SEC Modernizes IC Act Senior Securities Rule

When the SEC voted last month to adopt new Rule 18f-4 under the Investment Company Act of 1940 (“IC Act” or the “Act”), it permitted the greater use of derivatives by certain registered investment companies. The new rule covers mutual funds (excluding money market funds), ETFs, closed-end funds, and business development companies (BDCs).

Derivative use in funds is subject to the “senior securities” restrictions imposed by Section 18 under the IC Act. Section 61 of the Act imposes similar restrictions on BDCs. In addition to new Rule 18f-4, the SEC also voted to adopt related fund reporting requirements and form amendments. Rule 18f-4 also allows funds and BDCs to enter into reverse repurchase agreements and “unfunded commitments.”

Below are the conditions under Rule 18f-4 that funds or BDCs may conduct derivatives transactions while meeting the prohibitions and restrictions on the issuance of senior securities:

  • Derivatives Risk Management Program. The fund or BDC must adopt a written program with risk guidelines covering certain elements, including stress testing, backtesting, internal reporting and escalation, and a program review.
  • Limit on Fund Leverage Risk. A new outer limit on fund/BDC leverage risk is required based on value at risk (VaR). VaR is an estimate of a portfolio’s potential loss over a given period of time and at a specified confidence level. This outer limit is based on a relative VaR test that compares the entity’s VaR to the VaR of a “designated reference portfolio” for that fund or BDC.
  • Board Oversight and Reporting. The board of directors is required to designate a Derivatives Risk Manager that will be responsible for administering the Derivatives Risk Management program and reporting to the board.
  • Recordkeeping. New recordkeeping requirements designed to provide the board and compliance personnel the ability to evaluate compliance with the requirements of Rule 18-4 such as VaR backtesting, stress testing, and any non-compliance issues.
  • Exception for limited derivatives users. A fund or BDC that limits its derivatives exposure to 10 percent of net assets will be deemed a “limited derivatives user” and not subject to the new requirements of Rule 18f-4, provided it adopts and implements written policies and procedures reasonably designed to manage derivative risks.

Under the new rule requirements, funds or BDCs with significant derivatives holdings and transactions will need to make meaningful changes to their compliance program.

View SEC Release No. IC-34084, “Use of Derivatives by Registered Investment Companies and Business Development Companies,” which becomes effective 60 days after publication in the Federal Register (TBD).