Use of Derivatives by Registered Investment Companies and Business Development

Conformed to Federal Register version 
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SECURITIES AND EXCHANGE COMMISSION 
17 CFR Parts 239, 240, 249, 270, 274 and 275 
Release No. 34-87607; I A-5413; IC-33704; File No. S7-24-15 
RIN: 3235-AL60 
Use of Derivatives by Registered Investment Companies and Business Development 
Companies; Required Due Diligence by Broker-Dealers and Registered Investment 
Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse 
Investment Vehicles 
AGENCY: Securities and Exchange Commission. 
ACTION: Proposed rule.  
SUMMARY: The Securities and Exchange Commission (the “Commission”) is re-proposing 
rule 18f-4, a new exemptive rule under the Investment Company Act of 1940 (the “Investment 
Company Act”) designed to address the investor protection purposes and concerns underlying 
section 18 of the Act and to provide an updated and more comprehensive approach to the 
regulation of funds’ use of derivatives and the other transactions addressed in the proposed rule. 
The Commission is also proposing new rule 15l-2 under the Securities Exchange Act of 1934 
(the “Exchange Act”) and new rule 211(h)-1 under the Investment Advisers Act of 1940 
(“Advisers Act”) (collectively, the “sales practices rules”). In addition, the Commission is 
proposing new reporting requirements and amendments to Form N-PORT, Form N-LIQUID 
(which we propose to be re-titled as “Form N-RN”), and Form N-CEN, which are designed to 
enhance the Commission’s ability to effectively oversee funds’ use of and compliance with the 
proposed rules, and for the Commission and the public to have greater insight into the impact 
that funds’ use of derivatives would have on their portfolios. Finally, the Commission is 
proposing to amend rule 6c-11 under the Investment Company Act to allow certain 

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leveraged/inverse ETFs that satisfy the rule’s conditions to operate without the expense and 
delay of obtaining an exemptive order. 
DATES: Comments should be submitted on or before March 24, 2020. 
ADDRESSES: Comments may be submitted by any of the following methods: 
Electronic comments: 
• Use the Commission’s internet comment form 
(http://www.sec.gov/rules/proposed.shtml); or 
• Send an email to [email protected]. Please include File No. S7-24-15 on the 
subject line. 
Paper comments: 
• Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street 
NE, Washington, DC 20549-1090. 
All submissions should refer to File Number S7-24-15. This file number should be included on 
the subject line if email is used. To help the Commission process and review your comments 
more efficiently, please use only one method of submission. The Commission will post all 
comments on the Commission’s website (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for website viewing and printing in the Commission’s Public Reference Room, 
100 F Street NE, Washington, DC 20549, on official business days between the hours of 
10:00 a.m. and 3:00 p.m. All comments received will be posted without change. Persons 
submitting comments are cautioned that we do not redact or edit personal identifying information 
from comment submissions. You should submit only information that you wish to make publicly 
available. 
Studies, memoranda, or other substantive items may be added by the Commission or staff 
to the comment file during this rulemaking. A notification of the inclusion in the comment file of 

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any such materials will be made available on the Commission’s website. To ensure direct 
electronic receipt of such notifications, sign up through the “Stay Connected” option at 
www.sec.gov to receive notifications by email. 
FOR FURTHER INFORMATION CONTACT: Asaf Barouk, Attorney-Adviser; Joel 
Cavanaugh, Senior Counsel; John Lee, Senior Counsel; Sirimal Mukerjee, Senior Counsel; 
Amanda Hollander Wagner, Branch Chief; Thoreau Bartmann, Senior Special Counsel; or Brian 
McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation 
Office, Division of Investment Management; and with respect to proposed rule 15l-2, Kelly 
Shoop, Senior Counsel; or Lourdes Gonzalez, Assistant Chief Counsel; Office of Chief Counsel, 
Division of Trading and Markets; Securities and Exchange Commission, 100 F Street, NE, 
Washington, DC 20549-1090. 
SUPPLEMENTARY INFORMATION: Proposed rule 18f-4 would apply to mutual funds 
(other than money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, 
and companies that have elected to be treated as business development companies (“BDCs”) 
under the Investment Company Act (collectively, “funds”). It would permit these funds to enter 
into derivatives transactions and certain other transactions, notwithstanding the restrictions under 
sections 18 and 61 of the Investment Company Act, provided that the funds comply with the 
conditions of the rule. The proposed sales practices rules would require a broker, dealer, or 
investment adviser that is registered with (or required to be registered with) the Commission to 
exercise due diligence in approving a retail customer’s or client’s account to buy or sell shares of 
certain “leveraged/inverse investment vehicles” before accepting an order from, or placing an 
order for, the customer or client to engage in these transactions. 

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The Commission is proposing for public comment 17 CFR 270.18f-4 (new rule 18f-4) 
under the Investment Company Act, 17 CFR 240.15l-2 (new rule 15l-2) under the Exchange Act, 
17 CFR 275.211(h)-1 (new rule 211(h)-1) under the Advisers Act; amendments to 17 CFR 
270.6c-11 (rule 6c-11) under the Investment Company Act; amendments to Form N -PORT 
[referenced in 17 CFR 274.150], Form N-LIQUID (which we propose to re-title as “Form N-
RN”) [referenced in 17 CFR 274.223], Form N-CEN [referenced in 17 CFR 274.101], and Form 
N-2 [referenced in 17 CFR 274.11a-1] under the Investment Company Act. 

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TABLE OF CONTENTS 
 
I.
 Introduction .................................................................................................................. 9 
A. Overview of Funds’ Use of Derivatives ................................................................13 
B. Derivatives and the Senior Securities Restrictions of the Investment  
Company Act .........................................................................................................17 
1. Requirements of Section 18 ............................................................................ 17 
2. Evolution of Commission and Staff Consideration of Section 18  
Restrictions as Applied to Funds’ Use of Derivatives .................................... 19
 
3. Need for Updated Regulatory Framework ...................................................... 28 
C. Overview of the Proposal.......................................................................................30 
II. Discussion ................................................................................................................... 36 
A. Scope of Proposed Rule 18f-4 ...............................................................................36 
1. Funds Permitted to Rely on Proposed Rule 18f-4 .......................................... 36 
2. Derivatives Transactions Permitted Under Proposed Rule 18f-4 ................... 39 
B. Derivatives Risk Management Program ................................................................45 
1. Summary ......................................................................................................... 45 
2. Program Administration.................................................................................. 48 
3. Required Elements of the Program ................................................................. 55 
C. Board Oversight and Reporting .............................................................................79 
1. Board Approval of the Derivatives Risk Manager ......................................... 81 
2. Board Reporting .............................................................................................. 84 
D. Proposed Limit on Fund Leverage Risk ................................................................90 
1. Use of VaR ...................................................................................................... 91 
2. Relative VaR Test ........................................................................................... 97 
3. Absolute VaR Test ........................................................................................ 113 
4. Choice of Model and Parameters for VaR Test ............................................ 117 
5. Implementation ............................................................................................. 126 
6. Other Regulatory Approaches to Limiting Fund Leverage Risk .................. 133 
E. Limited Derivatives Users ...................................................................................148 
1. Exposure-Based Exception ........................................................................... 149 
2. Currency Hedging Exception ........................................................................ 164 
3. Risk Management ......................................................................................... 167 
F. Asset Segregation.................................................................................................171 
G. Alternative Requirements for Certain Leveraged/Inverse Funds and  
Proposed Sales Practices Rules for Certain Leveraged/Inverse  
Investment Vehicles .............................................................................................176 
1. Background on Proposed Approach to Certain Leveraged/Inverse Funds ...    176 
2. Proposed Sales Practices Rules for Leveraged/Inverse  
Investment Vehicles ...................................................................................... 181 

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3. Alternative Provision for Leveraged/Inverse Funds Under Proposed  
Rule 18f-4 ..................................................................................................... 200 
4. Proposed Amendments to Rule 6c-11 under the Investment Company  
Act and Proposed Rescission of Exemptive Relief for  
Leveraged/Inverse ETFs ............................................................................... 204 
H. Amendments to Fund Reporting Requirements ...................................................206 
1. Amendments to Form N-PORT .................................................................... 208 
2. Amendments to Current Reporting Requirements ........................................ 213 
3. Amendments to Form N-CEN ...................................................................... 220 
4. BDC Reporting ............................................................................................. 221 
I. Reverse Repurchase Agreements .........................................................................223 
J. Unfunded Commitment Agreements ...................................................................229 
K. Recordkeeping Provisions ...................................................................................239 
L. Transition Periods ................................................................................................243 
M. Conforming Amendments ....................................................................................247 
III. Economic Analysis ................................................................................................... 248 
A. Introduction ..........................................................................................................249 
B. Economic Baseline...............................................................................................253 
1. Fund Industry Overview ............................................................................... 253 
2. Funds’ Use of Derivatives ............................................................................ 254 
3. Current Regulatory Framework for Derivatives ........................................... 255 
4. Funds’ Derivatives Risk Management Practices and Use of VaR Models ...    256 
5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse Funds ....... 257 
C. Benefits and Costs of the Proposed Rules and Amendments ..............................260 
1. Derivatives Risk Management Program and Board Oversight and  
Reporting....................................................................................................... 261 
2. VaR-Based Limit on Fund Leverage Risk .................................................... 269 
3. Limited Derivatives Users ............................................................................ 281 
4. Reverse Repurchase Agreements and Similar Financing Transactions ........ 285 
5. Alternative Requirements for Certain Leveraged/Inverse Funds and  
Proposed Sales Practices Rules for Certain Leveraged/Inverse  
Investment Vehicles ...................................................................................... 287
 
6. Proposed Amendments to Rule 6c-11 under the Investment Company  
Act and Proposed Rescission of Exemptive Relief for  
Leveraged/Inverse ETFs ............................................................................... 294 
7. Unfunded Commitment Agreements ............................................................ 295 
8. Recordkeeping .............................................................................................. 296 
9. Amendments to Fund Reporting Requirements ............................................ 299 
10. Money Market Funds .................................................................................... 304 
D. Effects on Efficiency, Competition, and Capital Formation ................................305 
1. Efficiency ...................................................................................................... 305 

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2. Competition................................................................................................... 310 
3. Capital Formation ......................................................................................... 312 
E. Reasonable Alternatives.......................................................................................313 
1. Alternative Implementations of the VaR Tests ............................................. 313 
2. Alternatives to the VaR Tests ....................................................................... 317 
3. Stress Testing Frequency .............................................................................. 321 
4. Alternative Exposure Limits for Leveraged/Inverse Funds .......................... 322 
5. No Sales Practices Rules and No Separate Exposure Limit for 
Leveraged/Inverse Funds .............................................................................. 324 
6. Enhanced Disclosure ..................................................................................... 326 
F. Request for Comments .........................................................................................327 
IV. Paperwork Reduction Act Analysis .......................................................................... 328 
A. Introduction ..........................................................................................................328 
B. Proposed Rule 18f-4 ............................................................................................330 
1. Derivatives Risk Management Program ....................................................... 332 
2. Board Oversight and Reporting .................................................................... 335 
3. Disclosure Requirement Associated with Limit on Fund Leverage Risk ..... 337 
4. Disclosure Requirement for Leveraged/Inverse Funds ................................. 339 
5. Disclosure Changes for Money Market Funds ............................................. 341 
6. Policies and Procedures for Limited Derivatives Users ............................... 343 
7. Recordkeeping Requirements ....................................................................... 345 
8. Proposed Rule 18f-4 Total Estimated Burden .............................................. 348 
C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers ...........................349 
1. Due Diligence and Account Approval .......................................................... 350 
2. Policies and Procedures ................................................................................ 354 
3. Recordkeeping .............................................................................................. 356 
4. Proposed Rule 15l-2 Total Estimated Burden .............................................. 357 
D. Proposed Rule 211(h)-1: Sales Practices for Registered Investment Advisers ...358 
1. Due Diligence and Account Approval .......................................................... 359 
2. Policies and Procedures ................................................................................ 362 
3. Recordkeeping .............................................................................................. 364 
4. Proposed Rule 211(h)-1 Total Estimated Burden ......................................... 365 
E. Rule 6c-11 ............................................................................................................366 
F. Form N-PORT .....................................................................................................369 
G. Form N-RN ..........................................................................................................372 
H. Form N-CEN ........................................................................................................376 
I. Request for Comments .........................................................................................379 
V. Initial Regulatory Flexbility Analysis ...................................................................... 379 
A. Reasons for and Objectives of the Proposed Actions ..........................................380 
B. Legal Basis ...........................................................................................................381 
C. Small Entities Subject to Proposed Rules ............................................................382 

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D. Projected Reporting, Recordkeeping, and Other Compliance Requirements ......384 
1. Proposed Rule 18f-4 ..................................................................................... 384 
2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN.......... 394 
3. Proposed Sales Practices Rules ..................................................................... 400 
4. Proposed Amendments to Rule 6c-11........................................................... 402 
E. Duplicative, Overlapping, or Conflicting Federal Rules .....................................403 
F. Significant Alternatives .......................................................................................404 
1. Proposed Rule 18f-4 ..................................................................................... 404 
2. Proposed Sales Practices Rules ..................................................................... 408 
3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN.......... 410 
4. Rule 6c-11 ..................................................................................................... 412 
G. Request for Comment ..........................................................................................413 
VI. Consideration of Impact on the Economy ................................................................ 413 
VII. Statutory Authority ............................................................................................. 414 
VIII. Appendix A ......................................................................................................... 446 
IX. Appendix B ............................................................................................................... 453 
 
  

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I. INTRODUCTION  
The fund industry has grown and evolved substantially in past decades in response to 
various factors, including investor demand, technological developments, and an increase in 
domestic and international investment opportunities, both retail and institutional.
1
 Funds today 
follow a broad variety of investment strategies and provide diverse investment opportunities for 
fund investors, including retail investors. As funds’ strategies have become increasingly diverse, 
funds’ use of derivatives has grown in both volume and complexity over the past several 
decades.
2
 Derivatives may be broadly described as instruments or contracts whose value is based 
upon, or derived from, some other asset or metric.
3
 Funds use derivatives for a variety of 
                                                      
1
  For example, the investment company industry consisted of more than 3,500 investment 
companies, and held over $1.3 trillion in assets, as of the end of 1991. See SEC Division of 
Investment Management, Protecting Investors: A Half Century of Investment Company 
Regulation (1992), available at https://www.sec.gov/divisions/investment/guidance/icreg50-
92.pdf. The assets held by U.S.-registered investment companies grew to approximately $7.1 
trillion as of the end of 1999, and from then until the end of 2018 grew over 200%, to 
approximately $21.4 trillion. See Investment Company Institute, 2018 Investment Company Fact 
Book at 32, available at 
https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.
pdf. Similarly, the number of mutual funds, registered closed-end funds, and ETFs grew from 
7,970, 512, and 30 (respectively) as of the end of 1999, to 9,599, 506, and 2,057 (respectively) as 
of the end of 2018. See id. at 50.  
 The diversity of fund strategies has also increased over time, including, more recently, the 
introduction of funds pursuing so-called “alternative strategies” (which tend to use derivatives 
more than other fund types). See Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang & 
William Yost, Use of Derivatives by Registered Investment Companies, Division of Economic 
and Risk Analysis (2015), available at http://www.sec.gov/dera/staffpapers/white-
papers/derivatives12-2015.pdf (“DERA White Paper”). 
2
  See Use of Derivatives by Registered Investment Companies and Business Development 
Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 
28, 2015)], at n.6 and accompanying text (“2015 Proposing Release”).  
3
  The asset or metric on which the derivative’s value is based, or from which its value is derived, is 
commonly referred to as the “reference asset,” “underlying asset,” or “underlier.” See id. at n.3 
and accompanying text (citing Use of Derivatives by Investment Companies under the Investment 
Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR 
55237 (Sept. 7, 2011)], at n.3 (“2011 Concept Release”)). The comment letters on the 2011 
Concept Release (File No. S7-33-11) are available at https://www.sec.gov/comments/s7-33-
 

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purposes. For example, funds use derivatives to seek higher returns through increased investment 
exposure, to hedge risks in their investment portfolios, or to obtain exposure to particular 
investments or markets more efficiently than may be possible through direct investments.
4
 At the 
same time, derivatives can introduce certain new risks and heighten certain risks to a fund and its 
investors. These risks can arise from, for example, leverage, liquidity, markets, operations, legal 
matters (e.g., contract enforceability), and counterparties.  
Funds using derivatives must consider requirements under the Investment Company Act 
of 1940.
5
 These include sections 18 and 61 of the Investment Company Act, which limit a fund’s 
ability to obtain leverage or incur obligations to persons other than the fund’s common 
shareholders through the issuance of “senior securities.”
6
 As we discuss more fully in this 
release, as derivatives markets have expanded and funds have increased their use of derivatives, 
the Commission and its staff have issued guidance addressing the use of specific derivatives 
instruments and practices, and other financial instruments, under section 18. In determining how 
                                                      
11/s73311.shtml.  
4
  See, e.g., My Nguyen, Using Financial Derivatives to Hedge Against Currency Risk, Arcada 
University of Applied Sciences (2012). 
5
  15 U.S.C. 80a (the “Investment Company Act,” or the “Act”). Except in connection with our 
discussion of proposed rule 15l-2 under the Securities Exchange Act of 1934 and proposed rule 
211(h)-1 under the Advisers Act or as otherwise noted, all references to statutory sections are to 
the Investment Company Act, and all references to rules under the Investment Company Act, 
including proposed rule 18f-4, will be to title 17, part 270 of the Code of Federal Regulations, 17 
CFR part 270.  
6
  See infra section I.B.1. Funds using derivatives must also comply with all other applicable 
statutory and regulatory requirements, such as other federal securities law provisions, the Internal 
Revenue Code, Regulation T of the Federal Reserve Board, and the rules and regulations of the 
Commodity Futures Trading Commission (the “CFTC”). See also Title VII of the Dodd-Frank 
Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) 
(the “Dodd-Frank Act”), available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.  
 Section 61 of the Investment Company Act makes section 18 of the Act applicable to BDCs, with 
certain modifications. See infra note 32 and accompanying text. Except as otherwise noted, or 
unless the context dictates otherwise, references in this release to section 18 of the Act should be 
read to refer also to section 61 with respect to BDCs.  

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they will comply with section 18, we understand that funds consider this Commission and staff 
guidance, as well as staff no-action letters and the practices that other funds disclose in their 
registration statements.
7
 
In the absence of Commission rules and guidance that address the current broad range of 
funds’ derivatives use, inconsistent industry practices have developed.
8
 We are concerned that 
certain of these practices may not address investor protection concerns that underlie section 18’s 
limitations on funds’ issuance of senior securities. Specifically, certain fund practices can 
heighten leverage-related risks, such as the risk of potentially significant losses and increased 
fund volatility, that section 18 is designed to address. We are also concerned that funds’ 
disparate practices could create an un-level competitive landscape and make it difficult for funds 
and our staff to evaluate funds’ compliance with section 18.
9
  
To address these concerns, in 2015 the Commission proposed new rule 18f-4 under the 
Investment Company Act, which would have permitted a fund to enter into derivatives 
transactions and “financial commitment transactions,” subject to certain conditions.
10
 We 
                                                      
7
  Any staff guidance or no-action letters discussed in this release represent the views of the staff of 
the Division of Investment Management. They are not a rule, regulation, or statement of the 
Commission. Furthermore, the Commission has neither approved nor disapproved their content. 
Staff guidance has no legal force or effect; it does not alter or amend applicable law; and it 
creates no new or additional obligations for any person. 
8
  See infra section I.B.2.b (discussing the asset segregation practices funds have developed to 
“cover” their derivatives positions, which vary based on the type of derivatives transaction and 
with respect to the types of assets that funds segregate to cover their derivatives positions).  
9
  See, e.g., Comment Letter of the Investment Company Institute on the 2011 Concept Release 
(Nov. 7, 2011) (File No. S7-33-11) at n.19 (“ICI Concept Release Comment Letter”) (noting that 
funds segregate the notional amount of physically-settled futures contracts, while some funds 
disclose that they segregate only the marked-to-marked obligation in respect of cash-settled 
futures and agreeing with the concern reflected in the 2011 Concept Release that this “results in 
differing treatment of arguably equivalent products”).  
10
  For purposes of this release, we will refer to the version of rule 18f-4 that the Commission 
proposed in the 2015 Proposing Release as the “2015 proposed rule.” We will generally refer to 
 

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received approximately 200 comment letters in response to the 2015 proposal.
11
 In developing 
this re-proposal we considered those comment letters, as well as subsequent staff engagement 
with large and small fund complexes and investor groups.
12
  
We are re-proposing rule 18f-4, which is designed to address the investor protection 
purposes and concerns underlying section 18 and to provide an updated and more comprehensive 
approach to the regulation of funds’ use of derivatives transactions and certain other transactions. 
The proposed rule would permit funds to enter into these transactions, notwithstanding the 
restrictions under section 18 of the Investment Company Act, provided that they comply with the 
conditions of the rule. The proposed rule’s conditions are designed to require funds to manage 
the risks associated with their use of derivatives and to limit fund leverage risk consistent with 
the investor protection purposes underlying section 18. Our proposal also includes requirements 
designed to address specific risks posed by certain registered investment companies and 
exchange-listed commodity- or currency-based trusts or funds that obtain leveraged or inverse 
                                                      
rule 18f-4 as we propose it here as the “proposed rule.”  
The 2015 proposed rule included four principal elements for funds entering into derivatives 
transactions: (1) a requirement to comply with one of two alternative portfolio limitations 
designed to limit the amount of leverage a fund may obtain through derivatives and other senior 
securities transactions; (2) asset segregation for derivatives transactions, designed to enable a 
fund to meet its derivatives-related obligations; (3) a derivatives risk management program 
requirement for funds that engage in more than limited derivatives transactions or that use 
complex derivatives; and (4) reporting requirements regarding a fund’s derivatives usage.  
 The 2015 proposed rule included different requirements for derivatives transactions and 
“financial commitment transactions” (collectively, reverse repurchase agreements, short sale 
borrowings, or any firm or standby commitment agreement or similar agreement). Rule 18f-4 as 
we propose it here does not separately define “financial commitment transactions,” although the 
proposed rule does address—either directly or indirectly—all of the types of transactions that 
composed that defined term in the 2015 proposed rule. See infra section II. 
11
 The comment letters on the 2015 proposed rule (File No. S7-24-15) are available at 
https://www.sec.gov/comments/s7-24-15/s72415.shtml. 
12
  See also Division of Economic and Risk Analysis, Memorandum re: Risk Adjustment and 
Haircut Schedules (Nov. 1, 2016), available at https://www.sec.gov/comments/s7-24-15/s72415-
260.pdf (“2016 DERA Memo”). 

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exposure to an underlying index, generally on a daily basis.
13
 The proposal also addresses funds’ 
use of reverse repurchase agreements and similar transactions and certain so-called “unfunded 
commitments.” Finally, we propose to amend rule 6c-11 under the Investment Company Act to 
allow certain leveraged/inverse ETFs that satisfy that rule’s conditions to operate without the 
expense and delay of obtaining an exemptive order. Together, the rules we are proposing are 
designed to promote funds’ ability to continue to use derivatives in a broad variety of ways that 
serve investors, while responding to the concerns underlying section 18 of the Investment 
Company Act and promoting a more modern and comprehensive framework for regulating 
funds’ use of derivatives and the other transactions addressed in the proposed rule. 
A. Overview of Funds’ Use of Derivatives 
Funds today use a variety of derivatives. These derivatives can reference a range of assets 
or metrics, such as: stocks, bonds, currencies, interest rates, market indexes, currency exchange 
rates, or other assets or interests. Examples of derivatives that funds commonly use include 
forwards, futures, swaps, and options. Derivatives are often characterized as either exchange-
traded or over-the-counter (“OTC”).
14
  
                                                      
13
  As discussed in more detail in section II.G, the proposed sales practices rules would cover 
transactions in “leveraged/inverse investment vehicles,” which include registered investment 
companies and certain exchange-listed commodity- or currency-based trusts or funds that seek, 
directly or indirectly, to provide investment returns that correspond to the performance of a 
market index by a specified multiple, or to provide investment returns that have an inverse 
relationship to the performance of a market index, over a predetermined period of time. For 
purposes of this release, we refer to leveraged, inverse, and leveraged inverse investment vehicles 
collectively as “leveraged/inverse.” 
14
  Exchange-traded derivatives—such as futures, certain options, and options on futures—are 
standardized contracts traded on regulated exchanges. See 2015 Proposing Release, supra note 2, 
at nn.10-13 and accompanying text. OTC derivatives—such as certain swaps, non-exchange-
traded options, and combination products such as swaptions and forward swaps—are contracts 
that parties negotiate and enter into outside of an organized exchange. See id. at nn.14-16 and 
accompanying text. Unlike exchange-traded derivatives, OTC derivatives may be significantly 
customized and may not be cleared by a central clearing organization. Title VII of the Dodd-
 

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A common characteristic of most derivatives is that they involve leverage or the potential 
for leverage. The Commission has stated that “[l]everage exists when an investor achieves the 
right to a return on a capital base that exceeds the investment which he has personally 
contributed to the entity or instrument achieving a return.”
15
 Many fund derivatives transactions, 
such as futures, swaps, and written options, involve leverage or the potential for leverage 
because they enable the fund to magnify its gains and losses compared to the fund’s investment, 
while also obligating the fund to make a payment or deliver assets to a counterparty under 
specified conditions.
16
 Other derivatives transactions, such as purchased call options, provide the 
economic equivalent of leverage because they can magnify the fund’s exposure beyond its 
investment but do not impose a payment obligation on the fund beyond its investment.
17
 
Funds use derivatives both to obtain investment exposures as part of their investment 
strategies and to manage risk. A fund may use derivatives to gain, maintain, or reduce exposure 
to a market, sector, or security more quickly, and with lower transaction costs and portfolio 
disruption, than investing directly in the underlying securities.
18
 A fund also may use derivatives 
to obtain exposure to reference assets for which it may be difficult or impractical for the fund to 
                                                      
Frank Act provides a comprehensive framework for the regulation of the OTC swaps market. See 
supra note 6.   
15
  See Securities Trading Practices of Registered Investment Companies, Investment Company Act 
Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)], at n.5 (“Release 10666”). 
16
  The leverage created by such an arrangement is sometimes referred to as “indebtedness leverage.” 
See 2015 Proposing Release, supra note 2, at n.21 (citing 2011 Concept Release, supra note 3, at 
n.31).  
17
  This type of leverage is sometimes referred to as “economic leverage.” See id. at n.22 (citing 
2011 Concept Release, supra note 3, at n.32).  
18
  See, e.g., id. at n.24 and accompanying text (citing 2011 Concept Release, supra note 3, at section 
I).  

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make a direct investment, such as commodities.
19
 With respect to risk management, funds may 
employ derivatives to hedge interest rate, currency, credit, and other risks, as well as to hedge 
portfolio exposures.
20
  
At the same time, a fund’s derivatives use may entail risks relating to, for example, 
leverage, markets, operations, liquidity (particularly with respect to complex OTC derivatives), 
and counterparties, as well as legal risks.
21
 A fund’s investment adviser, therefore, must manage 
(and the board of directors oversee) the fund’s derivatives use, consistent with the fund’s 
investment objectives, policies, restrictions, and risk profile.
 
Furthermore, a fund’s investment 
adviser and board of directors must bear in mind the requirements of section 18 of the 
Investment Company Act, as well as the Act’s other requirements, when considering the use of 
derivatives.
 
 
Section 18 is designed to limit the leverage a fund can obtain or incur through the 
issuance of senior securities. Although the leverage limitations in section 18 apply regardless of 
whether the relevant fund actually experiences significant losses, several recent examples 
involving significant losses illustrate how a fund’s use of derivatives may raise the investor 
protection concerns underlying section 18.
 
The 2015 proposal discussed several circumstances in 
                                                      
19
  See, e.g., Comment Letter of Stone Ridge Asset Management LLC (Mar. 28, 2016) (“[I]t is not 
possible for AVRPX [a Stone Ridge fund] to trade many of the physical assets underlying the 
derivatives included in our portfolio—Stone Ridge does not maintain facilities to store oil or live 
hogs, for example.”); Comment Letter of Vanguard (Mar. 28, 2016) (“Vanguard Comment 
Letter”) (stating t hat a fund may use a derivative, such as commodity futures, when it is 
impractical to take delivery of physical commodities).  
20
 See 2015 Proposing Release, supra note 2, at n.25 and accompanying text; see also 2011 Concept 
Release, supra note 3, at section I.B. 
21
  See 2015 Proposing Release, supra note 2, at n.26 and accompanying text (citing 2011 Concept 
Release, supra note 3, at n.34).  

16 
which substantial and rapid losses resulted from a fund’s investment in derivatives.
22
 For 
example, one of these cases shows that further losses can result when a fund’s portfolio securities 
decline in value at the same time that the fund is required to make additional payments under its 
derivatives contracts.
23
  
Similarly, last year the LJM Preservation and Growth Fund liquidated after sustaining 
considerable losses (with its net asset value declining approximately 80% in two days) when 
market volatility spiked. The fund’s principal investment strategy involved purchasing and 
selling call and put options on the Standard & Poor’s (“S&P”) 500 Futures Index.
24
 S&P 500 
                                                      
22
  See 2015 Proposing Release, supra note 2, at section II.D.1.d. (discussing, among other things, 
the following settled actions: In the Matter of OppenheimerFunds, Inc. and OppenheimerFunds 
Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action) 
(“OppenheimerFunds Settled Action”) (involving two mutual funds that suffered losses driven 
primarily by their exposure to certain commercial mortgage-backed securities, obtained mainly 
through total return swaps); In the Matter of Claymore Advisors, LLC, Investment Company Act 
Release No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset Management, LLC, 
Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled actions) (involving a 
registered closed-end fund that pursued an investment strategy involving written out-of-the-
money put options and short variance swaps, which led to substantial losses for the fund); In the 
Matter of UBS Willow Management L.L.C. and UBS Fund Advisor L.L.C., Investment Company 
Act Release No. 31869 (Oct. 16, 2015) (settled action) (involving a registered closed-end fund 
that incurred significant losses due in part to large losses on the fund’s credit default swap 
portfolio)). 
See also In the Matter of Team Financial Asset Management, LLC, Team Financial Managers, 
Inc., and James L. Dailey, Investment Company Act Release No. 32951 (Dec. 22, 2017) (settled 
action) (involving a mutual fund incurring substantial losses arising out of speculative derivatives 
instruments, including losing $34.67 million in 2013 from trading in derivatives such as futures, 
options, and currency contracts); In the Matter of Mohammed Riad and Kevin Timothy Swanson, 
Investment Company Act Release No. 33338 (Dec. 21, 2018) (settled action) (involving a 
registered closed-end fund incurring substantial losses resulting from the implementation of a 
new derivatives trading strategy); In the Matter of Top Fund Management, Inc. and Barry C. 
Ziskin, Investment Company Act Release No. 30315 (Dec. 21, 2012) (settled action) (involving a 
mutual fund engaged in a strategy of buying options for speculative purposes contrary to its stated 
investment policy, which permitted options trading for hedging purposes, losing about 69% of its 
assets as a result of this activity before liquidating).   
23
  See OppenheimerFunds Settled Action, supra note 22.  
24
  See Prospectus, LJM Preservation and Growth Fund (Feb. 28, 2017), available at 
https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm.  

17 
options prices are determined in part by market volatility, and a volatility spike in early February 
2018 caused the fund to incur significant losses. The fund closed to new investments on February 
7, 2018 and announced on February 27, 2018 that it would liquidate its assets and dissolve on 
March 29, 2018.
25
 
The losses suffered by this fund and in the other examples we discuss above are extreme. 
Funds rarely suffer such large and rapid losses. We note these examples to illustrate the rapid 
and extensive losses that can result from a fund’s investments in derivatives absent effective 
derivatives risk management. In contrast, there are many other instances in which funds, by 
employing derivatives, have avoided losses, increased returns, and lowered risk.  
B. Derivatives and the Senior Securities Restrictions of the Investment 
Company Act 
1. Requirements of Section 18 
Section 18 of the Investment Company Act imposes various limits on the capital structure 
of funds, including, in part, by restricting the ability of funds to issue “senior securities.” 
Protecting investors against the potentially adverse effects of a fund’s issuance of senior 
securities, and in particular the risks associated with excessive leverage of investment 
companies, is a core purpose of the Investment Company Act.
26
 “ Senior security” is defined, in 
                                                      
25
  See Supplement to the Prospectus dated Feb. 28, 2017, LJM Preservation and Growth Fund (Feb. 
27, 2018), available at 
https://www.sec.gov/Archives/edgar/data/1552947/000158064218001068/ljm497.htm.  
26
  See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of the Investment Company Act; see also 
Provisions Of The Proposed Bill Related To Capital Structure (Sections 18, 19(B), And 21(C)),
 
Introduced by L.M.C Smith, Associate Counsel, Investment Trust Study, Securities and Exchange 
Commission, Hearings on S.3580 Before a Subcommittee of the Senate Committee on Banking 
and Currency, 76th Congress, 3rd session (1940), at 1028 (“Senate Hearings”) (“Because of the 
leverage influence, a substantial swing of the securities market is likely to deprive the common 
stock of a leverage investment company of both its asset and market value.... [H]ad investment 
companies been simple structure companies exclusively, a very substantial part of the losses 
sustained by investors in the common stock would have been avoided.”).  

18 
part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and 
evidencing indebtedness.”
27
 
Congress’ concerns underlying the limits in section 18 focused on: (1) excessive 
borrowing and the issuance of excessive amounts of senior securities by funds when these 
activities increase unduly the speculative character of funds’ junior securities; (2) funds 
operating without adequate assets and reserves; and (3) potential abuse of the purchasers of 
senior securities.
28
 To address these concerns, section 18 prohibits an open-end fund from 
issuing or selling any “senior security,” other than borrowing from a bank (subject to a 
requirement to maintain 300% “asset coverage”).
29
 Section 18 similarly prohibits a closed-end 
                                                      
27
  See section 18(g) of the Investment Company Act. The definition of “senior security” in 
section 18(g) also includes “any stock of a class having priority over any other class as to the 
distribution of assets or payment of dividends” and excludes certain limited temporary 
borrowings.  
28
  For discussion of the excessive borrowing concern, see section 1(b)(7) of the Investment 
Company Act; Release 10666, supra note 15, at n.8; see also Senate Hearings, supra note 26, at 
1028 (“The Commission believes that it has been clearly shown that it is the leverage aspect of 
the senior-junior capital structure in investment companies... which may be held accountable for 
a large part of the losses which have been suffered by the investor who purchases the common 
stock of a leverage company.”). 
 For discussion of concerns regarding funds operating without adequate assets and reserves, see 
section 1(b)(8) of the Investment Company Act; Release 10666, supra note 15, at n.8. 
For discussion of, among other things, potential abuse of the purchasers of senior securities, see 
Senate Hearings, supra note 26, at 265-78; see also Mutual Funds and Derivative Instruments, 
Division of Investment Management Memorandum transmitted by Chairman Levitt to 
Representatives Markey and Fields (Sept. 26, 1994), at 23, available at 
http://www.sec.gov/news/studies/deriv.txt (“1994 Letter to Congress”) (describing practices in 
the 1920s and 1930s that gave rise to section 18’s limits on leverage). 
29
  See section 18(f)(1) of the Investment Company Act. “Asset coverage” of a class of senior 
securities representing indebtedness of an issuer generally is defined in section 18(h) of the 
Investment Company Act as “the ratio which the value of the total assets of such issuer, less all 
liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of 
senior securities representing indebtedness of such issuer.” Take, for example, an open-end fund 
with $100 in assets and with no liabilities or senior securities outstanding. The fund could, while 
maintaining the required coverage of 300% of the value of its assets, borrow an additional $50 
from a bank. The $50 in borrowings would represent one-third of the fund’s $150 in total assets, 
measured after the borrowing (or 50% of the fund’s $100 net assets). 

19 
fund from issuing or selling any “senior security [that] represents an indebtedness” unless it has 
at least 300% “asset coverage,” although closed-end funds’ ability to issue senior securities 
representing indebtedness is not limited to bank borrowings.
30
 Closed-end funds also may issue 
senior securities that are a stock, subject to the limitations of section 18.
31
 The Investment 
Company Act also subjects BDCs to the limitations of section 18 to the same extent as registered 
closed-end funds, except the applicable asset coverage amount for any senior security 
representing indebtedness is 200% (and can be decreased to 150% under certain 
circumstances).
32
 
2. Evolution of Commission and Staff Consideration of Section 18 
Restrictions as Applied to Funds’ Use of Derivatives  
a. Investment Company Act Release 10666 
In a 1979 General Statement of Policy (Release 10666), the Commission considered the 
application of section 18’s restrictions on the issuance of senior securities to reverse repurchase 
agreements, firm commitment agreements, and standby commitment agreements.
33
 T he 
Commission concluded that these agreements fall within the “functional meaning of the term 
‘evidence of indebtedness’ for purposes of Section 18 of the Investment Company Act,”  noting 
                                                      
30
  See section 18(a)(1) of the Investment Company Act.  
31
  See section 18(a)(2) of the Investment Company Act. If a closed-end fund issues or sells a class 
of senior securities that is a stock, it must have an asset coverage of at least 200% immediately 
after such issuance or sale. Id. 
32
  See section 61(a)(1) of the Investment Company Act. BDCs, like registered closed-end funds, 
also may issue a senior security that is a stock (e.g., preferred stock), subject to limitations in 
section 18. See sections 18(a)(2) and 61(a)(1) of the Investment Company Act. In 2018, Congress 
passed the Small Business Credit Availability Act, which, among other things, modified the 
statutory asset coverage requirements applicable to BDCs (permitting BDCs that meet certain 
specified conditions to elect to decrease their effective asset coverage requirement from 200% to 
150%). See section 802 of the Small Business Credit Availability Act, Pub. L. No. 115-141, 132 
Stat. 348 (2018).  
33
  See Release 10666, supra note 15. 

20 
“the unique legislative purposes and policies underlying Section 18 of the Act.”
34
 The 
Commission stated in Release 10666 that, for purposes of section 18, “evidence of indebtedness” 
would include “all contractual obligations to pay in the future for consideration presently 
received.” The Commission recognized that, while section 18 would generally prohibit open-end 
funds’ use of reverse repurchase agreements, firm commitment agreements, and standby 
commitment agreements, the Commission nonetheless permitted funds to use these and similar 
arrangements subject to the constraints that Release 10666 describes.  
These constraints relied on funds’ use of “segregated accounts” to “cover” senior 
securities, which “if properly created and maintained, would limit the investment company’s risk 
of loss.”
35
 The Commission also stated that the segregated account functions as “a practical limit 
on the amount of leverage which the investment company may undertake and on the potential 
increase in the speculative character of its outstanding common stock” and that it “[would] 
assure the availability of adequate funds to meet the obligations arising from such activities.”
36
 
The Commission stated that its expressed views were not limited to the particular trading 
practices discussed, but that the Commission sought to address the implications of comparable 
trading practices that could similarly affect funds’ capital structures.
37
 
We continue to view the transactions described in Release 10666 as falling within the 
functional meaning of the term “evidence of indebtedness,” for purposes of section 18.
38
 The 
                                                      
34
     See id. 
35
  See 2015 Proposing Release, supra note 2, at nn.45-47 and accompanying text (discussing 
Release 10666’s discussion of segregated accounts). 
36
  See Release 10666, supra note 15, at 25132; see also 2015 Proposing Release, supra note 2, at 
n.48 and accompanying text. 
37
  See 2015 Proposing Release, supra note 2, at nn.49-50 and accompanying text. 
38
  See Release 10666, supra note 15, at “The Agreements as Securities” discussion. The Investment 
 

21 
trading practices that Release 10666 describes, as well as short sales of securities for which the 
staff initially developed the segregated account approach that the Commission applied in Release 
10666, all impose on a fund a contractual obligation under which the fund is or may be required 
to pay or deliver assets in the future to a counterparty. These transactions therefore involve the 
issuance of a senior security for purposes of section 18.
39
  
We apply the same analysis to all derivatives transactions that create future payment 
obligations. This is the case where the fund has a contractual obligation to pay or deliver cash or 
other assets to a counterparty in the future, either during the life of the instrument or at maturity 
                                                      
Company Act’s definition of the term “security” is broader than the term’s definition in other 
federal securities laws. See 2015 Proposing Release, supra note 2, at n.61. Compare 
section 2(a)(36) of the Investment Company Act with sections 2(a)(1) and 2A of the Securities 
Act of 1933 (15 U.S.C. 77a et seq.) (“Securities Act”) and sections 3(a)(10) and 3A of the 
Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) (“Exchange Act”). See also 2011 
Concept Release, supra note 3, at n.57 and accompanying text (explaining that the Commission 
has interpreted the term “security” in light of the policies and purposes underlying the Investment 
Company Act).  
39
  See Release 10666, supra note 15, at “The Agreements as Securities” discussion; see also 
section 18(g) (defining the term “senior security,” in part, as “any bond, debenture, note, or 
similar obligation or instrument constituting a security and evidencing indebtedness”).  
 The Commission received several comments on the 2015 proposal that objected to the 
Commission treating derivatives and financial commitment transactions as involving senior 
securities where a fund has “appropriately” covered its obligations under those transactions. 
These comments generally argued that this approach is not consistent with the Commission’s 
views in Release 10666 and that funds have for many years addressed senior security concerns 
raised by these transactions by segregating assets or engaging in offsetting, or “cover,” 
transactions that take into account Release 10666 and staff guidance. See, e.g., Comment Letter 
of the American Action Forum (Mar. 25, 2016) (“AAF Comment Letter”); Comment Letter of 
Financial Services Roundtable (Mar. 28, 2016) (“FSR Comment Letter”); Comment Letter of 
Franklin Resources, Inc. (Mar. 28, 2016) (“Franklin Resources Comment Letter”); Comment 
Letter of Dechert LLP (Mar. 28, 2016) (“Dechert Comment Letter”). Whether a transaction 
involves the issuance of a senior security will depend on whether that transaction involves a 
senior security within the meaning of section 18(g). A fund’s segregation of assets, although one 
way to address policy concerns underlying section 18 as the Commission described in Release 
10666, does not, itself, affect the legal question of whether a fund has issued a senior security. 

22 
or early termination.
40
 As was the case for trading practices that Release 10666 describes, where 
the fund has entered into a derivatives transaction and has such a future payment obligation, we 
believe that such a transaction involves an evidence of indebtedness that is a senior security for 
purposes of section 18.
41
 
The express scope of section 18 supports this interpretation. Section 18 defines the term 
“senior security” broadly to include instruments and transactions that other provisions of the 
federal securities laws might not otherwise consider to be securities.
42
 For example, 
section 18(f)(1) generally prohibits an open-end fund from issuing or selling any senior security 
“except [that the fund] shall be permitted to borrow from any bank.”
43
 This statutory permission 
                                                      
40
  These payments—which may include payments of cash, or delivery of other assets—may occur 
as margin, as settlement payments, or otherwise.  
41
  As the Commission explained in Release 10666, we believe that an evidence of indebtedness, for 
purposes of section 18, includes not only a firm and un-contingent obligation, but also a 
contingent obligation, such as a standby commitment or a “put” (or call) option sold by a fund. 
See Release 10666, supra note 15, at “Standby Commitment Agreements” discussion. We 
understand it has been asserted that a contingent obligation that a standby commitment or similar 
agreement creates does not involve a senior security under section 18, unless and until generally 
accepted accounting principles (“GAAP”) would require the fund to recognize the contingent 
obligation as a liability on the fund’s financial statements. The treatment of derivatives 
transactions under GAAP, including whether the derivatives transaction constitutes a liability for 
financial statement purposes at any given time or the extent of the liability for that purpose, is not 
determinative with respect to whether the derivatives transaction involves the issuance of a senior 
security under section 18. This is consistent with the Commission’s analysis of a fund’s 
obligation, and the corresponding segregated asset amounts, under the trading practices that 
Release 10666 describes. See id.  
42
  Consistent with Release 10666, and as the Commission stated in the 2015 Proposing Release, we 
are only expressing our views in this release concerning the scope of the term “senior security” in 
section 18 of the Investment Company Act. See also section 12(a) of the Investment Company 
Act (prohibiting funds from engaging in short sales in contravention of Commission rules or 
orders). 
43
  Section 18(c)(2) similarly treats all promissory notes or evidences of indebtedness issued in 
consideration of any loan as senior securities except as section 18 otherwise specifically provides. 

23 
to engage in a specific borrowing makes clear that such borrowings are senior securities, which 
otherwise section 18 would prohibit absent this specific permission.
44
  
This interpretation also is consistent with the fundamental policy and purposes 
underlying the Investment Company Act expressed in sections 1(b)(7) and 1(b)(8) of the Act.
45
 
These respectively declare that “the national public interest and the interest of investors are 
adversely affected” when funds “by excessive borrowing and the issuance of excessive amounts 
of senior securities increase unduly the speculative character” of securities issued to common 
shareholders and when funds “operate without adequate assets or reserves.” The Commission 
emphasized these concerns in Release 10666, and we continue to believe that the prohibitions 
and restrictions under the senior security provisions of section 18 should “function as a practical 
limit on the amount of leverage which the investment company may undertake and on the 
potential increase in the speculative character of its outstanding common stock” and that funds 
should not “operate without adequate assets or reserves.”
46
 Funds’ use of derivatives, like the 
                                                      
44
  The Commission similarly observed in Release 10666 that section 18(f)(1), “by implication, 
treats all borrowings as senior securities,” and that “[s]ection 18(f)(1) of the Act prohibits such 
borrowings unless entered into with banks and only if there is 300% asset coverage on all 
borrowings of the investment company.” See Release 10666, supra note 15, at “Reverse 
Repurchase Agreements” discussion.  
45
  The Commission received several comments on the 2015 proposal asserting that the provisions in 
section 1(b) of the Investment Company Act do not, themselves, provide us authority to regulate 
senior securities transactions. See, e.g., AAF Comment Letter; Franklin Resources Comment 
Letter; Comment Letter of the Securities Industry and Financial Markets Association (Mar. 28, 
2016) (“SIFMA Comment Letter”).  
The fundamental statutory policy and purposes underlying the Investment Company Act, as 
expressed in section 1(b) of the Act, inform our interpretation of the scope of the term “senior 
security” in section 18, as we discuss in the paragraph accompanying this note (and separately 
inform our consideration of appropriate conditions for the exemption that proposed rule 18f-4 
provides, as we discuss in sections II.B-II.G infra). The authority under which we are proposing 
rules today is set forth in section VII of this release and includes, among other provisions, section 
6(c) of the Act.  
46
  See Release 10666, supra note 15, at “Segregated Account” discussion. 

24 
trading practices the Commission addressed in Release 10666, may raise the undue speculation 
and asset sufficiency concerns in section 1(b).
47
 First, funds’ obtaining leverage (or potential for 
leverage) through derivatives may raise the Investment Company Act’s undue speculation 
concern because a fund may experience gains and losses that substantially exceed the fund’s 
investment, and also may incur a conditional or unconditional obligation to make a payment or 
deliver assets to a counterparty.
48
 Not viewing derivatives that impose a future payment 
obligation on the fund as involving senior securities, s  ubject to appropriate limits under 
section 18, would frustrate the concerns underlying section 18.
49
  
                                                      
47
  As the Commission stated in Release 10666, leveraging an investment company’s portfolio 
through the issuance of senior securities “magnifies the potential for gain or loss on monies 
invested and therefore results in an increase in the speculative character of the investment 
company’s outstanding securities” and “leveraging without any significant limitation” was 
identified “as one of the major abuses of investment companies prior to the passage of the Act by 
Congress.” Id. 
48
 See, e.g., The Report of the Task Force on Investment Company Use of Derivatives and Leverage, 
Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6, 2010), at 
8 (“2010 ABA Derivatives Report”) (stating that “[f]utures contracts, forward contracts, written 
options and swaps can produce a leveraging effect on a fund’s portfolio” because “for a relatively 
small up-front payment made by a fund (or no up-front payment, in the case with many swaps 
and written options), the fund contractually obligates itself to one or more potential future 
payments until the contract terminates or expires”; noting, for example, that an “[interest rate] 
swap presents the possibility that the fund will be required to make payments out of its assets” 
and that “[t]he same possibility exists when a fund writes puts and calls, purchases short and long 
futures and forwards, and buys or sells credit protection through [credit default swaps]”).  
49
  One commenter on the 2011 Concept Release made this point directly. See Comment Letter of 
Stephen A. Keen on the 2011 Concept Release (Nov. 8, 2011) (File No. S7-33-11), at 3 (“Keen 
Concept Release Comment Letter”) (“If permitted without limitation, derivative contracts can 
pose all of the concerns that section 18 was intended to address with respect to borrowings and 
the issuance of senior securities by investment companies.”); see also, e.g., ICI Concept Release 
Comment Letter, at 8 (“The Act is thus designed to regulate the degree to which a fund issues any 
form of debt—including contractual obligations that could require a fund to make payments in the 
future.”). The Commission similarly noted in Release 10666 that, given the potential for reverse 
repurchase agreements to be used for leveraging and their ability to magnify the risk of investing 
in a fund, “one of the important policies underlying section 18 would be rendered substantially 
nugatory” if funds’ use of reverse repurchase agreements were not subject to limitation. See 2015 
Proposing Release, supra note 2, at text preceding n.76. 

25 
Second, with respect to the Investment Company Act’s asset sufficiency concern, a 
fund’s use of derivatives with future payment obligations also may raise concerns regarding the 
fund’s ability to meet those obligations. Many fund derivatives investments, such as futures 
contracts, swaps, and written options, pose a risk of loss that can result in payment obligations 
owed to the fund’s counterparties.
50
 Losses on derivatives therefore can result in counterparty 
payment obligations that directly affect the capital structure of a fund and the relative rights of 
the fund’s counterparties and shareholders. These losses and payment obligations also can force 
a fund’s adviser to sell the fund’s investments to meet its obligations. When a fund uses 
derivatives to leverage its portfolio, this can amplify the risk of a fund having to sell its 
investments, potentially generating additional losses for the fund.
51
 In an extreme situation, a 
fund could default on its payment obligations.
52
  
b. Market and Industry Developments Following Release 
10666 
Following the issuance of Release 10666, Commission staff issued more than thirty no-
action letters to funds concerning the maintenance of segregated accounts or otherwise 
“covering” their obligations in connection with various transactions otherwise restricted by 
                                                      
50
  Some derivatives transactions, like physically-settled futures and forwards, can require the fund 
to deliver the underlying reference assets regardless of whether the fund experiences losses on the 
transaction.  
51
  See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen, Market Liquidity and Funding 
Liquidity, 22 The Review of Financial Studies 6, 2201-2238 (June 2009), available at 
https://www.princeton.edu/~markus/research/papers/liquidity.pdf (providing both empirical 
support as well as a theoretical foundation for how short-term leverage obtained through 
borrowings or derivative positions can result in funds and other financial intermediaries becoming 
vulnerable to tighter funding conditions and increased margins, specifically during economic 
downturns (as in the recent financial crisis), thus potentially increasing the need for the fund or 
intermediary to de-lever and sell portfolio assets at a loss). 
52
  See 2015 Proposing Release, supra note 2, at n.80.  

26 
section 18.
53
 In these letters (issued primarily in the 1970s through 1990s) and through other 
staff guidance, Commission staff has addressed questions—generally on an instrument-by-
instrument basis—regarding the application of the Commission’s statements in Release 10666 to 
various types of derivatives and other transactions.  
Funds have developed certain general asset segregation practices to cover their 
derivatives positions, based at least in part on the staff’s no-action letters and guidance. Practices 
vary based on the type of derivatives transaction. For certain derivatives, funds generally 
segregate an amount equal to the full amount of the fund’s potential obligation under the 
contract, or the full market value of the underlying reference asset for the derivative (“notional 
amount segregation”).
54
 For certain cash-settled derivatives, funds often segregate an amount 
equal to the fund’s daily mark-to-market liability, if any (“mark-to-market segregation”).
55
  
Similarly, funds use different practices regarding the types of assets that they segregate to 
cover their derivatives positions. Release 10666 states that the assets eligible to be included in 
segregated accounts should be “liquid assets” such as cash, U.S. government securities, or other 
appropriate high-grade debt obligations.
56
 However, a subsequent staff no-action letter stated 
that the staff would not recommend enforcement action if a fund were to segregate any liquid 
                                                      
53
  See id. at n.51 and accompanying text (citing 2011 Concept Release, supra note 3, at section I). 
54
  See id. at nn.54-55 and accompanying text. 
55
  See id. at nn.56-58, 96-98 and accompanying text (stating that funds initially applied the mark-to-
market approach to segregation to specific types of transactions addressed through guidance by 
our staff (interest rate swaps, cash-settled futures, non-deliverable forwards), but that funds now 
apply mark-to-market segregation to a wider range of cash-settled instruments, with our staff 
observing that some funds appear to apply the mark-to-market approach to any derivative that is 
cash settled). 
56
  See id. at n.47 and accompanying text. 

27 
asset, including equity securities and non-investment grade debt securities, to cover its senior 
securities-related obligations.
57
  
As a result of these asset segregation practices, funds’ derivatives use—and thus funds’ 
potential leverage through derivatives transactions—does not appear to be subject to a practical 
limit as the Commission contemplated in Release 10666. Funds’ mark-to-market liability often 
does not reflect the full investment exposure associated with their derivatives positions.
58
 As a 
result, a fund that segregates only the mark-to-market liability could theoretically incur virtually 
unlimited investment leverage.
59
  
These current asset segregation practices also may not assure the availability of adequate 
assets to meet funds’ derivatives obligations, as the Commission contemplated in Release 10666. 
A fund using the mark-to-market approach could segregate assets that only reflect the losses (and 
corresponding potential payment obligations) that the fund would then incur as a result of 
transaction termination. This practice provides no assurances that future losses will not exceed 
the value of the segregated assets or the value of all assets then available to meet the payment 
                                                      
57
  See id. at n.59 and accompanying text (citing Merrill Lynch Asset Management, L.P., SEC Staff 
No-Action Letter (July 2, 1996), available at 
https://www.sec.gov/divisions/investment/imseniorsecurities/merrilllynch070196.pdf).  
58
  For example, for derivatives where there is no loss in a given day, a fund applying the mark-to-
market approach might not segregate any assets. This may be the case, for example, because the 
derivative is currently in a gain position, or because the derivative has a market value of zero (as 
will generally be the case at the inception of a transaction). The fund may, however, still be 
required to post collateral to comply with other regulatory or contractual requirements.  
59
  See, e.g., Comment Letter of Ropes & Gray LLC on the Concept Release (Nov. 7, 2011) (File 
No. S7-33-11), at 4 (stating that “[o]f course, in many cases [a fund’s daily mark-to -market 
liability, if any] will not fully reflect the ultimate investment exposure associated with the swap 
position” and that, “[a]s a result, a fund that segregates only the market-to-market liability could 
theoretically incur virtually unlimited investment leverage using cash-settled swaps”); Keen 
Concept Release Comment Letter, at 20 (stating that the mark-to-market approach, as applied to 
cash settled swaps, “imposes no effective control over the amount of investment leverage created 
by these swaps, and leaves it to the market to limit the amount of leverage a fund may use”). 

28 
obligations resulting from such losses.
60
 We also recognize that when a fund segregates any 
liquid asset, rather than the more narrow range of high-quality assets the Commission described 
in Release 10666, the segregated assets may be more likely to decline in value at the same time 
as the fund experiences losses on its derivatives.
61
 In this case, or when a fund’s derivatives 
payment obligations are substantial relative to the fund’s liquid assets, the fund may be forced to 
sell portfolio securities to meet its derivatives payment obligations. These forced sales could 
occur during stressed market conditions, including at times when prudent management could 
advise against such liquidation.
62
 
3. Need for Updated Regulatory Framework 
As the Commission observed in the 2015 proposal and for the reasons discussed above, 
we continue to be concerned that funds’ current practices regarding derivatives use may not 
address the undue speculation and asset sufficiency concerns underlying section 18.
63
 
Additionally, as recent events demonstrate, a fund’s derivatives use may involve risks that can 
result in significant losses to a fund.
64
 Accordingly, we continue to believe that it is appropriate 
for funds to address these risks and considerations relating to their derivatives use. Nevertheless, 
                                                      
60
  A fund’s mark-to-market liability on any particular day, if any, could be substantially smaller 
than the fund’s ultimate obligations under a derivative. See 2015 Proposing Release, supra note 2, 
at n.113. 
61
  See id. at n.115. 
62
  The Commission noted in Release 10666 that “in an extreme case an investment company which 
has segregated all its liquid assets might be forced to sell non-segregated portfolio securities to 
meet its obligations upon shareholder requests for redemption. Such forced sales could cause an 
investment company to sell securities which it wanted to retain or to realize gains or losses which 
it did not originally intend.” See Release 10666, supra note 15, at “Segregated Account” 
discussion.  
63
  See 2015 Proposing Release, supra note 2, at sections II.D.1.b and II.D.1.c; see also supra 
paragraphs accompanying notes 58-62.  
64
  See supra paragraph accompanying notes 22-25. 

29 
we also recognize the valuable role derivatives can play in helping funds to achieve their 
objectives efficiently or manage their investment risks. 
We therefore believe funds that significantly use derivatives should adopt and implement 
formalized programs to manage the risks derivatives may pose.
 
In addition, a more modern 
framework for regulating funds’ derivatives use would respond to our concern that funds today 
are not subject to a practical limit on potential leverage that they may obtain through derivatives 
transactions. The risk management program requirement and limit on fund leverage risk we are 
proposing are designed to address these considerations, in turn. 
A comprehensive approach to regulating funds’ derivatives use also would help address 
potential adverse results from funds’ current, disparate asset segregation practices. The 
development of staff guidance and industry practice on an instrument-by-instrument basis, 
together with growth in the volume and complexity of derivatives markets over past decades, has 
resulted in situations in which different funds may treat the same kind of derivative differently, 
based on their own view of our staff’s guidance or observation of industry practice. This may 
unfairly disadvantage some funds.
65
 The lack of comprehensive guidance also makes it difficult 
for funds and our staff to evaluate and inspect for funds’ compliance with section 18 of the 
Investment Company Act. Moreover, where there is no specific guidance, or where the 
application of existing guidance is unclear or applied inconsistently, funds may take approaches 
that involve an extensive use of derivatives and may not address the purposes and concerns 
underlying section 18.  
                                                      
65
  See, e.g., Comment Letter of Davis Polk on the 2011 Concept Release (Nov. 11, 2011), at 1-2 
(stating that “funds and their sponsors may interpret the available guidance differently, even when 
applying it to the same instruments, which may unfairly disadvantage some funds”); see also 
Comment Letter of Federated Investors, Inc. (Mar. 23, 2016) (“Federated Comment Letter”); 
Comment Letter of Salient Partners, L.P. (Mar. 25, 2016) (“Salient Comment Letter). 

30 
C. Overview of the Proposal 
Our proposal consists of three parts. Proposed rule 18f-4 is designed to provide an 
updated, comprehensive approach to the regulation of funds’ use of derivatives and the other 
transactions that the proposed rule addresses. The proposed sales practices rules are designed to 
address investor protection concerns with respect to leveraged/inverse funds by requiring broker-
dealers and investment advisers to exercise due diligence on retail investors before approving 
retail investor accounts to invest in leveraged/inverse funds. The proposed amendments to Forms 
N-PORT, N-LIQUID (which we propose to re-title as “Form N-RN”), and N-CEN are designed 
to enhance the Commission’s ability to oversee funds’ use of and compliance with the proposed 
rules, and for the Commission and the public to have greater insight into the impact that funds’ 
use of derivatives would have on their portfolios.  
Proposed rule 18f-4   would permit a fund to enter into derivatives transactions, 
notwithstanding the prohibitions and restrictions on the issuance of senior securities under 
section 18 of the Investment Company Act, subject to the following conditions:
66
  
• Derivatives risk management program.
67
 The proposed rule would generally require a 
fund to adopt a written derivatives risk management program with risk guidelines that 
must cover certain elements, but that otherwise would be tailored based on how the 
fund’s use of derivatives may affect its investment portfolio and overall risk profile. The 
                                                      
66
  See proposed rule 18f-4(b) and (d). Proposed rule 18f-4(b) would provide an exemption for 
funds’ derivatives transactions from sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment 
Company Act. See supra section I.B.1 of this release (providing an overview of the requirements 
of section 18). Because the proposed conditions are designed to provide a tailored set of 
requirements for derivatives transactions, the proposed rule would also provide that a fund’s 
derivatives transactions would not be considered for purposes of computing asset coverage under 
section 18(h). Applying section 18(h) asset coverage to a fund’s derivatives transactions appears 
unnecessary in light of the tailored restrictions we are proposing. See also infra section II.M.  
67
  See proposed rule 18f-4(c)(1); infra section II.A.2. 

31 
program also would have to include stress testing, backtesting, internal reporting and 
escalation, and program review elements. The program would institute a standardized 
risk management framework for funds that engage in more than a limited amount of 
derivatives transactions, while allowing principles-based tailoring to the fund’s particular 
risks. We believe that a formalized derivatives risk management program is critical to 
appropriate derivatives risk management and is foundational to providing exemptive 
relief under section 18. 
• Limit on fund leverage risk.
68
 T he proposed rule would generally require funds when 
engaging in derivatives transactions to comply with an outer limit on fund leverage risk 
based on value at risk, or “ VaR.”  This outer limit would be based on a relative VaR test 
that compares the fund’s VaR to the VaR of a “designated reference index” for that fund. 
If the fund’s derivatives risk manager is unable to identify an appropriate designated 
reference index, the fund would be required to comply with an absolute VaR test. These 
proposed requirements are designed to limit fund leverage risk consistent with the 
investor protection purposes underlying section 18 and to complement the proposed risk 
management program. Because VaR is a commonly-known and broadly-used industry 
metric that enables risk to be measured in a reasonably comparable and consistent 
manner across the diverse instruments that may be included in a fund’s portfolio, the 
proposed VaR-based limit is designed to address leverage risk for a variety of fund 
strategies. 
                                                      
68
  See proposed rule 18f-4(c)(2); infra section II.D. 

32 
• Board oversight and reporting.
69
 The proposed rule would require a fund’s board of 
directors to approve the fund’s designation of a derivatives risk manager, who would be 
responsible for administering the fund’s derivatives risk management program. The 
fund’s derivatives risk manager would have to report to the fund’s board on the 
derivatives risk management program’s implementation and effectiveness and the results 
of the fund’s stress testing. The derivatives risk manager would have a direct reporting 
line to the fund’s board. We believe requiring a fund’s derivatives risk manager to be 
responsible for the day-to-day administration of the fund’s program, subject to board 
oversight, is consistent with the way we understand many funds currently manage 
derivatives risks and is key to appropriately managing these risks. 
• Exception for limited derivatives users.
70
 The proposed rule would except limited 
derivatives users from the derivatives risk management program requirement and the 
VaR-based limit on fund leverage risk. This proposed exception would be available to a 
fund that either limits its derivatives exposure to 10% of its net assets or uses derivatives 
transactions solely to hedge certain currency risks and, in either case, that also adopts and 
implements policies and procedures reasonably designed to manage the fund’s 
derivatives risks. Requiring a derivatives risk management program that includes all of 
the program elements specified in the rule for funds that use derivatives only in a limited 
way could potentially require these funds to incur costs and bear compliance burdens that 
are disproportionate to the resulting benefits.  
                                                      
69
  See proposed rule 18f-4(c)(5); infra section II.C. 
70
  See proposed rule 18f-4(c)(3); infra section II.E. 

33 
• Alternative requirements for certain leveraged/inverse funds.
71
 The proposed rule would 
provide an exception from the limit on fund leverage risk for certain leveraged/inverse 
funds in light of the additional safeguards provided by the proposed requirements under 
the sales practices rules that broker-dealers and investment advisers exercise due 
diligence on retail investors before approving the investors’ accounts to invest in these 
funds.
72
 The conditions of this exception are designed to address the investor protection 
concerns that underlie section 18 of the Investment Company Act, while preserving 
choice for investors the investment adviser or broker-dealer reasonably believes have 
such financial knowledge and experience that they may reasonably be expected to be 
capable of evaluating the risk of these funds.  
• Recordkeeping.
73
 The proposed rule would require a fund to adhere to recordkeeping 
requirements that are designed to provide the Commission’s staff, and the fund’s board of 
directors and compliance personnel, the ability to evaluate the fund’s compliance with the 
proposed rule’s requirements. 
Proposed rule 18f-4 would also permit funds to enter into reverse repurchase agreements 
and similar financing transactions, as well as “unfunded commitments” to make certain loans or 
investments, subject to conditions tailored to these transactions.
74
 A fund would be permitted to 
engage in reverse repurchase agreements and similar financing transactions so long as they meet 
                                                      
71
      See proposed rule 18f-4(c)(4); infra section II.G. 
72
  In our discussion in this release of the entities subject to the proposed sales practices rules, we use 
“broker-dealer” to refer to a broker-dealer that is registered with, or required to register with, the 
Commission. Similarly, we use “investment adviser” to refer to an investment adviser that is 
registered with, or required to register with, the Commission. 
73
  See proposed rule 18f-4(c)(6); infra section II.K. 
74
  See proposed rule 18f-4(d) and (e); infra sections II.I and II.J. 

34 
the asset coverage requirements under section 18. If the fund also borrows from a bank or issues 
bonds, for example, these senior securities as well as the reverse repurchase agreement would be 
required to comply with the asset coverage requirements under the Investment Company Act. 
This approach would provide the same asset coverage requirements under section 18 for reverse 
repurchase agreements and similar financing transactions, bank borrowings, and other 
borrowings permitted under the Investment Company Act. A fund would be permitted to enter 
into unfunded commitment agreements if the fund reasonably believes that its assets will allow 
the fund to meet its obligations under these agreements. This approach recognizes that, while 
unfunded commitment agreements do raise the risk that a fund may be unable to meet its 
obligations under these transactions, such unfunded commitments do not generally involve the 
leverage and other risks associated with derivatives transactions.  
The proposed sales practices rules are designed to address certain specific considerations 
raised by certain leveraged/inverse funds and listed commodity pools that obtain leveraged or 
inverse exposure to an underlying index, on a periodic (generally, daily) basis.
75
 These rules 
would require broker-dealers and investment advisers to exercise due diligence in determining 
whether to approve a retail customer or client’s account to buy or sell these products. A broker-
dealer or adviser could only approve the account if it had a reasonable basis to believe that the 
customer or client is capable of evaluating the risk associated with these products.  In this regard, 
the proposed sales practices rules would complement the leveraged/inverse funds exception from 
proposed rule 18f-4’s limit on leverage risk by subjecting broker-dealers or advisers to the 
proposed sales practices rules’ due diligence and approval requirements.   
                                                      
75
  See infra note 328 and accompanying text (defining “listed commodity pools”). 

35 
In connection with proposed rules 15l-2, 211(h)-1, and 18f-4, we are proposing 
amendments to rule 6c-11 under the Investment Company Act. Rule 6c-11 generally permits 
ETFs to operate without obtaining a Commission exemptive order, subject to certain 
conditions.
76
 The rule currently excludes leveraged/inverse ETFs from relying on the rule, 
however, to allow the Commission to consider the section 18 issues raised by these funds’ 
investment strategies as part of a broader consideration of derivatives use by registered funds and 
BDCs.
77
 As part of this further consideration, we are proposing to remove this provision and 
permit leveraged/inverse ETFs to rely on rule 6c-11 because the proposed sales practices rules 
and rule 18f-4 are designed to address these issues. In this regard, we are also proposing to 
rescind the exemptive orders previously issued to the sponsors of leveraged/inverse ETFs. 
Amending rule 6c-11 and rescinding these exemptive orders would promote a level playing field 
by allowing any sponsor (in addition to the sponsors currently granted exemptive orders) to form 
and launch a leveraged/inverse ETF subject to the conditions in rule 6c-11 and proposed 
rule 18f-4, with transactions in the fund subject to the proposed sales practices rules. 
The proposed amendments to Forms N-PORT, N-LIQUID, and N-CEN would require a 
fund to provide information regarding: (1) the fund’s exposure to derivatives; (2) the fund’s VaR 
(and, if applicable, the fund’s designated reference index) and backtesting results; (3) VaR test 
breaches, to be reported to the Commission in a non-public current report; and (4) certain 
identifying information about the fund (e.g., whether the fund is a limited derivatives user that is 
                                                      
76
  See generally Exchange-Traded Funds, Investment Company Act Release No. 33646 (Sept. 25, 
2019) [84 FR 57162 (Oct. 24, 2019)] (“ETFs Adopting Release”). 
77
  See id. at nn.72-74 and accompanying text. 

36 
excepted from certain of the proposed requirements, or whether the fund is a “leveraged/inverse 
fund”). 
Finally, in view of our proposal for an updated, comprehensive approach to the regulation 
of funds’ derivative use, we are proposing to rescind Release 10666. In addition, staff in the 
Division of Investment Management is reviewing certain of its no-action letters and other 
guidance addressing derivatives transactions and other transactions covered by proposed rule 
18f-4 to determine which letters and other staff guidance, or portions thereof, should be 
withdrawn in connection with any adoption of this proposal. Upon the adoption of any final rule, 
some of these letters and other staff guidance, or portions thereof, would be moot, superseded, or 
otherwise inconsistent with the final rule and, therefore, would be withdrawn. We would expect 
to provide funds a one-year transition period while they prepare to come into compliance with 
rule 18f-4 before Release 10666 is withdrawn.  
II. DISCUSSION 
A. Scope of Proposed Rule 18f-4 
1. Funds Permitted to Rely on Proposed Rule 18f-4 
The proposed rule would apply to a “fund,” defined as a registered open-end or closed-
end company or a BDC, including any separate series thereof. The rule would therefore apply to 
mutual funds, ETFs, registered closed-end funds, and BDCs. The proposed rule’s definition of a 
“fund” would, however, exclude money market funds regulated under rule 2a-7 under the 
Investment Company Act (“money market funds”). Under rule 2a-7, money market funds seek to 
maintain a stable share price or limit principal volatility by limiting their investments to short-
term, high-quality debt securities that fluctuate very little in value under normal market 
conditions. As a result of these and other requirements in rule 2a-7, we believe that money 
market funds currently do not typically engage in derivatives transactions or the other 

37 
transactions permitted by rule 18f-4.
78
 We believe that these transactions would generally be 
inconsistent with a money market fund maintaining a stable share price or limiting principal 
volatility, and especially if used to leverage the fund’s portfolio.
79
 We therefore believe that 
excluding money market funds from the scope of the proposed rule is appropriate. 
Section 18 applies only to open-end or closed-end companies, i.e., to management 
investment companies. Proposed rule 18f-4 therefore also would not apply to unit investment 
trusts (“UITs”) because they are not management investment companies. In addition, as the 
Commission has noted, derivatives transactions generally require a significant degree of 
management, and a UIT engaging in derivatives transactions therefore may not meet the 
Investment Company Act requirements applicable to UITs.
80
  
We request comment on all aspects of the proposed rule’s definition of the term “fund,” 
including the following items. 
 The proposed definition excludes money market funds. Should we include money 
market funds in the definition? Why or why not?  
 Do money market funds currently engage in any transactions that might qualify as 
derivatives transactions under the rule or any of the other transactions permitted by 
the rule? For example, do money market funds engage in reverse repurchase 
                                                      
78
  See infra note 584. 
79
  See Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release 
No. 31166 (July 23, 2014) [79 FR 47735 (Aug. 14, 2014)] (discussing (1) retail and government 
money market funds, which seek to maintain a stable net asset value per share and (2) 
institutional non-government money market funds whose net asset value fluctuates, but still must 
stress test their ability to minimize principal volatility given that “commenters pointed out 
investors in floating NAV funds will continue to expect a relatively stable NAV”). 
80
  See section 4(2) of the Investment Company Act; see also Custody Of Investment Company 
Assets with Futures Commission Merchants And Commodity Clearing Organizations, Investment 
Company Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT portfolios are 
generally unmanaged). See also ETFs Adopting Release, supra note 76, at n.42. 

38 
agreements, “to be announced” dollar rolls, or “when issued” transactions? If so, 
which transactions, to what extent, and for what purpose? For example, do money 
market funds engage in reverse repurchase agreements for liquidity management 
purposes but not to leverage the fund’s portfolio? If so, what effects would the 
proposed rule have on money market funds’ liquidity management if they are 
excluded from the rule’s scope as proposed? To the extent money market funds 
engage in any of the transactions that the proposed rule would permit, how do money 
market funds analyze them under rule 2a-7?  
 Should we permit money market funds to engage in some of the transactions that the 
rule would permit? If so, which transactions and why, and how would the transactions 
be consistent with rule 2a-7? If we were to include money market funds in the rule, or 
permit them to engage in specific types of transactions, should the rule provide 
specific conditions tailored to money market funds entering into those transactions? 
What kinds of conditions and why? Should they be permitted to engage in all (or 
certain types) of derivatives transactions, or reverse repurchase or similar financing 
transactions, for liquidity management or other purposes that do not leverage the 
fund’s portfolio? If money market funds were permitted to rely on the rule for any 
transactions, should those transactions be limited in scale? For example, should that 
limit be the same as the proposed approach for limited derivatives users that limit the 
extent of their derivatives exposure, as discussed below in section 
II.E.1? Would even 
such limited use be consistent with funds that seek to maintain a stable share price or 
limit principal volatility? 
 If we were to include money market funds in the scope of rule 18f-4, should we 

39 
revise Form N-MFP so that money market funds filing reports on the form could 
select among the list of investment categories set forth in Item C.6 of Form N-MFP 
derivatives and the other transactions addressed in the proposed rule 18f-4?
81
 Why or 
why not? 
2. Derivatives Transactions Permitted Under Proposed 
Rule 18f-4 
The proposed rule would permit funds to enter into derivatives transactions, subject to the 
rule’s conditions. The proposed rule would define the term “derivatives transaction” to mean: 
(1) any swap, security-based swap, futures contract, forward contract, option, any combination of 
the foregoing, or any similar instrument (“derivatives instrument”), under which a fund is or may 
be required to make any payment or delivery of cash or other assets during the life of the 
instrument or at maturity or early termination, whether as margin or settlement payment or 
otherwise; and (2) any short sale borrowing.
82
  
The first prong of this proposed definition is designed to describe those derivatives 
transactions that involve the issuance of a senior security, because they involve a contractual 
                                                      
81
  See infra note 584. 
82
  Proposed rule 18f-4(a). The 2015 proposal similarly defined a derivatives transaction as including 
enumerated derivatives instruments “under which the fund is or may be required to make any 
payment or delivery of cash or other assets during the life of the instrument or at maturity or early 
termination, whether as a margin or settlement payment or otherwise.” 2015 proposed 
rule 18f-4(c)(2). Most commenters did not address the proposed definition of the term 
“derivatives transaction,” although those commenters who did address the definition generally 
supported it. Some commenters more generally supported the view, or sought confirmation, that a 
derivative does not involve the issuance of a senior security if it does not impose an obligation 
under which the fund is or may be required to make a future payment (e.g., a standard purchased 
option). See, e.g., Comment Letter of The Options Clearing Corporation (Mar. 25, 2016); 
Comment Letter of Investment Adviser Association (Mar. 28, 2016) (“IAA Comment Letter”); 
FSR Comment Letter. 

40 
future payment obligation.
83
 When a fund engages in these transactions, the fund will have an 
obligation (or potential obligation) to make payments or deliver assets to the fund’s counterparty. 
This prong of the definition incorporates a list of derivatives instruments that, together with the 
proposed inclusion in the definition of “any similar instrument,” covers the types of derivatives 
that funds currently use and that the requirements of section 18 would restrict. This list is 
designed to be sufficiently comprehensive to include derivatives that may be developed in the 
future. We believe that this approach is clearer than a more principles-based definition of the 
term “derivatives transaction,” such as defining this term as an instrument or contract whose 
value is based upon, or derived from, some other asset or metric.  
This prong of the definition also provides that a derivatives instrument, for purposes of 
the proposed rule, must involve a future payment obligation.
84
 This aspect of the definition 
recognizes that not every derivatives instrument imposes an obligation that may require the fund 
to make a future payment, and therefore not every derivatives instrument will involve the 
issuance of a senior security.
85
 A derivative that does not impose any future payment obligation 
on a fund generally resembles a securities investment that is not a senior security, in that it may 
                                                      
83
  See supra note 27 and accompanying text, and text following note 34 (together, noting that 
“senior security” is defined in part as “any . . .similar obligation or instrument constituting a 
security and evidencing indebtedness,” and that the Commission has previously stated that, for 
purposes of section 18, “evidence of indebtedness” would include “all contractual obligations to 
pay in the future for consideration presently received”); see also infra notes 85-87 (recognizing 
that not every derivative instrument will involve the issuance of a senior security). 
84
  Under the proposed rule, a derivatives instrument is one where the fund “is or may be required to 
make any payment or delivery of cash or other assets during the life of the instrument or at 
maturity or early termination, whether as margin or settlement payment or otherwise.” 
85
  See 2015 Proposing Release, supra note 2, at paragraph accompanying nn.82-83. A fund that 
purchases a standard option traded on an exchange, for example, generally will make a non-
refundable premium payment to obtain the right to acquire (or sell) securities under the option. 
However, the option purchaser generally will not have any subsequent obligation to deliver cash 
or assets to the counterparty unless the fund chooses to exercise the option. 

41 
lose value but will not require the fund to make any payments in the future.
86
 Whether a 
transaction involves the issuance of a senior security will depend on the nature of the transaction. 
The label that a fund or its counterparty assigns to the transaction is not determinative.
87
  
Unlike the 2015 proposal, this proposal does not include references to, or a definition of, 
“financial commitment transaction” in addition to the proposed definition of “derivatives 
transaction.” The 2015 proposal defined a “financial commitment transaction” as any reverse 
repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or 
similar agreement.
88
 Because our proposal addresses funds’ use of reverse repurchase 
agreements and unfunded commitment agreements separately from funds’ use of derivatives, the 
                                                      
86
  See id. at n.82. 
87
  For example, the Commission received a comment on the 2015 proposal addressing a type of 
total return swap, asserting that “[t]he Swap operates in a manner similar to a purchased option or 
structure, in that the fund’s losses under the Swap cannot exceed the amount posted to its tri-party 
custodian agreement for purposes of entering into the Swap,” and that, in the commenter’s view, 
the swap should be “afforded the same treatment as a purchased option or structured note” 
because “[a]lthough the Swap involves interim payments through the potential posting of margin 
from the custodial account, the payment obligations cannot exceed the [amount posted for 
purposes of entering into the Swap].” See Comment Letter of Dearborn Capital Management 
(Mar. 24, 2016) (“Dearborn Comment Letter”). Unlike a fund’s payment of a one-time non-
refundable premium in connection with a standard purchased option or a fund’s purchase of a 
structured note, this transaction appears to involve a fund obligation to make interim payments of 
fund assets posted as margin or collateral to the fund’s counterparty during the life of the 
transaction in response to market value changes of the underlying reference asset, as this 
commenter described. The fund also must deposit additional margin or collateral to maintain the 
position if the fund’s losses deplete the assets that the fund posted to initiate the transaction; if a 
fund effectively pursues its strategy through such a swap, or a small number of these swaps, the 
fund may as a practical matter be required to continue reestablishing the trade or refunding the 
collateral account in order to continue to offer the fund’s strategy. The transaction therefore 
appears to involve the issuance of a senior security as the fund may be required to make future 
payments. 
 See also infra section II.J (discussing the characterization of “unfunded commitment” agreements 
for purposes of the proposed rule, and as senior securities).  
88
  See 2015 Proposing Release, supra note 2, at section III.A.2; 2015 proposed rule 18f-4(c)(4); see 
also supra note 10. 

42 
proposed definition of “derivatives transaction” does not include reverse repurchase agreements 
and unfunded commitment agreements.
89
  
Short sale borrowings, however, are included in the second prong of the proposed 
definition of “derivatives transaction.” We appreciate that short sales of securities do not involve 
derivatives instruments such as swaps, futures, and options. The value of a short position is, 
however, derived from the price of another asset, i.e., the asset sold short. A short sale of a 
security provides the same economic exposure as a derivatives instrument, like a future or swap, 
that provides short exposure to the same security. The proposed rule therefore treats short sale 
borrowings and derivatives instruments identically for purposes of funds’ reliance on the rule’s 
exemption.
90
  
While this proposal does not specifically list firm or standby commitment agreements in 
the definition of “derivatives transaction,” we interpret the definitional phrase “or any similar 
instrument” to include these agreements. A firm commitment agreement has the same economic 
characteristics as a forward contract.
91
 Similarly, a standby commitment agreement has the same 
economic characteristics as an option contract, and the Commission has previously stated that 
such an agreement is economically equivalent to the issuance of a put option.
92
 To the extent that 
                                                      
89
  See infra section II.I. 
90
  See proposed rule 18f-4(b). 
91
  Indeed, the Commission noted in Release 10666 that a firm commitment is known by other 
names such as a “forward contract.” See Release 10666, supra note 15, at nn.10-12 and 
accompanying text.  
92
  See id. at “Standby Commitment Agreements” (“The standby commitment agreement is a 
delayed delivery agreement in which the investment company contractually binds itself to accept 
delivery of a Ginnie Mae with a stated price and fixed yield upon the exercise of an option held 
by the other party to the agreement at a stated future date. . . . The Commission believes that the 
standby commitment agreement involves, in economic reality, the issuance and sale by the 
investment company of a ‘put.’”). 

43 
a fund engages in transactions similar to firm or standby commitment agreements, they may fall 
within the “any similar instrument” definitional language, depending on the facts and 
circumstances.
93
  
We request comment on all aspects of the proposed rule’s definition of the term 
“derivatives transaction,” including the following items. 
 Is the definition of “derivatives transaction” sufficiently clear? Are there additional 
types of derivatives instruments, or other transactions, that we should include or 
exclude? Adding additional transactions to the definition would permit a fund to 
engage in those transactions by complying with the proposed rule, rather than section 
18. Are there transactions that we should exclude from the definition so that funds 
must comply with the limits of section 18 (to the extent permitted under section 18) 
with respect to these transactions, rather than the proposed rule’s conditions?  
 The proposed rule’s definition of the term “derivatives transaction” is designed to 
describe those derivatives transactions that would involve the issuance of a senior 
security. Do commenters agree that derivatives transactions that involve obligations 
to make a payment or deliver assets involve the issuance of a senior security under 
section 18 of the Act? Does the rule effectively describe all of the types of derivatives 
transactions that would involve the issuance of a senior security? Conversely, are 
there any types of transactions that are included in the proposed definition of 
“derivatives transaction” that should not be considered to involve the issuance of a 
senior security? If so, which types of transactions and why?  
                                                      
93
  See, e.g., infra paragraph accompanying notes 420-421 (discussing agreements that would not 
qualify for the proposed rule’s treatment of unfunded commitment agreements because they are 
functionally similar to derivatives transactions). 

44 
 Is it appropriate that the proposed rule’s definition of “derivatives transaction” 
incorporates a list of derivatives instruments plus “any similar instrument,” rather 
than a principles-based definition, such as an instrument or contract whose value is 
based upon, or derived from, some other asset or metric? Why or why not? Is the 
reference to “any similar instrument” in the proposed definition sufficiently clear to 
address transactions that may be developed in the future? If not, how should we 
modify the rule to provide additional clarity?  
 Should the proposed definition of “derivatives transaction” include short sale 
borrowings? Would this approach cause any confusion because short sales are not 
typically understood as derivatives instruments? If the latter, what alternative 
approach would be preferable?  
 Should we specifically list firm or standby commitments in the proposed definition of 
“derivatives transaction”? Would funds understand the phrase “or any similar 
instrument” in the proposed definition to include these agreements? Do funds 
currently use the terms “firm commitment agreement” or “standby commitment 
agreement” to describe any of their transactions?  
 Are there any transactions similar to firm or standby commitments that we should 
specifically address, either in the proposed definition of “derivatives transaction” or 
otherwise as guidance? Are there any other types of transactions that the Commission 
should address—either in the proposed definition or as guidance—as transactions that 
fall within the “any similar instrument” definitional language?  

45 
B. Derivatives Risk Management Program 
1. Summary  
Fund investments in derivatives transactions can pose a variety of risks, and poor risk 
management can cause significant harm to funds and their investors.
 
Derivatives can raise 
potential risks such as market, counterparty, leverage, liquidity, and operational risk. Although 
many of these risks are not limited to derivatives, the complexity and character of certain 
derivatives—such as their multiple contingencies and optionality, path dependency, and non-
linearity—may heighten these risks.
94
 E ven simple derivatives without multiple contingencies 
and optionality, for example, can present additional risks beyond a fund’s investment in the 
underlying reference assets, such as the risk that a fund must have margin-eligible assets on hand 
to meet margin or collateral calls. We also recognize the valuable role derivatives can play in 
helping funds to achieve their objectives efficiently or manage their investment risks. 
An investment adviser of a fund that uses derivatives therefore should manage this use to 
ensure alignment with the fund’s investment objectives, policies, and restrictions, its risk profile, 
and relevant regulatory requirements. In addition, a fund’s board of directors is responsible for 
overseeing the fund’s activities and the adviser’s management of risks, including any derivatives 
risks.
95
 Given the dramatic growth in the volume and complexity of the derivatives markets over 
                                                      
94
  See E uropean Securities and Markets Authority (formerly Committee of European Securities 
Regulators), Guidelines on Risk Measurement and the Calculation of Global Exposure and 
Counterparty Risk for UCITS, CESR/10-788 (July 28, 2010), at 12, available at 
https://www.esma.europa.eu/sites/default/files/library/2015/11/10_788.pdf (“CESR Global 
Guidelines”). 
95
  See, e.g., Interpretive Matters Concerning Independent Directors of Investment Companies, 
Investment Company Act Release No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role 
of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 
(Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)]; Independent Directors Council, Fund Board 
Oversight of Risk Management (Sept. 2011), available at 
http://www.ici.org/pdf/pub_11_oversight_risk.pdf (“2011 IDC Report”). 

46 
the past two decades, and the increased use of derivatives by certain funds and their related risks, 
we believe that requiring funds that are users of derivatives (other than limited derivatives users) 
to have a formalized risk management program with certain specified elements (a “program”) 
supports exempting these transactions from section 18.  
Under the proposed program requirement, a fund would have to adopt and implement a 
written derivatives risk management program, which would include policies and procedures 
reasonably designed to manage the fund’s derivatives risks.
96
 A fund’s risk management 
program should take into the account the way the fund uses derivatives, whether to increase 
investment exposures in ways that increase portfolio risks or, conversely, to reduce portfolio 
risks or facilitate efficient portfolio management.
97
 
The program requirement is designed to result in a program with elements that are 
tailored to the particular types of derivatives that the fund uses and their related risks, as well as 
how those derivatives impact the fund’s investment portfolio and strategy. The proposal would 
require a fund’s program to include the following elements:  
• Risk identification and assessment.
98
 The program would have to provide for the 
identification and assessment of a fund’s derivatives risks, which would take into account 
the fund’s derivatives transactions and other investments. 
• Risk guidelines.
99
 The program would have to provide for the establishment, 
maintenance, and enforcement of investment, risk management, or related guidelines that 
                                                      
96
      Proposed rule 18f-4(c)(1). 
97
  See supra note 4 and accompanying text; infra section II.B.3.a. 
98
  Proposed rule 18f-4(c)(1)(i); see also infra section II.B.3.a. 
99
  Proposed rule 18f-4(c)(1)(ii); see also infra section II.B.3.b. 

47 
provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to 
a fund’s derivatives risks. 
• Stress testing.
100
 The program would have to provide for stress testing of derivatives risks 
to evaluate potential losses to a fund’s portfolio under stressed conditions.  
• Backtesting.
101
 The program would have to provide for backtesting of the VaR 
calculation model that the fund uses under the proposed rule. 
• Internal reporting and escalation.
102
 The program would have to provide for the 
reporting of certain matters relating to a fund’s derivatives use to the fund’s portfolio 
management and board of directors. 
• Periodic review of the program.
103
 A fund’s derivatives risk manager would be required 
to periodically review the program,  at least annually, to evaluate the program’s 
effectiveness and to reflect changes in risk over time.  
The proposed program requirement is drawn from existing fund best practices. We believe it 
would enhance practices for funds that have not already implemented a derivatives risk 
management program, while building off practices of funds that already have one in place.
104
  
Most commenters generally supported the 2015 proposal’s derivatives risk management 
program requirement, which had many similar foundational elements to those of the program we 
are proposing here. These commenters stated that the use of derivatives transactions by a fund 
                                                      
100
  Proposed rule 18f-4(c)(1)(iii); see also infra section II.B.3.c. 
101
  Proposed rule 18f-4(c)(1)(iv); see also infra section II.B.3.d. 
102
  Proposed rule 18f-4(c)(1)(v); see also infra section II.B.3.e. 
103
  Proposed rule 18f-4(c)(1)(vi); see also infra section II.B.3.f. 
104
  See, e.g., Aviva Comment Letter (discussing the implementation of formalized derivatives risk 
management programs); Vanguard Comment Letter. 

48 
should be subject to a comprehensive and appropriate written risk management program, which 
would benefit investors.
105
 Our proposal includes elements from the 2015 proposal’s derivatives 
risk management program framework, and adds elements that take into account our analysis of 
the comments we received. 
2. Program Administration 
The proposed rule would require a fund adviser’s officer or officers to serve as the fund’s 
derivatives risk manager.
106
 This requirement is  designed to centralize derivatives risk 
management and to promote accountability. The designation of the derivatives risk manager 
must be approved by the fund’s board of directors, and the derivatives risk manager must have 
direct communication with the fund’s board of directors. Allowing multiple officers of the fund’s 
adviser (including any sub-advisers) to serve as the fund’s derivatives risk manager is designed 
to allow funds with differing sizes, organizational structures, or investment strategies to more 
effectively tailor the programs to their operations.
107
 We understand that many advisers today 
involve committees or groups of officers in the vetting and analysis of portfolio risk and other 
types of risk.
108
 Although the proposed rule would not permit a third party to serve as a fund’s 
                                                      
105
  See, e.g., Comment Letter of AFG-French Asset Management Association (Mar. 25, 2016) 
(“AFG Comment Letter”); Comment Letter of American Beacon Advisors (Mar. 28, 2016) 
(“American Beacon Comment Letter”); Comment Letter of AQR Capital Management (Mar. 28, 
2016) (“AQR Comment Letter”); Federated Comment Letter; Comment Letter of Fidelity (Mar. 
28, 2016) (“Fidelity Comment Letter”); Comment Letter of AFL-CIO (Mar. 28, 2016); Comment 
Letter of Alternative Investment Management Association (Mar. 28, 2016) (“AIMA Comment 
Letter”); Comment Letter of Aviva (Mar. 28, 2016) (“Aviva Comment Letter”); Comment Letter 
of BlackRock (Mar. 28, 2016) (“BlackRock Comment Letter”); Comment Letter of Capital 
Research and Management Company (Mar. 28, 2016) (“CRMC Comment Letter”). 
106
  Proposed rule 18f-4(a). 
107
  The term “adviser” as used in this release and rule 18f-4 generally refers to any person, including 
a sub-adviser, that is an “investment adviser” of an investment company as that term is defined in 
section 2(a)(20) of the Investment Company Act.  
108
  See, e.g., IAA Comment Letter. 

49 
derivatives risk manager, the derivatives risk manager could obtain assistance from third parties 
in administering the program. For example, third parties could provide data relevant to the 
administration of a fund’s program or other analysis that may inform the fund’s derivatives risk 
management. 
The proposed rule would also require that the fund’s derivatives risk manager have 
relevant experience regarding derivatives risk management.
109
 This requirement is designed to 
reflect the potential complex and unique risks that derivatives can pose to funds and promote the 
selection of a derivatives risk manager who is well-positioned to manage these risks. As 
discussed below, under the proposed rule, a fund’s board must approve the designation of the 
fund’s derivatives risk manager, taking into account the derivatives risk manager’s relevant 
experience regarding derivatives risk management.
110
 
The proposed rule would require a fund to reasonably segregate the functions of the 
program from its portfolio management.
111
 S egregating derivatives risk management from 
portfolio management is designed to promote objective and independent identification, 
assessment, and management of the risks associated with derivatives use. Accordingly, this 
element is designed to enhance the accountability of the derivatives risk manager and other risk 
management personnel and, therefore, to enhance the program’s effectiveness.
112
 We understand 
that funds today often segregate risk management from portfolio management. Many have 
observed that independent oversight of derivatives activities by compliance and internal audit 
                                                      
109
  Proposed rule 18f-4(a). 
110
  See infra section II.C.1. 
111
  Proposed rule 18f-4(c)(1). 
112
  See, e.g., Comptroller of the Currency Administrator of National Banks, Risk Management of 
Financial Derivatives: Comptroller’s Handbook (Jan. 1997), at 9 (discussing the importance of 
independent risk management functions in the banking context).  

50 
functions is valuable.
113
 Because a fund may compensate its portfolio management personnel in 
part based on the returns of the fund, the incentives of portfolio managers may not always be 
consistent with the restrictions that a risk management program would impose. Keeping the 
functions separate in the context of derivatives risk management should help mitigate the 
possibility that these competing incentives diminish the program’s effectiveness.  
Separation of functions creates important checks and balances,  and funds could institute 
this proposed requirement through a variety of methods, such as independent reporting chains, 
oversight arrangements, or separate monitoring systems and personnel. The proposed rule would 
require reasonable segregation of functions, rather than taking a more prescriptive approach, 
such as requiring funds to implement strict protocols regarding communications between specific 
fund personnel, to allow funds to structure their risk management and portfolio management 
functions in ways that are tailored to each fund’s facts and circumstances, including the size and 
resources of the fund’s adviser. In this regard, the reasonable segregation requirement is not 
meant to indicate that the derivatives risk manager and portfolio management must be subject to 
a communications “firewall.” We recognize the important perspective and insight regarding the 
fund’s use of derivatives that the portfolio manager can provide and generally understand that the 
fund’s derivatives risk manager would work with the fund’s portfolio management in 
implementing the program requirement.  
For similar reasons, the proposed rule would also prohibit the derivatives risk manager 
position from being filled solely by the fund’s portfolio manager, if a single fund officer serves 
                                                      
113
  See, e.g., Kenneth K. Marshall, Internal Control and Derivatives, The CPA Journal (Oct. 1995), 
available at http://archives.cpajournal.com/1995/OCT95/f461095.htm. 

51 
in the position.
114
 The proposed rule also would prohibit a majority of the officers who compose 
the derivatives risk manager position from being portfolio managers, if multiple fund officers 
serve in the position.  
Commenters generally supported the 2015 proposal’s requirement that a fund’s 
derivatives risk management program be administered by a derivatives risk manager and that the 
fund’s derivatives risk management be segregated from the fund’s portfolio management.
115
 
Commenters did, however, express concern about the 2015 proposal’s requirement that there be 
a single derivatives risk manager and urged that the Commission permit a fund’s portfolio 
managers to provide some input into the fund’s derivatives risk management function.
116
 This re-
proposal addresses these concerns by permitting a group or committee to serve as a fund’s 
derivatives risk manager, a portion of whom could be portfolio managers. 
We request comment on the proposed requirements that a fund’s derivatives risk manager 
administer the fund’s program, and that the derivatives risk management function be reasonably 
segregated from the fund’s portfolio management. 
 Is the proposed definition of “derivatives risk manager” sufficiently clear? Why or 
why not? Should the rule, as proposed, require that a fund’s derivatives risk manager 
be an officer or officers of the fund’s adviser, and would this requirement further the 
goals of centralizing derivatives risk management and promoting accountability? 
Why or why not? Should the rule, as proposed, permit a fund’s derivatives risk 
                                                      
114
     Proposed rule 18f-4(a). 
115
  See, e.g., BlackRock Comment Letter. 
116
  See, e.g., BlackRock Comment Letter; Comment Letter of Morningstar (Mar. 28, 2016) 
(“Morningstar Comment Letter”); Comment Letter of the Investment Company Institute (Mar. 
28, 2016) (“ICI Comment Letter I”); Comment Letter of WisdomTree (Mar. 28, 2016). 

52 
manager to be an officer or officers of the fund’s sub-advisers? Why or why not? If 
so, should the rule require that at least one of the officers be an officer of the adviser 
or otherwise limit the number of sub-adviser officers? Why or why not? Would a 
fund’s program be more effective if we required the derivatives risk manager to be a 
single individual? Why or why not? If so, should this individual be required to be an 
officer of a fund’s adviser?  
 Should the rule, as proposed, require that a fund’s derivatives risk manager have 
relevant experience regarding derivatives risk management? Why or why not? Is the 
proposed requirement that the derivatives risk manager have “relevant experience 
regarding the management of derivatives risk” sufficiently clear? Would this raise 
questions about whether portfolio management experience, or experience outside of 
formal derivatives risk management, would suffice for purposes of the rule? Should 
the rule, instead, require that a fund’s derivatives risk manager simply have “relevant 
experience”? Should the rule specify that the derivatives risk manager must have 
relevant experience as determined by the fund’s board, to allow a board to determine 
the experience that would be appropriate? Or should the rule identify specific 
qualifications, training, or experience of a fund’s derivatives risk manager? Why or 
why not? If so, what should they be and why?  
 Should the rule, as proposed, require a fund to segregate derivatives risk management 
functions from portfolio management? Why or why not? If we were not to require 
independence between a fund’s derivatives risk manager and the fund’s portfolio 
managers, how could we ensure that a fund’s portfolio management personnel, who 
may have conflicting incentives, do not unduly influence the fund’s program 

53 
management?  
 Should we provide any additional clarification regarding the proposed reasonable 
segregation requirement? If so, what changes should we make? Should we add any 
specific requirements? For example, should we limit the extent to which fund risk 
management personnel can be compensated in part based on fund performance? 
 Is our understanding that many funds already segregate functions correct? If so, how 
and why do current approaches differ from the proposed rule’s requirement to 
segregate functions? 
 Are there other ways to facilitate objective and independent risk assessment of 
portfolio strategies that we should consider? If so, what are they and how would these 
alternatives be more effective than the proposed rule’s requirement to reasonably 
segregate functions? 
 Rule 22e-4 under the Investment Company Act, similar to the proposed rule, requires 
certain funds to implement a risk management program. In particular, rule 22e-4 
requires person(s) designated to administer a fund’s liquidity risk management 
program to be the fund’s investment adviser, officer, or officers (which may not be 
solely portfolio managers of the fund) (the “liquidity risk manager”). Should we 
amend rule 22e-4 to more closely align the definition of “liquidity risk manager” with 
the proposed definition of “derivatives risk manager” by prohibiting a fund’s adviser 
from serving as a liquidity risk manager? Why or why not? Conversely, should we 
align the standard for derivatives risk manager with the liquidity risk manager 
standard under rule 22e-4?  
 Would the proposed derivatives risk manager requirement raise any particular 

54 
challenges for funds with smaller advisers and, if so, what could we do to help 
mitigate these challenges? For example, should we modify the rule to permit funds to 
authorize the use of third parties not employed by the adviser to administer the 
program and, if so, under what conditions? Why or why not? Would allowing third 
parties to act as derivatives risk managers enhance the program by allowing 
specialized personnel to administer the program or detract from it by allowing for a 
derivatives risk manager who may not be as focused on the specific risks of the 
particular fund or as accountable to its board? Would the proposed requirement that a 
fund reasonably segregate derivatives risk management from portfolio management 
pose particular challenges for funds with smaller advisers? If so, how and why, and 
would additional guidance on this proposed requirement or changes to the proposed 
rule be useful? Conversely, would this proposed requirement (which does not 
prescribe how funds must segregate functions) provide appropriate flexibility for 
funds with smaller advisers?  
 Rule 38a-1(c) under the Investment Company Act prohibits officers, directors, and 
employees of the fund and its adviser from, among other things, coercing or unduly 
influencing a fund’s chief compliance officer in the performance of his or her duties. 
Should we include such a prohibition on unduly influencing a fund’s derivatives risk 
manager in the proposed rule? Why or why not?  
 Should we include any other program administration requirements? If so, what? For 
example, should we include a requirement for training staff responsible for day-to-
day management of the program, or for portfolio managers, senior management, and 
any personnel whose functions may include engaging in, or managing the risk of, 

55 
derivatives transactions? If we require such training, should that involve setting 
minimum qualifications for staff responsible for carrying out the requirements of the 
program? Why or why not? Should we require training and education with respect to 
any new derivatives instruments that a fund may trade? Why or why not? Should we 
require a new instrument review committee? 
3. Required Elements of the Program 
a. Risk Identification and Assessment 
The proposed program requirement would require a fund to identify and assess its 
derivatives risks in order to manage these risks.
117
 It would require that the fund’s identification 
and assessment take into account the fund’s other investments as well as its derivatives 
transactions. An appropriate assessment of derivatives risks generally involves assessing how a 
fund’s derivatives may interact with the fund’s other investments or whether the fund’s 
derivatives have the effect of helping the fund manage risks. For example, the risks associated 
with a currency forward would differ if a fund is using the forward to hedge the fund’s exposure 
to currency risk associated with a fund investment denominated in a foreign currency or, 
conversely, to take a speculative position on the relative price movements of two currencies. We 
believe that by assessing its derivatives use holistically, a fund will be better positioned to 
implement a derivatives risk management program that does not over- or understate the risks its 
derivatives use may pose. Accordingly, we believe that this approach would result in a more-
tailored derivatives risk management program.  
The proposed rule would define the derivatives risks that must be identified and managed 
to include leverage, market, counterparty, liquidity, operational, and legal risks, as well as any 
                                                      
117
  Proposed rule 18f-4(c)(1)(i). 

56 
other risks the derivatives risk manager deems material.
118
 In the context of a fund’s derivatives 
transactions: 
• Leverage risk generally refers to the risk that derivatives transactions can magnify the 
fund’s gains and losses;
119
 
• Market risk generally refers to risk from potential adverse market movements in relation 
to the fund’s derivatives positions, or the risk that markets could experience a change in 
volatility that adversely impacts fund returns and the fund’s obligations and exposures;
120
  
• Counterparty risk generally refers to the risk that a counterparty on a derivatives 
transaction may not be willing or able to perform its obligations under the derivatives 
contract, and the related risks of having concentrated exposure to such a counterparty;
121
  
• Liquidity risk generally refers to risk involving the liquidity demands that derivatives can 
create to make payments of margin, collateral, or settlement payments to counterparties;
 
 
                                                      
118
  Proposed rule 18f-4(a). In the case of funds that are limited derivatives users under the proposed 
rule, the definition would include any other risks that the fund’s investment adviser (as opposed 
to the fund’s derivatives risk manager) deems material, because a fund that is a limited 
derivatives user would be exempt from the requirement to adopt a derivatives risk management 
program (and therefore also exempt from the requirement to have a derivatives risk manager). See 
infra section II.E. 
119
  See, e.g., Independent Directors Council, Board Oversight of Derivatives Task Force Report (July 
2008), at 12 (“2008 IDC Report”). 
120
  Funds should consider market risk together with leverage risk because leveraged exposures can 
magnify such impacts. See,  e.g., NAPF, Derivatives and Risk Management Made Simple (Dec. 
2013), available at 
https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=132066
3533358&blobheader=application/pdf&blobheadername1=Cache-
Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs.  
121
  See, e.g., Nils Beier, et al., Getting to Grips with Counterparty Risk, McKinsey Working Papers 
on Risk, Number 20
 (June 2010).  

57 
• Operational risk generally refers to risk related to potential operational issues, including 
documentation issues, settlement issues, systems failures, inadequate controls, and human 
error;
122
 and  
• Legal risk generally refers to insufficient documentation, insufficient capacity or 
authority of counterparty, or legality or enforceability of a contract.
123
 
We believe these risks are common to most derivatives transactions.
124
  
                                                      
122
  See, e.g., 2008 IDC Report, supra note 119; RMA, Statement on best practices for managing risk 
in derivatives transactions (2004) (“Statement on best practices for managing risk in derivatives 
transactions”), available at http://www.rmahq.org/securities-lending/best-practices.  
123
  See, e.g., Raimonda Martinkutė-Kaulienė, Risk Factors in Derivatives Markets, 2 Entrepreneurial 
Business and Economics Review 4 (2014); Capital, Margin, and Segregation Requirements for 
Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital and 
Segregation Requirements for Broker-Dealers, Exchange Act Release No. 86175 (June 21, 2019), 
84 FR 43872 (Aug. 22, 2019), n.1055 (“Capital Margin Release”) ( “Market participants face 
risks associated with the financial and legal ability of counterparties to perform under the terms of 
specific transactions”); see also Office of the Comptroller of the Currency, Risk Management of 
Financial Derivatives, Comptroller’s Handbook (Jan. 1997) (narrative), (Feb. 1998) (procedures).  
Because derivatives contracts that are traded over the counter are not standardized, they bear a 
certain amount of legal risk in that poor draftsmanship, changes in laws, or other reasons may 
cause the contract to not be legally enforceable against the counterparty. See, e.g., Comprehensive 
Risk Management of OTC Derivatives, supra note 124. For example, some netting agreements or 
qualified financial contracts contain so-called “walkaway” clauses, such as provisions that, under 
certain circumstances, suspend, condition, or extinguish a party’s payment obligation under the 
contract. These provisions would not be enforceable where the Federal Deposit Insurance Act is 
applicable. See 12 U.S.C 1821(e)(8)(G). As another example, many derivatives contracts and 
prime brokerage agreements that hedge funds and other counterparties had entered into with 
Lehman Brothers included cross-netting that allowed for payments owed to and from different 
Lehman affiliates to be offset against each other, and cross-liens that granted security interests to 
all Lehman affiliates (rather than only the specific Lehman entity entering into a particular 
transaction). In 2011, the U.S. Bankruptcy Court for the Southern District of New York held that 
cross-affiliate netting provisions in an ISDA swap agreement were unenforceable against a debtor 
in bankruptcy. In the Matter of Lehman Brothers Inc., Bankr. Case No. 08-01420 (JPM) (SIPA), 
458 B.R. 134, 1135-137 (Bankr. S.D.N.Y. Oct. 4, 2011). 
124
  See Numerix, Comprehensive Risk Management of OTC Derivatives; A Tricky Endeavor (July 
16, 2013), available at http://www.numerix.com/comprehensive-risk-management-otc-
derivatives-tricky-endeavor (“Comprehensive Risk Management of OTC Derivatives”); 
Statement on best practices for managing risk in derivatives transactions, supra note 122; 2008 
IDC Report, supra note 119; Lawrence Metzger, Derivatives Danger: internal auditors can play 
a role in reigning in the complex risks associated with financial instruments, FSA Times (2011), 
available at http://www.theiia.org/fsa/2011-features/derivatives-danger (“FSA Times Derivatives 
 

58 
The proposed rule would not limit a fund’s identification and assessment of derivatives 
risks to only those specified in the rule. The proposed definition of the term “derivatives risks” 
includes any other risks a fund’s derivatives risk manager deems material.
125
 S ome derivatives 
transactions could pose certain idiosyncratic risks. For example, some derivatives transactions 
could pose a risk that a complex OTC derivative could fail to produce the expected result (e.g., 
because historical correlations change or unexpected merger events occur) or pose a political risk 
(e.g., events that affect currencies).  
Commenters to the 2015 proposal generally supported its requirement that a fund engage 
in a process of identifying and evaluating the potential risks posed by its derivatives 
transactions.
126
  
We request comment on all aspects of the proposed requirement to identify and assess a 
fund’s derivatives risks, as well as the proposed definition of the term “derivatives risks.”   
 Is the proposed definition of “derivatives risks” sufficiently clear? Why or why not?  
 Are the categories of risks that we have identified in the proposed rule appropriate? 
Why or why not? Should we remove any of the identified risk categories? If so, what 
categories should be removed, and why? Should we add any other specified 
categories of risks that should be addressed? If so, what additional categories and 
why? Should we provide further guidance regarding the assessment of any of these 
                                                      
Dangers”). See also 17 CFR 240.15c3-4(a) (“An OTC derivatives dealer shall establish, 
document, and maintain a system of internal risk management controls to assist it in managing the 
risks associated with its business activities, including market, credit, leverage, liquidity, legal, and 
operational risks.”). Nonbank security-based swap dealers and broker-dealers authorized to use 
internal models to compute net capital also are subject to rule 15c3-4. See Capital Margin 
Release, supra note 123.  
125
     See supra note 118. 
126
  See, e.g., ICI Comment Letter I; Comment Letter of the Consumer Federation of America (Mar. 
28, 2016) (“CFA Comment Letter”). 

59 
risks? If so, what should the guidance be, and why? 
 Do commenters believe the proposed approach with respect to risk identification and 
assessment is appropriate? Why or why not?  
 Do funds currently assess the risks associated with their derivatives transactions by 
taking into account both their derivatives transactions and other investments? If so, 
how do they perform this assessment? Are there certain derivatives transactions 
whose risks do not involve an assessment of other investments in a fund’s portfolio? 
If so, which derivatives transactions, and why? 
 Should we require policies and procedures to include an assessment of particular risks 
based on an evaluation of certain identified risk categories as proposed? If not, why?  
b. Risk Guidelines 
The proposed rule would require a fund’s program to provide for the establishment, 
maintenance, and enforcement of investment, risk management, or related guidelines that 
provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s 
derivatives risks (the “guidelines”).
127
 The guidelines would be required to specify levels of the 
given criterion, metric, or threshold that a fund does not normally expect to exceed and the 
measures to be taken if they are exceeded. The proposed guidelines requirement is designed to 
address the derivatives risks that a fund would be required to monitor routinely as part of its 
program, and to help the fund identify when it should respond to changes in those risks. We 
understand that many funds today have established risk management guidelines, with varying 
degrees of specificity. 
                                                      
127
  Proposed rule 18f-4(c)(1)(ii). 

60 
The proposed rule would not impose specific risk limits for these guidelines. It would, 
however, require a fund to adopt guidelines that provide for quantitative thresholds that the fund 
determines to be appropriate and that are most pertinent to its investment portfolio, and that the 
fund reasonably determines are consistent with its risk disclosure.
128
 R equiring a fund to 
establish discrete metrics to monitor its derivatives risks w ould require the fund and its 
derivatives risk manager to measure changes in its risks regularly, and this in turn is designed to 
lead to more timely steps to manage these risks. Moreover, requiring a fund to identify its 
response when these metrics have been exceeded would provide the fund’s derivatives risk 
manager with a clear basis from which to determine whether to involve other persons, such as 
the fund’s portfolio management or board of directors, in addressing derivatives risks 
appropriately.
129
  
Funds may use a variety of approaches in developing guidelines that comply with the 
proposed rule.
130
 This would draw on the risk identification element of the program and the 
scope and objectives of the fund’s use of derivatives. A fund could use quantitative metrics that 
it determines would allow it to monitor and manage its particular derivatives risks most 
appropriately. We understand that today funds use a variety of quantitative models or 
methodologies to measure the risks associated with the derivatives transactions. With respect to 
market risk, we understand that funds commonly use VaR, stress testing, or horizon analysis. 
                                                      
128
  See, e.g., Mutual Fund Directors Forum, Risk Principles for Fund Directors: Practical Guidance 
for Fund Directors on Effective Risk Management Oversight (Apr. 2010), available at 
http://www.mfdf.org/images/Newsroom/Risk_Principles_6.pdf (“MFDF Guidance”).  
129
  See proposed rule 18f-4(c)(1)(v); see also infra section II.B.3.e. 
130
  See, e.g., Comprehensive Risk Management of OTC Derivatives, supra note 124; Statement on 
best practices for managing risk in derivatives transactions, supra note 122; 2008 IDC Report, 
supra note 119.  

61 
Concentration risk metrics are also being used in connection with monitoring counterparty risk 
(e.g., requiring specific credit committee approval for transactions with a notional exposure in 
excess of a specified amount, aggregated with other outstanding positions with the same of 
affiliated counterparties). In addition, liquidity models have been designed to address liquidity 
risks over specified periods (e.g., models identifying margin outlay requirements over a specified 
period under specified volatility scenarios).   
In developing the guidelines, a fund generally should consider how to implement them in 
view of its investment portfolio a nd the fund’s disclosure to investors. For example, a fund may 
wish to consider establishing corresponding investment size controls or lists of approved 
transactions across the fund.
131
 A fund generally should consider whether to implement 
appropriate monitoring mechanisms designed to allow the fund to abide by the guidelines, 
including their quantitative metrics.   
While the 2015 proposal did not require funds to adopt risk guidelines, commenters on 
the 2015 proposal generally supported the concept of a requirement that a fund adopt and 
implement policies and procedures reasonably designed to manage the risks of its derivatives 
transactions, including by monitoring whether those risks continue to be consistent with any 
investment guidelines established by the fund or the fund’s investment adviser.
132
  
We request comment on the proposed rule’s guidelines requirement.  
 Should we require, as proposed, a fund’s program to provide for the establishment, 
maintenance, and enforcement of investment, risk management, or related guidelines? 
                                                      
131
  A fund could also consider establishing an “approved list” of specific derivatives instruments or 
strategies that may be used, as well as a list of persons authorized to engage in the transactions on 
behalf of the fund. A fund may wish to provide new instruments (or instruments newly used by 
the fund) additional scrutiny. See, e.g., MFDF Guidance, supra note 128, at 8. 
132
  See, e.g., BlackRock Comment Letter; CRMC Comment Letter; ICI Comment Letter I. 

62 
Why or why not? Should we require, as proposed, that the guidelines provide for 
quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s 
derivatives risks? Why or why not? If not, is there an alternative program element 
that would be more appropriate in promoting effective derivatives risk management? 
Should we prescribe particular tools or approaches that funds must use to manage 
specific risks related to their use of derivatives? For example, should we require funds 
to manage derivatives’ liquidity risks by maintaining highly liquid assets to cover 
potential future losses and other liquidity demands?  
 Should we require a specific number or range of numbers of guidelines that a fund 
should establish? For example, should we require a fund to establish a minimum of 2, 
3, 4, or more different guidelines to cover a range of different risks? Why or why not?  
 Do funds currently adopt, and monitor compliance with, such guidelines? If so, do 
these guidelines provide for quantitative or otherwise measurable criteria, metrics, or 
thresholds of the funds’ derivatives risks? If so, what criteria, metrics, or thresholds 
are provided for? Should we require that funds use specific risk management tools? If 
so, what tools should we require?  
 Should we specify a menu of guideline categories that all funds should use to promote 
consistency in risk management among funds? For example, should we identify 
certain commonly-used types of guidelines such as VaR, notional amounts, and 
duration, and require funds to choose among those commonly-used types? If we were 
to do so, which metrics should we allow funds to use? Would such a menu become 
stale as new risk measurement tools are developed?  
 Should we require, as proposed, that the guidelines specify set levels of a given 

63 
criterion, metric, or threshold that the fund does not generally expect to exceed? Why 
or why not? If so, how would these levels be set or calculated? Should we instead set 
maximum levels for certain guidelines a fund would not exceed?  
 Should we require that a fund publicly disclose the guidelines it uses and the 
quantitative levels selected? If so, where (for example, in the fund’s prospectus, 
website, or on Form N-PORT or N-CEN)? Should we instead require that funds 
confidentially report to us the guidelines they use and the quantitative levels selected? 
If so, on what form should they report this information?  
 Should we require, as proposed, that the guidelines identify measures to be taken 
when the fund exceeds a criterion, metric, or threshold in the fund’s guidelines? Why 
or why not? 
 Should we require any form of public disclosure or confidential reporting to us if a 
fund were to exceed its risk guidelines? Would such reporting or disclosure result in 
funds setting guidelines that are so restrictive or lax that they would be unlikely to be 
useful as a monitoring and risk management tool?  
 Should the rule require the guidelines to provide for other elements? If so, what 
elements and why? 
c. Stress Testing 
The proposed rule would require a fund’s program to provide for stress testing to evaluate 
potential losses to the fund’s portfolio.
133
 We understand that, as a derivatives risk management 
                                                      
133
  Proposed rule 18f-4(c)(1)(iii); see also infra section II.D.6.a (discussing an alternative to the 
proposed limit on fund leverage risk that would rely on a stress testing framework). The proposed 
rule would require a fund that is required to establish a derivatives risk mangement program to 
stress test its portfolio, that is, all of the fund’s investments, and not just the fund’s derivatives 
transactions.  

64 
tool, stress testing is effective at measuring different drivers of derivatives risks, including non-
linear derivatives risks that may be understated by metrics or analyses that do not focus on 
periods of stress. Stress testing is an important tool routinely used in other areas of the financial 
markets and in other regulatory regimes, and we understand that funds engaging in derivatives 
transactions have increasingly used stress testing as a risk management tool over the past 
decade.
134
 The Commission has also required certain types of funds to conduct stress tests or 
otherwise consider the effect of stressed market conditions on their portfolios.
135
 We believe that 
requiring a fund to stress test its portfolio would help the fund better manage its derivatives risks 
and facilitate board oversight.   
We also believe that stress testing would serve as an important complement to the 
proposed VaR-based limit on fund leverage risk, as well as any VaR testing under the fund’s risk 
guidelines.
136
 D uring periods of stress, returns, correlations, and volatilities tend to change 
dramatically over a very short period of time. Losses under stressed conditions—or “tail risks”—
would not be reflected in VaR analyses that are not calibrated to a period of market stress and 
that do not estimate losses that occur on the trading days with the highest losses.
137
 Requiring 
funds to stress test their portfolios would provide information regarding these “tail risks” that 
VaR and other analyses may miss.  
                                                      
134
  See, e.g., Comment Letter of Investment Company Institute (Oct. 8, 2019) (“ICI Comment Letter 
III”) (stating that, based on a survey of member firms, many funds perform ex ante stress testing). 
135
  See rule 2a-7 under the Investment Company Act [17 CFR 270.2a-7]; see also rule 22e-4 under 
the Investment Company Act [17 CFR 270.22e-4] (requiring a fund subject to the rule to assess 
its liquidity risk by considering, for example, its investment strategy and portfolio investment 
liquidity under reasonably foreseeable stressed conditions). 
136
  See proposed rule 18f-4(c)(2); infra section II.D. 
137
  The proposed rule would not require a fund to implement a stressed VaR test. See infra section 
II.D.1.   

65 
Under the proposed rule, the fund’s stress tests would be required to evaluate potential 
losses to the fund’s portfolio in response to extreme but plausible market changes or changes in 
market risk factors that would have a significant adverse effect on the fund’s portfolio.
138
 The 
stress tests also would have to take into account correlations of market risk factors and resulting 
payments to derivatives counterparties.
139
 We believe that these requirements would promote 
stress tests that produce results that are valuable in appropriately managing derivatives risks by 
focusing the testing on extreme events that may provide actionable information to inform a 
fund’s derivatives risk management.
140
 We understand that funds commonly consider the 
following market risk factors: liquidity, volatility, yield curve shifts, sector movements, or 
changes in the price of the underlying reference security or asset.
141
 In addition, we believe it is 
important for a fund’s stress testing to take into account payments to counterparties,  as losses can 
result when the fund’s portfolio securities decline in value at the same time that the fund is 
required to make additional payments under its derivatives contracts.
142
  
To inform a fund’s derivatives risk management effectively, a fund should stress test its 
portfolio with a frequency that would best position the derivative risk manager to appropriately 
administer, and the board to appropriately oversee, a fund’s derivatives risk management, taking 
into account the frequency of change in the fund’s investments and market conditions. The 
proposed rule, therefore,  would permit a fund to determine the frequency of stress tests, provided 
                                                      
138
  Proposed rule 18f-4(c)(1)(iii). 
139
  Id. 
140
  Krishan Mohan Nagpal, Designing Stress Scenarios for Portfolios, 19 Risk Management 323 
(2017). 
141
  See, e.g., ICI Comment Letter I; Thomas Breuer, et al., How to Find Plausible, Severe, and 
Useful Stress Scenarios, International Journal of Central Banking 205 (Sept. 2009). 
142
  See OppenheimerFunds Settled Action, supra note 22.  

66 
that the fund must conduct stress testing at least weekly. In establishing such frequency, a fund 
must take into account the fund’s strategy and investments and current market conditions. For 
example, a fund whose strategy involves a high portfolio turnover might determine to conduct 
stress testing more frequently than a fund with a more static portfolio. A fund similarly might 
conduct more frequent stress tests in response to increases in market stress. The minimum 
weekly stress testing frequency is designed to balance the potential benefits of relatively frequent 
stress testing with the burdens of administering stress testing.
143
 We also considered a less 
frequent requirement, such as monthly stress testing. A less frequent requirement, however, may 
fail to provide a fund’s derivatives risk manager adequate and timely insight into the fund’s 
derivatives risk, particularly where the fund has a high portfolio turnover. In determining this 
minimum frequency, we also took into account that this requirement would only apply to funds 
that do not qualify for the limited derivatives user exception because they use derivatives in more 
than a limited way. In addition, in view of the proposed rule’s internal reporting and periodic 
review requirements, the weekly stress testing minimum would provide a fund’s derivatives risk 
manager and board with multiple sets of stress testing results, which would allow them to 
observe trends and how the results may change over time.
144
 
Although the 2015 proposal’s risk management program did not include a stress testing 
requirement, some commenters stated that stress testing would serve as an important component 
                                                      
143
  We recognize that the costs associated with stress testing may increase with the frequency of 
conducting such tests. We understand, however, that once a fund initially implements a stress 
testing framework, subsequent stress tests could be automated and, as a result, be less costly. 
144
  See infra sections II.B.3.e and II.C. 

67 
of derivatives risk management and recommended that the Commission require a fund’s 
designated risk manager to perform stress testing and report the results to the fund’s board.
145
 
We request comment on the proposed rule’s stress testing requirement. 
 Should we require, as proposed, that funds conduct stress testing as part of the 
program requirement? Why or why not? How, if at all, would stress testing serve as a 
complement for other risk measurement tools, such as VaR? What does stress testing 
capture as part of derivatives risk management that other tools do not, and why? 
 Should the rule require funds to conduct a particular type of stress testing? If so, what 
type,  and what should the required elements be? For example, should the rule require 
funds to conduct scenario analysis?  
 Should the rule identify specific stress events to be applied? Should any required 
stress events vary based on the primary risks of particular funds? 
 Do funds currently conduct stress testing? If so, what types of stress testing, for what 
purposes, and how does the stress testing that funds currently conduct differ from the 
proposed rule’s requirement? 
 For funds that currently conduct stress testing, how frequently do they conduct it? 
Daily, weekly, or monthly? Why? Does it depend on the type of stress testing? On the 
investment objective or strategy of a fund? With what minimum frequency should the 
rule require stress testing be conducted? For example, instead of weekly tests should 
we require daily tests? Conversely should we allow longer periods of time between 
tests, such as monthly, or quarterly? Why? Should we require more frequent testing 
                                                      
145
  See, e.g., Comment Letter of Blackstone Alternative Investment Advisors LLC (Mar. 28, 2016) 
(“Blackstone Comment Letter”); Comment Letter of Invesco Management Group, Inc. (Mar. 28, 
2016) (“Invesco Comment Letter”); see also ICI Comment Letter III. 

68 
for funds with some investment objectives or strategies than other funds? If so, for 
which objectives or strategies should we require more frequent testing? 
 Is the proposed rule’s reference to “extreme but plausible market changes or changes 
in market risk factors” sufficiently clear? Should we identify more quantitative 
changes, such as the worst change in a specific risk factor seen in the last 10, 20, or 
50 years? Is the proposed rule’s reference to “significant adverse effect” sufficiently 
clear? Should we instead identify quantitative levels of NAV change, such as a drop 
of 20, 30, or 50% of the fund’s NAV?  
 Should we require stress tests to include certain identified market risk factors such as 
changes in interest rates or spreads, market volatility, market liquidity, or other 
market factors? If so, which market risk factors should we identify, and why? If we 
were to identify certain market risk factors to be tested, should we require a fund to 
take action (such as reporting to its board or to the Commission, or reducing its 
derivatives usage) if a stress test were to show that one of these factors would result 
in the fund losing a certain percentage of its NAV? If so, what level of NAV, what 
types of risk factors, and what types of action should we consider?  
 Should we require, as proposed, that funds take into account their strategy, 
investments, and current market conditions in considering the appropriate frequency 
for a fund’s stress tests? Why or why not? Should we require, as proposed, that funds 
to take into account correlations of market risk factors and payments to derivatives 
counterparties as part of the fund’s stress tests? Why or why not? Would any 
additional guidance help funds to better understand, and more consistently conduct, 
the stress tests that the proposed rule would require?  

69 
 We discuss and request comment below on the proposed rule’s requirements to 
provide information to a fund’s board of directors, including the derivatives risk 
manager’s analysis of a fund’s stress testing. In addition to providing this information 
to the board, should we require funds to disclose stress test results to investors or 
report them confidentially to us? If so, what information should be disclosed or 
reported? 
d. Backtesting 
The proposed rule would require a fund to backtest the results of the VaR calculation 
model used by the fund in connection with the relative VaR or absolute VaR test, as applicable, 
as part of the program.
146
 This proposed requirement is designed to require a fund to monitor the 
effectiveness of its VaR model. It would assist a fund in confirming the appropriateness of its 
model and related assumptions and help identify when funds should consider model 
adjustments.
147
 We are proposing this requirement in light of the central role that VaR plays in 
the proposed VaR-based limit on leverage risk. This also is consistent with the comments we 
received on the 2015 proposal suggesting that we require backtesting, which we had not included 
in that proposal.
148
 
Specifically, the proposed backtesting requirement provides that, each business day, the 
fund must compare its actual gain or loss for that business day with the VaR the fund had 
                                                      
146
  See proposed rule 18f-4(c)(1)(iv). 
147
  Some commenters on the 2015 proposal suggested that the Commission require backtesting of a 
fund’s VaR calculation models. See, e.g., Blackstone Comment Letter; Comment Letter of 
Investment Company Institute (Sept. 27, 2016) (“ICI Comment Letter II”); Aviva Comment 
Letter; Comment Letter of the Global Association of Risk Professionals (Mar. 21, 2016) (“GARP 
Comment Letter”). 
148
  See, e.g., Blackstone Comment Letter; ICI Comment Letter II; Aviva Comment Letter; GARP 
Comment Letter. 

70 
calculated for that day. For purposes of the backtesting requirement, the VaR would be estimated 
over a one-trading day time horizon. For example, on Monday at the end of the trading day, a 
fund would analyze whether the gain or loss it experienced that day exceeds the VaR calculated 
for that day.  In this backtesting example, the fund could calculate the VaR for Monday on Friday 
evening ( after Friday trading closes) or Monday morning (before Monday trading begins). The 
fund would have to identify as an exception any instance in which the fund experiences a loss 
exceeding the corresponding VaR calculation’s estimated loss. T his approach is generally 
consistent with the practice of firms that use internal models to compute regulatory capital and 
other regulatory approaches.
149
 Because the proposed rule would require that the fund’s backtest 
be conducted using a 99% confidence level and over a one-day time horizon, and assuming 250 
trading days in a year, a fund would be expected to experience a backtesting exception 
approximately 2.5 times a year, or 1% of the 250 trading days.
150
 If the fund were consistently to 
experience backtesting exceptions more (or less) frequently, this could suggest that the fund’s 
VaR model may not be effectively taking into account and incorporating all significant, 
                                                      
149
  See, e.g., rule 15c3-1e under the Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 
240.15c3-1) (“On the last business day of each quarter, the broker or dealer must identify the 
number of backtesting exceptions of the VaR model, that is, the number of business days in the 
past 250 business days, or other period as may be appropriate for the first year of its use, for 
which the actual net trading loss, if any, exceeds the corresponding VaR measure.”); CESR 
Global Guidelines, supra note 94 (“The UCITS should carry out the back testing program at least 
on a monthly basis, subject to always performing retroactively the comparison for each business 
day,” i.e., “provid[ing] for each business day a comparison of the one-day value-at-risk measure 
generated by the UCITS model for the UCITS’ end-of-day positions to the one-day change of the 
UCITS’ portfolio value by the end of the subsequent business day”); see also infra note 152 
(discussing frequency variations for backtesting requirements).  
150
  The proposed backtesting requirement would be based on a one-day time horizon. See infra 
section II.D.4 (discussing the proposed VaR model requirements that would be based on a 
twenty-day time horizon). 

