of 
prior return data and calculated using historical simulation at a 
99% confidence level for a 20-day horizon using overlapping 
observations.
---------------------------------------------------------------------------

    DERA staff analyzed the S&P 500 because funds often select broad-
based large capitalization equities indexes such as the S&P 500 for 
performance comparison purposes, including funds that are not broad-
based large capitalization equity funds.\219\ Many investors may 
therefore understand the risk inherent in these indexes as the level of 
risk inherent in the markets generally.\220\ An absolute VaR test set 
to approximate, or not substantially exceed, this level of risk would 
therefore often approximate the level of risk that investors may 
understand, and frequently choose to undertake, through investments in 
funds. We are proposing a single absolute VaR limit that would apply to 
open-end funds and registered closed-end funds and BDCs for the same 
reasons we are proposing that all funds relying on the relative VaR 
test must limit their VaR to 150% of the VaR of their designated 
reference index.\221\
---------------------------------------------------------------------------

    \219\ This is based on staff experience and analysis of data 
obtained from Morningstar.
    \220\ Some commenters to the 2015 proposal also expressed the 
view that the S&P 500 Index is an appropriate risk-based reference 
point because it is widely used with a risk profile that is well 
understood and commonly acceptable to investors. See, e.g., AQR 
Comment Letter; Comment Letter of Millburn Ridgefield Corporation 
(Mar. 28, 2016).
    \221\ See supra section II.D.2.b.
---------------------------------------------------------------------------

    The proposed absolute VaR test is also broadly consistent with the 
European Union regulatory framework that that applies to UCITS 
funds.\222\ Advisers that manage (or have affiliates that manage) UCITS 
funds may derive some efficiencies from reasonably comparable 
requirements across jurisdictions.\223\ Commenters to the 2015 proposal 
also generally supported an absolute VaR test.\224\
---------------------------------------------------------------------------

    \222\ See CESR Global Guidelines, supra note 94, at 26. The 
absolute VaR test for UCITS funds is similar to the proposed 
absolute VaR test in rule 18f-4, although it sets a 20% limit for 
UCITS funds, rather than 15% as we propose in rule 18f-4.
    \223\ See, e.g., ICI Comment Letter III (stating that, in 
response to the Investment Company Institute's survey, ``45 percent 
of respondents indicated that it would be only slightly burdensome 
to implement a UCITS VaR test that used the same parameters as 
prescribed for UCITS. An additional 34 percent reported that it 
would be moderately burdensome.'').
    \224\ See, e.g., ICI Comment Letter I; Franklin Resources 
Comment Letter; SIFMA Comment Letter; Comment Letter of T. Rowe 
Price Associates, Inc. (Mar. 28, 2016) (``T. Rowe Price Comment 
Letter'').

---------------------------------------------------------------------------

[[Page 4476]]

    We request comment on the proposed absolute VaR test requirement.
    102. Is the proposed absolute VaR test requirement appropriate? Are 
we correct that in some cases a fund's derivatives risk manager may be 
unable to identify an appropriate designated reference index? Why or 
why not? What are examples of funds that would likely use the absolute 
VaR test because a derivatives risk manager would be unable to identify 
an appropriate designated reference index? Is it appropriate for these 
funds to use an absolute VaR test? Why or why not?
    103. Should we provide additional guidance on the circumstances 
under which a fund's derivatives risk manager would be ``unable'' to 
identify an appropriate index? If so, what guidance should we provide? 
Should the rule include a different standard than the inability to 
identify a designated reference index for funds to be able to use the 
absolute VaR test instead of the relative VaR test? If so, what 
standard and why? For example, should we identify certain types of fund 
strategies that may not typically have appropriate reference indexes or 
for which absolute VaR would otherwise be appropriate? If so, which 
fund strategies, and how would we keep any list of fund strategies 
current over time?
    104. Should the proposed absolute VaR test include a limit other 
than 15% of the fund's net assets? Please explain. For example, should 
it be 12, 18, 20, or 25%? If so, which limit, and why? Would funds 
using the absolute VaR test manage their VaRs to a certain amount below 
the limit the Commission sets? If so, to what extent and should we take 
this into account in determining the appropriate limit under this test? 
Should we look to different market data in determining an appropriate 
level of absolute VaR? Which other sources, and why would they be 
appropriate?
    105. For funds that use an absolute VaR test as part of their risk 
management practices, do risk managers set internal absolute VaR 
limits, and if so, at what level and why? For funds that currently use 
both absolute VaR and relative VaR, are the internal limits set at 
comparable levels? Why or why not? Please describe each internal level 
set with respect to these two VaR tests. Do certain fund types or 
strategies more commonly use either absolute VaR or relative VaR for 
risk management purposes? If so, why?
    106. Should the rule include both a relative and absolute VaR test, 
as proposed, or should it include only a relative VaR test or an 
absolute VaR test? Why, and which test should the rule include? Should 
it use a different VaR-based test? If so, which one?
    107. Should the rule permit funds to choose which VaR test to 
comply with regardless of the derivatives risk manager's ability or 
inability to identify a designated reference index? If so, would this 
be consistent with investor expectations and section 18?
4. Choice of Model and Parameters for VaR Test
    The proposed rule would require that any VaR model a fund uses for 
purposes of the relative or absolute VaR test take into account and 
incorporate all significant, identifiable market risk factors 
associated with a fund's investments.\225\ The proposed rule includes a 
non-exhaustive list of common market risk factors that a fund must 
account for in its VaR model, if applicable. These market risk factors 
are: (1) Equity price risk, interest rate risk, credit spread risk, 
foreign currency risk and commodity price risk; (2) material risks 
arising from the nonlinear price characteristics of a fund's 
investments, including options and positions with embedded optionality; 
and (3) the sensitivity of the market value of the fund's investments 
to changes in volatility.\226\ VaR models are often categorized 
according to three modeling methods--historical simulation, Monte Carlo 
simulation, or parametric models.\227\ Each method has certain benefits 
and drawbacks, which may make a particular method more or less 
suitable, depending on a fund's strategy, investments and other 
factors. In particular, some VaR methodologies may not adequately 
incorporate all of the material risks inherent in particular 
investments, or all material risks arising from the nonlinear price 
characteristics of certain derivatives.\228\ We believe it should be 
the responsibility of the derivatives risk manager to choose the 
appropriate VaR model for the fund's portfolio, and the proposed 
requirement is designed to allow funds to use a VaR model that is 
appropriate for the fund's investments. Commenters that addressed the 
same proposed requirement for VaR models in the 2015 proposal generally 
supported it.\229\
---------------------------------------------------------------------------

    \225\ See proposed rule 18f-4(a) (defining the term ``value-at-
risk'' or ``VaR'').
    \226\ See id.
    \227\ Historical simulation models rely on past observed 
historical returns to estimate VaR. Historical VaR involves taking a 
fund's current portfolio, subjecting it to changes in the relevant 
market risk factors observed over a prior historical period, and 
constructing a distribution of hypothetical profits and losses. The 
resulting VaR is then determined by looking at the largest (100 
minus the confidence level) percent of losses in the resulting 
distribution.
    Monte Carlo simulation uses a random number generator to produce 
a large number (often tens of thousands) of hypothetical changes in 
market values that simulate changes in market factors. These outputs 
are then used to construct a distribution of hypothetical profits 
and losses on the fund's current portfolio, from which the resulting 
VaR is ascertained by looking at the largest (100 minus the 
confidence level) percent of losses in the resulting distribution.
    Parametric methods for calculating VaR rely on estimates of key 
parameters (such as the mean returns, standard deviations of 
returns, and correlations among the returns of the instruments in a 
fund's portfolio) to create a hypothetical statistical distribution 
of returns for a fund, and use statistical methods to calculate VaR 
at a given confidence level.
    See, e.g., Dowd, supra note 177; see also Thomas J. Linsmeier & 
Neil D. Pearson, Value at Risk, 56 Journal of Financial Analysts 2 
(Mar.-Apr. 2000) (``Linsmeier & Pearson'').
    \228\ For example, some parametric methodologies may be more 
likely to yield misleading VaR estimates for assets or portfolios 
that exhibit non-linear returns, due, for example, to the presence 
of options or instruments that have embedded optionality (such as 
callable or convertible bonds). See, e.g., Linsmeier & Pearson, 
supra note 226 (stating that historical and Monte Carlo simulation 
``work well regardless of the presence of options and option-like 
instruments in the portfolio. In contrast, the standard [parametric] 
delta-normal method works well for instruments and portfolios with 
little option content but not as well as the two simulation methods 
when options and option-like instruments are significant in the 
portfolio.'').
    \229\ See, e.g., Oppenheimer Comment Letter; CFA Comment Letter.
---------------------------------------------------------------------------

    The proposed rule also requires that a fund's VaR model use a 99% 
confidence level and a time horizon of 20 trading days.\230\ We 
understand that market participants currently using VaR most commonly 
use 95% or 99% confidence levels and often use time horizons of 10 or 
20 days. The proposed confidence level and time horizon requirements 
also are similar to those in other VaR-based regulatory schemes.\231\

[[Page 4477]]

VaR models that use relatively high confidence levels and longer time 
horizons--as the proposed rule parameters reflect--result in a focus on 
more-``extreme'' but less-frequent losses. We propose relatively high 
confidence level and longer time horizon requirements so that the VaR 
model is designed to measure, and seek to limit the severity of, these 
less-frequent but larger losses. This is because a fund's VaR model 
would be based on a distribution of returns, where a higher confidence 
level would go further into the tail of the distribution (i.e., more-
``extreme'' but less-frequent losses) and a longer time horizon would 
result in larger losses in the distribution (i.e., losses have the 
potential to be larger over twenty days when compared, for example, to 
over one day).
---------------------------------------------------------------------------

    \230\ See proposed rule 18f-4(a) (defining the term ``value-at-
risk'' or ``VaR'').
    We recognize that many market participants today also may 
calculate VaR over a one-day time horizon. See also supra section 
II.B.3.d (the proposed rule would require calculating a fund's one-
day VaR as part of the proposed backtesting requirement). A VaR 
calculation based on a one-day time horizon can be scaled to a 20-
day time horizon. For example, a common VaR model time-scaling 
technique is to multiply the one-day VaR by the square root of the 
designated time period (i.e., for the proposed rule it would be the 
square root of 20). But for funds with returns that are not 
identically and independently normally distributed, simple time-
scaling techniques may be inaccurate. If this inaccuracy results in 
meaningful underestimation of VaR, this simple time-scaling 
technique would be inappropriate.
    \231\ See, e.g., CESR Global Guidelines, supra note 94 
(providing default VaR calculation standards that require funds that 
use the relative VaR or absolute VaR approach to calculate VaR using 
a ``one-tailed confidence interval of 99%''); rule 15c3-1e under the 
Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) 
(requiring VaR models to use ``a 99 percent, one-tailed confidence 
level with price changes equivalent to a ten business-day movement 
in rates and prices''). See also the Basel Committee on Banking 
Supervision, Amendment To The Capital Accord To Incorporate Market 
Risks (Jan. 1996), available at https://www.bis.org/publ/bcbs24.pdf 
(contemplating banks' use of internal models for measuring market 
risk based on a 10-day time horizon); CESR Global Guidelines, supra 
note 94 (specifying generally a 20-day time horizon as a 
quantitative requirement when calculating VaR for risk measurement 
and the calculation of global exposure and counterparty risk for 
UCITS).
---------------------------------------------------------------------------

    In proposing a higher confidence level and longer time horizon, we 
considered whether this would result in a VaR model based on fewer data 
points in comparison to lower confidence levels and shorter time 
horizons. However, we understand that a longer trading day horizon only 
results in reduced data points if the fund uses historical simulation 
and measures historical losses using non-overlapping periods, which our 
proposal would not require. For example, a fund measuring non-
overlapping twenty-day periods, assuming 250 trading days in a year, 
would expect approximately 12 or 13 data points (250 trading days/20-
day time horizons). But if the fund measured the twenty-day periods on 
a rolling and overlapping basis, it could expect as many as 250 data 
points where each data point captures the return over the trailing 20 
trading days. A fund could use either a non-overlapping or overlapping 
approach under the proposed rule.
    The 2015 proposal similarly specified the particular confidence 
level and time horizon parameters that funds would use in their VaR 
models for purposes of the proposed risk-based portfolio limit. These 
parameters were a 99% confidence level and a time horizon range of not 
less than 10 and not more than 20 trading days.\232\ Comments were 
mixed but generally supported a confidence level in the range of 95% to 
99%.\233\ Rather than a time horizon range providing funds discretion 
to select the number of trading days for which to compute their VaR 
models, some commenters suggested that the rule should specify a 
particular number of days.\234\ Because our proposal, unlike the 2015 
proposal, includes an absolute VaR test, our proposed VaR model 
parameters reflect commenter suggestions by proposing a confidence 
level within the generally supported range and proposing a specific VaR 
model time horizon rather than a range of permissible time horizons.
---------------------------------------------------------------------------

    \232\ 2015 Proposing Release, supra note 2, at section 
III.B.2.b.
    \233\ See, e.g., AQR Comment Letter; ICI Comment Letter II.
    \234\ See, e.g., Morningstar Comment Letter; AIMA Comment 
Letter; AQR Comment Letter; ICI Comment Letter II.
---------------------------------------------------------------------------

    In addition to specifying the confidence level and time horizon 
that a fund's VaR model would use, we are also proposing that the 
fund's chosen VaR model must be based on at least three years of 
historical market data. We understand that the availability of data is 
a key consideration when calculating VaR, and that the length of the 
data observation period may significantly influence the results of a 
VaR calculation. For example, a shorter observation period means that 
each observation will have a greater influence on the result of the VaR 
calculation (as compared to a longer observation period), such that 
periods of unusually high or low volatility could result in unusually 
high or low VaR estimates.\235\ Longer observation periods, however, 
can lead to data collection problems, if sufficient historical data is 
not available.\236\ We believe requiring a fund's chosen VaR model to 
be based on at least three years of historical market data strikes an 
appropriate balance.
---------------------------------------------------------------------------

    \235\ See Linsmeier & Pearson, supra note 226 (stating that, 
because historical simulation relies directly on historical data, a 
danger is that the price and rate changes in the last 100 (or 500 or 
1,000) days might not be typical. For example, if by chance the last 
100 days were a period of low volatility in market rates and prices, 
the VAR computed through historical simulation would understate the 
risk in the portfolio).
    \236\ See Dowd, supra note 177 (stating that ``[a] long sample 
period can lead to data collection problems. This is a particular 
concern with new or emerging market instruments, where long runs of 
historical data don't exist and are not necessarily easy to 
proxy'').
---------------------------------------------------------------------------

    The proposed historical market data requirement would permit a fund 
to base its VaR estimates on a meaningful number of observations, while 
also recognizing the concern that requiring a longer historical period 
could make it difficult for a fund to obtain sufficient historical data 
to estimate VaR for the instruments in its portfolio.\237\ The 2015 
proposal would have required three years of market data for funds using 
historical simulation (but did not require three years of market data 
for VaR models based on Monte Carlo simulation or parametric 
methods).\238\ A number of commenters supported our approach in the 
2015 proposal to require three years of market data for funds using 
historical simulation.\239\ However, some commenters suggested that the 
rule should require a longer period of historical market data.\240\ As 
discussed above, we believe that three years strikes an appropriate 
balance. We also are proposing to require funds to use three years of 
market data for all VaR calculations under the proposed rule--rather 
than only historical simulation as in the 2015 proposal. We believe 
this is appropriate because all methods for calculating VaR--not just 
historical simulation--rely on historical data.
---------------------------------------------------------------------------

    \237\ See Michael Minnich, Perspectives On Interest Rate Risk 
Management For Money Managers And Traders (Frank Fabozzi, ed.) 
(1998) (stating that for historical simulation, ``[l]onger periods 
of data have a richer return distribution while shorter periods 
allow the VAR to react more quickly to changing market events'' and 
that ``[t]hree to five years of historical data are typical''); see 
also Darryll Hendricks, Evaluation of Value-at-Risk Models Using 
Historical Data, FRBNY Economic Policy Review (Apr. 1996) (finding 
that, when using historical VaR, ``[e]xtreme [confidence level] 
percentiles such as the 95th and particularly the 99th are very 
difficult to estimate accurately with small samples'' and that the 
complete dependence of historical VaR models on historical 
observation data ``to estimate these percentiles directly is one 
rationale for using long observation periods'').
    \238\ See 2015 Proposing Release, supra note 2, at section 
III.B.2.b; see also supra note 177 (discussing historical 
simulation, Monte Carlo simulation, and parametric methods).
    \239\ See, e.g., Comment Letter of Abbey Capital (Mar. 28, 
2016); AIMA Comment Letter; Comment Letter of Aspect Capital Limited 
(Mar. 28, 2016); Comment Letter of Intercontinental Exchange (Apr. 
15, 2016).
    \240\ See, e.g., materials attached to the memorandum included 
in the comment file concerning a meeting between representatives of 
AlphaSimplex Group LLC and members of the staff of the Division of 
Investment Management (July 8, 2016); AQR Comment Letter.
---------------------------------------------------------------------------

    Unlike the 2015 proposal, the proposed rule does not require a fund 
to apply its VaR model consistently (i.e., the same VaR model applied 
in the same way) when calculating the VaR of its portfolio and the VaR 
of its designated reference index.\241\ The proposed rule would, 
however, require that VaR calculations comply with the same proposed 
VaR definition and its specified model requirements.\242\ Our proposal 
does not include the 2015

[[Page 4478]]

proposal's model consistency requirement because if the proposed rule 
required funds to apply the same VaR model to its portfolio and the 
designated reference index, it could prevent funds from using less-
costly approaches. For example, under the proposed approach, in many 
cases a fund could calculate the VaR of a designated reference index 
based on the index levels over time without having to obtain access to 
more-detailed information about the index constituents. A fund also 
would have the flexibility to obtain the VaR from a third-party vendor 
instead of analyzing it in-house. A model consistency requirement could 
preclude these approaches, however, because a fund might not be able 
apply the same approach to its portfolio. For example, if a fund 
invested significantly in options, it generally would not be 
appropriate to use certain parametric VaR models.\243\ The fund might 
instead use Monte Carlo simulation, which is more computationally 
intensive and takes more time to perform. A model consistency 
requirement would require the fund to apply the same Monte Carlo 
simulation model to its unleveraged designated reference index, for 
which a parametric or other simpler and less costly VaR model might be 
appropriate.
---------------------------------------------------------------------------

    \241\ See 2015 Proposing Release, supra note 2, at section 
III.B.2.b.
    \242\ See infra section II.D.4 (discussing the proposed VaR 
model requirements).
    \243\ See supra note 227 (explaining that some parametric 
methodologies may be more likely to yield misleading VaR estimates 
for assets or portfolios that exhibit non-linear returns, due, for 
example, to the presence of options or instruments that have 
embedded optionality).
---------------------------------------------------------------------------

    Although requiring a fund to apply the same VaR model to its 
portfolio and the designated reference index could result in a more 
precise comparison of the two values, we do not believe that the 
additional precision is necessary for the relative VaR test to identify 
where funds' use of derivatives is more likely to raise the concerns 
underlying section 18 because the proposed rule would provide certain 
common parameters for all VaR calculations under the rule. Because a 
fund's designated reference index must be unleveraged, we believe it is 
generally unlikely that different VaR models calibrated to these common 
parameters would produce substantially different results for a fund's 
designated reference index. Additionally, the derivatives risk manager 
would be responsible for administering and maintaining the derivatives 
risk management program, which includes the integrity of the VaR test. 
On balance, we believe the proposed approach would not materially 
diminish the efficacy of the proposed relative VaR test while 
permitting less-costly approaches for funds.
    We request comment on the proposed requirements regarding a fund's 
choice of VaR model, and the required parameters for a VaR model that 
funds would use under the proposed rule.
    108. Should the rule specify a particular VaR model(s) that funds 
must use (i.e., a historical simulation, Monte Carlo simulation, or 
parametric methodology)? If so, which methodology (or methodologies) 
and why?
    109. Is the proposed requirement that a fund's VaR model 
incorporate all significant, identifiable market risk factors 
associated with a fund's investments appropriate? Why or why not?
    110. The proposed rule would provide a non-exhaustive list of risk 
factors that may be relevant in light of a fund's strategy and 
investments. Should the final rule include this non-exhaustive list of 
risk factors? Are risk factors included in the proposed list 
appropriate? Should we include any additional risk factors to this 
list? If so, which ones and why?
    111. The proposed rule would require a fund to use a 99% confidence 
level for its VaR model. Is the proposed confidence level appropriate? 
Should the rule include a different confidence level? If so, which 
level and why, and if not, why not?
    112. The proposed rule would require a fund to use a time horizon 
of 20 trading days for its VaR model. Is the proposed time horizon 
appropriate? Should the rule include a different time horizon? If so, 
which time horizon and why, and if not, why not?
    113. The proposed rule would require a fund to use at least three 
years of historical market data for its VaR model. Is the historical 
market data requirement appropriate? Should the rule set forth a 
different length of time for requiring historical market data? Should 
the requirement be limited to funds using historical simulation? Would 
funds experience challenges in identifying sufficient data for 
particular types of investments? If so, which types of investments and 
how should the rule address these challenges? Please explain.
    114. The proposed rule does not include any requirement for third-
party validation of a fund's chosen VaR model, either at inception or 
upon material changes, to confirm that the model is structurally sound 
and adequately captures all material risks.\244\ Should we require 
third-party validation? Why or why not?
---------------------------------------------------------------------------

    \244\ The Global Exposure Guidelines applicable to UCITS' 
requires such validation. See CESR Global Guidelines, supra note 94.
---------------------------------------------------------------------------

    115. Should the rule require a fund's board to approve the VaR 
model and any material changes to the model? Why or why not?
    116. Should the final rule also include a requirement that a fund 
that uses the relative VaR test apply the same VaR model when 
calculating the fund's portfolio and the VaR of the designated 
reference portfolio? Would the requirement to apply the same VaR model 
to the fund's portfolio and the designated reference portfolio address 
any concerns that funds could inappropriately manipulate the results of 
VaR testing under the proposed rule's requirements? What additional 
cost, if any, would such a requirement impose on funds? Are there other 
ways that we could prevent such manipulations? To what extent would 
this requirement promote additional precision in the relative VaR test 
and would any additional precision increase the efficacy of the test in 
limiting fund leverage risk? Please explain.
5. Implementation
a. Testing Frequency
    The proposed rule would require a fund to determine its compliance 
with the applicable VaR test at least once each business day.\245\ 
Although we believe that funds would calculate their VaRs at a 
consistent time each day, which would generally be either in the 
mornings before markets open or in the evenings after markets close, we 
do not propose to require one at the exclusion of the other, to allow 
funds to conduct their VaR tests at the time that is most efficient 
based on each fund's facts and circumstances. We considered proposing 
that funds determine compliance with the proposed VaR test at the time 
of, or immediately after, entering into a derivatives transaction. We 
recognize, however, that conducting a VaR test on a trade-by-trade 
basis could present operational challenges for some funds and could 
limit the fund's choice of VaR modeling. For example, we believe that 
most funds would be unable to perform computationally-intensive Monte 
Carlo simulations so frequently based on computing resources and 
compliance costs. Requiring this VaR calculation each day, in contrast, 
would provide funds flexibility to use VaR models they believe to be 
appropriate while also providing for fairly frequent calculations. The 
2015 proposal included a testing frequency of

[[Page 4479]]

immediately after entering into any senior securities transactions, but 
many commenters raised concerns about operational complexity related to 
transaction-by-transaction testing, and instead generally suggested a 
daily testing frequency.\246\
---------------------------------------------------------------------------

    \245\ Proposed rule 18f-4(c)(2)(ii).
    \246\ See, e.g., ICI Comment Letter I; Franklin Resources 
Comment Letter; SIFMA Comment Letter; AIMA Comment Letter; BlackRock 
Comment Letter.
---------------------------------------------------------------------------

    We believe that determining compliance with the VaR test less 
frequently than each business day would not be consistent with the 
purpose of a condition to limit fund leverage risk. Section 18 sets 
forth certain fund leverage risk protections that are fundamental to 
protecting investors. If this testing requirement were less frequent 
than each business day, then a fund could satisfy the condition only on 
business days requiring a VaR test and modify its trading strategy to 
circumvent the purpose of the test on other business days. 
Additionally, we believe that testing each business day is appropriate 
in light of the potential for market risk factors associated with a 
fund's investments to change quickly.
    We request comment on the proposed frequency of conducting the 
relative or absolute VaR test.
    117. Is the proposed required frequency for conducting the VaR test 
appropriate? Should the rule require a fund to conduct the required VaR 
test more frequently or less frequently, such as--respectively--either 
before or after each transaction, multiple times throughout the day, or 
on a weekly basis? Why or why not? Should the required frequency vary 
depending on fund type or whether the fund is conducting an absolute 
VaR test or relative VaR test? Please explain.
    118. Should the rule require funds to conduct the test at the same 
time each day? If so, why? What compliance or operational challenges, 
if any, would funds have to conduct the test at the same time each day? 
Would the absence of such a requirement allow funds to ``game'' the 
test?
b. Remediation
    If a fund determines that it is not in compliance with the 
applicable proposed VaR test, then under our proposal a fund must come 
back into compliance promptly and within no more than three business 
days after such determination.\247\ If the fund is not in compliance 
within three business days, then: (1) The derivatives risk manager must 
report to the fund's board of directors and explain how and by when 
(i.e., the number of business days) the derivatives risk manager 
reasonably expects that the fund will come back into compliance; (2) 
the derivatives risk manager must analyze the circumstances that caused 
the fund to be out of compliance for more than three business days and 
update any program elements as appropriate to address those 
circumstances; and (3) the fund may not enter into derivatives 
transactions (other than derivatives transactions that, individually or 
in the aggregate, are designed to reduce the fund's VaR) until the fund 
has been back in compliance with the applicable VaR test for three 
consecutive business days and satisfied the board reporting requirement 
and program analysis and update requirements.\248\
---------------------------------------------------------------------------

    \247\ See proposed rule 18f-4(c)(2)(ii).
    \248\ See proposed rule 18f-4(c)(2)(iii); see also infra section 
II.H.2 (discussing the proposed requirement to submit a confidential 
report to the Commission if the fund is out of compliance with the 
applicable proposed VaR test for three business days).
---------------------------------------------------------------------------

    The proposed three-business-day remediation provision is designed 
to provide funds with some flexibility in coming back into compliance 
with the applicable proposed VaR tests. It reflects our view that it 
would be inappropriate for a fund to purposefully exceed the VaR-based 
limit on fund leverage risk, but allows funds to take reasonable steps 
to come back into compliance without harming fund investors. The three-
business-day period is designed to provide an appropriate time period 
to permit remediation efforts because it balances investor protections 
related to fund leverage risk and potential harm to a fund if it were 
required to sell assets or unwind transactions even more quickly. This 
remediation approach is similar to the remediation approach that 
section 18 of the Investment Company Act provides for asset coverage 
compliance with respect to bank borrowings, which also includes a 
three-day period to come back into compliance.\249\
---------------------------------------------------------------------------

    \249\ Section 18(f)(1) of the Investment Company Act.
---------------------------------------------------------------------------

    If the fund does not come back into compliance within three 
business days, the proposed rule would not require the fund to exit its 
derivatives transactions or make other portfolio adjustments.\250\ 
Although a fund remaining out of compliance with the applicable VaR 
test raises investor protection concerns related to fund leverage risk, 
if the proposed rule were to force a fund to exit derivatives 
transactions immediately at the end of the three-day period, this could 
harm investors, for example, by requiring the fund to realize trading 
losses that could have been avoided under a more-flexible approach. The 
proposed remediation provision reflects the balancing of these multiple 
investor protection concerns.
---------------------------------------------------------------------------

    \250\ Under the proposed rule, a fund that is not in compliance 
within three business days also would be required to file a report 
to the Commission on proposed Form N-RN. See proposed rule 18f-
4(c)(7); infra section II.H.2.
---------------------------------------------------------------------------

    Instead of requiring a fund to come back into compliance under 
these circumstances immediately, the fund must satisfy three 
requirements before it can enter into derivatives transactions other 
than those designed to reduce the fund's VaR. First, the derivatives 
risk manager must report to the fund's board of directors and explain 
how and by when (i.e., the number of business days) the derivatives 
risk manager reasonably expects that the fund will come back into 
compliance.\251\ This requirement is designed to facilitate the fund 
coming back into compliance promptly by requiring the derivatives risk 
manager to develop a specific course of action to come back into 
compliance and to facilitate the board's oversight by requiring the 
derivatives risk manager to report this information to the board.
---------------------------------------------------------------------------

    \251\ Proposed rule 18f-4(c)(2)(iii)(A).
---------------------------------------------------------------------------

    Second, the derivatives risk manager must analyze the circumstances 
that caused the fund to be out of compliance for more than three 
business days and update any program elements as appropriate to address 
those circumstances.\252\ That the fund was unable to come back into 
compliance with the applicable VaR test within three business days may 
suggest there are deficiencies in the fund's program. This requires the 
derivatives risk manager to analyze and update any program elements as 
appropriate before the fund is able to enter into derivatives 
transactions other than those designed to reduce VaR.
---------------------------------------------------------------------------

    \252\ Proposed rule 18f-4(c)(2)(iii)(B).
---------------------------------------------------------------------------

    Finally, a fund may not enter into derivatives transactions (other 
than those designed to reduce the fund's VaR) until the fund has been 
back in compliance with the applicable VaR test for at least three 
consecutive business days and has satisfied the applicable board 
reporting and program analysis and update requirements.\253\ If the 
proposed rule were to permit a fund that is out of compliance with the 
limit on fund leverage risk to comply for just one day before entering 
into derivatives transactions that would increase the fund's market 
risk, this could potentially lead to some funds having persistently 
high levels of leverage risk

[[Page 4480]]

beyond that permitted by the applicable VaR test.
---------------------------------------------------------------------------

    \253\ Proposed rule 18f-4(c)(2)(iii)(C).
---------------------------------------------------------------------------

    We request comment on the proposed remediation requirement for a 
fund that is out of compliance with the applicable VaR test.
    119. Is the proposed three-business-day remediation provision 
appropriate? Could such a limited remediation period exacerbate fund or 
market instability and harm investors? Should the rule require a longer 
or shorter period, such as one or seven days? Why or why not, and if 
so, what should the alternative remediation period be? In light of the 
balancing of investor protection concerns (fund compliance with the 
VaR-based limit on fund leverage risk and not forcing asset sales or 
unwinding transactions to comply), is there a more-effective means to 
structure a remediation provision that balances these concerns? If so, 
how?
    120. Should we change the rule's remediation provision to include 
an escalating provision that requires longer periods of compliance 
based on the number of three-day (or more) periods that a fund has been 
out of compliance? If so, how should we structure such a provision?
    121. Should we change the rule to factor in the aggregate number of 
days in a trailing year that a fund has been out of compliance? What 
additional remediation consequences should a fund address before 
entering into derivatives transactions (other than those designed to 
reduce the fund's VaR)? Please explain.
    122. Should the remediation provision provide further or different 
limitations for a fund that continuously goes in and out of compliance 
with its VaR test? For example, should the rule provide that such a 
fund is not permitted to rely on the proposed rule indefinitely or for 
a set period of time? How should a rule define ``continuously going in 
and out of compliance''? Should such a fund be subject to a lower VaR 
requirement? If so, what level of VaR and why? How long should the fund 
remain subject to any lower VaR requirement? Should the fund be subject 
to limits on its derivatives exposure?
    123. Should the remediation provision, as proposed, require the 
derivatives risk manager to report to the fund's board of directors 
that the fund has been out of compliance with the VaR-based limit for 
more than three consecutive business days? Why or why not? Should the 
derivatives risk manager be required to explain how the fund will come 
back into compliance promptly and by when? Should we change the rule to 
require such a fund to take certain specific actions? Should we change 
the rule to require fund compliance within a specific time period? If 
so, how should we change the rule and why?
    124. Should the remediation provision, as proposed, require the 
derivatives risk manager to analyze the circumstances for the fund 
being out of compliance for more than three business days? Should we 
change the rule to require specific program updates? Should we change 
the rule to require a complete program review and update? What 
challenges would such a remediation requirement impose on funds? What 
are the benefits of specifying program updates? Under what 
circumstances, if any, would a fund be out of compliance for more than 
three business days and not have risk management program elements to 
update? Please explain.
6. Other Regulatory Approaches To Limiting Fund Leverage Risk
a. Stress Testing
    In addition to our proposal to require stress testing as a 
derivatives risk management program element, we considered a stress 
testing requirement as a means to limit fund leverage risk in lieu of, 
or in addition to, the proposed VaR tests. We understand that many 
funds that use derivatives transactions already conduct stress tests 
for purposes of risk management.\254\
---------------------------------------------------------------------------

    \254\ See, e.g., ICI Comment Letter III. While we do not propose 
to require stress testing as a means for limiting a fund's leverage 
risk, as discussed above, one element of the proposed program 
requires stress testing for risk management purposes. See supra 
section II.B.3.c.
---------------------------------------------------------------------------

    For example, we considered proposing a single-factor stress test 
requirement that would enumerate a limited number of shocks, 
corresponding to different asset classes in which funds commonly 
invest, and specify the required shock levels for each asset class. 
Similar to Form PF, the rule could categorize stress testing shocks 
based on market factors such as equity prices, risk-free interest 
rates, credit spreads, currency rates, commodity prices, option implied 
volatilities, default rates for asset-backed securities, and default 
rates for corporate bonds and credit-default swaps.\255\ The rule could 
also include an ``other,'' general category for which the corresponding 
shock level would be a specific or otherwise determinable factor based 
on extreme but plausible market conditions determined by the 
derivatives risk manager. A fund would ``fail'' this stress test if one 
of the prescribed shocks would cause the fund to experience a level of 
loss that we would specify.
---------------------------------------------------------------------------

    \255\ Question 42 on Form PF requires some private fund advisers 
to report the impact on the fund's portfolio from specified changes 
to the identified market factors.
---------------------------------------------------------------------------

    We could, for example, specify the shock levels for each market 
factor based on a certain number of standard deviations from the mean 
of historical distributions of returns for that factor, such as three 
or four standard deviations, as a means of establishing standardized 
shock levels.\256\ We could then specify that a fund fails the stress 
test if any such shock leads to a loss of a certain percentage of the 
fund's net assets over a single trading day or series of trading days, 
such as 20% over one trading day. We could determine these metrics 
based on how funds that do not engage in derivatives, but that have 
borrowed up to and in compliance with the requirements of section 18, 
would perform against the stress test. For example, the stress test 
outer limit could be based on a fund that is not using derivatives but 
has invested $150 in securities based on $100 of net assets and $50 in 
bank borrowings. To be consistent with section 18, a fund that uses 
derivatives and conducts a stress test resulting in losses greater than 
the stress test losses of this hypothetical bank-borrowing-leveraged 
fund would fail the single-factor stress test.
---------------------------------------------------------------------------

    \256\ If normally distributed, shock levels based on historical 
returns of a market factor that is three standard deviations from 
the mean of that market factor would correspond to approximately a 
99.7% confidence level.
---------------------------------------------------------------------------

    This approach would have the benefit of setting forth a 
comparatively simple-to-conduct test that a broad variety of funds 
could apply. The challenges of a single-factor stress testing 
requirement, however, include identifying an appropriate universe of 
market risk factors for the broad universe of derivatives in which 
funds invest and strategies they follow, setting the appropriate level 
of each shock for each factor, and determining the level of losses that 
would result in a fund ``failing'' the test. Making these 
determinations would be particularly challenging in a rule that would 
apply to all funds. Any prescribed shocks and related values could 
become stale over time and necessarily would not include all of the 
relevant risk factors for each fund. As funds continue to innovate, 
there could be funds for which no prescribed shock would be relevant. 
An approach that looks at a fund's losses in response to changes in a 
single market risk factor also may not effectively take into account 
correlations among market risk factors under stressed market 
conditions. Stress testing is useful as a risk management tool because 
it

[[Page 4481]]

provides a framework for advisers to consider a range of potential 
scenarios tailored to each fund and refined over time. Its benefits as 
a limit of fund leverage risk may not be fully realized, however, by 
single-factor stress testing that includes static values that a rule 
specifies.\257\
---------------------------------------------------------------------------

    \257\ We recognize that these concerns do not apply to all uses 
of single-factor stress testing. For example, money market fund 
stress testing does not raise similar concerns in part because of 
money market funds' common strategies and limited universe of 
investment holdings. See rule 2a-7(g)(8) under the Investment 
Company Act (requiring periodic stress testing).
---------------------------------------------------------------------------

    We also considered requiring a multi-factor stress test based on 
scenario analysis. Rather than a fund applying a single-factor shock to 
each relevant asset class, this approach would require funds to create 
a stress test model that takes into account multiple asset classes 
simultaneously, which a fund would have to identify to tailor the 
stress test to its fund. The fund would then run numerous scenarios 
against the model, shocking the multiple asset classes identified, 
based on a high number of iterations and permutations akin to a Monte 
Carlo simulation. A multi-factor stress test would result in a matrix 
or range of estimated potential losses during stressed market 
conditions because each scenario permutation would create one estimated 
potential loss calculation. The benefits of multi-factor stress testing 
include tailoring the stress test to the investment and risk 
characteristics of a fund's portfolio, which may result in more 
meaningful derivatives risk management. But in considering a multi-
factor stress testing requirement, we would have to consider whether 
such a framework, if highly particularized, would permit enough long-
term flexibility as an applicable regulatory limit on fund leverage 
risk. For example, the multi-factor stress test could identify specific 
correlations and assumptions that funds should reflect in their stress 
tests based on their strategies and investments, or identify specific 
historical market events to run as scenarios against their stress test 
model. In addition, if we were to propose a principles-based multi-
factor stress testing requirement that would rely on funds to tailor 
their stress tests, it would present regulatory challenges in 
determining whether funds were adhering to a limit on fund leverage 
risk consistent with section 18.
    Finally, our proposed VaR-based limit on fund leverage risk, as 
opposed to stress testing, may better align with section 18's investor 
protection goals concerning the level of risk in a registered fund. 
This is because the limitations in section 18 apply under both normal 
and stressed market conditions.\258\ For these reasons, as well as the 
regulatory design challenges of specifying the universe of asset class 
shocks and setting their corresponding levels, we are proposing a VaR-
based limit on fund leverage risk instead of a stress testing approach 
to limiting fund leverage risk.
---------------------------------------------------------------------------

    \258\ See supra section I.B.1.
---------------------------------------------------------------------------

    We request comment on stress testing as a means to limit funds' 
leverage risk.
    125. In addition to our proposed stress testing requirement as part 
of the derivatives risk management program, should the rule require 
stress testing as a means to limit fund leverage risk in lieu of or in 
addition to the VaR-based limit on fund leverage risk? Why or why not? 
Is a stress test an effective means to limit a fund's leverage risk? 
Please explain. If we were to include a stress testing requirement in 
addition to a VaR-based limit on fund leverage risk, should we require 
a fund to comply with both requirements, or should we allow a fund to 
choose one or the other? If we were to allow funds to comply with 
either approach, would that result in inconsistent limits across funds 
and would that be appropriate if so?
    126. To measure and/or limit fund leverage risk, do funds currently 
use VaR tests, stress tests or both? If a fund uses VaR tests but not 
stress tests (or vice versa), did the fund consider using the other 
approach as a means to measure and limit its leverage risk? Why or why 
not?
    127. If funds use both VaR tests and stress tests to measure and/or 
limit fund leverage risk, why do they use both tests? Are there certain 
fund types or strategies that are better suited for VaR or for stress 
testing? If so, which ones and why?
    128. Should the limit of fund leverage risk focus on normal market 
conditions, stressed market conditions, or both? Please explain.
    129. Should the rule require a single-factor stress test as an 
alternative to the proposed VaR-based limit on fund leverage risk? If 
so, what single-factor shocks should the test require? What would the 
corresponding shock levels be for each factor? Are the example single-
factor shocks discussed above appropriate? Please explain. How 
frequently and on what basis, if at all, do commenters anticipate that 
the Commission would need to amend a rule that incorporated the 
enumerated shocks and their corresponding levels?
    130. What number of standard deviations from the mean of historical 
distributions of returns should the single-factor shock levels for each 
market risk factor be? Would three standard deviations or four standard 
deviations be appropriate? How should the rule define a failed stress 
test? Would a loss expressed as a percentage of the fund's net assets 
over a single trading day or series of trading days be appropriate? 
What percentage and over what period would be appropriate? Would 20% 
over one trading day be appropriate? How frequently, if at all, do 
commenters anticipate that the Commission would need to amend the rule 
to revise the specified loss level?
    131. Should the rule require a multi-factor stress test as an 
alternative to the proposed VaR-based limit on fund leverage risk? If 
so, how might the rule include a multi-factor stress testing 
requirement that permits adequate flexibility and tailoring but could 
also promote comparability and regulatory consistency in setting a 
leverage risk limit?
    132. Should the single-factor or multi-factor stress testing 
methods be required as part of the proposed program's stress testing 
requirement? If so, which one and why?
b. Asset Segregation
    We considered applying an asset segregation approach to derivatives 
transactions, similar to asset segregation under Release 10666, as a 
tool to limit funds' leverage-related risks.\259\ Under this approach, 
we could require a fund engaging in derivatives transactions to 
segregate cash and cash equivalents equal in value to the full amount 
of the conditional and unconditional obligations incurred by the fund 
(also referred to as ``notional amount segregation''). We could allow 
funds to segregate additional types of assets beyond cash and cash 
equivalents subject to prescribed haircuts based on the assets' 
volatilities. The 2016 DERA Memo, for example, analyzed different risk-
based ``haircuts'' that could apply to a broader range of assets.\260\ 
Allowing a broader range of segregated assets would have the effect of 
allowing funds to take on additional leverage because it would increase 
a fund's ability to obtain market exposure through a combination of 
cash, market securities investments, and derivatives transactions. 
Allowing funds to segregate a broader range of assets, even if subject 
to haircuts, also may not effectively address all of the section 18 
concerns underlying an asset segregation requirement. For example, if

[[Page 4482]]

a fund must raise cash to pay a derivatives counterparty by selling a 
segregated security with unrealized trading losses, then the fund still 
would realize trading losses on the sale of the security regardless of 
whether the fund applied haircuts to the value of the security when 
determining the amount of its segregated assets. The haircuts therefore 
could help to prevent a fund from defaulting on its derivatives 
transactions obligations, but may not prevent a fund from realizing 
trading losses to meet those obligations.
---------------------------------------------------------------------------

    \259\ We separately discuss below our consideration of asset 
segregation as a complement to the proposed limitations on fund 
leverage risk. See infra section II.F.
    \260\ See, e.g., 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------

    Notional amount segregation, although generally an effective way to 
limit leverage risk, is a non-risk-sensitive and often more restrictive 
approach to limiting potential leverage risk as compared to the 
proposed VaR tests. Notional amount segregation could limit funds' 
ability to engage in derivatives transactions that may not raise the 
concerns underlying section 18. For example, if a fund had segregated 
all available qualifying assets, it would not be permitted to enter 
into a derivatives transaction that would reduce portfolio risk. The 
proposed VaR tests would not constrain such a transaction because it 
would reduce the fund's VaR.
    We also considered proposing an approach that would require funds 
to segregate liquid assets in an amount equal to the fund's daily mark-
to-market liability plus a ``cushion amount'' designed to address 
potential future losses. Requiring funds to segregate liquid assets 
would indirectly limit a fund's leverage risk because each derivatives 
transaction and segregation of liquid assets would limit the net assets 
available for segregation to support additional derivatives. This 
approach would require segregating a smaller amount of liquid assets 
than the notional amount segregation approach.\261\ In light of the 
smaller amount of segregated assets, we could provide that only a 
specified percentage of a fund's assets can be segregated. We could 
provide, for example, that a fund's segregated amount cannot exceed 
one-third of its total assets or one-half of its net assets because 
this is the maximum amount that an open-end fund can owe a bank under 
section 18.
---------------------------------------------------------------------------

    \261\ See 2010 ABA Derivatives Report (recommending a risk-
adjusted segregated amounts approach); 2011 Concept Release, supra 
note 3, at sections II.B.2, II.C.2 (citing and requesting comment on 
the 2010 ABA Derivatives Report approach).
---------------------------------------------------------------------------

    This approach, however, would raise compliance complexities and may 
not be as effective as the proposed VaR tests in limiting fund leverage 
risk. For example, under this approach we would have to define the 
risk-based ``cushion amount'' funds would segregate. We could define 
this amount as we proposed in 2015: A reasonable estimate of the 
potential amount payable by the fund if the fund were to exit the 
derivatives transaction under stressed conditions.\262\ Some commenters 
suggested determining these amounts could raise compliance 
challenges.\263\ Another approach would be to use the amount of 
required initial margin, for transactions subject to regulatory initial 
margin requirements. Not all derivatives transactions are subject to 
initial margin requirements, however, and these requirements generally 
vary based on the type of derivatives instrument. An approach that were 
to allow a fund to have more leverage when trading futures as compared 
to swaps, for example, would not seem consistent with the concerns 
underlying section 18.
---------------------------------------------------------------------------

    \262\ See 2015 proposed rule 18f-4(c)(9).
    \263\ We discuss these challenges in more detail below in 
section II.F. See also, e.g., AAF Comment Letter; Angel; Comment 
Letter of James J. Angel, Ph.D., CFA (Mar. 28, 2016).
---------------------------------------------------------------------------

    Requiring funds to segregate liquid assets in an amount equal to 
the fund's daily mark-to-market liability plus a ``cushion amount'' 
therefore could introduce unnecessary complexity and compliance costs 
and may not result in an effective limit on fund leverage. We believe 
that the proposed VaR-based tests would be a more direct and effective 
method of limiting fund leverage risk consistent with section 18.
    We request comment on asset segregation as an alternative or 
complement to VaR.
    133. Should the rule require asset segregation in lieu of or in 
addition to the proposed VaR-based limit on fund leverage risk? Is 
asset segregation equally effective or more effective than the proposed 
VaR tests in limiting a fund's leverage risk? Why or why not?
    134. Are there certain fund types or strategies for which an asset 
segregation approach would be more effective or appropriate for 
limiting a fund's leverage risk? Which ones and why?
    135. Should the proposed rule require notional amount segregation? 
What challenges, if any, would funds have with complying with notional 
amount segregation? Would this be an effective means to limit a fund's 
leverage risk? If so, how? Please describe.
    136. Should the proposed rule require an asset segregation risk-
based approach based on the fund's daily mark-to-market liability and 
``cushion amount''? Please explain why or why not. If so, how should 
funds calculate the risk-based cushions? Should we use the approach in 
the 2015 proposal for risk-based coverage amounts? Would funds 
encounter challenges in determining stressed conditions for purposes of 
that analysis? Would that approach lead to consistent segregated 
amounts across funds for the same or similar investments? Why or why 
not? Could we provide for greater consistency by prescribing a 
standardized schedule for computing these amounts based on the 
volatility of the underlying reference assets? What values should we 
prescribe? Rather than the approach in the 2015 proposal, should we use 
the amounts posted to satisfy regulatory margin requirements? Would it 
be appropriate for different instruments that provide the same economic 
exposure (e.g., futures and swaps that reference the same index) to 
have different segregated amounts? Under this approach, how should 
funds calculate risk-based cushions for transactions that are not 
subject to regulatory initial margin requirements?
    137. Should we use the risk-based cushion amount approach to 
indirectly limit leverage risk? If so, should we provide that a fund's 
segregated amount cannot exceed one-third of its total assets, one-half 
of its net assets, or some other percentage of a fund's total or net 
assets? Would such an approach be sufficiently risk-sensitive and 
dynamic? If we were to use such an approach, how should we address 
derivatives transactions that may require little or no margin or 
collateral to be posted?
    138. Are there other reasons that the proposed rule should include 
asset segregation? Should the derivatives risk management program 
specify asset segregation requirements? Would market practices 
adequately address asset coverage concerns? If not, why?
    139. We included an asset segregation requirement as part of the 
2015 proposal designed in part to address the asset sufficiency related 
concerns underlying section 18. Would an asset segregation requirement 
help to address fund leverage risk and complement the proposed VaR 
tests? If so, what type of asset sufficiency test?
c. Exposure-Based Test
    We considered an exposure-based approach for limiting fund leverage 
risk. For example, we could design an exposure-based approach that 
permits a fund to enter into derivatives transactions so long as its 
derivatives exposure does not exceed a specified percentage of the 
fund's net assets, such as 50%. This would be similar to an exposure-
based test under the European

[[Page 4483]]

Union guidelines that apply to UCITS funds.\264\
---------------------------------------------------------------------------

    \264\ CESR (now known as the European Securities and Markets 
Authority (``ESMA'')) issued its Guidelines on Risk Measurement and 
the Calculation of Global Exposure and Counterparty Risk for UCITS 
(``Global Exposure Guidelines'') in 2010, addressing the 
implementation of the European Commission's 2009 revised UCITS 
Directive (``2009 Directive''). See CESR Global Guidelines, supra 
note 94, at 9.
     A UCITS fund may, instead of complying with the European 
Union's VaR-based test, satisfy a ``commitment approach.'' The 
commitment approach provides that a UCITS fund is in compliance with 
the leverage limits under the guidelines if its derivatives notional 
amounts (taking into account netting and hedging) do not exceed 100% 
of the fund's net asset value. See 2009 Directive.
---------------------------------------------------------------------------

    A fund's ``derivatives exposure'' could be defined as in proposed 
rule 18f-4.\265\ A similar approach would be to provide that the sum of 
a fund's derivatives exposure and the value of its other investments 
cannot exceed 150% of the fund's net asset value. This latter approach, 
and particularly if cash and cash equivalents were not included in the 
calculation, would allow a fund to achieve the level of market exposure 
permitted for an open-end fund under section 18 using any combination 
of derivatives and other investments.\266\
---------------------------------------------------------------------------

    \265\ Proposed rule 18f-4(a) (defining derivatives exposure to 
mean the sum of the notional amounts of the fund's derivatives 
instruments and, in the case of short sale borrowings, the value of 
the asset sold short. In determining derivatives exposure a fund may 
convert the notional amount of interest rate derivatives to 10-year 
bond equivalents and delta adjust the notional amounts of options 
contracts).
    \266\ This approach would exclude cash and cash equivalents 
because they do not meaningfully contribute to a fund's market 
exposure.
---------------------------------------------------------------------------

    This alternative approach would recognize that for most types of 
derivatives, the notional amount generally serves as a measure of the 
fund's economic exposure to the underlying reference asset or metric. 
It also would provide a simple approach because a fund would just add 
the relevant values rather than having to perform VaR tests.
    An exposure-based test does have certain limitations. One drawback 
to this alternative approach is that a derivative's notional amount 
does not reflect the way in which the fund uses the derivative and is 
not a risk measurement. For this reason, an exposure-based approach may 
be viewed as a relatively blunt measurement. It would not differentiate 
between derivatives transactions having the same notional amount but 
different underlying reference assets with potentially very different 
risks.
    There are adjustments to notional amounts available that may better 
reflect the risk associated with derivatives transactions. One way to 
attempt to address these drawbacks would be to define the circumstances 
under which funds could subtract the exposure associated with 
``hedging'' and ``netting'' transactions from a fund's derivatives 
exposure. This would be similar to the ``commitment method'' applicable 
to UCITS funds.\267\ Defining these kinds of transactions can be 
challenging. For example, determining whether transactions are 
``hedges'' can involve an analysis of historical correlations and 
predicting future price movements of related instruments or underlying 
reference assets, among other things. Historical correlations also can 
break down in times of market stress.\268\
---------------------------------------------------------------------------

    \267\ See, e.g., CESR Global Guidelines, supra note 94, at 13-14 
(defining netting as ``combinations of trades on financial 
derivative instruments and/or security positions which refer to the 
same underlying asset, irrespective--in the case of financial 
derivative instruments--of the contracts' due date; and where the 
trades on financial derivative instruments and/or security positions 
are concluded with the sole aim of eliminating the risks linked to 
positions taken through the other financial derivative instruments 
and/or security positions'' and hedging as ``combinations of trades 
on financial derivative instruments and/or security positions which 
do not necessarily refer to the same underlying asset and where the 
trades on financial derivative instruments and/or security positions 
are concluded with the sole aim of offsetting risks linked to 
positions taken through the other financial derivative instruments 
and/or security positions'').
    \268\ In times of extreme market stress, price correlations 
between asset classes frequently break down. See Mico Loretan & 
William B. English, Evaluating ``Correlation Breakdowns'' During 
Periods of Market Volatility, Federal Reserve System International 
Finance Working Paper No. 658 (Feb. 2000), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=231857 (``[I]n periods 
of heightened market volatility correlations between asset returns 
can differ substantially from those seen in quieter markets. The 
problem of `correlation breakdown' during periods of greater 
volatility is well known.''). During periods of stressed conditions, 
correlations between asset classes with historically weak or inverse 
correlations may change significantly. See Whitney Kisling, Greed 
Beats Fear With Stock-Bond Correlation Falling, Bloomberg (Nov. 22, 
2010) (stating that the 30-day correlation between S&P 500 prices 
and 10-year Treasury yields showed equity and bond markets, 
typically inversely correlated markets, moving in lockstep after the 
2008 financial crisis); see also A Review of Financial Market Events 
in Autumn 1998, Bank for International Settlements, Committee on the 
Global Financial System (1999), available at https://www.bis.org/publ/cgfs12.htm (during the Russian financial crisis in August 1998 
the average correlation between five-day changes in yield spreads 
for 26 instruments in 10 economies rose from 11% in the first half 
of 1998 to 37% during the height of the crisis).
---------------------------------------------------------------------------

    Another potential way to modify an exposure-based test would be to 
adjust the notional amounts that contribute to a fund's derivatives 
exposure based on the volatility of their underlying reference assets. 
Some commenters on the 2015 proposal suggested we take this approach, 
and DERA staff prepared an analysis of commenters' suggestions.\269\ 
This would make an exposure-based test more risk-sensitive, but would 
not provide the more-comprehensive analysis of portfolio risk that VaR 
provides. An exposure-based test, even with these various adjustments 
to notional amounts for purposes of calculating a fund's derivatives 
exposure, still would be a relatively blunt measurement. For example, 
this approach could limit certain fund strategies that rely on 
derivatives more extensively but that do not seek to take on 
significant leverage risk.
---------------------------------------------------------------------------

    \269\ See 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------

    While we do not propose an exposure-based test element as a means 
for limiting all funds' leverage risk, we are proposing an exposure-
based test for limited derivatives users (as discussed below).\270\
---------------------------------------------------------------------------

    \270\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------

    We request comment on an exposure-based test as a means to limit 
funds' leverage risk.
    140. Should the rule incorporate an exposure-based approach in 
addition to, or in lieu of, the proposed VaR-based limit on fund 
leverage risk? If so, what derivatives exposure amount should this 
approach permit? For example, should we modify the proposed rule so 
that a fund would not be required to satisfy either VaR test if the 
fund limited its derivatives exposure, as defined for purposes of the 
limited derivatives user exception discussed below, to 50% of a fund's 
net assets? Should an exposure-based approach focus on a fund's overall 
gross market exposure and be based on the sum of the fund's derivatives 
exposure and the value of its other investments, less any cash and cash 
equivalents? If so, should a fund's gross market exposure be limited to 
150% of net assets to allow a fund to achieve the level of market 
exposure permitted for an open-end fund under section 18 using any 
combination of derivatives and other investments? Would any of these 
approaches to implementing an exposure-based limit on fund leverage 
risk effectively address the potential leverage associated with a 
fund's derivatives transactions? If so, would funds find it more cost 
effective or otherwise preferable to have the option to comply with an 
exposure-based test in lieu of the proposed VaR tests? Please explain.
    141. If the rule were to incorporate an exposure-based approach, 
should we permit funds to make netting and hedging adjustments when 
calculating their derivatives exposures? If so, why? How should we 
define permissible

[[Page 4484]]

netting and hedging transactions? If we permit netting and hedging to 
be incorporated into the exposure calculation, should the rule include 
third-party verification to test whether a fund's netting and hedging 
calculations were reasonable and appropriate? What other provisions 
could achieve these concerns with netting and hedging? Please describe.
    142. If the rule were to incorporate an exposure-based approach, 
should we permit funds to make risk-sensitive adjustments as discussed 
in the 2016 DERA Memo? If so, why? How should we define the permissible 
risk-adjusted notional amounts? If we permit these adjustments to be 
incorporated into the exposure calculation, should the rule include 
third-party verification to test whether a fund's adjustments were 
reasonable and appropriate? What other provisions could achieve these 
concerns with risk-adjusted notional amounts? Please describe.
    143. Are there certain fund types or strategies where an exposure-
based test would be more appropriate? If so, which ones and why? Would 
these fund types or strategies have difficulty conducting either a 
relative VaR test or absolute VaR test? If so, why would an exposure-
based test be less challenging to conduct than a VaR-based test?
    144. What challenges, if any, would funds have in conducting an 
exposure-based test? How could an exposure-based test rule account for 
these challenges?
    145. Do funds currently conduct exposure-based tests as a means of 
measuring and limiting a fund's leverage risk? If so, which ones and 
why? Are these exposure-based tests in place of or in addition to VaR-
based tests or other risk measurements? Should the rule be modified to 
require both, and what benefits do funds find when running an exposure-
based test and VaR-based test and comparing results? Would these 
additional compliance burdens result in a more-accurate limit on fund 
leverage risk? If so, how much so, and what would the additional 
compliance burdens be?
    146. In what ways is the proposed approach to limiting leverage 
risk superior or inferior to the current regulatory approach or 
alternative approaches, including the stress testing, asset segregation 
and exposure-based alternatives discussed herein?

E. Limited Derivatives Users

    We are proposing an exception from the proposed rule's risk 
management program requirement and VaR-based limit on fund leverage 
risk for funds that use derivatives in a limited manner. Requiring 
funds that use derivatives only in a limited way to adopt a derivatives 
risk management program that includes all of the proposed program 
elements could potentially require funds (and therefore their 
shareholders) to incur costs and bear compliance burdens that may be 
disproportionate to the resulting benefits.\271\ We recognize that the 
risks and potential impact of derivatives transactions on a fund's 
portfolio generally increase as the fund's level of derivatives usage 
increases and when funds use derivatives for speculative purposes.
---------------------------------------------------------------------------

    \271\ The cost burden concern extends to smaller funds as well, 
which could experience an even more disproportionate cost than 
larger funds. See infra sections III.C.3and V.D.1.c.
---------------------------------------------------------------------------

    The proposed exception would cover two alternative types of limited 
derivatives use. It would be available to a fund that either limits its 
derivatives exposure to 10% of its net assets, or that uses derivatives 
transactions solely to hedge certain currency risks.\272\ A fund that 
relies on the proposed exception would also be required to adopt 
policies and procedures that are reasonably designed to manage its 
derivatives risks.\273\ We believe that the risks and potential impact 
of these funds' derivatives use may not be as significant, compared to 
those of funds that do not qualify for the exception, and that a 
principles-based policies and procedures requirement would 
appropriately address these risks. We discuss and request comment on 
each of the elements of this proposed exception below.
---------------------------------------------------------------------------

    \272\ See proposed rule 18f-4(c)(3)(i)-(ii); see also infra 
sections II.E.1 and II.E.2 (discussing the specific requirements for 
funds relying on either alternative of the proposed exception).
    \273\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------

1. Exposure-Based Exception
    Under one alternative set of conditions, a fund would be permitted 
to rely on the limited derivatives user exception if its derivatives 
exposure does not exceed 10% of its net assets. The proposed rule would 
generally define the term ``derivatives exposure'' to mean the sum of 
the notional amounts of the fund's derivatives instruments and, for 
short sale borrowings, the value of any asset sold short.\274\ This 
definition is designed to provide a measure of the market exposure 
associated with a fund's derivatives transactions entered into in 
reliance on proposed rule 18f-4.\275\
---------------------------------------------------------------------------

    \274\ See proposed rule 18f-4(a) (defining the term 
``derivatives exposure'').
    \275\ Id.
---------------------------------------------------------------------------

    We recognize that using notional amounts as a measure of market 
exposure could be viewed as a relatively blunt measurement in that 
different derivatives transactions having the same notional amount but 
different underlying reference assets--for example, an interest rate 
swap and a credit default swap having the same notional amount--may 
expose a fund to very different potential investment risks and 
potential payment obligations. The derivatives exposure threshold in 
the limited derivatives user exception, however, is not designed to 
provide a precise measure of a fund's market exposure or to serve as a 
risk measure, but rather to serve as an efficient way to identify funds 
that use derivatives in a limited way.
    The proposed definition of ``derivatives exposure'' would, however, 
include two adjustments designed to address certain limitations 
associated with measures of market exposure that use derivatives' 
notional amounts without adjustments. Specifically, the proposed rule 
would permit a fund to convert the notional amount of interest rate 
derivatives to 10-year bond equivalents and delta adjust the notional 
amounts of options contracts.\276\ Converting interest rate derivatives 
to 10-year bond equivalents would provide for greater comparability of 
the notional amounts of different interest rate derivatives that 
provide similar exposure to changes in interest rates but that have 
different unadjusted notional amount. In addition, absent this 
adjustment, short-term interest rate derivatives in particular can 
produce large unadjusted notional amounts that may not correspond to 
large exposures to interest rate changes.\277\ Permitting funds to 
convert these and other interest rate derivatives to 10-year bond 
equivalents is designed to result in adjusted notional amounts that 
better represent a fund's exposure to interest rate changes. Similarly, 
permitting delta adjusting of options is designed to provide for a more 
tailored notional amount that better reflects the exposure that an 
option creates to the underlying reference asset.
---------------------------------------------------------------------------

    \276\ Id. Delta refers to the ratio of change in the value of an 
option to the change in value of the asset into which the option is 
convertible. A fund would delta adjust an option by multiplying the 
option's unadjusted notional amount by the option's delta.
    \277\ Id.
---------------------------------------------------------------------------

    These adjustments are therefore designed to provide for more 
tailored notional amounts that better reflect the exposure that a 
derivative creates to the underlying reference asset. Providing these 
adjustments also would be efficient for funds because the adjustments 
are consistent with the

[[Page 4485]]

reporting requirements in Form PF and Form ADV.\278\ We do not believe 
additional adjustments are necessary for purposes of identifying 
limited derivatives users. For example, commenters on the 2015 proposal 
suggested an approach to adjusting notional amounts based on the 
volatility of the underlying reference assets, and DERA staff analyzed 
these suggestions.\279\ We believe, however, that whether a fund is 
using derivatives in a limited way for purposes of the limited 
derivatives user exception should not depend on the volatility of the 
underlying reference assets, but rather on the extent to which a fund 
uses derivatives to implement its investment strategy.
---------------------------------------------------------------------------

    \278\ See, e.g., General Instruction 15 to Form PF; Item B.30 of 
Section 2b of Form PF; Glossary of Terms, Gross Notional Value of 
Form ADV; Schedule D of Part 1A of Form ADV.
    \279\ See 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------

    The proposed 10% derivatives exposure condition represents a 
threshold that is designed to exclude funds from the program 
requirement and the VaR-based limit on fund leverage risk when their 
derivatives exposure is relatively limited. This proposed threshold is 
based in part on staff analysis of funds' practices regarding 
derivatives use. Specifically, DERA staff analyzed funds' use of 
derivatives based on Form N-PORT filings as of September 2019. As 
discussed in more detail in section III, these filings covered mutual 
funds, ETFs, registered closed-end funds, and variable annuity separate 
accounts registered as management investment companies. Based on this 
analysis, 59% of funds report no derivatives holdings and 14% of funds 
report derivatives holdings with gross notional amounts above 50% of 
NAV.
    DERA staff also analyzed the levels of these funds' derivatives 
exposure after adjusting interest rate derivatives and options, as 
permitted under the proposed rule. Taking these adjustments into 
account, DERA staff's analysis showed that 78% of funds have adjusted 
notional amounts below 10% of NAV; 80% of funds have adjusted notional 
amounts below 15% of NAV; 81% of funds have adjusted notional amounts 
below 20% of NAV; and 82% of funds have adjusted notional amounts below 
25% of NAV. Although BDCs are not required to file reports on Form N-
PORT, our staff separately analyzed a sampling of BDCs, finding that of 
the sampled BDCs, 54% did not report any derivatives holdings and a 
further 29% reported using derivatives with gross notional amounts 
below 10% of net assets.\280\
---------------------------------------------------------------------------

    \280\ See infra section III.B.2. As noted above, our staff did 
not have sufficient information to adjust the notional amounts of 
the BDCs' interest rate derivatives or options. Some of the 17% of 
the sampled BDCs with gross notional amounts exceeding 10% of net 
assets likely would have lower notional amounts after applying these 
adjustments.
---------------------------------------------------------------------------

    We recognize that not all funds are currently required to file 
reports on Form N-PORT.\281\ It appears, however, that funds' use of 
derivatives reflected in the Form N-PORT data is generally consistent 
with that in the representative sample studied in the White Paper 
prepared in connection with the 2015 proposal, entitled ``Use of 
Derivatives by Investment Companies.'' \282\ For example, DERA staff 
compared the percentages of funds in both data sets that reported no 
derivatives and the percentage with gross notional amounts less than 
50% of net assets. These figures were comparable, suggesting that the 
Form N-PORT data provides a representative sample of current funds, and 
not just the set of funds currently required to file reports on Form N-
PORT.\283\ Taking these results into account, we are proposing to 
permit a fund to operate as a limited derivatives user if its 
derivatives exposure is below 10% of net assets. DERA staff analysis 
suggests that most funds either do not use derivatives or do so to a 
more limited extent, and that setting the derivatives exposure 
threshold for the limited user exception at 10%, 15%, 20%, or 25%, for 
example, would result in nearly the same percentages of funds 
qualifying for the exception. We therefore are proposing a lower 
threshold of 10% because the lower threshold would result in nearly the 
same percentage of funds qualifying for the exception based on current 
practices while potentially providing greater investor protections in 
the future by requiring funds that exceed the lower 10% threshold to 
establish a program and comply with the VaR-based limit on fund 
leverage risk.
---------------------------------------------------------------------------

    \281\ Larger fund groups--funds that together with other 
investment companies in the same ``group of related investment 
companies'' have net assets of $1 billion or more as of the end of 
the most recent fiscal year of the fund--currently are required to 
file reports on N-PORT. Smaller fund groups must begin to file 
reports on Form N-PORT by April 30, 2020. While only larger fund 
groups are currently required to file reports on Form N-PORT, 
existing filings nevertheless covered 89% of funds representing 94% 
of assets. See infra note 457 and accompanying text.
    \282\ DERA White Paper, supra note 1; see also ICI Comment 
Letter III (regarding a survey related to funds' use of derivatives 
sent to its member firms, the Investment Company Institute stated 
``The survey was distributed to smaller fund complex members, yet 
relatively few responses were received from these smaller fund 
members. Based on anecdotal conversations with staff at these member 
complexes, the smaller fund firms described no to minimal use of 
derivatives.'').
    \283\ Specifically, the DERA White Paper observes that 68% of 
funds held no derivatives and 89% of funds had gross notional 
amounts less than 50% of net assets. See DERA White Paper, supra 
note 1. The respective figures from the N-PORT data were 59% and 86% 
of funds.
---------------------------------------------------------------------------

    The 2015 proposal also included an exception from that proposal's 
risk management program requirement for funds: (1) Whose notional 
derivatives exposure does not exceed 50% of net assets; and (2) that do 
not enter into ``complex derivatives transactions,'' defined in that 
proposal to include certain path-dependent and non-linear 
transactions.\284\ The 2015 proposal permitted funds to use delta-
adjusted notional amounts for options but did not provide an adjustment 
for interest rate derivatives.
---------------------------------------------------------------------------

    \284\ Specifically, the 2015 proposal defined the term ``complex 
derivatives transaction'' to mean any derivatives transaction for 
which the amount payable by either party upon settlement date, 
maturity or exercise: (1) Is dependent on the value of the 
underlying reference asset at multiple points in time during the 
term of the transaction; or (2) is a non-linear function of the 
value of the underlying reference asset, other than due to 
optionality arising from a single strike price. 2015 proposed rule 
18f-4(c)(1).
---------------------------------------------------------------------------

    We are proposing a 10% derivatives exposure threshold that takes 
into account certain adjustments rather than a higher figure, like the 
50% threshold we proposed in 2015 that did not include adjustments for 
interest rate derivatives, because we believe this approach would more 
effectively identify funds whose derivatives may be effectively managed 
without a fund needing to establish a derivatives risk management 
program that includes all of the proposed program elements. A fund with 
derivatives exposure equal to 50% of net assets, for example, would be 
at risk of substantial losses, notwithstanding that an open-end fund 
could borrow an amount equal to 50% of its net assets from a bank.\285\ 
Conversely, if a fund were entering into interest rate derivatives--and 
especially short-term interest rate derivatives--those transactions' 
unadjusted notional amounts could cause a fund to exceed the threshold 
we proposed in 2015 even though the fund's derivatives risks could be 
less significant than those of

[[Page 4486]]

other funds that would qualify for the exception. The approach the 
Commission proposed in 2015 therefore could have permitted some funds 
to rely on the exception while still taking on significant derivatives 
risks, while disqualifying other funds whose derivatives transactions 
may have posed less-significant risks but that had high unadjusted 
notional amounts. Here, our proposal is designed to address these 
concerns by proposing a lower derivatives exposure threshold while also 
allowing funds to adjust interest rate derivatives' notional amounts 
because the unadjusted values may be more likely to overstate a fund's 
market exposure.
---------------------------------------------------------------------------

    \285\ See, e.g., CFA Comment Letter (stating that the commenter 
did not believe it was ``appropriate that a fund with 40 or 45 
percent notional exposure should be viewed as having a limited 
amount of exposure obviating the requirement for that fund to 
implement a formal risk management program'' and that ``Section 18's 
limit reflects a congressional determination on the level of 
exposure funds may not exceed; it does not reflect the level of 
exposure at which funds should begin to establish formal risk 
management practices'').
---------------------------------------------------------------------------

    We also are not proposing to prohibit funds relying on the 
exception from entering into complex derivatives transactions as we 
proposed in 2015 because, as discussed in more detail below, we are 
proposing to require that limited derivatives users manage all of the 
risks associated with their derivatives transactions, including any 
complex derivatives transactions. In addition, if these or other 
complex or exotic derivatives were to embed multiple forms of 
optionality or other non-linearities such that the fund could not 
reliably compute the transaction's notional amount, the fund would not 
be able to confirm that its derivatives exposure is below 10% of the 
fund's net assets and therefore would not be able to rely on the 
limited derivatives user exception. Finally, if these complex 
derivatives transactions were to cause a fund's derivatives exposure to 
exceed 10% of the fund's net assets--or the fund were to exceed the 
limit for any other reason--the fund would have to reduce its 
derivatives exposure promptly or establish a derivatives risk 
management program and comply with the VaR-based limit on fund leverage 
risk as soon as reasonably practicable.
    We also considered an alternative approach to identifying funds 
that use derivatives in a limited way based on a fund's disclosure. 
Specifically, we considered providing that a fund would be a limited 
derivatives user if its principal investment strategies disclosed in 
its prospectus do not involve the use of derivatives.\286\ A fund that 
does not identify the use of derivatives in its principal investment 
strategies should generally be using derivatives less extensively than 
a fund that does include the use of derivatives as a principal 
investment strategy. This approach would provide some efficiencies for 
funds because they already are required to make this disclosure.\287\
---------------------------------------------------------------------------

