On November 25, 2019, the SEC proposed a new exemptive rule under the Investment Company Act of 1940—Rule 18f-4—intended to overhaul the current regulatory framework governing the use of derivatives by registered investment companies. The SEC initially proposed a derivatives rule in December 2015, and this proposal contains several significant changes from the 2015 proposal. The new rule would supersede historical guidance provided by the SEC and its staff relating to the use of derivatives by registered funds.

The proposed rule would permit a fund to engage in derivatives transactions, notwithstanding the prohibitions and restrictions on the issuance of “senior securities” under Section 18 of the 1940 Act, subject to the following conditions:

• Derivatives Risk Management Program. A fund would be required to adopt a written derivatives risk management program (DRMP) with, among other things, risk guidelines reflecting how the fund’s use of derivatives may affect its investment portfolio and overall risk profile. A fund would also be required to appoint a derivatives risk manager (DRM) to administer the DRMP.

• Limit on Fund Leverage Risk. A fund engaging in derivatives transactions would be required to comply with an outer limit on leverage based on a comparison of the fund’s value at risk (VaR) to the VaR of a “designated reference index” for that fund. If the fund’s DRM is unable to identify an appropriate designated reference index, the fund’s VaR could not exceed 15% of the value of the fund’s net assets—referred to as the “absolute VaR test.”

• Board Oversight and Reporting. A fund’s board of directors would be required to approve the fund’s DRM. The fund’s DRM would be required to report to the fund’s board on the implementation and effectiveness of the DRMP and the results of the fund’s stress testing. In general, the responsibilities that would be imposed on fund boards by this proposal are substantially less onerous than those that would have been required under the 2015 proposal.

Other elements of the proposal include:

• Exception of Limited Derivatives Users. Limited derivatives users—i.e., a fund that either (1) limits its derivatives exposure to 10% of its net assets or (2) uses derivatives transactions solely to hedge certain currency risks—would be excepted from the DRMP requirement and from the VaR-based limit on fund leverage risk.

• Alternative Requirements for Certain Leveraged/Inverse Funds. An exception on the limit on fund leverage risk would be provided for certain leveraged/inverse funds in light of a proposed new sales practices rule that requires broker-dealers and investment advisers to exercise due diligence on retail investors before permitting transactions in these types of funds.

Comments on the SEC’s proposal are due March 24, 2020.