71 
identifiable market risk factors associated with a fund’s investments, as required by the proposed 
rule.
151
  
The proposed rule would require funds to conduct a backtest each day so that a fund and 
its derivatives risk manager could more readily and efficiently adjust or calibrate its VaR 
calculation model and, therefore, could more effectively manage the risks associated with its 
derivatives use. We understand that some funds perform these calculations less frequently than 
daily.
152
 We are proposing a daily backtesting requirement because market risk factors and fund 
investments are dynamic, which might result in frequent changes to the accuracy and 
effectiveness of a VaR model and calculations using the model. Some commenters on the 2015 
proposal supported a backtesting requirement with a daily frequency.
153
 We also believe that the 
additional costs associated with a daily backtesting requirement would be limited because a fund 
                                                      
151
  If 10 or more exceptions are generated in a year from backtesting that is conducted using a 99% 
confidence level and over a one-day time horizon, and assuming 250 trading days in a year, it is 
statistically likely that such exceptions are a result of a VaR model that is not accurately 
estimating VaR. See, e.g., Philippe Jorion, Value at Risk: The New Benchmark for Managing 
Financial Risk (3d ed. 2006), at 149-150 (“Jorion”). See also rule 15c3-1e under the Exchange 
Act (requiring backtesting of VaR models and the use of a multiplication factor based on the 
number of backtesting exceptions). 
152
  See, e.g., CESR Global Guidelines, supra note 94 (“The UCITS should carry out the back testing 
program at least on a monthly basis, subject to always performing retroactively the comparison 
for each business day,” i.e., “provid[ing] for each business day a comparison of the one-day 
value-at-risk measure generated by the UCITS model for the UCITS’ end-of-day positions to the 
one-day change of the UCITS’ portfolio value by the end of the subsequent business day”); 
Blackstone Comment Letter (suggesting monthly backtests); Aviva Comment Letter 
(recommending reporting to the Commission on a semi-annual basis if a fund experienced a 
certain number of backtest exceptions). Cf. rule 15c3-1e under the Exchange Act [17 CFR 
240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) (“On the last business day of each quarter, the 
broker or dealer must identify the number of backtesting exceptions of the VaR model, that is, the 
number of business days in the past 250 business days, or other period as may be appropriate for 
the first year of its use, for which the actual net trading loss, if any, exceeds the corresponding 
VaR measure.”). 
153
  See, e.g., GARP Comment Letter; Aviva Comment Letter; ICI Comment Letter II.  

72 
would be required to calculate its portfolio VaR each business day to satisfy the proposed limits 
on fund leverage discussed in section II.D of this release. 
We request comment on the proposed backtesting requirement. 
 Is the proposed requirement that a fund backtest its VaR model each business day 
appropriate? Why or why not? Would less-frequent backtesting be sufficient? Is 
backtesting an effective tool to promote derivatives risk management and VaR model 
accuracy? Why or why not? 
 Should the rule specify the number of exceedances, or the number of consecutive 
days without an exceedance, that would require VaR model calibration? Why or why 
not? 
 How often do funds that currently use VaR backtest their VaR models and why? 
Should the backtesting requirement be less frequent? For example, should we require 
a fund to perform backtests weekly, monthly, or quarterly, in each case considering 
the one-day value change for each trading day in the period? Please explain. 
 For funds that currently backtest their VaR models, how often and for what reasons 
do funds recalibrate their VaR models? Are certain market risk factors or investment 
types particularly prone to requiring VaR model recalibrations (as well as 
backtesting)? 
e. Internal Reporting and Escalation 
The proposed rule would require communication between a fund’s risk management and 
portfolio management regarding the operation of the program.
154
 We believe these lines of 
                                                      
154
  Proposed rule 18f-4(c)(1)(v). 

73 
communication are a key part of derivatives risk management.
155
 Providing portfolio managers 
with the insight of a fund’s derivatives risk manager is  designed to inform portfolio managers’ 
execution of the fund’s strategy and recognize that portfolio managers will generally be 
responsible for transactions that could mitigate or address derivatives risks as they arise. The 
proposed rule also would require communication between a fund’s derivatives risk manager and 
its board, as appropriate. We understand that funds today often have a dialogue between risk 
professionals and fund boards. Requiring a dialogue between a fund’s derivatives risk manager 
and the fund’s board would provide the fund’s board with key information to facilitate its 
oversight function.  
To provide flexibility for funds to communicate among these groups as they deem 
appropriate and taking into account funds’ own facts and circumstances, the proposed rule would 
require a fund’s program to identify the circumstances under which a fund must communicate 
with its portfolio management about the fund’s derivatives risk management, including its 
program’s operation.
156
 A fund’s program, in addition, could require that the fund’s derivatives 
risk manager inform the fund’s portfolio management, for example, by meeting with the fund’s 
portfolio management on a regular and frequent basis, or require that the fund’s portfolio 
management is notified of the fund’s exceedances or stress tests through software designed to 
provide automated updates. 
The proposed rule would also require a fund’s derivatives risk manager to communicate 
material risks to the fund’s portfolio management and, as appropriate, its board of directors.
157
 
                                                      
155
  See 2011 IDC Report, supra note 95. 
156
  Proposed rule 18f-4(c)(1)(v)(A). 
157
  Proposed rule 18f-4(c)(1)(v)(B).  

74 
Specifically, the rule would require the derivatives risk manager to inform, in a timely manner, 
persons responsible for the fund’s portfolio management—and the fund’s board of directors, as 
appropriate—of material risks arising from the fund’s derivatives transactions.
158
 The proposed 
rule would not require a fund’s derivatives risk manager to escalate these risks to the fund’s 
board automatically, but would require that the derivatives risk manager directly inform the 
fund’s board of directors regarding these material risks if the manager determines board 
escalation to be appropriate. A fund’s derivatives risk manager, for example, could determine to 
inform the fund’s adviser’s senior officers of material derivatives risks after informing the fund’s 
portfolio management, and before informing the fund’s board. As another example, a fund’s 
derivatives risk manager could determine that it would be appropriate to communicate certain 
material derivatives risks (for example, those that put more than a certain percentage of the 
fund’s assets at imminent risk) to the board at the same time it informs the fund’s portfolio 
management. We believe that a fund’s derivatives risk manager is best positioned to determine 
when to appropriately inform the fund’s portfolio management and board of material risks.  
The proposed rule would require that these material risks include any material risks 
identified by the fund’s guideline exceedances or stress testing. For example, an unexpected risk 
may arise due to a sudden market event, such as a downgrade of a large investment bank that is a 
substantial derivatives counterparty to the fund. This requirement is designed to inform portfolio 
managers of material risks identified by a fund’s derivatives risk management function so that 
portfolio managers can take them into account in managing the fund’s portfolio and address or 
mitigate them as appropriate. It also would facilitate board oversight by empowering the 
derivatives risk manager to escalate a material risk directly to the fund’s board where 
                                                      
158
  Id. 

75 
appropriate. Requiring that a fund’s derivatives risk manager have this direct line of 
communication with the board regarding material risks arising from the fund’s derivatives 
transactions is designed to foster an open and effective dialogue among the derivatives risk 
manager and the board. 
We request comment on the internal reporting and escalation elements of the proposed 
program requirement. 
 Are the proposed internal reporting and escalation requirements appropriate? Why or 
why not? Should the rule describe the circumstances under which a fund must inform 
its portfolio management regarding the operation of the program, including any 
exceedances of its guidelines and the results of its stress tests? Why or why not? If so, 
what should the circumstances be and why? Should the rule require a fund to report to 
others at the fund or its adviser (e.g., the fund’s chief compliance officer)? If so, who 
should a fund report to and why?  
 Should we prescribe the types of internal reporting information that persons 
responsible for a fund’s portfolio management or the fund’s board should receive, and 
the means by which these persons receive such information? Why or why not? If so, 
what should we prescribe and why? 
 Are the proposed requirements to escalate material risks to the fund’s portfolio 
management (and, as appropriate, the fund’s board of directors) appropriate? Why or 
why not? Should these material risks include risks identified by the fund’s guideline 
exceedances or stress testing? Why or why not? Should a fund’s derivatives risk 
manager be required to report all material derivatives risks to the fund’s board, as 
well as to its portfolio management? Why or why not? 

76 
 Should the rule, as proposed, permit a fund to determine what risks arising from its 
derivatives transactions are material to the fund, for purposes of the proposed 
escalation requirement? Why or why not? If so, should the rule specifically require a 
fund’s derivatives risk manager to make this determination?  
 Should the rule require the means by which internal reporting and/or material risk 
escalation occur? For example, should the rule specify that certain communications 
must be in writing? Why or why not?  
 Should the rule require a fund’s derivatives risk manager to inform the fund’s 
portfolio management regarding the operation of the program on a regular basis? 
Why or why not? If so, what should the frequency be and why? 
 Should the rule require a fund to report material risks to us? Why or why not? If so, 
what should a fund report and how should it be reported? For example, should a fund 
be required to report material exceedances to its guidelines? Why or why not? Should 
such a report be confidential? 
 Should the rule permit a fund to determine whether the material risk warrants 
informing the fund’s board? Why or why not? If so, which person or persons at the 
fund or its adviser should be responsible for that determination? Should a fund’s 
board always be informed of material risks regarding the fund’s derivatives use? Why 
or why not? If so, under what circumstances and frequency should the board be 
informed, and why? 
 Should we require that a fund’s derivatives risk manager be permitted to 
communicate directly with the fund’s board of directors? If not, how should we 
otherwise address the concern that a board may not receive the derivatives risk 

77 
manager’s independent risk assessments if the derivatives risk manager is not 
empowered to communicate directly with the board?  
f. Periodic Review of the Program 
The proposed rule would require a fund’s derivatives risk manager to review the program 
at least annually to evaluate the program’s effectiveness and to reflect changes in the fund’s 
derivatives risks over time.
159
 T he   review would apply to the overall program, including each of 
the specific program elements discussed above. 
The periodic review would also cover the VaR model a fund uses to comply with the 
proposed VaR-based limit on fund leverage risk and related matters. As discussed below, the 
proposed rule would require a fund to comply with a relative or absolute VaR test.
160
 For the 
relative VaR test, the fund would compare its VaR to a “designated reference index,” as defined 
in the rule and selected by the fund’s derivatives risk manager. The proposed periodic review 
would therefore include the VaR calculation model that the fund used in connection with either 
of the proposed VaR tests (including the fund’s backtesting of the model) and any designated 
reference index that the derivatives risk manager selected, to evaluate whether the calculation 
model and designated reference index remain appropriate.  
We believe that the periodic review of a fund’s program and VaR calculation model is 
necessary to determine whether the fund is appropriately addressing its derivatives risks. A 
fund’s derivatives risk manager, as a result of the review, could determine whether the fund 
should update its program, its VaR calculation model, or any designated reference index. 
                                                      
159
  Proposed rule 18f-4(c)(1)(vi). 
160
  See proposed rule 18f-4(c)(2); infra section II.D.  

78 
Commenters on the 2015 proposal generally supported a similar proposed requirement that a 
fund review and update its derivatives risk management program at least annually.
161
 
The proposed rule would not prescribe review procedures or incorporate specific 
developments that a derivatives risk manager must consider as part of its review. We believe a 
derivatives risk manager generally should implement periodic review procedures for evaluating 
regulatory, market-wide, and fund-specific developments affecting the fund’s program so that it 
is well positioned to evaluate the program’s effectiveness.  
We believe that a fund should review its program, VaR calculation model, and designated 
reference index on at least an annual basis, because derivatives and fund leverage risks, and the 
means by which funds evaluate such risks, can change. The proposed rule would require at least 
an annual review so that there would be a recurring dialogue between a fund’s derivatives risk 
manager and its board regarding the implementation of the program and its effectiveness. This 
frequency also mirrors the minimum period in which the fund’s derivatives risk manager would 
be required to provide a written report on the effectiveness of the program to the board.
162
 A  
fund’s derivatives risk manager could, however, determine that more frequent reviews are 
appropriate based on the fund’s particular derivatives risks, the fund’s policies and procedures 
implementing the program, market conditions, or other facts and circumstances.
163
  
We request comment on the proposed rule’s periodic review requirement.  
 Should the rule, as proposed, specifically require that a fund’s derivatives risk 
                                                      
161
  See, e.g., Vanguard Comment Letter. 
162
  See infra section II.C.2. 
163
  See also proposed rule 18f-4(c)(2)(iii)(A) (requiring, for a fund that is not in compliance with the 
applicable VaR test within three business days, the derivatives risk manager to report to the 
fund’s board of directors and explain how and by when (i.e., number of business days) the 
derivatives risk manager reasonably expects that the fund will come back into compliance). 

79 
manager periodically review the program’s effectiveness, including the program’s 
VaR calculation model and any designated reference index? Why or why not? 
 Should the rule, as proposed, require this review to take place at least annually, or 
should it require a more frequent review, such as quarterly? Should we, instead, not 
prescribe a minimum frequency for the periodic review? Why or why not? 
 Are there certain review procedures that the proposed rule should require and/or on 
which the Commission should provide guidance? If so, what are they? For example, 
should the periodic review involve board input? Should the Commission provide any 
additional guidance on regulatory, market-wide, and fund-specific developments that 
a fund’s review procedures might cover? Why or why not? If so, how? 
 Should the rule, as proposed, specifically require that other program elements be 
periodically reviewed? Why or why not? If so, which elements and why, and should 
they be reviewed with the same frequency? 
C. Board Oversight and Reporting 
The proposed rule would require: (1) a fund’s board of directors to approve the 
designation of the fund’s derivatives risk manager and (2) the derivatives risk manager to 
provide regular written reports to the board regarding the program’s implementation and 
effectiveness, and describing any exceedances of the fund’s guidelines and the results of the 
fund’s stress testing.
164
 Requiring a fund’s derivatives risk manager approved by the fund’s 
board and with relevant experience as determined by the fund’s board to be responsible for the 
day-to-day administration of the fund’s program, subject to board oversight, is consistent with 
                                                      
164
  Proposed rule 18f-4(c)(5). The board could designate a committee of directors to receive the 
report. 

80 
the way we believe many funds currently manage derivatives risks.
165
 It is also consistent with a 
board’s duty to oversee other aspects of the management and operations of a fund.  
The proposed rule’s requirements regarding board oversight and reporting are designed to 
further facilitate the board’s oversight of the fund’s derivatives risk management.
166
 Board 
oversight should not be a passive activity. Consistent with that view, we believe that directors 
should understand the program and the derivatives risks it is designed to manage as well as 
participate in determining who should administer the program. They also should ask questions 
and seek relevant information regarding the adequacy of the program and the effectiveness of its 
implementation. The board should view oversight as an iterative process. Therefore, the board 
should inquire about material risks arising from the fund’s derivatives transactions and follow up 
regarding the steps the fund has taken to address such risks, including as those risks may change 
over time. To facilitate the board’s oversight, the proposed rule, as discussed below, would 
require the fund’s derivatives risk manager to provide reports to the board.  
A fund’s board would also be responsible for overseeing a fund’s compliance with 
proposed rule 18f-4. Rule 38a-1 under the Investment Company Act requires a fund’s board, 
including a majority of its independent directors, to approve policies and procedures reasonably 
designed to prevent violation of the federal securities laws by the fund and its service 
                                                      
165
  See, e.g., Comment Letter of the Independent Directors Council (June 22, 2016) (providing views 
regarding the appropriate oversight role of fund directors). 
166
  Many commenters to the 2015 proposal expressed the view that the appropriate role of the board 
in the context of funds’ derivatives risk management is one of oversight. See, e.g., Comment 
Letter of Mutual Fund Directors Forum (Mar. 28, 2016) (stating it has long taken the position that 
boards and independent trustees have an important role to play in overseeing the risks associated 
with funds’ use of derivatives, including the manner in which those risks are managed); see also 
Comment Letter of the Independent Directors Council (Mar. 28, 2016) (“IDC Comment Letter”); 
Morningstar Comment Letter. 

81 
providers.
167
 Rule 38a-1 provides for oversight of compliance by the fund’s adviser and other 
service providers through which the fund conducts its activities. Rule 38a-1 would encompass a 
fund’s compliance obligations with respect to proposed rule 18f-4. 
1. Board Approval of the Derivatives Risk Manager 
The proposed rule would require a fund’s board to approve the designation of the fund’s 
derivatives risk manager, taking into account the derivatives risk manager’s relevant experience 
regarding the management of derivatives risk.
168
 T his requirement is designed to establish the 
foundation for an effective relationship and line of communication between a fund’s board and 
its derivatives risk manager, and to ensure that the board receives information it needs to approve 
the designation.
169
 The requirement that the board consider the derivatives risk manager’s 
relevant experience is designed to provide flexibility for a fund’s board to take into account a 
derivatives risk manager’s specific experience, rather than the rule taking a more prescriptive 
approach in identifying a specific amount or type of experience that a derivatives risk manager 
must have. Detailing a derivatives risk manager’s required experience in the rule would not be 
practical, given the numerous ways in which a person could obtain experience with derivatives 
or risk management. Any specification in the rule of the specific experience required to serve as 
a derivatives risk manager likely would be over- or under-inclusive and would not take into 
account the way that any particular fund uses derivatives. We believe that a fund’s board, in its 
oversight role, is best-positioned to consider a prospective derivatives risk manager’s experience 
                                                      
167
   See rule 38a-1 under the Investment Company Act; Compliance Programs of Investment 
Companies and Investment Advisers, Investment Company Act Release No. 26299 (Dec. 17, 
2003) [68 FR 74714 (Dec. 24, 2003)] (discussing the adoption and implementation of policies 
and procedures required under rule 38-1) (“Compliance Program Release”). 
168
  Proposed rule 18f-4(c)(5)(i).  
169
  Cf. rules 22e-4 and 38a-1 under the Investment Company Act. 

82 
based on all the facts and circumstances relevant to the fund in considering whether to approve 
the derivatives risk manager’s designation. 
Commenters on the 2015 proposal generally supported a requirement that the board 
approve a fund’s derivatives risk manager, although some of these commenters objected to the 
proposed requirement that only a single individual could serve in that role. These commenters 
asserted that requiring the board to approve a single individual as the derivatives risk manager 
would have required the board to participate too closely in the management function of the 
fund.
170
 This re-proposal, in contrast, would permit a fund’s board to approve the designation of 
a single individual or group of individuals, subject to the other proposed requirements about who 
may serve as a derivatives risk manager.   
We request comment on the proposed requirement that a fund’s board approve the 
designation of the fund’s derivatives risk manager.  
 Should we require, as proposed, that a fund’s board approve the designation of the 
fund’s derivatives risk manager? Why or why not? Are there any specific 
requirements we should include with respect to the derivatives risk manager’s 
relationship with the board? For example, should we require the board to meet with 
the derivatives risk manager in executive session? Should we also require the 
derivatives risk manager to be removable only by the fund’s board? Should we 
require the derivatives risk manager’s compensation be approved by the board, like a 
fund’s chief compliance officer? If so, why? Would such a requirement pose undue 
burdens on fund boards or place the board in an inappropriate role? If so, why?  
                                                      
170
  See, e.g., Comment Letter of Guggenheim (Mar. 28, 2016) (“Guggenheim Comment Letter”); 
Dechert Comment Letter; IDC Comment Letter; American Beacon Comment Letter; Fidelity 
Comment Letter; IAA Comment Letter; ICI Comment Letter I; Invesco Comment Letter. 

83 
 Should the rule permit a board committee to approve the designation of the 
derivatives risk manager, rather than the full board (and a majority of directors who 
are not interested persons of the fund) as proposed? Why or why not? If so, should 
there be any requirements or guidance with respect to such a board committee (e.g., 
composition or responsibilities)? 
 Should the rule, as proposed, require that a fund’s board in approving the fund’s 
derivatives risk manager, take into account the derivatives risk manager’s relevant 
experience regarding the management of derivatives risk? Why or why not? Would a 
fund’s board, in approving the designation of the fund’s derivatives risk manager, 
only approve individuals with relevant experience even without this express 
requirement? Is the proposed requirement that a fund’s board must take into account 
the derivatives risk manager’s “relevant experience regarding the management of 
derivatives risk” sufficiently clear? Would this raise questions for a fund’s board 
about whether portfolio management experience, or experience outside of formal 
derivatives risk management, would suffice for purposes of the rule? Should the rule, 
instead, require that a fund’s board take into account the derivatives risk manager’s 
“relevant experience”? Or should the rule identify specific qualifications or 
experience of a fund’s derivatives risk manager that the fund’s board must consider? 
Why or why not? If so, what should they be and why? 
 Should we require a fund’s board, or a committee thereof, to approve the derivatives 
risk management program or any material changes to the program? Why or why not? 
If so, should we require that the committee have a majority that are disinterested? 
Would such an approval requirement promote greater board engagement and 

84 
oversight? Do a fund’s derivatives use and related derivatives risks present matters 
for which it would be appropriate to require the fund’s board, or committee thereof, to 
approve the program or any material changes to the program? Why or why not? 
2. Board Reporting 
The proposed rule would require the derivatives risk manager to provide a written report 
on the effectiveness of the program to the board at least annually and also to provide regular 
written reports at a frequency determined by the board. This requirement is designed to facilitate 
the board’s oversight role, including its role under rule 38a-1.
171
 
Many commenters to the 2015 proposal did not support the proposal’s requirement that 
the board approve material changes to the program. Many commenters did state, however, that a 
fund’s board of directors should be provided with notices of changes to the policies and 
procedures implementing the derivatives risk management program and that the fund’s 
derivatives risk manager should provide the board with a written report describing the adequacy 
of the derivatives risk management program and the effectiveness of its implementation and the 
results of the fund’s stress testing.
172
 
Reporting on Program Implementation and Effectiveness 
The proposed rule would require a fund’s derivatives risk manager to provide to the 
fund’s board, on or before the implementation of the program and at least annually thereafter, a 
written report providing a representation that the program is reasonably designed to manage the 
fund’s derivatives risks and to incorporate the required elements of the program as well as the 
                                                      
171
  See Compliance Program Release, supra note 167, at n.33 and accompanying text. 
172
  See, e.g., BlackRock Comment Letter; Vanguard Comment Letter. 

85 
basis for the representation.
173
 This requirement, as discussed below, is designed to provide a 
fund’s board with information about the effectiveness and implementation of the program so that 
the board may appropriately exercise its oversight responsibilities, including its role under rule 
38a-1.  
To facilitate the board’s oversight, the proposed rule would require the written report to 
include the basis for the derivatives risk manager’s representation along with such information as 
may be reasonably necessary to evaluate the adequacy of the fund’s program and the 
effectiveness of its implementation. In addition, the representation may be based on the 
derivatives risk manager’s reasonable belief after due inquiry. A derivatives risk manager, for 
example, could form its reasonable belief based on an assessment of the program and taking into 
account input from fund personnel, including the fund’s portfolio management, or from third 
parties. We propose to require that the derivatives risk manager include this representation and 
its basis, because we believe the derivatives risk manager—rather than the board—is best 
positioned to make this determination. Requiring the derivatives risk manager to include the 
information in a board report would also reinforce that the fund and its adviser are responsible 
for derivatives risk management while the board’s responsibility is to oversee this activity. 
Reports following the initial implementation of the program must also address the effectiveness 
of the program. This requirement is  designed to provide the board with appropriate and useful 
information so it can exercise its judgment in overseeing the program, and in light of its role 
under rule 38a-1.  
The proposed rule would also require the written report to include a fund’s derivatives 
risk manager’s basis for the selection of the designated reference index used under the proposed 
                                                      
173
  Proposed rule 18f-4(c)(5)(ii). 

86 
relative VaR test or, if applicable, an explanation of why the derivatives risk manager was unable 
to identify a designated reference index appropriate for the fund such that the fund relied on the 
proposed absolute VaR test instead. The derivatives risk manager’s selection of a particular 
designated reference index, or conclusion that one is not available, can affect the amount of 
leverage risk a fund may obtain under the proposed rule.
174
 We therefore believe it is important 
that a fund’s board have sufficient information to oversee this activity. 
Regular Board Reporting 
The proposed rule would require a fund’s derivatives risk manager to provide to the 
fund’s board, at a frequency determined by the board, a written report analyzing any exceedances 
of the fund’s risk guidelines and the results of the fund’s stress tests and backtesting.
175
 
Requiring the derivatives risk manager to provide information about how the fund performed 
relative to these measures and at a board-determined frequency is designed to provide the board 
with timely information to facilitate its oversight of the fund and the operation of the program. 
The program’s guidelines and stress testing requirements are designed to address a fund’s 
particular derivatives risks and are areas the fund should routinely monitor. The program’s 
backtesting requirement is designed to require a fund to monitor the effectiveness of the fund’s 
VaR model, which plays a central role in the proposed VaR-based limit on fund leverage risk. 
Therefore, we believe that a board overseeing a fund’s derivatives risk management should 
receive regular reporting regarding the derivatives risk manager’s analysis of guideline 
exceedances and the results of stress testing and backtesting. We also understand that many fund 
                                                      
174
  See infra section II.D.2.b. The proposed rule would not limit a derivatives risk manager from 
receiving input from the fund’s portfolio managers or others regarding the fund’s designated 
reference index.  
175
  Proposed rule 18f-4(c)(5)(iii); see also proposed rule 18f-4(c)(1)(ii)–(iv); see also supra sections 
II.B.3.b, II.B.3.c, and II.B.3.d. 

87 
advisers today provide regular reports to fund boards, often in connection with quarterly board 
meetings, regarding a fund’s use of derivatives and their effects on a fund’s portfolio, among 
other information.  
Accordingly, the proposed rule would require that the report include the derivatives risk 
manager’s analysis of any exceedances and stress testing and backtesting results, and to include 
such information as may be reasonably necessary for the board to evaluate the fund’s response to 
any exceedances and the stress testing and backtesting results. This requirement is designed to 
provide the board with information in a format, and with appropriate context, that would 
facilitate the board’s understanding of the information. A simple listing of exceedances and 
stress testing and backtesting results without context, in contrast, would provide less useful 
information for a fund’s board and would not satisfy this proposed requirement. 
Under the proposed regular board reporting requirement, a fund’s board would determine 
the frequency of this written report. Boards should be allowed flexibility in determining the 
frequency of reporting so that they can tailor their oversight to their funds’ particular facts and 
circumstances.  
We request comment on the proposed board reporting requirements.  
 Are the proposed requirements for the fund’s derivatives risk manager to provide 
written reports to the fund’s board on the program’s implementation and effectiveness 
appropriate? Why or why not? Should the board receive a written report on or before 
the implementation of the program? Why or why not? S hould we modify the 
proposed rule to require funds to provide boards reports with greater frequency than 
annually? Why or why not?  
 Is the proposed representation that the derivatives risk manager would have to make 

88 
in the report appropriate? Why or why not? What should the representation entail, and 
why? Should we provide guidance as to what the representation should look like? 
Why or why not? Would the representation be helpful for a fund’s board in exercising 
its oversight responsibilities? Why or why not? What effect, if any, would the 
representation have on a fund’s derivatives risk management apart from the board’s 
oversight of such risk management?  
 Would the responsibilities the proposed rule allocates to a fund’s derivatives risk 
manager affect a fund’s ability to hire or retain a derivatives risk manager? If so, 
how? 
 Is the proposed requirement for the written report to include the basis for the 
derivatives risk manager’s representation along with information to evaluate the 
program’s adequacy and effectiveness, appropriate? Why or why not? Should the rule 
require specific information in the written report? Why or why not? If so, what 
information and why? Should the rule, as proposed, permit the representation to be 
based on the derivatives risk manager’s reasonable belief after due inquiry? Why or 
why not? Should we provide more guidance regarding the basis for the 
representation? If so, what should we provide? For example, should we provide 
guidance regarding the types of information on which a fund’s derivatives risk 
manager may base this representation? Why or why not? Is the reference to due 
inquiry appropriate in this context? Is the reference sufficiently clear?  
 Should the rule require the written report to include a fund’s derivatives risk 
manager’s basis for the selection of the designated reference index or, if applicable, 
an explanation of why the derivatives risk manager was unable to identify a 

89 
designated reference index appropriate for the fund? Why or why not? Should the 
rule require the written report to identify and explain any difference between the 
selected index and any indices that are used for performance comparisons in the 
fund’s registration statement and shareholder reports? Why or why not? 
 Should the rule require a fund’s derivatives risk manager to provide a written report 
regarding any exceedances to thresholds provided for in the fund’s guidelines? Why 
or why not? Should the rule require a fund’s derivatives risk manager to provide a 
written report regarding the results of the stress tests and backtests? Why or why not? 
 Should the rule require that a fund’s derivatives risk manager report to the board? 
Why or why not? If not, should the fund determine who should report to the board, 
and why? Should the rule permit the derivatives risk manager to delegate its reporting 
obligations under the rule to other officers or employees of the adviser? Why or why 
not? If so, to whom should they be able to delegate these obligations? 
 Should the rule permit a fund’s board to determine the frequency with which it 
receives the written report? Why or why not? Or should the rule require that the 
derivatives risk manager provide the written report with a certain frequency? Why or 
why not? If so, what frequency should the rule require, and why? Should the rule 
permit a fund’s derivatives risk manager to determine to report to the board sooner 
than the frequency determined by the board if appropriate? Why or why not? 
 Should the rule require that the written report include such information as may be 
reasonably necessary for the board to evaluate a fund’s response to any exceedances 
and the results of the fund’s stress testing? Why or why not? What information may 
be reasonably necessary for the board’s evaluation? Should the rule require certain 

90 
information to be provided in the written report? Why or why not? If so, what 
information should be required to be provided? 
 Should the rule require the report to be written? Why or why not? Should the rule 
require that the derivatives risk manager prepare the written report? Why or why not? 
 Would the approach provided by the proposed rule’s board oversight provisions 
appropriately provide the board the ability to oversee a fund’s derivatives risk 
management? Why or why not? Does the proposed rule provide an appropriate 
balance between the board’s role of general oversight and the fund’s roles of day-to-
day risk management and portfolio management? Why or why not? 
 Should the board be required to approve the program, including initially, and any 
material changes to the program? Why or why not? What is current industry practice 
with respect to the board’s oversight of a fund’s derivatives risk management? 
D. Proposed Limit on Fund Leverage Risk 
The proposed rule would also generally require funds relying on the rule when engaging 
in derivatives transactions to comply with a VaR-based limit on fund leverage risk. This outer 
limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a 
“designated reference index.”  If the fund’s derivatives risk manager is unable to identify an 
appropriate designated reference index, the fund would be required to comply with an absolute 
VaR test.
176
 
                                                      
176
  A fund that is a leveraged/inverse investment vehicle, as defined in the proposed sales practices 
rules, would not be required to comply with the proposed VaR-based limit on fund leverage risk. 
Broker-dealers and investment advisers would be required to approve retail investors’ accounts to 
purchase or sell shares in these funds. See infra section II.G (discussing leveraged/inverse 
investment vehicles). The proposed rule also would provide an exception from the proposed VaR 
tests for funds that use derivatives to a limited extent or only to hedge currency risks. See infra 
sections II.E and II.G (discussing the proposed rule’s provisions regarding limited derivatives 
 

91 
1. Use of VaR 
VaR is an estimate of an instrument or portfolio’s potential losses over a given time 
horizon and at a specified confidence level. VaR will not provide, and is not intended to provide, 
an estimate of an instrument or portfolio’s maximum loss amount. For example, if a fund’s VaR 
calculated at a 99% confidence level was $100, this means the fund’s VaR model estimates that, 
99% of the time, the fund would not be expected to lose more than $100. However, 1% of the 
time, the fund would be expected to lose more than $100, and VaR does not estimate the extent 
of this loss. 
We propose to use VaR tests to limit fund leverage risk associated with derivatives 
because VaR generally enables risk to be measured in a reasonably comparable and consistent 
manner across diverse types of instruments that may be included in a fund’s portfolio. One 
benefit of the proposed VaR-based approach is that different funds could, and would be required 
to, tailor their VaR models to incorporate and reflect the risk characteristics of their fund’s 
particular investments.
177
 VaR is a commonly-known and broadly-used industry metric that 
integrates the market risk associated with different instruments into a single number that 
provides an overall indication of market risk, including the market risk associated with the fund’s 
derivatives transactions.
178
 We recognize that funds use many other risk analytic metrics suited 
                                                      
users and leveraged/inverse funds covered by the sales practices rules). 
177
  See infra section II.D.4 (discussing the choice of model and parameters for the VaR test). 
178
  See Kevin Dowd, An Introduction to Market Risk Measurement (Oct. 2002), at 10 (“Dowd”) 
(VaR “provides a common consistent measure of risk across different positions and risk factors. It 
enables us to measure the risk associated with a fixed-income position, say, in a way that is 
comparable to and consistent with a measure of the risk associated with equity positions”); see 
also   Jorion, supra note 151, at 159 (stating that VaR “explicitly accounts for leverage and 
portfolio diversification and provides a simple, single measure of risk based on current 
positions”). 

92 
to particular financial instrument categories.
179
 G iven the diverse portfolios of many funds, these 
more category-specific risk metrics may be less suitable for establishing a proposed limit on fund 
leverage risk that is applied more generally. 
We recognize that VaR is not itself a leverage measure. But a  VaR test, and especially 
one that compares a fund’s VaR to an unleveraged index that reflects the markets or asset classes 
in which the fund invests, can be used to analyze whether a fund is using derivatives transactions 
to leverage the fund’s portfolio, magnifying its potential for losses and significant payment 
obligations of fund assets to derivatives counterparties. At the same time, VaR tests can also be 
used to analyze whether a fund is using derivatives with effects other than leveraging the fund’s 
portfolio that may be less likely to raise the concerns underlying section 18. For example, fixed-
income funds use a range of derivatives instruments, including credit default swaps, interest rate 
swaps, swaptions, futures, and currency forwards. These funds often use these derivatives in part 
to seek to mitigate the risks associated with a fund’s bond investments or to achieve particular 
risk targets, such as a specified duration. If a fund were using derivatives extensively, but had 
either a low VaR or a VaR that did not substantially exceed the VaR of an appropriate 
benchmark, this would indicate that the fund’s derivatives were not substantially leveraging the 
fund’s portfolio.
 
                                                      
179 
 See Jorion, supra note 151.  For example, risk measures for government bonds can include 
duration, convexity and term-structure models; for corporate bonds, ratings and default models; 
for stocks, volatility, correlations and beta; for options, delta, gamma and vega; and for foreign 
exchange, target zones and spreads. Certain funds are required to report on Form N-PORT some 
of these metrics, such as portfolio-level duration (DV01 and SDV01) and position-level delta. See 
Investment Company Reporting Modernization, Investment Company Act Release No. 32314 
(Oct. 13, 2016) [81 FR 81870 (Nov. 18, 2016)] (“Investment Company Reporting Modernization 
Adopting Release”). 

93 
We also understand that VaR calculation tools are widely available,  and many advisers 
that enter into derivatives transactions already use risk management or portfolio management 
platforms that include VaR capability.
180
 A dvisers to the funds that use derivatives transactions 
more extensively may be particularly likely to already use risk management or portfolio 
management platforms that include VaR capability, as compared to advisers to the funds that are 
within the scope of the proposed provision for limited derivatives users and that would not be 
subject to the proposed VaR tests.
181
 
While we believe there are significant benefits to using the proposed VaR-based limit on 
fund leverage risk, we recognize risk literature critiques of VaR (especially since the 2007-2009 
financial crisis). One common critique of VaR is that it does not reflect the size of losses that 
may occur on the trading days during which the greatest losses occur—sometimes referred to as 
“tail risks.”
182
 A related critique is that VaR calculations may underestimate the risk of loss 
                                                      
180
  See, e.g., ICI Comment Letter III (“73 percent of respondents [to an Investment Company 
Institute survey of its member firms] use both some form of VaR and stress testing as derivatives 
risk management tools.)”; Comment Letter of OppenheimerFunds (Mar. 28, 2016) 
(“Oppenheimer Comment Letter”); Federated Comment Letter; Franklin Resources Comment 
Letter; see also Christopher L. Culp, Merton H. Miller & Andres M. P. Neves, Value at Risk: 
Uses and Abuses, 10 Journal of Applied Corporate Finance 26 (Jan. 1998) (VaR is “used 
regularly by nonfinancial corporations, pension plans and mutual funds, clearing organizations, 
brokers and futures commission merchants, and insurers.”). Moreover, the proposed relative VaR 
test is similar to a relative VaR approach that applies to UCITS under European guidelines. See 
infra section II.D.6.c (discussing the UCITS approach). 
181
  See, e.g., ICI Comment Letter III. 
182
  See Chris Downing, Ananth Madhavan, Alex Ulitsky & Ajit Singh, Portfolio Construction and 
Tail Risk, 42 The Journal of Portfolio Management 1, 85-102 (Fall 2015), available at 
https://jpm.iijournals.com/content/42/1/85 (“for especially fat-tailed return distributions the VaR 
threshold value might appear to be low, but the actual amount of value at risk is high because 
VaR does not measure the mass of distribution beyond the threshold value”). 
With respect to VaR, the “tail” refers to the observations in a probability distribution curve that 
are outside the specified confidence level. “Tail risk” describes the concern that losses outside the 
confidence level may be extreme. 

94 
under stressed market conditions.
183
 These critiques often arise in the context of discussing risk 
managers’ use of additional risk tools to address VaR’s shortcomings. Our proposed VaR tests 
are designed to provide a metric that can help assess the extent to which a fund’s derivatives 
transactions raise concerns underlying section 18, but we do not believe they should be the sole 
component of a derivatives risk management program.
184
 We do not intend to encourage risk 
managers to over-rely on VaR as a stand-alone risk management tool.
185
 Instead, as discussed 
above, the proposed rule would require a fund to establish risk guidelines and to stress test its 
portfolio as part of its risk management program in part because of concerns that VaR as a risk 
management tool may not adequately reflect tail risks.
186
 We also recognize that a fund’s use of 
derivatives transactions may pose other risks ( such as counterparty risk and liquidity risk) that 
VaR does not capture. A fund that adopts a derivatives risk management program under the 
proposed rule would have to consider these risks as part of its derivatives risk management 
program.
187
  
                                                      
183
  See Jorion, supra note 151, at 357 (VaR “quantif[ies] potential losses under ‘normal’ market 
conditions, where normal is defined by the confidence level, typically 99 percent. . . . In practice, 
[VaR] measures based on recent historical data can fail to identify extreme unusual situations that 
could cause severe losses.”). 
184
  See supra section II.B.3. 
185
  See, e.g., James O’Brien & Pawel J. Szerszen, An Evaluation of Bank VaR Measures for Market 
Risk During and Before the Financial Crisis, Federal Reserve Board Staff Working Paper 2014-
21 (Mar. 7, 2014), available at  
https://www.federalreserve.gov/pubs/feds/2014/201421/201421pap.pdf (“Criticism of banks’ 
VaR measures became vociferous during the financial crisis as the banks’ risk measures appeared 
to give little forewarning of the loss potential and the high frequency and level of realized losses 
during the crisis period.”); see also Pablo Triana, VaR: The Number That Killed Us, Futures 
Magazine (Dec. 1, 2010), available at http://www.futuresmag.com/2010/11/30/var-number-
killed-us ( stating that “in mid-2007, the VaR of the big Wall Street firms was relatively quite low, 
reflecting the fact that the immediate past had been dominated by uninterrupted good times and 
negligible volatility”).  
186
  See supra section II.B.3.b. 
187
  See supra section II.B.3.a. 

95 
We also considered proposing tests based on stressed VaR, expected shortfall, or both. 
Stressed VaR refers to a VaR model that is calibrated to a period of market stress. A stressed 
VaR approach would address some of the VaR test critiques related to tail risk and 
underestimating expected losses during stressed conditions. Calibrating VaR to a period of 
market stress, however, can pose quantitative challenges by requiring funds to identify a stress 
period with a full set of risk factors for which historical data is available. Expected shortfall 
analysis is similar to VaR, but accounts for tail risk by taking the average of the potential losses 
beyond the specified confidence level. For example, if a fund’s VaR at a 99% confidence level is 
$100, the fund’s expected shortfall would be the average of the potential losses in the 1% “tail.” 
Because there are fewer observations in the tail, however, there is an inherent difficulty in 
estimating the expected value of larger losses. Expected shortfall analysis also could involve 
potentially greater sensitivity to extreme outlier losses because it is based on an average of a 
smaller number of observations that are in the tail. Taking these considerations into account, we 
are proposing tests based on VaR, which is commonly used and does not present all of the 
quantitative challenges associated with stressed VaR and expected shortfall, complemented by 
elements in the proposed risk management program designed to address VaR’s limitations. 
We request comment on the proposed definition of VaR, the proposed use of VaR as a 
means to limit funds’ leverage risk, as well as alternative VaR-based methodologies (stressed 
VaR and expected shortfall). We also request comment and discuss alternatives to VaR and 
VaR-based methodologies in section II.D.6 below.
 
 
 Is the proposed definition of the term “VaR” appropriate? Why or why not? If not, 
how should we define it? 
 Is a VaR-based test an appropriate way to limit funds’ leverage risk? Why or why 

96 
not? Do commenters agree with our observations regarding VaR’s characteristics and 
its critiques? Do commenters believe that the proposed derivatives risk management 
program requirement would help to address VaR’s limitations? Please explain. 
 Should we change the rule to require stressed VaR, either as part of the program’s 
stress testing requirement or as part of the limit on fund leverage risk? If so, how 
should we implement a stressed VaR requirement? Should the rule provide, for 
example, that the historical data used to calculate VaR must include a period of 
market stress? What VaR model requirements should we include if the rule required 
stressed VaR? Please describe in detail. Are there any other corresponding changes 
we should make to the proposed VaR model requirements or proposed VaR tests if 
we used stressed VaR? Why or why not? 
 Should we change the rule to require expected shortfall or stressed expected shortfall, 
either as part of the program’s stress testing requirement or as part of the limit on 
fund leverage risk? If so, how should we implement this element? What VaR model 
requirements should we include if the rule required expected shortfall or stressed 
expected shortfall? Please describe in detail. Are there any other corresponding 
changes we should make to the proposed VaR model requirements or proposed VaR 
tests if we were to require expected shortfall or stressed expected shortfall   ? Why or 
why not? 
 Are there risk metrics or measurements other than VaR that similarly can be applied 
to a wide breadth of fund strategy types and investments and used to limit fund 
leverage risk? Please explain. 
 Should we use VaR as the only methodology to establish an outside limit on funds’ 

97 
leverage risk in rule 18f-4? We discuss below additional alternatives to VaR for this 
purpose. Should we include in rule 18f-4 some combination of the proposed VaR 
tests and the alternatives discussed in that section, and provide flexibility to funds to 
comply with the approach that they believe is most appropriate based on their 
strategies and investments? If so, which approaches should we include in the rule and 
why? 
2. Relative VaR Test 
The proposed relative VaR test would require a fund to calculate the VaR of the fund’s 
portfolio and compare it to the VaR of a “designated reference index.” As discussed in more 
detail below, a fund’s designated reference index must be unleveraged and reflect the markets or 
asset classes in which the fund invests, among other requirements. This index is designed to 
create a baseline VaR that approximates the VaR of a fund’s unleveraged portfolio. To the extent 
a fund entered into derivatives to leverage its portfolio, the relative VaR test is designed to 
identify this leveraging effect. If a fund is using derivatives and its VaR exceeds that of the 
designated reference index, this difference may be attributable to leverage risk. 
A fund would be required to comply with the relative VaR test unless a designated 
reference index is unavailable. We propose a relative VaR test as the default means of limiting 
fund leverage risk because it resembles the way that section 18 limits a fund’s leverage risk. 
Section 18 limits the extent to which a fund can potentially increase its market exposure through 
leveraging by issuing senior securities, but it does not directly limit a fund’s level of risk or 
volatility. For example, a fund that invests in less-volatile securities and leverages itself to the 
maximum extent may not be as volatile as a completely unleveraged fund that invests in more-
volatile securities. The proposed relative VaR test likewise is designed to limit the extent to 
which a fund increases its market risk by leveraging its portfolio through derivatives, while not 

98 
restricting a fund’s ability to use derivatives for other purposes. For example, if a derivatives 
transaction reduces (or does not substantially increase) a fund’s VaR relative to the VaR of the 
designated reference index, the transaction would not be restricted by the relative VaR test.  
In addition, allowing funds to rely on the proposed absolute VaR test may be inconsistent 
with investors’ expectations where a designated reference index is available. For example, a fund 
that invests in short-term fixed income securities would have a relatively low level of volatility. 
The fund’s investors could reasonably expect that the fund might exhibit a degree of volatility 
that is broadly consistent with the volatility of the markets or asset classes in which the fund 
invests, as represented by the fund’s designated reference index. This fund’s designated 
reference index would be composed of short-term fixed income securities, and could, for 
example, have a VaR of 4%. If the fund were permitted to rely on the absolute VaR test, 
however, the fund could substantially leverage its portfolio almost four times its designated 
reference index’s VaR to achieve a level of volatility that substantially exceeds the volatility 
associated with fixed-income securities.  
a. Designated Reference Index 
A fund would satisfy the proposed relative VaR test if the VaR of its entire portfolio does 
not exceed 150% of the VaR of its designated reference index.
188
 The proposed rule would 
define a “designated reference index” as an unleveraged index that is selected by the derivatives 
risk manager,  and that reflects the markets or asset classes in which the fund invests.
189
 The 
proposed definition also would require that the designated reference index not be administered 
by an organization that is an affiliated person of the fund, its investment adviser, or principal 
                                                      
188
  See proposed rule 18f-4(a) (defining the term “relative VaR test”); proposed rule 18f-4(c)(2)(i); 
infra section II.D.2.b (discussing the 150% limit under the relative VaR test). 
189
  See proposed rule 18f-4(a) (defining the term “designated reference index”). 

99 
underwriter, or created at the request of the fund or its investment adviser, unless the index is 
widely recognized and used.
190
 Additionally, the designated reference index must either be an 
“appropriate broad-based securities market index” or an “additional index” as defined in Item 27 
of Form N -1A.
191
 A  fund would have to disclose its designated reference index in the annual 
report, together with a presentation of the fund’s performance relative to the designated reference 
index.
192
  
The requirement that the designated reference index reflect the markets or asset classes in 
which the fund invests is designed to provide an appropriate baseline for the relative VaR test. 
Because of this requirement, differences between the fund’s VaR and the VaR of the designated 
reference index are more likely to represent leverage than other factors, like differences between 
the securities in the fund’s portfolio and those in the index, as compared to a relative VaR test 
that compares the fund’s VaR to an index that does not reflect the markets or asset classes in 
which the fund invests.
193
 Take, for example, a fund that invests primarily in S&P 500 index 
options and uses that index as its designated reference index. Differences between the fund’s 
                                                      
190
  Furthermore, for a blended index, none of the indexes that compose the blended index may be 
administered by an organization that is an affiliated person of the fund, its investment adviser, or 
principal underwriter, or created at the request of the fund or its investment adviser, unless the 
index is widely recognized and used. See id.  
191
  See proposed rule 18f-4(a) (defining the term “designated reference index”); see also Instructions 
5 and 6 to Item 27(b)(7)(ii) of Form N-1A (discussing the terms “appropriate broad-based 
securities market index” and “additional index”). 
192
  See proposed rule 18f-4(c)(2)(iv). 
193
  To the extent a fund discloses in its annual report an “appropriate broad-based securities market 
index” that does not reflect the markets or asset classes in which the fund invests, such a fund 
may satisfy the performance disclosure requirements of Form N-1A, but it would not satisfy the 
proposed designated reference index requirement. For example, a fund that pursues its strategy 
primarily through commodity futures contracts could select the S&P 500 to satisfy its 
performance disclosure requirement under Form N-1A, but such an index would not satisfy the 
proposed designated reference index requirement because a commodity fund would not invest in 
stocks included in the S&P 500 or large cap stocks generally. 

100 
VaR and the VaR of the S&P 500 would be more likely attributable to the leverage risk 
associated with the options than, for example, if the fund were permitted to use an index that did 
not reflect the markets or assets classes in which the fund invests, such as an index of small 
capitalization stocks in this example. The derivatives risk manager could select a designated 
reference index that is a blended index under the proposed rule (assuming that the blended index 
meets the proposed requirements for a designated reference index), which would give some 
flexibility in identifying or constructing a designated reference index that provides an appropriate 
baseline for the relative VaR test.
194
 For example, the derivatives risk manager of a balanced 
fund may determine that a blended index of an unleveraged equity index and an unleveraged 
fixed income index would be an appropriate designated reference index.  
The requirement that the designated reference index be an unleveraged index also is 
designed to provide an appropriate baseline against which to measure a fund’s portfolio VaR for 
purposes of assessing the fund’s leverage risk. Conducting a VaR test on a designated reference 
index that itself is leveraged would distort the leverage-limiting purpose of the VaR comparison 
by inflating the volatility of the index that serves as the reference portfolio for the relative VaR 
test. For example, an equity fund might select as its designated reference index an index that 
tracks a basket of large-cap U.S. listed equity securities such as the S&P 500. But the fund could 
not select an index that is leveraged, such as an index that tracks 200% of the performance of the 
                                                      
194
  If the derivatives risk manager selects a designated reference index that is a blended index, the 
designated reference index would have to be disclosed as an “additional index” (as opposed to an 
“appropriate broad-based securities market index”) as defined in the instruction to Item 27 in 
Form N-1A. Form N-1A defines the term “appropriate broad-based securities market index” to 
mean an index “that is administered by an organization that is not an affiliated person of the 
[f]und, its investment adviser, or principal underwriter, unless the index is widely recognized and 
used.” See Instruction 5 to Item 27(b)(7)(ii) of Form N-1A. A blended index that is administered 
by the fund’s investment adviser, for example, would therefore not qualify as an “appropriate 
broad-based securities market index.” 

101 
S&P 500. A relative VaR test based on this index would effectively permit additional leveraging 
inconsistent with the Investment Company Act.
195
 
Our proposal would prohibit the designated reference index from being an index 
administered by an organization that is an affiliated person of the fund, its investment adviser, or 
its principal underwriter, or created at the request of the fund or its investment adviser. This 
proposed prohibition would not, however, extend to indexes that are “widely recognized and 
used.”
196
 We believe that the indexes permissible under the proposed rule would be less likely to 
be designed with the intent of permitting a fund to incur additional leverage-related risk. 
The proposed rule would require that a fund publicly disclose to its investors in its annual 
reports the designated reference index. An open-end fund would have to disclose its designated 
reference index in the fund’s annual report as the fund’s “appropriate broad-based securities 
market index” or an “additional index” that Form N-1A describes in the context of the annual 
report performance presentation requirements.
197
 Form N-2, on the other hand, does not require 
closed-end funds to disclose a benchmark index for comparing a fund’s performance. 
                                                      
195
  See supra section I.B.1. But see infra section II.G (discussing leveraged/inverse funds covered by 
the proposed sales practices rules). 
196
  See proposed rule 18f-4(a) (defining the term “designated reference index”). This “widely 
recognized and used” standard has historically been used to permit a fund to employ affiliated-
administered indexes for disclosure purposes, when the use of such indexes otherwise would not 
be permitted. See supra note 194. 
197
  See proposed rule 18f-4(c)(2)(iv); Item 27(b)(7)(ii) of Form N-1A. 
See also Instructions to Items 4 and 27(b)(7)(ii) of Form N-1A. Form N-1A provides that “New 
Funds,” as defined in the form, are not required to disclose an appropriate broad-based securities 
market index and the fund’s performance in the annual report because of the fund’s limited 
operating history. See Instruction 6 to Item 3 of Form N-1A (defining a “New Fund” to mean a 
“Fund that does not include in Form N-1A financial statements reporting operating results or that 
includes financial statements for the Fund’s initial fiscal year reporting operating results for a 
period of 6 months or less”). For the same reason, the proposed rule would provide that a fund 
would not be required to disclose its designated reference index in the fund’s annual report if the 
fund is a “New Fund,” or would meet that definition if it were filing on Form N-1A, at the time 
the fund files its annual report. See proposed rule 18f-4(c)(2)(iv). 

102 
Nevertheless, some closed-end funds choose to disclose a benchmark index in their annual 
reports to shareholders. Under the proposed rule, a closed-end fund seeking to satisfy the relative 
VaR test would have to disclose the fund’s designated reference index in its annual report 
together with a presentation of the fund’s performance.
198
 In proposing this approach, we 
considered the role of investor expectations in selecting funds that correspond to investors’ 
desired level of investment risk.
199
 We believe that investors could reasonably expect that their 
fund might exhibit a degree of volatility that is broadly consistent with the volatility of the 
markets or asset classes in which the fund invests, as represented by the fund’s designated 
reference index. Requiring a fund to select a designated reference index that it publicly discloses 
would promote the fund’s selection of an appropriate index that reflects the fund’s portfolio risks 
and its investor expectations. 
Some registered closed-end funds currently elect to provide a Management’s Discussion 
of Fund Performance (“MDFP”) in their annual reports.
200
 These registered closed-end funds 
could disclose their performance relative to the performance of the designated reference index in 
the fund’s MDFP. BDCs that are publicly traded must disclose, in their annual reports filed on 
Form 10-K, a line graph comparing the yearly percentage change in fund share price with the 
                                                      
198
  See proposed rule 18f-4(c)(2)(iv). 
199
  To the extent a fund’s use of derivatives transactions is part of its principal investment strategy or 
is a principal risk, it is required to be disclosed as such in the fund’s prospectus. See Item 4 of 
Form N-1A; Item 8 of Form N-2. 
200
  The Commission recently proposed to amend Form N-2 to require registered closed-end funds to 
include MDFP disclosure in their annual reports. See Securities Offering Reform for Closed-End 
Investment Companies, Investment Company Act Release No. 33427 (Mar. 20, 2019) [84 FR 
14448 (Apr. 10, 2019)], at 14471-72 (“Securities Offering Reform Proposing Release”). 

103 
return of a broad equity market index.
201
 A  publicly-traded BDC could choose to include its 
designated reference index in this line graph disclosure. 
We recognize the concern that funds could have the incentive to select an inappropriate 
designated reference index composed of more volatile securities to allow the fund to obtain more 
leverage risk under the relative VaR test. The proposed rule includes three provisions designed to 
address this concern. In addition to requiring that the designated reference index reflect the 
markets or asset classes in which the fund invests, and that the index not be administered by 
certain affiliated persons or created at the request of the fund or its investment adviser, as 
described above, the proposed rule would require: (1) the derivatives risk manager to select the 
designated reference index and to periodically review it; (2) the fund to disclose the designated 
reference index, relative to its performance, in its annual report, creating the disincentive for a 
fund to present performance that may be significantly lower than, or not related to, the disclosed 
index; and (3) the board of directors to receive a written report providing the derivatives risk 
manager’s basis for selecting the designated reference index.
202
 These requirements, collectively, 
are designed to require funds to use designated reference indexes that provide an appropriate 
baseline for the relative VaR test and to prohibit funds from, instead, selecting indexes solely for 
the purpose of maximizing the fund’s permissible leverage risk under the proposed rule.  
We recognize that some (but not all) popular benchmark indexes charge funds a licensing 
fee for their inclusion in fund prospectuses and annual reports. Funds could incur licensing fees 
if their derivatives risk managers select a designated reference index whose provider charges 
                                                      
201
  17 CFR 229.201(e)(1)(i). 
202
  See proposed rule 18f-4(a), (c)(1)(vi), (c)(2)(iii), (c)(5)(ii)-(iii); see also supra sections II.B.3.f, 
II.C.2. 

104 
such a fee and the fund is not already using the index. We are nevertheless proposing this 
disclosure requirement because the relative VaR test’s ability to limit a fund’s leverage risk is 
directly tied to the appropriateness of its designated reference index. This disclosure requirement 
is designed to address concerns about inappropriate indexes, as discussed above, by creating the 
disincentive for a fund to select an inappropriate index because the fund would have to disclose 
its performance against that index in its annual report and likely would not want to present 
performance that is significantly lower than, or not related to, the disclosed index.
203
 At the same 
time, the proposed rule provides funds flexibility to use any index that meets the proposed 
requirements. The proposed rule would provide this flexibility in light of the conditions 
discussed above designed to require that a fund use a designated reference index that is 
appropriate for the relative VaR test. 
The 2015 Proposing Release also included a risk-based portfolio limit based on VaR.
204
 
The 2015 proposal provided that a fund would satisfy its risk-based portfolio limit condition if a 
fund’s full portfolio VaR was less than the fund’s “securities VaR” (i.e., the VaR of the fund’s 
portfolio of securities and other investments, but excluding any derivatives transactions).
205
 Our 
proposal, however, differs from the 2015 proposal in that the proposed relative VaR test 
compares the fund’s VaR to the VaR of the fund’s designated reference index, rather than the 
fund’s “securities VaR.” This is because some funds that use derivatives extensively hold 
primarily cash, cash equivalents, and derivatives. These funds’ “securities VaRs” would be based 
primarily on the fund’s cash and cash equivalents. As some commenters on the 2015 proposal 
                                                      
203
  See supra note 202 and accompanying paragraph. 
204
  See 2015 Proposing Release, supra note 2, at section III.B.2. 
205
  Under that proposal, a fund that satisfied this VaR test was also required to limit its aggregate 
exposure—including derivatives exposure—to 300% of the fund’s net assets. See id. 

105 
noted, this would not provide an appropriate comparison for a relative VaR test because the VaR 
of the cash and cash equivalents would be very low and would not provide a reference level of 
risk associated with the fund’s strategy.
206
 
We request comment on the proposed requirements regarding the selection and disclosure 
of a designated reference index for purposes of compliance with the proposed relative VaR test. 
 Is the proposed definition of the term “designated reference index” appropriate? Why 
or why not? Should the Commission provide additional guidance, or requirements in 
the proposed rule, addressing when an index reflects the markets or asset classes in 
which a fund invests? Are there particular types of indexes that would not be 
appropriate as a designated reference index? Why or why not? If so, what types of 
indexes and why would they be inappropriate for this purpose? 
 Should the rule require that the designated reference index be an unleveraged index? 
Should the rule specify with greater particularity what constitutes an unleveraged 
index? Please explain. Alternatively, should the Commission provide guidance on 
when an index will be “leveraged”? 
 Are there other considerations that would present challenges for funds in light of the 
proposed requirement to select a designated reference index for purposes of the 
proposed relative VaR test requirement? If so, what? 
 To what extent do funds expect that the requirement to disclose the designated 
reference index would result in additional licensing fees? Please explain. What 
consequences would such charges create? 
 Should we change the proposed definition of the term “designated reference index” to 
                                                      
206
  See, e.g., AlphaSimplex Comment Letter; AQR Comment Letter; ICI Comment Letter I. 

106 
no longer track in part the definition of an “appropriate broad-based securities market 
index” in Form N -1A (Instruction 5 of Item 27(b)(7)) and allow a derivatives risk 
manager to select an index administered by an affiliated person of the fund, its 
investment adviser, or principal underwriter? Should we change the proposed 
definition to allow a derivatives risk manager to select an index created at the request 
of the fund or its investment adviser? Is it appropriate to exclude such indexes from 
the definition of “designated reference index,” and is it appropriate that widely 
recognized and used indexes be carved out from this exclusion, as proposed? Would 
the proposed exclusion help ensure the selection of indexes that are appropriately 
designed to create a baseline VaR that approximates the VaR of a fund’s unleveraged 
portfolio? Please explain. Would allowing funds to use indexes that would fall within 
the proposed exclusion raise concerns that the indexes would not be appropriate, or—
if the Commission were to permit the use of such indexes—would the rule’s other 
proposed conditions designed to address this concern work equally well for all 
indexes? If the Commission were to permit the use of indexes that would fall within 
the proposed exclusion, would any additional limits on the use of these indexes be 
appropriate? If so, what limits and why? 
 If we were to further limit or restrict the types of indexes that a fund could select as 
its designated reference index under the proposed rule, what additional limits would 
be appropriate? Should we, for example, provide that a fund’s designated reference 
index must meet the definition of an “appropriate broad-based securities market 
index” as defined in Form N-1A? Should we require that the index be widely 
recognized and used?  

107 
 Similar to UCITS guidelines, should the proposed definition specifically require that 
the risk profile of the designated reference index be consistent with the fund’s 
investment objectives and policies, as well as investment limits?
207
 Why or why not? 
 Should the rule require funds to disclose their designated reference indexes in their 
annual reports to shareholders, as proposed? Should such disclosure also appear in the 
fund’s prospectus? What reasons, if any, should the designated reference index not be 
an index a fund includes as part of its performance disclosure? Please explain. Should 
a fund be required to specify that the index it includes in its performance disclosure is 
the fund’s designated reference index, which has been selected for purposes of the 
fund’s compliance with rule 18f-4? If so, what other information or explanations 
should a fund also have to include (if any), in order to best promote investor 
understanding of how the fund’s designated reference index affects the fund’s ability 
to use leverage, and how this in turn affects the risks associated with an investment in 
the fund? For example, should a fund also be required to disclose the index’s 
historical (e.g., 1-year) average VaR? What accompanying narrative disclosure would 
help investors best understand the significance of this information? Would this 
disclosure be useful to supplement the VaR information that a fund would be required 
to disclose on Form N-PORT under the proposal? 
 Should the rule permit a fund to compare its portfolio VaR to its “ securities VaR” for 
purposes of the rule’s relative VaR test, as provided for in the 2015 proposed rule, in 
addition to its designated reference index?
208
 Why or why not? If the relative VaR 
                                                      
207
  See infra section II.D.6.c (discussing the UCITS framework). 
208
  See supra note 205 and accompanying text. 

108 
test permitted a fund to compare its porfolio’s VaR against its designated reference 
index or its “securities VaR,” would funds prefer to use their “securities VaRs”? If so, 
why? In what circumstances or what fund strategies would “securities VaR” be a 
more or equally appropriate baseline for funds calculating their relative VaR? What 
benefits or drawbacks are there with respect to this approach? Please explain.  
 For a registered closed-end fund, is the proposed requirement that it must disclose its 
designated reference index in its annual report together with a presentation of the 
fund’s performance appropriate? Why or why not? What challenges, if any, would the 
proposed disclosure requirement have for closed-end funds that do not currently 
disclose their performance relative to a benchmark index in their annual reports? 
Please explain. 
 For a registered closed-end fund, should we prescribe in rule 18f-4 or Form N -2 
where in the fund’s annual report it must disclose its designated reference index? 
Why or why not?  
 What challenges, if any,  would a BDC have in disclosing its designated reference 
index together with its performance in the BDC’s annual report? Please explain. 
 Should we also amend Forms N-1A and/or N-2 to require a fund relying on rule 18f-4 
and subject to the relative VaR test to disclose its performance relative to the 
performance of its designated reference index? Would it be helpful to have this 
requirement both in rule 18f-4 and in the registration forms?  
 What changes should we make to the rule in light of the concern that a fund could 
have an incentive to select an inappropriate designated reference index to obtain more 
leverage risk? Is the proposed requirement that the derivatives risk manager select the 

109 
designated reference index useful for this purpose? Is the proposed requirement that 
the designated reference index be an appropriate broad-based securities index or an 
additional index effective for this purpose? Is the proposed requirement that the fund 
disclose the designated reference index relative to its performance in the annual report 
useful for this purpose? Is the proposed requirement that the board of directors 
receive a written report from the derivatives risk manager about the basis for the 
designated reference index subject to periodic review useful for this purpose? Please 
explain. 
b. 150% Limit Under Proposed Relative VaR Test 
We are proposing that a fund’s VaR must not exceed 150% of the VaR of the fund’s 
designated reference index.
209
 In proposing a 150% limit, we first considered the extent to which 
a fund could borrow in compliance with the requirements of section 18. For example, a mutual 
fund with $100 in assets and no liabilities or senior securities outstanding could borrow an 
additional $50 from a bank. With the additional $50 in bank borrowings, the mutual fund could 
invest $150 in securities based on $100 of net assets. This fund’s VaR would be approximately 
150% of the VaR of the fund’s designated reference index. The proposed 150% limit would 
therefore effectively limit a fund’s leverage risk related to derivatives transactions similar to the 
way that section 18 limits a registered open- or closed-end fund’s ability to borrow from a bank 
(or issue other senior securities representing indebtedness for registered closed-end funds) 
subject to section 18’s 300% asset coverage requirement. We recognize that while a fund could 
achieve certain levels of market exposure through borrowings permitted under section 18, it may 
be more efficient to obtain those exposures through derivatives transactions. Allowing a fund to 
                                                      
209
  See proposed rule 18f-4(a) (defining the term “relative VaR test”). 

110 
have a VaR that is 150% of its designated reference index, rather than a higher or lower relative 
VaR, is designed to provide what we believe is an appropriate degree of flexibility for funds to 
use derivatives.  
We considered proposing different relative VaR tests for different types of investment 
companies, tied to the asset coverage requirements applicable to registered open-end funds, 
registered closed-end funds, and BDCs.
210
 Registered closed-end funds, like open-end funds, are 
only permitted to issue senior securities representing indebtedness under section 18 subject to a 
300% asset coverage requirement, although closed-end funds’ indebtedness is not limited to 
bank borrowings.
211
 Using the example above, a registered closed-end fund with $100 in assets 
likewise could only borrow $50. Although registered closed-end funds also are permitted to issue 
senior securities that are stocks,
212
 proposed rule 18f-4 is focused on the indebtedness leverage 
that derivatives transactions create. We do not believe that a registered closed-end fund’s ability 
to issue preferred stock, for example, suggests that registered closed-end funds should be 
permitted to obtain additional indebtedness leverage through derivatives transactions. 
The Investment Company Act also provides greater flexibility for BDCs to issue senior 
securities. BDCs, however, generally do not use derivatives or do so only to a limited extent. To 
help evaluate the extent to which BDCs use derivatives, our staff sampled 48 of the current 99 
BDCs by reviewing their most recent financial statements filed with the Commission. The staff’s 
sample included both BDCs with shares listed on an exchange and BDCs whose shares are not 
listed. The sampled BDCs’ net assets ranged from $32 million to $7.4 billion. Of the 48 sampled, 
                                                      
210
  See supra notes 29-32 and accompanying paragraph (discussing asset coverage requirements for 
different investment company types). 
211
  See supra note 30 and accompanying text. 
212
  See supra note 31 and accompanying text. 

111 
54% did not report any derivatives holdings, and a further 29% reported using derivatives with 
gross notional amounts below 10% of net assets.  A few BDCs used derivatives more extensively, 
when measured on a gross notional basis, mainly due to interest rate swaps—which likely would 
have lower adjusted notional amounts if they were converted to ten-year bond equivalents, as the 
proposed rule would permit.
213
 Finally, two of the sampled BDCs used total return swaps to gain 
a substantial portion of their exposure. We therefore believe that most BDCs either would not 
use derivatives or would rely on the exception for limited derivatives users.
214
 
In addition, the greater flexibility for BDCs to issue senior securities allows them to 
provide additional equity or debt financing to the “eligible portfolio companies” in which BDCs 
are required to invest at least 70% of their total assets. Derivatives transactions, in contrast, 
generally will not have similar capital formation benefits for portfolio companies unless the 
fund’s counterparty makes an investment in the underlying reference assets equal to the notional 
amount of the derivatives transaction. Allowing BDCs to leverage their portfolios with 
derivatives to a greater extent than other funds therefore would not appear to further the capital 
formation benefits that underlie BDCs’ ability to obtain additional leverage under the Investment 
Company Act. We also understand that, even when BDCs do use derivatives more extensively, 
derivatives generally do not play as significant of a role in implementing the BDC’s strategy, as 
compared to many other types of funds that use derivatives extensively. BDCs are required under 
the Investment Company Act to invest at least 70% of their total assets in “eligible portfolio 
companies,” which may limit the role that derivatives can play in a BDC’s portfolio relative to 
                                                      
213
  Our staff did not have access to sufficient information to adjust the notional amounts of the 
BDCs’ interest rate derivatives or options. Some of the 17% of the sampled BDCs with gross 
notional amounts exceeding 10% of net assets likely would have lower notional amounts after 
applying these adjustments.  
214
  See infra section II.E (discussing the proposed exception for limited derivatives users). 

112 
other kinds of funds that would generally execute their strategies primarily through derivatives 
transactions (e.g., a managed futures fund). For these reasons, and to provide a consistent 
framework regarding funds’ use of derivatives, we believe that it is appropriate to set a single 
limit on fund leverage risk under the proposed rule for derivatives transactions. The proposed 
rule would not restrict a fund from issuing senior securities subject to the limits in section 18 to 
the full extent permitted by the Investment Company Act.
215
  
We request comment on the following aspects of the proposed relative VaR test. 
 Is the proposed relative VaR test requirement appropriate? Why or why not? As 
proposed, should funds be required to comply with a relative VaR test, rather than an 
absolute VaR test, except where a designated reference index is unavailable? 
 Should the limit in the proposed relative VaR test be lower or higher than 150% of 
the VaR of the designated reference index, and if so why? For example, the relative 
VaR test applicable to UCITS funds allows a UCITS fund to have a relative VaR up 
to 200% of the VaR of the relevant index.
216
 Should rule 18f-4 similarly permit a 
fund to have a VaR up to 200% of the VaR of its designated reference index? If so, 
how should the rule incorporate investor protection provisions consistent with section 
18? Conversely, should the relative VaR test be set at a lower level, such as 125% of 
                                                      
215
  For purposes of calculating asset coverage, as defined in section 18(h), BDCs have used 
derivatives transactions’ notional amounts, less any posted cash collateral, as the “amount of 
senior securities representing indebtedness” associated with the transactions. We believe this 
approach—and not the transactions’ market values—represents the “amount of senior securities 
representing indebtedness” for purposes of this calculation. Open-end funds cannot enter into 
derivatives transactions under section 18, absent relief from that section’s requirements, because 
section 18 limits open-end funds’ senior securities to bank borrowings. Section 18(c) also limits a 
registered closed-end fund’s ability to enter into derivatives transactions absent such relief. 
216
  See infra section II.D.6.c (discussing the UCITS framework); see also ICI Comment Letter III 
(suggesting that a Commission rule limiting the use of derivatives by registered investment 
companies allow funds to use either ex ante stress testing or UCITS VaR for that purpose).  

113 
the VaR of the designated reference index? If so, why? 
 Should the proposed relative VaR test incorporate different leverage limit levels 
according to fund type and corresponding to the asset coverage requirements under 
the Investment Company Act? Why or why not and how? 
 Are there any challenges in calculating the VaR of the designated reference index? If 
so, would certain types of funds particularly encounter these challenges, and if so 
which ones? How should we address any challenges? 
 Are there any fund-type specific challenges to open-end funds, registered closed-end 
funds, or BDCs complying with the VaR-based limit on fund leverage risk? For 
example, would registered closed-end funds or BDCs encounter any unique 
challenges in calculating VaR because of the nature of their investments? If so, what 
kinds of challenges and how should we address them? Please also explain specifically 
the nature of any challenges given that a number of financial institutions such as 
banks and UCITS funds calculate VaR for regulatory purposes, and these institutions’ 
portfolios hold a wide range of assets.  
3. Absolute VaR Test 
We recognize that, for some funds, the derivatives risk manager may be unable to 
identify an appropriate designated reference index. For example, some multi-strategy funds 
manage their portfolios based on target volatilities but implement a variety of investment 
strategies, making it difficult to identify a single index (even a blended index) that would be 
appropriate. If a derivatives risk manager is unable to identify an appropriate designated 

114 
reference index, a fund relying on the proposed rule would be required to comply with the 
absolute VaR test.
217
 
To comply with the proposed absolute VaR test, the VaR of the fund’s portfolio must not 
exceed 15% of the value of the fund’s net assets. In proposing an absolute VaR test of 15% of a 
fund’s net assets, we considered the comparison of a fund complying with the absolute VaR test 
and a fund complying with the relative VaR test. A fund that uses the S&P 500 as its benchmark 
index, as many funds do, would be permitted to have a VaR equal to 150% of the VaR of the 
S&P 500 if the fund also used that index as its designated reference index. The Division of 
Economic and Risk Analysis (“DERA”) staff calculated the VaR of the S&P 500, using the 
parameters specified in this proposed rule over various time periods. DERA staff’s calculation of 
the S&P 500’s VaR since inception, for example, produced a mean VaR of approximately 
10.4%, although the VaR of the S&P 500 varied over time.
218
 Setting the level of loss in the 
proposed absolute VaR test at 15% of a fund’s net assets would therefore provide approximately 
comparable treatment for funds that rely on the absolute VaR test and funds that rely on the 
relative VaR test and use the S&P 500 as their designated reference index during periods where 
the S&P 500’s VaR is approximately equal to the historical mean.  
                                                      
217
  See supra note 174 and accompanying text (discussing the proposed requirement for the fund’s 
derivatives risk manager to provide written reports to the fund’s board of directors that must 
include, among other things, the derivatives risk manager’s basis for the selection of the 
designated reference index or, if applicable, an explanation of why the derivatives risk manager 
was unable to identify a designated reference index appropriate for the fund); infra notes 426-427 
and accompanying text (discussing proposed recordkeeping requirements for such written reports 
provided to the fund’s board). 
218
  DERA staff calculated descriptive statistics for the VaR of the S&P 500 using Morningstar data 
from March 4, 1957 to June 28, 2019, based on daily VaR calculations, each using three years of 
prior return data and calculated using historical simulation at a 99% confidence level for a 20-day 
horizon using overlapping observations.  

115 
DERA staff analyzed the S&P 500 because funds often select broad-based large 
capitalization equities indexes such as the S&P 500 for performance comparison purposes, 
including funds that are not broad-based large capitalization equity funds.
219
 Many investors may 
therefore understand the risk inherent in these indexes as the level of risk inherent in the markets 
generally.
220
 An absolute VaR test set to approximate, or not substantially exceed, this level of 
risk would therefore often approximate the level of risk that investors may understand, and 
frequently choose to undertake, through investments in funds. We are proposing a single 
absolute VaR limit that would apply to open-end funds and registered closed-end funds and 
BDCs for the same reasons we are proposing that all funds relying on the relative VaR test must 
limit their VaR to 150% of the VaR of their designated reference index.
221
  
The proposed absolute VaR test is also broadly consistent with the European Union 
regulatory framework that that applies to UCITS funds.
222
 Advisers that manage (or have 
affiliates that manage) UCITS funds may derive some efficiencies from reasonably comparable 
                                                      
219
  This is based on staff experience and analysis of data obtained from Morningstar. 
220
  Some commenters to the 2015 proposal also expressed the view that the S&P 500 Index is an 
appropriate risk-based reference point because it is widely used with a risk profile that is well 
understood and commonly acceptable to investors. See, e.g., AQR Comment Letter; Comment 
Letter of Millburn Ridgefield Corporation (Mar. 28, 2016). 
221
  See supra section II.D.2.b. 
222
  See CESR Global Guidelines, supra note 94, at 26. The absolute VaR test for UCITS funds is 
similar to the proposed absolute VaR test in rule 18f-4, although it sets a 20% limit for UCITS 
funds, rather than 15% as we propose in rule 18f-4. 

116 
requirements across jurisdictions.
223
 Commenters to the 2015 proposal also generally supported 
an absolute VaR test.
224
 
We request comment on the proposed absolute VaR test requirement. 
 Is the proposed absolute VaR test requirement appropriate? Are we correct that in 
some cases a fund’s derivatives risk manager may be unable to identify an 
appropriate designated reference index? Why or why not? What are examples of 
funds that would likely use the absolute VaR test because a derivatives risk manager 
would be unable to identify an appropriate designated reference index? Is it 
appropriate for these funds to use an absolute VaR test? Why or why not? 
 Should we provide additional guidance on the circumstances under which a fund’s 
derivatives risk manager would be “unable” to identify an appropriate index? If so, 
what guidance should we provide? Should the rule include a different standard than 
the inability to identify a designated reference index for funds to be able to use the 
absolute VaR test instead of the relative VaR test? If so, what standard and why? For 
example, should we identify certain types of fund strategies that may not typically 
have appropriate reference indexes or for which absolute VaR would otherwise be 
appropriate? If so, which fund strategies, and how would we keep any list of fund 
strategies current over time? 
 Should the proposed absolute VaR test include a limit other than 15% of the fund’s 
                                                      
223
  See, e.g., ICI Comment Letter III (stating that, in response to the Investment Company Institute’s 
survey, “45 percent of respondents indicated that it would be only slightly burdensome to 
implement a UCITS VaR test that used the same parameters as prescribed for UCITS. An 
additional 34 percent reported that it would be moderately burdensome.”). 
224
  See, e.g., ICI Comment Letter I; Franklin Resources Comment Letter; SIFMA Comment Letter; 
Comment Letter of T. Rowe Price Associates, Inc. (Mar. 28, 2016) (“T. Rowe Price Comment 
Letter”). 

117 
net assets? Please explain. For example, should it be 12, 18, 20, or 25%? If so, which 
limit, and why? Would funds using the absolute VaR test manage their VaRs to a 
certain amount below the limit the Commission sets? If so, to what extent and should 
we take this into account in determining the appropriate limit under this test? Should 
we look to different market data in determining an appropriate level of absolute VaR? 
Which other sources, and why would they be appropriate? 
 For funds that use an absolute VaR test as part of their risk management practices, do 
risk managers set internal absolute VaR limits, and if so, at what level and why? For 
funds that currently use both absolute VaR and relative VaR, are the internal limits 
set at comparable levels? Why or why not? Please describe each internal level set 
with respect to these two VaR tests. Do certain fund types or strategies more 
commonly use either absolute VaR or relative VaR for risk management purposes? If 
so, why? 
 Should the rule include both a relative and absolute VaR test, as proposed, or should 
it include only a relative VaR test or an absolute VaR test? Why, and which test 
should the rule include? Should it use a different VaR-based test? If so, which one? 
 Should the rule permit funds to choose which VaR test to comply with regardless of 
the derivatives risk manager’s ability or inability to identify a designated reference 
index? If so, would this be consistent with investor expectations and section 18?  
4. Choice of Model and Parameters for VaR Test 
The proposed rule would require that any VaR model a fund uses for purposes of the 
relative or absolute VaR test take into account and incorporate all significant, identifiable market 

118 
risk factors associated with a fund’s investments.
225
 The proposed rule includes a non-exhaustive 
list of common market risk factors that a fund must account for in its VaR model, if applicable. 
These market risk factors are: (1) equity price risk, interest rate risk, credit spread risk, foreign 
currency risk and commodity price risk; (2) material risks arising from the nonlinear price 
characteristics of a fund’s investments, including options and positions with embedded 
optionality; and (3) the sensitivity of the market value of the fund’s investments to changes in 
volatility.
226
 VaR models are often categorized according to three modeling methods—historical 
simulation, Monte Carlo simulation, or parametric models.
227
 Each method has certain benefits 
and drawbacks, which may make a particular method more or less suitable, depending on a 
fund’s strategy, investments and other factors. In particular, some VaR methodologies may not 
adequately incorporate all of the material risks inherent in particular investments, or all material 
                                                      
225
  See proposed rule 18f-4(a) (defining the term “value-at-risk” or “VaR”). 
226
  See id. 
227
  Historical simulation models rely on past observed historical returns to estimate VaR. Historical 
VaR involves taking a fund’s current portfolio, subjecting it to changes in the relevant market risk 
factors observed over a prior historical period, and constructing a distribution of hypothetical 
profits and losses. The resulting VaR is then determined by looking at the largest (100 minus the 
confidence level) percent of losses in the resulting distribution. 
 
Monte Carlo simulation uses a random number generator to produce a large number (often tens of 
thousands) of hypothetical changes in market values that simulate changes in market factors. 
These outputs are then used to construct a distribution of hypothetical profits and losses on the 
fund’s current portfolio, from which the resulting VaR is ascertained by looking at the largest 
(100 minus the confidence level) percent of losses in the resulting distribution. 
 
Parametric methods for calculating VaR rely on estimates of key parameters (such as the mean 
returns, standard deviations of returns, and correlations among the returns of the instruments in a 
fund’s portfolio) to create a hypothetical statistical distribution of returns for a fund, and use 
statistical methods to calculate VaR at a given confidence level. 
 See, e.g., Dowd, supra note 178; see also Thomas J. Linsmeier & Neil D. Pearson, Value at Risk, 
56 Journal of Financial Analysts
 2 (Mar.-Apr. 2000) (“Linsmeier & Pearson”). 

119 
risks arising from the nonlinear price characteristics of certain derivatives.
228
 We believe it 
should be the responsibility of the derivatives risk manager to choose the appropriate VaR model 
for the fund’s portfolio, and the proposed requirement is designed to allow funds to use a VaR 
model that is appropriate for the fund’s investments. Commenters that addressed the same 
proposed requirement for VaR models in the 2015 proposal generally supported it.
229
 
The proposed rule also requires that a fund’s VaR model use a 99% confidence level and 
a time horizon of 20 trading days.
230
 We understand that market participants currently using VaR 
most commonly use 95% or 99% confidence levels and often use time horizons of 10 or 20 days. 
The proposed confidence level and time horizon requirements also are similar to those in other 
VaR-based regulatory schemes.
231
 VaR models that use relatively high confidence levels and 
                                                      
228
  For example, some parametric methodologies may be more likely to yield misleading VaR 
estimates for assets or portfolios that exhibit non-linear returns, due, for example, to the presence 
of options or instruments that have embedded optionality (such as callable or convertible bonds). 
See, e.g., Linsmeier & Pearson, supra note 227 (stating that historical and Monte Carlo 
simulation “work well regardless of the presence of options and option-like instruments in the 
portfolio. In contrast, the standard [parametric] delta-normal method works well for instruments 
and portfolios with little option content but not as well as the two simulation methods when 
options and option-like instruments are significant in the portfolio.”). 
229
  See, e.g., Oppenheimer Comment Letter; CFA Comment Letter. 
230
  See proposed rule 18f-4(a) (defining the term “value-at-risk” or “VaR”).  
We recognize that many market participants today also may calculate VaR over a one-day time 
horizon. See also supra section II.B.3.d (the proposed rule would require calculating a fund’s 
one-day VaR as part of the proposed backtesting requirement). A VaR calculation based on a 
one-day time horizon can be scaled to a 20-day time horizon. For example, a common VaR model 
time-scaling technique is to multiply the one-day VaR by the square root of the designated time 
period (i.e., for the proposed rule it would be the square root of 20). But for funds with returns 
that are not identically and independently normally distributed, simple time-scaling techniques 
may be inaccurate. If this inaccuracy results in meaningful underestimation of VaR, this simple 
time-scaling technique would be inappropriate. 
231
  See, e.g., CESR Global Guidelines, supra note 94 (providing default VaR calculation standards 
that require funds that use the relative VaR or absolute VaR approach to calculate VaR using a 
“one-tailed confidence interval of 99%”); rule 15c3-1e under the Exchange Act [17 CFR 
240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) (requiring VaR models to use “a 99 percent, 
one-tailed confidence level with price changes equivalent to a ten business-day movement in rates 
 

120 
longer time horizons—as the proposed rule parameters reflect—result in a focus on more-
“extreme” but less-frequent losses. We propose relatively high confidence level and longer time 
horizon requirements so that the VaR model is designed to measure, and seek to limit the 
severity of, these less-frequent but larger losses. This is because a fund’s VaR model would be 
based on a distribution of returns, where a higher confidence level would go further into the tail 
of the distribution (i.e., more-“extreme” but less-frequent losses) and a longer time horizon 
would result in larger losses in the distribution (i.e ., losses have the potential to be larger over 
twenty days when compared, for example, to over one day). 
In proposing a higher confidence level and longer time horizon, we considered whether 
this would result in a VaR model based on fewer data points in comparison to lower confidence 
levels and shorter time horizons. However, we understand that a longer trading day horizon only 
results in reduced data points if the fund uses historical simulation and measures historical losses 
using non-overlapping periods, which our proposal would not require. For example, a fund 
measuring non-overlapping twenty-day periods, assuming 250 trading days in a year, would 
expect approximately 12 or 13 data points (250 trading days / 20-day time horizons). But if the 
fund measured the twenty-day periods on a rolling and overlapping basis, it could expect as 
many as 250 data points where each data point captures the return over the trailing 20 trading 
days.  A fund could use either a non-overlapping or overlapping approach under the proposed 
rule.  
                                                      
and prices”). See also the Basel Committee on Banking Supervision, Amendment To The Capital 
Accord To Incorporate Market Risks (Jan. 1996), available at 
https://www.bis.org/publ/bcbs24.pdf (contemplating banks’ use of internal models for measuring 
market risk based on a 10-day time horizon); CESR Global Guidelines, supra note 94 (specifying 
generally a 20-day time horizon as a quantitative requirement when calculating VaR for risk 
measurement and the calculation of global exposure and counterparty risk for UCITS). 

121 
The 2015 proposal similarly specified the particular confidence level and time horizon 
parameters that funds would use in their VaR models for purposes of the proposed risk-based 
portfolio limit. These parameters were a 99% confidence level and a time horizon range of not 
less than 10 and not more than 20 trading days.
232
 Comments were mixed but generally 
supported a confidence level in the range of 95% to 99%.
233
 Rather than a time horizon range 
providing funds discretion to select the number of trading days for which to compute their VaR 
models, some commenters suggested that the rule should specify a particular number of days.
234
 
Because our proposal, unlike the 2015 proposal, includes an absolute VaR test, our proposed 
VaR model parameters reflect commenter suggestions by proposing a confidence level within the 
generally supported range and proposing a specific VaR model time horizon rather than a range 
of permissible time horizons. 
In addition to specifying the confidence level and time horizon that a fund’s VaR model 
would use, we are also proposing that the fund’s chosen VaR model must be based on at least 
three years of historical market data. We understand that the availability of data is a key 
consideration when calculating VaR, and that the length of the data observation period may 
significantly influence the results of a VaR calculation. For example, a shorter observation 
period means that each observation will have a greater influence on the result of the VaR 
calculation (as compared to a longer observation period), such that periods of unusually high or 
low volatility could result in unusually high or low VaR estimates.
235
 Longer observation 
                                                      
232
  2015 Proposing Release, supra note 2, at section III.B.2.b. 
233
  See, e.g., AQR Comment Letter; ICI Comment Letter II. 
234
  See, e.g., Morningstar Comment Letter; AIMA Comment Letter; AQR Comment Letter; ICI 
Comment Letter II. 
235
  See Linsmeier & Pearson, supra note 227 (stating that, because historical simulation relies 
 

122 
periods, however, can lead to data collection problems, if sufficient historical data is not 
available.
236
 We believe requiring a fund’s chosen VaR model to be based on at least three years 
of historical market data strikes an appropriate balance. 
The proposed historical market data requirement would permit a fund to base its VaR 
estimates on a meaningful number of observations, while also recognizing the concern that 
requiring a longer historical period could make it difficult for a fund to obtain sufficient 
historical data to estimate VaR for the instruments in its portfolio.
237
 The 2015 proposal would 
have required three years of market data for funds using historical simulation (but did not require 
three years of market data for VaR models based on Monte Carlo simulation or parametric 
methods).
238
 A number of commenters supported our approach in the 2015 proposal to require 
three years of market data for funds using historical simulation.
239
 However, some commenters 
                                                      
directly on historical data, a danger is that the price and rate changes in the last 100 (or 500 or 
1,000) days might not be typical. For example, if by chance the last 100 days were a period of 
low volatility in market rates and prices, the VAR computed through historical simulation would 
understate the risk in the portfolio). 
236
  See Dowd, supra note 178 (stating that “[a] long sample period can lead to data collection 
problems. This is a particular concern with new or emerging market instruments, where long runs 
of historical data don’t exist and are not necessarily easy to proxy”).  
237
  See Michael Minnich, Perspectives On Interest Rate Risk Management For Money Managers 
And Traders (Frank Fabozzi, ed.) (1998) (stating that for historical simulation, “[l]onger periods 
of data have a richer return distribution while shorter periods allow the VAR to react more 
quickly to changing market events” and that “[t]hree to five years of historical data are typical”); 
see also Darryll Hendricks, Evaluation of Value-at-Risk Models Using Historical Data, FRBNY
 
Economic Policy Review (Apr. 1996) (finding that, when using historical VaR, “[e]xtreme 
[confidence level] percentiles such as the 95th and particularly the 99th are very difficult to 
estimate accurately with small samples” and that the complete dependence of historical VaR 
models on historical observation data “to estimate these percentiles directly is one rationale for 
using long observation periods”). 
238
  See 2015 Proposing Release, supra note 2, at section III.B.2.b; see also supra note 177 
(discussing historical simulation, Monte Carlo simulation, and parametric methods). 
239
  See, e.g., Comment Letter of Abbey Capital (Mar. 28, 2016); AIMA Comment Letter; Comment 
Letter of Aspect Capital Limited (Mar. 28, 2016); Comment Letter of Intercontinental Exchange 
(Apr. 15, 2016).  

123 
suggested that the rule should require a longer period of historical market data.
240
 As discussed 
above, we believe that three years strikes an appropriate balance. We also are proposing to 
require funds to use three years of market data for all VaR calculations under the proposed 
rule—rather than only historical simulation as in the 2015 proposal. We believe this is 
appropriate because all methods for calculating VaR—not just historical simulation—rely on 
historical data. 
Unlike the 2015 proposal, the proposed rule does not require a fund to apply its VaR 
model consistently (i.e., the same VaR model applied in the same way) when calculating the 
VaR of its portfolio and the VaR of its designated reference index.
241
 The proposed rule would, 
however, require that VaR calculations comply with the same proposed VaR definition and its 
specified model requirements.
242
 Our proposal does not include the 2015 proposal’s model 
consistency requirement because if the proposed rule required funds to apply the same VaR 
model to its portfolio and the designated reference index, it could prevent funds from using less-
costly approaches. For example, under the proposed approach, in many cases a fund could 
calculate the VaR of a designated reference index based on the index levels over time without 
having to obtain access to more-detailed information about the index constituents. A fund also 
would have the flexibility to obtain the VaR from a third-party vendor instead of analyzing it in-
house. A model consistency requirement could preclude these approaches, however, because a 
fund might not be able apply the same approach to its portfolio. For example, if a fund invested 
                                                      
240
  See, e.g., materials attached to the memorandum included in the comment file concerning a 
meeting between representatives of AlphaSimplex Group LLC and members of the staff of the 
Division of Investment Management (July 8, 2016); AQR Comment Letter.  
241
  See 2015 Proposing Release, supra note 2, at section III.B.2.b. 
242
  See infra section II.D.4 (discussing the proposed VaR model requirements). 

124 
significantly in options, it generally would not be appropriate to use certain parametric VaR 
models.
243
 The fund might instead use Monte Carlo simulation, which is more computationally 
intensive and takes more time to perform. A model consistency requirement would require the 
fund to apply the same Monte Carlo simulation model to its unleveraged designated reference 
index, for which a parametric or other simpler and less costly VaR model might be appropriate.  
Although requiring a fund to apply the same VaR model to its portfolio and the 
designated reference index could result in a more precise comparison of the two values, we do 
not believe that the additional precision is necessary for the relative VaR test to identify where 
funds’ use of derivatives is more likely to raise the concerns underlying section 18 because the 
proposed rule would provide certain common parameters for all VaR calculations under the rule. 
Because a fund’s designated reference index must be unleveraged, we believe it is generally 
unlikely that different VaR models calibrated to these common parameters would produce 
substantially different results for a fund’s designated reference index. Additionally, the 
derivatives risk manager would be responsible for administering and maintaining the derivatives 
risk management program, which includes the integrity of the VaR test. On balance, we believe 
the proposed approach would not materially diminish the efficacy of the proposed relative VaR 
test while permitting less-costly approaches for funds.  
We request comment on the proposed requirements regarding a fund’s choice of VaR 
model, and the required parameters for a VaR model that funds would use under the proposed 
rule. 
 Should the rule specify a particular VaR model(s) that funds must use (i.e., a 
                                                      
243
  See supra note 228 (explaining that some parametric methodologies may be more likely to yield 
misleading VaR estimates for assets or portfolios that exhibit non-linear returns, due, for 
example, to the presence of options or instruments that have embedded optionality). 

125 
historical simulation, Monte Carlo simulation, or parametric methodology)? If so, 
which methodology (or methodologies) and why? 
 Is the proposed requirement that a fund’s VaR model incorporate all significant, 
identifiable market risk factors associated with a fund’s investments appropriate? 
Why or why not? 
 The proposed rule would provide a non-exhaustive list of risk factors that may be 
relevant in light of a fund’s strategy and investments. Should the final rule include 
this non-exhaustive list of risk factors? Are risk factors included in the proposed list 
appropriate? Should we include any additional risk factors to this list? If so, which 
ones and why? 
 The proposed rule would require a fund to use a 99% confidence level for its VaR 
model. Is the proposed confidence level appropriate? Should the rule include a 
different confidence level? If so, which level and why, and if not, why not? 
 The proposed rule would require a fund to use a time horizon of 20 trading days for 
its VaR model. Is the proposed time horizon appropriate? Should the rule include a 
different time horizon? If so, which time horizon and why, and if not, why not?  
 The proposed rule would require a fund to use at least three years of historical market 
data for its VaR model. Is the historical market data requirement appropriate? Should 
the rule set forth a different length of time for requiring historical market data? 
Should the requirement be limited to funds using historical simulation? Would funds 
experience challenges in identifying sufficient data for particular types of 
investments? If so, which types of investments and how should the rule address these 
challenges? Please explain. 

126 
 The proposed rule does not include any requirement for third-party validation of a 
fund’s chosen VaR model, either at inception or upon material changes, to confirm 
that the model is structurally sound and adequately captures all material risks.
244
 
Should we require third-party validation? Why or why not? 
 Should the rule require a fund’s board to approve the VaR model and any material 
changes to the model? Why or why not?  
 Should the final rule also include a requirement that a fund that uses the relative VaR 
test apply the same VaR model when calculating the fund’s portfolio and the VaR of 
the designated reference portfolio? Would the requirement to apply the same VaR 
model to the fund’s portfolio and the designated reference portfolio address any 
concerns that funds could inappropriately manipulate the results of VaR testing under 
the proposed rule’s requirements? What additional cost, if any, would such a 
requirement impose on funds? Are there other ways that we could prevent such 
manipulations? To what extent would this requirement promote additional precision 
in the relative VaR test and would any additional precision increase the efficacy of 
the test in limiting fund leverage risk? Please explain. 
5. Implementation 
a. Testing Frequency 
The proposed rule would require a fund to determine its compliance with the applicable 
VaR test at least once each business day.
245
 Although we believe that funds would calculate their 
VaRs at a consistent time each day, which would generally be either in the mornings before 
                                                      
244
  The Global Exposure Guidelines applicable to UCITS’ requires such validation. See CESR 
Global Guidelines, supra note 94. 
245
  Proposed rule 18f-4(c)(2)(ii). 

127 
markets open or in the evenings after markets close, we do not propose to require one at the 
exclusion of the other, to allow funds to conduct their VaR tests at the time that is most efficient 
based on each fund’s facts and circumstances. We considered proposing that funds determine 
compliance with the proposed VaR test at the time of, or immediately after, entering into a 
derivatives transaction. We recognize, however, that conducting a VaR test on a trade-by-trade 
basis could present operational challenges for some funds and could limit the fund’s choice of 
VaR modeling. For example, we believe that most funds would be unable to perform 
computationally-intensive Monte Carlo simulations so frequently based on computing resources 
and compliance costs. Requiring this VaR calculation each day, in contrast, would provide funds 
flexibility to use VaR models they believe to be appropriate while also providing for fairly 
frequent calculations. The 2015 proposal included a testing frequency of immediately after 
entering into any senior securities transactions, but many commenters raised concerns about 
operational complexity related to transaction-by-transaction testing, and instead generally 
suggested a daily testing frequency.
246
 
We believe that determining compliance with the VaR test less frequently than each 
business day would not be consistent with the purpose of a condition to limit fund leverage risk. 
Section 18 sets forth certain fund leverage risk protections that are fundamental to protecting 
investors. If this testing requirement were less frequent than each business day, then a fund could 
satisfy the condition only on business days requiring a VaR test and modify its trading strategy to 
circumvent the purpose of the test on other business days. Additionally, we believe that testing 
                                                      
246
  See, e.g., ICI Comment Letter I; Franklin Resources Comment Letter; SIFMA Comment Letter; 
AIMA Comment Letter; BlackRock Comment Letter. 

128 
each business day is appropriate in light of the potential for market risk factors associated with a 
fund’s investments to change quickly. 
We request comment on the proposed frequency of conducting the relative or absolute 
VaR test. 
 Is the proposed required frequency for conducting the VaR test appropriate? Should 
the rule require a fund to conduct the required VaR test more frequently or less 
frequently, such as—respectively—either before or after each transaction, multiple 
times throughout the day, or on a weekly basis? Why or why not? Should the required 
frequency vary depending on fund type or whether the fund is conducting an absolute 
VaR test or relative VaR test? Please explain.  
 Should the rule require funds to conduct the test at the same time each day? If so, 
why? What compliance or operational challenges, if any, would funds have to 
conduct the test at the same time each day? Would the absence of such a requirement 
allow funds to “game” the test?  
b. Remediation 
If a fund determines that it is not in compliance with the applicable proposed VaR test, 
then under our proposal a fund must come back into compliance promptly and within no more 
than three business days after such determination.
247
 If the fund is not in compliance within three 
business days, then: (1) the derivatives risk manager must report to the fund’s board of directors 
and explain how and by when (i.e., the number of business days) the derivatives risk manager 
reasonably expects that the fund will come back into compliance; (2) the derivatives risk 
manager must analyze the circumstances that caused the fund to be out of compliance for more 
                                                      
247
  See proposed rule 18f-4(c)(2)(ii). 

129 
than three business days and update any program elements as appropriate to address those 
circumstances; and (3) the fund may not enter into derivatives transactions (other than 
derivatives transactions that, individually or in the aggregate, are designed to reduce the fund’s 
VaR) until the fund has been back in compliance with the applicable VaR test for three 
consecutive business days and satisfied the board reporting requirement and program analysis 
and update requirements.
248
 
The proposed three-business-day remediation provision is designed to provide funds with 
some flexibility in coming back into compliance with the applicable proposed VaR tests. It 
reflects our view that it would be inappropriate for a fund to purposefully exceed the VaR-based 
limit on fund leverage risk, but allows funds to take reasonable steps to come back into 
compliance without harming fund investors. The three-business-day period is designed to 
provide an appropriate time period to permit remediation efforts because it balances investor 
protections related to fund leverage risk and potential harm to a fund if it were required to sell 
assets or unwind transactions even more quickly. This remediation approach is similar to the 
remediation approach that section 18 of the Investment Company Act provides for asset 
coverage compliance with respect to bank borrowings, which also includes a three-day period to 
come back into compliance.
249
  
If the fund does not come back into compliance within three business days, the proposed 
rule would not require the fund to exit its derivatives transactions or make other portfolio 
                                                      
248
  See proposed rule 18f-4(c)(2)(iii); see also infra section II.H.2 (discussing the proposed 
requirement to submit a confidential report to the Commission if the fund is out of compliance 
with the applicable proposed VaR test for three business days). 
249
  Section 18(f)(1) of the Investment Company Act. 

130 
adjustments.
250
 Although a fund remaining out of compliance with the applicable VaR test raises 
investor protection concerns related to fund leverage risk, if the proposed rule were to force a 
fund to exit derivatives transactions immediately at the end of the three-day period, this could 
harm investors, for example, by requiring the fund to realize trading losses that could have been 
avoided under a more-flexible approach. The proposed remediation provision reflects the 
balancing of these multiple investor protection concerns. 
Instead of requiring a fund to come back into compliance under these circumstances 
immediately, the fund must satisfy three requirements before it can enter into derivatives 
transactions other than those designed to reduce the fund’s VaR. First, the derivatives risk 
manager must report to the fund’s board of directors and explain how and by when (i.e., the 
number of business days) the derivatives risk manager reasonably expects that the fund will 
come back into compliance.
251
 This requirement is designed to facilitate the fund coming back 
into compliance promptly by requiring the derivatives risk manager to develop a specific course 
of action to come back into compliance and to facilitate the board’s oversight by requiring the 
derivatives risk manager to report this information to the board.  
Second, the derivatives risk manager must analyze the circumstances that caused the fund 
to be out of compliance for more than three business days and update any program elements as 
appropriate to address those circumstances.
252
 That the fund was unable to come back into 
compliance with the applicable VaR test within three business days may suggest there are 
                                                      
250
  Under the proposed rule, a fund that is not in compliance within three business days also would 
be required to file a report to the Commission on proposed Form N-RN. See proposed rule 18f-
4(c)(7); infra section II.H.2. 
251
  Proposed rule 18f-4(c)(2)(iii)(A). 
252
  Proposed rule 18f-4(c)(2)(iii)(B). 

131 
deficiencies in the fund’s program. This requires the derivatives risk manager to analyze and 
update any program elements as appropriate before the fund is able to enter into derivatives 
transactions other than those designed to reduce VaR.  
Finally, a fund may not enter into derivatives transactions (other than those designed to 
reduce the fund’s VaR) until the fund has been back in compliance with the applicable VaR test 
for at least three consecutive business days and has satisfied the applicable board reporting and 
program analysis and update requirements.
253
 If the proposed rule were to permit a fund that is 
out of compliance with the limit on fund leverage risk to comply for just one day before entering 
into derivatives transactions that would increase the fund’s market risk, this could potentially 
lead to some funds having persistently high levels of leverage risk beyond that permitted by the 
applicable VaR test. 
We request comment on the proposed remediation requirement for a fund that is out of 
compliance with the applicable VaR test. 
 Is the proposed three-business-day remediation provision appropriate? Could such a 
limited remediation period exacerbate fund or market instability and harm investors? 
Should the rule require a longer or shorter period, such as one or seven days? Why or 
why not, and if so, what should the alternative remediation period be? In light of the 
balancing of investor protection concerns (fund compliance with the VaR-based limit 
on fund leverage risk and not forcing asset sales or unwinding transactions to 
comply), is there a more-effective means to structure a remediation provision that 
balances these concerns? If so, how?  
 Should we change the rule’s remediation provision to include an escalating provision 
                                                      
253
  Proposed rule 18f-4(c)(2)(iii)(C). 

132 
that requires longer periods of compliance based on the number of three-day (or 
more) periods that a fund has been out of compliance? If so, how should we structure 
such a provision? 
 Should we change the rule to factor in the aggregate number of days in a trailing year 
that a fund has been out of compliance? What additional remediation consequences 
should a fund address before entering into derivatives transactions (other than those 
designed to reduce the fund’s VaR)? Please explain.  
 Should the remediation provision provide further or different limitations for a fund 
that continuously goes in and out of compliance with its VaR test? For example, 
should the rule provide that such a fund is not permitted to rely on the proposed rule 
indefinitely or for a set period of time? How should a rule define “continuously going 
in and out of compliance”? Should such a fund be subject to a lower VaR 
requirement? If so, what level of VaR and why? How long should the fund remain 
subject to any lower VaR requirement? Should the fund be subject to limits on its 
derivatives exposure? 
 Should the remediation provision, as proposed, require the derivatives risk manager 
to report to the fund’s board of directors that the fund has been out of compliance 
with the VaR-based limit for more than three consecutive business days? Why or why 
not? Should the derivatives risk manager be required to explain how the fund will 
come back into compliance promptly and by when? Should we change the rule to 
require such a fund to take certain specific actions? Should we change the rule to 
require fund compliance within a specific time period? If so, how should we change 
the rule and why?  

133 
 Should the remediation provision, as proposed, require the derivatives risk manager 
to analyze the circumstances for the fund being out of compliance for more than three 
business days? Should we change the rule to require specific program updates? 
Should we change the rule to require a complete program review and update? What 
challenges would such a remediation requirement impose on funds? What are the 
benefits of specifying program updates? Under what circumstances, if any, would a 
fund be out of compliance for more than three business days and not have risk 
management program elements to update? Please explain.  
6. Other Regulatory Approaches to Limiting Fund Leverage Risk 
a. Stress Testing 
In addition to our proposal to require stress testing as a derivatives risk management 
program element, we considered a stress testing requirement as a means to limit fund leverage 
risk in lieu of, or in addition to, the proposed VaR tests. We understand that many funds that use 
derivatives transactions already conduct stress tests for purposes of risk management.
254
 
For example, we considered proposing a single-factor stress test requirement that would 
enumerate a limited number of shocks, corresponding to different asset classes in which funds 
commonly invest, and specify the required shock levels for each asset class. Similar to Form PF, 
the rule could categorize stress testing shocks based on market factors such as equity prices, risk-
free interest rates, credit spreads, currency rates, commodity prices, option implied volatilities, 
default rates for asset-backed securities, and default rates for corporate bonds and credit-default 
                                                      
254
  See, e.g., ICI Comment Letter III. While we do not propose to require stress testing as a means 
for limiting a fund’s leverage risk, as discussed above, one element of the proposed program 
requires stress testing for risk management purposes. See supra section II.B.3.c. 

134 
swaps.
255
 The rule could also include an “other,”  general category for which the corresponding 
shock level would be a specific or otherwise determinable factor based on extreme but plausible 
market conditions determined by the derivatives risk manager. A fund would “fail” this stress 
test if one of the prescribed shocks would cause the fund to experience a level of loss that we 
would specify.  
We could, for example, specify the shock levels for each market factor based on a certain 
number of standard deviations from the mean of historical distributions of returns for that factor, 
such as three or four standard deviations, as a means of establishing standardized shock levels.
256
 
We could then specify that a fund fails the stress test if any such shock leads to a loss of a certain 
percentage of the fund’s net assets over a single trading day or series of trading days, such as 
20% over one trading day. We could determine these metrics based on how funds that do not 
engage in derivatives, but that have borrowed up to and in compliance with the requirements of 
section 18, would perform against the stress test. For example, the stress test outer limit could be 
based on a fund that is not using derivatives but has invested $150 in securities based on $100 of 
net assets and $50 in bank borrowings. To be consistent with section 18, a fund that uses 
derivatives and conducts a stress test resulting in losses greater than the stress test losses of this 
hypothetical bank-borrowing-leveraged fund would fail the single-factor stress test. 
This approach would have the benefit of setting forth a comparatively simple-to-conduct 
test that a broad variety of funds could apply. The challenges of a single-factor stress testing 
requirement, however, include identifying an appropriate universe of market risk factors for the 
                                                      
255
  Question 42 on Form PF requires some private fund advisers to report the impact on the fund’s 
portfolio from specified changes to the identified market factors. 
256
  If normally distributed, shock levels based on historical returns of a market factor that is three 
standard deviations from the mean of that market factor would correspond to approximately a 
99.7% confidence level. 

135 
broad universe of derivatives in which funds invest and strategies they follow, setting the 
appropriate level of each shock for each factor,  and determining the level of losses that would 
result in a fund “failing” the test. Making these determinations would be particularly challenging 
in a rule that would apply to all funds. Any prescribed shocks and related values could become 
stale over time and necessarily would not include all of the relevant risk factors for each fund. As 
funds continue to innovate, there could be funds for which no prescribed shock would be 
relevant. An approach that looks at a fund’s losses in response to changes in a single market risk 
factor also may not effectively take into account correlations among market risk factors under 
stressed market conditions. Stress testing is useful as a risk management tool because it provides 
a framework for advisers to consider a range of potential scenarios tailored to each fund and 
refined over time. Its   benefits as a limit of fund leverage risk may not be fully realized, however, 
by single-factor stress testing that includes static values that a rule specifies.
257
 
We also considered requiring a multi-factor stress test based on scenario analysis. Rather 
than a fund applying a single-factor shock to each relevant asset class, this approach would 
require funds to create a stress test model that takes into account multiple asset classes 
simultaneously, which a fund would have to identify to tailor the stress test to its fund. The fund 
would then run numerous scenarios against the model, shocking the multiple asset classes 
identified, based on a high number of iterations and permutations akin to a Monte Carlo 
simulation. A multi-factor stress test would result in a matrix or range of estimated potential 
losses during stressed market conditions because each scenario permutation would create one 
                                                      
257
  We recognize that these concerns do not apply to all uses of single-factor stress testing. For 
example, money market fund stress testing does not raise similar concerns in part because of 
money market funds’ common strategies and limited universe of investment holdings. See 
rule 2a-7(g)(8) under the Investment Company Act (requiring periodic stress testing). 

136 
estimated potential loss calculation. The benefits of multi-factor stress testing include tailoring 
the stress test to the investment and risk characteristics of a fund’s portfolio, which may result in 
more meaningful derivatives risk management. But in considering a multi-factor stress testing 
requirement, we would have to consider whether such a framework, if highly particularized, 
would permit enough long-term flexibility as an applicable regulatory limit on fund leverage 
risk. For example, the multi-factor stress test could identify specific correlations and assumptions 
that funds should reflect in their stress tests based on their strategies and investments, or identify 
specific historical market events to run as scenarios against their stress test model. In addition, if 
we were to propose a principles-based multi-factor stress testing requirement that would rely on 
funds to tailor their stress tests, it would present regulatory challenges in determining whether 
funds were adhering to a limit on fund leverage risk consistent with section 18.  
Finally, our proposed VaR-based limit on fund leverage risk, as opposed to stress testing, 
may better align with section 18’s investor protection goals concerning the level of risk in a 
registered fund. This is because the limitations in section 18 apply under both normal and 
stressed market conditions.
258
 For these reasons, as well as the regulatory design challenges of 
specifying the universe of asset class shocks and setting their corresponding levels, we are 
proposing a VaR-based limit on fund leverage risk instead of a stress testing approach to limiting 
fund leverage risk.  
We request comment on stress testing as a means to limit funds’ leverage risk. 
 In addition to our proposed stress testing requirement as part of the derivatives risk 
management program, should the rule require stress testing as a means to limit fund 
leverage risk in lieu of or in addition to the VaR-based limit on fund leverage risk? 
                                                      
258
  See supra section I.B.1. 

137 
Why or why not? Is a stress test an effective means to limit a fund’s leverage risk? 
Please explain. If we were to include a stress testing requirement in addition to a 
VaR-based limit on fund leverage risk, should we require a fund to comply with both 
requirements, or should we allow a fund to choose one or the other? If we were to 
allow funds to comply with either approach, would that result in inconsistent limits 
across funds and would that be appropriate if so? 
 To measure and/or limit fund leverage risk, do funds currently use VaR tests, stress 
tests or both? If a fund uses VaR tests but not stress tests (or vice versa), did the fund 
consider using the other approach as a means to measure and limit its leverage risk? 
Why or why not? 
 If funds use both VaR tests and stress tests to measure and/or limit fund leverage risk, 
why do they use both tests? Are there certain fund types or strategies that are better 
suited for VaR or for stress testing? If so, which ones and why? 
 Should the limit of fund leverage risk focus on normal market conditions, stressed 
market conditions, or both? Please explain. 
 Should the rule require a single-factor stress test as an alternative to the proposed 
VaR-based limit on fund leverage risk? If so, what single-factor shocks should the 
test require? What would the corresponding shock levels be for each factor? Are the 
example single-factor shocks discussed above appropriate? Please explain. How 
frequently and on what basis, if at all, do commenters anticipate that the Commission 
would need to amend a rule that incorporated the enumerated shocks and their 
corresponding levels? 
 What number of standard deviations from the mean of historical distributions of 

138 
returns should the single-factor shock levels for each market risk factor be? Would 
three standard deviations or four standard deviations be appropriate? How should the 
rule define a failed stress test? Would a loss expressed as a percentage of the fund’s 
net assets over a single trading day or series of trading days be appropriate? What 
percentage and over what period would be appropriate? Would 20% over one trading 
day be appropriate? How frequently, if at all, do commenters anticipate that the 
Commission would need to amend the rule to revise the specified loss level? 
 Should the rule require a multi-factor stress test as an alternative to the proposed 
VaR-based limit on fund leverage risk? If so, how might the rule include a multi-
factor stress testing requirement that permits adequate flexibility and tailoring but 
could also promote comparability and regulatory consistency in setting a leverage risk 
limit? 
 Should the single-factor or multi-factor stress testing methods be required as part of 
the proposed program’s stress testing requirement? If so, which one and why? 
b. Asset Segregation 
We considered applying an asset segregation approach to derivatives transactions, similar 
to asset segregation under Release 10666, as a tool to limit funds’ leverage-related risks.
259
 
Under this approach, we could require a fund engaging in derivatives transactions to segregate 
cash and cash equivalents equal in value to the full amount of the conditional and unconditional 
obligations incurred by the fund (also referred to as “notional amount segregation”). We could 
allow funds to segregate additional types of assets beyond cash and cash equivalents subject to 
                                                      
259
  We separately discuss below our consideration of asset segregation as a complement to the 
proposed limitations on fund leverage risk. See infra section II.F. 

139 
prescribed haircuts based on the assets’ volatilities. The 2016 DERA Memo, for example, 
analyzed different risk-based “haircuts” that could apply to a broader range of assets.
260
 
Allowing a broader range of segregated assets would have the effect of allowing funds to take on 
additional leverage because it would increase a fund’s ability to obtain market exposure through 
a combination of cash, market securities investments, and derivatives transactions. Allowing 
funds to segregate a broader range of assets, even if subject to haircuts, also may not effectively 
address all of the section 18 concerns underlying an asset segregation requirement. For example, 
if a fund must raise cash to pay a derivatives counterparty by selling a segregated security with 
unrealized trading losses, then the fund still would realize trading losses on the sale of the 
security regardless of whether the fund applied haircuts to the value of the security when 
determining the amount of its segregated assets. The haircuts therefore could help to prevent a 
fund from defaulting on its derivatives transactions obligations, but may not prevent a fund from 
realizing trading losses to meet those obligations.  
Notional amount segregation, although generally an effective way to limit leverage risk, 
is a non-risk-sensitive and often more restrictive approach to limiting potential leverage risk as 
compared to the proposed VaR tests. Notional amount segregation could limit funds’ ability to 
engage in derivatives transactions that may not raise the concerns underlying section 18. For 
example, if a fund had segregated all available qualifying assets, it would not be permitted to 
enter into a derivatives transaction that would reduce portfolio risk. The proposed VaR tests 
would not constrain such a transaction because it would reduce the fund’s VaR.  
We also considered proposing an approach that would require funds to segregate liquid 
assets in an amount equal to the fund’s daily mark-to-market liability plus a “cushion amount” 
                                                      
260
  See, e.g., 2016 DERA Memo, supra note 12. 

140 
designed to address potential future losses. Requiring funds to segregate liquid assets would 
indirectly limit a fund’s leverage risk because each derivatives transaction and segregation of 
liquid assets would limit the net assets available for segregation to support additional derivatives. 
This approach would require segregating a smaller amount of liquid assets than the notional 
amount segregation approach.
261
 In light of the smaller amount of segregated assets, we could 
provide that only a specified percentage of a fund’s assets can be segregated. We could provide, 
for example, that a fund’s segregated amount cannot exceed one-third of its total assets or one-
half of its net assets because this is the maximum amount that an open-end fund can owe a bank 
under section 18. 
This approach, however, would raise compliance complexities and may not be as 
effective as the proposed VaR tests in limiting fund leverage risk. For example, under this 
approach we would have to define the risk-based “cushion amount” funds would segregate. We 
could define this amount as we proposed in 2015: a reasonable estimate of the potential amount 
payable by the fund if the fund were to exit the derivatives transaction under stressed 
conditions.
262
 Some commenters suggested determining these amounts could raise compliance 
challenges.
263
 Another approach would be to use the amount of required initial margin, for 
transactions subject to regulatory initial margin requirements. Not all derivatives transactions are 
subject to initial margin requirements, however, and these requirements generally vary based on 
the type of derivatives instrument. An approach that were to allow a fund to have more leverage 
                                                      
261
  See 2010 ABA Derivatives Report (recommending a risk-adjusted segregated amounts approach); 
2011 Concept Release, supra note 3, at sections II.B.2, II.C.2 (citing and requesting comment on 
the 2010 ABA Derivatives Report approach). 
262
  See 2015 proposed rule 18f-4(c)(9). 
263
  We discuss these challenges in more detail below in section II.F. See also, e.g., AAF Comment 
Letter; Angel; Comment Letter of James J. Angel, Ph.D., CFA (Mar. 28, 2016).  

141 
when trading futures as compared to swaps, for example, would not seem consistent with the 
concerns underlying section 18. 
Requiring funds to segregate liquid assets in an amount equal to the fund’s daily mark-to-
market liability plus a “cushion amount” therefore could introduce unnecessary complexity and 
compliance costs and may not result in an effective limit on fund leverage. We believe that the 
proposed VaR-based tests would be a more direct and effective method of limiting fund leverage 
risk consistent with section 18.  
We request comment on asset segregation as an alternative or complement to VaR. 
 Should the rule require asset segregation in lieu of or in addition to the proposed 
VaR-based limit on fund leverage risk? Is asset segregation equally effective or more 
effective than the proposed VaR tests in limiting a fund’s leverage risk? Why or why 
not? 
 Are there certain fund types or strategies for which an asset segregation approach 
would be more effective or appropriate for limiting a fund’s leverage risk? Which 
ones and why? 
 Should the proposed rule require notional amount segregation? What challenges, if 
any, would funds have with complying with notional amount segregation? Would this 
be an effective means to limit a fund’s leverage risk? If so, how? Please describe. 
 Should the proposed rule require an asset segregation risk-based approach based on 
the fund’s daily mark-to-market liability and “cushion amount”? Please explain why 
or why not.  If so, how should funds calculate the risk-based cushions? Should we use 
the approach in the 2015 proposal for risk-based coverage amounts? Would funds 
encounter challenges in determining stressed conditions for purposes of that analysis? 

142 
Would that approach lead to consistent segregated amounts across funds for the same 
or similar investments? Why or why not? Could we provide for greater consistency 
by prescribing a standardized schedule for computing these amounts based on the 
volatility of the underlying reference assets? What values should we prescribe? 
Rather than the approach in the 2015 proposal, should we use the amounts posted to 
satisfy regulatory margin requirements? Would it be appropriate for different 
instruments that provide the same economic exposure (e.g., futures and swaps that 
reference the same index) to have different segregated amounts? Under this approach, 
how should funds calculate risk-based cushions for transactions that are not subject to 
regulatory initial margin requirements? 
 Should we use the risk-based cushion amount approach to indirectly limit leverage 
risk? If so, should we provide that a fund’s segregated amount cannot exceed one-
third of its total assets, one-half of its net assets, or some other percentage of a fund’s 
total or net assets? Would such an approach be sufficiently risk-sensitive and 
dynamic? If we were to use such an approach, how should we address derivatives 
transactions that may require little or no margin or collateral to be posted?  
 Are there other reasons that the proposed rule should include asset segregation? 
Should the derivatives risk management program specify asset segregation 
requirements? Would market practices adequately address asset coverage concerns? 
If not, why? 
 We included an asset segregation requirement as part of the 2015 proposal designed 
in part to address the asset sufficiency related concerns underlying section 18. Would 
an asset segregation requirement help to address fund leverage risk and complement 

143 
the proposed VaR tests? If so, what type of asset sufficiency test? 
c. Exposure-Based Test 
We considered an exposure-based approach for limiting fund leverage risk. For example, 
we could design an exposure-based approach that permits a fund to enter into derivatives 
transactions so long as its derivatives exposure does not exceed a specified percentage of the 
fund’s net assets, such as 50%. This would be similar to an exposure-based test under the 
European Union guidelines that apply to UCITS funds.
264
  
A fund’s “derivatives exposure” could be defined as in proposed rule 18f-4.
265
 A similar 
approach would be to provide that the sum of a fund’s derivatives exposure and the value of its 
other investments cannot exceed 150% of the fund’s net asset value. This latter approach, and 
particularly if cash and cash equivalents were not included in the calculation, would allow a fund 
to achieve the level of market exposure permitted for an open-end fund under section 18 using 
any combination of derivatives and other investments.
266
  
                                                      
264
  CESR (now known as the European Securities and Markets Authority (“ESMA”)) issued its 
Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk 
for UCITS (“Global Exposure Guidelines”) in 2010, addressing the implementation of the 
European Commission’s 2009 revised UCITS Directive (“2009 Directive”). See CESR Global 
Guidelines, supra note 94, at 9. 
 A UCITS fund may, instead of complying with the European Union’s VaR-based test, satisfy a 
“commitment approach.” The commitment approach provides that a UCITS fund is in 
compliance with the leverage limits under the guidelines if its derivatives notional amounts 
(taking into account netting and hedging) do not exceed 100% of the fund’s net asset value. See 
2009 Directive. 
265
  Proposed rule 18f-4(a) (defining derivatives exposure to mean the sum of the notional amounts of 
the fund’s derivatives instruments and, in the case of short sale borrowings, the value of the asset 
sold short. In determining derivatives exposure a fund may convert the notional amount of 
interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of 
options contracts). 
266
  This approach would exclude cash and cash equivalents because they do not meaningfully 
contribute to a fund’s market exposure.  

144 
This alternative approach would recognize that for most types of derivatives, the notional 
amount generally serves as a measure of the fund’s economic exposure to the underlying 
reference asset or metric. It also would provide a simple approach because a fund would just add 
the relevant values rather than having to perform VaR tests. 
An exposure-based test does have certain limitations. One drawback to this alternative 
approach is that a derivative’s notional amount does not reflect the way in which the fund uses 
the derivative and is not a risk measurement. For this reason, an exposure-based approach may 
be viewed as a relatively blunt measurement.  It would not differentiate between derivatives 
transactions having the same notional amount but different underlying reference assets with 
potentially very different risks.  
There are adjustments to notional amounts available that may better reflect the risk 
associated with derivatives transactions. One way to attempt to address these drawbacks would 
be to define the circumstances under which funds could subtract the exposure associated with 
“hedging” and “netting” transactions from a fund’s derivatives exposure. This would be similar 
to the “commitment method” applicable to UCITS funds.
267
 Defining these kinds of transactions 
can be challenging. For example, determining whether transactions are “hedges” can involve an 
analysis of historical correlations and predicting future price movements of related instruments 
                                                      
267
  See, e.g., CESR Global Guidelines, supra note 94, at 13-14 (defining netting as “combinations of 
trades on financial derivative instruments and/or security positions which refer to the same 
underlying asset, irrespective—in the case of financial derivative instruments—of the contracts’ 
due date; and where the trades on financial derivative instruments and/or security positions are 
concluded with the sole aim of eliminating the risks linked to positions taken through the other 
financial derivative instruments and/or security positions” and hedging as “combinations of trades 
on financial derivative instruments and/or security positions which do not necessarily refer to the 
same underlying asset and where the trades on financial derivative instruments and/or security 
positions are concluded with the sole aim of offsetting risks linked to positions taken through the 
other financial derivative instruments and/or security positions”). 

145 
or underlying reference assets, among other things. Historical correlations also can break down 
in times of market stress.
268
 
Another potential way to modify an exposure-based test would be to adjust the notional 
amounts that contribute to a fund’s derivatives exposure based on the volatility of their 
underlying reference assets. Some commenters on the 2015 proposal suggested we take this 
approach,  and DERA staff prepared an analysis of commenters’ suggestions.
269
 This would make 
an exposure-based test more risk-sensitive, but would not provide the more-comprehensive 
analysis of portfolio risk that VaR provides. An exposure-based test, even with these various 
adjustments to notional amounts for purposes of calculating a fund’s derivatives exposure, still 
would be a relatively blunt measurement. For example, this approach could limit certain fund 
strategies that rely on derivatives more extensively but that do not seek to take on significant 
leverage risk. 
                                                      
268
  In times of extreme market stress, price correlations between asset classes frequently break down. 
See Mico Loretan & William B. English, Evaluating “Correlation Breakdowns” During Periods 
of Market Volatility, Federal Reserve System International Finance Working Paper No. 658 (Feb. 
2000), available at h ttps://papers.ssrn.com/sol3/papers.cfm?abstract_id=231857 (“[I]n periods of 
heightened market volatility correlations between asset returns can differ substantially from those 
seen in quieter markets. The problem of ‘correlation breakdown’ during periods of greater 
volatility is well known.”). During periods of stressed conditions, correlations between asset 
classes with historically weak or inverse correlations may change significantly. See Whitney 
Kisling, Greed Beats Fear With Stock-Bond Correlation Falling, Bloomberg (Nov. 22, 2010) 
(stating that the 30-day correlation between S&P 500 prices and 10-year Treasury yields showed 
equity and bond markets, typically inversely correlated markets, moving in lockstep after the 
2008 financial crisis); s ee also A Review of Financial Market Events in Autumn 1998, Bank for 
International Settlements, Committee on the Global Financial System (1999), available at 
http://www.bis.org/publ/cgfs12.htm (during the Russian financial crisis in August 1998 the 
average correlation between five-day changes in yield spreads for 26 instruments in 10 economies 
rose from 11% in the first half of 1998 to 37% during the height of the crisis). 
269
  See 2016 DERA Memo, supra note 12. 

146 
While we do not propose an exposure-based test element as a means for limiting all 
funds’ leverage risk, we are proposing an exposure-based test for limited derivatives users (as 
discussed below).
270
  
We request comment on an exposure-based test as a means to limit funds’ leverage risk. 
 Should the rule incorporate an exposure-based approach in addition to, or in lieu of, 
the proposed VaR-based limit on fund leverage risk? If so, what derivatives exposure 
amount should this approach permit? For example, should we modify the proposed 
rule so that a fund would not be required to satisfy either VaR test if the fund limited 
its derivatives exposure, as defined for purposes of the limited derivatives user 
exception discussed below, to 50% of a fund’s net assets? Should an exposure-based 
approach focus on a fund’s overall gross market exposure and be based on the sum of 
the fund’s derivatives exposure and the value of its other investments, less any cash 
and cash equivalents? If so, should a fund’s gross market exposure be limited to 
150% of net assets to allow a fund to achieve the level of market exposure permitted 
for an open-end fund under section 18 using any combination of derivatives and other 
investments? Would any of these approaches to implementing an exposure-based 
limit on fund leverage risk effectively address the potential leverage associated with a 
fund’s derivatives transactions? If so, would funds find it more cost effective or 
otherwise preferable to have the option to comply with an exposure-based test in lieu 
of the proposed VaR tests? Please explain.  
 If the rule were to incorporate an exposure-based approach, should we permit funds to 
make netting and hedging adjustments when calculating their derivatives exposures? 
                                                      
270
  See proposed rule 18f-4(c)(3). 

147 
If so, why? How should we define permissible netting and hedging transactions? If 
we permit netting and hedging to be incorporated into the exposure calculation, 
should the rule include third-party verification to test whether a fund’s netting and 
hedging calculations were reasonable and appropriate? What other provisions could 
achieve these concerns with netting and hedging? Please describe. 
 If the rule were to incorporate an exposure-based approach, should we permit funds to 
make risk-sensitive adjustments as discussed in the 2016 DERA Memo? If so, why? 
How should we define the permissible risk-adjusted notional amounts? If we permit 
these adjustments to be incorporated into the exposure calculation, should the rule 
include third-party verification to test whether a fund’s adjustments were reasonable 
and appropriate? What other provisions could achieve these concerns with risk-
adjusted notional amounts? Please describe. 
 Are there certain fund types or strategies where an exposure-based test would be 
more appropriate? If so, which ones and why? Would these fund types or strategies 
have difficulty conducting either a relative VaR test or absolute VaR test? If so, why 
would an exposure-based test be less challenging to conduct than a VaR-based test? 
 What challenges, if any, would funds have in conducting an exposure-based test? 
How could an exposure-based test rule account for these challenges? 
 Do funds currently conduct exposure-based tests as a means of measuring and 
limiting a fund’s leverage risk? If so, which ones and why? Are these exposure-based 
tests in place of or in addition to VaR-based tests or other risk measurements? Should 
the rule be modified to require both, and what benefits do funds find when running an 
exposure-based test and VaR-based test and comparing results? Would these 

148 
additional compliance burdens result in a more-accurate limit on fund leverage risk? 
If so, how much so, and what would the additional compliance burdens be? 
 In what ways is the proposed approach to limiting leverage risk superior or inferior to 
the current regulatory approach or alternative approaches, including the stress testing, 
asset segregation and exposure-based alternatives discussed herein? 
E. Limited Derivatives Users 
We are proposing an exception from the proposed rule’s risk management program 
requirement and VaR-based limit on fund leverage risk for funds that use derivatives in a limited 
manner. Requiring funds that use derivatives only in a limited way to adopt a derivatives risk 
management program that includes all of the proposed program elements could potentially 
require funds (and therefore their shareholders) to incur costs and bear compliance burdens that 
may be disproportionate to the resulting benefits.
271
 We recognize that the risks and potential 
impact of derivatives transactions on a fund’s portfolio generally increase as the fund’s level of 
derivatives usage increases and when funds use derivatives for speculative purposes.
 