    \286\ See, e.g., ICI Comment Letter III (stating that an 
appropriate threshold for limited derivatives users could be whether 
a fund listed derivatives in its prospectus as a principal 
investment strategy). Form N-1A requires an open-end fund to 
disclose its principal investment strategies, including the 
particular type or types of securities in which the fund principally 
invests or will invest. See Item 9 of Form N-1A. Form N-1A also 
provides, in part, that ``[i]n determining what is a principal 
investment strategy, consider, among other things, the amount of the 
Fund's assets expected to be committed to the strategy, the amount 
of the Fund's assets expected to be placed at risk by the strategy, 
and the likelihood of the Fund's losing some or all of those assets 
from implementing the strategy.'' See Instruction 2 to Item 9 of 
Form N-1A. Form N-2 requires a closed-end fund to concisely describe 
the fund's investment objectives and policies that will constitute 
its principal portfolio emphasis, including the types of securities 
in which the fund invests or will invest principally. See Item 8 of 
Form N-2. The instructions to this item direct the fund to briefly 
describe the significant investment practices or techniques that the 
fund employs or intends to employ with several examples, including 
examples related to derivatives transactions.
    \287\ See ICI Comment Letter III (stating that 92% of the firms 
surveyed indicated that their firms have funds that list derivatives 
as a principal investment strategy in their prospectus).
---------------------------------------------------------------------------

    This approach would, however, have certain drawbacks. For example, 
whether a fund's use of derivatives is a principal investment strategy 
is a facts-and-circumstances-based analysis. Funds that may appear 
broadly similar could provide different disclosures, leading to less 
consistency in the application of the derivatives risk management 
program requirement and in the application of the VaR-based limit on 
leverage risk.
    Taking these considerations into account, we are proposing to look 
at a uniform metric of a fund's derivatives exposure, rather than at 
the more fact-specific question of whether a fund views the use of 
derivatives as a principal investment strategy. We believe the proposed 
approach should result in more-consistent determinations by funds and 
would be more appropriate in determining whether a fund should qualify 
for the limited derivatives user exception.
    We request comment on the proposed exposure-based exception.
    147. Is it appropriate to permit funds to rely on the limited 
derivatives user exception if their derivatives exposure does not 
exceed 10% of their net assets? Why or why not? Should we lower or 
raise the proposed derivatives exposure threshold, for example to 5% or 
to 15%? Why or why not? Should we lower it to a de minimis amount, such 
as 1% or 3%, and provide that a fund with derivatives exposure below 
these levels is not required to adopt policies and procedures designed 
to manage derivatives risk? Should the threshold vary based on whether 
a fund is an open-end fund, registered closed-end fund, or BDC? If so, 
why, and which levels would be appropriate for each kind of fund?
    148. The derivatives exposure of certain types of transactions may 
be difficult to calculate or may change rapidly, which may make it 
difficult for a fund to consistently comply with the limited 
derivatives user exception. Should we provide that a fund relying on 
the limited derivatives user exception may not enter into complex or 
exotic derivatives transactions, whose risks may not be fully reflected 
in their notional amounts? If so, what kinds of complex or exotic 
transactions? For example, should we provide that a fund relying on the 
exception may not enter into complex derivatives transactions, as 
defined in the 2015 proposal? Should we only permit a fund to have a 
more-limited amount of derivatives exposure associated with these 
transactions, such as 1% or 5% of net assets? Why or why not?
    149. Should we prescribe how a fund must calculate its notional 
amounts, or is that term in the proposed rule sufficiently clear? If we 
should prescribe the calculation, what should we prescribe? For 
example, in 2015 the Commission proposed to define a derivatives 
transaction's notional amount to mean, among other things: (1) The 
market value of an equivalent position in the underlying reference 
asset for the derivatives transaction (expressed as a positive amount 
for both long and short positions); or (2) the principal amount on 
which payment obligations under the derivatives transaction are 
calculated. Should we include this definition in rule 18f-4? The 2015 
proposal also included specific provisions for calculating a 
derivatives transaction's notional amount for: (1) Derivatives that 
provide a return based on the leveraged performance of a reference 
asset; and (2) derivatives transactions for which the reference asset 
is a managed account or entity formed or operated primarily for the 
purpose of investing in or trading derivatives transactions, or an 
index that reflects the performance of such a managed account or 
entity.\288\ Should we include either or both of these provisions in 
rule 18f-4? Why or why not? Would funds calculate their notional 
amounts consistently with these provisions even if they were not 
included in the rule text because the calculations would be consistent 
with the way market participants determine

[[Page 4487]]

derivatives transactions' notional amounts?
---------------------------------------------------------------------------

    \288\ See 2015 Proposing Release, supra 2, at n.158 and 
accompanying text.
---------------------------------------------------------------------------

    150. Would funds be able to calculate notional amounts for complex 
derivatives and, if so, would they reflect the market risk in the 
transactions? Why or why? If we permit funds to enter into complex 
derivatives transactions as defined in the 2015 proposal while relying 
on the limited derivatives user exception, should we require that funds 
calculate these transactions' notional amounts as the Commission 
proposed in 2015? That proposal would have provided that the notional 
amount of a complex derivatives transaction would be the aggregate 
notional amounts of derivatives transactions (excluding complex 
derivatives transactions) reasonably estimated to offset substantially 
all of the market risk of the complex derivatives transaction.
    151. For purposes of determining a fund's derivatives exposure, 
should the proposed rule treat differently derivatives that create 
synthetic positions where the fund holds cash and cash equivalents with 
a value equal to the derivative's notional amount less any posted 
margin? These transactions may not leverage the fund's portfolio 
because of the fund's holding cash and cash equivalents equal to the 
notional amount of the derivatives transaction less any posted margin, 
rather than investing in additional securities or making other 
investments. Take, for example, a fund with $100 that posts $20 of 
initial margin to initiate a long position in a swap contract 
referencing a market index. If the fund posted cash and cash 
equivalents as initial margin and maintains the remaining $80 in cash 
and cash equivalents as well, the fund would have a market exposure 
that would be similar to having invested the fund's $100 in the stocks 
composing the index. Such a transaction could, however, present other 
risks, such as counterparty risk. Because these synthetic transactions 
may not leverage a fund's portfolio, should we permit a fund to exclude 
these transactions from its derivatives exposure? Conversely, because 
they can raise other risks, such as counterparty risks, should they be 
included in derivatives exposure as proposed?
    152. Should the rule define limited derivatives users using an 
alternative methodology other than the proposed threshold tied to 
derivatives exposure (or, as discussed below, for funds that use 
derivatives to hedge currency risks)? Why or why not? For example, 
should the limited derivatives user exception be defined to include 
funds that do not disclose the use of derivatives as a principal 
investment strategy in their prospectuses? Would this disclosure-based 
exception threshold be over- or under-inclusive? Would it lead to less 
consistency in the requirement to establish a derivatives risk 
management program and comply with a VaR-based limit on leverage risk 
and potentially create uncertainty for funds as to when they would 
qualify for the limited user exception? Why or why not? If this could 
lead to less consistency, would any additional instructions in funds' 
registration forms, regarding what a fund should disclose as a 
principal investment strategy in its prospectus, help mitigate this 
concern, and if so, what should those instructions be? Is it 
appropriate to tie an exception to the derivatives risk management 
program requirement and VaR-based limit on fund leverage risk to a 
prospectus disclosure requirement? Why or why not?
    153. Should the condition that a limited derivatives user's 
derivatives exposure not exceed 10% of the fund's net assets address 
exceedances and remediation? Why or why not? For example, as noted 
above, if a fund's derivatives exposure were to exceed 10% of the 
fund's net assets, the fund would have to promptly reduce its 
derivatives exposure or establish a derivatives risk management program 
and comply with the VaR-based limit on fund leverage risk as soon as 
reasonably practicable. Should we provide in rule 18f-4 specific time 
periods for these actions and, if so, which time periods would be 
appropriate? As an alternative way to address temporary exceedances, 
should the rule provide that a fund will be a limited derivatives user 
if it adopts a policy providing that, under normal circumstances, the 
fund's derivatives exposure will not exceed 10% of the fund's net 
assets? If so, what should be considered ``normal circumstances''? 
Would this standard be too subjective such that funds would have 
substantial derivatives exposures while still qualifying as limited 
derivatives users? Rather than a policy referring to ``normal 
circumstances,'' should we require a fund to disclose in its prospectus 
that it does not expect its derivatives exposure to exceed 10% of the 
fund's net assets? Should this disclosure also appear in the fund's 
annual report?
    154. Should we prohibit a fund whose derivatives exposure 
repeatedly exceeds 10% of net assets from relying on the exception 
again for a period of time? For example, if a fund were to exceed this 
limit more than two or three times in a year, should we provide that 
the fund cannot rely on the limited derivatives user exception for one 
or two years?
    155. In calculating derivatives exposure, should we permit a fund 
to convert the notional amount of interest rate derivatives to 10-year 
bond equivalents and delta adjust the notional amounts of options 
contracts, as proposed? Would delta adjusting options raise the concern 
that a fund's delta-adjusted options exposure would be small, allowing 
a fund to avoid establishing a program, but could quickly grow in 
response to large price changes in the option's reference asset? How 
should we address this concern? Should we permit additional 
adjustments? Why or why not? If so, what additional adjustments should 
we permit? For example, should we permit funds to adjust notional 
amounts based on the volatility of the underlying reference assets? Why 
or why not?
    156. The proposed rule provides that, for a fund to operate as a 
limited derivatives user under the exposure-based prong, the fund's 
derivatives exposure must not exceed 10% of net assets. The rule does 
not, however, prescribe the frequency with which funds must calculate 
their derivatives exposure to evaluate their compliance. Should we 
require that a fund calculate its notional amounts daily, or at some 
other specified frequency? Are there other requirements we should 
specify regarding a fund's calculation of its derivatives exposure? If 
so, what are they, and why would these other requirements more 
accurately address a fund's derivatives exposure?
    157. Should we permit a fund to adjust its derivatives exposure for 
purposes of the proposed exception to account for certain netting and 
hedging transactions? \289\ Why or why not? If so, how should we define 
netting and hedging transactions for this purpose? How should we 
prescribe in rule 18f-4 the circumstances under which different 
derivatives--and particularly derivatives with different reference 
assets--should be treated as hedged or offsetting? If the rule were to 
permit funds to exclude hedging or netting transactions from their 
derivatives exposure, should we require funds to maintain records 
concerning these transactions to help our staff and fund compliance 
personnel evaluate if the transactions reasonably could be viewed as 
hedging or netting? If so, what information should those records 
reflect? For example, the regulations under section 13 of the Bank 
Holding Company Act, commonly known as the Volcker Rule, require 
certain banking entities to maintain certain

[[Page 4488]]

documentation relating to hedging strategies, including positions and 
techniques.\290\ Should the proposed rule take this or a similar 
approach? As another example, should we require funds to identify both 
the asset being hedged or netted and the derivatives transaction used 
to hedge or net that asset? How should we consider the risk that the 
historical correlations underlying an adviser's view that assets will 
have inverse price correlations can break down in times of market 
stress? How could a standard in the rule be reasonably objective such 
that funds and our staff could confirm a fund's compliance? Should we 
permit funds to account for netting but not hedging or vice versa? Why 
or why not? Would the compliance burden to calculate netting and 
hedging transactions for purposes of such adjustments justify the 
benefits of permitting these adjustments? Why or why not? What other 
challenges could funds face in accounting for netting and hedging 
transactions that could increase the costs associated with this 
exercise, or that could negatively affect a fund's ability to assess 
its derivatives exposure accurately? Could these challenges be 
mitigated in any way? If so, how?
---------------------------------------------------------------------------

    \289\ See paragraph accompanying supra notes 266-267.
    \290\ See 17 CFR 255.5(c).
---------------------------------------------------------------------------

    158. Should we specify in the rule that a fund calculating its 
derivatives exposure may net any directly-offsetting derivatives 
transactions that are the same type of instrument and have the same 
underlying reference asset, maturity and other material terms, as we 
proposed in 2015? Why or why not?
    159. In determining a fund's derivatives exposure, or the level of 
derivatives exposure a fund may obtain while remaining a limited 
derivatives user, should we consider other types of investments, like 
structured notes, that have return profiles that are similar to many 
derivatives instruments? Take, for example, a fund with derivatives 
exposure exceeding the proposed 10% threshold by 2% that reallocates 
that 2% of its net asset value from a derivatives instrument to a 
structured note with a similar return profile. The fund would be a 
limited derivatives user on the basis that its derivatives exposure was 
below the threshold, but would present a similar risk profile to its 
prior portfolio that exceeded the threshold. Are there circumstances 
where we should require the fund in this example to include the value 
of the structured note (or similar investment) in determining its 
derivatives exposure? If so, which circumstances and what kinds of 
instruments should be included? As another alternative, should we 
provide that, when funds that invest in derivatives also invest in 
structured notes or similar investments, they should be subject to a 
lower threshold of derivatives exposure to remain a limited derivatives 
user? If so, what lower level would be appropriate?
2. Currency Hedging Exception
    Under the second alternative set of conditions, a fund could rely 
on the limited derivatives user exception if it limits its use of 
derivatives transactions to currency derivatives for hedging purposes 
as specified in the proposed rule.\291\ Under this exception, a fund 
could only use currency derivatives to hedge currency risk associated 
with specific foreign-currency-denominated equity or fixed-income 
investments in the fund's portfolio. In addition, the notional amount 
of the currency derivatives the fund holds could not exceed the value 
of the instruments denominated in the foreign currency by more than a 
negligible amount.\292\
---------------------------------------------------------------------------

    \291\ See proposed rule 18f-4(c)(3)(ii).
    \292\ Id.
---------------------------------------------------------------------------

    The proposed currency hedging exception reflects our view that 
using currency derivatives solely to hedge currency risk does not raise 
the policy concerns underlying section 18. While distinguishing most 
hedging transactions from leveraged or speculative transactions is 
challenging, we believe that the currency hedging described in the 
proposed rule is definable because it involves a single risk factor 
(currency risk) and requires that the derivatives instrument must be 
tied to specific hedged investments (foreign-currency-denominated 
securities held by the fund).\293\ Although we recognize that most 
funds that use derivatives do not use them solely to hedge currency 
risks, these currency hedges are not intended to leverage the fund's 
portfolio, and conversely could mitigate potential losses.\294\
---------------------------------------------------------------------------

    \293\ Many hedges are imperfect, which makes it difficult to 
distinguish purported hedges from leveraged or speculative 
exposures. See 2015 Proposing Release, supra 2, at n.238 and 
accompanying text.
    \294\ See infra section III.C.3 (discussing the number of funds 
whose current derivatives transactions practices would qualify them 
for the currency hedging exception).
---------------------------------------------------------------------------

    We also recognize that certain funds hedge all of the foreign 
currency risk associated with their foreign securities investments. A 
fund that invests all or substantially all of its assets in foreign 
securities and currency derivatives to hedge currency risks associated 
with the foreign securities necessarily would have derivatives exposure 
exceeding 10% of net asset value. This is because such a fund could 
have derivatives exposure up to approximately 100% of the fund's net 
assets to hedge the risks associated with all of its foreign security 
investments. We therefore are proposing a separate basis for the 
limited derivatives user exception for currency hedging because certain 
funds that hedge currency risks would be unable to qualify for the 
exposure-based limited derivatives user exception discussed above.
    Rather than proposing two alternative bases to qualify for the 
limited derivatives user exception, we considered permitting a fund to 
qualify as a limited derivatives user if its derivatives exposure does 
not exceed 10% of net assets, excluding any currency hedges as 
discussed above. We are not taking this combined approach, however, to 
preclude a fund that is operating as a limited derivatives user from 
engaging in a broad range of derivatives transactions that may raise 
risks that we believe should be managed through a derivatives 
management program and subject to the proposed VaR-based limit on fund 
leverage risk.
    We request comment on the proposed currency hedging exception.
    160. Is the proposed currency risk hedging exception appropriate? 
Why or why not? Should we modify the proposed exception in any way? Why 
or why not? For example, should we limit the derivatives exposure of a 
fund that relies on the currency hedging exception, and if so, what 
should be that exposure threshold? Should we prescribe the kinds of 
currency derivatives that a fund may use while relying on the 
exception? If so, which derivatives should be permitted and which 
should be prohibited and why? Should the rule refer to other foreign-
currency-denominated assets in addition to equity or fixed-income 
investments? For example, do funds hedge holdings of foreign currencies 
themselves in addition to foreign-currency-denominated investments?
    161. Are there other types of derivatives that funds use that are 
less likely to raise the policy concerns underlying section 18? If so, 
which derivatives, and how do funds use them? For instance, we are 
aware that funds use interest rate derivatives to hedge interest rate 
risk arising from fixed income investments in their portfolios. Should 
we modify the proposed hedging-based exception to also include interest 
rate derivatives that funds use for hedging purposes? Why or why not? 
If so, what challenges could funds encounter in identifying interest 
rate derivatives that are used for hedging purposes (instead of for 
speculation or to accomplish

[[Page 4489]]

leveraging)? How could we define interest rate hedging in rule 18f-4 in 
a way that would allow hedging transactions while not permitting 
transactions that simply are speculating on the direction of interest 
rates? How could conditions in the rule help identify interest rate 
derivatives that funds use for ``true'' hedging? For example, should we 
require that any interest rate derivative that is treated as a hedge be 
tied to specific fixed-income securities or groups of specific fixed-
income securities in the fund's portfolio? This would be analogous to 
the proposed nexus between a fund's currency derivatives and the fund's 
hedged foreign-currency-denominated investments. Should we similarly 
allow a fund to treat as a hedging transaction an interest rate 
derivative that converts a fund's fixed rate borrowings to floating 
rate borrowings or vice versa? To what extent do funds engage in these 
transactions? For funds that do engage in these transactions, how large 
are the notional amounts of these transactions, in ten-year bond 
equivalents, as a percentage of the fund's net assets?
    162. Should the rule address what happens if a fund using currency 
derivatives exceeds the notional amount of the value of the instruments 
denominated in a foreign currency by more than a negligible amount? If 
so, how should we address exceedances? Should we provide further 
guidance on what a negligible amount would be? For example, should we 
provide guidance or provide in rule 18f-4 that exceedances of 1% or 2%, 
for example, would be negligible?
    163. Should we permit funds that rely on the first alternative set 
of limited derivatives user conditions (limiting their derivatives 
exposure to 10% of net assets) to deduct the notional amounts of their 
currency derivatives used for hedging purposes when calculating their 
derivatives exposure for purposes of the proposed exception? Why or why 
not? Should we allow funds to rely on both exceptions at the same time, 
instead of the exceptions being alternatives? If the exceptions were 
combined, could that result in funds relying on the limited derivatives 
user exception developing larger and potentially more complex 
derivatives portfolios that that may raise risks more appropriately 
managed through a derivatives management program and subject to the 
proposed VaR-based limit on fund leverage risk? Why or why not?
3. Risk Management
    A fund relying on the limited derivatives user exception would be 
required to manage the risks associated with its derivatives 
transactions by adopting and implementing policies and procedures that 
are reasonably designed to manage the fund's derivatives risks.\295\ 
The requirement that funds relying on the exception manage their 
derivatives risks recognizes that even a limited use of derivatives can 
present risks that should be managed.
---------------------------------------------------------------------------

    \295\ See proposed rule 18f-4(c)(3); see also proposed rule 18f-
4(a) (definition of ``derivatives risks'') and supra note 118 and 
accompanying text (discussing the proposed definition of 
``derivatives risks'').
---------------------------------------------------------------------------

    For example, a fund that uses derivatives solely to hedge currency 
risks would not be introducing leverage risk, but could still introduce 
other risks, including counterparty risk and the risk that a fund could 
be required to sell its investments to meet margin calls. As another 
example, certain derivatives, and particularly derivatives with non-
linear or path-dependent returns, may pose risks that require 
monitoring even when the derivatives represent a small portion of net 
asset value. For example, because of the non-linear payout profiles 
associated with put and call options, changes in the value of the 
option's underlying reference asset can increase the option's delta, 
and thus the extent of the fund's derivatives exposure from the option. 
An options transaction that represented a small percentage of a fund's 
net asset value can rapidly increase to a larger percentage.
    The proposed rule would require funds relying on the limited 
derivatives user exception to adopt and implement policies and 
procedures reasonably designed to manage the funds' derivatives risks. 
Because they would be reasonably designed to address each fund's 
derivatives risks, these policies and procedures would reflect the 
extent and nature of a fund's use of derivatives within the parameters 
provided in the exception. For example, a fund that uses derivatives 
only occasionally and for a limited purpose, such as to equitize cash, 
could have limited policies and procedures commensurate with this 
limited use. A fund that uses more complex derivatives with derivatives 
exposure approaching 10% of net asset value, in contrast, would need to 
have policies and procedures tailored to the risks these derivatives 
could present. These policies and procedures could be more extensive 
and could include elements similar to those required under the proposed 
derivatives risk management program.
    The 2015 proposal would have required funds relying on that 
proposal's exception to the derivatives risk management program 
requirement to manage derivatives risks by determining (and maintaining 
certain assets to cover) a ``risk-based coverage amount'' associated 
with the fund's derivatives. This amount represented an estimate of the 
amount the fund would expect to pay to exit the derivatives transaction 
under stressed conditions.
    The approach we are proposing here is designed to require a fund 
relying on the limited derivatives user exception to manage all of the 
risks associated with its derivatives transactions, and not just the 
risks that an asset segregation requirement could address.\296\ 
Moreover, our proposal is designed to limit derivatives risks by 
limiting the extent to which a fund can use derivatives while relying 
on the exception. As discussed above, the 2015 proposal would have 
permitted funds to obtain substantially greater derivatives exposure--
up to 50% of net assets--without establishing a derivatives risk 
management program. On balance, we believe that the proposed bases for 
the limited derivatives user exception, together with the requirement 
that a fund manage any risks its limited use of derivatives presents, 
would provide both important investor protections and flexibility for 
funds to use derivatives in a way that is consistent with the policy 
concerns underlying section 18.
---------------------------------------------------------------------------

    \296\ We discuss the limitations of an asset segregation 
requirement in section II.F below.
---------------------------------------------------------------------------

    We request comment on the proposed requirement that a fund relying 
on the limited derivatives user exception manage the risks associated 
with its derivatives transactions by adopting policies and procedures 
that are reasonably designed to manage its derivatives risks.
    164. Is it appropriate to require funds relying on the limited 
derivatives user exception to adopt policies and procedures that are 
reasonably designed to manage their derivatives risks, in lieu of 
requiring such a fund to adopt a derivatives risk management program 
that includes all of the proposed program elements and comply with the 
proposed VaR-based limit on fund leverage risk? Would this requirement 
effectively address the risks entailed by the levels and types of 
derivatives use in which a fund that qualifies for the proposed 
exception might engage?
    165. Alternatively, should funds eligible for the proposed limited 
derivatives user exception be subject to a tailored version of the 
proposed program requirement (e.g., a program requirement that would 
specify only certain elements, such as risk identification and 
assessment, establishing risk guidelines, stress

[[Page 4490]]

testing, etc.)? If so, if so what should this entail?
    166. Either in addition to or in lieu of policies and procedures 
reasonably designed to manage a fund's derivatives risk, should we 
require funds relying on the limited derivatives user exception to 
comply with an asset segregation requirement? Should we use the same 
approach we proposed in 2015? Should we use that approach but allow 
funds to segregate a broader range of assets, such as the assets with 
corresponding haircuts analyzed in the 2016 DERA Memo?
    167. Should we require limited derivatives users to publicly 
disclose that they are limited derivatives users in their prospectus, 
annual report, or on their website? If so, should we require any 
particular disclosure to enhance investors' understanding of, for 
example: (1) The risks of investing in a fund that qualifies as a 
limited derivatives user under the proposed rule, or (2) such a fund's 
derivatives risk management practices?

F. Asset Segregation

    The Commission and staff have historically taken the position that 
a fund may appropriately manage the risks that section 18 is designed 
to address if the fund ``covers'' its obligations in connection with 
various transactions by maintaining ``segregated accounts.'' \297\ 
Funds' practices regarding the amount of ``cover'' they segregate, and 
the assets available for segregation, have evolved over time. In 
addition, different funds have applied those practices in varying ways 
to derivatives transactions with comparable economic exposures. 
Moreover, regulatory and contractual margin requirements have developed 
significantly since the adoption of Release 10666.
---------------------------------------------------------------------------

    \297\ See supra section I.B.2.
---------------------------------------------------------------------------

    The 2015 proposal drew on the Commission's historical approach--and 
sought to primarily address the Investment Company Act's asset 
sufficiency concern--by including an asset segregation requirement as 
part of the 2015 proposed rule.\298\ Under the Commission's 2015 
proposed approach, a fund relying on the proposed rule, in addition to 
complying with one of two portfolio limitations, would have had to 
maintain an amount of ``qualifying coverage assets'' designed to enable 
a fund to meet its derivatives-related obligations. Under the 2015 
proposed rule, a fund would not have been required to segregate a 
derivative's full notional amount, but instead would have had to 
segregate qualifying coverage assets (generally cash and cash 
equivalents) equal to the sum of two amounts: (1) The amount that would 
be payable by the fund if the fund were to exit the derivatives 
transaction at the time of determination (the ``mark-to-market coverage 
amount''), and (2) a reasonable estimate of the potential amount 
payable by the fund if the fund were to exit the derivatives 
transaction under stressed conditions (the ``risk-based coverage 
amount'').\299\
---------------------------------------------------------------------------

    \298\ See 2015 Proposing Release supra note 2, at section III.C.
    \299\ See id. at section III.C.2 (discussing the composition of 
qualifying coverage assets as either: (1) Cash and cash equivalents, 
or (2) with respect to any derivatives transaction under which the 
fund may satisfy its obligations under the transaction by delivering 
a particular asset, that particular asset).
---------------------------------------------------------------------------

    Although commenters generally supported the overarching framework 
of the 2015 proposed rule's asset segregation requirement, they 
identified several operational complexities. For example, commenters 
stated that additional clarity was necessary for funds to determine 
risk-based coverage amounts, including how funds should determine 
stressed conditions for this purpose.\300\ Commenters also raised 
questions about how funds could reduce segregated amounts to account 
for posted initial or variation margin and, more generally, how rule 
provisions governing coverage amounts would apply to cleared 
transactions (as opposed to OTC transactions covered by netting 
agreements).\301\ A number of commenters also expressed concerns about 
the proposed requirement that funds generally segregate cash and cash 
equivalents.\302\ Commenters suggested alternatives to this proposed 
requirement, including allowing funds to segregate a broader range of 
assets subject to ``haircuts'' prescribed by the Commission based on 
the relative volatility of different asset classes.\303\
---------------------------------------------------------------------------

    \300\ See, e.g., ICI Comment Letter I; BlackRock Comment Letter; 
Dechert Comment Letter; FSR Comment Letter; Guggenheim Comment 
Letter.
    \301\ See, e.g., SIFMA Comment Letter (stating that ``[i]n 
practice, variation margin and initial margin are often calculated 
in the aggregate, on a net basis, rather than separately'' and 
recommending that funds ``be able to get credit for both initial and 
variation margin posted on a net basis . . .'' rather than limiting 
the type of coverage amount against which initial or variation 
margin may be credited); BlackRock Comment Letter (stating that 
initial and variation margin are used for cleared and OTC 
derivatives transactions by the clearinghouse and counterparties, 
respectively, when a derivatives transaction is exited and that 
distinguishing between the uses of the two types of margin will 
introduce complexity given that both forms of margin are available 
to cover potential obligations under derivatives in the event of a 
party's default).
    \302\ See, e.g., AIMA Comment Letter; AQR Comment Letter; 
BlackRock Comment Letter; Dechert Comment Letter; Comment Letter of 
Eaton Vance Management (Mar. 28, 2016) (``Eaton Vance Comment 
Letter''); Guggenheim Comment Letter; Comment Letter of JPMorgan 
(Mar. 28, 2016); Oppenheimer Comment Letter; PIMCO Comment Letter.
    \303\ See, e.g., Dechert Comment Letter; Eaton Vance Comment 
Letter; IAA Comment Letter; SIFMA Comment Letter, Guggenheim Comment 
Letter.
---------------------------------------------------------------------------

    Our proposal does not include a specific asset segregation 
requirement because we do not believe that an asset segregation 
requirement is necessary in light of the proposed rule's requirements, 
including the requirements that funds establish risk management 
programs and comply with the proposed VaR-based limit on fund leverage 
risk. As discussed in more detail above, a fund relying on proposed 
rule 18f-4 would be required to adopt and implement a written 
derivatives risk management program that, among other things, would 
require the fund to: Identify and assess its derivatives risks; put in 
place guidelines to manage these risks; stress test the fund's 
portfolio at least weekly; and escalate material risks to the fund's 
portfolio managers and, as appropriate, the board of directors.\304\ 
These proposed requirements are designed to require a fund to manage 
all of the risks associated with its derivatives transactions. These 
include--but are not limited to--the risk that a fund may be required 
to sell its investments to generate cash to pay derivatives 
counterparties, which the 2015 proposal's asset segregation was 
designed to address.
---------------------------------------------------------------------------

    \304\ Proposed rule 18f-4(c)(1). Funds that rely on the limited 
derivatives user exception also would be required to manage the 
risks associated with their more limited use of derivatives. See 
supra section II.E.
---------------------------------------------------------------------------

    Moreover, the proposed rule would require that a fund's stress 
testing for purposes of its derivatives management program specifically 
take into account the fund's payments to derivatives counterparties 
that could result from losses in stressed conditions. Rather than 
require a fund to evaluate the amounts it would pay to exit derivatives 
transactions under stressed conditions on a transaction-by-transaction 
basis as in the 2015 proposal,\305\ our proposal would require funds to 
conduct portfolio-wide stress tests, taking into account potential 
payments to counterparties. Although counterparties often require funds 
to post margin or collateral for individual transactions (or groups of 
transactions) in order to cover potential loss exposure, the proposed

[[Page 4491]]

rule's stress testing requirement is designed to provide a portfolio-
wide assessment of how the fund may respond to stressed conditions and 
any resulting payment obligations. This portfolio-wide assessment also 
would be buttressed by the other provisions in the risk management 
program and the proposed VaR-based limit on fund leverage risk, which 
are designed to limit a fund's leverage risk and therefore the 
potential for payments to derivatives counterparties. The 2015 
proposal's derivatives risk management program, in contrast, did not 
include such a portfolio-wide assessment. We believe that the proposed 
rule's requirements, in their totality, would appropriately address the 
asset sufficiency risks underlying section 18.
---------------------------------------------------------------------------

    \305\ In the 2015 proposal, funds were required to determine 
qualifying coverage assets on a transaction-by-transaction basis, 
with the exception that funds could determine the amount of 
qualifying coverage assets on a net basis for derivatives 
transactions covered by netting agreements. See 2015 proposed rule 
18f-4(c)(6) and (9).
---------------------------------------------------------------------------

    A separate asset segregation requirement, in contrast, may be less 
effective. As derivatives markets evolve, questions may arise about the 
amount (and composition) of assets that funds must segregate for novel 
types of transactions. Although the Commission in 2015 sought to take a 
principles-based approach to the amount of assets that funds would 
segregate, many commenters asserted that additional clarity would be 
necessary to administer this approach. It would be difficult in this 
context for the Commission to specify the amount of assets that funds 
should segregate on a transaction-by-transaction basis and to keep any 
specific requirements current as markets develop. And a principles-
based approach to asset segregation, if it does not provide sufficient 
clarity, may contribute to the kinds of divergent asset segregation 
practices that exist today, which in turn have led to situations in 
which funds are not subject to a practical limit on potential leverage 
that they may obtain through derivatives transactions.\306\ By building 
on current risk management practices and techniques, including VaR and 
stress testing, the proposed rule is designed to provide a framework 
that we believe funds can apply to a broad variety of fund types and 
derivatives uses without our having to specify the operational details 
that an asset segregation requirement would entail.
---------------------------------------------------------------------------

    \306\ See supra sections I.B.2 and I.B.3.
---------------------------------------------------------------------------

    We request comment on our proposal not to include a specific asset 
segregation requirement.
    168. Do commenters believe that the proposed rule's requirements 
discussed above, in their totality, would appropriately address the 
asset sufficiency risks underlying section 18? If not and commenters 
believe rule 18f-4 should include an asset segregation requirement, 
what should that requirement entail? What added benefits would an asset 
segregation requirement provide that the current proposed rule 
requirements would not?
    169. Should we require funds relying on the limited derivatives 
user exposure-based exception to segregate assets for purposes of the 
exception? Why or why not? Would an asset segregation requirement for 
such limited derivatives users obviate any need for a policies and 
procedures requirement? Why or why not?
    170. Commenters in the 2015 release requested further clarity about 
the Commission's 2015 proposal to require a principles-based asset 
segregation regime. What aspect of that proposal required further 
clarity and why?

G. Alternative Requirements for Certain Leveraged/Inverse Funds and 
Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment 
Vehicles

1. Background on Proposed Approach to Certain Leveraged/Inverse Funds
    Proposed rule 18f-4 would include an alternative approach for 
certain funds that seek to provide leveraged or inverse exposure to an 
underlying index, generally on a daily basis. This alternative approach 
would be available for a registered investment company that is a 
``leveraged/inverse investment vehicle,'' as that term is defined in 
proposed Exchange Act rule 15l-2 and proposed Advisers Act rule 211(h)-
1 (which we refer to collectively as the proposed ``sales practices 
rules,'' as noted above). As discussed below, the proposed sales 
practices rules would require broker-dealers and investment advisers to 
engage in due diligence before accepting or placing an order for a 
customer or client that is a natural person (``retail investor'') to 
trade a leveraged/inverse investment vehicle, or approving a retail 
investor's account for such trading. The definition of the term 
``leveraged/inverse investment vehicle'' in the proposed sales 
practices rules would include certain entities that seek, directly or 
indirectly, to provide investment returns that correspond to the 
performance of a market index by a specified multiple, or to provide 
investment returns that have an inverse relationship to the performance 
of a market index, over a predetermined period of time.\307\ The 
entities included in the proposed scope of the sales practices rules 
would include registered investment companies and certain exchange-
listed commodity- or currency-based trusts or funds. In this release, 
we refer to the registered investment companies covered by the proposed 
sales practices rules as ``leveraged/inverse funds'' (which in turn 
would be subject to the proposed alternative approach under rule 18f-
4). We use the proposed sales practices rules' defined term 
``leveraged/inverse investment vehicle'' to refer to both such 
leveraged/inverse funds and to the exchange-listed commodity- or 
currency-based trusts or funds covered by those rules.
---------------------------------------------------------------------------

    \307\ See proposed rules 15l-2(d) and 211(h)-1(d) (defining the 
term ``leveraged/inverse investment vehicle''); see also, e.g., ETFs 
Adopting Release, supra note 76, at section II.A.3; rule 6c-11(c)(3) 
under the Investment Company Act.
---------------------------------------------------------------------------

    Leveraged/inverse funds, which today are structured primarily as 
leveraged/inverse ETFs, seek to amplify the returns of an underlying 
index by a specified multiple or to profit from a decline in the value 
of their underlying index over a predetermined period of time using 
financial derivatives.\308\ These funds reset periodically and are 
designed to hedge against or profit from short-term market movements 
without using margin, and, as such, are generally intended as short-
term trading tools.\309\ To achieve their targeted returns, leveraged/
inverse funds use derivatives extensively. In contrast to other funds 
that use derivatives as part of their broader investment strategy, 
leveraged/inverse funds' strategies (and use of derivatives) are 
predicated on leverage. Accordingly, leveraged/inverse funds raise the 
issues that section 18 of the

[[Page 4492]]

Investment Company Act is designed to address.
---------------------------------------------------------------------------

    \308\ See infra section III.B for baseline statistics regarding 
leveraged/inverse ETFs and mutual funds. Leveraged/inverse ETFs 
operate under Commission orders providing exemptive relief from 
certain provisions of the Investment Company Act. These orders, 
however, do not provide exemptive relief from section 18 of the 
Investment Company Act. Rather, like other funds that use derivative 
investments, leveraged/inverse ETFs rely upon Release 10666 and 
operate consistent with the conditions in staff no-action letters 
and other staff guidance on derivatives transactions. See infra 
section II.L (discussing our proposal to rescind Release 10666, and 
stating that staff in the Division of Investment Management is 
reviewing certain of its no-action letters and other guidance to 
determine which letters and other staff guidance should be withdrawn 
in connection with any adoption of this proposal).
    The Commission recently adopted rule 6c-11 under the Investment 
Company Act to permit ETFs that satisfy certain conditions to 
operate without obtaining an exemptive order from the Commission. 
Rule 6c-11 includes a provision excluding leveraged/inverse ETFs 
from the scope of that rule. See infra section II.G.4 (discussing 
proposed amendments to rule 6c-11 and proposed rescission of 
exemptive orders issued to leveraged/inverse ETFs).
    \309\ See Commission Interpretation Regarding Standard of 
Conduct for Investment Advisers, Investment Advisers Act Release No. 
5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at text preceding 
n.39 (``Fiduciary Interpretation'').
---------------------------------------------------------------------------

    Leveraged/inverse funds and certain commodity pools following the 
same strategy also present unique considerations because they rebalance 
their portfolios on a daily (or other predetermined) basis in order to 
maintain a constant leverage ratio. This reset, and the effects of 
compounding, can result in performance over longer holding periods that 
differs significantly from the leveraged or inverse performance of the 
underlying reference index over those longer holding periods.\310\ This 
effect can be more pronounced in volatile markets.\311\ As a result, 
buy-and-hold investors in a leveraged/inverse fund who have an 
intermediate or long-term time horizon--and who may not evaluate their 
portfolios frequently--may experience large and unexpected losses or 
otherwise experience returns that are different from what they 
anticipated.\312\
---------------------------------------------------------------------------

    \310\ For example, as a result of compounding, a leveraged/
inverse fund can outperform a simple multiple of its index's returns 
over several days of consistently positive returns, or underperform 
a simple multiple of its index's returns over several days of 
volatile returns.
    \311\ See FINRA Regulatory Notice 09-31, Non-Traditional ETFs--
FINRA Reminds Firms of Sales Practice Obligations Relating to 
Leveraged and Inverse Exchange-Traded Funds (June 2009) (``FINRA 
Regulatory Notice 09-31'') (``Using a two-day example, if the index 
goes from 100 to close at 101 on the first day and back down to 
close at 100 on the next day, the two-day return of an inverse ETF 
will be different than if the index had moved up to close at 110 the 
first day but then back down to close at 100 on the next day. In the 
first case with low volatility, the inverse ETF loses 0.02 percent; 
but in the more volatile scenario the inverse ETF loses 1.82 
percent. The effects of mathematical compounding can grow 
significantly over time, leading to scenarios such as those noted 
above.'').
    \312\ See id. (reminding member firms of their sales practice 
obligations relating to leveraged/inverse ETFs and stating that 
leveraged/inverse ETFs are typically not suitable for retail 
investors who plan to hold these products for more than one trading 
session). See also Fiduciary Interpretation, supra note 308 (stating 
that ``leveraged exchange-traded products are designed primarily as 
short-term trading tools for sophisticated investors . . . [and] 
require daily monitoring . . . .''); Securities Litigation and 
Consulting Group, Leveraged ETFs, Holding Periods and Investment 
Shortfalls, (2010), at 13 (``The percentage of investors that we 
estimate hold [leveraged/inverse ETFs] longer than a month is quite 
striking.''); ETFs Adopting Release, supra note 76, at n.78 
(discussing comment letters submitted by Consumer Federation of 
America (urging the Commission to consider additional investor 
protection requirements for leveraged/inverse ETFs) and by Nasdaq 
(stating that ``there is significant investor confusion regarding 
existing leveraged/inverse ETFs' daily investment horizon'')).
---------------------------------------------------------------------------

    The Commission's Office of Investor Education and Advocacy and 
FINRA have issued alerts in the past decade to highlight issues 
investors should consider when investing in leveraged/inverse 
funds.\313\ In addition, some commenters to the 2015 proposal indicated 
that at least some segment of investors may hold leveraged/inverse 
funds for long periods of time, which can lead to significant losses 
under certain circumstances.\314\ FINRA has sanctioned a number of 
brokerage firms for making unsuitable sales of leveraged/inverse 
ETFs.\315\ More recently, the Commission has brought enforcement 
actions against investment advisers for, among other things, soliciting 
advisory clients to purchase leveraged/inverse ETFs for their 
retirement accounts with long-term time horizons, and holding those 
securities in the client accounts for months or years.\316\
---------------------------------------------------------------------------

    \313\ SEC Investor Alert and Bulletins, Leveraged and Inverse 
ETFs: Specialized Products with Extra Risks for Buy-and-Hold 
Investors (Aug. 1, 2009), available at https://www.sec.gov/investor/pubs/leveragedetfs-alert.htm. This investor alert, jointly issued by 
SEC staff and FINRA, followed FINRA's June 2009 alert, which raised 
concerns about retail investors holding leveraged/inverse ETFs over 
periods of time longer than one day. See FINRA Regulatory Notice 9-
31, supra note 310.
    \314\ See, e.g., CFA Comment Letter (``There is evidence that 
suggests investors are incorrectly using certain alternative 
investments that use derivatives extensively. For example, despite 
the fact that double and triple leveraged ETFs are short-term 
trading vehicles that are not meant to be held longer than one day, 
a significant number of shares are held for several days, if not 
weeks.''). But cf. Comment Letter of Rafferty Asset Management (Mar. 
28, 2016) (asserting that there is no evidence that investors do not 
understand the leveraged/inverse ETF product, citing, for example, 
an analysis of eight of its leveraged/inverse ETFs between May 1, 
2009 and July 31, 2015, and finding an average implied holding 
period ranging from 1.18 days to 4.03 days and suggesting, 
therefore, that investors understand the products are designed for 
active trading). We note, however, that the analysis relied upon in 
the Comment Letter of Rafferty Asset Management did not analyze 
shareholder-level trading activity or provide any information on the 
distribution of shareholder holding periods.
    \315\ See FINRA News Release, FINRA Sanctions Four Firms $9.1 
Million for Sales of Leveraged and Inverse Exchange-Traded Funds 
(May 1, 2012), available at https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus 
and Century Securities to Pay Fines and Restitution Totaling More 
Than $1 Million for Unsuitable Sales of Leveraged and Inverse ETFs, 
and Related Supervisory Deficiencies (Jan. 9, 2014), available at 
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-fines-and-restitution-totaling; FINRA 
News Release, FINRA Sanctions Oppenheimer & Co. $2.9 Million for 
Unsuitable Sales of Non-Traditional ETFs and Related Supervisory 
Failures (June 8, 2016), available at https://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of 
Acceptance, Waiver and Consent (``AWC'') No. 2014039418801 (Aug. 8, 
2016), available at https://disciplinaryactions.finra.org/Search/ViewDocument/66461; Citigroup Global Markets Inc., FINRA Letter of 
AWC No. 20090191134 (May, 1, 2012), available at https://disciplinaryactions.finra.org/Search/ViewDocument/31714. See also 
Regulation Best Interest: The Broker-Dealer Standard of Conduct, 
Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12, 
2019)], at paragraph accompanying nn.593-98 (``Regulation Best 
Interest: The Broker-Dealer Standard of Conduct''). See also, e.g., 
SEC. v. Hallas, No 1:17-cv-2999 (S.D.N.Y. Sept. 27, 2017) (default 
judgement); In the Matter of Demetrios Hallas, SEC. Release No. 1358 
(Feb. 22, 2019) (initial decision), Exchange Act Release No 85926 
(May 23, 2019) (final decision) (involving a former registered 
representative of registered broker-dealers purchasing and selling 
leveraged ETFs and exchange-traded notes for customer accounts while 
knowingly or recklessly disregarding that they were unsuitable for 
these customers, in violation of section 17(a) of the Securities Act 
and section 10(b) and rule 10b-5 thereunder of the Exchange Act).
    \316\ See, e.g., In the Matter of Morgan Stanley Smith Barney, 
LLC, Investment Advisers Act Release No. 4649 (Feb. 14, 2017) 
(settled action).
---------------------------------------------------------------------------

    Most leveraged/inverse funds could not satisfy the limit on fund 
leverage risk in proposed rule 18f-4 because they provide leveraged or 
inverse market exposure exceeding 150% of the return or inverse return 
of the relevant index.\317\ These funds therefore would fail the 
relative VaR test and would not be eligible to use the absolute VaR 
test.\318\ Requiring these funds to comply with the proposed VaR tests 
therefore effectively would preclude sponsors from offering the funds 
in their current form. Investors who are capable of evaluating these 
funds' characteristics and their unique risks, however, may want to use 
them to meet specific short-term or other investment goals. We 
therefore are proposing a set of alternative requirements for 
leveraged/inverse funds designed to address the investor protection 
concerns that underlie section 18 of the Investment Company Act, while 
preserving choice for these investors. These requirements, discussed 
below, are designed to help ensure that retail investors in leveraged/
inverse investment vehicles are limited to those who are capable of 
evaluating the risks these products present. They also would limit the 
amount of leverage that leveraged/inverse funds subject to rule 18f-4 
can obtain to their current levels.
---------------------------------------------------------------------------

    \317\ See supra section II.D (discussing the proposed VaR-based 
limit on fund leverage risk).
    \318\ See supra section II.D (discussing relative and absolute 
VaR tests under proposed rule 18f-4). In addition, we understand 
that even if leveraged/inverse funds were to apply the proposed 
absolute VaR test, many of those funds also would fail that test.
---------------------------------------------------------------------------

2. Proposed Sales Practices Rules for Leveraged/Inverse Investment 
Vehicles
    As a complement to proposed rule 18f-4, we are proposing sales 
practices rules under the rulemaking authority provided in Exchange Act 
section 15(l)(2) and Advisers Act section

[[Page 4493]]

211(h).\319\ The proposed sales practices rules would require broker-
dealers and investment advisers to exercise due diligence on retail 
investors before approving retail investor accounts to invest in 
leveraged/inverse investment vehicles. Specifically, proposed rule 15l-
2 under the Exchange Act would require a broker-dealer (or any 
associated person of the broker-dealer) to exercise due diligence to 
ascertain certain essential facts about a customer who is a retail 
investor before accepting the customer's order to buy or sell shares of 
a leveraged/inverse investment vehicle, or approving the customer's 
account to engage in those transactions.\320\ Similarly, proposed rule 
211(h)-1 under the Advisers Act would require an investment adviser (or 
any supervised person of the investment adviser) to exercise due 
diligence to ascertain the same set of essential facts about a client 
who is a retail investor before placing an order for that client's 
account to buy or sell shares of a leveraged/inverse investment 
vehicle, or approving the client's account to engage in those 
transactions.\321\ Under both of the proposed sales practices rules, a 
firm could approve the retail investor's account to buy or sell shares 
of leveraged/inverse investment vehicles only if the firm had a 
reasonable basis to believe that the investor is capable of evaluating 
the risks associated with these products.
---------------------------------------------------------------------------

    \319\ These provisions provide the Commission with authority to 
``where appropriate, promulgate rules prohibiting or restricting 
certain sales practices, conflicts of interest, and compensation 
schemes for brokers, dealers, and investment advisers that the 
Commission deems contrary to the public interest and the protection 
of investors.''
    \320\ Proposed rule 15l-2(a). In this release, the term 
``firm,'' which collectively refers to Commission-registered broker-
dealers and investment advisers, also includes associated persons of 
such broker-dealers.
    \321\ Proposed rule 211(h)-1(a). In this release, the term 
``firm,'' which collectively refers to Commission-registered broker-
dealers and investment advisers, also includes supervised persons of 
such investment advisers.
---------------------------------------------------------------------------

    The proposed sales practices rules are designed to establish a 
single, uniform set of enhanced due diligence and approval requirements 
for broker-dealers and investment advisers with respect to retail 
investors that engage in leveraged/inverse investment vehicle 
transactions, including transactions where no recommendation or 
investment advice is provided by a firm. These rules therefore would 
apply the same due diligence requirements to both broker-dealers and 
investment advisers.\322\ They are designed to help ensure that 
investors in these funds are limited to those who are capable of 
evaluating their characteristics--including that the funds would not be 
subject to all of the leverage-related requirements applicable to 
registered investment companies generally--and the unique risks they 
present. Compliance with the proposed rules would not supplant or by 
itself satisfy other broker-dealer or investment adviser obligations, 
such as a broker-dealer's obligations under Regulation Best Interest or 
an investment adviser's fiduciary duty under the Advisers Act.\323\
---------------------------------------------------------------------------

    \322\ Although we expect that the proposed sales practices rules 
would cover a significant percentage of the retail investors who 
invest in leveraged/inverse investment vehicles, we recognize that 
not every purchase or sale of a leveraged/inverse investment vehicle 
will involve a customer or client of a Commission-registered broker-
dealer or investment adviser that would be subject to the proposed 
sales practices rules.
    \323\ See Regulation Best Interest: The Broker-Dealer Standard 
of Conduct, supra note 314 (discussing broker-dealer obligations 
when providing a recommendation to a retail customer of any 
securities transaction or investment strategy involving securities 
based on the customer's investment profile); Fiduciary 
Interpretation, supra note 308 (discussing an investment adviser's 
fiduciary duty to its client, and stating that as fiduciaries, 
investment advisers owe their clients duties of care and loyalty).
---------------------------------------------------------------------------

    The approval and due diligence requirements under the proposed 
rules are modeled after current FINRA options account approval 
requirements for broker-dealers.\324\ Under the FINRA rules governing 
options, a broker-dealer may not accept a customer's options order 
unless the broker-dealer has approved the customer's account for 
options trading.\325\ Similarly, the proposed sales practices rules 
would require that a firm approve a retail investor's account before 
the retail investor may invest in leveraged/inverse investment 
vehicles. As such, the proposed sales practices rules, like the FINRA 
rule, would not require firms to evaluate retail investors' eligibility 
to transact in these products on a transaction-by-transaction basis. We 
have generally modeled the proposed rules after the FINRA options 
account framework in part because leveraged/inverse investment 
vehicles, when held over longer periods of time, may have certain 
similarities to options.\326\ The options account approval requirements 
also represent a current framework that can be used in connection with 
complex products generally.\327\ This approach may provide some 
efficiencies and reduced compliance costs for broker-dealers that 
already have compliance procedures in place for approving options 
accounts, although we recognize that these efficiencies and reduced 
compliance costs would not apply to investment advisers that are not 
dually registered as, or affiliated with, broker-dealers subject to 
FINRA rules.
---------------------------------------------------------------------------

    \324\ See, e.g., FINRA rule 2360(b)(16), (17) (requiring for 
options accounts, firm approval, diligence and recordkeeping).
    \325\ FINRA rule 2360(b)(16). The same requirements apply for 
transactions in index warrants, currency index warrants, and 
currency warrants. See FINRA rules 2352 and 2353. Similar 
requirements apply for transactions in security futures. See FINRA 
rule 2370(b)(16) (requiring broker-dealer approval and diligence 
regarding the opening of accounts to trade security futures).
    \326\ For example, both leveraged/inverse investment vehicles 
and options provide exposure that is economically equivalent to a 
dynamically rebalanced inverse or leveraged position in an 
underlying asset. As a result, both have return characteristics that 
are more complex than those of the underlying asset, particularly as 
a leveraged/inverse investment vehicle's leverage multiple and/or 
holding period increase. See infra section III.B.5.
    \327\ See FINRA Regulatory Notice 12-03 (providing, among other 
things, that FINRA members ``should consider prohibiting their sales 
force from recommending the purchase of some complex products to 
retail investors whose accounts have not been approved for options 
trading'').
---------------------------------------------------------------------------

a. Definition of Leveraged/Inverse Investment Vehicle
    The proposed sales practices rules would define a ``leveraged/
inverse investment vehicle'' to mean a registered investment company or 
an exchange-listed commodity- or currency-based trust or fund (a 
``listed commodity pool''), that seeks, directly or indirectly, to 
provide investment returns that correspond to the performance of a 
market index by a specified multiple, or to provide investment returns 
that have an inverse relationship to the performance of a market index, 
over a predetermined period of time.\328\ Although the scope of this 
definition extends beyond just ETFs (as defined in rule 6c-11), this 
definition otherwise is substantively identical to the provision in 
rule 6c-11 excluding leveraged/inverse ETFs from the scope of that 
rule. The substantive requirements in the proposed definition in the 
sales practices rules have the same meaning as the provision in rule 
6c-11.\329\
---------------------------------------------------------------------------

    \328\ See proposed rule 15l-2(d) and proposed rule 211(h)-1(d).
    \329\ See rule 6c-11(c)(4) (providing that scope of rule 6c-11 
does not include ETFs that ``seek, directly or indirectly, to 
provide investment returns that correspond to the performance of a 
market index by a specified multiple, or to provide investment 
returns that have an inverse relationship to the performance of a 
market index, over a predetermined period of time.''). See also ETFs 
Adopting Release, supra note 76, at section II.A.3 (discussing rule 
6c-11(c)(4)).
---------------------------------------------------------------------------

    We believe it is appropriate for the scope of the proposed sales 
practices rules to include leveraged/inverse funds as well as listed 
commodity pools that follow a similar leveraged or inverse

[[Page 4494]]

strategy. The same investor protection concerns regarding aligning 
firms' transaction practices with investors' capability of evaluating 
the risks of these trading tools apply to this broader category of 
leveraged/inverse investment vehicles, and not just leveraged/inverse 
funds specifically.\330\ Indeed, we understand that leveraged/inverse 
funds and listed commodity pools following the same strategy can have 
virtually identical investment portfolios. Applying the proposed rule 
to all leveraged/inverse investment vehicles, as defined in the 
proposed rules, would avoid potential regulatory arbitrage that could 
result if we were to place different requirements on these products.
---------------------------------------------------------------------------

    \330\ The definition of commodity- or currency-based trusts or 
funds that we propose to include in the leveraged/inverse investment 
vehicle definition tracks a definition recently provided by Congress 
in the Fair Access to Investment Research Act of 2017, Public Law 
115-66, 131 Stat. 1196 (2017) (the ``FAIR Act''), which we 
understand includes the kinds of commodity pools that generally 
pursue leveraged or inverse investment strategies. Our proposed 
definition differs from the FAIR Act definition because it would not 
include a trust or fund that holds only commodities or currencies 
and does not hold derivatives. Because we believe that trusts or 
funds that seek to provide a leveraged or inverse return of an index 
generally would use derivatives to do so, we do not believe it is 
necessary to include trusts or funds that do not hold derivatives in 
the proposed definition in the sales practices rules.
---------------------------------------------------------------------------

    We request comment on the definition of the term ``leveraged/
inverse investment vehicle'' in the proposed sales practices rules.
    171. Is the scope of the proposed definition of the term 
``leveraged/inverse investment vehicle'' appropriate? The definition 
includes a fund that seeks to provide investment returns that have an 
inverse relationship to the performance of a market index. Do 
commenters agree that this is appropriate? Should the definition 
instead only include an inverse fund that seeks investment returns that 
exceed the inverse performance of a market index by a specified 
multiple (e.g., -1.5 or lower)? Why or why not? The definition also 
includes a fund that seeks to provide performance results ``over a 
predetermined period of time.'' Do commenters agree that this is 
appropriate? Generally, the extent to which a fund's performance can be 
expected to deviate from the multiple or inverse multiple of the 
performance of its index when held over longer periods is larger for 
funds that track a multiple or inverse multiple of the performance of 
an index over shorter time intervals, as those funds typically 
rebalance their portfolios more frequently. Should we specify a time 
period in the definition and, if so, what time period would be 
appropriate? For example, should the definition only include a fund 
that seeks investment returns that correspond to a multiple or inverse 
multiple of an index over a fixed period of time that is less than a 
year, a quarter, or a month? Please explain.
    172. Do commenters agree with our proposal to include listed 
commodity pools within the definition? Are we correct that the 
similarities between the investment strategies and return profiles of 
listed commodity pools and other leveraged/inverse investment vehicles, 
such as leveraged/inverse ETFs, warrant including listed commodity 
pools within the scope of this definition?
    173. Are there other types of investments or products that we 
should include in the leveraged/inverse investment vehicle definition? 
For example, should we include exchange-traded notes within the scope 
of the proposed sales practices rules if they have the same or similar 
return profile as the leveraged/inverse funds and listed commodity 
pools included in the proposed definition? \331\ Are there additional 
complex financial products, such as those discussed in FINRA Regulatory 
Notice 12-03 (including, among others, certain structured or asset-
backed notes, unlisted REITs, securitized products, and products that 
offer exposure to stock market volatility), that commenters believe 
should be subject to the due diligence and account approval 
requirements that we are proposing for leveraged/inverse investment 
vehicles? \332\
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    \331\ The Commission also recently brought and settled an 
enforcement action against a dually-registered broker-dealer/
investment adviser, certain of its supervisory personnel, and one of 
its registered representatives arising out of that representative's 
recommending that his customers buy and hold leveraged and inverse 
exchange-traded funds and exchange traded notes (including 
allegations that the registered representative recommended that his 
customers hold a triple-leveraged exchange-traded note for longer 
than the one-day holding period set forth in the product's 
prospectus). See In the Matter of Cadaret Grant, et al., Exchange 
Act Release No. 84074 (Sept. 11, 2018) (alleging, among other 
things, a violation of section 206(4) of the Advisers Act and rule 
206(4)-7 thereunder and failure to supervise) (settled action). See 
In the Matter of Cadaret Grant, et al., Exchange Act Release No. 
84074 (Sept. 11, 2018) (settled action).
    \332\ See FINRA Regulatory Notice 12-03, supra note 326.
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b. Required Approval and Due Diligence in Opening Accounts
    Under the proposed sales practices rules, no firm may accept an 
order from or place an order for a retail investor to buy or sell 
shares of a leveraged/inverse investment vehicle, or approve such a 
retail investor's account to engage in those transactions, unless the 
firm has complied with certain conditions. Specifically, the proposed 
rules would require the firm to (1) approve the retail investor's 
account for buying and selling shares of leveraged/inverse investment 
vehicles pursuant to a due diligence requirement; and (2) adopt and 
implement policies and procedures reasonably designed to achieve 
compliance with the proposed rules.
    The proposed due diligence requirement provides that a firm must 
exercise due diligence to ascertain the essential facts relative to the 
retail investor, his or her financial situation, and investment 
objectives. A firm must seek to obtain, at a minimum, certain 
information about its retail investor's:
     Investment objectives (e.g., safety of principal, income, 
growth, trading profits, speculation) and time horizon;
     employment status (name of employer, self-employed or 
retired);
     estimated annual income from all sources;
     estimated net worth (exclusive of family residence);
     estimated liquid net worth (cash, liquid securities, 
other);
     percentage of the retail investor's liquid net worth that 
he or she intends to invest in leveraged/inverse investment vehicles; 
and
     investment experience and knowledge (e.g., number of 
years, size, frequency and type of transactions) regarding leveraged/
inverse investment vehicles, options, stocks and bonds, commodities, 
and other financial instruments.\333\
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    \333\ See proposed rule 15l-2(b)(2). For joint accounts, the 
firm must seek to obtain the information for all participants in 
joint retail investor accounts.

Based on its evaluation of this information, the firm would be required 
specifically to approve or disapprove the retail investor's account for 
buying or selling shares of leveraged/inverse investment vehicles. If 
the firm approves the account, the approval must be in writing.
    Under the proposed rules, to provide this approval a firm must have 
a reasonable basis for believing that the retail investor has the 
financial knowledge and experience to be reasonably expected to be 
capable of evaluating the risks of buying and selling leveraged/inverse 
investment vehicles. We are not proposing a bright-line test for this 
determination. Rather, the determination would be based on all of the 
relevant facts and circumstances.
    The information that a firm would collect includes information 
about the retail investor's financial status (e.g.,

[[Page 4495]]

employment status, income, and net worth (including liquid net worth)); 
and information about his or her investment objectives generally and 
his or her anticipated investments in, and experience with, leveraged/
inverse investment vehicles (e.g., general investment objectives, 
percentage of liquid net worth intended for investment in leveraged/
inverse investment vehicles, and investment experience and knowledge). 
This information is designed to provide a comprehensive picture of the 
retail investor to allow a firm to evaluate whether the retail investor 
has the financial knowledge and experience to be reasonably expected to 
be capable of evaluating the risks of buying and selling leveraged/
inverse investment vehicles.
    While not required under the proposed rules, firms could consider 
establishing multiple levels of account approvals for a retail investor 
seeking to trade leveraged/inverse investment vehicles. We understand 
that broker-dealers set different levels of options account approval 
depending on the customer's trading experience and financial 
sophistication.\334\ Similarly, a firm may determine that certain 
leveraged/inverse investment vehicles (e.g., those with lower leverage 
multiples or that invest in less-volatile asset classes) are more 
appropriate for a lower level of account approval, while other types of 
leveraged/inverse investment vehicles may be more appropriate for a 
higher level of account approval. Any such approaches generally should 
be addressed in the policies and procedures that the proposed sales 
practices rules would require a firm to adopt and implement.\335\
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    \334\ These increasing levels generally track the riskiness of 
the product or trading strategy; for example, the initial option 
account approval may permit covered call writing of equity options 
but higher account approvals would be needed for writing uncovered 
index options.
    \335\ See proposed rules 15l-2(a) and 211(h)-1(a).
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    The proposed rules' scope with respect to a firm's customer or 
client is limited to ``a natural person'' or ``the legal representative 
of a natural person.'' \336\ The rules include all natural persons--
including high-net worth individuals--to provide the related investor 
protections to all natural persons. The proposed rules require firms to 
seek to obtain and to consider information related to a retail 
investor's net worth as part of their consideration of whether to 
approve the investor's account for trading in leveraged/inverse 
investment vehicles. We interpret ``legal representative'' of a natural 
person to mean non-professional legal representatives of a natural 
person.\337\ This interpretation would exclude institutions and certain 
professional fiduciaries, but it would include certain legal entities 
such as trusts that represent the assets of a natural person.\338\ This 
interpretation is designed to provide the protections of the sales 
practices rules where non-professional persons are acting on behalf of 
natural persons, but where such professional persons are not regulated 
financial services industry professionals retained by natural persons 
to exercise independent professional judgment.\339\
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    \336\ See proposed rules 15l-2(a) and 211(h)-1(a).
    \337\ See, e.g., Form CRS Relationship Summary, Exchange Act 
Release No. 34-86032 (June 5, 2019) [84 FR 33492 (July 12, 2019)] 
(``Form CRS Release''), at n.629 and accompanying text.
    \338\ See Form CRS Release, supra note 336, at nn.645-647 and 
accompanying text (clarifying interpretation of ``legal 
representative'' of a natural person to cover only non-professional 
legal representatives (e.g., a non-professional trustee that 
represents the assets of a natural person and similar 
representatives such as executors, conservators, and persons holding 
a power of attorney for a natural person)); Regulation Best 
Interest: The Broker-Dealer Standard of Conduct, supra note 314, at 
n.237 and accompanying text (defining ``retail customer'').
    \339\ See Form CRS Release, supra note 336, at nn.645-647 and 
accompanying text.
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    In addition, we are proposing to specify in the sales practices 
rules that, although the rules would apply to transactions by broker-
dealers and investment advisers for retail investors--including those 
investors who have existing accounts before the rules' compliance 
date--the sales practices rules would not apply to a position in a 
leveraged/inverse investment vehicle established before the rules' 
compliance date. This provision is designed to allow existing investors 
in leveraged/inverse investment vehicles with open investments as of 
the rules' compliance date to sell their holdings (or to purchase 
leveraged/inverse investment vehicles to close out short positions in 
the leveraged/inverse investment vehicle) without the additional steps 
we propose to require for their broker-dealer or investment adviser to 
determine whether to approve the retail investor's account to trade in 
these products.\340\ Absent this provision, the sales practices rules 
could prevent or delay a retail investor's ability to close or reduce a 
position in a leveraged/inverse investment vehicle that he or she 
entered into before firms were required to comply with the rules.
---------------------------------------------------------------------------

    \340\ This provision is designed to allow a retail investor to 
exit a legacy position in a leveraged/inverse investment vehicle, as 
discussed above, and does not reflect any view on whether any 
recommendation for these legacy positions was suitable when made.
---------------------------------------------------------------------------

    We also do not believe it would be appropriate to apply the sales 
practices rules only to retail accounts established after the rules' 
compliance date, because the investor protection concerns underlying 
the rules would apply equally to pre-existing retail investor accounts. 
Accordingly, the proposed rules would make clear that, even if a retail 
investor had already been trading leveraged/inverse investment 
vehicles, a firm would have to satisfy the due diligence and account 
approval requirements for that investor's account before the investor 
could make additional investments in leveraged/inverse investment 
vehicles.\341\
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    \341\ As discussed above, this evaluation would take into 
account, among other things, the investor's experience with 
leveraged/inverse investment vehicles. See, e.g., proposed rules 
211(h)-1(b)(2) and 15l-2(b)(2).
---------------------------------------------------------------------------

    The proposed sales practices rules also would require firms to 
adopt and implement written policies and procedures addressing 
compliance with the applicable sales practices rule.\342\ We are not 
proposing to impose specific requirements for these policies and 
procedures, provided that they are reasonably designed to achieve 
compliance with the applicable sales practices rule, including the due 
diligence and account approval requirements. This requirement, together 
with the proposed recordkeeping requirements discussed below, is 
designed to provide comparable policies and procedures and 
recordkeeping requirements for both broker-dealers and investment 
advisers.
---------------------------------------------------------------------------

    \342\ See proposed rule 15l-2(a); proposed rule 211(h)-1(a).
---------------------------------------------------------------------------

    We request comment on the proposed approval and due diligence 
requirements for approving retail investors' accounts to trade in 
shares of leveraged/inverse investment vehicles.
    174. Is modeling these rules on FINRA's options rule the 
appropriate approach? Why or why not?
    175. Should the proposed sales practices rules apply to Commission-
registered broker-dealers and investment advisers? Why or why not? What 
challenges, if any, would broker-dealers or investment advisers face 
complying with the proposed rules, and what compliance burdens would 
the proposed rules create for broker-dealers and investment advisers? 
Would compliance burdens be substantially different for investment 
advisers than for broker-dealers (for example, because of any 
compliance efficiencies that might result to the extent broker-dealers 
are already complying with FINRA's

[[Page 4496]]

rules for approving options accounts), or vice versa? Should we apply 
proposed Advisers Act rule 211(h)-1 to investment advisers that are 
registered with one or more states but not registered with the 
Commission? Why or why not? Should the proposed rule for investment 
advisers apply equally to advisers with discretionary authority and 
with non-discretionary authority over client accounts? If the sales 
practices rule for investment advisers applies to both discretionary 
and non-discretionary advisory accounts, should we apply different due 
diligence and account approval requirements based on whether an account 
is discretionary or non-discretionary? Should the proposed sales 
practices rules apply to investment advisers, in light of their 
fiduciary duties to their clients? Why or why not? Should the sales 
practices rules apply to a broker-dealer if the broker-dealer does not 
effect transactions in leveraged investment vehicles for retail 
investors other than transactions resulting from recommendations that 
are subject to Regulation Best Interest? Why or why not?
    176. Should the proposed rules apply to transactions in leveraged/
inverse investment vehicles that are directed by a retail investor 
without any recommendation or advice from a broker-dealer or investment 
adviser? Why or why not?
    177. Should the proposed rules apply on a transaction-by-
transaction basis rather than requiring an initial account approval to 
transact in leveraged/inverse investment vehicles? Why or why not?
    178. As proposed, the sales practices rules would require that a 
firm could provide account approval only if the firm has a reasonable 
basis for believing that the investor has such knowledge and experience 
in financial matters that he or she may reasonably be expected to be 
capable of evaluating the risks of buying and selling leveraged/inverse 
investment vehicles. Is this account approval standard appropriate? Why 
or why not? If not, what should the account approval standard be? 
Should it be tied instead, for example, to an investor's ability to 
absorb losses, and if so how should a firm assess this?
    179. Is the investor information that the proposed rules would 
require firms to seek to obtain under the rules' due diligence 
requirements appropriate, and would this information effectively assist 
in forming a reasonable basis for assessing the investor's knowledge 
and experience in financial matters as required under the proposed 
account approval standard? Why or why not? What modifications, if any, 
should we make to the information items that the proposed rules would 
require a firm to seek to obtain? Are there any information items that 
we should remove from the proposed list, or any additional information 
items that we should include? For example, instead of tracking 
generally the information elements set forth under FINRA's option rule, 
should the proposed rules track generally the information set forth in 
the definition of ``retail customer investment profile'' under 
Regulation Best Interest (i.e., ``age, other investments, financial 
situation and needs, tax status, investment objectives, investment 
experience, investment time horizon, liquidity needs, risk tolerance, 
and any other information the retail customer may disclose to the 
broker, dealer, or a natural person who is an associated person of a 
broker or dealer'')? As proposed, should the rules require firms to 
seek to obtain the percentage of the investments that the retail 
investor intends to invest in leveraged/inverse investment vehicles? 
Why or why not?
    180. Should the sales practices rules require firms to obtain the 
specified information, rather than to seek to obtain it? Would a firm 
be able to form a reasonable basis for believing that a retail investor 
has such knowledge and experience in financial matters that he or she 
may reasonably be expected to be capable of evaluating the risks of 
buying and selling leveraged/inverse investment vehicles if the retail 
investor provides some, but not all, of the information specified in 
the sales practices rules?
    181. What special procedures, if any, do firms currently undertake 
in permitting or not permitting retail investors to trade in leveraged/
inverse investment vehicles? At account opening? With respect to 
specific transactions? With respect to concentration limits? Do firms 
already have approval processes in place designed to evaluate whether 
their retail investors are reasonably expected to be capable of 
evaluating the risks of buying and selling leveraged/inverse investment 
vehicles? If so, do firms distinguish between types of vehicles or 
trading strategies? Do these practices differ between broker-dealers 
and investment advisers? If so, please explain the differences.
    182. What special procedures, if any, do firms currently undertake 
in permitting or not permitting retail investors to trade in other 
types of complex products? Please explain in detail, including products 
to which such procedures apply and what the approval process entails.
    183. The proposed sales practices rules would require that firms' 
approvals of retail investors' accounts for buying or selling shares of 
leveraged/inverse investment vehicles be in writing. The proposed rules 
would not require account disapprovals to be in writing. Should we 
require account disapprovals also to be in writing? Would such a 
requirement raise any practical concerns, or other concerns, for firms? 
In other investor approval contexts, do firms currently put both their 
approvals and disapprovals in writing?
    184. How do broker-dealers apply the options eligibility 
requirement with respect to clients of investment advisers, if at all, 
when those advisers submit orders on behalf of their clients? Do 
broker-dealer practices differ with respect to orders submitted by 
other types of intermediaries? Please explain.
    185. How do broker-dealers currently analyze the information they 
collect under FINRA rule 2360? Which data elements do broker-dealers 
find most important and which elements are less important? What 
standards do broker-dealers apply in determining whether to approve a 
customer's account on the basis of the information collected?
    186. Should the proposed rules require firms to provide specific 
disclosure as part of the approval process, similar to the options 
disclosure document that must be provided under FINRA rule 2360? If so, 
what information should it contain? Should the rules require that 
receipt of such disclosure be acknowledged?
    187. Should the rules require firms to provide retail investors a 
short, plain-English disclosure generally describing the risks 
associated with leveraged/inverse investment vehicles as part of the 
proposed account approval process? For example, before a firm approves 
a retail investor's account for buying and selling shares of a 
leveraged/inverse investment vehicle, should the rules require a firm 
to incorporate and distill into a short disclosure the specific risk 
factors associated with leveraged/inverse investment vehicles (such as 
the risks related to compounding and other risks that leveraged/inverse 
funds disclose in their prospectuses)?
    188. Should the rules apply to all customers or clients, and not 
just natural persons? Should they apply to a different subset of 
customers or clients and, if so, which ones and why? If the rule were 
to apply to all customers or clients, including institutional accounts, 
what changes should we make to the information that firms must collect 
or to the basis upon which a firm would approve or disapprove the 
account? Are

