The US Securities and Exchange Commission has adopted a revised version of a re-proposal of ICA Rule 18f-4 (entitled "Exemption from the Requirements of Section 18 and Section 61 for Certain Senior Securities Transactions"). The new rule will replace SEC Release IC-10666 (18 April 1979), which will no longer be effective.

Final ICA Rule 18f-4 provides an exemption from section 18 (entitled "Capital structure of investment companies") and section 61 (entitled "Board of Directors") under the Investment Company Act for mutual funds, exchange-traded funds (ETFs), registered closed-end funds and business development companies (BDCs) when entering into derivatives transactions. Reliance on Rule 18f-4 will be subject to certain conditions, including:

• the establishment in every case of a written derivatives risk management programme that includes, among other things, (i) a standardised risk management regime tailored to the fund's particular risks, (ii) risk guidelines and (iii) periodic reviews of the programme;
• the designation by the fund's board of directors of a derivatives risk manager;
• the establishment of an outer limit on fund leverage based on a relative value-at-risk ("VaR") test that compares the fund's VaR and the VaR of a "designated reference index"; and
• recordkeeping requirements.

The final rule will exempt both funds that use derivatives in a limited way from the requirement for a derivatives risk management programme and the limit on fund leverage. It will also exempt certain leveraged/inverse funds from the limit on fund leverage (permitting an investment return of 200% of the return, or its inverse, of the reference index).

The SEC also amended ICA Rule 6c-11 (entitled "Exchange-Traded Funds") to permit certain leveraged or inverse ETFs to operate without receiving individual exemptive orders. (When that rule came into force to permit the establishment of an ETF without any need for an individual exemptive order, the SEC barred leveraged ETFs from relying on it).

The SEC also amended Forms N-PORT, N-LIQUID and N-CEN to require funds to provide certain information regarding their exposures to derivatives and VaR (value-at-risk) and VaR test breaches.

The final rule will go into effect 60 days after its publication in the Federal Register and its compliance date is 18 months after its effective date.

What the commissioners said

SEC Chairman Jay Clayton stated that the final rule allows a fund to continue using derivatives in a way that adequately serves its investment goals while also providing for concerns about section 18 to be addressed in a clear and consistent manner. Commissioner Elad Roisman also supported the final rule, stating that it achieves the goal of balancing careful risk management requirements with flexibility for advisors in a way that is necessary for meeting investors' demands.

Commissioner Allison Herren Lee dissented, citing major differences between the proposal, which she supported, and the final rule. In particular, she expressed her disapproval of (i) the provision of the rule that doubles the leverage risk amount allowed by the SEC, (ii) the SEC's decision to remove "a significant amount of proposed disclosure around a fund's VaR" and (iii) the SEC's decision not to include the proposed sales practice rules. Commissioner Caroline Crenshaw also disapproved of the adoption, stating that it failed to adequately limit the ability of a registered fund to take on leverage.

Although Commissioner Hester Peirce supported the adoption, she expressed concern that the rule "sets an unwelcome precedent" that imposes a duty (the selection of the fund's derivatives risk manager), which should belong to an advisor, on a fund's board. Additionally, Ms Peirce questioned the decision of the SEC to prohibit new investors from investing in 300% ETFs, saying that it raised "thorny questions of investor protection and investor opportunity."

More to be done for no-action relief

Rather than the SEC and Commodities and Futures Trading Commissions reining in their staffs, I believe that they ought to be giving their people more authority to grant no-action relief.

The interpretative release that Rule 18f-4 replaces is more than forty years old. As swaps developed and the use of listed futures increased over that time, it became obvious that it treated similar transactions very differently and produced economically irrational results.

The lesson to be learned is not that the regulators should allow their staffs to engage in a comprehensive rulemaking as to the use of derivatives by registered investment companies. Rather, it is that they need to concentrate on the big stuff, such as this new rule, and give more freedom to staff to allow divergences from rules.

It is of course uncomfortable to give up control, but it should be even more uncomfortable to allow an interpretative release, in such an important area, to remain unfixed. The commissioners can only do so much. The less that they allow staff to make decisions, the more will go undone.

* Steven Lofchie can be reached at Steven.Lofchie@cwt.com