 
The proposed exception would cover two alternative types of limited derivatives use. It 
would be available to a fund that either limits its derivatives exposure to 10% of its net assets, or 
that uses derivatives transactions solely to hedge certain currency risks.
272
 A fund that relies on 
the proposed exception would also be required to adopt policies and procedures that are 
reasonably designed to manage its derivatives risks.
273
 We believe that the risks and potential 
                                                      
271
  The cost burden concern extends to smaller funds as well, which could experience an even more 
disproportionate cost than larger funds. See infra sections III.C.3and V.D.1.c. 
272
  See proposed rule 18f-4(c)(3)(i)-(ii); see also infra sections II.E.1 and II.E.2 (discussing the 
specific requirements for funds relying on either alternative of the proposed exception).  
273
  See proposed rule 18f-4(c)(3). 

149 
impact of these funds’ derivatives use may not be as significant, compared to those of funds that 
do not qualify for the exception, and that a principles-based policies and procedures requirement 
would appropriately address these risks. We discuss and request comment on each of the 
elements of this proposed exception below. 
1. Exposure-Based Exception 
Under one alternative set of conditions, a fund would be permitted to rely on the limited 
derivatives user exception if its derivatives exposure does not exceed 10% of its net assets. The 
proposed rule would generally define the term “ derivatives exposure” to mean the sum of the 
notional amounts of the fund’s derivatives instruments and, for short sale borrowings, the value 
of any asset sold short.
274
 This definition is  designed to provide a measure of the market 
exposure associated with a fund’s derivatives transactions entered into in reliance on proposed 
rule 18f-4.
275
  
We recognize that using notional amounts as a measure of market exposure could be 
viewed as a relatively blunt measurement
 in that different derivatives transactions having the 
same notional amount but different underlying reference assets—for example, an interest rate 
swap and a credit default swap having the same notional amount—may expose a fund to very 
different potential investment risks and potential payment obligations. The derivatives exposure 
threshold in the limited derivatives user exception, however, is not designed to provide a precise 
measure of a fund’s market exposure or to serve as a risk measure, but rather to serve as an 
efficient way to identify funds that use derivatives in a limited way.  
                                                      
274
  See proposed rule 18f-4(a) (defining the term “derivatives exposure”). 
275
  Id. 

150 
The proposed definition of “derivatives exposure” would, however, include two 
adjustments designed to address certain limitations associated with measures of market exposure 
that use derivatives’ notional amounts without adjustments. Specifically, the proposed rule 
would permit a fund to convert the notional amount of interest rate derivatives to 10-year bond 
equivalents and delta adjust the notional amounts of options contracts.
276
 Converting interest rate 
derivatives to 10-year bond equivalents would provide for greater comparability of the notional 
amounts of different interest rate derivatives that provide similar exposure to changes in interest 
rates but that have different unadjusted notional amount. In addition, absent this adjustment, 
short-term interest rate derivatives in particular can produce large unadjusted notional amounts 
that may not correspond to large exposures to interest rate changes.
277
 Permitting funds to 
convert these and other interest rate derivatives to 10-year bond equivalents is designed to result 
in adjusted notional amounts that better represent a fund’s exposure to interest rate changes. 
Similarly, permitting delta adjusting of options is designed to provide for a more tailored 
notional amount that better reflects the exposure that an option creates to the underlying 
reference asset.  
These adjustments are therefore designed to provide for more tailored notional amounts 
that better reflect the exposure that a derivative creates to the underlying reference asset. 
Providing these adjustments also would be efficient for funds because the adjustments are 
consistent with the reporting requirements in Form PF and Form ADV.
278
 We do not believe 
                                                      
276
  Id. Delta refers to the ratio of change in the value of an option to the change in value of the asset 
into which the option is convertible. A fund would delta adjust an option by multiplying the 
option’s unadjusted notional amount by the option’s delta.  
277
     Id. 
278
  See, e.g., General Instruction 15 to Form PF; Item B.30 of Section 2b of Form PF; Glossary of 
Terms, Gross Notional Value of Form ADV; Schedule D of Part 1A of Form ADV. 

151 
additional adjustments are necessary for purposes of identifying limited derivatives users. For 
example, commenters on the 2015 proposal suggested an approach to adjusting notional amounts 
based on the volatility of the underlying reference assets, and DERA staff analyzed these 
suggestions.
279
 We believe, however, that whether a fund is using derivatives in a limited way 
for purposes of the limited derivatives user exception should not depend on the volatility of the 
underlying reference assets, but rather on the extent to which a fund uses derivatives to 
implement its investment strategy.  
The proposed 10% derivatives exposure condition represents a threshold that is designed 
to exclude funds from the program requirement and the VaR-based limit on fund leverage risk 
when their derivatives exposure is relatively limited. This proposed threshold is based in part on 
staff analysis of funds’ practices regarding derivatives use. Specifically, DERA staff analyzed 
funds’ use of derivatives based on Form N-PORT filings as of September 2019. As discussed in 
more detail in section III, these filings covered mutual funds, ETFs, registered closed-end funds, 
and variable annuity separate accounts registered as management investment companies. Based 
on this analysis, 59% of funds report no derivatives holdings and 14% of funds report derivatives 
holdings with gross notional amounts above 50% of NAV. 
DERA staff also analyzed the levels of these funds’ derivatives exposure after adjusting 
interest rate derivatives and options, as permitted under the proposed rule. Taking these 
adjustments into account, DERA staff’s analysis showed that 78% of funds have adjusted 
notional amounts below 10% of NAV; 80% of funds have adjusted notional amounts below 15% 
of NAV; 81% of funds have adjusted notional amounts below 20% of NAV; and 82% of funds 
have adjusted notional amounts below 25% of NAV. Although BDCs are not required to file 
                                                      
279
  See 2016 DERA Memo, supra note 12. 

152 
reports on Form N-PORT, our staff separately analyzed a sampling of BDCs, finding that of the 
sampled BDCs, 54% did not report any derivatives holdings and a further 29% reported using 
derivatives with gross notional amounts below 10% of net assets.
280
 
We recognize that not all funds are currently required to file reports on Form N-PORT.
281
 
It appears, however, that funds’ use of derivatives reflected in the Form N-PORT data is 
generally consistent with that in the representative sample studied in the White Paper prepared in 
connection with the 2015 proposal, entitled “Use of Derivatives by Investment Companies.”
282
 
For example, DERA staff compared the percentages of funds in both data sets that reported no 
derivatives and the percentage with gross notional amounts less than 50% of net assets. These 
figures were comparable, suggesting that the Form N-PORT data provides a representative 
sample of current funds, and not just the set of funds currently required to file reports on Form 
N-PORT.
283
 Taking these results into account, we are proposing to permit a fund to operate as a 
limited derivatives user if its derivatives exposure is below 10% of net assets. DERA staff 
                                                      
280
  See infra section III.B.2. As noted above, our staff did not have sufficient information to adjust 
the notional amounts of the BDCs’ interest rate derivatives or options. Some of the 17% of the 
sampled BDCs with gross notional amounts exceeding 10% of net assets likely would have lower 
notional amounts after applying these adjustments.  
281
  Larger fund groups—funds that together with other investment companies in the same “group of 
related investment companies” have net assets of $1 billion or more as of the end of the most 
recent fiscal year of the fund—currently are required to file reports on N-PORT. Smaller fund 
groups must begin to file reports on Form N-PORT by April 30, 2020. While only larger fund 
groups are currently required to file reports on Form N-PORT, existing filings nevertheless 
covered 89% of funds representing 94% of assets. See infra note 458 and accompanying text. 
282
  DERA White Paper, supra note 1 ; see also ICI Comment Letter III (regarding a survey related to 
funds’ use of derivatives sent to its member firms, the Investment Company Institute stated “The 
survey was distributed to smaller fund complex members, yet relatively few responses were 
received from these smaller fund members. Based on anecdotal conversations with staff at these 
member complexes, the smaller fund firms described no to minimal use of derivatives.”). 
283
  Specifically, the DERA White Paper observes that 68% of funds held no derivatives and 89% of 
funds had gross notional amounts less than 50% of net assets. See DERA White Paper, supra note 
1. The respective figures from the N-PORT data were 59% and 86% of funds.  

153 
analysis suggests that most funds either do not use derivatives or do so to a more limited extent, 
and that setting the derivatives exposure threshold for the limited user exception at 10%, 15%, 
20%, or 25%, for example, would result in nearly the same percentages of funds qualifying for 
the exception. We therefore are proposing a lower threshold of 10% because the lower threshold 
would result in nearly the same percentage of funds qualifying for the exception based on current 
practices while potentially providing greater investor protections in the future by requiring funds 
that exceed the lower 10% threshold to establish a program and comply with the VaR-based limit 
on fund leverage risk. 
The 2015 proposal also included an exception from that proposal’s risk management 
program requirement for funds: (1) whose notional derivatives exposure does not exceed 50% of 
net assets; and (2) that do not enter into “complex derivatives transactions,” defined in that 
proposal to include certain path-dependent and non-linear transactions.
284
 The 2015 proposal 
permitted funds to use delta-adjusted notional amounts for options but did not provide an 
adjustment for interest rate derivatives.  
We are proposing a 10% derivatives exposure threshold that takes into account certain 
adjustments rather than a higher figure, like the 50% threshold we proposed in 2015 that did not 
include adjustments for interest rate derivatives, because we believe this approach would more 
effectively identify funds whose derivatives may be effectively managed without a fund needing 
to establish a derivatives risk management program that includes all of the proposed program 
                                                      
284
  Specifically, the 2015 proposal defined the term “complex derivatives transaction” to mean any 
derivatives transaction for which the amount payable by either party upon settlement date, 
maturity or exercise: (1) is dependent on the value of the underlying reference asset at multiple 
points in time during the term of the transaction; or (2) is a non-linear function of the value of the 
underlying reference asset, other than due to optionality arising from a single strike price. 2015 
proposed rule 18f-4(c)(1).  

154 
elements. A fund with derivatives exposure equal to 50% of net assets, for example, would be at 
risk of substantial losses, notwithstanding that an open-end fund could borrow an amount equal 
to 50% of its net assets from a bank.
285
 Conversely, if a fund were entering into interest rate 
derivatives—and especially short-term interest rate derivatives—those transactions’ unadjusted 
notional amounts could cause a fund to exceed the threshold we proposed in 2015 even though 
the fund’s derivatives risks could be less significant than those of other funds that would qualify 
for the exception. The approach the Commission proposed in 2015 therefore could have 
permitted some funds to rely on the exception while still taking on significant derivatives risks, 
while disqualifying other funds whose derivatives transactions may have posed less-significant 
risks but that had high unadjusted notional amounts. Here, our proposal is designed to address 
these concerns by proposing a lower derivatives exposure threshold while also allowing funds to 
adjust interest rate derivatives’ notional amounts because the unadjusted values may be more 
likely to overstate a fund’s market exposure.  
We also are not proposing to prohibit funds relying on the exception from entering into 
complex derivatives transactions as we proposed in 2015 because, as discussed in more detail 
below, we are proposing to require that limited derivatives users manage all of the risks 
associated with their derivatives transactions, including any complex derivatives transactions. In 
addition, if these or other complex or exotic derivatives were to embed multiple forms of 
optionality or other non-linearities such that the fund could not reliably compute the transaction’s 
                                                      
285
  See, e.g., CFA Comment Letter (stating that the commenter did not believe it was “appropriate 
that a fund with 40 or 45 percent notional exposure should be viewed as having a limited amount 
of exposure obviating the requirement for that fund to implement a formal risk management 
program” and that “Section 18’s limit reflects a congressional determination on the level of 
exposure funds may not exceed; it does not reflect the level of exposure at which funds should 
begin to establish formal risk management practices”).  

155 
notional amount, the fund would not be able to confirm that its derivatives exposure is below 
10% of the fund’s net assets and therefore would not be able to rely on the limited derivatives 
user exception. Finally, if these complex derivatives transactions were to cause a fund’s 
derivatives exposure to exceed 10% of the fund’s net assets—or the fund were to exceed the 
limit for any other reason—the fund would have to reduce its derivatives exposure promptly or 
establish a derivatives risk management program and comply with the VaR-based limit on fund 
leverage risk as soon as reasonably practicable. 
We also considered an alternative approach to identifying funds that use derivatives in a 
limited way based on a fund’s disclosure. Specifically, we considered providing that a fund 
would be a limited derivatives user if its principal investment strategies disclosed in its 
prospectus do not involve the use of derivatives.
286
 A fund that does not identify the use of 
derivatives in its principal investment strategies should generally be using derivatives less 
extensively than a fund that does include the use of derivatives as a principal investment strategy. 
                                                      
286
  See, e.g., ICI Comment Letter III (stating that an appropriate threshold for limited derivatives 
users could be whether a fund listed derivatives in its prospectus as a principal investment 
strategy). Form N-1A requires an open-end fund to disclose its principal investment strategies, 
including the particular type or types of securities in which the fund principally invests or will 
invest. See Item 9 of Form N-1A. Form N-1A also provides, in part, that “[i]n determining what 
is a principal investment strategy, consider, among other things, the amount of the Fund’s assets 
expected to be committed to the strategy, the amount of the Fund’s assets expected to be placed at 
risk by the strategy, and the likelihood of the Fund’s losing some or all of those assets from 
implementing the strategy.” See Instruction 2 to Item 9 of Form N-1A. Form N-2 requires a 
closed-end fund to concisely describe the fund’s investment objectives and policies that will 
constitute its principal portfolio emphasis, including the types of securities in which the fund 
invests or will invest principally. See Item 8 of Form N-2. The instructions to this item direct the 
fund to briefly describe the significant investment practices or techniques that the fund employs 
or intends to employ with several examples, including examples related to derivatives 
transactions.  

156 
This approach would provide some efficiencies for funds because they already are required to 
make this disclosure.
287
  
This approach would, however, have certain drawbacks. For example, whether a fund’s 
use of derivatives is a principal investment strategy is a facts-and-circumstances-based analysis. 
Funds that may appear broadly similar could provide different disclosures, leading to less 
consistency in the application of the derivatives risk management program requirement and in 
the application of the VaR-based limit on leverage risk.  
Taking these considerations into account, we are proposing to look at a uniform metric of 
a fund’s derivatives exposure, rather than at the more fact-specific question of whether a fund 
views the use of derivatives as a principal investment strategy. We believe the proposed 
approach should result in more-consistent determinations by funds and would be more 
appropriate in determining whether a fund should qualify for the limited derivatives user 
exception.  
We request comment on the proposed exposure-based exception. 
 Is it appropriate to permit funds to rely on the limited derivatives user exception if 
their derivatives exposure does not exceed 10% of their net assets? Why or why not? 
Should we lower or raise the proposed derivatives exposure threshold, for example to 
5% or to 15%? Why or why not? Should we lower it to a de minimis amount, such as 
1% or 3%, and provide that a fund with derivatives exposure below these levels is not 
required to adopt policies and procedures designed to manage derivatives risk? 
Should the threshold vary based on whether a fund is an open-end fund, registered 
                                                      
287
  See ICI Comment Letter III (stating that 92% of the firms surveyed indicated that their firms have 
funds that list derivatives as a principal investment strategy in their prospectus). 

157 
closed-end fund, or BDC? If so, why, and which levels would be appropriate for each 
kind of fund? 
 The derivatives exposure of certain types of transactions may be difficult to calculate 
or may change rapidly, which may make it difficult for a fund to consistently comply 
with the limited derivatives user exception. Should we provide that a fund relying on 
the limited derivatives user exception may not enter into complex or exotic 
derivatives transactions, whose risks may not be fully reflected in their notional 
amounts? If so, what kinds of complex or exotic transactions? For example, should 
we provide that a fund relying on the exception may not enter into complex 
derivatives transactions, as defined in the 2015 proposal? Should we only permit a 
fund to have a more-limited amount of derivatives exposure associated with these 
transactions, such as 1% or 5% of net assets? Why or why not?  
 Should we prescribe how a fund must calculate its notional amounts, or is that term in 
the proposed rule sufficiently clear? If we should prescribe the calculation, what 
should we prescribe? For example, in 2015 the Commission proposed to define a 
derivatives transaction’s notional amount to mean, among other things: (1) the market 
value of an equivalent position in the underlying reference asset for the derivatives 
transaction (expressed as a positive amount for both long and short positions); or (2) 
the principal amount on which payment obligations under the derivatives transaction 
are calculated. Should we include this definition in rule 18f-4? The 2015 proposal 
also included specific provisions for calculating a derivatives transaction’s notional 
amount for: (1) derivatives that provide a return based on the leveraged performance 
of a reference asset; and (2) derivatives transactions for which the reference asset is a 

158 
managed account or entity formed or operated primarily for the purpose of investing 
in or trading derivatives transactions, or an index that reflects the performance of such 
a managed account or entity.
288
 Should we include either or both of these provisions 
in rule 18f-4? Why or why not? Would funds calculate their notional amounts 
consistently with these provisions even if they were not included in the rule text 
because the calculations would be consistent with the way market participants 
determine derivatives transactions’ notional amounts?  
 Would funds be able to calculate notional amounts for complex derivatives and, if so, 
would they reflect the market risk in the transactions? Why or why? If we permit 
funds to enter into complex derivatives transactions as defined in the 2015 proposal 
while relying on the limited 
derivatives user exception, should we require that funds 
calculate these transactions’ notional amounts as the Commission proposed in 2015? 
That proposal would have provided that the notional amount of a complex derivatives 
transaction would be the aggregate notional amounts of derivatives transactions 
(excluding complex derivatives transactions) reasonably estimated to offset 
substantially all of the market risk of the complex derivatives transaction. 
 For purposes of determining a fund’s derivatives exposure, should the proposed rule 
treat differently derivatives that create synthetic positions where the fund holds cash 
and cash equivalents with a value equal to the derivative’s notional amount less any 
posted margin? These transactions may not leverage the fund’s portfolio because of 
the fund’s holding cash and cash equivalents equal to the notional amount of the 
derivatives transaction less any posted margin, rather than investing in additional 
                                                      
288
     See 2015 Proposing Release, supra 2, at n.158 and accompanying text. 

159 
securities or making other investments. Take, for example, a fund with $100 that 
posts $20 of initial margin to initiate a long position in a swap contract referencing a 
market index. If the fund posted cash and cash equivalents as initial margin and 
maintains the remaining $80 in cash and cash equivalents as well, the fund would 
have a market exposure that would be similar to having invested the fund’s $100 in 
the stocks composing the index. Such a transaction could, however, present other 
risks, such as counterparty risk. Because these synthetic transactions may not 
leverage a fund’s portfolio, should we permit a fund to exclude these transactions 
from its derivatives exposure? Conversely, because they can raise other risks, such as 
counterparty risks, should they be included in derivatives exposure as proposed?  
 Should the rule define limited derivatives users using an alternative methodology 
other than the proposed threshold tied to derivatives exposure (or, as discussed below, 
for funds that use derivatives to hedge currency risks)? Why or why not? For 
example, should the limited derivatives user exception be defined to include funds 
that do not disclose the use of derivatives as a principal investment strategy in their 
prospectuses?
 
Would this disclosure-based exception threshold be over- or under-
inclusive? Would it lead to less consistency in the requirement to establish a 
derivatives risk management program and comply with a VaR-based limit on 
leverage risk and potentially create uncertainty for funds as to when they would 
qualify for the limited user exception? Why or why not? If this could lead to less 
consistency, would any additional instructions in funds’ registration forms, regarding 
what a fund should disclose as a principal investment strategy in its prospectus, help 
mitigate this concern, and if so, what should those instructions be? Is it appropriate to 

160 
tie an exception to the derivatives risk management program requirement and VaR-
based limit on fund leverage risk to a prospectus disclosure requirement? Why or why 
not?  
 Should the condition that a limited derivatives user’s derivatives exposure not exceed 
10% of the fund’s net assets address exceedances and remediation? Why or why not? 
For example, as noted above, if a fund’s derivatives exposure were to exceed 10% of 
the fund’s net assets, the fund would have to promptly reduce its derivatives exposure 
or establish a derivatives risk management program and comply with the VaR-based 
limit on fund leverage risk as soon as reasonably practicable. Should we provide in 
rule 18f-4 specific time periods for these actions and, if so, which time periods would 
be appropriate? As an alternative way to address temporary exceedances, should the 
rule provide that a fund will be a limited derivatives user if it adopts a policy 
providing that, under normal circumstances, the fund’s derivatives exposure will not 
exceed 10% of the fund’s net assets? If so, what should be considered “normal 
circumstances”? Would this standard be too subjective such that funds would have 
substantial derivatives exposures while still qualifying as limited derivatives users? 
Rather than a policy referring to “normal circumstances,” should we require a fund to 
disclose in its prospectus that it does not expect its derivatives exposure to exceed 
10% of the fund’s net assets? Should this disclosure also appear in the fund’s annual 
report? 
 Should we prohibit a fund whose derivatives exposure repeatedly exceeds 10% of net 
assets from relying on the exception again for a period of time? For example, if a 
fund were to exceed this limit more than two or three times in a year, should we 

161 
provide that the fund cannot rely on the limited derivatives user exception for one or 
two years?  
 In calculating derivatives exposure, should we permit a fund to convert the notional 
amount of interest rate derivatives to 10-year bond equivalents and delta adjust the 
notional amounts of options contracts, as proposed? Would delta adjusting options 
raise the concern that a fund’s delta-adjusted options exposure would be small, 
allowing a fund to avoid establishing a program, but could quickly grow in response 
to large price changes in the option’s reference asset? How should we address this 
concern? Should we permit additional adjustments? Why or why not? If so, what 
additional adjustments should we permit? For example, should we permit funds to 
adjust notional amounts based on the volatility of the underlying reference assets? 
Why or why not? 
 The proposed rule provides that, for a fund to operate as a limited derivatives user 
under the exposure-based prong, the fund’s derivatives exposure must not exceed 
10% of net assets. The rule does not, however, prescribe the frequency with which 
funds must calculate their derivatives exposure to evaluate their compliance. Should 
we require that a fund calculate its notional amounts daily, or at some other specified 
frequency? Are there other requirements we should specify regarding a fund’s 
calculation of its derivatives exposure? If so, what are they,  and why would these 
other requirements more accurately address a fund’s derivatives exposure?  
 Should we permit a fund to adjust its derivatives exposure for purposes of the 

162 
proposed exception to account for certain netting and hedging transactions?
289
 Why 
or why not? If so, how should we define netting and hedging transactions for this 
purpose? How should we prescribe in rule 18f-4 the circumstances under which 
different derivatives—and particularly derivatives with different reference assets—
should be treated as hedged or offsetting? If the rule were to permit funds to exclude 
hedging or netting transactions from their derivatives exposure, should we require 
funds to maintain records concerning these transactions to help our staff and fund 
compliance personnel evaluate if the transactions reasonably could be viewed as 
hedging or netting? If so, what information should those records reflect? For example, 
the regulations under section 13 of the Bank Holding Company Act, commonly 
known as the Volcker Rule, require certain banking entities to maintain certain 
documentation relating to hedging strategies, including positions and techniques.
290
 
Should the proposed rule take this or a similar approach? As another example, should 
we require funds to identify both the asset being hedged or netted and the derivatives 
transaction used to hedge or net that asset? How should we consider the risk that the 
historical correlations underlying an adviser’s view that assets will have inverse price 
correlations can break down in times of market stress? How could a standard in the 
rule be reasonably objective such that funds and our staff could confirm a fund’s 
compliance? Should we permit funds to account for netting but not hedging or vice 
versa? Why or why not? Would the compliance burden to calculate netting and 
hedging transactions for purposes of such adjustments justify the benefits of 
                                                      
289
     See paragraph accompanying supra notes 267-268. 
290
  See 17 CFR 255.5(c). 

163 
permitting these adjustments? Why or why not? What other challenges could funds 
face in accounting for netting and hedging transactions that could increase the costs 
associated with this exercise, or that could negatively affect a fund’s ability to assess 
its derivatives exposure accurately? Could these challenges be mitigated in any way? 
If so, how?  
 Should we specify in the rule that a fund calculating its derivatives exposure may net 
any directly-offsetting derivatives transactions that are the same type of instrument 
and have the same underlying reference asset, maturity and other material terms, as 
we proposed in 2015? Why or why not? 
 In determining a fund’s derivatives exposure, or the level of derivatives exposure a 
fund may obtain while remaining a limited derivatives user, should we consider other 
types of investments, like structured notes, that have return profiles that are similar to 
many derivatives instruments? Take, for example, a fund with derivatives exposure 
exceeding the proposed 10% threshold by 2% that reallocates that 2% of its net asset 
value from a derivatives instrument to a structured note with a similar return profile. 
The fund would be a limited derivatives user on the basis that its derivatives exposure 
was below the threshold, but would present a similar risk profile to its prior portfolio 
that exceeded the threshold. Are there circumstances where we should require the 
fund in this example to include the value of the structured note (or similar investment) 
in determining its derivatives exposure? If so, which circumstances and what kinds of 
instruments should be included? As another alternative, should we provide that, when 
funds that invest in derivatives also invest in structured notes or similar investments, 
they should be subject to a lower threshold of derivatives exposure to remain a 

164 
limited derivatives user? If so, what lower level would be appropriate?  
2. Currency Hedging Exception 
Under the second alternative set of conditions, a fund could rely on the limited 
derivatives user exception if it limits its use of derivatives transactions to currency derivatives for 
hedging purposes as specified in the proposed rule.
291
 Under this exception, a fund could only 
use currency derivatives to hedge currency risk associated with specific foreign-currency-
denominated equity or fixed-income investments in the fund’s portfolio. In addition, the notional 
amount of the currency derivatives the fund holds could not exceed the value of the instruments 
denominated in the foreign currency by more than a negligible amount.
292
  
The proposed currency hedging exception reflects our view that using currency 
derivatives solely to hedge currency risk does not raise the policy concerns underlying 
section 18. While distinguishing most hedging transactions from leveraged or speculative 
transactions is  challenging, we believe that the currency hedging described in the proposed rule 
is definable because it involves a single risk factor (currency risk) and requires that the 
derivatives instrument must be tied to specific hedged investments (foreign-currency-
denominated securities held by the fund).
293
 Although we recognize that most funds that use 
derivatives do not use them solely to hedge currency risks, these currency hedges are not 
intended to leverage the fund’s portfolio, and conversely could mitigate potential losses.
294
  
                                                      
291
  See proposed rule 18f-4(c)(3)(ii).  
292
     Id. 
293
  Many hedges are imperfect, which makes it difficult to distinguish purported hedges from 
leveraged or speculative exposures. See 2015 Proposing Release, supra 2, at n.238 and 
accompanying text. 
294
  See infra section III.C.3 (discussing the number of funds whose current derivatives transactions 
practices would qualify them for the currency hedging exception). 

165 
We also recognize that certain funds hedge all of the foreign currency risk associated 
with their foreign securities investments. A fund that invests all or substantially all of its assets in 
foreign securities and currency derivatives to hedge currency risks associated with the foreign 
securities necessarily would have derivatives exposure exceeding 10% of net asset value. This is 
because such a fund could have derivatives exposure up to approximately 100% of the fund’s net 
assets to hedge the risks associated with all of its foreign security investments. We therefore are 
proposing a separate basis for the limited derivatives user exception for currency hedging 
because certain funds that hedge currency risks would be unable to qualify for the exposure-
based limited derivatives user exception discussed above. 
Rather than proposing two alternative bases to qualify for the limited derivatives user 
exception, we considered permitting a fund to qualify as a limited derivatives user if its 
derivatives exposure does not exceed 10% of net assets, excluding any currency hedges as 
discussed above. We are not taking this combined approach, however, to preclude a fund that is 
operating as a limited derivatives user from engaging in a broad range of derivatives transactions 
that may raise risks that we believe should be managed through a derivatives management 
program and subject to the proposed VaR-based limit on fund leverage risk.  
We request comment on the proposed currency hedging exception. 
 Is the proposed currency risk hedging exception appropriate? Why or why not? 
Should we modify the proposed exception in any way? Why or why not? For 
example, should we limit the derivatives exposure of a fund that relies on the 
currency hedging exception, and if so, what should be that exposure threshold? 
Should we prescribe the kinds of currency derivatives that a fund may use while 
relying on the exception? If so, which derivatives should be permitted and which 

166 
should be prohibited and why? Should the rule refer to other foreign-currency-
denominated assets in addition to equity or fixed-income investments? For example, 
do funds hedge holdings of foreign currencies themselves in addition to foreign-
currency-denominated investments?  
 Are there other types of derivatives that funds use that are less likely to raise the 
policy concerns underlying section 18? If so, which derivatives,  and how do funds 
use them? For instance, we are aware that funds use interest rate derivatives to hedge 
interest rate risk arising from fixed income investments in their portfolios. Should we 
modify the proposed hedging-based exception to also include interest rate derivatives 
that funds use for hedging purposes? Why or why not? If so, what challenges could 
funds encounter in identifying interest rate derivatives that are used for hedging 
purposes (instead of for speculation or to accomplish leveraging)? How could we 
define interest rate hedging in rule 18f-4 in a way that would allow hedging 
transactions while not permitting transactions that simply are speculating on the 
direction of interest rates? How could conditions in the rule help identify interest rate 
derivatives that funds use for “true” hedging? For example, should we require that 
any interest rate derivative that is treated as a hedge be tied to specific fixed-income 
securities or groups of specific fixed-income securities in the fund’s portfolio? This 
would be analogous to the proposed nexus between a fund’s currency derivatives and 
the fund’s hedged foreign-currency-denominated investments. Should we similarly 
allow a fund to treat as a  hedging transaction an interest rate derivative that converts a 
fund’s fixed rate borrowings to floating rate borrowings or vice versa? To what extent 
do funds engage in these transactions? For funds that do engage in these transactions, 

167 
how large are the notional amounts of these transactions, in ten-year bond 
equivalents, as a percentage of the fund’s net assets?  
 Should the rule address what happens if a fund using currency derivatives exceeds the 
notional amount of the value of the instruments denominated in a foreign currency by 
more than a negligible amount? If so, how should we address exceedances? Should 
we provide further guidance on what a negligible amount would be? For example, 
should we provide guidance or provide in rule 18f-4 that exceedances of 1 % or 2%, 
for example, would be negligible?  
 Should we permit funds that rely on the first alternative set of limited derivatives user 
conditions (limiting their derivatives exposure to 10% of net assets) to deduct the 
notional amounts of their currency derivatives used for hedging purposes when 
calculating their derivatives exposure for purposes of the proposed exception? Why 
or why not? Should we allow funds to rely on both exceptions at the same time, 
instead of the exceptions being alternatives? If the exceptions were combined, could 
that result in funds relying on the limited 
derivatives user exception developing larger 
and potentially more complex derivatives portfolios that that may raise risks more 
appropriately managed through a derivatives management program and subject to the 
proposed VaR-based limit on fund leverage risk? Why or why not? 
3. Risk Management 
A fund relying on the limited derivatives user exception would be required to manage the 
risks associated with its derivatives transactions by adopting and implementing policies and 

168 
procedures that are reasonably designed to manage the fund’s derivatives risks.
295
 T he 
requirement that funds relying on the exception manage their derivatives risks recognizes that 
even a limited use of derivatives can present risks that should be managed.  
For example, a fund that uses derivatives solely to hedge currency risks would not be 
introducing leverage risk, but could still introduce other risks, including counterparty risk and the 
risk that a fund could be required to sell its investments to meet margin calls. As another 
example, certain derivatives, and particularly derivatives with non-linear or path-dependent 
returns, may pose risks that require monitoring even when the derivatives represent a small 
portion of net asset value. For example, because of the non-linear payout profiles associated with 
put and call options, changes in the value of the option’s underlying reference asset can increase 
the option’s delta, and thus the extent of the fund’s derivatives exposure from the option. An 
options transaction that represented a small percentage of a fund’s net asset value can rapidly 
increase to a larger percentage. 
The proposed rule would require funds relying on the limited derivatives user exception 
to adopt and implement policies and procedures reasonably designed to manage the funds’ 
derivatives risks. Because they would be reasonably designed to address each fund’s derivatives 
risks, these policies and procedures would reflect the extent and nature of a fund’s use of 
derivatives within the parameters provided in the exception. For example, a fund that uses 
derivatives only occasionally and for a limited purpose, such as to equitize cash, could have 
limited policies and procedures commensurate with this limited use. A fund that uses more 
complex derivatives with derivatives exposure approaching 10% of net asset value, in contrast, 
                                                      
295
  See proposed rule 18f-4(c)(3); see also proposed rule 18f-4(a) (definition of “derivatives risks”) 
and supra note 118 and accompanying text (discussing the proposed definition of “derivatives 
risks”). 

169 
would need to have policies and procedures tailored to the risks these derivatives could present. 
These policies and procedures could be more extensive and could include elements similar to 
those required under the proposed derivatives risk management program.  
The 2015 proposal would have required funds relying on that proposal’s exception to the 
derivatives risk management program requirement to manage derivatives risks by determining 
(and maintaining certain assets to cover) a “risk-based coverage amount” associated with the 
fund’s derivatives. This amount represented an estimate of the amount the fund would expect to 
pay to exit the derivatives transaction under stressed conditions.  
The approach we are proposing here is designed to require a fund relying on the limited 
derivatives user exception to manage all of the risks associated with its derivatives transactions, 
and not just the risks that an asset segregation requirement could address.
296
 Moreover, our 
proposal is designed to limit derivatives risks by limiting the extent to which a fund can use 
derivatives while relying on the exception. As discussed above, the 2015 proposal would have 
permitted funds to obtain substantially greater derivatives exposure—up to 50% of net assets—
without establishing a derivatives risk management program. On balance, we believe that the 
proposed bases for the limited derivatives user exception, together with the requirement that a 
fund manage any risks its limited use of derivatives presents, would provide both important 
investor protections and flexibility for funds to use derivatives in a way that is consistent with the 
policy concerns underlying section 18.  
We request comment on the proposed requirement that a fund relying on the limited 
derivatives user exception manage the risks associated with its derivatives transactions by 
adopting policies and procedures that are reasonably designed to manage its derivatives risks. 
                                                      
296
  We discuss the limitations of an asset segregation requirement in section II.F below. 

170 
 Is it appropriate to require funds relying on the limited derivatives user exception to 
adopt policies and procedures that are reasonably designed to manage their 
derivatives risks, in lieu of requiring such a fund to adopt a derivatives risk 
management program that includes all of the proposed program elements and comply 
with the proposed VaR-based limit on fund leverage risk? Would this requirement 
effectively address the risks entailed by the levels and types of derivatives use in 
which a fund that qualifies for the proposed exception might engage?  
 Alternatively, should funds eligible for the proposed limited derivatives user 
exception be subject to a tailored version of the proposed program requirement (e.g., 
a program requirement that would specify only certain elements, such as risk 
identification and assessment, establishing risk guidelines, stress testing, etc.)? If so, 
if so what should this entail? 
 Either in addition to or in lieu of policies and procedures reasonably designed to 
manage a fund’s derivatives risk, should we require funds relying on the limited 
derivatives user exception to comply with an asset segregation requirement? Should 
we use the same approach we proposed in 2015? Should we use that approach but 
allow funds to segregate a broader range of assets, such as the assets with 
corresponding haircuts analyzed in the 2016 DERA Memo?  
 Should we require limited derivatives users to publicly disclose that they are limited 
derivatives users in their prospectus, annual report, or on their website? If so, should 
we require any particular disclosure to enhance investors’ understanding of, for 
example: (1) the risks of investing in a fund that qualifies as a limited derivatives user 
under the proposed rule, or (2) such a fund’s derivatives risk management practices? 

171 
F. Asset Segregation 
The Commission and staff have historically taken the position that a fund may 
appropriately manage the risks that section 18 is designed to address if the fund “covers” its 
obligations in connection with various transactions by maintaining “segregated accounts.”
297
 
Funds’ practices regarding the amount of “cover” they segregate, and the assets available for 
segregation, have evolved over time. In addition, different funds have applied those practices in 
varying ways to derivatives transactions with comparable economic exposures. Moreover, 
regulatory and contractual margin requirements have developed significantly since the adoption 
of Release 10666.  
The 2015 proposal drew on the Commission’s historical approach—and sought to 
primarily address the Investment Company Act’s asset sufficiency concern—by including an 
asset segregation requirement as part of the 2015 proposed rule.
298
 Under the Commission’s 
2015 proposed approach, a fund relying on the proposed rule, in addition to complying with one 
of two portfolio limitations, would have had to maintain an amount of “qualifying coverage 
assets” designed to enable a fund to meet its derivatives-related obligations. Under the 2015 
proposed rule, a fund would not have been required to segregate a derivative’s full notional 
amount, but instead would have had to segregate qualifying coverage assets (generally cash and 
cash equivalents) equal to the sum of two amounts: (1) the amount that would be payable by the 
fund if the fund were to exit the derivatives transaction at the time of determination (the “mark-
to-market coverage amount”), and (2) a reasonable estimate of the potential amount payable by 
                                                      
297
  See supra section I.B.2. 
298
  See 2015 Proposing Release supra note 2, at section III.C. 

172 
the fund if the fund were to exit the derivatives transaction under stressed conditions (the “risk-
based coverage amount”).
299
  
Although commenters generally supported the overarching framework of the 2015 
proposed rule’s asset segregation requirement, they identified several operational complexities. 
For example, commenters stated that additional clarity was necessary for funds to determine risk-
based coverage amounts, including how funds should determine stressed conditions for this 
purpose.
300
 Commenters also raised questions about how funds could reduce segregated amounts 
to account for posted initial or variation margin and, more generally, how rule provisions 
governing coverage amounts would apply to cleared transactions (as opposed to OTC 
transactions covered by netting agreements).
301
 A number of commenters also expressed 
concerns about the proposed requirement that funds generally segregate cash and cash 
equivalents.
302
 Commenters suggested alternatives to this proposed requirement, including 
                                                      
299
  See id. at section III.C.2 (discussing the composition of qualifying coverage assets as either: (1) 
cash and cash equivalents, or (2) with respect to any derivatives transaction under which the fund 
may satisfy its obligations under the transaction by delivering a particular asset, that particular 
asset). 
300
  See, e.g., ICI Comment Letter I; BlackRock Comment Letter; Dechert Comment Letter; FSR 
Comment Letter; Guggenheim Comment Letter.  
301
  See, e.g., SIFMA Comment Letter (stating that “[i]n practice, variation margin and initial margin 
are often calculated in the aggregate, on a net basis, rather than separately” and recommending 
that funds “be able to get credit for both initial and variation margin posted on a net basis ...” 
rather than limiting the type of coverage amount against which initial or variation margin may be 
credited); BlackRock Comment Letter ( stating that initial and variation margin are used for 
cleared and OTC derivatives transactions by the clearinghouse and counterparties, respectively, 
when a derivatives transaction is exited and that distinguishing between the uses of the two types 
of margin will introduce complexity given that both forms of margin are available to cover 
potential obligations under derivatives in the event of a party’s default). 
302
  See, e.g., AIMA Comment Letter; AQR Comment Letter; BlackRock Comment Letter; Dechert 
Comment Letter; Comment Letter of Eaton Vance Management (Mar. 28, 2016) (“Eaton Vance 
Comment Letter”); Guggenheim Comment Letter; Comment Letter of JPMorgan (Mar. 28, 
2016); Oppenheimer Comment Letter; PIMCO Comment Letter. 

173 
allowing funds to segregate a broader range of assets subject to “haircuts” prescribed by the 
Commission based on the relative volatility of different asset classes.
303
  
Our proposal does not include a specific asset segregation requirement because we do not 
believe that an asset segregation requirement is necessary in light of the proposed rule’s 
requirements, including the requirements that funds establish risk management programs and 
comply with the proposed VaR-based limit on fund leverage risk. As discussed in more detail 
above, a fund relying on proposed rule 18f-4 would be required to adopt and implement a written 
derivatives risk management program that, among other things, would require the fund to: 
identify and assess its derivatives risks; put in place guidelines to manage these risks; stress test 
the fund’s portfolio at least weekly; and escalate material risks to the fund’s portfolio managers 
and, as appropriate, the board of directors.
304
 These proposed requirements are designed to 
require a fund to manage all of the risks associated with its derivatives transactions. These 
include—but are not limited to—the risk that a fund may be required to sell its investments to 
generate cash to pay derivatives counterparties, which the 2015 proposal’s asset segregation was 
designed to address.  
Moreover, the proposed rule would require that a fund’s stress testing for purposes of its 
derivatives management program specifically take into account the fund’s payments to 
derivatives counterparties that could result from losses in stressed conditions. Rather than require 
a fund to evaluate the amounts it would pay to exit derivatives transactions under stressed 
                                                      
303
  See, e.g., Dechert Comment Letter; Eaton Vance Comment Letter; IAA Comment Letter; SIFMA 
Comment Letter, Guggenheim Comment Letter. 
304
  Proposed rule 18f-4(c)(1). Funds that rely on the limited derivatives user exception also would be 
required to manage the risks associated with their more limited use of derivatives. See supra 
section II.E.  

174 
conditions on a transaction-by-transaction basis as in the 2015 proposal,
305
 our proposal would 
require funds to conduct portfolio-wide stress tests, taking into account potential payments to 
counterparties. Although counterparties often require funds to post margin or collateral for 
individual transactions (or groups of transactions) in order to cover potential loss exposure, the 
proposed rule’s stress testing requirement is designed to provide a portfolio-wide assessment of 
how the fund may respond to stressed conditions and any resulting payment obligations. This 
portfolio-wide assessment also would be buttressed by the other provisions in the risk 
management program and the proposed VaR-based limit on fund leverage risk, which are 
designed to limit a fund’s leverage risk and therefore the potential for payments to derivatives 
counterparties. The 2015 proposal’s derivatives risk management program, in contrast, did not 
include such a portfolio-wide assessment. We believe that the proposed rule’s requirements, in 
their totality, would appropriately address the asset sufficiency risks underlying section 18. 
A separate asset segregation requirement, in contrast, may be less effective. As 
derivatives markets evolve, questions may arise about the amount (and composition) of assets 
that funds must segregate for novel types of transactions. Although the Commission in 2015 
sought to take a principles-based approach to the amount of assets that funds would segregate, 
many commenters asserted that additional clarity would be necessary to administer this 
approach. It would be difficult in this context for the Commission to specify the amount of assets 
that funds should segregate on a transaction-by-transaction basis and to keep any specific 
requirements current as markets develop. And a principles-based approach to asset segregation, 
                                                      
305
  In the 2015 proposal, funds were required to determine qualifying coverage assets on a 
transaction-by-transaction basis, with the exception that funds could determine the amount of 
qualifying coverage assets on a net basis for derivatives transactions covered by netting 
agreements. See 2015 proposed rule 18f-4(c)(6) and (9). 

175 
if it does not provide sufficient clarity, may contribute to the kinds of divergent asset segregation 
practices that exist today, which in turn have led to situations in which funds are not subject to a 
practical limit on potential leverage that they may obtain through derivatives transactions.
306
 By 
building on current risk management practices and techniques, including VaR and stress testing, 
the proposed rule is designed to provide a framework that we believe funds can apply to a broad 
variety of fund types and derivatives uses without our having to specify the operational details 
that an asset segregation requirement would entail.  
We request comment on our proposal not to include a specific asset segregation 
requirement. 
 Do commenters believe that the proposed rule’s requirements discussed above, in 
their totality, would appropriately address the asset sufficiency risks underlying 
section 18? If not and commenters believe rule 18f-4 should include an asset 
segregation requirement, what should that requirement entail? What added benefits 
would an asset segregation requirement provide that the current proposed rule 
requirements would not? 
 Should we require funds relying on the limited derivatives user exposure-based 
exception to segregate assets for purposes of the exception? Why or why not? Would 
an asset segregation requirement for such limited derivatives users obviate any need 
for a policies and procedures requirement? Why or why not? 
 Commenters in the 2015 release requested further clarity about the Commission’s 
2015 proposal to require a principles-based asset segregation regime. What aspect of 
that proposal required further clarity and why?  
                                                      
306
  See supra sections I.B.2 and I.B.3. 

176 
G. Alternative Requirements for Certain Leveraged/Inverse Funds and 
Proposed Sales Practices Rules for Certain Leveraged/Inverse 
Investment Vehicles 
1. Background on Proposed Approach to Certain 
Leveraged/Inverse Funds 
Proposed rule 18f-4 would include an alternative approach for certain funds that seek to 
provide leveraged or inverse exposure to an underlying index, generally on a daily basis. This 
alternative approach would be available for a registered investment company that is a 
“leveraged/inverse investment vehicle,” as that term is defined in proposed Exchange Act rule 
15l-2 and proposed Advisers Act rule 211(h)  -1 (which we refer to collectively as the proposed 
“sales practices rules,”  as noted above). As discussed below, the proposed sales practices rules 
would require broker-dealers and investment advisers to engage in due diligence before 
accepting or placing an order for a customer or client that is a natural person (“retail investor”) to 
trade a leveraged/inverse investment vehicle, or approving a retail investor’s account for such 
trading. The definition of the term “leveraged/inverse investment vehicle” in the proposed sales 
practices rules would include certain entities that seek, directly or indirectly, to provide 
investment returns that correspond to the performance of a market index by a specified multiple, 
or to provide investment returns that have an inverse relationship to the performance of a market 
index, over a predetermined period of time.
307
 The entities included in the proposed scope of the 
sales practices rules would include registered investment companies and certain exchange-listed 
commodity- or currency-based trusts or funds.  In this release, we refer to the registered 
investment companies covered by the proposed sales practices rules as “leveraged/inverse funds” 
                                                      
307
  See proposed rules 15l-2(d) and 211(h)-1(d) (defining the term “leveraged/inverse investment 
vehicle”); see also, e.g., ETFs Adopting Release, supra note 76, at section II.A.3; rule 6c-11(c)(3) 
under the Investment Company Act.  

177 
(which in turn would be subject to the proposed alternative approach under rule 18f-4)  . We use 
the proposed sales practices rules’ defined term “leveraged/inverse investment vehicle” to refer 
to both such leveraged/inverse funds and to the exchange-listed commodity- or currency-based 
trusts or funds covered by those rules. 
Leveraged/inverse funds, which today are structured primarily as leveraged/inverse 
ETFs, seek to amplify the returns of an underlying index by a specified multiple or to profit from 
a decline in the value of their underlying index over a predetermined period of time using 
financial derivatives.
308
 These funds reset periodically and are designed to hedge against or profit 
from short-term market movements without using margin, and, as such, are generally intended as 
short-term trading tools.
309
 To achieve their targeted returns, leveraged/inverse funds use 
derivatives extensively. In contrast to other funds that use derivatives as part of their broader 
investment strategy, leveraged/inverse funds’ strategies (and use of derivatives) are predicated on 
                                                      
308
  See infra section III.B for baseline statistics regarding leveraged/inverse ETFs and mutual funds. 
Leveraged/inverse ETFs operate under Commission orders providing exemptive relief from 
certain provisions of the Investment Company Act. These orders, however, do not provide 
exemptive relief from section 18 of the Investment Company Act. Rather, like other funds that 
use derivative investments, leveraged/inverse ETFs rely upon Release 10666 and operate 
consistent with the conditions in staff no-action letters and other staff guidance on derivatives 
transactions. See infra section II.L (discussing our proposal to rescind Release 10666, and stating 
that staff in the Division of Investment Management is reviewing certain of its no-action letters 
and other guidance to determine which letters and other staff guidance should be withdrawn in 
connection with any adoption of this proposal).  
The Commission recently adopted rule 6c-11 under the Investment Company Act to permit ETFs 
that satisfy certain conditions to operate without obtaining an exemptive order from the 
Commission. Rule 6c-11 includes a provision excluding leveraged/inverse ETFs from the scope 
of that rule. See infra section II.G.4 (discussing proposed amendments to rule 6c-11 and proposed 
rescission of exemptive orders issued to leveraged/inverse ETFs). 
309
  See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 
Investment Advisers Act Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at text 
preceding n.39 (“Fiduciary Interpretation”). 

178 
leverage. Accordingly, leveraged/inverse funds raise the issues that section 18 of the Investment 
Company Act is designed to address. 
Leveraged/inverse funds and certain commodity pools following the same strategy also 
present unique considerations because they rebalance their portfolios on a daily (or other 
predetermined) basis in order to maintain a constant leverage ratio. This reset, and the effects of 
compounding, can result in performance over longer holding periods that differs significantly 
from the leveraged or inverse performance of the underlying reference index over those longer 
holding periods.
310
 This effect can be more pronounced in volatile markets.
311
 As a result, buy-
and-hold investors in a leveraged/inverse fund who have an intermediate or long-term time 
horizon—and who may not evaluate their portfolios frequently—may experience large and 
unexpected losses or otherwise experience returns that are different from what they 
anticipated.
312
 
                                                      
310
  For example, as a result of compounding, a leveraged/inverse fund can outperform a simple 
multiple of its index’s returns over several days of consistently positive returns, or underperform 
a simple multiple of its index’s returns over several days of volatile returns.  
311
  See FINRA Regulatory Notice 09-31, Non-Traditional ETFs – FINRA Reminds Firms of Sales 
Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds (June 2009) 
(“FINRA Regulatory Notice 09-31”) (“Using a two-day example, if the index goes from 100 to 
close at 101 on the first day and back down to close at 100 on the next day, the two-day return of 
an inverse ETF will be different than if the index had moved up to close at 110 the first day but 
then back down to close at 100 on the next day. In the first case with low volatility, the inverse 
ETF loses 0.02 percent; but in the more volatile scenario the inverse ETF loses 1.82 percent. The 
effects of mathematical compounding can grow significantly over time, leading to scenarios such 
as those noted above.”). 
312
  See id. (reminding member firms of their sales practice obligations relating to leveraged/inverse 
ETFs and stating that leveraged/inverse ETFs are typically not suitable for retail investors who 
plan to hold these products for more than one trading session). See also Fiduciary Interpretation, 
supra note 309 (stating that “leveraged exchange-traded products are designed primarily as short-
term trading tools for sophisticated investors ... [and] require daily monitoring ....”); Securities 
Litigation and Consulting Group, Leveraged ETFs, Holding Periods and Investment Shortfalls, 
(2010), at 13 (“The percentage of investors that we estimate hold [leveraged/inverse ETFs] longer 
than a month is quite striking.”); ETFs Adopting Release, supra note 76, at n.78 (discussing 
comment letters submitted by Consumer Federation of America (urging the Commission to 
 

179 
The Commission’s Office of Investor Education and Advocacy and FINRA have issued 
alerts in the past decade to highlight issues investors should consider when investing in 
leveraged/inverse funds.
313
 In addition, some commenters to the 2015 proposal indicated that at 
least some segment of investors may hold leveraged/inverse funds for long periods of time, 
which can lead to significant losses under certain circumstances.
314
 FINRA has sanctioned a 
number of brokerage firms for making unsuitable sales of leveraged/inverse ETFs.
315
 More 
                                                      
consider additional investor protection requirements for leveraged/inverse ETFs) and by Nasdaq 
(stating that “there is significant investor confusion regarding existing leveraged/inverse ETFs’ 
daily investment horizon”)). 
313
  SEC Investor Alert and Bulletins, Leveraged and Inverse ETFs: Specialized Products with Extra 
Risks for Buy-and-Hold Investors (Aug. 1, 2009), available at 
http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm. This investor alert, jointly issued by 
SEC staff and FINRA, followed FINRA’s June 2009 alert, which raised concerns about retail 
investors holding leveraged/inverse ETFs over periods of time longer than one day. See FINRA 
Regulatory Notice 9-31, supra note 311. 
314
  See, e.g., CFA Comment Letter (“There is evidence that suggests investors are incorrectly using 
certain alternative investments that use derivatives extensively. For example, despite the fact that 
double and triple leveraged ETFs are short-term trading vehicles that are not meant to be held 
longer than one day, a significant number of shares are held for several days, if not weeks.”). But 
cf. Comment Letter of Rafferty Asset Management (Mar. 28, 2016) (asserting that there is no 
evidence that investors do not understand the leveraged/inverse ETF product, citing, for example, 
an analysis of eight of its leveraged/inverse ETFs between May 1, 2009 and July 31, 2015, and 
finding an average implied holding period ranging from 1.18 days to 4.03 days and suggesting, 
therefore, that investors understand the products are designed for active trading). We note, 
however, that the analysis relied upon in the Comment Letter of Rafferty Asset Management did 
not analyze shareholder-level trading activity or provide any information on the distribution of 
shareholder holding periods. 
315
  See FINRA News Release, FINRA Sanctions Four Firms $9.1 Million for Sales of Leveraged and 
Inverse Exchange-Traded Funds (May 1, 2012), available at 
https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-
inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus and Century 
Securities to Pay Fines and Restitution Totaling More Than $1 Million for Unsuitable Sales of 
Leveraged and Inverse ETFs, and Related Supervisory Deficiencies (Jan. 9, 2014), available at 
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-
fines-and-restitution-totaling; FINRA News Release, FINRA Sanctions Oppenheimer & Co. $2.9 
Million for Unsuitable Sales of Non-Traditional ETFs and Related Supervisory Failures (June 8, 
2016), available at http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-
million-unsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of 
Acceptance, Waiver and Consent (“AWC”) No. 2014039418801 (Aug. 8, 2016), available at 
http://disciplinaryactions.finra.org/Search/ViewDocument/66461; Citigroup Global Markets Inc., 
 

180 
recently, the Commission has brought enforcement actions against investment advisers for, 
among other things, soliciting advisory clients to purchase leveraged/inverse ETFs for their 
retirement accounts with long-term time horizons, and holding those securities in the client 
accounts for months or years.
316
 
Most leveraged/inverse funds could not satisfy the limit on fund leverage risk in proposed 
rule 18f-4 because they provide leveraged or inverse market exposure exceeding 150% of the 
return or inverse return of the relevant index.
317
 These funds therefore would fail the relative 
VaR test and would not be eligible to use the absolute VaR test.
318
 R equiring these funds to 
comply with the proposed VaR tests therefore effectively would preclude sponsors from offering 
the funds in their current form. Investors who are capable of evaluating these funds’ 
characteristics and their unique risks, however, may want to use them to meet specific short-term 
or other investment goals. We therefore are proposing a set of alternative requirements for 
leveraged/inverse funds designed to address the investor protection concerns that underlie 
                                                      
FINRA Letter of AWC No. 20090191134 (May, 1, 2012), available at 
http://disciplinaryactions.finra.org/Search/ViewDocument/31714. See also Regulation Best 
Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86031 (June 5, 
2019) [84 FR 33318 (July 12, 2019)], at paragraph accompanying nn.593-98 (“Regulation Best 
Interest: The Broker-Dealer Standard of Conduct”). 
 
See also, e.g., S.E.C. v. Hallas, No 1:17-cv-2999 (S.D.N.Y. Sept. 27, 2017) (default judgement); 
In the Matter of Demetrios Hallas, S.E.C. Release No. 1358 (Feb. 22, 2019) (initial decision), 
Exchange Act Release No 85926 (May 23, 2019) (final decision) ( involving a former registered 
representative of registered broker-dealers purchasing and selling leveraged ETFs and exchange-
traded notes for customer accounts while knowingly or recklessly disregarding that they were 
unsuitable for these customers, in violation of section 17(a) of the Securities Act and 
section 10(b) and rule 10b-5 thereunder of the Exchange Act). 
316
  See, e.g., In the Matter of Morgan Stanley Smith Barney, LLC, Investment Advisers Act Release 
No. 4649 (Feb. 14, 2017) (settled action).  
317
  See supra section II.D (discussing the proposed VaR-based limit on fund leverage risk). 
318
  See supra section II.D (discussing relative and absolute VaR tests under proposed rule 18f-4). In 
addition, we understand that even if leveraged/inverse funds were to apply the proposed absolute 
VaR test, many of those funds also would fail that test. 

181 
section 18 of the Investment Company Act, while preserving choice for these investors. These 
requirements, discussed below, are designed to help ensure that retail investors in 
leveraged/inverse investment vehicles a re limited to those who are capable of evaluating the 
risks these products present. They also would limit the amount of leverage that leveraged/inverse 
funds subject to rule 18f-4 can obtain to their current levels. 
2. Proposed Sales Practices Rules for Leveraged/Inverse 
Investment Vehicles 
As a complement to proposed rule 18f-4, we are proposing sales practices rules under the 
rulemaking authority provided in Exchange Act section 15(l)(2) and Advisers Act section 
211(h).
319
 T he proposed sales practices rules would require broker-dealers and investment 
advisers to exercise due diligence on retail investors before approving retail investor accounts to 
invest in leveraged/inverse investment vehicles. Specifically, proposed rule 15l-2 under the 
Exchange Act would require a broker-dealer (or any associated person of the broker-dealer) to 
exercise due diligence to ascertain certain essential facts about a customer who is a retail investor 
before accepting the customer’s order to buy or sell shares of a leveraged/inverse investment 
vehicle, or approving the customer’s account to engage in those transactions.
320
 Similarly, 
proposed rule 211(h)-1 under the Advisers Act would require an investment adviser (or any 
supervised person of the investment adviser) to exercise due diligence to ascertain the same set 
of essential facts about a client who is a retail investor before placing an order for that client’s 
                                                      
319
  These provisions provide the Commission with authority to “where appropriate, promulgate rules 
prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes 
for brokers, dealers, and investment advisers that the Commission deems contrary to the public 
interest and the protection of investors.”  
320
  Proposed rule 15l-2(a). In this release, the term “firm,” which collectively refers to Commission-
registered broker-dealers and investment advisers, also includes associated persons of such 
broker-dealers.  

182 
account to buy or sell shares of a leveraged/inverse investment vehicle, or approving the client’s 
account to engage in those transactions.
321
 Under both of the proposed sales practices rules, a 
firm could approve the retail investor’s account to buy or sell shares of leveraged/inverse 
investment vehicles only if the firm had a reasonable basis to believe that the investor is capable 
of evaluating the risks associated with these products.  
The proposed sales practices rules are designed to establish a single, uniform set of 
enhanced due diligence and approval requirements for broker-dealers and investment advisers 
with respect to retail investors that engage in leveraged/inverse investment vehicle transactions, 
including transactions where no recommendation or investment advice is provided by a firm. 
These rules therefore would apply the same due diligence requirements to both broker-dealers 
and investment advisers.
322
 They are designed to help ensure that investors in these funds are 
limited to those who are capable of evaluating their characteristics—including that the funds 
would not be subject to all of the leverage-related requirements applicable to registered 
investment companies generally—and the unique risks they present. Compliance with the 
proposed rules would not supplant or by itself satisfy other broker-dealer or investment adviser 
obligations, such as a broker-dealer’s obligations under Regulation Best Interest or an investment 
adviser’s fiduciary duty under the Advisers Act.
323
 
                                                      
321
  Proposed rule 211(h)-1(a). In this release, the term “firm,” which collectively refers to 
Commission-registered broker-dealers and investment advisers, also includes supervised persons 
of such investment advisers. 
322
  Although we expect that the proposed sales practices rules would cover a significant percentage 
of the retail investors who invest in leveraged/inverse investment vehicles, we recognize that not 
every purchase or sale of a leveraged/inverse investment vehicle will involve a customer or client 
of a Commission-registered broker-dealer or investment adviser that would be subject to the 
proposed sales practices rules. 
323
  See Regulation Best Interest: The Broker-Dealer Standard of Conduct, supra note 315 (discussing 
broker-dealer obligations when providing a recommendation to a retail customer of any securities 
 

183 
The approval and due diligence requirements under the proposed rules are modeled after 
current FINRA options account approval requirements for broker-dealers.
324
 Under the FINRA 
rules governing options, a broker-dealer may not accept a customer’s options order unless the 
broker-dealer has approved the customer’s account for options trading.
325
 Similarly, the 
proposed sales practices rules would require that a firm approve a retail investor’s account before 
the retail investor may invest in leveraged/inverse investment vehicles. As such, the proposed 
sales practices rules, like the FINRA rule, would not require firms to evaluate retail investors’ 
eligibility to transact in these products on a transaction-by-transaction basis. We have generally 
modeled the proposed rules after the FINRA options account framework in part because 
leveraged/inverse investment vehicles, when held over longer periods of time, may have certain 
similarities to options.
326
 The options account approval requirements also represent a current 
framework that can be used in connection with complex products generally.
327
 T his approach 
may provide some efficiencies and reduced compliance costs for broker-dealers that already have 
                                                      
transaction or investment strategy involving securities based on the customer’s investment 
profile); Fiduciary Interpretation, supra note 309 (discussing an investment adviser’s fiduciary 
duty to its client, and stating that as fiduciaries, investment advisers owe their clients duties of 
care and loyalty). 
324
  See, e.g., FINRA rule 2360(b)(16), (17) (requiring for options accounts, firm approval, diligence 
and recordkeeping). 
325
  FINRA rule 2360(b)(16). The same requirements apply for transactions in index warrants, 
currency index warrants, and currency warrants. See FINRA rules 2352 and 2353. Similar 
requirements apply for transactions in security futures. See FINRA rule 2370(b)(16) (requiring 
broker-dealer approval and diligence regarding the opening of accounts to trade security futures). 
326
  For example, both leveraged/inverse investment vehicles and options provide exposure that is 
economically equivalent to a dynamically rebalanced inverse or leveraged position in an 
underlying asset. As a result, both have return characteristics that are more complex than those of 
the underlying asset, particularly as a leveraged/inverse investment vehicle’s leverage multiple 
and/or holding period increase. See infra section III.B.5. 
327
  See FINRA Regulatory Notice 12-03 (providing, among other things, that FINRA members 
“should consider prohibiting their sales force from recommending the purchase of some complex 
products to retail investors whose accounts have not been approved for options trading”).  

184 
compliance procedures in place for approving options accounts, although we recognize that these 
efficiencies and reduced compliance costs would not apply to investment advisers that are not 
dually registered as, or affiliated with, broker-dealers subject to FINRA rules.  
a. Definition of Leveraged/Inverse Investment Vehicle 
The proposed sales practices rules would define a “leveraged/inverse investment vehicle” 
to mean a registered investment company or an exchange-listed commodity- or currency-based 
trust or fund (a “listed commodity pool”), that seeks, directly or indirectly,  to provide investment 
returns that correspond to the performance of a market index by a specified multiple, or to 
provide investment returns that have an inverse relationship to the performance of a market 
index, over a predetermined period of time.
328
 Although the scope of this definition extends 
beyond just ETFs (as defined in rule 6c-11), this definition otherwise is substantively identical to 
the provision in rule 6c-11 excluding leveraged/inverse ETFs from the scope of that rule. The 
substantive requirements in the proposed definition in the sales practices rules have the same 
meaning as the provision in rule 6c-11.
329
 
We believe it is appropriate for the scope of the proposed sales practices rules to include 
leveraged/inverse funds as well as listed commodity pools that follow a similar leveraged or 
inverse strategy. The same investor protection concerns regarding aligning firms’ transaction 
practices with investors’ capability of evaluating the risks of these trading tools apply to this 
broader category of leveraged/inverse investment vehicles, and not just leveraged/inverse funds 
                                                      
328
  See proposed rule 15l-2(d) and proposed rule 211(h)-1(d). 
329
  See rule 6c-11(c)(4) (providing that scope of rule 6c-11 does not include ETFs that “ seek, directly 
or indirectly, to provide investment returns that correspond to the performance of a market index 
by a specified multiple, or to provide investment returns that have an inverse relationship to the 
performance of a market index, over a predetermined period of time.”). See also ETFs Adopting 
Release, supra note 76, at section II.A.3 (discussing rule 6c-11(c)(4)). 

185 
specifically.
330
 Indeed, we understand that leveraged/inverse funds and listed commodity pools 
following the same strategy can have virtually identical investment portfolios. Applying the 
proposed rule to all leveraged/inverse investment vehicles, as defined in the proposed rules, 
would avoid potential regulatory arbitrage that could result if we were to place different 
requirements on these products. 
We request comment on the definition of the term “leveraged/inverse investment vehicle” 
in the proposed sales practices rules. 
 Is the scope of the proposed definition of the term “leveraged/inverse investment 
vehicle” appropriate? The definition includes a fund that seeks to provide investment 
returns that have an inverse relationship to the performance of a market index. Do 
commenters agree that this is appropriate? Should the definition instead only include 
an inverse fund that seeks investment returns that exceed the inverse performance of a 
market index by a specified multiple (e.g., -1.5 or lower)? Why or why not? The 
definition also includes a fund that seeks to provide performance results “over a 
predetermined period of time.” Do commenters agree that this is appropriate? 
Generally, the extent to which a fund’s performance can be expected to deviate from 
the multiple or inverse multiple of the performance of its index when held over longer 
periods is larger for funds that track a multiple or inverse multiple of the performance 
                                                      
330
 The definition of commodity- or currency-based trusts or funds that we propose to include in the 
leveraged/inverse investment vehicle definition tracks a definition recently provided by Congress 
in the Fair Access to Investment Research Act of 2017, Public Law No. 115-66, 131 Stat. 1196 
(2017) (the “FAIR Act”), which we understand includes the kinds of commodity pools that 
generally pursue leveraged or inverse investment strategies. Our proposed definition differs from 
the FAIR Act definition because it would not include a trust or fund that holds only commodities 
or currencies and does not hold derivatives. Because we believe that trusts or funds that seek to 
provide a leveraged or inverse return of an index generally would use derivatives to do so, we do 
not believe it is necessary to include trusts or funds that do not hold derivatives in the proposed 
definition in the sales practices rules. 

186 
of an index over shorter time intervals, as those funds typically rebalance their 
portfolios more frequently. Should we specify a time period in the definition and, if 
so, what time period would be appropriate? For example, should the definition only 
include a fund that seeks investment returns that correspond to a multiple or inverse 
multiple of an index over a fixed period of time that is less than a year, a quarter, or a 
month? Please explain.  
 Do commenters agree with our proposal to include listed commodity pools within the 
definition? Are we correct that the similarities between the investment strategies and 
return profiles of listed commodity pools and other leveraged/inverse investment 
vehicles, such as leveraged/inverse ETFs, warrant including listed commodity pools 
within the scope of this definition? 
 Are there other types of investments or products that we should include in the 
leveraged/inverse investment vehicle definition? For example, should we include 
exchange-traded notes within the scope of the proposed sales practices rules if they 
have the same or similar return profile as the leveraged/inverse funds and listed 
commodity pools included in the proposed definition?
331
 Are there additional 
complex financial products, such as those discussed in FINRA Regulatory Notice 12-
03 (including, among others, certain structured or asset-backed notes, unlisted REITs, 
                                                      
331
  The Commission also recently brought and settled an enforcement action against a dually-
registered broker-dealer/investment adviser, certain of its supervisory personnel, and one of its 
registered representatives arising out of that representative’s recommending that his customers 
buy and hold leveraged and inverse exchange-traded funds and exchange traded notes (including 
allegations that the registered representative recommended that his customers hold a triple-
leveraged exchange-traded note for longer than the one-day holding period set forth in the 
product’s prospectus). See In the Matter of Cadaret Grant, et al., Exchange Act Release No. 
84074 (Sept. 11, 2018) (alleging, among other things, a violation of section 206(4) of the 
Advisers Act and rule 206(4)-7 thereunder and failure to supervise) (settled action). See In the 
Matter of Cadaret Grant, et al., Exchange Act Release No. 84074 (Sept. 11, 2018) (settled action). 

187 
securitized products, and products that offer exposure to stock market volatility), that 
commenters believe should be subject to the due diligence and account approval 
requirements that we are proposing for leveraged/inverse investment vehicles?
332
 
b. Required Approval and Due Diligence in Opening 
Accounts 
Under the proposed sales practices rules, no firm may accept an order from or place an 
order for a retail investor to buy or sell shares of a leveraged/inverse investment vehicle, or 
approve such a retail investor’s account to engage in those transactions, unless the firm has 
complied with certain conditions. Specifically, the proposed rules would require the firm to (1) 
approve the retail investor’s account for buying and selling shares of leveraged/inverse 
investment vehicles pursuant to a due diligence requirement; and (2) adopt and implement 
policies and procedures reasonably designed to achieve compliance with the proposed rules. 
The proposed due diligence requirement provides that a firm must exercise due diligence 
to ascertain the essential facts relative to the retail investor, his or her financial situation, and 
investment objectives. A firm must seek to obtain, at a minimum, certain information about its 
retail investor’s: 
• investment objectives (e.g., safety of principal, income, growth, trading profits, 
speculation) and time horizon; 
• employment status (name of employer, self-employed or retired); 
• estimated annual income from all sources; 
• estimated net worth (exclusive of family residence); 
• estimated liquid net worth (cash, liquid securities, other); 
                                                      
332
  See FINRA Regulatory Notice 12-03, supra note 327. 

188 
• percentage of the retail investor’s liquid net worth that he or she intends to invest in 
leveraged/inverse investment vehicles; and 
• investment experience and knowledge (e.g., number of years, size, frequency and type of 
transactions) regarding leveraged/inverse investment vehicles, options, stocks and bonds, 
commodities, and other financial instruments.
333
 
Based on its evaluation of this information, the firm would be required specifically to approve or  
disapprove the retail investor’s account for buying or selling shares of leveraged/inverse 
investment vehicles. If the firm approves the account, the approval must be in writing. 
Under the proposed rules, to provide this approval a firm must have a reasonable basis for 
believing that the retail investor has the financial knowledge and experience to be reasonably 
expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment 
vehicles. We are not proposing a bright-line test for this determination. Rather, the determination 
would be based on all of the relevant facts and circumstances.    
The information that a firm would collect includes information about the retail investor’s 
financial status (e.g., employment status, income, and net worth (including liquid net worth)); 
and information about his or her investment objectives generally and his or her anticipated 
investments in, and experience with, leveraged/inverse investment vehicles (e.g., general 
investment objectives, percentage of liquid net worth intended for investment in 
leveraged/inverse investment vehicles, and investment experience and knowledge). This 
information is designed to provide a comprehensive picture of the retail investor to allow a firm 
to evaluate whether the retail investor has the financial knowledge and experience to be 
                                                      
333
  See proposed rule 15l-2(b)(2). For joint accounts, the firm must seek to obtain the information for 
all participants in joint retail investor accounts. 

189 
reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse 
investment vehicles. 
While not required under the proposed rules, firms could consider establishing multiple 
levels of account approvals for a retail investor seeking to trade leveraged/inverse investment 
vehicles. We understand that broker-dealers set different levels of options account approval 
depending on the customer’s trading experience and financial sophistication.
334
 Similarly, a firm 
may determine that certain leveraged/inverse investment vehicles (e.g., those with lower leverage 
multiples or that invest in less-volatile asset classes) are more appropriate for a lower level of 
account approval, while other types of leveraged/inverse investment vehicles may be more 
appropriate for a higher level of account approval. Any such approaches generally should be 
addressed in the policies and procedures that the proposed sales practices rules would require a 
firm to adopt and implement.
335
  
The proposed rules’ scope with respect to a firm’s customer or client is limited to “a 
natural person” or “the legal representative of a natural person.”
336
 The rules include all natural 
persons—including high-net worth individuals—to provide the related investor protections to all 
natural persons. The proposed rules require firms to seek to obtain and to consider information 
related to a retail investor’s net worth as part of their consideration of whether to approve the 
investor’s account for trading in leveraged/inverse investment vehicles. We interpret “legal 
representative” of a natural person to mean non-professional legal representatives of a natural 
                                                      
334
  These increasing levels generally track the riskiness of the product or trading strategy; for 
example, the initial option account approval may permit covered call writing of equity options but 
higher account approvals would be needed for writing uncovered index options. 
335
  See proposed rules 15l-2(a) and 211(h)-1(a). 
336
  See proposed rules 15l-2(a) and 211(h)-1(a). 

190 
person.
  337
 This interpretation would exclude institutions and certain professional fiduciaries, but 
it would include certain legal entities such as trusts that represent the assets of a natural 
person.
338
 This interpretation is designed to provide the protections of the sales practices rules 
where non-professional persons are acting on behalf of natural persons, but where such 
professional persons are not regulated financial services industry professionals retained by 
natural persons to exercise independent professional judgment.
339
 
In addition, we are proposing to specify in the sales practices rules that, although the 
rules would apply to transactions by broker-dealers and investment advisers for retail investors—
including those investors who have existing accounts before the rules’ compliance date—the 
sales practices rules would not apply to a position in a leveraged/inverse investment vehicle 
established before the rules’ compliance date. This provision is designed to allow existing 
investors in leveraged/inverse investment vehicles with open investments as of the rules’ 
compliance date to sell their holdings (or to purchase leveraged/inverse investment vehicles to 
close out short positions in the leveraged/inverse investment vehicle) without the additional steps 
we propose to require for their broker-dealer or investment adviser to determine whether to 
approve the retail investor’s account to trade in these products.
340
 Absent this provision, the sales 
                                                      
337
  See, e.g., Form CRS Relationship Summary, Exchange Act Release No. 34-86032 (June 5, 2019) 
[84 FR 33492 (July 12, 2019)] (“Form CRS Release”), at n.629 and accompanying text. 
338
  See Form CRS Release, supra note 337, at nn.645-647 and accompanying text (clarifying 
interpretation of “legal representative” of a natural person to cover only non-professional legal 
representatives (e.g., a non-professional trustee that represents the assets of a natural person and 
similar representatives such as executors, conservators, and persons holding a power of attorney 
for a natural person)); Regulation Best Interest: The Broker-Dealer Standard of Conduct, supra 
note 315, at n.237 and accompanying text (defining “retail customer”). 
339
  See Form CRS Release, supra note 337, at nn.645-647 and accompanying text. 
340
  This provision is designed to allow a retail investor to exit a legacy position in a 
leveraged/inverse investment vehicle, as discussed above, and does not reflect any view on 
whether any recommendation for these legacy positions was suitable when made.  

191 
practices rules could prevent or delay a retail investor’s ability to close or reduce a position in a 
leveraged/inverse investment vehicle that he or she entered into before firms were required to 
comply with the rules. 
We also do not believe it would be appropriate to apply the sales practices rules only to 
retail accounts established after the rules’ compliance date, because the investor protection 
concerns underlying the rules would apply equally to pre-existing retail investor accounts. 
Accordingly, the proposed rules would make clear that, even if a retail investor had already been 
trading leveraged/inverse investment vehicles, a firm would have to satisfy the due diligence and 
account approval requirements for that investor’s account before the investor could make 
additional investments in leveraged/inverse investment vehicles.
341
 
The proposed sales practices rules also would require firms to adopt and implement 
written policies and procedures addressing compliance with the applicable sales practices rule.
342
 
We are not proposing to impose specific requirements for these policies and procedures, 
provided that they are reasonably designed to achieve compliance with the applicable sales 
practices rule, including the due diligence and account approval requirements. This requirement, 
together with the proposed recordkeeping requirements discussed below, is designed to provide 
comparable policies and procedures and recordkeeping requirements for both broker-dealers and 
investment advisers.  
We request comment on the proposed approval and due diligence requirements for 
approving retail investors’ accounts to trade in shares of leveraged/inverse investment vehicles. 
                                                      
341
  As discussed above, this evaluation would take into account, among other things, the investor’s 
experience with leveraged/inverse investment vehicles. See, e.g., proposed rules 211(h)-1(b)(2) 
and 15l-2(b)(2). 
342
  See proposed rule 15l-2(a); proposed rule 211(h)-1(a). 

192 
 Is modeling these rules on FINRA’s options rule the appropriate approach? Why or 
why not?  
 Should the proposed sales practices rules apply to Commission-registered broker-
dealers and investment advisers? Why or why not? What challenges, if any, would 
broker-dealers or investment advisers face complying with the proposed rules, and 
what compliance burdens would the proposed rules create for broker-dealers and 
investment advisers? Would compliance burdens be substantially different for 
investment advisers than for broker-dealers (for example, because of any compliance 
efficiencies that might result to the extent broker-dealers are already complying with 
FINRA’s rules for approving options accounts), or vice versa? Should we apply 
proposed Advisers Act rule 211(h)  -1 to investment advisers that are registered with 
one or more states but not registered with the Commission? Why or why not? Should 
the proposed rule for investment advisers apply equally to advisers with discretionary 
authority and with non-discretionary authority over client accounts? If the sales 
practices rule for investment advisers applies to both discretionary and non-
discretionary advisory accounts, should we apply different due diligence and account 
approval requirements based on whether an account is discretionary or non-
discretionary? Should the proposed sales practices rules apply to investment advisers, 
in light of their fiduciary duties to their clients? Why or why not? Should the sales 
practices rules apply to a broker-dealer if the broker-dealer does not effect 
transactions in leveraged investment vehicles for retail investors other than 
transactions resulting from recommendations that are subject to Regulation Best 
Interest? Why or why not? 

193 
 Should the proposed rules apply to transactions in leveraged/inverse investment 
vehicles that are directed by a retail investor without any recommendation or advice 
from a broker-dealer or investment adviser? Why or why not? 
 Should the proposed rules apply on a transaction-by-transaction basis rather than 
requiring an initial account approval to transact in leveraged/inverse investment 
vehicles? Why or why not? 
 As proposed, the sales practices rules would require that a firm could provide account 
approval only if the firm has a reasonable basis for believing that the investor has 
such knowledge and experience in financial matters that he or she may reasonably be 
expected to be capable of evaluating the risks of buying and selling leveraged/inverse 
investment vehicles. Is this account approval standard appropriate? Why or why not? 
If not, what should the account approval standard be? Should it be tied instead, for 
example, to an investor’s ability to absorb losses, and if so how should a firm assess 
this? 
 Is the investor information that the proposed rules would require firms to seek to 
obtain under the rules’ due diligence requirements appropriate, and would this 
information effectively assist in forming a reasonable basis for assessing the 
investor’s knowledge and experience in financial matters as required under the 
proposed account approval standard? Why or why not? What modifications, if any, 
should we make to the information items that the proposed rules would require a firm 
to seek to obtain? Are there any information items that we should remove from the 
proposed list, or any additional information items that we should include? For 
example, instead of tracking generally the information elements set forth under 

194 
FINRA’s option rule, should the proposed rules track generally the information set 
forth in the definition of “retail customer investment profile” under Regulation Best 
Interest (i.e .,  “age, other investments, financial situation and needs, tax status, 
investment objectives, investment experience, investment time horizon, liquidity 
needs, risk tolerance, and any other information the retail customer may disclose to 
the broker, dealer, or a natural person who is an associated person of a broker or 
dealer”)? As proposed, should the rules require firms to seek to obtain the percentage 
of the investments that the retail investor intends to invest in leveraged/inverse 
investment vehicles? Why or why not? 
 Should the sales practices rules require firms to obtain the specified information, 
rather than to seek to obtain it? Would a firm be able to form a reasonable basis for 
believing that a retail investor has such knowledge and experience in financial matters 
that he or she may reasonably be expected to be capable of evaluating the risks of 
buying and selling leveraged/inverse investment vehicles if the retail investor 
provides some, but not all, of the information specified in the sales practices rules? 
 What special procedures, if any, do firms currently undertake in permitting or not 
permitting retail investors to trade in leveraged/inverse investment vehicles? At 
account opening? With respect to specific transactions? With respect to concentration 
limits? Do firms already have approval processes in place designed to evaluate 
whether their retail investors are reasonably expected to be capable of evaluating the 
risks of buying and selling leveraged/inverse investment vehicles? If so, do firms 
distinguish between types of vehicles or trading strategies? Do these practices differ 
between broker-dealers and investment advisers? If so, please explain the differences.  

195 
 What special procedures, if any, do firms currently undertake in permitting or not 
permitting retail investors to trade in other types of complex products? Please explain 
in detail, including products to which such procedures apply and what the approval 
process entails. 
 The proposed sales practices rules would require that firms’ approvals of retail 
investors’ accounts for buying or selling shares of leveraged/inverse investment 
vehicles be in writing. The proposed rules would not require account disapprovals to 
be in writing. Should we require account disapprovals also to be in writing? Would 
such a requirement raise any practical concerns, or other concerns, for firms? In other 
investor approval contexts, do firms currently put both their approvals and 
disapprovals in writing? 
 How do broker-dealers apply the options eligibility requirement with respect to 
clients of investment advisers, if at all, when those advisers submit orders on behalf 
of their clients? Do broker-dealer practices differ with respect to orders submitted by 
other types of intermediaries? Please explain.  
 How do broker-dealers currently analyze the information they collect under FINRA 
rule 2360? Which data elements do broker-dealers find most important and which 
elements are less important? What standards do broker-dealers apply in determining 
whether to approve a customer’s account on the basis of the information collected?  
 Should the proposed rules require firms to provide specific disclosure as part of the 
approval process, similar to the options disclosure document that must be provided 
under FINRA rule 2360? If so, what information should it contain? Should the rules 
require that receipt of such disclosure be acknowledged? 

196 
 Should the rules require firms to provide retail investors a short, plain-English 
disclosure generally describing the risks associated with leveraged/inverse investment 
vehicles as part of the proposed account approval process? For example, before a firm 
approves a retail investor’s account for buying and selling shares of a 
leveraged/inverse investment vehicle, should the rules require a firm to incorporate 
and distill into a short disclosure the specific risk factors associated with 
leveraged/inverse investment vehicles ( such as the risks related to compounding and 
other risks that leveraged/inverse funds disclose in their prospectuses)? 
 Should the rules apply to all customers or clients, and not just natural persons? 
Should they apply to a different subset of customers or clients and, if so, which ones 
and why? If the rule were to apply to all customers or clients, including institutional 
accounts, what changes should we make to the information that firms must collect or 
to the basis upon which a firm would approve or disapprove the account? Are there 
distinctions between institutional investors and natural persons that invest in 
leveraged/inverse investment vehicles that we should consider? For example, do 
commenters have data or information on the percentage of leveraged investment 
vehicles’ investors who are natural persons, and how natural persons use these 
investment products (e.g., how long do these investors hold the products)?  
 As discussed above, we understand that certain purchases or sales of 
leveraged/inverse investment vehicles do not involve a customer or client of a broker-
dealer or investment adviser that would be subject to the proposed sales practices 

197 
rules.
343
 Should the proposed rules apply to these transactions? For example, should 
the proposed sales practices rule for broker-dealers apply to a mutual fund principal 
underwriter’s transactions with any retail investor who is purchasing fund shares 
directly from the fund? 
 Should the sales practices rules include different account-approval conditions for 
different types of leveraged/inverse investment vehicles? For example, should the 
rules include different conditions for investment vehicles that seek to exceed the 
performance of a market index by a specified multiple, versus those that provide 
returns that have an inverse relationship to the performance of a market index? 
Should the rules include different levels of account approval, such as heightened 
requirements for investors to transact in leveraged/inverse investment vehicles with 
higher leverage multiples or that invest in more volatile asset classes? Similarly, 
should the rules include different levels of account-approval conditions based on a 
retail investor’s trading experience and financial sophistication? 
 Do commenters agree that we should apply the sales practices rules to all retail 
investors, including those who have opened accounts with an investment adviser or 
broker-dealer before the rules’ compliance date? Should the sales practices rules 
include exceptions from the due diligence and account approval requirements for 
retail investors that have already traded in leveraged/inverse investment vehicles as of 
the rules’ compliance date? Should the sales practices rules provide exceptions for 
retail investors who meet established criteria, such as retail investors who are 
accredited investors? Why or why not? 
                                                      
343
  See supra note 322. 

198 
 The proposed rules also would not apply to, and therefore would not restrict a retail 
investor’s ability to close or reduce, a position in a leveraged/inverse investment 
vehicle established before the rules’ compliance date. Do commenters agree that this 
is appropriate? Are there modifications we should make to the rules so that they 
would not impede an investor’s ability to close or reduce an existing position in a 
leveraged/inverse investment vehicle? Which modifications and why? Alternatively, 
should the sales practices rules apply to retail investors with positions in 
leveraged/inverse investment vehicles established before the rules’ compliance date 
even if they do not seek to make additional purchases or sales of leveraged 
investment vehicles? If so, how would firms comply, in practice, with the due 
diligence and account approval requirements for these investors? 
 Do commenters agree with the proposed policies and procedures requirement? Should 
the rule provide specific requirements for firms’ policies and procedures relating to 
compliance with the sales practices rules? 
c. Recordkeeping 
Under the proposed sales practices rules, a firm would have to maintain a written record 
of the investor information that it obtained under the rules’ due diligence requirements, the 
firm’s written approval of the retail investor’s account for buying and selling shares of 
leveraged/inverse investment vehicles, and the versions of the firm’s policies and procedures that 
it adopted under the proposed rules that were in place when it approved or disapproved the 
account. We propose that firms be required to retain these records for a period of not less than 
six years (the first two years in an easily accessible place) after the date of the closing of the 

199 
investor’s account.
344
 We believe that it is appropriate for the proposed rules to include a 
recordkeeping provision to facilitate compliance,  and regulatory oversight of a firm’s 
compliance, with the rules. Also, because an investor account that was approved to trade in 
leveraged/inverse investment vehicles could remain open with a firm for more than six years, we 
believe it is appropriate to require that records be preserved for a minimum of six years after the 
closing of the account, rather than six years after the creation of the records.
345
 We believe that 
this recordkeeping requirement would provide sufficient investor protection and, because it is 
generally consistent with recordkeeping requirements for broker-dealers and investment advisers, 
would not impose overly burdensome recordkeeping costs.
346
  
We request comment on the recordkeeping requirement in the proposed sales practices 
rules: 
 Is the proposed recordkeeping requirement appropriate? Why or why not?  
 What changes, if any, should we make to this proposed requirement (e.g., by 
modifying the types of records that a firm would have to keep)? 
 Does our proposal to apply the same recordkeeping requirement to both broker-
                                                      
344
  See proposed rules 15l-2(c) and 211(h)-1(c). 
345
  This is consistent with other Commission recordkeeping requirements relating to investor account 
documentation. See, e.g., rule 17a-4(c) under the Exchange Act (requiring broker-dealers to 
preserve for a period of not less than six years after the closing of any customer’s account any 
account cards or records relating to the terms and conditions with respect to the opening and 
maintenance of the account).  
346
  See, e.g., id.; see also rule 204-2(e)(1) under the Investment Advisers Act (requiring investment 
advisers to preserve certain records in an easily accessible place for a period of not less than five 
years from the end of the fiscal year during which the last entry was made on such record, the 
first two years in an appropriate office of the investment adviser). While we recognize that our 
existing recordkeeping requirements generally require broker-dealers to preserve records for six 
years and investment advisers for five years, we believe it would be appropriate for the 
recordkeeping requirements under the proposed sales practices rule to be consistent, in part 
because many broker-dealers and investment advisers are dual-registered, and thus are proposing 
a six-year period for both rules. 

200 
dealers and investment advisers raise any specific recordkeeping concerns for either 
broker-dealers or investment advisers (e.g., do investment advisers believe it would 
be particularly burdensome to comply with a six-year recordkeeping period)? Should 
the proposed rules include different requirements for broker-dealers and investment 
advisers? 
 Is the proposed duration of the recordkeeping provision, including the proposed 
requirement that the records be maintained for a minimum of six years after the 
closing of the investor’s account, appropriate? Does using the closing of the 
investor’s account as the starting point for the recordkeeping period raise any 
practical difficulties for firms? Should we lengthen or shorten the required 
recordkeeping periods? Why or why not? 
3. Alternative Provision for Leveraged/Inverse Funds Under 
Proposed Rule 18f-4 
Under proposed rule 18f-4, a fund would not have to comply with the proposed VaR-
based leverage risk limit if it: (1) meets the definition of a “leveraged/inverse investment 
vehicle” in the proposed sales practices rules; (  2) limits the investment results it seeks to 300% 
of the return (or inverse of the return) of the underlying index; and (3)   discloses in its prospectus 
that it is not subject to proposed rule 18f-4’s limit on fund leverage risk. We refer to this set of 
proposed conditions collectively as the “alternative provision for l everaged/inverse funds.” A 
leveraged/inverse fund that satisfies these conditions still would be required to satisfy all of the 
additional conditions in proposed rule 18f-4 other than the VaR tests, including the proposed 

201 
conditions requiring a derivatives risk management program, board oversight and reporting, and 
recordkeeping.
347
  
First, the alternative provision for leveraged/inverse funds requires that a 
leveraged/inverse fund be a “leveraged/inverse investment vehicle” as defined in the proposed 
sales practices rules.
348
 As discussed above, the proposed sales practices rules are designed to 
help ensure that investors in leveraged/inverse investment vehicles are limited to those who are 
capable of evaluating their general characteristics and the unique risks they present.  
Second, the alternative provision for leveraged/inverse funds would limit a 
leveraged/inverse fund’s market exposure by providing that the fund must not seek or obtain, 
directly or indirectly, investment results exceeding 300% of the return (or inverse of the return) 
of the underlying index.
349
 This limitation reflects the highest leverage level currently permitted 
by our exemptive orders for leveraged/inverse ETFs.
350
 It therefore reflects the maximum 
amount of leverage in these funds with which investors and other market participants are 
familiar. To permit leveraged/inverse funds to use a higher level of leverage would heighten the 
investor protection concerns these funds present, notwithstanding their more limited investor 
base.
351
 Moreover, allowing leveraged/inverse funds to increase their leverage beyond current 
levels would result in a non-linear increase in the extent of leveraged/inverse funds’ rebalancing 
activity, which may have adverse effects on the markets for the constituent securities as 
                                                      
347
  See proposed rule18f-4(c)(1), (5)-(6). 
348
  See proposed rule 18f-4(c)(4)(i); proposed rules 15l-2(d) and 211(h)-1(d) (defining the term 
“leveraged/inverse investment vehicle”). 
349
  See proposed rule 18f-4(c)(4)(iii). 
350
  See ETFs Adopting Release, supra note 76, at n.75 and accompanying text. 
351
  See also section III.C.5. 

202 
discussed in more detail in sections III.D.1 and III.E.4. For these reasons, and because the 
Commission does not have experience with leveraged/inverse funds that seek returns above 
300% of the return (or inverse of the return) of the underlying index, we are not proposing to 
permit higher levels of leveraged market exposure for leveraged/inverse funds in this rule.
 
 
Third, the alternative provision for leveraged/inverse funds would require a 
leveraged/inverse fund to disclose in its prospectus that it is not subject to the condition of 
proposed rule 18f-4 limiting fund leverage risk.
352
 This requirement is designed to provide 
investors and the market with information to clarify that leveraged/inverse funds—which as 
discussed above, use derivatives extensively—are not subject to rule 18f-4’s limit on fund 
leverage risk. 
We request comment on the proposed alternative provision for leveraged/inverse funds. 
 Should the rule include an alternative set of requirements for leveraged/inverse 
funds? Should leveraged/inverse funds instead be required to meet the proposed 
requirements for all funds that use derivatives, including the VaR-based limit on fund 
leverage risk? If commenters agree that we should permit leveraged/inverse ETFs to 
rely on rule 18f-4 based on an alternative set of requirements, are there additional 
conditions—either relating to these funds’ derivatives risk management or 
otherwise—that we should consider requiring those funds to satisfy? To what extent 
would additional limitations or restrictions on leveraged investment vehicles’ 
advertising or marketing materials help to address the investor protection concerns 
discussed above? 
 Does our proposal to include within the scope of the rule only leveraged/inverse 
                                                      
352
  See proposed rule 18f-4(c)(4)(ii). 

203 
funds that are covered by the proposed sales practices rules, along with the conditions 
comprising the alternative provision for leveraged/inverse funds, address the investor 
protection concerns related to leveraged/inverse funds? 
 If leveraged/inverse funds operate pursuant to the proposed alternative provision, 
should they nonetheless be subject to other requirements in the proposed rule (e.g., 
the proposed risk management program requirement, board oversight and reporting 
requirement, and recordkeeping requirement)?  
 Should leveraged/inverse funds relying on the alternative provision be required to 
disclose in their prospectuses that the fund is not subject to the proposed VaR-based 
limit on fund leverage risk, as proposed? If so, what would be the most appropriate 
method of disclosure? In addition to requiring this disclosure under rule 18f-4, should 
we also include this requirement in Form N-1A? Would it aid practitioners for a 
leveraged/inverse fund’s registration form to specify this requirement? 
 Should a leveraged/inverse fund relying on rule 18f-4 be required to limit the 
investment results it seeks or obtains to 300% of the return (or inverse of the return) 
of the underlying index? Would some other threshold be more appropriate? Should 
the threshold be higher, such as 400%, or lower, such as 150% or 200%? 
 Any registered investment company that operates as a leveraged/inverse fund would 
be eligible to comply with the proposed alternative provision for leveraged/inverse 
funds in rule 18f-4. Should we limit the scope of leveraged/inverse funds eligible for 
this provision to open-end funds, including ETFs?  

204 
4. Proposed Amendments to Rule 6c-11 under the Investment 
Company Act and Proposed Rescission of Exemptive Relief for 
Leveraged/Inverse ETFs  
Earlier this year, the Commission adopted rule 6c-11, which permits ETFs that satisfy 
certain conditions to operate without obtaining an exemptive order from the Commission.
353
 
Rule 6c-11 includes a provision excluding leveraged/inverse ETFs from the scope of ETFs that 
may rely on that rule.
354
 Leveraged/inverse ETFs, therefore, continue to rely on their 
Commission exemptive orders. In adopting rule 6c-11, the Commission stated that the particular 
section 18 concerns raised by leveraged/inverse ETFs’ use of derivatives distinguish those funds 
from the other ETFs permitted to rely on that rule, and that those section 18 concerns would be 
more appropriately addressed in a rulemaking addressing the use of derivatives by funds more 
broadly.
355
 The Commission further stated that leveraged/inverse ETFs are similar in structure 
and operation to the other types of ETFs that are within the scope of rule 6c-11.
356
 The rules we 
are proposing, rule 18f-4 under the Investment Company Act and the sales practices rules under 
the Exchange Act and the Advisers Act, would create an updated and more comprehensive 
regulatory framework for the use of derivatives by funds, including provisions specifically 
applicable to leveraged/inverse ETFs. Accordingly, we propose to amend rule 6c-11 to remove 
the provision excluding leveraged/inverse ETFs from the scope of that rule one year following 
the publication of the final amendments in the Federal Register. 
                                                      
353
  See ETFs Adopting Release, supra note 76. 
354
  See rule 6c-11(c)(4). 
355
  See ETFs Adopting Release, supra note 76, at nn.72-75 and accompanying text.  
356
  See id. at text following n.86. In addition, one sponsor of leveraged/inverse ETFs has stated that 
its ETFs would prefer to rely on rule 6c-11 over their exemptive orders and that leveraged/inverse 
ETFs would be able to comply with rule 6c-11 because they are structured and operated in the 
same manner as other ETFs that fall within the scope of that rule. See id. at n.83 and 
accompanying text. 

205 
In addition, because the proposed amendments to rule 6c-11 would permit 
leveraged/inverse ETFs to rely on that rule rather than their exemptive orders, we are proposing 
to rescind the exemptive orders we have previously issued to leveraged/inverse ETFs. The 
exemptive relief granted to leveraged/inverse ETFs has resulted in an uneven playing field 
among market participants because the Commission has permitted only three ETF sponsors to 
operate leveraged/inverse ETFs and has not granted any exemptive relief for leveraged/inverse 
ETFs since 2009.
357
 We believe that amending rule 6c-11 and rescinding these exemptive orders 
would promote a more level playing field and greater competition by allowing any sponsor to 
form and launch a leveraged/inverse ETF subject to the conditions in rules 6c-11 and proposed 
rule 18f-4, with transactions in the funds subject to the proposed sales practices rules. We 
propose to rescind these exemptive orders on the effective date of the proposed amendments to 
rule 6c-11 (one year following the publication of the final rule amendments in the Federal 
Register), to coincide with the compliance date for the sales practices rules and to allow time for 
broker-dealers and investment advisers to make any adjustments necessary to comply with the 
proposed sales practices rules. Providing a  one-year period for existing leveraged/inverse ETFs 
also would provide time for them to prepare to comply with rule 6c-11 rather than their 
exemptive orders.
358
  
                                                      
357
  There are currently two ETF sponsors that rely upon this exemptive relief today. See supra note 
308 and accompanying text; infra note 474 and accompanying text. We also discuss below in 
section III.E alternative approaches for leveraged/inverse funds, including an approach under 
which the Commission would rescind the exemptive orders issued to leveraged/inverse ETF 
sponsors, permit leveraged/inverse funds to operate under rule 6c-11, but require 
leveraged/inverse funds to comply with rule 18f-4’s VaR-based limit on fund leverage risk in lieu 
of adopting the proposed sales practices rules.  
358
  See ETFs Adopting Release, supra note 76, at text following n.451. 

206 
We request comment on the proposed amendments to rule 6c-11 and rescission of 
leveraged/inverse ETF exemptive orders. 
 If leveraged/inverse funds are permitted to rely on rule 18f-4, should the Commission 
amend rule 6c-11 to permit leveraged/inverse funds to operate under that rule, as 
proposed? Do the requirements of proposed rule 18f-4, together with the proposed 
sales practices rules, adequately address the section 18 concerns relating to 
leveraged/inverse funds? Are there are other concerns regarding leveraged/inverse 
funds that we should consider in determining whether to allow s uch funds to rely on 
rule 6c-11? 
 In addition, do commenters agree with our proposal to rescind the existing 
leveraged/inverse ETF exemptive relief in view of our proposed treatment of 
leveraged/inverse funds under rule 18f-4 and proposed amendments to rule 6c-11? 
Are there other approaches to the existing leveraged/inverse ETF exemptive relief 
that we should consider in view of proposed rule 18f-4 and the proposed sales 
practices rules? 
H. Amendments to Fund Reporting Requirements 
We are proposing amendments to the reporting requirements for funds that would rely on 
proposed rule 18f-4—in particular, amendments to Forms N-PORT, N-LIQUID (which we 
propose to re-title as “Form N-RN”), and N -CEN.
359
 T hese proposed amendments are designed 
to enhance the Commission’s ability to oversee funds’ use of and compliance with the proposed 
rules effectively, and for the Commission and the public to have greater insight into the impact 
                                                      
359
  17 CFR 274.150; 17 CFR 274.223; and 17 CFR 249.330 and 17 CFR 274.101. 

207 
that funds’ use of derivatives would have on their portfolios.
360
 They would allow the 
Commission and others to identify and monitor industry trends, as well as risks associated with 
funds’ investments in derivatives (including by requiring current, non-public reporting to the 
Commission when certain significant events related to a fund’s leverage risk occur). The 
proposed amendments also would aid the Commission in evaluating the activities of investment 
companies in order to better carry out its regulatory functions.  
                                                      
360
  The funds that would rely on proposed rule 18f-4 other than BDCs generally are subject to 
reporting requirements on Form N-PORT. All registered management investment companies, 
other than registered money market funds and small business investment companies, are (or will 
be) required to electronically file with the Commission, on a quarterly basis, monthly portfolio 
investment information on Form N-PORT, as of the end of each month. See Investment Company 
Reporting Modernization Adopting Release, supra note 179. As of April 30, 2019, larger fund 
groups (defined as having $1 billion or more in net assets) have begun submitting reports on 
Form N -PORT for the period ending March 31, 2019. Smaller fund groups (less than $1 billion in 
net assets) will begin submitting reports on Form N-PORT by April 30, 2020. See Investment 
Company Reporting Modernization, Investment Company Act Release No. 32936 (Dec. 8, 2017) 
[82 FR 58731 (Dec. 14, 2017)]. Only information reported for the third month of each fund’s 
fiscal quarter on Form N-PORT will be publicly available (60 days after the end of the fiscal 
quarter). See Amendments to the Timing Requirements for Filing Reports on Form N-PORT, 
Investment Company Act Release No. 33384 (Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)].  
 Currently, only open-end funds that are not regulated as money market funds under rule 2a-7 
under the Investment Company Act are required to file current reports on Form N-LIQUID, under 
section 30(b) of the Investment Company Act and rule 30b1-10 under the Act. See Investment 
Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 
(Oct. 13, 2016) [81 FR 82142 (Nov. 18, 2016)], at section III.L.2 (“Liquidity Adopting Release”). 
Our proposal, including proposed amendments to Form N-LIQUID, rule 30b1-10 and proposed 
rule 18f-4(c)(7), would add new VaR-related items to the form, and would extend the requirement 
to file current reports with respect to these new items to any fund (including registered open-end 
funds, registered closed-end funds, and BDCs) that relies on rule 18f-4 and that is subject to the 
rule’s limit on leverage risk.  
The funds that would rely on proposed rule 18f-4 other than BDCs generally are subject to 
reporting requirements on Form N-CEN. Specifically, all registered investment companies, 
including money market funds but excluding face amount certificate companies, are currently 
required to file annual reports on Form N-CEN. See Investment Company Reporting 
Modernization Adopting Release, supra note 179. Form N-CEN requires these funds to report 
census-type information including reports on whether a fund relied upon certain enumerated rules 
under the Investment Company Act during the reporting period. See, e.g., Item C.7 of Form N-
CEN.  

208 
1. Amendments to Form N-PORT 
We are proposing to amend Form N-PORT to add new items to Part B (“Information 
About the Fund”), as well as to make certain amendments to the form’s General Instructions.  
a. Derivatives Exposure 
We are proposing to amend Form N-PORT to include a new reporting item on funds’ 
derivatives exposure.
361
 A fund would be required to provide its derivatives exposure as of the 
end of the reporting period.
362
 This information would be publicly available for the third month 
of each fund’s quarter and would provide market-wide insight into the levels of funds’ 
derivatives exposure to the Commission, its staff, and market participants.
363
 It also would allow 
                                                      
361
  See proposed Item B.9 of Form N-PORT; see also proposed amendments to General Instruction E 
to Form N-PORT (adding a new definition for “derivatives exposure,”  as defined in proposed rule 
18f-4(a),which would permit a fund to convert the notional amounts of interest rate derivatives to 
10-year bond equivalents and delta adjust the notional amounts of options contracts).  
362
  See proposed Item B.9 of Form N-PORT. Just as the proposed definition of “derivatives 
transaction” in rule 18f-4 includes derivatives instruments as well as short sale borrowings, Form 
N-PORT would require a fund to report exposure associated with derivatives instruments and 
short sales. 
The proposed requirement to report derivatives exposure at the end of the reporting period 
reflects the form’s requirement to report information about funds’ portfolio holdings as of the last 
business day, or last calendar day, of each month. See General Instruction A to Form N-PORT. 
While we are proposing that funds report their highest daily VaR and median daily VaR during 
the reporting period (see infra section II.H.1.b), we are not also proposing that funds report their 
highest daily derivatives exposure (or median daily derivatives exposure) during the reporting 
period. This is because proposed rule 18f-4 requires daily calculation of a fund’s VaR but does 
not require a fund to calculate its derivatives exposure daily.  
363
  We are not proposing to amend General Instruction F to Form N-PORT, which specifies the 
information that funds report on Form N-PORT that the Commission does not make publicly 
available. 
 While the information for the first two months of a fund’s quarter would be non-public, the 
information for the third month of a fund’s quarter would be publicly available. See supra note 
360. 

209 
the Commission and its staff to oversee and monitor compliance with the proposed rule’s 
exception for limited derivatives users.
364
 
We seek comment on the Commission’s proposed amendments to Form N-PORT 
requiring reporting of derivatives exposure: 
 Is the proposed requirement that funds report their derivatives exposure on 
Form N -PORT appropriate? Why or why not? Should we modify the proposed 
derivatives exposure reporting item in any way? If so, how should we modify this 
reporting item?  
 Our proposal would make public the information that a fund would report in response 
to the new derivatives exposure Form N-PORT item. Is there any reason why this 
information should not be publicly available?  
 Should we require this reporting only from certain funds—for example, those that 
qualify either as limited derivatives users or leveraged/inverse funds under proposed 
rule 18f-4—during the reporting period?  
 Should we require funds to report metrics tied to their daily notional amount 
calculation on Form N-PORT (for example, a fund’s highest daily derivatives 
exposure during the reporting period and the date of its highest exposure, and its 
median daily derivatives exposure during the reporting period)? Should we only 
require funds to report these types of metrics if we were also to modify proposed rule 
18f-4 to require funds to calculate their notional amounts daily? Would this type of 
reporting requirement help to mitigate any potential “window dressing” concerns 
                                                      
364
  Under this proposal, a fund would have to indicate whether it is a limited derivatives user on 
Form N-CEN. See infra section II.H.3. 

210 
about funds’ reporting of their derivatives exposure, and/or provide additional 
beneficial transparency with respect to any particular type of funds (for example, 
leveraged/inverse funds)? If so, would these benefits outweigh related costs?  
b. VaR Information 
We are also proposing to amend Form N-PORT to include a new reporting item related to 
the proposed VaR tests.
365
 Information that a fund would report under this new reporting item 
would be made public for the third month of each fund’s quarter.
366
 The proposed item would 
apply to funds that were subject to the proposed VaR-based limit on fund leverage risk during 
the reporting period.  
Funds that are subject to the new VaR-related N-PORT item would have to report their 
highest daily VaR during the reporting period and its corresponding date, as well as their median 
daily VaR for the monthly reporting period.
367
 Funds subject to the relative VaR test during the 
reporting period would report the name of the fund’s designated reference index, and index 
identifier.
368
 These funds also would have to report the fund’s highest daily VaR ratio (that is, 
the value of the fund’s portfolio VaR divided by the VaR of the designated reference index) 
                                                      
365
  See proposed Item B.10 of Form N-PORT. Proposed item B.10 would require that a fund provide 
the applicable VaR information in accordance with proposed rule 18f-4(c)(2)(ii), which requires a 
fund to determine compliance with its applicable VaR test at least once each business day. 
366
 See supra note 363. While the information for the first two months of a fund’s quarter would be 
non-public, the information for the third month of a fund’s quarter would be publicly available. 
See supra note 360. 
367
  See proposed Items B.10.a.-c of Form N-PORT. The proposed form amendments would require 
each of the reported metrics to be determined in accordance with the requirement under proposed 
rule 18f-4 to determine the fund’s compliance with the applicable VaR test at least once each 
business day. 
368
  See proposed Item B.10.d.i.-ii of Form N-PORT. 

211 
during the reporting period and its corresponding date, as well as the fund’s median daily VaR 
ratio for the reporting period.
369
  
The proposed requirement for a fund to report highest daily VaR (and, for a fund that is 
subject to the relative VaR test, information about the fund’s VaR ratio) is designed to help 
assess compliance with the proposed rule. These requirements, and the proposed requirement for 
a fund to report its median daily VaR (and, for a fund that is subject to the relative VaR test, the 
median VaR ratio) are designed to help identify changes in a fund’s VaR over time, and to help 
identify trends involving a single fund or group of funds regarding their VaRs. The proposed 
requirement that a fund report information about its designated reference index is designed to 
help analyze whether funds are using designated reference indexes that meet the rule’s 
requirements, and also to assess any trends in the designated reference indexes that funds select.  
A fund also would have to report the number of exceptions the fund identified during the 
reporting period arising from backtesting the fund’s VaR calculation model.
370
 This proposed 
requirement is  designed to help analyze whether a fund’s VaR model is effectively taking into 
account and incorporating all significant, identifiable market risk factors associated with a fund’s 
investments, as required by the proposed rule.
371
 This information would assist in monitoring for 
compliance with the proposed VaR tests and also would provide high-level information to 
market participants, as well as researchers and analysts, to help evaluate the extent to which 
                                                      
369
 See proposed Item B.10.d.iii.-v of Form N-PORT.  
370
  See proposed Item B.10.e of Form N-PORT; see also supra section II.B.3.d (discussing proposed 
backtesting requirement); ICI Comment Letter II (discussing UCITS funds being similarly 
required to report to their primary regulator, on a semi-annual basis, the number of VaR breaks 
that exceed a specified threshold (a VaR break occurs when the actual one-day loss exceeds that 
day’s VaR), and recommending the Commission require funds to report the number of VaR 
breaks and the dates on which they occurred).  
371
  See supra note 151.  

212 
funds’ VaR models, used as part of the proposed VaR tests, are operating effectively. Because 
this information would be made publicly available on a delayed basis, and would not provide 
details about backtesting exceptions other than the number of exceptions, we do not believe that 
this proposed reporting requirement would produce adverse effects such that the reported 
information should be made non-public.
372
  
We seek comment on the Commission’s proposed amendments to Form N-PORT 
requiring reporting of VaR information: 
 Are the proposed requirements that funds report VaR information on Form N-PORT, 
and each of the elements that a fund would have to report under this requirement, 
appropriate? Why or why not? Should we modify the proposed VaR information 
reporting item in any way? If so, how should we modify this reporting item? 
 Our proposal would make public all of the information that a fund would report in 
response to the new VaR information item on Form N-PORT. Is there any reason 
why this information should not be publicly available? For example, would making 
this information public lead to harm arising from investor confusion, adverse 
competitive effects, or for any other reason? If we require that this reported 
information be made public, is there additional information we should require funds 
to report to provide contextualization or mitigate any adverse effects that could arise 
from public disclosure? Should we make non-public some of these disclosures (e.g., 
portfolio VaR or a fund’s designated reference index, or information about 
                                                      
372
  See supra notes 363, 366. But see infra section II.H.2 (discussing adverse effects that might arise 
from the real-time public reporting of a fund’s VaR test breaches under the proposed amendments 
to Form N-LIQUID).  
Information reported for the third month of each fund’s fiscal quarter on Form N-PORT will be 
made publicly available 60 days after the end of the fiscal quarter. See supra note 360. 

213 
backtesting results) but not others? If so, which ones should we make non-public and 
why?  
 Would any of the proposed N-PORT reporting requirements be more appropriately 
structured as Form N-CEN reporting requirements, or items to be reported on a 
current basis on Form N-RN? 
 Is there any additional information related to funds’ derivatives exposure or 
derivatives risk management that we should require funds to report on Form N-
PORT? What information and why, and should this reported information be made 
public?  
2. Amendments to Current Reporting Requirements 
We are also proposing current reporting requirements for funds that are relying on 
proposed rule 18f-4. We are proposing to re-title Form N-LIQUID as Form N-RN and to amend 
this form to include new reporting events for funds that are subject to the proposed VaR-based 
limit on fund leverage risk.
373
 These funds would be required to determine their compliance with 
the applicable VaR test on at least a daily basis.
374
 We are proposing to require these funds to file 
Form N-RN to report information about VaR test breaches under certain circumstances. 
Proposed rule 18f-4 would require a fund that has determined that it is not in compliance with 
the applicable VaR test to come back into compliance promptly and within no more than three 
business days after such determination.
375
 We are therefore proposing that a fund that determines 
that it is out of compliance with the VaR test and has not come back into compliance within three 
                                                      
373
     See proposed Parts E -G of Form N-RN. 
374
     See supra section II.D; see also proposed rule 18f-4(c)(2). 
375
     See supra section II.D.5.b. 

214 
business days after such determination would file a report on Form N-RN providing certain 
information regarding its VaR test breaches.
376
  
If the portfolio VaR of a fund subject to the relative VaR test were to exceed 150% of the 
VaR of its designated reference index for three business days, we are proposing to require that 
such a fund report: (1) the dates on which the fund portfolio’s VaR exceeded 150% of the VaR 
of its designated reference index; (2) the VaR of its portfolio for each of these days; (3)   the VaR 
of its designated reference index for each of these days; (4) the name of the designated reference 
index; and (5) the index identifier.
377
 A fund would have to report this information within one 
business day following the third business day after the fund has determined that its portfolio VaR 
exceeds 150% of its designated reference index VaR.
378
 Such a fund also would have to file a 
report on Form N-RN when it is back in compliance with the relative VaR test.
379
 
If the portfolio VaR of a fund subject to the absolute VaR test were to exceed 15% of the 
value of the fund’s net assets for three business days, we are proposing to require that such a 
fund report: (1) the dates the on which the fund portfolio’s VaR exceeded 15% of the value of its 
net assets; (2) the VaR of its portfolio for each of these days; and (3) the value of the fund’s net 
                                                      
376
     See proposed Parts E and F of Form N-RN. 
377
     See proposed Part E of Form N-RN. 
378
  For example, if the fund were to determine, on the evening of Monday, June 1, that its portfolio 
VaR exceeded 150% of the fund’s designated reference index VaR, and this exceedance were to 
persist through Tuesday (June 2), Wednesday (June 3), and Thursday (June 4), the fund would 
file Form N-RN on Friday, June 5 (because 3 business days following the determination on June 
1 is June 4, and 1 business day following June 4 is June 5). If the exceedance were to still persist 
on June 5 (the date that the fund would file Form N-RN), the fund’s report on Form N-RN would 
provide the required information elements for June 1, 2, 3, 4, and 5. 
379
  See proposed Part G of Form N-RN. The report would include the dates on which the fund was 
not in compliance with the VaR test, and the current VaR of the fund’s portfolio on the date the 
fund files the report. See also proposed rule 18f-4(c)(2)(iii) (providing that a fund must meet 
specific requirements to be back in compliance). 

215 
assets for each of these days.
380
 A fund would have to report this information within one 
business day following the third business day that the fund determined that its portfolio VaR 
exceeds 15% of the value of its net assets. Such a fund also would have to file a report on Form 
N-RN when it is back in compliance with the absolute VaR test.
381
 
The data points, collectively, would aid the Commission in assessing funds’ compliance 
with the VaR tests. In addition, the information would provide staff the ability to assess how long 
a fund is precluded from entering into derivatives transactions as a consequence of its lack of 
compliance with its VaR test.  
Currently, only registered open-end funds (excluding money market funds) are required 
to file reports on Form N-LIQUID.
382
 We are proposing to amend this form, as well as rule 
30b1-10 under the Investment Company Act, to reflect the proposed 18f-4 requirement that all 
funds that are subject to the relative VaR test or absolute VaR test file current reports regarding 
VaR test breaches under the circumstances that Form N-RN specifies.
383
 The scope of funds that 
would be subject to the new VaR test breach current reporting requirements would thus include 
registered open-end funds as well as registered closed-end funds and BDCs. In addition to 
                                                      
380
  See proposed Part F of Form N-RN. 
381
     See supra note 379.  
382
  See General Instruction A.(1) to Form N-LIQUID; see also rule 30b1-10 [17 CFR 270.30b1-10]. 
383
  See proposed Form N-RN; see also proposed amendments to rule 30b1-10 under the Investment 
Company Act, and proposed rule 18f-4(c)(7) (requiring a fund that experiences an event specified 
in the parts of Form N-RN titled “Relative VaR Test Breaches,” “Absolute VaR Test Breaches,” 
or “Compliance with VaR Test” to file with the Commission a report on Form N-RN within the 
period and according to the instructions specified in that form).  

216 
extending the scope of funds required to respond to Form N-LIQUID, we are proposing to 
amend the general instructions to the form to reflect the expanded scope and application.
384
 
We are proposing to require funds to provide this information in a current report because 
we believe that the Commission should be notified promptly when a fund is out of compliance 
with the proposed VaR-based limit on fund leverage risk, which in turn we believe could indicate 
that a fund is experiencing heightened risks as a result of the fund’s use of derivatives 
transactions. VaR test breaches could indicate that a fund is using derivatives transactions to 
leverage the fund’s portfolio, magnifying its potential for losses and significant payments of fund 
assets to derivatives counterparties. Such breaches also could indicate market events that are 
drivers of potential derivatives risks or other risks across the fund industry. Either of these 
scenarios—increased fund-specific risks, or market events that affect funds’ risks broadly—may, 
depending on the facts and circumstances, require attention by the Commission. The proposed 
current reporting requirement is designed to provide the Commission current information 
regarding potential increased risks and stress events (as opposed to a requirement to report the 
same or similar information later, for example on Form N-PORT).
385
 The one-business-day time-
frame for submitting a report on Form N-RN regarding a fund’s VaR test breaches is designed to 
provide an appropriately early notification to the Commission of potential heightened risks, 
                                                      
384
  See, e.g., proposed General Instruction A.(1) to Form N-RN (amending the defined term 
“registrant”); proposed General Instruction A.(2) to Form N-RN (amending the submission 
requirement to clarify application to the new VaR-test-breach-related items); proposed General 
Instruction A.(3) to Form N-RN (clarifying that only open-end funds required to comply with rule 
22e-4 under the Investment Company Act would be required to respond to events occurring in 
Parts B – D, as applicable, while funds required to comply with the limit on fund leverage risk in 
proposed rule 18f-4 would be required to respond to events specified in proposed Parts E-G, as 
applicable); and proposed General Instruction F to Form N-RN (clarifying that the terms used in 
proposed Parts E-G, unless otherwise specified, would have the same meaning as the terms in 
proposed rule 18f-4). 
385
  See supra section II.H.1.b. 

217 
while at the same time providing sufficient time for a fund to compile and file its report on Form 
N-RN. This time-frame is also consistent with the current required timing for reporting other 
events on Form N-LIQUID.
386
  
We are cognizant that certain adverse effects might arise from real-time public reporting 
of a fund’s VaR test breaches. For example, publicly disclosing this information could lead to 
investor confusion. Investors might mistakenly assume that a fund that breached the applicable 
VaR test actually had suffered substantial losses or that substantial losses necessarily were 
imminent. Investors might also believe that a fund’s failing the VaR test suggests a sudden 
increase in fund risk when, in some cases, a fund can fail a VaR test—and especially an absolute 
VaR test—due to changes in market volatility generally. Investors also might believe that a 
fund’s real-time reporting of a VaR test breach necessarily meant that the fund was not 
complying with applicable regulations. Information about VaR breaches would therefore provide 
important information to the Commission and its staff for regulatory purposes but could confuse 
investors and lead them and other market participants to make incorrect assumptions about a  
fund’s relative riskiness. This could have potential adverse effects for funds if investors redeem 
or sell fund shares as a result. Other market participants also could react to real-time reporting of 
VaR breaches in ways that could adversely affect funds. For example, if market participants 
knew on a real-time basis that a fund had breached the applicable VaR test, market participants 
might seek to anticipate the trading activity the fund might undertake to come back into 
compliance and engage in predatory trading that could adversely affect the fund. Accordingly, 
we are proposing to make funds’ reports on Form N-RN regarding VaR test breaches (like their 
reports on this form regarding liquidity-related items) non-public, because we preliminarily 
                                                      
386
     See General Instruction A of Form N-LIQUID. 

218 
believe that public disclosure of this information is neither necessary nor appropriate in the 
public interest or for the protection of investors.
387
 
We seek comment on the Commission’s proposed amendments to Form N-LIQUID 
requiring reporting of certain information regarding a fund’s VaR test breaches: 
 Is the proposed new current reporting requirement for funds that are subject to the 
VaR-based limit on fund leverage risk appropriate? Why or why not? If not, how 
should the scope of the proposed current reporting requirement be modified? Should 
we require additional current reporting requirements for funds to report other 
derivatives-risk-related information? For example, should funds that are limited 
derivatives users pursuant to the proposed exposure-based exception be required to 
file current reports if their derivatives exposure were to exceed 10% of their net 
assets?
388 
Should we require a fund to file a current report if it identifies a certain 
number of exceptions as a result of backtesting its VaR calculation model, and if so, 
what circumstances should trigger the requirement to file a current report?
389 
 
 Is each of the pieces of information that we propose a fund would include in a report 
about a VaR test breach on proposed Form N-RN appropriate? Why or why not? 
Should we modify the required information in any way?  
 For a fund that is out of compliance with the VaR test, and is unable to come back 
                                                      
387
  See proposed General Instruction A.(1) to Form N-RN; see also section 45(a) of the Investment 
Company Act (requiring information in reports filed with the Commission pursuant to the 
Investment Company Act to be made available to the public, unless we find that public disclosure 
is neither necessary nor appropriate in the public interest or for the protection of investors). 
388
     See supra section II.E.1. 
389
  See supra section II.B.3.d (discussing backtesting requirements in proposed rule 18f-4); see also 
supra section II.H.1.b (discussing proposed requirement to report backtesting results on Form N-
PORT). 

219 
into compliance within three business days after its initial determination, the proposed 
current reporting requirement would require that fund to file a report on Form N-RN 
providing certain information regarding its VaR test breaches. Is the proposed three-
business-day current reporting requirement appropriate? Why or why not? Should the 
rule require a shorter or longer period, such as one or seven days, before prompting a 
current reporting requirement? Which time period would be appropriate and why? 
 We are proposing that a fund’s reports regarding VaR test breaches on Form N-RN 
would not be made public. Would there be a benefit to publicly reporting this 
information, and would it be appropriate to make these disclosures public? Why or 
why not? Should we make public some of these disclosures but not others? If so, 
which ones should we make public and why?  
 As an alternative or an addition to the proposed current reporting requirement, should 
we require funds to report information regarding VaR test breaches on Form N-
PORT? Why or why not? If so, should we make public this information reported on 
Form N-PORT?  
 Should we modify the proposed current reporting requirement to require reporting by 
certain types of funds and not others? If so which types of funds, and why? For 
example, should we require BDCs also to report the information that we are 
proposing them to report on Form N-RN on Form 8-K? Why or why not?  
 As an alternative to amending Form N-LIQUID to require current reporting on VaR 
test breaches, should we provide a new, separate current reporting form for funds to 
use to report VaR test breaches (and/or any other current reporting items relating to 
their derivatives risk management programs under proposed rule 18f-4)? Why or why 

220 
not? 
3. Amendments to Form N-CEN 
Form N-CEN currently includes an item that requires a fund to indicate—in a manner 
similar to “checking a box”—whether the fund has relied on certain Investment Company Act 
rules during the reporting period.
390
 We are proposing amendments to this item to require a fund 
to identify whether it relied on proposed rule 18f-4 during the reporting period.
391
 We are also 
proposing amendments to require a fund to identify whether it relied on any of the exceptions 
from various requirements under the proposed rule, specifically: 
• Whether the fund is a limited derivatives user excepted from the proposed rule’s 
program requirement, under either the proposed exception for funds that limit 
their derivatives exposure to 10% of their net assets or under the exception for 
funds that limit their derivatives use to certain currency hedging;
392
 or 
• Whether the fund is a leveraged/inverse fund covered by the proposed sales 
practices rules that, under proposed rule 18f-4, would be excepted from the 
proposed limit on fund leverage risk.
393
  
Finally, a fund would have to identify whether it has entered into reverse repurchase agreements 
or similar financing transactions, or unfunded commitment agreements, as provided under the 
proposed rule.
394
 T his information would assist the Commission and staff with our oversight 
functions by allowing us to identify which funds were excepted from certain of the proposed 
                                                      
390
     See Item C.7 of Form N-CEN. 
391
     See proposed Item C.7.l of Form N-CEN.  
392
     See proposed Item C.7.l.i.-ii of Form N-CEN; see also supra section II.E. 
393
  See proposed Item C.7.l.iii of Form N-CEN; see also supra section II.G. 
394
  See proposed Item C.7.l.iv-v of Form N-CEN; see also infra sections II.I and II.J. 

221 
rule’s provisions or relied on the rule’s provisions regarding reverse repurchase agreements and 
unfunded commitment agreements. 
We seek comment on the Commission’s proposed amendments to Form N-CEN: 
 Should we require, as proposed, that funds identify that they relied on rule 18f-4, 
including whether they are limited derivatives users that are excepted from the 
proposed program requirement? Why or why not?  
 Should we require, as proposed, that funds identify that they are leveraged/inverse 
funds that are excepted from the proposed limit on fund leverage risk? Why or why 
not?  
 Should we require, as proposed, that funds identify that they entered into reverse 
repurchase agreements or similar financing transactions, or unfunded commitment 
agreements? Why or why not?  
 Are there other means that funds use to disclose or report information (e.g., 
prospectus or annual report disclosure in addition to the other disclosure requirements 
in this proposal) that would be more appropriate for reporting any of the information 
that the proposed amendments to Form N-CEN would require? Should any of the 
disclosures required in the proposed amendments to Form N-PORT above be made 
on Form N-CEN? Why or why not? 
4. BDC Reporting 
BDCs do not file reports on Form N-CEN or Form N-PORT. We considered proposing to 
require that BDCs provide the new information that we propose registered funds report on 
Form N -CEN, and the new information regarding derivatives exposure and VaR that we propose 

222 
to require funds to report on Form N-PORT, in their annual reports on Form 10-K. BDCs, 
however, generally do not enter into derivatives transactions or do so to a limited extent.
395
 We 
therefore believe that most BDCs that enter into derivatives transactions would qualify for the 
limited derivatives user exception (which would make the proposed VaR reporting items on 
Form N-PORT inapplicable to BDCs). In addition, and as noted above, we understand that even 
when BDCs do use derivatives more extensively, derivatives generally do not play as significant 
of a role in implementing the BDC’s strategy, as compared to many other types of funds that use 
derivatives extensively. BDCs are required under the Investment Company Act to invest at least 
70% of their total assets in “eligible portfolio companies,” which may limit the role that 
derivatives can play in a BDC’s portfolio relative to other kinds of funds that would generally 
execute their strategies primarily through derivatives transactions (e.g. a managed futures fund). 
BDCs that would not qualify as limited derivatives users under the proposed rule also would be 
subject to the proposed new requirement to file current reports regarding VaR test breaches on 
Form N-RN.
396
 Taking these factors into account, we are not proposing additional reporting 
requirements for BDCs because we believe that the reporting framework we are proposing for 
BDCs adequately addresses the Commission’s ability to monitor BDCs’ compliance with the 
proposed rules, as well as any competitive disparities that could result from disparate reporting 
requirements among funds that rely on proposed rule 18f-4.
397
 
                                                      
395
     See supra section II.D.2.b. 
396
  See supra section II.H.2.  
397
  We have separately proposed to require BDCs to tag their financial statements using Inline 
XBRL, a structured, machine-readable format, which would provide structured data about BDCs’ 
derivatives and other investments. See Securities Offering Reform Proposing Release, supra note 
200, at section II.H.1. In addition, BDCs are currently required to disclose certain information 
about their exposures to market risks, including risks that may arise as a result of their 
derivatives-related activity. See, e.g., Items 303 and 305 of Regulation S-K [17 CFR 229.303 and 
 

223 
We seek comment on the Commission’s proposal to not require BDCs to report on Forms 
N-PORT or N -CEN: 
 Should we require BDCs to report any of the same information on Form 10-K (or 
elsewhere, such as in a BDC’s prospectus) that we are proposing to require registered 
investment companies to report on Forms N-CEN and N-PORT? Why or why not? 
Should we require, for example, that a BDC report its derivatives exposure, whether it 
is a limited derivatives user, and/or its designated reference index (if applicable)? If 
so, where? If a BDC uses derivatives and does not qualify as a limited derivatives 
user, should it have to report information about its derivatives exposure and portfolio 
VaR on Form N-PORT (or elsewhere)? 
 Should we require BDCs to report on Form 10-K or elsewhere whether they have 
relied on the rule’s provision regarding reverse repurchase agreements and similar 
financing transactions or unfunded commitment agreements? 
I. Reverse Repurchase Agreements 
Funds may engage in certain transactions that may involve senior securities primarily as a 
means of obtaining financing. For example, open-end funds are permitted to borrow money from 
a bank, provided they maintain a 300% asset coverage ratio.
398
 Another common method of 
obtaining financing is through the use of reverse repurchase agreements. In a reverse repurchase 
agreement, a fund transfers a security to another party in return for a percentage of the value of 
                                                      
229.305]. 
 See also infra section III.D.2 (discussing, among other things, potential competitive effects 
resulting from BDCs not being subject to the proposed additional reporting requirements on Form 
N-PORT and Form N-CEN). 
398
  See section 18(f)(1) of the Investment Company Act.  