[[Page 4497]]

there distinctions between institutional investors and natural persons 
that invest in leveraged/inverse investment vehicles that we should 
consider? For example, do commenters have data or information on the 
percentage of leveraged investment vehicles' investors who are natural 
persons, and how natural persons use these investment products (e.g., 
how long do these investors hold the products)?
    189. As discussed above, we understand that certain purchases or 
sales of leveraged/inverse investment vehicles do not involve a 
customer or client of a broker-dealer or investment adviser that would 
be subject to the proposed sales practices rules.\343\ Should the 
proposed rules apply to these transactions? For example, should the 
proposed sales practices rule for broker-dealers apply to a mutual fund 
principal underwriter's transactions with any retail investor who is 
purchasing fund shares directly from the fund?
---------------------------------------------------------------------------

    \343\ See supra note 321.
---------------------------------------------------------------------------

    190. Should the sales practices rules include different account-
approval conditions for different types of leveraged/inverse investment 
vehicles? For example, should the rules include different conditions 
for investment vehicles that seek to exceed the performance of a market 
index by a specified multiple, versus those that provide returns that 
have an inverse relationship to the performance of a market index? 
Should the rules include different levels of account approval, such as 
heightened requirements for investors to transact in leveraged/inverse 
investment vehicles with higher leverage multiples or that invest in 
more volatile asset classes? Similarly, should the rules include 
different levels of account-approval conditions based on a retail 
investor's trading experience and financial sophistication?
    191. Do commenters agree that we should apply the sales practices 
rules to all retail investors, including those who have opened accounts 
with an investment adviser or broker-dealer before the rules' 
compliance date? Should the sales practices rules include exceptions 
from the due diligence and account approval requirements for retail 
investors that have already traded in leveraged/inverse investment 
vehicles as of the rules' compliance date? Should the sales practices 
rules provide exceptions for retail investors who meet established 
criteria, such as retail investors who are accredited investors? Why or 
why not?
    192. The proposed rules also would not apply to, and therefore 
would not restrict a retail investor's ability to close or reduce, a 
position in a leveraged/inverse investment vehicle established before 
the rules' compliance date. Do commenters agree that this is 
appropriate? Are there modifications we should make to the rules so 
that they would not impede an investor's ability to close or reduce an 
existing position in a leveraged/inverse investment vehicle? Which 
modifications and why? Alternatively, should the sales practices rules 
apply to retail investors with positions in leveraged/inverse 
investment vehicles established before the rules' compliance date even 
if they do not seek to make additional purchases or sales of leveraged 
investment vehicles? If so, how would firms comply, in practice, with 
the due diligence and account approval requirements for these 
investors?
    193. Do commenters agree with the proposed policies and procedures 
requirement? Should the rule provide specific requirements for firms' 
policies and procedures relating to compliance with the sales practices 
rules?
c. Recordkeeping
    Under the proposed sales practices rules, a firm would have to 
maintain a written record of the investor information that it obtained 
under the rules' due diligence requirements, the firm's written 
approval of the retail investor's account for buying and selling shares 
of leveraged/inverse investment vehicles, and the versions of the 
firm's policies and procedures that it adopted under the proposed rules 
that were in place when it approved or disapproved the account. We 
propose that firms be required to retain these records for a period of 
not less than six years (the first two years in an easily accessible 
place) after the date of the closing of the investor's account.\344\ We 
believe that it is appropriate for the proposed rules to include a 
recordkeeping provision to facilitate compliance, and regulatory 
oversight of a firm's compliance, with the rules. Also, because an 
investor account that was approved to trade in leveraged/inverse 
investment vehicles could remain open with a firm for more than six 
years, we believe it is appropriate to require that records be 
preserved for a minimum of six years after the closing of the account, 
rather than six years after the creation of the records.\345\ We 
believe that this recordkeeping requirement would provide sufficient 
investor protection and, because it is generally consistent with 
recordkeeping requirements for broker-dealers and investment advisers, 
would not impose overly burdensome recordkeeping costs.\346\
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    \344\ See proposed rules 15l-2(c) and 211(h)-1(c).
    \345\ This is consistent with other Commission recordkeeping 
requirements relating to investor account documentation. See, e.g., 
rule 17a-4(c) under the Exchange Act (requiring broker-dealers to 
preserve for a period of not less than six years after the closing 
of any customer's account any account cards or records relating to 
the terms and conditions with respect to the opening and maintenance 
of the account).
    \346\ See, e.g., id.; see also rule 204-2(e)(1) under the 
Investment Advisers Act (requiring investment advisers to preserve 
certain records in an easily accessible place for a period of not 
less than five years from the end of the fiscal year during which 
the last entry was made on such record, the first two years in an 
appropriate office of the investment adviser). While we recognize 
that our existing recordkeeping requirements generally require 
broker-dealers to preserve records for six years and investment 
advisers for five years, we believe it would be appropriate for the 
recordkeeping requirements under the proposed sales practices rule 
to be consistent, in part because many broker-dealers and investment 
advisers are dual-registered, and thus are proposing a six-year 
period for both rules.
---------------------------------------------------------------------------

    We request comment on the recordkeeping requirement in the proposed 
sales practices rules:
    194. Is the proposed recordkeeping requirement appropriate? Why or 
why not?
    195. What changes, if any, should we make to this proposed 
requirement (e.g., by modifying the types of records that a firm would 
have to keep)?
    196. Does our proposal to apply the same recordkeeping requirement 
to both broker-dealers and investment advisers raise any specific 
recordkeeping concerns for either broker-dealers or investment advisers 
(e.g., do investment advisers believe it would be particularly 
burdensome to comply with a six-year recordkeeping period)? Should the 
proposed rules include different requirements for broker-dealers and 
investment advisers?
    197. Is the proposed duration of the recordkeeping provision, 
including the proposed requirement that the records be maintained for a 
minimum of six years after the closing of the investor's account, 
appropriate? Does using the closing of the investor's account as the 
starting point for the recordkeeping period raise any practical 
difficulties for firms? Should we lengthen or shorten the required 
recordkeeping periods? Why or why not?
3. Alternative Provision for Leveraged/Inverse Funds Under Proposed 
Rule 18f-4
    Under proposed rule 18f-4, a fund would not have to comply with the 
proposed VaR-based leverage risk limit if it: (1) Meets the definition 
of a ``leveraged/inverse investment vehicle'' in the proposed sales 
practices rules; (2) limits the investment results it seeks to

[[Page 4498]]

300% of the return (or inverse of the return) of the underlying index; 
and (3) discloses in its prospectus that it is not subject to proposed 
rule 18f-4's limit on fund leverage risk. We refer to this set of 
proposed conditions collectively as the ``alternative provision for 
leveraged/inverse funds.'' A leveraged/inverse fund that satisfies 
these conditions still would be required to satisfy all of the 
additional conditions in proposed rule 18f-4 other than the VaR tests, 
including the proposed conditions requiring a derivatives risk 
management program, board oversight and reporting, and 
recordkeeping.\347\
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    \347\ See proposed rule 18f-4(c)(1), (5)-(6).
---------------------------------------------------------------------------

    First, the alternative provision for leveraged/inverse funds 
requires that a leveraged/inverse fund be a ``leveraged/inverse 
investment vehicle'' as defined in the proposed sales practices 
rules.\348\ As discussed above, the proposed sales practices rules are 
designed to help ensure that investors in leveraged/inverse investment 
vehicles are limited to those who are capable of evaluating their 
general characteristics and the unique risks they present.
---------------------------------------------------------------------------

    \348\ See proposed rule 18f-4(c)(4)(i); proposed rules 15l-2(d) 
and 211(h)-1(d) (defining the term ``leveraged/inverse investment 
vehicle'').
---------------------------------------------------------------------------

    Second, the alternative provision for leveraged/inverse funds would 
limit a leveraged/inverse fund's market exposure by providing that the 
fund must not seek or obtain, directly or indirectly, investment 
results exceeding 300% of the return (or inverse of the return) of the 
underlying index.\349\ This limitation reflects the highest leverage 
level currently permitted by our exemptive orders for leveraged/inverse 
ETFs.\350\ It therefore reflects the maximum amount of leverage in 
these funds with which investors and other market participants are 
familiar. To permit leveraged/inverse funds to use a higher level of 
leverage would heighten the investor protection concerns these funds 
present, notwithstanding their more limited investor base.\351\ 
Moreover, allowing leveraged/inverse funds to increase their leverage 
beyond current levels would result in a non-linear increase in the 
extent of leveraged/inverse funds' rebalancing activity, which may have 
adverse effects on the markets for the constituent securities as 
discussed in more detail in sections III.D.1 and III.E.4. For these 
reasons, and because the Commission does not have experience with 
leveraged/inverse funds that seek returns above 300% of the return (or 
inverse of the return) of the underlying index, we are not proposing to 
permit higher levels of leveraged market exposure for leveraged/inverse 
funds in this rule.
---------------------------------------------------------------------------

    \349\ See proposed rule 18f-4(c)(4)(iii).
    \350\ See ETFs Adopting Release, supra note 76, at n.75 and 
accompanying text.
    \351\ See also section III.C.5.
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    Third, the alternative provision for leveraged/inverse funds would 
require a leveraged/inverse fund to disclose in its prospectus that it 
is not subject to the condition of proposed rule 18f-4 limiting fund 
leverage risk.\352\ This requirement is designed to provide investors 
and the market with information to clarify that leveraged/inverse 
funds--which as discussed above, use derivatives extensively--are not 
subject to rule 18f-4's limit on fund leverage risk.
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    \352\ See proposed rule 18f-4(c)(4)(ii).
---------------------------------------------------------------------------

    We request comment on the proposed alternative provision for 
leveraged/inverse funds.
    198. Should the rule include an alternative set of requirements for 
leveraged/inverse funds? Should leveraged/inverse funds instead be 
required to meet the proposed requirements for all funds that use 
derivatives, including the VaR-based limit on fund leverage risk? If 
commenters agree that we should permit leveraged/inverse ETFs to rely 
on rule 18f-4 based on an alternative set of requirements, are there 
additional conditions--either relating to these funds' derivatives risk 
management or otherwise--that we should consider requiring those funds 
to satisfy? To what extent would additional limitations or restrictions 
on leveraged investment vehicles' advertising or marketing materials 
help to address the investor protection concerns discussed above?
    199. Does our proposal to include within the scope of the rule only 
leveraged/inverse funds that are covered by the proposed sales 
practices rules, along with the conditions comprising the alternative 
provision for leveraged/inverse funds, address the investor protection 
concerns related to leveraged/inverse funds?
    200. If leveraged/inverse funds operate pursuant to the proposed 
alternative provision, should they nonetheless be subject to other 
requirements in the proposed rule (e.g., the proposed risk management 
program requirement, board oversight and reporting requirement, and 
recordkeeping requirement)?
    201. Should leveraged/inverse funds relying on the alternative 
provision be required to disclose in their prospectuses that the fund 
is not subject to the proposed VaR-based limit on fund leverage risk, 
as proposed? If so, what would be the most appropriate method of 
disclosure? In addition to requiring this disclosure under rule 18f-4, 
should we also include this requirement in Form N-1A? Would it aid 
practitioners for a leveraged/inverse fund's registration form to 
specify this requirement?
    202. Should a leveraged/inverse fund relying on rule 18f-4 be 
required to limit the investment results it seeks or obtains to 300% of 
the return (or inverse of the return) of the underlying index? Would 
some other threshold be more appropriate? Should the threshold be 
higher, such as 400%, or lower, such as 150% or 200%?
    203. Any registered investment company that operates as a 
leveraged/inverse fund would be eligible to comply with the proposed 
alternative provision for leveraged/inverse funds in rule 18f-4. Should 
we limit the scope of leveraged/inverse funds eligible for this 
provision to open-end funds, including ETFs?
4. Proposed Amendments to Rule 6c-11 Under the Investment Company Act 
and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs
    Earlier this year, the Commission adopted rule 6c-11, which permits 
ETFs that satisfy certain conditions to operate without obtaining an 
exemptive order from the Commission.\353\ Rule 6c-11 includes a 
provision excluding leveraged/inverse ETFs from the scope of ETFs that 
may rely on that rule.\354\ Leveraged/inverse ETFs, therefore, continue 
to rely on their Commission exemptive orders. In adopting rule 6c-11, 
the Commission stated that the particular section 18 concerns raised by 
leveraged/inverse ETFs' use of derivatives distinguish those funds from 
the other ETFs permitted to rely on that rule, and that those section 
18 concerns would be more appropriately addressed in a rulemaking 
addressing the use of derivatives by funds more broadly.\355\ The 
Commission further stated that leveraged/inverse ETFs are similar in 
structure and operation to the other types of ETFs that are within the 
scope of rule 6c-11.\356\ The rules we are proposing, rule 18f-4 under 
the

[[Page 4499]]

Investment Company Act and the sales practices rules under the Exchange 
Act and the Advisers Act, would create an updated and more 
comprehensive regulatory framework for the use of derivatives by funds, 
including provisions specifically applicable to leveraged/inverse ETFs. 
Accordingly, we propose to amend rule 6c-11 to remove the provision 
excluding leveraged/inverse ETFs from the scope of that rule one year 
following the publication of the final amendments in the Federal 
Register.
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    \353\ See ETFs Adopting Release, supra note 76.
    \354\ See rule 6c-11(c)(4).
    \355\ See ETFs Adopting Release, supra note 76, at nn.72-75 and 
accompanying text.
    \356\ See id. at text following n.86. In addition, one sponsor 
of leveraged/inverse ETFs has stated that its ETFs would prefer to 
rely on rule 6c-11 over their exemptive orders and that leveraged/
inverse ETFs would be able to comply with rule 6c-11 because they 
are structured and operated in the same manner as other ETFs that 
fall within the scope of that rule. See id. at n.83 and accompanying 
text.
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    In addition, because the proposed amendments to rule 6c-11 would 
permit leveraged/inverse ETFs to rely on that rule rather than their 
exemptive orders, we are proposing to rescind the exemptive orders we 
have previously issued to leveraged/inverse ETFs. The exemptive relief 
granted to leveraged/inverse ETFs has resulted in an uneven playing 
field among market participants because the Commission has permitted 
only three ETF sponsors to operate leveraged/inverse ETFs and has not 
granted any exemptive relief for leveraged/inverse ETFs since 
2009.\357\ We believe that amending rule 6c-11 and rescinding these 
exemptive orders would promote a more level playing field and greater 
competition by allowing any sponsor to form and launch a leveraged/
inverse ETF subject to the conditions in rules 6c-11 and proposed rule 
18f-4, with transactions in the funds subject to the proposed sales 
practices rules. We propose to rescind these exemptive orders on the 
effective date of the proposed amendments to rule 6c-11 (one year 
following the publication of the final rule amendments in the Federal 
Register), to coincide with the compliance date for the sales practices 
rules and to allow time for broker-dealers and investment advisers to 
make any adjustments necessary to comply with the proposed sales 
practices rules. Providing a one-year period for existing leveraged/
inverse ETFs also would provide time for them to prepare to comply with 
rule 6c-11 rather than their exemptive orders.\358\
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    \357\ There are currently two ETF sponsors that rely upon this 
exemptive relief today. See supra note 307 and accompanying text; 
infra note 473 and accompanying text. We also discuss below in 
section III.E alternative approaches for leveraged/inverse funds, 
including an approach under which the Commission would rescind the 
exemptive orders issued to leveraged/inverse ETF sponsors, permit 
leveraged/inverse funds to operate under rule 6c-11, but require 
leveraged/inverse funds to comply with rule 18f-4's VaR-based limit 
on fund leverage risk in lieu of adopting the proposed sales 
practices rules.
    \358\ See ETFs Adopting Release, supra note 76, at text 
following n.451.
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    We request comment on the proposed amendments to rule 6c-11 and 
rescission of leveraged/inverse ETF exemptive orders.
    204. If leveraged/inverse funds are permitted to rely on rule 18f-
4, should the Commission amend rule 6c-11 to permit leveraged/inverse 
funds to operate under that rule, as proposed? Do the requirements of 
proposed rule 18f-4, together with the proposed sales practices rules, 
adequately address the section 18 concerns relating to leveraged/
inverse funds? Are there are other concerns regarding leveraged/inverse 
funds that we should consider in determining whether to allow such 
funds to rely on rule 6c-11?
    205. In addition, do commenters agree with our proposal to rescind 
the existing leveraged/inverse ETF exemptive relief in view of our 
proposed treatment of leveraged/inverse funds under rule 18f-4 and 
proposed amendments to rule 6c-11? Are there other approaches to the 
existing leveraged/inverse ETF exemptive relief that we should consider 
in view of proposed rule 18f-4 and the proposed sales practices rules?

H. Amendments to Fund Reporting Requirements

    We are proposing amendments to the reporting requirements for funds 
that would rely on proposed rule 18f-4--in particular, amendments to 
Forms N-PORT, N-LIQUID (which we propose to re-title as ``Form N-RN''), 
and N-CEN.\359\ These proposed amendments are designed to enhance the 
Commission's ability to oversee funds' use of and compliance with the 
proposed rules effectively, and for the Commission and the public to 
have greater insight into the impact that funds' use of derivatives 
would have on their portfolios.\360\ They would allow the Commission 
and others to identify and monitor industry trends, as well as risks 
associated with funds' investments in derivatives (including by 
requiring current, non-public reporting to the Commission when certain 
significant events related to a fund's leverage risk occur). The 
proposed amendments also would aid the Commission in evaluating the 
activities of investment companies in order to better carry out its 
regulatory functions.
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    \359\ 17 CFR 274.150; 17 CFR 274.223; and 17 CFR 249.330 and 17 
CFR 274.101.
    \360\ The funds that would rely on proposed rule 18f-4 other 
than BDCs generally are subject to reporting requirements on Form N-
PORT. All registered management investment companies, other than 
registered money market funds and small business investment 
companies, are (or will be) required to electronically file with the 
Commission, on a quarterly basis, monthly portfolio investment 
information on Form N-PORT, as of the end of each month. See 
Investment Company Reporting Modernization Adopting Release, supra 
note 178. As of April 30, 2019, larger fund groups (defined as 
having $1 billion or more in net assets) have begun submitting 
reports on Form N-PORT for the period ending March 31, 2019. Smaller 
fund groups (less than $1 billion in net assets) will begin 
submitting reports on Form N-PORT by April 30, 2020. See Investment 
Company Reporting Modernization, Investment Company Act Release No. 
32936 (Dec. 8, 2017) [82 FR 58731 (Dec. 14, 2017)]. Only information 
reported for the third month of each fund's fiscal quarter on Form 
N-PORT will be publicly available (60 days after the end of the 
fiscal quarter). See Amendments to the Timing Requirements for 
Filing Reports on Form N-PORT, Investment Company Act Release No. 
33384 (Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)].
     Currently, only open-end funds that are not regulated as money 
market funds under rule 2a-7 under the Investment Company Act are 
required to file current reports on Form N-LIQUID, under section 
30(b) of the Investment Company Act and rule 30b1-10 under the Act. 
See Investment Company Liquidity Risk Management Programs, 
Investment Company Act Release No. 32315 (Oct. 13, 2016) [81 FR 
82142 (Nov. 18, 2016)], at section III.L.2 (``Liquidity Adopting 
Release''). Our proposal, including proposed amendments to Form N-
LIQUID, rule 30b1-10 and proposed rule 18f-4(c)(7), would add new 
VaR-related items to the form, and would extend the requirement to 
file current reports with respect to these new items to any fund 
(including registered open-end funds, registered closed-end funds, 
and BDCs) that relies on rule 18f-4 and that is subject to the 
rule's limit on leverage risk.
    The funds that would rely on proposed rule 18f-4 other than BDCs 
generally are subject to reporting requirements on Form N-CEN. 
Specifically, all registered investment companies, including money 
market funds but excluding face amount certificate companies, are 
currently required to file annual reports on Form N-CEN. See 
Investment Company Reporting Modernization Adopting Release, supra 
note 178. Form N-CEN requires these funds to report census-type 
information including reports on whether a fund relied upon certain 
enumerated rules under the Investment Company Act during the 
reporting period. See, e.g., Item C.7 of Form N-CEN.
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1. Amendments to Form N-PORT
    We are proposing to amend Form N-PORT to add new items to Part B 
(``Information About the Fund''), as well as to make certain amendments 
to the form's General Instructions.
a. Derivatives Exposure
    We are proposing to amend Form N-PORT to include a new reporting 
item on funds' derivatives exposure.\361\ A fund would be required to 
provide its derivatives exposure as of the end of the reporting 
period.\362\ This information

[[Page 4500]]

would be publicly available for the third month of each fund's quarter 
and would provide market-wide insight into the levels of funds' 
derivatives exposure to the Commission, its staff, and market 
participants.\363\ It also would allow the Commission and its staff to 
oversee and monitor compliance with the proposed rule's exception for 
limited derivatives users.\364\
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    \361\ See proposed Item B.9 of Form N-PORT; see also proposed 
amendments to General Instruction E to Form N-PORT (adding a new 
definition for ``derivatives exposure,'' as defined in proposed rule 
18f-4(a),which would permit a fund to convert the notional amounts 
of interest rate derivatives to 10-year bond equivalents and delta 
adjust the notional amounts of options contracts).
    \362\ See proposed Item B.9 of Form N-PORT. Just as the proposed 
definition of ``derivatives transaction'' in rule 18f-4 includes 
derivatives instruments as well as short sale borrowings, Form N-
PORT would require a fund to report exposure associated with 
derivatives instruments and short sales.
    The proposed requirement to report derivatives exposure at the 
end of the reporting period reflects the form's requirement to 
report information about funds' portfolio holdings as of the last 
business day, or last calendar day, of each month. See General 
Instruction A to Form N-PORT. While we are proposing that funds 
report their highest daily VaR and median daily VaR during the 
reporting period (see infra section II.H.1.b), we are not also 
proposing that funds report their highest daily derivatives exposure 
(or median daily derivatives exposure) during the reporting period. 
This is because proposed rule 18f-4 requires daily calculation of a 
fund's VaR but does not require a fund to calculate its derivatives 
exposure daily.
    \363\ We are not proposing to amend General Instruction F to 
Form N-PORT, which specifies the information that funds report on 
Form N-PORT that the Commission does not make publicly available.
    While the information for the first two months of a fund's 
quarter would be non-public, the information for the third month of 
a fund's quarter would be publicly available. See supra note 359.
    \364\ Under this proposal, a fund would have to indicate whether 
it is a limited derivatives user on Form N-CEN. See infra section 
II.H.3.
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    We seek comment on the Commission's proposed amendments to Form N-
PORT requiring reporting of derivatives exposure:
    206. Is the proposed requirement that funds report their 
derivatives exposure on Form N-PORT appropriate? Why or why not? Should 
we modify the proposed derivatives exposure reporting item in any way? 
If so, how should we modify this reporting item?
    207. Our proposal would make public the information that a fund 
would report in response to the new derivatives exposure Form N-PORT 
item. Is there any reason why this information should not be publicly 
available?
    208. Should we require this reporting only from certain funds--for 
example, those that qualify either as limited derivatives users or 
leveraged/inverse funds under proposed rule 18f-4--during the reporting 
period?
    209. Should we require funds to report metrics tied to their daily 
notional amount calculation on Form N-PORT (for example, a fund's 
highest daily derivatives exposure during the reporting period and the 
date of its highest exposure, and its median daily derivatives exposure 
during the reporting period)? Should we only require funds to report 
these types of metrics if we were also to modify proposed rule 18f-4 to 
require funds to calculate their notional amounts daily? Would this 
type of reporting requirement help to mitigate any potential ``window 
dressing'' concerns about funds' reporting of their derivatives 
exposure, and/or provide additional beneficial transparency with 
respect to any particular type of funds (for example, leveraged/inverse 
funds)? If so, would these benefits outweigh related costs?
b. VaR Information
    We are also proposing to amend Form N-PORT to include a new 
reporting item related to the proposed VaR tests.\365\ Information that 
a fund would report under this new reporting item would be made public 
for the third month of each fund's quarter.\366\ The proposed item 
would apply to funds that were subject to the proposed VaR-based limit 
on fund leverage risk during the reporting period.
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    \365\ See proposed Item B.10 of Form N-PORT. Proposed item B.10 
would require that a fund provide the applicable VaR information in 
accordance with proposed rule 18f-4(c)(2)(ii), which requires a fund 
to determine compliance with its applicable VaR test at least once 
each business day.
    \366\ See supra note 362. While the information for the first 
two months of a fund's quarter would be non-public, the information 
for the third month of a fund's quarter would be publicly available. 
See supra note 359.
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    Funds that are subject to the new VaR-related N-PORT item would 
have to report their highest daily VaR during the reporting period and 
its corresponding date, as well as their median daily VaR for the 
monthly reporting period.\367\ Funds subject to the relative VaR test 
during the reporting period would report the name of the fund's 
designated reference index, and index identifier.\368\ These funds also 
would have to report the fund's highest daily VaR ratio (that is, the 
value of the fund's portfolio VaR divided by the VaR of the designated 
reference index) during the reporting period and its corresponding 
date, as well as the fund's median daily VaR ratio for the reporting 
period.\369\
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    \367\ See proposed Items B.10.a.-c of Form N-PORT. The proposed 
form amendments would require each of the reported metrics to be 
determined in accordance with the requirement under proposed rule 
18f-4 to determine the fund's compliance with the applicable VaR 
test at least once each business day.
    \368\ See proposed Item B.10.d.i.-ii of Form N-PORT.
    \369\ See proposed Item B.10.d.iii.-v of Form N-PORT.
---------------------------------------------------------------------------

    The proposed requirement for a fund to report highest daily VaR 
(and, for a fund that is subject to the relative VaR test, information 
about the fund's VaR ratio) is designed to help assess compliance with 
the proposed rule. These requirements, and the proposed requirement for 
a fund to report its median daily VaR (and, for a fund that is subject 
to the relative VaR test, the median VaR ratio) are designed to help 
identify changes in a fund's VaR over time, and to help identify trends 
involving a single fund or group of funds regarding their VaRs. The 
proposed requirement that a fund report information about its 
designated reference index is designed to help analyze whether funds 
are using designated reference indexes that meet the rule's 
requirements, and also to assess any trends in the designated reference 
indexes that funds select.
    A fund also would have to report the number of exceptions the fund 
identified during the reporting period arising from backtesting the 
fund's VaR calculation model.\370\ This proposed requirement is 
designed to help analyze whether a fund's VaR model is effectively 
taking into account and incorporating all significant, identifiable 
market risk factors associated with a fund's investments, as required 
by the proposed rule.\371\ This information would assist in monitoring 
for compliance with the proposed VaR tests and also would provide high-
level information to market participants, as well as researchers and 
analysts, to help evaluate the extent to which funds' VaR models, used 
as part of the proposed VaR tests, are operating effectively. Because 
this information would be made publicly available on a delayed basis, 
and would not provide details about backtesting exceptions other than 
the number of exceptions, we do not believe that this proposed 
reporting requirement would produce adverse effects such that the 
reported information should be made non-public.\372\
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    \370\ See proposed Item B.10.e of Form N-PORT; see also supra 
section II.B.3.d (discussing proposed backtesting requirement); ICI 
Comment Letter II (discussing UCITS funds being similarly required 
to report to their primary regulator, on a semi-annual basis, the 
number of VaR breaks that exceed a specified threshold (a VaR break 
occurs when the actual one-day loss exceeds that day's VaR), and 
recommending the Commission require funds to report the number of 
VaR breaks and the dates on which they occurred).
    \371\ See supra note 151.
    \372\ See supra notes 362, 365. But see infra section II.H.2 
(discussing adverse effects that might arise from the real-time 
public reporting of a fund's VaR test breaches under the proposed 
amendments to Form N-LIQUID).
    Information reported for the third month of each fund's fiscal 
quarter on Form N-PORT will be made publicly available 60 days after 
the end of the fiscal quarter. See supra note 359.
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    We seek comment on the Commission's proposed amendments to

[[Page 4501]]

Form N-PORT requiring reporting of VaR information:
    210. Are the proposed requirements that funds report VaR 
information on Form N-PORT, and each of the elements that a fund would 
have to report under this requirement, appropriate? Why or why not? 
Should we modify the proposed VaR information reporting item in any 
way? If so, how should we modify this reporting item?
    211. Our proposal would make public all of the information that a 
fund would report in response to the new VaR information item on Form 
N-PORT. Is there any reason why this information should not be publicly 
available? For example, would making this information public lead to 
harm arising from investor confusion, adverse competitive effects, or 
for any other reason? If we require that this reported information be 
made public, is there additional information we should require funds to 
report to provide contextualization or mitigate any adverse effects 
that could arise from public disclosure? Should we make non-public some 
of these disclosures (e.g., portfolio VaR or a fund's designated 
reference index, or information about backtesting results) but not 
others? If so, which ones should we make non-public and why?
    212. Would any of the proposed N-PORT reporting requirements be 
more appropriately structured as Form N-CEN reporting requirements, or 
items to be reported on a current basis on Form N-RN?
    213. Is there any additional information related to funds' 
derivatives exposure or derivatives risk management that we should 
require funds to report on Form N-PORT? What information and why, and 
should this reported information be made public?
2. Amendments to Current Reporting Requirements
    We are also proposing current reporting requirements for funds that 
are relying on proposed rule 18f-4. We are proposing to re-title Form 
N-LIQUID as Form N-RN and to amend this form to include new reporting 
events for funds that are subject to the proposed VaR-based limit on 
fund leverage risk.\373\ These funds would be required to determine 
their compliance with the applicable VaR test on at least a daily 
basis.\374\ We are proposing to require these funds to file Form N-RN 
to report information about VaR test breaches under certain 
circumstances. Proposed rule 18f-4 would require a fund that has 
determined that it is not in compliance with the applicable VaR test to 
come back into compliance promptly and within no more than three 
business days after such determination.\375\ We are therefore proposing 
that a fund that determines that it is out of compliance with the VaR 
test and has not come back into compliance within three business days 
after such determination would file a report on Form N-RN providing 
certain information regarding its VaR test breaches.\376\
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    \373\ See proposed Parts E-G of Form N-RN.
    \374\ See supra section II.D; see also proposed rule 18f-
4(c)(2).
    \375\ See supra section II.D.5.b.
    \376\ See proposed Parts E and F of Form N-RN.
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    If the portfolio VaR of a fund subject to the relative VaR test 
were to exceed 150% of the VaR of its designated reference index for 
three business days, we are proposing to require that such a fund 
report: (1) The dates on which the fund portfolio's VaR exceeded 150% 
of the VaR of its designated reference index; (2) the VaR of its 
portfolio for each of these days; (3) the VaR of its designated 
reference index for each of these days; (4) the name of the designated 
reference index; and (5) the index identifier.\377\ A fund would have 
to report this information within one business day following the third 
business day after the fund has determined that its portfolio VaR 
exceeds 150% of its designated reference index VaR.\378\ Such a fund 
also would have to file a report on Form N-RN when it is back in 
compliance with the relative VaR test.\379\
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    \377\ See proposed Part E of Form N-RN.
    \378\ For example, if the fund were to determine, on the evening 
of Monday, June 1, that its portfolio VaR exceeded 150% of the 
fund's designated reference index VaR, and this exceedance were to 
persist through Tuesday (June 2), Wednesday (June 3), and Thursday 
(June 4), the fund would file Form N-RN on Friday, June 5 (because 3 
business days following the determination on June 1 is June 4, and 1 
business day following June 4 is June 5). If the exceedance were to 
still persist on June 5 (the date that the fund would file Form N-
RN), the fund's report on Form N-RN would provide the required 
information elements for June 1, 2, 3, 4, and 5.
    \379\ See proposed Part G of Form N-RN. The report would include 
the dates on which the fund was not in compliance with the VaR test, 
and the current VaR of the fund's portfolio on the date the fund 
files the report. See also proposed rule 18f-4(c)(2)(iii) (providing 
that a fund must meet specific requirements to be back in 
compliance).
---------------------------------------------------------------------------

    If the portfolio VaR of a fund subject to the absolute VaR test 
were to exceed 15% of the value of the fund's net assets for three 
business days, we are proposing to require that such a fund report: (1) 
The dates the on which the fund portfolio's VaR exceeded 15% of the 
value of its net assets; (2) the VaR of its portfolio for each of these 
days; and (3) the value of the fund's net assets for each of these 
days.\380\ A fund would have to report this information within one 
business day following the third business day that the fund determined 
that its portfolio VaR exceeds 15% of the value of its net assets. Such 
a fund also would have to file a report on Form N-RN when it is back in 
compliance with the absolute VaR test.\381\
---------------------------------------------------------------------------

    \380\ See proposed Part F of Form N-RN.
    \381\ See supra note 378.
---------------------------------------------------------------------------

    The data points, collectively, would aid the Commission in 
assessing funds' compliance with the VaR tests. In addition, the 
information would provide staff the ability to assess how long a fund 
is precluded from entering into derivatives transactions as a 
consequence of its lack of compliance with its VaR test.
    Currently, only registered open-end funds (excluding money market 
funds) are required to file reports on Form N-LIQUID.\382\ We are 
proposing to amend this form, as well as rule 30b1-10 under the 
Investment Company Act, to reflect the proposed 18f-4 requirement that 
all funds that are subject to the relative VaR test or absolute VaR 
test file current reports regarding VaR test breaches under the 
circumstances that Form N-RN specifies.\383\ The scope of funds that 
would be subject to the new VaR test breach current reporting 
requirements would thus include registered open-end funds as well as 
registered closed-end funds and BDCs. In addition to extending the 
scope of funds required to respond to Form N-LIQUID, we are proposing 
to amend the general instructions to the form to reflect the expanded 
scope and application.\384\
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    \382\ See General Instruction A.(1) to Form N-LIQUID; see also 
rule 30b1-10 [17 CFR 270.30b1-10].
    \383\ See proposed Form N-RN; see also proposed amendments to 
rule 30b1-10 under the Investment Company Act, and proposed rule 
18f-4(c)(7) (requiring a fund that experiences an event specified in 
the parts of Form N-RN titled ``Relative VaR Test Breaches,'' 
``Absolute VaR Test Breaches,'' or ``Compliance with VaR Test'' to 
file with the Commission a report on Form N-RN within the period and 
according to the instructions specified in that form).
    \384\ See, e.g., proposed General Instruction A.(1) to Form N-RN 
(amending the defined term ``registrant''); proposed General 
Instruction A.(2) to Form N-RN (amending the submission requirement 
to clarify application to the new VaR-test-breach-related items); 
proposed General Instruction A.(3) to Form N-RN (clarifying that 
only open-end funds required to comply with rule 22e-4 under the 
Investment Company Act would be required to respond to events 
occurring in Parts B-D, as applicable, while funds required to 
comply with the limit on fund leverage risk in proposed rule 18f-4 
would be required to respond to events specified in proposed Parts 
E-G, as applicable); and proposed General Instruction F to Form N-RN 
(clarifying that the terms used in proposed Parts E-G, unless 
otherwise specified, would have the same meaning as the terms in 
proposed rule 18f-4).

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[[Page 4502]]

    We are proposing to require funds to provide this information in a 
current report because we believe that the Commission should be 
notified promptly when a fund is out of compliance with the proposed 
VaR-based limit on fund leverage risk, which in turn we believe could 
indicate that a fund is experiencing heightened risks as a result of 
the fund's use of derivatives transactions. VaR test breaches could 
indicate that a fund is using derivatives transactions to leverage the 
fund's portfolio, magnifying its potential for losses and significant 
payments of fund assets to derivatives counterparties. Such breaches 
also could indicate market events that are drivers of potential 
derivatives risks or other risks across the fund industry. Either of 
these scenarios--increased fund-specific risks, or market events that 
affect funds' risks broadly--may, depending on the facts and 
circumstances, require attention by the Commission. The proposed 
current reporting requirement is designed to provide the Commission 
current information regarding potential increased risks and stress 
events (as opposed to a requirement to report the same or similar 
information later, for example on Form N-PORT).\385\ The one-business-
day time-frame for submitting a report on Form N-RN regarding a fund's 
VaR test breaches is designed to provide an appropriately early 
notification to the Commission of potential heightened risks, while at 
the same time providing sufficient time for a fund to compile and file 
its report on Form N-RN. This time-frame is also consistent with the 
current required timing for reporting other events on Form N-
LIQUID.\386\
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    \385\ See supra section II.H.1.b.
    \386\ See General Instruction A of Form N-LIQUID.
---------------------------------------------------------------------------

    We are cognizant that certain adverse effects might arise from 
real-time public reporting of a fund's VaR test breaches. For example, 
publicly disclosing this information could lead to investor confusion. 
Investors might mistakenly assume that a fund that breached the 
applicable VaR test actually had suffered substantial losses or that 
substantial losses necessarily were imminent. Investors might also 
believe that a fund's failing the VaR test suggests a sudden increase 
in fund risk when, in some cases, a fund can fail a VaR test--and 
especially an absolute VaR test--due to changes in market volatility 
generally. Investors also might believe that a fund's real-time 
reporting of a VaR test breach necessarily meant that the fund was not 
complying with applicable regulations. Information about VaR breaches 
would therefore provide important information to the Commission and its 
staff for regulatory purposes but could confuse investors and lead them 
and other market participants to make incorrect assumptions about a 
fund's relative riskiness. This could have potential adverse effects 
for funds if investors redeem or sell fund shares as a result. Other 
market participants also could react to real-time reporting of VaR 
breaches in ways that could adversely affect funds. For example, if 
market participants knew on a real-time basis that a fund had breached 
the applicable VaR test, market participants might seek to anticipate 
the trading activity the fund might undertake to come back into 
compliance and engage in predatory trading that could adversely affect 
the fund. Accordingly, we are proposing to make funds' reports on Form 
N-RN regarding VaR test breaches (like their reports on this form 
regarding liquidity-related items) non-public, because we preliminarily 
believe that public disclosure of this information is neither necessary 
nor appropriate in the public interest or for the protection of 
investors.\387\
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    \387\ See proposed General Instruction A.(1) to Form N-RN; see 
also section 45(a) of the Investment Company Act (requiring 
information in reports filed with the Commission pursuant to the 
Investment Company Act to be made available to the public, unless we 
find that public disclosure is neither necessary nor appropriate in 
the public interest or for the protection of investors).
---------------------------------------------------------------------------

    We seek comment on the Commission's proposed amendments to Form N-
LIQUID requiring reporting of certain information regarding a fund's 
VaR test breaches:
    214. Is the proposed new current reporting requirement for funds 
that are subject to the VaR-based limit on fund leverage risk 
appropriate? Why or why not? If not, how should the scope of the 
proposed current reporting requirement be modified? Should we require 
additional current reporting requirements for funds to report other 
derivatives-risk-related information? For example, should funds that 
are limited derivatives users pursuant to the proposed exposure-based 
exception be required to file current reports if their derivatives 
exposure were to exceed 10% of their net assets? \388\ Should we 
require a fund to file a current report if it identifies a certain 
number of exceptions as a result of backtesting its VaR calculation 
model, and if so, what circumstances should trigger the requirement to 
file a current report? \389\
---------------------------------------------------------------------------

    \388\ See supra section II.E.1.
    \389\ See supra section II.B.3.d (discussing backtesting 
requirements in proposed rule 18f-4); see also supra section 
II.H.1.b (discussing proposed requirement to report backtesting 
results on Form N-PORT).
---------------------------------------------------------------------------

    215. Is each of the pieces of information that we propose a fund 
would include in a report about a VaR test breach on proposed Form N-RN 
appropriate? Why or why not? Should we modify the required information 
in any way?
    216. For a fund that is out of compliance with the VaR test, and is 
unable to come back into compliance within three business days after 
its initial determination, the proposed current reporting requirement 
would require that fund to file a report on Form N-RN providing certain 
information regarding its VaR test breaches. Is the proposed three-
business-day current reporting requirement appropriate? Why or why not? 
Should the rule require a shorter or longer period, such as one or 
seven days, before prompting a current reporting requirement? Which 
time period would be appropriate and why?
    217. We are proposing that a fund's reports regarding VaR test 
breaches on Form N-RN would not be made public. Would there be a 
benefit to publicly reporting this information, and would it be 
appropriate to make these disclosures public? Why or why not? Should we 
make public some of these disclosures but not others? If so, which ones 
should we make public and why?
    218. As an alternative or an addition to the proposed current 
reporting requirement, should we require funds to report information 
regarding VaR test breaches on Form N-PORT? Why or why not? If so, 
should we make public this information reported on Form N-PORT?
    219. Should we modify the proposed current reporting requirement to 
require reporting by certain types of funds and not others? If so which 
types of funds, and why? For example, should we require BDCs also to 
report the information that we are proposing them to report on Form N-
RN on Form 8-K? Why or why not?
    220. As an alternative to amending Form N-LIQUID to require current 
reporting on VaR test breaches, should we provide a new, separate 
current reporting form for funds to use to report VaR test breaches 
(and/or any other current reporting items relating to their derivatives 
risk management programs under proposed rule 18f-4)? Why or why not?
3. Amendments to Form N-CEN
    Form N-CEN currently includes an item that requires a fund to 
indicate--in a manner similar to ``checking a

[[Page 4503]]

box''--whether the fund has relied on certain Investment Company Act 
rules during the reporting period.\390\ We are proposing amendments to 
this item to require a fund to identify whether it relied on proposed 
rule 18f-4 during the reporting period.\391\ We are also proposing 
amendments to require a fund to identify whether it relied on any of 
the exceptions from various requirements under the proposed rule, 
specifically:
---------------------------------------------------------------------------

    \390\ See Item C.7 of Form N-CEN.
    \391\ See proposed Item C.7.l of Form N-CEN.
---------------------------------------------------------------------------

     Whether the fund is a limited derivatives user excepted 
from the proposed rule's program requirement, under either the proposed 
exception for funds that limit their derivatives exposure to 10% of 
their net assets or under the exception for funds that limit their 
derivatives use to certain currency hedging; \392\ or
---------------------------------------------------------------------------

    \392\ See proposed Item C.7.l.i.-ii of Form N-CEN; see also 
supra section II.E.
---------------------------------------------------------------------------

     Whether the fund is a leveraged/inverse fund covered by 
the proposed sales practices rules that, under proposed rule 18f-4, 
would be excepted from the proposed limit on fund leverage risk.\393\
---------------------------------------------------------------------------

    \393\ See proposed Item C.7.l.iii of Form N-CEN; see also supra 
section II.G.
---------------------------------------------------------------------------

    Finally, a fund would have to identify whether it has entered into 
reverse repurchase agreements or similar financing transactions, or 
unfunded commitment agreements, as provided under the proposed 
rule.\394\ This information would assist the Commission and staff with 
our oversight functions by allowing us to identify which funds were 
excepted from certain of the proposed rule's provisions or relied on 
the rule's provisions regarding reverse repurchase agreements and 
unfunded commitment agreements.
---------------------------------------------------------------------------

    \394\ See proposed Item C.7.l.iv-v of Form N-CEN; see also infra 
sections II.I and II.J.
---------------------------------------------------------------------------

    We seek comment on the Commission's proposed amendments to Form N-
CEN:
    221. Should we require, as proposed, that funds identify that they 
relied on rule 18f-4, including whether they are limited derivatives 
users that are excepted from the proposed program requirement? Why or 
why not?
    222. Should we require, as proposed, that funds identify that they 
are leveraged/inverse funds that are excepted from the proposed limit 
on fund leverage risk? Why or why not?
    223. Should we require, as proposed, that funds identify that they 
entered into reverse repurchase agreements or similar financing 
transactions, or unfunded commitment agreements? Why or why not?
    224. Are there other means that funds use to disclose or report 
information (e.g., prospectus or annual report disclosure in addition 
to the other disclosure requirements in this proposal) that would be 
more appropriate for reporting any of the information that the proposed 
amendments to Form N-CEN would require? Should any of the disclosures 
required in the proposed amendments to Form N-PORT above be made on 
Form N-CEN? Why or why not?
4. BDC Reporting
    BDCs do not file reports on Form N-CEN or Form N-PORT. We 
considered proposing to require that BDCs provide the new information 
that we propose registered funds report on Form N-CEN, and the new 
information regarding derivatives exposure and VaR that we propose to 
require funds to report on Form N-PORT, in their annual reports on Form 
10-K. BDCs, however, generally do not enter into derivatives 
transactions or do so to a limited extent.\395\ We therefore believe 
that most BDCs that enter into derivatives transactions would qualify 
for the limited derivatives user exception (which would make the 
proposed VaR reporting items on Form N-PORT inapplicable to BDCs). In 
addition, and as noted above, we understand that even when BDCs do use 
derivatives more extensively, derivatives generally do not play as 
significant of a role in implementing the BDC's strategy, as compared 
to many other types of funds that use derivatives extensively. BDCs are 
required under the Investment Company Act to invest at least 70% of 
their total assets in ``eligible portfolio companies,'' which may limit 
the role that derivatives can play in a BDC's portfolio relative to 
other kinds of funds that would generally execute their strategies 
primarily through derivatives transactions (e.g., a managed futures 
fund). BDCs that would not qualify as limited derivatives users under 
the proposed rule also would be subject to the proposed new requirement 
to file current reports regarding VaR test breaches on Form N-RN.\396\ 
Taking these factors into account, we are not proposing additional 
reporting requirements for BDCs because we believe that the reporting 
framework we are proposing for BDCs adequately addresses the 
Commission's ability to monitor BDCs' compliance with the proposed 
rules, as well as any competitive disparities that could result from 
disparate reporting requirements among funds that rely on proposed rule 
18f-4.\397\
---------------------------------------------------------------------------

    \395\ See supra section II.D.2.b.
    \396\ See supra section II.H.2.
    \397\ We have separately proposed to require BDCs to tag their 
financial statements using Inline XBRL, a structured, machine-
readable format, which would provide structured data about BDCs' 
derivatives and other investments. See Securities Offering Reform 
Proposing Release, supra note 199, at section II.H.1. In addition, 
BDCs are currently required to disclose certain information about 
their exposures to market risks, including risks that may arise as a 
result of their derivatives-related activity. See, e.g., Items 303 
and 305 of Regulation S-K [17 CFR 229.303 and 229.305].
     See also infra section III.D.2 (discussing, among other things, 
potential competitive effects resulting from BDCs not being subject 
to the proposed additional reporting requirements on Form N-PORT and 
Form N-CEN).
---------------------------------------------------------------------------

    We seek comment on the Commission's proposal to not require BDCs to 
report on Forms N-PORT or N-CEN:
    225. Should we require BDCs to report any of the same information 
on Form 10-K (or elsewhere, such as in a BDC's prospectus) that we are 
proposing to require registered investment companies to report on Forms 
N-CEN and N-PORT? Why or why not? Should we require, for example, that 
a BDC report its derivatives exposure, whether it is a limited 
derivatives user, and/or its designated reference index (if 
applicable)? If so, where? If a BDC uses derivatives and does not 
qualify as a limited derivatives user, should it have to report 
information about its derivatives exposure and portfolio VaR on Form N-
PORT (or elsewhere)?
    226. Should we require BDCs to report on Form 10-K or elsewhere 
whether they have relied on the rule's provision regarding reverse 
repurchase agreements and similar financing transactions or unfunded 
commitment agreements?

I. Reverse Repurchase Agreements

    Funds may engage in certain transactions that may involve senior 
securities primarily as a means of obtaining financing. For example, 
open-end funds are permitted to borrow money from a bank, provided they 
maintain a 300% asset coverage ratio.\398\ Another common method of 
obtaining financing is through the use of reverse repurchase 
agreements. In a reverse repurchase agreement, a fund transfers a 
security to another party in return for a percentage of the value of 
the security. At an agreed-upon future date, the fund repurchases the 
transferred security by paying an amount equal to the proceeds of the 
initial sale transaction plus interest.\399\ A reverse repurchase

[[Page 4504]]

agreement is economically equivalent to a secured borrowing.\400\
---------------------------------------------------------------------------

    \398\ See section 18(f)(1) of the Investment Company Act.
    \399\ See Release 10666, supra note 15, at ``Reverse Repurchase 
Agreements'' discussion (stating that a reverse repurchase agreement 
may not have an agreed-upon repurchase date, and in that case the 
agreement would be treated as if it were reestablished each day).
    \400\ See, e.g., Office of Financial Research, Reference Guide 
to U.S. Repo and Securities Lending Markets (Sept. 9, 2015), 
available at https://www.financialresearch.gov/working-papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-Markets.pdf.
---------------------------------------------------------------------------

    We believe that reverse repurchase agreements and other similar 
financing transactions that have the effect of allowing a fund to 
obtain additional cash that can be used for investment purposes or to 
finance fund assets should be treated for section 18 purposes like a 
bank borrowing or other borrowing, as they achieve effectively 
identical results. Accordingly, we are proposing that a fund may engage 
in reverse repurchase agreements and other similar financing 
transactions so long as they are subject to the relevant asset coverage 
requirements of section 18.\401\ For example, this would have the 
effect of permitting an open-end fund to obtain financing by borrowing 
from a bank, engaging in a reverse repurchase agreement, or any 
combination thereof, so long as all sources of financing are included 
when calculating the fund's asset coverage ratio.\402\
---------------------------------------------------------------------------

    \401\ Proposed rule 18f-4(d). Among other things, section 18 
prescribes the required amount of asset coverage for a fund's senior 
securities and provides certain consequences for a fund that fails 
to maintain this amount. See, e.g., section 18(a) (restrictions on 
dividend issuance). This provision in rule 18f-4 would not provide 
any exemptions from the requirements of section 61 for BDCs because 
that section does not limit a BDC's ability to engage in reverse 
repurchase or similar transactions in parity with other senior 
security transactions permitted under that section.
    \402\ Section 18 states that certain borrowings that are made 
for temporary purposes (less than 60 days) and that do not exceed 5% 
of the total assets of the issuer at the time when the loan is made 
(temporary loans) are not senior securities for purposes of certain 
paragraphs in section 18. As we noted in Release 10666, reverse 
repurchase agreements and similar financing transactions could be 
designed to appear to fall within the temporary loans exception, and 
then could be ``rolled-over,'' perhaps indefinitely, with such 
short-term transactions being entered into, closed out, and later 
re-entered. If substantially similar financing arrangements were 
being ``rolled over'' in any manner for a total period of 60 days or 
more, we would treat the later transactions as renewals of the 
earlier ones, and all such transactions would fall outside the 
exclusion for temporary loans.
---------------------------------------------------------------------------

    Reverse repurchase agreements and similar financing transactions 
are not treated as derivatives transactions under the proposed rule 
because they have the economic effects of a secured borrowing, and thus 
more closely resemble bank borrowings with a known repayment obligation 
rather than the more-uncertain payment obligations of many derivatives. 
However, such transactions can have the effect of introducing leverage 
into a fund's portfolio if the fund were to use the proceeds of the 
financing transaction to purchase additional investments. In addition, 
such transactions impose a requirement to return assets at the 
termination of the agreement, which can raise section 18 asset 
sufficiency concerns to the extent the fund needs to sell less-liquid 
securities at a loss to obtain the necessary assets.
    Reverse repurchase agreements and similar financing transactions 
would not be included in calculating a fund's derivatives exposure 
under the limited derivatives user provisions of the proposed rule. 
However, if a fund did not qualify as a limited derivatives user due to 
its other investment activity, any portfolio leveraging effect of 
reverse repurchase agreements or similar financing transactions would 
be included and restricted through the proposed VaR-based limit on fund 
leverage risk. This is because the proposed VaR tests estimate a fund's 
risk of loss taking into account all of its investments, including the 
proceeds of reverse repurchase agreements and similar investments the 
fund purchased with those proceeds.
    Securities lending arrangements are structurally similar to reverse 
repurchase agreements in that, in both cases, a fund transfers a 
portfolio security to a counterparty in exchange for cash (or other 
assets). Although these arrangements are structurally similar, under 
our proposal we would not view a fund's obligation to return securities 
lending collateral as a ``similar financing transaction'' in the 
circumstances discussed below. In the 2015 Proposing Release, we sought 
comment on whether rule 18f-4 should address funds' compliance with 
section 18 in connection with securities lending.\403\ Commenters 
stated that the staff's current guidance on securities lending forms 
the basis for funds' securities lending practices and effectively 
addresses the senior securities implications of securities lending, and 
thus securities lending practices need not be addressed in the final 
rule.\404\
---------------------------------------------------------------------------

    \403\ 2015 Proposing Release, supra note 2, at paragraph 
accompanying n.149.
    \404\ See, e.g., ICI Comment Letter I; Guggenheim Comment 
Letter; SIFMA Comment Letter; Comment Letter of the Risk Management 
Association (Mar. 28, 2016). Staff guidance on Securities Lending by 
U.S. Open-End and Closed-End Investment Companies (Feb. 27, 2014), 
available at https://www.sec.gov/divisions/investment/securities-lending-open-closed-end-investment-companies.htm (providing guidance 
on certain no-action letters that funds consider when engaging in 
securities lending and summarizing areas those letters address, 
including limitations on the amount that may be lent and 
collateralization for such loans).
---------------------------------------------------------------------------

    Currently, funds that engage in securities lending typically 
reinvest cash collateral in highly liquid, short-term investments, such 
as money market funds or other cash or cash equivalents, and funds 
generally do not sell or otherwise use non-cash collateral to leverage 
the fund's portfolio.\405\ We believe a fund that engages in securities 
lending under these circumstances is limited in its ability to use 
securities lending transactions to increase leverage in its portfolio. 
Accordingly, the proposed rule does not treat a fund's obligation to 
return securities lending collateral as a financing transaction similar 
to a reverse repurchase agreement, so long as the obligation relates to 
an agreement under which a fund engages in securities lending, the fund 
does not sell or otherwise use non-cash collateral received for loaned 
securities to leverage the fund's portfolio, and the fund invests cash 
collateral solely in cash or cash equivalents. If a fund were to engage 
in securities lending and to invest the cash collateral in securities 
other than cash or cash equivalents, this may result in leveraging of 
the fund's portfolio, and we believe this activity would be a ``similar 
financing transaction'' and should thus be included when calculating a 
funds asset coverage ratio.
---------------------------------------------------------------------------

    \405\ See ICI, Securities Lending by Mutual Funds, ETFs, and 
Closed-End Funds: The Basics (Sept. 14, 2014), available at https://www.ici.org/viewpoints/view_14_sec_lending_01 (``[T]he collateral 
that funds can accept from borrowers must be highly liquid, such as 
cash, government securities, or bank letters of credit. U.S. 
regulated funds typically demand cash collateral. . . . In practice, 
U.S. regulated funds most often invest cash collateral in money 
market funds.''); SIFMA, Master Securities Lending Agreement, 
section 4.2 (2000), available at https://www.sifma.org/wp-content/uploads/2017/08/MSLA_Master-Securities-Loan-Agreement-2000-Version.pdf (generally limiting lenders from re-hypothecating non-
cash collateral).
---------------------------------------------------------------------------

    We believe that a fund's obligation with respect to a ``tender 
option bond'' (``TOB'') financing may be similar to a reverse 
repurchase agreement in some circumstances. One commenter on the 2015 
proposal explained that TOB financings are economically similar to 
reverse repurchase agreements because a fund employing a TOB trust has 
in effect used the underlying bond as collateral to secure a borrowing 
analogous to a fund's use of a security to secure a reverse repurchase 
agreement.\406\ We believe that determining whether a TOB is a similar 
financing transaction as a reverse repurchase agreement would depend on 
the facts and circumstances. To the

[[Page 4505]]

extent a fund concludes that there are economic similarities between a 
TOB financing and a reverse repurchase agreement, the fund should treat 
obligations with respect to the TOB financing as a similar financing 
transaction under the proposed rule.
---------------------------------------------------------------------------

    \406\ See SIFMA Comment Letter.
---------------------------------------------------------------------------

    We request comment on our proposed approach to reverse repurchase 
agreements and similar financing transactions under the proposed rule.
    227. As proposed, should we treat reverse repurchase agreements and 
similar financing transactions as economically equivalent to bank 
borrowings under section 18, and subject them to the same asset 
coverage requirements? Why or why not?
    228. Should we not combine reverse repurchase agreements with bank 
borrowing and other senior securities under the provision, and instead 
treat them separately but with the same limit? For example, should we 
allow a fund to borrow from a bank subject to the 300% asset coverage 
limit and also separately use reverse repurchase agreements up to a 
300% asset coverage limit?
    229. Should we instead treat such reverse repurchase agreements and 
similar financing transactions as derivatives transactions under the 
proposed rule? Would this have any disparate effects on certain types 
of funds?
    230. Is there a way to distinguish reverse repurchase agreements 
and similar financing transactions that funds use to leverage their 
portfolios from instances in which funds use those transactions for 
other purposes? If so, should we treat such transactions engaged in for 
leveraging purposes differently than transactions engaged in for other 
purposes?
    231. Should we include securities lending transactions as a similar 
financing transaction (regardless of how the proceeds are invested) 
under the proposed provision? Why or why not? Should we define in rule 
18f-4 the circumstances under which securities lending would not be 
treated as a similar financing transaction?
    232. Are there other types of transactions that we should identify 
and treat as similar financing transactions to reverse repurchase 
agreements that we have not identified above? What are they and why 
should they be treated accordingly?

J. Unfunded Commitment Agreements

    Under unfunded commitment agreements, a fund commits, conditionally 
or unconditionally, to make a loan to a company or to invest equity in 
a company in the future.\407\ They include capital commitments to a 
private fund requiring investors to fund capital contributions or to 
purchase shares upon delivery of a drawdown notice. The proposed rule 
would therefore define an unfunded commitment agreement to mean a 
contract that is not a derivatives transaction, under which a fund 
commits, conditionally or unconditionally, to make a loan to a company 
or to invest equity in a company in the future, including by making a 
capital commitment to a private fund that can be drawn at the 
discretion of the fund's general partner.\408\
---------------------------------------------------------------------------

    \407\ We understand that the types of funds that enter into 
unfunded commitment agreements typically include BDCs and registered 
closed-end funds.
    \408\ Proposed rule 18f-4(a).
---------------------------------------------------------------------------

    The Commission's 2015 proposal would have treated these agreements 
as ``financial commitment transactions.'' As a result, a fund's 
obligations under the agreements could not exceed the fund's net asset 
value.\409\ Commenters on the 2015 proposal identified characteristics 
of these agreements that they believed distinguished unfunded 
commitments from the derivatives transactions and financial commitment 
transactions covered by that proposal, which are also covered by re-
proposed rule 18f-4.\410\ First, commenters stated that a fund often 
does not expect to lend or invest up to the full amount committed. 
Second, commenters stated that a fund's obligation to lend is commonly 
subject to conditions, such as a borrower's obligation to meet certain 
financial metrics and performance benchmarks, which are not typically 
present under the types of agreements that the Commission described in 
Release 10666.\411\ Commenters also asserted that unfunded commitment 
agreements do not give rise to the risks that Release 10666 identified 
and do not have a leveraging effect on the fund's portfolio because 
they do not present an opportunity for the fund to realize gains or 
losses between the date of the fund's commitment and its subsequent 
investment when the other party to the agreement calls the 
commitment.\412\ These commenters contrasted firm and standby 
commitment agreements, under which a fund commits itself to purchase a 
security with a stated price and fixed yield without condition or upon 
the counterparty's demand.\413\ They argued that the firm and standby 
commitment agreements that Release 10666 describes expose the fund to 
investment risk during the life of the transaction, because the value 
of the fund's commitment agreement will change as interest rates 
change.
---------------------------------------------------------------------------

    \409\ See 2015 proposed rule 18f-4(c)(4) (defining ``financial 
commitment transactions''); 2015 proposed rule 18f-4(b) (permitting 
funds to engage in financial commitment transactions if the fund 
maintains qualifying coverage assets with a value equal to at least 
the fund's aggregate financial commitment obligations); 2015 
proposed rule 18f-4(c)(5) (defining a fund's ``financial commitment 
obligations,'' in part, to mean ``the amount of cash or other assets 
that the fund is conditionally or unconditionally obligated to pay 
or deliver under a financial commitment transaction).
    \410\ Specifically, these commenters generally compared unfunded 
commitment agreements to firm and standby commitment agreements 
(which we would in turn interpret the phrase ``or any similar 
instrument'' in proposed rule 18f-4's definition of ``derivatives 
transaction'' to include, see supra note 91 and accompanying 
paragraph). See, e.g., Letter of Ares Capital Corporation (Mar. 28, 
2016) (``Ares Comment Letter''); Comment Letter of the Small 
Business Investor Alliance (Mar. 28, 2016) (``SBIA Comment 
Letter''); Comment Letter of the Center for Capital Markets 
Competitiveness, U.S. Chamber of Commerce (Mar. 28, 2016); Comment 
Letter of Skadden, Arps, Slate, Meagher & Flom LLP (Mar. 28, 2016) 
(``Skadden Comment Letter''); Dechert Comment Letter; Private Equity 
Growth Capital Council (Mar. 28, 2016) (``PEGCC Comment Letter'').
    \411\ See, e.g., SBIA Comment Letter; Comment Letter of Hercules 
Capital (Mar. 29, 2016); see also, e.g., Skadden Comment Letter 
(contingent loan commitments typically have ``funding conditions 
that excuse the BDC from funding if the borrower does not continue 
to satisfy various representations, financial and non-financial 
metrics and performance conditions . . . [and] cannot result in 
substantial risk of loss prior to funding because the BDC is not 
required to fund the loan if the borrower's credit or financial 
position degenerates meaningfully.'').
    \412\ See, e.g., PEGCC Comment Letter (distinguishing the 
agreements that Release 10666 discusses because, while the value of 
the fund's limited partnership interest may fluctuate based on the 
amount of capital it invests in the private fund, the fund has no 
profit or loss on the unfunded commitment); Ares Comment Letter 
(stating that, in general, unfunded loan commitments do not reflect 
a bet on interest rate movements because the yields for unfunded 
loan commitments are determined as a spread over a prevailing market 
interest rate); see also Altegris Comment Letter (explaining that 
unfunded commitment agreements do not have a potential for 
``pyramiding'' because--in contrast to a reverse repurchase 
agreement--a fund ``receives nothing from the underlying private 
equity funds in return for its capital commitments and, as a result, 
its gross assets remain unchanged.'').
    \413\ See, e.g., SBIA Comment Letter; see also Altegris Comment 
Letter; Ares Comment Letter; Comment Letter of Dechert (Feb. 7, 
2016); Skadden Comment Letter.
---------------------------------------------------------------------------

    We agree that these factors distinguish unfunded commitment 
agreements from the derivatives transactions covered by proposed rule 
18f-4. The derivatives transactions covered by proposed rule 18f-4--
including the firm and standby commitment agreements the Commission 
described in Release 10666--expose the fund to investment risk during 
the life of the transaction. Derivatives transactions therefore can be 
used to leverage a fund's portfolio by enabling a fund to magnify its 
gains and

[[Page 4506]]

losses compared to the fund's investment, while also obligating the 
fund to make a payment to a counterparty. Based on the characteristics 
of unfunded commitment agreements commenters described, which we 
understand are typical of these agreements, we do not believe that such 
unfunded commitment agreements are undertaken to leverage a fund's 
portfolio. For example, if the yield for an unfunded loan commitment is 
determined as a spread over a prevailing market interest rate, the 
agreement creates a risk that the fund would not have liquid assets to 
fund the loan, but the agreement would not reflect a speculative 
position on the direction of interest rates.\414\ We therefore do not 
believe that such unfunded commitment agreements generally raise the 
Investment Company Act's concerns regarding the risks of undue 
speculation.\415\
---------------------------------------------------------------------------

    \414\ Cf. Release 10666, supra note 15, at n.12 (``Commitments 
to purchase securities whose yields are determined on the date of 
delivery with reference to prevailing market interest rates are not 
intended to be included in this general statement of policy. Such 
commitments neither create nor shift the risk associated with 
interest rate changes in the marketplace, and in economic reality 
have no discernible potential for leverage.'').
    \415\ See supra notes 45-47 and accompanying text.
---------------------------------------------------------------------------

    Depending on the facts and circumstances, however, an unfunded 
commitment agreement could raise the asset sufficiency concerns 
underlying the Investment Company Act.\416\ A fund could be required to 
liquidate other assets to obtain the cash needed to satisfy its 
obligation under an unfunded commitment agreement if the fund did not 
have cash on hand to meet its obligation to provide a committed loan or 
make a committed equity investment. If the fund is unable to meet its 
obligations, the fund would be subject to default remedies available to 
its counterparty. For example, if a fund fails to fulfill its 
commitments to invest in a private fund when called to do so, the fund 
could be subject to the remedies specified in the limited partnership 
agreement (or similar document) relating to that private fund. These 
remedies can have the practical effect of forfeiture of some or all of 
the fund's investment in the private fund.\417\ In these and other 
circumstances a fund's investors could be harmed if the fund is unable 
to meet its obligations under an unfunded commitment agreement.
---------------------------------------------------------------------------

    \416\ See id.
    \417\ See, e.g., Phyllis A. Schwartz & Stephanie R. Breslow, 
Private Equity Funds: Formation and Operation (June 2015 ed.), at 2-
34 (remedies private equity funds may apply in event of investor 
default include, among other things, the right to charge high 
interest on late payments, the right to force a sale of the 
defaulting investor's interest, the right to continue to charge 
losses and expenses to defaulting investors while cutting off their 
interest in future profits, and the right to take any other action 
permitted at law or in equity).
---------------------------------------------------------------------------

    Because unfunded commitment agreements can raise the asset 
sufficiency concern underlying section 18, but generally do not raise 
the undue speculation concern associated with derivatives transactions 
(and reverse repurchase agreements and similar financing transactions), 
we are proposing to permit a fund to enter into unfunded commitment 
agreements if it reasonably believes, at the time it enters into such 
an agreement, that it will have sufficient cash and cash equivalents to 
meet its obligations with respect to all of its unfunded commitment 
agreements, in each case as they come due.\418\ While a fund should 
consider its unique facts and circumstances to have such a reasonable 
belief, the proposed rule would prescribe certain specific factors that 
a fund must take into account.\419\
---------------------------------------------------------------------------

    \418\ See proposed rule 18f-4(e)(1). Because this proposed 
condition is designed to provide an approach tailored to unfunded 
commitment agreements, the proposed rule would also provide that 
these transactions would not be considered for purposes of computing 
asset coverage under section 18(h). As with our approach to 
derivatives transactions, applying section 18(h) asset coverage to 
these transactions appears unnecessary in light of the tailored 
requirement we are proposing. See supra note 66.
    \419\ The proposed rule would also require the fund to make and 
maintain records documenting the basis for this belief. See proposed 
rule 18f-4(e)(2); see also infra section II.K.
---------------------------------------------------------------------------

    First, the proposed rule would require a fund to take into account 
its reasonable expectations with respect to other obligations 
(including any obligation with respect to senior securities or 
redemptions). This is because other obligations can place competing 
demands on cash a fund otherwise might intend to use to fund an 
unfunded commitment agreement. Second, the proposed rule would provide 
that a fund may not take into account cash that may become available 
from the sale or disposition of any investment at a price that deviates 
significantly from the market value of those investments. This 
provision is designed to address the risk that a fund could suffer 
losses by selling assets to raise cash to fund an unfunded commitment 
agreement, ultimately having an adverse impact on the fund's investors. 
Finally, the proposed rule would provide that a fund may not consider 
cash that may become available from issuing additional equity. Whether 
a fund would be able to raise capital in the future and the amount of 
any additional capital would depend on a variety of factors, including 
future market conditions, that we believe are too speculative to 
support a fund's reasonable belief that it could fund an unfunded 
commitment with the proceeds from future sales of the fund's 
securities. The proposed rule would not preclude a fund from 
considering the issuance of debt to support a reasonable belief that it 
could fund an unfunded commitment, as we understand that funds often 
satisfy their obligations under unfunded commitments through 
borrowings. Moreover, such borrowings by funds would be limited by 
section 18's asset coverage requirements, which would limit the extent 
to which a fund's belief regarding its ability to borrow would allow 
the fund to enter into unfunded commitment agreements.
    To have a reasonable belief, a fund therefore could consider, for 
example, its strategy, its assets' liquidity, its borrowing capacity 
under existing committed lines of credit, and the contractual 
provisions of its unfunded commitment agreements. A fund with unfunded 
loan commitments, for instance, could evaluate the likelihood that 
different potential borrowers would meet contractual ``milestones'' 
that the borrowers would have to satisfy as a condition to the 
obligation to fund a loan, as well as the amount of the anticipated 
borrowing. The fund's historical experience with comparable obligations 
should inform this analysis. Whether a fund has a reasonable belief 
also could be informed by a fund's assessment of the likeliness that 
subsequent developments could impair the fund's ability to have 
sufficient cash and cash equivalents to meet its unfunded commitment 
obligations.
    This proposed approach for unfunded commitment agreements reflects 
the staff's experience in reviewing and commenting on fund registration 
statements, which have disclosure regarding the funds' unfunded 
commitments. These funds have generally represented, in substance, that 
they reasonably believe that their assets will provide adequate cover 
to allow them to satisfy all of their unfunded investment commitments, 
without taking into account any projected securities offerings. In 
their responses to staff comments, funds also have provided a general 
explanation as to the process by which they reached this reasonable 
belief.
    Finally, the proposed rule would provide that an agreement that 
meets the rule's definition of a derivatives transaction is not an 
unfunded

[[Page 4507]]

commitment.\420\ This is because the proposed rule's treatment of 
unfunded commitments is predicated on these agreements having 
characteristics that distinguish them from the derivatives transactions 
covered by the proposed rule, as discussed above. Because the proposed 
definition of the term ``derivatives transaction'' includes any 
instrument that is similar to certain listed derivatives instruments, a 
contract that is functionally similar to a listed derivatives 
instrument would be a derivatives transaction and therefore would not 
qualify for the proposed rule's treatment of unfunded commitment 
agreements.\421\ For example, a fund that enters into a binding 
commitment to make a loan or purchase a note upon demand by the 
borrower, with stated principal and term and a fixed interest rate, 
would appear to have entered into an agreement that is similar to a 
standby commitment agreement or a written put option.\422\ This 
transaction would expose the fund to investment risk during the life of 
the transaction because the value of the fund's commitment agreement 
will change as interest rates change. Such an agreement thus would fall 
within the proposed rule's definition of ``derivatives transaction'' 
and would not be an unfunded commitment agreement under the proposed 
rule.
---------------------------------------------------------------------------

    \420\ See proposed rule 18f-4(a) (defining the term ``unfunded 
commitment agreement'').
    \421\ See supra section II.A (discussing proposed definition of 
``derivatives transaction'').
    \422\ See supra paragraph accompanying notes 408-412 (discussing 
factors distinguishing unfunded commitment agreements from the 
derivatives transactions covered by proposed rule 18f-4).
---------------------------------------------------------------------------

    We request comment on our proposed approach to unfunded commitment 
agreements.
    233. Are unfunded commitment agreements distinguishable from 
derivatives transactions? Can funds use unfunded commitment agreements 
for speculation or to accomplish leveraging? If so, how? What types of 
funds enter into unfunded commitment agreements, and for what purposes?
    234. Does funds' use of unfunded commitment agreements raise the 
undue speculation and/or the assets sufficiency concerns underlying 
section 18 of the Investment Company Act? Why or why not?
    235. Is the proposed approach to unfunded commitment agreements 
appropriate? Would the proposed approach appropriately address any 
asset sufficiency concerns that funds' use of unfunded commitment 
agreements might entail? Why or why not?
    236. Is the proposed requirement that a fund must have a 
``reasonable belief'' regarding its ability to meet its unfunded 
commitment obligations, at the time it enters into an unfunded 
commitment agreement, appropriate? Should the rule instead, or also, 
require a fund to reassess whether this belief remains reasonable at 
various points during the period of the unfunded commitment agreement?
    237. Are the rule's provisions regarding the factors that a fund 
must consider in determining whether it has the required ``reasonable 
belief'' appropriate? Why or why not? Are they sufficiently clear? 
Should we specify other factors that a fund could consider? Should the 
rule provide, for example, that a fund may consider potential 
borrowings only to the extent the fund has committed lines of credit or 
other committed borrowing capacity? If so, how should we define 
``committed'' for this purpose?
    238. Under the proposed rule, a fund's reasonable belief that it 
has sufficient cash to satisfy its unfunded commitments may not be 
based on cash that may become available from issuing additional equity. 
Do commenters agree that a fund's ability to raise capital in the 
future, and the amount of any such additional capital, are based on 
factors that are too speculative to support a fund's reasonable belief 
that it could use that capital to fund an unfunded commitment? Are 
there circumstances in which a fund can expect to raise capital in the 
future, such as expected inflows from retirement plan platforms, that 
would not raise the same concerns about supporting a reasonable belief 
under the proposed rule? Should the rule permit a fund to consider such 
additional capital as a basis for forming a reasonable belief?
    239. Should the rule otherwise limit funds' use of unfunded 
commitment agreements? If so, how? For example, should the rule specify 
that funds' unfunded commitment agreements, in the aggregate, may not 
exceed the fund's net asset value? Or should we adopt different 
requirements for unfunded commitment agreements for different types of 
funds, based on their ability to borrow money under the Investment 
Company Act? \423\ Should the rule limit the agreements' counterparties 
or otherwise restrict the agreements' terms in any way? If so, how? 
Should we adopt different requirements for unfunded loan commitments, 
which generally will be contingent upon a borrower meeting certain 
``milestones,'' as compared to commitments to invest in a private fund 
due upon demand by the fund's adviser? If so, which requirements should 
apply to each type of transaction and why?
---------------------------------------------------------------------------

    \423\ See supra notes 29-32 and accompanying text.
---------------------------------------------------------------------------

    240. Should the rule instead treat all--or a specified subset of--
unfunded commitment agreements in the same way that it treats 
derivatives transactions? If a subset of these agreements, should the 
rule specify that certain characteristics of these agreements are 
indicative that these agreements are ``similar instruments'' in the 
proposed rule's definition of ``derivatives transaction''? Should a 
fund that enters into unfunded commitment agreements, but that 
otherwise does not use derivatives (or that limits its derivatives 
exposure, either as the proposed rule specifies in the limited 
derivative user provisions or otherwise) be subject to the proposed 
VaR-based limit on fund leverage risk? Should such a fund be exempt 
from any of the proposed rule's other requirements, and if so, which 
ones and why?
    241. Is the proposed definition of ``unfunded commitment 
agreement'' clear and appropriate? If not, how should the Commission 
modify it? Should the Commission clarify any aspect of the definition 
(e.g., should the Commission further define or provide guidance 
regarding agreements that involve a commitment to ``make a loan to a 
company'' or to ``invest equity in a company in the future'')? Would 
funds experience any challenges in practice differentiating between 
unfunded commitments, on the one hand, and firm or standby commitment 
agreements or other transactions included in the definition of 
``derivatives transaction,'' on the other? If so, how should the 
Commission provide additional clarity?
    242. Are there other types of transactions that we should identify 
and treat as similar to unfunded commitment agreements? What are they 
and why should they be treated accordingly? Are there any transactions 
that may be viewed as firm or standby commitment agreements, but that 
commenters believe should be given the same treatment as unfunded 
commitments under the proposed rule? What kinds of transactions and 
why?
    243. Would any adverse market effects result from the proposed 
treatment of unfunded commitment agreements? For example, would the 
proposal lead funds to restructure transactions as unfunded commitment 
agreements, and if so would this adversely affect investor protection? 
Would any modifications to the proposed rule, or additional

[[Page 4508]]

Commission guidance, help mitigate potential adverse market effects?

