Analysis of the SEC’s Final Rulemaking to Regulate the Use of Derivatives and Other Transactions by Registered Investment Companies and BDCs

November 23, 2020

The U.S. Securities and Exchange Commission on October 28, 2020 approved by a 3-2 vote a new rule and rule and form amendments related to the use of derivatives and certain other transactions by registered investment companies (i.e., open-end funds other than money market funds; closed-end funds; and exchange-traded funds) and business development companies (BDCs) (collectively, funds).

These regulatory actions include: (1) new Rule 18f‑4 under the Investment Company Act of 1940 (the Final Rule); (2) a related rule amendment under the 1940 Act pertaining to leveraged/inverse exchange-traded funds (ETFs); (3) related fund reporting rule and form and registration statement form amendments; and (4) a conforming amendment to Rule 22e-4 under the 1940 Act (collectively, the Final Rulemaking).

The Final Rulemaking represents the most significant change to the way the Commission regulates funds’ use of derivatives and other transactions and the obligations of fund boards with respect to such transactions since the Commission’s foundational Release 10666 was published in 1979. The Final Rulemaking was proposed in November 2019 and was a re-proposal of a 2015 Commission rulemaking effort. The 2015 proposed rulemaking was the first significant Commission or staff action relating to funds’ use of derivatives and certain other transactions that create leverage since the Commission’s issuance of a Concept Release in 2011.

The Final Rulemaking includes a number of significant changes from the 2019 Proposal. The Adopting Release highlights that many of the changes from the 2019 Proposal were made in response to industry comments, and that certain changes take into account in particular commenters’ experiences in managing funds’ derivatives risk through the period of market volatility following the 2020 outbreak of the COVID-19 coronavirus across the world.

In light of the Final Rule, and consistent with the approach identified under the Proposed Rule, the Commission is rescinding Release 10666 and the related “asset segregation” requirements articulated in that release, after an 18-month transition period to allow funds to prepare to come into compliance with the Final Rulemaking following its effective date, which will be 60 days after its publication in the Federal Register. The Commission staff also will withdraw related no-action letters and other guidance or portions thereof to the extent moot, superseded or otherwise inconsistent with the Final Rule. As a result, any fund will need to comply with the conditions set forth in the Final Rule in order to engage in the applicable transactions.

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