224 
the security. At an agreed-upon future date, the fund repurchases the transferred security by 
paying an amount equal to the proceeds of the initial sale transaction plus interest.
399
 A reverse 
repurchase agreement is economically equivalent to a secured borrowing.
400
  
We believe that reverse repurchase agreements and other similar financing transactions 
that have the effect of allowing a fund to obtain additional cash that can be used for investment 
purposes or to finance fund assets should be treated for section 18 purposes like a bank 
borrowing or other borrowing, as they achieve effectively identical results. Accordingly, we are 
proposing that a fund may engage in reverse repurchase agreements and other similar financing 
transactions so long as they are subject to the relevant asset coverage requirements of 
section 18.
401
 For example, this would have the effect of permitting an open-end fund to obtain 
financing by borrowing from a bank, engaging in a reverse repurchase agreement, or any 
combination thereof, so long as all sources of financing are included when calculating the fund’s 
asset coverage ratio.
402
  
                                                      
399
  See Release 10666, supra note 15, at “Reverse Repurchase Agreements” discussion (stating that a 
reverse repurchase agreement may not have an agreed-upon repurchase date, and in that case the 
agreement would be treated as if it were reestablished each day). 
400
  See, e.g., Office of Financial Research, Reference Guide to U.S. Repo and Securities Lending 
Markets (Sept. 9, 2015), available at https://www.financialresearch.gov/working-
papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-
Markets.pdf.  
401
  Proposed rule 18f-4(d). Among other things, section 18 prescribes the required amount of asset 
coverage for a fund’s senior securities and provides certain consequences for a fund that fails to 
maintain this amount. See, e.g., section 18(a) (restrictions on dividend issuance). This provision 
in rule 18f-4 would not provide any exemptions from the requirements of section 61 for BDCs 
because that section does not limit a BDC’s ability to engage in reverse repurchase or similar 
transactions in parity with other senior security transactions permitted under that section.  
402
  Section 18 states that certain borrowings that are made for temporary purposes (less than 60 days) 
and that do not exceed 5% of the total assets of the issuer at the time when the loan is made 
(temporary loans) are not senior securities for purposes of certain paragraphs in section 18. As we 
noted in Release 10666, reverse repurchase agreements and similar financing transactions could 
be designed to appear to fall within the temporary loans exception, and then could be “rolled-
 

225 
Reverse repurchase agreements and similar financing transactions are not treated as 
derivatives transactions under the proposed rule because they have the economic effects of a 
secured borrowing, and thus more closely resemble bank borrowings with a known repayment 
obligation rather than the more-uncertain payment obligations of many derivatives. However, 
such transactions can have the effect of introducing leverage into a fund’s portfolio if the fund 
were to use the proceeds of the financing transaction to purchase additional investments. In 
addition, such transactions impose a requirement to return assets at the termination of the 
agreement, which can raise section 18 asset sufficiency concerns to the extent the fund needs to 
sell less-liquid securities at a loss to obtain the necessary assets.  
Reverse repurchase agreements and similar financing transactions would not be included 
in calculating a fund’s derivatives exposure under the limited derivatives user provisions of the 
proposed rule. However, if a fund did not qualify as a limited derivatives user due to its other 
investment activity, any portfolio leveraging effect of reverse repurchase agreements or similar 
financing transactions would be included and restricted through the proposed VaR-based limit on 
fund leverage risk. This is because the proposed VaR tests estimate a fund’s risk of loss taking 
into account all of its investments, including the proceeds of reverse repurchase agreements and 
similar investments the fund purchased with those proceeds.  
Securities lending arrangements are structurally similar to reverse repurchase agreements 
in that, in both cases, a fund transfers a portfolio security to a counterparty in exchange for cash 
(or other assets). Although these arrangements are structurally similar, under our proposal we 
                                                      
over,” perhaps indefinitely, with such short-term transactions being entered into, closed out, and 
later re-entered. If substantially similar financing arrangements were being “rolled over” in any 
manner for a total period of 60 days or more, we would treat the later transactions as renewals of 
the earlier ones, and all such transactions would fall outside the exclusion for temporary loans. 

226 
would not view a fund’s obligation to return securities lending collateral as a “similar financing 
transaction” in the circumstances discussed below. In the 2015 Proposing Release, we sought 
comment on whether rule 18f-4 should address funds’ compliance with section 18 in connection 
with securities lending.
403
 Commenters stated that the staff’s current guidance on securities 
lending forms the basis for funds’ securities lending practices and effectively addresses the 
senior securities implications of securities lending, and thus securities lending practices need not 
be addressed in the final rule.
404
  
Currently, funds that engage in securities lending typically reinvest cash collateral in 
highly liquid, short-term investments, such as money market funds or other cash or cash 
equivalents, and funds generally do not sell or otherwise use non-cash collateral to leverage the 
fund’s portfolio.
405
 We believe a fund that engages in securities lending under these 
circumstances is limited in its ability to use securities lending transactions to increase leverage in 
its portfolio. Accordingly, the proposed rule does not treat a fund’s obligation to return securities 
lending collateral as a financing transaction similar to a reverse repurchase agreement, so long as 
                                                      
403
  2015 Proposing Release, supra note 2, at paragraph accompanying n.149. 
404
  See, e.g., ICI Comment Letter I; Guggenheim Comment Letter; SIFMA Comment Letter; 
Comment Letter of the Risk Management Association (Mar. 28, 2016). Staff guidance on 
Securities Lending by U.S. Open-End and Closed-End Investment Companies (Feb. 27, 2014), 
available at https://www.sec.gov/divisions/investment/securities-lending-open-closed-end-
investment-companies.htm (providing guidance on certain no-action letters that funds consider 
when engaging in securities lending and summarizing areas those letters address, including 
limitations on the amount that may be lent and collateralization for such loans).  
405
  See ICI, Securities Lending by Mutual Funds, ETFs, and Closed-End Funds: The Basics (Sept. 
14, 2014), available at https://www.ici.org/viewpoints/view_14_sec_lending_01 (“[T]he 
collateral that funds can accept from borrowers must be highly liquid, such as cash, government 
securities, or bank letters of credit. U.S. regulated funds typically demand cash collateral. ... In 
practice, U.S. regulated funds most often invest cash collateral in money market funds.”); 
SIFMA, Master Securities Lending Agreement, section 4.2 (2000), available at 
https://www.sifma.org/wp-content/uploads/2017/08/MSLA_Master-Securities-Loan-Agreement-
2000-Version.pdf (generally limiting lenders from re-hypothecating non-cash collateral).  

227 
the obligation relates to an agreement under which a fund engages in securities lending, the fund 
does not sell or otherwise use non-cash collateral received for loaned securities to leverage the 
fund’s portfolio, and the fund invests cash collateral solely in cash or cash equivalents. If a fund 
were to engage in securities lending and to invest the cash collateral in securities other than cash 
or cash equivalents, this may result in leveraging of the fund’s portfolio, and we believe this 
activity would be a “similar financing transaction” and should thus be included when calculating 
a funds asset coverage ratio.  
We believe that a fund’s obligation with respect to a “tender option bond” (“TOB”) 
financing may be similar to a reverse repurchase agreement in some circumstances. One 
commenter on the 2015 proposal explained that TOB financings are economically similar to 
reverse repurchase agreements because a fund employing a TOB trust has in effect used the 
underlying bond as collateral to secure a borrowing analogous to a fund’s use of a security to 
secure a reverse repurchase agreement.
406
 We believe that determining whether a TOB is a 
similar financing transaction as a reverse repurchase agreement would depend on the facts and 
circumstances. To the extent a fund concludes that there are economic similarities between a 
TOB financing and a reverse repurchase agreement, the fund should treat obligations with 
respect to the TOB financing as a similar financing transaction under the proposed rule.  
We request comment on our proposed approach to reverse repurchase agreements and 
similar financing transactions under the proposed rule.  
 As proposed, should we treat reverse repurchase agreements and similar financing 
transactions as economically equivalent to bank borrowings under section 18, and 
subject them to the same asset coverage requirements? Why or why not?  
                                                      
406
     See SIFMA Comment Letter.  

228 
 Should we not combine reverse repurchase agreements with bank borrowing and 
other senior securities under the provision, and instead treat them separately but with 
the same limit? For example, should we allow a fund to borrow from a bank subject 
to the 300% asset coverage limit and also separately use reverse repurchase 
agreements up to a 300% asset coverage limit?  
 Should we instead treat such reverse repurchase agreements and similar financing 
transactions as derivatives transactions under the proposed rule? Would this have any 
disparate effects on certain types of funds?  
 Is there a way to distinguish reverse repurchase agreements and similar financing 
transactions that funds use to leverage their portfolios from instances in which funds 
use those transactions for other purposes? If so, should we treat such transactions 
engaged in for leveraging purposes differently than transactions engaged in for other 
purposes?  
 Should we include securities lending transactions as a similar financing transaction 
(regardless of how the proceeds are invested) under the proposed provision? Why or 
why not? Should we define in rule 18f-4 the circumstances under which securities 
lending would not be treated as a similar financing transaction?  
 Are there other types of transactions that we should identify and treat as similar 
financing transactions to reverse repurchase agreements that we have not identified 
above? What are they and why should they be treated accordingly?  

229 
J. Unfunded Commitment Agreements 
Under unfunded commitment agreements, a fund commits, conditionally or 
unconditionally, to make a loan to a company or to invest equity in a company in the future.
407
 
They include capital commitments to a private fund requiring investors to fund capital 
contributions or to purchase shares upon delivery of a drawdown notice. The proposed rule 
would therefore define an unfunded commitment agreement to mean a contract that is not a 
derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a 
loan to a company or to invest equity in a company in the future, including by making a capital 
commitment to a private fund that can be drawn at the discretion of the fund’s general partner.
408
 
The Commission’s 2015 proposal would have treated these agreements as “financial 
commitment transactions.” As a result, a fund’s obligations under the agreements could not 
exceed the fund’s net asset value.
409
 Commenters on the 2015 proposal identified characteristics 
of these agreements that they believed distinguished unfunded commitments from the derivatives 
transactions and financial commitment transactions covered by that proposal, which are also 
covered by re-proposed rule 18f-4.
410
 First, commenters stated that a fund often does not expect 
                                                      
407
  We understand that the types of funds that enter into unfunded commitment agreements typically 
include BDCs and registered closed-end funds. 
408
  Proposed rule 18f-4(a). 
409
  See 2015 proposed rule 18f-4(c)(4) (defining “financial commitment transactions”); 2015 
proposed rule 18f-4(b) (permitting funds to engage in financial commitment transactions if the 
fund maintains qualifying coverage assets with a value equal to at least the fund’s aggregate 
financial commitment obligations); 2015 proposed rule 18f-4(c)(5) (defining a fund’s “financial 
commitment obligations,” in part, to mean “the amount of cash or other assets that the fund is 
conditionally or unconditionally obligated to pay or deliver under a financial commitment 
transaction). 
410
  Specifically, these commenters generally compared unfunded commitment agreements to firm 
and standby commitment agreements (which we would in turn interpret the phrase “or any similar 
instrument” in proposed rule 18f-4’s definition of “derivatives transaction” to include, see supra 
note 91 and accompanying paragraph). See, e.g., Letter of Ares Capital Corporation (Mar. 28, 
 

230 
to lend or invest up to the full amount committed. Second, commenters stated that a fund’s 
obligation to lend is commonly subject to conditions, such as a borrower’s obligation to meet 
certain financial metrics and performance benchmarks, which are not typically present under the 
types of agreements that the Commission described in Release 10666.
411
 C ommenters also 
asserted that unfunded commitment agreements do not give rise to the risks that Release 10666 
identified and do not have a leveraging effect on the fund’s portfolio because they do not present 
an opportunity for the fund to realize gains or losses between the date of the fund’s commitment 
and its subsequent investment when the other party to the agreement calls the commitment.
412
 
These commenters contrasted firm and standby commitment agreements, under which a fund 
commits itself to purchase a  security with a stated price and fixed yield without condition or 
                                                      
2016) (“Ares Comment Letter”); Comment Letter of the Small Business Investor Alliance (Mar. 
28, 2016) (“SBIA Comment Letter”); Comment Letter of the Center for Capital Markets 
Competitiveness, U.S. Chamber of Commerce (Mar. 28, 2016); Comment Letter of Skadden, 
Arps, Slate, Meagher & Flom LLP (Mar. 28, 2016) (“Skadden Comment Letter”); Dechert 
Comment Letter; Private Equity Growth Capital Council (Mar. 28, 2016) (“PEGCC Comment 
Letter”).  
411
  See, e.g., SBIA Comment Letter; Comment Letter of Hercules Capital (Mar. 29, 2016); see also, 
e.g., Skadden Comment Letter (contingent loan commitments typically have “funding conditions 
that excuse the BDC from funding if the borrower does not continue to satisfy various 
representations, financial and non-financial metrics and performance conditions .   . . [and] cannot 
result in substantial risk of loss prior to funding because the BDC is not required to fund the loan 
if the borrower’s credit or financial position degenerates meaningfully.”).  
412
  See, e.g., PEGCC Comment Letter (distinguishing the agreements that Release 10666 discusses 
because, while the value of the fund’s limited partnership interest may fluctuate based on the 
amount of capital it invests in the private fund, the fund has no profit or loss on the unfunded 
commitment); Ares Comment Letter (stating that, in general, unfunded loan commitments do not 
reflect a bet on interest rate movements because the yields for unfunded loan commitments are 
determined as a spread over a prevailing market interest rate); see also Altegris Comment Letter 
(explaining that unfunded commitment agreements do not have a potential for “pyramiding” 
because—in contrast to a reverse repurchase agreement—a fund “receives nothing from the 
underlying private equity funds in return for its capital commitments and, as a result, its gross 
assets remain unchanged.”).  

231 
upon the counterparty’s demand.
413
 They argued that the firm and standby commitment 
agreements that Release 10666 describes expose the fund to investment risk during the life of the 
transaction, because the value of the fund’s commitment agreement will change as interest rates 
change.  
We agree that these factors distinguish unfunded commitment agreements from the 
derivatives transactions covered by proposed rule 18f-4. The derivatives transactions covered by 
proposed rule 18f-4—including the firm and standby commitment agreements the Commission 
described in Release 10666—expose the fund to investment risk during the life of the transaction. 
Derivatives transactions therefore can be used to leverage a fund’s portfolio by enabling a fund 
to magnify its gains and losses compared to the fund’s investment, while also obligating the fund 
to make a payment to a counterparty. Based on the characteristics of unfunded commitment 
agreements commenters described, which we understand are typical of these agreements, we do 
not believe that such unfunded commitment agreements are undertaken to leverage a fund’s 
portfolio. For example, if the yield for an unfunded loan commitment is determined as a spread 
over a prevailing market interest rate, the agreement creates a risk that the fund would not have 
liquid assets to fund the loan, but the agreement would not reflect a speculative position on the 
direction of interest rates.
414
 We therefore do not believe that such unfunded commitment 
                                                      
413
  See, e.g., SBIA Comment Letter; see also Altegris Comment Letter; Ares Comment Letter; 
Comment Letter of Dechert (Feb. 7, 2016); Skadden Comment Letter.  
414
  Cf. Release 10666, supra note 15, at n.12 (“Commitments to purchase securities whose yields are 
determined on the date of delivery with reference to prevailing market interest rates are not 
intended to be included in this general statement of policy. Such commitments neither create nor 
shift the risk associated with interest rate changes in the marketplace, and in economic reality 
have no discernible potential for leverage.”). 

232 
agreements generally raise the Investment Company Act’s concerns regarding the risks of undue 
speculation.
415
  
Depending on the facts and circumstances, however, an unfunded commitment agreement 
could raise the asset sufficiency concerns underlying the Investment Company Act.
416
 A fund 
could be required to liquidate other assets to obtain the cash needed to satisfy its obligation under 
an unfunded commitment agreement if the fund did not have cash on hand to meet its obligation 
to provide a committed loan or make a committed equity investment. If the fund is unable to 
meet its obligations, the fund would be subject to default remedies available to its counterparty. 
For example, if a fund fails to fulfill its commitments to invest in a private fund when called to 
do so, the fund could be subject to the remedies specified in the limited partnership agreement 
(or similar document) relating to that private fund. These remedies can have the practical effect 
of forfeiture of some or all of the fund’s investment in the private fund.
417
 In these and other 
circumstances a fund’s investors could be harmed if the fund is unable to meet its obligations 
under an unfunded commitment agreement.  
Because unfunded commitment agreements can raise the asset sufficiency concern 
underlying section 18, but generally do not raise the undue speculation concern associated with 
derivatives transactions (and reverse repurchase agreements and similar financing transactions), 
we are proposing to permit a fund to enter into unfunded commitment agreements if it 
                                                      
415
     See supra notes 45-47 and accompanying text. 
416
     See id. 
417
  See, e.g., Phyllis A. Schwartz & Stephanie R. Breslow, Private Equity Funds: Formation and 
Operation (June 2015 ed.), at 2-34 (remedies private equity funds may apply in event of investor 
default include, among other things, the right to charge high interest on late payments, the right to 
force a sale of the defaulting investor’s interest, the right to continue to charge losses and 
expenses to defaulting investors while cutting off their interest in future profits, and the right to 
take any other action permitted at law or in equity).  

233 
reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash 
and cash equivalents to meet its obligations with respect to all of its unfunded commitment 
agreements, in each case as they come due.
418
 While a fund should consider its unique facts and 
circumstances to have such a reasonable belief, the proposed rule would prescribe certain 
specific factors that a fund must take into account.
419
  
First, the proposed rule would require a fund to take into account its reasonable 
expectations with respect to other obligations (including any obligation with respect to senior 
securities or redemptions). This is because other obligations can place competing demands on 
cash a fund otherwise might intend to use to fund an unfunded commitment agreement. Second, 
the proposed rule would provide that a fund may not take into account cash that may become 
available from the sale or disposition of any investment at a price that deviates significantly from 
the market value of those investments. This provision is designed to address the risk that a fund 
could suffer losses by selling assets to raise cash to fund an unfunded commitment agreement, 
ultimately having an adverse impact on the fund’s investors. Finally, the proposed rule would 
provide that a fund may not consider cash that may become available from issuing additional 
equity. Whether a fund would be able to raise capital in the future and the amount of any 
additional capital would depend on a variety of factors, including future market conditions, that 
we believe are too speculative to support a fund’s reasonable belief that it could fund an 
                                                      
418
  See proposed rule 18f-4(e)(1). Because this proposed condition is designed to provide an 
approach tailored to unfunded commitment agreements, the proposed rule would also provide that 
these transactions would not be considered for purposes of computing asset coverage under 
section 18(h). As with our approach to derivatives transactions, applying section 18(h) asset 
coverage to these transactions appears unnecessary in light of the tailored requirement we are 
proposing. See supra note 66. 
419
  The proposed rule would also require the fund to make and maintain records documenting the 
basis for this belief. See proposed rule 18f-4(e)(2); see also infra section II.K. 

234 
unfunded commitment with the proceeds from future sales of the fund’s securities. The proposed 
rule would not preclude a fund from considering the issuance of debt to support a reasonable 
belief that it could fund an unfunded commitment, as we understand that funds often satisfy their 
obligations under unfunded commitments through borrowings. Moreover, such borrowings by 
funds would be limited by section 18’s asset coverage requirements, which would limit the 
extent to which a fund’s belief regarding its ability to borrow would allow the fund to enter into 
unfunded commitment agreements.  
To have a reasonable belief, a fund therefore could consider, for example, its strategy, its 
assets’ liquidity, its borrowing capacity under existing committed lines of credit, and the 
contractual provisions of its unfunded commitment agreements. A fund with unfunded loan 
commitments, for instance, could evaluate the likelihood that different potential borrowers would 
meet contractual “milestones” that the borrowers would have to satisfy as a condition to the 
obligation to fund a loan, as well as the amount of the anticipated borrowing. The fund’s 
historical experience with comparable obligations should inform this analysis. Whether a fund 
has a reasonable belief also could be informed by a fund’s assessment of the likeliness that 
subsequent developments could impair the fund’s ability to have sufficient cash and cash 
equivalents to meet its unfunded commitment obligations. 
This proposed approach for unfunded commitment agreements reflects the staff’s 
experience in reviewing and commenting on fund registration statements, which have disclosure 
regarding the funds’ unfunded commitments. These funds have generally represented, in 
substance, that they reasonably believe that their assets will provide adequate cover to allow 
them to satisfy all of their unfunded investment commitments, without taking into account any 

235 
projected securities offerings. In their responses to staff comments, funds also have provided a 
general explanation as to the process by which they reached this reasonable belief.  
Finally, the proposed rule would provide that an agreement that meets the rule’s 
definition of a derivatives transaction is not an unfunded commitment.
420
 This is because the 
proposed rule’s treatment of unfunded commitments is predicated on these agreements having 
characteristics that distinguish them from the derivatives transactions covered by the proposed 
rule, as discussed above. Because the proposed definition of the term “derivatives transaction” 
includes any instrument that is similar to certain listed derivatives instruments, a contract that is 
functionally similar to a listed derivatives instrument would be a derivatives transaction and 
therefore would not qualify for the proposed rule’s treatment of unfunded commitment 
agreements.
421
 For example, a fund that enters into a binding commitment to make a loan or 
purchase a note upon demand by the borrower, with stated principal and term and a fixed interest 
rate, would appear to have entered into an agreement that is similar to a standby commitment 
agreement or a written put option.
422
 This transaction would expose the fund to investment risk 
during the life of the transaction because the value of the fund’s commitment agreement will 
change as interest rates change. Such an agreement thus would fall within the proposed rule’s 
definition of “derivatives transaction” and would not be an unfunded commitment agreement 
under the proposed rule.  
We request comment on our proposed approach to unfunded commitment agreements.  
 Are unfunded commitment agreements distinguishable from derivatives transactions? 
                                                      
420
     See proposed rule 18f-4(a) (defining the term “unfunded commitment agreement”).  
421
     See supra section II.A (discussing proposed definition of “derivatives transaction”). 
422
  See supra paragraph accompanying notes 409-413 (discussing factors distinguishing unfunded 
commitment agreements from the derivatives transactions covered by proposed rule 18f-4). 

236 
Can funds use unfunded commitment agreements for speculation or to accomplish 
leveraging? If so, how? What types of funds enter into unfunded commitment 
agreements, and for what purposes? 
 Does funds’ use of unfunded commitment agreements raise the undue speculation 
and/or the assets sufficiency concerns underlying section 18 of the Investment 
Company Act? Why or why not? 
 Is the proposed approach to unfunded commitment agreements appropriate? Would 
the proposed approach appropriately address any asset sufficiency concerns that 
funds’ use of unfunded commitment agreements might entail? Why or why not? 
 Is the proposed requirement that a fund must have a “reasonable belief” regarding its 
ability to meet its unfunded commitment obligations, at the time it enters into an 
unfunded commitment agreement, appropriate? Should the rule instead, or also, 
require a fund to reassess whether this belief remains reasonable at various points 
during the period of the unfunded commitment agreement? 
 Are the rule’s provisions regarding the factors that a fund must consider in 
determining whether it has the required “reasonable belief” appropriate? Why or why 
not? Are they sufficiently clear? Should we specify other factors that a fund could 
consider? Should the rule provide, for example, that a fund may consider potential 
borrowings only to the extent the fund has committed lines of credit or other 
committed borrowing capacity? If so, how should we define “committed” for this 
purpose? 
 Under the proposed rule,  a fund’s reasonable belief that it has sufficient cash to 
satisfy its unfunded commitments may not be based on cash that may become 

237 
available from issuing additional equity. Do commenters agree that a fund’s ability to 
raise capital in the future, and the amount of any such additional capital, are based on 
factors that are too speculative to support a fund’s reasonable belief that it could use 
that capital to fund an unfunded commitment? Are there circumstances in which a 
fund can expect to raise capital in the future, such as expected inflows from 
retirement plan platforms, that would not raise the same concerns about supporting a 
reasonable belief under the proposed rule? Should the rule permit a fund to consider 
such additional capital as a basis for forming a reasonable belief?  
 Should the rule otherwise limit funds’ use of unfunded commitment agreements? If 
so, how? For example, should the rule specify that funds’ unfunded commitment 
agreements, in the aggregate, may not exceed the fund’s net asset value? Or should 
we adopt different requirements for unfunded commitment agreements for different 
types of funds, based on their ability to borrow money under the Investment 
Company Act?
423
 Should the rule limit the agreements’ counterparties or otherwise 
restrict the agreements’ terms in any way? If so, how? Should we adopt different 
requirements for unfunded loan commitments, which generally will be contingent 
upon a borrower meeting certain “milestones,” as compared to commitments to invest 
in a private fund due upon demand by the fund’s adviser? If so, which requirements 
should apply to each type of transaction and why?  
 Should the rule instead treat all—or a specified subset of—unfunded commitment 
agreements in the same way that it treats derivatives transactions? If a subset of these 
agreements, should the rule specify that certain characteristics of these agreements are 
                                                      
423
     See supra notes 29-32 and accompanying text.  

238 
indicative that these agreements are “similar instruments” in the proposed rule’s 
definition of “derivatives transaction”? Should a fund that enters into unfunded 
commitment agreements, but that otherwise does not use derivatives (or that limits its 
derivatives exposure, either as the proposed rule specifies in the limited derivative 
user provisions or otherwise) be subject to the proposed VaR-based limit on fund 
leverage risk? Should such a fund be exempt from any of the proposed rule’s other 
requirements, and if so, which ones and why? 
 Is the proposed definition of “unfunded commitment agreement” clear and 
appropriate? If not, how should the Commission modify it? Should the Commission 
clarify any aspect of the definition (e.g., should the Commission further define or 
provide guidance regarding agreements that involve a commitment to “make a loan to 
a company” or to “invest equity in a company in the future”)? Would funds 
experience any challenges in practice differentiating between unfunded commitments, 
on the one hand, and firm or standby commitment agreements or other transactions 
included in the definition of “derivatives transaction,” on the other? If so, how should 
the Commission provide additional clarity?  
 Are there other types of transactions that we should identify and treat as similar to 
unfunded commitment agreements? What are they and why should they be treated 
accordingly? Are there any transactions that may be viewed as firm or standby 
commitment agreements, but that commenters believe should be given the same 
treatment as unfunded commitments under the proposed rule? What kinds of 
transactions and why? 
 Would any adverse market effects result from the proposed treatment of unfunded 

239 
commitment agreements? For example, would the proposal lead funds to restructure 
transactions as unfunded commitment agreements, and if so would this adversely 
affect investor protection? Would any modifications to the proposed rule, or 
additional Commission guidance, help mitigate potential adverse market effects?  
K. Recordkeeping Provisions 
Proposed rule 18f-4 also includes certain recordkeeping requirements. These proposed 
requirements are designed to provide our staff, and a fund’s compliance personnel, the ability to 
evaluate the fund’s compliance with the proposed rule’s requirements.  
First, the proposed rule would require the fund to maintain certain records documenting 
the fund’s derivatives risk management program. Specifically, for a fund subject to the proposed 
rule’s program requirements, the proposed rule would require the fund to maintain a written 
record of its policies and procedures that are designed to manage the fund’s derivatives risks.
424
 
The proposed rule would also require a fund to maintain a written record of the results of any 
stress testing of its portfolio, results of any VaR test backtesting it conducts, records 
documenting any internal reporting or escalation of material risks under the program, and records 
documenting any periodic reviews of the program.
425
 These records would allow our staff to 
understand a fund’s derivatives risk management program and how the fund administered it.  
Second, the proposed rule would require funds to keep records of any materials provided 
to the fund’s board of directors in connection with approving the designation of the derivatives 
                                                      
424
  Proposed rule 18f-4(c)(6)(i)(A); see also supra section II.B.3. 
 Under proposed rule 18f-4(c)(4), leveraged/inverse funds would be subject to the proposed rule’s 
derivatives risk management program requirement. Such funds would therefore also be subject to 
the program-related recordkeeping provisions of the proposed rule. 
425
 Proposed rule 18f-4(c)(6)(i)(A). 

240 
risk manager.
426
 The proposed rule would also require a fund to keep records of any written 
reports provided to the board of directors relating to the program, and any written reports 
provided to the board that the rule would require regarding the fund’s non-compliance with the 
applicable VaR test.
427
 These records would help our staff to understand what was provided to 
the fund’s board while overseeing the fund’s program.  
Third, for a fund that is required to comply with the proposed VaR-based limit on fund 
leverage risk, the fund would have to maintain records documenting the fund’s determination of: 
the VaR of its portfolio; the VaR of the fund’s designated reference index, as applicable; the 
fund’s VaR ratio (the value of the VaR of the fund’s portfolio divided by the VaR of the 
designated reference index), as applicable; and any updates to any VaR calculation models used 
by the fund, as well as the basis for any material changes made to those models.
428
 These records 
would provide information on the operation of a fund’s VaR test and, for example, would allow 
our staff to better understand how a fund (and funds generally) implement the proposed VaR 
tests. 
Fourth, the proposed rule would require a fund that is a limited derivatives user to 
maintain a written record of its policies and procedures that are reasonably designed to manage 
its derivatives risk.
429
 These records would help our staff to understand what policies and 
procedures that a limited derivatives user has adopted and implemented to address the risks 
associated with its use of derivatives.  
                                                      
426
  Proposed rule 18f-4(c)(6)(i)(B); see also supra section II.C. 
427
     Id.; see also supra section II.D.5.b. 
428
  Proposed rule 18f-4(c)(6)(i)(C); see also supra section II.K. 
429
     Proposed rule 18f-4(c)(6)(i)(D); see also supra section II.K. 

241 
Fifth, the proposed rule would require a fund that enters into unfunded commitment 
agreements to maintain a record documenting the basis for the fund’s belief regarding the 
sufficiency of its cash and cash equivalents to meet its obligations with respect to its unfunded 
commitment agreements.
430
 A fund must make such a record each time it enters into such an 
agreement.
431
 These records would allow our staff to understand and evaluate funds’ 
determinations regarding their ability to meet their obligations under their unfunded commitment 
agreements. 
Finally, the proposed rule would require funds to maintain the required records for a 
period of five years.
432
 In particular, a fund must retain a copy of its written policies and 
procedures under the rule that are currently in effect, or were in effect at any time within the past 
five years, in an easily accessible place.
433
 In addition, a fund would have to maintain all other 
records and materials that the rule would require the fund to keep for at least five years (the first 
two years in an easily accessible place).
434 
The proposed five-year retention period is consistent 
with the period provided in rule 38a-1(d) and rule 22e-4 under the Investment Company Act. We 
believe consistency in these retention periods is appropriate because funds currently have 
compliance-program-related recordkeeping procedures in place incorporating a five-year 
retention period, which we believe would lessen the proposed new recordkeeping compliance 
burden to funds, compared to choosing a different, longer retention period. 
                                                      
430
     Proposed rule 18f-4(e)(2); see also supra section II.K. 
431
     Id. 
432
  Proposed rule 18f-4(c)(6)(ii); proposed rule 18f-4(e)(2).  
433
  Proposed rule 18f-4(c)(6)(ii)(A); see also supra notes 424 and 429 and accompanying text. The 
retention requirement would apply to both funds that are required to implement a derivatives risk 
management program and funds that are limited derivatives users under proposed rule 18f-
4(c)(3). 
434
  Proposed rule 18f-4(c)(6)(ii)(B); proposed rule 18f-4(e)(2). 

242 
We request comment on the proposed rule’s recordkeeping requirements.  
 Are the proposed recordkeeping provisions appropriate? Are there any other records 
relating to a fund’s derivatives transactions that a fund should be required to 
maintain? For example, should we also require a fund to maintain written records 
relating to any action the fund took after exceeding a risk guideline (or any internal 
reporting that occurred following the exceedance of a risk guideline)?
435
 Or, as 
another example, should we include a provision in the proposed rule that would 
require a fund that enters into reverse repurchase agreements under proposed rule 18f-
4(d) to maintain records documenting the fund’s c ompliance with the applicable asset 
coverage requirement of section 18? Why or why not? The proposed rule would 
require a fund to maintain records of the VaR of its portfolio, the VaR of its 
designated reference index (as applicable), and its VaR ratio. To what extent would 
the requirement to maintain records of the fund’s VaR ratio involve burdens in 
addition to the requirement to maintain the fund’s VaR and the VaR of the designated 
reference index? 
 Are there feasible alternatives to the proposed recordkeeping requirements that would 
minimize recordkeeping burdens, including the costs of maintaining the required 
records, while promoting the goals of providing the Commission and its staff, and a 
fund’s compliance personnel, sufficient information to understand: (1) a fund’s 
derivatives risk management program and how the fund had administered it, (2) how 
a fund’s board oversees the program, (3) the administration and effectiveness of a 
fund’s VaR test, (4) how a limited derivatives user’s policies and procedures are 
                                                      
435
     See, e.g., proposed rule 18f-4(c)(1)(ii), proposed rule 18f-4(c)(1)(v)(A). 

243 
designed to address the risks associated with its use of derivatives, and (5) the basis 
for a fund’s determination regarding the sufficiency of its cash to meet its obligations 
with respect to unfunded commitment agreements?  
 Are the record retention time periods that we have proposed appropriate? Should we 
require records to be maintained for a longer or shorter period? If so, for how long?  
L. Transition Periods 
In view of our proposal for an updated, comprehensive approach to the regulation of 
funds’ derivatives use, we are proposing to rescind Release 10666.
436
 In addition, staff in the 
Division of Investment Management is reviewing its no-action letters and other guidance 
addressing derivatives transactions and other transactions covered by proposed rule 18f-4 to 
determine which letters and other staff guidance, or portions thereof, should be withdrawn in 
connection with any adoption of this proposal. Upon the adoption of any final rule, some of these 
letters and other staff guidance, or portions thereof, would be moot, superseded, or otherwise 
inconsistent with the final rule and, therefore, would be withdrawn. If interested parties believe 
that additional letters or other staff guidance, or portions thereof, should be withdrawn, they 
should identify the letter or guidance, state why it is relevant to the proposed rule, how it or any 
specific portion thereof should be treated, and the reason therefor. The staff review would 
include, but would not necessarily be limited to, all of the staff no-action letters and other staff 
guidance listed below, including our staff’s position regarding TOBs.
437
 
• Dreyfus Strategic Investing & Dreyfus Strategic Income (pub. avail. June 22, 1987) 
                                                      
436
     See supra section I.C. 
437
  See Investment Management Staff Issues of Interest, available at 
https://www.sec.gov/divisions/investment/issues-of-interest.shtml#tobfinancing; see also 
Registered Investment Company Use of Senior Securities — Select Bibliography, available at 
https://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.  

244 
• Merrill Lynch Asset Management, L.P. (pub. avail. July 2, 1996) 
• Robertson Stephens Investment Trust (pub. avail. Aug. 24, 1995) 
• Claremont Capital Corp (pub. avail. Sept. 16, 1979) 
• Emerald Mgt. Co. (pub. avail. Jan. 21, 1978) 
• Sanford C. Bernstein (pub. avail. June 25, 1990) 
• Hutton Options Trading,  L.P . (pub. avail. Feb. 2, 1989) 
• Prudential-Bache IncomeVertible Plus Fund (pub. avail. Nov. 20, 1985) 
• State Street Income Fund, State Street Balanced Fund (pub. avail. Oct. 21, 1985) 
• New England Life Government Securities Trust (pub. avail. Sept. 26, 1985) 
• Putnam Option Income Trust II (pub. avail. Sept. 23, 1985) 
• Thomson McKinnon Government Securities Fund (pub. avail. Sept. 23, 1985) 
• GMO Core Trust (pub. avail. Aug. 19, 1985) 
• Bartlett Capital Trust (pub. avail. Aug. 19, 1985) 
• Continental Option Income Plus Fund (pub. avail. Aug. 12, 1985) 
• Colonial High Yield Securities Trust, Colonial Enhanced Mortgage Trust (pub. avail. 
July 25, 1985) 
• Putnam High Income Government Trust (pub. avail. June 3, 1985) 
• Bartlett Management Trust (pub. avail. May 17, 1985) 
• Drexel Series Trust — Government Securities Series (pub. avail. Apr. 25, 1985) 
• Koenig Tax Advantaged Liquidity Fund (pub. avail. Mar. 27, 1985) 
• Colonial Tax-Managed Trust (pub. avail. Dec. 31, 1984) 
• Monitrend Fund (pub. avail. Nov. 14, 1984) 
• Pilot Fund (pub. avail. Sept. 14, 1984) 

245 
• Colonial Government Securities Plus Trust (pub. avail. June 15, 1984) 
• Z-Seven Fund (pub. avail. May 21, 1984) 
• Pension Hedge Fund (pub. avail. Jan. 20, 1984) 
• Steinroe Bond Fund (pub. avail. Jan. 17, 1984) 
• IDS Bond Fund (pub. avail. Apr. 11, 1983) 
• Safeco Municipal Bond, Inc (pub. avail. Nov. 26, 1982) 
• “Dear Chief Financial Officer” Letter, from Lawrence A. Friend, Chief Accountant, 
Division of Investment Management (pub. avail. Nov. 7, 1997) 
Accordingly, following a one-year transition period to provide time for funds to prepare 
to come into compliance with the new rule, funds could only enter into derivatives transactions, 
reverse repurchase agreements and similar financing transactions, and unfunded commitments to 
the extent permitted by, and consistent with the requirements of, proposed rule 18f-4 or section 
18. At that time, Release 10666 would be rescinded and, as determined appropriate in connection 
with the staff’s review of no-action letters and other staff guidance described in this release, staff 
no-action letters and other staff guidance, or portions thereof, would be withdrawn. 
We similarly propose to provide a one-year compliance period for the sales practices 
rules to provide time for broker-dealers and investment advisers to bring their operations into 
conformity with the new rule. We also propose a one-year delay to the effective date of the 
amendments to rule 6c-11, which would permit leveraged/inverse ETFs to rely on that rule, and 
to rescind the exemptive orders we have provided to leveraged/inverse ETF s ponsors on the 
effective date of the amendments to rule 6c-11.  
We propose that each of the transition periods discussed in this section would run from 
the date of the publication of any final rule in the Federal Register. Accordingly, one year after 

246 
that date: ( 1) any fund that enters into the transactions permitted by rule 18f-4 would do so 
relying on that rule; (2) broker-dealers and investment advisers would be required to comply 
with the sales practices rules; and (3) leveraged/inverse ETFs could operate under rule 6c-11 and 
the current leveraged/inverse ETF sponsors’ orders would be rescinded.   
We request comment on these transition periods. 
 Do commenters agree that a one-year transition period to provide time for funds to 
prepare to come into compliance with proposed rule 18f-4 is appropriate? Should the 
period be shorter or longer? 
 Should we adopt tiered transition periods for smaller entities? For example, should 
we provide an additional 6 months for smaller entities (or some other shorter or 
longer period) in any transition period that we provide? Should the transition period 
be the same for all funds that rely on proposed rule 18f-4 (for example 12 months 
after any adoption of proposed rule 18f-4, or any shorter or longer period)? 
 Is the proposed one-year compliance period for the sales practices rules appropriate? 
Why or why not? Is a longer or shorter compliance period necessary to allow 
investment advisers and broker-dealers to comply with the proposed sales practices 
rules? Why or why not? If we provide small and large funds a tiered transition period 
to comply with proposed rule 18f-4, should we similarly implement a tiered 
compliance period for investment advisers and broker-dealers to comply with the 
proposed sales practices rules? Why or why not? 
 Would our proposal to rescind the current leveraged/inverse ETF sponsors’ 
exemptive orders on the delayed effective date of the amendments to rule 6c-11 
provide sufficient time for the leveraged/inverse ETF sponsors to transition to 

247 
rule 6c-11? 
M. Conforming Amendments 
Form N-2 requires a closed-end fund to disclose a senior securities table with certain 
information about any senior securities it has issued.
438
 Outstanding senior securities may bear on 
the likelihood, frequency, and size of distributions from the fund to its investors because section 18 
prohibits distributions when a closed-end fund does not have the asset coverage required under that 
section. 
Proposed rule 18f-4 would provide that a fund’s derivatives transactions and unfunded 
commitments entered into under the proposed rule would not be considered for purposes of 
computing section 18 asset coverage.
439
 These transactions therefore would not affect a fund’s 
ability under section 18 to make distributions to investors. Registered closed-end funds are 
already required to disclose extensive information about their derivatives transactions on 
Form N -PORT. In light of this treatment under proposed rule 18f-4   and the information that is 
already available regarding registered closed-end funds’ derivatives transactions, we are 
proposing to amend Form N-2 to provide that funds relying on proposed rule 18f-4 would not be 
required to include their derivatives transactions and unfunded commitment agreements in the 
senior securities table on Form N -2.
440
 C ommenters on the 2015 proposal that addressed this 
topic supported such a conforming amendment with respect to asset coverage calculations and 
disclosure.
441
 
We request comment on the proposed conforming amendment to Form N-2, and other 
conforming amendments that commenters suggest would be necessary or appropriate. 
                                                      
438
  See Item 4.3 of Form N-2. 
439
  See proposed rule 18f-4(b). 
440
     See proposed amendment to Instruction 2 of Item 4.3 of Form N-2. 
441
  See, e.g., Ares Comment Letter; ICI Comment Letter I. 

248 
 Is the proposed conforming amendment appropriate? We have not proposed to 
exclude reverse repurchase agreements and similar financing transactions from the 
senior securities table in Form N-2 because these transactions may bear on the 
likelihood, frequency, and size of distributions from a fund to its investors. Do 
commenters agree that this is appropriate? Why or why not? If commenters do not 
believe that these transactions should be included in the senior securities table, what 
other disclosure would be appropriate?  
 Rule 22e-4 requires funds subject to the rule, in classifying the liquidity of their 
portfolios and in determining whether a fund primarily holds highly liquid 
investments, to take into account the fund’s highly liquid investments that it has 
“segregated” to cover certain less liquid investments.
442
 Proposed rule 18f-4, 
however, does not include an asset segregation requirement, and would supersede 
Release 10666 and related staff guidance. Should we remove any references in rule 
22e-4 to “segregated” assets (while retaining rule 22e-4’s references to assets pledged 
to satisfy margin requirements)? Is there any other basis on which funds “segregate” 
assets that would warrant our retaining these references?  
 Are there other conforming amendments to any of our other rules or forms that we 
should make? If so, what rules or forms should be amended and why? 
III. ECONOMIC ANALYSIS 
We are mindful of the costs imposed by, and the benefits obtained from, our rules. 
Section 3(f) of the Exchange Act and section 2(c) of the Investment Company Act state that 
                                                      
442
  See rule 22e-4(b)(1)(ii)(C); rule 22e-4(b)(1)(iii)(B). A fund would also have to take into account 
the percentage of its highly liquid investments that it has pledged to satisfy margin requirements. 
See id. 

249 
when the Commission is engaging in rulemaking under such titles and is required to consider or 
determine whether the action is necessary or appropriate in (or, with respect to the Investment 
Company Act, consistent with) the public interest, the Commission shall consider whether the 
action will promote efficiency, competition, and capital formation, in addition to the protection 
of investors. Further, section 23(a)(2) of the Exchange Act requires the Commission to consider, 
among other matters, the impact such rules would have on competition and states that the 
Commission shall not adopt any rule that would impose a burden on competition not necessary 
or appropriate in furtherance of the purposes of the Exchange Act. The following analysis 
considers, in detail, the potential economic effects that may result from the proposed rule, 
including the benefits and costs to investors and other market participants as well as the broader 
implications of the proposal for efficiency, competition, and capital formation. 
A. Introduction 
Funds today use a variety of derivatives, referencing a range of assets or metrics. Funds 
use derivatives both to obtain investment exposure as part of their investment strategies and to 
manage risks. A fund may use derivatives to gain, maintain, or reduce exposure to a market, 
sector, or security more quickly, or to obtain exposure to a reference asset for which it may be 
difficult or impractical for the fund to make a direct investment. A fund may use derivatives to 
hedge interest rate, currency, credit, and other risks, as well as to hedge portfolio exposures.
443
 
As funds’ strategies have become increasingly diverse, funds’ use of derivatives has grown in 
both volume and complexity over the past several decades. At the same time, a fund’s 
                                                      
443
     See supra section I.A. 

250 
derivatives use may entail risks relating to, for example, leverage, markets, operations, liquidity, 
and counterparties, as well as legal risks.
444
 
Section 18 of the Investment Company Act is designed to limit the leverage a fund can 
obtain through the issuance of senior securities.
445
 As discussed above, a fund’s derivatives use 
may raise the investor protections concerns underlying section 18. In addition, funds’ asset 
segregation practices have developed such that funds’ derivatives use—and thus funds’ potential 
leverage through derivatives transactions—does not appear to be subject to a practical limit as 
the Commission contemplated in Release 10666. Accordingly, we continue to be concerned that 
certain fund asset segregation practices may not address the concerns underlying section 18.
446
  
Proposed rule 18f-4 is designed to provide an updated, comprehensive approach to the 
regulation of funds’ use of derivatives and certain other transactions. The proposed rule would 
permit a fund, subject to certain conditions, to enter into derivatives or other transactions, 
notwithstanding the prohibitions and restrictions on the issuance of senior securities under 
section 18 of the Investment Company Act. We believe that the proposed rule’s requirements, 
including the derivatives risk management program requirement and VaR-based limit on fund 
leverage risk, would benefit investors by mitigating derivatives-related risks, including those that 
may lead to unanticipated and potentially significant losses for investors. 
Certain funds use derivatives in a limited manner, which we believe presents a lower 
degree of risk or potential impact and generally a lower degree of leverage than permitted under 
section 18. The proposed rule would provide an exception from the proposed derivative risk 
                                                      
444
     See, e.g., supra notes 16-17 and accompanying text. 
445
     See supra section I.B.1. 
446
     See supra sections I.B.3. 

251 
management program requirement and VaR-based limit on fund leverage risk for these limited 
derivatives users. Instead, the proposed rule would require a fund relying on this exception to 
adopt policies and procedures that are reasonably designed to manage its derivatives risks. Funds 
with limited derivatives exposure and funds that use derivatives transactions solely to hedge 
certain currency risk would therefore not be required to incur costs and bear compliance burdens 
that may be disproportionate to the resulting benefits, while still being required to manage the 
risks their limited use of derivatives may present.
447
  
The proposed rule would also provide an exception from the VaR-based limit on fund 
leverage risk for certain leveraged/inverse funds in light of the requirements under the proposed 
sales practices rules that broker-dealers and investment advisers exercise due diligence in 
approving the accounts of retail investors to invest in these funds, and other conditions for these 
funds that proposed rule 18f-4 includes.
448
 This would allow these funds, which generally could 
not currently satisfy the proposed VaR-based limit on fund leverage risk, to continue offering 
their current strategies. The proposed sales practices rules’ due diligence and account approval 
requirements also would apply to accounts of investors in certain exchange-listed commodity- or 
currency-based trusts or funds, which are not investment companies subject to section 18 but 
present similar investor protection concerns. We believe the proposed sales practices rules would 
enhance investor protection by helping to ensure that investors in these funds are limited to those 
who are capable of evaluating their characteristics—including that the funds would not be 
subject to all of the leverage-related requirements applicable to registered investment companies 
generally—and the unique risks they present.  
                                                      
447
  See supra sections I.C and II.E. 
448
  See supra section II.G. 

252 
Proposed rule 18f-4 also contains requirements for funds’ use of certain senior securities 
that are not derivatives. Specifically, the proposed rule would permit reverse repurchase 
agreements and other similar financing transactions if they comply with the asset coverage 
requirements of section 18; this approach would align the treatment of reverse repurchase 
agreements and similar financing transactions, for section 18 purposes, with the treatment of 
bank borrowings and other senior securities transactions subject to section 18’s asset coverage 
requirements.
449
 In addition, the proposed rule would permit a fund to enter into unfunded 
commitment agreements if it reasonably believes, at the time it enters into such an agreement, 
that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of 
its unfunded commitment agreements.
450
 This requirement is designed to address the concern 
that a fund may experience losses as a result of having insufficient assets to meet its obligations 
with respect to these transactions, and we believe that the requirement would benefit investors by 
mitigating such losses or other adverse effects if a fund is unable to satisfy an unfunded 
commitment agreement.
451
  
This proposal also includes certain recordkeeping requirements and reporting 
requirements for funds that use derivatives.
452
 We expect that the proposed recordkeeping 
requirements would benefit investors by facilitating fund compliance with the proposed rule and 
our staff’s review of funds’ compliance. In addition, we expect that the proposed amendments to 
                                                      
449
  Similar financing transactions may include securities lending arrangements and TOBs, depending 
on the particular facts and circumstances of the individual transaction. See supra section II.I. 
450
  See supra section II.J. 
451
  We believe that the proposed treatment of unfunded commitment transactions is consistent with 
general market practices. Therefore, we believe that the proposed requirements for both types of 
senior securities would not have significant economic effects when measured against this 
baseline.  
452
     See supra sections II.C and II.H. 

253 
Forms N-PORT, N-CEN, and N-RN would further benefit investors by enhancing the 
Commission’s and the public’s understanding of the impact of funds’ use of derivatives on fund 
portfolios, and by facilitating the Commission’s ability to oversee funds’ use of derivatives and 
compliance with the proposed rules.
453
  
B. Economic Baseline 
1. Fund Industry Overview 
The fund industry has grown and evolved substantially in past decades in response to 
various factors, including investor demand, technological developments, and an increase in 
domestic and international investment opportunities, both retail and institutional.
454
 As of 
September 2019, there were 9,788 mutual funds (excluding money market funds) with $21,333 
billion in total net assets, 1,910 ETFs organized as an open-end fund or as a share-class of an 
open-end fund with $3,081 billion in total net assets, 664 registered closed-end funds with 294 
billion in total net assets, and 13 variable annuity separate accounts registered as management 
investment companies on Form N-3 with $224 billion in total net assets. There also were 413 
money market funds with $3,392 billion in total net assets.
455
 Finally, as of June 2019, there 
were 99 BDCs with $63 billion in total net assets.
456
 
                                                      
453
  Because leveraged/inverse funds would not be subject to the proposed VaR-based limit on fund 
leverage risk, these funds would not be subject to the related proposed reporting requirements on 
Forms N-PORT and N-RN. Leveraged/inverse funds would, however, be subject to the proposed 
new reporting requirements on funds’ derivatives exposure on form N-PORT as well as to the 
proposed new requirements on Form N-CEN.  
454
  See supra note 1. 
455
  Estimates of the number of registered investment companies and their total net assets are based 
on a staff analysis of Form N-CEN filings as of September 5, 2019. For open-end funds that have 
mutual fund and ETF share classes, we count each type of share class as a separate fund and use 
data from Morningstar to determine the amount of total net assets reported on Form N-CEN 
attributable to the ETF share class. Money market funds are excluded from the scope of proposed 
rule 18f-4 but may experience economic effects as a result of being excluded from the rule’s 
scope. We therefore report their number and net assets separately from those of other mutual 
 

254 
2. Funds’ Use of Derivatives 
DERA staff analyzed funds’ use of derivatives based on Form N-PORT filings as of 
September 2019. The filings covered 9,074 mutual funds with $19,590 billion in total net assets, 
1,711 ETFs with $3,317 billion in total net assets, 565 registered closed-end funds with $327 
billion in net assets, and 13 variable annuity separate accounts registered as management 
investment companies with $219 billion in total net assets.
457
 While only larger fund groups are 
currently required to file reports on Form N-PORT, existing filings nevertheless covered 89% of 
funds representing 94% of assets.
458 
 
Based on this analysis, 59% of funds reported no derivatives holdings,  and a further 27% 
of funds reported using derivatives with gross notional amounts below 50% of net assets. These 
results are comparable to and consistent with the findings of the DERA White Paper, which 
studied a random sample of 10% of funds in 2014.
459
 
BDCs do not file Form N-PORT. To help evaluate the extent to which BDCs use 
derivatives, our staff reviewed the most recent financial statements of 48 of the current 99 BDCs 
                                                      
funds.  
456  
Estimates of the number of BDCs and their net assets are based on a staff analysis of Form 10-K 
and Form 10-Q filings as of June 30, 2019. Our estimate includes BDCs that may be delinquent 
or have filed extensions for their filings, and it excludes 6 wholly-owned subsidiaries of other 
BDCs.  
457 
 The analysis is based on each registrant’s latest Form N-PORT filing as of September 23, 2019. 
Money market funds are excluded from the analysis; they do not file monthly reports on Form N-
PORT and are excluded from the scope of proposed rule 18f-4. For open-end funds that have 
mutual fund and ETF share classes, we count each type of share class as a separate fund and use 
data from Morningstar to determine the amount of total net assets reported on Form N-PORT 
attributable to the ETF share class.  
458
  See supra note 281. 
459 
 See DERA White Paper, supra note 1. 

255 
as of September 2019.
460
 Based on this analysis, we observe that most BDCs do not use 
derivatives extensively. Of the sampled BDCs, 54% did not report any derivatives holdings, and 
a further 29% reported using derivatives with gross notional amounts below 10% of net assets. 
3. Current Regulatory Framework for Derivatives  
Funds have developed certain general asset segregation practices to “cover” their 
derivatives positions, consistent with the conditions in staff no-action letters and guidance.
461
 
However, staff has observed that practices vary based on the type of derivatives transaction, and 
that funds use different practices regarding the types of assets that they segregate to cover their 
derivatives positions. For purposes of establishing the baseline, we assume that funds generally 
segregate sufficient assets to at least cover any mark-to-market liabilities on the funds’ 
derivatives transactions, with some funds segregating more assets for certain types of derivatives 
transactions (sufficient to cover the full notional amount of the transaction or an amount between 
the transaction’s full notional amount and any mark-to-market liability).
462
 As the mark-to-
market liability of a derivative can be much smaller than the full investment exposure associated 
with the position, funds’ current use of the mark-to-market asset segregation approach, and 
funds’ segregation of any liquid asset, do not appear to place a practical limit on their use of 
derivatives.
463
 
                                                      
460
  See supra note 280 and accompanying text. 
461
  See supra section II.B.2.b. 
462 
 See supra notes 54-55 and accompanying text. 
463 
 See supra section I.B.2.b.  

256 
4. Funds’ Derivatives Risk Management Practices and Use of 
VaR Models  
There is currently no requirement for funds that use derivatives to have a formalized 
derivatives risk management program. However, we understand that advisers to many funds 
whose investment strategies entail the use of derivatives, including leveraged/inverse funds, 
already assess and manage risks associated with their derivatives transactions to varying extents. 
In addition, we understand that funds engaging in derivatives transactions have increasingly used 
stress testing as a risk management tool over the past decade.
464
  
We also understand that VaR calculation tools are widely available,  and many advisers 
that enter into derivatives transactions already use risk management or portfolio management 
platforms that include VaR tools.
465
 Advisers to funds that use derivatives more extensively may 
be particularly likely to currently use risk management or portfolio management platforms that 
include VaR capability. Moreover, advisers that manage (or that have affiliates that manage) 
UCITS funds may already be familiar with using VaR models in connection with European 
guidelines.
466
 One commenter submitted the results of a survey based on responses from 24 fund 
complexes with $13.8 trillion in assets.
467
 The results of this survey indicate that 73% of 
respondents used some form of both VaR and stress testing as derivatives risk management tools. 
                                                      
464 
 See also supra note 145 and accompanying text. 
465 
 See also supra note 180. 
466 
 See supra note 222 and accompanying text. 
467
  See ICI Comment Letter III. The commenter also indicated that the surveyed ICI member firms 
accounted for 67% of mutual fund and ETF assets as of June 2019 and that survey responses were 
submitted by firms “whose assets under management spanned the spectrum from small to very 
large.” However, these representations alone do not provide sufficient information about whether 
the surveyed firms were representative of all mutual funds and ETFs in terms of the exact 
distribution of specific characteristics, such as firm size or type of investment strategy.  

257 
5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse 
Funds  
Leveraged/inverse investment vehicles, as defined in the proposed sales practices rules, 
include leveraged/inverse funds and certain exchange-listed commodity- or currency-based trusts 
or funds. Currently, there are 164 leveraged/inverse ETFs with $33.9 billion in total net assets; 
105 leveraged/inverse mutual funds with $4.9 billion in total net assets; and 17 exchange-listed 
commodity- or currency-based trusts or funds with $1.2 billion in total net assets.
468
  
Leveraged/inverse investment vehicles generally target a daily return (or a return over 
another predetermined time period) that is a multiple, inverse, or inverse multiple of the return of 
an underlying index; however over longer holding periods, the realized leverage multiple of the 
returns of an investment in a leveraged/inverse investment vehicle relative to the returns of its 
underlying index can vary substantially from the vehicle’s daily leverage multiple. 
In addition, the returns of leveraged/inverse investment vehicles over longer holding 
periods share certain features with the returns of holding an option.
469
 For example, a call option 
on an index with a strike price that is much higher than the current index price (i.e., the option is 
significantly “out of the money”) is likely to expire worthless. If the option expires worthless, an 
investor that holds the option until expiry receives no payoff in exchange for their initial 
investment (the option premium) and therefore experiences a return of -100%. Holding all other 
                                                      
468 
 Estimates of the number of leveraged/inverse mutual funds and leveraged/inverse ETFs and their 
total net assets are based on a staff analysis of Form N-CEN filings as of September 5, 2019. 
Estimates of the number of exchange-listed commodity- or currency-based trusts or funds and 
their total net assets are based on Bloomberg data as of September 20, 2019. 
469
  For a technical analysis of the similarities between the returns of leveraged/inverse ETFs over 
longer holding periods and the returns of holding an option, see Division of Economic and Risk 
Analysis, Economics Note: The Distribution of Leveraged ETF Returns (Nov. 2019), available at 
https://www.sec.gov/files/DERA_LETF_Economics_Note_Nov2019.pdf. The results of that 
analysis also apply more generally to other types of leveraged/inverse investment vehicles. 

258 
factors fixed, the likelihood of this outcome increases with the strike price of the option, and the 
option is priced accordingly—options that are further out of the money, all else equal, will have 
lower premiums. At the same time, on the rare occasions when the index price exceeds the strike 
price at expiration, the investor will earn a high return on his or her initial investment because the 
initial price paid for a call option is lower when the strike price is higher. While the payoff to 
holding a leveraged/inverse investment vehicle over long periods generally lacks this strict 
discontinuous nature (expiring either in the money or out of the money), it is nevertheless similar 
to that of an option in the sense that, as the vehicle’s leverage multiple or investor’s holding 
period increases, the likelihood of experiencing a loss increases (analogous to the option expiring 
out of the money) while gains, when they do occur, tend to be larger (analogous to the option 
expiring in the money).
470
  
To achieve the stated leverage multiple, most leveraged/inverse investment vehicles 
rebalance their exposure to the underlying index daily.
471
 This is also similar to options, whose 
payoffs can be replicated by trading dynamically in the underlying asset and a low-risk bond. For 
example, call options are economically equivalent to holding a long position in the underlying 
asset and a short position in a low-risk bond.
472
 Both leveraged/inverse investment vehicles and 
                                                      
470 
 In statistical terms, the option returns and returns of holding leveraged/inverse investment 
vehicles over longer holding periods both exhibit positive skewness. 
471 
 Leveraged/inverse investment vehicles that track the returns of an underlying index over time 
periods that are longer than one day rebalance their portfolios at the end of each such period. 
Leveraged/inverse investment vehicles use derivatives to achieve their targeted returns.  
472 
 Conversely, put options are economically equivalent to holding a short position in the underlying 
and a long position in a low-risk bond—their replicating portfolio consists of an inverse leveraged 
position in the underlying. 

259 
options are therefore economically equivalent to a dynamically rebalanced leveraged/inverse or 
inverse leveraged/inverse position in the underlying asset or reference index.
473
 
The majority of assets held in leveraged/inverse funds are held in leveraged/inverse 
ETFs. There are currently two ETF sponsors that rely upon exemptive relief from the 
Commission that permits them to operate leveraged/inverse ETFs.
474
 Since 2009, the 
Commission has not granted leveraged/inverse exemptive relief to any additional sponsors. In 
addition, leveraged/inverse ETFs are currently excluded from the scope of rule 6c-11, which the 
Commission adopted earlier this year and which allows ETFs satisfying certain conditions to 
operate without obtaining an exemptive order from the Commission.
475
 
Retail investors predominantly purchase and sell shares of leveraged/inverse investment 
vehicles through broker-dealers and investment advisers.
476
 T o the extent that broker-dealers or 
investment advisers recommend leveraged/inverse investment vehicles to their customers or 
clients, they should have processes in place to satisfy their obligations to make only suitable 
recommendations or provide best interest advice, respectively.
477
 For example, the basis for an 
investment adviser’s reasonable understanding generally would include, for retail clients of 
investment advisers, a reasonable inquiry into the client’s financial situation, level of financial 
                                                      
473 
 Option replication portfolios need to be rebalanced continuously throughout the day as the price 
of the underlying asset changes. While the implied rebalancing happens continuously during the 
trading day for options, leveraged/inverse investment vehicles perform rebalancing trades in the 
underlying less frequently (daily for most leveraged/inverse investment vehicles).  
474 
 See supra notes 308 and 357. The exemptive orders of the two sponsors that operate 
leveraged/inverse ETFs permit these sponsors to launch additional funds under the terms and 
conditions of those orders. 
475
  See supra notes 353-354 and accompanying text. 
476
  See supra note 322. 
477
  Following the June 30, 2020 compliance date for Regulation Best Interest, broker-dealers will 
have to provide recommendations in the best interest of their retail customers. See Regulation 
Best Interest: The Broker-Dealer Standard of Conduct, supra note 308. 

260 
sophistication, investment experience, and financial goals.
478
 When an adviser is assessing 
whether complex or high-risk products—such as leveraged/inverse funds—are in a retail client’s 
best interest, the adviser should generally apply heightened scrutiny to whether such investments 
fall within the retail client’s risk tolerance and objectives.
479
 Broker-dealers also will be required 
to comply with Regulation Best Interest beginning on June 30, 2020.
480
 Broker-dealers 
complying with Regulation Best Interest will have to exercise reasonable diligence, care, and 
skill when making a recommendation to a retail customer, including by understanding potential 
risks, rewards, and costs associated with a recommendation in light of the customer’s investment 
profile.
481
 
C. Benefits and Costs of the Proposed Rules and Amendments  
The Commission is sensitive to the economic effects that may result from the proposed 
rules and rule and form amendments, including benefits and costs. Where possible, we have 
attempted to quantify the likely economic effects; however, we are unable to quantify certain 
economic effects because we lack the information necessary to provide reasonable estimates. In 
some cases, it is difficult to predict how market participants would act under the conditions of 
the proposed rules. For example, we are unable to predict whether the proposed derivatives risk 
management program requirement and VaR-based limit on fund leverage risk may make 
investors more or less likely to invest in funds that would be subject to these requirements or the 
                                                      
478
  See, e.g., Fiduciary Interpretation, supra note 309, at text preceding n.36.  
479
  See id. at text preceding n.39. The Commission further stated in the Fiduciary Interpretation that 
leveraged/inverse funds and other complex products “may not be in the best interest of a retail 
client absent an identified, short-term, client-specific trading objective and, to the extent that such 
products are in the best interest of a retail client initially, they would require daily monitoring by 
the adviser.” See id. 
480
  See Regulation Best Interest: The Broker-Dealer Standard of Conduct, supra note 305. 
481
  See id. at section II.C.2. 

261 
degree to which these requirements may affect the use of derivatives by these funds. 
Nevertheless, as described more fully below, we are providing both a qualitative assessment and 
quantified estimate of the economic effects, including the initial and ongoing costs of the 
additional reporting requirements, where feasible. 
Direct costs incurred by funds discussed below may, to some extent, be absorbed by the 
fund’s investment adviser or be passed on to investors in the form of increased management fees. 
The share of these costs borne by funds, their advisers, and investors depends on multiple 
factors, including the nature of competition between advisers, and investors’ relative sensitivity 
to changes in fund fees, the joint effects of which are particularly challenging to predict due to 
the number of assumptions that the Commission would need to make. 
1. Derivatives Risk Management Program and Board Oversight 
and Reporting  
Proposed rule 18f-4 would require funds that enter into derivatives transactions and are 
not limited derivatives users to adopt and implement a derivatives risk management program. 
The program would provide for the establishment of risk guidelines that must include certain 
elements, but that are otherwise tailored based on how the fund’s use of derivatives may affect 
its investment portfolio and overall risk profile. The program also would have to include stress 
testing, backtesting, internal reporting and escalation, and program review elements. The 
proposed rule would require a fund’s board of directors to approve the fund’s designation of a 
derivatives risk manager, who would be responsible for administering the derivatives risk 
management program. The fund’s derivatives risk manager would have to report to the fund’s 
board on the derivatives risk management program’s implementation and effectiveness and the 
results of the fund’s stress testing and backtesting. 

262 
We understand that advisers to many funds whose investment strategies entail the use of 
derivatives already assess and manage risks associated with their derivatives transactions.
482
 
However, proposed rule 18f-4’s requirement that funds establish written derivatives risk 
management programs would create a standardized framework for funds’ derivatives risk 
management by requiring each fund’s program to include all of the proposed program elements. 
To the extent that the resulting risk management activities are more comprehensive than funds’ 
current practices, this may result in more-effective risk management across funds. While the 
adoption of a derivatives risk management program requirement may not eliminate all 
derivatives-related risks, including that investors could experience large, unexpected losses from 
funds’ use of derivatives, we expect that investors would benefit from a decrease in leverage-
related risks.  
Some funds may reduce or otherwise alter their use of derivatives transactions to respond 
to risks identified after adopting and implementing their risk management programs. In 
particular, we expect that funds currently utilizing risk management practices that are not tailored 
to their use of derivatives may decide to make such changes to their portfolios.
483
  
The proposed rule would require a fund to reasonably segregate the functions of its 
derivatives risk management program from those of its portfolio management.
484
 T his 
segregation requirement is designed to enhance the program’s effectiveness by promoting the 
objective and independent identification and assessment of derivatives risk.
485
 Segregating the 
                                                      
482
  See supra section III.B.4. 
483
  As a consequence of reducing risk, such funds may earn reduced returns. 
484
  See supra section II.B.2. 
485
  See supra note 112 and accompanying text. While some portfolio managers may find it 
burdensome to collaborate with a derivatives risk manager, to the extent that portfolio managers 
 

263 
functions of a fund’s derivatives risk management program from those of its portfolio 
management may also mitigate the risks of competing incentives between a fund’s portfolio 
managers and its investors.
486
 
Finally, to the extent that the periodic stress testing and backtesting requirements of the 
proposed derivatives risk management program result in fund managers developing a more 
complete understanding of the risks associated with their use of derivatives, we expect that funds 
and their investors will benefit from improved risk management.
487
 Such benefits would be in 
addition to benefits derived from the proposed VaR-based limit on fund leverage risk discussed 
below.
488
 VaR analysis, while yielding a simple yet general measure of a fund’s portfolio risk, 
does not provide a complete picture of a fund’s financial risk exposures.
489
 Complementing VaR 
analysis with stress testing would provide a more complete understanding of the fund’s potential 
                                                      
already consider the impact of trades on the fund’s portfolio risk, we believe that having the 
involvement of a derivatives risk manager may typically make a portfolio manager’s tasks more 
rather than less efficient. 
486
 For example, portfolio managers of actively-managed funds that are underperforming competing 
funds may have an incentive to increase risk exposures through use of derivatives in an effort to 
increase returns. This behavior may result in a fund also increasing risk beyond investor 
expectations. (For theoretical motivation of such behaviors see, e.g., Keith C. Brown, W.V. 
Harlow, & Laura T. Starks, Of Tournaments and Temptations: An Analysis of Managerial 
Incentives in the Mutual Fund Industry, 51 Journal of Finance 85 (1996), available at 
https://www.onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1996.tb05203.x; Judith 
Chevalier & Glenn Ellison, Risk-Taking by Mutual Funds as a Response to Incentives, 105 
Journal of Political Economy 1167 (1997), available at 
https://www.jstor.org/stable/10.1086/516389?seq=1#metadata_info_tab_contents).  
487
  See supra sections II.B.3.c and II.B.3.d; see also supra section II.C.2 (discussing the proposed 
requirements that a fund’s derivatives risk manager provide to the fund’s board: (1) a written 
report, at least annually, providing a representation that the program is reasonably designed to 
manage the fund’s derivatives risks and to incorporate the required elements of the program 
(including a review of the VaR calculation model used by the fund under proposed rule 18f-
4(c)(2), and the backtesting required by proposed rule 18f-4(c)(1)(iv)); and (2) a written report, at 
the frequency determined by the board, regarding any exceedances of the fund’s risk guidelines 
and the results of the fund’s stress tests).  
488
     See infra section III.C.2. 
489
     See id. 

264 
losses under different sets of market conditions. For example, simulating potential stressed 
market conditions not reflected in historical correlations between fund returns and asset prices 
observed in normal markets may provide derivatives risk managers with important information 
pertaining to derivatives risks in stressed environments.
490
 By incorporating the potential impact 
of future economic outcomes and market volatility in its stress test analysis, a fund may be able 
to analyze future potential swings in its portfolio that may impact the fund’s long-term 
performance. This forward-looking aspect of stress testing would supplement the proposed rule’s 
VaR analysis requirement, which would rely on historical data.  
In addition, requiring that a fund backtest the results of its VaR analysis each business 
day would assist funds in examining the effectiveness of the fund’s VaR model. T he proposed 
rule would require that, each business day, the fund compare its actual gain or loss for that 
business day with the fund’s VaR calculated for that day.
491
 This comparison would help identify 
days where the fund’s portfolio losses exceed the VaR calculated for that day, as well as 
systematic over- or under-estimation of VaR suggesting that the fund may not be accurately 
measuring all significant, identifiable market risk factors.
492
  
Proposed rule 18f-4 would also require that a fund’s board of directors approve the 
designation of the fund’s derivatives risk manager, taking into account the derivatives risk 
                                                      
490
  See supra section II.B.3.c (proposed rule 18f-4 would require the program to provide for stress 
testing to “evaluate potential losses to the fund’s portfolio in response to extreme but plausible 
market changes or changes in market risk factors that would have a significant adverse effect on 
the fund’s portfolio, taking into account correlations of market risk factors as appropriate and 
resulting payments to derivatives counterparties”). 
491
  See supra section II.B.3.d. 
492
  See supra notes 150-151 and accompanying text. 

265 
manager’s relevant experience.
493
 We anticipate that this requirement, along with the derivatives 
risk manager’s direct reporting line to the board, would result in effective communication 
between the board and the derivatives risk manager that would enhance oversight of the program 
to the benefit of the fund and its investors.  
Proposed rule 18f-4 would require that the derivatives risk manager provide the fund’s 
board a written report at least once a year on the program’s effectiveness as well as regular 
written reports at a frequency determined by the board that analyze exceedances of the fund’s 
risk guidelines and present the results of the fund’s stress tests and backtests.
494
 T he proposed 
board reporting requirements may facilitate the board’s oversight of the fund and the operation of 
the derivatives risk management program, to the extent the fund does not have such regular 
reporting mechanisms already in place. In the event the derivatives risk manager encounters 
material risks that need to be escalated to the fund’s board, the proposed provision that the 
derivatives risk manager may directly inform the board of these risks in a timely manner as 
appropriate may help prevent delays in resolving such risks.  
Funds today employ a range of different practices, with varying levels of 
comprehensiveness and sophistication, for managing the risks associated with their use of 
derivatives.
495
 We expect that compliance costs associated with the proposed derivatives risk 
management program requirement would vary based on the fund’s current risk management 
practices, as well as the fund’s characteristics, including in particular the fund’s investment 
strategy, and the nature and type of derivatives transactions used by the fund.  
                                                      
493
     See supra section II.C.1. 
494
  See supra section II.C.2. 
495
  See supra section III.B.4. 

266 
We understand that VaR models are widely used in the industry and that backtesting is 
commonly performed in conjunction with VaR analyses. As a result, we believe that many funds 
that would be required to establish derivatives risk management programs already have VaR 
models with backtesting in place. Moreover, the proposed rule’s derivatives risk management 
program requirements, including stress testing and backtesting requirements are, generally, high-
level and principles-based. As a result, it is likely that many funds’ current risk management 
practices may already be in line with many of the proposed rule’s derivatives risk management 
program requirements or could be readily conformed without material change. Thus, the costs of 
adjusting funds current’ practices and procedures to comply with the parallel requirements of 
proposed rule 18f-4 may be minimal for such funds.  
Certain costs of the proposed derivatives risk management program may be fixed, while 
other costs may vary with the size and complexity of the fund and its portfolio allocation. For 
instance, costs associated with purchasing certain third-party data used in the program’s stress 
tests may not vary much across funds. On the other hand, certain third-party services may vary in 
terms of costs based on the portfolio positions to be analyzed. Further, t  he extent to which a cost 
corresponding to the program is fixed or variable may also depend on the third-party service 
provider.  
Larger funds or funds that are part of a large fund complex may incur higher costs in 
absolute terms but find it less costly, per dollar managed, to establish and administer a 
derivatives risk management program relative to a smaller fund or a fund that is part of a smaller 
fund complex. For example, larger funds may have to allocate a smaller portion of existing 

267 
resources for the program, and fund complexes may realize economies of scale in developing 
and implementing derivatives risk management programs for several funds.
496
  
For funds that do not already have a derivatives risk management program in place that 
could be readily adapted to meet the proposed rule’s requirements without significant additional 
cost, we estimate that the one-time costs to establish and implement a derivatives risk 
management program would range from $70,000 to $500,000 per fund, depending on the 
particular facts and circumstances, including whether a fund is part of a larger fund complex and 
therefore may benefit from economies of scale. These estimated costs are attributable to the 
following activities: (1)   developing risk guidelines and processes for stress testing, backtesting, 
internal reporting and escalation, and program review; (2)   integrating and implementing the 
guidelines and processes described above; and (3) preparing training materials and administering 
training sessions for staff in affected areas.  
For funds that do not already have a derivatives risk management program in place that 
could be readily adapted to meet the proposed rule’s requirements without significant additional 
cost, based on our understanding, we estimate that the ongoing annual program-related costs that 
a fund would incur range from 65% to 75% of the one-time costs to establish and implement a 
derivatives risk management program. Thus, a fund would incur ongoing annual costs that range 
                                                      
496
  Although we believe that many funds have existing risk officers whose role extends to managing 
derivatives risks, we note that some funds, and in particular smaller funds or those that are part of 
a smaller fund complex, may not have existing personnel capable of fulfilling the responsibilities 
of the derivatives risk manager, or may choose to hire a new employee or employees to fulfill this 
role, rather than assigning that responsibility to a current employee or officer of the fund or the 
fund’s investment adviser. We expect that a fund that would hire new employees would likely 
incur larger costs compared to a fund that has existing employees that could serve as a fund’s 
derivatives risk manager.  

268 
from $45,500 to $375,000.
497
 These estimated costs are attributable to the following activities: 
(1) assessing, monitoring, and managing the risks associated with the fund’s derivatives 
transactions; (2) periodically reviewing and updating (A) the program including any models or 
measurement tools (including any VaR calculation models) to evaluate the program’s 
effectiveness and to reflect changes in risk over time, and (B) any designated reference index to 
evaluate its appropriateness; (3) providing written reports to the fund’s board on the derivatives 
risk management program’s implementation and effectiveness and the results of the fund’s stress 
testing; and (4)   additional staff training. 
Under the proposed rule, a fund that is a limited derivatives user would not be required to 
establish a derivatives risk management program.
498
 Based on an analysis of Form N-PORT 
filings, as well as financial statements filed with the Commission by BDCs, we estimate that 
about 22% of funds that would be subject to the proposed rule, or 2,693 funds total, would be 
required to implement a risk management program.
499
 As many funds belong to a fund complex 
and are likely to experience economies of scale, we expect that the lower end of the estimated 
range of costs ($70,000 in one-time costs; $45,500 in annual costs) better reflects the total costs 
likely to be incurred by those funds.
500
 In addition, we believe that many funds already have a 
derivatives risk management program in place that could be readily adapted to meet the proposed 
                                                      
497
  This estimate is based on the following calculations: 0.65 x $70,000 = $45,500; 0.75 x $500,000 
= $375,000. 
498
  The estimates of the one-time and ongoing costs described in this section include the costs 
associated with determining whether a fund is a limited derivatives user.  
499
  We estimate that about 22% of all funds that would be subject to the proposed rule hold some 
derivatives and would not qualify as a limited derivatives user under the proposed rule.  
500
  A fund that uses derivatives in a complex manner, has existing risk management practices that are 
not commensurate with such use of derivatives, and may have to hire additional personnel to 
fulfill the role of derivatives risk manager would be particularly likely to experience costs at the 
upper end of this range. 

269 
rule’s requirements without significant additional cost.
 501
 However, as we do not have data to 
determine how many funds already have a program in place that would substantially satisfy the 
proposed rule’s requirements, we over-inclusively assume that all funds would incur a cost 
associated with this requirement. Based on these assumptions, we provide an upper-end estimate 
for total industry cost in the first year of $311,041,500.
502
 
2. VaR-Based Limit on Fund Leverage Risk 
The proposed rule would generally impose a VaR-based limit on fund leverage risk on 
funds relying on the rule to engage in derivatives transactions.
503
 This outer limit would be based 
on a relative VaR test or, if the fund’s derivatives risk manager is unable to identify an 
appropriate designated reference index, an absolute VaR test. In either case a fund would apply 
the test at least once each business day. The proposed rule would include an exception from the 
limit on fund leverage risk for limited derivatives users and also certain funds that are 
“leveraged/inverse investment vehicles,” as defined in the proposed sales practices rules.
504
 
The proposed relative VaR test would limit a fund’s VaR to 150% of the VaR of the 
fund’s designated reference index.
505
 T he designated reference index would have to be 
unleveraged and reflect the markets or asset classes in which the fund invests.
506
 Therefore, the 
                                                      
501
  One commenter indicated that implementing stress testing, which would be one of the required 
elements of the proposed derivatives risk management program, would be only slightly 
burdensome for 27% of respondents to a survey of ICI member firms and would be moderately 
burdensome for an additional 50% of respondents. See ICI Comment Letter III; see also supra 
note 467. 
502
  This estimate is based on the following calculation: 2,693 funds x ($70,000 + $45,500) = 
$311,041,500. 
503
  See supra section II.D. 
504
  See supra sections II.E and II.G.3. 
505
  See supra section II.D.2. 
506
  See supra section II.D.2.a. The proposed definition of “designated reference index” also includes 
 

270 
relative VaR test restricts the incremental risk associated with a fund’s portfolio relative to a 
similar but unleveraged investment strategy. In this sense, the relative VaR test restricts the 
degree to which a fund can use derivatives to leverage its portfolio.  
We recognize that the derivatives risk managers of some funds may not be able to 
identify an appropriate designated reference index.
507
 As these funds would not be able to 
comply with the proposed relative VaR test, the proposed rule would require these funds to 
comply with the proposed absolute VaR test instead.
508
 To comply with the absolute VaR test, 
the VaR of the fund’s portfolio must not exceed 15% of the value of the fund’s net assets. The 
level of loss in the proposed absolute VaR test would provide approximately comparable 
treatment for funds that rely on the absolute VaR test and funds that rely on the relative VaR test 
and use the S&P 500 as their designated reference index during periods where the S&P 500’s 
VaR is approximately equal to the historical mean.
509
 
One common critique of VaR is that it does not reflect the conditional distribution of 
losses beyond the specified confidence level.
510
 In other words, the proposed VaR tests would 
not capture the size and relative frequency of losses in the “tail” of the distribution of losses 
                                                      
other requirements, as discussed above. See id. For example, a designated reference index could 
not be administered by an organization that is an affiliated person of the fund, its investment 
adviser, or principal underwriter, or created at the request of the fund or its investment adviser, 
unless the index is widely recognized and used. 
507
  See supra section II.D.3. 
508
  Whether a fund complies with the proposed relative or absolute VaR test would depend on 
whether the fund’s derivatives risk manager would be able to identify a designated reference 
index that is appropriate for the fund taking into account the fund’s investments, investment 
objectives, and strategy. See id. We therefore anticipate that industry norms that reflect the 
availability of an appropriate designated reference index would develop under which funds with 
similar strategies would generally comply with the same type of VaR test (that is, either the 
proposed relative VaR test or the proposed absolute VaR test). 
509
     See supra section II.D.3. 
510
  See supra note 182 and accompanying text.  

271 
beyond the measured confidence level.
511
 As a result, two funds with the same VaR level could 
differ significantly in the magnitude and relative frequency of extreme losses, even though the 
probability of a VaR breach would be the same for the two funds. To demonstrate this limitation 
of VaR, we construct a simplified portfolio with an equity investment that also achieves leverage 
through derivatives. By varying the type of derivatives included in the portfolio, we illustrate that 
the tail risk varies significantly across portfolios with equal VaR. 
The details of the strategy are as follows. Assume a fund has initial assets of $100 in 
cash. On day 푡푡, the manager of the portfolio achieves the additional leverage by writing $ 푋푋 
worth of put options, and then invests the proceeds from the sale of the options and the initial 
cash balance, i.e., $(100+푋푋), into the S&P 500 index.
512
 For simplicity, we further assume that 
the underlying asset of the shorted put options is also the S&P 500 index, so that the fund’s 
designated reference index is the S&P 500. The maturity of the put option is assumed to be one 
month, and the price of the S&P on day 푡푡 is normalized to $100. On day 푡푡+1, the manager buys 
back the put options and realizes the returns of the strategy. The one-day gross return of the fund 
can be described mathematically as 
푅푅
퐹퐹퐹퐹퐹퐹퐹퐹
=
100+푋푋
100
푅푅
푀푀
−
푋푋
100
푅푅
푝푝퐹퐹푝푝
, 
where 푅푅
푀푀
 is the gross one-day return of the S&P 500 index, and 푅푅
푝푝퐹퐹푝푝
=푃푃
(
푡푡+1
)
/푃푃
(
푡푡
)
 is the 
gross one-day return of the put option, with the price of the put option at time t denoted by 푃푃(푡푡). 
                                                      
511
  The term “relative frequency” here refers to the frequency of loss outcomes in the tail of the 
distribution relative to other loss outcomes that are also in the tail of the distribution. This relative 
frequency of the loss outcomes together with the magnitude of the associated losses describe the 
conditional distribution of losses in the tail of the distribution.  
512
  This strategy could be implemented by either investing in the constituent securities of the S&P 
500 directly or, for example, by investing in an ETF that tracks the S&P 500 index.  

272 
The return of the put option depends on the return of the underlying asset, and the money-ness of 
the put—the lower the strike price, the more out-of-the-money is the put. In our exercise, we 
look at three options with three different strike prices, ranging from more out-of-the-money to at-
the-money. The strike prices, denoted by K, are equal to 퐾퐾=92%,퐾퐾=96%, and 퐾퐾=100% of 
the current level of the S&P 500 index respectively.
513
 Assuming the portfolio manager wants to 
achieve as much leverage as possible with each of the three options, while still abiding by the 
proposed limit set by the relative VaR level of 150% at a 99% confidence level, we calculate the 
amount of puts she would short, the expected returns of the three portfolios, and the relative VaR 
for confidence levels of 95%, 99%, and 99.9%. In our calculation, the model is calibrated to 
approximately match the historical return distribution of the S&P 500. Returns are assumed to be 
normally distributed (for simplicity) with an annualized mean return of 6% and an annual 
standard deviation of roughly 16%. The latter implies a daily standard deviation of 1%. For 
simplicity, the risk-free rate is assumed to be zero. The results are in Table 1. 
 
TABLE 1: PORTFOLIO COMPOSITION, RETURNS AND VAR LEVELS 
 K=92% Portfolio K=96% Portfolio K=100% Portfolio 
Portfolio Weight -0.58% -0.93% -1.54% 
Number of Contracts -9.92  -2.05 -0.84 
Fund Expected Return 6.68% 7.00% 7.30% 
Fund Relative VaR (99%) 1.49 1.49 1.49 
Fund Relative VaR (99.9%) 2.14 2.07 2.03 
 
Relative VaR levels are identical and no greater than 150% for all three portfolios at the 
99% confidence level and, as expected, for each portfolio relative VaR is higher for higher 
                                                      
513
  Given the historical volatility of the S&P 500 – approximately 16% annually, or 1% daily – an 
8% daily drop in the price is an 8 standard deviation event. Therefore, an option with a strike 
price of 92% of the current value of the S&P 500 index could be considered a deep out-of-the-
money option. 

273 
confidence levels. However, this example illustrates that relative VaR varies across these 
portfolio for confidence levels above 99%. The fund writing the more out-of-the-money option 
(퐾퐾=92%) is riskier in the tail of the S&P 500 return distribution (when the S&P 500 drops over 
the one-day period) than the fund writing the at-the-money option (퐾퐾=100%), but the relative 
VaR level at the 99% confidence level does not reflect this difference.  
Figure 1 shows the daily return profile of the three portfolios as a function of daily 
returns to the S&P 500 index. Along the x-axis are daily returns to the S&P 500 index, ranging 
from -8% to +8%. The dotted line represents the daily return profile of a portfolio that tracks 1.5 
times the returns of the S&P 500 index. The figure shows that the degree of tail risk differs 
across portfolios. While the returns to all portfolios are equal at the 150% relative VaR limit at a 
99% confidence level, returns beyond the 150% relative VaR limit are lower for portfolios that 
write puts that are further out-of-the-money.  
FIGURE 1: DAILY PORTFOLIO RETURNS 
 

274 
 
 
FIGURE 2: THREE-DAY RETURNS WITH DAILY REBALANCING 
 
We also considered the effect that a decline in the S&P 500 over three consecutive days 
would have on the fund that is short the put options with a 퐾퐾=92% strike price considered 
above. The proposed rule requires that a fund determine its compliance with the applicable VaR 
test at least once each business day.  In computing three-day returns for the fund, we assume that, 
as the fund exceeds the relative VaR test each business day, the fund rebalances its portfolio, at 
the beginning of each day, to bring the fund back into compliance with the 150% relative VaR 
limit. The solid line in Figure 2 shows the three-day cumulative return of the fund as a function 
of the per-day returns of the S&P 500 on the x-axis, which is assumed to be the same for three 
consecutive days. The dashed curve in Figure 2 shows the corresponding first-day returns of the 
portfolio for comparison, which are the same as those denoted by the solid line in Figure 1. The 
figure shows that the three-day cumulative returns shown by the solid curve (in Figure 2) a re less 

275 
than three times the single-day losses shown by the dashed curve. This is a result of the daily 
rebalancing of the portfolio, which, in this example, reduces the incremental downside risk over 
time.  
As discussed in more detail above, the proposed VaR tests are designed to address the 
concerns underlying section 18, but they are not a substitute for a fully-developed derivatives 
risk management program.
514
 Recognizing VaR’s limitations, the proposed rule also would 
require the fund to adopt and implement a derivatives risk management program that, among 
other things, would require the fund to establish risk guidelines and to stress test its portfolio in 
part because of concerns that VaR as a risk management tool may not adequately reflect tail 
risks. 
DERA staff analyzed the VaR levels of the portfolios of all funds that would be subject to 
the proposed rule and of certain benchmark indexes as of December 2018 in order to estimate 
how many of the funds that would be subject to the proposed VaR-based limit on fund leverage 
risk currently operate in exceedance of that limit.
515
 This analysis identified only six funds that 
would be subject to the proposed limit that DERA staff estimated may fail the relative VaR test. 
In the case of these six funds, DERA staff calculated the relative VaR test using the primary 
benchmark disclosed in the funds’ prospectuses. To the extent that these funds’ derivatives risk 
managers were to determine that a different index would be more appropriate for purposes of 
                                                      
514
  See supra note 184 and accompanying text. 
515
  This analysis is based on Morningstar data as of December 31, 2018. DERA staff computed the 
VaR of each fund and that of a reference index using historical simulation from three years of 
prior daily return data. Staff generally computed the relative VaR test based on a fund’s primary 
prospectus benchmark. In cases where historical return data for the primary prospectus 
benchmark was not available or where the primary prospectus benchmark did not appear to 
capture the markets or asset classes in which a fund invests, DERA staff instead used a broad-
based unleveraged index that captures a fund’s markets or asset classes or a broad-based U.S. 
equity index. 

276 
computing the relative VaR test or that no appropriate designated reference index were available, 
some or all of these funds could be compliant with the VaR-based limit on fund leverage risk 
either under the relative VaR test with a more appropriate index or under the absolute VaR 
test.
516
 As a result, we estimate that there would only be a very small number of funds, if any, 
that would have to adjust their portfolios in order to comply with the VaR-based limit on fund 
leverage risk. This is consistent with the VaR-based limit on fund leverage risk functioning as an 
outer bound on fund leverage risk. 
To the extent that there are funds that would have to adjust their portfolios to comply 
with the VaR-based limit on fund leverage risk, these funds would incur associated trading costs. 
If there were a fund that would have to adjust its portfolio so significantly that it could no longer 
pursue its investment strategy, such a fund may also lose investors or, if it chooses to cease 
operating, incur costs associated with unwinding the fund.  
In addition, funds could be required to adjust their portfolios to comply in the future and, 
if so, would incur associated trading costs. For example, as market conditions change, a fund’s 
VaR could exceed the proposed limits, especially if a fund relies on the absolute VaR test. The 
proposed VaR tests also would eliminate the flexibility that funds currently have to leverage their 
portfolios to a greater extent than the proposed VaR tests would permit. Although funds 
currently may not be exercising this flexibility, they may nevertheless value the ability to so 
increase leverage in the future. While, on the one hand, the proposed VaR tests impose costs on 
funds by restricting the strategies they may employ, the proposed limit on fund leverage risk 
would benefit fund investors, to the extent that it would prevent these investors from 
                                                      
516
  Based on our analysis, we estimate that only one of the six funds that we identified may fail the 
proposed relative VaR test would also fail the proposed absolute VaR test.  

277 
experiencing unexpected losses from a fund’s increased risk exposure that are prevented by the 
proposed VaR-based limit on fund leverage risk.  
By establishing a bright-line limit on the amount of leverage risk that a fund can take on 
using derivatives, the proposed rule may make some funds and their advisers more comfortable 
with using derivatives. As a result, some funds that currently invest in derivatives to an extent 
that would result in the fund’s VaR being below the proposed limit may react by increasing the 
extent of their derivatives usage.  
The proposed requirement could also indirectly result in changing the amount of 
investments in funds. On the one hand, the proposed rule could attract additional investment, if 
investors become more comfortable with funds’ general level of riskiness as a result of funds’ 
compliance with an outside limit on fund leverage risk. On the other hand, to the extent that 
investors currently expect funds to limit their risk to levels below those which the proposed 
limits would produce (which investors could observe from the required VaR reporting 
requirements on form N-PORT for funds other than limited derivatives users and 
leveraged/inverse funds), or investors see funds’ general level of riskiness increasing after funds 
come into compliance with the proposed limits, the proposed limits may result in investors re-
evaluating how much risk they are willing to take and reducing their investments in funds. Due 
to a lack of data regarding current investor expectations about fund risk, however, we are unable 
to predict which of the two effects would more likely dominate the other.  
As the proposed requirements would prevent funds from offering investment strategies 
that exceed the proposed outer limit on fund leverage risk, those investors who prefer to invest in 
such funds because they value the increased potential for gains that is generally associated with 
riskier investment strategies may see their investment opportunities restricted by the proposed 

278 
rules. As a result, such investors may instead invest in alternative investment vehicles, exchange-
traded notes, or structured products, which can provide leveraged market exposure but would not 
be subject to the VaR-based limit on fund leverage risk of rule 18f-4.
517
 Alternatively, such 
investors, particularly institutional ones, may instead borrow themselves or trade on margin to 
achieve leverage.  
Funds that would be subject to the proposed VaR-based limit on fund leverage risk would 
incur the cost of determining their compliance with the applicable VaR test at least once each 
business day. Part of these costs would be associated with obtaining the necessary data required 
for the VaR calculation. Funds implementing the relative VaR test would likely incur larger data 
costs compared to funds implementing the absolute VaR test, as the absolute VaR test would 
require funds to obtain data only for the VaR calculation for the fund’s portfolio, whereas the 
relative VaR test also would require funds to obtain data for the VaR calculation for their 
designated reference index. In addition, some index providers may charge licensing fees to funds 
for including indexes in their disclosure documents or for access to information about the index’s 
constituent securities and weightings.
518
  
Funds that do not already have systems to perform the proposed VaR calculations in 
place would also incur the costs associated with setting up these systems or updating existing 
systems.
519
 Both the data costs and the systems costs would likely be larger for funds that use 
                                                      
517
  See supra section III.C.5.  
518 
 We understand that industry practices around licensing indexes for regulatory purposes vary 
widely, with some providers not charging any fees and others charging fees in excess of $10,000 
per year.  
519
  One commenter indicated that implementing a UCITS VaR test would be only slightly 
burdensome for 45% of respondents to a survey of ICI member firms and would be moderately 
burdensome for an additional 34% of respondents. The commenter also indicated that 
respondents commonly reported that the burden would increase, in some cases very substantially, 
 

279 
multiple types of derivatives, use derivatives more extensively, or otherwise have more 
complicated derivatives portfolios, compared to funds with less complicated derivatives 
portfolios.  
Larger funds or funds that are part of a large fund complex may incur higher costs in 
absolute terms but find it less costly, per dollar managed, to perform VaR tests relative to a 
smaller fund or a fund that is part of a smaller fund complex. For example, larger funds may 
have to allocate a smaller portion of existing resources for the VaR test and fund complexes may 
realize economies of scale in implementing systems to compute VaR. In particular, the costs 
associated with implementing or updating systems to calculate VaR would likely only be 
incurred once at the level of a fund complex, as such systems can be used to perform VaR tests 
for all funds in the complex that are subject to the VaR test requirement. Similarly, larger fund 
complexes may incur lower costs associated with purchasing data per fund, to the extent that the 
VaR calculations for multiple funds in the complex partially or completely require the same data.  
Under the proposed rule, a fund that holds derivatives that is  either a limited derivatives 
user or a leveraged/inverse fund that complies with the alternative requirements for 
leveraged/inverse investment vehicles would not be subject to the proposed VaR-based limit on 
fund leverage risk. Based on an analysis of Form N-PORT filings and financial statements filed 
with the Commission by BDCs, we estimate that about 19% of funds that would be subject to the 
proposed rule, or 2,424 funds total, would be required to implement VaR tests.
520
 We estimate 
                                                      
if a VaR test has different parameters or is more prescriptive than UCITS VaR. See ICI Comment 
Letter III; see also supra note 451. As the requirements of the proposed VaR test are generally 
consistent with existing market practice, including that of UCITs funds, the results of this survey 
therefore support our view that many funds would likely experience efficiencies in implementing 
the proposed VaR test.  
520 
 We estimate that about 19% of all funds that would be subject to the proposed rule hold some 
 

280 
that the incremental annual cost associated with the VaR test would range from $5,000 to 
$100,000 per fund, depending on the particular facts and circumstances, including whether the 
fund currently computes VaR; whether the fund is implementing the relative or absolute VaR 
test; and whether a fund that is part of a larger complex may be able to realize economies of 
scale. Funds that currently already compute VaR would be particularly likely to experience costs 
at the very low end of this range.
 Assuming that the midpoint of this range reflects the cost to the 
average fund subject to the VaR requirement, we estimate a total additional annual industry cost 
of $127,260,000.
521
  
In addition, a fund that today or in the future may operate in a manner that would result in 
the fund’s portfolio VaR being just under the proposed limit on fund leverage risk may need to 
alter its portfolio during periods of increased market volatility in order to avoid falling out of 
compliance with the proposed limit. We would expect such a scenario to be more likely for a 
fund that would rely on the absolute VaR test, because the relative VaR test would allow a fund 
to operate with a higher portfolio VaR when the VaR of its designated reference index increases.  
A fund that were to eliminate some of its leverage risk associated with derivatives in 
order to comply with the proposed VaR-based limit on leverage risk might do so through 
unwinding or hedging its derivatives transactions or through some other means. These portfolio 
adjustments may be costly, particularly in conditions of market stress and reduced liquidity. The 
                                                      
derivatives, would not qualify as a limited derivatives user, and are not a leveraged/inverse fund 
that could comply with the alternative requirements for leveraged/inverse investment vehicles.  
521 
 This estimate is based on the following calculation: 2,424 funds x 0.5 x ($5,000 + $100,000) = 
$127,260,000. Some funds may find it more cost effective to restrict their use of derivatives in 
order to be able to rely on the proposed rule’s exception for limited derivatives users compared to 
complying with the proposed VaR-based limit on fund leverage risk. See supra section II.E; infra 
section III.C.3. As we do not have data that would allow us to quantify the costs and benefits that 
define the tradeoff for any particular fund of changing its use of derivatives in order to qualify for 
the limited user exception, we are unable to quantify how many funds would make this choice. 

281 
proposed rule would, however, give a fund the flexibility to mitigate these potential costs by not 
requiring the fund to exit positions or change its portfolio if it is out of compliance with the VaR 
test. Instead, the rule would provide that, if a fund has been out of compliance with the 
applicable VaR test for more than three business days, then: (1) the derivatives risk manager 
must report to the fund’s board of directors and explain how and by when (i.e., the number of 
business days) the derivatives risk manager reasonably expects that the fund will come back into 
compliance;
522
 (2) the derivatives risk manager must analyze the circumstances that caused the 
fund to be out of compliance for more than three business days and update any program elements 
as appropriate to address those circumstances; and (3) the fund may not enter into derivatives 
transactions other than derivatives transactions that, individually or in the aggregate, are 
designed to reduce the fund’s VaR, until the fund has been back in compliance with the 
applicable VaR test for three consecutive business days and satisfied the board reporting 
requirement and program analysis and update requirements.
523
 These provisions of the proposed 
rule collectively would provide some flexibility for a fund that is out of compliance with the VaR 
test to make any portfolio adjustments, which may allow funds to avoid some of the costs that 
otherwise could result from forced changes in the fund’s portfolio.  
3. Limited Derivatives Users 
Proposed rule 18f-4 includes an exception from the proposed risk management program 
requirement and VaR-based limit on fund leverage risk for limited derivatives users.
524
 The 
                                                      
522
  Proposed rule 18f-4(c)(2)(iii)(A). See also infra section II.H.2 (discussing a report to the 
Commission regarding the fund being out of compliance with the applicable proposed VaR test 
for three business days). 
523
  See proposed rule 18f-4(c)(2)(iii). 
524
     See supra section II.E. 

282 
proposed exception would be available for a  fund that either limits its derivatives exposure to 
10% of its net assets or uses derivatives transactions solely to hedge certain currency risks and 
that also adopts and implements policies and procedures reasonably designed to manage the 
fund’s derivative risks. We expect that the risks and potential impact of these funds’ derivatives 
use may not be as significant, compared to those of funds that do not qualify for the exception.
525
 
Therefore, we believe that a principles-based policies and procedures requirement would 
appropriately address these risks. 
We believe that investors in funds that use derivatives in a limited manner would benefit 
from the proposed requirement, which we anticipate would reduce, but not eliminate, the 
frequency and severity of derivatives-related losses for such funds. In addition, to the extent that 
the proposed framework is more comprehensive than funds’ current practices, the proposed 
requirement may result in more effective risk management across funds and increased fund 
industry stability. 
For funds that do not already have policies and procedures in place that could be readily 
adapted to meet the proposed rule’s requirements without significant additional cost, we estimate 
that the one-time costs would range from $1,000 to $100,000 per fund, depending on the 
particular facts and circumstances, including whether a fund is part of a larger fund complex; the 
extent to which the fund uses derivatives within the parameters of the limited user exception, 
including whether the fund uses more complex derivatives; and the fund’s current derivatives 
risk management practices. These estimated costs are attributable to the following activities: 
(1)   assessing whether a fund is a limited derivatives user; (2) developing policies and procedures 
reasonably designed to manage a fund’s derivatives risks; (3)   integrating and implementing the 
                                                      
525
     See supra note 271 and accompanying and immediately-following text.  

283 
policies and procedures; and (4) preparing training materials and administering training sessions 
for staff in affected areas.  
For funds that do not already have policies and procedures in place that could be readily 
adapted to meet the proposed rule’s requirements without significant additional cost, we estimate 
that the ongoing annual costs that a fund that is a limited derivatives user would incur range from 
65% to 75% of the one-time costs to establish and implement the policies and procedures. Thus, 
a fund would incur ongoing annual costs that range from $650 to $75,000.
526
 These estimated 
costs are attributable to the following activities: (1) assessing, monitoring, and managing the 
risks associated with the fund’s derivatives transactions; (2) periodically reviewing and updating 
a fund’s policies and procedures; and ( 3) additional staff training. 
Based on an analysis of Form N-PORT filings, as well as financial statements filed with 
the Commission by BDCs, we estimate that about 19% of funds that would be subject to the 
proposed rule, or 2,398 funds total, would qualify as limited derivatives users. Almost all of 
these funds would be able to rely on the exposure-based exception. While some funds, about 1%, 
could rely on both the exposure-based exception and the currency hedging exception, only a 
fraction of 1% of funds would qualify as limited derivatives users solely based on the currency 
hedging exception.  
As many funds belong to a fund complex and are likely to experience economies of scale, 
we expect that the lower end of the estimated range of costs ($1,000 in one-time costs; $650 in 
annual costs) better reflects the total costs likely to be incurred by many funds. In addition, we 
believe that many funds already have policies and procedures in place that could be readily 
                                                      
526
  This estimate is based on the following calculations: 0.65 x $1,000 = $650; 0.75 x $100,000 = 
$75,000.  

284 
adapted to meet the proposed rule’s requirements without significant additional cost. However, 
as we do not have data to determine how many funds already have such policies and procedures 
in place that would substantially satisfy the proposed rule’s requirements, we assume that all 
funds would incur a cost associated with this requirement. Based on these assumptions, we over-
inclusively estimate a lower bound for the total industry cost in the first year of $751,773.
527
 
Some funds may change how they use derivatives in order to qualify for the limited 
derivatives user exception and thereby avoid the potentially increased compliance cost associated 
with the proposed derivatives risk management program and VaR-based limit on fund leverage 
risk. Specifically, a fund with derivatives exposure just below 10% of its net assets may forego 
taking on additional derivatives positions, or a fund with derivatives exposure just above 10% of 
its net assets may close out some existing derivatives positions. Similarly, a fund that uses 
derivatives to hedge certain currency risks may forego or eliminate its use of derivatives for 
other purposes. As a result, the proposed exception for limited derivatives users may reduce the 
extent to which some funds use derivatives.
528
  
                                                      
527
  This estimate is based on the following calculation: 2,398 funds x 0.19 x ($1,000 + $650) = 
$751,773. This cost estimate assumes that none of the funds that currently do not hold any 
derivatives would choose to establish and implement policies and procedures reasonably designed 
to manage the fund’s derivatives risks in anticipation of a future limited use of derivatives. 
Notwithstanding this assumption, we acknowledge some funds that currently do not use 
derivatives may still choose to establish and implement such policies and procedures 
prophylactically in order to preserve the flexibility to engage in a limited use of derivatives on 
short notice.  
528
  As we do not have data that would allow us to quantify the costs and benefits that define the 
tradeoff for any particular fund of changing its use of derivatives in order to qualify for the 
limited user exception, we are unable to quantify how many funds would make this choice.  

285 
4. Reverse Repurchase Agreements and Similar Financing 
Transactions 
The proposed rule would allow funds to engage in reverse repurchase agreements and 
other similar financing transactions. However, as these transactions achieve economically 
identical results to other secured loans, the proposed rule would require that they be treated the 
same as bank borrowings and other borrowings under section 18. The proposal would therefore 
require a fund to combine any bank borrowings or other borrowings and reverse repurchase 
agreements when assessing compliance with the relevant asset coverage requirements of 
section 18.
529
  
Today, funds rely on the asset segregation approach that Release 10666 describes with 
respect to reverse repurchase agreements, which funds may view as separate from the limitations 
established on bank borrowings (and other senior securities that are evidence of indebtedness) by 
the asset coverage requirements of section 18.
530
 As a result, the degree to which funds could 
engage in reverse repurchase agreements may differ under the proposed rule from the baseline. A 
fund that engages solely in reverse repurchase agreements, or solely in bank borrowings (for 
example), would be unaffected by the proposed requirement.
531
 However, to the extent that a 
fund engages in both reverse repurchase agreements and bank borrowings (or similar 
transactions), because we believe these transactions a re economically equivalent, they would be 
combined for purposes of analyzing whether a fund is in compliance with section 18’s asset 
coverage requirement. This may have the effect of limiting the overall scale of these transactions 
                                                      
529
  See supra section II.I. 
530
  See supra section I.B.2.a. 
531
  For example, an open-end fund with no other senior securities outstanding could borrow an 
amount equivalent to 50% of its net assets using reverse repurchase agreements or bank 
borrowings under the baseline. 

286 
under the proposed requirement compared to the baseline, to the extent that funds today 
separately analyze their asset coverage requirements with respect to reverse repurchase 
agreements under Release 10666 and bank borrowings and similar senior securities under 
section 18.  
DERA staff analyzed funds’ use of reverse repurchase agreements and borrowings using 
Form N-PORT filings as well as financial statements filed with the Commission by BDCs. Based 
on our analysis of Form N-PORT filings, we estimate that about 0.36% of funds that would be 
subject to the proposed rule, or 45 funds total, used these transactions in combined amounts that 
exceeded the asset coverage requirement.
532
 These funds would have to adjust their use of 
reverse repurchase agreements, similar financing transactions, or borrowings in order to comply 
with the proposed rule and may incur associated transactions costs. 
In addition, under the proposed rule, if a fund did not qualify as a limited derivatives user 
due to its other investment activity, any portfolio leveraging effect of reverse repurchase 
agreements, similar financing transactions, and borrowings would also be restricted indirectly 
through the VaR-based limit on fund leverage risk. As a result, a fund could be restricted through 
the VaR-based limit on fund leverage risk from investing the proceeds of borrowings through 
reverse repurchase agreements to the full extent otherwise permitted by the asset coverage 
requirements in section 18 if the fund did not qualify as a limited derivatives user. 
                                                      
532
  In our review of form N-PORT filings, we observed that several of the funds that used reverse 
repurchase agreements and similar financing transactions (bank borrowings and similar 
securities) in combined amounts that exceeded 50% of net assets already exceeded the 50% limit 
for either repurchase agreements, similar financing transactions (bank borrowings and similar 
securities, or both, when considered separately. In our review of financial statements filed by the 
Commission by BDCs, we observed that no BDCs exceeded the asset coverage requirement.  

287 
5. Alternative Requirements for Certain Leveraged/Inverse 
Funds and Proposed Sales Practices Rules for Certain 
Leveraged/Inverse Investment Vehicles  
The proposed sales practices rules would require a broker-dealer or investment adviser to 
(1) exercise due diligence in approving a retail investor’s account to buy or sell shares of 
leveraged/inverse investment vehicles before accepting an order from, or placing an order for, 
such an investor to engage in these transactions; and (2) adopt and implement policies and 
procedures reasonably designed to achieve compliance with the proposed rules.
533
 Additionally, 
a leveraged/inverse fund that meets the definition of a “leveraged/inverse investment vehicle” in 
the proposed sales practices rules would not have to comply with the VaR-based leverage risk 
limit under proposed rule 18f-4, provided the fund limits the investment results it seeks to 300% 
of the return (or inverse of the return) of the underlying index and discloses in its prospectus that 
it is not subject to the proposed VaR-based limit on fund leverage risk.
534
  
These due diligence and approval requirements are designed to address potential investor 
protection concerns with respect to leveraged/inverse investment vehicles by subjecting retail 
investors to specific due diligence and account approval requirements by broker-dealers and 
investment advisers. The proposed rules also are designed to help to ensure that investors in 
these funds are limited to those who are capable of evaluating their characteristics—including 
                                                      
533 
 See supra section II.G.2. The proposed sales practices rules define “leveraged/inverse investment 
vehicle” to mean a registered investment company or an exchange-listed commodity- or 
currency-based trust or fund that seeks, directly or indirectly, to provide investment returns that 
correspond to the performance of a market index by a specified multiple, or to provide investment 
returns that have an inverse relationship to the performance of a market index, over a 
predetermined period of time. See proposed rules 15l-2(d) and 211(h)-1(d). 
534 
 See supra section II.G.3. A leveraged/inverse fund that meets these requirements still would be 
required to satisfy all of the conditions in proposed rule 18f-4 other than the proposed VaR-based 
limit on fund leverage risk, including the proposed conditions requiring a derivatives risk 
management program, board oversight and reporting, and recordkeeping. 

288 
that the funds would not be subject to all of the leverage-related requirements applicable to 
registered investment companies generally—and the unique risks they present. There is a body of 
academic literature providing empirical evidence that retail investors may not fully understand 
the risks inherent in their investment decisions and not fully understand the effects of 
compounding returns over time.
535
 Retail investors could face additional burdens in investing in 
leveraged/inverse investment vehicles, to the extent that they do not currently possess the 
requisite capability of evaluating the risks of these products to satisfy the approval requirements 
implemented by broker-dealers and investment advisers in connection with the proposed rules’ 
due diligence and account approval obligations. However, we expect such retail investors would 
benefit from the proposed requirement, which we believe would help to ensure that investors in 
these funds are limited to those who are capable of evaluating the characteristics and unique risks 
of these products.
536
 We acknowledge that these benefits may be reduced, to the extent that they 
overlap with the effects of investment advisers’ or broker-dealers’ existing requirements or 
practices related to a retail investors’ suitability for investments in these produces as discussed in 
section III.B.5 above.  
                                                      
535
  See, e.g., Annamaria Lusardi & Olivia S. Mitchell, The Economic Importance of Financial 
Literacy: Theory and Evidence, 52 Journal of Economic Literature 5 (2014), available at 
https://www.aeaweb.org/articles?id=10.1257/jel.52.1.5, which provides a literature review of 
recent survey-based work indicating that many retail investors have limited financial literacy and, 
for example, do not always understand the compounding of returns, which may directly apply in 
the context of the daily compounding feature of leveraged/inverse ETFs. The literature does not 
address retail investor’s inattention to investment risk or the unique dynamics of compounding of 
daily returns in the context of leveraged/inverse ETFs or other leveraged/inverse investment 
vehicles specifically, but studies investor inattention to financial products more generally. 
536
  The sales practices rules would not apply to a position in a leveraged/inverse investment vehicle 
established before the rules’ compliance date. See supra note 340 and associated text. As a result, 
investors with such existing positions would only be affected by the proposed sales practices rules 
if they seek to increase an existing or add a new position in a leveraged/inverse investment 
vehicle. 

289 
Since the alternative provision for leveraged/inverse funds under proposed rule 18f-4 
includes a requirement that a leveraged/inverse fund disclose in its prospectus that it is not 
subject to the proposed limit on fund leverage risk, both investors and the market would benefit 
from transparency regarding which funds are exempt from rule 18f-4’s limit on fund leverage 
fund risk. Some investors may value this information to the extent that it helps them make better-
informed choices between funds.  
The costs that broker-dealers and investment advisers may incur as a result of the 
proposed sales practices rules would vary depending on the firm. For example, as the proposed 
requirements are generally modeled after the options account requirements, broker-dealers that 
already have compliance procedures in place for approving options accounts would likely have 
reduced compliance costs.
537
 In addition, some broker-dealers and investment advisers may incur 
costs associated with training customer-facing personnel and supervisory review of account 
approval decisions. Investment advisers’ and broker-dealers’ existing processes, as discussed 
above in section III.B.5,  may reduce the costs that the proposed sales practices rules otherwise 
would involve to the extent that investment advisers or broker-dealers can build on existing 
processes in complying with the proposed sales practices rules. 
Broker-dealers and investment advisers would incur costs associated with the proposed 
sales practices rules. We estimate that one-time costs for a broker-dealer or investment adviser 
related to the due diligence and account approval requirements would range from $7,749 to 
$12,915
538
 and that one-time costs related to drafting the associated policies and procedures 
                                                      
537
  These efficiencies and the resulting reduced compliance costs would not apply to investment 
advisers that are not also registered broker-dealers because they are not subject to FINRA rules. 
538
  This estimated range is based on the following calculations: (6 hours x $365 (compliance 
attorney) + 9 hours x $284 (senior systems analyst) + 12 hours x $331 (senior programmer)) = 
 

290 
would range from $1,367 to $2,278.
539
 Thus, we estimate total one-time costs for a broker-dealer 
or investment adviser would range from $9,116 to $15,193.
540
  
In addition, we estimate that ongoing costs for a broker-dealer or investment adviser 
related to the due diligence and account approval requirements would range from $1,211 to 
$2,018 per year,
541
 that ongoing costs related to the associated policies and procedures 
requirement would range from $903 to $1,505 per year,
542
 and that ongoing costs related to the 
associated recordkeeping requirements would range from $157 to $393 per year.
543
 Thus, we 
                                                      
($2,190 + $2,556 + $3,972) = $8,718 for development and implementation of online client 
questionnaire; (3 hours x $365 (compliance attorney) + 3 hour x $70 (compliance clerk)) = 
$1,305 for customer due diligence; and 1 hour x $309 (compliance manager) = $309 for 
evaluation of client information for account approval/disapproval for a total of $10,332. 
Assuming a range of +/- 25% around the average total of $10,332 gives a range for one-time 
costs from $10,332 x 75% = $7,749 to $10,332 x 125% = $12,915. 
539
  This estimated range is based on the following calculations: (3 hours x $309 (senior manager) + 1 
hour x $365 (compliance attorney) + 1 hour x $530 (chief compliance officer)) = ($927 + $365 + 
$530) = $1,822 for establishing and implementing rule 15l-2 policies and procedures. Assuming a 
range of +/- 25% around the average total of $1,822 gives a range for one-time costs from $1,822 
x 75% = $1,366.50 to $1,822 x 125% = $2,277.50. 
540
  This estimated range is based on the following calculations: $7,749 + $1,366.50 = $9,115.50 for 
the minimum of the cost range and $12,915 + $2,277.50 = $15,192.50 for the maximum of the 
cost range.  
541
  This estimated range is based on the following calculations: (3 hours x $365 (compliance 
attorney) + 3 hour x $70 (compliance clerk)) = $1,305 per year for customer due diligence; and 1 
hour x $309 (compliance manager) = $309 per year for evaluation of client information for 
account approval/disapproval for a total of $1,614 per year. Assuming a range of +/- 25% around 
the average total of $1,614 per year gives a range for ongoing costs from $1,614 x 75% = 
$1,210.50 per year to $1,614 x 125% = $2,017.50 per year. 
542
  This estimated range is based on the following calculations: (1 hour x $309 (senior manager) + 1 
hour x $365 (compliance attorney) + 1 hour x $530 (chief compliance officer)) = $1,204 per year 
for reviewing and updating rule 15l-2 policies and procedures. Assuming a range of +/- 25% 
around the average total of $1,204 per year gives a range for ongoing costs from $1,204 x 75% = 
$903 per year to $1,204 x 125% = $1,505 per year. 
543
  This estimated range is based on the following calculations: (1 hour x $62 (general clerk) + 1 
hour x $95 (senior computer operator)) = $157 per year for the minimum of the cost range and 
(2.5 hours x $62 (general clerk) + 2.5 hours x $95 (senior computer operator) = ($155 + 
$237.50)) = $392.50 per year for the maximum of the cost range.  

291 
estimate that total ongoing costs for a broker-dealer or investment adviser would range from 
$2,271 to $3,915 per year.
544
 
As of December 2018, there were 2,766 broker-dealers that reported some sales to retail 
customer investors.
545
 We estimate that 700 of these broker dealers with retail customer accounts 
(approximately 25%) have retail customer accounts that invest in leveraged/inverse investment 
vehicles.
 
Our staff further estimates that 715,000 existing customer accounts with such broker-
dealers would require account approval for trading in leveraged/inverse investment vehicles and 
that 10,000 new customer accounts opened each year would require such approval.
 546
  
In addition, as of December 2018, there were 8,235 investment advisers registered with 
the Commission having some portion of their business dedicated to retail investors, including 
either individual high net worth clients or individual non-high net worth clients.
547
 We estimate 
that 2,000 of these investment advisers with retail client accounts (approximately 25%) have 
retail client accounts that invest in leveraged/inverse investment vehicles.
 
We further estimate 
that 715,000 existing customer accounts with such investment advisers would require account 
                                                      
544
  This estimated range is based on the following calculations: ($1,210.50 + $903 + $157) = 
$2,270.50 per year for the minimum of the cost range and ($2,017.50 + $1,505 + $392.50) = 
$3,915 per year for the maximum of the cost range.  
545
  Our estimate of the number of broker-dealers with retail customers are based on data obtained 
from Form BD and Form BR as of December 31, 2018.  
546
  The number of broker-dealers that have retail client accounts that invest in leveraged/inverse 
investment vehicles as well as the numbers of existing and new customer accounts with these 
broker-dealers that would require approval for trading in these products are based on staff 
experience, as we do not have data that would allow us to determine these numbers more 
precisely. 
547
  Our estimate of the number of investment advisers with retail accounts are based on data obtained 
from responses to Item 5.D of Form ADV as of December 31, 2018.  

292 
approval for trading in leveraged/inverse investment vehicles, and that 10,000 new customer 
accounts opened each year would require such approval.
548 
 
To the extent that many broker-dealers already have compliance procedures in place for 
approving options accounts, which is a common industry practice, these broker-dealers would 
likely have reduced costs associated with the proposed requirements of the sales practices rules. 
Thus, we estimate that many broker-dealers would incur one-time and ongoing costs that are 
closer to the low end of the provided ranges, while broker-dealers that cannot take advantage of 
such efficiencies and many investment advisors would likely experience costs closer to the high 
end of the provided ranges.
549
 We estimate that the total industry cost for the proposed 
requirements of the sales practice rule in the first year for both broker-dealers and investment 
advisers would equal $2,377,503,800, which is based on the midpoint of the sum of the ranges 
for both one-time and ongoing costs.
550
 S ome broker-dealers and investment advisers may 
decide to pass these compliance costs on to their customers.
 551
  
                                                      
548
  The number of investment advisors that have retail client accounts that invest in 
leveraged/inverse investment vehicles as well as the numbers of existing and new customer 
accounts with these investment advisers that would require approval for trading in these products 
are based on staff experience, as we do not have data that would allow us to determine these 
numbers more precisely.  
549
     See supra notes 514 and 518. 
550
  This estimate is based on the following calculations: (700 broker-dealers + 2,000 registered 
investment advisers having retail customer accounts that invest in leveraged/inverse investment 
vehicles) x ($8,718 + $1,822)) = $28,458,000 + ((2 x 715,000) existing customer accounts with 
broker-dealers and registered investment advisers requiring account approval for trading in 
leveraged/inverse investment vehicles) x ($1,305 + $309) = $2,308,020,000 for total one-time 
industry costs to broker-dealers and investment advisers of $2,336,478,000; and ((2 x 10,000) 
new customer accounts requiring account approval for trading in leveraged/inverse investment 
vehicles) x ($1,305 + $309) = $32,280,000 + (700 broker-dealers + 2,000 registered investment 
advisers having retail customer accounts that invest in leveraged/inverse investment vehicles) x 
$1,204) = $3,250,800 + (10,000 new customer accounts requiring account approval for trading in 
leveraged/inverse investment vehicles) x ($157 (broker-dealer recordkeeping costs) + $392.50 
(investment adviser recordkeeping costs)) = $5,495,000 for total ongoing annual industry costs to 
broker-dealers and investment advisers of $41,025,800 per year. Total industry cost for proposed 
 

293 
In addition, some leveraged/inverse investment vehicles may lose existing or potential 
investors as a result of some retail investors not being approved by their broker-dealer or 
investment adviser to transact in leveraged/inverse investment vehicles or some retail investors 
being deterred by the time costs and delay introduced by the account-opening procedures. 
Broker-dealers or investment advisers with a larger fraction of retail customers or clients that can 
no longer transact in leveraged/inverse investment vehicles as a result of the proposed sales 
practices rules may experience larger declines in their customer or client base and associated 
reductions in profits.
552
  
It is our understanding that no funds that would meet the definition of a 
“leveraged/inverse investment vehicle,” and that seek returns above 300% of the return (or 
inverse of the return) of the underlying index, currently exist. Therefore we do not expect any 
costs associated with existing funds having to alter their investment strategies or business 
practices to comply with proposed rule 18f-4’s alternative requirements for leveraged/inverse 
funds.  
Requiring a leveraged/inverse fund covered by the proposed sales practices rules to limit 
its exposure to 300% of the return (or inverse of the return) of the underlying index while 
                                                      
requirements of sales practice rule in the first year is $2,336,478,000 + $41,025,800 = 
$2,377,503,800, which is consistent with being the midpoint of the sum of the ranges for both 
one-time and ongoing costs discussed in preceding calculations.  
551
  The share of these costs passed on to investors by investment advisers or broker-dealers would 
depend on multiple factors, including the nature of competition between investment advisers and 
broker-dealers as well as investors’ relative sensitivity to changes in fees, the joint effects of 
which are inherently impossible to predict. Some broker-dealers offer transactions in certain 
leveraged/inverse investment vehicles, such as some leveraged/inverse ETFs, without charging 
commissions. In these cases, broker-dealers may pass on some of the compliance costs associated 
with the proposed requirements by charging some amount of commission on these trades.  
552
  Any such reduction in a broker-dealer’s or investment adviser’s customer base may be offset to 
the extent that clients transact in other products with the same broker dealer or investment adviser 
instead.  

294 
preventing a fund that does not qualify as a leveraged/inverse investment vehicle from offering 
investment strategies that exceed the proposed outer limit on fund leverage risk may also have 
competitive effects, which we discuss in section III.B.5 below. As an alternative to the proposed 
exposure limit for leveraged/inverse funds, we also discuss the effects of conditioning the 
exemption for leveraged/inverse funds on compliance with a higher or lower exposure limit in 
section III.D.1 below.  
6. Proposed Amendments to Rule 6c-11 under the Investment 
Company Act and Proposed Rescission of Exemptive Relief for 
Leveraged/Inverse ETFs 
Existing leveraged/inverse ETFs rely on exemptive relief, which the Commission has not 
granted to a leveraged/inverse ETF sponsor since 2009. We are proposing to amend rule 6c-11 to 
remove the provision excluding leveraged/inverse ETFs from its scope, which would permit fund 
sponsors to operate a leveraged/inverse ETF under that rule and without obtaining an exemptive 
order.  
The proposed amendments to rule 6c-11 would benefit any fund sponsors seeking to 
launch leveraged/inverse ETFs that did not obtain the required exemptive relief due to the 
Commission’s moratorium on granting such relief as well as fund sponsors seeking to launch 
leveraged/inverse ETFs in the future. A fund sponsor planning to seek exemptive relief from the 
Commission to form and operate a leveraged/inverse ETF would also no longer incur the cost 
associated with applying for an exemptive order.
553
 To the extent that the amendments result in 
                                                      
553 
 In the ETFs Adopting Release, we estimated that the direct cost of a typical fund’s application for 
ETF relief (associated with, for example, legal fees) is approximately $100,000. As exemptive 
applications for leveraged/inverse ETFs are significantly more complex than those of the average 
fund, we estimate that the direct costs of an application for leveraged/inverse ETF relief would 
amount to approximately $250,000. See ETFs Adopting Release, supra note 76, at nn.537-539 
and accompanying text.  

295 
new leveraged/inverse ETFs coming to market, the industry-wide assets under management of 
leveraged/inverse ETFs could increase and investors that would be eligible under the proposed 
sales practices rules to invest in leveraged/inverse ETFs could benefit from an increase in 
investment choices.
554
  
Because our proposed amendments to rule 6c-11 would permit leveraged/inverse ETFs to 
rely on that rule, we also are proposing to rescind the exemptive orders the Commission has 
previously granted to leveraged/inverse ETFs. As a result, existing and future leveraged/inverse 
ETFs would operate under a consistent regulatory framework. We believe that the costs to 
leveraged/inverse ETFs associated with rescinding their existing exemptive relief would be 
minimal, as we anticipate that all existing leveraged/inverse ETFs would be able to continue 
operating with only minor adjustments, other than being required to comply with the 
requirements in rule 6c-11 for additional website disclosures and basket asset policies and 
procedures.
555
  
Additional economic considerations that the proposed treatment of leveraged/inverse 
ETFs presents with regards to efficiency and competition are discussed below in section III.D. 
7. Unfunded Commitment Agreements 
The proposed rule would permit a fund to enter into unfunded commitment agreements if 
it reasonably believes, at the time it enters into such an agreement, that it will have sufficient 
                                                      
554
  The increase in assets under management among leveraged/inverse ETFs could be attenuated, to 
the extent that proposed rule 15l-2’s and 211(h)-1’s due diligence requirements would lead to a 
reduction in the number of investors that invest in these funds. See infra section III.C.5. 
555
  In this section as well as in section III.D below, we have accounted for the costs and benefits to 
leveraged/inverse ETFs as a result of the removal of the current exclusion of these funds from 
rule 6c-11. We believe that the additional considerations the Commission analyzed in the ETFs 
Adopting Release for ETFs other than leveraged/inverse ETFs that were included in the scope of 
rule 6c-11 at adoption would apply substantially similarly to leveraged/inverse ETFs. See ETFs 
Adopting Release, supra note 76. 

296 
cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment 
agreements, in each case as they come due.
556
 While a fund should consider its unique facts and 
circumstances, the proposed rule would prescribe certain specific factors that a fund must take 
into account in having such a reasonable belief. We believe that the proposed requirements are 
consistent with current market practices, based on the staff’s experience in reviewing and 
commenting on fund registration statements, which have disclosure regarding their unfunded 
commitments, as well as representations funds have made to the staff.
557
 As a result, we do not 
believe that the rule’s treatment of unfunded commitment agreements represents a change from 
the baseline, although we acknowledge that there may be some variation in the specific factors 
that funds consider today, as well as the potential for some variation between those factors and 
those prescribed in the proposed rule. Because we believe that the proposed approach is 
consistent with general market practices and we do not have specific granular information to 
identify differences in funds’ current practices relative to the proposed rule, we believe this 
proposed requirement would not lead to significant economic effects.  
8. Recordkeeping 
Proposed rule 18f-4 includes certain recordkeeping requirements.
558
 Specifically, the 
proposed rule would require a fund to maintain certain records documenting its derivatives risk 
management program’s written policies and procedures, along with its stress test results, VaR 
backtesting results, internal reporting or escalation of material risks under the program, and 
                                                      
556
  See supra section II.J. 
557
  See supra discussion in paragraph preceding note 420. 
558
  See supra section II.K. 

297 
reviews of the program.
559
 It would also require a fund to maintain records of any materials 
provided to the fund’s board of directors in connection with approving the designation of the 
derivatives risk manager and any written reports relating to the derivatives risk management 
program.
560
 A fund that would be required to comply with the proposed VaR test would also 
have to maintain records documenting the determination of: its portfolio’s VaR; its designated 
reference index VaR, as applicable; its VaR ratio (the value of the VaR of the Fund’s portfolio 
divided by the VaR of the designated reference index), as applicable; and any updates to any of 
its VaR calculation models and the basis for any material changes to its VaR models.
561
 A fund 
that would be a limited derivatives user under the proposed rule would have to maintain a written 
record of its policies and procedures that are reasonably designed to manage derivatives risks.
562
 
Finally, a fund engaging in unfunded commitment agreements would be required to maintain 
records documenting the sufficiency of its funds to meet its obligations with respect to all 
unfunded commitment agreements.
563
  
We believe that these proposed requirements would increase the effectiveness of the 
Commission’s oversight of the fund industry, which will, in turn, benefit investors. Further, the 
requirement to keep records documenting the derivatives risk management program, including 
records documenting periodic review of the program and reports provided to the board of 
directors relating to the program, would help our staff evaluate a fund’s compliance with the 
proposed derivatives risk management program requirements. We anticipate that these 
                                                      
559
  See proposed rule 18f-4(c)(i)(A). 
560
  See proposed rule 18f-4(c)(6)(i)(B). 
561
  See proposed rule 18f-4(c)(6)(i)(C). 
562
  See proposed rule 18f-4(c)(6)(i)(D). 
563
  See proposed rule 18f-4(c)(6)(i)(E). 