K. Recordkeeping Provisions

    Proposed rule 18f-4 also includes certain recordkeeping 
requirements. These proposed requirements are designed to provide our 
staff, and a fund's compliance personnel, the ability to evaluate the 
fund's compliance with the proposed rule's requirements.
    First, the proposed rule would require the fund to maintain certain 
records documenting the fund's derivatives risk management program. 
Specifically, for a fund subject to the proposed rule's program 
requirements, the proposed rule would require the fund to maintain a 
written record of its policies and procedures that are designed to 
manage the fund's derivatives risks.\424\ The proposed rule would also 
require a fund to maintain a written record of the results of any 
stress testing of its portfolio, results of any VaR test backtesting it 
conducts, records documenting any internal reporting or escalation of 
material risks under the program, and records documenting any periodic 
reviews of the program.\425\ These records would allow our staff to 
understand a fund's derivatives risk management program and how the 
fund administered it.
---------------------------------------------------------------------------

    \424\ Proposed rule 18f-4(c)(6)(i)(A); see also supra section 
II.B.3.
     Under proposed rule 18f-4(c)(4), leveraged/inverse funds would 
be subject to the proposed rule's derivatives risk management 
program requirement. Such funds would therefore also be subject to 
the program-related recordkeeping provisions of the proposed rule.
    \425\ Proposed rule 18f-4(c)(6)(i)(A).
---------------------------------------------------------------------------

    Second, the proposed rule would require funds to keep records of 
any materials provided to the fund's board of directors in connection 
with approving the designation of the derivatives risk manager.\426\ 
The proposed rule would also require a fund to keep records of any 
written reports provided to the board of directors relating to the 
program, and any written reports provided to the board that the rule 
would require regarding the fund's non-compliance with the applicable 
VaR test.\427\ These records would help our staff to understand what 
was provided to the fund's board while overseeing the fund's program.
---------------------------------------------------------------------------

    \426\ Proposed rule 18f-4(c)(6)(i)(B); see also supra section 
II.C.
    \427\ Id.; see also supra section II.D.5.b.
---------------------------------------------------------------------------

    Third, for a fund that is required to comply with the proposed VaR-
based limit on fund leverage risk, the fund would have to maintain 
records documenting the fund's determination of: The VaR of its 
portfolio; the VaR of the fund's designated reference index, as 
applicable; the fund's VaR ratio (the value of the VaR of the fund's 
portfolio divided by the VaR of the designated reference index), as 
applicable; and any updates to any VaR calculation models used by the 
fund, as well as the basis for any material changes made to those 
models.\428\ These records would provide information on the operation 
of a fund's VaR test and, for example, would allow our staff to better 
understand how a fund (and funds generally) implement the proposed VaR 
tests.
---------------------------------------------------------------------------

    \428\ Proposed rule 18f-4(c)(6)(i)(C); see also supra section 
II.K.
---------------------------------------------------------------------------

    Fourth, the proposed rule would require a fund that is a limited 
derivatives user to maintain a written record of its policies and 
procedures that are reasonably designed to manage its derivatives 
risk.\429\ These records would help our staff to understand what 
policies and procedures that a limited derivatives user has adopted and 
implemented to address the risks associated with its use of 
derivatives.
---------------------------------------------------------------------------

    \429\ Proposed rule 18f-4(c)(6)(i)(D); see also supra section 
II.K.
---------------------------------------------------------------------------

    Fifth, the proposed rule would require a fund that enters into 
unfunded commitment agreements to maintain a record documenting the 
basis for the fund's belief regarding the sufficiency of its cash and 
cash equivalents to meet its obligations with respect to its unfunded 
commitment agreements.\430\ A fund must make such a record each time it 
enters into such an agreement.\431\ These records would allow our staff 
to understand and evaluate funds' determinations regarding their 
ability to meet their obligations under their unfunded commitment 
agreements.
---------------------------------------------------------------------------

    \430\ Proposed rule 18f-4(e)(2); see also supra section II.K.
    \431\ Id.
---------------------------------------------------------------------------

    Finally, the proposed rule would require funds to maintain the 
required records for a period of five years.\432\ In particular, a fund 
must retain a copy of its written policies and procedures under the 
rule that are currently in effect, or were in effect at any time within 
the past five years, in an easily accessible place.\433\ In addition, a 
fund would have to maintain all other records and materials that the 
rule would require the fund to keep for at least five years (the first 
two years in an easily accessible place).\434\ The proposed five-year 
retention period is consistent with the period provided in rule 38a-
1(d) and rule 22e-4 under the Investment Company Act. We believe 
consistency in these retention periods is appropriate because funds 
currently have compliance-program-related recordkeeping procedures in 
place incorporating a five-year retention period, which we believe 
would lessen the proposed new recordkeeping compliance burden to funds, 
compared to choosing a different, longer retention period.
---------------------------------------------------------------------------

    \432\ Proposed rule 18f-4(c)(6)(ii); proposed rule 18f-4(e)(2).
    \433\ Proposed rule 18f-4(c)(6)(ii)(A); see also supra notes 423 
and 428 and accompanying text. The retention requirement would apply 
to both funds that are required to implement a derivatives risk 
management program and funds that are limited derivatives users 
under proposed rule 18f-4(c)(3).
    \434\ Proposed rule 18f-4(c)(6)(ii)(B); proposed rule 18f-
4(e)(2).
---------------------------------------------------------------------------

    We request comment on the proposed rule's recordkeeping 
requirements.
    244. Are the proposed recordkeeping provisions appropriate? Are 
there any other records relating to a fund's derivatives transactions 
that a fund should be required to maintain? For example, should we also 
require a fund to maintain written records relating to any action the 
fund took after exceeding a risk guideline (or any internal reporting 
that occurred following the exceedance of a risk guideline)? \435\ Or, 
as another example, should we include a provision in the proposed rule 
that would require a fund that enters into reverse repurchase 
agreements under proposed rule 18f-4(d) to maintain records documenting 
the fund's compliance with the applicable asset coverage requirement of 
section 18? Why or why not? The proposed rule would require a fund to 
maintain records of the VaR of its portfolio, the VaR of its designated 
reference index (as applicable), and its VaR ratio. To what extent 
would the requirement to maintain records of the fund's VaR ratio 
involve burdens in addition to the requirement to maintain the fund's 
VaR and the VaR of the designated reference index?
---------------------------------------------------------------------------

    \435\ See, e.g., proposed rule 18f-4(c)(1)(ii), proposed rule 
18f-4(c)(1)(v)(A).
---------------------------------------------------------------------------

    245. Are there feasible alternatives to the proposed recordkeeping 
requirements that would minimize recordkeeping burdens, including the 
costs of maintaining the required records, while promoting the goals of 
providing the Commission and its staff, and a fund's compliance 
personnel, sufficient information to understand: (1) A fund's 
derivatives risk management program and how the fund had administered 
it, (2) how a fund's board oversees the program, (3) the administration 
and effectiveness of a fund's VaR test, (4) how a limited derivatives 
user's policies and procedures are designed to address the risks 
associated with its use of derivatives, and (5) the basis for a fund's 
determination regarding the sufficiency

[[Page 4509]]

of its cash to meet its obligations with respect to unfunded commitment 
agreements?
    246. Are the record retention time periods that we have proposed 
appropriate? Should we require records to be maintained for a longer or 
shorter period? If so, for how long?

L. Transition Periods

    In view of our proposal for an updated, comprehensive approach to 
the regulation of funds' derivatives use, we are proposing to rescind 
Release 10666.\436\ In addition, staff in the Division of Investment 
Management is reviewing its no-action letters and other guidance 
addressing derivatives transactions and other transactions covered by 
proposed rule 18f-4 to determine which letters and other staff 
guidance, or portions thereof, should be withdrawn in connection with 
any adoption of this proposal. Upon the adoption of any final rule, 
some of these letters and other staff guidance, or portions thereof, 
would be moot, superseded, or otherwise inconsistent with the final 
rule and, therefore, would be withdrawn. If interested parties believe 
that additional letters or other staff guidance, or portions thereof, 
should be withdrawn, they should identify the letter or guidance, state 
why it is relevant to the proposed rule, how it or any specific portion 
thereof should be treated, and the reason therefor. The staff review 
would include, but would not necessarily be limited to, all of the 
staff no-action letters and other staff guidance listed below, 
including our staff's position regarding TOBs.\437\
---------------------------------------------------------------------------

    \436\ See supra section I.C.
    \437\ See Investment Management Staff Issues of Interest, 
available at https://www.sec.gov/divisions/investment/issues-of-interest.shtml#tobfinancing; see also Registered Investment Company 
Use of Senior Securities--Select Bibliography, available at https://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.

 Dreyfus Strategic Investing & Dreyfus Strategic Income (pub. 
avail. June 22, 1987)
 Merrill Lynch Asset Management, L.P. (pub. avail. July 2, 
1996)
 Robertson Stephens Investment Trust (pub. avail. Aug. 24, 
1995)
 Claremont Capital Corp (pub. avail. Sept. 16, 1979)
 Emerald Mgt. Co. (pub. avail. Jan. 21, 1978)
 Sanford C. Bernstein (pub. avail. June 25, 1990)
 Hutton Options Trading, L.P. (pub. avail. Feb. 2, 1989)
 Prudential-Bache IncomeVertible Plus Fund (pub. avail. Nov. 
20, 1985)
 State Street Income Fund, State Street Balanced Fund (pub. 
avail. Oct. 21, 1985)
 New England Life Government Securities Trust (pub. avail. 
Sept. 26, 1985)
 Putnam Option Income Trust II (pub. avail. Sept. 23, 1985)
 Thomson McKinnon Government Securities Fund (pub. avail. Sept. 
23, 1985)
 GMO Core Trust (pub. avail. Aug. 19, 1985)
 Bartlett Capital Trust (pub. avail. Aug. 19, 1985)
 Continental Option Income Plus Fund (pub. avail. Aug. 12, 
1985)
 Colonial High Yield Securities Trust, Colonial Enhanced 
Mortgage Trust (pub. avail. July 25, 1985)
 Putnam High Income Government Trust (pub. avail. June 3, 1985)
 Bartlett Management Trust (pub. avail. May 17, 1985)
 Drexel Series Trust--Government Securities Series (pub. avail. 
Apr. 25, 1985)
 Koenig Tax Advantaged Liquidity Fund (pub. avail. Mar. 27, 
1985)
 Colonial Tax-Managed Trust (pub. avail. Dec. 31, 1984)
 Monitrend Fund (pub. avail. Nov. 14, 1984)
 Pilot Fund (pub. avail. Sept. 14, 1984)
 Colonial Government Securities Plus Trust (pub. avail. June 
15, 1984)
 Z-Seven Fund (pub. avail. May 21, 1984)
 Pension Hedge Fund (pub. avail. Jan. 20, 1984)
 Steinroe Bond Fund (pub. avail. Jan. 17, 1984)
 IDS Bond Fund (pub. avail. Apr. 11, 1983)
 Safeco Municipal Bond, Inc (pub. avail. Nov. 26, 1982)
 ``Dear Chief Financial Officer'' Letter, from Lawrence A. 
Friend, Chief Accountant, Division of Investment Management (pub. 
avail. Nov. 7, 1997)

    Accordingly, following a one-year transition period to provide time 
for funds to prepare to come into compliance with the new rule, funds 
could only enter into derivatives transactions, reverse repurchase 
agreements and similar financing transactions, and unfunded commitments 
to the extent permitted by, and consistent with the requirements of, 
proposed rule 18f-4 or section 18. At that time, Release 10666 would be 
rescinded and, as determined appropriate in connection with the staff's 
review of no-action letters and other staff guidance described in this 
release, staff no-action letters and other staff guidance, or portions 
thereof, would be withdrawn.
    We similarly propose to provide a one-year compliance period for 
the sales practices rules to provide time for broker-dealers and 
investment advisers to bring their operations into conformity with the 
new rule. We also propose a one-year delay to the effective date of the 
amendments to rule 6c-11, which would permit leveraged/inverse ETFs to 
rely on that rule, and to rescind the exemptive orders we have provided 
to leveraged/inverse ETF sponsors on the effective date of the 
amendments to rule 6c-11.
    We propose that each of the transition periods discussed in this 
section would run from the date of the publication of any final rule in 
the Federal Register. Accordingly, one year after that date: (1) Any 
fund that enters into the transactions permitted by rule 18f-4 would do 
so relying on that rule; (2) broker-dealers and investment advisers 
would be required to comply with the sales practices rules; and (3) 
leveraged/inverse ETFs could operate under rule 6c-11 and the current 
leveraged/inverse ETF sponsors' orders would be rescinded.
    We request comment on these transition periods.
    247. Do commenters agree that a one-year transition period to 
provide time for funds to prepare to come into compliance with proposed 
rule 18f-4 is appropriate? Should the period be shorter or longer?
    248. Should we adopt tiered transition periods for smaller 
entities? For example, should we provide an additional 6 months for 
smaller entities (or some other shorter or longer period) in any 
transition period that we provide? Should the transition period be the 
same for all funds that rely on proposed rule 18f-4 (for example 12 
months after any adoption of proposed rule 18f-4, or any shorter or 
longer period)?
    249. Is the proposed one-year compliance period for the sales 
practices rules appropriate? Why or why not? Is a longer or shorter 
compliance period necessary to allow investment advisers and broker-
dealers to comply with the proposed sales practices rules? Why or why 
not? If we provide small and large funds a tiered transition period to 
comply with proposed rule 18f-4, should we similarly implement a tiered 
compliance period for investment advisers and broker-dealers to comply 
with the proposed sales practices rules? Why or why not?
    250. Would our proposal to rescind the current leveraged/inverse 
ETF sponsors' exemptive orders on the delayed effective date of the 
amendments to rule 6c-11 provide sufficient time for the leveraged/
inverse

[[Page 4510]]

ETF sponsors to transition to rule 6c-11?

M. Conforming Amendments

    Form N-2 requires a closed-end fund to disclose a senior securities 
table with certain information about any senior securities it has 
issued.\438\ Outstanding senior securities may bear on the likelihood, 
frequency, and size of distributions from the fund to its investors 
because section 18 prohibits distributions when a closed-end fund does 
not have the asset coverage required under that section. Proposed rule 
18f-4 would provide that a fund's derivatives transactions and unfunded 
commitments entered into under the proposed rule would not be 
considered for purposes of computing section 18 asset coverage.\439\ 
These transactions therefore would not affect a fund's ability under 
section 18 to make distributions to investors. Registered closed-end 
funds are already required to disclose extensive information about 
their derivatives transactions on Form N-PORT. In light of this 
treatment under proposed rule 18f-4 and the information that is already 
available regarding registered closed-end funds' derivatives 
transactions, we are proposing to amend Form N-2 to provide that funds 
relying on proposed rule 18f-4 would not be required to include their 
derivatives transactions and unfunded commitment agreements in the 
senior securities table on Form N-2.\440\ Commenters on the 2015 
proposal that addressed this topic supported such a conforming 
amendment with respect to asset coverage calculations and 
disclosure.\441\
---------------------------------------------------------------------------

    \438\ See Item 4.3 of Form N-2.
    \439\ See proposed rule 18f-4(b).
    \440\ See proposed amendment to Instruction 2 of Item 4.3 of 
Form N-2.
    \441\ See, e.g., Ares Comment Letter; ICI Comment Letter I.
---------------------------------------------------------------------------

    We request comment on the proposed conforming amendment to Form N-
2, and other conforming amendments that commenters suggest would be 
necessary or appropriate.
    251. Is the proposed conforming amendment appropriate? We have not 
proposed to exclude reverse repurchase agreements and similar financing 
transactions from the senior securities table in Form N-2 because these 
transactions may bear on the likelihood, frequency, and size of 
distributions from a fund to its investors. Do commenters agree that 
this is appropriate? Why or why not? If commenters do not believe that 
these transactions should be included in the senior securities table, 
what other disclosure would be appropriate?
    252. Rule 22e-4 requires funds subject to the rule, in classifying 
the liquidity of their portfolios and in determining whether a fund 
primarily holds highly liquid investments, to take into account the 
fund's highly liquid investments that it has ``segregated'' to cover 
certain less liquid investments.\442\ Proposed rule 18f-4, however, 
does not include an asset segregation requirement, and would supersede 
Release 10666 and related staff guidance. Should we remove any 
references in rule 22e-4 to ``segregated'' assets (while retaining rule 
22e-4's references to assets pledged to satisfy margin requirements)? 
Is there any other basis on which funds ``segregate'' assets that would 
warrant our retaining these references?
---------------------------------------------------------------------------

    \442\ See rule 22e-4(b)(1)(ii)(C); rule 22e-4(b)(1)(iii)(B). A 
fund would also have to take into account the percentage of its 
highly liquid investments that it has pledged to satisfy margin 
requirements. See id.
---------------------------------------------------------------------------

    253. Are there other conforming amendments to any of our other 
rules or forms that we should make? If so, what rules or forms should 
be amended and why?

III. Economic Analysis

    We are mindful of the costs imposed by, and the benefits obtained 
from, our rules. Section 3(f) of the Exchange Act and section 2(c) of 
the Investment Company Act state that when the Commission is engaging 
in rulemaking under such titles and is required to consider or 
determine whether the action is necessary or appropriate in (or, with 
respect to the Investment Company Act, consistent with) the public 
interest, the Commission shall consider whether the action will promote 
efficiency, competition, and capital formation, in addition to the 
protection of investors. Further, section 23(a)(2) of the Exchange Act 
requires the Commission to consider, among other matters, the impact 
such rules would have on competition and states that the Commission 
shall not adopt any rule that would impose a burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act. The following analysis considers, in detail, the potential 
economic effects that may result from the proposed rule, including the 
benefits and costs to investors and other market participants as well 
as the broader implications of the proposal for efficiency, 
competition, and capital formation.

A. Introduction

    Funds today use a variety of derivatives, referencing a range of 
assets or metrics. Funds use derivatives both to obtain investment 
exposure as part of their investment strategies and to manage risks. A 
fund may use derivatives to gain, maintain, or reduce exposure to a 
market, sector, or security more quickly, or to obtain exposure to a 
reference asset for which it may be difficult or impractical for the 
fund to make a direct investment. A fund may use derivatives to hedge 
interest rate, currency, credit, and other risks, as well as to hedge 
portfolio exposures.\443\ As funds' strategies have become increasingly 
diverse, funds' use of derivatives has grown in both volume and 
complexity over the past several decades. At the same time, a fund's 
derivatives use may entail risks relating to, for example, leverage, 
markets, operations, liquidity, and counterparties, as well as legal 
risks.\444\
---------------------------------------------------------------------------

    \443\ See supra section I.A.
    \444\ See, e.g., supra notes 16-17 and accompanying text.
---------------------------------------------------------------------------

    Section 18 of the Investment Company Act is designed to limit the 
leverage a fund can obtain through the issuance of senior 
securities.\445\ As discussed above, a fund's derivatives use may raise 
the investor protections concerns underlying section 18. In addition, 
funds' asset segregation practices have developed such that funds' 
derivatives use--and thus funds' potential leverage through derivatives 
transactions--does not appear to be subject to a practical limit as the 
Commission contemplated in Release 10666. Accordingly, we continue to 
be concerned that certain fund asset segregation practices may not 
address the concerns underlying section 18.\446\
---------------------------------------------------------------------------

    \445\ See supra section I.B.1.
    \446\ See supra sections I.B.3.
---------------------------------------------------------------------------

    Proposed rule 18f-4 is designed to provide an updated, 
comprehensive approach to the regulation of funds' use of derivatives 
and certain other transactions. The proposed rule would permit a fund, 
subject to certain conditions, to enter into derivatives or other 
transactions, notwithstanding the prohibitions and restrictions on the 
issuance of senior securities under section 18 of the Investment 
Company Act. We believe that the proposed rule's requirements, 
including the derivatives risk management program requirement and VaR-
based limit on fund leverage risk, would benefit investors by 
mitigating derivatives-related risks, including those that may lead to 
unanticipated and potentially significant losses for investors.
    Certain funds use derivatives in a limited manner, which we believe 
presents a lower degree of risk or

[[Page 4511]]

potential impact and generally a lower degree of leverage than 
permitted under section 18. The proposed rule would provide an 
exception from the proposed derivative risk management program 
requirement and VaR-based limit on fund leverage risk for these limited 
derivatives users. Instead, the proposed rule would require a fund 
relying on this exception to adopt policies and procedures that are 
reasonably designed to manage its derivatives risks. Funds with limited 
derivatives exposure and funds that use derivatives transactions solely 
to hedge certain currency risk would therefore not be required to incur 
costs and bear compliance burdens that may be disproportionate to the 
resulting benefits, while still being required to manage the risks 
their limited use of derivatives may present.\447\
---------------------------------------------------------------------------

    \447\ See supra sections I.C and II.E.
---------------------------------------------------------------------------

    The proposed rule would also provide an exception from the VaR-
based limit on fund leverage risk for certain leveraged/inverse funds 
in light of the requirements under the proposed sales practices rules 
that broker-dealers and investment advisers exercise due diligence in 
approving the accounts of retail investors to invest in these funds, 
and other conditions for these funds that proposed rule 18f-4 
includes.\448\ This would allow these funds, which generally could not 
currently satisfy the proposed VaR-based limit on fund leverage risk, 
to continue offering their current strategies. The proposed sales 
practices rules' due diligence and account approval requirements also 
would apply to accounts of investors in certain exchange-listed 
commodity- or currency-based trusts or funds, which are not investment 
companies subject to section 18 but present similar investor protection 
concerns. We believe the proposed sales practices rules would enhance 
investor protection by helping to ensure that investors in these funds 
are limited to those who are capable of evaluating their 
characteristics--including that the funds would not be subject to all 
of the leverage-related requirements applicable to registered 
investment companies generally--and the unique risks they present.
---------------------------------------------------------------------------

    \448\ See supra section II.G.
---------------------------------------------------------------------------

    Proposed rule 18f-4 also contains requirements for funds' use of 
certain senior securities that are not derivatives. Specifically, the 
proposed rule would permit reverse repurchase agreements and other 
similar financing transactions if they comply with the asset coverage 
requirements of section 18; this approach would align the treatment of 
reverse repurchase agreements and similar financing transactions, for 
section 18 purposes, with the treatment of bank borrowings and other 
senior securities transactions subject to section 18's asset coverage 
requirements.\449\ In addition, the proposed rule would permit a fund 
to enter into unfunded commitment agreements if it reasonably believes, 
at the time it enters into such an agreement, that it will have 
sufficient cash and cash equivalents to meet its obligations with 
respect to all of its unfunded commitment agreements.\450\ This 
requirement is designed to address the concern that a fund may 
experience losses as a result of having insufficient assets to meet its 
obligations with respect to these transactions, and we believe that the 
requirement would benefit investors by mitigating such losses or other 
adverse effects if a fund is unable to satisfy an unfunded commitment 
agreement.\451\
---------------------------------------------------------------------------

    \449\ Similar financing transactions may include securities 
lending arrangements and TOBs, depending on the particular facts and 
circumstances of the individual transaction. See supra section II.I.
    \450\ See supra section II.J.
    \451\ We believe that the proposed treatment of unfunded 
commitment transactions is consistent with general market practices. 
Therefore, we believe that the proposed requirements for both types 
of senior securities would not have significant economic effects 
when measured against this baseline.
---------------------------------------------------------------------------

    This proposal also includes certain recordkeeping requirements and 
reporting requirements for funds that use derivatives.\452\ We expect 
that the proposed recordkeeping requirements would benefit investors by 
facilitating fund compliance with the proposed rule and our staff's 
review of funds' compliance. In addition, we expect that the proposed 
amendments to Forms N-PORT, N-CEN, and N-RN would further benefit 
investors by enhancing the Commission's and the public's understanding 
of the impact of funds' use of derivatives on fund portfolios, and by 
facilitating the Commission's ability to oversee funds' use of 
derivatives and compliance with the proposed rules.\453\
---------------------------------------------------------------------------

    \452\ See supra sections II.C and II.H.
    \453\ Because leveraged/inverse funds would not be subject to 
the proposed VaR-based limit on fund leverage risk, these funds 
would not be subject to the related proposed reporting requirements 
on Forms N-PORT and N-RN. Leveraged/inverse funds would, however, be 
subject to the proposed new reporting requirements on funds' 
derivatives exposure on form N-PORT as well as to the proposed new 
requirements on Form N-CEN.
---------------------------------------------------------------------------

B. Economic Baseline

1. Fund Industry Overview
    The fund industry has grown and evolved substantially in past 
decades in response to various factors, including investor demand, 
technological developments, and an increase in domestic and 
international investment opportunities, both retail and 
institutional.\454\ As of September 2019, there were 9,788 mutual funds 
(excluding money market funds) with $21,333 billion in total net 
assets, 1,910 ETFs organized as an open-end fund or as a share-class of 
an open-end fund with $3,081 billion in total net assets, 664 
registered closed-end funds with 294 billion in total net assets, and 
13 variable annuity separate accounts registered as management 
investment companies on Form N-3 with $224 billion in total net assets. 
There also were 413 money market funds with $3,392 billion in total net 
assets.\455\ Finally, as of June 2019, there were 99 BDCs with $63 
billion in total net assets.\456\
---------------------------------------------------------------------------

    \454\ See supra note 1.
    \455\ Estimates of the number of registered investment companies 
and their total net assets are based on a staff analysis of Form N-
CEN filings as of September 5, 2019. For open-end funds that have 
mutual fund and ETF share classes, we count each type of share class 
as a separate fund and use data from Morningstar to determine the 
amount of total net assets reported on Form N-CEN attributable to 
the ETF share class. Money market funds are excluded from the scope 
of proposed rule 18f-4 but may experience economic effects as a 
result of being excluded from the rule's scope. We therefore report 
their number and net assets separately from those of other mutual 
funds.
    \456\ Estimates of the number of BDCs and their net assets are 
based on a staff analysis of Form 10-K and Form 10-Q filings as of 
June 30, 2019. Our estimate includes BDCs that may be delinquent or 
have filed extensions for their filings, and it excludes 6 wholly-
owned subsidiaries of other BDCs.
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2. Funds' Use of Derivatives
    DERA staff analyzed funds' use of derivatives based on Form N-PORT 
filings as of September 2019. The filings covered 9,074 mutual funds 
with $19,590 billion in total net assets, 1,711 ETFs with $3,317 
billion in total net assets, 565 registered closed-end funds with $327 
billion in net assets, and 13 variable annuity separate accounts 
registered as management investment companies with $219 billion in 
total net assets.\457\ While only larger fund groups are currently 
required to file reports on Form N-PORT, existing filings nevertheless 
covered 89% of funds representing 94% of assets.\458\
---------------------------------------------------------------------------

    \457\ The analysis is based on each registrant's latest Form N-
PORT filing as of September 23, 2019. Money market funds are 
excluded from the analysis; they do not file monthly reports on Form 
N-PORT and are excluded from the scope of proposed rule 18f-4. For 
open-end funds that have mutual fund and ETF share classes, we count 
each type of share class as a separate fund and use data from 
Morningstar to determine the amount of total net assets reported on 
Form N-PORT attributable to the ETF share class.
    \458\ See supra note 280.

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[[Page 4512]]

    Based on this analysis, 59% of funds reported no derivatives 
holdings, and a further 27% of funds reported using derivatives with 
gross notional amounts below 50% of net assets. These results are 
comparable to and consistent with the findings of the DERA White Paper, 
which studied a random sample of 10% of funds in 2014.\459\
---------------------------------------------------------------------------

    \459\ See DERA White Paper, supra note 1.
---------------------------------------------------------------------------

    BDCs do not file Form N-PORT. To help evaluate the extent to which 
BDCs use derivatives, our staff reviewed the most recent financial 
statements of 48 of the current 99 BDCs as of September 2019.\460\ 
Based on this analysis, we observe that most BDCs do not use 
derivatives extensively. Of the sampled BDCs, 54% did not report any 
derivatives holdings, and a further 29% reported using derivatives with 
gross notional amounts below 10% of net assets.
---------------------------------------------------------------------------

    \460\ See supra note 279 and accompanying text.
---------------------------------------------------------------------------

3. Current Regulatory Framework for Derivatives
    Funds have developed certain general asset segregation practices to 
``cover'' their derivatives positions, consistent with the conditions 
in staff no-action letters and guidance.\461\ However, staff has 
observed that practices vary based on the type of derivatives 
transaction, and that funds use different practices regarding the types 
of assets that they segregate to cover their derivatives positions. For 
purposes of establishing the baseline, we assume that funds generally 
segregate sufficient assets to at least cover any mark-to-market 
liabilities on the funds' derivatives transactions, with some funds 
segregating more assets for certain types of derivatives transactions 
(sufficient to cover the full notional amount of the transaction or an 
amount between the transaction's full notional amount and any mark-to-
market liability).\462\ As the mark-to-market liability of a derivative 
can be much smaller than the full investment exposure associated with 
the position, funds' current use of the mark-to-market asset 
segregation approach, and funds' segregation of any liquid asset, do 
not appear to place a practical limit on their use of derivatives.\463\
---------------------------------------------------------------------------

    \461\ See supra section II.B.2.b.
    \462\ See supra notes 54-55 and accompanying text.
    \463\ See supra section I.B.2.b.
---------------------------------------------------------------------------

4. Funds' Derivatives Risk Management Practices and Use of VaR Models
    There is currently no requirement for funds that use derivatives to 
have a formalized derivatives risk management program. However, we 
understand that advisers to many funds whose investment strategies 
entail the use of derivatives, including leveraged/inverse funds, 
already assess and manage risks associated with their derivatives 
transactions to varying extents. In addition, we understand that funds 
engaging in derivatives transactions have increasingly used stress 
testing as a risk management tool over the past decade.\464\
---------------------------------------------------------------------------

    \464\ See also supra note 145 and accompanying text.
---------------------------------------------------------------------------

    We also understand that VaR calculation tools are widely available, 
and many advisers that enter into derivatives transactions already use 
risk management or portfolio management platforms that include VaR 
tools.\465\ Advisers to funds that use derivatives more extensively may 
be particularly likely to currently use risk management or portfolio 
management platforms that include VaR capability. Moreover, advisers 
that manage (or that have affiliates that manage) UCITS funds may 
already be familiar with using VaR models in connection with European 
guidelines.\466\ One commenter submitted the results of a survey based 
on responses from 24 fund complexes with $13.8 trillion in assets.\467\ 
The results of this survey indicate that 73% of respondents used some 
form of both VaR and stress testing as derivatives risk management 
tools.
---------------------------------------------------------------------------

    \465\ See also supra note 179.
    \466\ See supra note 221 and accompanying text.
    \467\ See ICI Comment Letter III. The commenter also indicated 
that the surveyed ICI member firms accounted for 67% of mutual fund 
and ETF assets as of June 2019 and that survey responses were 
submitted by firms ``whose assets under management spanned the 
spectrum from small to very large.'' However, these representations 
alone do not provide sufficient information about whether the 
surveyed firms were representative of all mutual funds and ETFs in 
terms of the exact distribution of specific characteristics, such as 
firm size or type of investment strategy.
---------------------------------------------------------------------------

5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse Funds
    Leveraged/inverse investment vehicles, as defined in the proposed 
sales practices rules, include leveraged/inverse funds and certain 
exchange-listed commodity- or currency-based trusts or funds. 
Currently, there are 164 leveraged/inverse ETFs with $33.9 billion in 
total net assets; 105 leveraged/inverse mutual funds with $4.9 billion 
in total net assets; and 17 exchange-listed commodity- or currency-
based trusts or funds with $1.2 billion in total net assets.\468\
---------------------------------------------------------------------------

    \468\ Estimates of the number of leveraged/inverse mutual funds 
and leveraged/inverse ETFs and their total net assets are based on a 
staff analysis of Form N-CEN filings as of September 5, 2019. 
Estimates of the number of exchange-listed commodity- or currency-
based trusts or funds and their total net assets are based on 
Bloomberg data as of September 20, 2019.
---------------------------------------------------------------------------

    Leveraged/inverse investment vehicles generally target a daily 
return (or a return over another predetermined time period) that is a 
multiple, inverse, or inverse multiple of the return of an underlying 
index; however over longer holding periods, the realized leverage 
multiple of the returns of an investment in a leveraged/inverse 
investment vehicle relative to the returns of its underlying index can 
vary substantially from the vehicle's daily leverage multiple.
    In addition, the returns of leveraged/inverse investment vehicles 
over longer holding periods share certain features with the returns of 
holding an option.\469\ For example, a call option on an index with a 
strike price that is much higher than the current index price (i.e., 
the option is significantly ``out of the money'') is likely to expire 
worthless. If the option expires worthless, an investor that holds the 
option until expiry receives no payoff in exchange for their initial 
investment (the option premium) and therefore experiences a return of -
100%. Holding all other factors fixed, the likelihood of this outcome 
increases with the strike price of the option, and the option is priced 
accordingly--options that are further out of the money, all else equal, 
will have lower premiums. At the same time, on the rare occasions when 
the index price exceeds the strike price at expiration, the investor 
will earn a high return on his or her initial investment because the 
initial price paid for a call option is lower when the strike price is 
higher. While the payoff to holding a leveraged/inverse investment 
vehicle over long periods generally lacks this strict discontinuous 
nature (expiring either in the money or out of the money), it is 
nevertheless similar to that of an option in the sense that, as the 
vehicle's leverage multiple or investor's holding period increases, the 
likelihood of experiencing a loss increases (analogous to the option 
expiring out of the money) while gains, when they do occur, tend to be 
larger (analogous to the option expiring in the money).\470\
---------------------------------------------------------------------------

    \469\ For a technical analysis of the similarities between the 
returns of leveraged/inverse ETFs over longer holding periods and 
the returns of holding an option, see Division of Economic and Risk 
Analysis, Economics Note: The Distribution of Leveraged ETF Returns 
(Nov. 2019), available at https://www.sec.gov/files/DERA_LETF_Economics_Note_Nov2019.pdf. The results of that analysis 
also apply more generally to other types of leveraged/inverse 
investment vehicles.
    \470\ In statistical terms, the option returns and returns of 
holding leveraged/inverse investment vehicles over longer holding 
periods both exhibit positive skewness.

---------------------------------------------------------------------------

[[Page 4513]]

    To achieve the stated leverage multiple, most leveraged/inverse 
investment vehicles rebalance their exposure to the underlying index 
daily.\471\ This is also similar to options, whose payoffs can be 
replicated by trading dynamically in the underlying asset and a low-
risk bond. For example, call options are economically equivalent to 
holding a long position in the underlying asset and a short position in 
a low-risk bond.\472\ Both leveraged/inverse investment vehicles and 
options are therefore economically equivalent to a dynamically 
rebalanced leveraged/inverse or inverse leveraged/inverse position in 
the underlying asset or reference index.\473\
---------------------------------------------------------------------------

    \471\ Leveraged/inverse investment vehicles that track the 
returns of an underlying index over time periods that are longer 
than one day rebalance their portfolios at the end of each such 
period. Leveraged/inverse investment vehicles use derivatives to 
achieve their targeted returns.
    \472\ Conversely, put options are economically equivalent to 
holding a short position in the underlying and a long position in a 
low-risk bond--their replicating portfolio consists of an inverse 
leveraged position in the underlying.
    \473\ Option replication portfolios need to be rebalanced 
continuously throughout the day as the price of the underlying asset 
changes. While the implied rebalancing happens continuously during 
the trading day for options, leveraged/inverse investment vehicles 
perform rebalancing trades in the underlying less frequently (daily 
for most leveraged/inverse investment vehicles).
---------------------------------------------------------------------------

    The majority of assets held in leveraged/inverse funds are held in 
leveraged/inverse ETFs. There are currently two ETF sponsors that rely 
upon exemptive relief from the Commission that permits them to operate 
leveraged/inverse ETFs.\474\ Since 2009, the Commission has not granted 
leveraged/inverse exemptive relief to any additional sponsors. In 
addition, leveraged/inverse ETFs are currently excluded from the scope 
of rule 6c-11, which the Commission adopted earlier this year and which 
allows ETFs satisfying certain conditions to operate without obtaining 
an exemptive order from the Commission.\475\
---------------------------------------------------------------------------

    \474\ See supra notes 307 and 356. The exemptive orders of the 
two sponsors that operate leveraged/inverse ETFs permit these 
sponsors to launch additional funds under the terms and conditions 
of those orders.
    \475\ See supra notes 352-353 and accompanying text.
---------------------------------------------------------------------------

    Retail investors predominantly purchase and sell shares of 
leveraged/inverse investment vehicles through broker-dealers and 
investment advisers.\476\ To the extent that broker-dealers or 
investment advisers recommend leveraged/inverse investment vehicles to 
their customers or clients, they should have processes in place to 
satisfy their obligations to make only suitable recommendations or 
provide best interest advice, respectively.\477\ For example, the basis 
for an investment adviser's reasonable understanding generally would 
include, for retail clients of investment advisers, a reasonable 
inquiry into the client's financial situation, level of financial 
sophistication, investment experience, and financial goals.\478\ When 
an adviser is assessing whether complex or high-risk products--such as 
leveraged/inverse funds--are in a retail client's best interest, the 
adviser should generally apply heightened scrutiny to whether such 
investments fall within the retail client's risk tolerance and 
objectives.\479\ Broker-dealers also will be required to comply with 
Regulation Best Interest beginning on June 30, 2020.\480\ Broker-
dealers complying with Regulation Best Interest will have to exercise 
reasonable diligence, care, and skill when making a recommendation to a 
retail customer, including by understanding potential risks, rewards, 
and costs associated with a recommendation in light of the customer's 
investment profile.\481\
---------------------------------------------------------------------------

    \476\ See supra note 321.
    \477\ Following the June 30, 2020 compliance date for Regulation 
Best Interest, broker-dealers will have to provide recommendations 
in the best interest of their retail customers. See Regulation Best 
Interest: The Broker-Dealer Standard of Conduct, supra note 308.
    \478\ See, e.g., Fiduciary Interpretation, supra note 308, at 
text preceding n.36.
    \479\ See id. at text preceding n.39. The Commission further 
stated in the Fiduciary Interpretation that leveraged/inverse funds 
and other complex products ``may not be in the best interest of a 
retail client absent an identified, short-term, client-specific 
trading objective and, to the extent that such products are in the 
best interest of a retail client initially, they would require daily 
monitoring by the adviser.'' See id.
    \480\ See Regulation Best Interest: The Broker-Dealer Standard 
of Conduct, supra note 305.
    \481\ See id. at section II.C.2.
---------------------------------------------------------------------------

C. Benefits and Costs of the Proposed Rules and Amendments

    The Commission is sensitive to the economic effects that may result 
from the proposed rules and rule and form amendments, including 
benefits and costs. Where possible, we have attempted to quantify the 
likely economic effects; however, we are unable to quantify certain 
economic effects because we lack the information necessary to provide 
reasonable estimates. In some cases, it is difficult to predict how 
market participants would act under the conditions of the proposed 
rules. For example, we are unable to predict whether the proposed 
derivatives risk management program requirement and VaR-based limit on 
fund leverage risk may make investors more or less likely to invest in 
funds that would be subject to these requirements or the degree to 
which these requirements may affect the use of derivatives by these 
funds. Nevertheless, as described more fully below, we are providing 
both a qualitative assessment and quantified estimate of the economic 
effects, including the initial and ongoing costs of the additional 
reporting requirements, where feasible.
    Direct costs incurred by funds discussed below may, to some extent, 
be absorbed by the fund's investment adviser or be passed on to 
investors in the form of increased management fees. The share of these 
costs borne by funds, their advisers, and investors depends on multiple 
factors, including the nature of competition between advisers, and 
investors' relative sensitivity to changes in fund fees, the joint 
effects of which are particularly challenging to predict due to the 
number of assumptions that the Commission would need to make.
1. Derivatives Risk Management Program and Board Oversight and 
Reporting
    Proposed rule 18f-4 would require funds that enter into derivatives 
transactions and are not limited derivatives users to adopt and 
implement a derivatives risk management program. The program would 
provide for the establishment of risk guidelines that must include 
certain elements, but that are otherwise tailored based on how the 
fund's use of derivatives may affect its investment portfolio and 
overall risk profile. The program also would have to include stress 
testing, backtesting, internal reporting and escalation, and program 
review elements. The proposed rule would require a fund's board of 
directors to approve the fund's designation of a derivatives risk 
manager, who would be responsible for administering the derivatives 
risk management program. The fund's derivatives risk manager would have 
to report to the fund's board on the derivatives risk management 
program's implementation and effectiveness and the results of the 
fund's stress testing and backtesting.
    We understand that advisers to many funds whose investment 
strategies entail the use of derivatives already assess and manage 
risks associated with their derivatives transactions.\482\ However, 
proposed rule 18f-4's requirement that funds establish written 
derivatives risk management programs would create a standardized 
framework for funds'

[[Page 4514]]

derivatives risk management by requiring each fund's program to include 
all of the proposed program elements. To the extent that the resulting 
risk management activities are more comprehensive than funds' current 
practices, this may result in more-effective risk management across 
funds. While the adoption of a derivatives risk management program 
requirement may not eliminate all derivatives-related risks, including 
that investors could experience large, unexpected losses from funds' 
use of derivatives, we expect that investors would benefit from a 
decrease in leverage-related risks.
---------------------------------------------------------------------------

    \482\ See supra section III.B.4.
---------------------------------------------------------------------------

    Some funds may reduce or otherwise alter their use of derivatives 
transactions to respond to risks identified after adopting and 
implementing their risk management programs. In particular, we expect 
that funds currently utilizing risk management practices that are not 
tailored to their use of derivatives may decide to make such changes to 
their portfolios.\483\
---------------------------------------------------------------------------

    \483\ As a consequence of reducing risk, such funds may earn 
reduced returns.
---------------------------------------------------------------------------

    The proposed rule would require a fund to reasonably segregate the 
functions of its derivatives risk management program from those of its 
portfolio management.\484\ This segregation requirement is designed to 
enhance the program's effectiveness by promoting the objective and 
independent identification and assessment of derivatives risk.\485\ 
Segregating the functions of a fund's derivatives risk management 
program from those of its portfolio management may also mitigate the 
risks of competing incentives between a fund's portfolio managers and 
its investors.\486\
---------------------------------------------------------------------------

    \484\ See supra section II.B.2.
    \485\ See supra note 112 and accompanying text. While some 
portfolio managers may find it burdensome to collaborate with a 
derivatives risk manager, to the extent that portfolio managers 
already consider the impact of trades on the fund's portfolio risk, 
we believe that having the involvement of a derivatives risk manager 
may typically make a portfolio manager's tasks more rather than less 
efficient.
    \486\ For example, portfolio managers of actively-managed funds 
that are underperforming competing funds may have an incentive to 
increase risk exposures through use of derivatives in an effort to 
increase returns. This behavior may result in a fund also increasing 
risk beyond investor expectations. (For theoretical motivation of 
such behaviors see, e.g., Keith C. Brown, W.V. Harlow, & Laura T. 
Starks, Of Tournaments and Temptations: An Analysis of Managerial 
Incentives in the Mutual Fund Industry, 51 Journal of Finance 85 
(1996), available at https://www.onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1996.tb05203.x; Judith Chevalier & Glenn 
Ellison, Risk-Taking by Mutual Funds as a Response to Incentives, 
105 Journal of Political Economy 1167 (1997), available at https://www.jstor.org/stable/10.1086/516389?seq=1#metadata_info_tab_contents).
---------------------------------------------------------------------------

    Finally, to the extent that the periodic stress testing and 
backtesting requirements of the proposed derivatives risk management 
program result in fund managers developing a more complete 
understanding of the risks associated with their use of derivatives, we 
expect that funds and their investors will benefit from improved risk 
management.\487\ Such benefits would be in addition to benefits derived 
from the proposed VaR-based limit on fund leverage risk discussed 
below.\488\ VaR analysis, while yielding a simple yet general measure 
of a fund's portfolio risk, does not provide a complete picture of a 
fund's financial risk exposures.\489\ Complementing VaR analysis with 
stress testing would provide a more complete understanding of the 
fund's potential losses under different sets of market conditions. For 
example, simulating potential stressed market conditions not reflected 
in historical correlations between fund returns and asset prices 
observed in normal markets may provide derivatives risk managers with 
important information pertaining to derivatives risks in stressed 
environments.\490\ By incorporating the potential impact of future 
economic outcomes and market volatility in its stress test analysis, a 
fund may be able to analyze future potential swings in its portfolio 
that may impact the fund's long-term performance. This forward-looking 
aspect of stress testing would supplement the proposed rule's VaR 
analysis requirement, which would rely on historical data.
---------------------------------------------------------------------------

    \487\ See supra sections II.B.3.c and II.B.3.d; see also supra 
section II.C.2 (discussing the proposed requirements that a fund's 
derivatives risk manager provide to the fund's board: (1) A written 
report, at least annually, providing a representation that the 
program is reasonably designed to manage the fund's derivatives 
risks and to incorporate the required elements of the program 
(including a review of the VaR calculation model used by the fund 
under proposed rule 18f-4(c)(2), and the backtesting required by 
proposed rule 18f-4(c)(1)(iv)); and (2) a written report, at the 
frequency determined by the board, regarding any exceedances of the 
fund's risk guidelines and the results of the fund's stress tests).
    \488\ See infra section III.C.2.
    \489\ See id.
    \490\ See supra section II.B.3.c (proposed rule 18f-4 would 
require the program to provide for stress testing to ``evaluate 
potential losses to the fund's portfolio 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, 
taking into account correlations of market risk factors as 
appropriate and resulting payments to derivatives counterparties'').
---------------------------------------------------------------------------

    In addition, requiring that a fund backtest the results of its VaR 
analysis each business day would assist funds in examining the 
effectiveness of the fund's VaR model. The proposed rule would require 
that, each business day, the fund compare its actual gain or loss for 
that business day with the fund's VaR calculated for that day.\491\ 
This comparison would help identify days where the fund's portfolio 
losses exceed the VaR calculated for that day, as well as systematic 
over- or under-estimation of VaR suggesting that the fund may not be 
accurately measuring all significant, identifiable market risk 
factors.\492\
---------------------------------------------------------------------------

    \491\ See supra section II.B.3.d.
    \492\ See supra notes 150-151 and accompanying text.
---------------------------------------------------------------------------

    Proposed rule 18f-4 would also require that a fund's board of 
directors approve the designation of the fund's derivatives risk 
manager, taking into account the derivatives risk manager's relevant 
experience.\493\ We anticipate that this requirement, along with the 
derivatives risk manager's direct reporting line to the board, would 
result in effective communication between the board and the derivatives 
risk manager that would enhance oversight of the program to the benefit 
of the fund and its investors.
---------------------------------------------------------------------------

    \493\ See supra section II.C.1.
---------------------------------------------------------------------------

    Proposed rule 18f-4 would require that the derivatives risk manager 
provide the fund's board a written report at least once a year on the 
program's effectiveness as well as regular written reports at a 
frequency determined by the board that analyze exceedances of the 
fund's risk guidelines and present the results of the fund's stress 
tests and backtests.\494\ The proposed board reporting requirements may 
facilitate the board's oversight of the fund and the operation of the 
derivatives risk management program, to the extent the fund does not 
have such regular reporting mechanisms already in place. In the event 
the derivatives risk manager encounters material risks that need to be 
escalated to the fund's board, the proposed provision that the 
derivatives risk manager may directly inform the board of these risks 
in a timely manner as appropriate may help prevent delays in resolving 
such risks.
---------------------------------------------------------------------------

    \494\ See supra section II.C.2.
---------------------------------------------------------------------------

    Funds today employ a range of different practices, with varying 
levels of comprehensiveness and sophistication, for managing the risks 
associated with their use of derivatives.\495\ We expect that 
compliance costs associated with the proposed derivatives risk 
management program requirement would vary based on the fund's current 
risk management practices, as well as the fund's characteristics, 
including in particular

[[Page 4515]]

the fund's investment strategy, and the nature and type of derivatives 
transactions used by the fund.
---------------------------------------------------------------------------

    \495\ See supra section III.B.4.
---------------------------------------------------------------------------

    We understand that VaR models are widely used in the industry and 
that backtesting is commonly performed in conjunction with VaR 
analyses. As a result, we believe that many funds that would be 
required to establish derivatives risk management programs already have 
VaR models with backtesting in place. Moreover, the proposed rule's 
derivatives risk management program requirements, including stress 
testing and backtesting requirements are, generally, high-level and 
principles-based. As a result, it is likely that many funds' current 
risk management practices may already be in line with many of the 
proposed rule's derivatives risk management program requirements or 
could be readily conformed without material change. Thus, the costs of 
adjusting funds current' practices and procedures to comply with the 
parallel requirements of proposed rule 18f-4 may be minimal for such 
funds.
    Certain costs of the proposed derivatives risk management program 
may be fixed, while other costs may vary with the size and complexity 
of the fund and its portfolio allocation. For instance, costs 
associated with purchasing certain third-party data used in the 
program's stress tests may not vary much across funds. On the other 
hand, certain third-party services may vary in terms of costs based on 
the portfolio positions to be analyzed. Further, the extent to which a 
cost corresponding to the program is fixed or variable may also depend 
on the third-party service provider.
    Larger funds or funds that are part of a large fund complex may 
incur higher costs in absolute terms but find it less costly, per 
dollar managed, to establish and administer a derivatives risk 
management program relative to a smaller fund or a fund that is part of 
a smaller fund complex. For example, larger funds may have to allocate 
a smaller portion of existing resources for the program, and fund 
complexes may realize economies of scale in developing and implementing 
derivatives risk management programs for several funds.\496\
---------------------------------------------------------------------------

    \496\ Although we believe that many funds have existing risk 
officers whose role extends to managing derivatives risks, we note 
that some funds, and in particular smaller funds or those that are 
part of a smaller fund complex, may not have existing personnel 
capable of fulfilling the responsibilities of the derivatives risk 
manager, or may choose to hire a new employee or employees to 
fulfill this role, rather than assigning that responsibility to a 
current employee or officer of the fund or the fund's investment 
adviser. We expect that a fund that would hire new employees would 
likely incur larger costs compared to a fund that has existing 
employees that could serve as a fund's derivatives risk manager.
---------------------------------------------------------------------------

    For funds that do not already have a derivatives risk management 
program in place that could be readily adapted to meet the proposed 
rule's requirements without significant additional cost, we estimate 
that the one-time costs to establish and implement a derivatives risk 
management program would range from $70,000 to $500,000 per fund, 
depending on the particular facts and circumstances, including whether 
a fund is part of a larger fund complex and therefore may benefit from 
economies of scale. These estimated costs are attributable to the 
following activities: (1) Developing risk guidelines and processes for 
stress testing, backtesting, internal reporting and escalation, and 
program review; (2) integrating and implementing the guidelines and 
processes described above; and (3) preparing training materials and 
administering training sessions for staff in affected areas.
    For funds that do not already have a derivatives risk management 
program in place that could be readily adapted to meet the proposed 
rule's requirements without significant additional cost, based on our 
understanding, we estimate that the ongoing annual program-related 
costs that a fund would incur range from 65% to 75% of the one-time 
costs to establish and implement a derivatives risk management program. 
Thus, a fund would incur ongoing annual costs that range from $45,500 
to $375,000.\497\ These estimated costs are attributable to the 
following activities: (1) Assessing, monitoring, and managing the risks 
associated with the fund's derivatives transactions; (2) periodically 
reviewing and updating (A) the program including any models or 
measurement tools (including any VaR calculation models) to evaluate 
the program's effectiveness and to reflect changes in risk over time, 
and (B) any designated reference index to evaluate its appropriateness; 
(3) providing written reports to the fund's board on the derivatives 
risk management program's implementation and effectiveness and the 
results of the fund's stress testing; and (4) additional staff 
training.
---------------------------------------------------------------------------

    \497\ This estimate is based on the following calculations: 0.65 
x $70,000 = $45,500; 0.75 x $500,000 = $375,000.
---------------------------------------------------------------------------

    Under the proposed rule, a fund that is a limited derivatives user 
would not be required to establish a derivatives risk management 
program.\498\ Based on an analysis of Form N-PORT filings, as well as 
financial statements filed with the Commission by BDCs, we estimate 
that about 22% of funds that would be subject to the proposed rule, or 
2,693 funds total, would be required to implement a risk management 
program.\499\ As many funds belong to a fund complex and are likely to 
experience economies of scale, we expect that the lower end of the 
estimated range of costs ($70,000 in one-time costs; $45,500 in annual 
costs) better reflects the total costs likely to be incurred by those 
funds.\500\ In addition, we believe that many funds already have a 
derivatives risk management program in place that could be readily 
adapted to meet the proposed rule's requirements without significant 
additional cost.\501\ However, as we do not have data to determine how 
many funds already have a program in place that would substantially 
satisfy the proposed rule's requirements, we over-inclusively assume 
that all funds would incur a cost associated with this requirement. 
Based on these assumptions, we provide an upper-end estimate for total 
industry cost in the first year of $311,041,500.\502\
---------------------------------------------------------------------------

    \498\ The estimates of the one-time and ongoing costs described 
in this section include the costs associated with determining 
whether a fund is a limited derivatives user.
    \499\ We estimate that about 22% of all funds that would be 
subject to the proposed rule hold some derivatives and would not 
qualify as a limited derivatives user under the proposed rule.
    \500\ A fund that uses derivatives in a complex manner, has 
existing risk management practices that are not commensurate with 
such use of derivatives, and may have to hire additional personnel 
to fulfill the role of derivatives risk manager would be 
particularly likely to experience costs at the upper end of this 
range.
    \501\ One commenter indicated that implementing stress testing, 
which would be one of the required elements of the proposed 
derivatives risk management program, would be only slightly 
burdensome for 27% of respondents to a survey of ICI member firms 
and would be moderately burdensome for an additional 50% of 
respondents. See ICI Comment Letter III; see also supra note 466.
    \502\ This estimate is based on the following calculation: 2,693 
funds x ($70,000 + $45,500) = $311,041,500.
---------------------------------------------------------------------------

2. VaR-Based Limit on Fund Leverage Risk
    The proposed rule would generally impose a VaR-based limit on fund 
leverage risk on funds relying on the rule to engage in derivatives 
transactions.\503\ This outer limit would be based on a relative VaR 
test or, if the fund's derivatives risk manager is unable to identify 
an appropriate designated reference index, an absolute VaR test. In 
either case a fund would apply the test at least once each business 
day. The proposed rule would include an exception from the limit on

[[Page 4516]]

fund leverage risk for limited derivatives users and also certain funds 
that are ``leveraged/inverse investment vehicles,'' as defined in the 
proposed sales practices rules.\504\
---------------------------------------------------------------------------

    \503\ See supra section II.D.
    \504\ See supra sections II.E and II.G.3.
---------------------------------------------------------------------------

    The proposed relative VaR test would limit a fund's VaR to 150% of 
the VaR of the fund's designated reference index.\505\ The designated 
reference index would have to be unleveraged and reflect the markets or 
asset classes in which the fund invests.\506\ Therefore, the relative 
VaR test restricts the incremental risk associated with a fund's 
portfolio relative to a similar but unleveraged investment strategy. In 
this sense, the relative VaR test restricts the degree to which a fund 
can use derivatives to leverage its portfolio.
---------------------------------------------------------------------------

    \505\ See supra section II.D.2.
    \506\ See supra section II.D.2.a. The proposed definition of 
``designated reference index'' also includes other requirements, as 
discussed above. See id. For example, a designated reference index 
could not be administered by an organization that is an affiliated 
person of the fund, its investment adviser, or principal 
underwriter, or created at the request of the fund or its investment 
adviser, unless the index is widely recognized and used.
---------------------------------------------------------------------------

    We recognize that the derivatives risk managers of some funds may 
not be able to identify an appropriate designated reference index.\507\ 
As these funds would not be able to comply with the proposed relative 
VaR test, the proposed rule would require these funds to comply with 
the proposed absolute VaR test instead.\508\ To comply with the 
absolute VaR test, the VaR of the fund's portfolio must not exceed 15% 
of the value of the fund's net assets. The level of loss in the 
proposed absolute VaR test would provide approximately comparable 
treatment for funds that rely on the absolute VaR test and funds that 
rely on the relative VaR test and use the S&P 500 as their designated 
reference index during periods where the S&P 500's VaR is approximately 
equal to the historical mean.\509\
---------------------------------------------------------------------------

    \507\ See supra section II.D.3.
    \508\ Whether a fund complies with the proposed relative or 
absolute VaR test would depend on whether the fund's derivatives 
risk manager would be able to identify a designated reference index 
that is appropriate for the fund taking into account the fund's 
investments, investment objectives, and strategy. See id. We 
therefore anticipate that industry norms that reflect the 
availability of an appropriate designated reference index would 
develop under which funds with similar strategies would generally 
comply with the same type of VaR test (that is, either the proposed 
relative VaR test or the proposed absolute VaR test).
    \509\ See supra section II.D.3.
---------------------------------------------------------------------------

    One common critique of VaR is that it does not reflect the 
conditional distribution of losses beyond the specified confidence 
level.\510\ In other words, the proposed VaR tests would not capture 
the size and relative frequency of losses in the ``tail'' of the 
distribution of losses beyond the measured confidence level.\511\ As a 
result, two funds with the same VaR level could differ significantly in 
the magnitude and relative frequency of extreme losses, even though the 
probability of a VaR breach would be the same for the two funds. To 
demonstrate this limitation of VaR, we construct a simplified portfolio 
with an equity investment that also achieves leverage through 
derivatives. By varying the type of derivatives included in the 
portfolio, we illustrate that the tail risk varies significantly across 
portfolios with equal VaR.
---------------------------------------------------------------------------

    \510\ See supra note 181 and accompanying text.
    \511\ The term ``relative frequency'' here refers to the 
frequency of loss outcomes in the tail of the distribution relative 
to other loss outcomes that are also in the tail of the 
distribution. This relative frequency of the loss outcomes together 
with the magnitude of the associated losses describe the conditional 
distribution of losses in the tail of the distribution.
---------------------------------------------------------------------------

    The details of the strategy are as follows. Assume a fund has 
initial assets of $100 in cash. On day t, the manager of the portfolio 
achieves the additional leverage by writing $ X worth of put options, 
and then invests the proceeds from the sale of the options and the 
initial cash balance, i.e., $(100 + X), into the S&P 500 index.\512\ 
For simplicity, we further assume that the underlying asset of the 
shorted put options is also the S&P 500 index, so that the fund's 
designated reference index is the S&P 500. The maturity of the put 
option is assumed to be one month, and the price of the S&P on day t is 
normalized to $100. On day t + 1, the manager buys back the put options 
and realizes the returns of the strategy. The one-day gross return of 
the fund can be described mathematically as
[GRAPHIC] [TIFF OMITTED] TP24JA20.000

where RM is the gross one-day return of the S&P 500 index, and Rput = 
P(t + 1)/P(t) is the gross one-day return of the put option, with the 
price of the put option at time t denoted by P(t). The return of the 
put option depends on the return of the underlying sset, and the money-
ness of the put--the lower the strike price, the more out-of-the-money 
is the put. In our exercise, we look at three options with three 
different strike prices, ranging from more out-of-the-money to at-the-
money. The strike prices, denoted by K, are equal to K = 92%, K = 96%, 
and K = 100%, of the current level of the S&P 500 index 
respectively.\513\ Assuming the portfolio manager wants to achieve as 
much leverage as possible with each of the three options, while still 
abiding by the proposed limit set by the relative VaR level of 150% at 
a 99% confidence level, we calculate the amount of puts she would 
short, the expected returns of the three portfolios, and the relative 
VaR for confidence levels of 95%, 99%, and 99.9%. In our calculation, 
the model is calibrated to approximately match the historical return 
distribution of the S&P 500. Returns are assumed to be normally 
distributed (for simplicity) with an annualized mean return of 6% and 
an annual standard deviation of roughly 16%. The latter implies a daily 
standard deviation of 1%. For simplicity, the risk-free rate is assumed 
to be zero. The results are in Table 1.
---------------------------------------------------------------------------

    \512\ This strategy could be implemented by either investing in 
the constituent securities of the S&P 500 directly or, for example, 
by investing in an ETF that tracks the S&P 500 index.
    \513\ Given the historical volatility of the S&P 500--
approximately 16% annually, or 1% daily--an 8% daily drop in the 
price is an 8 standard deviation event. Therefore, an option with a 
strike price of 92% of the current value of the S&P 500 index could 
be considered a deep out-of-the-money option.

