An Overview of the SEC’s Derivatives and Senior Securities Transactions Rule Proposal

March 02, 2016

Proposed Rule 18f-4 under the Investment Company Act of 1940 (1940 Act) would substan­tially limit the ability of registered investment funds and business development companies (BDCs) (collec­tively, funds) to invest in derivatives and incur other forms of leverage. In some cases, the proposed rule could cause certain types of funds, such as leveraged ETFs and managed futures mutual funds, to cease operations as currently structured or otherwise operate in a form other than as a registered investment fund.

Under the proposed rule, a fund could enter into derivatives and certain financial commitment transactions only if three conditions are satisfied: (i) compliance with notional portfolio limitations, (ii) compliance with uniform asset segregation requirements, and (iii) implementation of board approved procedures and derivatives risk manage­ment programs for certain funds.

The proposed rule’s portfolio limitation and asset segregation conditions are designed to (i) limit the leverage a fund may obtain through certain transactions and thereby avoid “undue speculation” concerns, and (ii) require the fund to have assets available to meet its obligations under those trans­actions. The Securities and Exchange Commission (SEC) believes that these conditions would address the “central investor protection purposes and con­cerns” underlying Section 18.

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