298 
recordkeeping requirements would generally not impose a large additional burden on funds, as 
most funds would likely choose to keep such records, even absent the proposed requirement to 
do so, in order to support their ongoing administration of the proposed derivatives risk 
management program and their compliance with the associated requirements. 
As discussed below in section IV.B.7, our estimated average one-time and ongoing 
annual costs associated with the recordkeeping requirements take into account the fact that 
certain funds can rely on the proposed rule’s limited derivatives user exception and may incur 
less extensive recordkeeping costs relative to those funds which may not rely on this exception. 
Of the estimated 5,091 funds that would be subject to the recordkeeping requirements, we 
estimate that 2,398 funds would be limited derivatives users. Assuming that both one-time and 
ongoing annual recordkeeping costs for limited derivatives users are 90% of those for funds that 
would not qualify as limited derivatives users, we estimate that, on average, each fund that could 
not rely on the limited user exception would incur a one-time cost of $2,047
 564
 and an ongoing 
cost of $330 per year
565
 and each fund that could rely on the exception would incur, a one-time 
                                                      
564
  This estimate is based on the following derivations and calculations: 1.5 hours x $62 (general 
clerk) / ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $97.60; and 1.5 hours x $95 (senior 
computer operator) / ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $149.54 for a total of 
$97.60 + $149.54 + ($1,800 for initial external cost burden) = $2,047.14, where (2,398/5,091) is 
the share of funds that are limited derivatives users and (5,091 – 2,398)/5,091) is the share of 
funds that are not limited derivatives users.  
565
  This estimate is based on the following derivations and calculations: 2 hours x $62 (general clerk) 
/ ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $130.13; and 2 hours x $95 (senior 
computer operator) / ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $199.39 for a total of 
$130.13 + $199.39 = $329.52, where (2,398/5,091) is the share of funds that are limited 
derivatives users and (5,091 – 2,398)/5,091) is the share of funds that are not limited derivatives 
users. 

299 
cost of $1,842
566
 and an ongoing cost of $297 per year.
567
 We thus estimate that the total 
industry cost for this requirement in the first year would equal $11,529,656.
568
 
9. Amendments to Fund Reporting Requirements 
a. Form N-PORT and Form N-CEN 
We are proposing to amend Form N-PORT to include a new reporting item on funds’ 
derivatives exposure, which would be publicly available for the third month of each fund’s 
quarter.
569
 In addition, we are proposing amendments that would require funds that are subject to 
the proposed VaR-based limit on fund leverage risk to report certain information related to their 
VaR.
570
 We are also proposing to amend Form N-CEN to require a fund to identify (1) whether it 
is a limited derivatives user (either under the proposed exception for funds that limit their 
derivatives exposure to 10% of their net assets or under the exception for funds that limit their 
derivatives use to certain currency hedging); (2) whether it is a leveraged/inverse investment 
vehicle as defined in proposed sales practices rules; and (3) whether it has entered into reverse 
repurchase agreements or similar financing transactions, or unfunded commitment 
                                                      
566
  This estimate is based on the following calculations: $2,047.14 x 90% = $1,842.43. 
567
  This estimate is based on the following calculations: $329.52 x 90% = $296.57. 
568
  This estimate is based on the following calculations: (5,091 – 2,398 = 2,693 funds which cannot 
rely on the limited derivatives user exception) x ($2,047.14 + $329.52) = $6,400,347.32; and 
(2,398 funds which can rely on the limited derivatives user exception) x ($1,842.43 + $296.57) = 
$5,129,309.17 for a total of $11,529,656.48. 
569 
 See supra section II.H.1.While the information for the first two months of a fund’s quarter would 
be non-public, the information for the third month of a fund’s quarter would be publicly 
available. See supra note 360. 
570 
 Specifically, this information would include: (1) the fund’s highest daily VaR during the 
reporting period and its corresponding date; and (2) the fund’s median daily VaR for the reporting 
period. Funds subject to the relative VaR test during the reporting period also would have to 
report: (1) the name of the fund’s designated reference index; (2) the index identifier; (3) the 
fund’s highest daily VaR ratio during the reporting period and its corresponding date; and (4) the 
fund’s median daily VaR ratio for the reporting period. Finally, all funds that are subject to the 
proposed limit on fund leverage risk also would have to report the number of exceptions that the 
fund identified as a result of the backtesting of its VaR calculation model. See id. 

300 
agreements.
571
 These additional reporting requirements would not apply to BDCs, which do not 
file reports on Form N-CEN or Form N-PORT.
572
  
To the extent that measures of derivatives exposure, and the other information that we 
would require funds to report on Forms N-PORT and N-CEN, are not currently available, the 
proposed requirements that funds make such information available periodically on these forms 
would improve the ability of the Commission to oversee reporting funds. It also would allow the 
Commission and its staff to oversee and monitor reporting funds’ compliance with the proposed 
rule and help identify trends in reporting funds’ use of derivatives, portfolio VaRs, and their 
choice of designated reference indexes. The expanded reporting also would increase the ability 
of the Commission staff to identify trends in investment strategies and fund products in reporting 
funds as well as industry outliers.
573
  
Investors, third-party information providers, and other potential users would also 
experience benefits from the proposed amendments to Forms N -PORT and N-CEN.  Investors 
and other potential users would have disclosure of additional information that is not currently 
available in any filings. We believe that the structured data format of this information in Forms 
N-PORT and N-CEN would allow investors and other potential users to more efficiently analyze 
portfolio investment information. The additional information, as well as the structure of that 
                                                      
571 
 We believe that many of these proposed new reporting items would be inapplicable to most 
BDCs. See supra section II.H.3. 
572  
See supra section II.H.4. 
573  
The structuring of the information in Form N-PORT would improve the ability of Commission 
staff to compile and aggregate information across all reporting funds, and to analyze individual 
funds or a group of funds, and would increase the overall efficiency of staff in analyzing the 
information.  

301 
information, would increase the transparency of a fund’s investment strategies and allow more 
efficient assessment of reporting funds’ potential leverage-related risks. 
The amendments to Forms N-PORT and N-CEN would also benefit investors, to the 
extent that they use the information, to better differentiate funds that are not limited derivatives 
users or leveraged/inverse funds based on their derivatives usage. For example, investors would 
be able to more efficiently identify the extent to which such funds use derivatives as part of their 
investment strategies. Investors, and in particular individual investors, could also indirectly 
benefit from the additional information in amended Forms N-PORT and N-CEN to the extent 
that third-party information providers and other interested parties obtain, aggregate, provide, 
analyze and report on the information. Investors could also indirectly benefit from the additional 
information in amended Forms N-PORT and N-CEN to the extent that other entities, including 
investment advisers and broker-dealers, utilize the information to help investors make more 
informed investment decisions related to funds that provide this information. 
As discussed below in section IV.F, our estimated average one-time and ongoing annual 
costs associated with the amendments to Forms N-PORT take into account the fact that certain 
funds that are not subject to the proposed VaR-based limit on fund leverage risk in proposed rule 
18f-4 would not have to report certain VaR-related information and may incur less extensive 
reporting costs relative to those funds subject to the limit, which are required to report such VaR-
related disclosure information. Of the estimated 5,091 funds that would be subject to the 
exposure-related disclosure requirement, we estimate that 2,424 funds would also be subject to 
the VaR-related disclosure requirements. We estimate that, on average, each fund that is not 

302 
subject to the VaR-related disclosure requirement would incur a one-time cost of $6,982
 574
 and 
an ongoing cost of $2,088 per year
575
 and each fund that is subject to the VaR-related disclosure 
requirement would incur a one-time cost of $8,374
576
 and an ongoing cost of $4,176 per year. 
577
 
We thus estimate that the total industry cost for this reporting requirement in the first year would 
equal $54,610,890.
578
 
As discussed below in section IV.H, we estimate that the average ongoing annual cost for 
a registered fund to prepare amendments to Form N-CEN is $6.96 per year.
 579
 We thus estimate 
that the total industry cost for all registered funds associated with this reporting requirement in 
the first year is $86,130.
580
 
                                                      
574
  This estimate is based on the following derivations and calculations: (2 hours x $365 (compliance 
attorney) + 2 hours x $331 (senior programmer) + ($5,590 for initial external cost burden)) = 
$6,982 to comply with the new N-PORT requirements of derivatives exposure information in the 
first reporting quarter of the fiscal year.  
575
  This estimate is based on the following derivations and calculations: (3 hours x $365 (compliance 
attorney) + 3 hours x $331 (senior programmer)) = $2,088 per year to comply with the new N-
PORT requirements of derivatives exposure information in the final three reporting quarters of 
the fiscal year. 
576
  This estimate is based on the following derivations and calculations: (4 hours x $365 (compliance 
attorney) + 4 hours x $331 (senior programmer) + ($5,590 for initial external cost burden)) = 
$8,374 to comply with the new N-PORT requirements of derivatives exposure and VaR-related 
information in the first reporting quarter of the fiscal year. 
577
  This estimate is based on the following derivations and calculations: (6 hours x $365 (compliance 
attorney) + 6 hours x $331 (senior programmer)) = $4,176 to comply with the new N-PORT 
requirements of derivatives exposure and VaR-related information in the final three reporting 
quarters of the fiscal year. 
578
  This estimate is based on the following calculations: (5,091 – 2,424 = 2,667 funds which are not 
subject to the VaR-related disclosure agreements) x ($6,982 + $2,088) = $24,189,690; and (2,424 
funds which are subject to the VaR-related disclosure agreements) x ($8,374 + $4,176) = 
$30,421,200 for a total of ($24,189,690 + $30,421,200) = $54,610,890. 
579
  This estimate is based on the following derivations and calculations: 0.01 hour x $365 
(compliance attorney) + 0.01 hour x $331 (senior programmer) = $3.65 + $3.31 = $6.96 per year 
580
  This estimate is based on the following derivations and calculations: (12,375 registered funds 
required to prepare a report on Form N-CEN as amended) x $6.96 = $86,130. 

303 
b. Amendments to Current Reporting Requirements 
We are also proposing current reporting requirements for funds that are relying on 
proposed rule 18f-4 and subject to the proposed VaR-based limit on fund leverage risk. 
Specifically, a fund that is out of compliance with the VaR test for more than three business days 
would be required to file a non-public report on Form N-RN providing certain information 
regarding its VaR test breaches and a fund will also be required to file a report when it is back in 
compliance with its applicable VaR test.
581
  
We anticipate that the enhanced current reporting requirements could produce significant 
benefits. For example, when a fund is out of compliance with the proposed VaR-based limit on 
fund leverage risk, this may indicate that a fund is experiencing heightened risks as a result of a 
fund’s use of derivatives transactions. Such breaches also could indicate market events that are 
drivers of potential derivatives risks across the fund industry and therefore complement other 
sources of information related to such market events for the Commission. As a result, we believe 
that the proposed current reporting requirement would increase the effectiveness of the 
Commission’s oversight of the fund industry by providing the Commission and staff with current 
information regarding potential increased risks and stress events, which in turn would benefit 
investors.  
As discussed below in section IV.G, our estimated average cost burdens associated with 
the amendments to form N-RN are based on the assumption that, of the estimated 2,424 funds 
that would be required to comply with either of the VaR tests, the Commission would receive 
approximately 30 filings per year in response to each of the new VaR-related items proposed to 
be included in Form N-RN, as amended. We estimate such funds would incur an average cost of 
                                                      
581
     See supra section II.H.2. 

304 
$3.49 per year on a per-fund basis
582
 to prepare amended Form N-RN. Thus, the estimated total 
industry cost for this reporting requirement in the first year for funds required to comply with 
either of the VaR tests is $8,460.
583
 
We do not believe there would be any potential indirect costs associated with filing Form 
N-RN, such as spillover effects or the potential for investor flight due to a VaR test breach (to 
the extent that investors would leave a fund if they believed a fund’s VaR test breaches indicate 
that a fund has a risk profile that is inconsistent with their investment goals and risk tolerance), 
because Form N-RN filings would not be publicly disclosed. Because the Form N-RN filing 
requirements would be triggered by events that are part of a fund’s proposed requirement to 
determine compliance with the applicable VaR test at least daily, any monitoring costs associated 
with Form N-RN are included in our estimates of the compliance costs for rule 18f-4 above. 
10. Money Market Funds 
Money market funds are excluded from the scope of proposed rule 18f-4. As we are 
proposing to rescind Release 10666, however, money market funds would not be able to enter 
into transactions covered by proposed rule 18f-4, including derivatives transactions and reverse 
repurchase agreements. As discussed above in section II.A.1, we believe that money market 
funds currently do not typically engage in derivatives transactions or the other transactions 
permitted by rule 18f-4.
584
 However, to the extent that there are money market funds that do 
                                                      
582
  This estimate is based on the following derivations and calculations: 0.005 hour x $365 
(compliance attorney) + 0.005 hour x $331 (senior programmer) = $1.83 + $1.66 = $3.49 per year 
on a per-fund basis. 
583
  This estimate is based on the following derivations and calculations: (30 filings per year 
fractionalized across the 2,424 funds per year required to comply with either of the VaR tests) x 
$3.49 = $8,460. 
584
  Money market funds file monthly reports on Form N-MFP and disclose schedules of portfolio 
securities held on the form. For each security held, Form N-MFP requires money market funds to 
 

305 
engage in such transactions to increase the efficiency of their portfolio management, these funds 
would bear the costs associated with losing any such efficiencies. 
However, we believe any costs to money market funds that may currently enter into 
transactions covered by proposed rule 18f-4 would likely be small. Specifically, as discussed 
above in section II.A.1, we believe that these transactions would generally be inconsistent with a 
money market fund maintaining a stable share price or limiting principal volatility, and 
especially if used to leverage the fund’s portfolio. Therefore, we do not believe that any fund that 
may currently engage in these transactions would use them as an integral part of its investment 
strategy.  
D. Effects on Efficiency, Competition, and Capital Formation  
This section evaluates the impact of the proposed rules and amendments on efficiency, 
competition, and capital formation. However, we are unable to quantify the effects on efficiency, 
competition, and capital formation because we lack the information necessary to provide a 
reasonable estimate. For example, we are unable to predict how the proposed rules, amendments, 
and form amendments would change investors’ propensity to invest in funds and ultimately 
affect capital formation. Therefore, much of the discussion below is qualitative in nature, 
although where possible we attempt to describe the direction of the economic effects. 
1. Efficiency 
Proposed rule 18f-4 in conjunction with the proposed rescission of Release 10666 may 
make derivatives use more efficient for certain funds, particularly for those funds that would 
                                                      
disclose the investment category most closely identifying the instrument held from a list of 
investment categories. See Item C.6 of Form N-MFP. However, the form does not contemplate 
nor include data element categories for transactions covered by proposed rule 18f-4, including 
derivatives transactions and reverse repurchase agreements. We therefore do not estimate the 
extent to which money market funds currently rely on these transactions.  

306 
qualify as limited derivatives users. Specifically, funds’ current asset segregation practices may 
provide a disincentive to use derivatives for which notional amount segregation is the practice, 
even if such derivatives would otherwise provide a lower-cost method of achieving desired 
exposures than purchasing the underlying reference asset directly. For example, a fund seeking 
to sell credit default swaps to take a position in an issuer’s credit risk may currently choose not to 
do so because of the large notional amounts that the fund would segregate for that specific 
derivatives position. The proposed rule therefore could increase efficiency by mitigating current 
incentives for funds to avoid use of certain derivatives (even if foregoing the use of those 
derivatives would entail cost and operational efficiencies).  
In addition, the proposed rules and amendments may change the degree to which some 
funds choose to use derivatives generally or the degree to which funds use certain derivatives 
over others.
585
 Changes in the degree to which certain derivatives are used by funds could affect 
the liquidity and price efficiency of these derivatives. Although unaddressed in the academic 
literature, we expect an increase in the use of derivatives to correspond to an increase in 
derivatives market liquidity as more derivatives contracts may be easily bought or sold in 
markets in a given period, as well as an increase in price efficiency since information regarding 
                                                      
585
  Specifically, (1) as discussed in the previous paragraph, funds may transact in more notional-
value based derivatives as a result of removing the incentive distortion of notional- vs. market-
value asset segregation under funds’ current asset segregation practices; (2) new potential funds 
may reduce their use of derivatives transactions to satisfy the proposed VaR-based limit on fund 
leverage risk (see supra section III.C.2); (3) existing funds may change their use of derivatives 
transactions to respond to risks identified after adopting and implementing their risk management 
programs (see supra section III.C.1); and (4) both existing and new potential funds may increase 
their use of derivatives transactions as a result of the exemptive rule’s bright-line limits on 
leverage risk (see supra section III.C.2). Overall, the effect of the proposed rules and amendments 
on funds use of derivatives transactions is ambiguous and depends on the type of derivatives 
transaction.  

307 
underlying securities (and other factors that affect derivatives prices) may be better reflected in 
the prices of derivative contracts. 
Changes in the degree to which certain derivatives are used could also affect the pricing 
efficiency and liquidity of securities underlying these derivatives and those of related securities. 
For example, one paper provides evidence that the introduction of credit default swap contracts 
decreases the liquidity and price efficiency of the equity security of the issuer referenced in the 
swap.
586
 Conversely, the paper also observes that the introduction of exchange-traded stock 
option contracts improves the liquidity and price efficiency of the underlying stocks. 
The proposed VaR-based limit on fund leverage risk would also establish a bright-line 
limit on the amount of leverage that a fund can take on using derivatives.
587
 To the extent that 
funds are more comfortable with managing their derivatives exposures to a clear outside limit, 
the proposed rule could improve the efficiency of fund’s portfolio risk management practices.  
In addition, the recordkeeping elements of proposed rule 18f-4 would facilitate more 
efficient evaluation of compliance with the rule while also providing the Commission with 
information that may be useful in assessing market risks associated with derivative products. 
                                                      
586
  This paper analyzed NYSE-listed firms and observed that, all else equal, equity markets become 
less liquid and equity prices become less efficient when single-name credit default swap contracts 
are introduced, while the opposite results hold when equity options are listed on exchanges. 
Ekkehart Boehmer, Sudheer Chava, & Heather E. Tookes, Related Securities and Equity Market 
Quality: The Case of CDS, 50 Journal of Financial and Quantitative Analysis 509 (2015), 
available at https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-
analysis/article/related-securities-and-equity-market-quality-the-case-of-
cds/08DE66A250F9950FA486AE818D5E0341. The latter result, that traded equity options are 
associated with more liquid and efficient equity prices,  is consistent with several other academic 
papers. See, e.g., Charles Cao, Zhiwu Chen, & John M. Griffin, Informational Content of Option 
Volume Prior to Takeovers, 78 Journal of Business 1073 (2005), as well as Jun Pan & Allen M. 
Poteshman, The Information in Option Volume for Future Stock Prices, 19 Review of Financial 
Studies 871 (2006). The effects described in the literature are based on studies of the introduction 
of derivative securities and may therefore apply differently to changes in the trading volume of 
derivatives securities that may occur as a result of the proposed rule.  
587
  See supra section III.C.2. 

308 
Moreover, the proposed amendments to fund’s current reporting requirements could facilitate the 
Commission’s oversight of funds subject to proposed rule 18f-4 with fewer resources, thus 
making its supervision more efficient.
  588
  
The amendments to Forms N-PORT and N-CEN would allow investors, to the extent that 
they use the information, to better differentiate funds that are not limited derivatives users or 
leveraged/inverse funds based on their derivatives usage.
589
 As a result, investors would be able 
to more efficiently identify the extent to which such funds use derivatives as part of their 
investment strategies, allowing them to make better-informed investment decisions. 
The proposed sales practices rules could also reduce investments in leveraged/inverse 
investment vehicles, to the extent that some retail investors would not be approved by their 
broker-dealer or investment adviser to transact in leveraged/inverse investment vehicles or to the 
extent that some retail investors would be deterred by the time costs and delay introduced by the 
account-opening procedures.
590
 The proposed amendments to rule 6c-11, however, would likely 
outweigh these effects in the case of leveraged/inverse ETFs and lead to an overall increase in 
the number and assets under management for these types of funds.  
To the extent that the proposed rules would lead to a  reduction in investment in 
leveraged/inverse commodity- or currency-based trusts or funds, the liquidity of these products 
may decline as a result. Conversely, to the extent that the proposed rules would lead to an overall 
increase in investments in leveraged/inverse ETFs, the liquidity of these funds may increase as a 
result. The likely increase in the number, and assets under management, of leveraged/inverse 
                                                      
588
  See supra section III.C.8. 
589
  See supra section III.C.9.a.  
590
  See supra section III.B.5. 

309 
ETFs as a result of the proposed amendments to rule 6c-11 may affect the quality of the markets 
for underlying securities and derivatives. Specifically, the academic literature to date provides 
some evidence, albeit inconclusive, that leveraged/inverse ETFs’ rebalancing activity may have 
an impact on the price and volatility of the constituent assets that make up the ETFs. For 
example, one paper empirically tests whether the rebalancing activity of leveraged/inverse ETFs 
impacts the price and price volatility of underlying stocks.
591
 The authors find a positive 
association, suggesting that rebalancing demand may affect the price and price volatility of 
component stocks, and may reduce the degree to which prices reflect fundamental value of the 
component stocks. As leveraged/inverse ETFs commonly use derivatives to rebalance their 
portfolios, similar effects could also extend to underlying derivatives, although we are not aware 
of any academic literature that has examined the effects of leveraged/inverse ETFs’ rebalancing 
activity on derivatives markets. Conversely, another paper argues that the existing literature that 
studies the effect of leveraged/inverse ETFs’ rebalancing activity on the constituent asset prices 
does not control for the effect of the creation and redemption transactions (i.e., fund flows) by 
authorized participants.
592
 The paper presents evidence that positively leveraged/inverse ETFs 
tend to have capital flows in the opposite direction of the underlying index, and inverse 
leveraged/inverse ETFs tend to have capital flows in the same direction as the underlying index, 
suggesting that investor behavior may attenuate the effect of leveraged/inverse ETFs’ 
rebalancing activity on the prices of underlying securities and derivatives.
593
 
                                                      
591
  See Qing Bai, Shaun A. Bond & Brian Hatch, The Impact of Leveraged and Inverse ETFs on 
Underlying Real Estate Returns, 43 Real Estate Economics 37 (2015). 
592
  See Ivan T. Ivanov & Stephen Lenkey, Are Concerns About Leveraged ETFs Overblown?, FEDS 
Working Paper No. 2014-106 (2014). 
593
  The literature we are aware of focuses on leveraged/inverse ETFs and does not study similar 
effects of leveraged/inverse mutual funds, although both types of funds generally engage in 
 

310 
2. Competition 
Certain aspects of the proposed rules and amendments may have an impact on 
competition.
 
Certain of these potential competitive effects result from the proposed rule imposing 
differential costs on different funds. Specifically, (1) large fund complexes may find it less costly 
to comply per fund with the new requirements of proposed rule 18f-4;
594
 ( 2) funds that would 
qualify as limited derivatives users would generally incur lower compliance costs associated with 
the rule than funds that would not qualify for this exception;
595
 ( 3) funds that would comply with 
the relative VaR test would generally incur higher compliance costs than those that would 
comply with the absolute VaR test; (4) BDCs are not subject to the additional reporting 
requirements on Forms N-CEN or N-PORT and would therefore not incur the increased 
compliance costs that would be imposed on filers of these forms; and (5) leveraged/inverse funds 
are not subject to several of the additional reporting requirements on forms N-CEN or N-PORT 
and would therefore incur a reduced additional burden compared to other funds that are not 
limited users of derivatives.
596
 To the extent that investors believe that the funds that would incur 
lower compliance burdens and the funds that would incur a higher compliance burden under the 
rule are substitutes, the rule would result in a competitive advantage for funds with the lower 
compliance burden to the extent that a lower burden makes such funds materially less costly to 
operate.  
                                                      
similar rebalancing activity. To the extent that similar effects may be attributable to 
leveraged/inverse mutual funds and that any increase in leveraged/inverse ETF assets would be 
(at least partially) offset by a decrease in leveraged/inverse mutual fund assets, this may 
ameliorate the overall effect on the price and volatility of constituent assets.  
594
  See supra section III.C.2. 
595
  See supra section III.C.3. 
596
  See supra section III.C.2. 

311 
To the extent that the proposed sales practices rules’ due diligence and account approval 
requirements limit certain customers or clients from buying or selling shares of certain 
leveraged/inverse investment vehicles, such investors may instead opt to invest in another 
product with a similar risk profile that is not subject to those requirements.
597
 Thus, the proposed 
sales practices rules may generate substitution spillover effects that increase competition 
between leveraged/inverse investment vehicles within the scope of the rule and other products 
outside the scope of the rule that provide similar exposures. 
Similarly, broker-dealers and investment advisers with a larger fraction of retail 
customers or clients that can no longer transact in leveraged/inverse investment vehicles as a 
result of the proposed sales practices rules’ due diligence and account approval requirements 
may experience larger declines in their customer or client base.
598
 As a result, broker-dealers and 
investment advisers that would see a larger reduction in customers or clients may be at a 
competitive disadvantage compared to broker-dealers and investment advisers that would see 
only a smaller reduction in customers or clients or no reduction at all. 
The Commission has not provided exemptive relief to new prospective sponsors of 
leveraged/inverse ETFs since 2009.
599
 The proposed amendments to rule 6c-11 would allow 
other leveraged/inverse ETFs to enter the leveraged/inverse ETF market, likely leading to more 
competition among leveraged/inverse ETFs and between leveraged/inverse ETFs and other 
                                                      
597 
 Some investors that are not approved to buy or sell leveraged/inverse investment vehicles may 
opt to move their capital into exchange-traded notes or other products with a similar risk profile. 
Conversely, some investors may transact in leveraged/inverse investment vehicles without 
involving a broker-dealer or investment adviser that would be subject to the proposed sales 
practices rules, although this is uncommon. See supra note 322. 
598 
 Any such reduction in a broker-dealer’s or investment adviser’s customer base may be offset to 
the extent that clients transact in other products with the same broker dealer or investment adviser 
instead. See supra section III.C.5. 
599 
 See supra text following note 474. 

312 
products that investors may perceive as substitutes, such as leveraged/inverse mutual funds. This 
increase in competition could be significant, as the leveraged/inverse ETF market is very 
concentrated; currently, only two fund sponsors operate leveraged/inverse ETFs.
600
 
In addition, 
fees for leveraged/inverse ETFs and substitute products, such as leveraged/inverse mutual funds, 
could fall as a result of any such increase in competition.  
3. Capital Formation 
Certain aspects of the proposed rules and amendments may have an impact on capital 
formation. Certain of these effects may arise from a change in investors’ propensity to invest in 
funds. On the one hand, investors may be more inclined to invest in funds as a result of increased 
investor protection arising from any decrease in leverage-related risks. On the other hand, some 
investors may reduce their investments in certain funds that may increase their use of derivatives 
in light of the bright-line VaR-based limit on fund leverage risk.
601
 Additionally, some investors 
may re-evaluate their desire to invest in funds generally as a result of the increased disclosure 
requirements, with some investors deciding to invest more and other investors deciding to invest 
less. While we are unable to determine whether the proposed rules and amendments would lead 
to an overall increase or decrease in fund assets, to the extent the overall fund assets change, this 
may have an effect on capital formation.  
The proposed rule may also decrease the use of reverse repurchase agreements, similar 
financing transactions, or borrowings by some funds, or reduce some funds’ ability to invest the 
                                                      
600
  The increase in competition among leveraged/inverse ETFs could be attenuated, to the extent that 
proposed rule 15l-2’s and 211(h)-1’s due diligence requirements would limit the number of 
investors that invest in these funds. See supra section III.C.5. 
601  
See supra section III.C.2. 

313 
borrowings obtained through reverse repurchase agreements.
602
 To the extent that this restricts a 
fund’s ability to obtain financing to invest in debt or equity securities, capital formation may be 
reduced.   
In addition, the proposed sales practices rules may reduce capital formation in asset 
markets directly connected with covered leveraged/inverse investment vehicles. By restricting 
the accounts of customers or clients seeking to buy or sell shares of a leveraged/inverse 
investment vehicle, the proposed rules may produce net capital outflows from retail investors. 
However, the size of this effect would depend on the number of retail investors that would no 
longer be approved to buy or sell shares of leveraged/inverse investment vehicles and any other 
investments these retail investors would make in lieu of investing in leveraged/inverse 
investment vehicles.  
E. Reasonable Alternatives 
1. Alternative Implementations of the VaR Tests  
a. Different Confidence Level or Time Horizon 
Proposed rule 18f-4   would require that a fund’s VaR model use a 99% confidence level 
and a time horizon of 20 trading days.
603
 We could alternatively require a different confidence 
level and/or a different time horizon for the VaR test.  
As discussed above in section II.D.4, market participants calculating VaR most 
commonly use 95% or 99% confidence levels and often use time horizons of 10 or 20 days. The 
proposed VaR parameters therefore represent a confidence level and time horizon at the high end 
of what is commonly used. Compared to requiring a lower confidence level and a shorter time 
                                                      
602
  See supra section III.C.4. 
603
  See supra section II.D.4.  

314 
horizon, the proposed parameters result in a VaR test that is designed to measure, and therefore 
limit the severity of, less frequent but larger losses. The cost of calculating VaR does not vary 
based on how the model is parametrized, meaning the proposed confidence level and time 
horizon would not lead to larger compliance costs for funds compared to the alternatives we 
considered. A lower confidence level or shorter time horizon may be less effective at placing a 
VaR-based outer limit on fund leverage risk associated with larger losses and would not result in 
cost savings for funds. 
b. Absolute VaR Test Only 
To establish an outer limit for a fund’s leverage risk, the proposed rule would generally 
require a fund engaging in derivatives transactions to comply with a relative VaR test; the fund 
could instead comply with an absolute VaR test only if the derivatives risk manager is unable to 
identify an appropriate designated reference index for the fund. As an alternative, we could 
require all funds that would be subject to the proposed VaR-based limit on fund leverage risk to 
comply with an absolute VaR test.  
Use of an absolute VaR test would be less costly for some funds that would be required 
to comply with the relative VaR test under the proposed rule, including because the relative VaR 
test may require some funds to pay licensing costs associated with the use of the reference 
index.
604
 In addition, use of an absolute VaR test would reduce the compliance challenge for 
fund risk managers who have difficulty identifying a designated reference index; however, this 
benefit would be limited for funds that have an existing or easy-to-identify benchmark.  
On the other hand, the absolute VaR test is a static measure of fund risk in the sense that 
the implied limit on a fund’s VaR will not change with the VaR of its designated reference index. 
                                                      
604
  See supra section III.C.2. 

315 
The absolute VaR test is therefore less suited for measuring leverage risk and limiting the degree 
to which a fund can use derivatives to leverage its portfolio, as measuring leverage inherently 
requires comparing a fund’s risk exposure to that of an unleveraged point of reference.
605
 An 
additional implication of this aspect of an absolute VaR test is that a fund may fall out of 
compliance with an absolute VaR test just because the market it invest in becomes more volatile 
even though the degree of leverage in the fund’s portfolio may not have changed. Overall, we 
believe that permitting funds to rely on an absolute VaR test only in those instances when a 
designated reference index is unavailable is justified.  
c. Choice of Absolute or Relative VaR Tests 
As another alternative, we could allow derivatives risk managers to choose between an 
absolute and a relative VaR limit, depending on their preferences and without regard to whether 
a designated reference index is available. Such an alternative would offer derivatives risk 
managers more flexibility than the proposed rule and could reduce compliance costs for funds, to 
the extent that derivatives risk managers would choose the VaR test that is cheaper to implement 
for their particular fund. However, this alternative may result in less uniformity in the outer limit 
on funds’ leverage risk across the industry, as individual derivatives risk managers would have 
the ability to choose between VaR-based tests that could provide for different limits on fund 
leverage risk. Funds that invest in assets with a low VaR, for example, could obtain significantly 
more leverage under an absolute VaR test because the VaR of the fund’s designated reference 
index would be low; as a result, investors in these funds would be less protected from leverage-
related risks compared to the proposed rule.   
                                                      
605
  Id. 

316 
d. Optional Relative VaR Test Using a Fund’s “Securities 
VaR” 
As another alternative, we could allow funds relying on the relative VaR test to compare 
the fund’s VaR to its “securities VaR” (i.e., the VaR of the fund’s portfolio of securities and 
other investments, but excluding any derivatives transactions), rather than the VaR of the fund’s 
designated reference index, depending on the derivatives risk manager’s preferences and without 
regard to whether a designated reference index is available.
606
  
While such an alternative would offer derivatives risk managers more flexibility than the 
proposed rule, we believe that it would not be easier to implement or lead to cost savings for a 
significant number of funds. Conversely, the alternative VaR test based on a fund’s “securities 
VaR” would provide an incentive for some funds to invest in volatile, riskier securities that 
would increase the fund’s “securities VaR,”  thereby reducing the test’s effectiveness at limiting 
fund leverage risk. As a result, investors in these funds would be less protected from leverage-
related risks compared to the proposed rule. 
e. Third-Party Validation of a Fund’s VaR Model 
The proposed rule does not require third-party validation of a fund’s chosen VaR model. 
As an alternative, we could require that a fund obtain third-party validation of its VaR model, 
either at inception or in connection with any material changes to the model, to independently 
confirm that the model is structurally sound and adequately captures all material risks.
607
 While 
such a requirement could help ensure funds’ compliance with the proposed VaR-based limit on 
                                                      
606
  The 2015 Proposing Release also included a risk-based portfolio limit based on VaR, which 
provided that a fund would satisfy its   risk-based portfolio limit condition if a fund’s full portfolio 
VaR was less than the fund’s “securities VaR.” See 2015 Proposing Release, supra note 2, at 
section III.B.2. 
 
607
  See also supra note 244. 

317 
fund leverage risk, this incremental benefit may not justify the potentially significant additional 
costs to funds associated with third-party validation of the fund’s VaR model.
608
  
2. Alternatives to the VaR Tests 
a. Stress Testing 
As an alternative to the proposed VaR-based limit on fund leverage risk, we could require 
a stress testing approach. A s discussed above in section II.D.6.a, we understand that many funds 
that use derivatives transactions already conduct stress testing for purposes of risk management. 
However, we do not believe that a stress testing approach would impose significantly lower costs 
on funds compared to a VaR-based approach, with the exception of those funds that already 
conduct stress testing but not VaR testing.
609
 
In addition, as also discussed in section II.D.6.a above, it would be challenging for the 
Commission to specify a set of asset class shocks, their corresponding shock levels, and, in the 
case of multi-factor stress testing, assumptions about the correlations of the shocks, in a manner 
that applies to all funds and does not become stale over time. While we could also prescribe a 
principles-based stress testing requirement, we believe that the flexibility such an approach 
would give to individual funds over how to implement the test would render it less effective than 
the proposed VaR test at establishing an outer limit on fund leverage risk.  
Finally, stress testing generally focuses on a narrower and more remote range of extreme 
loss events compared to VaR analysis. As a result, a limit on fund leverage risk based on stress 
                                                      
608
  We note that the UCITS regime requires third-party validation of funds’ VaR models; as a result, 
these additional costs could be mitigated for fund that are part of a complex that also includes 
UCITS funds. See supra note 244. 
609
  See also ICI Comment Letter III (stating that, “depending on the type of fund managed and 
whether the fund currently employs the test for risk management purposes, some respondents 
viewed a stress loss test as being more burdensome to implement, while others viewed a VaR test 
as being more burdensome to implement.”).  

318 
testing would likely be less effective at limiting fund leverage risk during more normal 
conditions and protecting investors from unexpected losses resulting from less extreme scenarios.  
b. Asset Segregation 
As another alternative, we could require an asset segregation approach in lieu of the 
proposed VaR-based limit on fund leverage risk. For example, we could consider an approach 
similar to the Commission’s position in Release 10666, under which a fund engaging in 
derivatives transactions would segregate cash and cash equivalents equal in value to the full 
amount of the conditional and unconditional obligations incurred by the fund (also referred to as 
“notional amount segregation”). Such an approach could also permit a fund to segregate a 
broader range of assets, subject to haircuts.
610
 Alternatively, we could require funds to segregate 
liquid assets in an amount equal to the fund’s daily mark-to-market liability plus a “cushion 
amount” designed to address potential future losses.  
As discussed above in section II.D.6.b, we believe that asset segregation approaches have 
several drawbacks as a means for limiting fund leverage risk, compared to the proposed VaR 
tests. For example, notional amount segregation is not risk-sensitive and could restrict 
derivatives transactions that would reduce portfolio risk. Similarly, segregation of liquid assets in 
an amount equal to the fund’s daily mark-to-market liability plus a “cushion amount” would be 
difficult to implement in a manner that is applied uniformly across all funds and types of 
derivatives. In addition, asset segregation approaches raise certain compliance complexities that 
                                                      
610
  The 2016 DERA Memo, for example, analyzed different risk-based “haircuts” that could apply to 
a broader range of assets. See, e.g., 2016 DERA Memo, supra note 12. 

319 
may not make them significantly less costly to implement for funds than the proposed VaR 
tests.
611
  
In conjunction with the proposed VaR-based limit, we could also require a fund relying 
on the proposed rule to maintain an amount of “qualifying coverage assets” designed to enable a 
fund to meet its derivatives-related obligations. As discussed above, we believe that the proposed 
rule’s requirements, including the requirements that funds establish risk management programs 
and comply with the proposed VaR-based limit on fund leverage risk, would address the risk that 
a fund may be required to realize trading losses by selling its investments to generate cash to pay 
derivatives counterparties.  
c. Exposure-Based Test 
We alternatively considered proposing an exposure-based approach for limiting fund 
leverage risk in lieu of the proposed VaR test. An exposure-based test could limit a fund’s 
derivatives exposure, as defined in the proposed rule, to a specified percentage of the fund’s net 
assets. For example, we considered proposing that a fund limit its derivatives exposure to 50% of 
net assets. This would allow a fund to add to its portfolio an amount of derivatives exposure 
equal to the amount that an open-end fund could borrow from a bank. A similar approach would 
be to provide that the sum of a fund’s derivatives exposure and the value of its other investments 
cannot exceed 150% of its net asset value. This latter approach, and particularly if cash and cash 
equivalents were not included in the calculation, would allow a fund to achieve the level of 
market exposure permitted for an open-end fund under section 18 using any combination of 
derivatives and other investments.  
                                                      
611
  See supra section II.D.6.b. 

320 
While an exposure-based test may be simpler and therefore less costly to implement for 
the typical fund than the proposed VaR tests, an exposure-based test has certain limitations 
compared to VaR tests, as discussed in detail in section above. One limitation is that measuring 
derivatives exposure based on notional amounts would not reflect how derivatives are used in a 
portfolio, whether to hedge or gain leverage, nor would it differentiate derivatives with different 
risk profiles. Various adjustments to the notional amount are available that may better reflect the 
risk associated with the derivatives transactions, although even with these adjustments the 
measure would remain relatively blunt. For example, an exposure-based limit could significantly 
limit certain strategies that rely on derivatives more extensively but that do not seek to take on 
significant leverage risk.  
Some of the limitations of an exposure-based approach could be addressed, however, if 
rule 18f-4 were to provide an exposure-based test as an optional alternative to the proposed VaR 
tests, rather than as the sole means of limiting fund leverage risk. Under this second alternative, 
funds with less complex portfolios might choose to rely on an exposure-based test because it 
would be simpler and impose lower compliance costs than the proposed VaR tests. Furthermore, 
if we provided that the sum of a fund’s derivatives exposure and the value of its other 
investments cannot exceed 150% of its net asset value, funds below this threshold would 
generally also pass the proposed relative VaR test.
612
 Conversely, funds with more complex 
portfolios that rely on derivatives more extensively but that do not seek to take on significant 
leverage risk might choose to rely on the proposed VaR test. As the proposed rule would already 
except limited derivatives users from the VaR-based limit on fund leverage risk, however, we do 
                                                      
612
  A fund that limited the sum of its derivatives exposure and the value of its other investments to 
150% of its net asset value would generally also pass the proposed relative VaR test, provided 
that derivatives notionals are either not adjusted or only adjusted for delta in the case of options. 

321 
not believe that also giving funds the option of relying on an exposure-based limit on fund 
leverage risk would be necessary or that it would significantly reduce the compliance burden 
associated with the rule. 
3. Stress Testing Frequency 
Proposed rule 18f-4 would require funds that enter into derivatives transactions and are 
not limited derivatives users to adopt and implement a derivatives risk management program that 
includes stress testing, among other elements. The proposed rule would permit a fund to 
determine the frequency of stress tests, provided that the fund must conduct stress testing at least 
weekly.  
As an alternative to the weekly requirement, we considered both shorter and longer 
minimum stress testing frequencies. On the one hand, more frequent stress testing would reflect 
changes in risk for fund strategies that involve frequent and significant portfolio turnover. In 
addition, more frequent stress testing may reflect increases in market stress in a timelier manner. 
On the other hand, given the forward-looking nature of stress testing, we expect that most funds 
would take foreseeable changes in market conditions and portfolio composition into account 
when conducting stress testing. In addition, more frequent stress testing may impose an increased 
cost burden on funds, although we would expect any additional cost burden to be small, to the 
extent that funds perform stress testing in an automated manner. Overall, we preliminarily 
believe that the proposed minimum weekly stress testing appropriately balances the anticipated 
benefits of relatively frequent stress testing against the burdens of administering stress testing. 
Another alternative would be to permit a fund to determine its own stress testing 
frequency without the proposed rule prescribing a minimum stress testing frequency. This 
approach would provide maximum flexibility to funds regarding the frequency of their stress 
tests, and would reduce compliance costs for funds that determine that stress testing less 

322 
frequently than weekly is warranted in light of their own particular facts and circumstances. 
However, allowing funds to individually determine the frequency with which stress tests are 
conducted could result in some funds stress testing their portfolios too infrequently to provide 
timely information to the fund’s derivatives risk manager and board. Taking these considerations 
into account, we are proposing to require weekly stress tests, rather than less frequent testing, to 
provide for consistent and reasonably frequent stress testing by all funds that would be required 
to establish a derivatives risk management program.  
4. Alternative Exposure Limits for Leveraged/Inverse Funds 
A fund that meets the definition of a “leveraged/inverse investment vehicle” in the 
proposed sales practices rules would not have to comply with the VaR-based leverage risk limit 
under proposed rule 18f-4, provided the fund limits the investment results it seeks to 300% of the 
return (or inverse of the return) of the underlying index and discloses in its prospectus that it is 
not subject to the proposed limit on fund leverage risk.
613
 Alternatively, we could condition the 
exemption on compliance with a higher or lower exposure limit.  
Over longer holding periods, the realized leverage multiple of the returns of an 
investment in a leveraged/inverse fund relative to the returns of its underlying index can vary 
substantially from the fund’s daily leverage multiple.
614
 All else equal, this effect becomes 
stronger as the fund’s leverage multiple increases. The extent of a leveraged/inverse fund’s 
rebalancing activity likewise increases as the fund’s leverage multiple increases.
615
 Therefore, 
                                                      
613 
 See supra section II.G.3. 
614
  See supra section III.B.5. 
615
  The rebalancing demand of a leveraged/inverse fund is a function of the fund’s assets, the 
realized return of its reference index, and is proportional to the term 
(
푥푥
2
−푥푥
)
, where 푥푥 denotes 
the fund’s leverage multiple. (See, e.g., Minder Cheng & Ananth Madhavan, The dynamics of 
leveraged/inverse and inverse exchange-traded funds, 7 Journal of Investment Management 4 
 

323 
the effects of leveraged/inverse funds’ rebalancing activity on the constituent asset prices may be 
heightened if a significant number of leveraged/inverse funds were to increase their leverage 
beyond the levels currently observed in markets and, conversely, could be diminished if a 
significant number of leveraged/inverse funds were to reduce their leverage below current levels.  
While permitting a higher exposure limit may benefit fund sponsors to the extent that 
some sponsors would bring funds with higher leverage multiples to market, we are concerned 
that a higher exposure limit would heighten the investor protection concerns these funds present. 
Conversely, limiting leveraged/inverse funds’ exposure could reduce the concerns these funds 
present, but could reduce investor choice relative to the baseline given that leveraged/inverse 
funds today operate with levels of leverage up to the exposure limit we propose. Allowing funds 
to continue to obtain this level of leverage, subject to the additional requirements in proposed 
rule 18f-4 and in light of the proposed sales practices rules, is designed to address the investor 
protection concerns that underlie section 18, while preserving choice for retail investors who are 
capable of evaluating their characteristics and unique risks. For these reasons, and because the 
Commission does not have experience with leveraged/inverse funds that seek returns above 
300% of the return (or inverse of the return) of the underlying index, we are not proposing to 
permit higher levels of leveraged/inverse market exposure for leveraged/inverse funds in this 
rule. We also are not proposing a lower exposure limit for these funds in light of the investor 
protections that we believe proposed rule 18f-4 and the sales practices rules would provide.
616
  
                                                      
(2009).) As a result, increasing a fund’s leverage multiple increases its rebalancing demand more 
than linearly.  
616
  See supra section II.G.3. 

324 
5. No Sales Practices Rules and No Separate Exposure Limit for 
Leveraged/Inverse Funds 
The proposed rules would require a leveraged/inverse fund that meets the definition of a 
“leveraged/inverse investment vehicle” to limit its investment results to 300% of the return (or 
inverse of the return) of the underlying index and would require a broker-dealer or investment 
adviser to exercise due diligence in approving a retail investor’s account to buy or sell shares of 
leveraged/inverse investment vehicles, as well as implement policies and procedures reasonably 
designed to achieve compliance with the proposed rules.
617
 In lieu of the proposed sales practices 
rules and associated exception from the VaR-based limit on fund leverage risk, we could 
alternatively require leveraged/inverse funds to comply with the proposed relative VaR test.  
Existing leveraged/inverse ETFs and mutual funds generally could comply with the 
proposed relative VaR test only if  they restricted the investment results they seek to 150% of the 
return (or inverse of the return) of the underlying index. Therefore, under this alternative, 
leveraged/inverse funds that seek investment results in excess of this limit would either have to 
significantly change their investment strategy or liquidate. Given that existing fund sponsors 
frequently offer leveraged/inverse funds with various target multiples referencing the same 
index, we would expect that this alternative would reduce the number of leveraged/inverse funds.  
Compared to the proposal, this alternative would also restrict choice for investors that 
prefer to invest in leveraged/inverse funds that pursue investment results in excess of 150% of 
the return (or inverse of the return) of the underlying index and who would satisfy the due 
diligence and approval requirements adopted by their broker-dealer or investment adviser in 
connection with the proposed rule. 
                                                      
617 
 See supra sections II.G.3 and II.G.2.  

325 
At the same time, the alternative could result in increased investor protection for 
investors in these funds compared to the proposal. While investors’ access to leveraged/inverse 
funds would not be subject to the proposed sales practice rules under this alternative (and 
investment advisers and broker-dealers would not incur the associated compliance costs), these 
funds would be required to limit their exposure to 150% of the return (or inverse of the return) of 
the underlying index, thereby reducing the potential consequences for leveraged/inverse fund 
investors who are not capable of evaluating their return characteristics and ameliorating the 
associated investor protection concerns. Conversely, the alternative would reduce protection for 
investors in leveraged/inverse commodity- and currency-based trusts or funds, as those funds 
would be subject to neither the 150% exposure limit nor the proposed sales practices rules.  
Finally, because leveraged/inverse funds would no longer be able to offer exposures 
above 150% of the return (or inverse of the return) of the underlying index, the alternative may 
ameliorate the concerns associated with the rebalancing activity of leveraged/inverse ETFs, 
which decreases with the targeted leverage multiple of these funds.
618
 As discussed above in 
section D.1, however, while the literature observes that leveraged/inverse ETFs’ rebalancing 
activity may have an adverse impact on the prices and volatility of the constituent assets that 
make up leveraged/inverse ETFs, the literature, overall, is not definitive.  
Overall, we believe that preserving investor choice justifies providing leveraged/inverse 
funds an exemption from the proposed VaR-based limit on fund leverage risk, particularly in 
light of the proposed sales practices rules, which we believe would help to ensure that investors 
                                                      
618
  See supra sections III.D.1 and III.E.4. While the literature focuses on leveraged/inverse ETFs, the 
results may apply similarly to leveraged/inverse mutual funds.  

326 
in these funds are limited to those who are capable of evaluating the characteristics and risks of 
these products.
619
 
6. Enhanced Disclosure 
As an alternative to the requirements in rule 18f-4, such as the proposed derivatives risk 
management program and the VaR-based limit on fund leverage risk, we could consider 
addressing the risks associated with funds’ use of derivatives through enhanced disclosures to 
investors with respect to a fund’s use of derivatives and the resulting derivatives-related risks.
620
 
While an approach focused on enhanced disclosures could result in greater fund investment 
flexibility, such an approach may be less effective than the proposed rule in addressing the 
purposes and concerns underlying section 18 of the Investment Company Act. Section 18 itself 
imposes a specific limit on the amount of senior securities that a fund may issue, regardless of 
the level of risk introduced or the disclosure that a fund provides regarding those risks. Absent 
additional requirements to limit leverage or potential leverage, requiring enhancement to 
derivatives disclosure alone would not appear to provide any limit on the amount of leverage a 
fund may obtain. Indeed, the degree to which funds use derivatives varies widely between funds. 
As a result, an approach focused solely on enhanced disclosure requirements may not provide a 
sufficient basis for an exemption from the requirements of section 18 of the Investment 
Company Act. 
                                                      
619
  See also supra note 536. 
620
  See, e.g., Comment Letter of the Fixed Income Market Structure Advisory Committee on 
proposed rule 6c-11 under the Investment Company Act (Oct. 29, 2018) (recommending that the 
Commission consider future rulemaking regarding “leveraged ETP” investor disclosure 
requirements). 

327 
F. Request for Comments 
The Commission requests comment on all aspects of this initial economic analysis, 
including whether the analysis has: (1) identified all benefits and costs, including all effects on 
efficiency, competition, and capital formation; (2) given due consideration to each benefit and 
cost, including each effect on efficiency, competition, and capital formation; and (3) identified 
and considered reasonable alternatives to the proposed new rules and rule amendments. We 
request and encourage any interested person to submit comments regarding the proposed rules, 
our analysis of the potential effects of the proposed rules and proposed amendments, and other 
matters that may have an effect on the proposed rules. We request that commenters identify 
sources of data and information as well as provide data and information to assist us in analyzing 
the economic consequences of the proposed rules and proposed amendments. We also are 
interested in comments on the qualitative benefits and costs we have identified and any benefits 
and costs we may have overlooked. In addition to our general request for comments on the 
economic analysis associated with the proposed rules and proposed amendments, we request 
specific comment on certain aspects of the proposal: 
 Are we correct that many funds already have a derivatives risk management program 
in place that could be readily adapted to meet the proposed rule’s requirements 
without significant additional cost? If so, for how many funds would this be true? 
 The proposed rule does not include any requirement for third-party validation of a 
fund’s chosen VaR model, either at inception or upon material changes, to confirm 
that the model is structurally sound and adequately captures all material risks.
621 
How 
costly would such a requirement be to funds? What would the benefits of such a 
                                                      
621
  See also supra note 244. 

328 
requirement be? 
 Are we correct that many funds that use derivatives in a limited manner already have 
in place policies and procedures that are reasonably designed to address their 
derivatives that could be readily adapted to meet the proposed rule’s requirements 
without significant additional cost? If so, for how many funds would this be true? 
 How many broker-dealers provide customers the ability to buy or sell interests in 
leveraged/inverse investment vehicles? How many investment advisers place orders 
to buy or sell leveraged/inverse investment vehicles for their advisory clients? How 
many retail investor accounts with broker-dealers and investment advisers trade 
leveraged/inverse investment vehicles? 
 How many current investors in leveraged/inverse investment vehicles would likely 
not be approved to buy or sell these products under the proposed sales practices rules’ 
due diligence and account approval requirements?  
 If we provided that the sum of a fund’s derivatives exposure and the value of its other 
investments cannot exceed 150% of its net asset value, funds below this threshold 
would generally also pass the proposed relative VaR test. How many funds would be 
likely to rely on such an exposure-based test if exempted funds that satisfied this limit 
from the proposed VaR tests?  
IV. PAPERWORK REDUCTION ACT ANALYSIS  
A. Introduction 
Proposed rule 18f-4, proposed rule 15l-2, and proposed rule 211(h)  -1 would result in new 
“collection of information” requirements within the meaning of the Paperwork Reduction Act of 

329 
1995 (“PRA”).
622
 In addition, the proposed amendments to rule 6c-11 under the Investment 
Company Act, as well as to Forms N -PORT, Form N-LIQUID (which would be renamed 
Form N -RN),  and N-CEN would affect the collection of information burden under those rules 
and forms.
623
 
The titles for the existing collections of information are: “Form N-PORT” (OMB Control 
No. 3235-0731); “Form N-LIQUID” (OMB Control No. 3235-0754); “Form N-CEN” (OMB 
Control No. 3235-0730); and “Rule 6c-11 under the Investment Company Act of 1940, 
Exchange-traded funds” (OMB Control No. xxxx-xxxx). The titles for the new collections of 
information would be: “Rule 18f-4 under the Investment Company Act of 1940, Use of 
Derivatives by Registered Investment Companies and Business Development Companies,”  “Rule 
15l-2 under the Securities Exchange Act of 1934, Broker and Dealer Sales Practices for 
Leveraged/Inverse Investment Vehicles,”  and “Rule 211(h)  -1 under the Investment Advisers Act 
of 1940, Investment Adviser Sales Practices for Leveraged/Inverse Investment Vehicles.” The 
Commission is submitting these collections of information to the Office of Management and 
Budget (“OMB”) for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. An 
agency may not conduct or sponsor, and a person is not required to respond to, a collection of 
information unless it displays a currently-valid control number. 
The Commission published notice soliciting comments on the collection of information 
requirements in the 2015 Proposing Release and submitted the proposed collections of 
                                                      
622
  44 U.S.C. 3501-3520. 
623
  We do not believe that the proposed conforming amendment to Form N-2, to reflect a 
clarification that funds do not have to disclose in their senior securities table the derivatives 
transactions and unfunded commitment agreements entered into in reliance on proposed rule 18f-
4, makes any new substantive recordkeeping or information collection within the meaning of the 
PRA. Accordingly, we do not revise any burden and cost estimates in connection with this 
proposed amendment. 

330 
information to OMB for review and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11.
624
 The Commission received comments on the 2015 proposal’s collection of 
information burden regarding the 2015 proposal’s trade-by-trade determination of compliance 
with portfolio limits.
625
 These comments were considered but did not form the basis of our 
burden estimates because we do not propose a trade-by-trade determination of compliance with 
the proposed VaR-based tests. 
We discuss below the collection of information burdens associated with proposed 
rule 18f-4, proposed rule 15l-2, proposed rule 211(h)  -1, as well as proposed amendments to 
rule 6c-11 and Forms N-PORT, N-LIQUID, and N-CEN. 
B. Proposed Rule 18f-4 
Proposed rule 18f-4   would permit a fund to enter into derivatives transactions, 
notwithstanding the prohibitions and restrictions on the issuance of senior securities under 
section 18 of the Investment Company Act. 
Proposed rule 18f-4   would generally require a fund that relies on the rule to enter into 
derivatives transactions to: adopt a derivatives risk management program; have its board of 
directors approve the fund’s designation of a derivatives risk manager and receive direct reports 
from the derivatives risk manager about the derivatives risk management program; and require a 
fund to comply with a VaR-based test designed to limit a fund’s leverage risk consistent with the 
investor protection purposes underlying section 18. Proposed rule 18f-4 includes an exception 
from the risk management program requirement and limit on fund leverage risk if a fund is a 
“limited derivatives user” that either limits its derivatives exposure to 10% of its net assets or it 
                                                      
624
  See 2015 Proposing Release, supra note 2. 
625
  See, e.g., Vanguard Comment Letter; Invesco Comment Letter; see also supra note 246 and 
accompanying text. 

331 
uses derivatives transactions solely to hedge certain currency risks. A fund relying on the 
proposed exception would be required to adopt policies and procedures that are reasonably 
designed to manage its derivatives risks. Proposed rule 18f-4 also includes alternative 
requirements for a l everaged/inverse fund not subject to the proposed VaR-based leverage risk 
limit, if such a fund: ( 1) meets the definition of a “leveraged/inverse investment vehicle” in the 
proposed sales practices rules; (  2)   limits the investment results it seeks to 300% of the return (or 
inverse of the return) of the underlying index; and (3)   discloses in its prospectus that it is not 
subject to proposed rule 18f-4’s limit on fund leverage risk.
626
 P roposed rule 18f-4 also would 
require a fund to adhere to certain recordkeeping requirements that are designed to provide the 
Commission’s staff, and the fund’s board of directors and compliance personnel, the ability to 
evaluate the fund’s compliance with the proposed rule’s requirements.  
The respondents to proposed rule 18f-4 would be registered open- and closed-end 
management investment companies and BDCs.
627
 We estimate that 5,091 funds would likely rely 
on rule 18f-4.
628
 Compliance with proposed rule 18f-4 would be mandatory for all funds that 
seek to engage in derivatives transactions in reliance on the rule, which would otherwise be 
                                                      
626
     See proposed rule 18f-4(c)(4); supra section II.G.3. 
627
  See proposed rule 18f-4(a) (defining “fund”). 
628
  See supra notes 468, 499 and accompanying text, and paragraph following note 526 (2,693 funds 
that would be subject to the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and 
complying with the related limited derivatives user requirements). 
The Commission’s estimates of the relevant wage rates in the tables below are based on salary 
information for the securities industry compiled by the Securities Industry and Financial Markets 
Association’s Office Salaries in the Securities Industry 2013. The estimated wage figures are 
modified by Commission staff to account for an 1,800-hour work-year and multiplied by 2.93 to 
account for bonuses, firm size, employee benefits, overhead, and adjusted to account for the 
effects of inflation. See Securities Industry and Financial Markets Association, Report on 
Management & Professional Earnings in the Securities Industry 2013 (“SIFMA Report”). 

332 
subject to the restrictions of section 18. To the extent that records required to be created and 
maintained by funds under the rule are provided to the Commission in connection with 
examinations or investigations, such information would be kept confidential subject to the 
provisions of applicable law.  
1. Derivatives Risk Management Program 
Proposed rule 18f-4   would require certain funds relying on the rule to adopt and 
implement a written derivatives risk management program, which would include policies and 
procedures reasonably designed to manage the fund’s derivatives risks. The proposal would 
require a fund’s program to include the following elements: (1) risk identification and 
assessment; (2) risk guidelines; (3) stress testing; (4) backtesting; (5) internal reporting and 
escalation; and (6) periodic review of the program.
629
 Under the proposed rule, the derivatives 
risk manager is responsible for administering the derivatives risk management program and its 
policies and procedures. Certain funds relying on the proposed rule would not be subject to the 
program requirement.
630
 We estimate that 2,693 funds would likely be subject to the program 
requirement.
631
 Below we estimate the initial and annual ongoing burdens associated with initial 
documentation of the program, and any revision (and related documentation) of the derivatives 
risk management program arising from the periodic review of the program. In addition to the 
initial burden to document the program, including policies and procedures reasonably designed 
to manage the fund’s derivatives risks, we estimate that a fund relying on the proposed rule 
                                                      
629
  See proposed rule 18f-4(c)(1)(i)-(vi); supra section II.A.2 (discussing the proposed derivatives 
risk management program requirement). 
630
  A fund that is a limited derivatives user would not be required to comply with the proposed 
program requirement. Funds that are limited derivatives users would be required to adopt policies 
and procedures that are reasonably designed to manage its derivatives risks. See proposed rule 
18f-4(c)(3); infra section IV.B.6 (discussing limited derivatives users). 
631
  See supra notes 499, 628 and accompanying text. 

333 
would have an ongoing burden associated with the proposed periodic review requirements to 
evaluate the program’s effectiveness and to reflect changes in the fund’s derivatives risks over 
time. Below we estimate the initial and annual ongoing burdens associated with documentation 
and any review and revision of funds’ programs including their policies and procedures. 
Table 2 below summarizes the proposed PRA initial and ongoing annual burden 
estimates associated with the derivatives risk management program requirement under proposed 
rule 18f-4. We do not estimate that there will be any initial or ongoing external costs associated 
with the derivatives risk management program requirement. 

334 
 
Table 2: Derivatives Risk Management Program PRA Estimates 
 Internal initial 
burden hours 
Internal annual 
burden hours
1
  Wage rate
2
 Internal time costs 
PROPOSED ESTIMATES 
Written derivatives risk management 
program development 
12 hours 4 hours × 
$357 (derivatives risk 
manager) 
$1,428 
12 hours 4 hours × 
$466 (assistant general 
counsel) 
$1,864 
12 hours 4 hours × $365 (compliance attorney) $1,460 
 
Periodic review and revisions of the 
program 
 
0 hours 2 hours × 
$357 (derivatives risk 
manager) 
$714 
0 hours 2 hours × 
$466 (assistant general 
counsel) 
$932 
0 hours 2 hours × $365 (compliance attorney) $730 
Total annual burden per fund  18 hours   $7,128 
Number of funds  × 2,693   × 2,693 
Total annual burden  48,474 hours   $19,195,704 
Notes: 
1. For “Written Derivatives Risk Management Program Development,” these 
estimates include initial burden estimates annualized over a three-year period. 
2. See supra note 
628.  
 

 
335 
2. Board Oversight and Reporting 
The proposed rule would require: (1) a fund’s board of directors to approve the 
designation of the fund’s derivatives risk manager,
632
 (2) the derivatives risk manager to provide 
written reports to the board regarding the program’s implementation and effectiveness,
633
 and 
(3) the derivatives risk manager to provide written reports describing any exceedances of the 
fund’s guidelines and the results of the fund’s stress testing and backtesting.
634
 We estimate that 
2,693 funds would be subject to these requirements.
635
 
Table 3 below summarizes the proposed PRA initial and ongoing annual burden 
estimates associated with the board oversight and reporting requirements under proposed 
rule 18f-4. We do not estimate that there will be any initial or ongoing external costs associated 
with the board oversight and reporting requirements. 
                                                      
632
  See proposed rule 18f-4(c)(5)(i); supra section II.C (discussing the proposed board oversight and 
reporting requirements). 
633
  See proposed rule 18f-4(c)(5)(ii); supra section II.C.  
634
  See proposed rule 18f-4(c)(5)(iii); supra section II.C. Burdens associated with reports to the 
fund’s board of directors of material risks arising from the fund’s derivatives transactions, as 
described in proposed rule 18f-4(c)(1)(v), are discussed above in supra section IV.B.1. 
635
     See supra notes 499, 628 and accompanying text. 

336 
Table 3: Board Oversight and Reporting PRA Estimates 
 Internal initial 
burden hours 
Internal annual 
burden hours
1
  Wage rate
2
 Internal time costs 
PROPOSED ESTIMATES 
Approving the designation of the 
derivatives risk manager 
3 hours 1 hour × 
$17,860 (combined rate for 4 
directors)
2
 
$17,860 
Derivatives risk manager written 
reports
3
 
 8 hours × 
$357 (derivatives risk 
manager) 
$2,856 
 1 hour × 
$17,860 (combined rate for 4 
directors) 
$17,860 
Total annual burden per fund  10 hours   $11,786 
Number of funds  × 2,693   × 2,693 
Total annual burden  26,930 hours   $31,739,698 
Notes: 
1. For “Approving the Designation of the Derivatives Risk Manager,” this estimate 
includes initial burden estimates annualized over a three-year period. 
2. See supra notes 
628. 
3. See supra notes 632-633 and accompanying text. 

 
337 
3. Disclosure Requirement Associated with Limit on Fund 
Leverage Risk 
The proposed rule would also generally require funds relying on the rule to comply with 
an outer limit on fund leverage risk based on VaR. This outer limit would be based on a relative 
VaR test that compares the fund’s VaR to the VaR of a “designated reference index.” If the 
fund’s derivatives risk manager is unable to identify an appropriate designated reference index, 
the fund would be required to comply with an absolute VaR test.
636
 Under the proposed rule, a 
fund must disclose its designated reference index in its annual report.
637
 We estimate that 2,424 
funds would be subject to this disclosure requirement.
638
 
Table 4 below summarizes the proposed PRA initial and ongoing annual burden 
estimates associated with the disclosure requirement associated with the proposed limit on fund 
leverage risk. We do not estimate that there will be any paperwork-related initial or ongoing 
external costs associated with this proposed disclosure requirement.   
                                                      
636
  The collections of information burdens for disclosure requirements associated with the proposed 
limit on fund leverage risk are reflected in the PRA for proposed rule 18f-4 and not in the funds’ 
applicable disclosure forms because the burden arises from the proposed rule. The Paperwork 
Reduction Act analysis for the funds’ applicable disclosure forms will not reflect the collections 
of information burdens for disclosure requirements associated with the proposed limit on fund 
leverage risk. 
A fund that is a leveraged/inverse investment vehicle, as defined in the proposed sales practices 
rules, would not be required to comply with the proposed VaR-based limit on fund leverage risk. 
Broker-dealers and investment advisers would be required to approve retail investors’ accounts to 
purchase or sell shares in these funds. See infra sections IV.C and IV.D (discussing 
leveraged/inverse investment vehicles and leveraged/inverse funds covered by the sales practices 
rules). The proposed rule also would provide an exception from the proposed VaR tests for funds 
that use derivatives to a limited extent or only to hedge currency risks. See infra sections IV.B.5 
(discussing the proposed rule’s provisions regarding limited derivatives users). 
VaR test burdens related to recordkeeping and reporting are reflected in the recordkeeping section 
below, and also in the Forms N-PORT, N-CURRENT, and N-CEN burdens discussed below. See 
infra sections IV.F, IV.G, and IV.H. 
637
  See proposed rule 18f-4(c)(2)(iv). 
638
     See supra notes 520-521 and accompanying text. 

338 
Table 4: Disclosure Requirement Associated with Limit on Fund Leverage Risk PRA Estimates 
 Internal initial 
burden hours 
Internal annual 
burden hours  Wage rate
1
 Internal time costs 
PROPOSED ESTIMATES 
Disclosure of designated reference 
index 
0 hours .5 hours × $309 (compliance manager) $154.50 
0 hours .5 hours × $365 (compliance attorney) $182.50 
Total annual burden per fund  1 hour   $337 
Number of funds  × 2,424   × 2,424 
Total annual burden  2,424 hours   $816,888 
 
Notes: 
1. See supra note 
628. 
 

 
339 
4. Disclosure Requirement for Leveraged/Inverse Funds 
Under the proposed rule, a fund would not have to comply with the proposed VaR-based 
leverage risk limit if it: (1) meets the definition of a “leveraged/inverse investment vehicle” in 
the proposed sales practices rules; (2)   limits the investment results it seeks to 300% of the return 
(or inverse of the return) of the underlying index; and (3)   discloses in its prospectus that it is not 
subject to proposed rule 18f-4’s limit on fund leverage risk.
639
 We estimate that 269 funds would 
be subject to the proposed prospectus disclosure requirement for leveraged/inverse funds.
640
 
Table 5 below summarizes the proposed PRA initial and ongoing annual burden 
estimates associated with the disclosure requirement in the proposed rule’s alternative provision 
for leveraged/inverse funds. We do not estimate that there will be any initial or ongoing external 
costs associated with this proposed disclosure requirement.  
                                                      
639
  See proposed rule 18f-4(c)(4); supra section II.G (discussing the alternative requirements for 
leveraged/inverse funds). 
640
  See supra note 468 and accompanying text (164 leveraged/inverse ETFs + 105 leveraged mutual 
funds). 

 
340 
Table 5: Disclosure Requirement Associated with Leveraged/Inverse Funds PRA Estimates 
 Internal initial 
burden hours 
Internal annual 
burden hours  Wage rate
1
 Internal time costs 
PROPOSED ESTIMATES 
Leveraged/inverse fund prospectus 
disclosure 
0 hours .25 hours × $309 (compliance manager) $77 
0 hours .25 hours × $365 (compliance attorney) $91 
Total annual burden per fund  1 hour   $168 
Number of funds  × 269   × 269 
Total annual burden  269 hours   $45,192 
 
Notes: 
1. See supra note 
628. 
 

 
341 
5. Disclosure Changes for Money Market Funds 
Money market funds are excluded from the scope of the rule and could not rely on 
proposed rule 18f-4 to enter into derivatives transactions or other transactions addressed in the 
proposed rule.
641
 To the extent a money market fund currently discloses in its prospectus that it 
may use any of these transactions—even if it is not currently entering into these transactions—
money market funds would be subject to the burdens associated with making disclosure changes 
to their prospectuses. We estimate that 413 funds could be subject to such disclosure changes on 
account of money market funds’ exclusion from the proposed rule.
642
 
Table 6 below summarizes the proposed PRA initial and ongoing annual burden 
estimates associated with disclosure changes that money market funds could make because of 
their exclusion from proposed rule 18f-4.
643
 We do not estimate that there will be any initial or 
ongoing external costs associated with this disclosure change requirement.   
                                                      
641
  See proposed rule 18f-4(a) (defining the term “Fund” to “...not include a registered open-end 
company that is regulated as a money market fund”); supra section II.A.1 (discussing the 
exclusion of money market funds from the scope of the proposed rule). 
642
  See supra note 455 and accompanying text. This likely overestimates the total number of funds 
subject to these disclosure changes, because we believe that money market funds currently do not 
typically engage in derivatives transactions or the other transactions addressed by proposed 
rule 18f-4. See supra section II.A.1. 
643
  These per-fund burden estimates likely overestimate the total burden associated with these 
disclosure changes. See supra note 642. 

 
342 
Table 6: Disclosure Changes for Money Market Funds PRA Estimates 
 Internal initial 
burden hours 
Internal annual 
burden hours  Wage rate
1
 Internal time costs 
PROPOSED ESTIMATES 
Money market prospectus disclosure 
changes 
.75 hours .25 hours × $309 (compliance manager) $77 
.75 hours .25 hours × $365 (compliance attorney) $91 
Total annual burden per fund  .5 hour   $168 
Number of funds  × 413   × 413 
Total annual burden  207 hours   $69,384 
 
Notes: 
1. See supra note 
628. 
 

 
343 
6. Policies and Procedures for Limited Derivatives Users 
Proposed rule 18f-4   would require funds relying on the limited derivatives user 
provisions to adopt and implement written policies and procedures reasonably designed to 
manage the fund’s derivatives risks.
644
 Only funds that limit their derivatives exposure to 10% of 
their net assets or that use derivatives transactions solely to hedge certain currency risks would 
be permitted to rely on these provisions. We estimate that 2,398 funds would be subject to the 
limited derivatives users requirements.
645
 In addition to the initial burden to document the 
policies and procedures, we estimate that limited derivatives users would have an ongoing 
burden associated with any review and revisions to its policies and procedures to ensure that they 
are “reasonably designed” to manage the fund’s derivatives risks. Below we estimate the initial 
and annual ongoing burdens associated with documentation and any review and revision of the 
limited derivatives users’ policies and procedures. 
Table 7 below summarizes the proposed PRA initial and ongoing annual burden 
estimates associated with the policies and procedures requirement for limited derivatives users 
under proposed rule 18f-4. We do not estimate that there will be any initial or ongoing external 
costs associated with the policies and procedures requirement for limited derivatives users. 
                                                      
644
  See proposed rule 18f-4(c)(3); supra section II.E (discussing the proposed policies and 
procedures requirement for limited derivatives users). 
645
  See supra paragraph following note 526. 

344 
Table 7: Policies and Procedures for Limited Derivatives Users PRA Estimates 
 Internal initial 
burden hours 
Internal annual 
burden hours
1
  Wage rate
2
 Internal time costs 
PROPOSED ESTIMATES 
Written policies and procedures 
3 hours 1 hour × $329 (senior manager)
 4
 $329 
3 hours 1 hour × $365 (compliance attorney)
 4
 $365 
Review of policies and procedures 
0 hours .25 hours  $329 (senior manager)
 4
 $82.25 
0 hours .25 hours  $365 (compliance attorney)
 4
 $91.25 
Total annual burden per fund  2.5 hours   $867.50 
Number of funds  × 2,398   × 2,398 
Total annual burden  5,995 hours   $2,080,265 
Notes: 
1. For “Written Policies and Procedures,” these estimates include initial burden 
estimates annualized over a three-year period. 
2. See supra note 628
. 
 

 
345 
7. Recordkeeping Requirements 
Proposed rule 18f-4 would require a fund to maintain certain records documenting its 
derivatives risk management program’s written policies and procedures, along with its stress test 
results, VaR backtesting results, internal reporting or escalation of material risks under the 
program, and reviews of the program.
646
 The proposed rule would also require a fund to maintain 
records of any materials provided to the fund’s board of directors in connection with approving 
the designation of the derivatives risk manager and any written reports relating to the derivatives 
ris  k management program.
647
 A fund that is required to comply with the proposed VaR test 
would also have to maintain records documenting the determination of: its portfolio VaR; the 
VaR of its designated reference indexes, as applicable; its VaR ratio ( the value of the VaR of the 
Fund’s portfolio divided by the VaR of the designated reference index), as applicable; and any 
updates to any of its VaR calculation model and the basis for any material changes to its VaR 
model.
648
 A fund that is a limited derivatives users under the proposed rule would have to 
maintain a written record of its policies and procedures that are reasonably designed to manage 
derivatives risks.
649
 A fund engaging in unfunded commitment agreements would be required to 
maintain records documenting the sufficiency of its funds to meet its obligations with respect to 
all unfunded commitment agreements.
650
  
                                                      
646
  See proposed rule 18f-4(c)(6)(i)(A); supra section II.K (discussing the proposed recordkeeping 
requirements). 
647
  See proposed rule 18f-4(c)(6)(i)(B). 
648
  See proposed rule 18f-4(c)(6)(i)(C). 
649
     See proposed rule 18f-4(c)(6)(i)(D). 
650
     See proposed rule 18f-4(e)(2). 

346 
We estimate that 5,091 funds would be subject to the recordkeeping requirements.
651
 
Below we estimate the average initial and ongoing annual burdens associated with the 
recordkeeping requirements. This average takes into account that some funds such as limited 
derivatives users may have less extensive recordkeeping burdens than other funds that use 
derivatives more substantially. 
Table 8 below summarizes the proposed PRA estimates associated with the 
recordkeeping requirements in rule 18f-4. 
                                                      
651
  See supra notes 468, 499 and accompanying text, and paragraph following note 526 (2,693 funds 
that would be subject to the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and 
complying with the related limited derivatives user requirements). 

347 
Table 8: Recordkeeping PRA Estimates 
 Internal 
initial 
burden 
hours 
Internal 
annual burden 
hours
1
  Wage rate
2
 
Internal time 
costs 
Initial external 
cost burden 
Annual 
external cost 
burden 
PROPOSED ESTIMATES 
Establishing recordkeeping 
policies and procedures 
1.5 .5  $62 (general clerk) $31 
$1,800 $600 
1.5 .5  $95 (senior computer operator) $47.50 
Recordkeeping 0 hours 2 hours × $62 (general clerk) $31 
$0 $0 
 0 hours 2 hours × $95 (senior computer operator) $47.50 
Total annual burden per 
fund 
 5 hours   $157  $600 
Number of funds  × 5,091   × 5,091  5,091 
Total annual burden  25,455 hours   $799,287  $3,054,600 
  
Notes: 
1. For “Establishing Recordkeeping Policies and Procedures,” these estimates 
include initial burden estimates annualized over a three-year period. 
2. See supra note 628. 
 
 

 
348 
8. Proposed Rule 18f-4 Total Estimated Burden 
As summarized in Table 9 below, we estimate that the total hour burdens and time costs 
associated with proposed rule 18f-4, including the burden associated with documenting the 
derivatives risk management program, board oversight and reporting, disclosure requirements 
associated with the proposed VaR tests, disclosure requirements associated with the alternative 
requirements for leveraged/inverse funds, policies and procedures development for limited 
derivatives users, and recordkeeping, amortized over three years, would result in an average 
aggregate annual burden of 109,754 hours and an average aggregate annual monetized time cost 
of $54,761,797. We also estimate that, amortized over three years, there would be external costs 
of $3,054,600 associated with this collection of information. Therefore, each fund that relies on 
the rule would incur an average annual burden of approximately 20.56 hours, at an average 
annual monetized time cost of approximately $10,757, and an external cost of $600 to comply 
with proposed rule 18f-4.
652
 
                                                      
652
  These per-fund burden estimates likely overestimate the total burden of proposed rule 18f-4 
because not all funds (e.g., limited derivatives users) would incur the various burdens set forth in 
the table.  

349 
Table 9: Proposed Rule 18f-4 Total PRA Estimates 
 Internal 
hour burden 
Internal  
burden time cost 
External  
cost burden 
Derivatives risk management program 
48,474 hours $19,195,704 $0 
Board oversight and reporting 26,930 hours $31,739,698 $0 
Disclosure requirement associated 
with limit on fund leverage risk 
2,424 hours $816,888 $0 
Disclosure requirement associated 
with alternative requirements for 
leveraged/inverse funds 
269 hours $45,192 $0 
Disclosure changes for money market 
funds 
207 hours $69,384 $0 
Policies and procedures for limited 
derivatives users 
5,995 hours $2,080,265 $0 
Recordkeeping requirements 25,455 hours $799,287 $3,054,600 
Total annual burden 109,754 $54,746,418 $3,054,600 
Number of funds ÷ 5,091 ÷ 5,091 ÷ 5,091 
Average annual burden per fund 20.56 hours $10,754 $600 
 
C. Proposed Rule 15
l-2: Sales Practices Rule for Broker-Dealers 
Proposed rule 15l-2 would impose burdens on registered broker-dealers relating to 
investments in leveraged/inverse investment vehicles by their retail customers.
653
 The proposed 
rule is designed to address investor protection concerns relating to leveraged/inverse investment 
vehicles by helping to ensure that retail investors in these products are capable of evaluating their 
characteristics and the unique risks they present. The collections of information under proposed 
rule 15l-2, discussed below, would assist the Commission with its accounting, auditing and 
oversight functions. The respondents to the proposed rule would be broker-dealers registered 
under the Exchange Act with retail customers that transact in leveraged/inverse investment 
vehicles. Compliance with proposed rule 15l-2 would be mandatory for all such broker-dealers. 
                                                      
653
  Specifically, the proposed sales practices rules (proposed rule 15l-2, as well as proposed rule 
211(h)-1 under the Advisers Act), would require broker-dealers and investment advisers to 
engage in due diligence before accepting or placing an order for a retail investor to trade a 
leveraged/inverse investment vehicle or approving an investor’s account for such trading. See 
supra section II.G.2.  

350 
To the extent that records required to be created and maintained by broker-dealers under the 
proposed rule are provided to the Commission in connection with examinations or investigations, 
such information would be kept confidential subject to the provisions of applicable law. 
We estimate that, as of December 31, 2018, there were approximately 2,766 broker-
dealers registered with the Commission that reported some sales to retail customer investors.
654
 
We further estimate that 700 of those broker dealers with retail customer accounts 
(approximately 25%) have retail customer accounts that invest in leveraged/inverse investment 
vehicles. 
1. Due Diligence and Account Approval 
Under proposed rule 15l-2, before accepting an order from a customer that is a natural 
person (or the legal representative of a natural person) to buy or sell shares of a leveraged/inverse 
investment vehicle, or approve such a customer’s account to engage in those transactions, the 
broker-dealer must approve the customer’s account to engage in those transactions in accordance 
with the proposed rule.
655
 To make this determination, the broker-dealer must exercise due 
diligence to ascertain certain facts about the customer, his or her financial situation, and 
investment objectives. To comply with this due diligence requirement, the broker-dealer must 
seek to obtain certain information described in the proposed rule. This proposed rule is modeled, 
in large part, after the FINRA rule requiring due diligence and account approval for retail 
investors to trade in options. Based on our understanding of how broker-dealers comply with the 
FINRA options account requirements, we believe that a common way for broker-dealers to 
comply with this due diligence obligation would be to utilize in-house legal and compliance 
                                                      
654
 Our estimates relating to retail sales by broker-dealers are based on data obtained from Form BD 
and Form BR. See also supra note 544 and accompanying text. 
655
  See supra section II.G.2.b. 

351 
counsel, as well as in-house computer and website specialists, to create an online form for 
customers to provide the required information for approval of their accounts to trade in 
leveraged/inverse investment vehicles. We also believe that a portion of the due diligence would 
be performed by individuals associated with a broker-dealer or by telephone or in-person 
meetings with investors. Based on our understanding of current broker-dealer practices, we do 
not believe there would be any initial or ongoing external costs associated with the proposed 
broker-dealer due diligence requirement. 
Currently, there are 105 leveraged/inverse mutual funds, 164 leveraged/inverse ETFs, 
and 17 exchange-listed commodity- or currency-based trusts or funds that meet the definition of 
“leveraged/inverse investment vehicle” under the proposed rule.
656
 Accordingly, there are 286 
leveraged/inverse investment vehicles in total for which a broker-dealer would be required to 
approve a retail customer’s account before the customer could transact in the shares of those 
vehicles. Based on our experience with broker-dealers and leveraged/inverse investment 
vehicles, we estimate that each of these leveraged/inverse investment vehicles is held by 
approximately 2,500 separate retail investor accounts held by registered broker dealers, for a 
total of 715,000 existing accounts requiring approval to trade in leveraged/inverse investment 
vehicles. We further estimate that approximately 10,000 new retail accounts will be opened each 
year requiring approval to trade in leveraged/inverse investment vehicles.
657
 
Table 10 below summarizes our initial and ongoing PRA burden estimates associated 
with the due diligence and account approval requirements in proposed rule 15l-2. Based on our 
understanding of current broker-dealer practices, we do not estimate that there will be any initial 
                                                      
656
  See supra note 468 and accompanying text. 
657
  See supra note 546 and accompanying text. 

352 
or ongoing external costs associated with the proposed due diligence and account approval 
requirements. 

 
353 
Table 10: Proposed Rule 15l-2 Due Diligence and Account Approval PRA Estimates 
 Internal initial 
burden hours 
Internal annual 
burden hours
1
  Wage rate
2
 
Internal time 
costs 
Initial external cost 
burden 
Annual external cost 
burden 
PROPOSED ESTIMATES 
Development and implementation of 
customer due diligence  
6 hours 2 hours × 
$365 (compliance 
attorney) 
$730 
  
9 hours 3 hours × 
$284 (senior systems 
analyst) 
$852 
12 hours 4 hours × 
$331 (senior 
programmer) 
$1324 
Annual burden per broker-dealer 
 9 hours   $2906   
Estimated number of affected  
broker- dealers 
 700   700   
Total burden (I) 
 6300 hours   $2,034,200   
Customer due diligence 
3 hours 1 hour × 
$365 (compliance 
attorney) 
$365 
  
3 hours 1 hour × 
$70 (compliance 
clerk) 
$70 
Evaluation of customer information for 
account approval/disapproval 
1 hour .33 hours × 
$309 (compliance 
manager) 
$101.97   
Total annual burden per customer account 
7 hours 2.33 hours   $536.97   
Estimated number of affected customer 
accounts 
 × 248,333.33
3
   × 248,333.33 × 248,333.33 × 248,333.33 
Total burden (II)  578,616.66 hours   $133,347,548   
Total annual burden (I+II)  584,916.66 hours   $135,381,748 $0 $0 
 
 
Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. 
3. We estimate that 715,000 existing customer accounts with broker-dealers would require the proposed rule 15l-2 account approval for trading in leveraged/inverse investment 
vehicles, and that 10,000 new customer accounts opened each year would require such approval. Accordingly, we believe that over a three-year period, a total of 745,000 accounts will 
require approval, which when annualized ov  er a three-year period, equals 248,333.33 accounts per year. 

 
354 
 
2. Policies and Procedures 
Proposed rule 15l-2 requires broker-dealers to adopt and implement policies and 
procedures reasonably designed to achieve compliance with the proposed rule’s provisions.
658
 
We believe that broker-dealers likely would establish these policies and procedures by adjusting 
their current systems for implementing and enforcing compliance policies and procedures. While 
broker-dealers already have policies and procedures in place to address compliance with other 
Commission rules (among other obligations), they would need to update their existing policies 
and procedures to account for rule 15l-2. To comply with this obligation, we believe that broker-
dealers would use in-house legal and compliance counsel to update their existing policies and 
procedures to account for the requirements of rule 15l-2. For purposes of these PRA estimates, 
we assume that broker-dealers would review the policies and procedures that they would adopt 
under proposed rule 15l-2 annually (for example, to assess whether the policies and procedures 
continue to be “reasonably designed” to achieve compliance with the proposed rule). We 
therefore have estimated initial and ongoing burdens associated with the proposed policies and 
procedures requirement. As discussed above, we estimate that approximately 700 broker dealers 
have retail customer accounts that invest in leveraged/inverse investment vehicles. We do not 
estimate that there will be any initial or ongoing external costs associated with the proposed 
policies and procedures requirement. 
Table 11 below summarizes our initial and ongoing annual PRA burden estimates 
associated with the policies and procedures requirement in proposed rule 15l-2.
                                                      
658
     See supra section II.G.2.b. 

 
355 
Table 11: Proposed Rule 15l-2 Policies and Procedures PRA Estimates 
 Internal 
initial 
burden 
hours 
Internal annual 
burden hours
1
  Wage rate
2
 
Internal time 
costs 
PROPOSED ESTIMATES 
Establishing and implementing rule 
15l-2 policies and procedures 
3 hours 1 hour × $309 (compliance manager) $309.00 
1 hours 0.33 hours × $365 (compliance attorney) $120.45 
1 hour 0.33 hours × $530 (chief compliance officer) $174.90 
Reviewing and updating rule 15l-2 
policies and procedures 
 1 hour × 
$309 (compliance manager) 
$309.00 
 1 hour × 
$365 (compliance attorney) 
$365.00 
 1 hour × 
$530 (chief compliance officer) 
$530.00 
Total annual burden per broker-dealer 
 4.66 hours   $1,808.35 
Number of affected broker-dealers 
 × 700   × 700 
Total annual burden  3,262 hours   $1,265,845 
Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. 
 

 
356 
3. Recordkeeping 
Under proposed rule 15l-2, a broker-dealer would have to maintain a written record of the 
information that it obtained under the rule 15l-2 due diligence requirement and its written 
approval of the customer’s account, as well as the firm’s policies and procedures, for a period of 
not less than six years (the first two years in an easily accessible place) after the date of the 
closing of the client’s account.
659
 To comply with this obligation, we believe that broker-dealers 
would use in-house personnel to compile and maintain the relevant records. We do not estimate 
that there will be any initial or ongoing external costs associated with this requirement. 
Table 12 below summarizes our PRA initial and ongoing annual burden estimates 
associated with the recordkeeping requirement in proposed rule 15l-2. 
  
                                                      
659
     See supra section II.G.2.c. 

357 
Table 12: Proposed Rule 15l-2 Recordkeeping PRA Estimates 
 Internal ini  tial burden 
hours 
Internal annual burden 
hours  Wage rate
1
 
Internal time 
costs 
PROPOSED ESTIMATES 
Recordkeeping 0 hours 1 hour × $62 (general clerk) $62 
 
0 hours 1 hour × 
$95 (senior computer 
operator) 
$95 
Total annual burden per broker-
dealer 
0 hours 2 hours   $157 
Number of affected broker-
dealers 
× 700 × 700   × 700 
Total annual burden 0 hours 1,400 hours   $109,900 
Notes: 
1. See supra note 628
.  
 
 
4. Proposed Rule 15l-2 Total Estimated Burden 
As summarized in Table 13 below, we estimate that the total hour burdens and time costs 
associated with proposed rule 15l-2, including the burden associated with the due diligence and 
account approval requirement, the policies and procedures requirement, and the recordkeeping 
requirement, would result in an average aggregate annual burden of 589,578.66 hours and an 
average aggregate time cost of $136,757,493. Therefore, each broker-dealer would incur an 
annual burden of approximately 842.26 hours, at an average time cost of approximately 
$195,367.85, to comply with proposed rule 15l-2.   
  

358 
Table 13: Proposed Rule 15l-2 Total PRA Estimates 
 Internal initial 
burden hours 
Internal burden 
time cost 
External  
cost burden 
Due diligence and account approval  
 584,916.66 
hours 
$135,381,748 
$0 
Policies and procedures 
3,262 hours 
$1,265,845 
$0 
Recordkeeping 1,400 hours $109,900 $0 
Total annual burden 589,578.66 hours $136,757,493 $0 
Number of affected broker-dealers  ÷ 700 ÷ 700 ÷ 700 
Average annual burden per affected 
broker-dealer 
 842.26 hours $195,367.85 $0 
 
D. Proposed Rule 211(h)-1: Sales Practices for Registered Investment 
Advisers 
Proposed 211(h)  -1 would impose burdens on registered investment advisers relating to 
investments in leveraged/inverse investment vehicles by their retail clients.
660
 P roposed rule 
211(h)  -1 is designed to address investor protection concerns relating to leveraged/inverse 
investment vehicles by helping to ensure that retail investors in these products are capable of 
evaluating their characteristics and the unique risks they present. The Commission also believes 
that the collections of information under proposed rule 211(h)-1, discussed below, would assist 
the Commission with its accounting, auditing and oversight functions. 
The respondents to the proposed rule would be investment advisers registered under the 
Advisers Act that place orders for retail clients to invest in leveraged/inverse investment 
vehicles. Compliance with proposed rule 211(h)-1 would be mandatory for all such investment 
advisers. To the extent that records required to be created and maintained by investment advisers 
under the proposed rule are provided to the Commission in connection with examinations or 
investigations, such information would be kept confidential subject to the provisions of 
applicable law. 
                                                      
660
     See supra note 653. 

359 
We estimate that, as of December 31, 2018, approximately 8,235 investment advisers 
registered with the Commission have some portion of their business dedicated to retail investors, 
including either individual high net worth clients or individual non-high net worth clients.
661
 
Based on our experience with registered investment advisers, we further estimate that 2,000 of 
these investment advisers with retail client accounts (approximately 25%) have retail client 
accounts that invest in leveraged/inverse investment vehicles. As such, the investment advisers 
for those client accounts would be subject to the requirements of proposed rule 211(h)  -1.
662
 
1. Due Diligence and Account Approval 
Under proposed rule 211(h)  -1, before placing an order for the account of a client that is a 
natural person (or the legal representative of a natural person) to buy or sell shares of a 
leveraged/inverse investment vehicle, or approving such a client’s account to engage in those 
transactions, the investment adviser must approve the client’s account to engage in those 
transactions in accordance with the proposed rule.
663
 To make this determination, the adviser 
must exercise due diligence to ascertain certain facts about the client, his or her financial 
situation, and investment objectives. To comply with this due diligence requirement, the 
investment adviser must seek to obtain certain information described in the proposed rule. Based 
on our understanding of how broker-dealers comply with the FINRA options account 
requirements, as discussed above (which we assume, for purposes of this PRA estimate, that 
investment advisers could model their compliance programs after), we believe that investment 
advisers likely would comply with this due diligence obligation by utilizing in-house legal and 
                                                      
661
  Based on responses to Item 5.D of Form ADV. 
662
  See supra note 548 and accompanying paragraph. 
663
    See proposed rule 211(h)-1; supra section II.G.2. 

360 
compliance counsel, as well as in-house computer and website specialists, to create an online 
form for clients to complete with the required information for approval of their accounts to trade 
in leveraged/inverse investment vehicles.
664
 We also believe that a portion of the due diligence 
would be performed by individuals associated with an investment adviser by telephone or in-
person meetings with investors. 
Currently, there are 105 leveraged/inverse mutual funds, 164 leveraged/inverse ETFs, 
and 17 exchange-listed commodity- or currency-based trusts or funds that meet the definition of 
“leveraged/inverse investment vehicle” under the proposed rule.
665
 Accordingly, there are 286 
leveraged/inverse investment vehicles in total for which an investment adviser would be required 
to approve a retail client’s account before the client could transact in the shares those vehicles. 
Based on our experience with registered investment advisers, we estimate that each of these 
leveraged/inverse investment vehicles is held by approximately 2,500 separate retail investor 
accounts held by investment advisers, for a total of 715,000 existing accounts requiring approval 
to trade in leveraged/inverse investment vehicles.   Based on our experience, we further estimate 
that approximately 10,000 new retail accounts will be opened each year requiring approval to 
trade in leveraged/inverse investment vehicles.
666
 
Table 14 below summarizes our initial and ongoing PRA burden estimates associated 
with the due diligence requirement in proposed rule 211(h)  -1. We do not estimate that there will 
be any initial or ongoing external costs associated with the proposed due diligence and approval 
requirements.
                                                      
664
     See supra paragraph accompanying note 655. 
665
  See supra note 468 and accompanying text. 
666
  See supra note 548 and accompanying text. 

 
361 
Table 14: Proposed Rule 211(h)-1 Due Diligence and Account Approval PRA Estimates 
 Internal 
initial 
burden 
hours 
Internal annual 
burden hours
1
  Wage rate
2
 
Internal time 
costs 
Initial 
external 
cost 
burden 
Annual external 
cost burden 
PROPOSED ESTIMATES 
Development and implementation of  
client due diligence   
6 hours 2 hours × $365 (compliance attorney) $730 
$0 $0 9 hours 3 hours × 
$284 (senior systems analyst) 
$852 
12 hours 4 hours × 
$331 (senior programmer) 
$1324 
Annual burden per investment adviser 
 9 hours   $2906   
Estimated number of affected  
investment advisers 
 2000   2000   
Total burden (I)  18,000 hours   $5,812,000   
Client due diligence 
3 hours 1 hour × $365 (compliance attorney) $365 
  
3 hours 1 hour ×  $70 (compliance clerk) $70 
Evaluation of client information for 
account approval/disapproval 
1 hour .33 hours  $309 (compliance manager)  $101.97   
Total annual burden per client 
account 
7 hours 2.33 hours   $536.97   
Estimated number of affected client 
accounts 
 × 248,333.33
3
   × 248,333.33   
Total burden (II)  578,616.66 hours   $133,347,548   
Total annual burden (I+II)  596,616.66 hours   $139,159,548 $0 $0 
 
 
Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. 
3. We estimate that 715,000 existing client accounts with registered investment advisers would require the proposed rule 211(h)-1 account approval for trading in leveraged/inverse 
investment vehicles, and that 10,000 new client accounts opened each year would require such approval. Accordingly, we believe that over a three-year period, a total of 745,000 client 
accounts would require approval, which when annualized over a three-year period, is 248,333.33 accounts per year.

 
362 
 
2. Policies and Procedures 
Proposed rule 211(h)  -1 requires investment advisers to adopt and implement policies and 
procedures reasonably designed to achieve compliance with the proposed rule’s provisions.
667
 
We believe that investment advisers likely would establish these policies and procedures by 
adjusting their current systems for implementing and enforcing compliance policies and 
procedures. While investment advisers already have policies and procedures in place to address 
compliance with other Commission rules (among other obligations), they would need to update 
their existing policies and procedures to account for rule 211(h)  -1. To comply with this 
obligation, we believe that investment advisers would use in-house legal and compliance counsel 
to update their existing policies and procedures to account for the requirements of rule 211(h)-1. 
For purposes of these PRA estimates, we assume that investment advisers would review the 
policies and procedures that they would adopt under proposed rule 211(h)-1 annually (for 
example, to assess whether the policies and procedures continue to be “reasonably designed” to 
achieve compliance with the proposed rule, and in compliance with Advisers Act rule 206(4)-
7(b)). We therefore have estimated initial and ongoing burdens associated with the proposed 
policies and procedures requirement. We do not estimate that there will be any initial or ongoing 
external costs associated with the proposed policies and procedures requirement. 
Table 15 below summarizes our PRA estimates associated with the policies and 
procedures requirement in proposed rule 211(h)-1.   
 
                                                      
667
     See supra section II.G.2.b. 

 
363 
Table 15: Proposed Rule 211(h)-1 Policies and Procedures PRA Estimates 
 
Internal 
initial 
burden 
hours 
Internal annual 
burden hours
1
  Wage rate
2
 
Internal time 
costs 
PROPOSED ESTIMATES 
Establishing and implementing rule 
211(h)-1 policies and procedures 
3 hours 1 hour x $309 (compliance manager) $309 
1 hours 0.33 hours x $365 (compliance attorney) $120.45 
1 hour 0.33 hours x $530 (chief compliance officer) $174.90 
Reviewing and updating rule 211(h)-1 
policies and procedures 
 1 hour  
$309 (compliance manager) 
$309 
 1 hour  
$365 (compliance attorney) 
$365 
 1 hour  
$530 (chief compliance officer) 
$530 
Total annual burden per investment 
adviser 
 4.66 hours   $1808.35 
Number of affected investment 
advisers 
 × 2,000   × 2,000 
Total annual burden 
 9,320 hours   $3,616,700 
Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628
.  
 
 

 
364 
3. Recordkeeping 
Under the proposed rule, a registered investment adviser would have to maintain a 
written record of the information that it obtained under the rule 211(h)  -1 due diligence 
requirement and its written approval of the client’s account for buying or selling shares of 
leveraged/inverse investment vehicles, as well as the firm’s policies and procedures, for a period 
of not less than six years (the first two years in an easily accessible place) after the date of the 
closing of the client’s account.
668
 To comply with this obligation, we believe that investment 
advisers would use in-house personnel to compile and maintain the relevant records. We do not 
estimate that there will be any initial or ongoing external costs associated with this requirement. 
Table 16 below summarizes our PRA estimates associated with the recordkeeping 
requirement in proposed rule 211(h)  -1.    
                                                      
668
     See supra section II.G.2.c. 

365 
Table 16: Proposed Rule 211(h)-1 Recordkeeping PRA Estimates 
 
Internal 
initial 
burden 
hours 
Internal 
annual burden 
hours
1
  Wage rate
2
 
Internal time 
costs 
PROPOSED ESTIMATES 
Recordkeeping 0 hours 2.5 hours × $62 (general clerk) $155 
 0 hours 2.5 hours × $95 (senior computer operator) $237.50 
Total annual burden per 
investment adviser 
0 hours 5 hours   $392.50 
Number of affected 
investment advisers 
× 2000 × 2000   × 2000 
Total annual burden 0 hours 10,000   $785,000 
Notes:  
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628
.  
 
 
4. Proposed Rule 211(h)-1 Total Estimated Burden 
As summarized in Table 17 below, we estimate that the total hour burdens and time costs 
associated with proposed rule 211(h)  -1, including the burden associated with the due diligence 
and account approval requirement, the policies and procedures requirement, and the 
recordkeeping requirement, would result in an average aggregate annual burden of 615,936.66 
hours and an average aggregate time cost of $143,561,248. Therefore, each investment adviser 
would incur an annual burden of approximately 307.97 hours, at an average time cost of 
approximately $71,780.62 to comply with proposed rule 211(h)  -1.   
Table 17: Proposed Rule 211(h)-1 Total Estimated PRA Burden 
 
Internal initial 
burden hours 
Internal  
burden time cost 
External  
cost burden 
Due diligence and account approval 
596,616.66 $139,159,548 $0 
Policies and procedures  9,320 $3,616,700 $0 
Recordkeeping 10,000 $785,000 $0 
Total annual burden 615,936.66 $143,561,248 $0 
Number of affected investment 
advisers 
÷ 2000 ÷ 2000 ÷ 2000 
Average annual burden per 
investment adviser 
307.97 $71,780.62 $0 
 

366 
E. Rule 6c-11 
We recently adopted rule 6c-11, which permits ETFs that satisfy certain conditions to 
operate without first obtaining an exemptive order from the Commission.
669
 The rule is designed 
to create a consistent, transparent, and efficient regulatory framework for such ETFs and 
facilitate greater competition and innovation among ETFs. Rule 6c-11 includes a provision 
excluding leveraged/inverse ETFs from the scope of ETFs that may rely on that rule. To promote 
a level playing field among ETFs, and in view of the other conditions we are proposing to place 
on leveraged/inverse ETFs under proposed rule 18f-4 and on transactions in leveraged/inverse 
ETFs’ securities under proposed rule 15l-2 and 211(h)  -1, we are proposing to amend rule 6c-11 
to permit leveraged/inverse ETFs to rely on that rule. Because we believe this proposed 
amendment would increase the number of funds relying on rule 6c-11, we are updating the PRA 
analysis for rule 6c-11 to account for any burden increases that would result from this increase in 
respondents to that rule. We are not updating the rule 6c-11 PRA analysis in any other respect. 
Rule 6c-11 requires an ETF to disclose certain information on its website, to maintain 
certain records, and to adopt and implement certain written policies and procedures. The purpose 
of these collections of information is to provide useful information to investors who purchase 
and sell ETF shares in secondary markets and to allow the Commission to better monitor reliance 
on rule 6c-11 and will assist the Commission with its accounting, auditing and oversight 
functions. 
The respondents to rule 6c-11 will be ETFs registered as open-end management 
investment companies other than share class ETFs and non-transparent ETFs. This collection 
will not be mandatory, but will be necessary for those ETFs seeking to operate without 
                                                      
669
  See supra notes 353-356 and accompanying text.  

367 
individual exemptive orders, including all ETFs whose existing exemptive orders will be 
rescinded. Information provided to the Commission in connection with staff examinations or 
investigations will be kept confidential subject to the provisions of applicable law. 
Under current PRA estimates, 1,735 ETFs would be subject to these requirements. The 
current PRA estimates for rule 6c-11 include 74,466.2 total internal burden hours, 
$24,771,740.10 in internal time costs, and $1,735,000 in external time costs. 
We continue to believe that the current annual burden and cost estimates for rule 6c-11 
are appropriate, but estimate that the proposed amendment to rule 6c-11 would result in an 
increase in the number of respondents. Specifically, we estimate that an additional 164 ETFs (all 
leveraged/inverse ETFs) would rely on rule 6c-11, resulting in an increase in the number of 
respondents to 1,899 ETFs.
670
 Table 18 below summarizes these revisions to the estimated 
annual responses, burden hours, and burden-hour costs based on the proposed amendment to rule 
6c-11. 
                                                      
670
 See supra note 468 and accompanying text. 

 
368 
Table 18: Rule 6c-11 PRA Estimates 
 
Previously estimated 
annual internal hour 
burden
1
 
Updated estimated 
annual internal hour 
burden
2
 
Previously estimated 
annual internal burden 
time cost 
Updated estimated 
annual internal time 
burden cost 
Previously estimated 
annual external cost 
burden 
Updated estimated 
annual external cost 
burden 
Website disclosure 33,398.75 hours 36,555.75 hours $10,717,945.15 $11,731,053.51 $1,735,000 $1,899,000 
Recordkeeping 8,675 hours 9,495 hours $680,987.50 $745,357.50 $0 $0 
Policies and 
procedures 
32,392.45 hours 35,454.33 hours $13,372,807.45 $14,636,865.33 $0 $0 
Total annual burden 74,466.2 hours 81,505.08 hours $24,771,740.10 $27,113,276.34 $1,735,000 $1,899,000 
Number of affected 
ETFs 
÷ 1,735 ÷ 1,899 ÷ 1,735 ÷ 1,899 ÷ 1,735 ÷ 1,899 
Average annual 
burden per ETF 
42.92 hours 42.92 hours $14,277.66 $14,277.66 $1,000 $1,000 
Notes:  
1. The previously estimated burdens and costs in this table are based on an estimate of 1,735 ETFs relying on rule 6c-11. 
2. The updated estimated burdens and costs in this table are based on an estimate of 164 leveraged/inverse ETFs that would rely on rule 6c-11 pursuant to the proposed amendment to that 
rule, for a total estimate of 1,899 ETFs that would rely on rule 6c-11. 

 
369 
F. Form N-PORT 
We are proposing to amend Form N-PORT to add new items to Part B (“Information 
About the Fund”), as well as to make certain amendments to the form’s General Instructions.  
Form N-PORT, as amended, would require funds to provide information about their 
derivatives exposure.
671
 We estimate that 5,091 funds would be subject to this exposure-related 
disclosure requirement.
672
  
In addition, funds that are subject to the limit on fund leverage risk in proposed rule 18f-4 
would have to report certain VaR-related information, including: (1) the fund’s highest daily 
VaR during the reporting period and its corresponding date; and (2) the fund’s median daily VaR 
for the reporting period. Funds subject to the relative VaR test during the reporting period also 
would have to report: (1) the name of the fund’s designated reference index, (2) the index 
identifier, (3) the fund’s highest daily VaR ratio during the reporting period and its 
corresponding date; and (4) the fund’s median daily VaR ratio for the reporting period.
673
 
Finally, all funds that are subject to the proposed limit on fund leverage risk also would have to 
report the number of exceptions that the fund identified as a result of the backtesting of its VaR 
calculation model.
674
 We estimate that 2,424 funds would be subject to these VaR-related 
disclosure requirements.
675
 
                                                      
671
     See proposed Item B.9 of Form N-PORT; supra section II.H.1.a. 
672
  See supra notes 468, 499 and accompanying text, and paragraph following note 526 (2,693 funds 
that would be subject to the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and 
complying with the related limited derivatives user requirements). 
673
     See proposed Item B.10 of Form N-PORT; supra section II.H.1.b. 
674
  See id. 
675
     See supra paragraph following note 526. 

370 
Preparing reports on Form N-PORT is mandatory for all management investment 
companies (other than money market funds and small business investment companies) and UITs 
that operate as ETFs and is a collection of information under the PRA. The information required 
by Form N-PORT must be data-tagged in XML format. Responses to the reporting requirements 
will be kept confidential, subject to the provisions of applicable law, for reports filed with 
respect to the first two months of each quarter; the third month of the quarter will not be kept 
confidential, but made public sixty days after the quarter end. Form N-PORT is designed to 
assist the Commission its regulatory, disclosure review, inspection, and policymaking roles, and 
to help investors and other market participants better assess different fund products.
676
 
Based on current PRA estimates, we estimate that funds prepare and file their reports on 
Form N-PORT either by (1) licensing a software solution and preparing and filing the reports in 
house, or (2) retaining a service provider to provide data aggregation, validation and/or filing 
services as part of the preparation and filing of reports on behalf of the fund. We estimate that 
35% of funds subject to the proposed N-PORT filing requirements would license a software 
solution and file reports on Form N-PORT in house, and the remainder would retain a service 
provider to file reports on behalf of the fund. 
Table 19 below summarizes our PRA initial and ongoing annual burden estimates 
associated with the proposed amendments to Form N-PORT. 
                                                      
676
  The specific purposes for each of the new proposed reporting items are discussed in section II.H.1 
supra. 

371 
Table 19: Form N-PORT PRA Estimates 
 
Internal initial 
burden hours 
Internal annual 
burden hours
1
  Wage rate
2
 
Internal time 
costs 
Initial external 
cost burden 
Annual external 
cost burden 
PROPOSED ESTIMATES 
Report derivatives exposure 
information 
2 hours 4.33 hours
3
 × $365 (compliance attorney) $1,580 
$5,590 $4,210 
2 hours 4.33 hours × $331 (senior programmer) $1,433 
Total new burden for derivatives 
exposure information 
 8.66 hours   $3,013 
Number of funds for derivatives 
exposure information 
 × 5,091   × 5,091 
Total new annual burden for 
derivatives exposure information (I) 
 44,088 hours   $15,339,183 
Report VaR-related information 
2 hours 4.33 hours × $365 (compliance attorney) $1,580 
2 hours 4.33 hours × $331 (senior programmer) $1,433 
Total new burden for VaR-related 
information 
 
 
8.66 hours 
× 2,424 
 
 
 
 
$3,013 
× 2,424 
Number of funds for VaR-related 
information 
Total new annual burden for VaR-
related information (II) 
 20,992 hours   $7,303,512 
Total new annual burden (I + II)  65,080 hours   $22,642,695  $21,433,110
4
 
Current burden estimates  1,803,826 hours     $103,776,240 
Revised burden estimates  1,868,906 hours     $125,209,350 
Notes:  
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. These PRA estimates assume that the same types of 
professionals would be involved in the proposed reporting requirements that we 
believe otherwise would be involved in preparing and filing reports on Form N-PORT. 
3. This estimate assumes that, annually after the initial 2 hours to comply with the 
new N-PORT requirements, each of a compliance attorney and a senior programmer 
would incur 1 burden hours per filing associated with the new reporting 
requirements. The estimate of 4.33 hours is based on the following calculation: ((2 
hours for the first filing x 1 = 2) + (3 additional filings in year 1 x 1 hour for each of 
the additional 3 filings in year 1 = 3) + (4 filings in years 2 and 3 x 1 hour per filing x 
2 years) = 8) / 3 = 4.33. 
4. This estimate is based on the following calculation: $4,210 (average costs for 
funds reporting the proposed information on Form N-PORT) * 5,091 funds (which 
includes funds reporting derivative exposure information and VaR-related 
information). 

 
372 
G. Form N-RN 
We are proposing to amend Form N-LIQUID (which we propose to re-title as “Form N-
RN”) to add new current reporting requirements for funds subject to the proposed VaR-based 
limit on fund leverage risk pursuant to proposed rule 18f-4.
677
 Specifically, a fund that 
determines that it is out of compliance with the VaR test and has not come back into compliance 
within three business days after such determination would have to file a non-public report on 
Form N-RN providing certain information regarding its VaR test breaches.
678
 I f the portfolio 
VaR of a fund subject to the relative VaR test were to exceed 150% of the VaR of its designated 
reference index for three business days, a fund would have to report: (1) the dates on which the 
fund portfolio’s VaR exceeded 150% of the VaR of its designated reference index; (2) the VaR 
of its portfolio for each of these days; (3) the VaR of its designated reference index for each of 
these days; (4) the name of the designated reference index; and (5) the index identifier. If the 
portfolio VaR of a fund subject to the absolute VaR test were to exceed 10% of the value of the 
fund’s net assets for three business days, a fund would have to report: (1) the dates on which the 
fund portfolio’s VaR exceeded 10% of the value of its net assets; (2) the VaR of its portfolio for 
each of these days; and (3) the value of the fund’s net assets for each of these days.  
In addition, if a fund that has filed Part E or Part F of Form N-RN to report it has 
breached its applicable VaR test, has come back into compliance with either the relative VaR test 
or the absolute VaR test, as applicable, it must file a report on Form N-RN to indicate that.
 679
 
                                                      
677
     See supra section II.H.2. 
678
  This requirement would be implemented through the proposed amendments to rule 30b1-10 under 
the Investment Company Act, and proposed rule 18f-4(c)(7). For purposes of this PRA analysis, 
the burden associated with the proposed amendments to rule 30b1-10 and proposed rule 18f-
4(c)(7) is included in the collection of information requirements for Form N-RN. 
679
     See proposed Part G of Form N-RN. 

373 
Specifically, a fund must report the dates on which its portfolio VaR exceeded, as applicable, 
150% of the VaR of its designated reference index (if the fund is subject to the relative VaR test 
under proposed rule 18f-4(c)(2)(i)) or exceeded 15% of the value of its net assets (if the fund is 
subject to the absolute VaR test under proposed rule 18f-4(c)(2)(ii)).
680
 Furthermore, a fund must 
also report the current VaR of its portfolio.
681
  
A fund would have to report information for either VaR test breach, within one business 
day following the third business day after the fund has determined that its portfolio VaR exceeds 
either of the VaR test thresholds, as applicable. Similarly, a fund that has come back into 
compliance with its applicable VaR test would have to file such a report within one business day. 
We estimate that 2,424 funds per year would be required to comply with either of the VaR tests, 
and the Commission would receive approximately 30 filing(s) per year in response to each of the 
new VaR-related items that we proposed to include on Form N-RN, as amended.
682
 
Under the proposed amendments to Form N-RN, preparing a report on this form would 
be mandatory for any fund that is out of compliance with its applicable VaR test for more than 
three business days, as described above, and for any fund that has come back into compliance 
with its applicable VaR test. A report on Form N-RN is a collection of information under the 
PRA. The VaR test breach information provided on Form N-RN, as well as the information a 
fund provides when it has come back into compliance, would enable the Commission to receive 
information on events that could impact funds’ leverage-related risk more uniformly and 
                                                      
680
     Id.  
681
     Id. 
682
  This estimate is similar to the Commission’s estimates of the number of reports that funds, in the 
aggregate, would submit annually in response to the liquidity-related items of Form N-LIQUID. 
See Liquidity Adopting Release, supra note 360, at nn.1281-1283 and accompanying paragraph. 
See also supra paragraph following note 526. 

374 
efficiently and would enhance the Commission’s oversight of funds when significant fund and/or 
market events occur. The Commission would be able to use the newly required information that 
funds would provide on Form N-RN in its regulatory, disclosure review, inspection, and 
policymaking roles. Responses to the reporting requirements and this collection of information 
would be kept confidential, subject to provisions of applicable law. 
Table 20 below summarizes our PRA initial and ongoing annual burden estimates 
associated with the proposed amendments to funds’ current reporting requirement. Staff 
estimates there will be no external costs associated with this collection of information. We 
further assume similar hourly and cost burdens, as well as similar response rates, for responses to 
either a breach of the absolute VaR test or the relative VaR test. 

375 
Table 20: Form N-RN PRA Estimates 
 
Internal initial 
burden hours 
Internal annual 
burden hours  Wage rate
1
 
Internal time 
costs 
PROPOSED ESTIMATES 
Relative or absolute VaR test breach 
reports 
0 hour 0.005 hours
2
 × $365 (compliance attorney) $1.83 
0 hour 0.005 hours × $331 (senior programmer) $1.66 
Total new annual burden per fund  0.01 hours   $3.49 
Number of funds  × 2,424   × 2,424 
Total new annual burden  24 hours   $8,460 
Current burden estimates  941 hours    
Revised burden estimates  965 hours    
Notes:  
1. See supra note 628. These PRA estimates assume that the same types of 
professionals would be involved in the proposed reporting requirements that we 
believe otherwise would be involved in preparing and filing reports on Form N-
LIQUID. 
2. This estimate is based on the assumption that, of the 2,424 funds that would be 
required to comply with either of the VaR tests, on average the Commission would 
receive 30 reports regarding a relative or absolute VaR test breach and that 
compliance attorney and senior programmer would each spend 30 minutes as part 
of preparing and submitting this report.  
 

 
376 
H. Form N-CEN 
We are proposing to amend Form N-CEN to require a fund to identify whether it relied 
on proposed rule 18f-4 during the reporting period.
683
 Form N-CEN is a structured form that 
requires registered funds to provide census-type information to the Commission on an annual 
basis. The proposed amendments also would require a fund to identify whether it relied on any of 
the exemptions from various requirements under the proposed rule, specifically: (1) whether the 
fund is a limited derivatives user excepted from the proposed rule’s program requirement, under 
either of the proposed exception’s alternatives (either a funds that limits its derivatives exposure 
to 10% of its net assets, or a fund that uses derivatives transactions solely to hedge certain 
currency risks); or (2) whether it is a leveraged/inverse investment fund covered by the proposed 
sales practices rules that, under proposed rule 18f-4, would be excepted from the proposed limit 
on fund leverage risk. Finally, a fund would have to identify whether it has entered into reverse 
repurchase agreements or similar financing transactions, or unfunded commitment agreements, 
as provided under the proposed rule.  
Preparing a report on Form N-CEN, as amended, would be mandatory for all registered 
funds. Responses would not be kept confidential. We estimate that 12,375 funds would be 
subject to these disclosure requirements.
684
 
The purpose of Form N-CEN is to satisfy the filing and disclosure requirements of 
section 30 of the Investment Company Act, and of amended rule 30a-1 thereunder. The 
information required to be filed with the Commission assures the public availability of the 
                                                      
683
  See supra section II.H.3. 
684
  See supra section III.B.1 ( 9,788 mutual funds + 1,910 ETFs organized as an open-end fund or as 
a share-class of an open-end fund + 664 registered closed-end funds + 13 variable annuity 
separate accounts registered as management investment companies on Form N -3)  . 

377 
information and is designed to facilitate the Commission’s oversight of registered funds and its 
ability to monitor trends and risks. 
Table 21 below summarizes our PRA initial and ongoing annual burden estimates 
associated with the proposed amendments to Form N-CEN based on current Form N-CEN 
practices and burdens associated with minor amendments to the form. Staff estimates there will 
be no external costs associated with this collection of information.

378 
Table 21: Form N-CEN PRA Estimates 
 
Internal initial 
burden hours 
Internal annual 
burden hours  Wage rate
1
 
Internal time 
costs 
PROPOSED ESTIMATES 
Reporting derivatives-related fund 
census information 
0 hour 0.01 hours × $365 (compliance attorney) $3.7 
0 hour 0.01 hours × $331 (senior programmer) $3.3 
Total new annual burden per fund  0.02 hours   $7 
Number of funds  × 12,375    × 12,375  
Total new annual burden  248 hours   $86,625 
Current burden estimates  74,425 hours    
Revised burden estimates  74,673 hours    
Notes:  
1. See supra note 628. These PRA estimates assume that the same types of 
professionals would be involved in the proposed reporting requirements that we 
believe otherwise would be involved in preparing and filing reports on Form N-CEN. 
2. This estimate assumes each fund reporting on Form N-CEN would spend 1 to 2 
minutes reporting these new data elements. 

 
379 
I. Request for Comments 
We request comment on whether these estimates are reasonable. Pursuant to 44 U.S.C. 
3506(c)(2)(B), the Commission solicits comments in order to: (1) evaluate whether the proposed 
collections of information are necessary for the proper performance of the functions of the 
Commission, including whether the information will have practical utility; (2) evaluate the 
accuracy of the Commission’s estimate of the burden of the proposed collections of information; 
(3) determine whether there are ways to enhance the quality, utility, and clarity of the 
information to be collected; and (4) determine whether there are ways to minimize the burden of 
the collections of information on those who are to respond, including through the use of 
automated collection techniques or other forms of information technology. 
Persons wishing to submit comments on the collection of information requirements of the 
proposed rules and amendments should direct them to the OMB, Attention Desk Officer for the 
Securities and Exchange Commission, Office of Information and Regulatory Affairs, 
Washington, DC 20503, and should send a copy to, Vanessa Countryman, Secretary, Securities 
and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090, with reference to 
File No. S7-24-15. OMB is required to make a decision concerning the collections of 
information between 30 and 60 days after publication of this release; therefore a comment to 
OMB is best assured of having its full effect if OMB receives it within 30 days after publication 
of this release. Requests for materials submitted to OMB by the Commission with regard to these 
collections of information should be in writing, refer to File No. S7-24-15, and be submitted to 
the Securities and Exchange Commission, Office of FOIA Services, 100 F Street, NE, 
Washington, DC 20549- 2736. 
V. INITIAL REGULATORY FLEXBILITY ANALYSIS 
This Initial Regulatory Flexibility Analysis has been prepared in accordance with 

380 
section 3 of the Regulatory Flexibility Act.
685
 It relates to proposed rules 18f-4, 15l-2, 211(h)  -1, 
and proposed amendments to Forms N -PORT, N-LIQUID (which we propose to re-title as 
“Form N-RN”), and N-CEN.
686
  
A. Reasons for and Objectives of the Proposed Actions 
The Commission is proposing new rules 18f-4, 211(h)  -1, and 15l-2, amendments to rule 
6c-11, as well as amendments to Forms N-PORT, N-LIQUID, and N-CEN. These proposed rules, 
and proposed rule and form amendments, are designed to address the investor protection 
purposes and concerns underlying section 18 of the Investment Company Act and to provide an 
updated and more comprehensive approach to the regulation of funds’ use of derivatives and the 
other transactions covered by proposed rule 18f-4.
687
  
Proposed rule 18f-4 is designed to provide an updated, comprehensive approach to the 
regulation of funds’ use of derivatives and certain other transactions, generally through the 
implementation of a derivatives risk management program, limits on fund leverage risk, board 
oversight and reporting,  and related recordkeeping requirements.
688
 The proposed sales practices 
rules are designed to address certain specific considerations raised by certain leveraged/inverse 
investment vehicles by requiring registered broker-dealers and investment advisers to satisfy due 
diligence and account approval requirements.
689
 Finally, the proposed amendments to 
                                                      
685
  5 U.S.C. 603.  
686
  As discussed above, the proposed conforming amendment to Form N-2 does not change the Form 
N-2 collection of information. See supra note 623. We also do not believe there to be any 
reporting, recordkeeping, or compliance burden associated with this proposed conforming 
amendment.  
687
  See supra section I.B (discussing the requirements of section 18, and as well as Congress’ 
concerns underlying the limits of section 18). 
688
  See supra section II.A.2. 
689
     See supra section II.G. 

381 
Forms N -PORT, N-LIQUID, and N-CEN are designed to enhance the Commission’s ability to 
effectively oversee the use by funds, broker-dealers and investment advisers of the proposed 
rules and to provide the Commission and the public with greater insight into the impact that 
funds’ use of derivatives may have on their portfolios.
690
  
All of these requirements are discussed in detail in section II of this release. The costs 
and burdens of these requirements on small funds, investment advisers, and broker-dealers are 
discussed below as well as above in our Economic Analysis and Paperwork Reduction Act 
Analysis, which discuss the applicable costs and burdens on all funds, investment advisers, and 
broker-dealers.
691
  
B. Legal Basis 
The Commission is proposing new rule 18f-4 under the authority set forth in sections 6(c), 
12(a), 18, 31(a), 38(a), and 61 of the Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-
12(a), 80a-18, 80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing amendments to 
rule 6c-11 under the authority set forth in sections 6(c), 22(c), and 38(a) of the Investment 
Company Act [15 U.S.C. 80a-6(c), 22(c), and 80a-37(a)]. The Commission is proposing new 
rule 15l-2 under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 17, 23(a), and 36 of 
the Securities Exchange Act of 1934 [15 U.S.C. 78c, 78c(b), 78c-5, 78j, 78o(l), 78o-10, 78q, 
78w(a), and 78mm]. The Commission is proposing new rule 211(h)-1 under the authority set 
forth in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment Advisers Act of 1940 
[15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and 80b-11(h)]. The Commission is proposing 
amendments to Form N-PORT, Form N-LIQUID (which we propose to re-title as “Form N-RN”), 
                                                      
690
     See supra section II.H. 
691
  See supra sections III and IV.  These sections also discuss the professional skills that we believe 
compliance with the proposed rules, and proposed rule and form amendments would entail. 

382 
Form N -CEN, and Form N-2 under the authority set forth in sections 8, 18, 30, and 38 of the 
Investment Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 80a-29, 80a-37, 80a-63], sections 6, 
7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C. 77f, 77g(a), 77j, 77s(a)], and sections 
10, 13, 15, 23, and 35A of the Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and 78ll]. 
C. Small Entities Subject to Proposed Rules 
For purposes of Commission rulemaking in connection with the Regulatory Flexibility 
Act, an investment company is a small entity if, together with other investment companies in the 
same group of related investment companies, it has net assets of $50 million or less as of the end 
of its most recent fiscal year (a “small fund”).
692
 Commission staff estimates that, as of June 
2019, approximately 42 registered open-end mutual funds, 8 registered ETFs, 33 registered 
closed-end funds, and 16 BDCs ( collectively, 99 funds) are small entities.
693
  
For purposes of Commission rulemaking in connection with the Regulatory Flexibility 
Act, a broker-dealer is a small entity if it: (1) had total capital (net worth plus subordinated 
liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited 
financial statements were prepared pursuant to rule 17a-5(d) under the Exchange Act, or, if not 
required to file such statements, had total capital (net worth plus subordinated liabilities) of less 
than $500,000 on the last business day of the preceding fiscal year (or in the time that it has been 
in business, if shorter); and (2) it is not affiliated with any person (other than a natural person) 
that is not a small business or small organization.
694
 Commission staff estimates that, as of June 
                                                      
692
  See rule 0-10(a) under the Investment Company Act [17 CFR 270.0-10(a)].  
693
  This estimate is derived an analysis of data obtained from Morningstar Direct as well as data 
reported to the Commission for the period ending June 2019.  
694
     See rule 0-10(c)(1)-(2) under the Exchange Act [17 CFR 240.0-10(c)(1)(2)]. 

383 
30, 2019, there are approximately 942 broker-dealers that may be considered small entities.
695
  
Under Commission rules, and for the purposes of the Advisers Act and the Regulatory 
Flexibility Act, a registered investment adviser generally is a small entity if it: (1) has assets 
under management having a total value of less than $25 million; (2) did not have total assets of 
$5 million or more on the last day of the most recent fiscal year; and (3) does not control, is not 
controlled by, and is not under common control with another investment adviser that has assets 
under management of $25 million or more, or any person (other than a natural person) that had 
total assets of $5 million or more on the last day of its most recent fiscal year.
696
 We believe that 
proposed rule 211(h)-1 would not affect most investment advisers that are small entities (“small 
advisers”). Many small advisers would not be affected because they are registered with one or 
more state securities authorities and not with the Commission. Under section 203A of the 
Advisers Act, many small advisers are prohibited from registering with the Commission and are 
regulated by state regulators.
697
 Of those advisers that are registered with the Commission, we 
estimate based on IARD data that as of June 30, 2019, approximately 470 SEC-registered 
investment advisers are small entities under the RFA.
698
 Of these, we estimate that 171 registered 
investment advisers are small entities that provide advice to individual clients.
699
  
                                                      
695
  This estimate is derived from an analysis of data for the period ending June 30, 2019 obtained 
from Financial and Operational Combined Uniform Single (FOCUS) Reports that broker-dealers 
generally are required to file with the Commission and/or SROs pursuant to rule 17a-5 under the 
Exchange Act [17 CFR 240.17a-5]. 
696
     See rule 0-7(a) under the Advisers Act [17 CFR 275.0-7(a)]. 
697
     15 U.S.C. 80b-3a. 
698
     Based on SEC registered investment adviser responses to Item 12 of Form ADV. 
699
  Based on SEC-registered investment adviser responses to Items 5.D.(1)(a)-(b), 5.D.(3)(a)-(b), 5.F 
and 12 of Form ADV. These responses indicate that: the investment adviser has clients that are 
high net worth individuals and/or individuals other than high net worth individuals; the 
investment adviser has regulatory assets under management attributable to clients that are high 
 

384 
D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements 
1. Proposed Rule 18f-4 
a. Derivatives Risk Management Program, and Board 
Oversight and Reporting 
Proposed rule 18f-4 would generally require a fund relying on the rule—including small 
entities, but not including funds that are limited derivatives users—to adopt and implement a 
derivatives risk management program.
700
 This risk management program would include policies 
and procedures reasonably designed to assess and manage the risks of the fund’s derivatives 
transactions.
701
 The program requirement is designed to permit a fund to tailor the program’s 
elements to the particular types of derivatives that the fund uses and related risks, as well as how 
those derivatives impact the fund’s investment portfolio and strategy. The proposal would 
require a fund’s program to include the following elements: (1) risk identification and 
assessment; (2) risk guidelines; (3) stress testing; (4) backtesting; (5) internal reporting and 
escalation; and (6) periodic review of the program. T he proposed rule also would require: (1) a 
fund’s board of directors to approve the designation of the fund’s derivatives risk manager and 
(2) the derivatives risk manager to provide written reports to the board regarding the program’s 
implementation and effectiveness, including describing any exceedances of the fund’s guidelines 
                                                      
net worth individuals and/or individuals other than high net worth individuals; and that the 
investment adviser is a small entity. Firms that are registered as a broker-dealer and an investment 
adviser are counted in both the total number of small investment advisers and small broker-
dealers that would be subject to the new requirements. We believe that counting these firms twice 
is appropriate because of any additional burdens of complying with the rules with respect to both 
their advisory and brokerage businesses.
 