                             Table 1--Portfolio Composition, Returns and VAR Levels
----------------------------------------------------------------------------------------------------------------
                                                                      K = 92%         K = 96%        K = 100%
                                                                     Portfolio       Portfolio       Portfolio
----------------------------------------------------------------------------------------------------------------
Portfolio Weight................................................          -0.58%          -0.93%          -1.54%
Number of Contracts.............................................           -9.92           -2.05           -0.84
Fund Expected Return............................................           6.68%           7.00%           7.30%
Fund Relative VaR (99%).........................................            1.49            1.49            1.49
Fund Relative VaR (99.9%).......................................            2.14            2.07            2.03
----------------------------------------------------------------------------------------------------------------


[[Page 4517]]

    Relative VaR levels are identical and no greater than 150% for all 
three portfolios at the 99% confidence level and, as expected, for each 
portfolio relative VaR is higher for higher confidence levels. However, 
this example illustrates that relative VaR varies across these 
portfolio for confidence levels above 99%. The fund writing the more 
out-of-the-money option (K = 92%) is riskier in the tail of the S&P 500 
return distribution (when the S&P 500 drops over the one-day period) 
than the fund writing the at-the-money option (K = 100%), but the 
relative VaR level at the 99% confidence level does not reflect this 
difference.
    Figure 1 shows the daily return profile of the three portfolios as 
a function of daily returns to the S&P 500 index. Along the x-axis are 
daily returns to the S&P 500 index, ranging from -8% to +8%. The dotted 
line represents the daily return profile of a portfolio that tracks 1.5 
times the returns of the S&P 500 index. The figure shows that the 
degree of tail risk differs across portfolios. While the returns to all 
portfolios are equal at the 150% relative VaR limit at a 99% confidence 
level, returns beyond the 150% relative VaR limit are lower for 
portfolios that write puts that are further out-of-the-money.
BILLING CODE 8011-01-P

[[Page 4518]]

[GRAPHIC] [TIFF OMITTED] TP24JA20.001

BILLING CODE 8011-01-C
    We also considered the effect that a decline in the S&P 500 over 
three consecutive days would have on the fund that is short the put 
options with a K = 92% strike price considered above. The proposed rule 
requires that a fund determine its compliance with the applicable VaR 
test at least once each business day. In computing three-day returns 
for the fund, we assume that, as the fund exceeds the relative

[[Page 4519]]

VaR test each business day, the fund rebalances its portfolio, at the 
beginning of each day, to bring the fund back into compliance with the 
150% relative VaR limit. The solid line in Figure 2 shows the three-day 
cumulative return of the fund as a function of the per-day returns of 
the S&P 500 on the x-axis, which is assumed to be the same for three 
consecutive days. The dashed curve in Figure 2 shows the corresponding 
first-day returns of the portfolio for comparison, which are the same 
as those denoted by the solid line in Figure 1. The figure shows that 
the three-day cumulative returns shown by the solid curve (in Figure 2) 
are less than three times the single-day losses shown by the dashed 
curve. This is a result of the daily rebalancing of the portfolio, 
which, in this example, reduces the incremental downside risk over 
time.
    As discussed in more detail above, the proposed VaR tests are 
designed to address the concerns underlying section 18, but they are 
not a substitute for a fully-developed derivatives risk management 
program.\514\ Recognizing VaR's limitations, the proposed rule also 
would require the fund to adopt and implement a derivatives risk 
management program that, among other things, would require the fund to 
establish risk guidelines and to stress test its portfolio in part 
because of concerns that VaR as a risk management tool may not 
adequately reflect tail risks.
---------------------------------------------------------------------------

    \514\ See supra note 183 and accompanying text.
---------------------------------------------------------------------------

    DERA staff analyzed the VaR levels of the portfolios of all funds 
that would be subject to the proposed rule and of certain benchmark 
indexes as of December 2018 in order to estimate how many of the funds 
that would be subject to the proposed VaR-based limit on fund leverage 
risk currently operate in exceedance of that limit.\515\ This analysis 
identified only six funds that would be subject to the proposed limit 
that DERA staff estimated may fail the relative VaR test. In the case 
of these six funds, DERA staff calculated the relative VaR test using 
the primary benchmark disclosed in the funds' prospectuses. To the 
extent that these funds' derivatives risk managers were to determine 
that a different index would be more appropriate for purposes of 
computing the relative VaR test or that no appropriate designated 
reference index were available, some or all of these funds could be 
compliant with the VaR-based limit on fund leverage risk either under 
the relative VaR test with a more appropriate index or under the 
absolute VaR test.\516\ As a result, we estimate that there would only 
be a very small number of funds, if any, that would have to adjust 
their portfolios in order to comply with the VaR-based limit on fund 
leverage risk. This is consistent with the VaR-based limit on fund 
leverage risk functioning as an outer bound on fund leverage risk.
---------------------------------------------------------------------------

    \515\ This analysis is based on Morningstar data as of December 
31, 2018. DERA staff computed the VaR of each fund and that of a 
reference index using historical simulation from three years of 
prior daily return data. Staff generally computed the relative VaR 
test based on a fund's primary prospectus benchmark. In cases where 
historical return data for the primary prospectus benchmark was not 
available or where the primary prospectus benchmark did not appear 
to capture the markets or asset classes in which a fund invests, 
DERA staff instead used a broad-based unleveraged index that 
captures a fund's markets or asset classes or a broad-based U.S. 
equity index.
    \516\ Based on our analysis, we estimate that only one of the 
six funds that we identified may fail the proposed relative VaR test 
would also fail the proposed absolute VaR test.
---------------------------------------------------------------------------

    To the extent that there are funds that would have to adjust their 
portfolios to comply with the VaR-based limit on fund leverage risk, 
these funds would incur associated trading costs. If there were a fund 
that would have to adjust its portfolio so significantly that it could 
no longer pursue its investment strategy, such a fund may also lose 
investors or, if it chooses to cease operating, incur costs associated 
with unwinding the fund.
    In addition, funds could be required to adjust their portfolios to 
comply in the future and, if so, would incur associated trading costs. 
For example, as market conditions change, a fund's VaR could exceed the 
proposed limits, especially if a fund relies on the absolute VaR test. 
The proposed VaR tests also would eliminate the flexibility that funds 
currently have to leverage their portfolios to a greater extent than 
the proposed VaR tests would permit. Although funds currently may not 
be exercising this flexibility, they may nevertheless value the ability 
to so increase leverage in the future. While, on the one hand, the 
proposed VaR tests impose costs on funds by restricting the strategies 
they may employ, the proposed limit on fund leverage risk would benefit 
fund investors, to the extent that it would prevent these investors 
from experiencing unexpected losses from a fund's increased risk 
exposure that are prevented by the proposed VaR-based limit on fund 
leverage risk.
    By establishing a bright-line limit on the amount of leverage risk 
that a fund can take on using derivatives, the proposed rule may make 
some funds and their advisers more comfortable with using derivatives. 
As a result, some funds that currently invest in derivatives to an 
extent that would result in the fund's VaR being below the proposed 
limit may react by increasing the extent of their derivatives usage.
    The proposed requirement could also indirectly result in changing 
the amount of investments in funds. On the one hand, the proposed rule 
could attract additional investment, if investors become more 
comfortable with funds' general level of riskiness as a result of 
funds' compliance with an outside limit on fund leverage risk. On the 
other hand, to the extent that investors currently expect funds to 
limit their risk to levels below those which the proposed limits would 
produce (which investors could observe from the required VaR reporting 
requirements on form N-PORT for funds other than limited derivatives 
users and leveraged/inverse funds), or investors see funds' general 
level of riskiness increasing after funds come into compliance with the 
proposed limits, the proposed limits may result in investors re-
evaluating how much risk they are willing to take and reducing their 
investments in funds. Due to a lack of data regarding current investor 
expectations about fund risk, however, we are unable to predict which 
of the two effects would more likely dominate the other.
    As the proposed requirements would prevent funds from offering 
investment strategies that exceed the proposed outer limit on fund 
leverage risk, those investors who prefer to invest in such funds 
because they value the increased potential for gains that is generally 
associated with riskier investment strategies may see their investment 
opportunities restricted by the proposed rules. As a result, such 
investors may instead invest in alternative investment vehicles, 
exchange-traded notes, or structured products, which can provide 
leveraged market exposure but would not be subject to the VaR-based 
limit on fund leverage risk of rule 18f-4.\517\ Alternatively, such 
investors, particularly institutional ones, may instead borrow 
themselves or trade on margin to achieve leverage.
---------------------------------------------------------------------------

    \517\ See supra section III.C.5.
---------------------------------------------------------------------------

    Funds that would be subject to the proposed VaR-based limit on fund 
leverage risk would incur the cost of determining their compliance with 
the applicable VaR test at least once each business day. Part of these 
costs would be associated with obtaining the necessary data required 
for the VaR calculation. Funds implementing the relative VaR test would 
likely incur larger data costs compared to funds implementing the 
absolute VaR test, as

[[Page 4520]]

the absolute VaR test would require funds to obtain data only for the 
VaR calculation for the fund's portfolio, whereas the relative VaR test 
also would require funds to obtain data for the VaR calculation for 
their designated reference index. In addition, some index providers may 
charge licensing fees to funds for including indexes in their 
disclosure documents or for access to information about the index's 
constituent securities and weightings.\518\
---------------------------------------------------------------------------

    \518\ We understand that industry practices around licensing 
indexes for regulatory purposes vary widely, with some providers not 
charging any fees and others charging fees in excess of $10,000 per 
year.
---------------------------------------------------------------------------

    Funds that do not already have systems to perform the proposed VaR 
calculations in place would also incur the costs associated with 
setting up these systems or updating existing systems.\519\ Both the 
data costs and the systems costs would likely be larger for funds that 
use multiple types of derivatives, use derivatives more extensively, or 
otherwise have more complicated derivatives portfolios, compared to 
funds with less complicated derivatives portfolios.
---------------------------------------------------------------------------

    \519\ One commenter indicated that implementing a UCITS VaR test 
would be only slightly burdensome for 45% of respondents to a survey 
of ICI member firms and would be moderately burdensome for an 
additional 34% of respondents. The commenter also indicated that 
respondents commonly reported that the burden would increase, in 
some cases very substantially, if a VaR test has different 
parameters or is more prescriptive than UCITS VaR. See ICI Comment 
Letter III; see also supra note 451. As the requirements of the 
proposed VaR test are generally consistent with existing market 
practice, including that of UCITs funds, the results of this survey 
therefore support our view that many funds would likely experience 
efficiencies in implementing the proposed VaR test.
---------------------------------------------------------------------------

    Larger funds or funds that are part of a large fund complex may 
incur higher costs in absolute terms but find it less costly, per 
dollar managed, to perform VaR tests relative to a smaller fund or a 
fund that is part of a smaller fund complex. For example, larger funds 
may have to allocate a smaller portion of existing resources for the 
VaR test and fund complexes may realize economies of scale in 
implementing systems to compute VaR. In particular, the costs 
associated with implementing or updating systems to calculate VaR would 
likely only be incurred once at the level of a fund complex, as such 
systems can be used to perform VaR tests for all funds in the complex 
that are subject to the VaR test requirement. Similarly, larger fund 
complexes may incur lower costs associated with purchasing data per 
fund, to the extent that the VaR calculations for multiple funds in the 
complex partially or completely require the same data.
    Under the proposed rule, a fund that holds derivatives that is 
either a limited derivatives user or a leveraged/inverse fund that 
complies with the alternative requirements for leveraged/inverse 
investment vehicles would not be subject to the proposed VaR-based 
limit on fund leverage risk. Based on an analysis of Form N-PORT 
filings and financial statements filed with the Commission by BDCs, we 
estimate that about 19% of funds that would be subject to the proposed 
rule, or 2,424 funds total, would be required to implement VaR 
tests.\520\ We estimate that the incremental annual cost associated 
with the VaR test would range from $5,000 to $100,000 per fund, 
depending on the particular facts and circumstances, including whether 
the fund currently computes VaR; whether the fund is implementing the 
relative or absolute VaR test; and whether a fund that is part of a 
larger complex may be able to realize economies of scale. Funds that 
currently already compute VaR would be particularly likely to 
experience costs at the very low end of this range. Assuming that the 
midpoint of this range reflects the cost to the average fund subject to 
the VaR requirement, we estimate a total additional annual industry 
cost of $127,260,000.\521\
---------------------------------------------------------------------------

    \520\ We estimate that about 19% of all funds that would be 
subject to the proposed rule hold some derivatives, would not 
qualify as a limited derivatives user, and are not a leveraged/
inverse fund that could comply with the alternative requirements for 
leveraged/inverse investment vehicles.
    \521\ This estimate is based on the following calculation: 2,424 
funds x 0.5 x ($5,000 + $100,000) = $127,260,000. Some funds may 
find it more cost effective to restrict their use of derivatives in 
order to be able to rely on the proposed rule's exception for 
limited derivatives users compared to complying with the proposed 
VaR-based limit on fund leverage risk. See supra section II.E; infra 
section III.C.3. As we do not have data that would allow us to 
quantify the costs and benefits that define the tradeoff for any 
particular fund of changing its use of derivatives in order to 
qualify for the limited user exception, we are unable to quantify 
how many funds would make this choice.
---------------------------------------------------------------------------

    In addition, a fund that today or in the future may operate in a 
manner that would result in the fund's portfolio VaR being just under 
the proposed limit on fund leverage risk may need to alter its 
portfolio during periods of increased market volatility in order to 
avoid falling out of compliance with the proposed limit. We would 
expect such a scenario to be more likely for a fund that would rely on 
the absolute VaR test, because the relative VaR test would allow a fund 
to operate with a higher portfolio VaR when the VaR of its designated 
reference index increases.
    A fund that were to eliminate some of its leverage risk associated 
with derivatives in order to comply with the proposed VaR-based limit 
on leverage risk might do so through unwinding or hedging its 
derivatives transactions or through some other means. These portfolio 
adjustments may be costly, particularly in conditions of market stress 
and reduced liquidity. The proposed rule would, however, give a fund 
the flexibility to mitigate these potential costs by not requiring the 
fund to exit positions or change its portfolio if it is out of 
compliance with the VaR test. Instead, the rule would provide that, if 
a fund has been out of compliance with the applicable VaR test for more 
than three business days, then: (1) The derivatives risk manager must 
report to the fund's board of directors and explain how and by when 
(i.e., the number of business days) the derivatives risk manager 
reasonably expects that the fund will come back into compliance; \522\ 
(2) the derivatives risk manager must analyze the circumstances that 
caused the fund to be out of compliance for more than three business 
days and update any program elements as appropriate to address those 
circumstances; and (3) the fund may not enter into derivatives 
transactions other than derivatives transactions that, individually or 
in the aggregate, are designed to reduce the fund's VaR, until the fund 
has been back in compliance with the applicable VaR test for three 
consecutive business days and satisfied the board reporting requirement 
and program analysis and update requirements.\523\ These provisions of 
the proposed rule collectively would provide some flexibility for a 
fund that is out of compliance with the VaR test to make any portfolio 
adjustments, which may allow funds to avoid some of the costs that 
otherwise could result from forced changes in the fund's portfolio.
---------------------------------------------------------------------------

    \522\ Proposed rule 18f-4(c)(2)(iii)(A). See also infra section 
II.H.2 (discussing a report to the Commission regarding the fund 
being out of compliance with the applicable proposed VaR test for 
three business days).
    \523\ See proposed rule 18f-4(c)(2)(iii).
---------------------------------------------------------------------------

3. Limited Derivatives Users
    Proposed rule 18f-4 includes an exception from the proposed risk 
management program requirement and VaR-based limit on fund leverage 
risk for limited derivatives users.\524\ The proposed exception would 
be available for a fund that either limits its derivatives exposure to 
10% of its net assets or uses derivatives transactions solely to hedge 
certain currency risks and that also adopts and implements policies and 
procedures reasonably

[[Page 4521]]

designed to manage the fund's derivative risks. We expect that the 
risks and potential impact of these funds' derivatives use may not be 
as significant, compared to those of funds that do not qualify for the 
exception.\525\ Therefore, we believe that a principles-based policies 
and procedures requirement would appropriately address these risks.
---------------------------------------------------------------------------

    \524\ See supra section II.E.
    \525\ See supra note 270 and accompanying and immediately-
following text.
---------------------------------------------------------------------------

    We believe that investors in funds that use derivatives in a 
limited manner would benefit from the proposed requirement, which we 
anticipate would reduce, but not eliminate, the frequency and severity 
of derivatives-related losses for such funds. In addition, to the 
extent that the proposed framework is more comprehensive than funds' 
current practices, the proposed requirement may result in more 
effective risk management across funds and increased fund industry 
stability.
    For funds that do not already have policies and procedures in place 
that could be readily adapted to meet the proposed rule's requirements 
without significant additional cost, we estimate that the one-time 
costs would range from $1,000 to $100,000 per fund, depending on the 
particular facts and circumstances, including whether a fund is part of 
a larger fund complex; the extent to which the fund uses derivatives 
within the parameters of the limited user exception, including whether 
the fund uses more complex derivatives; and the fund's current 
derivatives risk management practices. These estimated costs are 
attributable to the following activities: (1) Assessing whether a fund 
is a limited derivatives user; (2) developing policies and procedures 
reasonably designed to manage a fund's derivatives risks; (3) 
integrating and implementing the policies and procedures; and (4) 
preparing training materials and administering training sessions for 
staff in affected areas.
    For funds that do not already have policies and procedures in place 
that could be readily adapted to meet the proposed rule's requirements 
without significant additional cost, we estimate that the ongoing 
annual costs that a fund that is a limited derivatives user would incur 
range from 65% to 75% of the one-time costs to establish and implement 
the policies and procedures. Thus, a fund would incur ongoing annual 
costs that range from $650 to $75,000.\526\ These estimated costs are 
attributable to the following activities: (1) Assessing, monitoring, 
and managing the risks associated with the fund's derivatives 
transactions; (2) periodically reviewing and updating a fund's policies 
and procedures; and (3) additional staff training.
---------------------------------------------------------------------------

    \526\ This estimate is based on the following calculations: 0.65 
x $1,000 = $650; 0.75 x $100,000 = $75,000.
---------------------------------------------------------------------------

    Based on an analysis of Form N-PORT filings, as well as financial 
statements filed with the Commission by BDCs, we estimate that about 
19% of funds that would be subject to the proposed rule, or 2,398 funds 
total, would qualify as limited derivatives users. Almost all of these 
funds would be able to rely on the exposure-based exception. While some 
funds, about 1%, could rely on both the exposure-based exception and 
the currency hedging exception, only a fraction of 1% of funds would 
qualify as limited derivatives users solely based on the currency 
hedging exception.
    As many funds belong to a fund complex and are likely to experience 
economies of scale, we expect that the lower end of the estimated range 
of costs ($1,000 in one-time costs; $650 in annual costs) better 
reflects the total costs likely to be incurred by many funds. In 
addition, we believe that many funds already have policies and 
procedures in place that could be readily adapted to meet the proposed 
rule's requirements without significant additional cost. However, as we 
do not have data to determine how many funds already have such policies 
and procedures in place that would substantially satisfy the proposed 
rule's requirements, we assume that all funds would incur a cost 
associated with this requirement. Based on these assumptions, we over-
inclusively estimate a lower bound for the total industry cost in the 
first year of $751,773.\527\
---------------------------------------------------------------------------

    \527\ This estimate is based on the following calculation: 2,398 
funds x 0.19 x ($1,000 + $650) = $751,773. This cost estimate 
assumes that none of the funds that currently do not hold any 
derivatives would choose to establish and implement policies and 
procedures reasonably designed to manage the fund's derivatives 
risks in anticipation of a future limited use of derivatives. 
Notwithstanding this assumption, we acknowledge some funds that 
currently do not use derivatives may still choose to establish and 
implement such policies and procedures prophylactically in order to 
preserve the flexibility to engage in a limited use of derivatives 
on short notice.
---------------------------------------------------------------------------

    Some funds may change how they use derivatives in order to qualify 
for the limited derivatives user exception and thereby avoid the 
potentially increased compliance cost associated with the proposed 
derivatives risk management program and VaR-based limit on fund 
leverage risk. Specifically, a fund with derivatives exposure just 
below 10% of its net assets may forego taking on additional derivatives 
positions, or a fund with derivatives exposure just above 10% of its 
net assets may close out some existing derivatives positions. 
Similarly, a fund that uses derivatives to hedge certain currency risks 
may forego or eliminate its use of derivatives for other purposes. As a 
result, the proposed exception for limited derivatives users may reduce 
the extent to which some funds use derivatives.\528\
---------------------------------------------------------------------------

    \528\ As we do not have data that would allow us to quantify the 
costs and benefits that define the tradeoff for any particular fund 
of changing its use of derivatives in order to qualify for the 
limited user exception, we are unable to quantify how many funds 
would make this choice.
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4. Reverse Repurchase Agreements and Similar Financing Transactions
    The proposed rule would allow funds to engage in reverse repurchase 
agreements and other similar financing transactions. However, as these 
transactions achieve economically identical results to other secured 
loans, the proposed rule would require that they be treated the same as 
bank borrowings and other borrowings under section 18. The proposal 
would therefore require a fund to combine any bank borrowings or other 
borrowings and reverse repurchase agreements when assessing compliance 
with the relevant asset coverage requirements of section 18.\529\
---------------------------------------------------------------------------

    \529\ See supra section II.I.
---------------------------------------------------------------------------

    Today, funds rely on the asset segregation approach that Release 
10666 describes with respect to reverse repurchase agreements, which 
funds may view as separate from the limitations established on bank 
borrowings (and other senior securities that are evidence of 
indebtedness) by the asset coverage requirements of section 18.\530\ As 
a result, the degree to which funds could engage in reverse repurchase 
agreements may differ under the proposed rule from the baseline. A fund 
that engages solely in reverse repurchase agreements, or solely in bank 
borrowings (for example), would be unaffected by the proposed 
requirement.\531\ However, to the extent that a fund engages in both 
reverse repurchase agreements and bank borrowings (or similar 
transactions), because we believe these transactions are economically 
equivalent, they would be combined for purposes of analyzing whether a 
fund is in compliance with section 18's asset

[[Page 4522]]

coverage requirement. This may have the effect of limiting the overall 
scale of these transactions under the proposed requirement compared to 
the baseline, to the extent that funds today separately analyze their 
asset coverage requirements with respect to reverse repurchase 
agreements under Release 10666 and bank borrowings and similar senior 
securities under section 18.
---------------------------------------------------------------------------

    \530\ See supra section I.B.2.a.
    \531\ For example, an open-end fund with no other senior 
securities outstanding could borrow an amount equivalent to 50% of 
its net assets using reverse repurchase agreements or bank 
borrowings under the baseline.
---------------------------------------------------------------------------

    DERA staff analyzed funds' use of reverse repurchase agreements and 
borrowings using Form N-PORT filings as well as financial statements 
filed with the Commission by BDCs. Based on our analysis of Form N-PORT 
filings, we estimate that about 0.36% of funds that would be subject to 
the proposed rule, or 45 funds total, used these transactions in 
combined amounts that exceeded the asset coverage requirement.\532\ 
These funds would have to adjust their use of reverse repurchase 
agreements, similar financing transactions, or borrowings in order to 
comply with the proposed rule and may incur associated transactions 
costs.
---------------------------------------------------------------------------

    \532\ In our review of form N-PORT filings, we observed that 
several of the funds that used reverse repurchase agreements and 
similar financing transactions (bank borrowings and similar 
securities) in combined amounts that exceeded 50% of net assets 
already exceeded the 50% limit for either repurchase agreements, 
similar financing transactions (bank borrowings and similar 
securities, or both, when considered separately. In our review of 
financial statements filed by the Commission by BDCs, we observed 
that no BDCs exceeded the asset coverage requirement.
---------------------------------------------------------------------------

    In addition, under the proposed rule, if a fund did not qualify as 
a limited derivatives user due to its other investment activity, any 
portfolio leveraging effect of reverse repurchase agreements, similar 
financing transactions, and borrowings would also be restricted 
indirectly through the VaR-based limit on fund leverage risk. As a 
result, a fund could be restricted through the VaR-based limit on fund 
leverage risk from investing the proceeds of borrowings through reverse 
repurchase agreements to the full extent otherwise permitted by the 
asset coverage requirements in section 18 if the fund did not qualify 
as a limited derivatives user.
5. Alternative Requirements for Certain Leveraged/Inverse Funds and 
Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment 
Vehicles
    The proposed sales practices rules would require a broker-dealer or 
investment adviser to (1) exercise due diligence in approving a retail 
investor's account to buy or sell shares of leveraged/inverse 
investment vehicles before accepting an order from, or placing an order 
for, such an investor to engage in these transactions; and (2) adopt 
and implement policies and procedures reasonably designed to achieve 
compliance with the proposed rules.\533\ Additionally, a leveraged/
inverse fund that meets the definition of a ``leveraged/inverse 
investment vehicle'' in the proposed sales practices rules would not 
have to comply with the VaR-based leverage risk limit under proposed 
rule 18f-4, provided the fund limits the investment results it seeks to 
300% of the return (or inverse of the return) of the underlying index 
and discloses in its prospectus that it is not subject to the proposed 
VaR-based limit on fund leverage risk.\534\
---------------------------------------------------------------------------

    \533\ See supra section II.G.2. The proposed sales practices 
rules define ``leveraged/inverse investment vehicle'' to mean a 
registered investment company or an exchange-listed commodity- or 
currency-based trust or fund that seeks, directly or indirectly, to 
provide investment returns that correspond to the performance of a 
market index by a specified multiple, or to provide investment 
returns that have an inverse relationship to the performance of a 
market index, over a predetermined period of time. See proposed 
rules 15l-2(d) and 211(h)-1(d).
    \534\ See supra section II.G.3. A leveraged/inverse fund that 
meets these requirements still would be required to satisfy all of 
the conditions in proposed rule 18f-4 other than the proposed VaR-
based limit on fund leverage risk, including the proposed conditions 
requiring a derivatives risk management program, board oversight and 
reporting, and recordkeeping.
---------------------------------------------------------------------------

    These due diligence and approval requirements are designed to 
address potential investor protection concerns with respect to 
leveraged/inverse investment vehicles by subjecting retail investors to 
specific due diligence and account approval requirements by broker-
dealers and investment advisers. The proposed rules also are designed 
to help to ensure that investors in these funds are limited to those 
who are capable of evaluating their characteristics--including that the 
funds would not be subject to all of the leverage-related requirements 
applicable to registered investment companies generally--and the unique 
risks they present. There is a body of academic literature providing 
empirical evidence that retail investors may not fully understand the 
risks inherent in their investment decisions and not fully understand 
the effects of compounding returns over time.\535\ Retail investors 
could face additional burdens in investing in leveraged/inverse 
investment vehicles, to the extent that they do not currently possess 
the requisite capability of evaluating the risks of these products to 
satisfy the approval requirements implemented by broker-dealers and 
investment advisers in connection with the proposed rules' due 
diligence and account approval obligations. However, we expect such 
retail investors would benefit from the proposed requirement, which we 
believe would help to ensure that investors in these funds are limited 
to those who are capable of evaluating the characteristics and unique 
risks of these products.\536\ We acknowledge that these benefits may be 
reduced, to the extent that they overlap with the effects of investment 
advisers' or broker-dealers' existing requirements or practices related 
to a retail investors' suitability for investments in these produces as 
discussed in section III.B.5 above.
---------------------------------------------------------------------------

    \535\ See, e.g., Annamaria Lusardi & Olivia S. Mitchell, The 
Economic Importance of Financial Literacy: Theory and Evidence, 52 
Journal of Economic Literature 5 (2014), available athttps://
www.aeaweb.org/articles?id=10.1257/jel.52.1.5, which provides a 
literature review of recent survey-based work indicating that many 
retail investors have limited financial literacy and, for example, 
do not always understand the compounding of returns, which may 
directly apply in the context of the daily compounding feature of 
leveraged/inverse ETFs. The literature does not address retail 
investor's inattention to investment risk or the unique dynamics of 
compounding of daily returns in the context of leveraged/inverse 
ETFs or other leveraged/inverse investment vehicles specifically, 
but studies investor inattention to financial products more 
generally.
    \536\ The sales practices rules would not apply to a position in 
a leveraged/inverse investment vehicle established before the rules' 
compliance date. See supra note 339 and associated text. As a 
result, investors with such existing positions would only be 
affected by the proposed sales practices rules if they seek to 
increase an existing or add a new position in a leveraged/inverse 
investment vehicle.
---------------------------------------------------------------------------

    Since the alternative provision for leveraged/inverse funds under 
proposed rule 18f-4 includes a requirement that a leveraged/inverse 
fund disclose in its prospectus that it is not subject to the proposed 
limit on fund leverage risk, both investors and the market would 
benefit from transparency regarding which funds are exempt from rule 
18f-4's limit on fund leverage fund risk. Some investors may value this 
information to the extent that it helps them make better-informed 
choices between funds.
    The costs that broker-dealers and investment advisers may incur as 
a result of the proposed sales practices rules would vary depending on 
the firm. For example, as the proposed requirements are generally 
modeled after the options account requirements, broker-dealers that 
already have compliance procedures in place for approving options 
accounts would likely have reduced compliance costs.\537\ In addition, 
some broker-dealers and investment advisers may incur costs associated 
with training

[[Page 4523]]

customer-facing personnel and supervisory review of account approval 
decisions. Investment advisers' and broker-dealers' existing processes, 
as discussed above in section III.B.5, may reduce the costs that the 
proposed sales practices rules otherwise would involve to the extent 
that investment advisers or broker-dealers can build on existing 
processes in complying with the proposed sales practices rules.
---------------------------------------------------------------------------

    \537\ These efficiencies and the resulting reduced compliance 
costs would not apply to investment advisers that are not also 
registered broker-dealers because they are not subject to FINRA 
rules.
---------------------------------------------------------------------------

    Broker-dealers and investment advisers would incur costs associated 
with the proposed sales practices rules. We estimate that one-time 
costs for a broker-dealer or investment adviser related to the due 
diligence and account approval requirements would range from $7,749 to 
$12,915 \538\ and that one-time costs related to drafting the 
associated policies and procedures would range from $1,367 to 
$2,278.\539\ Thus, we estimate total one-time costs for a broker-dealer 
or investment adviser would range from $9,116 to $15,193.\540\
---------------------------------------------------------------------------

    \538\ This estimated range is based on the following 
calculations: (6 hours x $365 (compliance attorney) + 9 hours x $284 
(senior systems analyst) + 12 hours x $331 (senior programmer)) = 
($2,190 + $2,556 + $3,972) = $8,718 for development and 
implementation of online client questionnaire; (3 hours x $365 
(compliance attorney) + 3 hour x $70 (compliance clerk)) = $1,305 
for customer due diligence; and 1 hour x $309 (compliance manager) = 
$309 for evaluation of client information for account approval/
disapproval for a total of $10,332. Assuming a range of +/-25% 
around the average total of $10,332 gives a range for one-time costs 
from $10,332 x 75% = $7,749 to $10,332 x 125% = $12,915.
    \539\ This estimated range is based on the following 
calculations: (3 hours x $309 (senior manager) + 1 hour x $365 
(compliance attorney) + 1 hour x $530 (chief compliance officer)) = 
($927 + $365 + $530) = $1,822 for establishing and implementing rule 
15l-2 policies and procedures. Assuming a range of +/-25% around the 
average total of $1,822 gives a range for one-time costs from $1,822 
x 75% = $1,366.50 to $1,822 x 125% = $2,277.50.
    \540\ This estimated range is based on the following 
calculations: $7,749 + $1,366.50 = $9,115.50 for the minimum of the 
cost range and $12,915 + $2,277.50 = $15,192.50 for the maximum of 
the cost range.
---------------------------------------------------------------------------

    In addition, we estimate that ongoing costs for a broker-dealer or 
investment adviser related to the due diligence and account approval 
requirements would range from $1,211 to $2,018 per year,\541\ that 
ongoing costs related to the associated policies and procedures 
requirement would range from $903 to $1,505 per year,\542\ and that 
ongoing costs related to the associated recordkeeping requirements 
would range from $157 to $393 per year.\543\ Thus, we estimate that 
total ongoing costs for a broker-dealer or investment adviser would 
range from $2,271 to $3,915 per year.\544\
---------------------------------------------------------------------------

    \541\ This estimated range is based on the following 
calculations: (3 hours x $365 (compliance attorney) + 3 hour x $70 
(compliance clerk)) = $1,305 per year for customer due diligence; 
and 1 hour x $309 (compliance manager) = $309 per year for 
evaluation of client information for account approval/disapproval 
for a total of $1,614 per year. Assuming a range of +/-25% around 
the average total of $1,614 per year gives a range for ongoing costs 
from $1,614 x 75% = $1,210.50 per year to $1,614 x 125% = $2,017.50 
per year.
    \542\ This estimated range is based on the following 
calculations: (1 hour x $309 (senior manager) + 1 hour x $365 
(compliance attorney) + 1 hour x $530 (chief compliance officer)) = 
$1,204 per year for reviewing and updating rule 15l-2 policies and 
procedures. Assuming a range of +/-25% around the average total of 
$1,204 per year gives a range for ongoing costs from $1,204 x 75% = 
$903 per year to $1,204 x 125% = $1,505 per year.
    \543\ This estimated range is based on the following 
calculations: (1 hour x $62 (general clerk) + 1 hour x $95 (senior 
computer operator)) = $157 per year for the minimum of the cost 
range and (2.5 hours x $62 (general clerk) + 2.5 hours x $95 (senior 
computer operator) = ($155 + $237.50)) = $392.50 per year for the 
maximum of the cost range.
    \544\ This estimated range is based on the following 
calculations: ($1,210.50 + $903 + $157) = $2,270.50 per year for the 
minimum of the cost range and ($2,017.50 + $1,505 + $392.50) = 
$3,915 per year for the maximum of the cost range.
---------------------------------------------------------------------------

    As of December 2018, there were 2,766 broker-dealers that reported 
some sales to retail customer investors.\545\ We estimate that 700 of 
these broker dealers with retail customer accounts (approximately 25%) 
have retail customer accounts that invest in leveraged/inverse 
investment vehicles. Our staff further estimates that 715,000 existing 
customer accounts with such broker-dealers would require account 
approval for trading in leveraged/inverse investment vehicles and that 
10,000 new customer accounts opened each year would require such 
approval.\546\
---------------------------------------------------------------------------

    \545\ Our estimate of the number of broker-dealers with retail 
customers are based on data obtained from Form BD and Form BR as of 
December 31, 2018.
    \546\ The number of broker-dealers that have retail client 
accounts that invest in leveraged/inverse investment vehicles as 
well as the numbers of existing and new customer accounts with these 
broker-dealers that would require approval for trading in these 
products are based on staff experience, as we do not have data that 
would allow us to determine these numbers more precisely.
---------------------------------------------------------------------------

    In addition, as of December 2018, there were 8,235 investment 
advisers registered with the Commission having some portion of their 
business dedicated to retail investors, including either individual 
high net worth clients or individual non-high net worth clients.\547\ 
We estimate that 2,000 of these investment advisers with retail client 
accounts (approximately 25%) have retail client accounts that invest in 
leveraged/inverse investment vehicles. Wefurther estimate that 715,000 
existing customer accounts with such investment advisers would require 
account approval for trading in leveraged/inverse investment vehicles, 
and that 10,000 new customer accounts opened each year would require 
such approval.\548\
---------------------------------------------------------------------------

    \547\ Our estimate of the number of investment advisers with 
retail accounts are based on data obtained from responses to Item 
5.D of Form ADV as of December 31, 2018.
    \548\ The number of investment advisors that have retail client 
accounts that invest in leveraged/inverse investment vehicles as 
well as the numbers of existing and new customer accounts with these 
investment advisers that would require approval for trading in these 
products are based on staff experience, as we do not have data that 
would allow us to determine these numbers more precisely.
---------------------------------------------------------------------------

    To the extent that many broker-dealers already have compliance 
procedures in place for approving options accounts, which is a common 
industry practice, these broker-dealers would likely have reduced costs 
associated with the proposed requirements of the sales practices rules. 
Thus, we estimate that many broker-dealers would incur one-time and 
ongoing costs that are closer to the low end of the provided ranges, 
while broker-dealers that cannot take advantage of such efficiencies 
and many investment advisors would likely experience costs closer to 
the high end of the provided ranges.\549\ We estimate that the total 
industry cost for the proposed requirements of the sales practice rule 
in the first year for both broker-dealers and investment advisers would 
equal $2,377,503,800, which is based on the midpoint of the sum of the 
ranges for both one-time and ongoing costs.\550\ Some broker-dealers 
and investment advisers may decide to pass

[[Page 4524]]

these compliance costs on to their customers.\551\
---------------------------------------------------------------------------

    \549\ See supra notes 514 and 518.
    \550\ This estimate is based on the following calculations: (700 
broker-dealers + 2,000 registered investment advisers having retail 
customer accounts that invest in leveraged/inverse investment 
vehicles) x ($8,718 + $1,822)) = $28,458,000 + ((2 x 715,000) 
existing customer accounts with broker-dealers and registered 
investment advisers requiring account approval for trading in 
leveraged/inverse investment vehicles) x ($1,305 + $309) = 
$2,308,020,000 for total one-time industry costs to broker-dealers 
and investment advisers of $2,336,478,000; and ((2 x 10,000) new 
customer accounts requiring account approval for trading in 
leveraged/inverse investment vehicles) x ($1,305 + $309) = 
$32,280,000 + (700 broker-dealers + 2,000 registered investment 
advisers having retail customer accounts that invest in leveraged/
inverse investment vehicles) x $1,204) = $3,250,800 + (10,000 new 
customer accounts requiring account approval for trading in 
leveraged/inverse investment vehicles) x ($157 (broker-dealer 
recordkeeping costs) + $392.50 (investment adviser recordkeeping 
costs)) = $5,495,000 for total ongoing annual industry costs to 
broker-dealers and investment advisers of $41,025,800 per year. 
Total industry cost for proposed requirements of sales practice rule 
in the first year is $2,336,478,000 + $41,025,800 = $2,377,503,800, 
which is consistent with being the midpoint of the sum of the ranges 
for both one-time and ongoing costs discussed in preceding 
calculations.
    \551\ The share of these costs passed on to investors by 
investment advisers or broker-dealers would depend on multiple 
factors, including the nature of competition between investment 
advisers and broker-dealers as well as investors' relative 
sensitivity to changes in fees, the joint effects of which are 
inherently impossible to predict. Some broker-dealers offer 
transactions in certain leveraged/inverse investment vehicles, such 
as some leveraged/inverse ETFs, without charging commissions. In 
these cases, broker-dealers may pass on some of the compliance costs 
associated with the proposed requirements by charging some amount of 
commission on these trades.
---------------------------------------------------------------------------

    In addition, some leveraged/inverse investment vehicles may lose 
existing or potential investors as a result of some retail investors 
not being approved by their broker-dealer or investment adviser to 
transact in leveraged/inverse investment vehicles or some retail 
investors being deterred by the time costs and delay introduced by the 
account-opening procedures. Broker-dealers or investment advisers with 
a larger fraction of retail customers or clients that can no longer 
transact in leveraged/inverse investment vehicles as a result of the 
proposed sales practices rules may experience larger declines in their 
customer or client base and associated reductions in profits.\552\
---------------------------------------------------------------------------

    \552\ Any such reduction in a broker-dealer's or investment 
adviser's customer base may be offset to the extent that clients 
transact in other products with the same broker dealer or investment 
adviser instead.
---------------------------------------------------------------------------

    It is our understanding that no funds that would meet the 
definition of a ``leveraged/inverse investment vehicle,'' and that seek 
returns above 300% of the return (or inverse of the return) of the 
underlying index, currently exist. Therefore we do not expect any costs 
associated with existing funds having to alter their investment 
strategies or business practices to comply with proposed rule 18f-4's 
alternative requirements for leveraged/inverse funds.
    Requiring a leveraged/inverse fund covered by the proposed sales 
practices rules to limit its exposure to 300% of the return (or inverse 
of the return) of the underlying index while preventing a fund that 
does not qualify as a leveraged/inverse investment vehicle from 
offering investment strategies that exceed the proposed outer limit on 
fund leverage risk may also have competitive effects, which we discuss 
in section III.B.5 below. As an alternative to the proposed exposure 
limit for leveraged/inverse funds, we also discuss the effects of 
conditioning the exemption for leveraged/inverse funds on compliance 
with a higher or lower exposure limit in section III.D.1 below.
6. Proposed Amendments to Rule 6c-11 Under the Investment Company Act 
and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs
    Existing leveraged/inverse ETFs rely on exemptive relief, which the 
Commission has not granted to a leveraged/inverse ETF sponsor since 
2009. We are proposing to amend rule 6c-11 to remove the provision 
excluding leveraged/inverse ETFs from its scope, which would permit 
fund sponsors to operate a leveraged/inverse ETF under that rule and 
without obtaining an exemptive order.
    The proposed amendments to rule 6c-11 would benefit any fund 
sponsors seeking to launch leveraged/inverse ETFs that did not obtain 
the required exemptive relief due to the Commission's moratorium on 
granting such relief as well as fund sponsors seeking to launch 
leveraged/inverse ETFs in the future. A fund sponsor planning to seek 
exemptive relief from the Commission to form and operate a leveraged/
inverse ETF would also no longer incur the cost associated with 
applying for an exemptive order.\553\ To the extent that the amendments 
result in new leveraged/inverse ETFs coming to market, the industry-
wide assets under management of leveraged/inverse ETFs could increase 
and investors that would be eligible under the proposed sales practices 
rules to invest in leveraged/inverse ETFs could benefit from an 
increase in investment choices.\554\
---------------------------------------------------------------------------

    \553\ In the ETFs Adopting Release, we estimated that the direct 
cost of a typical fund's application for ETF relief (associated 
with, for example, legal fees) is approximately $100,000. As 
exemptive applications for leveraged/inverse ETFs are significantly 
more complex than those of the average fund, we estimate that the 
direct costs of an application for leveraged/inverse ETF relief 
would amount to approximately $250,000. See ETFs Adopting Release, 
supra note 76, at nn.537-539 and accompanying text.
    \554\ The increase in assets under management among leveraged/
inverse ETFs could be attenuated, to the extent that proposed rule 
15l-2's and 211(h)-1's due diligence requirements would lead to a 
reduction in the number of investors that invest in these funds. See 
infra section III.C.5.
---------------------------------------------------------------------------

    Because our proposed amendments to rule 6c-11 would permit 
leveraged/inverse ETFs to rely on that rule, we also are proposing to 
rescind the exemptive orders the Commission has previously granted to 
leveraged/inverse ETFs. As a result, existing and future leveraged/
inverse ETFs would operate under a consistent regulatory framework. We 
believe that the costs to leveraged/inverse ETFs associated with 
rescinding their existing exemptive relief would be minimal, as we 
anticipate that all existing leveraged/inverse ETFs would be able to 
continue operating with only minor adjustments, other than being 
required to comply with the requirements in rule 6c-11 for additional 
website disclosures and basket asset policies and procedures.\555\
---------------------------------------------------------------------------

    \555\ In this section as well as in section III.D below, we have 
accounted for the costs and benefits to leveraged/inverse ETFs as a 
result of the removal of the current exclusion of these funds from 
rule 6c-11. We believe that the additional considerations the 
Commission analyzed in the ETFs Adopting Release for ETFs other than 
leveraged/inverse ETFs that were included in the scope of rule 6c-11 
at adoption would apply substantially similarly to leveraged/inverse 
ETFs. See ETFs Adopting Release, supra note 76.
---------------------------------------------------------------------------

    Additional economic considerations that the proposed treatment of 
leveraged/inverse ETFs presents with regards to efficiency and 
competition are discussed below in section III.D.
7. Unfunded Commitment Agreements
    The proposed rule would permit a fund to enter into unfunded 
commitment agreements if it reasonably believes, at the time it enters 
into such an agreement, that it will have sufficient cash and cash 
equivalents to meet its obligations with respect to all of its unfunded 
commitment agreements, in each case as they come due.\556\ While a fund 
should consider its unique facts and circumstances, the proposed rule 
would prescribe certain specific factors that a fund must take into 
account in having such a reasonable belief. We believe that the 
proposed requirements are consistent with current market practices, 
based on the staff's experience in reviewing and commenting on fund 
registration statements, which have disclosure regarding their unfunded 
commitments, as well as representations funds have made to the 
staff.\557\ As a result, we do not believe that the rule's treatment of 
unfunded commitment agreements represents a change from the baseline, 
although we acknowledge that there may be some variation in the 
specific factors that funds consider today, as well as the potential 
for some variation between those factors and those prescribed in the 
proposed rule. Because we believe that the proposed approach is 
consistent with general market practices and we do not have specific 
granular information to identify differences in funds' current 
practices relative to the proposed rule, we believe this proposed 
requirement would not lead to significant economic effects.
---------------------------------------------------------------------------

    \556\ See supra section II.J.
    \557\ See supra discussion in paragraph preceding note 419.
---------------------------------------------------------------------------

8. Recordkeeping
    Proposed rule 18f-4 includes certain recordkeeping 
requirements.\558\ Specifically, the proposed rule would

[[Page 4525]]

require a fund to maintain certain records documenting its derivatives 
risk management program's written policies and procedures, along with 
its stress test results, VaR backtesting results, internal reporting or 
escalation of material risks under the program, and reviews of the 
program.\559\ It would also require a fund to maintain records of any 
materials provided to the fund's board of directors in connection with 
approving the designation of the derivatives risk manager and any 
written reports relating to the derivatives risk management 
program.\560\ A fund that would be required to comply with the proposed 
VaR test would also have to maintain records documenting the 
determination of: Its portfolio's VaR; its designated reference index 
VaR, as applicable; its VaR ratio (the value of the VaR of the Fund's 
portfolio divided by the VaR of the designated reference index), as 
applicable; and any updates to any of its VaR calculation models and 
the basis for any material changes to its VaR models.\561\ A fund that 
would be a limited derivatives user under the proposed rule would have 
to maintain a written record of its policies and procedures that are 
reasonably designed to manage derivatives risks.\562\ Finally, a fund 
engaging in unfunded commitment agreements would be required to 
maintain records documenting the sufficiency of its funds to meet its 
obligations with respect to all unfunded commitment agreements.\563\
---------------------------------------------------------------------------

    \558\ See supra section II.K.
    \559\ See proposed rule 18f-4(c)(i)(A).
    \560\ See proposed rule 18f-4(c)(6)(i)(B).
    \561\ See proposed rule 18f-4(c)(6)(i)(C).
    \562\ See proposed rule 18f-4(c)(6)(i)(D).
    \563\ See proposed rule 18f-4(c)(6)(i)(E).
---------------------------------------------------------------------------

    We believe that these proposed requirements would increase the 
effectiveness of the Commission's oversight of the fund industry, which 
will, in turn, benefit investors. Further, the requirement to keep 
records documenting the derivatives risk management program, including 
records documenting periodic review of the program and reports provided 
to the board of directors relating to the program, would help our staff 
evaluate a fund's compliance with the proposed derivatives risk 
management program requirements. We anticipate that these recordkeeping 
requirements would generally not impose a large additional burden on 
funds, as most funds would likely choose to keep such records, even 
absent the proposed requirement to do so, in order to support their 
ongoing administration of the proposed derivatives risk management 
program and their compliance with the associated requirements.
    As discussed below in section IV.B.7, our estimated average one-
time and ongoing annual costs associated with the recordkeeping 
requirements take into account the fact that certain funds can rely on 
the proposed rule's limited derivatives user exception and may incur 
less extensive recordkeeping costs relative to those funds which may 
not rely on this exception. Of the estimated 5,091 funds that would be 
subject to the recordkeeping requirements, we estimate that 2,398 funds 
would be limited derivatives users. Assuming that both one-time and 
ongoing annual recordkeeping costs for limited derivatives users are 
90% of those for funds that would not qualify as limited derivatives 
users, we estimate that, on average, each fund that could not rely on 
the limited user exception would incur a one-time cost of $2,047 \564\ 
and an ongoing cost of $330 per year \565\ and each fund that could 
rely on the exception would incur, a one-time cost of $1,842 \566\ and 
an ongoing cost of $297 per year.\567\ We thus estimate that the total 
industry cost for this requirement in the first year would equal 
$11,529,656.\568\
---------------------------------------------------------------------------

    \564\ This estimate is based on the following derivations and 
calculations: 1.5 hours x $62 (general clerk)/((2,398/5,091) x 90% + 
((5,091-2,398)/5,091)) = $97.60; and 1.5 hours x $95 (senior 
computer operator)/((2,398/5,091) x 90% + ((5,091-2,398)/5,091)) = 
$149.54 for a total of $97.60 + $149.54 + ($1,800 for initial 
external cost burden) = $2,047.14, where (2,398/5,091) is the share 
of funds that are limited derivatives users and (5,091-2,398)/5,091) 
is the share of funds that are not limited derivatives users.
    \565\ This estimate is based on the following derivations and 
calculations: 2 hours x $62 (general clerk)/((2,398/5,091) x 90% + 
((5,091-2,398)/5,091)) = $130.13; and 2 hours x $95 (senior computer 
operator)/((2,398/5,091) x 90% + ((5,091-2,398)/5,091)) = $199.39 
for a total of $130.13 + $199.39 = $329.52, where (2,398/5,091) is 
the share of funds that are limited derivatives users and (5,091-
2,398)/5,091) is the share of funds that are not limited derivatives 
users.
    \566\ This estimate is based on the following calculations: 
$2,047.14 x 90% = $1,842.43.
    \567\ This estimate is based on the following calculations: 
$329.52 x 90% = $296.57.
    \568\ This estimate is based on the following calculations: 
(5,091-2,398 = 2,693 funds which cannot rely on the limited 
derivatives user exception) x ($2,047.14 + $329.52) = $6,400,347.32; 
and (2,398 funds which can rely on the limited derivatives user 
exception) x ($1,842.43 + $296.57) = $5,129,309.17 for a total of 
$11,529,656.48.
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9. Amendments to Fund Reporting Requirements
a. Form N-PORT and Form N-CEN
    We are proposing to amend Form N-PORT to include a new reporting 
item on funds' derivatives exposure, which would be publicly available 
for the third month of each fund's quarter.\569\ In addition, we are 
proposing amendments that would require funds that are subject to the 
proposed VaR-based limit on fund leverage risk to report certain 
information related to their VaR.\570\ We are also proposing to amend 
Form N-CEN to require a fund to identify (1) whether it is a limited 
derivatives user (either under the proposed exception for funds that 
limit their derivatives exposure to 10% of their net assets or under 
the exception for funds that limit their derivatives use to certain 
currency hedging); (2) whether it is a leveraged/inverse investment 
vehicle as defined in proposed sales practices rules; and (3) whether 
it has entered into reverse repurchase agreements or similar financing 
transactions, or unfunded commitment agreements.\571\ These additional 
reporting requirements would not apply to BDCs, which do not file 
reports on Form N-CEN or Form N-PORT.\572\
---------------------------------------------------------------------------

    \569\ See supra section II.H.1. While the information for the 
first two months of a fund's quarter would be non-public, the 
information for the third month of a fund's quarter would be 
publicly available. See supra note 359.
    \570\ Specifically, this information would include: (1) The 
fund's highest daily VaR during the reporting period and its 
corresponding date; and (2) the fund's median daily VaR for the 
reporting period. Funds subject to the relative VaR test during the 
reporting period also would have to report: (1) The name of the 
fund's designated reference index; (2) the index identifier; (3) the 
fund's highest daily VaR ratio during the reporting period and its 
corresponding date; and (4) the fund's median daily VaR ratio for 
the reporting period. Finally, all funds that are subject to the 
proposed limit on fund leverage risk also would have to report the 
number of exceptions that the fund identified as a result of the 
backtesting of its VaR calculation model. See id.
    \571\ We believe that many of these proposed new reporting items 
would be inapplicable to most BDCs. See supra section II.H.3.
    \572\ See supra section II.H.4.
---------------------------------------------------------------------------

    To the extent that measures of derivatives exposure, and the other 
information that we would require funds to report on Forms N-PORT and 
N-CEN, are not currently available, the proposed requirements that 
funds make such information available periodically on these forms would 
improve the ability of the Commission to oversee reporting funds. It 
also would allow the Commission and its staff to oversee and monitor 
reporting funds' compliance with the proposed rule and help identify 
trends in reporting funds' use of derivatives, portfolio VaRs, and 
their choice of designated reference indexes. The expanded reporting 
also would increase the ability of the Commission staff to identify 
trends in investment strategies and fund products in reporting funds as 
well as industry outliers.\573\
---------------------------------------------------------------------------

    \573\ The structuring of the information in Form N-PORT would 
improve the ability of Commission staff to compile and aggregate 
information across all reporting funds, and to analyze individual 
funds or a group of funds, and would increase the overall efficiency 
of staff in analyzing the information.

---------------------------------------------------------------------------

[[Page 4526]]

    Investors, third-party information providers, and other potential 
users would also experience benefits from the proposed amendments to 
Forms N-PORT and N-CEN. Investors and other potential users would have 
disclosure of additional information that is not currently available in 
any filings. We believe that the structured data format of this 
information in Forms N-PORT and N-CEN would allow investors and other 
potential users to more efficiently analyze portfolio investment 
information. The additional information, as well as the structure of 
that information, would increase the transparency of a fund's 
investment strategies and allow more efficient assessment of reporting 
funds' potential leverage-related risks.
    The amendments to Forms N-PORT and N-CEN would also benefit 
investors, to the extent that they use the information, to better 
differentiate funds that are not limited derivatives users or 
leveraged/inverse funds based on their derivatives usage. For example, 
investors would be able to more efficiently identify the extent to 
which such funds use derivatives as part of their investment 
strategies. Investors, and in particular individual investors, could 
also indirectly benefit from the additional information in amended 
Forms N-PORT and N-CEN to the extent that third-party information 
providers and other interested parties obtain, aggregate, provide, 
analyze and report on the information. Investors could also indirectly 
benefit from the additional information in amended Forms N-PORT and N-
CEN to the extent that other entities, including investment advisers 
and broker-dealers, utilize the information to help investors make more 
informed investment decisions related to funds that provide this 
information.
    As discussed below in section IV.F, our estimated average one-time 
and ongoing annual costs associated with the amendments to Forms N-PORT 
take into account the fact that certain funds that are not subject to 
the proposed VaR-based limit on fund leverage risk in proposed rule 
18f-4 would not have to report certain VaR-related information and may 
incur less extensive reporting costs relative to those funds subject to 
the limit, which are required to report such VaR-related disclosure 
information. Of the estimated 5,091 funds that would be subject to the 
exposure-related disclosure requirement, we estimate that 2,424 funds 
would also be subject to the VaR-related disclosure requirements. We 
estimate that, on average, each fund that is not subject to the VaR-
related disclosure requirement would incur a one-time cost of $6,982 
\574\ and an ongoing cost of $2,088 per year \575\ and each fund that 
is subject to the VaR-related disclosure requirement would incur a one-
time cost of $8,374 \576\ and an ongoing cost of $4,176 per year.\577\ 
We thus estimate that the total industry cost for this reporting 
requirement in the first year would equal $54,610,890.\578\
---------------------------------------------------------------------------

    \574\ This estimate is based on the following derivations and 
calculations: (2 hours x $365 (compliance attorney) + 2 hours x $331 
(senior programmer) + ($5,590 for initial external cost burden)) = 
$6,982 to comply with the new N-PORT requirements of derivatives 
exposure information in the first reporting quarter of the fiscal 
year.
    \575\ This estimate is based on the following derivations and 
calculations: (3 hours x $365 (compliance attorney) + 3 hours x $331 
(senior programmer)) = $2,088 per year to comply with the new N-PORT 
requirements of derivatives exposure information in the final three 
reporting quarters of the fiscal year.
    \576\ This estimate is based on the following derivations and 
calculations: (4 hours x $365 (compliance attorney) + 4 hours x $331 
(senior programmer) + ($5,590 for initial external cost burden)) = 
$8,374 to comply with the new N-PORT requirements of derivatives 
exposure and VaR-related information in the first reporting quarter 
of the fiscal year.
    \577\ This estimate is based on the following derivations and 
calculations: (6 hours x $365 (compliance attorney) + 6 hours x $331 
(senior programmer)) = $4,176 to comply with the new N-PORT 
requirements of derivatives exposure and VaR-related information in 
the final three reporting quarters of the fiscal year.
    \578\ This estimate is based on the following calculations: 
(5,091-2,424 = 2,667 funds which are not subject to the VaR-related 
disclosure agreements) x ($6,982 + $2,088) = $24,189,690; and (2,424 
funds which are subject to the VaR-related disclosure agreements) x 
($8,374 + $4,176) = $30,421,200 for a total of ($24,189,690 + 
$30,421,200) = $54,610,890.
---------------------------------------------------------------------------

    As discussed below in section IV.H, we estimate that the average 
ongoing annual cost for a registered fund to prepare amendments to Form 
N-CEN is $6.96 per year.\579\ We thus estimate that the total industry 
cost for all registered funds associated with this reporting 
requirement in the first year is $86,130.\580\
---------------------------------------------------------------------------

    \579\ This estimate is based on the following derivations and 
calculations: 0.01 hour x $365 (compliance attorney) + 0.01 hour x 
$331 (senior programmer) = $3.65 + $3.31 = $6.96 per year.
    \580\ This estimate is based on the following derivations and 
calculations: (12,375 registered funds required to prepare a report 
on Form N-CEN as amended) x $6.96 = $86,130.
---------------------------------------------------------------------------

b. Amendments to Current Reporting Requirements
    We are also proposing current reporting requirements for funds that 
are relying on proposed rule 18f-4 and subject to the proposed VaR-
based limit on fund leverage risk. Specifically, a fund that is out of 
compliance with the VaR test for more than three business days would be 
required to file a non-public report on Form N-RN providing certain 
information regarding its VaR test breaches and a fund will also be 
required to file a report when it is back in compliance with its 
applicable VaR test.\581\
---------------------------------------------------------------------------

    \581\ See supra section II.H.2.
---------------------------------------------------------------------------

    We anticipate that the enhanced current reporting requirements 
could produce significant benefits. For example, when a fund is out of 
compliance with the proposed VaR-based limit on fund leverage risk, 
this may indicate that a fund is experiencing heightened risks as a 
result of a fund's use of derivatives transactions. Such breaches also 
could indicate market events that are drivers of potential derivatives 
risks across the fund industry and therefore complement other sources 
of information related to such market events for the Commission. As a 
result, we believe that the proposed current reporting requirement 
would increase the effectiveness of the Commission's oversight of the 
fund industry by providing the Commission and staff with current 
information regarding potential increased risks and stress events, 
which in turn would benefit investors.
    As discussed below in section IV.G, our estimated average cost 
burdens associated with the amendments to Form N-RN are based on the 
assumption that, of the estimated 2,424 funds that would be required to 
comply with either of the VaR tests, the Commission would receive 
approximately 30 filings per year in response to each of the new VaR-
related items proposed to be included in Form N-RN, as amended. We 
estimate such funds would incur an average cost of $3.49 per year on a 
per-fund basis \582\ to prepare amended Form N-RN. Thus, the estimated 
total industry cost for this reporting requirement in the first year 
for funds required to comply with either of the VaR tests is 
$8,460.\583\
---------------------------------------------------------------------------

    \582\ This estimate is based on the following derivations and 
calculations: 0.005 hour x $365 (compliance attorney) + 0.005 hour x 
$331 (senior programmer) = $1.83 + $1.66 = $3.49 per year on a per-
fund basis.
    \583\ This estimate is based on the following derivations and 
calculations: (30 filings per year fractionalized across the 2,424 
funds per year required to comply with either of the VaR tests) x 
$3.49 = $8,460.
---------------------------------------------------------------------------

    We do not believe there would be any potential indirect costs 
associated with filing Form N-RN, such as spillover effects or the 
potential for investor flight due to a VaR test breach (to the extent 
that investors would leave a fund if they believed a fund's VaR test 
breaches

[[Page 4527]]

indicate that a fund has a risk profile that is inconsistent with their 
investment goals and risk tolerance), because Form N-RN filings would 
not be publicly disclosed. Because the Form N-RN filing requirements 
would be triggered by events that are part of a fund's proposed 
requirement to determine compliance with the applicable VaR test at 
least daily, any monitoring costs associated with Form N-RN are 
included in our estimates of the compliance costs for rule 18f-4 above.
10. Money Market Funds
    Money market funds are excluded from the scope of proposed rule 
18f-4. As we are proposing to rescind Release 10666, however, money 
market funds would not be able to enter into transactions covered by 
proposed rule 18f-4, including derivatives transactions and reverse 
repurchase agreements. As discussed above in section II.A.1, we believe 
that money market funds currently do not typically engage in 
derivatives transactions or the other transactions permitted by rule 
18f-4.\584\ However, to the extent that there are money market funds 
that do engage in such transactions to increase the efficiency of their 
portfolio management, these funds would bear the costs associated with 
losing any such efficiencies.
---------------------------------------------------------------------------

    \584\ Money market funds file monthly reports on Form N-MFP and 
disclose schedules of portfolio securities held on the form. For 
each security held, Form N-MFP requires money market funds to 
disclose the investment category most closely identifying the 
instrument held from a list of investment categories. See Item C.6 
of Form N-MFP. However, the form does not contemplate nor include 
data element categories for transactions covered by proposed rule 
18f-4, including derivatives transactions and reverse repurchase 
agreements. We therefore do not estimate the extent to which money 
market funds currently rely on these transactions.
---------------------------------------------------------------------------

    However, we believe any costs to money market funds that may 
currently enter into transactions covered by proposed rule 18f-4 would 
likely be small. Specifically, as discussed above in section II.A.1, we 
believe that these transactions would generally be inconsistent with a 
money market fund maintaining a stable share price or limiting 
principal volatility, and especially if used to leverage the fund's 
portfolio. Therefore, we do not believe that any fund that may 
currently engage in these transactions would use them as an integral 
part of its investment strategy.

D. Effects on Efficiency, Competition, and Capital Formation

    This section evaluates the impact of the proposed rules and 
amendments on efficiency, competition, and capital formation. However, 
we are unable to quantify the effects on efficiency, competition, and 
capital formation because we lack the information necessary to provide 
a reasonable estimate. For example, we are unable to predict how the 
proposed rules, amendments, and form amendments would change investors' 
propensity to invest in funds and ultimately affect capital formation. 
Therefore, much of the discussion below is qualitative in nature, 
although where possible we attempt to describe the direction of the 
economic effects.
1. Efficiency
    Proposed rule 18f-4 in conjunction with the proposed rescission of 
Release 10666 may make derivatives use more efficient for certain 
funds, particularly for those funds that would qualify as limited 
derivatives users. Specifically, funds' current asset segregation 
practices may provide a disincentive to use derivatives for which 
notional amount segregation is the practice, even if such derivatives 
would otherwise provide a lower-cost method of achieving desired 
exposures than purchasing the underlying reference asset directly. For 
example, a fund seeking to sell credit default swaps to take a position 
in an issuer's credit risk may currently choose not to do so because of 
the large notional amounts that the fund would segregate for that 
specific derivatives position. The proposed rule therefore could 
increase efficiency by mitigating current incentives for funds to avoid 
use of certain derivatives (even if foregoing the use of those 
derivatives would entail cost and operational efficiencies).
    In addition, the proposed rules and amendments may change the 
degree to which some funds choose to use derivatives generally or the 
degree to which funds use certain derivatives over others.\585\ Changes 
in the degree to which certain derivatives are used by funds could 
affect the liquidity and price efficiency of these derivatives. 
Although unaddressed in the academic literature, we expect an increase 
in the use of derivatives to correspond to an increase in derivatives 
market liquidity as more derivatives contracts may be easily bought or 
sold in markets in a given period, as well as an increase in price 
efficiency since information regarding underlying securities (and other 
factors that affect derivatives prices) may be better reflected in the 
prices of derivative contracts.
---------------------------------------------------------------------------

    \585\ Specifically, (1) as discussed in the previous paragraph, 
funds may transact in more notional-value based derivatives as a 
result of removing the incentive distortion of notional- vs. market-
value asset segregation under funds' current asset segregation 
practices; (2) new potential funds may reduce their use of 
derivatives transactions to satisfy the proposed VaR-based limit on 
fund leverage risk (see supra section III.C.2); (3) existing funds 
may change their use of derivatives transactions to respond to risks 
identified after adopting and implementing their risk management 
programs (see supra section III.C.1); and (4) both existing and new 
potential funds may increase their use of derivatives transactions 
as a result of the exemptive rule's bright-line limits on leverage 
risk (see supra section III.C.2). Overall, the effect of the 
proposed rules and amendments on funds use of derivatives 
transactions is ambiguous and depends on the type of derivatives 
transaction.
---------------------------------------------------------------------------

    Changes in the degree to which certain derivatives are used could 
also affect the pricing efficiency and liquidity of securities 
underlying these derivatives and those of related securities. For 
example, one paper provides evidence that the introduction of credit 
default swap contracts decreases the liquidity and price efficiency of 
the equity security of the issuer referenced in the swap.\586\ 
Conversely, the paper also observes that the introduction of exchange-
traded stock option contracts improves the liquidity and price 
efficiency of the underlying stocks.
---------------------------------------------------------------------------

    \586\ This paper analyzed NYSE-listed firms and observed that, 
all else equal, equity markets become less liquid and equity prices 
become less efficient when single-name credit default swap contracts 
are introduced, while the opposite results hold when equity options 
are listed on exchanges. Ekkehart Boehmer, Sudheer Chava, & Heather 
E. Tookes, Related Securities and Equity Market Quality: The Case of 
CDS, 50 Journal of Financial and Quantitative Analysis 509 (2015), 
available at https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/related-securities-and-equity-market-quality-the-case-of-cds/08DE66A250F9950FA486AE818D5E0341. The latter result, that traded 
equity options are associated with more liquid and efficient equity 
prices, is consistent with several other academic papers. See, e.g., 
Charles Cao, Zhiwu Chen, & John M. Griffin, Informational Content of 
Option Volume Prior to Takeovers, 78 Journal of Business 1073 
(2005), as well as Jun Pan & Allen M. Poteshman, The Information in 
Option Volume for Future Stock Prices, 19 Review of Financial 
Studies 871 (2006). The effects described in the literature are 
based on studies of the introduction of derivative securities and 
may therefore apply differently to changes in the trading volume of 
derivatives securities that may occur as a result of the proposed 
rule.
---------------------------------------------------------------------------

    The proposed VaR-based limit on fund leverage risk would also 
establish a bright-line limit on the amount of leverage that a fund can 
take on using derivatives.\587\ To the extent that funds are more 
comfortable with managing their derivatives exposures to a clear 
outside limit, the proposed rule could improve the efficiency of fund's 
portfolio risk management practices.
---------------------------------------------------------------------------

    \587\ See supra section III.C.2.
---------------------------------------------------------------------------

    In addition, the recordkeeping elements of proposed rule 18f-4 
would facilitate more efficient evaluation of

[[Page 4528]]

compliance with the rule while also providing the Commission with 
information that may be useful in assessing market risks associated 
with derivative products. Moreover, the proposed amendments to fund's 
current reporting requirements could facilitate the Commission's 
oversight of funds subject to proposed rule 18f-4 with fewer resources, 
thus making its supervision more efficient.\588\
---------------------------------------------------------------------------

    \588\ See supra section III.C.8.
---------------------------------------------------------------------------

    The amendments to Forms N-PORT and N-CEN would allow investors, to 
the extent that they use the information, to better differentiate funds 
that are not limited derivatives users or leveraged/inverse funds based 
on their derivatives usage.\589\ As a result, investors would be able 
to more efficiently identify the extent to which such funds use 
derivatives as part of their investment strategies, allowing them to 
make better-informed investment decisions.
---------------------------------------------------------------------------

    \589\ See supra section III.C.9.a.
---------------------------------------------------------------------------

    The proposed sales practices rules could also reduce investments in 
leveraged/inverse investment vehicles, to the extent that some retail 
investors would not be approved by their broker-dealer or investment 
adviser to transact in leveraged/inverse investment vehicles or to the 
extent that some retail investors would be deterred by the time costs 
and delay introduced by the account-opening procedures.\590\ The 
proposed amendments to rule 6c-11, however, would likely outweigh these 
effects in the case of leveraged/inverse ETFs and lead to an overall 
increase in the number and assets under management for these types of 
funds.
---------------------------------------------------------------------------

    \590\ See supra section III.B.5.
---------------------------------------------------------------------------

    To the extent that the proposed rules would lead to a reduction in 
investment in leveraged/inverse commodity- or currency-based trusts or 
funds, the liquidity of these products may decline as a result. 
Conversely, to the extent that the proposed rules would lead to an 
overall increase in investments in leveraged/inverse ETFs, the 
liquidity of these funds may increase as a result. The likely increase 
in the number, and assets under management, of leveraged/inverse ETFs 
as a result of the proposed amendments to rule 6c-11 may affect the 
quality of the markets for underlying securities and derivatives. 
Specifically, the academic literature to date provides some evidence, 
albeit inconclusive, that leveraged/inverse ETFs' rebalancing activity 
may have an impact on the price and volatility of the constituent 
assets that make up the ETFs. For example, one paper empirically tests 
whether the rebalancing activity of leveraged/inverse ETFs impacts the 
price and price volatility of underlying stocks.\591\ The authors find 
a positive association, suggesting that rebalancing demand may affect 
the price and price volatility of component stocks, and may reduce the 
degree to which prices reflect fundamental value of the component 
stocks. As leveraged/inverse ETFs commonly use derivatives to rebalance 
their portfolios, similar effects could also extend to underlying 
derivatives, although we are not aware of any academic literature that 
has examined the effects of leveraged/inverse ETFs' rebalancing 
activity on derivatives markets. Conversely, another paper argues that 
the existing literature that studies the effect of leveraged/inverse 
ETFs' rebalancing activity on the constituent asset prices does not 
control for the effect of the creation and redemption transactions 
(i.e., fund flows) by authorized participants.\592\ The paper presents 
evidence that positively leveraged/inverse ETFs tend to have capital 
flows in the opposite direction of the underlying index, and inverse 
leveraged/inverse ETFs tend to have capital flows in the same direction 
as the underlying index, suggesting that investor behavior may 
attenuate the effect of leveraged/inverse ETFs' rebalancing activity on 
the prices of underlying securities and derivatives.\593\
---------------------------------------------------------------------------

    \591\ See Qing Bai, Shaun A. Bond & Brian Hatch, The Impact of 
Leveraged and Inverse ETFs on Underlying Real Estate Returns, 43 
Real Estate Economics 37 (2015).
    \592\ See Ivan T. Ivanov & Stephen Lenkey, Are Concerns About 
Leveraged ETFs Overblown?, FEDS Working Paper No. 2014-106 (2014).
    \593\ The literature we are aware of focuses on leveraged/
inverse ETFs and does not study similar effects of leveraged/inverse 
mutual funds, although both types of funds generally engage in 
similar rebalancing activity. To the extent that similar effects may 
be attributable to leveraged/inverse mutual funds and that any 
increase in leveraged/inverse ETF assets would be (at least 
partially) offset by a decrease in leveraged/inverse mutual fund 
assets, this may ameliorate the overall effect on the price and 
volatility of constituent assets.
---------------------------------------------------------------------------

2. Competition
    Certain aspects of the proposed rules and amendments may have an 
impact on competition. Certain of these potential competitive effects 
result from the proposed rule imposing differential costs on different 
funds. Specifically, (1) large fund complexes may find it less costly 
to comply per fund with the new requirements of proposed rule 18f-4; 
\594\ (2) funds that would qualify as limited derivatives users would 
generally incur lower compliance costs associated with the rule than 
funds that would not qualify for this exception; \595\ (3) funds that 
would comply with the relative VaR test would generally incur higher 
compliance costs than those that would comply with the absolute VaR 
test; (4) BDCs are not subject to the additional reporting requirements 
on Forms N-CEN or N-PORT and would therefore not incur the increased 
compliance costs that would be imposed on filers of these forms; and 
(5) leveraged/inverse funds are not subject to several of the 
additional reporting requirements on Forms N-CEN or N-PORT and would 
therefore incur a reduced additional burden compared to other funds 
that are not limited users of derivatives.\596\ To the extent that 
investors believe that the funds that would incur lower compliance 
burdens and the funds that would incur a higher compliance burden under 
the rule are substitutes, the rule would result in a competitive 
advantage for funds with the lower compliance burden to the extent that 
a lower burden makes such funds materially less costly to operate.
---------------------------------------------------------------------------

    \594\ See supra section III.C.2.
    \595\ See supra section III.C.3.
    \596\ See supra section III.C.2.
---------------------------------------------------------------------------

    To the extent that the proposed sales practices rules' due 
diligence and account approval requirements limit certain customers or 
clients from buying or selling shares of certain leveraged/inverse 
investment vehicles, such investors may instead opt to invest in 
another product with a similar risk profile that is not subject to 
those requirements.\597\ Thus, the proposed sales practices rules may 
generate substitution spillover effects that increase competition 
between leveraged/inverse investment vehicles within the scope of the 
rule and other products outside the scope of the rule that provide 
similar exposures.
---------------------------------------------------------------------------

    \597\ Some investors that are not approved to buy or sell 
leveraged/inverse investment vehicles may opt to move their capital 
into exchange-traded notes or other products with a similar risk 
profile. Conversely, some investors may transact in leveraged/
inverse investment vehicles without involving a broker-dealer or 
investment adviser that would be subject to the proposed sales 
practices rules, although this is uncommon. See supra note 321.
---------------------------------------------------------------------------

    Similarly, broker-dealers and investment advisers with a larger 
fraction of retail customers or clients that can no longer transact in 
leveraged/inverse investment vehicles as a result of the proposed sales 
practices rules' due diligence and account approval requirements may 
experience larger declines in their customer or client base.\598\ As a 
result, broker-dealers and investment advisers that would see a larger 
reduction in customers or clients may be at a competitive disadvantage

[[Page 4529]]

compared to broker-dealers and investment advisers that would see only 
a smaller reduction in customers or clients or no reduction at all.
---------------------------------------------------------------------------

    \598\ Any such reduction in a broker-dealer's or investment 
adviser's customer base may be offset to the extent that clients 
transact in other products with the same broker dealer or investment 
adviser instead. See supra section III.C.5.
---------------------------------------------------------------------------

    The Commission has not provided exemptive relief to new prospective 
sponsors of leveraged/inverse ETFs since 2009.\599\ The proposed 
amendments to rule 6c-11 would allow other leveraged/inverse ETFs to 
enter the leveraged/inverse ETF market, likely leading to more 
competition among leveraged/inverse ETFs and between leveraged/inverse 
ETFs and other products that investors may perceive as substitutes, 
such as leveraged/inverse mutual funds. This increase in competition 
could be significant, as the leveraged/inverse ETF market is very 
concentrated; currently, only two fund sponsors operate leveraged/
inverse ETFs.\600\ In addition, fees for leveraged/inverse ETFs and 
substitute products, such as leveraged/inverse mutual funds, could fall 
as a result of any such increase in competition.
---------------------------------------------------------------------------

    \599\ See supra text following note 473.
    \600\ The increase in competition among leveraged/inverse ETFs 
could be attenuated, to the extent that proposed rule 15l-2's and 
211(h)-1's due diligence requirements would limit the number of 
investors that invest in these funds. See supra section III.C.5.
---------------------------------------------------------------------------

3. Capital Formation
    Certain aspects of the proposed rules and amendments may have an 
impact on capital formation. Certain of these effects may arise from a 
change in investors' propensity to invest in funds. On the one hand, 
investors may be more inclined to invest in funds as a result of 
increased investor protection arising from any decrease in leverage-
related risks. On the other hand, some investors may reduce their 
investments in certain funds that may increase their use of derivatives 
in light of the bright-line VaR-based limit on fund leverage risk.\601\ 
Additionally, some investors may re-evaluate their desire to invest in 
funds generally as a result of the increased disclosure requirements, 
with some investors deciding to invest more and other investors 
deciding to invest less. While we are unable to determine whether the 
proposed rules and amendments would lead to an overall increase or 
decrease in fund assets, to the extent the overall fund assets change, 
this may have an effect on capital formation.
---------------------------------------------------------------------------

    \601\ See supra section III.C.2.
---------------------------------------------------------------------------

    The proposed rule may also decrease the use of reverse repurchase 
agreements, similar financing transactions, or borrowings by some 
funds, or reduce some funds' ability to invest the borrowings obtained 
through reverse repurchase agreements.\602\ To the extent that this 
restricts a fund's ability to obtain financing to invest in debt or 
equity securities, capital formation may be reduced.
---------------------------------------------------------------------------

    \602\ See supra section III.C.4.
---------------------------------------------------------------------------

    In addition, the proposed sales practices rules may reduce capital 
formation in asset markets directly connected with covered leveraged/
inverse investment vehicles. By restricting the accounts of customers 
or clients seeking to buy or sell shares of a leveraged/inverse 
investment vehicle, the proposed rules may produce net capital outflows 
from retail investors. However, the size of this effect would depend on 
the number of retail investors that would no longer be approved to buy 
or sell shares of leveraged/inverse investment vehicles and any other 
investments these retail investors would make in lieu of investing in 
leveraged/inverse investment vehicles.