700
  See supra section II.A.2; proposed rule 18f-4(c)(1).  
701
  See proposed rule 18f-4(a).  

385 
and the results of the fund’s stress testing and backtesting.
702
 
As discussed above, we estimate that the one-time operational costs necessary to 
establish and implement a derivatives risk management program would range from $70,000 to 
$500,000 per fund, depending on the particular facts and circumstances and current derivatives 
risk management practices of the fund.
703
 We also estimate that each fund would incur ongoing 
program-related costs that range from 65% to 75% of the one-time costs necessary to establish 
and implement a derivatives risk management program.
704
 Thus, we estimate that a fund would 
incur ongoing annual costs associated with proposed rule 18f-4 that would range from $45,500 to 
$375,000.
705
 We estimate that approximately 22% of funds would be required to implement a 
derivatives risk management program, including board oversight.
706
 We similarly estimate—
applying to small funds the same estimated percentage of funds that would implement a 
derivatives risk management program—that approximately 22% of small funds (approximately 
22 small funds) would establish a derivatives risk management program.
707
  
There are different factors that would affect whether a smaller fund incurs program-
related costs that are on the higher or lower end of the estimated range. For example, we would 
expect that smaller funds—and more specifically, smaller funds that are not part of a fund 
                                                      
702
  See supra sections II.C and III.C.1. 
703
  See supra section III.C.1. This section, along with sections IV.B.1 and IV.B.2, also discusses the 
professional skills that we believe compliance with this aspect of the proposal would entail. 
704
     Id. 
705
     Id. 
706
  These are funds that would not be considered limited derivatives users under the proposed rule. 
See supra sections II.E, III.C.1, IV.B.1 and IV.B.2; infra section V.D.1.c. 
707
  See supra sections III.C.1 and V.C.  We estimate that there are 99 small funds that meet the small 
entity definition. See supra note 693 and accompanying text. 99 small funds x 22% = 
approximately 22 funds that are small entities.  

386 
complex—may not have existing personnel capable of fulfilling the responsibilities of the 
proposed derivatives risk manager, or may choose to hire a derivatives risk manager rather than 
assigning that responsibility to a current officer (or officers) of the fund’s investment adviser 
who is not a portfolio manager. Also, while we would expect larger funds or funds that are part 
of a large fund complex to incur higher program-related costs in absolute terms relative to a 
smaller fund or a fund that is part of a smaller fund complex, we would expect a smaller fund to 
find it more costly, per dollar managed, to comply with the proposed program requirement 
because it would not be able to benefit from a larger fund complex’s economies of scale.
708
 
b. Limit on Fund Leverage Risk 
Proposed rule 18f-4 would also generally require a fund relying on the rule—including 
small entities, but not including funds that are limited derivatives users or that are certain 
leveraged/inverse funds that the rule describes—to comply with an outer limit on fund leverage 
ris  k based on VaR.
709
 This outer limit would be based on a relative VaR test that compares the 
fund’s VaR to the VaR of a designated reference index. If the fund’s derivatives risk manager is 
unable to identify an appropriate designated reference index, the fund would be required to 
comply with an absolute VaR test.
710
 Under the proposed rule, a fund must disclose its 
designated reference index in its annual report.
711
 This proposed requirement is designed to limit 
fund leverage risk consistent with the investor protection purposes underlying section 18.  
As discussed above, we estimate that the one-time operational costs necessary to 
establish and implement a VaR calculation model consistent with the proposed limit on fund 
                                                      
708
     See supra section III.C.1. 
709
     See supra sections II.D, II.E, and II.G. 
710
  See supra sections II.D.2, II.D.3. 
711
  Proposed rule 18f-4(c)(2)(iv). 

387 
leverage risk would range from $5,000 to $100,000 per fund, depending on the particular facts 
and circumstances and current derivatives risk management practices of the fund.
712
 We estimate 
that approximately 19% of funds would be required to comply with the proposed limit on fund 
leverage risk.
713
 We similarly estimate—applying to small funds the same estimated percentage 
of funds overall that would comply with this requirement—that approximately 19% of small 
funds (approximately 19 small funds) would be required to comply with the proposed limit on 
fund leverage risk.
714
  
There are multiple factors that could affect whether the costs that smaller funds would 
incur in complying with the proposed limit on fund leverage risk would be on the lower versus 
higher end of this estimated range. To the extent that funds (including smaller funds) have 
already established and implemented portfolio VaR testing practices and procedures, these funds 
would incur fewer costs relative to those funds that have not already established and 
implemented VaR-based analysis in their risk management. If as a result of fewer resources, a 
smaller fund, and more specifically a smaller fund not part of a fund complex, hired a third-party 
vendor to comply with the VaR-based limit on fund leverage risk, this could increase costs of 
complying with the proposed limit for those funds. Finally, costs would vary based on factors 
such as whether the fund uses multiple types of derivatives or uses derivatives more extensively, 
whether the fund would be implementing the absolute VaR test versus the relative VaR test, and 
                                                      
712
  See supra section III.C.2. This section, along with section IV.B.3, also discusses the professional 
skills that we believe compliance with this aspect of the proposal would entail. 
713
  See supra section III.C.2. This estimate excludes both: (1) limited derivatives users, and (2) funds 
that are leveraged/inverse investment vehicles under the proposed sales practices rules. Id.; see 
also supra sections II.E, II.G, III.C.2,  III.C.3, III.C.5, and IV.B.3; infra section V.D.1.c. 
714
  See supra sections III.C.2 and V.C.  We estimate that there are 99 small funds that meet the small 
entity definition. See supra note 693 and accompanying text. 99 small entities x 19% = 
approximately 19 funds that are small entities.  

388 
whether (for a fund that uses the relative VaR test) the fund uses a designated reference index for 
which the index provider charges a licensing fee.
715
  
c. Requirements for Limited Derivatives Users 
Proposed rule 18f-4 includes an exception from the proposed rule’s risk management 
program requirement and limit on fund leverage risk for “limited derivatives users.”
716
 T he 
proposed exception would be available to a fund that either limits its derivatives exposure to 
10% of its net assets, or that uses derivatives transactions solely to hedge certain currency risks. 
Any fund that relies on the proposed exception—small funds as well as large funds—would also 
be required to adopt policies and procedures that are reasonably designed to manage its 
derivatives risks. We expect that the risks and potential impact of these funds’ derivatives use 
may not be as significant, compared to those of funds that do not qualify for the exception, and 
that a principles-based policies and procedures requirement would appropriately address these 
risks. These “reasonably designed” policies and procedures would have a scope that that reflects 
the extent and nature of a fund’s use of derivatives within the parameters that the proposed 
exception provides. 
As discussed above, we estimate that the one-time costs to establish and implement 
policies and procedures reasonably designed to manage a fund’s derivative risks would range 
from $1,000 to $100,000 per fund, depending on the particular facts and circumstances and 
current derivatives risk management practices of the fund.
717
 We also estimate that the ongoing 
                                                      
715
  See supra note 203 and accompanying paragraph; note 518 and accompanying sentence. 
716
     See supra section II.E; proposed rule 18f-4(c)(3)(i)-(ii). 
717
  See supra section III.C.3 (discussing the one-time range of costs for implementing the limited 
derivatives user requirements under proposed rule18f-4 and the variables impacting a fund 
incurring costs at the lower or higher end of the estimated cost range). This section, along with 
 

389 
annual costs that a fund that is a limited derivatives user would incur range from 65% to 75% of 
the one-time costs to establish and implement the policies and procedures. Thus, we estimate that 
a fund would incur ongoing annual costs associated with the proposed limited derivatives user 
exception that would range from $650 to $75,000.
718
 We anticipate that larger funds that are 
limited derivatives users—or limited derivatives user funds that are part of a large fund 
complex—would likely experience economies of scale in complying with the proposed 
requirements for limited derivatives users that smaller funds would not necessarily experience.
719
 
Thus, smaller funds that are limited derivatives users could incur costs on the higher end of the 
estimated range. However, a smaller fund whose derivatives use is limited could benefit from the 
proposed limited derivatives user exception, because it would not be required to adopt a 
derivatives risk management program (including all of the proposed program elements), and 
therefore such a fund could potentially avoid incurring costs and bearing compliance burdens 
that may be disproportionate to any benefits.
720
 
We estimate that approximately 19% of funds that use derivatives would qualify for the 
limited derivatives user exception.
721
 We would expect some small funds to fall within the 
proposed limited derivatives user exception.
722
 However, not all small funds that use derivatives 
                                                      
section IV.B.6, also discusses the professional skills that we believe compliance with this aspect 
of the proposal would entail. 
718
  Id. 
719
  See supra note 708 and accompanying text.  
720
     See supra section II.E. 
721
  Id. This estimate excludes both: (1) funds that would comply with the derivatives risk 
management program, and (2) funds that would be leveraged/inverse investment vehicles under 
proposed rule 15l-2. See also supra sections II.A.2, II.E, II.G, III.C.1, III.C.3, III.C.5, IV.B.4, and 
V.D.1.a. 
722
  Id.; see also supra section III.C.3. 

390 
would necessarily qualify as limited derivatives users. We estimate—applying to small funds the 
same estimated percentage of funds overall that would qualify as limited derivatives users—that 
approximately 19% of small funds that use derivatives (approximately 19 small funds) would 
comply with the proposed requirements for limited derivatives users under the proposed rule.
723
  
d. Reverse Repurchase Agreements and Unfunded 
Commitment Agreements 
Proposed rule 18f-4 would permit a fund to engage in reverse repurchase agreements and 
other similar financing transactions so long as they are subject to the relevant asset coverage 
requirements of section 18.
724
 Because funds are required to rely on the asset segregation 
approach in Release 10666, the degree to which funds could engage in reverse repurchase 
agreements under the proposal would generally be the same as under current practice. Therefore 
we do not estimate a significant compliance burden—either for small funds that engage in 
reverse repurchase agreements or for larger funds—associated with the proposed provisions 
regarding reverse repurchase agreements in rule 18f-4.
725
 For large and small funds subject to the 
proposed limit on fund leverage risk, any portfolio leveraging effect of reverse repurchase 
agreements or similar financing transactions would be included and restricted through the 
proposed VaR-based limits, and therefore would incrementally affect the costs associated with 
complying with these limits.
726
  
                                                      
723
  Id.; see also supra sections III.C.3 and V.C.  We estimate that there are 99 small funds that meet 
the small entity definition. See supra note 693 and accompanying text. 99 small entities x 19% = 
approximately 19 funds that are small entities.  
724
  See supra section II.I.  
725
     See supra section III.C.4. 
726
     See supra section II.I. 

391 
The proposed rule also includes a provision that codifies an approach for funds’ 
participation in unfunded commitment agreements in light of the concerns underlying section 
18.
727
 P roposed rule 18f-4   would permit a fund to enter into unfunded commitment agreements if 
it reasonably believes, at the time it enters into such agreement, that it will have sufficient cash 
and cash equivalents to meet its obligations with respect to all of its unfunded commitment 
agreements, in each case as they come due. The proposed rule would prescribe factors that a fund 
must consider in forming such a reasonable belief. If a fund enters into unfunded comment 
agreements in compliance with this requirement, the proposed rule specifies that unfunded 
commitment agreements will not be considered for purposes of computing asset coverage, as 
defined in section 18(h) of the Investment Company Act. This proposed approach for unfunded 
commitment agreements reflects the staff’s experience in reviewing and commenting on fund 
registration statements, as discussed above.
728
 We therefore do not expect that the proposed 
approach would result in significant costs to small or large funds because we believe the 
proposed approach is generally consistent with the current practices of funds that enter into 
unfunded commitment agreements.  
e. Recordkeeping 
Proposed rule 18f-4 includes certain recordkeeping provisions that are designed to 
provide the Commission’s staff, and the fund’s board of directors and compliance personnel, the 
ability to evaluate the fund’s compliance with the proposed rule’s requirements.
729
 The proposed 
rule would require a fund to maintain certain records documenting its derivatives risk 
                                                      
727
     See supra section II.J.  
728
  See id. 
729
     See supra section II.K. 

392 
management program, including a written record of: (1) its policies and procedures designed to 
manage the fund’s derivatives risks, (2) the results of any stress testing of its portfolio, (3) the 
results of any VaR test backtesting it conducts, (4) records documenting any internal reporting or 
escalation of material risks under the program, and (5) records documenting any periodic reviews 
of the program.
730
  
Second, the proposed rule would also require a fund to maintain a written record of any 
materials provided to the fund’s board of directors in connection with approving the designation 
of the derivatives risk manager. The proposed rule would also require a fund to keep records of 
any written reports provided to the board of directors relating to the program, and any written 
reports provided to the board that the rule would require regarding the fund’s non-compliance 
with the applicable VaR test.
731
  
Third, a fund that is required to comply with the proposed VaR test would also have to 
maintain written records documenting the determination of: its portfolio VaR; the VaR of its 
designated reference index, as applicable; its VaR ratio (the value of the VaR of the Fund’s 
portfolio divided by the VaR of the designated reference index), as applicable; and any updates 
to the VaR calculation models used by the fund, as well as the basis for any material changes 
made to those models.
732
  
                                                      
730
  See proposed rule 18f-4(c)(6)(i)(A). 
731
  See proposed rule 18f-4(c)(6)(i)(B). 
732
  See proposed rule 18f-4(c)(6)(i)(C). 

393 
Fourth, the proposed rule would require a f und that is a limited derivatives user to 
maintain a written record of its policies and procedures that are reasonably designed to manage 
its derivatives risks.
733
  
Finally, a fund that enters into unfunded commitment agreements would be required to 
maintain a records documenting the basis for the fund’s belief regarding the sufficiency of its 
cash and cash equivalents to meet its obligations with respect to its unfunded commitment 
agreements.
734
 A record must be made each time a fund enters into such an agreement.
735
 
As discussed above, we estimate that the average one-time recordkeeping costs for funds 
that would not qualify as limited derivatives users would be $2,047 per fund, depending on the 
particular facts and circumstances and current derivatives risk management practices of the 
fund.
736
 We also estimate that such a fund would incur an average ongoing annual recordkeeping 
costs of $330.
737
 We further estimate that the one-time and ongoing annual recordkeeping costs 
for a limited derivatives user to be 90% of those for funds that do not qualify as limited 
derivatives users.
738
 Thus, for each fund that could rely on the limited derivatives user exception, 
we estimate a one-time cost of $1,842 and an ongoing cost of $297 per year.
739
 To the extent that 
we estimate that small funds would be subject to the various provisions of the proposed rule that 
would necessitate recordkeeping requirements, as discussed above, these small funds also would 
                                                      
733
     See proposed rule 18f-4(c)(6)(i)(D). 
734
     See proposed rule 18f-4e)(2); see also supra note 430 and accompanying text. 
735
     Id.; see also supra note 431 and accompanying text. 
736
  See supra section III.C.8. This section, along with section IV.B.7, also discusses the professional 
skills that we believe compliance with this aspect of the proposal would entail. 
737
     Id.  
738
     Id.  
739
     Id. 

394 
be subject to the associated proposed recordkeeping requirements. Therefore, we estimate that: 
22% of small funds (approximately 22 small funds) would have to comply with the program-
related recordkeeping requirements and requirements regarding materials provided to the fund’s 
board; 19% of small funds (approximately 19 small funds) would have to comply with 
requirements to maintain records of compliance with the proposed VaR test; and 19% of small 
funds (approximately 19 funds) would have to comply with the recordkeeping requirements for 
limited derivatives users.
740
  
A fund’s recordkeeping-related costs will vary, depending on the provisions of proposed 
rule 18f-4 that the fund relies on. For example, funds that are required to adopt derivatives risk 
management programs, versus funds that are limited derivatives users under the proposed rule, 
would be subject to different recordkeeping requirements. However, while small funds’ 
recordkeeping burdens would vary based on the provisions of the proposed rule that a fund relies 
on, their recordkeeping burdens would not vary solely because they are small funds. We do not 
anticipate that larger funds, or funds that are part of a large fund complex, would experience any 
significant economies of scale related to the proposed recordkeeping requirements. 
2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-
CEN 
a. Proposed Amendments to Form N-PORT  
The proposed amendments to Form N-PORT would require funds to report information 
about their derivatives exposure, and also—as applicable for funds that are subject to the 
proposed rule 18f-4 VaR-based limit on fund leverage risk—to report certain VaR-related 
                                                      
740
  See supra sections III.C.1, III.C.2, III.C.3, V.D.1.a, V.D.1.b, and V.D.1.c. 

395 
information.
741
 These proposed amendments would provide market-wide insight into the levels 
of reporting funds’ derivatives exposure to the Commission, its staff, and market participants at 
the specific points in time covered by the reporting. They also would help the Commission and 
its staff assess compliance with proposed rule 18f-4.  
All funds that file Form N-PORT would have to provide information regarding their 
derivatives exposure on this form. We estimate that 41% of small funds that file Form N-PORT 
(approximately 34 small funds) use derivatives, and thus only these funds would have 
substantive information to report in response to this new exposure-related disclosure 
requirement.
742
  
In addition, funds that are subject to the proposed limit on fund leverage risk would have 
to report: (1) the fund’s highest daily VaR during the reporting period and its corresponding date; 
and (2) the fund’s median daily VaR for the reporting period. Funds subject to the relative VaR 
test during the reporting period also would have to report: (1) the name of the fund’s designated 
reference index, (2) the index identifier, (3) the fund’s highest daily VaR ratio during the 
reporting period and its corresponding date; and (4) the fund’s median daily VaR ratio for the 
                                                      
741
  See supra section II.H.1; see also proposed Items B.9 and B.10 of Form N-PORT. 
742
  See supra sections V.C, V.D.1.a, and V.D.1.c. Because BDCs do not file reports on Form N-
PORT, we deduct the number of BDCs from the total number of small funds that we estimate (99 
small funds – 16 BDCs that are small entities = 83 small funds that file reports on Form N-
PORT). See supra note 693 and accompanying text.  
We estimate that approximately 22% of funds would be subject to the proposed rule’s derivatives 
risk management program requirements and approximately 19% of funds would be subject to 
either of the limited derivatives user exceptions, with funds from both groups subject to reporting 
requirements on Form N-PORT. See supra notes 707, 721, and accompanying text. Although 
both of these estimated percentages include BDCs, we note that the total number of BDCs 
relative to the number of registered open- and closed-end funds is small, and therefore our 
estimates do not adjust these percentages to reflect the fact that BDCs do not file Forms N-PORT. 
See supra section III.B.1. Therefore, we estimate the total number of small funds subject to the 
proposed Form N-PORT requirements as follows: 83 small funds that file reports on Form N-
PORT x (22% + 19% = 41%) = 34 small funds. 

396 
reporting period. A fund would be required to determine its compliance with its applicable VaR 
test once each business day.
743
  
All funds that are subject to the proposed limit on fund leverage risk also would have to 
report the number of exceptions that the fund identified as a result of the backtesting of its VaR 
calculation model. We estimate that 19% of small funds (approximately 16 small funds) would 
be subject to these VaR-related disclosure requirements.
744
 
We estimate that each fund that reports information in response to the proposed VaR-
related disclosure requirements on Form N-PORT would incur a one-time cost of $2,784 and an 
ongoing cost of $4,176 per year, and each fund that is not subject to the VaR-related disclosure 
requirement would incur a one-time cost of $1,392
 
and an ongoing cost of $2,088 per year.
745
 
Notwithstanding the economies of scale experienced by large versus small funds, we would not 
expect the costs of compliance associated with the new Form N-PORT requirements to be 
meaningfully different for small versus large funds. The costs of compliance would vary only 
based on fund characteristics tied to their derivatives use. For example, a fund that uses 
derivatives extensively would incur more costs to calculate its derivatives exposure than a fund 
                                                      
743
     See supra note 365. 
744
  We estimate 83 small funds that file reports on Form N-PORT. See supra note 742.  
 We estimate that approximately 19% of funds would be subject to the proposed limit on fund 
leverage risk. See supra note 713 and accompanying text. Although this estimated percentage 
include BDCs, we note that the total number of BDCs relative to the number of registered open- 
and closed-end funds is small, and therefore our estimate does not adjust this percentage to reflect 
the fact that BDCs do not file Forms N-PORT. See supra section III.B.1. Therefore, we estimate 
the total number of small funds that would make VaR-related disclosures on Form N-PORT as 
follows: 83 small funds that file reports on Form N-PORT x 19% = approximately 16 small 
funds. 
745
  See supra section III.C.9.a.; see also supra section IV.F (discussing the professional skills that we 
believe compliance with this aspect of the proposal would entail). 

397 
that does not use derivatives extensively.
746
 And a fund that is a limited derivatives user, or that 
otherwise is not subject to the proposed VaR test, would not incur any costs to comply with the 
proposed new VaR-related N-PORT items.
747
 
b. Proposed Amendments to Form N-LIQUID 
We are proposing to re-title Form N-LIQUID as Form N-RN, and amend this form to 
include new reporting events for funds that are subject to proposed rule 18f-4’s limit on fund 
leverage risk.
748
 The proposed amendments would require funds subject to the limit on fund 
leverage risk to report information about VaR test breaches under certain circumstances. These 
proposed current reporting requirements are designed to aid the Commission in assessing funds’ 
compliance with the VaR tests, and to provide staff the ability to assess how long a fund is 
precluded from entering into derivatives transactions as a consequence of its lack of compliance 
with its VaR test. We are proposing to require funds to provide this information in a current 
report because we believe that the Commission should be notified promptly when a fund is out of 
compliance with the proposed VaR-based limit on fund leverage risk (and also when it has come 
back into compliance with its applicable VaR test). We believe this information could indicate 
that a fund is experiencing heightened risks as a result of a fund’s use of derivatives transactions, 
as well as provide the Commission insight about the duration and severity of those risks, and 
whether those heightened risks are fund-specific or industry-wide. 
As discussed above, we estimate that each fund subject to the proposed new current 
reporting requirements would incur an average cost of $10 per year
 
to prepare amended Form N-
                                                      
746
     See supra note 715. 
747
     See proposed Item B.10 to Form N-PORT. 
748
     See supra section II.H.2. 

398 
RN.
749
 We estimate that approximately 19 registered open- and closed-end funds, and BDCs, are 
small entities that would be required to report VaR test related information on Form N-RN.
750
 
Because the proposed amendments to Form N-RN would require both large and small funds to 
report VaR test breaches, the burden to report is not associated with fund size, and consequently, 
we would not expect the costs of compliance with the new Form N-RN requirements to be 
meaningfully different for small versus large funds.  
c. Proposed Amendments to Form N-CEN 
The proposed amendments to Form N-CEN would require a fund to identify whether it 
relied on proposed rule 18f-4 during the reporting period.
751
 The proposed amendments also 
would require a fund to identify whether it relied on any of the exemptions from various 
requirements under the proposed rule, specifically: (1) whether the fund is a limited derivatives 
user excepted from the proposed rule’s program requirement, under either of the proposed 
exception’s alternatives (either a funds that limits its derivatives exposure to 10% of its net assets, 
or a fund that uses derivatives transactions solely to hedge certain currency risks); or (2) whether 
it is a leveraged/inverse fund covered by the proposed sales practices rules that, under proposed 
rule 18f-4, would be excepted from the proposed limit on fund leverage risk. Finally, a fund 
would have to identify whether it has entered into reverse repurchase agreements or similar 
financing transactions, or unfunded commitment agreements, as provided under the proposed 
                                                      
749
  See supra section III.C.9.b; see also supra section IV.G ( discussing the professional skills that we 
believe compliance with this aspect of the proposal would entail). 
750
  This estimate is based on an estimate that 16 small registered open- and closed-end funds would 
make VaR-related disclosures on Form N-PORT (see supra note 744 and accompanying text), 
plus 3 BDCs (16 total small BDCs (see supra note 693 and accompanying text) x 19% (our 
estimate of the percentage of funds subject to a VaR-based limit on fund leverage risk, see supra 
note 713 and accompanying text) = approximately 3 BDCs). Thus, 16 small registered open- and 
closed-end funds + 3 BDCs = 19 funds. 
751
     See supra section II.H.3. 

399 
rule.
752
 The proposed amendments to Form N-CEN are designed to assist the Commission and 
staff with our oversight functions by allowing us to identify which funds were excepted from 
certain of the proposed rule’s provisions or relied on the rule’s provisions regarding reverse 
repurchase agreements and unfunded commitment agreements.   
As discussed above, we estimate that each fund subject to the proposed new Form N -
CEN reporting requirements would incur on average an ongoing annual cost of $6.96 per year.
753
 
We estimate that approximately 34 registered open- and closed-end funds are small entities that 
would be subject to the proposed new Form N-CEN reporting requirements.
754
 Notwithstanding 
any economies of scale experienced by large versus small funds, we would not expect the costs 
of compliance with the new Form N-CEN requirements to be meaningfully different for small 
versus large funds. 
                                                      
752
  See proposed Item C.7.l.iv-v of Form N-CEN; see also supra section II.I and II.J; proposed rule 
18f-4(d); and proposed rule 18f-4(e). 
753
  See supra section III.C.9.a; see also supra section IV.H ( discussing the professional skills that we 
believe compliance with this aspect of the proposal would entail). 
754
  Because BDCs do not file reports on Form N-CEN, we deduct the number of BDCs from the total 
number of small funds that we estimate (99 small funds – 16 BDCs that are small entities = 83 
small funds that file reports on Form N-CEN). See supra note 693 and accompanying text.  
The estimate of 34 funds is based on the percentage of funds we believe would be subject to the 
proposed derivatives risk management program requirement (22% of funds, see supra note 499 
and accompanying text) plus the percentage of funds we believe would qualify as limited 
derivatives users (19% of funds, see supra note 721 and accompanying text). We estimate that 83 
small funds that file reports on Form N-CEN (99 total small funds less 16 small BDCs) x 41% 
(22% + 19%) = 34 small funds subject to the proposed Form N-CEN reporting requirements. To 
the extent that there are funds that either (1) would not adopt a derivatives risk management 
program or (2) would not qualify as limited derivatives user, but that would rely on the rule’s 
provisions with respect to reverse repurchase agreements or unfunded commitment agreements, 
this analysis might underestimate the number of funds that would be subject to the new Form N-
CEN reporting requirements. 

400 
3. Proposed Sales Practices Rules  
The proposed sales practices rules under the Exchange Act and the Advisers Act would 
require a firm to exercise due diligence in determining whether to approve the account of a retail 
investor to buy or sell shares of a leveraged/inverse investment vehicle before accepting an order 
from, or placing an order for, the retail investor to engage in these transactions.
755
 Under the 
proposed sales practices rules, no firm may accept an order from or place an order for a retail 
investor to buy or sell shares of a leveraged/inverse investment vehicle, or approve such an 
investor’s account to engage in those transactions, unless the firm has complied with certain 
conditions.  
Specifically, the proposed sales practices rules would require the firm to: (1) approve the 
retail investor’s account for buying and selling shares of leveraged/inverse investment vehicles 
pursuant to a due diligence requirement; and (2) adopt and implement policies and procedures 
reasonably designed to achieve compliance with the proposed rules.
756
 The proposed sales 
practices rules’ due diligence requirements provide that a firm must exercise due diligence to 
ascertain the essential facts relative to the retail investor, his or her financial situation, and 
investment objectives. A firm must seek to obtain, at a minimum, certain specified information 
about the retail investor. The proposed sales practices rules also include recordkeeping 
requirements relating to the information that the firm obtained through its due diligence, the 
firm’s approval or disapproval of the retail investor’s account for buying and selling shares of 
                                                      
755
     See supra section II.G.1. 
756
     See supra section II.G.2.b. 

401 
leveraged/inverse investment vehicles (account approvals must be in writing), and the firm’s 
policies and procedures that it adopted pursuant to those rules.
757
  
The proposed sales practices rules are designed to establish a uniform set of enhanced 
due diligence and account approval requirements for all leveraged/inverse investment vehicle 
transactions, including transactions where no recommendation or investment advice is provided 
by a firm. They also are designed in part to help to ensure that investors in these funds are 
limited to those who understand their characteristics—including that these funds would not be 
subject to all of the leverage-related requirements applicable to registered investment companies 
generally—and the unique risks they present. 
As discussed above, we estimate that each broker-dealer subject to proposed rule 15l-2, 
and each investment adviser subject to proposed rule 211(h)-1, would incur total one-time costs 
that would range from $9,115.50 to $15,192.50 to comply with the proposed rules, and total 
ongoing costs that would range from $2,270.50 to $3,915 per year to comply with the proposed 
rules.
758
 We estimate that approximately 236 broker-dealers and 43 registered investment 
advisers are small entities that would be subject to the proposed sales practices rules.
759
 
                                                      
757
     See supra section II.G.2.c. 
758
  See supra notes 540 and 544 and accompanying text. This discussion, along with sections IV.C 
and IV.D supra, also discusses the professional skills that we believe compliance with this aspect 
of the proposal would entail. 
759
  We estimate there are currently 942 small broker-dealers. See supra note 695 and accompanying 
text. We further estimate that 700 broker-dealers (or 25% of all 2,766 broker-dealers registered 
with the Commission) have retail customer accounts that invest in leveraged/inverse investment 
vehicles. See supra section III.C.5. Our estimate of 236 broker-dealers is based on the following 
calculation: 942 small broker dealers x 25% = approximately 236 small broker-dealers that have 
retail customer accounts that invest in leveraged/inverse investment vehicles. 
We estimate that there are currently 470 SEC-registered investment advisers that are small 
entities. See supra note 698 and accompanying text. Of these, we estimate that 171 provide 
advice to individual clients, and could therefore be subject to the proposed new sales practices 
rules under the Advisers Act. See supra note 699 and accompanying text. We further estimate 
 

402 
The costs that broker-dealers and investment advisers may incur as a result of the 
proposed sales practices rules would vary depending on the firm and the due diligence 
requirements that the firm adopts as a result of the proposed rules’ requirements.
760
 We expect 
that economies of scale among larger firms could result in cost reductions for larger firms. 
Compliance costs could, however, be different across firms with relatively smaller or larger 
numbers of retail investors as customers or clients.
761
  
4. Proposed Amendments to Rule 6c-11  
We are proposing to amend rule 6c-11 to remove the provision excluding 
leveraged/inverse ETFs from the scope of that rule and to newly permit leveraged/inverse ETFs 
to rely on that rule.
762
 Rule 6c-11 permits ETFs that satisfy certain conditions to operate without 
obtaining an exemptive order from the Commission.
763
 The rule is designed to create a consistent, 
transparent, and efficient regulatory framework for such ETFs and facilitate greater competition 
and innovation among ETFs. As a consequence of our proposed amendment to rule 6c-11, and 
proposal to rescind the exemptive orders we have previously issued to leveraged/inverse ETFs, 
                                                      
that 2,000 investment advisers (or approximately 25% of the 8,235 investment advisers that are 
registered with the Commission and offer some part of their business to retail investors) have 
retail client accounts that invest in leveraged/inverse investment vehicles. See supra sections 
III.C.5 and IV.D. Our estimate of 43 investment advisers is based on the following calculation: 
171 small investment advisers that provide advice to individual clients x 25% = approximately 43 
small investment advisers that have retail client accounts that invest in leveraged/inverse 
investment vehicles. 
760
     See supra section III.C.5 (discussing costs and benefits of proposed sales practices rules). 
761
  See supra section II.G.2.b (discussing required approval and due diligence for retail investors’ 
accounts to trade shares of leveraged/inverse investment vehicles under the proposed sales 
practices rules). 
762
     See supra section II.G.4. 
763
  Id. 

403 
these proposed amendments would newly permit leveraged/inverse ETFs to come within scope 
of the rule’s exemptive relief.  
Currently, there are 73 leveraged/inverse ETFs.
764
 As a result of the proposed 
amendments, we would expect the number of funds relying on rule 6c-11 to increase, and we 
estimate that all 73 leveraged/inverse ETFs would newly seek to use rule 6c-11. We also 
estimate, for purposes of this Regulatory Flexibility Act analysis, that approximately 1 of these 
leveraged/inverse ETFs would be a small leveraged/inverse ETF that would seek to rely on rule 
6c-11.
765
 We do not estimate our amendments to rule 6c-11 would change the estimated per-fund 
cost burden associated with rule 6c-11, but we do believe the number of funds using the rule, as a 
result of our amendment, would now increase.
766
 The costs associated with complying with rule 
6c-11 are discussed in the ETFs Adopting Release.
767
 
E. Duplicative, Overlapping, or Conflicting Federal Rules 
Commission staff has not identified any federal rules that duplicate, overlap, or conflict 
with proposed Investment Company Act rule 18f-4, proposed Exchange Act rule 15l-2, proposed 
Advisers Act rule 211(h)-1, or the proposed amendments to Form N-PORT, Form N-LIQUID, 
and Form N-CEN. 
We recognize that other broker-dealer or investment adviser obligations require these 
entities to engage in due diligence with respect to transactions they recommend to customers or 
clients. The proposed sales practices rules, in contrast, would apply regardless of whether a 
                                                      
764
     See supra note 468.   
765
  This estimate is based on the following calculation: 8 small ETFs / 1,190 total ETFs = 
approximately 0.67% of ETFs that are small ETFs. See supra sections III.B.1 and V.C. 0.67% of 
73 leveraged/inverse ETFs = approximately 1 leveraged/inverse ETF.  
766
     See supra section IV.E. 
767
  See ETFs Adopting Release, supra note 76, at section IV. 

404 
broker-dealer or investment adviser recommends that a customer or client buy or sell 
leveraged/inverse investment vehicles. We therefore do not believe that the sales practices rules 
would conflict with existing broker-dealer or investment adviser obligations, and believe that any 
overlap or duplication should be limited because a broker-dealer or investment adviser could 
consider the information it collects in connection with the sales practices rules in connection with 
the due diligence the broker-dealer or investment adviser conducts in connection with other, 
existing obligations for recommended transactions. 
F.  Significant Alternatives 
The Regulatory Flexibility Act directs the Commission to consider significant 
alternatives that would accomplish our stated objectives, while minimizing any significant 
economic impact on small entities. We considered the following alternatives for small entities in 
relation to our proposal: (1) exempting funds, broker-dealers, and registered investment advisers 
that are small entities from the proposed reporting, recordkeeping, and other compliance 
requirements, to account for resources available to small entities; (2) establishing different 
reporting, recordkeeping, and other compliance requirements or frequency, to account for 
resources available to small entities; (3) clarifying, consolidating, or simplifying the compliance 
requirements under the proposal for small entities; and (4) using performance rather than design 
standards. 
1. Proposed Rule 18f-4 
We do not believe that exempting small funds from the provisions in proposed rule 18f-4 
would permit us to achieve our stated objectives. Because proposed rule 18f-4 is an exemptive 
rule, it would require funds to comply with new requirements only if they wish to enter into 

405 
derivatives or certain other transactions.
768
 Therefore, if a small entity does not enter into 
derivatives or such other transactions as part of its investment strategy, then the small entity 
would not be subject to the provisions of proposed rule 18f-4. In addition, a small fund whose 
derivatives use is limited could benefit from the proposed limited derivatives user exception, 
because it would not be required to adopt a derivatives risk management program (including all 
of the proposed program elements). 
We estimate that 59% of all funds do not have any exposure to derivatives or such other 
transactions.
769
 This estimate indicates that many funds, including many small funds, would be 
unaffected by the proposed rule. However, for small funds that would be affected by our 
proposed rule, providing an exemption for them could subject investors in small funds that invest 
in derivatives or engage in such other transactions to a higher degree of risk than investors to 
large funds that would be required to comply with the proposed elements of the rule. 
The undue speculation concern expressed in section 1(b)(7) of the Investment Company 
Act, and the asset sufficiency concern reflected in section 1(b)(8) of the Act—both of which the 
proposed rule is designed to address—apply to both small as well as large funds. As discussed 
throughout this release, we believe that the proposed rule would result in investor protection 
benefits, and these benefits should apply to investors in smaller funds as well as investors in 
larger funds. We therefore do not believe it would be appropriate to exempt small funds from the 
proposed rule’s program requirement or VaR-based limit on fund leverage risk, or to establish 
different requirements applicable to funds of different sizes under these provisions to account for 
resources available to small entities. We believe that all of the proposed elements of rule 18f-4 
                                                      
768
  See supra sections II.D.6 and III.E. 
769
     See supra note 459 and accompanying paragraph. 

406 
should work together to produce the anticipated investor protection benefits, and therefore do not 
believe it is appropriate to except smaller funds because we believe this would limit the benefits 
to investors in such funds. 
We also do not believe that it would be appropriate to subject small funds to different 
reporting, recordkeeping, and other compliance requirements or frequency. Similar to the 
concerns discussed above, if the proposal included different requirements for small funds, it 
could raise investor protection concerns for investors in small funds including subjecting small 
fund investors to a higher degree of risk if the small fund uses derivatives transactions. We also 
believe that all fund investors will benefit from enhanced Commission monitoring and oversight 
of the fund industry, which we anticipate will result from the disclosure and reporting 
requirements.  
We do not believe that clarifying, consolidating, or simplifying the compliance 
requirements under the proposal for small funds would permit us to achieve our stated 
objectives. Again, this approach would raise investor protection concerns for investors in small 
funds using derivatives transactions. However, as discussed above, the proposed rule contains an 
exception for limited derivatives users that we anticipate would subject funds that qualify for this 
exception to fewer compliance burdens. We recognize that the risks and potential impact of 
derivatives transactions on a fund’s portfolio generally increase as the fund’s level of derivatives 
usage increases and when funds use derivatives for speculative purposes. Therefore the proposed 
rule would entail a less significant compliance burden for funds—including small funds—that 
choose to limit their derivatives usage in the manner that the proposed exception specifies. The 
proposal, therefore, does include provisions designed to consider the requirement burdens based 
on the fund’s use of derivatives (rather than the size of the fund).  

407 
The costs associated with proposed rule 18f-4 would vary depending on the fund’s 
particular circumstances, and thus the proposed rule could result in different burdens on funds’ 
resources. In particular, we expect that a fund that pursues an investment strategy that involves 
greater derivatives risk may have greater costs associated with its derivatives risk management 
program. For example, a fund that qualifies as a limited derivatives user under the proposed rule 
would be exempt from the proposed requirements to adopt and implement a derivatives risk 
management program, and to adhere to the proposed rule’s VaR-based limit on fund leverage 
risk. The costs of compliance with the proposed rule would vary even for limited derivatives 
users, as these funds would be required to adopt policies and procedures that are “reasonably 
designed” to manage their derivatives risks. Thus, to the extent a fund that is a small entity faces 
relatively little derivatives risk, we believe it would incur relatively low costs to comply with the 
proposed rule. However, we believe that it is appropriate to correlate the costs associated with 
the proposed rule with the level of derivatives risk facing a fund, and not necessarily with the 
fund’s size in light of our investor protection objectives. 
Finally, with respect to the use of performance rather than design standards, the proposed 
rule generally uses performance standards for all funds relying on the proposed rule, regardless 
of size. We believe that providing funds with the flexibility with respect to investment strategies 
and use of derivatives transactions is appropriate, as well as the derivatives risk management 
program design. However, the proposed rule also uses design standards with respect to certain 
requirements such as complying with the VaR-based limit on fund leverage risk and the specified 
program elements in the derivatives risk management program. For the reasons discussed above, 
we believe that this use of design standards is appropriate to address investor protection concerns, 
particularly the concerns expressed in sections 1(b)(7), 1(b)(8), and 18 of the Investment 

408 
Company Act. 
2. Proposed Sales Practices Rules 
Similarly, we do not believe that exempting any subset of broker-dealers or registered 
investment advisers, including those firms that are small entities, from the provisions in the 
proposed sales practices rules would permit us to achieve our stated investor protection 
objectives. We also do not believe that it would be desirable to establish different requirements 
applicable to firms of different sizes under the proposed sales practices rules to account for 
resources available to small entities, to consolidate or simplify the compliance requirements 
under the proposal for small entities, or to use performance standards rather than design 
standards for small entities.  
We do not believe exempting small broker-dealers and investment advisers from the 
proposed sales practices rules would serve the interest of investors. As we discussed above, 
leveraged/inverse investment vehicles present unique considerations, and the proposed sales 
practices rules are designed in part to address the investor protection concerns leveraged/inverse 
funds present.
770
 The proposed sales practices rules would permit broker-dealers and investment 
advisers to accept or place orders to buy or sell shares of a “leveraged/inverse investment vehicle” 
only for investors that they have approved for those transactions, based on certain required 
criteria.
771
 Exempting smaller broker-dealer and investment adviser firms would create a 
regulatory gap, whereby larger funds would be required to comply with the proposed sales 
practices rules’ due diligence requirements to determine whether to approve the account of retail 
investor to buy or sell shares of a leveraged/inverse investment vehicle, and small entities would 
                                                      
770
     See supra section II.G. 
771
  See proposed rule 15l-2(b). 

409 
not need to conduct this same diligence.   
As discussed above, we believe that this limitation on leveraged/inverse investment 
vehicles’ investor base would help provide that investors in these vehicles understand the 
characteristics of these vehicles and the unique risks they present.
772
 Providing different 
requirements or simplifying the requirements for small entities would dilute these investor 
protection benefits for customers or clients of small entities. We do not believe that the investor 
protection benefits of the proposed sales practices rules should depend on whether an investor is 
transacting through a small or a large firm. Furthermore, a broker-dealer or investment adviser 
would have to comply with the applicable proposed rule’s requirements only if it transacts with 
retail investors in the shares of leveraged/inverse investment vehicles.
773
 
Finally, we are not proposing performance standards rather than design standards for 
smaller entities. We believe that subjecting smaller entities to different standards under the 
proposed rules could lead to inconsistency in how investors would transact in leveraged/inverse 
investment vehicles, depending on whether the investor has a relationship with a large or small 
broker-dealer or investment adviser. This would be inconsistent with the regulatory and investor 
protections purposes of the proposed rules and could subject investors who interact with small 
firms to a higher degree of risk than investors who interact with larger firms.  It could also 
circumvent the proposed rules’ ability to establish a uniform set of enhanced due diligence and 
                                                      
772
  See supra section II.G.  
773
  We estimate that approximately 236 broker-dealers and 43 registered investment advisers are 
small entities that would be subject to the proposed sales practices rules. See supra note 759 and 
accompanying text. 
 Broker-dealers and investment advisers that would have to comply with the proposed sales 
practices rules also might currently have processes in place that would provide efficiencies in 
complying with the proposed rules. See supra note 537 and accompanying text. 

410 
approval requirements for all leveraged/inverse investment vehicle transactions, and to address 
the investor protection concerns underlying section 18 for leveraged/inverse funds by limiting 
their investor base. 
3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-
CEN 
We do not believe that the interests of investors would be served by exempting funds that 
are small entities from the proposed disclosure and reporting requirements. We believe that the 
form amendments are necessary to help identify and provide the Commission, staff, investors, 
and other market participants timely information about funds that comply with proposed rule 
18f-4, and to realize the anticipated benefits of the proposed reporting requirements.
774
 
Exempting small funds from coverage under all or any part of the proposed form amendments 
could compromise the effectiveness of the required disclosures, which the Commission believes 
would not be consistent with its goals of industry oversight and investor protection. We believe 
that all fund investors, including investors in small funds, would benefit from disclosure and 
reporting requirements that would permit them to make investment choices that better match 
their risk tolerances. We also believe that all fund investors would benefit from enhanced 
Commission monitoring and oversight of the fund industry, which we anticipate would result 
from the proposed disclosure and reporting requirements.  
For similar reasons, we do not believe that the interests of investors would be served by 
establishing different reporting, recordkeeping, or other compliance requirements for small 
funds. We considered providing small funds simplified compliance or disclosure requirements. 
However, we believe this too would subject investors in small funds that invest in derivatives to 
                                                      
774
     See supra section III.C.9. 

411 
a higher degree of risk and information asymmetry than investors to large funds that would be 
required to comply with the proposed disclosure requirements. We also note that registered open- 
and closed-end management investment companies, including those that are small entities, have 
already updated their systems and have established internal processes to prepare, validate, and 
file reports on Forms N-PORT and N-CEN (or will do so shortly).
775
 For funds that will be 
required to file reports on Form N-RN, the vast majority of them are open-end funds, which 
already are required to submit the form upon specified events. With respect to the additional 
registered closed-end funds and BDCs newly required to file reports on Form N-RN, we do not 
believe they would need more time to comply with the new reporting requirements, given the 
limited set of reporting requirements they would be subject to and the relatively low burden we 
estimate of filing reports on Form N-RN. 
We also do not believe that the interests of investors would be served by clarifying, 
consolidating, or simplifying the compliance requirements under the proposal for small funds. 
Small funds are as vulnerable to the same potential risks associated with their derivatives use as 
larger funds are, and therefore we believe that simplifying or consolidating the proposed 
reporting requirements for small funds would not allow us to meet our stated objectives. 
Moreover, we believe many of the proposed disclosure requirements involve minimal burden. 
For example, the Form N-CEN “checking a box” reporting requirement is completed on an 
annual basis.  
Finally, we did not prescribe performance standards rather than design standards for 
                                                      
775
  See supra note 360 (discussing, among other things, Form N-PORT compliance dates and noting 
that the funds that would rely on proposed rule 18f-4 (if adopted) other than BDCs generally are 
subject to reporting requirements on Form N-CEN); see also Investment Report Modernization 
Adopting Release supra note 179, at section II.H. 

412 
small funds because we believe this too could diminish the ability of the proposed rules to 
achieve their intended regulatory purpose by creating inconsistent reporting requirements 
between small and large funds, and weakening the benefits of the proposed reporting 
requirement for investors in small funds. 
4. Rule 6c-11 
Rule 6c-11 is designed to modernize the regulatory framework for ETFs and to create a 
consistent, transparent, and efficient regulatory framework.
776
 The Commission’s full Regulatory 
Flexibility Act Analysis regarding rule 6c-11, including analysis of significant alternatives, 
appears in the 2019 ETFs Adopting Release and the 2018 ETFs Proposing Release.
777
 Our 
analysis of alternatives for small leveraged/inverse ETFs here is consistent with the 
Commission’s analysis of alternatives for small ETFs in those releases.  
We do not believe that permitting or requiring different treatment for any subset of 
leveraged/inverse ETFs, including small leveraged/inverse ETFs, under the proposed 
amendments to rule 6c-11, and the rule’s related recordkeeping, disclosure and reporting 
requirements, would permit us to achieve our stated objectives. Similarly, we do not believe that 
we can establish simplified or consolidated compliance requirements for small leveraged/inverse 
ETFs under the proposed amendments to rule 6c-11 without compromising our objectives. The 
Commission discussed the bases for this determination (with respect to ETFs other than 
leveraged/inverse ETFs) in more detail in the ETFs Proposing Release and the ETFs Adopting 
Release, and we are extending that analysis to leveraged/inverse ETFs in this Initial Regulatory 
Flexibility Act Analysis. In addition, we do not believe it would be appropriate to exempt small 
                                                      
776
     See ETFs Adopting Release, supra note 76, at section I. 
777
  See id. at section VI; see also Exchange-Traded Funds, Investment Company Act Release No. 
10515 (June 28, 2018) [83 FR 37332 (July 31, 2018)] (“ETFs Proposing Release”), at section V.  

413 
leveraged/inverse ETFs from the proposed amendments to rule 6c-11 (or to establish different 
disclosure, reporting, or recordkeeping requirements, or simplified or consolidated compliance 
requirements under rule 6c-11 for these entities) because of the particular risks that 
leveraged/inverse ETFs may present.
778
 We also do not think it would be appropriate to establish 
different requirements under rule 6c-11 for small leveraged/inverse ETFs, which could produce a 
competitive advantage for these funds compared to larger leveraged/inverse ETFs (and compared 
to other ETFs that rely on the rule). This would conflict with our goals of creating a consistent, 
transparent, and efficient regulatory framework for ETFs and to facilitate greater competition 
and innovation among ETFs.  
G. Request for Comment 
The Commission requests comments regarding this analysis. We request comment on the 
number of small entities that would be subject to our proposal and whether our proposal would 
have any effects that have not been discussed. We request that commenters describe the nature of 
any effects on small entities subject to our proposal and provide empirical data to support the 
nature and extent of such effects. We also request comment on the estimated compliance burdens 
of our proposal and how they would affect small entities. 
VI. CONSIDERATION OF IMPACT ON THE ECONOMY 
For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996 
(“SBREFA”), the Commission must advise OMB whether a proposed regulation constitutes a 
“major” rule. Under SBREFA, a rule is considered “major” where, if adopted, it results in or is 
likely to result in:  
• An annual effect on the economy of $100 million or more;  
                                                      
778
     See supra section II.G.1. 

414 
• A major increase in costs or prices for consumers or individual industries; or  
• Significant adverse effects on competition, investment, or innovation.  
We request comment on whether our proposal would be a “major rule” for purposes of 
SBREFA. We solicit comment and empirical data on:  
• The potential effect on the U.S. economy on an annual basis;  
• Any potential increase in costs or prices for consumers or individual industries; and  
• Any potential effect on competition, investment, or innovation.  
Commenters are requested to provide empirical data and other factual support for their 
views to the extent possible. 
VII. STATUTORY AUTHORITY 
The Commission is proposing new rule 18f-4 under the authority set forth in sections 
6(c), 12(a), 18, 31(a), 38(a), and 61 of the Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 
80a-12(a), 80a-18, 80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing 
amendments to rule 6c-11 under the authority set forth in sections 6(c), 22(c), and 38(a) of the 
Investment Company Act [15 U.S.C. 80a-6(c), 22(c), and 80a-37(a)]. The Commission is 
proposing new rule 15l-2 under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 17, 
23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C. 78c, 78c(b), 78c-5, 78j, 78o(l), 
78o-10, 78q, 78w(a), and 78mm]. The Commission is proposing new rule 211(h)-1 under the 
authority set forth in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment 
Advisers Act of 1940 [15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and 80b-11(h)]. The 
Commission is proposing amendments to Form N-PORT, Form N-LIQUID (which we propose 
to re-title as “Form N-RN”), Form N-CEN, and Form N-2 under the authority set forth in 
sections 8, 18, 30, and 38 of the Investment Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 
80a-29, 80a-37, 80a-63], sections 6, 7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C. 

415 
77f, 77g(a), 77j, 77s(a)], and sections 10, 13, 15, 23, and 35A of the Exchange Act [15 U.S.C. 
78j, 78m, 78o, 78w, and 78ll]. 
TEXT OF RULES AND FORMS  
List of Subjects  
17 CFR Parts 240 and 249 
 Brokers, Fraud, Reporting and recordkeeping requirements, Securities. 
17 CFR Parts 270 and 274  
Investment companies, Reporting and recordkeeping requirements, Securities.  
17 CFR Part 275 
 Reporting and recordkeeping requirements, Securities. 
For the reasons set out in the preamble, title 17, chapter II of the Code of Federal 
Regulations is proposed to be amended as follows:  
* * * * * 
PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT 
OF 1934 
 
1. The authority citation for part 240 is amended by adding a subauthority 
for Section 240.15l-2 to read as follows: 
 
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 77eee, 77ggg, 77nnn, 77sss, 
77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f, 78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 
78o-4, 78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 
80a-37, 80b-3, 80b-4, 80b-11, and 7201 et seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 
5221(e)(3); 18 U.S.C. 1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-106, 
sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted. 

416 
* * * * * 
Section 240.15l-2 is also issued under Pub. L. 111-203, sec. 913, 124 Stat. 1376, 1827 
(2010). 
* * * * * 
2. Section 240-15l-2 is added to read as follows: 
§ 240.15l-2     Broker and dealer sales practices for leveraged/inverse investment vehicles. 
(a) Required approval of customer account. No broker or dealer registered or 
required to be registered under the Securities Exchange Act of 1934, or any associated person of 
the broker or dealer, may accept an order from a customer that is a natural person (or the legal 
representative of a natural person) to buy or sell shares of a leveraged/inverse investment vehicle 
unless the broker or dealer has approved such a customer’s account to engage in those 
transactions and has adopted and implemented policies and procedures reasonably designed to 
achieve compliance with this section. Any approval of a customer’s account for buying or selling 
leveraged/inverse investment vehicles must be effected as provided in paragraph (b). 
(b) Diligence in approving accounts. (1) In determining whether to approve a 
customer’s account to buy or sell leveraged/inverse investment vehicles, the broker or dealer 
must exercise due diligence to ascertain the essential facts relative to the customer, his or her 
financial situation, and investment objectives, including, at a minimum, the information specified 
in paragraph (b)(2) of this section (and must seek to obtain information for all participants in a 
joint account). Based upon this information, the broker or dealer must specifically approve or 
disapprove the customer’s account for buying and selling shares of leveraged/inverse investment 
vehicles. An approval of a customer account must be in writing. A broker or dealer may provide 
this approval if the broker or dealer has a reasonable basis for believing that the customer has 

417 
such knowledge and experience in financial matters that he or she may reasonably be expected to 
be capable of evaluating the risks of buying and selling leveraged/inverse i nvestment vehicles. 
(2) A broker or dealer must seek to obtain the following information at a minimum 
regarding the customer: 
(i) Investment objectives (e.g., safety of principal, income, growth, trading 
profits, speculation) and time horizon; 
(ii) Employment status (name of employer, self-employed or retired); 
(iii) Estimated annual income from all sources; 
(iv) Estimated net worth (exclusive of family residence); 
(v) Estimated liquid net worth (cash, liquid securities, other); 
 (vi) Percentage of the customer’s estimated liquid net worth that he or she 
intends to invest in leveraged/inverse investment vehicles; and 
(vii) Investment experience and knowledge (e.g., number of years, size, 
frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, 
stocks and bonds, commodities, and other financial instruments. 
(c) Recordkeeping. A broker or dealer must maintain a written record of the 
information that it obtained under paragraph (b) of this section and, if applicable, its written 
approval of the customer’s account, as well as the versions of the firm’s policies and procedures 
required under paragraph (a) that were in place when it approved or disapproved the customer’s 
account, for a period of not less than six years (the first two years in an easily accessible place) 
after the date of the closing of the customer’s account.  
(d) Definitions. For purposes of this section: 

418 
Associated person of the broker dealer means any partner, officer, director, or branch 
manager of such broker or dealer (or any person occupying a similar status or performing similar 
functions), any person directly or indirectly controlling, controlled by, or under common control 
with such broker or dealer, or any employee of such broker or dealer, except that any person 
associated with a broker or dealer whose functions are solely clerical or ministerial shall not be 
included in the meaning of such term for purposes of section 15(b) of the Exchange Act (other 
than paragraph (6) thereof). 
Commodity- or Currency-Based Trust or Fund means a trust or other person: 
(1) Issuing securities in an offering registered under the Securities Act of 
1933 (15 U.S.C. 77a et seq.) and which class of securities is listed for trading on a national 
securities exchange; 
(2) The assets of which consist primarily of derivative instruments that 
reference commodities or currencies, or interests in the foregoing; and 
(3) That provides in its registration statement under the Securities Act of 1933 
(15 U.S.C. 77a et seq.) that a class of its securities are purchased or redeemed, subject to 
conditions or limitations, for a ratable share of its assets. 
Leveraged/inverse investment vehicle means a registered investment company (including 
any separate series thereof), or commodity- or currency-based trust or fund, that seeks, directly 
or indirectly, to provide investment returns that correspond to the performance of a market index 
by a specified multiple, or to provide investment returns that have an inverse relationship to the 
performance of a market index, over a predetermined period of time. 
(e) Transition. This section applies to all customers of the broker or dealer, including 
customers who have opened accounts with the broker or dealer before the compliance date for 

419 
this section, provided that this section does not apply to, and therefore will not restrict a 
customer’s ability to close or reduce, a position in a leveraged/inverse investment vehicle that a 
customer established before the compliance date of this section. 
 
PART 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940  
3. The authority citation for part 270 continues to read, in part, as follows: 
 
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39, and Pub. L. 111-203, sec. 
939A, 124 Stat. 1376 (2010), unless otherwise noted.  
* * * * * 
 
Section 270.6c-11 is also issued under 15 U.S.C. 80a-6(c) and 80a-37(a). 
 
* * * * * 
 
4. Amend §6c-11 by removing paragraph (c)(4). 
 
 
5. Section 270.18f-4 is added to read as follows: 
 
§ 270.18f-4 Exemption from the requirements of section 18 and section 61 for certain 
senior securities transactions. 
(a) Definitions. For purposes of this section: 
Absolute VaR test means that the VaR of the fund’s portfolio does not exceed 15% of the 
value of the fund’s net assets. 
Derivatives exposure means the sum of the notional amounts of the fund’s derivatives 
instruments and, in the case of short sale borrowings, the value of the asset sold short. In 
determining derivatives exposure a fund may convert the notional amount of interest rate 
derivatives to 10-year bond equivalents and delta adjust the notional amounts of options 
contracts. 

420 
Derivatives risks means the risks associated with a fund’s derivatives transactions or its 
use of derivatives transactions, including leverage, market, counterparty, liquidity, operational, 
and legal risks and any other risks the derivatives risk manager (or, in the case of a fund that is a 
limited derivatives user as described in paragraph (c)(3) of this section, the fund’s investment 
adviser) deems material. 
Derivatives risk manager means an officer or officers of the fund’s investment adviser 
responsible for administering the program and policies and procedures required by paragraph 
(c)(1) of this section, provided that the derivatives risk manager: 
(1) May not be a portfolio manager of the fund, or if multiple officers serve as 
derivatives risk manager, may not have a majority composed of portfolio managers of the fund; 
and 
(2) Must have relevant experience regarding the management of derivatives 
risk. 
Derivatives transaction means:  
(1) Any swap, security-based swap, futures contract, forward contract, option, 
any combination of the foregoing, or any similar instrument (“derivatives instrument”), under 
which a fund is or may be required to make any payment or delivery of cash or other assets 
during the life of the instrument or at maturity or early termination, whether as margin or 
settlement payment or otherwise; and 
(2) Any short sale borrowing. 
Designated reference index means an unleveraged index that: (1) is selected by the 
derivatives risk manager and that reflects the markets or asset classes in which the fund invests; 
(2) is not administered by an organization that is an affiliated person of the fund, its investment 

421 
adviser, or principal underwriter, or created at the request of the fund or its investment adviser, 
unless the index is widely recognized and used; and (3) is an “appropriate broad-based securities 
market index” or an “additional index,” as defined in the instruction to Item 27 in Form N-1A 
[17 CFR 274.11A]. In the case of a blended index, none of the indexes that compose the blended 
index may be administered by an organization that is an affiliated person of the fund, its 
investment adviser, or principal underwriter, or created at the request of the fund or its 
investment adviser, unless the index is widely recognized and used. 
Fund means a registered open-end or closed-end company or a business development 
company, including any separate series thereof, but does not include a registered open-end 
company that is regulated as a money market fund under § 270.2a-7. 
Relative VaR test means that the VaR of the fund’s portfolio does not exceed 150% of the 
VaR of the designated reference index. 
Unfunded commitment agreement means a contract that is not a derivatives transaction, 
under which a fund commits, conditionally or unconditionally, to make a loan to a company or to 
invest equity in a company in the future, including by making a capital commitment to a private 
fund that can be drawn at the discretion of the fund’s general partner. 
Value-at-risk or VaR means an estimate of potential losses on an instrument or portfolio, 
expressed as a percentage of the value of the portfolio’s net assets, over a specified time horizon 
and at a given confidence level, provided that any VaR model used by a fund for purposes of 
determining the fund’s compliance with the relative VaR test or the absolute VaR test must: 
(1) Take into account and incorporate all significant, identifiable market risk 
factors associated with a fund’s investments, including, as applicable: 

422 
(i) Equity price risk, interest rate risk, credit spread risk, foreign 
currency risk and commodity price risk; 
(ii)   Material risks arising from the nonlinear price characteristics of a 
fund’s investments, including options and positions with embedded optionality; and 
(iii) The sensitivity of the market value of the fund’s investments to 
changes in volatility;  
(2) Use a 99% confidence level and a time horizon of 20 trading days; and 
(3) Be based on at least three years of historical market data. 
(b) Derivatives transactions. If a fund satisfies the conditions of paragraph (c) of this 
section, the fund may enter into derivatives transactions, notwithstanding the requirements of 
sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a-
18(a)(1), 80a-18(c), 80a-18(f)(1), and 80a-60), and derivatives transactions entered into by the 
fund in compliance with this section will not be considered for purposes of computing asset 
coverage, as defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-18(h)). 
(c) Conditions. (1) Derivatives risk management program. The fund adopts and 
implements a written derivatives risk management program (“program”), which must include 
policies and procedures that are reasonably designed to manage the fund’s derivatives risks and 
to reasonably segregate the functions associated with the program from the portfolio 
management of the fund. The program must include the following elements: 
(i) Risk identification and assessment. The program must provide for the 
identification and assessment of the fund’s derivatives risks. This assessment must take into 
account the fund’s derivatives transactions and other investments. 

423 
(ii) Risk guidelines. The program must provide for the establishment, 
maintenance, and enforcement of investment, risk management, or related guidelines that 
provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s 
derivatives risks. These guidelines must specify levels of the given criterion, metric, or threshold 
that the fund does not normally expect to exceed, and measures to be taken if they are exceeded. 
(iii) Stress testing. The program must provide for stress testing to evaluate 
potential losses to the fund’s portfolio in response to extreme but plausible market changes or 
changes in market risk factors that would have a significant adverse effect on the fund’s 
portfolio, taking into account correlations of market risk factors and resulting payments to 
derivatives counterparties. The frequency with which the stress testing under this paragraph is 
conducted must take into account the fund’s strategy and investments and current market 
conditions, provided that these stress tests must be conducted no less frequently than weekly. 
(iv) Backtesting. The program must provide for backtesting of the results of 
the VaR calculation model used by the fund in connection with the relative VaR test or the 
absolute VaR test by, each business day, comparing the fund’s gain or loss with the 
corresponding VaR calculation for that day, estimated over a one-trading day time horizon, and 
identifying as an exception any instance in which the fund experiences a loss exceeding the 
corresponding VaR calculation’s estimated loss. 
(v) Internal reporting and escalation. (A) Internal reporting. The program 
must identify the circumstances under which persons responsible for portfolio management will 
be informed regarding the operation of the program, including exceedances of the guidelines 
specified in paragraph (c)(1)(ii) of this section and the results of the stress tests specified in 
paragraph (c)(1)(iii) of this section. 

424 
(B) Escalation of material risks. The derivatives risk manager must 
inform in a timely manner persons responsible for portfolio management of the fund, and also 
directly inform the fund’s board of directors as appropriate, of material risks arising from the 
fund’s derivatives transactions, including risks identified by the fund’s exceedance of a criterion, 
metric, or threshold provided for in the fund’s risk guidelines established under paragraph 
(c)(1)(ii) of this section or by the stress testing described in paragraph (c)(1)(iii) of this section.  
(vi) Periodic review of the program. The derivatives risk manager must review 
the program at least annually to evaluate the program’s effectiveness and to reflect changes in 
risk over time. The periodic review must include a review of the VaR calculation model used by 
the fund under paragraph (c)(2) of this section (including the backtesting required by paragraph 
(c)(1)(iv) of this section) and any designated reference index to evaluate whether it remains 
appropriate. 
(2) Limit on fund leverage risk. (i) The fund must comply with the relative VaR test 
or, if the derivatives risk manager is unable to identify a designated reference index that is 
appropriate for the fund taking into account the fund’s investments, investment objectives, and 
strategy, the absolute VaR test.  
(ii) The fund must determine its compliance with the applicable VaR test at 
least once each business day. If the fund determines that it is not in compliance with the 
applicable VaR test, the fund must come back into compliance promptly and within no more than 
three business days after such determination. 
(iii) If the fund is not in compliance with the applicable VaR test within three 
business days: 

425 
(A) The derivatives risk manager must report to the fund’s board of 
directors and explain how and by when (i.e., number of business days) the derivatives risk 
manager reasonably expects that the fund will come back into compliance; 
(B) The derivatives risk manager must analyze the circumstances that 
caused the fund to be out of compliance for more than three business days and update any 
program elements as appropriate to address those circumstances; and 
(C) The fund may not enter into any derivatives transactions (other 
than derivatives transactions that, individually or in the aggregate, are designed to reduce the 
fund’s VaR) until the fund has been back in compliance with the applicable VaR test for three 
consecutive business days and has satisfied the requirements set forth in paragraphs (c)(2)(iii)(A) 
and (B) of this section. 
(iv) If the fund is complying with the relative VaR test, an open-end fund must 
disclose in its annual report the fund’s designated reference index as the fund’s “appropriate 
broad-based securities market index” or an “additional index,” as defined in the instruction to 
Item 27 in Form N-1A [17 CFR 274.11A], and a registered closed-end fund or business 
development company must disclose its designated reference index in the annual report, together 
with a presentation of the fund’s performance relative to the designated reference index. A fund 
is not required to include this disclosure in an annual report if the fund is a “New Fund,” as 
defined in Form N-1A [17 CFR 274.11A], or would meet that definition if it were filing on Form 
N-1A [17 CFR 274.11A], at the time the fund files the annual report. 
(3) Limited derivatives users. A fund is not required to adopt a program as prescribed 
in paragraph (c)(1) of this section, or comply with the limit on fund leverage risk in paragraph 

426 
(c)(2) of this section, if the fund adopts and implements policies and procedures reasonably 
designed to manage the fund’s derivatives risks and: 
(i) The fund’s derivatives exposure does not exceed 10 percent of the fund’s 
net assets; or  
(ii) The fund limits its use of derivatives transactions to currency derivatives 
that hedge the currency risks associated with specific foreign-currency-denominated equity or 
fixed-income investments held by the fund, provided that the currency derivatives are entered 
into and maintained by the fund for hedging purposes and that the notional amounts of such 
derivatives do not exceed the value of the hedged instruments denominated in the foreign 
currency (or the par value thereof, in the case of fixed-income investments) by more than a 
negligible amount. 
(4) Leveraged/inverse funds. A fund is not required to comply with the limit on fund 
leverage risk in paragraph (c)(2) of this section if: 
(i) The fund is a leveraged/inverse investment vehicle as defined in § 
240.15l-2 and § 275.211(h)-1;  
(ii) The fund discloses in its prospectus that it is not subject to the limit on 
fund leverage risk in paragraph (c)(2) of this section; and  
(iii) The fund does not seek or obtain, directly or indirectly, investment results 
exceeding 300% of the return (or inverse of the return) of the underlying index. 
(5) Board oversight and reporting. (i) Approval of the derivatives risk manager. A 
fund’s board of directors, including a majority of directors who are not interested persons of the 
fund, must approve the designation of the derivatives risk manager, taking into account the 
derivatives risk manager’s relevant experience regarding the management of derivatives risk. 

427 
(ii) Reporting on program implementation and effectiveness. On or before the 
implementation of the program, and at least annually thereafter, the derivatives risk manager 
must provide to the board of directors a written report providing a representation that the 
program is reasonably designed to manage the fund’s derivatives risks and to incorporate the 
elements provided in paragraphs (c)(1)(i)–(vi) of this section. The representation may be based 
on the derivatives risk manager’s reasonable belief after due inquiry. The written report must 
include the basis for the representation along with such information as may be reasonably 
necessary to evaluate the adequacy of the fund’s program and, for reports following the 
program’s initial implementation, the effectiveness of its implementation. The written report also 
must include the derivatives risk manager’s basis for the selection of the designated reference 
index or, if applicable, an explanation of why the derivatives risk manager was unable to identify 
a designated reference index appropriate for the fund. 
(iii) Regular board reporting. The derivatives risk manager must provide to 
the board of directors, at a frequency determined by the board, a written report regarding the 
derivatives risk manager’s analysis of any exceedances described in paragraph (c)(1)(ii) of this 
section, the results of the stress testing conducted under paragraph (c)(1)(iii) of this section, and 
the results of the backtesting conducted under paragraph (c)(1)(iv) of this section since the last 
report to the board. Each report under this paragraph must include such information as may be 
reasonably necessary for the board of directors to evaluate the fund’s response to any 
exceedances and the results of the fund’s stress testing. 
(6) Recordkeeping. (i) Records to be maintained. A fund must maintain a written 
record documenting, as applicable: 

428 
(A) The fund’s written policies and procedures required by paragraph 
(c)(1) of this section, along with: 
(1) The results of the fund’s stress tests under paragraph 
(c)(1)(iii) of this section; 
(2) The results of the backtesting conducted under paragraph 
(c)(1)(iv) of this section; 
(3) Records documenting any internal reporting or escalation 
of material risks under paragraph (c)(1)(v)(B) of this section; and  
(4) Records documenting the reviews conducted under 
paragraph (c)(1)(vi) of this section. 
(B) Copies of any materials provided to the board of directors in 
connection with its approval of the designation of the derivatives risk manager, any written 
reports provided to the board of directors relating to the program, and any written reports 
provided to the board of directors under paragraph (c)(2)(iii)(A) of this section. 
(C) Any determination and/or action the fund made under paragraphs 
(c)(2)(i)-(ii) of this section, including a fund’s determination of: the VaR of its portfolio; the VaR 
of the fund’s designated reference index, as applicable; the fund’s VaR ratio (the value of the 
VaR of the Fund’s portfolio divided by the VaR of the designated r eference index), as 
applicable; and any updates to any VaR calculation models used by the fund and the basis for 
any material changes thereto. 
(D) If applicable, the fund’s written policies and procedures required 
by paragraph (c)(3) of this section.  

429 
(ii) Retention periods. (A) A fund must maintain a copy of the written policies 
and procedures that the fund adopted under paragraphs (c)(1) or (c)(3) of this section that are in 
effect, or at any time within the past five years were in effect, in an easily accessible place. 
(B) A fund must maintain all records and materials that paragraphs 
(c)(6)(i)(A)(1)-(4) and (c)(6)(i)(B)-(D) of this section describe for a period of not less than five 
years (the first two years in an easily accessible place) following each determination, action, or 
review that these paragraphs describe.  
(7) Current reports. A fund that experiences an event specified in the parts of Form 
N-RN [referenced in 17 CFR 274.223] titled “Relative VaR Test Breaches,” “Absolute VaR Test 
Breaches,”  or “Compliance with VaR Test” must file with the Commission a report on Form N-
RN within the period and according to the instructions specified in that form. 
(d) Reverse repurchase agreements. A fund may enter into reverse repurchase 
agreements or similar financing transactions, notwithstanding the requirements of sections 18(c), 
and 18(f)(1) of the Investment Company Act, if the fund complies with the asset coverage 
requirements of section 18 and combines the aggregate amount of indebtedness associated with 
the reverse repurchase agreement or similar financing transaction with the aggregate amount of 
any other senior securities representing indebtedness when calculating the asset coverage ratio.  
(e) Unfunded commitment agreements. (1) A fund may enter into an unfunded 
commitment agreement, notwithstanding the requirements of sections 18(a), 18(c), 18(f)(1), and 
61 of the Investment Company Act, if the fund reasonably believes, at the time it enters into such 
agreement, that it will have sufficient cash and cash equivalents to meet its obligations with 
respect to all of its unfunded commitment agreements, in each case as they come due. In forming 
a reasonable belief, the fund must take into account its reasonable expectations with respect to 

430 
other obligations (including any obligation with respect to senior securities or redemptions), and 
may not take into account cash that may become available from the sale or disposition of any 
investment at a price that deviates significantly from the market value of those investments, or 
from issuing additional equity. Unfunded commitment agreements entered into by the fund in 
compliance with this section will not be considered for purposes of computing asset coverage, as 
defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-18(h)). 
(2) For each unfunded commitment agreement that a fund enters into under paragraph 
(e)(1) of this section, a fund must document the basis for its reasonable belief regarding the 
sufficiency of its cash and cash equivalents to meet its unfunded commitment agreement 
obligations, and maintain a record of this documentation for a period of not less than five years 
(the first two years in an easily accessible place) following the date that the fund entered into the 
agreement. 
* * * * * 
6. Revise §270.30b1-10 to read as follows: 
 
§270.30b1-10   Current report for open-end and closed-end management 
investment companies. 
Every registered open-end management investment company, or series thereof, and every 
registered closed-end management investment company, but not a fund that is regulated as a 
money market fund under §270.2a-7, that experiences an event specified on Form N-RN, must 
file with the Commission a current report on Form N-RN within the period and according to the 
instructions specified in that form. 
 
PART 274 - FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 
1940 
 

431 
7. The general authority for part 274 continues to read as follows: 
 
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 78n, 78o(d), 80a-8, 80a-
24, 80a-26, 80a-29, and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless otherwise 
noted. 
* * * * * 
8. Amend Form N-2 (referenced in §§ 239.14 and 274.11a-1) by revising 
instruction 2. to sub-item “3. Senior Securities” of “Item 4. Financial Highlights” to 
read as follows: 
Note: The text of Form N-2 does not, and this amendment will not, appear in the Code of 
Federal Regulations.  
 
Form N-2 
 
* * * * * 
 
Item 4. Financial Highlights 
 
* * * * * 
 
3. Senior Securities 
 
* * * * * 
 
Instructions 
 
* * * * * 
 
2. Use the method described in section 18(h) of the 1940 Act [15 U.S.C. 80a-18(h)] to calculate 
the asset coverage to be set forth in column (3). However, in lieu of expressing asset coverage in 
terms of a ratio, as described in section 18(h), express it for each class of senior securities in 
terms of dollar amounts per share (in the case of preferred stock) or per $1,000 of indebtedness 
(in the case of senior indebtedness). A fund should not consider any derivatives transactions, or 

432 
any unfunded commitment agreements, that it enters into in compliance with rule 18f-4 under the 
Investment Company Act [17 CFR 270.18f-4] for purposes of computing asset coverage.  
* * * * * 
 
9. Amend Form N-CEN (referenced in §§249.330 and 274.101) by adding 
new Item C.7.l. to read as follows: 
 
Note: The text of Form N-CEN does not, and this amendment will not, appear in the Code of 
Federal Regulations.  
 
 
FORM N-CEN 
 
ANNUAL REPORT FOR REGISTERED INVESTMENT COMPANIES 
 
* * * * * 
 
Item C.7. * * * 
 
l. Rule 18f-4 (17 CFR 270.18f-4):  _____ 
i. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4) program 
requirement under rule 18f-4(c)(3)(i) (17 CFR 270.18f-4(c)(3)(i))?   _____ 
ii. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4) program 
requirement under rule 18f-4(c)(3)(ii) (17 CFR 
270.18f-4(c)(3)(ii))?   _____ 
iii. Is the Fund a leveraged/inverse fund covered by rule 15l-2 under the 
Exchange Act (17 CFR 240.15l-2) or rule 211(h)-1 under the Investment 
Advisers Act of 1940 (17 CFR 275.211(h)-1) that, under rule 18f-4(c)(4) 
(17 CFR 270.18f-4(c)(4)), is excepted from the requirement to comply 
with the limit on leverage risk described in rule 18f-4(c)(2) (17 CFR 
270.18f-4(c)(2))?   ____ 
iv. Has the Fund entered into any reverse repurchase agreements or similar 
financing transactions under rule 18f-4(d) (17 CFR 270.18f-4(d))?   ____ 
v. Has the Fund entered into any unfunded commitment agreements under 
rule 18f-4(e) (17 CFR 270.18f-4(e))?   ____ 
 
* * * * * 

433 
 
10. Amend Form N-PORT (referenced in §274.150) by: 
a. Adding to General Instruction E. “Definitions” in alphabetical order, the 
following definitions: 
i. “Absolute VaR Test”; 
ii. “Designated Reference Index”; 
iii. “Derivatives Exposure”; 
iv. “Relative VaR Test”; 
v. “Value-at-risk”; 
vi. “VaR Ratio”; and  
b. Adding Items B.9 and B.10. 
The additions read as follows: 
 
Note: The text of Form N-PORT does not, and this amendment will not, appear in the Code of 
Federal Regulations. 
 
 
 
Form N-PORT 
MONTHLY PORTFOLIO INVESTMENTS REPORT 
 
* * * * * 
 
GENERAL INSTRUCTIONS 
 
* * * * * 
 
E. Definitions 
 
* * * * * 
 
 “Absolute VaR Test” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)].  
 
* * * * * 
 
“Derivatives Exposure” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 

434 
 
* * * * * 
 
“Designated Reference Index” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 
 
* * * * * 
 
“Relative VaR Test” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 
 
* * * * * 
 
 “Value-at-risk” or VaR has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 
 
* * * * * 
“VaR Ratio” means the value of the Fund’s portfolio VaR divided by the VaR of the Designated 
Reference Index. 
 
* * * * * 
 
PART B. * * * 
 
Item B.9 Derivatives Exposure. Report as a percentage of the Fund’s net asset value: 
a. Derivatives Exposure. 
i. Exposure from derivatives instruments. 
ii. Exposure from short sales. 
Item B.10 VaR Information. For Funds subject to the limit on fund leverage risk in rule 18f-
4(c)(2) [17 CFR 270.18f-4(c)(2)], provide the following information, as 
determined in accordance with the requirement under rule 18f-4(c)(2)(ii) to 
determine the fund’s compliance with the applicable VaR test at least once each 
business day:  
a. Highest daily VaR during the reporting period. 
b. Date of highest daily VaR during the reporting period. 
c. Median daily VaR during the reporting period. 
d. For Funds that were subject to the Relative VaR Test during the reporting period, 
provide: 
i. Name of the Fund’s Designated Reference Index. 
ii. Index Identifier for the Fund’s Designated Reference Index. 
iii. Highest VaR Ratio during the reporting period. 

435 
iv. Date of highest VaR Ratio during the reporting period. 
v. Median VaR Ratio during the reporting period. 
e. Backtesting Results. Number of exceptions that the Fund identified as a result of its 
backtesting of its VaR calculation model (as described in rule 18f-4(c)(1)(iv) [17 CFR 
270.18f-4(c)(1)(iv)] during the reporting period. 
 
* * * * * 
 
11. Revise §274.223, its sectional heading, and Form N-LIQUID (referenced 
in §274.223) and its title to read as follows: 
§274.223   Form N-RN, Current report, open- and closed-end investment company 
reporting. 
This form shall be used by registered open-end management investment companies, or 
series thereof, and closed-end management investment companies, or series thereof, to file 
reports pursuant to §270.18f-4(c)(7) and §270.30b1-10 of this chapter. 
 
Note: The text of Form N-RN does not, and this amendment will not, appear in the Code of 
Federal Regulations.  
 
 
UNITED STATES  
SECURITIES AND EXCHANGE COMMISSION 
WASHINGTON, D.C. 20549  
 
FORM N-RN 
CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT 
COMPANIES AND BUSINESS DEVELOPMENT COMPANIES 
 
Form N-RN is to be used by a registered open-end management investment company or 
series thereof, but not including a fund that is regulated as a money market fund under rule 2a-7 
under the Act (17 CFR 270.2A-7) (a “registered open-end fund”), a registered closed-end 
management investment company (a “registered closed-end fund”), or a closed-end management 
investment company that has elected to be regulated as a business development company (a 

436 
“business development company”), to file current reports with the Commission pursuant to rule 
18f-4 and rule 30b1-10 under the Investment Company of 1940 Act [15 U.S.C. 80a] (“Act”) (17 
CFR 270.18f-4; 17 CFR 270.30b1-10). The Commission may use the information provided on 
Form N-RN in its regulatory, disclosure review, inspection, and policymaking roles. 
GENERAL INSTRUCTIONS  
A. Rules as to Use of Form N-RN. 
(1) Form N-RN is the reporting form that is to be used for current reports of registered open-
end funds (not including funds that are regulated as money market funds under rule 2a-7 under 
the Act), registered closed-end funds, and business development companies (together, 
“registrants”) required by, as applicable, section 30(b) of the Act and rule 30b1-10 under the Act, 
as well as rule 18f-4 under the Act. The Commission does not intend to make public information 
reported on Form N-RN that is identifiable to any particular registrant, although the Commission 
may use Form N-RN information in an enforcement action. 
(2) Unless otherwise specified, a report on this Form N-RN is required to be filed, as 
applicable, within one business day of the occurrence of the event specified in Parts B – G of this 
form. If the event occurs on a Saturday, Sunday, or holiday on which the Commission is not 
open for business, then the one business day period shall begin to run on, and include, the first 
business day thereafter. 
(3)  For registered open-end funds required to comply with rule 22e-4 under the Investment 
Company Act [17 CFR 270.22e-4], complete Parts B – D of this form, as applicable. For 
registrants that rely on rule 18f-4 of the Act [17 CFR 270.18f-4], complete Parts E – G of this 
form, as applicable. 

437 
B. Application of General Rules and Regulations 
The General Rules and Regulations under the Act contain certain general requirements 
that are applicable to reporting on any form under the Act. These general requirements should be 
carefully read and observed in the preparation and filing of reports on this form, except that any 
provision in the form or in these instructions shall be controlling. 
C. Information to Be Included in Report Filed on Form N-RN 
Upon the occurrence of the event specified in Parts B – G of Form N-RN, as applicable, a 
registrant must file a report on Form N-RN that includes information in response to each of the 
items in Part A of the form, as well as each of the items in the applicable Parts B – G of the Form. 
D. Filing of Form N-RN  
A registrant must file Form N-RN in accordance with rule 232.13 of Regulation S-T (17 
CFR Part 232). Form N-RN must be filed electronically using the Commission’s Electronic Data 
Gathering, Analysis and Retrieval System (“EDGAR”). 
E. Paperwork Reduction Act Information 
A registrant is not required to respond to the collection of information contained in Form 
N-RN unless the form displays a currently valid Office of Management and Budget (“OMB”) 
control number. Please direct comments concerning the accuracy of the information collection 
burden estimate and any suggestions for reducing the burden to the Secretary, Securities and 
Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. The OMB has reviewed 
this collection of information under the clearance requirements of 44 U.S.C. 3507. 
F. Definitions 

438 
(1) References to sections and rules in this Form N-RN are to the Investment Company Act 
(15 U.S.C 80a), unless otherwise indicated. Terms used in this Form N-RN have the same 
meaning as in the Investment Company Act, rule 22e-4 under the Investment Company Act (for 
Parts B-D of the Form), or rule 18f-4 under the Investment Company Act (for Part E – G of the 
Form), unless otherwise indicated. In addition, as used in this Form N-RN, the term registrant 
means the registrant or a separate series of the registrant, as applicable. 
 
UNITED STATES  
SECURITIES AND EXCHANGE COMMISSION 
WASHINGTON, D.C. 20549  
 
FORM N-RN 
CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT 
COMPANIES AND BUSINESS DEVELOPMENT COMPANIES 
PART A.  General Information 
Item A.1. Report for [mm/dd/yyyy].  
Item A.2. CIK Number of registrant.  
Item A.3. EDGAR Series Identifier.  
Item A.4. Securities Act File Number, if applicable.  
Item A.5. Provide the name, e-mail address, and telephone number of the person authorized 
to receive information and respond to questions about this Form N-RN. 
PART B.  Above 15% Illiquid Investments 
If more than 15 percent of the registrant’s net assets are, or become, illiquid investments 
that are assets as defined in rule 22e-4, then report the following information:  
Item B.1. Date(s) on which the registrant’s illiquid investments that are assets exceeded 15 
percent of its net assets. 

439 
Item B.2. The current percentage of the registrant’s net assets that are illiquid investments 
that are assets. 
Item B.3. Identification of illiquid investments. For each investment that is an asset that is 
held by the registrant that is considered illiquid, disclose (1) the name of the 
issuer, the title of the issue or description of the investment, the CUSIP (if any), 
and at least one other identifier, if available (e.g., ISIN, Ticker, or other unique 
identifier (if ticker and ISIN are not available)) (indicate the type of identifier 
used), and (2) the percentage of the fund’s net assets attributable to that 
investment. 
PART C.  At or Below 15% Illiquid Investments 
 If a registrant that has filed Part B of Form N-RN determines that its holdings in illiquid 
investments that are assets have changed to be less than or equal to 15 percent of the registrant’s 
net assets, then report the following information: 
Item C.1. Date(s) on which the registrant’s illiquid investments that are assets fell to or 
below 15 percent of net assets. 
Item C.2. The current percentage of the registrant’s net assets that are illiquid investments 
that are assets. 
PART D.  Assets that are Highly Liquid Investments Below the Highly Liquid Investment 
Minimum 

440 
If a registrant’s holdings in assets that are highly liquid investments fall below its highly 
liquid investment minimum for more than 7 consecutive calendar days, then report the following 
information: 
Item D.1. Date(s) on which the registrant’s holdings of assets that are highly liquid 
investments fell below the fund’s highly liquid investment minimum. 
PART E.  Relative VaR Test Breaches 
 If a registrant is subject to the relative VaR test under rule 18f-4(c)(2)(i) [17 CFR 
270.18f-4(c)(2)(i)], and the fund determines that it is not in compliance with the relative VaR test 
and has not come back into compliance within 3 business days after such determination, provide: 
Item E.1. The dates on which the VaR of the registrant’s portfolio exceeded 150% of the 
VaR of its designated reference index. 
Item E.2. The VaR of the registrant’s portfolio on the dates each exceedance occurred. 
Item E.3. The VaR of the registrant’s designated reference index on the dates each 
exceedance occurred. 
Item E.4. The name of the registrant’s designated reference index. 
Item E.5. The index identifier for the registrant’s designated reference index. 
PART F.  Absolute VaR Test Breaches 
If a registrant is subject to the absolute VaR test under rule 18f-4(c)(2)(i) [17 CFR 
270.18f-4(c)(2)(i)], and the fund determines that it is not in compliance with the absolute VaR 

441 
test and has not come back into compliance within 3 business days after such determination, 
provide: 
Item F.1. The dates on which the VaR of the registrant’s portfolio exceeded 15% of the 
value of the registrant’s net assets. 
Item F.2. The VaR of the registrant’s portfolio on the dates each exceedance occurred. 
Item F.3. The value of the registrant’s net assets on the dates each exceedance occurred. 
 
PART G.  Compliance with VaR Test 
 If a registrant that has filed Part E or Part F of Form N-RN has come back into 
compliance with either the relative VaR test or the absolute VaR test, as applicable, then report 
the following information: 
Item G.1. Dates on which the VaR of the registrant’s portfolio exceeded, as applicable, 
150% of the VaR of its designated reference index (if the registrant is subject to 
the relative VaR test under rule 18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]) or 
15% of the value of the registrant’s net assets (if the registrant is subject to the 
absolute VaR test under rule 18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]). 
Item G.2. The current VaR of the registrant’s portfolio.  
PART H.  Explanatory Notes (if any) 
 A registrant may provide any information it believes would be helpful in understanding 
the information reported in response to any Item of this Form.
  

442 
SIGNATURES  
Pursuant to the requirements of the Investment Company Act of 1940, the registrant has duly caused 
this report to be signed on its behalf by the undersigned hereunto duly authorized. 
______________________________________  
(Registrant)  
Date ______________________________  
________________________________________  
(Signature)*  
*Print name and title of the signing officer under his/her signature. 
 
* * * * * 
 
 
PART 275 - RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940 
 
12. The authority citation for part 275 continues to read, in part, and the 
subauthority for Section 275.211h-1 is added to read as follows: 
 
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-2(a)(17), 80b-3, 80b-4, 
80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted. 
* * * * * 
Section 275.211(h)  -1 is also issued under sec. 913, Pub. L. 111-203, 124 Stat. 1827-28 
(2010). 
* * * * * 
13. Section 275.211(h)-1 is added to read as follows: 
 

443 
§ 275.211(h)-1   Investment adviser sales practices for leveraged/inverse investment 
vehicles. 
(a) Required approval of client account. No investment adviser registered or required 
to be registered under the Advisers Act, or any supervised person of the investment adviser, may 
place an order for the account of an advisory client that is a natural person (or the legal 
representative of a natural person) to buy or sell shares of a leveraged/inverse investment vehicle 
unless the investment adviser has approved such a client’s account to engage in those 
transactions and has adopted and implemented policies and procedures reasonably designed to 
achieve compliance with this section. Any approval of a client’s account for buying or selling 
leveraged/inverse investment vehicles must be effected as provided in paragraph (b). 
(b) Diligence in approving accounts. (1) In determining whether to approve a client’s 
account to buy or sell leveraged/inverse investment vehicles, the investment adviser must 
exercise due diligence to ascertain the essential facts relative to the client, his or her financial 
situation, and investment objectives, including, at a minimum, the information specified in 
paragraph (b)(2) of this section (and must seek to obtain information for all participants in a joint 
account). Based upon this information, the investment adviser must specifically approve or 
disapprove the client’s account for buying and selling shares of leveraged/inverse investment 
vehicles. An approval of a client account must be in writing. An investment adviser may provide 
this approval if the investment adviser has a reasonable basis for believing that the client has 
such knowledge and experience in financial matters that he or she may reasonably be expected to 
be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. 
(2) An investment adviser must seek to obtain the following information at a 
minimum regarding the client: 

444 
(i) Investment objectives (e.g., safety of principal, income, growth, trading 
profits, speculation) and time horizon; 
(ii) Employment status (name of employer, self-employed or retired); 
(iii) Estimated annual income from all sources; 
(iv) Estimated net worth (exclusive of family residence); 
(v) Estimated liquid net worth (cash, liquid securities, other); 
(vi  ) Percentage of the client’s estimated liquid net worth that he or she intends 
to invest in leveraged/inverse investment vehicles; and 
(vii) Investment experience and knowledge (e.g., number of years, size, 
frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, 
stocks and bonds, commodities, and other financial instruments. 
(c) Recordkeeping. An investment adviser must maintain a written record of the 
information that it obtained under paragraph (b) of this section and, if applicable, its written 
approval of the client’s account, as well as the versions of the firm’s policies and procedures 
required under paragraph (a) that were in place when it approved or disapproved the client’s 
account, for a period of not less than six years (the first two years in an easily accessible place) 
after the date of the closing of the client’s account.  
(d) Definitions. For purposes of this section: 
Commodity- or currency-based trust or fund means a trust or other person: 
(1) Issuing securities in an offering registered under the Securities Act of 
1933 (15 U.S.C. 77a et seq.) and which class of securities is listed for trading on a national 
securities exchange; 

445 
(2) The assets of which consist primarily of derivative instruments that 
reference commodities or currencies, or interests in the foregoing; and 
(3)  That provides in its registration statement under the Securities Act of 1933 
(15 U.S.C. 77a et seq.) that a class of its securities are purchased or redeemed, subject to 
conditions or limitations, for a ratable share of its assets. 
Leveraged/inverse investment vehicle means a registered investment company (including 
any separate series thereof), or commodity- or currency-based trust or fund, that seeks, directly 
or indirectly, to provide investment returns that correspond to the performance of a market index 
by a specified multiple, or to provide investment returns that have an inverse relationship to the 
performance of a market index, over a predetermined period of time. 
Supervised person means any partner, officer, director (or other person occupying a 
similar status or performing similar functions), or employee of an investment adviser, or other 
person who provides investment advice on behalf of the investment adviser. 
(e) Transition. This section applies to all clients of the investment adviser, including 
clients who have opened accounts with the investment adviser before the compliance date for 
this section, provided that this section does not apply to, and therefore will not restrict the ability 
to close or reduce, a client’s position in a leveraged/inverse investment vehicle that a client 
established before the compliance date of this section. 

446 
 
By the Commission. 
Dated: November 25, 2019 
 
 
Eduardo A. Aleman  
Deputy Secretary 
 
VIII. APPENDIX A 
Note: Appendix A will not appear in the Code of Federal Regulations.  
Feedback Flier: Funds’ Use of Derivatives 
We are proposing a new regulatory approach for funds’ use of derivatives. This includes 
proposed rule 18f-4 under the Investment Company Act of 1940, a new exemptive rule designed 
to address the investor protection purposes and concerns underlying section 18 of the Act and to 
provide an updated and more comprehensive approach to the regulation of funds’ use of 
derivatives. The proposal also includes certain new proposed reporting requirements relating to 
funds’ derivatives use. More information about our proposal is available at 
https://www.sec.gov/rules/proposed/2019/34-87607.pdf. 
We are particularly interested in learning what small funds think about the requirements 
of proposed new rule 18f-4 and the proposed new reporting requirements. Hearing from small 
funds could help us learn how the proposed rule and new reporting requirements would affect 
these entities, and evaluate how we could address any unintended consequences resulting from 
the cost and effort of regulatory compliance while still promoting investor protection. We would 
appreciate your feedback on any or all of the following questions.  

447 
All of the following questions are optional, including any questions that ask about 
identifying information. Please note that responses to these questions – including any other 
general identifying information you provide – will be made public. 
Item 1: General Identifying Information  
 
Instructions: At your option, you may include general identifying information that would 
help us contextualize your other feedback on the proposal. This information could include 
responses to the following questions, as well as any other general identifying information you 
would like to provide. Responses to these items—like responses to the other items on this 
Feedback Flier—will be made public. 
a. How big is the fund in terms of net asset value? (This may be expressed in a 
range, for example, $40 million - $50 million.) 
b.  What is/are the principal investment strategy/strategies of the fund? 
c. Does the fund use derivatives transactions (as defined in the proposed rule) to 
pursue the fund’s principal investment strategy/strategies? [Y/N] 
d. Is the fund part of a fund complex? [Y/N] 
e. Please include any additional general identifying information that you wish to 
provide, that could add context for your other feedback on the proposal. 
Item 2: Derivatives Risk Management Program  
Instructions: If you believe the fund would be required to adopt and implement a derivatives 
risk management program under the proposed rules, please answer the following questions. If 
you do not believe so, please proceed to Item 4. 
a. The proposed derivatives risk management program requirement would include 
the following seven elements. In the following chart, please indicate which of the 
proposed program elements you think would be the most expensive for the fund 
to implement and which would be least expensive to implement, by ranking the 
following elements from one (1) – most expensive – through seven (7) – least 

448 
expensive – using each number only once. If you have any comments about the 
factors informing your analysis, please include.  
Derivatives Risk Management 
Program Elements 
Rank by Cost 
(1 – most expensive; 7 – 
least expensive) 
Use each number once 
Comments 
a) 
Risk identification and 
assessment 
  
b) Risk guidelines 
  
c) Stress testing 
  
d) Backtesting 
  
e) 
Internal reporting and 
escalation 
  
f) 
Periodic review of the 
program 
  
g) 
Board reporting and 
oversight 
  
 
b. Implementation timing. 
1.) How many months do you think it would take the fund to adopt and 
implement a derivatives risk management program (check one box)?  
6 months – 12 
months 
12 months – 18 
months 
18 months – 24 
months 
> 24 months 
[  ] [  ] [  ] [  ] 
 
2.) If the response above is more than 12 months, what would help to shorten 
that time period? 
3.) Please provide any explanatory notes that you would like to include. 
c. Implementation cost. 

449 
1.) Approximately how much do you think it would cost the fund to 
implement a derivatives risk management program (in terms of combined 
internal and external costs) (check one box)?  
 
2.) Please include any explanatory notes that you would like to provide. These 
could describe, for example, how a fund that is part of a fund complex 
might share these costs, any particular cost considerations for a fund that 
uses sub-advisers, or the extent to which the estimated costs would arise 
from internal versus external costs (such as those associated with third-
party service providers). 
d. To the extent that the fund is a sub-advised fund, would any of the proposed 
program elements present any particular challenges for the fund to implement in 
light of its advisory structure? If so please explain. 
Item 3: Limit on Fund Leverage Risk  
Instructions: The proposed rule would require certain funds to comply with a limit on fund 
leverage risk based on value at risk (“VaR”). The following questions relate to this proposed 
requirement. 
a. Does the fund currently use VaR testing? [Y/N] 
b. Implementation cost. 
1.) If you anticipate that, if the proposed rules were adopted, the fund would 
have to comply with the VaR testing requirement, approximately how 
Estimated cost ($) 
$0 - $150,000 $150,001 - $350,000 $350,001 - $500,000 > $500,000 
[  ] [  ] [  ] [  ] 

450 
much do you think it would cost the fund to implement the proposed VaR 
test requirements (in terms of combined internal and external costs) (check 
one box)?  
 
2.) Please include any explanatory notes that you would like to provide. These 
could describe, for example, how a fund that is part of a fund complex 
might share these costs, any particular cost considerations for a fund that 
uses sub-advisers, or the extent to which the estimated costs would arise 
from internal versus external costs (such as those associated with third-
party service providers). 
c. Use of relative VaR test and absolute VaR test. 
1.) Would the fund anticipate that it would use the proposed relative VaR 
test or the proposed absolute VaR test (check one box)?  
Relative VaR test Absolute VaR test 
[  ] [  ] 
 
2.) If you anticipate that you would use the proposed relative VaR test, and 
you already disclose a benchmark index for performance disclosure, do 
you anticipate that the index would also qualify as a designated reference 
index under the proposed rule? [Y/N] 
Estimated cost ($) 
$0 - $25,000 $25,001 - $50,000 $50,001 - $75,000 > $75,000 
[  ] [  ] [  ] [  ] 

451 
d. To the extent that the fund is a sub-advised fund, would the proposed limit on 
fund leverage risk present any particular challenges for the fund to implement in 
light of its advisory structure? If so please explain. 
Item 4: Limited Derivatives Users  
Instructions: If you believe the fund would qualify as a limited derivatives user under the 
proposed rule, please answer the following questions. If you do not believe so, please 
proceed to question 5. 
a. Please state which basis for the proposed limited derivatives user exception you 
think the fund would seek to rely on (check one box):  
Exposure-based test 
(The fund’s derivatives exposure 
does not exceed 10% of the fund’s 
net asset value) 
Currency hedging exception 
(The fund only uses derivatives for 
currency hedging purposes as 
specified in the proposed rule) 
[  ] [  ] 
 
b. Should the rule include any other bases for a fund to qualify as a limited 
derivatives user? What alternative approach and why?  
c. Implementation cost. 
1.) Approximately how much do you think it would cost the fund to adopt and 
implement policies and procedures reasonably designed to manage its 
derivatives risks (in terms of combined internal and external costs) (check 
one box)?  
Estimated cost ($) 
$0 - $25,000 $25,001 - $50,000 $50,001 - $75,000 $75,001 - $100,000 > $100,000 
[  ] [  ] [  ] [  ] [  ] 

452 
 
2.) Please include any explanatory notes that you would like to provide. 
Item 5: Recordkeeping 
a. Approximately how much would it cost the fund to comply with the proposed 
recordkeeping requirements associated with rule 18f-4 (in terms of combined 
internal and external costs)? 
b. Should we modify any of the proposed recordkeeping requirements, and if so, 
how? 
Item 6: Reporting Requirements 
a. Approximately how much would it cost the fund to comply with the proposed 
new requirements for reporting on Form N-PORT, Form N-CEN, and Form N-
RN (in terms of combined internal and external costs)? 
b. Should we modify any of the proposed reporting requirements, and if so, how? 
Item 7: Other Feedback on Proposed Rule 18f-4 and Proposed New Reporting 
Requirements  
 
Instructions: Please include any other additional suggestions or comments about proposed 
rule 18f-4, and/or the proposed new reporting requirements, that you would like to provide. 
 
We will post your feedback on our website. Your submission will be posted without change; we 
do not redact or edit personal identifying information from submissions. You should only make 
submissions that you wish to make available publicly. 
If    you are interested in more information on the proposal, or want to provide feedback on 
additional questions, click here. Comments should be received on or before March 24, 2020. 
Thank You! 
 
Other Ways to Submit Your Feedback 

453 
You also can send us feedback in the following ways (include the file number S7-24-15 in your 
response): 
 
Print Your Responses and Mail 
Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090 
 
Print a PDF of Your Responses and Email 
Use the printer friendly page and select a PDF printer to create a file you can email to: rule-
[email protected] 
 
Print a Blank Copy of This Flier, Fill it Out, and Mail 
Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090
 
IX. APPENDIX B 
Note: Appendix B will not appear in the Code of Federal Regulations. 
Feedback Flier: Sales Practices Rules for Transacting in Shares of Leveraged/Inverse 
Investment Vehicles 
We are proposing two new sales practices rules—rule 15l-2 under the Securities 
Exchange Act of 1934, and Rule 211(h)-1 under the Investment Advisers Act of 1940—that 
would require a broker, dealer, or registered investment adviser to exercise due diligence in 
approving a retail customer’s or client’s account to buy or sell shares of certain 
“leveraged/inverse investment vehicles.” More information about our proposal is available at 
https://www.sec.gov/rules/proposed/2019/34-87607.pdf. 
We are particularly interested in learning what small broker-dealers and investment 
advisers think about the proposed new sales practices rules’ requirements. Hearing from these 

454 
smaller firms could help us learn how our proposed rules would affect them, and evaluate how 
we could address any unintended consequences resulting from the cost and effort of regulatory 
compliance while still promoting investor protection. We would appreciate your feedback on any 
or all of the following questions.  
All of the following questions are optional, including any questions that ask about 
identifying information. Please note that responses to these questions – including any other 
general identifying information you provide – will be made public. 
Item 1: General Identifying Information 
 
Instructions: At your option, you may include general identifying information that would 
help us contextualize your other feedback on the proposal. This information could include 
responses to the following questions, as well as any other general identifying information you 
would like to provide. Responses to these items—like responses to the other items on this 
Feedback Flier—will be made public. 
 
a. Is the firm a Commission-registered investment adviser or a broker-dealer? 
b. What is the size of the firm in terms of: 
1.) The number of retail investors (as defined in the release)? 
2.) For Investment Advisers, regulatory assets under management? 
3.) For broker-dealers, regulatory net capital? 
4.) Other (please specify)? 
c. Please include any additional general identifying information that you wish to 
provide, that could add context to your other feedback on the proposal. 
d. Does the firm accept orders from or place orders for the accounts of retail 
investors to buy or sell shares of leveraged/inverse investment vehicles (as 
defined in the proposed sales practices rules)? 

455 
Item 2: Cost to Comply with the Proposed Due Diligence and Account Approval 
Requirements 
 
a. What do you expect the cost to your firm would be in order to comply with these 
proposed requirements (in terms of combined internal and external costs)?  
1.) For an investment adviser (check one box): 
Estimated cost ($) 
$0 - $5,000 $5,001 - $10,000 > $10,000 
[  ] [  ] [  ] 
 
2.) For a broker-dealer (check one box): 
Estimated cost ($) 
$0 - $25,000 $25,001 - $50,000 > $50,000 
[  ] [  ] [  ] 
 
b. Are there any less expensive alternatives to the proposed requirements you can 
suggest that would still preserve the proposed rules’ intended investor protection 
safeguards? 
Item 3: Other Feedback on Proposed Sales Practices Rules 
 
Instructions: Please include any other additional suggestions or comments about the 
proposed sales practices rules that you would like to provide. 
 
We will post your feedback on our website. Your submission will be posted without change; we 
do not redact or edit personal identifying information from submissions. You should only make 
submissions that you wish to make available publicly. 

456 
If you are interested in more information on the proposal, or want to provide feedback on 
additional questions, click here. Comments should be received on or before March 24, 2020. 
Thank You! 
 
Other Ways to Submit Your Feedback 
You also can send us feedback in the following ways (include the file number S7-24-15 in your 
response): 
 
Print Your Responses and Mail 
Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090 
 
Print a PDF of Your Responses and Email 
Use the printer friendly page and select a PDF printer to create a file you can email to: rule-
[email protected] 
 
Print a Blank Copy of This Flier, Fill it Out, and Mail 
Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090
 
 

Conformed to Federal Register version 

1 

SECURITIES AND EXCHANGE COMMISSION 

17 CFR Parts 239, 240, 249, 270, 274 and 275 

Release No. 34-87607; IA-5413; IC-33704; File No. S7-24-15 

RIN: 3235-AL60 

Use of Derivatives by Registered Investment Companies and Business Development 
Companies; Required Due Diligence by Broker-Dealers and Registered Investment 
Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse 
Investment Vehicles 

AGENCY: Securities and Exchange Commission. 

ACTION: Proposed rule.  

SUMMARY: The Securities and Exchange Commission (the “Commission”) is re-proposing 

rule 18f-4, a new exemptive rule under the Investment Company Act of 1940 (the “Investment 

Company Act”) designed to address the investor protection purposes and concerns underlying 

section 18 of the Act and to provide an updated and more comprehensive approach to the 

regulation of funds’ use of derivatives and the other transactions addressed in the proposed rule. 

The Commission is also proposing new rule 15l-2 under the Securities Exchange Act of 1934 

(the “Exchange Act”) and new rule 211(h)-1 under the Investment Advisers Act of 1940 

(“Advisers Act”) (collectively, the “sales practices rules”). In addition, the Commission is 

proposing new reporting requirements and amendments to Form N-PORT, Form N-LIQUID 

(which we propose to be re-titled as “Form N-RN”), and Form N-CEN, which are designed to 

enhance the Commission’s ability to effectively oversee funds’ use of and compliance with the 

proposed rules, and for the Commission and the public to have greater insight into the impact 

that funds’ use of derivatives would have on their portfolios. Finally, the Commission is 

proposing to amend rule 6c-11 under the Investment Company Act to allow certain 



2 

leveraged/inverse ETFs that satisfy the rule’s conditions to operate without the expense and 

delay of obtaining an exemptive order. 

DATES: Comments should be submitted on or before March 24, 2020. 

ADDRESSES: Comments may be submitted by any of the following methods: 

Electronic comments: 
• Use the Commission’s internet comment form 

(http://www.sec.gov/rules/proposed.shtml); or 

• Send an email to [email protected]. Please include File No. S7-24-15 on the 

subject line. 

Paper comments: 
• Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street 

NE, Washington, DC 20549-1090. 

All submissions should refer to File Number S7-24-15. This file number should be included on 

the subject line if email is used. To help the Commission process and review your comments 

more efficiently, please use only one method of submission. The Commission will post all 

comments on the Commission’s website (http://www.sec.gov/rules/proposed.shtml). Comments 

are also available for website viewing and printing in the Commission’s Public Reference Room, 

100 F Street NE, Washington, DC 20549, on official business days between the hours of 

10:00 a.m. and 3:00 p.m. All comments received will be posted without change. Persons 

submitting comments are cautioned that we do not redact or edit personal identifying information 

from comment submissions. You should submit only information that you wish to make publicly 

available. 

Studies, memoranda, or other substantive items may be added by the Commission or staff 

to the comment file during this rulemaking. A notification of the inclusion in the comment file of 

http://www.sec.gov/rules/proposed.shtml


3 

any such materials will be made available on the Commission’s website. To ensure direct 

electronic receipt of such notifications, sign up through the “Stay Connected” option at 

www.sec.gov to receive notifications by email. 

FOR FURTHER INFORMATION CONTACT: Asaf Barouk, Attorney-Adviser; Joel 

Cavanaugh, Senior Counsel; John Lee, Senior Counsel; Sirimal Mukerjee, Senior Counsel; 

Amanda Hollander Wagner, Branch Chief; Thoreau Bartmann, Senior Special Counsel; or Brian 

McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation 

Office, Division of Investment Management; and with respect to proposed rule 15l-2, Kelly 

Shoop, Senior Counsel; or Lourdes Gonzalez, Assistant Chief Counsel; Office of Chief Counsel, 

Division of Trading and Markets; Securities and Exchange Commission, 100 F Street, NE, 

Washington, DC 20549-1090. 

SUPPLEMENTARY INFORMATION: Proposed rule 18f-4 would apply to mutual funds 

(other than money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, 

and companies that have elected to be treated as business development companies (“BDCs”) 

under the Investment Company Act (collectively, “funds”). It would permit these funds to enter 

into derivatives transactions and certain other transactions, notwithstanding the restrictions under 

sections 18 and 61 of the Investment Company Act, provided that the funds comply with the 

conditions of the rule. The proposed sales practices rules would require a broker, dealer, or 

investment adviser that is registered with (or required to be registered with) the Commission to 

exercise due diligence in approving a retail customer’s or client’s account to buy or sell shares of 

certain “leveraged/inverse investment vehicles” before accepting an order from, or placing an 

order for, the customer or client to engage in these transactions. 



4 

The Commission is proposing for public comment 17 CFR 270.18f-4 (new rule 18f-4) 

under the Investment Company Act, 17 CFR 240.15l-2 (new rule 15l-2) under the Exchange Act, 

17 CFR 275.211(h)-1 (new rule 211(h)-1) under the Advisers Act; amendments to 17 CFR 

270.6c-11 (rule 6c-11) under the Investment Company Act; amendments to Form N-PORT 

[referenced in 17 CFR 274.150], Form N-LIQUID (which we propose to re-title as “Form N-

RN”) [referenced in 17 CFR 274.223], Form N-CEN [referenced in 17 CFR 274.101], and Form 

N-2 [referenced in 17 CFR 274.11a-1] under the Investment Company Act. 



5 

TABLE OF CONTENTS 
 

I. Introduction .................................................................................................................. 9 
A. Overview of Funds’ Use of Derivatives ................................................................13 
B. Derivatives and the Senior Securities Restrictions of the Investment  

Company Act .........................................................................................................17 
1. Requirements of Section 18 ............................................................................ 17 
2. Evolution of Commission and Staff Consideration of Section 18  

Restrictions as Applied to Funds’ Use of Derivatives .................................... 19 
3. Need for Updated Regulatory Framework ...................................................... 28 

C. Overview of the Proposal.......................................................................................30 
II. Discussion ................................................................................................................... 36 

A. Scope of Proposed Rule 18f-4 ...............................................................................36 
1. Funds Permitted to Rely on Proposed Rule 18f-4 .......................................... 36 
2. Derivatives Transactions Permitted Under Proposed Rule 18f-4 ................... 39 

B. Derivatives Risk Management Program ................................................................45 
1. Summary ......................................................................................................... 45 
2. Program Administration.................................................................................. 48 
3. Required Elements of the Program ................................................................. 55 

C. Board Oversight and Reporting .............................................................................79 
1. Board Approval of the Derivatives Risk Manager ......................................... 81 
2. Board Reporting .............................................................................................. 84 

D. Proposed Limit on Fund Leverage Risk ................................................................90 
1. Use of VaR ...................................................................................................... 91 
2. Relative VaR Test ........................................................................................... 97 
3. Absolute VaR Test ........................................................................................ 113 
4. Choice of Model and Parameters for VaR Test ............................................ 117 
5. Implementation ............................................................................................. 126 
6. Other Regulatory Approaches to Limiting Fund Leverage Risk .................. 133 

E. Limited Derivatives Users ...................................................................................148 
1. Exposure-Based Exception ........................................................................... 149 
2. Currency Hedging Exception ........................................................................ 164 
3. Risk Management ......................................................................................... 167 

F. Asset Segregation.................................................................................................171 
G. Alternative Requirements for Certain Leveraged/Inverse Funds and  

Proposed Sales Practices Rules for Certain Leveraged/Inverse  
Investment Vehicles .............................................................................................176 
1. Background on Proposed Approach to Certain Leveraged/Inverse Funds ... 176 
2. Proposed Sales Practices Rules for Leveraged/Inverse  

Investment Vehicles ...................................................................................... 181 



6 

3. Alternative Provision for Leveraged/Inverse Funds Under Proposed  
Rule 18f-4 ..................................................................................................... 200 

4. Proposed Amendments to Rule 6c-11 under the Investment Company  
Act and Proposed Rescission of Exemptive Relief for  
Leveraged/Inverse ETFs ............................................................................... 204 

H. Amendments to Fund Reporting Requirements ...................................................206 
1. Amendments to Form N-PORT .................................................................... 208 
2. Amendments to Current Reporting Requirements ........................................ 213 
3. Amendments to Form N-CEN ...................................................................... 220 
4. BDC Reporting ............................................................................................. 221 

I. Reverse Repurchase Agreements .........................................................................223 
J. Unfunded Commitment Agreements ...................................................................229 
K. Recordkeeping Provisions ...................................................................................239 
L. Transition Periods ................................................................................................243 
M. Conforming Amendments ....................................................................................247 

III. Economic Analysis ................................................................................................... 248 
A. Introduction ..........................................................................................................249 
B. Economic Baseline...............................................................................................253 

1. Fund Industry Overview ............................................................................... 253 
2. Funds’ Use of Derivatives ............................................................................ 254 
3. Current Regulatory Framework for Derivatives ........................................... 255 
4. Funds’ Derivatives Risk Management Practices and Use of VaR Models ... 256 
5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse Funds ....... 257 

C. Benefits and Costs of the Proposed Rules and Amendments ..............................260 
1. Derivatives Risk Management Program and Board Oversight and  

Reporting....................................................................................................... 261 
2. VaR-Based Limit on Fund Leverage Risk .................................................... 269 
3. Limited Derivatives Users ............................................................................ 281 
4. Reverse Repurchase Agreements and Similar Financing Transactions ........ 285 
5. Alternative Requirements for Certain Leveraged/Inverse Funds and  

Proposed Sales Practices Rules for Certain Leveraged/Inverse  
Investment Vehicles ...................................................................................... 287 

6. Proposed Amendments to Rule 6c-11 under the Investment Company  
Act and Proposed Rescission of Exemptive Relief for  
Leveraged/Inverse ETFs ............................................................................... 294 

7. Unfunded Commitment Agreements ............................................................ 295 
8. Recordkeeping .............................................................................................. 296 
9. Amendments to Fund Reporting Requirements ............................................ 299 
10. Money Market Funds .................................................................................... 304 

D. Effects on Efficiency, Competition, and Capital Formation ................................305 
1. Efficiency ...................................................................................................... 305 



7 

2. Competition................................................................................................... 310 
3. Capital Formation ......................................................................................... 312 

E. Reasonable Alternatives.......................................................................................313 
1. Alternative Implementations of the VaR Tests ............................................. 313 
2. Alternatives to the VaR Tests ....................................................................... 317 
3. Stress Testing Frequency .............................................................................. 321 
4. Alternative Exposure Limits for Leveraged/Inverse Funds .......................... 322 
5. No Sales Practices Rules and No Separate Exposure Limit for 

Leveraged/Inverse Funds .............................................................................. 324 
6. Enhanced Disclosure ..................................................................................... 326 

F. Request for Comments .........................................................................................327 
IV. Paperwork Reduction Act Analysis .......................................................................... 328 

A. Introduction ..........................................................................................................328 
B. Proposed Rule 18f-4 ............................................................................................330 

1. Derivatives Risk Management Program ....................................................... 332 
2. Board Oversight and Reporting .................................................................... 335 
3. Disclosure Requirement Associated with Limit on Fund Leverage Risk ..... 337 
4. Disclosure Requirement for Leveraged/Inverse Funds ................................. 339 
5. Disclosure Changes for Money Market Funds ............................................. 341 
6. Policies and Procedures for Limited Derivatives Users ............................... 343 
7. Recordkeeping Requirements ....................................................................... 345 
8. Proposed Rule 18f-4 Total Estimated Burden .............................................. 348 

C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers ...........................349 
1. Due Diligence and Account Approval .......................................................... 350 
2. Policies and Procedures ................................................................................ 354 
3. Recordkeeping .............................................................................................. 356 
4. Proposed Rule 15l-2 Total Estimated Burden .............................................. 357 

D. Proposed Rule 211(h)-1: Sales Practices for Registered Investment Advisers ...358 
1. Due Diligence and Account Approval .......................................................... 359 
2. Policies and Procedures ................................................................................ 362 
3. Recordkeeping .............................................................................................. 364 
4. Proposed Rule 211(h)-1 Total Estimated Burden ......................................... 365 

E. Rule 6c-11 ............................................................................................................366 
F. Form N-PORT .....................................................................................................369 
G. Form N-RN ..........................................................................................................372 
H. Form N-CEN ........................................................................................................376 
I. Request for Comments .........................................................................................379 

V. Initial Regulatory Flexbility Analysis ...................................................................... 379 
A. Reasons for and Objectives of the Proposed Actions ..........................................380 
B. Legal Basis ...........................................................................................................381 
C. Small Entities Subject to Proposed Rules ............................................................382 



8 

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements ......384 
1. Proposed Rule 18f-4 ..................................................................................... 384 
2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN.......... 394 
3. Proposed Sales Practices Rules ..................................................................... 400 
4. Proposed Amendments to Rule 6c-11........................................................... 402 

E. Duplicative, Overlapping, or Conflicting Federal Rules .....................................403 
F. Significant Alternatives .......................................................................................404 

1. Proposed Rule 18f-4 ..................................................................................... 404 
2. Proposed Sales Practices Rules ..................................................................... 408 
3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN.......... 410 
4. Rule 6c-11 ..................................................................................................... 412 

G. Request for Comment ..........................................................................................413 
VI. Consideration of Impact on the Economy ................................................................ 413 
VII. Statutory Authority ............................................................................................. 414 
VIII. Appendix A ......................................................................................................... 446 
IX. Appendix B ............................................................................................................... 453 

 
  



9 

I. INTRODUCTION  

The fund industry has grown and evolved substantially in past decades in response to 

various factors, including investor demand, technological developments, and an increase in 

domestic and international investment opportunities, both retail and institutional.1 Funds today 

follow a broad variety of investment strategies and provide diverse investment opportunities for 

fund investors, including retail investors. As funds’ strategies have become increasingly diverse, 

funds’ use of derivatives has grown in both volume and complexity over the past several 

decades.2 Derivatives may be broadly described as instruments or contracts whose value is based 

upon, or derived from, some other asset or metric.3 Funds use derivatives for a variety of 

                                                      
1  For example, the investment company industry consisted of more than 3,500 investment 

companies, and held over $1.3 trillion in assets, as of the end of 1991. See SEC Division of 
Investment Management, Protecting Investors: A Half Century of Investment Company 
Regulation (1992), available at https://www.sec.gov/divisions/investment/guidance/icreg50-
92.pdf. The assets held by U.S.-registered investment companies grew to approximately $7.1 
trillion as of the end of 1999, and from then until the end of 2018 grew over 200%, to 
approximately $21.4 trillion. See Investment Company Institute, 2018 Investment Company Fact 
Book at 32, available at 
https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.
pdf. Similarly, the number of mutual funds, registered closed-end funds, and ETFs grew from 
7,970, 512, and 30 (respectively) as of the end of 1999, to 9,599, 506, and 2,057 (respectively) as 
of the end of 2018. See id. at 50.  

 The diversity of fund strategies has also increased over time, including, more recently, the 
introduction of funds pursuing so-called “alternative strategies” (which tend to use derivatives 
more than other fund types). See Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang & 
William Yost, Use of Derivatives by Registered Investment Companies, Division of Economic 
and Risk Analysis (2015), available at http://www.sec.gov/dera/staffpapers/white-
papers/derivatives12-2015.pdf (“DERA White Paper”). 

2  See Use of Derivatives by Registered Investment Companies and Business Development 
Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 
28, 2015)], at n.6 and accompanying text (“2015 Proposing Release”).  

3  The asset or metric on which the derivative’s value is based, or from which its value is derived, is 
commonly referred to as the “reference asset,” “underlying asset,” or “underlier.” See id. at n.3 
and accompanying text (citing Use of Derivatives by Investment Companies under the Investment 
Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR 
55237 (Sept. 7, 2011)], at n.3 (“2011 Concept Release”)). The comment letters on the 2011 
Concept Release (File No. S7-33-11) are available at https://www.sec.gov/comments/s7-33-

 

https://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf
https://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf
https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf
https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf
http://www.sec.gov/dera/staffpapers/white-papers/derivatives12-2015.pdf
http://www.sec.gov/dera/staffpapers/white-papers/derivatives12-2015.pdf
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10 

purposes. For example, funds use derivatives to seek higher returns through increased investment 

exposure, to hedge risks in their investment portfolios, or to obtain exposure to particular 

investments or markets more efficiently than may be possible through direct investments.4 At the 

same time, derivatives can introduce certain new risks and heighten certain risks to a fund and its 

investors. These risks can arise from, for example, leverage, liquidity, markets, operations, legal 

matters (e.g., contract enforceability), and counterparties.  

Funds using derivatives must consider requirements under the Investment Company Act 

of 1940.5 These include sections 18 and 61 of the Investment Company Act, which limit a fund’s 

ability to obtain leverage or incur obligations to persons other than the fund’s common 

shareholders through the issuance of “senior securities.”6 As we discuss more fully in this 

release, as derivatives markets have expanded and funds have increased their use of derivatives, 

the Commission and its staff have issued guidance addressing the use of specific derivatives 

instruments and practices, and other financial instruments, under section 18. In determining how 
                                                      

11/s73311.shtml.  
4  See, e.g., My Nguyen, Using Financial Derivatives to Hedge Against Currency Risk, Arcada 

University of Applied Sciences (2012). 
5  15 U.S.C. 80a (the “Investment Company Act,” or the “Act”). Except in connection with our 

discussion of proposed rule 15l-2 under the Securities Exchange Act of 1934 and proposed rule 
211(h)-1 under the Advisers Act or as otherwise noted, all references to statutory sections are to 
the Investment Company Act, and all references to rules under the Investment Company Act, 
including proposed rule 18f-4, will be to title 17, part 270 of the Code of Federal Regulations, 17 
CFR part 270.  

6  See infra section I.B.1. Funds using derivatives must also comply with all other applicable 
statutory and regulatory requirements, such as other federal securities law provisions, the Internal 
Revenue Code, Regulation T of the Federal Reserve Board, and the rules and regulations of the 
Commodity Futures Trading Commission (the “CFTC”). See also Title VII of the Dodd-Frank 
Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) 
(the “Dodd-Frank Act”), available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.  

 Section 61 of the Investment Company Act makes section 18 of the Act applicable to BDCs, with 
certain modifications. See infra note 32 and accompanying text. Except as otherwise noted, or 
unless the context dictates otherwise, references in this release to section 18 of the Act should be 
read to refer also to section 61 with respect to BDCs.  

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11 

they will comply with section 18, we understand that funds consider this Commission and staff 

guidance, as well as staff no-action letters and the practices that other funds disclose in their 

registration statements.7 

In the absence of Commission rules and guidance that address the current broad range of 

funds’ derivatives use, inconsistent industry practices have developed.8 We are concerned that 

certain of these practices may not address investor protection concerns that underlie section 18’s 

limitations on funds’ issuance of senior securities. Specifically, certain fund practices can 

heighten leverage-related risks, such as the risk of potentially significant losses and increased 

fund volatility, that section 18 is designed to address. We are also concerned that funds’ 

disparate practices could create an un-level competitive landscape and make it difficult for funds 

and our staff to evaluate funds’ compliance with section 18.9  

To address these concerns, in 2015 the Commission proposed new rule 18f-4 under the 

Investment Company Act, which would have permitted a fund to enter into derivatives 

transactions and “financial commitment transactions,” subject to certain conditions.10 We 

                                                      
7  Any staff guidance or no-action letters discussed in this release represent the views of the staff of 

the Division of Investment Management. They are not a rule, regulation, or statement of the 
Commission. Furthermore, the Commission has neither approved nor disapproved their content. 
Staff guidance has no legal force or effect; it does not alter or amend applicable law; and it 
creates no new or additional obligations for any person. 

8  See infra section I.B.2.b (discussing the asset segregation practices funds have developed to 
“cover” their derivatives positions, which vary based on the type of derivatives transaction and 
with respect to the types of assets that funds segregate to cover their derivatives positions).  

9  See, e.g., Comment Letter of the Investment Company Institute on the 2011 Concept Release 
(Nov. 7, 2011) (File No. S7-33-11) at n.19 (“ICI Concept Release Comment Letter”) (noting that 
funds segregate the notional amount of physically-settled futures contracts, while some funds 
disclose that they segregate only the marked-to-marked obligation in respect of cash-settled 
futures and agreeing with the concern reflected in the 2011 Concept Release that this “results in 
differing treatment of arguably equivalent products”).  

10  For purposes of this release, we will refer to the version of rule 18f-4 that the Commission 
proposed in the 2015 Proposing Release as the “2015 proposed rule.” We will generally refer to 

 



12 

received approximately 200 comment letters in response to the 2015 proposal.11 In developing 

this re-proposal we considered those comment letters, as well as subsequent staff engagement 

with large and small fund complexes and investor groups.12  

We are re-proposing rule 18f-4, which is designed to address the investor protection 

purposes and concerns underlying section 18 and to provide an updated and more comprehensive 

approach to the regulation of funds’ use of derivatives transactions and certain other transactions. 

The proposed rule would permit funds to enter into these transactions, notwithstanding the 

restrictions under section 18 of the Investment Company Act, provided that they comply with the 

conditions of the rule. The proposed rule’s conditions are designed to require funds to manage 

the risks associated with their use of derivatives and to limit fund leverage risk consistent with 

the investor protection purposes underlying section 18. Our proposal also includes requirements 

designed to address specific risks posed by certain registered investment companies and 

exchange-listed commodity- or currency-based trusts or funds that obtain leveraged or inverse 
                                                      

rule 18f-4 as we propose it here as the “proposed rule.”  

The 2015 proposed rule included four principal elements for funds entering into derivatives 
transactions: (1) a requirement to comply with one of two alternative portfolio limitations 
designed to limit the amount of leverage a fund may obtain through derivatives and other senior 
securities transactions; (2) asset segregation for derivatives transactions, designed to enable a 
fund to meet its derivatives-related obligations; (3) a derivatives risk management program 
requirement for funds that engage in more than limited derivatives transactions or that use 
complex derivatives; and (4) reporting requirements regarding a fund’s derivatives usage.  

 The 2015 proposed rule included different requirements for derivatives transactions and 
“financial commitment transactions” (collectively, reverse repurchase agreements, short sale 
borrowings, or any firm or standby commitment agreement or similar agreement). Rule 18f-4 as 
we propose it here does not separately define “financial commitment transactions,” although the 
proposed rule does address—either directly or indirectly—all of the types of transactions that 
composed that defined term in the 2015 proposed rule. See infra section II. 

11 The comment letters on the 2015 proposed rule (File No. S7-24-15) are available at 
https://www.sec.gov/comments/s7-24-15/s72415.shtml. 

12  See also Division of Economic and Risk Analysis, Memorandum re: Risk Adjustment and 
Haircut Schedules (Nov. 1, 2016), available at https://www.sec.gov/comments/s7-24-15/s72415-
260.pdf (“2016 DERA Memo”). 

https://www.sec.gov/comments/s7-24-15/s72415.shtml
https://www.sec.gov/comments/s7-24-15/s72415-260.pdf
https://www.sec.gov/comments/s7-24-15/s72415-260.pdf


13 

exposure to an underlying index, generally on a daily basis.13 The proposal also addresses funds’ 

use of reverse repurchase agreements and similar transactions and certain so-called “unfunded 

commitments.” Finally, we propose to amend rule 6c-11 under the Investment Company Act to 

allow certain leveraged/inverse ETFs that satisfy that rule’s conditions to operate without the 

expense and delay of obtaining an exemptive order. Together, the rules we are proposing are 

designed to promote funds’ ability to continue to use derivatives in a broad variety of ways that 

serve investors, while responding to the concerns underlying section 18 of the Investment 

Company Act and promoting a more modern and comprehensive framework for regulating 

funds’ use of derivatives and the other transactions addressed in the proposed rule. 

A. Overview of Funds’ Use of Derivatives 

Funds today use a variety of derivatives. These derivatives can reference a range of assets 

or metrics, such as: stocks, bonds, currencies, interest rates, market indexes, currency exchange 

rates, or other assets or interests. Examples of derivatives that funds commonly use include 

forwards, futures, swaps, and options. Derivatives are often characterized as either exchange-

traded or over-the-counter (“OTC”).14  

                                                      
13  As discussed in more detail in section II.G, the proposed sales practices rules would cover 

transactions in “leveraged/inverse investment vehicles,” which include registered investment 
companies and certain exchange-listed commodity- or currency-based trusts or funds that seek, 
directly or indirectly, to provide investment returns that correspond to the performance of a 
market index by a specified multiple, or to provide investment returns that have an inverse 
relationship to the performance of a market index, over a predetermined period of time. For 
purposes of this release, we refer to leveraged, inverse, and leveraged inverse investment vehicles 
collectively as “leveraged/inverse.” 

14  Exchange-traded derivatives—such as futures, certain options, and options on futures—are 
standardized contracts traded on regulated exchanges. See 2015 Proposing Release, supra note 2, 
at nn.10-13 and accompanying text. OTC derivatives—such as certain swaps, non-exchange-
traded options, and combination products such as swaptions and forward swaps—are contracts 
that parties negotiate and enter into outside of an organized exchange. See id. at nn.14-16 and 
accompanying text. Unlike exchange-traded derivatives, OTC derivatives may be significantly 
customized and may not be cleared by a central clearing organization. Title VII of the Dodd-

 



14 

A common characteristic of most derivatives is that they involve leverage or the potential 

for leverage. The Commission has stated that “[l]everage exists when an investor achieves the 

right to a return on a capital base that exceeds the investment which he has personally 

contributed to the entity or instrument achieving a return.”15 Many fund derivatives transactions, 

such as futures, swaps, and written options, involve leverage or the potential for leverage 

because they enable the fund to magnify its gains and losses compared to the fund’s investment, 

while also obligating the fund to make a payment or deliver assets to a counterparty under 

specified conditions.16 Other derivatives transactions, such as purchased call options, provide the 

economic equivalent of leverage because they can magnify the fund’s exposure beyond its 

investment but do not impose a payment obligation on the fund beyond its investment.17 

Funds use derivatives both to obtain investment exposures as part of their investment 

strategies and to manage risk. A fund may use derivatives to gain, maintain, or reduce exposure 

to a market, sector, or security more quickly, and with lower transaction costs and portfolio 

disruption, than investing directly in the underlying securities.18 A fund also may use derivatives 

to obtain exposure to reference assets for which it may be difficult or impractical for the fund to 

                                                      

Frank Act provides a comprehensive framework for the regulation of the OTC swaps market. See 
supra note 6. 

15  See Securities Trading Practices of Registered Investment Companies, Investment Company Act 
Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)], at n.5 (“Release 10666”). 

16  The leverage created by such an arrangement is sometimes referred to as “indebtedness leverage.” 
See 2015 Proposing Release, supra note 2, at n.21 (citing 2011 Concept Release, supra note 3, at 
n.31).  

17  This type of leverage is sometimes referred to as “economic leverage.” See id. at n.22 (citing 
2011 Concept Release, supra note 3, at n.32).  

18  See, e.g., id. at n.24 and accompanying text (citing 2011 Concept Release, supra note 3, at section 
I).  



15 

make a direct investment, such as commodities.19 With respect to risk management, funds may 

employ derivatives to hedge interest rate, currency, credit, and other risks, as well as to hedge 

portfolio exposures.20  

At the same time, a fund’s derivatives use may entail risks relating to, for example, 

leverage, markets, operations, liquidity (particularly with respect to complex OTC derivatives), 

and counterparties, as well as legal risks.21 A fund’s investment adviser, therefore, must manage 

(and the board of directors oversee) the fund’s derivatives use, consistent with the fund’s 

investment objectives, policies, restrictions, and risk profile. Furthermore, a fund’s investment 

adviser and board of directors must bear in mind the requirements of section 18 of the 

Investment Company Act, as well as the Act’s other requirements, when considering the use of 

derivatives.  

Section 18 is designed to limit the leverage a fund can obtain or incur through the 

issuance of senior securities. Although the leverage limitations in section 18 apply regardless of 

whether the relevant fund actually experiences significant losses, several recent examples 

involving significant losses illustrate how a fund’s use of derivatives may raise the investor 

protection concerns underlying section 18. The 2015 proposal discussed several circumstances in 

                                                      
19  See, e.g., Comment Letter of Stone Ridge Asset Management LLC (Mar. 28, 2016) (“[I]t is not 

possible for AVRPX [a Stone Ridge fund] to trade many of the physical assets underlying the 
derivatives included in our portfolio—Stone Ridge does not maintain facilities to store oil or live 
hogs, for example.”); Comment Letter of Vanguard (Mar. 28, 2016) (“Vanguard Comment 
Letter”) (stating that a fund may use a derivative, such as commodity futures, when it is 
impractical to take delivery of physical commodities).  

20 See 2015 Proposing Release, supra note 2, at n.25 and accompanying text; see also 2011 Concept 
Release, supra note 3, at section I.B. 

21  See 2015 Proposing Release, supra note 2, at n.26 and accompanying text (citing 2011 Concept 
Release, supra note 3, at n.34).  



16 

which substantial and rapid losses resulted from a fund’s investment in derivatives.22 For 

example, one of these cases shows that further losses can result when a fund’s portfolio securities 

decline in value at the same time that the fund is required to make additional payments under its 

derivatives contracts.23  

Similarly, last year the LJM Preservation and Growth Fund liquidated after sustaining 

considerable losses (with its net asset value declining approximately 80% in two days) when 

market volatility spiked. The fund’s principal investment strategy involved purchasing and 

selling call and put options on the Standard & Poor’s (“S&P”) 500 Futures Index.24 S&P 500 

                                                      
22  See 2015 Proposing Release, supra note 2, at section II.D.1.d. (discussing, among other things, 

the following settled actions: In the Matter of OppenheimerFunds, Inc. and OppenheimerFunds 
Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action) 
(“OppenheimerFunds Settled Action”) (involving two mutual funds that suffered losses driven 
primarily by their exposure to certain commercial mortgage-backed securities, obtained mainly 
through total return swaps); In the Matter of Claymore Advisors, LLC, Investment Company Act 
Release No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset Management, LLC, 
Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled actions) (involving a 
registered closed-end fund that pursued an investment strategy involving written out-of-the-
money put options and short variance swaps, which led to substantial losses for the fund); In the 
Matter of UBS Willow Management L.L.C. and UBS Fund Advisor L.L.C., Investment Company 
Act Release No. 31869 (Oct. 16, 2015) (settled action) (involving a registered closed-end fund 
that incurred significant losses due in part to large losses on the fund’s credit default swap 
portfolio)). 

See also In the Matter of Team Financial Asset Management, LLC, Team Financial Managers, 
Inc., and James L. Dailey, Investment Company Act Release No. 32951 (Dec. 22, 2017) (settled 
action) (involving a mutual fund incurring substantial losses arising out of speculative derivatives 
instruments, including losing $34.67 million in 2013 from trading in derivatives such as futures, 
options, and currency contracts); In the Matter of Mohammed Riad and Kevin Timothy Swanson, 
Investment Company Act Release No. 33338 (Dec. 21, 2018) (settled action) (involving a 
registered closed-end fund incurring substantial losses resulting from the implementation of a 
new derivatives trading strategy); In the Matter of Top Fund Management, Inc. and Barry C. 
Ziskin, Investment Company Act Release No. 30315 (Dec. 21, 2012) (settled action) (involving a 
mutual fund engaged in a strategy of buying options for speculative purposes contrary to its stated 
investment policy, which permitted options trading for hedging purposes, losing about 69% of its 
assets as a result of this activity before liquidating).  

23  See OppenheimerFunds Settled Action, supra note 22.  
24  See Prospectus, LJM Preservation and Growth Fund (Feb. 28, 2017), available at 

https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm.  

https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm


17 

options prices are determined in part by market volatility, and a volatility spike in early February 

2018 caused the fund to incur significant losses. The fund closed to new investments on February 

7, 2018 and announced on February 27, 2018 that it would liquidate its assets and dissolve on 

March 29, 2018.25 

The losses suffered by this fund and in the other examples we discuss above are extreme. 

Funds rarely suffer such large and rapid losses. We note these examples to illustrate the rapid 

and extensive losses that can result from a fund’s investments in derivatives absent effective 

derivatives risk management. In contrast, there are many other instances in which funds, by 

employing derivatives, have avoided losses, increased returns, and lowered risk.  

B. Derivatives and the Senior Securities Restrictions of the Investment 
Company Act 

1. Requirements of Section 18 

Section 18 of the Investment Company Act imposes various limits on the capital structure 

of funds, including, in part, by restricting the ability of funds to issue “senior securities.” 

Protecting investors against the potentially adverse effects of a fund’s issuance of senior 

securities, and in particular the risks associated with excessive leverage of investment 

companies, is a core purpose of the Investment Company Act.26 “Senior security” is defined, in 

                                                      
25  See Supplement to the Prospectus dated Feb. 28, 2017, LJM Preservation and Growth Fund (Feb. 

27, 2018), available at 
https://www.sec.gov/Archives/edgar/data/1552947/000158064218001068/ljm497.htm.  

26  See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of the Investment Company Act; see also 
Provisions Of The Proposed Bill Related To Capital Structure (Sections 18, 19(B), And 21(C)), 
Introduced by L.M.C Smith, Associate Counsel, Investment Trust Study, Securities and Exchange 
Commission, Hearings on S.3580 Before a Subcommittee of the Senate Committee on Banking 
and Currency, 76th Congress, 3rd session (1940), at 1028 (“Senate Hearings”) (“Because of the 
leverage influence, a substantial swing of the securities market is likely to deprive the common 
stock of a leverage investment company of both its asset and market value…. [H]ad investment 
companies been simple structure companies exclusively, a very substantial part of the losses 
sustained by investors in the common stock would have been avoided.”).  

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18 

part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and 

evidencing indebtedness.”27 

Congress’ concerns underlying the limits in section 18 focused on: (1) excessive 

borrowing and the issuance of excessive amounts of senior securities by funds when these 

activities increase unduly the speculative character of funds’ junior securities; (2) funds 

operating without adequate assets and reserves; and (3) potential abuse of the purchasers of 

senior securities.28 To address these concerns, section 18 prohibits an open-end fund from 

issuing or selling any “senior security,” other than borrowing from a bank (subject to a 

requirement to maintain 300% “asset coverage”).29 Section 18 similarly prohibits a closed-end 

                                                      
27  See section 18(g) of the Investment Company Act. The definition of “senior security” in 

section 18(g) also includes “any stock of a class having priority over any other class as to the 
distribution of assets or payment of dividends” and excludes certain limited temporary 
borrowings.  

28  For discussion of the excessive borrowing concern, see section 1(b)(7) of the Investment 
Company Act; Release 10666, supra note 15, at n.8; see also Senate Hearings, supra note 26, at 
1028 (“The Commission believes that it has been clearly shown that it is the leverage aspect of 
the senior-junior capital structure in investment companies… which may be held accountable for 
a large part of the losses which have been suffered by the investor who purchases the common 
stock of a leverage company.”). 

 For discussion of concerns regarding funds operating without adequate assets and reserves, see 
section 1(b)(8) of the Investment Company Act; Release 10666, supra note 15, at n.8. 

For discussion of, among other things, potential abuse of the purchasers of senior securities, see 
Senate Hearings, supra note 26, at 265-78; see also Mutual Funds and Derivative Instruments, 
Division of Investment Management Memorandum transmitted by Chairman Levitt to 
Representatives Markey and Fields (Sept. 26, 1994), at 23, available at 
http://www.sec.gov/news/studies/deriv.txt (“1994 Letter to Congress”) (describing practices in 
the 1920s and 1930s that gave rise to section 18’s limits on leverage). 

29  See section 18(f)(1) of the Investment Company Act. “Asset coverage” of a class of senior 
securities representing indebtedness of an issuer generally is defined in section 18(h) of the 
Investment Company Act as “the ratio which the value of the total assets of such issuer, less all 
liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of 
senior securities representing indebtedness of such issuer.” Take, for example, an open-end fund 
with $100 in assets and with no liabilities or senior securities outstanding. The fund could, while 
maintaining the required coverage of 300% of the value of its assets, borrow an additional $50 
from a bank. The $50 in borrowings would represent one-third of the fund’s $150 in total assets, 
measured after the borrowing (or 50% of the fund’s $100 net assets). 

http://www.sec.gov/news/studies/deriv.txt


19 

fund from issuing or selling any “senior security [that] represents an indebtedness” unless it has 

at least 300% “asset coverage,” although closed-end funds’ ability to issue senior securities 

representing indebtedness is not limited to bank borrowings.30 Closed-end funds also may issue 

senior securities that are a stock, subject to the limitations of section 18.31 The Investment 

Company Act also subjects BDCs to the limitations of section 18 to the same extent as registered 

closed-end funds, except the applicable asset coverage amount for any senior security 

representing indebtedness is 200% (and can be decreased to 150% under certain 

circumstances).32 

2. Evolution of Commission and Staff Consideration of Section 18 
Restrictions as Applied to Funds’ Use of Derivatives  

a. Investment Company Act Release 10666 

In a 1979 General Statement of Policy (Release 10666), the Commission considered the 

application of section 18’s restrictions on the issuance of senior securities to reverse repurchase 

agreements, firm commitment agreements, and standby commitment agreements.33 The 

Commission concluded that these agreements fall within the “functional meaning of the term 

‘evidence of indebtedness’ for purposes of Section 18 of the Investment Company Act,” noting 

                                                      
30  See section 18(a)(1) of the Investment Company Act.  
31  See section 18(a)(2) of the Investment Company Act. If a closed-end fund issues or sells a class 

of senior securities that is a stock, it must have an asset coverage of at least 200% immediately 
after such issuance or sale. Id. 

32  See section 61(a)(1) of the Investment Company Act. BDCs, like registered closed-end funds, 
also may issue a senior security that is a stock (e.g., preferred stock), subject to limitations in 
section 18. See sections 18(a)(2) and 61(a)(1) of the Investment Company Act. In 2018, Congress 
passed the Small Business Credit Availability Act, which, among other things, modified the 
statutory asset coverage requirements applicable to BDCs (permitting BDCs that meet certain 
specified conditions to elect to decrease their effective asset coverage requirement from 200% to 
150%). See section 802 of the Small Business Credit Availability Act, Pub. L. No. 115-141, 132 
Stat. 348 (2018).  

33  See Release 10666, supra note 15. 



20 

“the unique legislative purposes and policies underlying Section 18 of the Act.”34 The 

Commission stated in Release 10666 that, for purposes of section 18, “evidence of indebtedness” 

would include “all contractual obligations to pay in the future for consideration presently 

received.” The Commission recognized that, while section 18 would generally prohibit open-end 

funds’ use of reverse repurchase agreements, firm commitment agreements, and standby 

commitment agreements, the Commission nonetheless permitted funds to use these and similar 

arrangements subject to the constraints that Release 10666 describes.  

These constraints relied on funds’ use of “segregated accounts” to “cover” senior 

securities, which “if properly created and maintained, would limit the investment company’s risk 

of loss.”35 The Commission also stated that the segregated account functions as “a practical limit 

on the amount of leverage which the investment company may undertake and on the potential 

increase in the speculative character of its outstanding common stock” and that it “[would] 

assure the availability of adequate funds to meet the obligations arising from such activities.”36 

The Commission stated that its expressed views were not limited to the particular trading 

practices discussed, but that the Commission sought to address the implications of comparable 

trading practices that could similarly affect funds’ capital structures.37 

We continue to view the transactions described in Release 10666 as falling within the 

functional meaning of the term “evidence of indebtedness,” for purposes of section 18.38 The 

                                                      
34  See id. 
35  See 2015 Proposing Release, supra note 2, at nn.45-47 and accompanying text (discussing 

Release 10666’s discussion of segregated accounts). 
36  See Release 10666, supra note 15, at 25132; see also 2015 Proposing Release, supra note 2, at 

n.48 and accompanying text. 
37  See 2015 Proposing Release, supra note 2, at nn.49-50 and accompanying text. 
38  See Release 10666, supra note 15, at “The Agreements as Securities” discussion. The Investment21 

trading practices that Release 10666 describes, as well as short sales of securities for which the 

staff initially developed the segregated account approach that the Commission applied in Release 

10666, all impose on a fund a contractual obligation under which the fund is or may be required 

to pay or deliver assets in the future to a counterparty. These transactions therefore involve the 

issuance of a senior security for purposes of section 18.39  

We apply the same analysis to all derivatives transactions that create future payment 

obligations. This is the case where the fund has a contractual obligation to pay or deliver cash or 

other assets to a counterparty in the future, either during the life of the instrument or at maturity 

                                                      

Company Act’s definition of the term “security” is broader than the term’s definition in other 
federal securities laws. See 2015 Proposing Release, supra note 2, at n.61. Compare 
section 2(a)(36) of the Investment Company Act with sections 2(a)(1) and 2A of the Securities 
Act of 1933 (15 U.S.C. 77a et seq.) (“Securities Act”) and sections 3(a)(10) and 3A of the 
Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) (“Exchange Act”). See also 2011 
Concept Release, supra note 3, at n.57 and accompanying text (explaining that the Commission 
has interpreted the term “security” in light of the policies and purposes underlying the Investment 
Company Act).  

39  See Release 10666, supra note 15, at “The Agreements as Securities” discussion; see also 
section 18(g) (defining the term “senior security,” in part, as “any bond, debenture, note, or 
similar obligation or instrument constituting a security and evidencing indebtedness”).  

 The Commission received several comments on the 2015 proposal that objected to the 
Commission treating derivatives and financial commitment transactions as involving senior 
securities where a fund has “appropriately” covered its obligations under those transactions. 
These comments generally argued that this approach is not consistent with the Commission’s 
views in Release 10666 and that funds have for many years addressed senior security concerns 
raised by these transactions by segregating assets or engaging in offsetting, or “cover,” 
transactions that take into account Release 10666 and staff guidance. See, e.g., Comment Letter 
of the American Action Forum (Mar. 25, 2016) (“AAF Comment Letter”); Comment Letter of 
Financial Services Roundtable (Mar. 28, 2016) (“FSR Comment Letter”); Comment Letter of 
Franklin Resources, Inc. (Mar. 28, 2016) (“Franklin Resources Comment Letter”); Comment 
Letter of Dechert LLP (Mar. 28, 2016) (“Dechert Comment Letter”). Whether a transaction 
involves the issuance of a senior security will depend on whether that transaction involves a 
senior security within the meaning of section 18(g). A fund’s segregation of assets, although one 
way to address policy concerns underlying section 18 as the Commission described in Release 
10666, does not, itself, affect the legal question of whether a fund has issued a senior security. 



22 

or early termination.40 As was the case for trading practices that Release 10666 describes, where 

the fund has entered into a derivatives transaction and has such a future payment obligation, we 

believe that such a transaction involves an evidence of indebtedness that is a senior security for 

purposes of section 18.41 

The express scope of section 18 supports this interpretation. Section 18 defines the term 

“senior security” broadly to include instruments and transactions that other provisions of the 

federal securities laws might not otherwise consider to be securities.42 For example, 

section 18(f)(1) generally prohibits an open-end fund from issuing or selling any senior security 

“except [that the fund] shall be permitted to borrow from any bank.”43 This statutory permission 

                                                      
40  These payments—which may include payments of cash, or delivery of other assets—may occur 

as margin, as settlement payments, or otherwise.  
41  As the Commission explained in Release 10666, we believe that an evidence of indebtedness, for 

purposes of section 18, includes not only a firm and un-contingent obligation, but also a 
contingent obligation, such as a standby commitment or a “put” (or call) option sold by a fund. 
See Release 10666, supra note 15, at “Standby Commitment Agreements” discussion. We 
understand it has been asserted that a contingent obligation that a standby commitment or similar 
agreement creates does not involve a senior security under section 18, unless and until generally 
accepted accounting principles (“GAAP”) would require the fund to recognize the contingent 
obligation as a liability on the fund’s financial statements. The treatment of derivatives 
transactions under GAAP, including whether the derivatives transaction constitutes a liability for 
financial statement purposes at any given time or the extent of the liability for that purpose, is not 
determinative with respect to whether the derivatives transaction involves the issuance of a senior 
security under section 18. This is consistent with the Commission’s analysis of a fund’s 
obligation, and the corresponding segregated asset amounts, under the trading practices that 
Release 10666 describes. See id.  

42  Consistent with Release 10666, and as the Commission stated in the 2015 Proposing Release, we 
are only expressing our views in this release concerning the scope of the term “senior security” in 
section 18 of the Investment Company Act. See also section 12(a) of the Investment Company 
Act (prohibiting funds from engaging in short sales in contravention of Commission rules or 
orders). 

43  Section 18(c)(2) similarly treats all promissory notes or evidences of indebtedness issued in 
consideration of any loan as senior securities except as section 18 otherwise specifically provides. 



23 

to engage in a specific borrowing makes clear that such borrowings are senior securities, which 

otherwise section 18 would prohibit absent this specific permission.44  

This interpretation also is consistent with the fundamental policy and purposes 

underlying the Investment Company Act expressed in sections 1(b)(7) and 1(b)(8) of the Act.45 

These respectively declare that “the national public interest and the interest of investors are 

adversely affected” when funds “by excessive borrowing and the issuance of excessive amounts 

of senior securities increase unduly the speculative character” of securities issued to common 

shareholders and when funds “operate without adequate assets or reserves.” The Commission 

emphasized these concerns in Release 10666, and we continue to believe that the prohibitions 

and restrictions under the senior security provisions of section 18 should “function as a practical 

limit on the amount of leverage which the investment company may undertake and on the 

potential increase in the speculative character of its outstanding common stock” and that funds 

should not “operate without adequate assets or reserves.”46 Funds’ use of derivatives, like the 

                                                      
44  The Commission similarly observed in Release 10666 that section 18(f)(1), “by implication, 

treats all borrowings as senior securities,” and that “[s]ection 18(f)(1) of the Act prohibits such 
borrowings unless entered into with banks and only if there is 300% asset coverage on all 
borrowings of the investment company.” See Release 10666, supra note 15, at “Reverse 
Repurchase Agreements” discussion.  

45  The Commission received several comments on the 2015 proposal asserting that the provisions in 
section 1(b) of the Investment Company Act do not, themselves, provide us authority to regulate 
senior securities transactions. See, e.g., AAF Comment Letter; Franklin Resources Comment 
Letter; Comment Letter of the Securities Industry and Financial Markets Association (Mar. 28, 
2016) (“SIFMA Comment Letter”).  

The fundamental statutory policy and purposes underlying the Investment Company Act, as 
expressed in section 1(b) of the Act, inform our interpretation of the scope of the term “senior 
security” in section 18, as we discuss in the paragraph accompanying this note (and separately 
inform our consideration of appropriate conditions for the exemption that proposed rule 18f-4 
provides, as we discuss in sections II.B-II.G infra). The authority under which we are proposing 
rules today is set forth in section VII of this release and includes, among other provisions, section 
6(c) of the Act.  

46  See Release 10666, supra note 15, at “Segregated Account” discussion. 



24 

trading practices the Commission addressed in Release 10666, may raise the undue speculation 

and asset sufficiency concerns in section 1(b).47 First, funds’ obtaining leverage (or potential for 

leverage) through derivatives may raise the Investment Company Act’s undue speculation 

concern because a fund may experience gains and losses that substantially exceed the fund’s 

investment, and also may incur a conditional or unconditional obligation to make a payment or 

deliver assets to a counterparty.48 Not viewing derivatives that impose a future payment 

obligation on the fund as involving senior securities, subject to appropriate limits under 

section 18, would frustrate the concerns underlying section 18.49  

                                                      
47  As the Commission stated in Release 10666, leveraging an investment company’s portfolio 

through the issuance of senior securities “magnifies the potential for gain or loss on monies 
invested and therefore results in an increase in the speculative character of the investment 
company’s outstanding securities” and “leveraging without any significant limitation” was 
identified “as one of the major abuses of investment companies prior to the passage of the Act by 
Congress.” Id. 

48 See, e.g., The Report of the Task Force on Investment Company Use of Derivatives and Leverage, 
Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6, 2010), at 
8 (“2010 ABA Derivatives Report”) (stating that “[f]utures contracts, forward contracts, written 
options and swaps can produce a leveraging effect on a fund’s portfolio” because “for a relatively 
small up-front payment made by a fund (or no up-front payment, in the case with many swaps 
and written options), the fund contractually obligates itself to one or more potential future 
payments until the contract terminates or expires”; noting, for example, that an “[interest rate] 
swap presents the possibility that the fund will be required to make payments out of its assets” 
and that “[t]he same possibility exists when a fund writes puts and calls, purchases short and long 
futures and forwards, and buys or sells credit protection through [credit default swaps]”).  

49  One commenter on the 2011 Concept Release made this point directly. See Comment Letter of 
Stephen A. Keen on the 2011 Concept Release (Nov. 8, 2011) (File No. S7-33-11), at 3 (“Keen 
Concept Release Comment Letter”) (“If permitted without limitation, derivative contracts can 
pose all of the concerns that section 18 was intended to address with respect to borrowings and 
the issuance of senior securities by investment companies.”); see also, e.g., ICI Concept Release 
Comment Letter, at 8 (“The Act is thus designed to regulate the degree to which a fund issues any 
form of debt—including contractual obligations that could require a fund to make payments in the 
future.”). The Commission similarly noted in Release 10666 that, given the potential for reverse 
repurchase agreements to be used for leveraging and their ability to magnify the risk of investing 
in a fund, “one of the important policies underlying section 18 would be rendered substantially 
nugatory” if funds’ use of reverse repurchase agreements were not subject to limitation. See 2015 
Proposing Release, supra note 2, at text preceding n.76. 



25 

Second, with respect to the Investment Company Act’s asset sufficiency concern, a 

fund’s use of derivatives with future payment obligations also may raise concerns regarding the 

fund’s ability to meet those obligations. Many fund derivatives investments, such as futures 

contracts, swaps, and written options, pose a risk of loss that can result in payment obligations 

owed to the fund’s counterparties.50 Losses on derivatives therefore can result in counterparty 

payment obligations that directly affect the capital structure of a fund and the relative rights of 

the fund’s counterparties and shareholders. These losses and payment obligations also can force 

a fund’s adviser to sell the fund’s investments to meet its obligations. When a fund uses 

derivatives to leverage its portfolio, this can amplify the risk of a fund having to sell its 

investments, potentially generating additional losses for the fund.51 In an extreme situation, a 

fund could default on its payment obligations.52  

b. Market and Industry Developments Following Release 
10666 

Following the issuance of Release 10666, Commission staff issued more than thirty no-

action letters to funds concerning the maintenance of segregated accounts or otherwise 

“covering” their obligations in connection with various transactions otherwise restricted by 

                                                      
50  Some derivatives transactions, like physically-settled futures and forwards, can require the fund 

to deliver the underlying reference assets regardless of whether the fund experiences losses on the 
transaction.  

51  See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen, Market Liquidity and Funding 
Liquidity, 22 The Review of Financial Studies 6, 2201-2238 (June 2009), available at 
https://www.princeton.edu/~markus/research/papers/liquidity.pdf (providing both empirical 
support as well as a theoretical foundation for how short-term leverage obtained through 
borrowings or derivative positions can result in funds and other financial intermediaries becoming 
vulnerable to tighter funding conditions and increased margins, specifically during economic 
downturns (as in the recent financial crisis), thus potentially increasing the need for the fund or 
intermediary to de-lever and sell portfolio assets at a loss). 

52  See 2015 Proposing Release, supra note 2, at n.80.  



26 

section 18.53 In these letters (issued primarily in the 1970s through 1990s) and through other 

staff guidance, Commission staff has addressed questions—generally on an instrument-by-

instrument basis—regarding the application of the Commission’s statements in Release 10666 to 

various types of derivatives and other transactions.  

Funds have developed certain general asset segregation practices to cover their 

derivatives positions, based at least in part on the staff’s no-action letters and guidance. Practices 

vary based on the type of derivatives transaction. For certain derivatives, funds generally 

segregate an amount equal to the full amount of the fund’s potential obligation under the 

contract, or the full market value of the underlying reference asset for the derivative (“notional 

amount segregation”).54 For certain cash-settled derivatives, funds often segregate an amount 

equal to the fund’s daily mark-to-market liability, if any (“mark-to-market segregation”).55  

Similarly, funds use different practices regarding the types of assets that they segregate to 

cover their derivatives positions. Release 10666 states that the assets eligible to be included in 

segregated accounts should be “liquid assets” such as cash, U.S. government securities, or other 

appropriate high-grade debt obligations.56 However, a subsequent staff no-action letter stated 

that the staff would not recommend enforcement action if a fund were to segregate any liquid 

                                                      
53  See id. at n.51 and accompanying text (citing 2011 Concept Release, supra note 3, at section I). 
54  See id. at nn.54-55 and accompanying text. 
55  See id. at nn.56-58, 96-98 and accompanying text (stating that funds initially applied the mark-to-

market approach to segregation to specific types of transactions addressed through guidance by 
our staff (interest rate swaps, cash-settled futures, non-deliverable forwards), but that funds now 
apply mark-to-market segregation to a wider range of cash-settled instruments, with our staff 
observing that some funds appear to apply the mark-to-market approach to any derivative that is 
cash settled). 

56  See id. at n.47 and accompanying text. 



27 

asset, including equity securities and non-investment grade debt securities, to cover its senior 

securities-related obligations.57  

As a result of these asset segregation practices, funds’ derivatives use—and thus funds’ 

potential leverage through derivatives transactions—does not appear to be subject to a practical 

limit as the Commission contemplated in Release 10666. Funds’ mark-to-market liability often 

does not reflect the full investment exposure associated with their derivatives positions.58 As a 

result, a fund that segregates only the mark-to-market liability could theoretically incur virtually 

unlimited investment leverage.59  

These current asset segregation practices also may not assure the availability of adequate 

assets to meet funds’ derivatives obligations, as the Commission contemplated in Release 10666. 

A fund using the mark-to-market approach could segregate assets that only reflect the losses (and 

corresponding potential payment obligations) that the fund would then incur as a result of 

transaction termination. This practice provides no assurances that future losses will not exceed 

the value of the segregated assets or the value of all assets then available to meet the payment 

                                                      
57  See id. at n.59 and accompanying text (citing Merrill Lynch Asset Management, L.P., SEC Staff 

No-Action Letter (July 2, 1996), available at 
https://www.sec.gov/divisions/investment/imseniorsecurities/merrilllynch070196.pdf).  

58  For example, for derivatives where there is no loss in a given day, a fund applying the mark-to-
market approach might not segregate any assets. This may be the case, for example, because the 
derivative is currently in a gain position, or because the derivative has a market value of zero (as 
will generally be the case at the inception of a transaction). The fund may, however, still be 
required to post collateral to comply with other regulatory or contractual requirements.  

59  See, e.g., Comment Letter of Ropes & Gray LLC on the Concept Release (Nov. 7, 2011) (File 
No. S7-33-11), at 4 (stating that “[o]f course, in many cases [a fund’s daily mark-to-market 
liability, if any] will not fully reflect the ultimate investment exposure associated with the swap 
position” and that, “[a]s a result, a fund that segregates only the market-to-market liability could 
theoretically incur virtually unlimited investment leverage using cash-settled swaps”); Keen 
Concept Release Comment Letter, at 20 (stating that the mark-to-market approach, as applied to 
cash settled swaps, “imposes no effective control over the amount of investment leverage created 
by these swaps, and leaves it to the market to limit the amount of leverage a fund may use”). 



28 

obligations resulting from such losses.60 We also recognize that when a fund segregates any 

liquid asset, rather than the more narrow range of high-quality assets the Commission described 

in Release 10666, the segregated assets may be more likely to decline in value at the same time 

as the fund experiences losses on its derivatives.61 In this case, or when a fund’s derivatives 

payment obligations are substantial relative to the fund’s liquid assets, the fund may be forced to 

sell portfolio securities to meet its derivatives payment obligations. These forced sales could 

occur during stressed market conditions, including at times when prudent management could 

advise against such liquidation.62 

3. Need for Updated Regulatory Framework 

As the Commission observed in the 2015 proposal and for the reasons discussed above, 

we continue to be concerned that funds’ current practices regarding derivatives use may not 

address the undue speculation and asset sufficiency concerns underlying section 18.63 

Additionally, as recent events demonstrate, a fund’s derivatives use may involve risks that can 

result in significant losses to a fund.64 Accordingly, we continue to believe that it is appropriate 

for funds to address these risks and considerations relating to their derivatives use. Nevertheless, 

                                                      
60  A fund’s mark-to-market liability on any particular day, if any, could be substantially smaller 

than the fund’s ultimate obligations under a derivative. See 2015 Proposing Release, supra note 2, 
at n.113. 

61  See id. at n.115. 
62  The Commission noted in Release 10666 that “in an extreme case an investment company which 

has segregated all its liquid assets might be forced to sell non-segregated portfolio securities to 
meet its obligations upon shareholder requests for redemption. Such forced sales could cause an 
investment company to sell securities which it wanted to retain or to realize gains or losses which 
it did not originally intend.” See Release 10666, supra note 15, at “Segregated Account” 
discussion.  

63  See 2015 Proposing Release, supra note 2, at sections II.D.1.b and II.D.1.c; see also supra 
paragraphs accompanying notes 58-62.  

64  See supra paragraph accompanying notes 22-25. 



29 

we also recognize the valuable role derivatives can play in helping funds to achieve their 

objectives efficiently or manage their investment risks. 

We therefore believe funds that significantly use derivatives should adopt and implement 

formalized programs to manage the risks derivatives may pose. In addition, a more modern 

framework for regulating funds’ derivatives use would respond to our concern that funds today 

are not subject to a practical limit on potential leverage that they may obtain through derivatives 

transactions. The risk management program requirement and limit on fund leverage risk we are 

proposing are designed to address these considerations, in turn. 

A comprehensive approach to regulating funds’ derivatives use also would help address 

potential adverse results from funds’ current, disparate asset segregation practices. The 

development of staff guidance and industry practice on an instrument-by-instrument basis, 

together with growth in the volume and complexity of derivatives markets over past decades, has 

resulted in situations in which different funds may treat the same kind of derivative differently, 

based on their own view of our staff’s guidance or observation of industry practice. This may 

unfairly disadvantage some funds.65 The lack of comprehensive guidance also makes it difficult 

for funds and our staff to evaluate and inspect for funds’ compliance with section 18 of the 

Investment Company Act. Moreover, where there is no specific guidance, or where the 

application of existing guidance is unclear or applied inconsistently, funds may take approaches 

that involve an extensive use of derivatives and may not address the purposes and concerns 

underlying section 18.  

                                                      
65  See, e.g., Comment Letter of Davis Polk on the 2011 Concept Release (Nov. 11, 2011), at 1-2 

(stating that “funds and their sponsors may interpret the available guidance differently, even when 
applying it to the same instruments, which may unfairly disadvantage some funds”); see also 
Comment Letter of Federated Investors, Inc. (Mar. 23, 2016) (“Federated Comment Letter”); 
Comment Letter of Salient Partners, L.P. (Mar. 25, 2016) (“Salient Comment Letter). 



30 

C. Overview of the Proposal 

Our proposal consists of three parts. Proposed rule 18f-4 is designed to provide an 

updated, comprehensive approach to the regulation of funds’ use of derivatives and the other 

transactions that the proposed rule addresses. The proposed sales practices rules are designed to 

address investor protection concerns with respect to leveraged/inverse funds by requiring broker-

dealers and investment advisers to exercise due diligence on retail investors before approving 

retail investor accounts to invest in leveraged/inverse funds. The proposed amendments to Forms 

N-PORT, N-LIQUID (which we propose to re-title as “Form N-RN”), and N-CEN are designed 

to enhance the Commission’s ability to oversee funds’ use of and compliance with the proposed 

rules, and for the Commission and the public to have greater insight into the impact that funds’ 

use of derivatives would have on their portfolios.  

Proposed rule 18f-4 would permit a fund to enter into derivatives transactions, 

notwithstanding the prohibitions and restrictions on the issuance of senior securities under 

section 18 of the Investment Company Act, subject to the following conditions:66  

• Derivatives risk management program.67 The proposed rule would generally require a 

fund to adopt a written derivatives risk management program with risk guidelines that 

must cover certain elements, but that otherwise would be tailored based on how the 

fund’s use of derivatives may affect its investment portfolio and overall risk profile. The 

                                                      
66  See proposed rule 18f-4(b) and (d). Proposed rule 18f-4(b) would provide an exemption for 

funds’ derivatives transactions from sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment 
Company Act. See supra section I.B.1 of this release (providing an overview of the requirements 
of section 18). Because the proposed conditions are designed to provide a tailored set of 
requirements for derivatives transactions, the proposed rule would also provide that a fund’s 
derivatives transactions would not be considered for purposes of computing asset coverage under 
section 18(h). Applying section 18(h) asset coverage to a fund’s derivatives transactions appears 
unnecessary in light of the tailored restrictions we are proposing. See also infra section II.M.  

67  See proposed rule 18f-4(c)(1); infra section II.A.2. 



31 

program also would have to include stress testing, backtesting, internal reporting and 

escalation, and program review elements. The program would institute a standardized 

risk management framework for funds that engage in more than a limited amount of 

derivatives transactions, while allowing principles-based tailoring to the fund’s particular 

risks. We believe that a formalized derivatives risk management program is critical to 

appropriate derivatives risk management and is foundational to providing exemptive 

relief under section 18. 

• Limit on fund leverage risk.68 The proposed rule would generally require funds when 

engaging in derivatives transactions to comply with an outer limit on fund leverage risk 

based on value at risk, or “VaR.” This outer limit would be based on a relative VaR test 

that compares the fund’s VaR to the VaR of a “designated reference index” for that fund. 

If the fund’s derivatives risk manager is unable to identify an appropriate designated 

reference index, the fund would be required to comply with an absolute VaR test. These 

proposed requirements are designed to limit fund leverage risk consistent with the 

investor protection purposes underlying section 18 and to complement the proposed risk 

management program. Because VaR is a commonly-known and broadly-used industry 

metric that enables risk to be measured in a reasonably comparable and consistent 

manner across the diverse instruments that may be included in a fund’s portfolio, the 

proposed VaR-based limit is designed to address leverage risk for a variety of fund 

strategies. 

                                                      
68  See proposed rule 18f-4(c)(2); infra section II.D. 



32 

• Board oversight and reporting.69 The proposed rule would require a fund’s board of 

directors to approve the fund’s designation of a derivatives risk manager, who would be 

responsible for administering the fund’s derivatives risk management program. The 

fund’s derivatives risk manager would have to report to the fund’s board on the 

derivatives risk management program’s implementation and effectiveness and the results 

of the fund’s stress testing. The derivatives risk manager would have a direct reporting 

line to the fund’s board. We believe requiring a fund’s derivatives risk manager to be 

responsible for the day-to-day administration of the fund’s program, subject to board 

oversight, is consistent with the way we understand many funds currently manage 

derivatives risks and is key to appropriately managing these risks. 

• Exception for limited derivatives users.70 The proposed rule would except limited 

derivatives users from the derivatives risk management program requirement and the 

VaR-based limit on fund leverage risk. This proposed exception would be available to a 

fund that either limits its derivatives exposure to 10% of its net assets or uses derivatives 

transactions solely to hedge certain currency risks and, in either case, that also adopts and 

implements policies and procedures reasonably designed to manage the fund’s 

derivatives risks. Requiring a derivatives risk management program that includes all of 

the program elements specified in the rule for funds that use derivatives only in a limited 

way could potentially require these funds to incur costs and bear compliance burdens that 

are disproportionate to the resulting benefits.  

                                                      
69  See proposed rule 18f-4(c)(5); infra section II.C. 
70  See proposed rule 18f-4(c)(3); infra section II.E. 



33 

• Alternative requirements for certain leveraged/inverse funds.71 The proposed rule would 

provide an exception from the limit on fund leverage risk for certain leveraged/inverse 

funds in light of the additional safeguards provided by the proposed requirements under 

the sales practices rules that broker-dealers and investment advisers exercise due 

diligence on retail investors before approving the investors’ accounts to invest in these 

funds.72 The conditions of this exception are designed to address the investor protection 

concerns that underlie section 18 of the Investment Company Act, while preserving 

choice for investors the investment adviser or broker-dealer reasonably believes have 

such financial knowledge and experience that they may reasonably be expected to be 

capable of evaluating the risk of these funds.  

• Recordkeeping.73 The proposed rule would require a fund to adhere to recordkeeping 

requirements that are designed to provide the Commission’s staff, and the fund’s board of 

directors and compliance personnel, the ability to evaluate the fund’s compliance with the 

proposed rule’s requirements. 

Proposed rule 18f-4 would also permit funds to enter into reverse repurchase agreements 

and similar financing transactions, as well as “unfunded commitments” to make certain loans or 

investments, subject to conditions tailored to these transactions.74 A fund would be permitted to 

engage in reverse repurchase agreements and similar financing transactions so long as they meet 

                                                      
71   See proposed rule 18f-4(c)(4); infra section II.G. 
72  In our discussion in this release of the entities subject to the proposed sales practices rules, we use 

“broker-dealer” to refer to a broker-dealer that is registered with, or required to register with, the 
Commission. Similarly, we use “investment adviser” to refer to an investment adviser that is 
registered with, or required to register with, the Commission. 

73  See proposed rule 18f-4(c)(6); infra section II.K. 
74  See proposed rule 18f-4(d) and (e); infra sections II.I and II.J. 



34 

the asset coverage requirements under section 18. If the fund also borrows from a bank or issues 

bonds, for example, these senior securities as well as the reverse repurchase agreement would be 

required to comply with the asset coverage requirements under the Investment Company Act. 

This approach would provide the same asset coverage requirements under section 18 for reverse 

repurchase agreements and similar financing transactions, bank borrowings, and other 

borrowings permitted under the Investment Company Act. A fund would be permitted to enter 

into unfunded commitment agreements if the fund reasonably believes that its assets will allow 

the fund to meet its obligations under these agreements. This approach recognizes that, while 

unfunded commitment agreements do raise the risk that a fund may be unable to meet its 

obligations under these transactions, such unfunded commitments do not generally involve the 

leverage and other risks associated with derivatives transactions.  

The proposed sales practices rules are designed to address certain specific considerations 

raised by certain leveraged/inverse funds and listed commodity pools that obtain leveraged or 

inverse exposure to an underlying index, on a periodic (generally, daily) basis.75 These rules 

would require broker-dealers and investment advisers to exercise due diligence in determining 

whether to approve a retail customer or client’s account to buy or sell these products. A broker-

dealer or adviser could only approve the account if it had a reasonable basis to believe that the 

customer or client is capable of evaluating the risk associated with these products. In this regard, 

the proposed sales practices rules would complement the leveraged/inverse funds exception from 

proposed rule 18f-4’s limit on leverage risk by subjecting broker-dealers or advisers to the 

proposed sales practices rules’ due diligence and approval requirements.  

                                                      
75  See infra note 328 and accompanying text (defining “listed commodity pools”). 



35 

In connection with proposed rules 15l-2, 211(h)-1, and 18f-4, we are proposing 

amendments to rule 6c-11 under the Investment Company Act. Rule 6c-11 generally permits 

ETFs to operate without obtaining a Commission exemptive order, subject to certain 

conditions.76 The rule currently excludes leveraged/inverse ETFs from relying on the rule, 

however, to allow the Commission to consider the section 18 issues raised by these funds’ 

investment strategies as part of a broader consideration of derivatives use by registered funds and 

BDCs.77 As part of this further consideration, we are proposing to remove this provision and 

permit leveraged/inverse ETFs to rely on rule 6c-11 because the proposed sales practices rules 

and rule 18f-4 are designed to address these issues. In this regard, we are also proposing to 

rescind the exemptive orders previously issued to the sponsors of leveraged/inverse ETFs. 

Amending rule 6c-11 and rescinding these exemptive orders would promote a level playing field 

by allowing any sponsor (in addition to the sponsors currently granted exemptive orders) to form 

and launch a leveraged/inverse ETF subject to the conditions in rule 6c-11 and proposed 

rule 18f-4, with transactions in the fund subject to the proposed sales practices rules. 

The proposed amendments to Forms N-PORT, N-LIQUID, and N-CEN would require a 

fund to provide information regarding: (1) the fund’s exposure to derivatives; (2) the fund’s VaR 

(and, if applicable, the fund’s designated reference index) and backtesting results; (3) VaR test 

breaches, to be reported to the Commission in a non-public current report; and (4) certain 

identifying information about the fund (e.g., whether the fund is a limited derivatives user that is 

                                                      
76  See generally Exchange-Traded Funds, Investment Company Act Release No. 33646 (Sept. 25, 

2019) [84 FR 57162 (Oct. 24, 2019)] (“ETFs Adopting Release”). 
77  See id. at nn.72-74 and accompanying text. 



36 

excepted from certain of the proposed requirements, or whether the fund is a “leveraged/inverse 

fund”). 

Finally, in view of our proposal for an updated, comprehensive approach to the regulation 

of funds’ derivative use, we are proposing to rescind Release 10666. In addition, staff in the 

Division of Investment Management is reviewing certain of its no-action letters and other 

guidance addressing derivatives transactions and other transactions covered by proposed rule 

18f-4 to determine which letters and other staff guidance, or portions thereof, should be 

withdrawn in connection with any adoption of this proposal. Upon the adoption of any final rule, 

some of these letters and other staff guidance, or portions thereof, would be moot, superseded, or 

otherwise inconsistent with the final rule and, therefore, would be withdrawn. We would expect 

to provide funds a one-year transition period while they prepare to come into compliance with 

rule 18f-4 before Release 10666 is withdrawn.  

II. DISCUSSION 

A. Scope of Proposed Rule 18f-4 

1. Funds Permitted to Rely on Proposed Rule 18f-4 

The proposed rule would apply to a “fund,” defined as a registered open-end or closed-

end company or a BDC, including any separate series thereof. The rule would therefore apply to 

mutual funds, ETFs, registered closed-end funds, and BDCs. The proposed rule’s definition of a 

“fund” would, however, exclude money market funds regulated under rule 2a-7 under the 

Investment Company Act (“money market funds”). Under rule 2a-7, money market funds seek to 

maintain a stable share price or limit principal volatility by limiting their investments to short-

term, high-quality debt securities that fluctuate very little in value under normal market 

conditions. As a result of these and other requirements in rule 2a-7, we believe that money 

market funds currently do not typically engage in derivatives transactions or the other 



37 

transactions permitted by rule 18f-4.78 We believe that these transactions would generally be 

inconsistent with a money market fund maintaining a stable share price or limiting principal 

volatility, and especially if used to leverage the fund’s portfolio.79 We therefore believe that 

excluding money market funds from the scope of the proposed rule is appropriate. 

Section 18 applies only to open-end or closed-end companies, i.e., to management 

investment companies. Proposed rule 18f-4 therefore also would not apply to unit investment 

trusts (“UITs”) because they are not management investment companies. In addition, as the 

Commission has noted, derivatives transactions generally require a significant degree of 

management, and a UIT engaging in derivatives transactions therefore may not meet the 

Investment Company Act requirements applicable to UITs.80  

We request comment on all aspects of the proposed rule’s definition of the term “fund,” 

including the following items. 

 The proposed definition excludes money market funds. Should we include money 

market funds in the definition? Why or why not?  

 Do money market funds currently engage in any transactions that might qualify as 

derivatives transactions under the rule or any of the other transactions permitted by 

the rule? For example, do money market funds engage in reverse repurchase 
                                                      
78  See infra note 584. 
79  See Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release 

No. 31166 (July 23, 2014) [79 FR 47735 (Aug. 14, 2014)] (discussing (1) retail and government 
money market funds, which seek to maintain a stable net asset value per share and (2) 
institutional non-government money market funds whose net asset value fluctuates, but still must 
stress test their ability to minimize principal volatility given that “commenters pointed out 
investors in floating NAV funds will continue to expect a relatively stable NAV”). 

80  See section 4(2) of the Investment Company Act; see also Custody Of Investment Company 
Assets with Futures Commission Merchants And Commodity Clearing Organizations, Investment 
Company Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT portfolios are 
generally unmanaged). See also ETFs Adopting Release, supra note 76, at n.42. 



38 

agreements, “to be announced” dollar rolls, or “when issued” transactions? If so, 

which transactions, to what extent, and for what purpose? For example, do money 

market funds engage in reverse repurchase agreements for liquidity management 

purposes but not to leverage the fund’s portfolio? If so, what effects would the 

proposed rule have on money market funds’ liquidity management if they are 

excluded from the rule’s scope as proposed? To the extent money market funds 

engage in any of the transactions that the proposed rule would permit, how do money 

market funds analyze them under rule 2a-7?  

 Should we permit money market funds to engage in some of the transactions that the 

rule would permit? If so, which transactions and why, and how would the transactions 

be consistent with rule 2a-7? If we were to include money market funds in the rule, or 

permit them to engage in specific types of transactions, should the rule provide 

specific conditions tailored to money market funds entering into those transactions? 

What kinds of conditions and why? Should they be permitted to engage in all (or 

certain types) of derivatives transactions, or reverse repurchase or similar financing 

transactions, for liquidity management or other purposes that do not leverage the 

fund’s portfolio? If money market funds were permitted to rely on the rule for any 

transactions, should those transactions be limited in scale? For example, should that 

limit be the same as the proposed approach for limited derivatives users that limit the 

extent of their derivatives exposure, as discussed below in section II.E.1? Would even 

such limited use be consistent with funds that seek to maintain a stable share price or 

limit principal volatility? 

 If we were to include money market funds in the scope of rule 18f-4, should we 



39 

revise Form N-MFP so that money market funds filing reports on the form could 

select among the list of investment categories set forth in Item C.6 of Form N-MFP 

derivatives and the other transactions addressed in the proposed rule 18f-4?81 Why or 

why not? 

2. Derivatives Transactions Permitted Under Proposed 
Rule 18f-4 

The proposed rule would permit funds to enter into derivatives transactions, subject to the 

rule’s conditions. The proposed rule would define the term “derivatives transaction” to mean: 

(1) any swap, security-based swap, futures contract, forward contract, option, any combination of 

the foregoing, or any similar instrument (“derivatives instrument”), under which a fund is or may 

be required to make any payment or delivery of cash or other assets during the life of the 

instrument or at maturity or early termination, whether as margin or settlement payment or 

otherwise; and (2) any short sale borrowing.82  

The first prong of this proposed definition is designed to describe those derivatives 

transactions that involve the issuance of a senior security, because they involve a contractual 

                                                      
81  See infra note 584. 
82  Proposed rule 18f-4(a). The 2015 proposal similarly defined a derivatives transaction as including 

enumerated derivatives instruments “under which the fund is or may be required to make any 
payment or delivery of cash or other assets during the life of the instrument or at maturity or early 
termination, whether as a margin or settlement payment or otherwise.” 2015 proposed 
rule 18f-4(c)(2). Most commenters did not address the proposed definition of the term 
“derivatives transaction,” although those commenters who did address the definition generally 
supported it. Some commenters more generally supported the view, or sought confirmation, that a 
derivative does not involve the issuance of a senior security if it does not impose an obligation 
under which the fund is or may be required to make a future payment (e.g., a standard purchased 
option). See, e.g., Comment Letter of The Options Clearing Corporation (Mar. 25, 2016); 
Comment Letter of Investment Adviser Association (Mar. 28, 2016) (“IAA Comment Letter”); 
FSR Comment Letter. 



40 

future payment obligation.83 When a fund engages in these transactions, the fund will have an 

obligation (or potential obligation) to make payments or deliver assets to the fund’s counterparty. 

This prong of the definition incorporates a list of derivatives instruments that, together with the 

proposed inclusion in the definition of “any similar instrument,” covers the types of derivatives 

that funds currently use and that the requirements of section 18 would restrict. This list is 

designed to be sufficiently comprehensive to include derivatives that may be developed in the 

future. We believe that this approach is clearer than a more principles-based definition of the 

term “derivatives transaction,” such as defining this term as an instrument or contract whose 

value is based upon, or derived from, some other asset or metric.  

This prong of the definition also provides that a derivatives instrument, for purposes of 

the proposed rule, must involve a future payment obligation.84 This aspect of the definition 

recognizes that not every derivatives instrument imposes an obligation that may require the fund 

to make a future payment, and therefore not every derivatives instrument will involve the 

issuance of a senior security.85 A derivative that does not impose any future payment obligation 

on a fund generally resembles a securities investment that is not a senior security, in that it may 

                                                      
83  See supra note 27 and accompanying text, and text following note 34 (together, noting that 

“senior security” is defined in part as “any . . .similar obligation or instrument constituting a 
security and evidencing indebtedness,” and that the Commission has previously stated that, for 
purposes of section 18, “evidence of indebtedness” would include “all contractual obligations to 
pay in the future for consideration presently received”); see also infra notes 85-87 (recognizing 
that not every derivative instrument will involve the issuance of a senior security). 

84  Under the proposed rule, a derivatives instrument is one where the fund “is or may be required to 
make any payment or delivery of cash or other assets during the life of the instrument or at 
maturity or early termination, whether as margin or settlement payment or otherwise.” 

85  See 2015 Proposing Release, supra note 2, at paragraph accompanying nn.82-83. A fund that 
purchases a standard option traded on an exchange, for example, generally will make a non-
refundable premium payment to obtain the right to acquire (or sell) securities under the option. 
However, the option purchaser generally will not have any subsequent obligation to deliver cash 
or assets to the counterparty unless the fund chooses to exercise the option.41 

lose value but will not require the fund to make any payments in the future.86 Whether a 

transaction involves the issuance of a senior security will depend on the nature of the transaction. 

The label that a fund or its counterparty assigns to the transaction is not determinative.87  

Unlike the 2015 proposal, this proposal does not include references to, or a definition of, 

“financial commitment transaction” in addition to the proposed definition of “derivatives 

transaction.” The 2015 proposal defined a “financial commitment transaction” as any reverse 

repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or 

similar agreement.88 Because our proposal addresses funds’ use of reverse repurchase 

agreements and unfunded commitment agreements separately from funds’ use of derivatives, the 

                                                      
86  See id. at n.82. 
87  For example, the Commission received a comment on the 2015 proposal addressing a type of 

total return swap, asserting that “[t]he Swap operates in a manner similar to a purchased option or 
structure, in that the fund’s losses under the Swap cannot exceed the amount posted to its tri-party 
custodian agreement for purposes of entering into the Swap,” and that, in the commenter’s view, 
the swap should be “afforded the same treatment as a purchased option or structured note” 
because “[a]lthough the Swap involves interim payments through the potential posting of margin 
from the custodial account, the payment obligations cannot exceed the [amount posted for 
purposes of entering into the Swap].” See Comment Letter of Dearborn Capital Management 
(Mar. 24, 2016) (“Dearborn Comment Letter”). Unlike a fund’s payment of a one-time non-
refundable premium in connection with a standard purchased option or a fund’s purchase of a 
structured note, this transaction appears to involve a fund obligation to make interim payments of 
fund assets posted as margin or collateral to the fund’s counterparty during the life of the 
transaction in response to market value changes of the underlying reference asset, as this 
commenter described. The fund also must deposit additional margin or collateral to maintain the 
position if the fund’s losses deplete the assets that the fund posted to initiate the transaction; if a 
fund effectively pursues its strategy through such a swap, or a small number of these swaps, the 
fund may as a practical matter be required to continue reestablishing the trade or refunding the 
collateral account in order to continue to offer the fund’s strategy. The transaction therefore 
appears to involve the issuance of a senior security as the fund may be required to make future 
payments. 

 See also infra section II.J (discussing the characterization of “unfunded commitment” agreements 
for purposes of the proposed rule, and as senior securities).  

88  See 2015 Proposing Release, supra note 2, at section III.A.2; 2015 proposed rule 18f-4(c)(4); see 
also supra note 10. 



42 

proposed definition of “derivatives transaction” does not include reverse repurchase agreements 

and unfunded commitment agreements.89  

Short sale borrowings, however, are included in the second prong of the proposed 

definition of “derivatives transaction.” We appreciate that short sales of securities do not involve 

derivatives instruments such as swaps, futures, and options. The value of a short position is, 

however, derived from the price of another asset, i.e., the asset sold short. A short sale of a 

security provides the same economic exposure as a derivatives instrument, like a future or swap, 

that provides short exposure to the same security. The proposed rule therefore treats short sale 

borrowings and derivatives instruments identically for purposes of funds’ reliance on the rule’s 

exemption.90  

While this proposal does not specifically list firm or standby commitment agreements in 

the definition of “derivatives transaction,” we interpret the definitional phrase “or any similar 

instrument” to include these agreements. A firm commitment agreement has the same economic 

characteristics as a forward contract.91 Similarly, a standby commitment agreement has the same 

economic characteristics as an option contract, and the Commission has previously stated that 

such an agreement is economically equivalent to the issuance of a put option.92 To the extent that 

                                                      
89  See infra section II.I. 
90  See proposed rule 18f-4(b). 
91  Indeed, the Commission noted in Release 10666 that a firm commitment is known by other 

names such as a “forward contract.” See Release 10666, supra note 15, at nn.10-12 and 
accompanying text.  

92  See id. at “Standby Commitment Agreements” (“The standby commitment agreement is a 
delayed delivery agreement in which the investment company contractually binds itself to accept 
delivery of a Ginnie Mae with a stated price and fixed yield upon the exercise of an option held 
by the other party to the agreement at a stated future date. . . . The Commission believes that the 
standby commitment agreement involves, in economic reality, the issuance and sale by the 
investment company of a ‘put.’”). 



43 

a fund engages in transactions similar to firm or standby commitment agreements, they may fall 

within the “any similar instrument” definitional language, depending on the facts and 

circumstances.93  

We request comment on all aspects of the proposed rule’s definition of the term 

“derivatives transaction,” including the following items. 

 Is the definition of “derivatives transaction” sufficiently clear? Are there additional 

types of derivatives instruments, or other transactions, that we should include or 

exclude? Adding additional transactions to the definition would permit a fund to 

engage in those transactions by complying with the proposed rule, rather than section 

18. Are there transactions that we should exclude from the definition so that funds 

must comply with the limits of section 18 (to the extent permitted under section 18) 

with respect to these transactions, rather than the proposed rule’s conditions?  

 The proposed rule’s definition of the term “derivatives transaction” is designed to 

describe those derivatives transactions that would involve the issuance of a senior 

security. Do commenters agree that derivatives transactions that involve obligations 

to make a payment or deliver assets involve the issuance of a senior security under 

section 18 of the Act? Does the rule effectively describe all of the types of derivatives 

transactions that would involve the issuance of a senior security? Conversely, are 

there any types of transactions that are included in the proposed definition of 

“derivatives transaction” that should not be considered to involve the issuance of a 

senior security? If so, which types of transactions and why?  
                                                      
93  See, e.g., infra paragraph accompanying notes 420-421 (discussing agreements that would not 

qualify for the proposed rule’s treatment of unfunded commitment agreements because they are 
functionally similar to derivatives transactions). 



44 

 Is it appropriate that the proposed rule’s definition of “derivatives transaction” 

incorporates a list of derivatives instruments plus “any similar instrument,” rather 

than a principles-based definition, such as an instrument or contract whose value is 

based upon, or derived from, some other asset or metric? Why or why not? Is the 

reference to “any similar instrument” in the proposed definition sufficiently clear to 

address transactions that may be developed in the future? If not, how should we 

modify the rule to provide additional clarity?  

 Should the proposed definition of “derivatives transaction” include short sale 

borrowings? Would this approach cause any confusion because short sales are not 

typically understood as derivatives instruments? If the latter, what alternative 

approach would be preferable?  

 Should we specifically list firm or standby commitments in the proposed definition of 

“derivatives transaction”? Would funds understand the phrase “or any similar 

instrument” in the proposed definition to include these agreements? Do funds 

currently use the terms “firm commitment agreement” or “standby commitment 

agreement” to describe any of their transactions?  

 Are there any transactions similar to firm or standby commitments that we should 

specifically address, either in the proposed definition of “derivatives transaction” or 

otherwise as guidance? Are there any other types of transactions that the Commission 

should address—either in the proposed definition or as guidance—as transactions that 

fall within the “any similar instrument” definitional language?  



45 

B. Derivatives Risk Management Program 

1. Summary  

Fund investments in derivatives transactions can pose a variety of risks, and poor risk 

management can cause significant harm to funds and their investors. Derivatives can raise 

potential risks such as market, counterparty, leverage, liquidity, and operational risk. Although 

many of these risks are not limited to derivatives, the complexity and character of certain 

derivatives—such as their multiple contingencies and optionality, path dependency, and non-

linearity—may heighten these risks.94 Even simple derivatives without multiple contingencies 

and optionality, for example, can present additional risks beyond a fund’s investment in the 

underlying reference assets, such as the risk that a fund must have margin-eligible assets on hand 

to meet margin or collateral calls. We also recognize the valuable role derivatives can play in 

helping funds to achieve their objectives efficiently or manage their investment risks. 

An investment adviser of a fund that uses derivatives therefore should manage this use to 

ensure alignment with the fund’s investment objectives, policies, and restrictions, its risk profile, 

and relevant regulatory requirements. In addition, a fund’s board of directors is responsible for 

overseeing the fund’s activities and the adviser’s management of risks, including any derivatives 

risks.95 Given the dramatic growth in the volume and complexity of the derivatives markets over 

                                                      
94  See European Securities and Markets Authority (formerly Committee of European Securities 

Regulators), Guidelines on Risk Measurement and the Calculation of Global Exposure and 
Counterparty Risk for UCITS, CESR/10-788 (July 28, 2010), at 12, available at 
https://www.esma.europa.eu/sites/default/files/library/2015/11/10_788.pdf (“CESR Global 
Guidelines”). 

95  See, e.g., Interpretive Matters Concerning Independent Directors of Investment Companies, 
Investment Company Act Release No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role 
of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 
(Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)]; Independent Directors Council, Fund Board 
Oversight of Risk Management (Sept. 2011), available at 
http://www.ici.org/pdf/pub_11_oversight_risk.pdf (“2011 IDC Report”). 

http://www.ici.org/pdf/pub_11_oversight_risk.pdf


46 

the past two decades, and the increased use of derivatives by certain funds and their related risks, 

we believe that requiring funds that are users of derivatives (other than limited derivatives users) 

to have a formalized risk management program with certain specified elements (a “program”) 

supports exempting these transactions from section 18.  

Under the proposed program requirement, a fund would have to adopt and implement a 

written derivatives risk management program, which would include policies and procedures 

reasonably designed to manage the fund’s derivatives risks.96 A fund’s risk management 

program should take into the account the way the fund uses derivatives, whether to increase 

investment exposures in ways that increase portfolio risks or, conversely, to reduce portfolio 

risks or facilitate efficient portfolio management.97 

The program requirement is designed to result in a program with elements that are 

tailored to the particular types of derivatives that the fund uses and their related risks, as well as 

how those derivatives impact the fund’s investment portfolio and strategy. The proposal would 

require a fund’s program to include the following elements:  

• Risk identification and assessment.98 The program would have to provide for the 

identification and assessment of a fund’s derivatives risks, which would take into account 

the fund’s derivatives transactions and other investments. 

• Risk guidelines.99 The program would have to provide for the establishment, 

maintenance, and enforcement of investment, risk management, or related guidelines that 

                                                      
96   Proposed rule 18f-4(c)(1). 
97  See supra note 4 and accompanying text; infra section II.B.3.a. 
98  Proposed rule 18f-4(c)(1)(i); see also infra section II.B.3.a. 
99  Proposed rule 18f-4(c)(1)(ii); see also infra section II.B.3.b. 



47 

provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to 

a fund’s derivatives risks. 

• Stress testing.100 The program would have to provide for stress testing of derivatives risks 

to evaluate potential losses to a fund’s portfolio under stressed conditions.  

• Backtesting.101 The program would have to provide for backtesting of the VaR 

calculation model that the fund uses under the proposed rule. 

• Internal reporting and escalation.102 The program would have to provide for the 

reporting of certain matters relating to a fund’s derivatives use to the fund’s portfolio 

management and board of directors. 

• Periodic review of the program.103 A fund’s derivatives risk manager would be required 

to periodically review the program, at least annually, to evaluate the program’s 

effectiveness and to reflect changes in risk over time.  

The proposed program requirement is drawn from existing fund best practices. We believe it 

would enhance practices for funds that have not already implemented a derivatives risk 

management program, while building off practices of funds that already have one in place.104  

Most commenters generally supported the 2015 proposal’s derivatives risk management 

program requirement, which had many similar foundational elements to those of the program we 

are proposing here. These commenters stated that the use of derivatives transactions by a fund 

                                                      
100  Proposed rule 18f-4(c)(1)(iii); see also infra section II.B.3.c. 
101  Proposed rule 18f-4(c)(1)(iv); see also infra section II.B.3.d. 
102  Proposed rule 18f-4(c)(1)(v); see also infra section II.B.3.e. 
103  Proposed rule 18f-4(c)(1)(vi); see also infra section II.B.3.f. 
104  See, e.g., Aviva Comment Letter (discussing the implementation of formalized derivatives risk 

management programs); Vanguard Comment Letter. 



48 

should be subject to a comprehensive and appropriate written risk management program, which 

would benefit investors.105 Our proposal includes elements from the 2015 proposal’s derivatives 

risk management program framework, and adds elements that take into account our analysis of 

the comments we received. 

2. Program Administration 

The proposed rule would require a fund adviser’s officer or officers to serve as the fund’s 

derivatives risk manager.106 This requirement is designed to centralize derivatives risk 

management and to promote accountability. The designation of the derivatives risk manager 

must be approved by the fund’s board of directors, and the derivatives risk manager must have 

direct communication with the fund’s board of directors. Allowing multiple officers of the fund’s 

adviser (including any sub-advisers) to serve as the fund’s derivatives risk manager is designed 

to allow funds with differing sizes, organizational structures, or investment strategies to more 

effectively tailor the programs to their operations.107 We understand that many advisers today 

involve committees or groups of officers in the vetting and analysis of portfolio risk and other 

types of risk.108 Although the proposed rule would not permit a third party to serve as a fund’s 

                                                      
105  See, e.g., Comment Letter of AFG-French Asset Management Association (Mar. 25, 2016) 

(“AFG Comment Letter”); Comment Letter of American Beacon Advisors (Mar. 28, 2016) 
(“American Beacon Comment Letter”); Comment Letter of AQR Capital Management (Mar. 28, 
2016) (“AQR Comment Letter”); Federated Comment Letter; Comment Letter of Fidelity (Mar. 
28, 2016) (“Fidelity Comment Letter”); Comment Letter of AFL-CIO (Mar. 28, 2016); Comment 
Letter of Alternative Investment Management Association (Mar. 28, 2016) (“AIMA Comment 
Letter”); Comment Letter of Aviva (Mar. 28, 2016) (“Aviva Comment Letter”); Comment Letter 
of BlackRock (Mar. 28, 2016) (“BlackRock Comment Letter”); Comment Letter of Capital 
Research and Management Company (Mar. 28, 2016) (“CRMC Comment Letter”). 

106  Proposed rule 18f-4(a). 
107  The term “adviser” as used in this release and rule 18f-4 generally refers to any person, including 

a sub-adviser, that is an “investment adviser” of an investment company as that term is defined in 
section 2(a)(20) of the Investment Company Act.  

108  See, e.g., IAA Comment Letter. 

https://www.sec.gov/comments/s7-24-15/s72415-153.pdf
https://www.sec.gov/comments/s7-24-15/s72415-153.pdf


49 

derivatives risk manager, the derivatives risk manager could obtain assistance from third parties 

in administering the program. For example, third parties could provide data relevant to the 

administration of a fund’s program or other analysis that may inform the fund’s derivatives risk 

management. 

The proposed rule would also require that the fund’s derivatives risk manager have 

relevant experience regarding derivatives risk management.109 This requirement is designed to 

reflect the potential complex and unique risks that derivatives can pose to funds and promote the 

selection of a derivatives risk manager who is well-positioned to manage these risks. As 

discussed below, under the proposed rule, a fund’s board must approve the designation of the 

fund’s derivatives risk manager, taking into account the derivatives risk manager’s relevant 

experience regarding derivatives risk management.110 

The proposed rule would require a fund to reasonably segregate the functions of the 

program from its portfolio management.111 Segregating derivatives risk management from 

portfolio management is designed to promote objective and independent identification, 

assessment, and management of the risks associated with derivatives use. Accordingly, this 

element is designed to enhance the accountability of the derivatives risk manager and other risk 

management personnel and, therefore, to enhance the program’s effectiveness.112 We understand 

that funds today often segregate risk management from portfolio management. Many have 

observed that independent oversight of derivatives activities by compliance and internal audit 
                                                      
109  Proposed rule 18f-4(a). 
110  See infra section II.C.1. 
111  Proposed rule 18f-4(c)(1). 
112  See, e.g., Comptroller of the Currency Administrator of National Banks, Risk Management of 

Financial Derivatives: Comptroller’s Handbook (Jan. 1997), at 9 (discussing the importance of 
independent risk management functions in the banking context).  



50 

functions is valuable.113 Because a fund may compensate its portfolio management personnel in 

part based on the returns of the fund, the incentives of portfolio managers may not always be 

consistent with the restrictions that a risk management program would impose. Keeping the 

functions separate in the context of derivatives risk management should help mitigate the 

possibility that these competing incentives diminish the program’s effectiveness.  

Separation of functions creates important checks and balances, and funds could institute 

this proposed requirement through a variety of methods, such as independent reporting chains, 

oversight arrangements, or separate monitoring systems and personnel. The proposed rule would 

require reasonable segregation of functions, rather than taking a more prescriptive approach, 

such as requiring funds to implement strict protocols regarding communications between specific 

fund personnel, to allow funds to structure their risk management and portfolio management 

functions in ways that are tailored to each fund’s facts and circumstances, including the size and 

resources of the fund’s adviser. In this regard, the reasonable segregation requirement is not 

meant to indicate that the derivatives risk manager and portfolio management must be subject to 

a communications “firewall.” We recognize the important perspective and insight regarding the 

fund’s use of derivatives that the portfolio manager can provide and generally understand that the 

fund’s derivatives risk manager would work with the fund’s portfolio management in 

implementing the program requirement.  

For similar reasons, the proposed rule would also prohibit the derivatives risk manager 

position from being filled solely by the fund’s portfolio manager, if a single fund officer serves 

                                                      
113  See, e.g., Kenneth K. Marshall, Internal Control and Derivatives, The CPA Journal (Oct. 1995), 

available at http://archives.cpajournal.com/1995/OCT95/f461095.htm. 



51 

in the position.114 The proposed rule also would prohibit a majority of the officers who compose 

the derivatives risk manager position from being portfolio managers, if multiple fund officers 

serve in the position.  

Commenters generally supported the 2015 proposal’s requirement that a fund’s 

derivatives risk management program be administered by a derivatives risk manager and that the 

fund’s derivatives risk management be segregated from the fund’s portfolio management.115 

Commenters did, however, express concern about the 2015 proposal’s requirement that there be 

a single derivatives risk manager and urged that the Commission permit a fund’s portfolio 

managers to provide some input into the fund’s derivatives risk management function.116 This re-

proposal addresses these concerns by permitting a group or committee to serve as a fund’s 

derivatives risk manager, a portion of whom could be portfolio managers. 

We request comment on the proposed requirements that a fund’s derivatives risk manager 

administer the fund’s program, and that the derivatives risk management function be reasonably 

segregated from the fund’s portfolio management. 

 Is the proposed definition of “derivatives risk manager” sufficiently clear? Why or 

why not? Should the rule, as proposed, require that a fund’s derivatives risk manager 

be an officer or officers of the fund’s adviser, and would this requirement further the 

goals of centralizing derivatives risk management and promoting accountability? 

Why or why not? Should the rule, as proposed, permit a fund’s derivatives risk 

                                                      
114   Proposed rule 18f-4(a). 
115  See, e.g., BlackRock Comment Letter. 
116  See, e.g., BlackRock Comment Letter; Comment Letter of Morningstar (Mar. 28, 2016) 

(“Morningstar Comment Letter”); Comment Letter of the Investment Company Institute (Mar. 
28, 2016) (“ICI Comment Letter I”); Comment Letter of WisdomTree (Mar. 28, 2016). 



52 

manager to be an officer or officers of the fund’s sub-advisers? Why or why not? If 

so, should the rule require that at least one of the officers be an officer of the adviser 

or otherwise limit the number of sub-adviser officers? Why or why not? Would a 

fund’s program be more effective if we required the derivatives risk manager to be a 

single individual? Why or why not? If so, should this individual be required to be an 

officer of a fund’s adviser?  

 Should the rule, as proposed, require that a fund’s derivatives risk manager have 

relevant experience regarding derivatives risk management? Why or why not? Is the 

proposed requirement that the derivatives risk manager have “relevant experience 

regarding the management of derivatives risk” sufficiently clear? Would this raise 

questions about whether portfolio management experience, or experience outside of 

formal derivatives risk management, would suffice for purposes of the rule? Should 

the rule, instead, require that a fund’s derivatives risk manager simply have “relevant 

experience”? Should the rule specify that the derivatives risk manager must have 

relevant experience as determined by the fund’s board, to allow a board to determine 

the experience that would be appropriate? Or should the rule identify specific 

qualifications, training, or experience of a fund’s derivatives risk manager? Why or 

why not? If so, what should they be and why?  

 Should the rule, as proposed, require a fund to segregate derivatives risk management 

functions from portfolio management? Why or why not? If we were not to require 

independence between a fund’s derivatives risk manager and the fund’s portfolio 

managers, how could we ensure that a fund’s portfolio management personnel, who 

may have conflicting incentives, do not unduly influence the fund’s program 



53 

management?  

 Should we provide any additional clarification regarding the proposed reasonable 

segregation requirement? If so, what changes should we make? Should we add any 

specific requirements? For example, should we limit the extent to which fund risk 

management personnel can be compensated in part based on fund performance? 

 Is our understanding that many funds already segregate functions correct? If so, how 

and why do current approaches differ from the proposed rule’s requirement to 

segregate functions? 

 Are there other ways to facilitate objective and independent risk assessment of 

portfolio strategies that we should consider? If so, what are they and how would these 

alternatives be more effective than the proposed rule’s requirement to reasonably 

segregate functions? 

 Rule 22e-4 under the Investment Company Act, similar to the proposed rule, requires 

certain funds to implement a risk management program. In particular, rule 22e-4 

requires person(s) designated to administer a fund’s liquidity risk management 

program to be the fund’s investment adviser, officer, or officers (which may not be 

solely portfolio managers of the fund) (the “liquidity risk manager”). Should we 

amend rule 22e-4 to more closely align the definition of “liquidity risk manager” with 

the proposed definition of “derivatives risk manager” by prohibiting a fund’s adviser 

from serving as a liquidity risk manager? Why or why not? Conversely, should we 

align the standard for derivatives risk manager with the liquidity risk manager 

standard under rule 22e-4?  

 Would the proposed derivatives risk manager requirement raise any particular 



54 

challenges for funds with smaller advisers and, if so, what could we do to help 

mitigate these challenges? For example, should we modify the rule to permit funds to 

authorize the use of third parties not employed by the adviser to administer the 

program and, if so, under what conditions? Why or why not? Would allowing third 

parties to act as derivatives risk managers enhance the program by allowing 

specialized personnel to administer the program or detract from it by allowing for a 

derivatives risk manager who may not be as focused on the specific risks of the 

particular fund or as accountable to its board? Would the proposed requirement that a 

fund reasonably segregate derivatives risk management from portfolio management 

pose particular challenges for funds with smaller advisers? If so, how and why, and 

would additional guidance on this proposed requirement or changes to the proposed 

rule be useful? Conversely, would this proposed requirement (which does not 

prescribe how funds must segregate functions) provide appropriate flexibility for 

funds with smaller advisers?  

 Rule 38a-1(c) under the Investment Company Act prohibits officers, directors, and 

employees of the fund and its adviser from, among other things, coercing or unduly 

influencing a fund’s chief compliance officer in the performance of his or her duties. 

Should we include such a prohibition on unduly influencing a fund’s derivatives risk 

manager in the proposed rule? Why or why not?  

 Should we include any other program administration requirements? If so, what? For 

example, should we include a requirement for training staff responsible for day-to-

day management of the program, or for portfolio managers, senior management, and 

any personnel whose functions may include engaging in, or managing the risk of, 



55 

derivatives transactions? If we require such training, should that involve setting 

minimum qualifications for staff responsible for carrying out the requirements of the 

program? Why or why not? Should we require training and education with respect to 

any new derivatives instruments that a fund may trade? Why or why not? Should we 

require a new instrument review committee? 

3. Required Elements of the Program 

a. Risk Identification and Assessment 

The proposed program requirement would require a fund to identify and assess its 

derivatives risks in order to manage these risks.117 It would require that the fund’s identification 

and assessment take into account the fund’s other investments as well as its derivatives 

transactions. An appropriate assessment of derivatives risks generally involves assessing how a 

fund’s derivatives may interact with the fund’s other investments or whether the fund’s 

derivatives have the effect of helping the fund manage risks. For example, the risks associated 

with a currency forward would differ if a fund is using the forward to hedge the fund’s exposure 

to currency risk associated with a fund investment denominated in a foreign currency or, 

conversely, to take a speculative position on the relative price movements of two currencies. We 

believe that by assessing its derivatives use holistically, a fund will be better positioned to 

implement a derivatives risk management program that does not over- or understate the risks its 

derivatives use may pose. Accordingly, we believe that this approach would result in a more-

tailored derivatives risk management program.  

The proposed rule would define the derivatives risks that must be identified and managed 

to include leverage, market, counterparty, liquidity, operational, and legal risks, as well as any 

                                                      
117  Proposed rule 18f-4(c)(1)(i). 



56 

other risks the derivatives risk manager deems material.118 In the context of a fund’s derivatives 

transactions: 

• Leverage risk generally refers to the risk that derivatives transactions can magnify the 

fund’s gains and losses;119 

• Market risk generally refers to risk from potential adverse market movements in relation 

to the fund’s derivatives positions, or the risk that markets could experience a change in 

volatility that adversely impacts fund returns and the fund’s obligations and exposures;120  

• Counterparty risk generally refers to the risk that a counterparty on a derivatives 

transaction may not be willing or able to perform its obligations under the derivatives 

contract, and the related risks of having concentrated exposure to such a counterparty;121  

• Liquidity risk generally refers to risk involving the liquidity demands that derivatives can 

create to make payments of margin, collateral, or settlement payments to counterparties;  

                                                      
118  Proposed rule 18f-4(a). In the case of funds that are limited derivatives users under the proposed 

rule, the definition would include any other risks that the fund’s investment adviser (as opposed 
to the fund’s derivatives risk manager) deems material, because a fund that is a limited 
derivatives user would be exempt from the requirement to adopt a derivatives risk management 
program (and therefore also exempt from the requirement to have a derivatives risk manager). See 
infra section II.E. 

119  See, e.g., Independent Directors Council, Board Oversight of Derivatives Task Force Report (July 
2008), at 12 (“2008 IDC Report”). 

120  Funds should consider market risk together with leverage risk because leveraged exposures can 
magnify such impacts. See, e.g., NAPF, Derivatives and Risk Management Made Simple (Dec. 
2013), available at 
https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=132066
3533358&blobheader=application/pdf&blobheadername1=Cache-
Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs.  

121  See, e.g., Nils Beier, et al., Getting to Grips with Counterparty Risk, McKinsey Working Papers 
on Risk, Number 20 (June 2010).  

https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=1320663533358&blobheader=application/pdf&blobheadername1=Cache-Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs
https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=1320663533358&blobheader=application/pdf&blobheadername1=Cache-Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs
https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=1320663533358&blobheader=application/pdf&blobheadername1=Cache-Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs


57 

• Operational risk generally refers to risk related to potential operational issues, including 

documentation issues, settlement issues, systems failures, inadequate controls, and human 

error;122 and  

• Legal risk generally refers to insufficient documentation, insufficient capacity or 

authority of counterparty, or legality or enforceability of a contract.123 

We believe these risks are common to most derivatives transactions.124  

                                                      
122  See, e.g., 2008 IDC Report, supra note 119; RMA, Statement on best practices for managing risk 

in derivatives transactions (2004) (“Statement on best practices for managing risk in derivatives 
transactions”), available at http://www.rmahq.org/securities-lending/best-practices.  

123  See, e.g., Raimonda Martinkutė-Kaulienė, Risk Factors in Derivatives Markets, 2 Entrepreneurial 
Business and Economics Review 4 (2014); Capital, Margin, and Segregation Requirements for 
Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital and 
Segregation Requirements for Broker-Dealers, Exchange Act Release No. 86175 (June 21, 2019), 
84 FR 43872 (Aug. 22, 2019), n.1055 (“Capital Margin Release”) ( “Market participants face 
risks associated with the financial and legal ability of counterparties to perform under the terms of 
specific transactions”); see also Office of the Comptroller of the Currency, Risk Management of 
Financial Derivatives, Comptroller’s Handbook (Jan. 1997) (narrative), (Feb. 1998) (procedures).  

Because derivatives contracts that are traded over the counter are not standardized, they bear a 
certain amount of legal risk in that poor draftsmanship, changes in laws, or other reasons may 
cause the contract to not be legally enforceable against the counterparty. See, e.g., Comprehensive 
Risk Management of OTC Derivatives, supra note 124. For example, some netting agreements or 
qualified financial contracts contain so-called “walkaway” clauses, such as provisions that, under 
certain circumstances, suspend, condition, or extinguish a party’s payment obligation under the 
contract. These provisions would not be enforceable where the Federal Deposit Insurance Act is 
applicable. See 12 U.S.C 1821(e)(8)(G). As another example, many derivatives contracts and 
prime brokerage agreements that hedge funds and other counterparties had entered into with 
Lehman Brothers included cross-netting that allowed for payments owed to and from different 
Lehman affiliates to be offset against each other, and cross-liens that granted security interests to 
all Lehman affiliates (rather than only the specific Lehman entity entering into a particular 
transaction). In 2011, the U.S. Bankruptcy Court for the Southern District of New York held that 
cross-affiliate netting provisions in an ISDA swap agreement were unenforceable against a debtor 
in bankruptcy. In the Matter of Lehman Brothers Inc., Bankr. Case No. 08-01420 (JPM) (SIPA), 
458 B.R. 134, 1135-137 (Bankr. S.D.N.Y. Oct. 4, 2011). 

124  See Numerix, Comprehensive Risk Management of OTC Derivatives; A Tricky Endeavor (July 
16, 2013), available at http://www.numerix.com/comprehensive-risk-management-otc-
derivatives-tricky-endeavor (“Comprehensive Risk Management of OTC Derivatives”); 
Statement on best practices for managing risk in derivatives transactions, supra note 122; 2008 
IDC Report, supra note 119; Lawrence Metzger, Derivatives Danger: internal auditors can play 
a role in reigning in the complex risks associated with financial instruments, FSA Times (2011), 
available at http://www.theiia.org/fsa/2011-features/derivatives-danger (“FSA Times Derivatives 

 

http://www.rmahq.org/securities-lending/best-practices
http://www.numerix.com/comprehensive-risk-management-otc-derivatives-tricky-endeavor
http://www.numerix.com/comprehensive-risk-management-otc-derivatives-tricky-endeavor
http://www.theiia.org/fsa/2011-features/derivatives-danger


58 

The proposed rule would not limit a fund’s identification and assessment of derivatives 

risks to only those specified in the rule. The proposed definition of the term “derivatives risks” 

includes any other risks a fund’s derivatives risk manager deems material.125 Some derivatives 

transactions could pose certain idiosyncratic risks. For example, some derivatives transactions 

could pose a risk that a complex OTC derivative could fail to produce the expected result (e.g., 

because historical correlations change or unexpected merger events occur) or pose a political risk 

(e.g., events that affect currencies).  

Commenters to the 2015 proposal generally supported its requirement that a fund engage 

in a process of identifying and evaluating the potential risks posed by its derivatives 

transactions.126  

We request comment on all aspects of the proposed requirement to identify and assess a 

fund’s derivatives risks, as well as the proposed definition of the term “derivatives risks.”  

 Is the proposed definition of “derivatives risks” sufficiently clear? Why or why not?  

 Are the categories of risks that we have identified in the proposed rule appropriate? 

Why or why not? Should we remove any of the identified risk categories? If so, what 

categories should be removed, and why? Should we add any other specified 

categories of risks that should be addressed? If so, what additional categories and 

why? Should we provide further guidance regarding the assessment of any of these 
                                                      

Dangers”). See also 17 CFR 240.15c3-4(a) (“An OTC derivatives dealer shall establish, 
document, and maintain a system of internal risk management controls to assist it in managing the 
risks associated with its business activities, including market, credit, leverage, liquidity, legal, and 
operational risks.”). Nonbank security-based swap dealers and broker-dealers authorized to use 
internal models to compute net capital also are subject to rule 15c3-4. See Capital Margin 
Release, supra note 123.  

125   See supra note 118. 
126  See, e.g., ICI Comment Letter I; Comment Letter of the Consumer Federation of America (Mar. 

28, 2016) (“CFA Comment Letter”). 



59 

risks? If so, what should the guidance be, and why? 

 Do commenters believe the proposed approach with respect to risk identification and 

assessment is appropriate? Why or why not?  

 Do funds currently assess the risks associated with their derivatives transactions by 

taking into account both their derivatives transactions and other investments? If so, 

how do they perform this assessment? Are there certain derivatives transactions 

whose risks do not involve an assessment of other investments in a fund’s portfolio? 

If so, which derivatives transactions, and why? 

 Should we require policies and procedures to include an assessment of particular risks 

based on an evaluation of certain identified risk categories as proposed? If not, why?  

b. Risk Guidelines 

The proposed rule would require a fund’s program to provide for the establishment, 

maintenance, and enforcement of investment, risk management, or related guidelines that 

provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s 

derivatives risks (the “guidelines”).127 The guidelines would be required to specify levels of the 

given criterion, metric, or threshold that a fund does not normally expect to exceed and the 

measures to be taken if they are exceeded. The proposed guidelines requirement is designed to 

address the derivatives risks that a fund would be required to monitor routinely as part of its 

program, and to help the fund identify when it should respond to changes in those risks. We 

understand that many funds today have established risk management guidelines, with varying 

degrees of specificity. 

                                                      
127  Proposed rule 18f-4(c)(1)(ii). 



60 

The proposed rule would not impose specific risk limits for these guidelines. It would, 

however, require a fund to adopt guidelines that provide for quantitative thresholds that the fund 

determines to be appropriate and that are most pertinent to its investment portfolio, and that the 

fund reasonably determines are consistent with its risk disclosure.128 Requiring a fund to 

establish discrete metrics to monitor its derivatives risks would require the fund and its 

derivatives risk manager to measure changes in its risks regularly, and this in turn is designed to 

lead to more timely steps to manage these risks. Moreover, requiring a fund to identify its 

response when these metrics have been exceeded would provide the fund’s derivatives risk 

manager with a clear basis from which to determine whether to involve other persons, such as 

the fund’s portfolio management or board of directors, in addressing derivatives risks 

appropriately.129  

Funds may use a variety of approaches in developing guidelines that comply with the 

proposed rule.130 This would draw on the risk identification element of the program and the 

scope and objectives of the fund’s use of derivatives. A fund could use quantitative metrics that 

it determines would allow it to monitor and manage its particular derivatives risks most 

appropriately. We understand that today funds use a variety of quantitative models or 

methodologies to measure the risks associated with the derivatives transactions. With respect to 

market risk, we understand that funds commonly use VaR, stress testing, or horizon analysis. 

                                                      
128  See, e.g., Mutual Fund Directors Forum, Risk Principles for Fund Directors: Practical Guidance 

for Fund Directors on Effective Risk Management Oversight (Apr. 2010), available at 
http://www.mfdf.org/images/Newsroom/Risk_Principles_6.pdf (“MFDF Guidance”).  

129  See proposed rule 18f-4(c)(1)(v); see also infra section II.B.3.e. 
130  See, e.g., Comprehensive Risk Management of OTC Derivatives, supra note 124; Statement on 

best practices for managing risk in derivatives transactions, supra note 122; 2008 IDC Report, 
supra note 119.  

http://www.mfdf.org/images/Newsroom/Risk_Principles_6.pdf61 

Concentration risk metrics are also being used in connection with monitoring counterparty risk 

(e.g., requiring specific credit committee approval for transactions with a notional exposure in 

excess of a specified amount, aggregated with other outstanding positions with the same of 

affiliated counterparties). In addition, liquidity models have been designed to address liquidity 

risks over specified periods (e.g., models identifying margin outlay requirements over a specified 

period under specified volatility scenarios).  

In developing the guidelines, a fund generally should consider how to implement them in 

view of its investment portfolio and the fund’s disclosure to investors. For example, a fund may 

wish to consider establishing corresponding investment size controls or lists of approved 

transactions across the fund.131 A fund generally should consider whether to implement 

appropriate monitoring mechanisms designed to allow the fund to abide by the guidelines, 

including their quantitative metrics.  

While the 2015 proposal did not require funds to adopt risk guidelines, commenters on 

the 2015 proposal generally supported the concept of a requirement that a fund adopt and 

implement policies and procedures reasonably designed to manage the risks of its derivatives 

transactions, including by monitoring whether those risks continue to be consistent with any 

investment guidelines established by the fund or the fund’s investment adviser.132  

We request comment on the proposed rule’s guidelines requirement.  

 Should we require, as proposed, a fund’s program to provide for the establishment, 

maintenance, and enforcement of investment, risk management, or related guidelines? 
                                                      
131  A fund could also consider establishing an “approved list” of specific derivatives instruments or 

strategies that may be used, as well as a list of persons authorized to engage in the transactions on 
behalf of the fund. A fund may wish to provide new instruments (or instruments newly used by 
the fund) additional scrutiny. See, e.g., MFDF Guidance, supra note 128, at 8. 

132  See, e.g., BlackRock Comment Letter; CRMC Comment Letter; ICI Comment Letter I. 



62 

Why or why not? Should we require, as proposed, that the guidelines provide for 

quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s 

derivatives risks? Why or why not? If not, is there an alternative program element 

that would be more appropriate in promoting effective derivatives risk management? 

Should we prescribe particular tools or approaches that funds must use to manage 

specific risks related to their use of derivatives? For example, should we require funds 

to manage derivatives’ liquidity risks by maintaining highly liquid assets to cover 

potential future losses and other liquidity demands?  

 Should we require a specific number or range of numbers of guidelines that a fund 

should establish? For example, should we require a fund to establish a minimum of 2, 

3, 4, or more different guidelines to cover a range of different risks? Why or why not?  

 Do funds currently adopt, and monitor compliance with, such guidelines? If so, do 

these guidelines provide for quantitative or otherwise measurable criteria, metrics, or 

thresholds of the funds’ derivatives risks? If so, what criteria, metrics, or thresholds 

are provided for? Should we require that funds use specific risk management tools? If 

so, what tools should we require?  

 Should we specify a menu of guideline categories that all funds should use to promote 

consistency in risk management among funds? For example, should we identify 

certain commonly-used types of guidelines such as VaR, notional amounts, and 

duration, and require funds to choose among those commonly-used types? If we were 

to do so, which metrics should we allow funds to use? Would such a menu become 

stale as new risk measurement tools are developed?  

 Should we require, as proposed, that the guidelines specify set levels of a given 



63 

criterion, metric, or threshold that the fund does not generally expect to exceed? Why 

or why not? If so, how would these levels be set or calculated? Should we instead set 

maximum levels for certain guidelines a fund would not exceed?  

 Should we require that a fund publicly disclose the guidelines it uses and the 

quantitative levels selected? If so, where (for example, in the fund’s prospectus, 

website, or on Form N-PORT or N-CEN)? Should we instead require that funds 

confidentially report to us the guidelines they use and the quantitative levels selected? 

If so, on what form should they report this information?  

 Should we require, as proposed, that the guidelines identify measures to be taken 

when the fund exceeds a criterion, metric, or threshold in the fund’s guidelines? Why 

or why not? 

 Should we require any form of public disclosure or confidential reporting to us if a 

fund were to exceed its risk guidelines? Would such reporting or disclosure result in 

funds setting guidelines that are so restrictive or lax that they would be unlikely to be 

useful as a monitoring and risk management tool?  

 Should the rule require the guidelines to provide for other elements? If so, what 

elements and why? 

c. Stress Testing 

The proposed rule would require a fund’s program to provide for stress testing to evaluate 

potential losses to the fund’s portfolio.133 We understand that, as a derivatives risk management 

                                                      
133  Proposed rule 18f-4(c)(1)(iii); see also infra section II.D.6.a (discussing an alternative to the 

proposed limit on fund leverage risk that would rely on a stress testing framework). The proposed 
rule would require a fund that is required to establish a derivatives risk mangement program to 
stress test its portfolio, that is, all of the fund’s investments, and not just the fund’s derivatives 
transactions.  



64 

tool, stress testing is effective at measuring different drivers of derivatives risks, including non-

linear derivatives risks that may be understated by metrics or analyses that do not focus on 

periods of stress. Stress testing is an important tool routinely used in other areas of the financial 

markets and in other regulatory regimes, and we understand that funds engaging in derivatives 

transactions have increasingly used stress testing as a risk management tool over the past 

decade.134 The Commission has also required certain types of funds to conduct stress tests or 

otherwise consider the effect of stressed market conditions on their portfolios.135 We believe that 

requiring a fund to stress test its portfolio would help the fund better manage its derivatives risks 

and facilitate board oversight.  

We also believe that stress testing would serve as an important complement to the 

proposed VaR-based limit on fund leverage risk, as well as any VaR testing under the fund’s risk 

guidelines.136 During periods of stress, returns, correlations, and volatilities tend to change 

dramatically over a very short period of time. Losses under stressed conditions—or “tail risks”—

would not be reflected in VaR analyses that are not calibrated to a period of market stress and 

that do not estimate losses that occur on the trading days with the highest losses.137 Requiring 

funds to stress test their portfolios would provide information regarding these “tail risks” that 

VaR and other analyses may miss.  

                                                      
134  See, e.g., Comment Letter of Investment Company Institute (Oct. 8, 2019) (“ICI Comment Letter 

III”) (stating that, based on a survey of member firms, many funds perform ex ante stress testing). 
135  See rule 2a-7 under the Investment Company Act [17 CFR 270.2a-7]; see also rule 22e-4 under 

the Investment Company Act [17 CFR 270.22e-4] (requiring a fund subject to the rule to assess 
its liquidity risk by considering, for example, its investment strategy and portfolio investment 
liquidity under reasonably foreseeable stressed conditions). 

136  See proposed rule 18f-4(c)(2); infra section II.D. 
137  The proposed rule would not require a fund to implement a stressed VaR test. See infra section 

II.D.1. 



65 

Under the proposed rule, the fund’s stress tests would be required to evaluate potential 

losses to the fund’s portfolio in response to extreme but plausible market changes or changes in 

market risk factors that would have a significant adverse effect on the fund’s portfolio.138 The 

stress tests also would have to take into account correlations of market risk factors and resulting 

payments to derivatives counterparties.139 We believe that these requirements would promote 

stress tests that produce results that are valuable in appropriately managing derivatives risks by 

focusing the testing on extreme events that may provide actionable information to inform a 

fund’s derivatives risk management.140 We understand that funds commonly consider the 

following market risk factors: liquidity, volatility, yield curve shifts, sector movements, or 

changes in the price of the underlying reference security or asset.141 In addition, we believe it is 

important for a fund’s stress testing to take into account payments to counterparties, as losses can 

result when the fund’s portfolio securities decline in value at the same time that the fund is 

required to make additional payments under its derivatives contracts.142  

To inform a fund’s derivatives risk management effectively, a fund should stress test its 

portfolio with a frequency that would best position the derivative risk manager to appropriately 

administer, and the board to appropriately oversee, a fund’s derivatives risk management, taking 

into account the frequency of change in the fund’s investments and market conditions. The 

proposed rule, therefore, would permit a fund to determine the frequency of stress tests, provided 

                                                      
138  Proposed rule 18f-4(c)(1)(iii). 
139  Id. 
140  Krishan Mohan Nagpal, Designing Stress Scenarios for Portfolios, 19 Risk Management 323 

(2017). 
141  See, e.g., ICI Comment Letter I; Thomas Breuer, et al., How to Find Plausible, Severe, and 

Useful Stress Scenarios, International Journal of Central Banking 205 (Sept. 2009). 
142  See OppenheimerFunds Settled Action, supra note 22.  



66 

that the fund must conduct stress testing at least weekly. In establishing such frequency, a fund 

must take into account the fund’s strategy and investments and current market conditions. For 

example, a fund whose strategy involves a high portfolio turnover might determine to conduct 

stress testing more frequently than a fund with a more static portfolio. A fund similarly might 

conduct more frequent stress tests in response to increases in market stress. The minimum 

weekly stress testing frequency is designed to balance the potential benefits of relatively frequent 

stress testing with the burdens of administering stress testing.143 We also considered a less 

frequent requirement, such as monthly stress testing. A less frequent requirement, however, may 

fail to provide a fund’s derivatives risk manager adequate and timely insight into the fund’s 

derivatives risk, particularly where the fund has a high portfolio turnover. In determining this 

minimum frequency, we also took into account that this requirement would only apply to funds 

that do not qualify for the limited derivatives user exception because they use derivatives in more 

than a limited way. In addition, in view of the proposed rule’s internal reporting and periodic 

review requirements, the weekly stress testing minimum would provide a fund’s derivatives risk 

manager and board with multiple sets of stress testing results, which would allow them to 

observe trends and how the results may change over time.144 

Although the 2015 proposal’s risk management program did not include a stress testing 

requirement, some commenters stated that stress testing would serve as an important component 

                                                      
143  We recognize that the costs associated with stress testing may increase with the frequency of 

conducting such tests. We understand, however, that once a fund initially implements a stress 
testing framework, subsequent stress tests could be automated and, as a result, be less costly. 

144  See infra sections II.B.3.e and II.C. 



67 

of derivatives risk management and recommended that the Commission require a fund’s 

designated risk manager to perform stress testing and report the results to the fund’s board.145 

We request comment on the proposed rule’s stress testing requirement. 

 Should we require, as proposed, that funds conduct stress testing as part of the 

program requirement? Why or why not? How, if at all, would stress testing serve as a 

complement for other risk measurement tools, such as VaR? What does stress testing 

capture as part of derivatives risk management that other tools do not, and why? 

 Should the rule require funds to conduct a particular type of stress testing? If so, what 

type, and what should the required elements be? For example, should the rule require 

funds to conduct scenario analysis?  

 Should the rule identify specific stress events to be applied? Should any required 

stress events vary based on the primary risks of particular funds? 

 Do funds currently conduct stress testing? If so, what types of stress testing, for what 

purposes, and how does the stress testing that funds currently conduct differ from the 

proposed rule’s requirement? 

 For funds that currently conduct stress testing, how frequently do they conduct it? 

Daily, weekly, or monthly? Why? Does it depend on the type of stress testing? On the 

investment objective or strategy of a fund? With what minimum frequency should the 

rule require stress testing be conducted? For example, instead of weekly tests should 

we require daily tests? Conversely should we allow longer periods of time between 

tests, such as monthly, or quarterly? Why? Should we require more frequent testing 
                                                      
145  See, e.g., Comment Letter of Blackstone Alternative Investment Advisors LLC (Mar. 28, 2016) 

(“Blackstone Comment Letter”); Comment Letter of Invesco Management Group, Inc. (Mar. 28, 
2016) (“Invesco Comment Letter”); see also ICI Comment Letter III. 



68 

for funds with some investment objectives or strategies than other funds? If so, for 

which objectives or strategies should we require more frequent testing? 

 Is the proposed rule’s reference to “extreme but plausible market changes or changes 

in market risk factors” sufficiently clear? Should we identify more quantitative 

changes, such as the worst change in a specific risk factor seen in the last 10, 20, or 

50 years? Is the proposed rule’s reference to “significant adverse effect” sufficiently 

clear? Should we instead identify quantitative levels of NAV change, such as a drop 

of 20, 30, or 50% of the fund’s NAV?  

 Should we require stress tests to include certain identified market risk factors such as 

changes in interest rates or spreads, market volatility, market liquidity, or other 

market factors? If so, which market risk factors should we identify, and why? If we 

were to identify certain market risk factors to be tested, should we require a fund to 

take action (such as reporting to its board or to the Commission, or reducing its 

derivatives usage) if a stress test were to show that one of these factors would result 

in the fund losing a certain percentage of its NAV? If so, what level of NAV, what 

types of risk factors, and what types of action should we consider?  

 Should we require, as proposed, that funds take into account their strategy, 

investments, and current market conditions in considering the appropriate frequency 

for a fund’s stress tests? Why or why not? Should we require, as proposed, that funds 

to take into account correlations of market risk factors and payments to derivatives 

counterparties as part of the fund’s stress tests? Why or why not? Would any 

additional guidance help funds to better understand, and more consistently conduct, 

the stress tests that the proposed rule would require?  



69 

 We discuss and request comment below on the proposed rule’s requirements to 

provide information to a fund’s board of directors, including the derivatives risk 

manager’s analysis of a fund’s stress testing. In addition to providing this information 

to the board, should we require funds to disclose stress test results to investors or 

report them confidentially to us? If so, what information should be disclosed or 

reported? 

d. Backtesting 

The proposed rule would require a fund to backtest the results of the VaR calculation 

model used by the fund in connection with the relative VaR or absolute VaR test, as applicable, 

as part of the program.146 This proposed requirement is designed to require a fund to monitor the 

effectiveness of its VaR model. It would assist a fund in confirming the appropriateness of its 

model and related assumptions and help identify when funds should consider model 

adjustments.147 We are proposing this requirement in light of the central role that VaR plays in 

the proposed VaR-based limit on leverage risk. This also is consistent with the comments we 

received on the 2015 proposal suggesting that we require backtesting, which we had not included 

in that proposal.148 

Specifically, the proposed backtesting requirement provides that, each business day, the 

fund must compare its actual gain or loss for that business day with the VaR the fund had 

                                                      
146  See proposed rule 18f-4(c)(1)(iv). 
147  Some commenters on the 2015 proposal suggested that the Commission require backtesting of a 

fund’s VaR calculation models. See, e.g., Blackstone Comment Letter; Comment Letter of 
Investment Company Institute (Sept. 27, 2016) (“ICI Comment Letter II”); Aviva Comment 
Letter; Comment Letter of the Global Association of Risk Professionals (Mar. 21, 2016) (“GARP 
Comment Letter”). 

148  See, e.g., Blackstone Comment Letter; ICI Comment Letter II; Aviva Comment Letter; GARP 
Comment Letter. 



70 

calculated for that day. For purposes of the backtesting requirement, the VaR would be estimated 

over a one-trading day time horizon. For example, on Monday at the end of the trading day, a 

fund would analyze whether the gain or loss it experienced that day exceeds the VaR calculated 

for that day. In this backtesting example, the fund could calculate the VaR for Monday on Friday 

evening (after Friday trading closes) or Monday morning (before Monday trading begins). The 

fund would have to identify as an exception any instance in which the fund experiences a loss 

exceeding the corresponding VaR calculation’s estimated loss. This approach is generally 

consistent with the practice of firms that use internal models to compute regulatory capital and 

other regulatory approaches.149 Because the proposed rule would require that the fund’s backtest 

be conducted using a 99% confidence level and over a one-day time horizon, and assuming 250 

trading days in a year, a fund would be expected to experience a backtesting exception 

approximately 2.5 times a year, or 1% of the 250 trading days.150 If the fund were consistently to 

experience backtesting exceptions more (or less) frequently, this could suggest that the fund’s 

VaR model may not be effectively taking into account and incorporating all significant, 

                                                      
149  See, e.g., rule 15c3-1e under the Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 

240.15c3-1) (“On the last business day of each quarter, the broker or dealer must identify the 
number of backtesting exceptions of the VaR model, that is, the number of business days in the 
past 250 business days, or other period as may be appropriate for the first year of its use, for 
which the actual net trading loss, if any, exceeds the corresponding VaR measure.”); CESR 
Global Guidelines, supra note 94 (“The UCITS should carry out the back testing program at least 
on a monthly basis, subject to always performing retroactively the comparison for each business 
day,” i.e., “provid[ing] for each business day a comparison of the one-day value-at-risk measure 
generated by the UCITS model for the UCITS’ end-of-day positions to the one-day change of the 
UCITS’ portfolio value by the end of the subsequent business day”); see also infra note 152 
(discussing frequency variations for backtesting requirements).  

150  The proposed backtesting requirement would be based on a one-day time horizon. See infra 
section II.D.4 (discussing the proposed VaR model requirements that would be based on a 
twenty-day time horizon). 



71 

identifiable market risk factors associated with a fund’s investments, as required by the proposed 

rule.151  

The proposed rule would require funds to conduct a backtest each day so that a fund and 

its derivatives risk manager could more readily and efficiently adjust or calibrate its VaR 

calculation model and, therefore, could more effectively manage the risks associated with its 

derivatives use. We understand that some funds perform these calculations less frequently than 

daily.152 We are proposing a daily backtesting requirement because market risk factors and fund 

investments are dynamic, which might result in frequent changes to the accuracy and 

effectiveness of a VaR model and calculations using the model. Some commenters on the 2015 

proposal supported a backtesting requirement with a daily frequency.153 We also believe that the 

additional costs associated with a daily backtesting requirement would be limited because a fund 

                                                      
151  If 10 or more exceptions are generated in a year from backtesting that is conducted using a 99% 

confidence level and over a one-day time horizon, and assuming 250 trading days in a year, it is 
statistically likely that such exceptions are a result of a VaR model that is not accurately 
estimating VaR. See, e.g., Philippe Jorion, Value at Risk: The New Benchmark for Managing 
Financial Risk (3d ed. 2006), at 149-150 (“Jorion”). See also rule 15c3-1e under the Exchange 
Act (requiring backtesting of VaR models and the use of a multiplication factor based on the 
number of backtesting exceptions). 

152  See, e.g., CESR Global Guidelines, supra note 94 (“The UCITS should carry out the back testing 
program at least on a monthly basis, subject to always performing retroactively the comparison 
for each business day,” i.e., “provid[ing] for each business day a comparison of the one-day 
value-at-risk measure generated by the UCITS model for the UCITS’ end-of-day positions to the 
one-day change of the UCITS’ portfolio value by the end of the subsequent business day”); 
Blackstone Comment Letter (suggesting monthly backtests); Aviva Comment Letter 
(recommending reporting to the Commission on a semi-annual basis if a fund experienced a 
certain number of backtest exceptions). Cf. rule 15c3-1e under the Exchange Act [17 CFR 
240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) (“On the last business day of each quarter, the 
broker or dealer must identify the number of backtesting exceptions of the VaR model, that is, the 
number of business days in the past 250 business days, or other period as may be appropriate for 
the first year of its use, for which the actual net trading loss, if any, exceeds the corresponding 
VaR measure.”). 

153  See, e.g., GARP Comment Letter; Aviva Comment Letter; ICI Comment Letter II.  



72 

would be required to calculate its portfolio VaR each business day to satisfy the proposed limits 

on fund leverage discussed in section II.D of this release. 

We request comment on the proposed backtesting requirement. 

 Is the proposed requirement that a fund backtest its VaR model each business day 

appropriate? Why or why not? Would less-frequent backtesting be sufficient? Is 

backtesting an effective tool to promote derivatives risk management and VaR model 

accuracy? Why or why not? 

 Should the rule specify the number of exceedances, or the number of consecutive 

days without an exceedance, that would require VaR model calibration? Why or why 

not? 

 How often do funds that currently use VaR backtest their VaR models and why? 

Should the backtesting requirement be less frequent? For example, should we require 

a fund to perform backtests weekly, monthly, or quarterly, in each case considering 

the one-day value change for each trading day in the period? Please explain. 

 For funds that currently backtest their VaR models, how often and for what reasons 

do funds recalibrate their VaR models? Are certain market risk factors or investment 

types particularly prone to requiring VaR model recalibrations (as well as 

backtesting)? 

e. Internal Reporting and Escalation 

The proposed rule would require communication between a fund’s risk management and 

portfolio management regarding the operation of the program.154 We believe these lines of 

                                                      
154  Proposed rule 18f-4(c)(1)(v). 



73 

communication are a key part of derivatives risk management.155 Providing portfolio managers 

with the insight of a fund’s derivatives risk manager is designed to inform portfolio managers’ 

execution of the fund’s strategy and recognize that portfolio managers will generally be 

responsible for transactions that could mitigate or address derivatives risks as they arise. The 

proposed rule also would require communication between a fund’s derivatives risk manager and 

its board, as appropriate. We understand that funds today often have a dialogue between risk 

professionals and fund boards. Requiring a dialogue between a fund’s derivatives risk manager 

and the fund’s board would provide the fund’s board with key information to facilitate its 

oversight function.  

To provide flexibility for funds to communicate among these groups as they deem 

appropriate and taking into account funds’ own facts and circumstances, the proposed rule would 

require a fund’s program to identify the circumstances under which a fund must communicate 

with its portfolio management about the fund’s derivatives risk management, including its 

program’s operation.156 A fund’s program, in addition, could require that the fund’s derivatives 

risk manager inform the fund’s portfolio management, for example, by meeting with the fund’s 

portfolio management on a regular and frequent basis, or require that the fund’s portfolio 

management is notified of the fund’s exceedances or stress tests through software designed to 

provide automated updates. 

The proposed rule would also require a fund’s derivatives risk manager to communicate 

material risks to the fund’s portfolio management and, as appropriate, its board of directors.157 

                                                      
155  See 2011 IDC Report, supra note 95. 
156  Proposed rule 18f-4(c)(1)(v)(A). 
157  Proposed rule 18f-4(c)(1)(v)(B).  



74 

Specifically, the rule would require the derivatives risk manager to inform, in a timely manner, 

persons responsible for the fund’s portfolio management—and the fund’s board of directors, as 

appropriate—of material risks arising from the fund’s derivatives transactions.158 The proposed 

rule would not require a fund’s derivatives risk manager to escalate these risks to the fund’s 

board automatically, but would require that the derivatives risk manager directly inform the 

fund’s board of directors regarding these material risks if the manager determines board 

escalation to be appropriate. A fund’s derivatives risk manager, for example, could determine to 

inform the fund’s adviser’s senior officers of material derivatives risks after informing the fund’s 

portfolio management, and before informing the fund’s board. As another example, a fund’s 

derivatives risk manager could determine that it would be appropriate to communicate certain 

material derivatives risks (for example, those that put more than a certain percentage of the 

fund’s assets at imminent risk) to the board at the same time it informs the fund’s portfolio 

management. We believe that a fund’s derivatives risk manager is best positioned to determine 

when to appropriately inform the fund’s portfolio management and board of material risks.  

The proposed rule would require that these material risks include any material risks 

identified by the fund’s guideline exceedances or stress testing. For example, an unexpected risk 

may arise due to a sudden market event, such as a downgrade of a large investment bank that is a 

substantial derivatives counterparty to the fund. This requirement is designed to inform portfolio 

managers of material risks identified by a fund’s derivatives risk management function so that 

portfolio managers can take them into account in managing the fund’s portfolio and address or 

mitigate them as appropriate. It also would facilitate board oversight by empowering the 

derivatives risk manager to escalate a material risk directly to the fund’s board where 
                                                      
158  Id. 



75 

appropriate. Requiring that a fund’s derivatives risk manager have this direct line of 

communication with the board regarding material risks arising from the fund’s derivatives 

transactions is designed to foster an open and effective dialogue among the derivatives risk 

manager and the board. 

We request comment on the internal reporting and escalation elements of the proposed 

program requirement. 

 Are the proposed internal reporting and escalation requirements appropriate? Why or 

why not? Should the rule describe the circumstances under which a fund must inform 

its portfolio management regarding the operation of the program, including any 

exceedances of its guidelines and the results of its stress tests? Why or why not? If so, 

what should the circumstances be and why? Should the rule require a fund to report to 

others at the fund or its adviser (e.g., the fund’s chief compliance officer)? If so, who 

should a fund report to and why?  

 Should we prescribe the types of internal reporting information that persons 

responsible for a fund’s portfolio management or the fund’s board should receive, and 

the means by which these persons receive such information? Why or why not? If so, 

what should we prescribe and why? 

 Are the proposed requirements to escalate material risks to the fund’s portfolio 

management (and, as appropriate, the fund’s board of directors) appropriate? Why or 

why not? Should these material risks include risks identified by the fund’s guideline 

exceedances or stress testing? Why or why not? Should a fund’s derivatives risk 

manager be required to report all material derivatives risks to the fund’s board, as 

well as to its portfolio management? Why or why not? 



76 

 Should the rule, as proposed, permit a fund to determine what risks arising from its 

derivatives transactions are material to the fund, for purposes of the proposed 

escalation requirement? Why or why not? If so, should the rule specifically require a 

fund’s derivatives risk manager to make this determination?  

 Should the rule require the means by which internal reporting and/or material risk 

escalation occur? For example, should the rule specify that certain communications 

must be in writing? Why or why not?  

 Should the rule require a fund’s derivatives risk manager to inform the fund’s 

portfolio management regarding the operation of the program on a regular basis? 

Why or why not? If so, what should the frequency be and why? 

 Should the rule require a fund to report material risks to us? Why or why not? If so, 

what should a fund report and how should it be reported? For example, should a fund 

be required to report material exceedances to its guidelines? Why or why not? Should 

such a report be confidential? 

 Should the rule permit a fund to determine whether the material risk warrants 

informing the fund’s board? Why or why not? If so, which person or persons at the 

fund or its adviser should be responsible for that determination? Should a fund’s 

board always be informed of material risks regarding the fund’s derivatives use? Why 

or why not? If so, under what circumstances and frequency should the board be 

informed, and why? 

 Should we require that a fund’s derivatives risk manager be permitted to 

communicate directly with the fund’s board of directors? If not, how should we 

otherwise address the concern that a board may not receive the derivatives risk 



77 

manager’s independent risk assessments if the derivatives risk manager is not 

empowered to communicate directly with the board?  

f. Periodic Review of the Program 

The proposed rule would require a fund’s derivatives risk manager to review the program 

at least annually to evaluate the program’s effectiveness and to reflect changes in the fund’s 

derivatives risks over time.159 The review would apply to the overall program, including each of 

the specific program elements discussed above. 

The periodic review would also cover the VaR model a fund uses to comply with the 

proposed VaR-based limit on fund leverage risk and related matters. As discussed below, the 

proposed rule would require a fund to comply with a relative or absolute VaR test.160 For the 

relative VaR test, the fund would compare its VaR to a “designated reference index,” as defined 

in the rule and selected by the fund’s derivatives risk manager. The proposed periodic review 

would therefore include the VaR calculation model that the fund used in connection with either 

of the proposed VaR tests (including the fund’s backtesting of the model) and any designated 

reference index that the derivatives risk manager selected, to evaluate whether the calculation 

model and designated reference index remain appropriate.  

We believe that the periodic review of a fund’s program and VaR calculation model is 

necessary to determine whether the fund is appropriately addressing its derivatives risks. A 

fund’s derivatives risk manager, as a result of the review, could determine whether the fund 

should update its program, its VaR calculation model, or any designated reference index. 

                                                      
159  Proposed rule 18f-4(c)(1)(vi). 
160  See proposed rule 18f-4(c)(2); infra section II.D.  



78 

Commenters on the 2015 proposal generally supported a similar proposed requirement that a 

fund review and update its derivatives risk management program at least annually.161 

The proposed rule would not prescribe review procedures or incorporate specific 

developments that a derivatives risk manager must consider as part of its review. We believe a 

derivatives risk manager generally should implement periodic review procedures for evaluating 

regulatory, market-wide, and fund-specific developments affecting the fund’s program so that it 

is well positioned to evaluate the program’s effectiveness.  

We believe that a fund should review its program, VaR calculation model, and designated 

reference index on at least an annual basis, because derivatives and fund leverage risks, and the 

means by which funds evaluate such risks, can change. The proposed rule would require at least 

an annual review so that there would be a recurring dialogue between a fund’s derivatives risk 

manager and its board regarding the implementation of the program and its effectiveness. This 

frequency also mirrors the minimum period in which the fund’s derivatives risk manager would 

be required to provide a written report on the effectiveness of the program to the board.162 A 

fund’s derivatives risk manager could, however, determine that more frequent reviews are 

appropriate based on the fund’s particular derivatives risks, the fund’s policies and procedures 

implementing the program, market conditions, or other facts and circumstances.163  

We request comment on the proposed rule’s periodic review requirement.  

 Should the rule, as proposed, specifically require that a fund’s derivatives risk 

                                                      
161  See, e.g., Vanguard Comment Letter. 
162  See infra section II.C.2. 
163  See also proposed rule 18f-4(c)(2)(iii)(A) (requiring, for a fund that is not in compliance with the 

applicable VaR test within three business days, the derivatives risk manager to report to the 
fund’s board of directors and explain how and by when (i.e., number of business days) the 
derivatives risk manager reasonably expects that the fund will come back into compliance). 



79 

manager periodically review the program’s effectiveness, including the program’s 

VaR calculation model and any designated reference index? Why or why not? 

 Should the rule, as proposed, require this review to take place at least annually, or 

should it require a more frequent review, such as quarterly? Should we, instead, not 

prescribe a minimum frequency for the periodic review? Why or why not? 

 Are there certain review procedures that the proposed rule should require and/or on 

which the Commission should provide guidance? If so, what are they? For example, 

should the periodic review involve board input? Should the Commission provide any 

additional guidance on regulatory, market-wide, and fund-specific developments that 

a fund’s review procedures might cover? Why or why not? If so, how? 

 Should the rule, as proposed, specifically require that other program elements be 

periodically reviewed? Why or why not? If so, which elements and why, and should 

they be reviewed with the same frequency? 

C. Board Oversight and Reporting 

The proposed rule would require: (1) a fund’s board of directors to approve the 

designation of the fund’s derivatives risk manager and (2) the derivatives risk manager to 

provide regular written reports to the board regarding the program’s implementation and 

effectiveness, and describing any exceedances of the fund’s guidelines and the results of the 

fund’s stress testing.164 Requiring a fund’s derivatives risk manager approved by the fund’s 

board and with relevant experience as determined by the fund’s board to be responsible for the 

day-to-day administration of the fund’s program, subject to board oversight, is consistent with 

                                                      
164  Proposed rule 18f-4(c)(5). The board could designate a committee of directors to receive the 

report. 



80 

the way we believe many funds currently manage derivatives risks.165 It is also consistent with a 

board’s duty to oversee other aspects of the management and operations of a fund.  

The proposed rule’s requirements regarding board oversight and reporting are designed to 

further facilitate the board’s oversight of the fund’s derivatives risk management.166 Board 

oversight should not be a passive activity. Consistent with that view, we believe that directors 

should understand the program and the derivatives risks it is designed to manage as well as 

participate in determining who should administer the program. They also should ask questions 

and seek relevant information regarding the adequacy of the program and the effectiveness of its 

implementation. The board should view oversight as an iterative process. Therefore, the board 

should inquire about material risks arising from the fund’s derivatives transactions and follow up 

regarding the steps the fund has taken to address such risks, including as those risks may change 

over time. To facilitate the board’s oversight, the proposed rule, as discussed below, would 

require the fund’s derivatives risk manager to provide reports to the board.  

A fund’s board would also be responsible for overseeing a fund’s compliance with 

proposed rule 18f-4. Rule 38a-1 under the Investment Company Act requires a fund’s board, 

including a majority of its independent directors, to approve policies and procedures reasonably 

designed to prevent violation of the federal securities laws by the fund and its service 

                                                      
165  See, e.g., Comment Letter of the Independent Directors Council (June 22, 2016) (providing views 

regarding the appropriate oversight role of fund directors). 
166  Many commenters to the 2015 proposal expressed the view that the appropriate role of the board 

in the context of funds’ derivatives risk management is one of oversight. See, e.g., Comment 
Letter of Mutual Fund Directors Forum (Mar. 28, 2016) (stating it has long taken the position that 
boards and independent trustees have an important role to play in overseeing the risks associated 
with funds’ use of derivatives, including the manner in which those risks are managed); see also 
Comment Letter of the Independent Directors Council (Mar. 28, 2016) (“IDC Comment Letter”); 
Morningstar Comment Letter.81 

providers.167 Rule 38a-1 provides for oversight of compliance by the fund’s adviser and other 

service providers through which the fund conducts its activities. Rule 38a-1 would encompass a 

fund’s compliance obligations with respect to proposed rule 18f-4. 

1. Board Approval of the Derivatives Risk Manager 

The proposed rule would require a fund’s board to approve the designation of the fund’s 

derivatives risk manager, taking into account the derivatives risk manager’s relevant experience 

regarding the management of derivatives risk.168 This requirement is designed to establish the 

foundation for an effective relationship and line of communication between a fund’s board and 

its derivatives risk manager, and to ensure that the board receives information it needs to approve 

the designation.169 The requirement that the board consider the derivatives risk manager’s 

relevant experience is designed to provide flexibility for a fund’s board to take into account a 

derivatives risk manager’s specific experience, rather than the rule taking a more prescriptive 

approach in identifying a specific amount or type of experience that a derivatives risk manager 

must have. Detailing a derivatives risk manager’s required experience in the rule would not be 

practical, given the numerous ways in which a person could obtain experience with derivatives 

or risk management. Any specification in the rule of the specific experience required to serve as 

a derivatives risk manager likely would be over- or under-inclusive and would not take into 

account the way that any particular fund uses derivatives. We believe that a fund’s board, in its 

oversight role, is best-positioned to consider a prospective derivatives risk manager’s experience 

                                                      
167   See rule 38a-1 under the Investment Company Act; Compliance Programs of Investment 

Companies and Investment Advisers, Investment Company Act Release No. 26299 (Dec. 17, 
2003) [68 FR 74714 (Dec. 24, 2003)] (discussing the adoption and implementation of policies 
and procedures required under rule 38-1) (“Compliance Program Release”). 

168  Proposed rule 18f-4(c)(5)(i).  
169  Cf. rules 22e-4 and 38a-1 under the Investment Company Act. 



82 

based on all the facts and circumstances relevant to the fund in considering whether to approve 

the derivatives risk manager’s designation. 

Commenters on the 2015 proposal generally supported a requirement that the board 

approve a fund’s derivatives risk manager, although some of these commenters objected to the 

proposed requirement that only a single individual could serve in that role. These commenters 

asserted that requiring the board to approve a single individual as the derivatives risk manager 

would have required the board to participate too closely in the management function of the 

fund.170 This re-proposal, in contrast, would permit a fund’s board to approve the designation of 

a single individual or group of individuals, subject to the other proposed requirements about who 

may serve as a derivatives risk manager.  

We request comment on the proposed requirement that a fund’s board approve the 

designation of the fund’s derivatives risk manager.  

 Should we require, as proposed, that a fund’s board approve the designation of the 

fund’s derivatives risk manager? Why or why not? Are there any specific 

requirements we should include with respect to the derivatives risk manager’s 

relationship with the board? For example, should we require the board to meet with 

the derivatives risk manager in executive session? Should we also require the 

derivatives risk manager to be removable only by the fund’s board? Should we 

require the derivatives risk manager’s compensation be approved by the board, like a 

fund’s chief compliance officer? If so, why? Would such a requirement pose undue 

burdens on fund boards or place the board in an inappropriate role? If so, why?  
                                                      
170  See, e.g., Comment Letter of Guggenheim (Mar. 28, 2016) (“Guggenheim Comment Letter”); 

Dechert Comment Letter; IDC Comment Letter; American Beacon Comment Letter; Fidelity 
Comment Letter; IAA Comment Letter; ICI Comment Letter I; Invesco Comment Letter. 



83 

 Should the rule permit a board committee to approve the designation of the 

derivatives risk manager, rather than the full board (and a majority of directors who 

are not interested persons of the fund) as proposed? Why or why not? If so, should 

there be any requirements or guidance with respect to such a board committee (e.g., 

composition or responsibilities)? 

 Should the rule, as proposed, require that a fund’s board in approving the fund’s 

derivatives risk manager, take into account the derivatives risk manager’s relevant 

experience regarding the management of derivatives risk? Why or why not? Would a 

fund’s board, in approving the designation of the fund’s derivatives risk manager, 

only approve individuals with relevant experience even without this express 

requirement? Is the proposed requirement that a fund’s board must take into account 

the derivatives risk manager’s “relevant experience regarding the management of 

derivatives risk” sufficiently clear? Would this raise questions for a fund’s board 

about whether portfolio management experience, or experience outside of formal 

derivatives risk management, would suffice for purposes of the rule? Should the rule, 

instead, require that a fund’s board take into account the derivatives risk manager’s 

“relevant experience”? Or should the rule identify specific qualifications or 

experience of a fund’s derivatives risk manager that the fund’s board must consider? 

Why or why not? If so, what should they be and why? 

 Should we require a fund’s board, or a committee thereof, to approve the derivatives 

risk management program or any material changes to the program? Why or why not? 

If so, should we require that the committee have a majority that are disinterested? 

Would such an approval requirement promote greater board engagement and 



84 

oversight? Do a fund’s derivatives use and related derivatives risks present matters 

for which it would be appropriate to require the fund’s board, or committee thereof, to 

approve the program or any material changes to the program? Why or why not? 

2. Board Reporting 

The proposed rule would require the derivatives risk manager to provide a written report 

on the effectiveness of the program to the board at least annually and also to provide regular 

written reports at a frequency determined by the board. This requirement is designed to facilitate 

the board’s oversight role, including its role under rule 38a-1.171 

Many commenters to the 2015 proposal did not support the proposal’s requirement that 

the board approve material changes to the program. Many commenters did state, however, that a 

fund’s board of directors should be provided with notices of changes to the policies and 

procedures implementing the derivatives risk management program and that the fund’s 

derivatives risk manager should provide the board with a written report describing the adequacy 

of the derivatives risk management program and the effectiveness of its implementation and the 

results of the fund’s stress testing.172 

Reporting on Program Implementation and Effectiveness 

The proposed rule would require a fund’s derivatives risk manager to provide to the 

fund’s board, on or before the implementation of the program and at least annually thereafter, a 

written report providing a representation that the program is reasonably designed to manage the 

fund’s derivatives risks and to incorporate the required elements of the program as well as the 

                                                      
171  See Compliance Program Release, supra note 167, at n.33 and accompanying text. 
172  See, e.g., BlackRock Comment Letter; Vanguard Comment Letter. 



85 

basis for the representation.173 This requirement, as discussed below, is designed to provide a 

fund’s board with information about the effectiveness and implementation of the program so that 

the board may appropriately exercise its oversight responsibilities, including its role under rule 

38a-1.  

To facilitate the board’s oversight, the proposed rule would require the written report to 

include the basis for the derivatives risk manager’s representation along with such information as 

may be reasonably necessary to evaluate the adequacy of the fund’s program and the 

effectiveness of its implementation. In addition, the representation may be based on the 

derivatives risk manager’s reasonable belief after due inquiry. A derivatives risk manager, for 

example, could form its reasonable belief based on an assessment of the program and taking into 

account input from fund personnel, including the fund’s portfolio management, or from third 

parties. We propose to require that the derivatives risk manager include this representation and 

its basis, because we believe the derivatives risk manager—rather than the board—is best 

positioned to make this determination. Requiring the derivatives risk manager to include the 

information in a board report would also reinforce that the fund and its adviser are responsible 

for derivatives risk management while the board’s responsibility is to oversee this activity. 

Reports following the initial implementation of the program must also address the effectiveness 

of the program. This requirement is designed to provide the board with appropriate and useful 

information so it can exercise its judgment in overseeing the program, and in light of its role 

under rule 38a-1.  

The proposed rule would also require the written report to include a fund’s derivatives 

risk manager’s basis for the selection of the designated reference index used under the proposed 
                                                      
173  Proposed rule 18f-4(c)(5)(ii). 



86 

relative VaR test or, if applicable, an explanation of why the derivatives risk manager was unable 

to identify a designated reference index appropriate for the fund such that the fund relied on the 

proposed absolute VaR test instead. The derivatives risk manager’s selection of a particular 

designated reference index, or conclusion that one is not available, can affect the amount of 

leverage risk a fund may obtain under the proposed rule.174 We therefore believe it is important 

that a fund’s board have sufficient information to oversee this activity. 

Regular Board Reporting 

The proposed rule would require a fund’s derivatives risk manager to provide to the 

fund’s board, at a frequency determined by the board, a written report analyzing any exceedances 

of the fund’s risk guidelines and the results of the fund’s stress tests and backtesting.175 

Requiring the derivatives risk manager to provide information about how the fund performed 

relative to these measures and at a board-determined frequency is designed to provide the board 

with timely information to facilitate its oversight of the fund and the operation of the program. 

The program’s guidelines and stress testing requirements are designed to address a fund’s 

particular derivatives risks and are areas the fund should routinely monitor. The program’s 

backtesting requirement is designed to require a fund to monitor the effectiveness of the fund’s 

VaR model, which plays a central role in the proposed VaR-based limit on fund leverage risk. 

Therefore, we believe that a board overseeing a fund’s derivatives risk management should 

receive regular reporting regarding the derivatives risk manager’s analysis of guideline 

exceedances and the results of stress testing and backtesting. We also understand that many fund 
                                                      
174  See infra section II.D.2.b. The proposed rule would not limit a derivatives risk manager from 

receiving input from the fund’s portfolio managers or others regarding the fund’s designated 
reference index.  

175  Proposed rule 18f-4(c)(5)(iii); see also proposed rule 18f-4(c)(1)(ii)–(iv); see also supra sections 
II.B.3.b, II.B.3.c, and II.B.3.d. 



87 

advisers today provide regular reports to fund boards, often in connection with quarterly board 

meetings, regarding a fund’s use of derivatives and their effects on a fund’s portfolio, among 

other information.  

Accordingly, the proposed rule would require that the report include the derivatives risk 

manager’s analysis of any exceedances and stress testing and backtesting results, and to include 

such information as may be reasonably necessary for the board to evaluate the fund’s response to 

any exceedances and the stress testing and backtesting results. This requirement is designed to 

provide the board with information in a format, and with appropriate context, that would 

facilitate the board’s understanding of the information. A simple listing of exceedances and 

stress testing and backtesting results without context, in contrast, would provide less useful 

information for a fund’s board and would not satisfy this proposed requirement. 