E. Reasonable Alternatives

1. Alternative Implementations of the VaR Tests
a. Different Confidence Level or Time Horizon
    Proposed rule 18f-4 would require that a fund's VaR model use a 99% 
confidence level and a time horizon of 20 trading days.\603\ We could 
alternatively require a different confidence level and/or a different 
time horizon for the VaR test.
---------------------------------------------------------------------------

    \603\ See supra section II.D.4.
---------------------------------------------------------------------------

    As discussed above in section II.D.4, market participants 
calculating VaR most commonly use 95% or 99% confidence levels and 
often use time horizons of 10 or 20 days. The proposed VaR parameters 
therefore represent a confidence level and time horizon at the high end 
of what is commonly used. Compared to requiring a lower confidence 
level and a shorter time horizon, the proposed parameters result in a 
VaR test that is designed to measure, and therefore limit the severity 
of, less frequent but larger losses. The cost of calculating VaR does 
not vary based on how the model is parametrized, meaning the proposed 
confidence level and time horizon would not lead to larger compliance 
costs for funds compared to the alternatives we considered. A lower 
confidence level or shorter time horizon may be less effective at 
placing a VaR-based outer limit on fund leverage risk associated with 
larger losses and would not result in cost savings for funds.
b. Absolute VaR Test Only
    To establish an outer limit for a fund's leverage risk, the 
proposed rule would generally require a fund engaging in derivatives 
transactions to comply with a relative VaR test; the fund could instead 
comply with an absolute VaR test only if the derivatives risk manager 
is unable to identify an appropriate designated reference index for the 
fund. As an alternative, we could require all funds that would be 
subject to the proposed VaR-based limit on fund leverage risk to comply 
with an absolute VaR test.
    Use of an absolute VaR test would be less costly for some funds 
that would be required to comply with the relative VaR test under the 
proposed rule, including because the relative VaR test may require some 
funds to pay licensing costs associated with the use of the reference 
index.\604\ In addition, use of an absolute VaR test would reduce the 
compliance challenge for fund risk managers who have difficulty 
identifying a designated reference index; however, this benefit would 
be limited for funds that have an existing or easy-to-identify 
benchmark.
---------------------------------------------------------------------------

    \604\ See supra section III.C.2.
---------------------------------------------------------------------------

    On the other hand, the absolute VaR test is a static measure of 
fund risk in the sense that the implied limit on a fund's VaR will not 
change with the VaR of its designated reference index. The absolute VaR 
test is therefore less suited for measuring leverage risk and limiting 
the degree to which a fund can use derivatives to leverage its 
portfolio, as measuring leverage inherently requires comparing a fund's 
risk exposure to that of an unleveraged point of reference.\605\ An 
additional implication of this aspect of an absolute VaR test is that a 
fund may fall out of compliance with an absolute VaR test just because 
the market it invest in becomes more volatile even though the degree of 
leverage in the fund's portfolio may not have changed. Overall, we 
believe that permitting funds to rely on an absolute VaR test only in 
those instances when a designated reference index is unavailable is 
justified.
---------------------------------------------------------------------------

    \605\ Id.
---------------------------------------------------------------------------

c. Choice of Absolute or Relative VaR Tests
    As another alternative, we could allow derivatives risk managers to 
choose between an absolute and a relative VaR limit, depending on their 
preferences and without regard to whether a designated reference index 
is available. Such an alternative would offer derivatives risk managers 
more flexibility than the proposed rule and

[[Page 4530]]

could reduce compliance costs for funds, to the extent that derivatives 
risk managers would choose the VaR test that is cheaper to implement 
for their particular fund. However, this alternative may result in less 
uniformity in the outer limit on funds' leverage risk across the 
industry, as individual derivatives risk managers would have the 
ability to choose between VaR-based tests that could provide for 
different limits on fund leverage risk. Funds that invest in assets 
with a low VaR, for example, could obtain significantly more leverage 
under an absolute VaR test because the VaR of the fund's designated 
reference index would be low; as a result, investors in these funds 
would be less protected from leverage-related risks compared to the 
proposed rule.
d. Optional Relative VaR Test Using a Fund's ``Securities VaR''
    As another alternative, we could allow funds relying on the 
relative VaR test to compare the fund's VaR to its ``securities VaR'' 
(i.e., the VaR of the fund's portfolio of securities and other 
investments, but excluding any derivatives transactions), rather than 
the VaR of the fund's designated reference index, depending on the 
derivatives risk manager's preferences and without regard to whether a 
designated reference index is available.\606\
---------------------------------------------------------------------------

    \606\ The 2015 Proposing Release also included a risk-based 
portfolio limit based on VaR, which provided that a fund would 
satisfy its risk-based portfolio limit condition if a fund's full 
portfolio VaR was less than the fund's ``securities VaR.'' See 2015 
Proposing Release, supra note 2, at section III.B.2.
---------------------------------------------------------------------------

    While such an alternative would offer derivatives risk managers 
more flexibility than the proposed rule, we believe that it would not 
be easier to implement or lead to cost savings for a significant number 
of funds. Conversely, the alternative VaR test based on a fund's 
``securities VaR'' would provide an incentive for some funds to invest 
in volatile, riskier securities that would increase the fund's 
``securities VaR,'' thereby reducing the test's effectiveness at 
limiting fund leverage risk. As a result, investors in these funds 
would be less protected from leverage-related risks compared to the 
proposed rule.
e. Third-Party Validation of a Fund's VaR Model
    The proposed rule does not require third-party validation of a 
fund's chosen VaR model. As an alternative, we could require that a 
fund obtain third-party validation of its VaR model, either at 
inception or in connection with any material changes to the model, to 
independently confirm that the model is structurally sound and 
adequately captures all material risks.\607\ While such a requirement 
could help ensure funds' compliance with the proposed VaR-based limit 
on fund leverage risk, this incremental benefit may not justify the 
potentially significant additional costs to funds associated with 
third-party validation of the fund's VaR model.\608\
---------------------------------------------------------------------------

    \607\ See also supra note 243.
    \608\ We note that the UCITS regime requires third-party 
validation of funds' VaR models; as a result, these additional costs 
could be mitigated for fund that are part of a complex that also 
includes UCITS funds. See supra note 243.
---------------------------------------------------------------------------

2. Alternatives to the VaR Tests
a. Stress Testing
    As an alternative to the proposed VaR-based limit on fund leverage 
risk, we could require a stress testing approach. As discussed above in 
section II.D.6.a, we understand that many funds that use derivatives 
transactions already conduct stress testing for purposes of risk 
management. However, we do not believe that a stress testing approach 
would impose significantly lower costs on funds compared to a VaR-based 
approach, with the exception of those funds that already conduct stress 
testing but not VaR testing.\609\
---------------------------------------------------------------------------

    \609\ See also ICI Comment Letter III (stating that, ``depending 
on the type of fund managed and whether the fund currently employs 
the test for risk management purposes, some respondents viewed a 
stress loss test as being more burdensome to implement, while others 
viewed a VaR test as being more burdensome to implement.'').
---------------------------------------------------------------------------

    In addition, as also discussed in section II.D.6.a above, it would 
be challenging for the Commission to specify a set of asset class 
shocks, their corresponding shock levels, and, in the case of multi-
factor stress testing, assumptions about the correlations of the 
shocks, in a manner that applies to all funds and does not become stale 
over time. While we could also prescribe a principles-based stress 
testing requirement, we believe that the flexibility such an approach 
would give to individual funds over how to implement the test would 
render it less effective than the proposed VaR test at establishing an 
outer limit on fund leverage risk.
    Finally, stress testing generally focuses on a narrower and more 
remote range of extreme loss events compared to VaR analysis. As a 
result, a limit on fund leverage risk based on stress testing would 
likely be less effective at limiting fund leverage risk during more 
normal conditions and protecting investors from unexpected losses 
resulting from less extreme scenarios.
b. Asset Segregation
    As another alternative, we could require an asset segregation 
approach in lieu of the proposed VaR-based limit on fund leverage risk. 
For example, we could consider an approach similar to the Commission's 
position in Release 10666, under which a fund engaging in derivatives 
transactions would segregate cash and cash equivalents equal in value 
to the full amount of the conditional and unconditional obligations 
incurred by the fund (also referred to as ``notional amount 
segregation''). Such an approach could also permit a fund to segregate 
a broader range of assets, subject to haircuts.\610\ Alternatively, we 
could require funds to segregate liquid assets in an amount equal to 
the fund's daily mark-to-market liability plus a ``cushion amount'' 
designed to address potential future losses.
---------------------------------------------------------------------------

    \610\ The 2016 DERA Memo, for example, analyzed different risk-
based ``haircuts'' that could apply to a broader range of assets. 
See, e.g., 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------

    As discussed above in section II.D.6.b, we believe that asset 
segregation approaches have several drawbacks as a means for limiting 
fund leverage risk, compared to the proposed VaR tests. For example, 
notional amount segregation is not risk-sensitive and could restrict 
derivatives transactions that would reduce portfolio risk. Similarly, 
segregation of liquid assets in an amount equal to the fund's daily 
mark-to-market liability plus a ``cushion amount'' would be difficult 
to implement in a manner that is applied uniformly across all funds and 
types of derivatives. In addition, asset segregation approaches raise 
certain compliance complexities that may not make them significantly 
less costly to implement for funds than the proposed VaR tests.\611\
---------------------------------------------------------------------------

    \611\ See supra section II.D.6.b.
---------------------------------------------------------------------------

    In conjunction with the proposed VaR-based limit, we could also 
require a fund relying on the proposed rule to maintain an amount of 
``qualifying coverage assets'' designed to enable a fund to meet its 
derivatives-related obligations. As discussed above, we believe that 
the proposed rule's requirements, including the requirements that funds 
establish risk management programs and comply with the proposed VaR-
based limit on fund leverage risk, would address the risk that a fund 
may be required to realize trading losses by selling its investments to 
generate cash to pay derivatives counterparties.

[[Page 4531]]

c. Exposure-Based Test
    We alternatively considered proposing an exposure-based approach 
for limiting fund leverage risk in lieu of the proposed VaR test. An 
exposure-based test could limit a fund's derivatives exposure, as 
defined in the proposed rule, to a specified percentage of the fund's 
net assets. For example, we considered proposing that a fund limit its 
derivatives exposure to 50% of net assets. This would allow a fund to 
add to its portfolio an amount of derivatives exposure equal to the 
amount that an open-end fund could borrow from a bank. A similar 
approach would be to provide that the sum of a fund's derivatives 
exposure and the value of its other investments cannot exceed 150% of 
its net asset value. This latter approach, and particularly if cash and 
cash equivalents were not included in the calculation, would allow a 
fund to achieve the level of market exposure permitted for an open-end 
fund under section 18 using any combination of derivatives and other 
investments.
    While an exposure-based test may be simpler and therefore less 
costly to implement for the typical fund than the proposed VaR tests, 
an exposure-based test has certain limitations compared to VaR tests, 
as discussed in detail in section above. One limitation is that 
measuring derivatives exposure based on notional amounts would not 
reflect how derivatives are used in a portfolio, whether to hedge or 
gain leverage, nor would it differentiate derivatives with different 
risk profiles. Various adjustments to the notional amount are available 
that may better reflect the risk associated with the derivatives 
transactions, although even with these adjustments the measure would 
remain relatively blunt. For example, an exposure-based limit could 
significantly limit certain strategies that rely on derivatives more 
extensively but that do not seek to take on significant leverage risk.
    Some of the limitations of an exposure-based approach could be 
addressed, however, if rule 18f-4 were to provide an exposure-based 
test as an optional alternative to the proposed VaR tests, rather than 
as the sole means of limiting fund leverage risk. Under this second 
alternative, funds with less complex portfolios might choose to rely on 
an exposure-based test because it would be simpler and impose lower 
compliance costs than the proposed VaR tests. Furthermore, if we 
provided that the sum of a fund's derivatives exposure and the value of 
its other investments cannot exceed 150% of its net asset value, funds 
below this threshold would generally also pass the proposed relative 
VaR test.\612\ Conversely, funds with more complex portfolios that rely 
on derivatives more extensively but that do not seek to take on 
significant leverage risk might choose to rely on the proposed VaR 
test. As the proposed rule would already except limited derivatives 
users from the VaR-based limit on fund leverage risk, however, we do 
not believe that also giving funds the option of relying on an 
exposure-based limit on fund leverage risk would be necessary or that 
it would significantly reduce the compliance burden associated with the 
rule.
---------------------------------------------------------------------------

    \612\ A fund that limited the sum of its derivatives exposure 
and the value of its other investments to 150% of its net asset 
value would generally also pass the proposed relative VaR test, 
provided that derivatives notionals are either not adjusted or only 
adjusted for delta in the case of options.
---------------------------------------------------------------------------

3. Stress Testing Frequency
    Proposed rule 18f-4 would require funds that enter into derivatives 
transactions and are not limited derivatives users to adopt and 
implement a derivatives risk management program that includes stress 
testing, among other elements. The proposed rule would permit a fund to 
determine the frequency of stress tests, provided that the fund must 
conduct stress testing at least weekly.
    As an alternative to the weekly requirement, we considered both 
shorter and longer minimum stress testing frequencies. On the one hand, 
more frequent stress testing would reflect changes in risk for fund 
strategies that involve frequent and significant portfolio turnover. In 
addition, more frequent stress testing may reflect increases in market 
stress in a timelier manner. On the other hand, given the forward-
looking nature of stress testing, we expect that most funds would take 
foreseeable changes in market conditions and portfolio composition into 
account when conducting stress testing. In addition, more frequent 
stress testing may impose an increased cost burden on funds, although 
we would expect any additional cost burden to be small, to the extent 
that funds perform stress testing in an automated manner. Overall, we 
preliminarily believe that the proposed minimum weekly stress testing 
appropriately balances the anticipated benefits of relatively frequent 
stress testing against the burdens of administering stress testing.
    Another alternative would be to permit a fund to determine its own 
stress testing frequency without the proposed rule prescribing a 
minimum stress testing frequency. This approach would provide maximum 
flexibility to funds regarding the frequency of their stress tests, and 
would reduce compliance costs for funds that determine that stress 
testing less frequently than weekly is warranted in light of their own 
particular facts and circumstances. However, allowing funds to 
individually determine the frequency with which stress tests are 
conducted could result in some funds stress testing their portfolios 
too infrequently to provide timely information to the fund's 
derivatives risk manager and board. Taking these considerations into 
account, we are proposing to require weekly stress tests, rather than 
less frequent testing, to provide for consistent and reasonably 
frequent stress testing by all funds that would be required to 
establish a derivatives risk management program.
4. Alternative Exposure Limits for Leveraged/Inverse Funds
    A fund that meets the definition of a ``leveraged/inverse 
investment vehicle'' in the proposed sales practices rules would not 
have to comply with the VaR-based leverage risk limit under proposed 
rule 18f-4, provided the fund limits the investment results it seeks to 
300% of the return (or inverse of the return) of the underlying index 
and discloses in its prospectus that it is not subject to the proposed 
limit on fund leverage risk.\613\ Alternatively, we could condition the 
exemption on compliance with a higher or lower exposure limit.
---------------------------------------------------------------------------

    \613\ See supra section II.G.3.
---------------------------------------------------------------------------

    Over longer holding periods, the realized leverage multiple of the 
returns of an investment in a leveraged/inverse fund relative to the 
returns of its underlying index can vary substantially from the fund's 
daily leverage multiple.\614\ All else equal, this effect becomes 
stronger as the fund's leverage multiple increases. The extent of a 
leveraged/inverse fund's rebalancing activity likewise increases as the 
fund's leverage multiple increases.\615\ Therefore, the effects of 
leveraged/inverse funds' rebalancing activity on the constituent asset 
prices may be heightened if a significant number of leveraged/inverse 
funds were to increase their leverage beyond the levels currently 
observed in markets and,

[[Page 4532]]

conversely, could be diminished if a significant number of leveraged/
inverse funds were to reduce their leverage below current levels.
---------------------------------------------------------------------------

    \614\ See supra section III.B.5.
    \615\ The rebalancing demand of a leveraged/inverse fund is a 
function of the fund's assets, the realized return of its reference 
index, and is proportional to the term , where denotes the fund's 
leverage multiple. (See, e.g., Minder Cheng & Ananth Madhavan, The 
dynamics of leveraged/inverse and inverse exchange-traded funds, 7 
Journal of Investment Management 4 (2009).) As a result, increasing 
a fund's leverage multiple increases its rebalancing demand more 
than linearly.
---------------------------------------------------------------------------

    While permitting a higher exposure limit may benefit fund sponsors 
to the extent that some sponsors would bring funds with higher leverage 
multiples to market, we are concerned that a higher exposure limit 
would heighten the investor protection concerns these funds present. 
Conversely, limiting leveraged/inverse funds' exposure could reduce the 
concerns these funds present, but could reduce investor choice relative 
to the baseline given that leveraged/inverse funds today operate with 
levels of leverage up to the exposure limit we propose. Allowing funds 
to continue to obtain this level of leverage, subject to the additional 
requirements in proposed rule 18f-4 and in light of the proposed sales 
practices rules, is designed to address the investor protection 
concerns that underlie section 18, while preserving choice for retail 
investors who are capable of evaluating their characteristics and 
unique risks. For these reasons, and because the Commission does not 
have experience with leveraged/inverse funds that seek returns above 
300% of the return (or inverse of the return) of the underlying index, 
we are not proposing to permit higher levels of leveraged/inverse 
market exposure for leveraged/inverse funds in this rule. We also are 
not proposing a lower exposure limit for these funds in light of the 
investor protections that we believe proposed rule 18f-4 and the sales 
practices rules would provide.\616\
---------------------------------------------------------------------------

    \616\ See supra section II.G.3.
---------------------------------------------------------------------------

5. No Sales Practices Rules and No Separate Exposure Limit for 
Leveraged/Inverse Funds
    The proposed rules would require a leveraged/inverse fund that 
meets the definition of a ``leveraged/inverse investment vehicle'' to 
limit its investment results to 300% of the return (or inverse of the 
return) of the underlying index and would require a broker-dealer or 
investment adviser to exercise due diligence in approving a retail 
investor's account to buy or sell shares of leveraged/inverse 
investment vehicles, as well as implement policies and procedures 
reasonably designed to achieve compliance with the proposed rules.\617\ 
In lieu of the proposed sales practices rules and associated exception 
from the VaR-based limit on fund leverage risk, we could alternatively 
require leveraged/inverse funds to comply with the proposed relative 
VaR test.
---------------------------------------------------------------------------

    \617\ See supra sections II.G.3 and II.G.2.
---------------------------------------------------------------------------

    Existing leveraged/inverse ETFs and mutual funds generally could 
comply with the proposed relative VaR test only if they restricted the 
investment results they seek to 150% of the return (or inverse of the 
return) of the underlying index. Therefore, under this alternative, 
leveraged/inverse funds that seek investment results in excess of this 
limit would either have to significantly change their investment 
strategy or liquidate. Given that existing fund sponsors frequently 
offer leveraged/inverse funds with various target multiples referencing 
the same index, we would expect that this alternative would reduce the 
number of leveraged/inverse funds.
    Compared to the proposal, this alternative would also restrict 
choice for investors that prefer to invest in leveraged/inverse funds 
that pursue investment results in excess of 150% of the return (or 
inverse of the return) of the underlying index and who would satisfy 
the due diligence and approval requirements adopted by their broker-
dealer or investment adviser in connection with the proposed rule.
    At the same time, the alternative could result in increased 
investor protection for investors in these funds compared to the 
proposal. While investors' access to leveraged/inverse funds would not 
be subject to the proposed sales practice rules under this alternative 
(and investment advisers and broker-dealers would not incur the 
associated compliance costs), these funds would be required to limit 
their exposure to 150% of the return (or inverse of the return) of the 
underlying index, thereby reducing the potential consequences for 
leveraged/inverse fund investors who are not capable of evaluating 
their return characteristics and ameliorating the associated investor 
protection concerns. Conversely, the alternative would reduce 
protection for investors in leveraged/inverse commodity- and currency-
based trusts or funds, as those funds would be subject to neither the 
150% exposure limit nor the proposed sales practices rules.
    Finally, because leveraged/inverse funds would no longer be able to 
offer exposures above 150% of the return (or inverse of the return) of 
the underlying index, the alternative may ameliorate the concerns 
associated with the rebalancing activity of leveraged/inverse ETFs, 
which decreases with the targeted leverage multiple of these 
funds.\618\ As discussed above in section D.1, however, while the 
literature observes that leveraged/inverse ETFs' rebalancing activity 
may have an adverse impact on the prices and volatility of the 
constituent assets that make up leveraged/inverse ETFs, the literature, 
overall, is not definitive.
---------------------------------------------------------------------------

    \618\ See supra sections III.D.1 and III.E.4. While the 
literature focuses on leveraged/inverse ETFs, the results may apply 
similarly to leveraged/inverse mutual funds.
---------------------------------------------------------------------------

    Overall, we believe that preserving investor choice justifies 
providing leveraged/inverse funds an exemption from the proposed VaR-
based limit on fund leverage risk, particularly in light of the 
proposed sales practices rules, which we believe would help to ensure 
that investors in these funds are limited to those who are capable of 
evaluating the characteristics and risks of these products.\619\
---------------------------------------------------------------------------

    \619\ See also supra note 535.
---------------------------------------------------------------------------

6. Enhanced Disclosure
    As an alternative to the requirements in rule 18f-4, such as the 
proposed derivatives risk management program and the VaR-based limit on 
fund leverage risk, we could consider addressing the risks associated 
with funds' use of derivatives through enhanced disclosures to 
investors with respect to a fund's use of derivatives and the resulting 
derivatives-related risks.\620\ While an approach focused on enhanced 
disclosures could result in greater fund investment flexibility, such 
an approach may be less effective than the proposed rule in addressing 
the purposes and concerns underlying section 18 of the Investment 
Company Act. Section 18 itself imposes a specific limit on the amount 
of senior securities that a fund may issue, regardless of the level of 
risk introduced or the disclosure that a fund provides regarding those 
risks. Absent additional requirements to limit leverage or potential 
leverage, requiring enhancement to derivatives disclosure alone would 
not appear to provide any limit on the amount of leverage a fund may 
obtain. Indeed, the degree to which funds use derivatives varies widely 
between funds. As a result, an approach focused solely on enhanced 
disclosure requirements may not provide a sufficient basis for an 
exemption from the requirements of section 18 of the Investment Company 
Act.
---------------------------------------------------------------------------

    \620\ See, e.g., Comment Letter of the Fixed Income Market 
Structure Advisory Committee on proposed rule 6c-11 under the 
Investment Company Act (Oct. 29, 2018) (recommending that the 
Commission consider future rulemaking regarding ``leveraged ETP'' 
investor disclosure requirements).

---------------------------------------------------------------------------

[[Page 4533]]

F. Request for Comments

    The Commission requests comment on all aspects of this initial 
economic analysis, including whether the analysis has: (1) Identified 
all benefits and costs, including all effects on efficiency, 
competition, and capital formation; (2) given due consideration to each 
benefit and cost, including each effect on efficiency, competition, and 
capital formation; and (3) identified and considered reasonable 
alternatives to the proposed new rules and rule amendments. We request 
and encourage any interested person to submit comments regarding the 
proposed rules, our analysis of the potential effects of the proposed 
rules and proposed amendments, and other matters that may have an 
effect on the proposed rules. We request that commenters identify 
sources of data and information as well as provide data and information 
to assist us in analyzing the economic consequences of the proposed 
rules and proposed amendments. We also are interested in comments on 
the qualitative benefits and costs we have identified and any benefits 
and costs we may have overlooked. In addition to our general request 
for comments on the economic analysis associated with the proposed 
rules and proposed amendments, we request specific comment on certain 
aspects of the proposal:
    254. Are we correct that many funds already have a derivatives risk 
management program in place that could be readily adapted to meet the 
proposed rule's requirements without significant additional cost? If 
so, for how many funds would this be true?
    255. The proposed rule does not include any requirement for third-
party validation of a fund's chosen VaR model, either at inception or 
upon material changes, to confirm that the model is structurally sound 
and adequately captures all material risks.\621\ How costly would such 
a requirement be to funds? What would the benefits of such a 
requirement be?
---------------------------------------------------------------------------

    \621\ See also supra note 243.
---------------------------------------------------------------------------

    256. Are we correct that many funds that use derivatives in a 
limited manner already have in place policies and procedures that are 
reasonably designed to address their derivatives that could be readily 
adapted to meet the proposed rule's requirements without significant 
additional cost? If so, for how many funds would this be true?
    257. How many broker-dealers provide customers the ability to buy 
or sell interests in leveraged/inverse investment vehicles? How many 
investment advisers place orders to buy or sell leveraged/inverse 
investment vehicles for their advisory clients? How many retail 
investor accounts with broker-dealers and investment advisers trade 
leveraged/inverse investment vehicles?
    258. How many current investors in leveraged/inverse investment 
vehicles would likely not be approved to buy or sell these products 
under the proposed sales practices rules' due diligence and account 
approval requirements?
    259. If we provided that the sum of a fund's derivatives exposure 
and the value of its other investments cannot exceed 150% of its net 
asset value, funds below this threshold would generally also pass the 
proposed relative VaR test. How many funds would be likely to rely on 
such an exposure-based test if exempted funds that satisfied this limit 
from the proposed VaR tests?

IV. Paperwork Reduction Act Analysis

A. Introduction

    Proposed rule 18f-4, proposed rule 15l-2, and proposed rule 211(h)-
1 would result in new ``collection of information'' requirements within 
the meaning of the Paperwork Reduction Act of 1995 (``PRA'').\622\ In 
addition, the proposed amendments to rule 6c-11 under the Investment 
Company Act, as well as to Forms N-PORT, Form N-LIQUID (which would be 
renamed Form N-RN), and N-CEN would affect the collection of 
information burden under those rules and forms.\623\
---------------------------------------------------------------------------

    \622\ 44 U.S.C. 3501-3520.
    \623\ We do not believe that the proposed conforming amendment 
to Form N-2, to reflect a clarification that funds do not have to 
disclose in their senior securities table the derivatives 
transactions and unfunded commitment agreements entered into in 
reliance on proposed rule 18f-4, makes any new substantive 
recordkeeping or information collection within the meaning of the 
PRA. Accordingly, we do not revise any burden and cost estimates in 
connection with this proposed amendment.
---------------------------------------------------------------------------

    The titles for the existing collections of information are: ``Form 
N-PORT'' (OMB Control No. 3235-0731); ``Form N-LIQUID'' (OMB Control 
No. 3235-0754); ``Form N-CEN'' (OMB Control No. 3235-0730); and ``Rule 
6c-11 under the Investment Company Act of 1940, Exchange-traded funds'' 
(OMB Control No. xxxx-xxxx). The titles for the new collections of 
information would be: ``Rule 18f-4 under the Investment Company Act of 
1940, Use of Derivatives by Registered Investment Companies and 
Business Development Companies,'' ``Rule 15l-2 under the Securities 
Exchange Act of 1934, Broker and Dealer Sales Practices for Leveraged/
Inverse Investment Vehicles,'' and ``Rule 211(h)-1 under the Investment 
Advisers Act of 1940, Investment Adviser Sales Practices for Leveraged/
Inverse Investment Vehicles.'' The Commission is submitting these 
collections of information to the Office of Management and Budget 
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a currently-valid control number.
    The Commission published notice soliciting comments on the 
collection of information requirements in the 2015 Proposing Release 
and submitted the proposed collections of information to OMB for review 
and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11.\624\ The Commission received comments on the 2015 proposal's 
collection of information burden regarding the 2015 proposal's trade-
by-trade determination of compliance with portfolio limits.\625\ These 
comments were considered but did not form the basis of our burden 
estimates because we do not propose a trade-by-trade determination of 
compliance with the proposed VaR-based tests.
---------------------------------------------------------------------------

    \624\ See 2015 Proposing Release, supra note 2.
    \625\ See, e.g., Vanguard Comment Letter; Invesco Comment 
Letter; see also supra note 245 and accompanying text.
---------------------------------------------------------------------------

    We discuss below the collection of information burdens associated 
with proposed rule 18f-4, proposed rule 15l-2, proposed rule 211(h)-1, 
as well as proposed amendments to rule 6c-11 and Forms N-PORT, N-
LIQUID, and N-CEN.

B. Proposed Rule 18f-4

    Proposed rule 18f-4 would permit a fund to enter into derivatives 
transactions, notwithstanding the prohibitions and restrictions on the 
issuance of senior securities under section 18 of the Investment 
Company Act.
    Proposed rule 18f-4 would generally require a fund that relies on 
the rule to enter into derivatives transactions to: Adopt a derivatives 
risk management program; have its board of directors approve the fund's 
designation of a derivatives risk manager and receive direct reports 
from the derivatives risk manager about the derivatives risk management 
program; and require a fund to comply with a VaR-based test designed to 
limit a fund's leverage risk consistent with the investor protection 
purposes underlying section 18.

[[Page 4534]]

Proposed rule 18f-4 includes an exception from the risk management 
program requirement and limit on fund leverage risk if a fund is a 
``limited derivatives user'' that either limits its derivatives 
exposure to 10% of its net assets or it uses derivatives transactions 
solely to hedge certain currency risks. A fund relying on the proposed 
exception would be required to adopt policies and procedures that are 
reasonably designed to manage its derivatives risks. Proposed rule 18f-
4 also includes alternative requirements for a leveraged/inverse fund 
not subject to the proposed VaR-based leverage risk limit, if such a 
fund: (1) Meets the definition of a ``leveraged/inverse investment 
vehicle'' in the proposed sales practices rules; (2) limits the 
investment results it seeks to 300% of the return (or inverse of the 
return) of the underlying index; and (3) discloses in its prospectus 
that it is not subject to proposed rule 18f-4's limit on fund leverage 
risk.\626\ Proposed rule 18f-4 also would require a fund to adhere to 
certain recordkeeping requirements that are designed to provide the 
Commission's staff, and the fund's board of directors and compliance 
personnel, the ability to evaluate the fund's compliance with the 
proposed rule's requirements.
---------------------------------------------------------------------------

    \626\ See proposed rule 18f-4(c)(4); supra section II.G.3.
---------------------------------------------------------------------------

    The respondents to proposed rule 18f-4 would be registered open- 
and closed-end management investment companies and BDCs.\627\ We 
estimate that 5,091 funds would likely rely on rule 18f-4.\628\ 
Compliance with proposed rule 18f-4 would be mandatory for all funds 
that seek to engage in derivatives transactions in reliance on the 
rule, which would otherwise be subject to the restrictions of section 
18. To the extent that records required to be created and maintained by 
funds under the rule are provided to the Commission in connection with 
examinations or investigations, such information would be kept 
confidential subject to the provisions of applicable law.
---------------------------------------------------------------------------

    \627\ See proposed rule 18f-4(a) (defining ``fund'').
    \628\ See supra notes 467, 498 and accompanying text, and 
paragraph following note 525 (2,693 funds that would be subject to 
the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited 
derivatives user exception and complying with the related limited 
derivatives user requirements).
    The Commission's estimates of the relevant wage rates in the 
tables below are based on salary information for the securities 
industry compiled by the Securities Industry and Financial Markets 
Association's Office Salaries in the Securities Industry 2013. The 
estimated wage figures are modified by Commission staff to account 
for an 1,800-hour work-year and multiplied by 2.93 to account for 
bonuses, firm size, employee benefits, overhead, and adjusted to 
account for the effects of inflation. See Securities Industry and 
Financial Markets Association, Report on Management & Professional 
Earnings in the Securities Industry 2013 (``SIFMA Report'').
---------------------------------------------------------------------------

1. Derivatives Risk Management Program
    Proposed rule 18f-4 would require certain funds relying on the rule 
to adopt and implement a written derivatives risk management program, 
which would include policies and procedures reasonably designed to 
manage the fund's derivatives risks. The proposal would require a 
fund's program to include the following elements: (1) Risk 
identification and assessment; (2) risk guidelines; (3) stress testing; 
(4) backtesting; (5) internal reporting and escalation; and (6) 
periodic review of the program.\629\ Under the proposed rule, the 
derivatives risk manager is responsible for administering the 
derivatives risk management program and its policies and procedures. 
Certain funds relying on the proposed rule would not be subject to the 
program requirement.\630\ We estimate that 2,693 funds would likely be 
subject to the program requirement.\631\ Below we estimate the initial 
and annual ongoing burdens associated with initial documentation of the 
program, and any revision (and related documentation) of the 
derivatives risk management program arising from the periodic review of 
the program. In addition to the initial burden to document the program, 
including policies and procedures reasonably designed to manage the 
fund's derivatives risks, we estimate that a fund relying on the 
proposed rule would have an ongoing burden associated with the proposed 
periodic review requirements to evaluate the program's effectiveness 
and to reflect changes in the fund's derivatives risks over time. Below 
we estimate the initial and annual ongoing burdens associated with 
documentation and any review and revision of funds' programs including 
their policies and procedures.
---------------------------------------------------------------------------

    \629\ See proposed rule 18f-4(c)(1)(i)-(vi); supra section 
II.A.2 (discussing the proposed derivatives risk management program 
requirement).
    \630\ A fund that is a limited derivatives user would not be 
required to comply with the proposed program requirement. Funds that 
are limited derivatives users would be required to adopt policies 
and procedures that are reasonably designed to manage its 
derivatives risks. See proposed rule 18f-4(c)(3); infra section 
IV.B.6 (discussing limited derivatives users).
    \631\ See supra notes 498, 627 and accompanying text.
---------------------------------------------------------------------------

    Table 2 below summarizes the proposed PRA initial and ongoing 
annual burden estimates associated with the derivatives risk management 
program requirement under proposed rule 18f-4. We do not estimate that 
there will be any initial or ongoing external costs associated with the 
derivatives risk management program requirement.

                           Table 2--Derivatives Risk Management Program PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \2\       Internal time
                                          hours         hours \1\                                      costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Written derivatives risk management              12               4   x   $357 (derivatives risk          $1,428
 program development.                                                      manager).
                                                 12               4   x   $466 (assistant                  1,864
                                                                           general counsel).
                                                 12               4   x   $365 (compliance                 1,460
                                                                           attorney).
Periodic review and revisions of                  0               2   x   $357 (derivatives risk             714
 the program.                                                              manager).
                                                  0               2   x   $466 (assistant                    932
                                                                           general counsel).
                                                  0               2   x   $365 (compliance                   730
                                                                           attorney).
                                    ----------------------------------------------------------------------------
    Total annual burden per fund...  ..............              18       ......................           7,128
        Number of funds............  ..............         x 2,693       ......................         x 2,693
                                    ----------------------------------------------------------------------------

[[Page 4535]]

 
    Total annual burden............  ..............          48,474       ......................      19,195,704
----------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Written Derivatives Risk Management Program Development,'' these estimates include initial burden
  estimates annualized over a three-year period.
2. See supra note 627.

2. Board Oversight and Reporting

    The proposed rule would require: (1) A fund's board of directors to 
approve the designation of the fund's derivatives risk manager,\632\ 
(2) the derivatives risk manager to provide written reports to the 
board regarding the program's implementation and effectiveness,\633\ 
and (3) the derivatives risk manager to provide written reports 
describing any exceedances of the fund's guidelines and the results of 
the fund's stress testing and backtesting.\634\ We estimate that 2,693 
funds would be subject to these requirements.\635\
---------------------------------------------------------------------------

    \632\ See proposed rule 18f-4(c)(5)(i); supra section II.C 
(discussing the proposed board oversight and reporting 
requirements).
    \633\ See proposed rule 18f-4(c)(5)(ii); supra section II.C.
    \634\ See proposed rule 18f-4(c)(5)(iii); supra section II.C. 
Burdens associated with reports to the fund's board of directors of 
material risks arising from the fund's derivatives transactions, as 
described in proposed rule 18f-4(c)(1)(v), are discussed above in 
supra section IV.B.1.
    \635\ See supra notes 498, 627 and accompanying text.
---------------------------------------------------------------------------

    Table 3 below summarizes the proposed PRA initial and ongoing 
annual burden estimates associated with the board oversight and 
reporting requirements under proposed rule 18f-4. We do not estimate 
that there will be any initial or ongoing external costs associated 
with the board oversight and reporting requirements.

                              Table 3--Board Oversight and Reporting PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \2\       Internal time
                                          hours         hours \1\                                      costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Approving the designation of the                  3               1   x   $17,860 (combined rate         $17,860
 derivatives risk manager.                                                 for 4 directors) \2\.
Derivatives risk manager written     ..............               8   x   $357 (derivatives risk           2,856
 reports \3\.                                                              manager).
                                     ..............               1   x   $17,860 (combined rate          17,860
                                                                           for 4 directors).
                                    ----------------------------------------------------------------------------
    Total annual burden per fund...  ..............              10       ......................          11,786
        Number of funds............  ..............         x 2,693       ......................         x 2,693
                                    ----------------------------------------------------------------------------
    Total annual burden............  ..............          26,930       ......................      31,739,698
----------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Approving the Designation of the Derivatives Risk Manager,'' this estimate includes initial burden
  estimates annualized over a three-year period.
2. See supra notes 627.
3. See supra notes 631-632 and accompanying text.

3. Disclosure Requirement Associated With Limit on Fund Leverage Risk
    The proposed rule would also generally require funds relying on the 
rule to comply with an outer limit on fund leverage risk based on VaR. 
This outer limit would be based on a relative VaR test that compares 
the fund's VaR to the VaR of a ``designated reference index.'' If the 
fund's derivatives risk manager is unable to identify an appropriate 
designated reference index, the fund would be required to comply with 
an absolute VaR test.\636\ Under the proposed rule, a fund must 
disclose its designated reference index in its annual report.\637\ We 
estimate that 2,424 funds would be subject to this disclosure 
requirement.\638\
---------------------------------------------------------------------------

    \636\ The collections of information burdens for disclosure 
requirements associated with the proposed limit on fund leverage 
risk are reflected in the PRA for proposed rule 18f-4 and not in the 
funds' applicable disclosure forms because the burden arises from 
the proposed rule. The Paperwork Reduction Act analysis for the 
funds' applicable disclosure forms will not reflect the collections 
of information burdens for disclosure requirements associated with 
the proposed limit on fund leverage risk.
    A fund that is a leveraged/inverse investment vehicle, as 
defined in the proposed sales practices rules, would not be required 
to comply with the proposed VaR-based limit on fund leverage risk. 
Broker-dealers and investment advisers would be required to approve 
retail investors' accounts to purchase or sell shares in these 
funds. See infra sections IV.C and IV.D (discussing leveraged/
inverse investment vehicles and leveraged/inverse funds covered by 
the sales practices rules). The proposed rule also would provide an 
exception from the proposed VaR tests for funds that use derivatives 
to a limited extent or only to hedge currency risks. See infra 
sections IV.B.5 (discussing the proposed rule's provisions regarding 
limited derivatives users).
    VaR test burdens related to recordkeeping and reporting are 
reflected in the recordkeeping section below, and also in the Forms 
N-PORT, N-CURRENT, and N-CEN burdens discussed below. See infra 
sections IV.F, IV.G, and IV.H.
    \637\ See proposed rule 18f-4(c)(2)(iv).
    \638\ See supra notes 519-520 and accompanying text.
---------------------------------------------------------------------------

    Table 4 below summarizes the proposed PRA initial and ongoing 
annual burden estimates associated with the disclosure requirement 
associated with the proposed limit on fund leverage risk. We do not 
estimate that there will be any paperwork-related initial or ongoing 
external costs associated with this proposed disclosure requirement.

[[Page 4536]]



            Table 4--Disclosure Requirement Associated With Limit on Fund Leverage Risk PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \1\       Internal time
                                          hours           hours                                        costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Disclosure of designated reference                0              .5   x   $309 (compliance               $154.50
 index.                                                                    manager).
                                                  0              .5   x   365 (compliance                 182.50
                                                                           attorney).
                                    ----------------------------------------------------------------------------
    Total annual burden per fund...  ..............          1 hour       ......................             337
        Number of funds............  ..............         x 2,424       ......................         x 2,424
                                    ----------------------------------------------------------------------------
    Total annual burden............  ..............           2,424       ......................         816,888
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.

4. Disclosure Requirement for Leveraged/Inverse Funds
    Under the proposed rule, a fund would not have to comply with the 
proposed VaR-based leverage risk limit if it: (1) Meets the definition 
of a ``leveraged/inverse investment vehicle'' in the proposed sales 
practices rules; (2) limits the investment results it seeks to 300% of 
the return (or inverse of the return) of the underlying index; and (3) 
discloses in its prospectus that it is not subject to proposed rule 
18f-4's limit on fund leverage risk.\639\ We estimate that 269 funds 
would be subject to the proposed prospectus disclosure requirement for 
leveraged/inverse funds.\640\
---------------------------------------------------------------------------

    \639\ See proposed rule 18f-4(c)(4); supra section II.G 
(discussing the alternative requirements for leveraged/inverse 
funds).
    \640\ See supra note 467 and accompanying text (164 leveraged/
inverse ETFs + 105 leveraged mutual funds).
---------------------------------------------------------------------------

    Table 5 below summarizes the proposed PRA initial and ongoing 
annual burden estimates associated with the disclosure requirement in 
the proposed rule's alternative provision for leveraged/inverse funds. 
We do not estimate that there will be any initial or ongoing external 
costs associated with this proposed disclosure requirement.

              Table 5--Disclosure Requirement Associated With Leveraged/Inverse Funds PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \1\       Internal time
                                          hours           hours                                        costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Leveraged/inverse fund prospectus                 0             .25   x   $309 (compliance                   $77
 disclosure.                                                               manager).
                                                  0             .25   x   365 (compliance                     91
                                                                           attorney).
                                    ----------------------------------------------------------------------------
    Total annual burden per fund...  ..............               1       ......................             168
        Number of funds............  ..............           x 269       ......................           x 269
                                    ----------------------------------------------------------------------------
    Total annual burden............  ..............             269       ......................          45,192
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.

5. Disclosure Changes for Money Market Funds
    Money market funds are excluded from the scope of the rule and 
could not rely on proposed rule 18f-4 to enter into derivatives 
transactions or other transactions addressed in the proposed rule.\641\ 
To the extent a money market fund currently discloses in its prospectus 
that it may use any of these transactions--even if it is not currently 
entering into these transactions--money market funds would be subject 
to the burdens associated with making disclosure changes to their 
prospectuses. We estimate that 413 funds could be subject to such 
disclosure changes on account of money market funds' exclusion from the 
proposed rule.\642\
---------------------------------------------------------------------------

    \641\ See proposed rule 18f-4(a) (defining the term ``Fund'' to 
``. . . not include a registered open-end company that is regulated 
as a money market fund''); supra section II.A.1 (discussing the 
exclusion of money market funds from the scope of the proposed 
rule).
    \642\ See supra note 454 and accompanying text. This likely 
overestimates the total number of funds subject to these disclosure 
changes, because we believe that money market funds currently do not 
typically engage in derivatives transactions or the other 
transactions addressed by proposed rule 18f-4. See supra section 
II.A.1.
---------------------------------------------------------------------------

    Table 6 below summarizes the proposed PRA initial and ongoing 
annual burden estimates associated with disclosure changes that money 
market funds could make because of their exclusion from proposed rule 
18f-4.\643\ We do not estimate that there will be any initial or 
ongoing external costs associated with this disclosure change 
requirement.
---------------------------------------------------------------------------

    \643\ These per-fund burden estimates likely overestimate the 
total burden associated with these disclosure changes. See supra 
note 641.

[[Page 4537]]



                        Table 6--Disclosure Changes for Money Market Funds PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \1\       Internal time
                                          hours           hours                                        costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Money market prospectus disclosure              .75             .25   x   $309 (compliance                   $77
 changes.                                                                  manager).
                                                .75             .25   x   $365 (compliance                    91
                                                                           attorney).
                                    ----------------------------------------------------------------------------
    Total annual burden per fund...  ..............              .5       ......................             168
        Number of funds............  ..............           x 413       ......................           x 413
                                    ----------------------------------------------------------------------------
    Total annual burden............  ..............             207       ......................          69,384
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.

6. Policies and Procedures for Limited Derivatives Users
    Proposed rule 18f-4 would require funds relying on the limited 
derivatives user provisions to adopt and implement written policies and 
procedures reasonably designed to manage the fund's derivatives 
risks.\644\ Only funds that limit their derivatives exposure to 10% of 
their net assets or that use derivatives transactions solely to hedge 
certain currency risks would be permitted to rely on these provisions. 
We estimate that 2,398 funds would be subject to the limited 
derivatives users requirements.\645\ In addition to the initial burden 
to document the policies and procedures, we estimate that limited 
derivatives users would have an ongoing burden associated with any 
review and revisions to its policies and procedures to ensure that they 
are ``reasonably designed'' to manage the fund's derivatives risks. 
Below we estimate the initial and annual ongoing burdens associated 
with documentation and any review and revision of the limited 
derivatives users' policies and procedures.
---------------------------------------------------------------------------

    \644\ See proposed rule 18f-4(c)(3); supra section II.E 
(discussing the proposed policies and procedures requirement for 
limited derivatives users).
    \645\ See supra paragraph following note 525.
---------------------------------------------------------------------------

    Table 7 below summarizes the proposed PRA initial and ongoing 
annual burden estimates associated with the policies and procedures 
requirement for limited derivatives users under proposed rule 18f-4. We 
do not estimate that there will be any initial or ongoing external 
costs associated with the policies and procedures requirement for 
limited derivatives users.

                  Table 7--Policies and Procedures for Limited Derivatives Users PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \2\       Internal time
                                          hours         hours \1\                                      costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Written policies and procedures....               3               1   x   $329 (senior manager)             $329
                                                                           \ 4\.
                                                  3               1   x   $365 (compliance                   365
                                                                           attorney) \ 4\.
Review of policies and procedures..               0             .25       $329 (senior manager)            82.25
                                                                           \4\.
                                                  0             .25       $365 (compliance                 91.25
                                                                           attorney) \4\.
                                    ----------------------------------------------------------------------------
    Total annual burden per fund...  ..............             2.5       ......................          867.50
        Number of funds............  ..............         x 2,398       ......................         x 2,398
                                    ----------------------------------------------------------------------------
    Total annual burden............  ..............           5,995       ......................       2,080,265
----------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Written Policies and Procedures,'' these estimates include initial burden estimates annualized over a
  three-year period.
2. See supra note 627.

7. Recordkeeping Requirements
    Proposed rule 18f-4 would require a fund to maintain certain 
records documenting its derivatives risk management program's written 
policies and procedures, along with its stress test results, VaR 
backtesting results, internal reporting or escalation of material risks 
under the program, and reviews of the program.\646\ The proposed rule 
would also require a fund to maintain records of any materials provided 
to the fund's board of directors in connection with approving the 
designation of the derivatives risk manager and any written reports 
relating to the derivatives risk management program.\647\ A fund that 
is required to comply with the proposed VaR test would also have to 
maintain records documenting the determination of: Its portfolio VaR; 
the VaR of its designated

[[Page 4538]]

reference indexes, as applicable; its VaR ratio (the value of the VaR 
of the Fund's portfolio divided by the VaR of the designated reference 
index), as applicable; and any updates to any of its VaR calculation 
model and the basis for any material changes to its VaR model.\648\ A 
fund that is a limited derivatives users under the proposed rule would 
have to maintain a written record of its policies and procedures that 
are reasonably designed to manage derivatives risks.\649\ A fund 
engaging in unfunded commitment agreements would be required to 
maintain records documenting the sufficiency of its funds to meet its 
obligations with respect to all unfunded commitment agreements.\650\
---------------------------------------------------------------------------

    \646\ See proposed rule 18f-4(c)(6)(i)(A); supra section II.K 
(discussing the proposed recordkeeping requirements).
    \647\ See proposed rule 18f-4(c)(6)(i)(B).
    \648\ See proposed rule 18f-4(c)(6)(i)(C).
    \649\ See proposed rule 18f-4(c)(6)(i)(D).
    \650\ See proposed rule 18f-4(e)(2).
---------------------------------------------------------------------------

    We estimate that 5,091 funds would be subject to the recordkeeping 
requirements.\651\ Below we estimate the average initial and ongoing 
annual burdens associated with the recordkeeping requirements. This 
average takes into account that some funds such as limited derivatives 
users may have less extensive recordkeeping burdens than other funds 
that use derivatives more substantially.
---------------------------------------------------------------------------

    \651\ See supra notes 467, 498 and accompanying text, and 
paragraph following note 525 (2,693 funds that would be subject to 
the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited 
derivatives user exception and complying with the related limited 
derivatives user requirements).
---------------------------------------------------------------------------

    Table 8 below summarizes the proposed PRA estimates associated with 
the recordkeeping requirements in rule 18f-4.

                                                          Table 8--Recordkeeping PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                            Internal        Internal                                                          Initial         Annual
                                         initial burden   annual burden              Wage rate \2\         Internal time   external cost   external cost
                                              hours         hours \1\                                          costs          burden          burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Establishing recordkeeping policies and             1.5              .5       $62 (general clerk).......             $31          $1,800            $600
 procedures.
                                                    1.5              .5       $95 (senior computer                 47.50  ..............  ..............
                                                                               operator).
Recordkeeping..........................               0               2   x   62 (general clerk)........              31               0               0
                                                      0               2   x   $95 (senior computer                 47.50  ..............  ..............
                                                                               operator).
                                        ----------------------------------------------------------------------------------------------------------------
    Total annual burden per fund.......  ..............               5       ..........................             157  ..............             600
        Number of funds................  ..............         x 5,091       ..........................         x 5,091  ..............           5,091
                                        ----------------------------------------------------------------------------------------------------------------
    Total annual burden................  ..............          25,455       ..........................         799,287  ..............       3,054,600
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Establishing Recordkeeping Policies and Procedures,'' these estimates include initial burden estimates annualized over a three-year period.
2. See supra note 627.

8. Proposed Rule 18f-4 Total Estimated Burden
    As summarized in Table 9 below, we estimate that the total hour 
burdens and time costs associated with proposed rule 18f-4, including 
the burden associated with documenting the derivatives risk management 
program, board oversight and reporting, disclosure requirements 
associated with the proposed VaR tests, disclosure requirements 
associated with the alternative requirements for leveraged/inverse 
funds, policies and procedures development for limited derivatives 
users, and recordkeeping, amortized over three years, would result in 
an average aggregate annual burden of 109,754 hours and an average 
aggregate annual monetized time cost of $54,761,797. We also estimate 
that, amortized over three years, there would be external costs of 
$3,054,600 associated with this collection of information. Therefore, 
each fund that relies on the rule would incur an average annual burden 
of approximately 20.56 hours, at an average annual monetized time cost 
of approximately $10,757, and an external cost of $600 to comply with 
proposed rule 18f-4.\652\
---------------------------------------------------------------------------

    \652\ These per-fund burden estimates likely overestimate the 
total burden of proposed rule 18f-4 because not all funds (e.g., 
limited derivatives users) would incur the various burdens set forth 
in the table.

                                Table 9--Proposed Rule 18f-4 Total PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                                                                     Internal
                                                                   Internal hour    burden time   External  cost
                                                                      burden           cost           burden
----------------------------------------------------------------------------------------------------------------
Derivatives risk management program.............................          48,474     $19,195,704              $0
Board oversight and reporting...................................          26,930      31,739,698               0
Disclosure requirement associated with limit on fund leverage              2,424         816,888               0
 risk...........................................................
Disclosure requirement associated with alternative requirements              269          45,192               0
 for leveraged/inverse funds....................................
Disclosure changes for money market funds.......................             207          69,384               0
Policies and procedures for limited derivatives users...........           5,995       2,080,265               0
Recordkeeping requirements......................................          25,455         799,287       3,054,600
                                                                 -----------------------------------------------
    Total annual burden.........................................         109,754      54,746,418       3,054,600
        Number of funds.........................................         / 5,091         / 5,091         / 5,091
                                                                 -----------------------------------------------
    Average annual burden per fund..............................           20.56          10,754             600
----------------------------------------------------------------------------------------------------------------


[[Page 4539]]

C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers

    Proposed rule 15l-2 would impose burdens on registered broker-
dealers relating to investments in leveraged/inverse investment 
vehicles by their retail customers.\653\ The proposed rule is designed 
to address investor protection concerns relating to leveraged/inverse 
investment vehicles by helping to ensure that retail investors in these 
products are capable of evaluating their characteristics and the unique 
risks they present. The collections of information under proposed rule 
15l-2, discussed below, would assist the Commission with its 
accounting, auditing and oversight functions. The respondents to the 
proposed rule would be broker-dealers registered under the Exchange Act 
with retail customers that transact in leveraged/inverse investment 
vehicles. Compliance with proposed rule 15l-2 would be mandatory for 
all such broker-dealers. To the extent that records required to be 
created and maintained by broker-dealers under the proposed rule are 
provided to the Commission in connection with examinations or 
investigations, such information would be kept confidential subject to 
the provisions of applicable law.
---------------------------------------------------------------------------

    \653\ Specifically, the proposed sales practices rules (proposed 
rule 15l-2, as well as proposed rule 211(h)-1 under the Advisers 
Act), would require broker-dealers and investment advisers to engage 
in due diligence before accepting or placing an order for a retail 
investor to trade a leveraged/inverse investment vehicle or 
approving an investor's account for such trading. See supra section 
II.G.2.
---------------------------------------------------------------------------

    We estimate that, as of December 31, 2018, there were approximately 
2,766 broker-dealers registered with the Commission that reported some 
sales to retail customer investors.\654\ We further estimate that 700 
of those broker dealers with retail customer accounts (approximately 
25%) have retail customer accounts that invest in leveraged/inverse 
investment vehicles.
---------------------------------------------------------------------------

    \654\ Our estimates relating to retail sales by broker-dealers 
are based on data obtained from Form BD and Form BR. See also supra 
note 543 and accompanying text.
---------------------------------------------------------------------------

1. Due Diligence and Account Approval
    Under proposed rule 15l-2, before accepting an order from a 
customer that is a natural person (or the legal representative of a 
natural person) to buy or sell shares of a leveraged/inverse investment 
vehicle, or approve such a customer's account to engage in those 
transactions, the broker-dealer must approve the customer's account to 
engage in those transactions in accordance with the proposed rule.\655\ 
To make this determination, the broker-dealer must exercise due 
diligence to ascertain certain facts about the customer, his or her 
financial situation, and investment objectives. To comply with this due 
diligence requirement, the broker-dealer must seek to obtain certain 
information described in the proposed rule. This proposed rule is 
modeled, in large part, after the FINRA rule requiring due diligence 
and account approval for retail investors to trade in options. Based on 
our understanding of how broker-dealers comply with the FINRA options 
account requirements, we believe that a common way for broker-dealers 
to comply with this due diligence obligation would be to utilize in-
house legal and compliance counsel, as well as in-house computer and 
website specialists, to create an online form for customers to provide 
the required information for approval of their accounts to trade in 
leveraged/inverse investment vehicles. We also believe that a portion 
of the due diligence would be performed by individuals associated with 
a broker-dealer or by telephone or in-person meetings with investors. 
Based on our understanding of current broker-dealer practices, we do 
not believe there would be any initial or ongoing external costs 
associated with the proposed broker-dealer due diligence requirement.
---------------------------------------------------------------------------

    \655\ See supra section II.G.2.b.
---------------------------------------------------------------------------

    Currently, there are 105 leveraged/inverse mutual funds, 164 
leveraged/inverse ETFs, and 17 exchange-listed commodity- or currency-
based trusts or funds that meet the definition of ``leveraged/inverse 
investment vehicle'' under the proposed rule.\656\ Accordingly, there 
are 286 leveraged/inverse investment vehicles in total for which a 
broker-dealer would be required to approve a retail customer's account 
before the customer could transact in the shares of those vehicles. 
Based on our experience with broker-dealers and leveraged/inverse 
investment vehicles, we estimate that each of these leveraged/inverse 
investment vehicles is held by approximately 2,500 separate retail 
investor accounts held by registered broker dealers, for a total of 
715,000 existing accounts requiring approval to trade in leveraged/
inverse investment vehicles. We further estimate that approximately 
10,000 new retail accounts will be opened each year requiring approval 
to trade in leveraged/inverse investment vehicles.\657\
---------------------------------------------------------------------------

    \656\ See supra note 467 and accompanying text.
    \657\ See supra note 545 and accompanying text.
---------------------------------------------------------------------------

    Table 10 below summarizes our initial and ongoing PRA burden 
estimates associated with the due diligence and account approval 
requirements in proposed rule 15l-2. Based on our understanding of 
current broker-dealer practices, we do not estimate that there will be 
any initial or ongoing external costs associated with the proposed due 
diligence and account approval requirements.

                                     Table 10--Proposed Rule 15l-2 Due Diligence and Account Approval PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                            Internal        Internal                                                          Initial         Annual
                                             initial     annual  burden              Wage rate \2\        Internal  time  external  cost  external  cost
                                          burden hours      hours \1\                                          costs          burden          burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Development and implementation of                     6               2   x   $365 (compliance attorney)            $730  ..............  ..............
 customer due diligence.
                                                      9               3   x   284 (senior systems                    852  ..............  ..............
                                                                               analyst).
                                                     12               4   x   331 (senior programmer)...           1,324  ..............  ..............
Annual burden per broker-dealer........  ..............               9       ..........................           2,906  ..............  ..............
Estimated number of affected broker-     ..............             700       ..........................             700  ..............  ..............
 dealers.
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
    Total burden (I)...................  ..............           6,300       ..........................       2,034,200  ..............  ..............
                                        ----------------------------------------------------------------------------------------------------------------
Customer due diligence.................               3               1   x   365 (compliance attorney).             365  ..............  ..............
                                                      3          1 hour   x   70 (compliance clerk).....              70  ..............  ..............
Evaluation of customer information for                1             .33   x   $309 (compliance manager).          101.97  ..............  ..............
 account approval/disapproval.

[[Page 4540]]

 
Total annual burden per customer                      7            2.33       ..........................          536.97  ..............  ..............
 account.
Estimated number of affected customer    ..............           \3\ x       ..........................    x 248,333.33    x 248,333.33    x 248,333.33
 accounts.                                                   248,333.33
                                        ----------------------------------------------------------------------------------------------------------------
    Total burden (II)..................  ..............      578,616.66       ..........................    $133,347,548  ..............  ..............
                                        ----------------------------------------------------------------------------------------------------------------
    Total annual burden (I + II).......  ..............      584,916.66       ..........................     135,381,748              $0              $0
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.
3. We estimate that 715,000 existing customer accounts with broker-dealers would require the proposed rule 15l-2 account approval for trading in
  leveraged/inverse investment vehicles, and that 10,000 new customer accounts opened each year would require such approval. Accordingly, we believe
  that over a three-year period, a total of 745,000 accounts will require approval, which when annualized over a three-year period, equals 248,333.33
  accounts per year.

2. Policies and Procedures

    Proposed rule 15l-2 requires broker-dealers to adopt and implement 
policies and procedures reasonably designed to achieve compliance with 
the proposed rule's provisions.\658\ We believe that broker-dealers 
likely would establish these policies and procedures by adjusting their 
current systems for implementing and enforcing compliance policies and 
procedures. While broker-dealers already have policies and procedures 
in place to address compliance with other Commission rules (among other 
obligations), they would need to update their existing policies and 
procedures to account for rule 15l-2. To comply with this obligation, 
we believe that broker-dealers would use in-house legal and compliance 
counsel to update their existing policies and procedures to account for 
the requirements of rule 15l-2. For purposes of these PRA estimates, we 
assume that broker-dealers would review the policies and procedures 
that they would adopt under proposed rule 15l-2 annually (for example, 
to assess whether the policies and procedures continue to be 
``reasonably designed'' to achieve compliance with the proposed rule). 
We therefore have estimated initial and ongoing burdens associated with 
the proposed policies and procedures requirement. As discussed above, 
we estimate that approximately 700 broker dealers have retail customer 
accounts that invest in leveraged/inverse investment vehicles. We do 
not estimate that there will be any initial or ongoing external costs 
associated with the proposed policies and procedures requirement.
---------------------------------------------------------------------------

    \658\ See supra section II.G.2.b.
---------------------------------------------------------------------------

    Table 11 below summarizes our initial and ongoing annual PRA burden 
estimates associated with the policies and procedures requirement in 
proposed rule 15l-2.

                       Table 11--Proposed Rule 15l-2 Policies and Procedures PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \2\       Internal time
                                          hours         hours \1\                                      costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Establishing and implementing rule                3               1   x   $309 (compliance               $309.00
 15l-2 policies and procedures.                                            manager).
                                                  1            0.33   x   365 (compliance                 $20.45
                                                                           attorney).
                                                  1            0.33   x   530 (chief compliance           174.90
                                                                           officer).
Reviewing and updating rule 15l-2    ..............               1   x   309 (compliance                 309.00
 policies and procedures.                                                  manager).
                                     ..............               1   x   365 (compliance                 365.00
                                                                           attorney).
                                     ..............               1   x   530 (chief compliance           530.00
                                                                           officer).
Total annual burden per broker-      ..............            4.66       ......................        1,808.35
 dealer.
Number of affected broker-dealers..  ..............           x 700       ......................           x 700
                                    ----------------------------------------------------------------------------
    Total annual burden............  ..............           3,262       ......................       1,265,845
----------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.

3. Recordkeeping
    Under proposed rule 15l-2, a broker-dealer would have to maintain a 
written record of the information that it obtained under the rule 15l-2 
due diligence requirement and its written approval of the customer's 
account, as well as the firm's policies and procedures, for a period of 
not less than six years (the first two years in an easily accessible 
place) after the date of the closing of the client's account.\659\ To 
comply with this obligation, we believe that broker-dealers would use 
in-house personnel to compile and maintain the relevant records. We do 
not estimate that there will be any initial or ongoing external costs 
associated with this requirement.
---------------------------------------------------------------------------

    \659\ See supra section II.G.2.c.
---------------------------------------------------------------------------

    Table 12 below summarizes our PRA initial and onging annual burden 
estimates associated with the recordkeeping requirement in proposed 
rule 15l-2.

[[Page 4541]]



                            Table 12--Proposed Rule 15l-2 Recordkeeping PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                         initial     annual  burden            Wage rate \1\      Internal  time
                                      burden  hours       hours                                        costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Recordkeeping......................               0               1   x   $62 (general clerk)...             $62
----------------------------------------------------------------------------------------------------------------
                                                  0               1   x   $95 (senior computer                95
                                                                           operator).
Total annual burden per broker-                   0               2       ......................             157
 dealer.
Number of affected broker-dealers..           x 700           x 700       ......................           x 700
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
    Total annual burden............               0           1,400       ......................         109,900
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.

4. Proposed Rule 15l-2 Total Estimated Burden
    As summarized in Table 13 below, we estimate that the total hour 
burdens and time costs associated with proposed rule 15l-2, including 
the burden associated with the due diligence and account approval 
requirement, the policies and procedures requirement, and the 
recordkeeping requirement, would result in an average aggregate annual 
burden of 589,578.66 hours and an average aggregate time cost of 
$136,757,493. Therefore, each broker-dealer would incur an annual 
burden of approximately 842.26 hours, at an average time cost of 
approximately $195,367.85, to comply with proposed rule 15l-2.

                                Table 13--Proposed Rule 15l-2 Total PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                                                     Internal        Internal
                                                                      initial      burden  time   External  cost
                                                                   burden hours        cost           burden
----------------------------------------------------------------------------------------------------------------
Due diligence and account approval..............................      584,916.66    $135,381,748              $0
Policies and procedures.........................................           3,262       1,265,845               0
Recordkeeping...................................................           1,400         109,900               0
    Total annual burden.........................................      589,578.66     136,757,493               0
                                                                 -----------------------------------------------
        Number of affected broker-dealers.......................           / 700           / 700           / 700
                                                                 -----------------------------------------------
    Average annual burden per affected broker-dealer............          842.26      195,367.85               0
----------------------------------------------------------------------------------------------------------------

D. Proposed Rule 211(h)-1: Sales Practices for Registered Investment 
Advisers

    Proposed 211(h)-1 would impose burdens on registered investment 
advisers relating to investments in leveraged/inverse investment 
vehicles by their retail clients.\660\ Proposed rule 211(h)-1 is 
designed to address investor protection concerns relating to leveraged/
inverse investment vehicles by helping to ensure that retail investors 
in these products are capable of evaluating their characteristics and 
the unique risks they present. The Commission also believes that the 
collections of information under proposed rule 211(h)-1, discussed 
below, would assist the Commission with its accounting, auditing and 
oversight functions.
---------------------------------------------------------------------------

    \660\ See supra note 652.
---------------------------------------------------------------------------

    The respondents to the proposed rule would be investment advisers 
registered under the Advisers Act that place orders for retail clients 
to invest in leveraged/inverse investment vehicles. Compliance with 
proposed rule 211(h)-1 would be mandatory for all such investment 
advisers. To the extent that records required to be created and 
maintained by investment advisers under the proposed rule are provided 
to the Commission in connection with examinations or investigations, 
such information would be kept confidential subject to the provisions 
of applicable law.
    We estimate that, as of December 31, 2018, approximately 8,235 
investment advisers registered with the Commission have some portion of 
their business dedicated to retail investors, including either 
individual high net worth clients or individual non-high net worth 
clients.\661\ Based on our experience with registered investment 
advisers, we further estimate that 2,000 of these investment advisers 
with retail client accounts (approximately 25%) have retail client 
accounts that invest in leveraged/inverse investment vehicles. As such, 
the investment advisers for those client accounts would be subject to 
the requirements of proposed rule 211(h)-1.\662\
---------------------------------------------------------------------------

    \661\ Based on responses to Item 5.D of Form ADV.
    \662\ See supra note 547 and accompanying paragraph.
---------------------------------------------------------------------------

1. Due Diligence and Account Approval
    Under proposed rule 211(h)-1, before placing an order for the 
account of a client that is a natural person (or the legal 
representative of a natural person) to buy or sell shares of a 
leveraged/inverse investment vehicle, or approving such a client's 
account to engage in those transactions, the investment adviser must 
approve the client's account to engage in those transactions in 
accordance with the proposed rule.\663\ To make this determination, the 
adviser must exercise due diligence to ascertain certain facts about 
the client, his or her financial situation, and investment objectives. 
To

[[Page 4542]]

comply with this due diligence requirement, the investment adviser must 
seek to obtain certain information described in the proposed rule. 
Based on our understanding of how broker-dealers comply with the FINRA 
options account requirements, as discussed above (which we assume, for 
purposes of this PRA estimate, that investment advisers could model 
their compliance programs after), we believe that investment advisers 
likely would comply with this due diligence obligation by utilizing in-
house legal and compliance counsel, as well as in-house computer and 
website specialists, to create an online form for clients to complete 
with the required information for approval of their accounts to trade 
in leveraged/inverse investment vehicles.\664\ We also believe that a 
portion of the due diligence would be performed by individuals 
associated with an investment adviser by telephone or in-person 
meetings with investors.
---------------------------------------------------------------------------

    \663\ See proposed rule 211(h)-1; supra section II.G.2.
    \664\ See supra paragraph accompanying note 654.
---------------------------------------------------------------------------

    Currently, there are 105 leveraged/inverse mutual funds, 164 
leveraged/inverse ETFs, and 17 exchange-listed commodity- or currency-
based trusts or funds that meet the definition of ``leveraged/inverse 
investment vehicle'' under the proposed rule.\665\ Accordingly, there 
are 286 leveraged/inverse investment vehicles in total for which an 
investment adviser would be required to approve a retail client's 
account before the client could transact in the shares those vehicles. 
Based on our experience with registered investment advisers, we 
estimate that each of these leveraged/inverse investment vehicles is 
held by approximately 2,500 separate retail investor accounts held by 
investment advisers, for a total of 715,000 existing accounts requiring 
approval to trade in leveraged/inverse investment vehicles. Based on 
our experience, we further estimate that approximately 10,000 new 
retail accounts will be opened each year requiring approval to trade in 
leveraged/inverse investment vehicles.\666\
---------------------------------------------------------------------------

    \665\ See supra note 467 and accompanying text.
    \666\ See supra note 547 and accompanying text.
---------------------------------------------------------------------------

    Table 14 below summarizes our initial and ongoing PRA burden 
estimates associated with the due diligence requirement in proposed 
rule 211(h)-1. We do not estimate that there will be any initial or 
ongoing external costs associated with the proposed due diligence and 
approval requirements.

                                    Table 14--Proposed Rule 211(h)-1 Due Diligence and Account Approval PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                            Internal        Internal                                                          Initial         Annual
                                         initial burden   annual burden              Wage rate \2\         Internal time   external cost   external cost
                                              hours         hours \1\                                          costs          burden          burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Development and implementation of                     6               2   x   $365 (compliance attorney)            $730              $0              $0
 client due diligence.
                                                      9               3   x   $284 (senior systems                   852  ..............  ..............
                                                                               analyst).
                                                     12               4   x   $331 (senior programmer)..           1,324  ..............  ..............
Annual burden per investment adviser...  ..............               9       ..........................           2,906  ..............  ..............
Estimated number of affected investment  ..............           2,000       ..........................           2,000  ..............  ..............
 advisers.
                                        ----------------------------------------------------------------------------------------------------------------
    Total burden (I)...................  ..............          18,000       ..........................       5,812,000  ..............  ..............
Client due diligence...................               3               1   x   $365 (compliance attorney)             365  ..............  ..............
                                                      3               1   x   $70 (compliance clerk)....              70  ..............  ..............
Evaluation of client information for                  1             .33       $309 (compliance manager).          101.97  ..............  ..............
 account approval/disapproval.
Total annual burden per client account.               7            2.33       ..........................          536.97  ..............  ..............
Estimated number of affected client                               \3\ x                                     x 248,333.33  ..............  ..............
 accounts.                                                   248,333.33
                                        ----------------------------------------------------------------------------------------------------------------
    Total burden (II)..................  ..............      578,616.66       ..........................     133,347,548  ..............  ..............
                                        ----------------------------------------------------------------------------------------------------------------
    Total annual burden (I + II).......  ..............      596,616.66       ..........................     139,159,548               0               0
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.
3. We estimate that 715,000 existing client accounts with registered investment advisers would require the proposed rule 211(h)-1 account approval for
  trading in leveraged/inverse investment vehicles, and that 10,000 new client accounts opened each year would require such approval. Accordingly, we
  believe that over a three-year period, a total of 745,000 client accounts would require approval, which when annualized over a three-year period, is
  248,333.33 accounts per year.

2. Policies and Procedures
    Proposed rule 211(h)-1 requires investment advisers to adopt and 
implement policies and procedures reasonably designed to achieve 
compliance with the proposed rule's provisions.\667\ We believe that 
investment advisers likely would establish these policies and 
procedures by adjusting their current systems for implementing and 
enforcing compliance policies and procedures. While investment advisers 
already have policies and procedures in place to address compliance 
with other Commission rules (among other obligations), they would need 
to update their existing policies and procedures to account for rule 
211(h)-1. To comply with this obligation, we believe that investment 
advisers would use in-house legal and compliance counsel to update 
their existing policies and procedures to account for the requirements 
of rule 211(h)-1. For purposes of these PRA estimates, we assume that 
investment advisers would review the policies and procedures that they 
would adopt under proposed rule 211(h)-1 annually (for example, to 
assess whether the policies and procedures continue to be ``reasonably 
designed'' to achieve compliance with the proposed rule, and in 
compliance with Advisers Act rule 206(4)-7(b)). We therefore have 
estimated initial and ongoing burdens associated with the proposed 
policies and procedures requirement. We do not estimate that there will 
be any initial or

[[Page 4543]]

ongoing external costs associated with the proposed policies and 
procedures requirement.
---------------------------------------------------------------------------

    \667\ See supra section II.G.2.b.
---------------------------------------------------------------------------

    Table 15 below summarizes our PRA estimates associated with the 
policies and procedures requirement in proposed rule 211(h)-1.

                     Table 15--Proposed Rule 211(h)-1 Policies and Procedures PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \2\       Internal time
                                          hours         hours \1\                                      costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Establishing and implementing rule                3          1 hour   x   $309 (compliance                  $309
 211(h)-1 policies and procedures.                                         manager).
                                                  1            0.33   x   $365 (compliance                120.45
                                                                           attorney).
                                                  1            0.33   x   $530 (chief compliance          174.90
                                                                           officer).
Reviewing and updating rule 211(h)-  ..............               1       $309 (compliance                   309
 1 policies and procedures.                                                manager).
                                                                  1       $365 (compliance                   365
                                                                           attorney).
                                                                  1       $530 (chief compliance             530
                                                                           officer).
Total annual burden per investment   ..............            4.66       ......................        1,808.35
 adviser.
Number of affected investment        ..............         x 2,000       ......................         x 2,000
 advisers.
                                    ----------------------------------------------------------------------------
    Total annual burden............  ..............           9,320       ......................       3,616,700
----------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.

3. Recordkeeping
    Under the proposed rule, a registered investment adviser would have 
to maintain a written record of the information that it obtained under 
the rule 211(h)-1 due diligence requirement and its written approval of 
the client's account for buying or selling shares of leveraged/inverse 
investment vehicles, as well as the firm's policies and procedures, for 
a period of not less than six years (the first two years in an easily 
accessible place) after the date of the closing of the client's 
account.\668\ To comply with this obligation, we believe that 
investment advisers would use in-house personnel to compile and 
maintain the relevant records. We do not estimate that there will be 
any initial or ongoing external costs associated with this requirement.
---------------------------------------------------------------------------

    \668\ See supra section II.G.2.c.
---------------------------------------------------------------------------

    Table 16 below summarizes our PRA estimates associated with the 
recordkeeping requirement in proposed rule 211(h)-1.

                          Table 16--Proposed Rule 211(h)-1 Recordkeeping PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \2\       Internal time
                                          hours         hours \1\                                      costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Recordkeeping......................               0             2.5   x   $62 (general clerk)...            $155
                                                  0             2.5   x   $95 (senior computer            237.50
                                                                           operator).
Total annual burden per investment                0               5       ......................          392.50
 adviser.
Number of affected investment               x 2,000         x 2,000       ......................         x 2,000
 advisers.
                                    ----------------------------------------------------------------------------
    Total annual burden............               0          10,000       ......................         785,000
----------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.

4. Proposed Rule 211(h)-1 Total Estimated Burden
    As summarized in Table 17 below, we estimate that the total hour 
burdens and time costs associated with proposed rule 211(h)-1, 
including the burden associated with the due diligence and account 
approval requirement, the policies and procedures requirement, and the 
recordkeeping requirement, would result in an average aggregate annual 
burden of 615,936.66 hours and an average aggregate time cost of 
$143,561,248. Therefore, each investment adviser would incur an annual 
burden of approximately 307.97 hours, at an average time cost of 
approximately $71,780.62 to comply with proposed rule 211(h)-1.

[[Page 4544]]



                           Table 17--Proposed Rule 211(h)-1 Total Estimated PRA Burden
----------------------------------------------------------------------------------------------------------------
                                                                     Internal        Internal
                                                                  initial burden    burden time   External  cost
                                                                       hours           cost           burden
----------------------------------------------------------------------------------------------------------------
Due diligence and account approval..............................      596,616.66    $139,159,548              $0
Policies and procedures.........................................           9,320       3,616,700               0
Recordkeeping...................................................          10,000         785,000               0
                                                                 -----------------------------------------------
    Total annual burden.........................................      615,936.66     143,561,248               0
        Number of affected investment advisers..................         / 2,000         / 2,000         / 2,000
                                                                 -----------------------------------------------
    Average annual burden per investment adviser................          307.97       71,780.62               0
----------------------------------------------------------------------------------------------------------------

E. Rule 6c-11
    We recently adopted rule 6c-11, which permits ETFs that satisfy 
certain conditions to operate without first obtaining an exemptive 
order from the Commission.\669\ The rule is designed to create a 
consistent, transparent, and efficient regulatory framework for such 
ETFs and facilitate greater competition and innovation among ETFs. Rule 
6c-11 includes a provision excluding leveraged/inverse ETFs from the 
scope of ETFs that may rely on that rule. To promote a level playing 
field among ETFs, and in view of the other conditions we are proposing 
to place on leveraged/inverse ETFs under proposed rule 18f-4 and on 
transactions in leveraged/inverse ETFs' securities under proposed rule 
15l-2 and 211(h)-1, we are proposing to amend rule 6c-11 to permit 
leveraged/inverse ETFs to rely on that rule. Because we believe this 
proposed amendment would increase the number of funds relying on rule 
6c-11, we are updating the PRA analysis for rule 6c-11 to account for 
any burden increases that would result from this increase in 
respondents to that rule. We are not updating the rule 6c-11 PRA 
analysis in any other respect.
---------------------------------------------------------------------------

    \669\ See supra notes 352-355 and accompanying text.
---------------------------------------------------------------------------

    Rule 6c-11 requires an ETF to disclose certain information on its 
website, to maintain certain records, and to adopt and implement 
certain written policies and procedures. The purpose of these 
collections of information is to provide useful information to 
investors who purchase and sell ETF shares in secondary markets and to 
allow the Commission to better monitor reliance on rule 6c-11 and will 
assist the Commission with its accounting, auditing and oversight 
functions.
    The respondents to rule 6c-11 will be ETFs registered as open-end 
management investment companies other than share class ETFs and non-
transparent ETFs. This collection will not be mandatory, but will be 
necessary for those ETFs seeking to operate without individual 
exemptive orders, including all ETFs whose existing exemptive orders 
will be rescinded. Information provided to the Commission in connection 
with staff examinations or investigations will be kept confidential 
subject to the provisions of applicable law.
    Under current PRA estimates, 1,735 ETFs would be subject to these 
requirements. The current PRA estimates for rule 6c-11 include 74,466.2 
total internal burden hours, $24,771,740.10 in internal time costs, and 
$1,735,000 in external time costs.
    We continue to believe that the current annual burden and cost 
estimates for rule 6c-11 are appropriate, but estimate that the 
proposed amendment to rule 6c-11 would result in an increase in the 
number of respondents. Specifically, we estimate that an additional 164 
ETFs (all leveraged/inverse ETFs) would rely on rule 6c-11, resulting 
in an increase in the number of respondents to 1,899 ETFs.\670\ Table 
18 below summarizes these revisions to the estimated annual responses, 
burden hours, and burden-hour costs based on the proposed amendment to 
rule 6c-11.
---------------------------------------------------------------------------

    \670\ See supra note 467 and accompanying text.

                                                           Table 18--Rule 6c-11 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                      Previously        Updated                                             Previously        Updated
                                                       estimated       estimated        Previously     Updated estimated     estimated       estimated
                                                        annual          annual       estimated annual   annual internal       annual          annual
                                                     internal hour   internal hour   internal burden    time burden cost   external cost   external cost
                                                      burden \1\      burden \2\        time cost                             burden          burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Website disclosure................................       33,398.75       36,555.75     $10,717,945.15     $11,731,053.51      $1,735,000      $1,899,000
Recordkeeping.....................................           8,675           9,495         680,987.50         745,357.50               0               0
Policies and procedures...........................       32,392.45       35,454.33      13,372,807.45      14,636,865.33               0               0
                                                   -----------------------------------------------------------------------------------------------------
    Total annual burden...........................        74,466.2       81,505.08      24,771,740.10      27,113,276.34       1,735,000       1,899,000
        Number of affected ETFs...................         / 1,735         / 1,899            / 1,735            / 1,899         / 1,735         / 1,899
                                                   -----------------------------------------------------------------------------------------------------
    Average annual burden per ETF.................           42.92           42.92          14,277.66          14,277.66           1,000           1,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. The previously estimated burdens and costs in this table are based on an estimate of 1,735 ETFs relying on rule 6c-11.
2. The updated estimated burdens and costs in this table are based on an estimate of 164 leveraged/inverse ETFs that would rely on rule 6c-11 pursuant
  to the proposed amendment to that rule, for a total estimate of 1,899 ETFs that would rely on rule 6c-11.


[[Page 4545]]

F. Form N-PORT

    We are proposing to amend Form N-PORT to add new items to Part B 
(``Information About the Fund''), as well as to make certain amendments 
to the form's General Instructions.
    Form N-PORT, as amended, would require funds to provide information 
about their derivatives exposure.\671\ We estimate that 5,091 funds 
would be subject to this exposure-related disclosure requirement.\672\
---------------------------------------------------------------------------

    \671\ See proposed Item B.9 of Form N-PORT; supra section 
II.H.1.a.
    \672\ See supra notes 467, 498 and accompanying text, and 
paragraph following note 525 (2,693 funds that would be subject to 
the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited 
derivatives user exception and complying with the related limited 
derivatives user requirements).
---------------------------------------------------------------------------

    In addition, funds that are subject to the limit on fund leverage 
risk in proposed rule 18f-4 would have to report certain VaR-related 
information, including: (1) The fund's highest daily VaR during the 
reporting period and its corresponding date; and (2) the fund's median 
daily VaR for the reporting period. Funds subject to the relative VaR 
test during the reporting period also would have to report: (1) The 
name of the fund's designated reference index, (2) the index 
identifier, (3) the fund's highest daily VaR ratio during the reporting 
period and its corresponding date; and (4) the fund's median daily VaR 
ratio for the reporting period.\673\ Finally, all funds that are 
subject to the proposed limit on fund leverage risk also would have to 
report the number of exceptions that the fund identified as a result of 
the backtesting of its VaR calculation model.\674\ We estimate that 
2,424 funds would be subject to these VaR-related disclosure 
requirements.\675\
---------------------------------------------------------------------------

    \673\ See proposed Item B.10 of Form N-Port; supra section 
II.H.1.b.
    \674\ See id.
    \675\ See supra paragraph following note 525.
---------------------------------------------------------------------------

    Preparing reports on Form N-Port is mandatory for all management 
investment companies (other than money market funds and small business 
investment companies) and UITs that operate as ETFs and is a collection 
of information under the PRA. The information required by Form N-Port 
must be data-tagged in XML format. Responses to the reporting 
requirements will be kept confidential, subject to the provisions of 
applicable law, for reports filed with respect to the first two months 
of each quarter; the third month of the quarter will not be kept 
confidential, but made public sixty days after the quarter end. Form N-
Port is designed to assist the Commission its regulatory, disclosure 
review, inspection, and policymaking roles, and to help investors and 
other market participants better assess different fund products.\676\
---------------------------------------------------------------------------

    \676\ The specific purposes for each of the new proposed 
reporting items are discussed in section II.H.1 supra.
---------------------------------------------------------------------------

    Based on current PRA estimates, we estimate that funds prepare and 
file their reports on Form N-Port either by (1) licensing a software 
solution and preparing and filing the reports in house, or (2) 
retaining a service provider to provide data aggregation, validation 
and/or filing services as part of the preparation and filing of reports 
on behalf of the fund. We estimate that 35% of funds subject to the 
proposed N-Port filing requirements would license a software solution 
and file reports on Form N-Port in house, and the remainder would 
retain a service provider to file reports on behalf of the fund.
    Table 19 below summarizes our PRA initial and ongoing annual burden 
estimates associated with the proposed amendments to Form N-Port.

                                                           Table 19--Form N-PORT PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                            Internal        Internal                                                          Initial         Annual
                                         initial burden   annual burden              Wage rate \2\         Internal time   external cost   external cost
                                              hours         hours \1\                                          costs          burden          burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Report derivatives exposure information               2        \3\ 4.33   x   $365 (compliance attorney)          $1,580  ..............  ..............
                                                      2            4.33   x   $331 (senior programmer)..           1,433  ..............  ..............
                                        ----------------------------------------------------------------------------------------------------------------
    Total new burden for derivatives     ..............            8.66       ..........................           3,013  ..............  ..............
     exposure information.
Number of funds for derivatives                                 x 5,091                                          x 5,091
 exposure information.
                                        ----------------------------------------------------------------------------------------------------------------
    Total new annual burden for          ..............          44,088       ..........................      15,339,183  ..............  ..............
     derivatives exposure information
     (I).
--------------------------------------------------------------------------------------------------------------------------------------------------------
Report VaR-related information.........               2            4.33   x   $365 (compliance attorney)           1,580          $5,490          $4,210
                                                      2            4.33   x   $331 (senior programmer)..           1,433  ..............  ..............
                                        ----------------------------------------------------------------------------------------------------------------
    Total new burden for VaR-related     ..............            8.66       ..........................           3,013  ..............  ..............
     information.
Number of funds for VaR-related                                 x 2,424                                          x 2,424
 information.
                                        ----------------------------------------------------------------------------------------------------------------

[[Page 4546]]

 
    Total new annual burden for VaR-     ..............          20,992       ..........................       7,303,512  ..............  ..............
     related information (II).
--------------------------------------------------------------------------------------------------------------------------------------------------------
    Total new annual burden (I + II)...  ..............          65,080       ..........................      22,642,695  ..............  \4\ 21,433,110
Current burden estimates...............  ..............       1,803,826       ..........................  ..............  ..............     103,776,240
                                        ----------------------------------------------------------------------------------------------------------------
    Revised burden estimates...........  ..............       1,868,906       ..........................  ..............  ..............     125,209,350
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the proposed reporting requirements that we
  believe otherwise would be involved in preparing and filing reports on Form N-PORT.
3. This estimate assumes that, annually after the initial 2 hours to comply with the new N-PORT requirements, each of a compliance attorney and a senior
  programmer would incur 1 burden hours per filing associated with the new reporting requirements. The estimate of 4.33 hours is based on the following
  calculation: ((2 hours for the first filing x 1 = 2) + (3 additional filings in year 1 x 1 hour for each of the additional 3 filings in year 1 = 3) +
  (4 filings in years 2 and 3 x 1 hour per filing x 2 years) = 8)/3 = 4.33.
4. This estimate is based on the following calculation: $4,210 (average costs for funds reporting the proposed information on Form N-PORT) * 5,091 funds
  (which includes funds reporting derivative exposure information and VaR-related information).

G. Form N-RN

    We are proposing to amend Form N-LIQUID (which we propose to re-
title as ``Form N-RN'') to add new current reporting requirements for 
funds subject to the proposed VaR-based limit on fund leverage risk 
pursuant to proposed rule 18f-4.\677\ Specifically, a fund that 
determines that it is out of compliance with the VaR test and has not 
come back into compliance within three business days after such 
determination would have to file a non-public report on Form N-RN 
providing certain information regarding its VaR test breaches.\678\ If 
the portfolio VaR of a fund subject to the relative VaR test were to 
exceed 150% of the VaR of its designated reference index for three 
business days, a fund would have to report: (1) The dates on which the 
fund portfolio's VaR exceeded 150% of the VaR of its designated 
reference index; (2) the VaR of its portfolio for each of these days; 
(3) the VaR of its designated reference index for each of these days; 
(4) the name of the designated reference index; and (5) the index 
identifier. If the portfolio VaR of a fund subject to the absolute VaR 
test were to exceed 10% of the value of the fund's net assets for three 
business days, a fund would have to report: (1) The dates on which the 
fund portfolio's VaR exceeded 10% of the value of its net assets; (2) 
the VaR of its portfolio for each of these days; and (3) the value of 
the fund's net assets for each of these days.
---------------------------------------------------------------------------

    \677\ See supra section II.H.2.
    \678\ This requirement would be implemented through the proposed 
amendments to rule 30b1-10 under the Investment Company Act, and 
proposed rule 18f-4(c)(7). For purposes of this PRA analysis, the 
burden associated with the proposed amendments to rule 30b1-10 and 
proposed rule 18f-4(c)(7) is included in the collection of 
information requirements for Form N-RN.
---------------------------------------------------------------------------

    In addition, if a fund that has filed Part E or Part F of Form N-RN 
to report it has breached its applicable VaR test, has come back into 
compliance with either the relative VaR test or the absolute VaR test, 
as applicable, it must file a report on Form N-RN to indicate 
that.\679\ Specifically, a fund must report the dates on which its 
portfolio VaR exceeded, as applicable, 150% of the VaR of its 
designated reference index (if the fund is subject to the relative VaR 
test under proposed rule 18f-4(c)(2)(i)) or exceeded 15% of the value 
of its net assets (if the fund is subject to the absolute VaR test 
under proposed rule 18f-4(c)(2)(ii)).\680\ Furthermore, a fund must 
also report the current VaR of its portfolio.\681\
---------------------------------------------------------------------------

    \679\ See proposed Part G of Form N-RN.
    \680\ Id.
    \681\ Id.
---------------------------------------------------------------------------

    A fund would have to report information for either VaR test breach, 
within one business day following the third business day after the fund 
has determined that its portfolio VaR exceeds either of the VaR test 
thresholds, as applicable. Similarly, a fund that has come back into 
compliance with its applicable VaR test would have to file such a 
report within one business day. We estimate that 2,424 funds per year 
would be required to comply with either of the VaR tests, and the 
Commission would receive approximately 30 filing(s) per year in 
response to each of the new VaR-related items that we proposed to 
include on Form N-RN, as amended.\682\
---------------------------------------------------------------------------

    \682\ This estimate is similar to the Commission's estimates of 
the number of reports that funds, in the aggregate, would submit 
annually in response to the liquidity-related items of Form N-
LIQUID. See Liquidity Adopting Release, supra note 359, at nn.1281-
1283 and accompanying paragraph. See also supra paragraph following 
note 525.
---------------------------------------------------------------------------

    Under the proposed amendments to Form N-RN, preparing a report on 
this form would be mandatory for any fund that is out of compliance 
with its applicable VaR test for more than three business days, as 
described above, and for any fund that has come back into compliance 
with its applicable VaR test. A report on Form N-RN is a collection of 
information under the PRA. The VaR test breach information provided on 
Form N-RN, as well as the information a fund provides when it has come 
back into compliance, would enable the Commission to receive 
information on events that could impact funds' leverage-related risk 
more uniformly and efficiently and would enhance the Commission's 
oversight of funds when significant fund and/or market events occur. 
The Commission would be able to use the newly required information that 
funds would provide on Form N-RN in its regulatory, disclosure review, 
inspection, and policymaking roles. Responses to the reporting 
requirements and this collection of information would be kept 
confidential, subject to provisions of applicable law.
    Table 20 below summarizes our PRA initial and ongoing annual burden 
estimates associated with the proposed amendments to funds' current 
reporting requirement. Staff estimates there will

[[Page 4547]]

be no external costs associated with this collection of information. We 
further assume similar hourly and cost burdens, as well as similar 
response rates, for responses to either a breach of the absolute VaR 
test or the relative VaR test.

                                        Table 20--Form N-RN PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                                Internal        Internal
                                             initial burden   annual burden        Wage rate \1\   Internal time
                                                  hours           hours                                costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Relative or absolute VaR test breach                      0       \2\ 0.005   x             $365           $1.83
 reports...................................                                          (compliance
                                                                                       attorney)
                                                          0           0.005   x     $331 (senior            1.66
                                                                                     programmer)
                                            --------------------------------------------------------------------
    Total new annual burden per fund.......  ..............            0.01       ..............            3.49
        Number of funds....................                         x 2,424                              x 2,424
                                            --------------------------------------------------------------------
    Total new annual burden................  ..............              24       ..............           8,460
Current burden estimates...................  ..............             941       ..............  ..............
                                            --------------------------------------------------------------------
    Revised burden estimates...............  ..............             965       ..............  ..............
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the
  proposed reporting requirements that we believe otherwise would be involved in preparing and filing reports on
  Form N-LIQUID.
2. This estimate is based on the assumption that, of the 2,424 funds that would be required to comply with
  either of the VaR tests, on average the Commission would receive 30 reports regarding a relative or absolute
  VaR test breach and that compliance attorney and senior programmer would each spend 30 minutes as part of
  preparing and submitting this report.

H. Form N-CEN

    We are proposing to amend Form N-CEN to require a fund to identify 
whether it relied on proposed rule 18f-4 during the reporting 
period.\683\ Form N-CEN is a structured form that requires registered 
funds to provide census-type information to the Commission on an annual 
basis. The proposed amendments also would require a fund to identify 
whether it relied on any of the exemptions from various requirements 
under the proposed rule, specifically: (1) Whether the fund is a 
limited derivatives user excepted from the proposed rule's program 
requirement, under either of the proposed exception's alternatives 
(either a funds that limits its derivatives exposure to 10% of its net 
assets, or a fund that uses derivatives transactions solely to hedge 
certain currency risks); or (2) whether it is a leveraged/inverse 
investment fund covered by the proposed sales practices rules that, 
under proposed rule 18f-4, would be excepted from the proposed limit on 
fund leverage risk. Finally, a fund would have to identify whether it 
has entered into reverse repurchase agreements or similar financing 
transactions, or unfunded commitment agreements, as provided under the 
proposed rule.
---------------------------------------------------------------------------

    \683\ See supra section II.H.3.
---------------------------------------------------------------------------

    Preparing a report on Form N-CEN, as amended, would be mandatory 
for all registered funds. Responses would not be kept confidential. We 
estimate that 12,375 funds would be subject to these disclosure 
requirements.\684\
---------------------------------------------------------------------------

    \684\ See supra section III.B.1 (9,788 mutual funds + 1,910 ETFs 
organized as an open-end fund or as a share-class of an open-end 
fund + 664 registered closed-end funds + 13 variable annuity 
separate accounts registered as management investment companies on 
Form N-3).
---------------------------------------------------------------------------

    The purpose of Form N-CEN is to satisfy the filing and disclosure 
requirements of section 30 of the Investment Company Act, and of 
amended rule 30a-1 thereunder. The information required to be filed 
with the Commission assures the public availability of the information 
and is designed to facilitate the Commission's oversight of registered 
funds and its ability to monitor trends and risks.
    Table 21 below summarizes our PRA initial and ongoing annual burden 
estimates associated with the proposed amendments to Form N-CEN based 
on current Form N-CEN practices and burdens associated with minor 
amendments to the form. Staff estimates there will be no external costs 
associated with this collection of information.

                                       Table 21--Form N-CEN PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                        Internal        Internal
                                     initial burden   annual burden            Wage rate \1\       Internal time
                                          hours           hours                                        costs
----------------------------------------------------------------------------------------------------------------
                                               Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Reporting derivatives-related fund                0            0.01   x   $365 (compliance                  $3.7
 census information.                                                       attorney).
                                                  0            0.01   x   $331 (senior                       3.3
                                                                           programmer).
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
    Total new annual burden per      ..............            0.02       ......................               7
     fund.
Number of funds....................                        x 12,375                                     x 12,375
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr

[[Page 4548]]

 
    Total new annual burden........  ..............             248       ......................          86,625
Current burden estimates...........  ..............          74,425       ......................  ..............
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
    Revised burden estimates.......  ..............          74,673       ......................  ..............
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the
  proposed reporting requirements that we believe otherwise would be involved in preparing and filing reports on
  Form N-CEN.
2. This estimate assumes each fund reporting on Form N-CEN would spend 1 to 2 minutes reporting these new data
  elements.

I. Request for Comments

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments 
in order to: (1) Evaluate whether the proposed collections of 
information are necessary for the proper performance of the functions 
of the Commission, including whether the information will have 
practical utility; (2) evaluate the accuracy of the Commission's 
estimate of the burden of the proposed collections of information; (3) 
determine whether there are ways to enhance the quality, utility, and 
clarity of the information to be collected; and (4) determine whether 
there are ways to minimize the burden of the collections of information 
on those who are to respond, including through the use of automated 
collection techniques or other forms of information technology.
    Persons wishing to submit comments on the collection of information 
requirements of the proposed rules and amendments should direct them to 
the OMB, Attention Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
DC 20503, and should send a copy to, Vanessa Countryman, Secretary, 
Securities and Exchange Commission, 100 F Street NE, Washington, DC 
20549-1090, with reference to File No. S7-24-15. OMB is required to 
make a decision concerning the collections of information between 30 
and 60 days after publication of this release; therefore a comment to 
OMB is best assured of having its full effect if OMB receives it within 
30 days after publication of this release. Requests for materials 
submitted to OMB by the Commission with regard to these collections of 
information should be in writing, refer to File No. S7-24-15, and be 
submitted to the Securities and Exchange Commission, Office of FOIA 
Services, 100 F Street NE, Washington, DC 20549-2736.

V. Initial Regulatory Flexbility Analysis

    This Initial Regulatory Flexibility Analysis has been prepared in 
accordance with section 3 of the Regulatory Flexibility Act.\685\ It 
relates to proposed rules 18f-4, 15l-2, 211(h)-1, and proposed 
amendments to Forms N-PORT, N-LIQUID (which we propose to re-title as 
``Form N-RN''), and N-CEN.\686\
---------------------------------------------------------------------------

    \685\ 5 U.S.C. 603.
    \686\ As discussed above, the proposed conforming amendment to 
Form N-2 does not change the Form N-2 collection of information. See 
supra note 622. We also do not believe there to be any reporting, 
recordkeeping, or compliance burden associated with this proposed 
conforming amendment.
---------------------------------------------------------------------------

A. Reasons for and Objectives of the Proposed Actions

    The Commission is proposing new rules 18f-4, 211(h)-1, and 15l-2, 
amendments to rule 6c-11, as well as amendments to Forms N-PORT, N-
LIQUID, and N-CEN. These proposed rules, and proposed rule and form 
amendments, are designed to address the investor protection purposes 
and concerns underlying section 18 of the Investment Company Act and to 
provide an updated and more comprehensive approach to the regulation of 
funds' use of derivatives and the other transactions covered by 
proposed rule 18f-4.\687\
---------------------------------------------------------------------------

    \687\ See supra section I.B (discussing the requirements of 
section 18, and as well as Congress' concerns underlying the limits 
of section 18).
---------------------------------------------------------------------------

    Proposed rule 18f-4 is designed to provide an updated, 
comprehensive approach to the regulation of funds' use of derivatives 
and certain other transactions, generally through the implementation of 
a derivatives risk management program, limits on fund leverage risk, 
board oversight and reporting, and related recordkeeping 
requirements.\688\ The proposed sales practices rules are designed to 
address certain specific considerations raised by certain leveraged/
inverse investment vehicles by requiring registered broker-dealers and 
investment advisers to satisfy due diligence and account approval 
requirements.\689\ Finally, the proposed amendments to Forms N-PORT, N-
LIQUID, and N-CEN are designed to enhance the Commission's ability to 
effectively oversee the use by funds, broker-dealers and investment 
advisers of the proposed rules and to provide the Commission and the 
public with greater insight into the impact that funds' use of 
derivatives may have on their portfolios.\690\
---------------------------------------------------------------------------

    \688\ See supra section II.A.2.
    \689\ See supra section II.G.
    \690\ See supra section II.H.
---------------------------------------------------------------------------

    All of these requirements are discussed in detail in section II of 
this release. The costs and burdens of these requirements on small 
funds, investment advisers, and broker-dealers are discussed below as 
well as above in our Economic Analysis and Paperwork Reduction Act 
Analysis, which discuss the applicable costs and burdens on all funds, 
investment advisers, and broker-dealers.\691\
---------------------------------------------------------------------------

    \691\ See supra sections III and IV. These sections also discuss 
the professional skills that we believe compliance with the proposed 
rules, and proposed rule and form amendments would entail.
---------------------------------------------------------------------------

B. Legal Basis

    The Commission is proposing new rule 18f-4 under the authority set 
forth in sections 6(c), 12(a), 18, 31(a), 38(a), and 61 of the 
Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-12(a), 80a-18, 
80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing 
amendments to rule 6c-11 under the authority set forth in sections 
6(c), 22(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a-
6(c), 22(c), and 80a-37(a)]. The Commission is proposing new rule 15l-2 
under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 
17, 23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C. 
78c, 78c(b), 78c-5, 78j, 78o(l), 78o-10, 78q, 78w(a), and 78mm]. The 
Commission is proposing new rule 211(h)-1 under the authority set forth 
in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment 
Advisers Act of 1940 [15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and 
80b-11(h)]. The Commission is

[[Page 4549]]

proposing amendments to Form N-PORT, Form N-LIQUID (which we propose to 
re-title as ``Form N-RN''), Form N-CEN, and Form N-2 under the 
authority set forth in sections 8, 18, 30, and 38 of the Investment 
Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 80a-29, 80a-37, 80a-63], 
sections 6, 7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C. 
77f, 77g(a), 77j, 77s(a)], and sections 10, 13, 15, 23, and 35A of the 
Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and 78ll].

C. Small Entities Subject to Proposed Rules

    For purposes of Commission rulemaking in connection with the 
Regulatory Flexibility Act, an investment company is a small entity if, 
together with other investment companies in the same group of related 
investment companies, it has net assets of $50 million or less as of 
the end of its most recent fiscal year (a ``small fund'').\692\ 
Commission staff estimates that, as of June 2019, approximately 42 
registered open-end mutual funds, 8 registered ETFs, 33 registered 
closed-end funds, and 16 BDCs (collectively, 99 funds) are small 
entities.\693\
---------------------------------------------------------------------------

    \692\ See rule 0-10(a) under the Investment Company Act [17 CFR 
270.0-10(a)].
    \693\ This estimate is derived an analysis of data obtained from 
Morningstar Direct as well as data reported to the Commission for 
the period ending June 2019.
---------------------------------------------------------------------------

    For purposes of Commission rulemaking in connection with the 
Regulatory Flexibility Act, a broker-dealer is a small entity if it: 
(1) Had total capital (net worth plus subordinated liabilities) of less 
than $500,000 on the date in the prior fiscal year as of which its 
audited financial statements were prepared pursuant to rule 17a-5(d) 
under the Exchange Act, or, if not required to file such statements, 
had total capital (net worth plus subordinated liabilities) of less 
than $500,000 on the last business day of the preceding fiscal year (or 
in the time that it has been in business, if shorter); and (2) it is 
not affiliated with any person (other than a natural person) that is 
not a small business or small organization.\694\ Commission staff 
estimates that, as of June 30, 2019, there are approximately 942 
broker-dealers that may be considered small entities.\695\
---------------------------------------------------------------------------

    \694\ See rule 0-10(c)(1)-(2) under the Exchange Act [17 CFR 
240.0-10(c)(1)(2)].
    \695\ This estimate is derived from an analysis of data for the 
period ending June 30, 2019 obtained from Financial and Operational 
Combined Uniform Single (FOCUS) Reports that broker-dealers 
generally are required to file with the Commission and/or SROs 
pursuant to rule 17a-5 under the Exchange Act [17 CFR 240.17a-5].
---------------------------------------------------------------------------

    Under Commission rules, and for the purposes of the Advisers Act 
and the Regulatory Flexibility Act, a registered investment adviser 
generally is a small entity if it: (1) Has assets under management 
having a total value of less than $25 million; (2) did not have total 
assets of $5 million or more on the last day of the most recent fiscal 
year; and (3) does not control, is not controlled by, and is not under 
common control with another investment adviser that has assets under 
management of $25 million or more, or any person (other than a natural 
person) that had total assets of $5 million or more on the last day of 
its most recent fiscal year.\696\ We believe that proposed rule 211(h)-
1 would not affect most investment advisers that are small entities 
(``small advisers''). Many small advisers would not be affected because 
they are registered with one or more state securities authorities and 
not with the Commission. Under section 203A of the Advisers Act, many 
small advisers are prohibited from registering with the Commission and 
are regulated by state regulators.\697\ Of those advisers that are 
registered with the Commission, we estimate based on IARD data that as 
of June 30, 2019, approximately 470 SEC-registered investment advisers 
are small entities under the RFA.\698\ Of these, we estimate that 171 
registered investment advisers are small entities that provide advice 
to individual clients.\699\
---------------------------------------------------------------------------

    \696\ See rule 0-7(a) under the Advisers Act [17 CFR 275.0-
7(a)].
    \697\ 15 U.S.C. 80b-3a.
    \698\ Based on SEC registered investment adviser responses to 
Item 12 of Form ADV.
    \699\ Based on SEC-registered investment adviser responses to 
Items 5.D.(1)(a)-(b), 5.D.(3)(a)-(b), 5.F and 12 of Form ADV. These 
responses indicate that: The investment adviser has clients that are 
high net worth individuals and/or individuals other than high net 
worth individuals; the investment adviser has regulatory assets 
under management attributable to clients that are high net worth 
individuals and/or individuals other than high net worth 
individuals; and that the investment adviser is a small entity. 
Firms that are registered as a broker-dealer and an investment 
adviser are counted in both the total number of small investment 
advisers and small broker-dealers that would be subject to the new 
requirements. We believe that counting these firms twice is 
appropriate because of any additional burdens of complying with the 
rules with respect to both their advisory and brokerage businesses.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

1. Proposed Rule 18f-4
a. Derivatives Risk Management Program, and Board Oversight and 
Reporting
    Proposed rule 18f-4 would generally require a fund relying on the 
rule--including small entities, but not including funds that are 
limited derivatives users--to adopt and implement a derivatives risk 
management program.\700\ This risk management program would include 
policies and procedures reasonably designed to assess and manage the 
risks of the fund's derivatives transactions.\701\ The program 
requirement is designed to permit a fund to tailor the program's 
elements to the particular types of derivatives that the fund uses and 
related risks, as well as how those derivatives impact the fund's 
investment portfolio and strategy. The proposal would require a fund's 
program to include the following elements: (1) Risk identification and 
assessment; (2) risk guidelines; (3) stress testing; (4) backtesting; 
(5) internal reporting and escalation; and (6) periodic review of the 
program. The proposed rule also would require: (1) A fund's board of 
directors to approve the designation of the fund's derivatives risk 
manager and (2) the derivatives risk manager to provide written reports 
to the board regarding the program's implementation and effectiveness, 
including describing any exceedances of the fund's guidelines and the 
results of the fund's stress testing and backtesting.\702\
---------------------------------------------------------------------------

    \700\ See supra section II.A.2; proposed rule 18f-4(c)(1).
    \701\ See proposed rule 18f-4(a).
    \702\ See supra sections II.C and III.C.1.
---------------------------------------------------------------------------

    As discussed above, we estimate that the one-time operational costs 
necessary to establish and implement a derivatives risk management 
program would range from $70,000 to $500,000 per fund, depending on the 
particular facts and circumstances and current derivatives risk 
management practices of the fund.\703\ We also estimate that each fund 
would incur ongoing program-related costs that range from 65% to 75% of 
the one-time costs necessary to establish and implement a derivatives 
risk management program.\704\ Thus, we estimate that a fund would incur 
ongoing annual costs associated with proposed rule 18f-4 that would 
range from $45,500 to $375,000.\705\ We estimate that approximately 22% 
of funds would be required to implement a derivatives risk management 
program, including board oversight.\706\ We

[[Page 4550]]

similarly estimate--applying to small funds the same estimated 
percentage of funds that would implement a derivatives risk management 
program--that approximately 22% of small funds (approximately 22 small 
funds) would establish a derivatives risk management program.\707\
---------------------------------------------------------------------------

    \703\ See supra section III.C.1. This section, along with 
sections IV.B.1 and IV.B.2, also discusses the professional skills 
that we believe compliance with this aspect of the proposal would 
entail.
    \704\ Id.
    \705\ Id.
    \706\ These are funds that would not be considered limited 
derivatives users under the proposed rule. See supra sections II.E, 
III.C.1, IV.B.1 and IV.B.2; infra section V.D.1.c.
    \707\ See supra sections III.C.1 and V.C. We estimate that there 
are 99 small funds that meet the small entity definition. See supra 
note 692 and accompanying text. 99 small funds x 22% = approximately 
22 funds that are small entities.
---------------------------------------------------------------------------

    There are different factors that would affect whether a smaller 
fund incurs program-related costs that are on the higher or lower end 
of the estimated range. For example, we would expect that smaller 
funds--and more specifically, smaller funds that are not part of a fund 
complex--may not have existing personnel capable of fulfilling the 
responsibilities of the proposed derivatives risk manager, or may 
choose to hire a derivatives risk manager rather than assigning that 
responsibility to a current officer (or officers) of the fund's 
investment adviser who is not a portfolio manager. Also, while we would 
expect larger funds or funds that are part of a large fund complex to 
incur higher program-related costs in absolute terms relative to a 
smaller fund or a fund that is part of a smaller fund complex, we would 
expect a smaller fund to find it more costly, per dollar managed, to 
comply with the proposed program requirement because it would not be 
able to benefit from a larger fund complex's economies of scale.\708\
---------------------------------------------------------------------------

    \708\ See supra section III.C.1.
---------------------------------------------------------------------------

b. Limit on Fund Leverage Risk
    Proposed rule 18f-4 would also generally require a fund relying on 
the rule--including small entities, but not including funds that are 
limited derivatives users or that are certain leveraged/inverse funds 
that the rule describes--to comply with an outer limit on fund leverage 
risk based on VaR.\709\ This outer limit would be based on a relative 
VaR test that compares the fund's VaR to the VaR of a designated 
reference index. If the fund's derivatives risk manager is unable to 
identify an appropriate designated reference index, the fund would be 
required to comply with an absolute VaR test.\710\ Under the proposed 
rule, a fund must disclose its designated reference index in its annual 
report.\711\ This proposed requirement is designed to limit fund 
leverage risk consistent with the investor protection purposes 
underlying section 18.
---------------------------------------------------------------------------

    \709\ See supra sections II.D, II.E, and II.G.
    \710\ See supra sections II.D.2, II.D.3.
    \711\ Proposed rule 18f-4(c)(2)(iv).
---------------------------------------------------------------------------

    As discussed above, we estimate that the one-time operational costs 
necessary to establish and implement a VaR calculation model consistent 
with the proposed limit on fund leverage risk would range from $5,000 
to $100,000 per fund, depending on the particular facts and 
circumstances and current derivatives risk management practices of the 
fund.\712\ We estimate that approximately 19% of funds would be 
required to comply with the proposed limit on fund leverage risk.\713\ 
We similarly estimate--applying to small funds the same estimated 
percentage of funds overall that would comply with this requirement--
that approximately 19% of small funds (approximately 19 small funds) 
would be required to comply with the proposed limit on fund leverage 
risk.\714\
---------------------------------------------------------------------------

    \712\ See supra section III.C.2. This section, along with 
section IV.B.3, also discusses the professional skills that we 
believe compliance with this aspect of the proposal would entail.
    \713\ See supra section III.C.2. This estimate excludes both: 
(1) Limited derivatives users, and (2) funds that are leveraged/
inverse investment vehicles under the proposed sales practices 
rules. Id.; see also supra sections II.E, II.G, III.C.2, III.C.3, 
III.C.5, and IV.B.3; infra section V.D.1.c.
    \714\ See supra sections III.C.2 and V.C. We estimate that there 
are 99 small funds that meet the small entity definition. See supra 
note 692 and accompanying text. 99 small entities x 19% = 
approximately 19 funds that are small entities.
---------------------------------------------------------------------------

    There are multiple factors that could affect whether the costs that 
smaller funds would incur in complying with the proposed limit on fund 
leverage risk would be on the lower versus higher end of this estimated 
range. To the extent that funds (including smaller funds) have already 
established and implemented portfolio VaR testing practices and 
procedures, these funds would incur fewer costs relative to those funds 
that have not already established and implemented VaR-based analysis in 
their risk management. If as a result of fewer resources, a smaller 
fund, and more specifically a smaller fund not part of a fund complex, 
hired a third-party vendor to comply with the VaR-based limit on fund 
leverage risk, this could increase costs of complying with the proposed 
limit for those funds. Finally, costs would vary based on factors such 
as whether the fund uses multiple types of derivatives or uses 
derivatives more extensively, whether the fund would be implementing 
the absolute VaR test versus the relative VaR test, and whether (for a 
fund that uses the relative VaR test) the fund uses a designated 
reference index for which the index provider charges a licensing 
fee.\715\
---------------------------------------------------------------------------

    \715\ See supra note 202 and accompanying paragraph; note 517 
and accompanying sentence.
---------------------------------------------------------------------------

c. Requirements for Limited Derivatives Users
    Proposed rule 18f-4 includes an exception from the proposed rule's 
risk management program requirement and limit on fund leverage risk for 
``limited derivatives users.'' \716\ The proposed exception would be 
available to a fund that either limits its derivatives exposure to 10% 
of its net assets, or that uses derivatives transactions solely to 
hedge certain currency risks. Any fund that relies on the proposed 
exception--small funds as well as large funds--would also be required 
to adopt policies and procedures that are reasonably designed to manage 
its derivatives risks. We expect that the risks and potential impact of 
these funds' derivatives use may not be as significant, compared to 
those of funds that do not qualify for the exception, and that a 
principles-based policies and procedures requirement would 
appropriately address these risks. These ``reasonably designed'' 
policies and procedures would have a scope that that reflects the 
extent and nature of a fund's use of derivatives within the parameters 
that the proposed exception provides.
---------------------------------------------------------------------------

    \716\ See supra section II.E; proposed rule 18f-4(c)(3)(i)-(ii).
---------------------------------------------------------------------------

    As discussed above, we estimate that the one-time costs to 
establish and implement policies and procedures reasonably designed to 
manage a fund's derivative risks would range from $1,000 to $100,000 
per fund, depending on the particular facts and circumstances and 
current derivatives risk management practices of the fund.\717\ We also 
estimate that the ongoing annual costs that a fund that is a limited 
derivatives user would incur range from 65% to 75% of the one-time 
costs to establish and implement the policies and procedures. Thus, we 
estimate that a fund would incur ongoing annual costs associated with 
the proposed limited derivatives user exception that would range from 
$650 to $75,000.\718\ We anticipate that larger funds that are limited 
derivatives users--or limited derivatives user funds that are part of a 
large fund complex--would likely experience economies of scale in 
complying with the proposed requirements for limited derivatives users 
that smaller funds would not

[[Page 4551]]

necessarily experience.\719\ Thus, smaller funds that are limited 
derivatives users could incur costs on the higher end of the estimated 
range. However, a smaller fund whose derivatives use is limited could 
benefit from the proposed limited derivatives user exception, because 
it would not be required to adopt a derivatives risk management program 
(including all of the proposed program elements), and therefore such a 
fund could potentially avoid incurring costs and bearing compliance 
burdens that may be disproportionate to any benefits.\720\
---------------------------------------------------------------------------

    \717\ See supra section III.C.3 (discussing the one-time range 
of costs for implementing the limited derivatives user requirements 
under proposed rule18f-4 and the variables impacting a fund 
incurring costs at the lower or higher end of the estimated cost 
range). This section, along with section IV.B.6, also discusses the 
professional skills that we believe compliance with this aspect of 
the proposal would entail.
    \718\ Id.
    \719\ See supra note 707 and accompanying text.
    \720\ See supra section II.E.
---------------------------------------------------------------------------

    We estimate that approximately 19% of funds that use derivatives 
would qualify for the limited derivatives user exception.\721\ We would 
expect some small funds to fall within the proposed limited derivatives 
user exception.\722\ However, not all small funds that use derivatives 
would necessarily qualify as limited derivatives users. We estimate--
applying to small funds the same estimated percentage of funds overall 
that would qualify as limited derivatives users--that approximately 19% 
of small funds that use derivatives (approximately 19 small funds) 
would comply with the proposed requirements for limited derivatives 
users under the proposed rule.\723\
---------------------------------------------------------------------------

    \721\ Id. This estimate excludes both: (1) Funds that would 
comply with the derivatives risk management program, and (2) funds 
that would be leveraged/inverse investment vehicles under proposed 
rule 15l-2. See also supra sections II.A.2, II.E, II.G, III.C.1, 
III.C.3, III.C.5, IV.B.4, and V.D.1.a.
    \722\ Id.; see also supra section III.C.3.
    \723\ Id.; see also supra sections III.C.3 and V.C. We estimate 
that there are 99 small funds that meet the small entity definition. 
See supra note 692 and accompanying text. 99 small entities x 19% = 
approximately 19 funds that are small entities.
---------------------------------------------------------------------------

d. Reverse Repurchase Agreements and Unfunded Commitment Agreements
    Proposed rule 18f-4 would permit a fund to engage in reverse 
repurchase agreements and other similar financing transactions so long 
as they are subject to the relevant asset coverage requirements of 
section 18.\724\ Because funds are required to rely on the asset 
segregation approach in Release 10666, the degree to which funds could 
engage in reverse repurchase agreements under the proposal would 
generally be the same as under current practice. Therefore we do not 
estimate a significant compliance burden--either for small funds that 
engage in reverse repurchase agreements or for larger funds--associated 
with the proposed provisions regarding reverse repurchase agreements in 
rule 18f-4.\725\ For large and small funds subject to the proposed 
limit on fund leverage risk, any portfolio leveraging effect of reverse 
repurchase agreements or similar financing transactions would be 
included and restricted through the proposed VaR-based limits, and 
therefore would incrementally affect the costs associated with 
complying with these limits.\726\
---------------------------------------------------------------------------

    \724\ See supra section II.I.
    \725\ See supra section III.C.4.
    \726\ See supra section II.I.
---------------------------------------------------------------------------

    The proposed rule also includes a provision that codifies an 
approach for funds' participation in unfunded commitment agreements in 
light of the concerns underlying section 18.\727\ Proposed rule 18f-4 
would permit a fund to enter into unfunded commitment agreements if it 
reasonably believes, at the time it enters into such agreement, that it 
will have sufficient cash and cash equivalents to meet its obligations 
with respect to all of its unfunded commitment agreements, in each case 
as they come due. The proposed rule would prescribe factors that a fund 
must consider in forming such a reasonable belief. If a fund enters 
into unfunded comment agreements in compliance with this requirement, 
the proposed rule specifies that unfunded commitment agreements will 
not be considered for purposes of computing asset coverage, as defined 
in section 18(h) of the Investment Company Act. This proposed approach 
for unfunded commitment agreements reflects the staff's experience in 
reviewing and commenting on fund registration statements, as discussed 
above.\728\ We therefore do not expect that the proposed approach would 
result in significant costs to small or large funds because we believe 
the proposed approach is generally consistent with the current 
practices of funds that enter into unfunded commitment agreements.
---------------------------------------------------------------------------

    \727\ See supra section II.J.
    \728\ See id.
---------------------------------------------------------------------------

e. Recordkeeping
    Proposed rule 18f-4 includes certain recordkeeping provisions that 
are designed to provide the Commission's staff, and the fund's board of 
directors and compliance personnel, the ability to evaluate the fund's 
compliance with the proposed rule's requirements.\729\ The proposed 
rule would require a fund to maintain certain records documenting its 
derivatives risk management program, including a written record of: (1) 
Its policies and procedures designed to manage the fund's derivatives 
risks, (2) the results of any stress testing of its portfolio, (3) the 
results of any VaR test backtesting it conducts, (4) records 
documenting any internal reporting or escalation of material risks 
under the program, and (5) records documenting any periodic reviews of 
the program.\730\
---------------------------------------------------------------------------

    \729\ See supra section II.K.
    \730\ See proposed rule 18f-4(c)(6)(i)(A).
---------------------------------------------------------------------------

    Second, the proposed rule would also require a fund to maintain a 
written record of any materials provided to the fund's board of 
directors in connection with approving the designation of the 
derivatives risk manager. The proposed rule would also require a fund 
to keep records of any written reports provided to the board of 
directors relating to the program, and any written reports provided to 
the board that the rule would require regarding the fund's non-
compliance with the applicable VaR test.\731\
---------------------------------------------------------------------------

    \731\ See proposed rule 18f-4(c)(6)(i)(B).
---------------------------------------------------------------------------

    Third, a fund that is required to comply with the proposed VaR test 
would also have to maintain written records documenting the 
determination of: Its portfolio VaR; the VaR of its designated 
reference index, as applicable; its VaR ratio (the value of the VaR of 
the Fund's portfolio divided by the VaR of the designated reference 
index), as applicable; and any updates to the VaR calculation models 
used by the fund, as well as the basis for any material changes made to 
those models.\732\
---------------------------------------------------------------------------

    \732\ See proposed rule 18f-4(c)(6)(i)(C).
---------------------------------------------------------------------------

    Fourth, the proposed rule would require a fund that is a limited 
derivatives user to maintain a written record of its policies and 
procedures that are reasonably designed to manage its derivatives 
risks.\733\
---------------------------------------------------------------------------

    \733\ See proposed rule 18f-4(c)(6)(i)(D).
---------------------------------------------------------------------------

    Finally, a fund that enters into unfunded commitment agreements 
would be required to maintain a records documenting the basis for the 
fund's belief regarding the sufficiency of its cash and cash 
equivalents to meet its obligations with respect to its unfunded 
commitment agreements.\734\ A record must be made each time a fund 
enters into such an agreement.\735\
---------------------------------------------------------------------------

    \734\ See proposed rule 18f-4e)(2); see also supra note 429 and 
accompanying text.
    \735\ Id.; see also supra note 430 and accompanying text.
---------------------------------------------------------------------------

    As discussed above, we estimate that the average one-time 
recordkeeping costs for funds that would not qualify as limited 
derivatives users would be $2,047 per fund, depending on the particular 
facts and circumstances and current derivatives risk management 
practices of the fund.\736\ We also

[[Page 4552]]

estimate that such a fund would incur an average ongoing annual 
recordkeeping costs of $330.\737\ We further estimate that the one-time 
and ongoing annual recordkeeping costs for a limited derivatives user 
to be 90% of those for funds that do not qualify as limited derivatives 
users.\738\ Thus, for each fund that could rely on the limited 
derivatives user exception, we estimate a one-time cost of $1,842 and 
an ongoing cost of $297 per year.\739\ To the extent that we estimate 
that small funds would be subject to the various provisions of the 
proposed rule that would necessitate recordkeeping requirements, as 
discussed above, these small funds also would be subject to the 
associated proposed recordkeeping requirements. Therefore, we estimate 
that: 22% of small funds (approximately 22 small funds) would have to 
comply with the program-related recordkeeping requirements and 
requirements regarding materials provided to the fund's board; 19% of 
small funds (approximately 19 small funds) would have to comply with 
requirements to maintain records of compliance with the proposed VaR 
test; and 19% of small funds (approximately 19 funds) would have to 
comply with the recordkeeping requirements for limited derivatives 
users.\740\
---------------------------------------------------------------------------

    \736\ See supra section III.C.8. This section, along with 
section IV.B.7, also discusses the professional skills that we 
believe compliance with this aspect of the proposal would entail.
    \737\ Id.
    \738\ Id.
    \739\ Id.
    \740\ See supra sections III.C.1, III.C.2, III.C.3, V.D.1.a, 
V.D.1.b, and V.D.1.c.
---------------------------------------------------------------------------

    A fund's recordkeeping-related costs will vary, depending on the 
provisions of proposed rule 18f-4 that the fund relies on. For example, 
funds that are required to adopt derivatives risk management programs, 
versus funds that are limited derivatives users under the proposed 
rule, would be subject to different recordkeeping requirements. 
However, while small funds' recordkeeping burdens would vary based on 
the provisions of the proposed rule that a fund relies on, their 
recordkeeping burdens would not vary solely because they are small 
funds. We do not anticipate that larger funds, or funds that are part 
of a large fund complex, would experience any significant economies of 
scale related to the proposed recordkeeping requirements.
2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
a. Proposed Amendments to Form N-PORT
    The proposed amendments to Form N-PORT would require funds to 
report information about their derivatives exposure, and also--as 
applicable for funds that are subject to the proposed rule 18f-4 VaR-
based limit on fund leverage risk--to report certain VaR-related 
information.\741\ These proposed amendments would provide market-wide 
insight into the levels of reporting funds' derivatives exposure to the 
Commission, its staff, and market participants at the specific points 
in time covered by the reporting. They also would help the Commission 
and its staff assess compliance with proposed rule 18f-4.
---------------------------------------------------------------------------

    \741\ See supra section II.H.1; see also proposed Items B.9 and 
B.10 of Form N-PORT.
---------------------------------------------------------------------------

    All funds that file Form N-PORT would have to provide information 
regarding their derivatives exposure on this form. We estimate that 41% 
of small funds that file Form N-PORT (approximately 34 small funds) use 
derivatives, and thus only these funds would have substantive 
information to report in response to this new exposure-related 
disclosure requirement.\742\
---------------------------------------------------------------------------

    \742\ See supra sections V.C, V.D.1.a, and V.D.1.c. Because BDCs 
do not file reports on Form N-PORT, we deduct the number of BDCs 
from the total number of small funds that we estimate (99 small 
funds-16 BDCs that are small entities = 83 small funds that file 
reports on Form N-PORT). See supra note 692 and accompanying text.
    We estimate that approximately 22% of funds would be subject to 
the proposed rule's derivatives risk management program requirements 
and approximately 19% of funds would be subject to either of the 
limited derivatives user exceptions, with funds from both groups 
subject to reporting requirements on Form N-PORT. See supra notes 
706, 720, and accompanying text. Although both of these estimated 
percentages include BDCs, we note that the total number of BDCs 
relative to the number of registered open- and closed-end funds is 
small, and therefore our estimates do not adjust these percentages 
to reflect the fact that BDCs do not file Forms N-PORT. See supra 
section III.B.1. Therefore, we estimate the total number of small 
funds subject to the proposed Form N-PORT requirements as follows: 
83 small funds that file reports on Form N-PORT x (22% + 19% = 41%) 
= 34 small funds.
---------------------------------------------------------------------------

    In addition, funds that are subject to the proposed limit on fund 
leverage risk would have to report: (1) The fund's highest daily VaR 
during the reporting period and its corresponding date; and (2) the 
fund's median daily VaR for the reporting period. Funds subject to the 
relative VaR test during the reporting period also would have to 
report: (1) The name of the fund's designated reference index, (2) the 
index identifier, (3) the fund's highest daily VaR ratio during the 
reporting period and its corresponding date; and (4) the fund's median 
daily VaR ratio for the reporting period. A fund would be required to 
determine its compliance with its applicable VaR test once each 
business day.\743\
---------------------------------------------------------------------------

    \743\ See supra note 364.
---------------------------------------------------------------------------

    All funds that are subject to the proposed limit on fund leverage 
risk also would have to report the number of exceptions that the fund 
identified as a result of the backtesting of its VaR calculation model. 
We estimate that 19% of small funds (approximately 16 small funds) 
would be subject to these VaR-related disclosure requirements.\744\
---------------------------------------------------------------------------

    \744\ We estimate 83 small funds that file reports on Form N-
PORT. See supra note 741.
     We estimate that approximately 19% of funds would be subject to 
the proposed limit on fund leverage risk. See supra note 712 and 
accompanying text. Although this estimated percentage include BDCs, 
we note that the total number of BDCs relative to the number of 
registered open- and closed-end funds is small, and therefore our 
estimate does not adjust this percentage to reflect the fact that 
BDCs do not file Forms N-PORT. See supra section III.B.1. Therefore, 
we estimate the total number of small funds that would make VaR-
related disclosures on Form N-PORT as follows: 83 small funds that 
file reports on Form N-PORT x 19% = approximately 16 small funds.
---------------------------------------------------------------------------

    We estimate that each fund that reports information in response to 
the proposed VaR-related disclosure requirements on Form N-PORT would 
incur a one-time cost of $2,784 and an ongoing cost of $4,176 per year, 
and each fund that is not subject to the VaR-related disclosure 
requirement would incur a one-time cost of $1,392 and an ongoing cost 
of $2,088 per year.\745\ Notwithstanding the economies of scale 
experienced by large versus small funds, we would not expect the costs 
of compliance associated with the new Form N-PORT requirements to be 
meaningfully different for small versus large funds. The costs of 
compliance would vary only based on fund characteristics tied to their 
derivatives use. For example, a fund that uses derivatives extensively 
would incur more costs to calculate its derivatives exposure than a 
fund that does not use derivatives extensively.\746\ And a fund that is 
a limited derivatives user, or that otherwise is not subject to the 
proposed VaR test, would not incur any costs to comply with the 
proposed new VaR-related N-PORT items.\747\
---------------------------------------------------------------------------

    \745\ See supra section III.C.9.a.; see also supra section IV.F 
(discussing the professional skills that we believe compliance with 
this aspect of the proposal would entail).
    \746\ See supra note 714.
    \747\ See proposed Item B.10 to Form N-PORT.
---------------------------------------------------------------------------

b. Proposed Amendments to Form N-LIQUID
    We are proposing to re-title Form N-LIQUID as Form N-RN, and amend 
this form to include new reporting events for funds that are subject to 
proposed rule 18f-4's limit on fund leverage risk.\748\ The proposed 
amendments would require funds subject to the limit on fund leverage 
risk to report information

[[Page 4553]]

about VaR test breaches under certain circumstances. These proposed 
current reporting requirements are designed to aid the Commission in 
assessing funds' compliance with the VaR tests, and to provide staff 
the ability to assess how long a fund is precluded from entering into 
derivatives transactions as a consequence of its lack of compliance 
with its VaR test. We are proposing to require funds to provide this 
information in a current report because we believe that the Commission 
should be notified promptly when a fund is out of compliance with the 
proposed VaR-based limit on fund leverage risk (and also when it has 
come back into compliance with its applicable VaR test). We believe 
this information could indicate that a fund is experiencing heightened 
risks as a result of a fund's use of derivatives transactions, as well 
as provide the Commission insight about the duration and severity of 
those risks, and whether those heightened risks are fund-specific or 
industry-wide.
---------------------------------------------------------------------------

    \748\ See supra section II.H.2.
---------------------------------------------------------------------------

    As discussed above, we estimate that each fund subject to the 
proposed new current reporting requirements would incur an average cost 
of $10 per year to prepare amended Form N-RN.\749\ We estimate that 
approximately 19 registered open- and closed-end funds, and BDCs, are 
small entities that would be required to report VaR test related 
information on Form N-RN.\750\ Because the proposed amendments to Form 
N-RN would require both large and small funds to report VaR test 
breaches, the burden to report is not associated with fund size, and 
consequently, we would not expect the costs of compliance with the new 
Form N-RN requirements to be meaningfully different for small versus 
large funds.
---------------------------------------------------------------------------

    \749\ See supra section III.C.9.b; see also supra section IV.G 
(discussing the professional skills that we believe compliance with 
this aspect of the proposal would entail).
    \750\ This estimate is based on an estimate that 16 small 
registered open- and closed-end funds would make VaR-related 
disclosures on Form N-PORT (see supra note 743 and accompanying 
text), plus 3 BDCs (16 total small BDCs (see supra note 692 and 
accompanying text) x 19% (our estimate of the percentage of funds 
subject to a VaR-based limit on fund leverage risk, see supra note 
712 and accompanying text) = approximately 3 BDCs). Thus, 16 small 
registered open- and closed-end funds + 3 BDCs = 19 funds.
---------------------------------------------------------------------------

c. Proposed Amendments to Form N-CEN
    The proposed amendments to Form N-CEN would require a fund to 
identify whether it relied on proposed rule 18f-4 during the reporting 
period.\751\ The proposed amendments also would require a fund to 
identify whether it relied on any of the exemptions from various 
requirements under the proposed rule, specifically: (1) Whether the 
fund is a limited derivatives user excepted from the proposed rule's 
program requirement, under either of the proposed exception's 
alternatives (either a funds that limits its derivatives exposure to 
10% of its net assets, or a fund that uses derivatives transactions 
solely to hedge certain currency risks); or (2) whether it is a 
leveraged/inverse fund covered by the proposed sales practices rules 
that, under proposed rule 18f-4, would be excepted from the proposed 
limit on fund leverage risk. Finally, a fund would have to identify 
whether it has entered into reverse repurchase agreements or similar 
financing transactions, or unfunded commitment agreements, as provided 
under the proposed rule.\752\ The proposed amendments to Form N-CEN are 
designed to assist the Commission and staff with our oversight 
functions by allowing us to identify which funds were excepted from 
certain of the proposed rule's provisions or relied on the rule's 
provisions regarding reverse repurchase agreements and unfunded 
commitment agreements.
---------------------------------------------------------------------------

    \751\ See supra section II.H.3.
    \752\ See proposed Item C.7.l.iv-v of Form N-CEN; see also supra 
section II.I and II.J; proposed rule 18f-4(d); and proposed rule 
18f-4(e).
---------------------------------------------------------------------------

    As discussed above, we estimate that each fund subject to the 
proposed new Form N-CEN reporting requirements would incur on average 
an ongoing annual cost of $6.96 per year.\753\ We estimate that 
approximately 34 registered open- and closed-end funds are small 
entities that would be subject to the proposed new Form N-CEN reporting 
requirements.\754\ Notwithstanding any economies of scale experienced 
by large versus small funds, we would not expect the costs of 
compliance with the new Form N-CEN requirements to be meaningfully 
different for small versus large funds.
---------------------------------------------------------------------------

    \753\ See supra section III.C.9.a; see also supra section IV.H 
(discussing the professional skills that we believe compliance with 
this aspect of the proposal would entail).
    \754\ Because BDCs do not file reports on Form N-CEN, we deduct 
the number of BDCs from the total number of small funds that we 
estimate (99 small funds - 16 BDCs that are small entities = 83 
small funds that file reports on Form N-CEN). See supra note 692 and 
accompanying text.
    The estimate of 34 funds is based on the percentage of funds we 
believe would be subject to the proposed derivatives risk management 
program requirement (22% of funds, see supra note 498 and 
accompanying text) plus the percentage of funds we believe would 
qualify as limited derivatives users (19% of funds, see supra note 
720 and accompanying text). We estimate that 83 small funds that 
file reports on Form N-CEN (99 total small funds less 16 small BDCs) 
x 41% (22% + 19%) = 34 small funds subject to the proposed Form N-
CEN reporting requirements. To the extent that there are funds that 
either (1) would not adopt a derivatives risk management program or 
(2) would not qualify as limited derivatives user, but that would 
rely on the rule's provisions with respect to reverse repurchase 
agreements or unfunded commitment agreements, this analysis might 
underestimate the number of funds that would be subject to the new 
Form N-CEN reporting requirements.
---------------------------------------------------------------------------

3. Proposed Sales Practices Rules
    The proposed sales practices rules under the Exchange Act and the 
Advisers Act would require a firm to exercise due diligence in 
determining whether to approve the account of a retail investor to buy 
or sell shares of a leveraged/inverse investment vehicle before 
accepting an order from, or placing an order for, the retail investor 
to engage in these transactions.\755\ Under the proposed sales 
practices rules, no firm may accept an order from or place an order for 
a retail investor to buy or sell shares of a leveraged/inverse 
investment vehicle, or approve such an investor's account to engage in 
those transactions, unless the firm has complied with certain 
conditions.
---------------------------------------------------------------------------

    \755\ See supra section II.G.1.
---------------------------------------------------------------------------

    Specifically, the proposed sales practices rules would require the 
firm to: (1) Approve the retail investor's account for buying and 
selling shares of leveraged/inverse investment vehicles pursuant to a 
due diligence requirement; and (2) adopt and implement policies and 
procedures reasonably designed to achieve compliance with the proposed 
rules.\756\ The proposed sales practices rules' due diligence 
requirements provide that a firm must exercise due diligence to 
ascertain the essential facts relative to the retail investor, his or 
her financial situation, and investment objectives. A firm must seek to 
obtain, at a minimum, certain specified information about the retail 
investor. The proposed sales practices rules also include recordkeeping 
requirements relating to the information that the firm obtained through 
its due diligence, the firm's approval or disapproval of the retail 
investor's account for buying and selling shares of leveraged/inverse 
investment vehicles (account approvals must be in writing), and the 
firm's policies and procedures that it adopted pursuant to those 
rules.\757\
---------------------------------------------------------------------------

    \756\ See supra section II.G.2.b.
    \757\ See supra section II.G.2.c.
---------------------------------------------------------------------------

    The proposed sales practices rules are designed to establish a 
uniform set of enhanced due diligence and account approval requirements 
for all leveraged/inverse investment vehicle transactions, including 
transactions where no recommendation or investment advice is provided 
by a firm. They also are designed in part to help to ensure that

[[Page 4554]]

investors in these funds are limited to those who understand their 
characteristics--including that these funds would not be subject to all 
of the leverage-related requirements applicable to registered 
investment companies generally--and the unique risks they present.
    As discussed above, we estimate that each broker-dealer subject to 
proposed rule 15l-2, and each investment adviser subject to proposed 
rule 211(h)-1, would incur total one-time costs that would range from 
$9,115.50 to $15,192.50 to comply with the proposed rules, and total 
ongoing costs that would range from $2,270.50 to $3,915 per year to 
comply with the proposed rules.\758\ We estimate that approximately 236 
broker-dealers and 43 registered investment advisers are small entities 
that would be subject to the proposed sales practices rules.\759\
---------------------------------------------------------------------------

    \758\ See supra notes 539 and 543 and accompanying text. This 
discussion, along with sections IV.C and IV.D supra, also discusses 
the professional skills that we believe compliance with this aspect 
of the proposal would entail.
    \759\ We estimate there are currently 942 small broker-dealers. 
See supra note 694 and accompanying text. We further estimate that 
700 broker-dealers (or 25% of all 2,766 broker-dealers registered 
with the Commission) have retail customer accounts that invest in 
leveraged/inverse investment vehicles. See supra section III.C.5. 
Our estimate of 236 broker-dealers is based on the following 
calculation: 942 small broker dealers x 25% = approximately 236 
small broker-dealers that have retail customer accounts that invest 
in leveraged/inverse investment vehicles.
    We estimate that there are currently 470 SEC-registered 
investment advisers that are small entities. See supra note 697 and 
accompanying text. Of these, we estimate that 171 provide advice to 
individual clients, and could therefore be subject to the proposed 
new sales practices rules under the Advisers Act. See supra note 698 
and accompanying text. We further estimate that 2,000 investment 
advisers (or approximately 25% of the 8,235 investment advisers that 
are registered with the Commission and offer some part of their 
business to retail investors) have retail client accounts that 
invest in leveraged/inverse investment vehicles. See supra sections 
III.C.5 and IV.D. Our estimate of 43 investment advisers is based on 
the following calculation: 171 small investment advisers that 
provide advice to individual clients x 25% = approximately 43 small 
investment advisers that have retail client accounts that invest in 
leveraged/inverse investment vehicles.
---------------------------------------------------------------------------

    The costs that broker-dealers and investment advisers may incur as 
a result of the proposed sales practices rules would vary depending on 
the firm and the due diligence requirements that the firm adopts as a 
result of the proposed rules' requirements.\760\ We expect that 
economies of scale among larger firms could result in cost reductions 
for larger firms. Compliance costs could, however, be different across 
firms with relatively smaller or larger numbers of retail investors as 
customers or clients.\761\
---------------------------------------------------------------------------

    \760\ See supra section III.C.5 (discussing costs and benefits 
of proposed sales practices rules).
    \761\ See supra section II.G.2.b (discussing required approval 
and due diligence for retail investors' accounts to trade shares of 
leveraged/inverse investment vehicles under the proposed sales 
practices rules).
---------------------------------------------------------------------------

4. Proposed Amendments to Rule 6c-11
    We are proposing to amend rule 6c-11 to remove the provision 
excluding leveraged/inverse ETFs from the scope of that rule and to 
newly permit leveraged/inverse ETFs to rely on that rule.\762\ Rule 6c-
11 permits ETFs that satisfy certain conditions to operate without 
obtaining an exemptive order from the Commission.\763\ The rule is 
designed to create a consistent, transparent, and efficient regulatory 
framework for such ETFs and facilitate greater competition and 
innovation among ETFs. As a consequence of our proposed amendment to 
rule 6c-11, and proposal to rescind the exemptive orders we have 
previously issued to leveraged/inverse ETFs, these proposed amendments 
would newly permit leveraged/inverse ETFs to come within scope of the 
rule's exemptive relief.
---------------------------------------------------------------------------

    \762\ See supra section II.G.4.
    \763\ Id.
---------------------------------------------------------------------------

    Currently, there are 73 leveraged/inverse ETFs.\764\ As a result of 
the proposed amendments, we would expect the number of funds relying on 
rule 6c-11 to increase, and we estimate that all 73 leveraged/inverse 
ETFs would newly seek to use rule 6c-11. We also estimate, for purposes 
of this Regulatory Flexibility Act analysis, that approximately 1 of 
these leveraged/inverse ETFs would be a small leveraged/inverse ETF 
that would seek to rely on rule 6c-11.\765\ We do not estimate our 
amendments to rule 6c-11 would change the estimated per-fund cost 
burden associated with rule 6c-11, but we do believe the number of 
funds using the rule, as a result of our amendment, would now 
increase.\766\ The costs associated with complying with rule 6c-11 are 
discussed in the ETFs Adopting Release.\767\
---------------------------------------------------------------------------

    \764\ See supra note 467.
    \765\ This estimate is based on the following calculation: 8 
small ETFs/1,190 total ETFs = approximately 0.67% of ETFs that are 
small ETFs. See supra sections III.B.1 and V.C. 0.67% of 73 
leveraged/inverse ETFs = approximately 1 leveraged/inverse ETF.
    \766\ See supra section IV.E.
    \767\ See ETFs Adopting Release, supra note 76, at section IV.
---------------------------------------------------------------------------

E. Duplicative, Overlapping, or Conflicting Federal Rules

    Commission staff has not identified any federal rules that 
duplicate, overlap, or conflict with proposed Investment Company Act 
rule 18f-4, proposed Exchange Act rule 15l-2, proposed Advisers Act 
rule 211(h)-1, or the proposed amendments to Form N-PORT, Form N-
LIQUID, and Form N-CEN.
    We recognize that other broker-dealer or investment adviser 
obligations require these entities to engage in due diligence with 
respect to transactions they recommend to customers or clients. The 
proposed sales practices rules, in contrast, would apply regardless of 
whether a broker-dealer or investment adviser recommends that a 
customer or client buy or sell leveraged/inverse investment vehicles. 
We therefore do not believe that the sales practices rules would 
conflict with existing broker-dealer or investment adviser obligations, 
and believe that any overlap or duplication should be limited because a 
broker-dealer or investment adviser could consider the information it 
collects in connection with the sales practices rules in connection 
with the due diligence the broker-dealer or investment adviser conducts 
in connection with other, existing obligations for recommended 
transactions.

F. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish our stated objectives, 
while minimizing any significant economic impact on small entities. We 
considered the following alternatives for small entities in relation to 
our proposal: (1) Exempting funds, broker-dealers, and registered 
investment advisers that are small entities from the proposed 
reporting, recordkeeping, and other compliance requirements, to account 
for resources available to small entities; (2) establishing different 
reporting, recordkeeping, and other compliance requirements or 
frequency, to account for resources available to small entities; (3) 
clarifying, consolidating, or simplifying the compliance requirements 
under the proposal for small entities; and (4) using performance rather 
than design standards.
1. Proposed Rule 18f-4
    We do not believe that exempting small funds from the provisions in 
proposed rule 18f-4 would permit us to achieve our stated objectives. 
Because proposed rule 18f-4 is an exemptive rule, it would require 
funds to comply with new requirements only if they wish to enter into 
derivatives or certain other transactions.\768\ Therefore, if a

[[Page 4555]]

small entity does not enter into derivatives or such other transactions 
as part of its investment strategy, then the small entity would not be 
subject to the provisions of proposed rule 18f-4. In addition, a small 
fund whose derivatives use is limited could benefit from the proposed 
limited derivatives user exception, because it would not be required to 
adopt a derivatives risk management program (including all of the 
proposed program elements).
---------------------------------------------------------------------------

    \768\ See supra sections II.D.6 and III.E.
---------------------------------------------------------------------------

    We estimate that 59% of all funds do not have any exposure to 
derivatives or such other transactions.\769\ This estimate indicates 
that many funds, including many small funds, would be unaffected by the 
proposed rule. However, for small funds that would be affected by our 
proposed rule, providing an exemption for them could subject investors 
in small funds that invest in derivatives or engage in such other 
transactions to a higher degree of risk than investors to large funds 
that would be required to comply with the proposed elements of the 
rule.
---------------------------------------------------------------------------

    \769\ See supra note 458 and accompanying paragraph.
---------------------------------------------------------------------------

    The undue speculation concern expressed in section 1(b)(7) of the 
Investment Company Act, and the asset sufficiency concern reflected in 
section 1(b)(8) of the Act--both of which the proposed rule is designed 
to address--apply to both small as well as large funds. As discussed 
throughout this release, we believe that the proposed rule would result 
in investor protection benefits, and these benefits should apply to 
investors in smaller funds as well as investors in larger funds. We 
therefore do not believe it would be appropriate to exempt small funds 
from the proposed rule's program requirement or VaR-based limit on fund 
leverage risk, or to establish different requirements applicable to 
funds of different sizes under these provisions to account for 
resources available to small entities. We believe that all of the 
proposed elements of rule 18f-4 should work together to produce the 
anticipated investor protection benefits, and therefore do not believe 
it is appropriate to except smaller funds because we believe this would 
limit the benefits to investors in such funds.
    We also do not believe that it would be appropriate to subject 
small funds to different reporting, recordkeeping, and other compliance 
requirements or frequency. Similar to the concerns discussed above, if 
the proposal included different requirements for small funds, it could 
raise investor protection concerns for investors in small funds 
including subjecting small fund investors to a higher degree of risk if 
the small fund uses derivatives transactions. We also believe that all 
fund investors will benefit from enhanced Commission monitoring and 
oversight of the fund industry, which we anticipate will result from 
the disclosure and reporting requirements.
    We do not believe that clarifying, consolidating, or simplifying 
the compliance requirements under the proposal for small funds would 
permit us to achieve our stated objectives. Again, this approach would 
raise investor protection concerns for investors in small funds using 
derivatives transactions. However, as discussed above, the proposed 
rule contains an exception for limited derivatives users that we 
anticipate would subject funds that qualify for this exception to fewer 
compliance burdens. We recognize that the risks and potential impact of 
derivatives transactions on a fund's portfolio generally increase as 
the fund's level of derivatives usage increases and when funds use 
derivatives for speculative purposes. Therefore the proposed rule would 
entail a less significant compliance burden for funds--including small 
funds--that choose to limit their derivatives usage in the manner that 
the proposed exception specifies. The proposal, therefore, does include 
provisions designed to consider the requirement burdens based on the 
fund's use of derivatives (rather than the size of the fund).
    The costs associated with proposed rule 18f-4 would vary depending 
on the fund's particular circumstances, and thus the proposed rule 
could result in different burdens on funds' resources. In particular, 
we expect that a fund that pursues an investment strategy that involves 
greater derivatives risk may have greater costs associated with its 
derivatives risk management program. For example, a fund that qualifies 
as a limited derivatives user under the proposed rule would be exempt 
from the proposed requirements to adopt and implement a derivatives 
risk management program, and to adhere to the proposed rule's VaR-based 
limit on fund leverage risk. The costs of compliance with the proposed 
rule would vary even for limited derivatives users, as these funds 
would be required to adopt policies and procedures that are 
``reasonably designed'' to manage their derivatives risks. Thus, to the 
extent a fund that is a small entity faces relatively little 
derivatives risk, we believe it would incur relatively low costs to 
comply with the proposed rule. However, we believe that it is 
appropriate to correlate the costs associated with the proposed rule 
with the level of derivatives risk facing a fund, and not necessarily 
with the fund's size in light of our investor protection objectives.
    Finally, with respect to the use of performance rather than design 
standards, the proposed rule generally uses performance standards for 
all funds relying on the proposed rule, regardless of size. We believe 
that providing funds with the flexibility with respect to investment 
strategies and use of derivatives transactions is appropriate, as well 
as the derivatives risk management program design. However, the 
proposed rule also uses design standards with respect to certain 
requirements such as complying with the VaR-based limit on fund 
leverage risk and the specified program elements in the derivatives 
risk management program. For the reasons discussed above, we believe 
that this use of design standards is appropriate to address investor 
protection concerns, particularly the concerns expressed in sections 
1(b)(7), 1(b)(8), and 18 of the Investment Company Act.
2. Proposed Sales Practices Rules
    Similarly, we do not believe that exempting any subset of broker-
dealers or registered investment advisers, including those firms that 
are small entities, from the provisions in the proposed sales practices 
rules would permit us to achieve our stated investor protection 
objectives. We also do not believe that it would be desirable to 
establish different requirements applicable to firms of different sizes 
under the proposed sales practices rules to account for resources 
available to small entities, to consolidate or simplify the compliance 
requirements under the proposal for small entities, or to use 
performance standards rather than design standards for small entities.
    We do not believe exempting small broker-dealers and investment 
advisers from the proposed sales practices rules would serve the 
interest of investors. As we discussed above, leveraged/inverse 
investment vehicles present unique considerations, and the proposed 
sales practices rules are designed in part to address the investor 
protection concerns leveraged/inverse funds present.\770\ The proposed 
sales practices rules would permit broker-dealers and investment 
advisers to accept or place orders to buy or sell shares of a 
``leveraged/inverse investment vehicle'' only for investors that they 
have approved for those transactions, based on certain required

[[Page 4556]]

criteria.\771\ Exempting smaller broker-dealer and investment adviser 
firms would create a regulatory gap, whereby larger funds would be 
required to comply with the proposed sales practices rules' due 
diligence requirements to determine whether to approve the account of 
retail investor to buy or sell shares of a leveraged/inverse investment 
vehicle, and small entities would not need to conduct this same 
diligence.
---------------------------------------------------------------------------

    \770\ See supra section II.G.
    \771\ See proposed rule 15l-2(b).
---------------------------------------------------------------------------

    As discussed above, we believe that this limitation on leveraged/
inverse investment vehicles' investor base would help provide that 
investors in these vehicles understand the characteristics of these 
vehicles and the unique risks they present.\772\ Providing different 
requirements or simplifying the requirements for small entities would 
dilute these investor protection benefits for customers or clients of 
small entities. We do not believe that the investor protection benefits 
of the proposed sales practices rules should depend on whether an 
investor is transacting through a small or a large firm. Furthermore, a 
broker-dealer or investment adviser would have to comply with the 
applicable proposed rule's requirements only if it transacts with 
retail investors in the shares of leveraged/inverse investment 
vehicles.\773\
---------------------------------------------------------------------------

    \772\ See supra section II.G.
    \773\ We estimate that approximately 236 broker-dealers and 43 
registered investment advisers are small entities that would be 
subject to the proposed sales practices rules. See supra note 758 
and accompanying text.
     Broker-dealers and investment advisers that would have to 
comply with the proposed sales practices rules also might currently 
have processes in place that would provide efficiencies in complying 
with the proposed rules. See supra note 536 and accompanying text.
---------------------------------------------------------------------------

    Finally, we are not proposing performance standards rather than 
design standards for smaller entities. We believe that subjecting 
smaller entities to different standards under the proposed rules could 
lead to inconsistency in how investors would transact in leveraged/
inverse investment vehicles, depending on whether the investor has a 
relationship with a large or small broker-dealer or investment adviser. 
This would be inconsistent with the regulatory and investor protections 
purposes of the proposed rules and could subject investors who interact 
with small firms to a higher degree of risk than investors who interact 
with larger firms. It could also circumvent the proposed rules' ability 
to establish a uniform set of enhanced due diligence and approval 
requirements for all leveraged/inverse investment vehicle transactions, 
and to address the investor protection concerns underlying section 18 
for leveraged/inverse funds by limiting their investor base.
3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
    We do not believe that the interests of investors would be served 
by exempting funds that are small entities from the proposed disclosure 
and reporting requirements. We believe that the form amendments are 
necessary to help identify and provide the Commission, staff, 
investors, and other market participants timely information about funds 
that comply with proposed rule 18f-4, and to realize the anticipated 
benefits of the proposed reporting requirements.\774\ Exempting small 
funds from coverage under all or any part of the proposed form 
amendments could compromise the effectiveness of the required 
disclosures, which the Commission believes would not be consistent with 
its goals of industry oversight and investor protection. We believe 
that all fund investors, including investors in small funds, would 
benefit from disclosure and reporting requirements that would permit 
them to make investment choices that better match their risk 
tolerances. We also believe that all fund investors would benefit from 
enhanced Commission monitoring and oversight of the fund industry, 
which we anticipate would result from the proposed disclosure and 
reporting requirements.
---------------------------------------------------------------------------

    \774\ See supra section III.C.9.
---------------------------------------------------------------------------

    For similar reasons, we do not believe that the interests of 
investors would be served by establishing different reporting, 
recordkeeping, or other compliance requirements for small funds. We 
considered providing small funds simplified compliance or disclosure 
requirements. However, we believe this too would subject investors in 
small funds that invest in derivatives to a higher degree of risk and 
information asymmetry than investors to large funds that would be 
required to comply with the proposed disclosure requirements. We also 
note that registered open- and closed-end management investment 
companies, including those that are small entities, have already 
updated their systems and have established internal processes to 
prepare, validate, and file reports on Forms N-PORT and N-CEN (or will 
do so shortly).\775\ For funds that will be required to file reports on 
Form N-RN, the vast majority of them are open-end funds, which already 
are required to submit the form upon specified events. With respect to 
the additional registered closed-end funds and BDCs newly required to 
file reports on Form N-RN, we do not believe they would need more time 
to comply with the new reporting requirements, given the limited set of 
reporting requirements they would be subject to and the relatively low 
burden we estimate of filing reports on Form N-RN.
---------------------------------------------------------------------------

    \775\ See supra note 359 (discussing, among other things, Form 
N-PORT compliance dates and noting that the funds that would rely on 
proposed rule 18f-4 (if adopted) other than BDCs generally are 
subject to reporting requirements on Form N-CEN); see also 
Investment Report Modernization Adopting Release supra note 178, at 
section II.H.
---------------------------------------------------------------------------

    We also do not believe that the interests of investors would be 
served by clarifying, consolidating, or simplifying the compliance 
requirements under the proposal for small funds. Small funds are as 
vulnerable to the same potential risks associated with their 
derivatives use as larger funds are, and therefore we believe that 
simplifying or consolidating the proposed reporting requirements for 
small funds would not allow us to meet our stated objectives. Moreover, 
we believe many of the proposed disclosure requirements involve minimal 
burden. For example, the Form N-CEN ``checking a box'' reporting 
requirement is completed on an annual basis.
    Finally, we did not prescribe performance standards rather than 
design standards for small funds because we believe this too could 
diminish the ability of the proposed rules to achieve their intended 
regulatory purpose by creating inconsistent reporting requirements 
between small and large funds, and weakening the benefits of the 
proposed reporting requirement for investors in small funds.
4. Rule 6c-11
    Rule 6c-11 is designed to modernize the regulatory framework for 
ETFs and to create a consistent, transparent, and efficient regulatory 
framework.\776\ The Commission's full Regulatory Flexibility Act 
Analysis regarding rule 6c-11, including analysis of significant 
alternatives, appears in the 2019 ETFs Adopting Release and the 2018 
ETFs Proposing Release.\777\ Our analysis of alternatives for small 
leveraged/inverse ETFs here is consistent with the Commission's 
analysis of alternatives for small ETFs in those releases.
---------------------------------------------------------------------------

    \776\ See ETFs Adopting Release, supra note 76, at section I.
    \777\ See id. at section VI; see also Exchange-Traded Funds, 
Investment Company Act Release No. 10515 (June 28, 2018) [83 FR 
37332 (July 31, 2018)] (``ETFs Proposing Release''), at section V.

---------------------------------------------------------------------------

[[Page 4557]]

    We do not believe that permitting or requiring different treatment 
for any subset of leveraged/inverse ETFs, including small leveraged/
inverse ETFs, under the proposed amendments to rule 6c-11, and the 
rule's related recordkeeping, disclosure and reporting requirements, 
would permit us to achieve our stated objectives. Similarly, we do not 
believe that we can establish simplified or consolidated compliance 
requirements for small leveraged/inverse ETFs under the proposed 
amendments to rule 6c-11 without compromising our objectives. The 
Commission discussed the bases for this determination (with respect to 
ETFs other than leveraged/inverse ETFs) in more detail in the ETFs 
Proposing Release and the ETFs Adopting Release, and we are extending 
that analysis to leveraged/inverse ETFs in this Initial Regulatory 
Flexibility Act Analysis. In addition, we do not believe it would be 
appropriate to exempt small leveraged/inverse ETFs from the proposed 
amendments to rule 6c-11 (or to establish different disclosure, 
reporting, or recordkeeping requirements, or simplified or consolidated 
compliance requirements under rule 6c-11 for these entities) because of 
the particular risks that leveraged/inverse ETFs may present.\778\ We 
also do not think it would be appropriate to establish different 
requirements under rule 6c-11 for small leveraged/inverse ETFs, which 
could produce a competitive advantage for these funds compared to 
larger leveraged/inverse ETFs (and compared to other ETFs that rely on 
the rule). This would conflict with our goals of creating a consistent, 
transparent, and efficient regulatory framework for ETFs and to 
facilitate greater competition and innovation among ETFs.
---------------------------------------------------------------------------

    \778\ See supra section II.G.1.
---------------------------------------------------------------------------

G. Request for Comment

    The Commission requests comments regarding this analysis. We 
request comment on the number of small entities that would be subject 
to our proposal and whether our proposal would have any effects that 
have not been discussed. We request that commenters describe the nature 
of any effects on small entities subject to our proposal and provide 
empirical data to support the nature and extent of such effects. We 
also request comment on the estimated compliance burdens of our 
proposal and how they would affect small entities.

VI. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996 (``SBREFA''), the Commission must advise OMB whether a 
proposed regulation constitutes a ``major'' rule. Under SBREFA, a rule 
is considered ``major'' where, if adopted, it results in or is likely 
to result in:
     An annual effect on the economy of $100 million or more;
     A major increase in costs or prices for consumers or 
individual industries; or
     Significant adverse effects on competition, investment, or 
innovation.
    We request comment on whether our proposal would be a ``major 
rule'' for purposes of SBREFA. We solicit comment and empirical data 
on:
     The potential effect on the U.S. economy on an annual 
basis;
     Any potential increase in costs or prices for consumers or 
individual industries; and
     Any potential effect on competition, investment, or 
innovation.
    Commenters are requested to provide empirical data and other 
factual support for their views to the extent possible.

VII. Statutory Authority

    The Commission is proposing new rule 18f-4 under the authority set 
forth in sections 6(c), 12(a), 18, 31(a), 38(a), and 61 of the 
Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-12(a), 80a-18, 
80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing 
amendments to rule 6c-11 under the authority set forth in sections 
6(c), 22(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a-
6(c), 22(c), and 80a-37(a)]. The Commission is proposing new rule 15l-2 
under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 
17, 23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C. 
78c, 78c(b), 78c-5, 78j, 78o(l), 78o-10, 78q, 78w(a), and 78mm]. The 
Commission is proposing new rule 211(h)-1 under the authority set forth 
in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment 
Advisers Act of 1940 [15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and 
80b-11(h)]. The Commission is proposing amendments to Form N-PORT, Form 
N-LIQUID (which we propose to re-title as ``Form N-RN''), Form N-CEN, 
and Form N-2 under the authority set forth in sections 8, 18, 30, and 
38 of the Investment Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 80a-
29, 80a-37, 80a-63], sections 6, 7(a), 10 and 19(a) of the Securities 
Act of 1933 [15 U.S.C. 77f, 77g(a), 77j, 77s(a)], and sections 10, 13, 
15, 23, and 35A of the Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and 
78ll].

Text of Rules and Forms

List of Subjects

17 CFR Parts 240 and 249

    Brokers, Fraud, Reporting and recordkeeping requirements, 
Securities.

17 CFR Parts 270 and 274

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

17 CFR Part 275

    Reporting and recordkeeping requirements, Securities.

    For the reasons set out in the preamble, title 17, chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:
* * * * *

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

0
1. The authority citation for part 240 is amended by adding a 
subauthority for Section 240.15l-2 to read as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f, 
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4, 
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm, 
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et 
seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 
1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-
106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted.
* * * * *
    Section 240.15l-2 is also issued under Pub. L. 111-203, sec. 
913, 124 Stat. 1376, 1827 (2010).
* * * * *
0
2. Section 240-15l-2 is added to read as follows:


Sec.  240.15l-2   Broker and dealer sales practices for leveraged/
inverse investment vehicles.

    (a) Required approval of customer account. No broker or dealer 
registered or required to be registered under the Securities Exchange 
Act of 1934, or any associated person of the broker or dealer, may 
accept an order from a customer that is a natural person (or the legal 
representative of a natural person) to buy or sell shares of a 
leveraged/inverse investment vehicle unless the broker or dealer has 
approved such a customer's account to engage in those transactions and 
has adopted and implemented policies and procedures reasonably designed 
to achieve compliance with this section. Any

[[Page 4558]]

approval of a customer's account for buying or selling leveraged/
inverse investment vehicles must be effected as provided in paragraph 
(b).
    (b) Diligence in approving accounts. (1) In determining whether to 
approve a customer's account to buy or sell leveraged/inverse 
investment vehicles, the broker or dealer must exercise due diligence 
to ascertain the essential facts relative to the customer, his or her 
financial situation, and investment objectives, including, at a 
minimum, the information specified in paragraph (b)(2) of this section 
(and must seek to obtain information for all participants in a joint 
account). Based upon this information, the broker or dealer must 
specifically approve or disapprove the customer's account for buying 
and selling shares of leveraged/inverse investment vehicles. An 
approval of a customer account must be in writing. A broker or dealer 
may provide this approval if the broker or dealer has a reasonable 
basis for believing that the customer has such knowledge and experience 
in financial matters that he or she may reasonably be expected to be 
capable of evaluating the risks of buying and selling leveraged/inverse 
investment vehicles.
    (2) A broker or dealer must seek to obtain the following 
information at a minimum regarding the customer:
    (i) Investment objectives (e.g., safety of principal, income, 
growth, trading profits, speculation) and time horizon;
    (ii) Employment status (name of employer, self-employed or 
retired);
    (iii) Estimated annual income from all sources;
    (iv) Estimated net worth (exclusive of family residence);
    (v) Estimated liquid net worth (cash, liquid securities, other);
    (vi) Percentage of the customer's estimated liquid net worth that 
he or she intends to invest in leveraged/inverse investment vehicles; 
and
    (vii) Investment experience and knowledge (e.g., number of years, 
size, frequency and type of transactions) regarding leveraged/inverse 
investment vehicles, options, stocks and bonds, commodities, and other 
financial instruments.
    (c) Recordkeeping. A broker or dealer must maintain a written 
record of the information that it obtained under paragraph (b) of this 
section and, if applicable, its written approval of the customer's 
account, as well as the versions of the firm's policies and procedures 
required under paragraph (a) that were in place when it approved or 
disapproved the customer's account, for a period of not less than six 
years (the first two years in an easily accessible place) after the 
date of the closing of the customer's account.
    (d) Definitions. For purposes of this section:
    Associated person of the broker dealer means any partner, officer, 
director, or branch manager of such broker or dealer (or any person 
occupying a similar status or performing similar functions), any person 
directly or indirectly controlling, controlled by, or under common 
control with such broker or dealer, or any employee of such broker or 
dealer, except that any person associated with a broker or dealer whose 
functions are solely clerical or ministerial shall not be included in 
the meaning of such term for purposes of section 15(b) of the Exchange 
Act (other than paragraph (6) thereof).
    Commodity- or Currency-Based Trust or Fund means a trust or other 
person:
    (1) Issuing securities in an offering registered under the 
Securities Act of 1933 (15 U.S.C. 77a et seq.) and which class of 
securities is listed for trading on a national securities exchange;
    (2) The assets of which consist primarily of derivative instruments 
that reference commodities or currencies, or interests in the 
foregoing; and
    (3) That provides in its registration statement under the 
Securities Act of 1933 (15 U.S.C. 77a et seq.) that a class of its 
securities are purchased or redeemed, subject to conditions or 
limitations, for a ratable share of its assets.
    Leveraged/inverse investment vehicle means a registered investment 
company (including any separate series thereof), or commodity- or 
currency-based trust or fund, that seeks, directly or indirectly, to 
provide investment returns that correspond to the performance of a 
market index by a specified multiple, or to provide investment returns 
that have an inverse relationship to the performance of a market index, 
over a predetermined period of time.
    (e) Transition. This section applies to all customers of the broker 
or dealer, including customers who have opened accounts with the broker 
or dealer before the compliance date for this section, provided that 
this section does not apply to, and therefore will not restrict a 
customer's ability to close or reduce, a position in a leveraged/
inverse investment vehicle that a customer established before the 
compliance date of this section.

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

0
3. The authority citation for part 270 continues to read, in part, as 
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39, 
and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless 
otherwise noted.
* * * * *
    Section 270.6c-11 is also issued under 15 U.S.C. 80a-6(c) and 
80a-37(a).
* * * * *


Sec.  270.6c-11   [Amended]

0
4. Amend Sec.  270.6c-11 by removing paragraph (c)(4).
0
5. Section 270.18f-4 is added to read as follows:


Sec.  270.18f-4  Exemption from the requirements of section 18 and 
section 61 for certain senior securities transactions.

    (a) Definitions. For purposes of this section:
    Absolute VaR test means that the VaR of the fund's portfolio does 
not exceed 15% of the value of the fund's net assets.
    Derivatives exposure means the sum of the notional amounts of the 
fund's derivatives instruments and, in the case of short sale 
borrowings, the value of the asset sold short. In determining 
derivatives exposure a fund may convert the notional amount of interest 
rate derivatives to 10-year bond equivalents and delta adjust the 
notional amounts of options contracts.
    Derivatives risks means the risks associated with a fund's 
derivatives transactions or its use of derivatives transactions, 
including leverage, market, counterparty, liquidity, operational, and 
legal risks and any other risks the derivatives risk manager (or, in 
the case of a fund that is a limited derivatives user as described in 
paragraph (c)(3) of this section, the fund's investment adviser) deems 
material.
    Derivatives risk manager means an officer or officers of the fund's 
investment adviser responsible for administering the program and 
policies and procedures required by paragraph (c)(1) of this section, 
provided that the derivatives risk manager:
    (1) May not be a portfolio manager of the fund, or if multiple 
officers serve as derivatives risk manager, may not have a majority 
composed of portfolio managers of the fund; and
    (2) Must have relevant experience regarding the management of 
derivatives risk.
    Derivatives transaction means:
    (1) Any swap, security-based swap, futures contract, forward 
contract, option, any combination of the foregoing, or any similar 
instrument (``derivatives instrument''), under which a fund is or may 
be required to make any payment or delivery of cash or other assets 
during the life of the instrument

[[Page 4559]]

or at maturity or early termination, whether as margin or settlement 
payment or otherwise; and
    (2) Any short sale borrowing.
    Designated reference index means an unleveraged index that: (1) Is 
selected by the derivatives risk manager and that reflects the markets 
or asset classes in which the fund invests; (2) is not administered by 
an organization that is an affiliated person of the fund, its 
investment adviser, or principal underwriter, or created at the request 
of the fund or its investment adviser, unless the index is widely 
recognized and used; and (3) is an ``appropriate broad-based securities 
market index'' or an ``additional index,'' as defined in the 
instruction to Item 27 in Form N-1A [17 CFR 274.11A]. In the case of a 
blended index, none of the indexes that compose the blended index may 
be administered by an organization that is an affiliated person of the 
fund, its investment adviser, or principal underwriter, or created at 
the request of the fund or its investment adviser, unless the index is 
widely recognized and used.
    Fund means a registered open-end or closed-end company or a 
business development company, including any separate series thereof, 
but does not include a registered open-end company that is regulated as 
a money market fund under Sec.  270.2a-7.
    Relative VaR test means that the VaR of the fund's portfolio does 
not exceed 150% of the VaR of the designated reference index.
    Unfunded commitment agreement means a contract that is not a 
derivatives transaction, under which a fund commits, conditionally or 
unconditionally, to make a loan to a company or to invest equity in a 
company in the future, including by making a capital commitment to a 
private fund that can be drawn at the discretion of the fund's general 
partner.
    Value-at-risk or VaR means an estimate of potential losses on an 
instrument or portfolio, expressed as a percentage of the value of the 
portfolio's net assets, over a specified time horizon and at a given 
confidence level, provided that any VaR model used by a fund for 
purposes of determining the fund's compliance with the relative VaR 
test or the absolute VaR test must:
    (1) Take into account and incorporate all significant, identifiable 
market risk factors associated with a fund's investments, including, as 
applicable:
    (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;
    (2) Use a 99% confidence level and a time horizon of 20 trading 
days; and
    (3) Be based on at least three years of historical market data.
    (b) Derivatives transactions. If a fund satisfies the conditions of 
paragraph (c) of this section, the fund may enter into derivatives 
transactions, notwithstanding the requirements of sections 18(a)(1), 
18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a-
18(a)(1), 80a-18(c), 80a-18(f)(1), and 80a-60), and derivatives 
transactions entered into by the fund in compliance with this section 
will not be considered for purposes of computing asset coverage, as 
defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-
18(h)).
    (c) Conditions. (1) Derivatives risk management program. The fund 
adopts and implements a written derivatives risk management program 
(``program''), which must include policies and procedures that are 
reasonably designed to manage the fund's derivatives risks and to 
reasonably segregate the functions associated with the program from the 
portfolio management of the fund. The program must include the 
following elements:
    (i) Risk identification and assessment. The program must provide 
for the identification and assessment of the fund's derivatives risks. 
This assessment must take into account the fund's derivatives 
transactions and other investments.
    (ii) Risk guidelines. The program must provide for the 
establishment, maintenance, and enforcement of investment, risk 
management, or related guidelines that provide for quantitative or 
otherwise measurable criteria, metrics, or thresholds of the fund's 
derivatives risks. These guidelines must specify levels of the given 
criterion, metric, or threshold that the fund does not normally expect 
to exceed, and measures to be taken if they are exceeded.
    (iii) Stress testing. The program must provide for stress testing 
to evaluate potential losses to the fund's portfolio 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, 
taking into account correlations of market risk factors and resulting 
payments to derivatives counterparties. The frequency with which the 
stress testing under this paragraph is conducted must take into account 
the fund's strategy and investments and current market conditions, 
provided that these stress tests must be conducted no less frequently 
than weekly.
    (iv) Backtesting. The program must provide for backtesting of the 
results of the VaR calculation model used by the fund in connection 
with the relative VaR test or the absolute VaR test by, each business 
day, comparing the fund's gain or loss with the corresponding VaR 
calculation for that day, estimated over a one-trading day time 
horizon, and identifying as an exception any instance in which the fund 
experiences a loss exceeding the corresponding VaR calculation's 
estimated loss.
    (v) Internal reporting and escalation. (A) Internal reporting. The 
program must identify the circumstances under which persons responsible 
for portfolio management will be informed regarding the operation of 
the program, including exceedances of the guidelines specified in 
paragraph (c)(1)(ii) of this section and the results of the stress 
tests specified in paragraph (c)(1)(iii) of this section.
    (B) Escalation of material risks. The derivatives risk manager must 
inform in a timely manner persons responsible for portfolio management 
of the fund, and also directly inform the fund's board of directors as 
appropriate, of material risks arising from the fund's derivatives 
transactions, including risks identified by the fund's exceedance of a 
criterion, metric, or threshold provided for in the fund's risk 
guidelines established under paragraph (c)(1)(ii) of this section or by 
the stress testing described in paragraph (c)(1)(iii) of this section.
    (vi) Periodic review of the program. The derivatives risk manager 
must review the program at least annually to evaluate the program's 
effectiveness and to reflect changes in risk over time. The periodic 
review must include a review of the VaR calculation model used by the 
fund under paragraph (c)(2) of this section (including the backtesting 
required by paragraph (c)(1)(iv) of this section) and any designated 
reference index to evaluate whether it remains appropriate.
    (2) Limit on fund leverage risk. (i) The fund must comply with the 
relative VaR test or, if the derivatives risk manager is unable to 
identify a designated reference index that is appropriate for the fund 
taking into account the fund's investments, investment objectives, and 
strategy, the absolute VaR test.
    (ii) The fund must determine its compliance with the applicable VaR 
test at least once each business day. If the fund determines that it is 
not in compliance with the applicable VaR test, the fund must come back 
into compliance promptly and within no

[[Page 4560]]

more than three business days after such determination.
    (iii) If the fund is not in compliance with the applicable VaR test 
within three business days:
    (A) The derivatives risk manager must report to the fund's board of 
directors and explain how and by when (i.e., number of business days) 
the derivatives risk manager reasonably expects that the fund will come 
back into compliance;
    (B) The derivatives risk manager must analyze the circumstances 
that caused the fund to be out of compliance for more than three 
business days and update any program elements as appropriate to address 
those circumstances; and
    (C) The fund may not enter into any derivatives transactions (other 
than derivatives transactions that, individually or in the aggregate, 
are designed to reduce the fund's VaR) until the fund has been back in 
compliance with the applicable VaR test for three consecutive business 
days and has satisfied the requirements set forth in paragraphs 
(c)(2)(iii)(A) and (B) of this section.
    (iv) If the fund is complying with the relative VaR test, an open-
end fund must disclose in its annual report the fund's designated 
reference index as the fund's ``appropriate broad-based securities 
market index'' or an ``additional index,'' as defined in the 
instruction to Item 27 in Form N-1A [17 CFR 274.11A], and a registered 
closed-end fund or business development company must disclose its 
designated reference index in the annual report, together with a 
presentation of the fund's performance relative to the designated 
reference index. A fund is not required to include this disclosure in 
an annual report if the fund is a ``New Fund,'' as defined in Form N-1A 
[17 CFR 274.11A], or would meet that definition if it were filing on 
Form N-1A [17 CFR 274.11A], at the time the fund files the annual 
report.
    (3) Limited derivatives users. A fund is not required to adopt a 
program as prescribed in paragraph (c)(1) of this section, or comply 
with the limit on fund leverage risk in paragraph (c)(2) of this 
section, if the fund adopts and implements policies and procedures 
reasonably designed to manage the fund's derivatives risks and:
    (i) The fund's derivatives exposure does not exceed 10 percent of 
the fund's net assets; or
    (ii) The fund limits its use of derivatives transactions to 
currency derivatives that hedge the currency risks associated with 
specific foreign-currency-denominated equity or fixed-income 
investments held by the fund, provided that the currency derivatives 
are entered into and maintained by the fund for hedging purposes and 
that the notional amounts of such derivatives do not exceed the value 
of the hedged instruments denominated in the foreign currency (or the 
par value thereof, in the case of fixed-income investments) by more 
than a negligible amount.
    (4) Leveraged/inverse funds. A fund is not required to comply with 
the limit on fund leverage risk in paragraph (c)(2) of this section if:
    (i) The fund is a leveraged/inverse investment vehicle as defined 
in Sec.  240.15l-2 and Sec.  275.211(h)-1;
    (ii) The fund discloses in its prospectus that it is not subject to 
the limit on fund leverage risk in paragraph (c)(2) of this section; 
and
    (iii) The fund does not seek or obtain, directly or indirectly, 
investment results exceeding 300% of the return (or inverse of the 
return) of the underlying index.
    (5) Board oversight and reporting. (i) Approval of the derivatives 
risk manager. A fund's board of directors, including a majority of 
directors who are not interested persons of the fund, must approve the 
designation of the derivatives risk manager, taking into account the 
derivatives risk manager's relevant experience regarding the management 
of derivatives risk.
    (ii) Reporting on program implementation and effectiveness. On or 
before the implementation of the program, and at least annually 
thereafter, the derivatives risk manager must provide to the board of 
directors a written report providing a representation that the program 
is reasonably designed to manage the fund's derivatives risks and to 
incorporate the elements provided in paragraphs (c)(1)(i) through (vi) 
of this section. The representation may be based on the derivatives 
risk manager's reasonable belief after due inquiry. The written report 
must include the basis for the representation along with such 
information as may be reasonably necessary to evaluate the adequacy of 
the fund's program and, for reports following the program's initial 
implementation, the effectiveness of its implementation. The written 
report also must include the derivatives risk manager's basis for the 
selection of the designated reference index or, if applicable, an 
explanation of why the derivatives risk manager was unable to identify 
a designated reference index appropriate for the fund.
    (iii) Regular board reporting. The derivatives risk manager must 
provide to the board of directors, at a frequency determined by the 
board, a written report regarding the derivatives risk manager's 
analysis of any exceedances described in paragraph (c)(1)(ii) of this 
section, the results of the stress testing conducted under paragraph 
(c)(1)(iii) of this section, and the results of the backtesting 
conducted under paragraph (c)(1)(iv) of this section since the last 
report to the board. Each report under this paragraph must include such 
information as may be reasonably necessary for the board of directors 
to evaluate the fund's response to any exceedances and the results of 
the fund's stress testing.
    (6) Recordkeeping. (i) Records to be maintained. A fund must 
maintain a written record documenting, as applicable:
    (A) The fund's written policies and procedures required by 
paragraph (c)(1) of this section, along with:
    (1) The results of the fund's stress tests under paragraph 
(c)(1)(iii) of this section;
    (2) The results of the backtesting conducted under paragraph 
(c)(1)(iv) of this section;
    (3) Records documenting any internal reporting or escalation of 
material risks under paragraph (c)(1)(v)(B) of this section; and
    (4) Records documenting the reviews conducted under paragraph 
(c)(1)(vi) of this section.
    (B) Copies of any materials provided to the board of directors in 
connection with its approval of the designation of the derivatives risk 
manager, any written reports provided to the board of directors 
relating to the program, and any written reports provided to the board 
of directors under paragraph (c)(2)(iii)(A) of this section.
    (C) Any determination and/or action the fund made under paragraphs 
(c)(2)(i)-(ii) of this section, including a fund's determination of: 
The VaR of its portfolio; the VaR of the fund's designated reference 
index, as applicable; the fund's VaR ratio (the value of the VaR of the 
Fund's portfolio divided by the VaR of the designated reference index), 
as applicable; and any updates to any VaR calculation models used by 
the fund and the basis for any material changes thereto.
    (D) If applicable, the fund's written policies and procedures 
required by paragraph (c)(3) of this section.
    (ii) Retention periods. (A) A fund must maintain a copy of the 
written policies and procedures that the fund adopted under paragraphs 
(c)(1) or (c)(3) of this section that are in effect, or at any time 
within the past five years were in effect, in an easily accessible 
place.

[[Page 4561]]

    (B) A fund must maintain all records and materials that paragraphs 
(c)(6)(i)(A)(1)-(4) and (c)(6)(i)(B)-(D) of this section describe for a 
period of not less than five years (the first two years in an easily 
accessible place) following each determination, action, or review that 
these paragraphs describe.
    (7) Current reports. A fund that experiences an event specified in 
the parts of Form N-RN [referenced in 17 CFR 274.223] titled ``Relative 
VaR Test Breaches,'' ``Absolute VaR Test Breaches,'' or ``Compliance 
with VaR Test'' must file with the Commission a report on Form N-RN 
within the period and according to the instructions specified in that 
form.
    (d) Reverse repurchase agreements. A fund may enter into reverse 
repurchase agreements or similar financing transactions, 
notwithstanding the requirements of sections 18(c), and 18(f)(1) of the 
Investment Company Act, if the fund complies with the asset coverage 
requirements of section 18 and combines the aggregate amount of 
indebtedness associated with the reverse repurchase agreement or 
similar financing transaction with the aggregate amount of any other 
senior securities representing indebtedness when calculating the asset 
coverage ratio.
    (e) Unfunded commitment agreements. (1) A fund may enter into an 
unfunded commitment agreement, notwithstanding the requirements of 
sections 18(a), 18(c), 18(f)(1), and 61 of the Investment Company Act, 
if the fund reasonably believes, at the time it enters into such 
agreement, that it will have sufficient cash and cash equivalents to 
meet its obligations with respect to all of its unfunded commitment 
agreements, in each case as they come due. In forming a reasonable 
belief, the fund must take into account its reasonable expectations 
with respect to other obligations (including any obligation with 
respect to senior securities or redemptions), and may not take into 
account cash that may become available from the sale or disposition of 
any investment at a price that deviates significantly from the market 
value of those investments, or from issuing additional equity. Unfunded 
commitment agreements entered into by the fund in compliance with this 
section will not be considered for purposes of computing asset 
coverage, as defined in section 18(h) of the Investment Company Act (15 
U.S.C. 80a-18(h)).
    (2) For each unfunded commitment agreement that a fund enters into 
under paragraph (e)(1) of this section, a fund must document the basis 
for its reasonable belief regarding the sufficiency of its cash and 
cash equivalents to meet its unfunded commitment agreement obligations, 
and maintain a record of this documentation for a period of not less 
than five years (the first two years in an easily accessible place) 
following the date that the fund entered into the agreement.
0
6. Revise Sec.  270.30b1-10 to read as follows:


Sec.  270.30b1-10   Current report for open-end and closed-end 
management investment companies.

    Every registered open-end management investment company, or series 
thereof, and every registered closed-end management investment company, 
but not a fund that is regulated as a money market fund under Sec.  
270.2a-7, that experiences an event specified on Form N-RN, must file 
with the Commission a current report on Form N-RN within the period and 
according to the instructions specified in that form.

PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940

0
7. The general authority for part 274 continues to read as follows:


    Authority:  15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 
78n, 78o(d), 80a-8, 80a-24, 80a-26, 80a-29, and Pub. L. 111-203, 
sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted.
* * * * *
0
8. Amend Form N-2 (referenced in Sec. Sec.  239.14 and 274.11a-1) by 
revising instruction 2. to sub-item ``3. Senior Securities'' of ``Item 
4. Financial Highlights'' to read as follows:

    Note:  The text of Form N-2 does not, and this amendment will 
not, appear in the Code of Federal Regulations.

Form N-2

* * * * *

Item 4. Financial Highlights

* * * * *

3. Senior Securities

* * * * *

Instructions

* * * * *
    2. Use the method described in section 18(h) of the 1940 Act [15 
U.S.C. 80a-18(h)] to calculate the asset coverage to be set forth in 
column (3). However, in lieu of expressing asset coverage in terms of a 
ratio, as described in section 18(h), express it for each class of 
senior securities in terms of dollar amounts per share (in the case of 
preferred stock) or per $1,000 of indebtedness (in the case of senior 
indebtedness). A fund should not consider any derivatives transactions, 
or any unfunded commitment agreements, that it enters into in 
compliance with rule 18f-4 under the Investment Company Act [17 CFR 
270.18f-4] for purposes of computing asset coverage.
* * * * *
0
9. Amend Form N-CEN (referenced in Sec. Sec.  249.330 and 274.101) by 
adding new Item C.7.l. to read as follows:

    Note:  The text of Form N-CEN does not, and this amendment will 
not, appear in the Code of Federal Regulations.

FORM N-CEN

ANNUAL REPORT FOR REGISTERED INVESTMENT COMPANIES

* * * * *
Item C.7. * * *
l. Rule 18f-4 (17 CFR 270.18f-4): _
    i. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4) 
program requirement under rule 18f-4(c)(3)(i) (17 CFR 270.18f-
4(c)(3)(i))? __
    ii. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4) 
program requirement under rule 18f-4(c)(3)(ii) (17 CFR 270.18f-
4(c)(3)(ii))? __
    iii. Is the Fund a leveraged/inverse fund covered by rule 15l-2 
under the Exchange Act (17 CFR 240.15l-2) or rule 211(h)-1 under the 
Investment Advisers Act of 1940 (17 CFR 275.211(h)-1) that, under rule 
18f-4(c)(4) (17 CFR 270.18f-4(c)(4)), is excepted from the requirement 
to comply with the limit on leverage risk described in rule 18f-4(c)(2) 
(17 CFR 270.18f-4(c)(2))? __
    iv. Has the Fund entered into any reverse repurchase agreements or 
similar financing transactions under rule 18f-4(d) (17 CFR 270.18f-
4(d))? __
    v. Has the Fund entered into any unfunded commitment agreements 
under rule 18f-4(e) (17 CFR 270.18f-4(e))? __
* * * * *
0
10. Amend Form N-PORT (referenced in Sec.  274.150) by:
0
a. Adding to General Instruction E. ``Definitions'' in alphabetical 
order, the following definitions:
0
i. ``Absolute VaR Test'';
0
ii. ``Designated Reference Index'';
0
iii. ``Derivatives Exposure'';
0
iv. ``Relative VaR Test'';
0
v. ``Value-at-risk'';
0
vi. ``VaR Ratio''; and
0
b. Adding Items B.9 and B.10.
    The additions read as follows:


[[Page 4562]]


    Note:  The text of Form N-PORT does not, and this amendment will 
not, appear in the Code of Federal Regulations.

Form N-PORT

MONTHLY PORTFOLIO INVESTMENTS REPORT

* * * * *

GENERAL INSTRUCTIONS

* * * * *

E. Definitions

* * * * *
``Absolute VaR Test'' has the meaning defined in rule 18f-4(a) [17 CFR 
270.18f-4(a)].
* * * * *
``Derivatives Exposure'' has the meaning defined in rule 18f-4(a) [17 
CFR 270.18f-4(a)].
* * * * *
``Designated Reference Index'' has the meaning defined in rule 18f-4(a) 
[17 CFR 270.18f-4(a)].
* * * * *
``Relative VaR Test'' has the meaning defined in rule 18f-4(a) [17 CFR 
270.18f-4(a)].
* * * * *
``Value-at-risk'' or VaR has the meaning defined in rule 18f-4(a) [17 
CFR 270.18f-4(a)].
* * * * *
``VaR Ratio'' means the value of the Fund's portfolio VaR divided by 
the VaR of the Designated Reference Index.
* * * * *
PART B. * * *
Item B.9 Derivatives Exposure. Report as a percentage of the Fund's net 
asset value:
a. Derivatives Exposure.
    i. Exposure from derivatives instruments.
    ii. Exposure from short sales.
Item B.10 VaR Information. For Funds subject to the limit on fund 
leverage risk in rule 18f-4(c)(2) [17 CFR 270.18f-4(c)(2)], provide the 
following information, as determined in accordance with the requirement 
under rule 18f-4(c)(2)(ii) to determine the fund's compliance with the 
applicable VaR test at least once each business day:
a. Highest daily VaR during the reporting period.
b. Date of highest daily VaR during the reporting period.
c. Median daily VaR during the reporting period.
d. For Funds that were subject to the Relative VaR Test during the 
reporting period, provide:
    i. Name of the Fund's Designated Reference Index.
    ii. Index Identifier for the Fund's Designated Reference Index.
    iii. Highest VaR Ratio during the reporting period.
    iv. Date of highest VaR Ratio during the reporting period.
    v. Median VaR Ratio during the reporting period.
e. Backtesting Results. Number of exceptions that the Fund identified 
as a result of its backtesting of its VaR calculation model (as 
described in rule 18f-4(c)(1)(iv) [17 CFR 270.18f-4(c)(1)(iv)] during 
the reporting period.
* * * * *
0
11. Revise Sec.  274.223, its sectional heading, and Form N-LIQUID 
(referenced in Sec.  274.223) and its title to read as follows:


Sec.  274.223   Form N-RN, Current report, open- and closed-end 
investment company reporting.

    This form shall be used by registered open-end management 
investment companies, or series thereof, and closed-end management 
investment companies, or series thereof, to file reports pursuant to 
Sec.  270.18f-4(c)(7) and Sec.  270.30b1-10 of this chapter.

    Note:  The text of Form N-RN does not, and this amendment will 
not, appear in the Code of Federal Regulations.

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549

FORM N-RN

CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND 
BUSINESS DEVELOPMENT COMPANIES

    Form N-RN is to be used by a registered open-end management 
investment company or series thereof, but not including a fund that is 
regulated as a money market fund under rule 2a-7 under the Act (17 CFR 
270.2A-7) (a ``registered open-end fund''), a registered closed-end 
management investment company (a ``registered closed-end fund''), or a 
closed-end management investment company that has elected to be 
regulated as a business development company (a ``business development 
company''), to file current reports with the Commission pursuant to 
rule 18f-4 and rule 30b1-10 under the Investment Company of 1940 Act 
[15 U.S.C. 80a] (``Act'') (17 CFR 270.18f-4; 17 CFR 270.30b1-10). The 
Commission may use the information provided on Form N-RN in its 
regulatory, disclosure review, inspection, and policymaking roles.

GENERAL INSTRUCTIONS

A. Rules as to Use of Form N-RN

    (1) Form N-RN is the reporting form that is to be used for current 
reports of registered open-end funds (not including funds that are 
regulated as money market funds under rule 2a-7 under the Act), 
registered closed-end funds, and business development companies 
(together, ``registrants'') required by, as applicable, section 30(b) 
of the Act and rule 30b1-10 under the Act, as well as rule 18f-4 under 
the Act. The Commission does not intend to make public information 
reported on Form N-RN that is identifiable to any particular 
registrant, although the Commission may use Form N-RN information in an 
enforcement action.
    (2) Unless otherwise specified, a report on this Form N-RN is 
required to be filed, as applicable, within one business day of the 
occurrence of the event specified in Parts B-G of this form. If the 
event occurs on a Saturday, Sunday, or holiday on which the Commission 
is not open for business, then the one business day period shall begin 
to run on, and include, the first business day thereafter.
    (3) For registered open-end funds required to comply with rule 22e-
4 under the Investment Company Act [17 CFR 270.22e-4], complete Parts 
B-D of this form, as applicable. For registrants that rely on rule 18f-
4 of the Act [17 CFR 270.18f-4], complete Parts E-G of this form, as 
applicable.

B. Application of General Rules and Regulations

    The General Rules and Regulations under the Act contain certain 
general requirements that are applicable to reporting on any form under 
the Act. These general requirements should be carefully read and 
observed in the preparation and filing of reports on this form, except 
that any provision in the form or in these instructions shall be 
controlling.

C. Information To Be Included in Report Filed on Form N-RN

    Upon the occurrence of the event specified in Parts B-G of Form N-
RN, as applicable, a registrant must file a report on Form N-RN that 
includes information in response to each of the items in Part A of the 
form, as well as each of the items in the applicable Parts B-G of the 
Form.

D. Filing of Form N-RN

    A registrant must file Form N-RN in accordance with rule 232.13 of 
Regulation S-T (17 CFR part 232). Form N-RN must be filed 
electronically using

[[Page 4563]]

the Commission's Electronic Data Gathering, Analysis and Retrieval 
System (``EDGAR'').

E. Paperwork Reduction Act Information

    A registrant is not required to respond to the collection of 
information contained in Form N-RN unless the form displays a currently 
valid Office of Management and Budget (``OMB'') control number. Please 
direct comments concerning the accuracy of the information collection 
burden estimate and any suggestions for reducing the burden to the 
Secretary, Securities and Exchange Commission, 100 F Street NE, 
Washington, DC 20549-1090. The OMB has reviewed this collection of 
information under the clearance requirements of 44 U.S.C. 3507.

F. Definitions

    (1) References to sections and rules in this Form N-RN are to the 
Investment Company Act (15 U.S.C. 80a), unless otherwise indicated. 
Terms used in this Form N-RN have the same meaning as in the Investment 
Company Act, rule 22e-4 under the Investment Company Act (for Parts B-D 
of the Form), or rule 18f-4 under the Investment Company Act (for Part 
E-G of the Form), unless otherwise indicated. In addition, as used in 
this Form N-RN, the term registrant means the registrant or a separate 
series of the registrant, as applicable.
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549

FORM N-RN

CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND 
BUSINESS DEVELOPMENT COMPANIES

PART A. General Information

Item A.1. Report for [mm/dd/yyyy].
Item A.2. CIK Number of registrant.
Item A.3. EDGAR Series Identifier.
Item A.4. Securities Act File Number, if applicable.
Item A.5. Provide the name, email address, and telephone number of the 
person authorized to receive information and respond to questions about 
this Form N-RN.

PART B. Above 15% Illiquid Investments

    If more than 15 percent of the registrant's net assets are, or 
become, illiquid investments that are assets as defined in rule 22e-4, 
then report the following information:

Item B.1. Date(s) on which the registrant's illiquid investments that 
are assets exceeded 15 percent of its net assets.
Item B.2. The current percentage of the registrant's net assets that 
are illiquid investments that are assets.
Item B.3. Identification of illiquid investments. For each investment 
that is an asset that is held by the registrant that is considered 
illiquid, disclose (1) the name of the issuer, the title of the issue 
or description of the investment, the CUSIP (if any), and at least one 
other identifier, if available (e.g., ISIN, Ticker, or other unique 
identifier (if ticker and ISIN are not available)) (indicate the type 
of identifier used), and (2) the percentage of the fund's net assets 
attributable to that investment.

PART C. At or Below 15% Illiquid Investments

    If a registrant that has filed Part B of Form N-RN determines that 
its holdings in illiquid investments that are assets have changed to be 
less than or equal to 15 percent of the registrant's net assets, then 
report the following information:

Item C.1. Date(s) on which the registrant's illiquid investments that 
are assets fell to or below 15 percent of net assets.
Item C.2. The current percentage of the registrant's net assets that 
are illiquid investments that are assets.

PART D. Assets That Are Highly Liquid Investments Below the Highly 
Liquid Investment Minimum

    If a registrant's holdings in assets that are highly liquid 
investments fall below its highly liquid investment minimum for more 
than 7 consecutive calendar days, then report the following 
information:

Item D.1. Date(s) on which the registrant's holdings of assets that are 
highly liquid investments fell below the fund's highly liquid 
investment minimum.

PART E. Relative VaR Test Breaches

    If a registrant is subject to the relative VaR test under rule 18f-
4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)], and the fund determines that it 
is not in compliance with the relative VaR test and has not come back 
into compliance within 3 business days after such determination, 
provide:

Item E.1. The dates on which the VaR of the registrant's portfolio 
exceeded 150% of the VaR of its designated reference index.
Item E.2. The VaR of the registrant's portfolio on the dates each 
exceedance occurred.
Item E.3. The VaR of the registrant's designated reference index on the 
dates each exceedance occurred.
Item E.4. The name of the registrant's designated reference index.
Item E.5. The index identifier for the registrant's designated 
reference index.

PART F. Absolute VaR Test Breaches

    If a registrant is subject to the absolute VaR test under rule 18f-
4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)], and the fund determines that it 
is not in compliance with the absolute VaR test and has not come back 
into compliance within 3 business days after such determination, 
provide:

Item F.1. The dates on which the VaR of the registrant's portfolio 
exceeded 15% of the value of the registrant's net assets.
Item F.2. The VaR of the registrant's portfolio on the dates each 
exceedance occurred.
Item F.3. The value of the registrant's net assets on the dates each 
exceedance occurred.

PART G. Compliance with VaR Test

    If a registrant that has filed Part E or Part F of Form N-RN has 
come back into compliance with either the relative VaR test or the 
absolute VaR test, as applicable, then report the following 
information:

Item G.1. Dates on which the VaR of the registrant's portfolio 
exceeded, as applicable, 150% of the VaR of its designated reference 
index (if the registrant is subject to the relative VaR test under rule 
18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]) or 15% of the value of the 
registrant's net assets (if the registrant is subject to the absolute 
VaR test under rule 18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]).
Item G.2. The current VaR of the registrant's portfolio.

PART H. Explanatory Notes (if any)

    A registrant may provide any information it believes would be 
helpful in understanding the information reported in response to any 
Item of this Form.

SIGNATURES

Pursuant to the requirements of the Investment Company Act of 1940, the 
registrant has duly caused this report to be signed on its behalf by 
the undersigned hereunto duly authorized.

-----------------------------------------------------------------------

[[Page 4564]]

(Registrant)

Date-------------------------------------------------------------------

-----------------------------------------------------------------------
(Signature) *
* Print name and title of the signing officer under his/her signature.
* * * * *

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
12. The authority citation for part 275 continues to read, in part, and 
the subauthority for Section 275.211h-1 is added to read as follows:

    Authority:  15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless 
otherwise noted.
* * * * *
    Section 275.211(h)-1 is also issued under sec. 913, Pub. L. 111-
203, 124 Stat. 1827-28 (2010).
* * * * *
0
13. Section 275.211(h)-1 is added to read as follows:


Sec.  275.211(h)-1   Investment adviser sales practices for leveraged/
inverse investment vehicles.

    (a) Required approval of client account. No investment adviser 
registered or required to be registered under the Advisers Act, or any 
supervised person of the investment adviser, may place an order for the 
account of an advisory client that is a natural person (or the legal 
representative of a natural person) to buy or sell shares of a 
leveraged/inverse investment vehicle unless the investment adviser has 
approved such a client's account to engage in those transactions and 
has adopted and implemented policies and procedures reasonably designed 
to achieve compliance with this section. Any approval of a client's 
account for buying or selling leveraged/inverse investment vehicles 
must be effected as provided in paragraph (b).
    (b) Diligence in approving accounts. (1) In determining whether to 
approve a client's account to buy or sell leveraged/inverse investment 
vehicles, the investment adviser must exercise due diligence to 
ascertain the essential facts relative to the client, his or her 
financial situation, and investment objectives, including, at a 
minimum, the information specified in paragraph (b)(2) of this section 
(and must seek to obtain information for all participants in a joint 
account). Based upon this information, the investment adviser must 
specifically approve or disapprove the client's account for buying and 
selling shares of leveraged/inverse investment vehicles. An approval of 
a client account must be in writing. An investment adviser may provide 
this approval if the investment adviser has a reasonable basis for 
believing that the client has such knowledge and experience in 
financial matters that he or she may reasonably be expected to be 
capable of evaluating the risks of buying and selling leveraged/inverse 
investment vehicles.
    (2) An investment adviser must seek to obtain the following 
information at a minimum regarding the client:
    (i) Investment objectives (e.g., safety of principal, income, 
growth, trading profits, speculation) and time horizon;
    (ii) Employment status (name of employer, self-employed or 
retired);
    (iii) Estimated annual income from all sources;
    (iv) Estimated net worth (exclusive of family residence);
    (v) Estimated liquid net worth (cash, liquid securities, other);
    (vi) Percentage of the client's estimated liquid net worth that he 
or she intends to invest in leveraged/inverse investment vehicles; and
    (vii) Investment experience and knowledge (e.g., number of years, 
size, frequency and type of transactions) regarding leveraged/inverse 
investment vehicles, options, stocks and bonds, commodities, and other 
financial instruments.
    (c) Recordkeeping. An investment adviser must maintain a written 
record of the information that it obtained under paragraph (b) of this 
section and, if applicable, its written approval of the client's 
account, as well as the versions of the firm's policies and procedures 
required under paragraph (a) that were in place when it approved or 
disapproved the client's account, for a period of not less than six 
years (the first two years in an easily accessible place) after the 
date of the closing of the client's account.
    (d) Definitions. For purposes of this section:
    Commodity- or currency-based trust or fund means a trust or other 
person:
    (1) Issuing securities in an offering registered under the 
Securities Act of 1933 (15 U.S.C. 77a et seq.) and which class of 
securities is listed for trading on a national securities exchange;
    (2) The assets of which consist primarily of derivative instruments 
that reference commodities or currencies, or interests in the 
foregoing; and
    (3) That provides in its registration statement under the 
Securities Act of 1933 (15 U.S.C. 77a et seq.) that a class of its 
securities are purchased or redeemed, subject to conditions or 
limitations, for a ratable share of its assets.
    Leveraged/inverse investment vehicle means a registered investment 
company (including any separate series thereof), or commodity- or 
currency-based trust or fund, that seeks, directly or indirectly, to 
provide investment returns that correspond to the performance of a 
market index by a specified multiple, or to provide investment returns 
that have an inverse relationship to the performance of a market index, 
over a predetermined period of time.
    Supervised person means any partner, officer, director (or other 
person occupying a similar status or performing similar functions), or 
employee of an investment adviser, or other person who provides 
investment advice on behalf of the investment adviser.
    (e) Transition. This section applies to all clients of the 
investment adviser, including clients who have opened accounts with the 
investment adviser before the compliance date for this section, 
provided that this section does not apply to, and therefore will not 
restrict the ability to close or reduce, a client's position in a 
leveraged/inverse investment vehicle that a client established before 
the compliance date of this section.

    By the Commission.

    Dated: November 25, 2019.
Eduardo A. Aleman,
Deputy Secretary.

VIII. APPENDIX A

    Note: Appendix A will not appear in the Code of Federal 
Regulations. Feedback Flier: Funds' Use of Derivatives

    We are proposing a new regulatory approach for funds' use of 
derivatives. This includes proposed rule 18f-4 under the Investment 
Company Act of 1940, a new exemptive rule 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. The proposal also 
includes certain new proposed reporting requirements relating to 
funds' derivatives use. More information about our proposal is 
available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
    We are particularly interested in learning what small funds 
think about the requirements of proposed new rule 18f-4 and the 
proposed new reporting requirements. Hearing from small funds could 
help us learn how the proposed rule and new reporting requirements 
would affect these entities, and evaluate how we could address any 
unintended consequences resulting from the cost and effort of 
regulatory compliance while still promoting investor protection. We 
would appreciate your feedback on any or all of the following 
questions.

[[Page 4565]]

    All of the following questions are optional, including any 
questions that ask about identifying information. Please note that 
responses to these questions--including any other general 
identifying information you provide--will be made public.

Item 1: General Identifying Information

Instructions: At your option, you may include general identifying 
information that would help us contextualize your other feedback on 
the proposal. This information could include responses to the 
following questions, as well as any other general identifying 
information you would like to provide. Responses to these items--
like responses to the other items on this Feedback Flier--will be 
made public.
a. How big is the fund in terms of net asset value? (This may be 
expressed in a range, for example, $40 million-$50 million.)
b. What is/are the principal investment strategy/strategies of the 
fund?
c. Does the fund use derivatives transactions (as defined in the 
proposed rule) to pursue the fund's principal investment strategy/
strategies? [Y/N]
d. Is the fund part of a fund complex? [Y/N]
e. Please include any additional general identifying information 
that you wish to provide, that could add context for your other 
feedback on the proposal.

Item 2: Derivatives Risk Management Program

Instructions: If you believe the fund would be required to adopt and 
implement a derivatives risk management program under the proposed 
rules, please answer the following questions. If you do not believe 
so, please proceed to Item 4.
a. The proposed derivatives risk management program requirement 
would include the following seven elements. In the following chart, 
please indicate which of the proposed program elements you think 
would be the most expensive for the fund to implement and which 
would be least expensive to implement, by ranking the following 
elements from one (1)--most expensive--through seven (7)--least 
expensive--using each number only once. If you have any comments 
about the factors informing your analysis, please include.

------------------------------------------------------------------------
                                Rank by cost (1--
 Derivatives risk management   most expensive; 7--
      program elements        least expensive) Use        Comments
                                each number once
------------------------------------------------------------------------
(a) Risk identification and
 assessment
------------------------------------------------------------------------
(b) Risk guidelines
------------------------------------------------------------------------
(c) Stress testing
------------------------------------------------------------------------
(d) Backtesting
------------------------------------------------------------------------
(e) Internal reporting and
 escalation
------------------------------------------------------------------------
(f) Periodic review of the
 program
------------------------------------------------------------------------
(g) Board reporting and
 oversight
------------------------------------------------------------------------

b. Implementation timing.
    (1.) How many months do you think it would take the fund to 
adopt and implement a derivatives risk management program (check one 
box)?

----------------------------------------------------------------------------------------------------------------
     6 months-12 months          12 months-18 months          18 months-24 months             >24 months
----------------------------------------------------------------------------------------------------------------
                    [ ]                          [ ]                          [ ]                         [ ]
----------------------------------------------------------------------------------------------------------------

    (2.) If the response above is more than 12 months, what would 
help to shorten that time period?
    (3.) Please provide any explanatory notes that you would like to 
include.
c. Implementation cost.
    (1.) Approximately how much do you think it would cost the fund 
to implement a derivatives risk management program (in terms of 
combined internal and external costs) (check one box)?

----------------------------------------------------------------------------------------------------------------
                                               Estimated cost ($)
-----------------------------------------------------------------------------------------------------------------
        $0-$150,000               $150,001-$350,000            $350,001-$500,000               >$500,000
----------------------------------------------------------------------------------------------------------------
                    [ ]                          [ ]                          [ ]                         [ ]
----------------------------------------------------------------------------------------------------------------

    (2.) Please include any explanatory notes that you would like to 
provide. These could describe, for example, how a fund that is part 
of a fund complex might share these costs, any particular cost 
considerations for a fund that uses sub-advisers, or the extent to 
which the estimated costs would arise from internal versus external 
costs (such as those associated with third-party service providers).
d. To the extent that the fund is a sub-advised fund, would any of 
the proposed program elements present any particular challenges for 
the fund to implement in light of its advisory structure? If so 
please explain.

Item 3: Limit on Fund Leverage Risk

Instructions: The proposed rule would require certain funds to 
comply with a limit on fund leverage risk based on value at risk 
(``VaR''). The following questions relate to this proposed 
requirement.
a. Does the fund currently use VaR testing? [Y/N]
b. Implementation cost.
    (1.) If you anticipate that, if the proposed rules were adopted, 
the fund would have to comply with the VaR testing requirement, 
approximately how much do you think it would cost the fund to 
implement the proposed VaR test requirements (in terms of combined 
internal and external costs) (check one box)?

[[Page 4566]]



----------------------------------------------------------------------------------------------------------------
                                               Estimated cost ($)
-----------------------------------------------------------------------------------------------------------------
         $0-$25,000                $25,001-$50,000              $50,001-$75,000                >$75,000
----------------------------------------------------------------------------------------------------------------
                    [ ]                          [ ]                          [ ]                         [ ]
----------------------------------------------------------------------------------------------------------------

    (2.) Please include any explanatory notes that you would like to 
provide. These could describe, for example, how a fund that is part 
of a fund complex might share these costs, any particular cost 
considerations for a fund that uses sub-advisers, or the extent to 
which the estimated costs would arise from internal versus external 
costs (such as those associated with third-party service providers).
c. Use of relative VaR test and absolute VaR test.
    (1.) Would the fund anticipate that it would use the proposed 
relative VaR test or the proposed absolute VaR test (check one box)?

----------------------------------------------------------------------------------------------------------------
                   Relative VaR test                                        Absolute VaR test
----------------------------------------------------------------------------------------------------------------
                                             [ ]                                                      [ ]
----------------------------------------------------------------------------------------------------------------

    (2.) If you anticipate that you would use the proposed relative 
VaR test, and you already disclose a benchmark index for performance 
disclosure, do you anticipate that the index would also qualify as a 
designated reference index under the proposed rule? [Y/N]
d. To the extent that the fund is a sub-advised fund, would the 
proposed limit on fund leverage risk present any particular 
challenges for the fund to implement in light of its advisory 
structure? If so please explain.

Item 4: Limited Derivatives Users

Instructions: If you believe the fund would qualify as a limited 
derivatives user under the proposed rule, please answer the 
following questions. If you do not believe so, please proceed to 
question 5.
a. Please state which basis for the proposed limited derivatives 
user exception you think the fund would seek to rely on (check one 
box):

----------------------------------------------------------------------------------------------------------------
                                                             Currency hedging exception  (The fund only uses
 Exposure-based test  (The fund's derivatives exposure   derivatives for currency hedging  purposes as specified
  does not exceed  10% of the fund's net asset value)                     in the proposed rule)
----------------------------------------------------------------------------------------------------------------
                                             [ ]                                                      [ ]
----------------------------------------------------------------------------------------------------------------

b. Should the rule include any other bases for a fund to qualify as 
a limited derivatives user? What alternative approach and why?
c. Implementation cost.
    (1.) Approximately how much do you think it would cost the fund 
to adopt and implement policies and procedures reasonably designed 
to manage its derivatives risks (in terms of combined internal and 
external costs) (check one box)?

----------------------------------------------------------------------------------------------------------------
                                               Estimated cost ($)
-----------------------------------------------------------------------------------------------------------------
    $0-$25,000          $25,001-$50,000           $50,001-$75,000          $75,001-$100,000         >$100,000
----------------------------------------------------------------------------------------------------------------
           [ ]                       [ ]                       [ ]                      [ ]               [ ]
----------------------------------------------------------------------------------------------------------------

    (2.) Please include any explanatory notes that you would like to 
provide.

Item 5: Recordkeeping

a. Approximately how much would it cost the fund to comply with the 
proposed recordkeeping requirements associated with rule 18f-4 (in 
terms of combined internal and external costs)?
b. Should we modify any of the proposed recordkeeping requirements, 
and if so, how?

Item 6: Reporting Requirements

a. Approximately how much would it cost the fund to comply with the 
proposed new requirements for reporting on Form N-PORT, Form N-CEN, 
and Form N-RN (in terms of combined internal and external costs)?
b. Should we modify any of the proposed reporting requirements, and 
if so, how?

Item 7: Other Feedback on Proposed Rule 18f-4 and Proposed New 
Reporting Requirements

Instructions: Please include any other additional suggestions or 
comments about proposed rule 18f-4, and/or the proposed new 
reporting requirements, that you would like to provide.

We will post your feedback on our website. Your submission will be 
posted without change; we do not redact or edit personal identifying 
information from submissions. You should only make submissions that 
you wish to make available publicly.

If you are interested in more information on the proposal, or want 
to provide feedback on additional questions, click here. Comments 
should be received on or before March 24, 2020

Thank You!

Other Ways to Submit Your Feedback
You also can send us feedback in the following ways (include the 
file number S7-24-15 in your response):

Print Your Responses and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE, 
Washington, DC 20549-1090

Print a PDF of Your Responses and Email
Use the printer friendly page and select a PDF printer to create a 
file you can email to: [email protected]

Print a Blank Copy of This Flier, Fill it Out, and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE, 
Washington, DC 20549-1090

IX. APPENDIX B

    Note: Appendix B will not appear in the Code of Federal 
Regulations. Feedback Flier: Sales Practices Rules for Transacting 
in Shares of Leveraged/Inverse Investment Vehicles

    We are proposing two new sales practices rules--rule 15l-2 under 
the Securities Exchange Act of 1934, and Rule 211(h)-1 under the 
Investment Advisers Act of 1940--that would require a broker, 
dealer, or

[[Page 4567]]

registered investment adviser 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.'' More information 
about our proposal is available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
    We are particularly interested in learning what small broker-
dealers and investment advisers think about the proposed new sales 
practices rules' requirements. Hearing from these smaller firms 
could help us learn how our proposed rules would affect them, and 
evaluate how we could address any unintended consequences resulting 
from the cost and effort of regulatory compliance while still 
promoting investor protection. We would appreciate your feedback on 
any or all of the following questions.
    All of the following questions are optional, including any 
questions that ask about identifying information. Please note that 
responses to these questions--including any other general 
identifying information you provide--will be made public.

Item 1: General Identifying Information

Instructions: At your option, you may include general identifying 
information that would help us contextualize your other feedback on 
the proposal. This information could include responses to the 
following questions, as well as any other general identifying 
information you would like to provide. Responses to these items--
like responses to the other items on this Feedback Flier--will be 
made public.
a. Is the firm a Commission-registered investment adviser or a 
broker-dealer?
b. What is the size of the firm in terms of:
    (1.) The number of retail investors (as defined in the release)?
    (2.) For Investment Advisers, regulatory assets under 
management?
    (3.) For broker-dealers, regulatory net capital?
    (4.) Other (please specify)?
c. Please include any additional general identifying information 
that you wish to provide, that could add context to your other 
feedback on the proposal.
d. Does the firm accept orders from or place orders for the accounts 
of retail investors to buy or sell shares of leveraged/inverse 
investment vehicles (as defined in the proposed sales practices 
rules)?

Item 2: Cost To Comply With the Proposed Due Diligence and Account 
Approval Requirements

a. What do you expect the cost to your firm would be in order to 
comply with these proposed requirements (in terms of combined 
internal and external costs)?
    (1.) For an investment adviser (check one box):

------------------------------------------------------------------------
                           Estimated cost ($)
-------------------------------------------------------------------------
       $0-$5,000              $5,001-$10,000             >$10,000
------------------------------------------------------------------------
                 [ ]                      [ ]                     [ ]
------------------------------------------------------------------------

    (2.) For a broker-dealer (check one box):

------------------------------------------------------------------------
                           Estimated cost ($)
-------------------------------------------------------------------------
       $0-$25,000            $25,001-$50,000             >$50,000
------------------------------------------------------------------------
                 [ ]                      [ ]                     [ ]
------------------------------------------------------------------------

b. Are there any less expensive alternatives to the proposed 
requirements you can suggest that would still preserve the proposed 
rules' intended investor protection safeguards?

Item 3: Other Feedback on Proposed Sales Practices Rules

Instructions: Please include any other additional suggestions or 
comments about the proposed sales practices rules that you would 
like to provide.

We will post your feedback on our website. Your submission will be 
posted without change; we do not redact or edit personal identifying 
information from submissions. You should only make submissions that 
you wish to make available publicly.

If you are interested in more information on the proposal, or want 
to provide feedback on additional questions, click here. Comments 
should be received on or before March 24, 2020.

Thank You!

Other Ways to Submit Your Feedback
You also can send us feedback in the following ways (include the 
file number S7-24-15 in your response):

Print Your Responses and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE, 
Washington, DC 20549-1090

Print a PDF of Your Responses and Email
Use the printer friendly page and select a PDF printer to create a 
file you can email to: [email protected]

Print a Blank Copy of This Flier, Fill it Out, and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE, 
Washington, DC 20549-1090

[FR Doc. 2020-00040 Filed 1-23-20; 8:45 am]
 BILLING CODE 8011-01-P

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