Under the proposed regular board reporting requirement, a fund’s board would determine 

the frequency of this written report. Boards should be allowed flexibility in determining the 

frequency of reporting so that they can tailor their oversight to their funds’ particular facts and 

circumstances.  

We request comment on the proposed board reporting requirements.  

 Are the proposed requirements for the fund’s derivatives risk manager to provide 

written reports to the fund’s board on the program’s implementation and effectiveness 

appropriate? Why or why not? Should the board receive a written report on or before 

the implementation of the program? Why or why not? Should we modify the 

proposed rule to require funds to provide boards reports with greater frequency than 

annually? Why or why not?  

 Is the proposed representation that the derivatives risk manager would have to make 



88 

in the report appropriate? Why or why not? What should the representation entail, and 

why? Should we provide guidance as to what the representation should look like? 

Why or why not? Would the representation be helpful for a fund’s board in exercising 

its oversight responsibilities? Why or why not? What effect, if any, would the 

representation have on a fund’s derivatives risk management apart from the board’s 

oversight of such risk management?  

 Would the responsibilities the proposed rule allocates to a fund’s derivatives risk 

manager affect a fund’s ability to hire or retain a derivatives risk manager? If so, 

how? 

 Is the proposed requirement for the written report to include the basis for the 

derivatives risk manager’s representation along with information to evaluate the 

program’s adequacy and effectiveness, appropriate? Why or why not? Should the rule 

require specific information in the written report? Why or why not? If so, what 

information and why? Should the rule, as proposed, permit the representation to be 

based on the derivatives risk manager’s reasonable belief after due inquiry? Why or 

why not? Should we provide more guidance regarding the basis for the 

representation? If so, what should we provide? For example, should we provide 

guidance regarding the types of information on which a fund’s derivatives risk 

manager may base this representation? Why or why not? Is the reference to due 

inquiry appropriate in this context? Is the reference sufficiently clear?  

 Should the rule require the written report to include a fund’s derivatives risk 

manager’s basis for the selection of the designated reference index or, if applicable, 

an explanation of why the derivatives risk manager was unable to identify a 



89 

designated reference index appropriate for the fund? Why or why not? Should the 

rule require the written report to identify and explain any difference between the 

selected index and any indices that are used for performance comparisons in the 

fund’s registration statement and shareholder reports? Why or why not? 

 Should the rule require a fund’s derivatives risk manager to provide a written report 

regarding any exceedances to thresholds provided for in the fund’s guidelines? Why 

or why not? Should the rule require a fund’s derivatives risk manager to provide a 

written report regarding the results of the stress tests and backtests? Why or why not? 

 Should the rule require that a fund’s derivatives risk manager report to the board? 

Why or why not? If not, should the fund determine who should report to the board, 

and why? Should the rule permit the derivatives risk manager to delegate its reporting 

obligations under the rule to other officers or employees of the adviser? Why or why 

not? If so, to whom should they be able to delegate these obligations? 

 Should the rule permit a fund’s board to determine the frequency with which it 

receives the written report? Why or why not? Or should the rule require that the 

derivatives risk manager provide the written report with a certain frequency? Why or 

why not? If so, what frequency should the rule require, and why? Should the rule 

permit a fund’s derivatives risk manager to determine to report to the board sooner 

than the frequency determined by the board if appropriate? Why or why not? 

 Should the rule require that the written report include such information as may be 

reasonably necessary for the board to evaluate a fund’s response to any exceedances 

and the results of the fund’s stress testing? Why or why not? What information may 

be reasonably necessary for the board’s evaluation? Should the rule require certain 



90 

information to be provided in the written report? Why or why not? If so, what 

information should be required to be provided? 

 Should the rule require the report to be written? Why or why not? Should the rule 

require that the derivatives risk manager prepare the written report? Why or why not? 

 Would the approach provided by the proposed rule’s board oversight provisions 

appropriately provide the board the ability to oversee a fund’s derivatives risk 

management? Why or why not? Does the proposed rule provide an appropriate 

balance between the board’s role of general oversight and the fund’s roles of day-to-

day risk management and portfolio management? Why or why not? 

 Should the board be required to approve the program, including initially, and any 

material changes to the program? Why or why not? What is current industry practice 

with respect to the board’s oversight of a fund’s derivatives risk management? 

D. Proposed Limit on Fund Leverage Risk 

The proposed rule would also generally require funds relying on the rule when engaging 

in derivatives transactions to comply with a VaR-based limit on fund leverage risk. This outer 

limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a 

“designated reference index.” If the fund’s derivatives risk manager is unable to identify an 

appropriate designated reference index, the fund would be required to comply with an absolute 

VaR test.176 

                                                      
176  A fund that is a leveraged/inverse investment vehicle, as defined in the proposed sales practices 

rules, would not be required to comply with the proposed VaR-based limit on fund leverage risk. 
Broker-dealers and investment advisers would be required to approve retail investors’ accounts to 
purchase or sell shares in these funds. See infra section II.G (discussing leveraged/inverse 
investment vehicles). The proposed rule also would provide an exception from the proposed VaR 
tests for funds that use derivatives to a limited extent or only to hedge currency risks. See infra 
sections II.E and II.G (discussing the proposed rule’s provisions regarding limited derivatives 

 



91 

1. Use of VaR 

VaR is an estimate of an instrument or portfolio’s potential losses over a given time 

horizon and at a specified confidence level. VaR will not provide, and is not intended to provide, 

an estimate of an instrument or portfolio’s maximum loss amount. For example, if a fund’s VaR 

calculated at a 99% confidence level was $100, this means the fund’s VaR model estimates that, 

99% of the time, the fund would not be expected to lose more than $100. However, 1% of the 

time, the fund would be expected to lose more than $100, and VaR does not estimate the extent 

of this loss. 

We propose to use VaR tests to limit fund leverage risk associated with derivatives 

because VaR generally enables risk to be measured in a reasonably comparable and consistent 

manner across diverse types of instruments that may be included in a fund’s portfolio. One 

benefit of the proposed VaR-based approach is that different funds could, and would be required 

to, tailor their VaR models to incorporate and reflect the risk characteristics of their fund’s 

particular investments.177 VaR is a commonly-known and broadly-used industry metric that 

integrates the market risk associated with different instruments into a single number that 

provides an overall indication of market risk, including the market risk associated with the fund’s 

derivatives transactions.178 We recognize that funds use many other risk analytic metrics suited 

                                                      

users and leveraged/inverse funds covered by the sales practices rules). 
177  See infra section II.D.4 (discussing the choice of model and parameters for the VaR test). 
178  See Kevin Dowd, An Introduction to Market Risk Measurement (Oct. 2002), at 10 (“Dowd”) 

(VaR “provides a common consistent measure of risk across different positions and risk factors. It 
enables us to measure the risk associated with a fixed-income position, say, in a way that is 
comparable to and consistent with a measure of the risk associated with equity positions”); see 
also Jorion, supra note 151, at 159 (stating that VaR “explicitly accounts for leverage and 
portfolio diversification and provides a simple, single measure of risk based on current 
positions”). 



92 

to particular financial instrument categories.179 Given the diverse portfolios of many funds, these 

more category-specific risk metrics may be less suitable for establishing a proposed limit on fund 

leverage risk that is applied more generally. 

We recognize that VaR is not itself a leverage measure. But a VaR test, and especially 

one that compares a fund’s VaR to an unleveraged index that reflects the markets or asset classes 

in which the fund invests, can be used to analyze whether a fund is using derivatives transactions 

to leverage the fund’s portfolio, magnifying its potential for losses and significant payment 

obligations of fund assets to derivatives counterparties. At the same time, VaR tests can also be 

used to analyze whether a fund is using derivatives with effects other than leveraging the fund’s 

portfolio that may be less likely to raise the concerns underlying section 18. For example, fixed-

income funds use a range of derivatives instruments, including credit default swaps, interest rate 

swaps, swaptions, futures, and currency forwards. These funds often use these derivatives in part 

to seek to mitigate the risks associated with a fund’s bond investments or to achieve particular 

risk targets, such as a specified duration. If a fund were using derivatives extensively, but had 

either a low VaR or a VaR that did not substantially exceed the VaR of an appropriate 

benchmark, this would indicate that the fund’s derivatives were not substantially leveraging the 

fund’s portfolio. 

                                                      
179  See Jorion, supra note 151. For example, risk measures for government bonds can include 

duration, convexity and term-structure models; for corporate bonds, ratings and default models; 
for stocks, volatility, correlations and beta; for options, delta, gamma and vega; and for foreign 
exchange, target zones and spreads. Certain funds are required to report on Form N-PORT some 
of these metrics, such as portfolio-level duration (DV01 and SDV01) and position-level delta. See 
Investment Company Reporting Modernization, Investment Company Act Release No. 32314 
(Oct. 13, 2016) [81 FR 81870 (Nov. 18, 2016)] (“Investment Company Reporting Modernization 
Adopting Release”). 



93 

We also understand that VaR calculation tools are widely available, and many advisers 

that enter into derivatives transactions already use risk management or portfolio management 

platforms that include VaR capability.180 Advisers to the funds that use derivatives transactions 

more extensively may be particularly likely to already use risk management or portfolio 

management platforms that include VaR capability, as compared to advisers to the funds that are 

within the scope of the proposed provision for limited derivatives users and that would not be 

subject to the proposed VaR tests.181 

While we believe there are significant benefits to using the proposed VaR-based limit on 

fund leverage risk, we recognize risk literature critiques of VaR (especially since the 2007-2009 

financial crisis). One common critique of VaR is that it does not reflect the size of losses that 

may occur on the trading days during which the greatest losses occur—sometimes referred to as 

“tail risks.”182 A related critique is that VaR calculations may underestimate the risk of loss 

                                                      
180  See, e.g., ICI Comment Letter III (“73 percent of respondents [to an Investment Company 

Institute survey of its member firms] use both some form of VaR and stress testing as derivatives 
risk management tools.)”; Comment Letter of OppenheimerFunds (Mar. 28, 2016) 
(“Oppenheimer Comment Letter”); Federated Comment Letter; Franklin Resources Comment 
Letter; see also Christopher L. Culp, Merton H. Miller & Andres M. P. Neves, Value at Risk: 
Uses and Abuses, 10 Journal of Applied Corporate Finance 26 (Jan. 1998) (VaR is “used 
regularly by nonfinancial corporations, pension plans and mutual funds, clearing organizations, 
brokers and futures commission merchants, and insurers.”). Moreover, the proposed relative VaR 
test is similar to a relative VaR approach that applies to UCITS under European guidelines. See 
infra section II.D.6.c (discussing the UCITS approach). 

181  See, e.g., ICI Comment Letter III. 
182  See Chris Downing, Ananth Madhavan, Alex Ulitsky & Ajit Singh, Portfolio Construction and 

Tail Risk, 42 The Journal of Portfolio Management 1, 85-102 (Fall 2015), available at 
https://jpm.iijournals.com/content/42/1/85 (“for especially fat-tailed return distributions the VaR 
threshold value might appear to be low, but the actual amount of value at risk is high because 
VaR does not measure the mass of distribution beyond the threshold value”). 

With respect to VaR, the “tail” refers to the observations in a probability distribution curve that 
are outside the specified confidence level. “Tail risk” describes the concern that losses outside the 
confidence level may be extreme. 

https://www.sec.gov/comments/s7-24-15/s72415-89.pdf
https://www.sec.gov/comments/s7-24-15/s72415-89.pdf
https://jpm.iijournals.com/content/42/1/85


94 

under stressed market conditions.183 These critiques often arise in the context of discussing risk 

managers’ use of additional risk tools to address VaR’s shortcomings. Our proposed VaR tests 

are designed to provide a metric that can help assess the extent to which a fund’s derivatives 

transactions raise concerns underlying section 18, but we do not believe they should be the sole 

component of a derivatives risk management program.184 We do not intend to encourage risk 

managers to over-rely on VaR as a stand-alone risk management tool.185 Instead, as discussed 

above, the proposed rule would require a fund to establish risk guidelines and to stress test its 

portfolio as part of its risk management program in part because of concerns that VaR as a risk 

management tool may not adequately reflect tail risks.186 We also recognize that a fund’s use of 

derivatives transactions may pose other risks (such as counterparty risk and liquidity risk) that 

VaR does not capture. A fund that adopts a derivatives risk management program under the 

proposed rule would have to consider these risks as part of its derivatives risk management 

program.187  

                                                      
183  See Jorion, supra note 151, at 357 (VaR “quantif[ies] potential losses under ‘normal’ market 

conditions, where normal is defined by the confidence level, typically 99 percent. . . . In practice, 
[VaR] measures based on recent historical data can fail to identify extreme unusual situations that 
could cause severe losses.”). 

184  See supra section II.B.3. 
185  See, e.g., James O’Brien & Pawel J. Szerszen, An Evaluation of Bank VaR Measures for Market 

Risk During and Before the Financial Crisis, Federal Reserve Board Staff Working Paper 2014-
21 (Mar. 7, 2014), available at  
https://www.federalreserve.gov/pubs/feds/2014/201421/201421pap.pdf (“Criticism of banks’ 
VaR measures became vociferous during the financial crisis as the banks’ risk measures appeared 
to give little forewarning of the loss potential and the high frequency and level of realized losses 
during the crisis period.”); see also Pablo Triana, VaR: The Number That Killed Us, Futures 
Magazine (Dec. 1, 2010), available at http://www.futuresmag.com/2010/11/30/var-number-
killed-us (stating that “in mid-2007, the VaR of the big Wall Street firms was relatively quite low, 
reflecting the fact that the immediate past had been dominated by uninterrupted good times and 
negligible volatility”).  

186  See supra section II.B.3.b. 
187  See supra section II.B.3.a. 

https://www.federalreserve.gov/pubs/feds/2014/201421/201421pap.pdf
http://www.futuresmag.com/2010/11/30/var-number-killed-us
http://www.futuresmag.com/2010/11/30/var-number-killed-us


95 

We also considered proposing tests based on stressed VaR, expected shortfall, or both. 

Stressed VaR refers to a VaR model that is calibrated to a period of market stress. A stressed 

VaR approach would address some of the VaR test critiques related to tail risk and 

underestimating expected losses during stressed conditions. Calibrating VaR to a period of 

market stress, however, can pose quantitative challenges by requiring funds to identify a stress 

period with a full set of risk factors for which historical data is available. Expected shortfall 

analysis is similar to VaR, but accounts for tail risk by taking the average of the potential losses 

beyond the specified confidence level. For example, if a fund’s VaR at a 99% confidence level is 

$100, the fund’s expected shortfall would be the average of the potential losses in the 1% “tail.” 

Because there are fewer observations in the tail, however, there is an inherent difficulty in 

estimating the expected value of larger losses. Expected shortfall analysis also could involve 

potentially greater sensitivity to extreme outlier losses because it is based on an average of a 

smaller number of observations that are in the tail. Taking these considerations into account, we 

are proposing tests based on VaR, which is commonly used and does not present all of the 

quantitative challenges associated with stressed VaR and expected shortfall, complemented by 

elements in the proposed risk management program designed to address VaR’s limitations. 

We request comment on the proposed definition of VaR, the proposed use of VaR as a 

means to limit funds’ leverage risk, as well as alternative VaR-based methodologies (stressed 

VaR and expected shortfall). We also request comment and discuss alternatives to VaR and 

VaR-based methodologies in section II.D.6 below.  

 Is the proposed definition of the term “VaR” appropriate? Why or why not? If not, 

how should we define it? 

 Is a VaR-based test an appropriate way to limit funds’ leverage risk? Why or why 



96 

not? Do commenters agree with our observations regarding VaR’s characteristics and 

its critiques? Do commenters believe that the proposed derivatives risk management 

program requirement would help to address VaR’s limitations? Please explain. 

 Should we change the rule to require stressed VaR, either as part of the program’s 

stress testing requirement or as part of the limit on fund leverage risk? If so, how 

should we implement a stressed VaR requirement? Should the rule provide, for 

example, that the historical data used to calculate VaR must include a period of 

market stress? What VaR model requirements should we include if the rule required 

stressed VaR? Please describe in detail. Are there any other corresponding changes 

we should make to the proposed VaR model requirements or proposed VaR tests if 

we used stressed VaR? Why or why not? 

 Should we change the rule to require expected shortfall or stressed expected shortfall, 

either as part of the program’s stress testing requirement or as part of the limit on 

fund leverage risk? If so, how should we implement this element? What VaR model 

requirements should we include if the rule required expected shortfall or stressed 

expected shortfall? Please describe in detail. Are there any other corresponding 

changes we should make to the proposed VaR model requirements or proposed VaR 

tests if we were to require expected shortfall or stressed expected shortfall? Why or 

why not? 

 Are there risk metrics or measurements other than VaR that similarly can be applied 

to a wide breadth of fund strategy types and investments and used to limit fund 

leverage risk? Please explain. 

 Should we use VaR as the only methodology to establish an outside limit on funds’ 



97 

leverage risk in rule 18f-4? We discuss below additional alternatives to VaR for this 

purpose. Should we include in rule 18f-4 some combination of the proposed VaR 

tests and the alternatives discussed in that section, and provide flexibility to funds to 

comply with the approach that they believe is most appropriate based on their 

strategies and investments? If so, which approaches should we include in the rule and 

why? 

2. Relative VaR Test 

The proposed relative VaR test would require a fund to calculate the VaR of the fund’s 

portfolio and compare it to the VaR of a “designated reference index.” As discussed in more 

detail below, a fund’s designated reference index must be unleveraged and reflect the markets or 

asset classes in which the fund invests, among other requirements. This index is designed to 

create a baseline VaR that approximates the VaR of a fund’s unleveraged portfolio. To the extent 

a fund entered into derivatives to leverage its portfolio, the relative VaR test is designed to 

identify this leveraging effect. If a fund is using derivatives and its VaR exceeds that of the 

designated reference index, this difference may be attributable to leverage risk. 

A fund would be required to comply with the relative VaR test unless a designated 

reference index is unavailable. We propose a relative VaR test as the default means of limiting 

fund leverage risk because it resembles the way that section 18 limits a fund’s leverage risk. 

Section 18 limits the extent to which a fund can potentially increase its market exposure through 

leveraging by issuing senior securities, but it does not directly limit a fund’s level of risk or 

volatility. For example, a fund that invests in less-volatile securities and leverages itself to the 

maximum extent may not be as volatile as a completely unleveraged fund that invests in more-

volatile securities. The proposed relative VaR test likewise is designed to limit the extent to 

which a fund increases its market risk by leveraging its portfolio through derivatives, while not 



98 

restricting a fund’s ability to use derivatives for other purposes. For example, if a derivatives 

transaction reduces (or does not substantially increase) a fund’s VaR relative to the VaR of the 

designated reference index, the transaction would not be restricted by the relative VaR test.  

In addition, allowing funds to rely on the proposed absolute VaR test may be inconsistent 

with investors’ expectations where a designated reference index is available. For example, a fund 

that invests in short-term fixed income securities would have a relatively low level of volatility. 

The fund’s investors could reasonably expect that the fund might exhibit a degree of volatility 

that is broadly consistent with the volatility of the markets or asset classes in which the fund 

invests, as represented by the fund’s designated reference index. This fund’s designated 

reference index would be composed of short-term fixed income securities, and could, for 

example, have a VaR of 4%. If the fund were permitted to rely on the absolute VaR test, 

however, the fund could substantially leverage its portfolio almost four times its designated 

reference index’s VaR to achieve a level of volatility that substantially exceeds the volatility 

associated with fixed-income securities.  

a. Designated Reference Index 

A fund would satisfy the proposed relative VaR test if the VaR of its entire portfolio does 

not exceed 150% of the VaR of its designated reference index.188 The proposed rule would 

define a “designated reference index” as an unleveraged index that is selected by the derivatives 

risk manager, and that reflects the markets or asset classes in which the fund invests.189 The 

proposed definition also would require that the designated reference index not be administered 

by an organization that is an affiliated person of the fund, its investment adviser, or principal 
                                                      
188  See proposed rule 18f-4(a) (defining the term “relative VaR test”); proposed rule 18f-4(c)(2)(i); 

infra section II.D.2.b (discussing the 150% limit under the relative VaR test). 
189  See proposed rule 18f-4(a) (defining the term “designated reference index”). 



99 

underwriter, or created at the request of the fund or its investment adviser, unless the index is 

widely recognized and used.190 Additionally, the designated reference index must either be an 

“appropriate broad-based securities market index” or an “additional index” as defined in Item 27 

of Form N-1A.191 A fund would have to disclose its designated reference index in the annual 

report, together with a presentation of the fund’s performance relative to the designated reference 

index.192  

The requirement that the designated reference index reflect the markets or asset classes in 

which the fund invests is designed to provide an appropriate baseline for the relative VaR test. 

Because of this requirement, differences between the fund’s VaR and the VaR of the designated 

reference index are more likely to represent leverage than other factors, like differences between 

the securities in the fund’s portfolio and those in the index, as compared to a relative VaR test 

that compares the fund’s VaR to an index that does not reflect the markets or asset classes in 

which the fund invests.193 Take, for example, a fund that invests primarily in S&P 500 index 

options and uses that index as its designated reference index. Differences between the fund’s 

                                                      
190  Furthermore, for a blended index, none of the indexes that compose the blended index may be 

administered by an organization that is an affiliated person of the fund, its investment adviser, or 
principal underwriter, or created at the request of the fund or its investment adviser, unless the 
index is widely recognized and used. See id.  

191  See proposed rule 18f-4(a) (defining the term “designated reference index”); see also Instructions 
5 and 6 to Item 27(b)(7)(ii) of Form N-1A (discussing the terms “appropriate broad-based 
securities market index” and “additional index”). 

192  See proposed rule 18f-4(c)(2)(iv). 
193  To the extent a fund discloses in its annual report an “appropriate broad-based securities market 

index” that does not reflect the markets or asset classes in which the fund invests, such a fund 
may satisfy the performance disclosure requirements of Form N-1A, but it would not satisfy the 
proposed designated reference index requirement. For example, a fund that pursues its strategy 
primarily through commodity futures contracts could select the S&P 500 to satisfy its 
performance disclosure requirement under Form N-1A, but such an index would not satisfy the 
proposed designated reference index requirement because a commodity fund would not invest in 
stocks included in the S&P 500 or large cap stocks generally. 



100 

VaR and the VaR of the S&P 500 would be more likely attributable to the leverage risk 

associated with the options than, for example, if the fund were permitted to use an index that did 

not reflect the markets or assets classes in which the fund invests, such as an index of small 

capitalization stocks in this example. The derivatives risk manager could select a designated 

reference index that is a blended index under the proposed rule (assuming that the blended index 

meets the proposed requirements for a designated reference index), which would give some 

flexibility in identifying or constructing a designated reference index that provides an appropriate 

baseline for the relative VaR test.194 For example, the derivatives risk manager of a balanced 

fund may determine that a blended index of an unleveraged equity index and an unleveraged 

fixed income index would be an appropriate designated reference index.  

The requirement that the designated reference index be an unleveraged index also is 

designed to provide an appropriate baseline against which to measure a fund’s portfolio VaR for 

purposes of assessing the fund’s leverage risk. Conducting a VaR test on a designated reference 

index that itself is leveraged would distort the leverage-limiting purpose of the VaR comparison 

by inflating the volatility of the index that serves as the reference portfolio for the relative VaR 

test. For example, an equity fund might select as its designated reference index an index that 

tracks a basket of large-cap U.S. listed equity securities such as the S&P 500. But the fund could 

not select an index that is leveraged, such as an index that tracks 200% of the performance of the 

                                                      
194  If the derivatives risk manager selects a designated reference index that is a blended index, the 

designated reference index would have to be disclosed as an “additional index” (as opposed to an 
“appropriate broad-based securities market index”) as defined in the instruction to Item 27 in 
Form N-1A. Form N-1A defines the term “appropriate broad-based securities market index” to 
mean an index “that is administered by an organization that is not an affiliated person of the 
[f]und, its investment adviser, or principal underwriter, unless the index is widely recognized and 
used.” See Instruction 5 to Item 27(b)(7)(ii) of Form N-1A. A blended index that is administered 
by the fund’s investment adviser, for example, would therefore not qualify as an “appropriate 
broad-based securities market index.”101 

S&P 500. A relative VaR test based on this index would effectively permit additional leveraging 

inconsistent with the Investment Company Act.195 

Our proposal would prohibit the designated reference index from being an index 

administered by an organization that is an affiliated person of the fund, its investment adviser, or 

its principal underwriter, or created at the request of the fund or its investment adviser. This 

proposed prohibition would not, however, extend to indexes that are “widely recognized and 

used.”196 We believe that the indexes permissible under the proposed rule would be less likely to 

be designed with the intent of permitting a fund to incur additional leverage-related risk. 

The proposed rule would require that a fund publicly disclose to its investors in its annual 

reports the designated reference index. An open-end fund would have to disclose its designated 

reference index in the fund’s annual report as the fund’s “appropriate broad-based securities 

market index” or an “additional index” that Form N-1A describes in the context of the annual 

report performance presentation requirements.197 Form N-2, on the other hand, does not require 

closed-end funds to disclose a benchmark index for comparing a fund’s performance. 
                                                      
195  See supra section I.B.1. But see infra section II.G (discussing leveraged/inverse funds covered by 

the proposed sales practices rules). 
196  See proposed rule 18f-4(a) (defining the term “designated reference index”). This “widely 

recognized and used” standard has historically been used to permit a fund to employ affiliated-
administered indexes for disclosure purposes, when the use of such indexes otherwise would not 
be permitted. See supra note 194. 

197  See proposed rule 18f-4(c)(2)(iv); Item 27(b)(7)(ii) of Form N-1A. 

See also Instructions to Items 4 and 27(b)(7)(ii) of Form N-1A. Form N-1A provides that “New 
Funds,” as defined in the form, are not required to disclose an appropriate broad-based securities 
market index and the fund’s performance in the annual report because of the fund’s limited 
operating history. See Instruction 6 to Item 3 of Form N-1A (defining a “New Fund” to mean a 
“Fund that does not include in Form N-1A financial statements reporting operating results or that 
includes financial statements for the Fund’s initial fiscal year reporting operating results for a 
period of 6 months or less”). For the same reason, the proposed rule would provide that a fund 
would not be required to disclose its designated reference index in the fund’s annual report if the 
fund is a “New Fund,” or would meet that definition if it were filing on Form N-1A, at the time 
the fund files its annual report. See proposed rule 18f-4(c)(2)(iv). 



102 

Nevertheless, some closed-end funds choose to disclose a benchmark index in their annual 

reports to shareholders. Under the proposed rule, a closed-end fund seeking to satisfy the relative 

VaR test would have to disclose the fund’s designated reference index in its annual report 

together with a presentation of the fund’s performance.198 In proposing this approach, we 

considered the role of investor expectations in selecting funds that correspond to investors’ 

desired level of investment risk.199 We believe that investors could reasonably expect that their 

fund might exhibit a degree of volatility that is broadly consistent with the volatility of the 

markets or asset classes in which the fund invests, as represented by the fund’s designated 

reference index. Requiring a fund to select a designated reference index that it publicly discloses 

would promote the fund’s selection of an appropriate index that reflects the fund’s portfolio risks 

and its investor expectations. 

Some registered closed-end funds currently elect to provide a Management’s Discussion 

of Fund Performance (“MDFP”) in their annual reports.200 These registered closed-end funds 

could disclose their performance relative to the performance of the designated reference index in 

the fund’s MDFP. BDCs that are publicly traded must disclose, in their annual reports filed on 

Form 10-K, a line graph comparing the yearly percentage change in fund share price with the 

                                                      
198  See proposed rule 18f-4(c)(2)(iv). 
199  To the extent a fund’s use of derivatives transactions is part of its principal investment strategy or 

is a principal risk, it is required to be disclosed as such in the fund’s prospectus. See Item 4 of 
Form N-1A; Item 8 of Form N-2. 

200  The Commission recently proposed to amend Form N-2 to require registered closed-end funds to 
include MDFP disclosure in their annual reports. See Securities Offering Reform for Closed-End 
Investment Companies, Investment Company Act Release No. 33427 (Mar. 20, 2019) [84 FR 
14448 (Apr. 10, 2019)], at 14471-72 (“Securities Offering Reform Proposing Release”). 



103 

return of a broad equity market index.201 A publicly-traded BDC could choose to include its 

designated reference index in this line graph disclosure. 

We recognize the concern that funds could have the incentive to select an inappropriate 

designated reference index composed of more volatile securities to allow the fund to obtain more 

leverage risk under the relative VaR test. The proposed rule includes three provisions designed to 

address this concern. In addition to requiring that the designated reference index reflect the 

markets or asset classes in which the fund invests, and that the index not be administered by 

certain affiliated persons or created at the request of the fund or its investment adviser, as 

described above, the proposed rule would require: (1) the derivatives risk manager to select the 

designated reference index and to periodically review it; (2) the fund to disclose the designated 

reference index, relative to its performance, in its annual report, creating the disincentive for a 

fund to present performance that may be significantly lower than, or not related to, the disclosed 

index; and (3) the board of directors to receive a written report providing the derivatives risk 

manager’s basis for selecting the designated reference index.202 These requirements, collectively, 

are designed to require funds to use designated reference indexes that provide an appropriate 

baseline for the relative VaR test and to prohibit funds from, instead, selecting indexes solely for 

the purpose of maximizing the fund’s permissible leverage risk under the proposed rule.  

We recognize that some (but not all) popular benchmark indexes charge funds a licensing 

fee for their inclusion in fund prospectuses and annual reports. Funds could incur licensing fees 

if their derivatives risk managers select a designated reference index whose provider charges 

                                                      
201  17 CFR 229.201(e)(1)(i). 
202  See proposed rule 18f-4(a), (c)(1)(vi), (c)(2)(iii), (c)(5)(ii)-(iii); see also supra sections II.B.3.f, 

II.C.2. 



104 

such a fee and the fund is not already using the index. We are nevertheless proposing this 

disclosure requirement because the relative VaR test’s ability to limit a fund’s leverage risk is 

directly tied to the appropriateness of its designated reference index. This disclosure requirement 

is designed to address concerns about inappropriate indexes, as discussed above, by creating the 

disincentive for a fund to select an inappropriate index because the fund would have to disclose 

its performance against that index in its annual report and likely would not want to present 

performance that is significantly lower than, or not related to, the disclosed index.203 At the same 

time, the proposed rule provides funds flexibility to use any index that meets the proposed 

requirements. The proposed rule would provide this flexibility in light of the conditions 

discussed above designed to require that a fund use a designated reference index that is 

appropriate for the relative VaR test. 

The 2015 Proposing Release also included a risk-based portfolio limit based on VaR.204 

The 2015 proposal provided that a fund would satisfy its risk-based portfolio limit condition if a 

fund’s full portfolio VaR was less than the fund’s “securities VaR” (i.e., the VaR of the fund’s 

portfolio of securities and other investments, but excluding any derivatives transactions).205 Our 

proposal, however, differs from the 2015 proposal in that the proposed relative VaR test 

compares the fund’s VaR to the VaR of the fund’s designated reference index, rather than the 

fund’s “securities VaR.” This is because some funds that use derivatives extensively hold 

primarily cash, cash equivalents, and derivatives. These funds’ “securities VaRs” would be based 

primarily on the fund’s cash and cash equivalents. As some commenters on the 2015 proposal 

                                                      
203  See supra note 202 and accompanying paragraph. 
204  See 2015 Proposing Release, supra note 2, at section III.B.2. 
205  Under that proposal, a fund that satisfied this VaR test was also required to limit its aggregate 

exposure—including derivatives exposure—to 300% of the fund’s net assets. See id. 



105 

noted, this would not provide an appropriate comparison for a relative VaR test because the VaR 

of the cash and cash equivalents would be very low and would not provide a reference level of 

risk associated with the fund’s strategy.206 

We request comment on the proposed requirements regarding the selection and disclosure 

of a designated reference index for purposes of compliance with the proposed relative VaR test. 

 Is the proposed definition of the term “designated reference index” appropriate? Why 

or why not? Should the Commission provide additional guidance, or requirements in 

the proposed rule, addressing when an index reflects the markets or asset classes in 

which a fund invests? Are there particular types of indexes that would not be 

appropriate as a designated reference index? Why or why not? If so, what types of 

indexes and why would they be inappropriate for this purpose? 

 Should the rule require that the designated reference index be an unleveraged index? 

Should the rule specify with greater particularity what constitutes an unleveraged 

index? Please explain. Alternatively, should the Commission provide guidance on 

when an index will be “leveraged”? 

 Are there other considerations that would present challenges for funds in light of the 

proposed requirement to select a designated reference index for purposes of the 

proposed relative VaR test requirement? If so, what? 

 To what extent do funds expect that the requirement to disclose the designated 

reference index would result in additional licensing fees? Please explain. What 

consequences would such charges create? 

 Should we change the proposed definition of the term “designated reference index” to 
                                                      
206  See, e.g., AlphaSimplex Comment Letter; AQR Comment Letter; ICI Comment Letter I. 



106 

no longer track in part the definition of an “appropriate broad-based securities market 

index” in Form N-1A (Instruction 5 of Item 27(b)(7)) and allow a derivatives risk 

manager to select an index administered by an affiliated person of the fund, its 

investment adviser, or principal underwriter? Should we change the proposed 

definition to allow a derivatives risk manager to select an index created at the request 

of the fund or its investment adviser? Is it appropriate to exclude such indexes from 

the definition of “designated reference index,” and is it appropriate that widely 

recognized and used indexes be carved out from this exclusion, as proposed? Would 

the proposed exclusion help ensure the selection of indexes that are appropriately 

designed to create a baseline VaR that approximates the VaR of a fund’s unleveraged 

portfolio? Please explain. Would allowing funds to use indexes that would fall within 

the proposed exclusion raise concerns that the indexes would not be appropriate, or—

if the Commission were to permit the use of such indexes—would the rule’s other 

proposed conditions designed to address this concern work equally well for all 

indexes? If the Commission were to permit the use of indexes that would fall within 

the proposed exclusion, would any additional limits on the use of these indexes be 

appropriate? If so, what limits and why? 

 If we were to further limit or restrict the types of indexes that a fund could select as 

its designated reference index under the proposed rule, what additional limits would 

be appropriate? Should we, for example, provide that a fund’s designated reference 

index must meet the definition of an “appropriate broad-based securities market 

index” as defined in Form N-1A? Should we require that the index be widely 

recognized and used?  



107 

 Similar to UCITS guidelines, should the proposed definition specifically require that 

the risk profile of the designated reference index be consistent with the fund’s 

investment objectives and policies, as well as investment limits?207 Why or why not? 

 Should the rule require funds to disclose their designated reference indexes in their 

annual reports to shareholders, as proposed? Should such disclosure also appear in the 

fund’s prospectus? What reasons, if any, should the designated reference index not be 

an index a fund includes as part of its performance disclosure? Please explain. Should 

a fund be required to specify that the index it includes in its performance disclosure is 

the fund’s designated reference index, which has been selected for purposes of the 

fund’s compliance with rule 18f-4? If so, what other information or explanations 

should a fund also have to include (if any), in order to best promote investor 

understanding of how the fund’s designated reference index affects the fund’s ability 

to use leverage, and how this in turn affects the risks associated with an investment in 

the fund? For example, should a fund also be required to disclose the index’s 

historical (e.g., 1-year) average VaR? What accompanying narrative disclosure would 

help investors best understand the significance of this information? Would this 

disclosure be useful to supplement the VaR information that a fund would be required 

to disclose on Form N-PORT under the proposal? 

 Should the rule permit a fund to compare its portfolio VaR to its “securities VaR” for 

purposes of the rule’s relative VaR test, as provided for in the 2015 proposed rule, in 

addition to its designated reference index?208 Why or why not? If the relative VaR 

                                                      
207  See infra section II.D.6.c (discussing the UCITS framework). 
208  See supra note 205 and accompanying text. 



108 

test permitted a fund to compare its porfolio’s VaR against its designated reference 

index or its “securities VaR,” would funds prefer to use their “securities VaRs”? If so, 

why? In what circumstances or what fund strategies would “securities VaR” be a 

more or equally appropriate baseline for funds calculating their relative VaR? What 

benefits or drawbacks are there with respect to this approach? Please explain.  

 For a registered closed-end fund, is the proposed requirement that it must disclose its 

designated reference index in its annual report together with a presentation of the 

fund’s performance appropriate? Why or why not? What challenges, if any, would the 

proposed disclosure requirement have for closed-end funds that do not currently 

disclose their performance relative to a benchmark index in their annual reports? 

Please explain. 

 For a registered closed-end fund, should we prescribe in rule 18f-4 or Form N-2 

where in the fund’s annual report it must disclose its designated reference index? 

Why or why not?  

 What challenges, if any, would a BDC have in disclosing its designated reference 

index together with its performance in the BDC’s annual report? Please explain. 

 Should we also amend Forms N-1A and/or N-2 to require a fund relying on rule 18f-4 

and subject to the relative VaR test to disclose its performance relative to the 

performance of its designated reference index? Would it be helpful to have this 

requirement both in rule 18f-4 and in the registration forms?  

 What changes should we make to the rule in light of the concern that a fund could 

have an incentive to select an inappropriate designated reference index to obtain more 

leverage risk? Is the proposed requirement that the derivatives risk manager select the 



109 

designated reference index useful for this purpose? Is the proposed requirement that 

the designated reference index be an appropriate broad-based securities index or an 

additional index effective for this purpose? Is the proposed requirement that the fund 

disclose the designated reference index relative to its performance in the annual report 

useful for this purpose? Is the proposed requirement that the board of directors 

receive a written report from the derivatives risk manager about the basis for the 

designated reference index subject to periodic review useful for this purpose? Please 

explain. 

b. 150% Limit Under Proposed Relative VaR Test 

We are proposing that a fund’s VaR must not exceed 150% of the VaR of the fund’s 

designated reference index.209 In proposing a 150% limit, we first considered the extent to which 

a fund could borrow in compliance with the requirements of section 18. For example, a mutual 

fund with $100 in assets and no liabilities or senior securities outstanding could borrow an 

additional $50 from a bank. With the additional $50 in bank borrowings, the mutual fund could 

invest $150 in securities based on $100 of net assets. This fund’s VaR would be approximately 

150% of the VaR of the fund’s designated reference index. The proposed 150% limit would 

therefore effectively limit a fund’s leverage risk related to derivatives transactions similar to the 

way that section 18 limits a registered open- or closed-end fund’s ability to borrow from a bank 

(or issue other senior securities representing indebtedness for registered closed-end funds) 

subject to section 18’s 300% asset coverage requirement. We recognize that while a fund could 

achieve certain levels of market exposure through borrowings permitted under section 18, it may 

be more efficient to obtain those exposures through derivatives transactions. Allowing a fund to 
                                                      
209  See proposed rule 18f-4(a) (defining the term “relative VaR test”). 



110 

have a VaR that is 150% of its designated reference index, rather than a higher or lower relative 

VaR, is designed to provide what we believe is an appropriate degree of flexibility for funds to 

use derivatives.  

We considered proposing different relative VaR tests for different types of investment 

companies, tied to the asset coverage requirements applicable to registered open-end funds, 

registered closed-end funds, and BDCs.210 Registered closed-end funds, like open-end funds, are 

only permitted to issue senior securities representing indebtedness under section 18 subject to a 

300% asset coverage requirement, although closed-end funds’ indebtedness is not limited to 

bank borrowings.211 Using the example above, a registered closed-end fund with $100 in assets 

likewise could only borrow $50. Although registered closed-end funds also are permitted to issue 

senior securities that are stocks,212 proposed rule 18f-4 is focused on the indebtedness leverage 

that derivatives transactions create. We do not believe that a registered closed-end fund’s ability 

to issue preferred stock, for example, suggests that registered closed-end funds should be 

permitted to obtain additional indebtedness leverage through derivatives transactions. 

The Investment Company Act also provides greater flexibility for BDCs to issue senior 

securities. BDCs, however, generally do not use derivatives or do so only to a limited extent. To 

help evaluate the extent to which BDCs use derivatives, our staff sampled 48 of the current 99 

BDCs by reviewing their most recent financial statements filed with the Commission. The staff’s 

sample included both BDCs with shares listed on an exchange and BDCs whose shares are not 

listed. The sampled BDCs’ net assets ranged from $32 million to $7.4 billion. Of the 48 sampled, 

                                                      
210  See supra notes 29-32 and accompanying paragraph (discussing asset coverage requirements for 

different investment company types). 
211  See supra note 30 and accompanying text. 
212  See supra note 31 and accompanying text. 



111 

54% did not report any derivatives holdings, and a further 29% reported using derivatives with 

gross notional amounts below 10% of net assets. A few BDCs used derivatives more extensively, 

when measured on a gross notional basis, mainly due to interest rate swaps—which likely would 

have lower adjusted notional amounts if they were converted to ten-year bond equivalents, as the 

proposed rule would permit.213 Finally, two of the sampled BDCs used total return swaps to gain 

a substantial portion of their exposure. We therefore believe that most BDCs either would not 

use derivatives or would rely on the exception for limited derivatives users.214 

In addition, the greater flexibility for BDCs to issue senior securities allows them to 

provide additional equity or debt financing to the “eligible portfolio companies” in which BDCs 

are required to invest at least 70% of their total assets. Derivatives transactions, in contrast, 

generally will not have similar capital formation benefits for portfolio companies unless the 

fund’s counterparty makes an investment in the underlying reference assets equal to the notional 

amount of the derivatives transaction. Allowing BDCs to leverage their portfolios with 

derivatives to a greater extent than other funds therefore would not appear to further the capital 

formation benefits that underlie BDCs’ ability to obtain additional leverage under the Investment 

Company Act. We also understand that, even when BDCs do use derivatives more extensively, 

derivatives generally do not play as significant of a role in implementing the BDC’s strategy, as 

compared to many other types of funds that use derivatives extensively. BDCs are required under 

the Investment Company Act to invest at least 70% of their total assets in “eligible portfolio 

companies,” which may limit the role that derivatives can play in a BDC’s portfolio relative to 
                                                      
213  Our staff did not have access to sufficient information to adjust the notional amounts of the 

BDCs’ interest rate derivatives or options. Some of the 17% of the sampled BDCs with gross 
notional amounts exceeding 10% of net assets likely would have lower notional amounts after 
applying these adjustments.  

214  See infra section II.E (discussing the proposed exception for limited derivatives users). 



112 

other kinds of funds that would generally execute their strategies primarily through derivatives 

transactions (e.g., a managed futures fund). For these reasons, and to provide a consistent 

framework regarding funds’ use of derivatives, we believe that it is appropriate to set a single 

limit on fund leverage risk under the proposed rule for derivatives transactions. The proposed 

rule would not restrict a fund from issuing senior securities subject to the limits in section 18 to 

the full extent permitted by the Investment Company Act.215  

We request comment on the following aspects of the proposed relative VaR test. 

 Is the proposed relative VaR test requirement appropriate? Why or why not? As 

proposed, should funds be required to comply with a relative VaR test, rather than an 

absolute VaR test, except where a designated reference index is unavailable? 

 Should the limit in the proposed relative VaR test be lower or higher than 150% of 

the VaR of the designated reference index, and if so why? For example, the relative 

VaR test applicable to UCITS funds allows a UCITS fund to have a relative VaR up 

to 200% of the VaR of the relevant index.216 Should rule 18f-4 similarly permit a 

fund to have a VaR up to 200% of the VaR of its designated reference index? If so, 

how should the rule incorporate investor protection provisions consistent with section 

18? Conversely, should the relative VaR test be set at a lower level, such as 125% of 

                                                      
215  For purposes of calculating asset coverage, as defined in section 18(h), BDCs have used 

derivatives transactions’ notional amounts, less any posted cash collateral, as the “amount of 
senior securities representing indebtedness” associated with the transactions. We believe this 
approach—and not the transactions’ market values—represents the “amount of senior securities 
representing indebtedness” for purposes of this calculation. Open-end funds cannot enter into 
derivatives transactions under section 18, absent relief from that section’s requirements, because 
section 18 limits open-end funds’ senior securities to bank borrowings. Section 18(c) also limits a 
registered closed-end fund’s ability to enter into derivatives transactions absent such relief. 

216  See infra section II.D.6.c (discussing the UCITS framework); see also ICI Comment Letter III 
(suggesting that a Commission rule limiting the use of derivatives by registered investment 
companies allow funds to use either ex ante stress testing or UCITS VaR for that purpose).  



113 

the VaR of the designated reference index? If so, why? 

 Should the proposed relative VaR test incorporate different leverage limit levels 

according to fund type and corresponding to the asset coverage requirements under 

the Investment Company Act? Why or why not and how? 

 Are there any challenges in calculating the VaR of the designated reference index? If 

so, would certain types of funds particularly encounter these challenges, and if so 

which ones? How should we address any challenges? 

 Are there any fund-type specific challenges to open-end funds, registered closed-end 

funds, or BDCs complying with the VaR-based limit on fund leverage risk? For 

example, would registered closed-end funds or BDCs encounter any unique 

challenges in calculating VaR because of the nature of their investments? If so, what 

kinds of challenges and how should we address them? Please also explain specifically 

the nature of any challenges given that a number of financial institutions such as 

banks and UCITS funds calculate VaR for regulatory purposes, and these institutions’ 

portfolios hold a wide range of assets.  

3. Absolute VaR Test 

We recognize that, for some funds, the derivatives risk manager may be unable to 

identify an appropriate designated reference index. For example, some multi-strategy funds 

manage their portfolios based on target volatilities but implement a variety of investment 

strategies, making it difficult to identify a single index (even a blended index) that would be 

appropriate. If a derivatives risk manager is unable to identify an appropriate designated 



114 

reference index, a fund relying on the proposed rule would be required to comply with the 

absolute VaR test.217 

To comply with the proposed absolute VaR test, the VaR of the fund’s portfolio must not 

exceed 15% of the value of the fund’s net assets. In proposing an absolute VaR test of 15% of a 

fund’s net assets, we considered the comparison of a fund complying with the absolute VaR test 

and a fund complying with the relative VaR test. A fund that uses the S&P 500 as its benchmark 

index, as many funds do, would be permitted to have a VaR equal to 150% of the VaR of the 

S&P 500 if the fund also used that index as its designated reference index. The Division of 

Economic and Risk Analysis (“DERA”) staff calculated the VaR of the S&P 500, using the 

parameters specified in this proposed rule over various time periods. DERA staff’s calculation of 

the S&P 500’s VaR since inception, for example, produced a mean VaR of approximately 

10.4%, although the VaR of the S&P 500 varied over time.218 Setting the level of loss in the 

proposed absolute VaR test at 15% of a fund’s net assets would therefore provide approximately 

comparable treatment for funds that rely on the absolute VaR test and funds that rely on the 

relative VaR test and use the S&P 500 as their designated reference index during periods where 

the S&P 500’s VaR is approximately equal to the historical mean.  

                                                      
217  See supra note 174 and accompanying text (discussing the proposed requirement for the fund’s 

derivatives risk manager to provide written reports to the fund’s board of directors that must 
include, among other things, the derivatives risk manager’s basis for the selection of the 
designated reference index or, if applicable, an explanation of why the derivatives risk manager 
was unable to identify a designated reference index appropriate for the fund); infra notes 426-427 
and accompanying text (discussing proposed recordkeeping requirements for such written reports 
provided to the fund’s board). 

218  DERA staff calculated descriptive statistics for the VaR of the S&P 500 using Morningstar data 
from March 4, 1957 to June 28, 2019, based on daily VaR calculations, each using three years of 
prior return data and calculated using historical simulation at a 99% confidence level for a 20-day 
horizon using overlapping observations.  



115 

DERA staff analyzed the S&P 500 because funds often select broad-based large 

capitalization equities indexes such as the S&P 500 for performance comparison purposes, 

including funds that are not broad-based large capitalization equity funds.219 Many investors may 

therefore understand the risk inherent in these indexes as the level of risk inherent in the markets 

generally.220 An absolute VaR test set to approximate, or not substantially exceed, this level of 

risk would therefore often approximate the level of risk that investors may understand, and 

frequently choose to undertake, through investments in funds. We are proposing a single 

absolute VaR limit that would apply to open-end funds and registered closed-end funds and 

BDCs for the same reasons we are proposing that all funds relying on the relative VaR test must 

limit their VaR to 150% of the VaR of their designated reference index.221  

The proposed absolute VaR test is also broadly consistent with the European Union 

regulatory framework that that applies to UCITS funds.222 Advisers that manage (or have 

affiliates that manage) UCITS funds may derive some efficiencies from reasonably comparable 

                                                      
219  This is based on staff experience and analysis of data obtained from Morningstar. 
220  Some commenters to the 2015 proposal also expressed the view that the S&P 500 Index is an 

appropriate risk-based reference point because it is widely used with a risk profile that is well 
understood and commonly acceptable to investors. See, e.g., AQR Comment Letter; Comment 
Letter of Millburn Ridgefield Corporation (Mar. 28, 2016). 

221  See supra section II.D.2.b. 
222  See CESR Global Guidelines, supra note 94, at 26. The absolute VaR test for UCITS funds is 

similar to the proposed absolute VaR test in rule 18f-4, although it sets a 20% limit for UCITS 
funds, rather than 15% as we propose in rule 18f-4. 



116 

requirements across jurisdictions.223 Commenters to the 2015 proposal also generally supported 

an absolute VaR test.224 

We request comment on the proposed absolute VaR test requirement. 

 Is the proposed absolute VaR test requirement appropriate? Are we correct that in 

some cases a fund’s derivatives risk manager may be unable to identify an 

appropriate designated reference index? Why or why not? What are examples of 

funds that would likely use the absolute VaR test because a derivatives risk manager 

would be unable to identify an appropriate designated reference index? Is it 

appropriate for these funds to use an absolute VaR test? Why or why not? 

 Should we provide additional guidance on the circumstances under which a fund’s 

derivatives risk manager would be “unable” to identify an appropriate index? If so, 

what guidance should we provide? Should the rule include a different standard than 

the inability to identify a designated reference index for funds to be able to use the 

absolute VaR test instead of the relative VaR test? If so, what standard and why? For 

example, should we identify certain types of fund strategies that may not typically 

have appropriate reference indexes or for which absolute VaR would otherwise be 

appropriate? If so, which fund strategies, and how would we keep any list of fund 

strategies current over time? 

 Should the proposed absolute VaR test include a limit other than 15% of the fund’s 
                                                      
223  See, e.g., ICI Comment Letter III (stating that, in response to the Investment Company Institute’s 

survey, “45 percent of respondents indicated that it would be only slightly burdensome to 
implement a UCITS VaR test that used the same parameters as prescribed for UCITS. An 
additional 34 percent reported that it would be moderately burdensome.”). 

224  See, e.g., ICI Comment Letter I; Franklin Resources Comment Letter; SIFMA Comment Letter; 
Comment Letter of T. Rowe Price Associates, Inc. (Mar. 28, 2016) (“T. Rowe Price Comment 
Letter”). 



117 

net assets? Please explain. For example, should it be 12, 18, 20, or 25%? If so, which 

limit, and why? Would funds using the absolute VaR test manage their VaRs to a 

certain amount below the limit the Commission sets? If so, to what extent and should 

we take this into account in determining the appropriate limit under this test? Should 

we look to different market data in determining an appropriate level of absolute VaR? 

Which other sources, and why would they be appropriate? 

 For funds that use an absolute VaR test as part of their risk management practices, do 

risk managers set internal absolute VaR limits, and if so, at what level and why? For 

funds that currently use both absolute VaR and relative VaR, are the internal limits 

set at comparable levels? Why or why not? Please describe each internal level set 

with respect to these two VaR tests. Do certain fund types or strategies more 

commonly use either absolute VaR or relative VaR for risk management purposes? If 

so, why? 

 Should the rule include both a relative and absolute VaR test, as proposed, or should 

it include only a relative VaR test or an absolute VaR test? Why, and which test 

should the rule include? Should it use a different VaR-based test? If so, which one? 

 Should the rule permit funds to choose which VaR test to comply with regardless of 

the derivatives risk manager’s ability or inability to identify a designated reference 

index? If so, would this be consistent with investor expectations and section 18?  

4. Choice of Model and Parameters for VaR Test 

The proposed rule would require that any VaR model a fund uses for purposes of the 

relative or absolute VaR test take into account and incorporate all significant, identifiable market 



118 

risk factors associated with a fund’s investments.225 The proposed rule includes a non-exhaustive 

list of common market risk factors that a fund must account for in its VaR model, if applicable. 

These market risk factors are: (1) equity price risk, interest rate risk, credit spread risk, foreign 

currency risk and commodity price risk; (2) material risks arising from the nonlinear price 

characteristics of a fund’s investments, including options and positions with embedded 

optionality; and (3) the sensitivity of the market value of the fund’s investments to changes in 

volatility.226 VaR models are often categorized according to three modeling methods—historical 

simulation, Monte Carlo simulation, or parametric models.227 Each method has certain benefits 

and drawbacks, which may make a particular method more or less suitable, depending on a 

fund’s strategy, investments and other factors. In particular, some VaR methodologies may not 

adequately incorporate all of the material risks inherent in particular investments, or all material 

                                                      
225  See proposed rule 18f-4(a) (defining the term “value-at-risk” or “VaR”). 
226  See id. 
227  Historical simulation models rely on past observed historical returns to estimate VaR. Historical 

VaR involves taking a fund’s current portfolio, subjecting it to changes in the relevant market risk 
factors observed over a prior historical period, and constructing a distribution of hypothetical 
profits and losses. The resulting VaR is then determined by looking at the largest (100 minus the 
confidence level) percent of losses in the resulting distribution. 
 
Monte Carlo simulation uses a random number generator to produce a large number (often tens of 
thousands) of hypothetical changes in market values that simulate changes in market factors. 
These outputs are then used to construct a distribution of hypothetical profits and losses on the 
fund’s current portfolio, from which the resulting VaR is ascertained by looking at the largest 
(100 minus the confidence level) percent of losses in the resulting distribution. 
 
Parametric methods for calculating VaR rely on estimates of key parameters (such as the mean 
returns, standard deviations of returns, and correlations among the returns of the instruments in a 
fund’s portfolio) to create a hypothetical statistical distribution of returns for a fund, and use 
statistical methods to calculate VaR at a given confidence level. 

 See, e.g., Dowd, supra note 178; see also Thomas J. Linsmeier & Neil D. Pearson, Value at Risk, 
56 Journal of Financial Analysts 2 (Mar.-Apr. 2000) (“Linsmeier & Pearson”). 



119 

risks arising from the nonlinear price characteristics of certain derivatives.228 We believe it 

should be the responsibility of the derivatives risk manager to choose the appropriate VaR model 

for the fund’s portfolio, and the proposed requirement is designed to allow funds to use a VaR 

model that is appropriate for the fund’s investments. Commenters that addressed the same 

proposed requirement for VaR models in the 2015 proposal generally supported it.229 

The proposed rule also requires that a fund’s VaR model use a 99% confidence level and 

a time horizon of 20 trading days.230 We understand that market participants currently using VaR 

most commonly use 95% or 99% confidence levels and often use time horizons of 10 or 20 days. 

The proposed confidence level and time horizon requirements also are similar to those in other 

VaR-based regulatory schemes.231 VaR models that use relatively high confidence levels and 

                                                      
228  For example, some parametric methodologies may be more likely to yield misleading VaR 

estimates for assets or portfolios that exhibit non-linear returns, due, for example, to the presence 
of options or instruments that have embedded optionality (such as callable or convertible bonds). 
See, e.g., Linsmeier & Pearson, supra note 227 (stating that historical and Monte Carlo 
simulation “work well regardless of the presence of options and option-like instruments in the 
portfolio. In contrast, the standard [parametric] delta-normal method works well for instruments 
and portfolios with little option content but not as well as the two simulation methods when 
options and option-like instruments are significant in the portfolio.”). 

229  See, e.g., Oppenheimer Comment Letter; CFA Comment Letter. 
230  See proposed rule 18f-4(a) (defining the term “value-at-risk” or “VaR”).  

We recognize that many market participants today also may calculate VaR over a one-day time 
horizon. See also supra section II.B.3.d (the proposed rule would require calculating a fund’s 
one-day VaR as part of the proposed backtesting requirement). A VaR calculation based on a 
one-day time horizon can be scaled to a 20-day time horizon. For example, a common VaR model 
time-scaling technique is to multiply the one-day VaR by the square root of the designated time 
period (i.e., for the proposed rule it would be the square root of 20). But for funds with returns 
that are not identically and independently normally distributed, simple time-scaling techniques 
may be inaccurate. If this inaccuracy results in meaningful underestimation of VaR, this simple 
time-scaling technique would be inappropriate. 

231  See, e.g., CESR Global Guidelines, supra note 94 (providing default VaR calculation standards 
that require funds that use the relative VaR or absolute VaR approach to calculate VaR using a 
“one-tailed confidence interval of 99%”); rule 15c3-1e under the Exchange Act [17 CFR 
240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) (requiring VaR models to use “a 99 percent, 
one-tailed confidence level with price changes equivalent to a ten business-day movement in rates 

 



120 

longer time horizons—as the proposed rule parameters reflect—result in a focus on more-

“extreme” but less-frequent losses. We propose relatively high confidence level and longer time 

horizon requirements so that the VaR model is designed to measure, and seek to limit the 

severity of, these less-frequent but larger losses. This is because a fund’s VaR model would be 

based on a distribution of returns, where a higher confidence level would go further into the tail 

of the distribution (i.e., more-“extreme” but less-frequent losses) and a longer time horizon 

would result in larger losses in the distribution (i.e., losses have the potential to be larger over 

twenty days when compared, for example, to over one day). 

In proposing a higher confidence level and longer time horizon, we considered whether 

this would result in a VaR model based on fewer data points in comparison to lower confidence 

levels and shorter time horizons. However, we understand that a longer trading day horizon only 

results in reduced data points if the fund uses historical simulation and measures historical losses 

using non-overlapping periods, which our proposal would not require. For example, a fund 

measuring non-overlapping twenty-day periods, assuming 250 trading days in a year, would 

expect approximately 12 or 13 data points (250 trading days / 20-day time horizons). But if the 

fund measured the twenty-day periods on a rolling and overlapping basis, it could expect as 

many as 250 data points where each data point captures the return over the trailing 20 trading 

days. A fund could use either a non-overlapping or overlapping approach under the proposed 

rule.  

                                                      

and prices”). See also the Basel Committee on Banking Supervision, Amendment To The Capital 
Accord To Incorporate Market Risks (Jan. 1996), available at 
https://www.bis.org/publ/bcbs24.pdf (contemplating banks’ use of internal models for measuring 
market risk based on a 10-day time horizon); CESR Global Guidelines, supra note 94 (specifying 
generally a 20-day time horizon as a quantitative requirement when calculating VaR for risk 
measurement and the calculation of global exposure and counterparty risk for UCITS).121 

The 2015 proposal similarly specified the particular confidence level and time horizon 

parameters that funds would use in their VaR models for purposes of the proposed risk-based 

portfolio limit. These parameters were a 99% confidence level and a time horizon range of not 

less than 10 and not more than 20 trading days.232 Comments were mixed but generally 

supported a confidence level in the range of 95% to 99%.233 Rather than a time horizon range 

providing funds discretion to select the number of trading days for which to compute their VaR 

models, some commenters suggested that the rule should specify a particular number of days.234 

Because our proposal, unlike the 2015 proposal, includes an absolute VaR test, our proposed 

VaR model parameters reflect commenter suggestions by proposing a confidence level within the 

generally supported range and proposing a specific VaR model time horizon rather than a range 

of permissible time horizons. 

In addition to specifying the confidence level and time horizon that a fund’s VaR model 

would use, we are also proposing that the fund’s chosen VaR model must be based on at least 

three years of historical market data. We understand that the availability of data is a key 

consideration when calculating VaR, and that the length of the data observation period may 

significantly influence the results of a VaR calculation. For example, a shorter observation 

period means that each observation will have a greater influence on the result of the VaR 

calculation (as compared to a longer observation period), such that periods of unusually high or 

low volatility could result in unusually high or low VaR estimates.235 Longer observation 

                                                      
232  2015 Proposing Release, supra note 2, at section III.B.2.b. 
233  See, e.g., AQR Comment Letter; ICI Comment Letter II. 
234  See, e.g., Morningstar Comment Letter; AIMA Comment Letter; AQR Comment Letter; ICI 

Comment Letter II. 
235  See Linsmeier & Pearson, supra note 227 (stating that, because historical simulation relies 

 



122 

periods, however, can lead to data collection problems, if sufficient historical data is not 

available.236 We believe requiring a fund’s chosen VaR model to be based on at least three years 

of historical market data strikes an appropriate balance. 

The proposed historical market data requirement would permit a fund to base its VaR 

estimates on a meaningful number of observations, while also recognizing the concern that 

requiring a longer historical period could make it difficult for a fund to obtain sufficient 

historical data to estimate VaR for the instruments in its portfolio.237 The 2015 proposal would 

have required three years of market data for funds using historical simulation (but did not require 

three years of market data for VaR models based on Monte Carlo simulation or parametric 

methods).238 A number of commenters supported our approach in the 2015 proposal to require 

three years of market data for funds using historical simulation.239 However, some commenters 

                                                      

directly on historical data, a danger is that the price and rate changes in the last 100 (or 500 or 
1,000) days might not be typical. For example, if by chance the last 100 days were a period of 
low volatility in market rates and prices, the VAR computed through historical simulation would 
understate the risk in the portfolio). 

236  See Dowd, supra note 178 (stating that “[a] long sample period can lead to data collection 
problems. This is a particular concern with new or emerging market instruments, where long runs 
of historical data don’t exist and are not necessarily easy to proxy”).  

237  See Michael Minnich, Perspectives On Interest Rate Risk Management For Money Managers 
And Traders (Frank Fabozzi, ed.) (1998) (stating that for historical simulation, “[l]onger periods 
of data have a richer return distribution while shorter periods allow the VAR to react more 
quickly to changing market events” and that “[t]hree to five years of historical data are typical”); 
see also Darryll Hendricks, Evaluation of Value-at-Risk Models Using Historical Data, FRBNY 
Economic Policy Review (Apr. 1996) (finding that, when using historical VaR, “[e]xtreme 
[confidence level] percentiles such as the 95th and particularly the 99th are very difficult to 
estimate accurately with small samples” and that the complete dependence of historical VaR 
models on historical observation data “to estimate these percentiles directly is one rationale for 
using long observation periods”). 

238  See 2015 Proposing Release, supra note 2, at section III.B.2.b; see also supra note 177 
(discussing historical simulation, Monte Carlo simulation, and parametric methods). 

239  See, e.g., Comment Letter of Abbey Capital (Mar. 28, 2016); AIMA Comment Letter; Comment 
Letter of Aspect Capital Limited (Mar. 28, 2016); Comment Letter of Intercontinental Exchange 
(Apr. 15, 2016).  



123 

suggested that the rule should require a longer period of historical market data.240 As discussed 

above, we believe that three years strikes an appropriate balance. We also are proposing to 

require funds to use three years of market data for all VaR calculations under the proposed 

rule—rather than only historical simulation as in the 2015 proposal. We believe this is 

appropriate because all methods for calculating VaR—not just historical simulation—rely on 

historical data. 

Unlike the 2015 proposal, the proposed rule does not require a fund to apply its VaR 

model consistently (i.e., the same VaR model applied in the same way) when calculating the 

VaR of its portfolio and the VaR of its designated reference index.241 The proposed rule would, 

however, require that VaR calculations comply with the same proposed VaR definition and its 

specified model requirements.242 Our proposal does not include the 2015 proposal’s model 

consistency requirement because if the proposed rule required funds to apply the same VaR 

model to its portfolio and the designated reference index, it could prevent funds from using less-

costly approaches. For example, under the proposed approach, in many cases a fund could 

calculate the VaR of a designated reference index based on the index levels over time without 

having to obtain access to more-detailed information about the index constituents. A fund also 

would have the flexibility to obtain the VaR from a third-party vendor instead of analyzing it in-

house. A model consistency requirement could preclude these approaches, however, because a 

fund might not be able apply the same approach to its portfolio. For example, if a fund invested 

                                                      
240  See, e.g., materials attached to the memorandum included in the comment file concerning a 

meeting between representatives of AlphaSimplex Group LLC and members of the staff of the 
Division of Investment Management (July 8, 2016); AQR Comment Letter.  

241  See 2015 Proposing Release, supra note 2, at section III.B.2.b. 
242  See infra section II.D.4 (discussing the proposed VaR model requirements). 



124 

significantly in options, it generally would not be appropriate to use certain parametric VaR 

models.243 The fund might instead use Monte Carlo simulation, which is more computationally 

intensive and takes more time to perform. A model consistency requirement would require the 

fund to apply the same Monte Carlo simulation model to its unleveraged designated reference 

index, for which a parametric or other simpler and less costly VaR model might be appropriate.  

Although requiring a fund to apply the same VaR model to its portfolio and the 

designated reference index could result in a more precise comparison of the two values, we do 

not believe that the additional precision is necessary for the relative VaR test to identify where 

funds’ use of derivatives is more likely to raise the concerns underlying section 18 because the 

proposed rule would provide certain common parameters for all VaR calculations under the rule. 

Because a fund’s designated reference index must be unleveraged, we believe it is generally 

unlikely that different VaR models calibrated to these common parameters would produce 

substantially different results for a fund’s designated reference index. Additionally, the 

derivatives risk manager would be responsible for administering and maintaining the derivatives 

risk management program, which includes the integrity of the VaR test. On balance, we believe 

the proposed approach would not materially diminish the efficacy of the proposed relative VaR 

test while permitting less-costly approaches for funds.  

We request comment on the proposed requirements regarding a fund’s choice of VaR 

model, and the required parameters for a VaR model that funds would use under the proposed 

rule. 

 Should the rule specify a particular VaR model(s) that funds must use (i.e., a 
                                                      
243  See supra note 228 (explaining that some parametric methodologies may be more likely to yield 

misleading VaR estimates for assets or portfolios that exhibit non-linear returns, due, for 
example, to the presence of options or instruments that have embedded optionality). 



125 

historical simulation, Monte Carlo simulation, or parametric methodology)? If so, 

which methodology (or methodologies) and why? 

 Is the proposed requirement that a fund’s VaR model incorporate all significant, 

identifiable market risk factors associated with a fund’s investments appropriate? 

Why or why not? 

 The proposed rule would provide a non-exhaustive list of risk factors that may be 

relevant in light of a fund’s strategy and investments. Should the final rule include 

this non-exhaustive list of risk factors? Are risk factors included in the proposed list 

appropriate? Should we include any additional risk factors to this list? If so, which 

ones and why? 

 The proposed rule would require a fund to use a 99% confidence level for its VaR 

model. Is the proposed confidence level appropriate? Should the rule include a 

different confidence level? If so, which level and why, and if not, why not? 

 The proposed rule would require a fund to use a time horizon of 20 trading days for 

its VaR model. Is the proposed time horizon appropriate? Should the rule include a 

different time horizon? If so, which time horizon and why, and if not, why not?  

 The proposed rule would require a fund to use at least three years of historical market 

data for its VaR model. Is the historical market data requirement appropriate? Should 

the rule set forth a different length of time for requiring historical market data? 

Should the requirement be limited to funds using historical simulation? Would funds 

experience challenges in identifying sufficient data for particular types of 

investments? If so, which types of investments and how should the rule address these 

challenges? Please explain. 



126 

 The proposed rule does not include any requirement for third-party validation of a 

fund’s chosen VaR model, either at inception or upon material changes, to confirm 

that the model is structurally sound and adequately captures all material risks.244 

Should we require third-party validation? Why or why not? 

 Should the rule require a fund’s board to approve the VaR model and any material 

changes to the model? Why or why not?  

 Should the final rule also include a requirement that a fund that uses the relative VaR 

test apply the same VaR model when calculating the fund’s portfolio and the VaR of 

the designated reference portfolio? Would the requirement to apply the same VaR 

model to the fund’s portfolio and the designated reference portfolio address any 

concerns that funds could inappropriately manipulate the results of VaR testing under 

the proposed rule’s requirements? What additional cost, if any, would such a 

requirement impose on funds? Are there other ways that we could prevent such 

manipulations? To what extent would this requirement promote additional precision 

in the relative VaR test and would any additional precision increase the efficacy of 

the test in limiting fund leverage risk? Please explain. 

5. Implementation 

a. Testing Frequency 

The proposed rule would require a fund to determine its compliance with the applicable 

VaR test at least once each business day.245 Although we believe that funds would calculate their 

VaRs at a consistent time each day, which would generally be either in the mornings before 
                                                      
244  The Global Exposure Guidelines applicable to UCITS’ requires such validation. See CESR 

Global Guidelines, supra note 94. 
245  Proposed rule 18f-4(c)(2)(ii). 



127 

markets open or in the evenings after markets close, we do not propose to require one at the 

exclusion of the other, to allow funds to conduct their VaR tests at the time that is most efficient 

based on each fund’s facts and circumstances. We considered proposing that funds determine 

compliance with the proposed VaR test at the time of, or immediately after, entering into a 

derivatives transaction. We recognize, however, that conducting a VaR test on a trade-by-trade 

basis could present operational challenges for some funds and could limit the fund’s choice of 

VaR modeling. For example, we believe that most funds would be unable to perform 

computationally-intensive Monte Carlo simulations so frequently based on computing resources 

and compliance costs. Requiring this VaR calculation each day, in contrast, would provide funds 

flexibility to use VaR models they believe to be appropriate while also providing for fairly 

frequent calculations. The 2015 proposal included a testing frequency of immediately after 

entering into any senior securities transactions, but many commenters raised concerns about 

operational complexity related to transaction-by-transaction testing, and instead generally 

suggested a daily testing frequency.246 

We believe that determining compliance with the VaR test less frequently than each 

business day would not be consistent with the purpose of a condition to limit fund leverage risk. 

Section 18 sets forth certain fund leverage risk protections that are fundamental to protecting 

investors. If this testing requirement were less frequent than each business day, then a fund could 

satisfy the condition only on business days requiring a VaR test and modify its trading strategy to 

circumvent the purpose of the test on other business days. Additionally, we believe that testing 

                                                      
246  See, e.g., ICI Comment Letter I; Franklin Resources Comment Letter; SIFMA Comment Letter; 

AIMA Comment Letter; BlackRock Comment Letter. 



128 

each business day is appropriate in light of the potential for market risk factors associated with a 

fund’s investments to change quickly. 

We request comment on the proposed frequency of conducting the relative or absolute 

VaR test. 

 Is the proposed required frequency for conducting the VaR test appropriate? Should 

the rule require a fund to conduct the required VaR test more frequently or less 

frequently, such as—respectively—either before or after each transaction, multiple 

times throughout the day, or on a weekly basis? Why or why not? Should the required 

frequency vary depending on fund type or whether the fund is conducting an absolute 

VaR test or relative VaR test? Please explain.  

 Should the rule require funds to conduct the test at the same time each day? If so, 

why? What compliance or operational challenges, if any, would funds have to 

conduct the test at the same time each day? Would the absence of such a requirement 

allow funds to “game” the test?  

b. Remediation 

If a fund determines that it is not in compliance with the applicable proposed VaR test, 

then under our proposal a fund must come back into compliance promptly and within no more 

than three business days after such determination.247 If the fund is not in compliance within three 

business days, then: (1) the derivatives risk manager must report to the fund’s board of directors 

and explain how and by when (i.e., the number of business days) the derivatives risk manager 

reasonably expects that the fund will come back into compliance; (2) the derivatives risk 

manager must analyze the circumstances that caused the fund to be out of compliance for more 
                                                      
247  See proposed rule 18f-4(c)(2)(ii). 



129 

than three business days and update any program elements as appropriate to address those 

circumstances; and (3) the fund may not enter into derivatives transactions (other than 

derivatives transactions that, individually or in the aggregate, are designed to reduce the fund’s 

VaR) until the fund has been back in compliance with the applicable VaR test for three 

consecutive business days and satisfied the board reporting requirement and program analysis 

and update requirements.248 

The proposed three-business-day remediation provision is designed to provide funds with 

some flexibility in coming back into compliance with the applicable proposed VaR tests. It 

reflects our view that it would be inappropriate for a fund to purposefully exceed the VaR-based 

limit on fund leverage risk, but allows funds to take reasonable steps to come back into 

compliance without harming fund investors. The three-business-day period is designed to 

provide an appropriate time period to permit remediation efforts because it balances investor 

protections related to fund leverage risk and potential harm to a fund if it were required to sell 

assets or unwind transactions even more quickly. This remediation approach is similar to the 

remediation approach that section 18 of the Investment Company Act provides for asset 

coverage compliance with respect to bank borrowings, which also includes a three-day period to 

come back into compliance.249  

If the fund does not come back into compliance within three business days, the proposed 

rule would not require the fund to exit its derivatives transactions or make other portfolio 

                                                      
248  See proposed rule 18f-4(c)(2)(iii); see also infra section II.H.2 (discussing the proposed 

requirement to submit a confidential report to the Commission if the fund is out of compliance 
with the applicable proposed VaR test for three business days). 

249  Section 18(f)(1) of the Investment Company Act. 



130 

adjustments.250 Although a fund remaining out of compliance with the applicable VaR test raises 

investor protection concerns related to fund leverage risk, if the proposed rule were to force a 

fund to exit derivatives transactions immediately at the end of the three-day period, this could 

harm investors, for example, by requiring the fund to realize trading losses that could have been 

avoided under a more-flexible approach. The proposed remediation provision reflects the 

balancing of these multiple investor protection concerns. 

Instead of requiring a fund to come back into compliance under these circumstances 

immediately, the fund must satisfy three requirements before it can enter into derivatives 

transactions other than those designed to reduce the fund’s VaR. First, the derivatives risk 

manager must report to the fund’s board of directors and explain how and by when (i.e., the 

number of business days) the derivatives risk manager reasonably expects that the fund will 

come back into compliance.251 This requirement is designed to facilitate the fund coming back 

into compliance promptly by requiring the derivatives risk manager to develop a specific course 

of action to come back into compliance and to facilitate the board’s oversight by requiring the 

derivatives risk manager to report this information to the board.  

Second, the derivatives risk manager must analyze the circumstances that caused the fund 

to be out of compliance for more than three business days and update any program elements as 

appropriate to address those circumstances.252 That the fund was unable to come back into 

compliance with the applicable VaR test within three business days may suggest there are 

                                                      
250  Under the proposed rule, a fund that is not in compliance within three business days also would 

be required to file a report to the Commission on proposed Form N-RN. See proposed rule 18f-
4(c)(7); infra section II.H.2. 

251  Proposed rule 18f-4(c)(2)(iii)(A). 
252  Proposed rule 18f-4(c)(2)(iii)(B). 



131 

deficiencies in the fund’s program. This requires the derivatives risk manager to analyze and 

update any program elements as appropriate before the fund is able to enter into derivatives 

transactions other than those designed to reduce VaR.  

Finally, a fund may not enter into derivatives transactions (other than those designed to 

reduce the fund’s VaR) until the fund has been back in compliance with the applicable VaR test 

for at least three consecutive business days and has satisfied the applicable board reporting and 

program analysis and update requirements.253 If the proposed rule were to permit a fund that is 

out of compliance with the limit on fund leverage risk to comply for just one day before entering 

into derivatives transactions that would increase the fund’s market risk, this could potentially 

lead to some funds having persistently high levels of leverage risk beyond that permitted by the 

applicable VaR test. 

We request comment on the proposed remediation requirement for a fund that is out of 

compliance with the applicable VaR test. 

 Is the proposed three-business-day remediation provision appropriate? Could such a 

limited remediation period exacerbate fund or market instability and harm investors? 

Should the rule require a longer or shorter period, such as one or seven days? Why or 

why not, and if so, what should the alternative remediation period be? In light of the 

balancing of investor protection concerns (fund compliance with the VaR-based limit 

on fund leverage risk and not forcing asset sales or unwinding transactions to 

comply), is there a more-effective means to structure a remediation provision that 

balances these concerns? If so, how?  

 Should we change the rule’s remediation provision to include an escalating provision 
                                                      
253  Proposed rule 18f-4(c)(2)(iii)(C). 



132 

that requires longer periods of compliance based on the number of three-day (or 

more) periods that a fund has been out of compliance? If so, how should we structure 

such a provision? 

 Should we change the rule to factor in the aggregate number of days in a trailing year 

that a fund has been out of compliance? What additional remediation consequences 

should a fund address before entering into derivatives transactions (other than those 

designed to reduce the fund’s VaR)? Please explain.  

 Should the remediation provision provide further or different limitations for a fund 

that continuously goes in and out of compliance with its VaR test? For example, 

should the rule provide that such a fund is not permitted to rely on the proposed rule 

indefinitely or for a set period of time? How should a rule define “continuously going 

in and out of compliance”? Should such a fund be subject to a lower VaR 

requirement? If so, what level of VaR and why? How long should the fund remain 

subject to any lower VaR requirement? Should the fund be subject to limits on its 

derivatives exposure? 

 Should the remediation provision, as proposed, require the derivatives risk manager 

to report to the fund’s board of directors that the fund has been out of compliance 

with the VaR-based limit for more than three consecutive business days? Why or why 

not? Should the derivatives risk manager be required to explain how the fund will 

come back into compliance promptly and by when? Should we change the rule to 

require such a fund to take certain specific actions? Should we change the rule to 

require fund compliance within a specific time period? If so, how should we change 

the rule and why?  



133 

 Should the remediation provision, as proposed, require the derivatives risk manager 

to analyze the circumstances for the fund being out of compliance for more than three 

business days? Should we change the rule to require specific program updates? 

Should we change the rule to require a complete program review and update? What 

challenges would such a remediation requirement impose on funds? What are the 

benefits of specifying program updates? Under what circumstances, if any, would a 

fund be out of compliance for more than three business days and not have risk 

management program elements to update? Please explain.  

6. Other Regulatory Approaches to Limiting Fund Leverage Risk 

a. Stress Testing 

In addition to our proposal to require stress testing as a derivatives risk management 

program element, we considered a stress testing requirement as a means to limit fund leverage 

risk in lieu of, or in addition to, the proposed VaR tests. We understand that many funds that use 

derivatives transactions already conduct stress tests for purposes of risk management.254 

For example, we considered proposing a single-factor stress test requirement that would 

enumerate a limited number of shocks, corresponding to different asset classes in which funds 

commonly invest, and specify the required shock levels for each asset class. Similar to Form PF, 

the rule could categorize stress testing shocks based on market factors such as equity prices, risk-

free interest rates, credit spreads, currency rates, commodity prices, option implied volatilities, 

default rates for asset-backed securities, and default rates for corporate bonds and credit-default 

                                                      
254  See, e.g., ICI Comment Letter III. While we do not propose to require stress testing as a means 

for limiting a fund’s leverage risk, as discussed above, one element of the proposed program 
requires stress testing for risk management purposes. See supra section II.B.3.c. 



134 

swaps.255 The rule could also include an “other,” general category for which the corresponding 

shock level would be a specific or otherwise determinable factor based on extreme but plausible 

market conditions determined by the derivatives risk manager. A fund would “fail” this stress 

test if one of the prescribed shocks would cause the fund to experience a level of loss that we 

would specify.  

We could, for example, specify the shock levels for each market factor based on a certain 

number of standard deviations from the mean of historical distributions of returns for that factor, 

such as three or four standard deviations, as a means of establishing standardized shock levels.256 

We could then specify that a fund fails the stress test if any such shock leads to a loss of a certain 

percentage of the fund’s net assets over a single trading day or series of trading days, such as 

20% over one trading day. We could determine these metrics based on how funds that do not 

engage in derivatives, but that have borrowed up to and in compliance with the requirements of 

section 18, would perform against the stress test. For example, the stress test outer limit could be 

based on a fund that is not using derivatives but has invested $150 in securities based on $100 of 

net assets and $50 in bank borrowings. To be consistent with section 18, a fund that uses 

derivatives and conducts a stress test resulting in losses greater than the stress test losses of this 

hypothetical bank-borrowing-leveraged fund would fail the single-factor stress test. 

This approach would have the benefit of setting forth a comparatively simple-to-conduct 

test that a broad variety of funds could apply. The challenges of a single-factor stress testing 

requirement, however, include identifying an appropriate universe of market risk factors for the 
                                                      
255  Question 42 on Form PF requires some private fund advisers to report the impact on the fund’s 

portfolio from specified changes to the identified market factors. 
256  If normally distributed, shock levels based on historical returns of a market factor that is three 

standard deviations from the mean of that market factor would correspond to approximately a 
99.7% confidence level. 



135 

broad universe of derivatives in which funds invest and strategies they follow, setting the 

appropriate level of each shock for each factor, and determining the level of losses that would 

result in a fund “failing” the test. Making these determinations would be particularly challenging 

in a rule that would apply to all funds. Any prescribed shocks and related values could become 

stale over time and necessarily would not include all of the relevant risk factors for each fund. As 

funds continue to innovate, there could be funds for which no prescribed shock would be 

relevant. An approach that looks at a fund’s losses in response to changes in a single market risk 

factor also may not effectively take into account correlations among market risk factors under 

stressed market conditions. Stress testing is useful as a risk management tool because it provides 

a framework for advisers to consider a range of potential scenarios tailored to each fund and 

refined over time. Its benefits as a limit of fund leverage risk may not be fully realized, however, 

by single-factor stress testing that includes static values that a rule specifies.257 

We also considered requiring a multi-factor stress test based on scenario analysis. Rather 

than a fund applying a single-factor shock to each relevant asset class, this approach would 

require funds to create a stress test model that takes into account multiple asset classes 

simultaneously, which a fund would have to identify to tailor the stress test to its fund. The fund 

would then run numerous scenarios against the model, shocking the multiple asset classes 

identified, based on a high number of iterations and permutations akin to a Monte Carlo 

simulation. A multi-factor stress test would result in a matrix or range of estimated potential 

losses during stressed market conditions because each scenario permutation would create one 

                                                      
257  We recognize that these concerns do not apply to all uses of single-factor stress testing. For 

example, money market fund stress testing does not raise similar concerns in part because of 
money market funds’ common strategies and limited universe of investment holdings. See 
rule 2a-7(g)(8) under the Investment Company Act (requiring periodic stress testing). 



136 

estimated potential loss calculation. The benefits of multi-factor stress testing include tailoring 

the stress test to the investment and risk characteristics of a fund’s portfolio, which may result in 

more meaningful derivatives risk management. But in considering a multi-factor stress testing 

requirement, we would have to consider whether such a framework, if highly particularized, 

would permit enough long-term flexibility as an applicable regulatory limit on fund leverage 

risk. For example, the multi-factor stress test could identify specific correlations and assumptions 

that funds should reflect in their stress tests based on their strategies and investments, or identify 

specific historical market events to run as scenarios against their stress test model. In addition, if 

we were to propose a principles-based multi-factor stress testing requirement that would rely on 

funds to tailor their stress tests, it would present regulatory challenges in determining whether 

funds were adhering to a limit on fund leverage risk consistent with section 18.  

Finally, our proposed VaR-based limit on fund leverage risk, as opposed to stress testing, 

may better align with section 18’s investor protection goals concerning the level of risk in a 

registered fund. This is because the limitations in section 18 apply under both normal and 

stressed market conditions.258 For these reasons, as well as the regulatory design challenges of 

specifying the universe of asset class shocks and setting their corresponding levels, we are 

proposing a VaR-based limit on fund leverage risk instead of a stress testing approach to limiting 

fund leverage risk.  

We request comment on stress testing as a means to limit funds’ leverage risk. 

 In addition to our proposed stress testing requirement as part of the derivatives risk 

management program, should the rule require stress testing as a means to limit fund 

leverage risk in lieu of or in addition to the VaR-based limit on fund leverage risk? 
                                                      
258  See supra section I.B.1. 



137 

Why or why not? Is a stress test an effective means to limit a fund’s leverage risk? 

Please explain. If we were to include a stress testing requirement in addition to a 

VaR-based limit on fund leverage risk, should we require a fund to comply with both 

requirements, or should we allow a fund to choose one or the other? If we were to 

allow funds to comply with either approach, would that result in inconsistent limits 

across funds and would that be appropriate if so? 

 To measure and/or limit fund leverage risk, do funds currently use VaR tests, stress 

tests or both? If a fund uses VaR tests but not stress tests (or vice versa), did the fund 

consider using the other approach as a means to measure and limit its leverage risk? 

Why or why not? 

 If funds use both VaR tests and stress tests to measure and/or limit fund leverage risk, 

why do they use both tests? Are there certain fund types or strategies that are better 

suited for VaR or for stress testing? If so, which ones and why? 

 Should the limit of fund leverage risk focus on normal market conditions, stressed 

market conditions, or both? Please explain. 

 Should the rule require a single-factor stress test as an alternative to the proposed 

VaR-based limit on fund leverage risk? If so, what single-factor shocks should the 

test require? What would the corresponding shock levels be for each factor? Are the 

example single-factor shocks discussed above appropriate? Please explain. How 

frequently and on what basis, if at all, do commenters anticipate that the Commission 

would need to amend a rule that incorporated the enumerated shocks and their 

corresponding levels? 

 What number of standard deviations from the mean of historical distributions of 



138 

returns should the single-factor shock levels for each market risk factor be? Would 

three standard deviations or four standard deviations be appropriate? How should the 

rule define a failed stress test? Would a loss expressed as a percentage of the fund’s 

net assets over a single trading day or series of trading days be appropriate? What 

percentage and over what period would be appropriate? Would 20% over one trading 

day be appropriate? How frequently, if at all, do commenters anticipate that the 

Commission would need to amend the rule to revise the specified loss level? 

 Should the rule require a multi-factor stress test as an alternative to the proposed 

VaR-based limit on fund leverage risk? If so, how might the rule include a multi-

factor stress testing requirement that permits adequate flexibility and tailoring but 

could also promote comparability and regulatory consistency in setting a leverage risk 

limit? 

 Should the single-factor or multi-factor stress testing methods be required as part of 

the proposed program’s stress testing requirement? If so, which one and why? 

b. Asset Segregation 

We considered applying an asset segregation approach to derivatives transactions, similar 

to asset segregation under Release 10666, as a tool to limit funds’ leverage-related risks.259 

Under this approach, we could require a fund engaging in derivatives transactions to segregate 

cash and cash equivalents equal in value to the full amount of the conditional and unconditional 

obligations incurred by the fund (also referred to as “notional amount segregation”). We could 

allow funds to segregate additional types of assets beyond cash and cash equivalents subject to 

                                                      
259  We separately discuss below our consideration of asset segregation as a complement to the 

proposed limitations on fund leverage risk. See infra section II.F. 



139 

prescribed haircuts based on the assets’ volatilities. The 2016 DERA Memo, for example, 

analyzed different risk-based “haircuts” that could apply to a broader range of assets.260 

Allowing a broader range of segregated assets would have the effect of allowing funds to take on 

additional leverage because it would increase a fund’s ability to obtain market exposure through 

a combination of cash, market securities investments, and derivatives transactions. Allowing 

funds to segregate a broader range of assets, even if subject to haircuts, also may not effectively 

address all of the section 18 concerns underlying an asset segregation requirement. For example, 

if a fund must raise cash to pay a derivatives counterparty by selling a segregated security with 

unrealized trading losses, then the fund still would realize trading losses on the sale of the 

security regardless of whether the fund applied haircuts to the value of the security when 

determining the amount of its segregated assets. The haircuts therefore could help to prevent a 

fund from defaulting on its derivatives transactions obligations, but may not prevent a fund from 

realizing trading losses to meet those obligations.  

Notional amount segregation, although generally an effective way to limit leverage risk, 

is a non-risk-sensitive and often more restrictive approach to limiting potential leverage risk as 

compared to the proposed VaR tests. Notional amount segregation could limit funds’ ability to 

engage in derivatives transactions that may not raise the concerns underlying section 18. For 

example, if a fund had segregated all available qualifying assets, it would not be permitted to 

enter into a derivatives transaction that would reduce portfolio risk. The proposed VaR tests 

would not constrain such a transaction because it would reduce the fund’s VaR.  

We also considered proposing an approach that would require funds to segregate liquid 

assets in an amount equal to the fund’s daily mark-to-market liability plus a “cushion amount” 
                                                      
260  See, e.g., 2016 DERA Memo, supra note 12. 



140 

designed to address potential future losses. Requiring funds to segregate liquid assets would 

indirectly limit a fund’s leverage risk because each derivatives transaction and segregation of 

liquid assets would limit the net assets available for segregation to support additional derivatives. 

This approach would require segregating a smaller amount of liquid assets than the notional 

amount segregation approach.261 In light of the smaller amount of segregated assets, we could 

provide that only a specified percentage of a fund’s assets can be segregated. We could provide, 

for example, that a fund’s segregated amount cannot exceed one-third of its total assets or one-

half of its net assets because this is the maximum amount that an open-end fund can owe a bank 

under section 18. 

This approach, however, would raise compliance complexities and may not be as 

effective as the proposed VaR tests in limiting fund leverage risk. For example, under this 

approach we would have to define the risk-based “cushion amount” funds would segregate. We 

could define this amount as we proposed in 2015: a reasonable estimate of the potential amount 

payable by the fund if the fund were to exit the derivatives transaction under stressed 

conditions.262 Some commenters suggested determining these amounts could raise compliance 

challenges.263 Another approach would be to use the amount of required initial margin, for 

transactions subject to regulatory initial margin requirements. Not all derivatives transactions are 

subject to initial margin requirements, however, and these requirements generally vary based on 

the type of derivatives instrument. An approach that were to allow a fund to have more leverage 

                                                      
261  See 2010 ABA Derivatives Report (recommending a risk-adjusted segregated amounts approach); 

2011 Concept Release, supra note 3, at sections II.B.2, II.C.2 (citing and requesting comment on 
the 2010 ABA Derivatives Report approach). 

262  See 2015 proposed rule 18f-4(c)(9). 
263  We discuss these challenges in more detail below in section II.F. See also, e.g., AAF Comment 

Letter; Angel; Comment Letter of James J. Angel, Ph.D., CFA (Mar. 28, 2016).141 

when trading futures as compared to swaps, for example, would not seem consistent with the 

concerns underlying section 18. 

Requiring funds to segregate liquid assets in an amount equal to the fund’s daily mark-to-

market liability plus a “cushion amount” therefore could introduce unnecessary complexity and 

compliance costs and may not result in an effective limit on fund leverage. We believe that the 

proposed VaR-based tests would be a more direct and effective method of limiting fund leverage 

risk consistent with section 18.  

We request comment on asset segregation as an alternative or complement to VaR. 

 Should the rule require asset segregation in lieu of or in addition to the proposed 

VaR-based limit on fund leverage risk? Is asset segregation equally effective or more 

effective than the proposed VaR tests in limiting a fund’s leverage risk? Why or why 

not? 

 Are there certain fund types or strategies for which an asset segregation approach 

would be more effective or appropriate for limiting a fund’s leverage risk? Which 

ones and why? 

 Should the proposed rule require notional amount segregation? What challenges, if 

any, would funds have with complying with notional amount segregation? Would this 

be an effective means to limit a fund’s leverage risk? If so, how? Please describe. 

 Should the proposed rule require an asset segregation risk-based approach based on 

the fund’s daily mark-to-market liability and “cushion amount”? Please explain why 

or why not. If so, how should funds calculate the risk-based cushions? Should we use 

the approach in the 2015 proposal for risk-based coverage amounts? Would funds 

encounter challenges in determining stressed conditions for purposes of that analysis? 



142 

Would that approach lead to consistent segregated amounts across funds for the same 

or similar investments? Why or why not? Could we provide for greater consistency 

by prescribing a standardized schedule for computing these amounts based on the 

volatility of the underlying reference assets? What values should we prescribe? 

Rather than the approach in the 2015 proposal, should we use the amounts posted to 

satisfy regulatory margin requirements? Would it be appropriate for different 

instruments that provide the same economic exposure (e.g., futures and swaps that 

reference the same index) to have different segregated amounts? Under this approach, 

how should funds calculate risk-based cushions for transactions that are not subject to 

regulatory initial margin requirements? 

 Should we use the risk-based cushion amount approach to indirectly limit leverage 

risk? If so, should we provide that a fund’s segregated amount cannot exceed one-

third of its total assets, one-half of its net assets, or some other percentage of a fund’s 

total or net assets? Would such an approach be sufficiently risk-sensitive and 

dynamic? If we were to use such an approach, how should we address derivatives 

transactions that may require little or no margin or collateral to be posted?  

 Are there other reasons that the proposed rule should include asset segregation? 

Should the derivatives risk management program specify asset segregation 

requirements? Would market practices adequately address asset coverage concerns? 

If not, why? 

 We included an asset segregation requirement as part of the 2015 proposal designed 

in part to address the asset sufficiency related concerns underlying section 18. Would 

an asset segregation requirement help to address fund leverage risk and complement 



143 

the proposed VaR tests? If so, what type of asset sufficiency test? 

c. Exposure-Based Test 

We considered an exposure-based approach for limiting fund leverage risk. For example, 

we could design an exposure-based approach that permits a fund to enter into derivatives 

transactions so long as its derivatives exposure does not exceed a specified percentage of the 

fund’s net assets, such as 50%. This would be similar to an exposure-based test under the 

European Union guidelines that apply to UCITS funds.264  

A fund’s “derivatives exposure” could be defined as in proposed rule 18f-4.265 A similar 

approach would be to provide that the sum of a fund’s derivatives exposure and the value of its 

other investments cannot exceed 150% of the fund’s net asset value. This latter approach, and 

particularly if cash and cash equivalents were not included in the calculation, would allow a fund 

to achieve the level of market exposure permitted for an open-end fund under section 18 using 

any combination of derivatives and other investments.266  

                                                      
264  CESR (now known as the European Securities and Markets Authority (“ESMA”)) issued its 

Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk 
for UCITS (“Global Exposure Guidelines”) in 2010, addressing the implementation of the 
European Commission’s 2009 revised UCITS Directive (“2009 Directive”). See CESR Global 
Guidelines, supra note 94, at 9. 

 A UCITS fund may, instead of complying with the European Union’s VaR-based test, satisfy a 
“commitment approach.” The commitment approach provides that a UCITS fund is in 
compliance with the leverage limits under the guidelines if its derivatives notional amounts 
(taking into account netting and hedging) do not exceed 100% of the fund’s net asset value. See 
2009 Directive. 

265  Proposed rule 18f-4(a) (defining derivatives exposure to mean the sum of the notional amounts of 
the fund’s derivatives instruments and, in the case of short sale borrowings, the value of the asset 
sold short. In determining derivatives exposure a fund may convert the notional amount of 
interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of 
options contracts). 

266  This approach would exclude cash and cash equivalents because they do not meaningfully 
contribute to a fund’s market exposure.  



144 

This alternative approach would recognize that for most types of derivatives, the notional 

amount generally serves as a measure of the fund’s economic exposure to the underlying 

reference asset or metric. It also would provide a simple approach because a fund would just add 

the relevant values rather than having to perform VaR tests. 

An exposure-based test does have certain limitations. One drawback to this alternative 

approach is that a derivative’s notional amount does not reflect the way in which the fund uses 

the derivative and is not a risk measurement. For this reason, an exposure-based approach may 

be viewed as a relatively blunt measurement. It would not differentiate between derivatives 

transactions having the same notional amount but different underlying reference assets with 

potentially very different risks.  

There are adjustments to notional amounts available that may better reflect the risk 

associated with derivatives transactions. One way to attempt to address these drawbacks would 

be to define the circumstances under which funds could subtract the exposure associated with 

“hedging” and “netting” transactions from a fund’s derivatives exposure. This would be similar 

to the “commitment method” applicable to UCITS funds.267 Defining these kinds of transactions 

can be challenging. For example, determining whether transactions are “hedges” can involve an 

analysis of historical correlations and predicting future price movements of related instruments 

                                                      
267  See, e.g., CESR Global Guidelines, supra note 94, at 13-14 (defining netting as “combinations of 

trades on financial derivative instruments and/or security positions which refer to the same 
underlying asset, irrespective—in the case of financial derivative instruments—of the contracts’ 
due date; and where the trades on financial derivative instruments and/or security positions are 
concluded with the sole aim of eliminating the risks linked to positions taken through the other 
financial derivative instruments and/or security positions” and hedging as “combinations of trades 
on financial derivative instruments and/or security positions which do not necessarily refer to the 
same underlying asset and where the trades on financial derivative instruments and/or security 
positions are concluded with the sole aim of offsetting risks linked to positions taken through the 
other financial derivative instruments and/or security positions”). 



145 

or underlying reference assets, among other things. Historical correlations also can break down 

in times of market stress.268 

Another potential way to modify an exposure-based test would be to adjust the notional 

amounts that contribute to a fund’s derivatives exposure based on the volatility of their 

underlying reference assets. Some commenters on the 2015 proposal suggested we take this 

approach, and DERA staff prepared an analysis of commenters’ suggestions.269 This would make 

an exposure-based test more risk-sensitive, but would not provide the more-comprehensive 

analysis of portfolio risk that VaR provides. An exposure-based test, even with these various 

adjustments to notional amounts for purposes of calculating a fund’s derivatives exposure, still 

would be a relatively blunt measurement. For example, this approach could limit certain fund 

strategies that rely on derivatives more extensively but that do not seek to take on significant 

leverage risk. 

                                                      
268  In times of extreme market stress, price correlations between asset classes frequently break down. 

See Mico Loretan & William B. English, Evaluating “Correlation Breakdowns” During Periods 
of Market Volatility, Federal Reserve System International Finance Working Paper No. 658 (Feb. 
2000), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=231857 (“[I]n periods of 
heightened market volatility correlations between asset returns can differ substantially from those 
seen in quieter markets. The problem of ‘correlation breakdown’ during periods of greater 
volatility is well known.”). During periods of stressed conditions, correlations between asset 
classes with historically weak or inverse correlations may change significantly. See Whitney 
Kisling, Greed Beats Fear With Stock-Bond Correlation Falling, Bloomberg (Nov. 22, 2010) 
(stating that the 30-day correlation between S&P 500 prices and 10-year Treasury yields showed 
equity and bond markets, typically inversely correlated markets, moving in lockstep after the 
2008 financial crisis); see also A Review of Financial Market Events in Autumn 1998, Bank for 
International Settlements, Committee on the Global Financial System (1999), available at 
http://www.bis.org/publ/cgfs12.htm (during the Russian financial crisis in August 1998 the 
average correlation between five-day changes in yield spreads for 26 instruments in 10 economies 
rose from 11% in the first half of 1998 to 37% during the height of the crisis). 

269  See 2016 DERA Memo, supra note 12. 

http://www.bis.org/publ/cgfs12.htm


146 

While we do not propose an exposure-based test element as a means for limiting all 

funds’ leverage risk, we are proposing an exposure-based test for limited derivatives users (as 

discussed below).270  

We request comment on an exposure-based test as a means to limit funds’ leverage risk. 

 Should the rule incorporate an exposure-based approach in addition to, or in lieu of, 

the proposed VaR-based limit on fund leverage risk? If so, what derivatives exposure 

amount should this approach permit? For example, should we modify the proposed 

rule so that a fund would not be required to satisfy either VaR test if the fund limited 

its derivatives exposure, as defined for purposes of the limited derivatives user 

exception discussed below, to 50% of a fund’s net assets? Should an exposure-based 

approach focus on a fund’s overall gross market exposure and be based on the sum of 

the fund’s derivatives exposure and the value of its other investments, less any cash 

and cash equivalents? If so, should a fund’s gross market exposure be limited to 

150% of net assets to allow a fund to achieve the level of market exposure permitted 

for an open-end fund under section 18 using any combination of derivatives and other 

investments? Would any of these approaches to implementing an exposure-based 

limit on fund leverage risk effectively address the potential leverage associated with a 

fund’s derivatives transactions? If so, would funds find it more cost effective or 

otherwise preferable to have the option to comply with an exposure-based test in lieu 

of the proposed VaR tests? Please explain.  

 If the rule were to incorporate an exposure-based approach, should we permit funds to 

make netting and hedging adjustments when calculating their derivatives exposures? 
                                                      
270  See proposed rule 18f-4(c)(3). 



147 

If so, why? How should we define permissible netting and hedging transactions? If 

we permit netting and hedging to be incorporated into the exposure calculation, 

should the rule include third-party verification to test whether a fund’s netting and 

hedging calculations were reasonable and appropriate? What other provisions could 

achieve these concerns with netting and hedging? Please describe. 

 If the rule were to incorporate an exposure-based approach, should we permit funds to 

make risk-sensitive adjustments as discussed in the 2016 DERA Memo? If so, why? 

How should we define the permissible risk-adjusted notional amounts? If we permit 

these adjustments to be incorporated into the exposure calculation, should the rule 

include third-party verification to test whether a fund’s adjustments were reasonable 

and appropriate? What other provisions could achieve these concerns with risk-

adjusted notional amounts? Please describe. 

 Are there certain fund types or strategies where an exposure-based test would be 

more appropriate? If so, which ones and why? Would these fund types or strategies 

have difficulty conducting either a relative VaR test or absolute VaR test? If so, why 

would an exposure-based test be less challenging to conduct than a VaR-based test? 

 What challenges, if any, would funds have in conducting an exposure-based test? 

How could an exposure-based test rule account for these challenges? 

 Do funds currently conduct exposure-based tests as a means of measuring and 

limiting a fund’s leverage risk? If so, which ones and why? Are these exposure-based 

tests in place of or in addition to VaR-based tests or other risk measurements? Should 

the rule be modified to require both, and what benefits do funds find when running an 

exposure-based test and VaR-based test and comparing results? Would these 



148 

additional compliance burdens result in a more-accurate limit on fund leverage risk? 

If so, how much so, and what would the additional compliance burdens be? 

 In what ways is the proposed approach to limiting leverage risk superior or inferior to 

the current regulatory approach or alternative approaches, including the stress testing, 

asset segregation and exposure-based alternatives discussed herein? 

E. Limited Derivatives Users 

We are proposing an exception from the proposed rule’s risk management program 

requirement and VaR-based limit on fund leverage risk for funds that use derivatives in a limited 

manner. Requiring funds that use derivatives only in a limited way to adopt a derivatives risk 

management program that includes all of the proposed program elements could potentially 

require funds (and therefore their shareholders) to incur costs and bear compliance burdens that 

may be disproportionate to the resulting benefits.271 We recognize that the risks and potential 

impact of derivatives transactions on a fund’s portfolio generally increase as the fund’s level of 

derivatives usage increases and when funds use derivatives for speculative purposes.  

The proposed exception would cover two alternative types of limited derivatives use. It 

would be available to a fund that either limits its derivatives exposure to 10% of its net assets, or 

that uses derivatives transactions solely to hedge certain currency risks.272 A fund that relies on 

the proposed exception would also be required to adopt policies and procedures that are 

reasonably designed to manage its derivatives risks.273 We believe that the risks and potential 

                                                      
271  The cost burden concern extends to smaller funds as well, which could experience an even more 

disproportionate cost than larger funds. See infra sections III.C.3and V.D.1.c. 
272  See proposed rule 18f-4(c)(3)(i)-(ii); see also infra sections II.E.1 and II.E.2 (discussing the 

specific requirements for funds relying on either alternative of the proposed exception).  
273  See proposed rule 18f-4(c)(3). 



149 

impact of these funds’ derivatives use may not be as significant, compared to those of funds that 

do not qualify for the exception, and that a principles-based policies and procedures requirement 

would appropriately address these risks. We discuss and request comment on each of the 

elements of this proposed exception below. 

1. Exposure-Based Exception 

Under one alternative set of conditions, a fund would be permitted to rely on the limited 

derivatives user exception if its derivatives exposure does not exceed 10% of its net assets. The 

proposed rule would generally define the term “derivatives exposure” to mean the sum of the 

notional amounts of the fund’s derivatives instruments and, for short sale borrowings, the value 

of any asset sold short.274 This definition is designed to provide a measure of the market 

exposure associated with a fund’s derivatives transactions entered into in reliance on proposed 

rule 18f-4.275  

We recognize that using notional amounts as a measure of market exposure could be 

viewed as a relatively blunt measurement in that different derivatives transactions having the 

same notional amount but different underlying reference assets—for example, an interest rate 

swap and a credit default swap having the same notional amount—may expose a fund to very 

different potential investment risks and potential payment obligations. The derivatives exposure 

threshold in the limited derivatives user exception, however, is not designed to provide a precise 

measure of a fund’s market exposure or to serve as a risk measure, but rather to serve as an 

efficient way to identify funds that use derivatives in a limited way.  

                                                      
274  See proposed rule 18f-4(a) (defining the term “derivatives exposure”). 
275  Id. 



150 

The proposed definition of “derivatives exposure” would, however, include two 

adjustments designed to address certain limitations associated with measures of market exposure 

that use derivatives’ notional amounts without adjustments. Specifically, the proposed rule 

would permit a fund to convert the notional amount of interest rate derivatives to 10-year bond 

equivalents and delta adjust the notional amounts of options contracts.276 Converting interest rate 

derivatives to 10-year bond equivalents would provide for greater comparability of the notional 

amounts of different interest rate derivatives that provide similar exposure to changes in interest 

rates but that have different unadjusted notional amount. In addition, absent this adjustment, 

short-term interest rate derivatives in particular can produce large unadjusted notional amounts 

that may not correspond to large exposures to interest rate changes.277 Permitting funds to 

convert these and other interest rate derivatives to 10-year bond equivalents is designed to result 

in adjusted notional amounts that better represent a fund’s exposure to interest rate changes. 

Similarly, permitting delta adjusting of options is designed to provide for a more tailored 

notional amount that better reflects the exposure that an option creates to the underlying 

reference asset.  

These adjustments are therefore designed to provide for more tailored notional amounts 

that better reflect the exposure that a derivative creates to the underlying reference asset. 

Providing these adjustments also would be efficient for funds because the adjustments are 

consistent with the reporting requirements in Form PF and Form ADV.278 We do not believe 

                                                      
276  Id. Delta refers to the ratio of change in the value of an option to the change in value of the asset 

into which the option is convertible. A fund would delta adjust an option by multiplying the 
option’s unadjusted notional amount by the option’s delta.  

277   Id. 
278  See, e.g., General Instruction 15 to Form PF; Item B.30 of Section 2b of Form PF; Glossary of 

Terms, Gross Notional Value of Form ADV; Schedule D of Part 1A of Form ADV. 



151 

additional adjustments are necessary for purposes of identifying limited derivatives users. For 

example, commenters on the 2015 proposal suggested an approach to adjusting notional amounts 

based on the volatility of the underlying reference assets, and DERA staff analyzed these 

suggestions.279 We believe, however, that whether a fund is using derivatives in a limited way 

for purposes of the limited derivatives user exception should not depend on the volatility of the 

underlying reference assets, but rather on the extent to which a fund uses derivatives to 

implement its investment strategy.  

The proposed 10% derivatives exposure condition represents a threshold that is designed 

to exclude funds from the program requirement and the VaR-based limit on fund leverage risk 

when their derivatives exposure is relatively limited. This proposed threshold is based in part on 

staff analysis of funds’ practices regarding derivatives use. Specifically, DERA staff analyzed 

funds’ use of derivatives based on Form N-PORT filings as of September 2019. As discussed in 

more detail in section III, these filings covered mutual funds, ETFs, registered closed-end funds, 

and variable annuity separate accounts registered as management investment companies. Based 

on this analysis, 59% of funds report no derivatives holdings and 14% of funds report derivatives 

holdings with gross notional amounts above 50% of NAV. 

DERA staff also analyzed the levels of these funds’ derivatives exposure after adjusting 

interest rate derivatives and options, as permitted under the proposed rule. Taking these 

adjustments into account, DERA staff’s analysis showed that 78% of funds have adjusted 

notional amounts below 10% of NAV; 80% of funds have adjusted notional amounts below 15% 

of NAV; 81% of funds have adjusted notional amounts below 20% of NAV; and 82% of funds 

have adjusted notional amounts below 25% of NAV. Although BDCs are not required to file 
                                                      
279  See 2016 DERA Memo, supra note 12. 



152 

reports on Form N-PORT, our staff separately analyzed a sampling of BDCs, finding that of the 

sampled BDCs, 54% did not report any derivatives holdings and a further 29% reported using 

derivatives with gross notional amounts below 10% of net assets.280 

We recognize that not all funds are currently required to file reports on Form N-PORT.281 

It appears, however, that funds’ use of derivatives reflected in the Form N-PORT data is 

generally consistent with that in the representative sample studied in the White Paper prepared in 

connection with the 2015 proposal, entitled “Use of Derivatives by Investment Companies.”282 

For example, DERA staff compared the percentages of funds in both data sets that reported no 

derivatives and the percentage with gross notional amounts less than 50% of net assets. These 

figures were comparable, suggesting that the Form N-PORT data provides a representative 

sample of current funds, and not just the set of funds currently required to file reports on Form 

N-PORT.283 Taking these results into account, we are proposing to permit a fund to operate as a 

limited derivatives user if its derivatives exposure is below 10% of net assets. DERA staff 

                                                      
280  See infra section III.B.2. As noted above, our staff did not have sufficient information to adjust 

the notional amounts of the BDCs’ interest rate derivatives or options. Some of the 17% of the 
sampled BDCs with gross notional amounts exceeding 10% of net assets likely would have lower 
notional amounts after applying these adjustments.  

281  Larger fund groups—funds that together with other investment companies in the same “group of 
related investment companies” have net assets of $1 billion or more as of the end of the most 
recent fiscal year of the fund—currently are required to file reports on N-PORT. Smaller fund 
groups must begin to file reports on Form N-PORT by April 30, 2020. While only larger fund 
groups are currently required to file reports on Form N-PORT, existing filings nevertheless 
covered 89% of funds representing 94% of assets. See infra note 458 and accompanying text. 

282  DERA White Paper, supra note 1; see also ICI Comment Letter III (regarding a survey related to 
funds’ use of derivatives sent to its member firms, the Investment Company Institute stated “The 
survey was distributed to smaller fund complex members, yet relatively few responses were 
received from these smaller fund members. Based on anecdotal conversations with staff at these 
member complexes, the smaller fund firms described no to minimal use of derivatives.”). 

283  Specifically, the DERA White Paper observes that 68% of funds held no derivatives and 89% of 
funds had gross notional amounts less than 50% of net assets. See DERA White Paper, supra note 
1. The respective figures from the N-PORT data were 59% and 86% of funds.  



153 

analysis suggests that most funds either do not use derivatives or do so to a more limited extent, 

and that setting the derivatives exposure threshold for the limited user exception at 10%, 15%, 

20%, or 25%, for example, would result in nearly the same percentages of funds qualifying for 

the exception. We therefore are proposing a lower threshold of 10% because the lower threshold 

would result in nearly the same percentage of funds qualifying for the exception based on current 

practices while potentially providing greater investor protections in the future by requiring funds 

that exceed the lower 10% threshold to establish a program and comply with the VaR-based limit 

on fund leverage risk. 

The 2015 proposal also included an exception from that proposal’s risk management 

program requirement for funds: (1) whose notional derivatives exposure does not exceed 50% of 

net assets; and (2) that do not enter into “complex derivatives transactions,” defined in that 

proposal to include certain path-dependent and non-linear transactions.284 The 2015 proposal 

permitted funds to use delta-adjusted notional amounts for options but did not provide an 

adjustment for interest rate derivatives.  

We are proposing a 10% derivatives exposure threshold that takes into account certain 

adjustments rather than a higher figure, like the 50% threshold we proposed in 2015 that did not 

include adjustments for interest rate derivatives, because we believe this approach would more 

effectively identify funds whose derivatives may be effectively managed without a fund needing 

to establish a derivatives risk management program that includes all of the proposed program 

                                                      
284  Specifically, the 2015 proposal defined the term “complex derivatives transaction” to mean any 

derivatives transaction for which the amount payable by either party upon settlement date, 
maturity or exercise: (1) is dependent on the value of the underlying reference asset at multiple 
points in time during the term of the transaction; or (2) is a non-linear function of the value of the 
underlying reference asset, other than due to optionality arising from a single strike price. 2015 
proposed rule 18f-4(c)(1).  



154 

elements. A fund with derivatives exposure equal to 50% of net assets, for example, would be at 

risk of substantial losses, notwithstanding that an open-end fund could borrow an amount equal 

to 50% of its net assets from a bank.285 Conversely, if a fund were entering into interest rate 

derivatives—and especially short-term interest rate derivatives—those transactions’ unadjusted 

notional amounts could cause a fund to exceed the threshold we proposed in 2015 even though 

the fund’s derivatives risks could be less significant than those of other funds that would qualify 

for the exception. The approach the Commission proposed in 2015 therefore could have 

permitted some funds to rely on the exception while still taking on significant derivatives risks, 

while disqualifying other funds whose derivatives transactions may have posed less-significant 

risks but that had high unadjusted notional amounts. Here, our proposal is designed to address 

these concerns by proposing a lower derivatives exposure threshold while also allowing funds to 

adjust interest rate derivatives’ notional amounts because the unadjusted values may be more 

likely to overstate a fund’s market exposure.  

We also are not proposing to prohibit funds relying on the exception from entering into 

complex derivatives transactions as we proposed in 2015 because, as discussed in more detail 

below, we are proposing to require that limited derivatives users manage all of the risks 

associated with their derivatives transactions, including any complex derivatives transactions. In 

addition, if these or other complex or exotic derivatives were to embed multiple forms of 

optionality or other non-linearities such that the fund could not reliably compute the transaction’s 

                                                      
285  See, e.g., CFA Comment Letter (stating that the commenter did not believe it was “appropriate 

that a fund with 40 or 45 percent notional exposure should be viewed as having a limited amount 
of exposure obviating the requirement for that fund to implement a formal risk management 
program” and that “Section 18’s limit reflects a congressional determination on the level of 
exposure funds may not exceed; it does not reflect the level of exposure at which funds should 
begin to establish formal risk management practices”).  



155 

notional amount, the fund would not be able to confirm that its derivatives exposure is below 

10% of the fund’s net assets and therefore would not be able to rely on the limited derivatives 

user exception. Finally, if these complex derivatives transactions were to cause a fund’s 

derivatives exposure to exceed 10% of the fund’s net assets—or the fund were to exceed the 

limit for any other reason—the fund would have to reduce its derivatives exposure promptly or 

establish a derivatives risk management program and comply with the VaR-based limit on fund 

leverage risk as soon as reasonably practicable. 

We also considered an alternative approach to identifying funds that use derivatives in a 

limited way based on a fund’s disclosure. Specifically, we considered providing that a fund 

would be a limited derivatives user if its principal investment strategies disclosed in its 

prospectus do not involve the use of derivatives.286 A fund that does not identify the use of 

derivatives in its principal investment strategies should generally be using derivatives less 

extensively than a fund that does include the use of derivatives as a principal investment strategy. 

                                                      
286  See, e.g., ICI Comment Letter III (stating that an appropriate threshold for limited derivatives 

users could be whether a fund listed derivatives in its prospectus as a principal investment 
strategy). Form N-1A requires an open-end fund to disclose its principal investment strategies, 
including the particular type or types of securities in which the fund principally invests or will 
invest. See Item 9 of Form N-1A. Form N-1A also provides, in part, that “[i]n determining what 
is a principal investment strategy, consider, among other things, the amount of the Fund’s assets 
expected to be committed to the strategy, the amount of the Fund’s assets expected to be placed at 
risk by the strategy, and the likelihood of the Fund’s losing some or all of those assets from 
implementing the strategy.” See Instruction 2 to Item 9 of Form N-1A. Form N-2 requires a 
closed-end fund to concisely describe the fund’s investment objectives and policies that will 
constitute its principal portfolio emphasis, including the types of securities in which the fund 
invests or will invest principally. See Item 8 of Form N-2. The instructions to this item direct the 
fund to briefly describe the significant investment practices or techniques that the fund employs 
or intends to employ with several examples, including examples related to derivatives 
transactions.  



156 

This approach would provide some efficiencies for funds because they already are required to 

make this disclosure.287  

This approach would, however, have certain drawbacks. For example, whether a fund’s 

use of derivatives is a principal investment strategy is a facts-and-circumstances-based analysis. 

Funds that may appear broadly similar could provide different disclosures, leading to less 

consistency in the application of the derivatives risk management program requirement and in 

the application of the VaR-based limit on leverage risk.  

Taking these considerations into account, we are proposing to look at a uniform metric of 

a fund’s derivatives exposure, rather than at the more fact-specific question of whether a fund 

views the use of derivatives as a principal investment strategy. We believe the proposed 

approach should result in more-consistent determinations by funds and would be more 

appropriate in determining whether a fund should qualify for the limited derivatives user 

exception.  

We request comment on the proposed exposure-based exception. 

 Is it appropriate to permit funds to rely on the limited derivatives user exception if 

their derivatives exposure does not exceed 10% of their net assets? Why or why not? 

Should we lower or raise the proposed derivatives exposure threshold, for example to 

5% or to 15%? Why or why not? Should we lower it to a de minimis amount, such as 

1% or 3%, and provide that a fund with derivatives exposure below these levels is not 

required to adopt policies and procedures designed to manage derivatives risk? 

Should the threshold vary based on whether a fund is an open-end fund, registered 

                                                      
287  See ICI Comment Letter III (stating that 92% of the firms surveyed indicated that their firms have 

funds that list derivatives as a principal investment strategy in their prospectus). 



157 

closed-end fund, or BDC? If so, why, and which levels would be appropriate for each 

kind of fund? 

 The derivatives exposure of certain types of transactions may be difficult to calculate 

or may change rapidly, which may make it difficult for a fund to consistently comply 

with the limited derivatives user exception. Should we provide that a fund relying on 

the limited derivatives user exception may not enter into complex or exotic 

derivatives transactions, whose risks may not be fully reflected in their notional 

amounts? If so, what kinds of complex or exotic transactions? For example, should 

we provide that a fund relying on the exception may not enter into complex 

derivatives transactions, as defined in the 2015 proposal? Should we only permit a 

fund to have a more-limited amount of derivatives exposure associated with these 

transactions, such as 1% or 5% of net assets? Why or why not?  

 Should we prescribe how a fund must calculate its notional amounts, or is that term in 

the proposed rule sufficiently clear? If we should prescribe the calculation, what 

should we prescribe? For example, in 2015 the Commission proposed to define a 

derivatives transaction’s notional amount to mean, among other things: (1) the market 

value of an equivalent position in the underlying reference asset for the derivatives 

transaction (expressed as a positive amount for both long and short positions); or (2) 

the principal amount on which payment obligations under the derivatives transaction 

are calculated. Should we include this definition in rule 18f-4? The 2015 proposal 

also included specific provisions for calculating a derivatives transaction’s notional 

amount for: (1) derivatives that provide a return based on the leveraged performance 

of a reference asset; and (2) derivatives transactions for which the reference asset is a 



158 

managed account or entity formed or operated primarily for the purpose of investing 

in or trading derivatives transactions, or an index that reflects the performance of such 

a managed account or entity.288 Should we include either or both of these provisions 

in rule 18f-4? Why or why not? Would funds calculate their notional amounts 

consistently with these provisions even if they were not included in the rule text 

because the calculations would be consistent with the way market participants 

determine derivatives transactions’ notional amounts?  

 Would funds be able to calculate notional amounts for complex derivatives and, if so, 

would they reflect the market risk in the transactions? Why or why? If we permit 

funds to enter into complex derivatives transactions as defined in the 2015 proposal 

while relying on the limited derivatives user exception, should we require that funds 

calculate these transactions’ notional amounts as the Commission proposed in 2015? 

That proposal would have provided that the notional amount of a complex derivatives 

transaction would be the aggregate notional amounts of derivatives transactions 

(excluding complex derivatives transactions) reasonably estimated to offset 

substantially all of the market risk of the complex derivatives transaction. 

 For purposes of determining a fund’s derivatives exposure, should the proposed rule 

treat differently derivatives that create synthetic positions where the fund holds cash 

and cash equivalents with a value equal to the derivative’s notional amount less any 

posted margin? These transactions may not leverage the fund’s portfolio because of 

the fund’s holding cash and cash equivalents equal to the notional amount of the 

derivatives transaction less any posted margin, rather than investing in additional 
                                                      
288   See 2015 Proposing Release, supra 2, at n.158 and accompanying text. 



159 

securities or making other investments. Take, for example, a fund with $100 that 

posts $20 of initial margin to initiate a long position in a swap contract referencing a 

market index. If the fund posted cash and cash equivalents as initial margin and 

maintains the remaining $80 in cash and cash equivalents as well, the fund would 

have a market exposure that would be similar to having invested the fund’s $100 in 

the stocks composing the index. Such a transaction could, however, present other 

risks, such as counterparty risk. Because these synthetic transactions may not 

leverage a fund’s portfolio, should we permit a fund to exclude these transactions 

from its derivatives exposure? Conversely, because they can raise other risks, such as 

counterparty risks, should they be included in derivatives exposure as proposed?  

 Should the rule define limited derivatives users using an alternative methodology 

other than the proposed threshold tied to derivatives exposure (or, as discussed below, 

for funds that use derivatives to hedge currency risks)? Why or why not? For 

example, should the limited derivatives user exception be defined to include funds 

that do not disclose the use of derivatives as a principal investment strategy in their 

prospectuses? Would this disclosure-based exception threshold be over- or under-

inclusive? Would it lead to less consistency in the requirement to establish a 

derivatives risk management program and comply with a VaR-based limit on 

leverage risk and potentially create uncertainty for funds as to when they would 

qualify for the limited user exception? Why or why not? If this could lead to less 

consistency, would any additional instructions in funds’ registration forms, regarding 

what a fund should disclose as a principal investment strategy in its prospectus, help 

mitigate this concern, and if so, what should those instructions be? Is it appropriate to 



160 

tie an exception to the derivatives risk management program requirement and VaR-

based limit on fund leverage risk to a prospectus disclosure requirement? Why or why 

not?  

 Should the condition that a limited derivatives user’s derivatives exposure not exceed 

10% of the fund’s net assets address exceedances and remediation? Why or why not? 

For example, as noted above, if a fund’s derivatives exposure were to exceed 10% of 

the fund’s net assets, the fund would have to promptly reduce its derivatives exposure 

or establish a derivatives risk management program and comply with the VaR-based 

limit on fund leverage risk as soon as reasonably practicable. Should we provide in 

rule 18f-4 specific time periods for these actions and, if so, which time periods would 

be appropriate? As an alternative way to address temporary exceedances, should the 

rule provide that a fund will be a limited derivatives user if it adopts a policy 

providing that, under normal circumstances, the fund’s derivatives exposure will not 

exceed 10% of the fund’s net assets? If so, what should be considered “normal 

circumstances”? Would this standard be too subjective such that funds would have 

substantial derivatives exposures while still qualifying as limited derivatives users? 

Rather than a policy referring to “normal circumstances,” should we require a fund to 

disclose in its prospectus that it does not expect its derivatives exposure to exceed 

10% of the fund’s net assets? Should this disclosure also appear in the fund’s annual 

report? 

 Should we prohibit a fund whose derivatives exposure repeatedly exceeds 10% of net 

assets from relying on the exception again for a period of time? For example, if a 

fund were to exceed this limit more than two or three times in a year, should we161 

provide that the fund cannot rely on the limited derivatives user exception for one or 

two years?  

 In calculating derivatives exposure, should we permit a fund to convert the notional 

amount of interest rate derivatives to 10-year bond equivalents and delta adjust the 

notional amounts of options contracts, as proposed? Would delta adjusting options 

raise the concern that a fund’s delta-adjusted options exposure would be small, 

allowing a fund to avoid establishing a program, but could quickly grow in response 

to large price changes in the option’s reference asset? How should we address this 

concern? Should we permit additional adjustments? Why or why not? If so, what 

additional adjustments should we permit? For example, should we permit funds to 

adjust notional amounts based on the volatility of the underlying reference assets? 

Why or why not? 

 The proposed rule provides that, for a fund to operate as a limited derivatives user 

under the exposure-based prong, the fund’s derivatives exposure must not exceed 

10% of net assets. The rule does not, however, prescribe the frequency with which 

funds must calculate their derivatives exposure to evaluate their compliance. Should 

we require that a fund calculate its notional amounts daily, or at some other specified 

frequency? Are there other requirements we should specify regarding a fund’s 

calculation of its derivatives exposure? If so, what are they, and why would these 

other requirements more accurately address a fund’s derivatives exposure?  

 Should we permit a fund to adjust its derivatives exposure for purposes of the 



162 

proposed exception to account for certain netting and hedging transactions?289 Why 

or why not? If so, how should we define netting and hedging transactions for this 

purpose? How should we prescribe in rule 18f-4 the circumstances under which 

different derivatives—and particularly derivatives with different reference assets—

should be treated as hedged or offsetting? If the rule were to permit funds to exclude 

hedging or netting transactions from their derivatives exposure, should we require 

funds to maintain records concerning these transactions to help our staff and fund 

compliance personnel evaluate if the transactions reasonably could be viewed as 

hedging or netting? If so, what information should those records reflect? For example, 

the regulations under section 13 of the Bank Holding Company Act, commonly 

known as the Volcker Rule, require certain banking entities to maintain certain 

documentation relating to hedging strategies, including positions and techniques.290 

Should the proposed rule take this or a similar approach? As another example, should 

we require funds to identify both the asset being hedged or netted and the derivatives 

transaction used to hedge or net that asset? How should we consider the risk that the 

historical correlations underlying an adviser’s view that assets will have inverse price 

correlations can break down in times of market stress? How could a standard in the 

rule be reasonably objective such that funds and our staff could confirm a fund’s 

compliance? Should we permit funds to account for netting but not hedging or vice 

versa? Why or why not? Would the compliance burden to calculate netting and 

hedging transactions for purposes of such adjustments justify the benefits of 

                                                      
289   See paragraph accompanying supra notes 267-268. 
290  See 17 CFR 255.5(c). 



163 

permitting these adjustments? Why or why not? What other challenges could funds 

face in accounting for netting and hedging transactions that could increase the costs 

associated with this exercise, or that could negatively affect a fund’s ability to assess 

its derivatives exposure accurately? Could these challenges be mitigated in any way? 

If so, how?  

 Should we specify in the rule that a fund calculating its derivatives exposure may net 

any directly-offsetting derivatives transactions that are the same type of instrument 

and have the same underlying reference asset, maturity and other material terms, as 

we proposed in 2015? Why or why not? 

 In determining a fund’s derivatives exposure, or the level of derivatives exposure a 

fund may obtain while remaining a limited derivatives user, should we consider other 

types of investments, like structured notes, that have return profiles that are similar to 

many derivatives instruments? Take, for example, a fund with derivatives exposure 

exceeding the proposed 10% threshold by 2% that reallocates that 2% of its net asset 

value from a derivatives instrument to a structured note with a similar return profile. 

The fund would be a limited derivatives user on the basis that its derivatives exposure 

was below the threshold, but would present a similar risk profile to its prior portfolio 

that exceeded the threshold. Are there circumstances where we should require the 

fund in this example to include the value of the structured note (or similar investment) 

in determining its derivatives exposure? If so, which circumstances and what kinds of 

instruments should be included? As another alternative, should we provide that, when 

funds that invest in derivatives also invest in structured notes or similar investments, 

they should be subject to a lower threshold of derivatives exposure to remain a 



164 

limited derivatives user? If so, what lower level would be appropriate?  

2. Currency Hedging Exception 

Under the second alternative set of conditions, a fund could rely on the limited 

derivatives user exception if it limits its use of derivatives transactions to currency derivatives for 

hedging purposes as specified in the proposed rule.291 Under this exception, a fund could only 

use currency derivatives to hedge currency risk associated with specific foreign-currency-

denominated equity or fixed-income investments in the fund’s portfolio. In addition, the notional 

amount of the currency derivatives the fund holds could not exceed the value of the instruments 

denominated in the foreign currency by more than a negligible amount.292  

The proposed currency hedging exception reflects our view that using currency 

derivatives solely to hedge currency risk does not raise the policy concerns underlying 

section 18. While distinguishing most hedging transactions from leveraged or speculative 

transactions is challenging, we believe that the currency hedging described in the proposed rule 

is definable because it involves a single risk factor (currency risk) and requires that the 

derivatives instrument must be tied to specific hedged investments (foreign-currency-

denominated securities held by the fund).293 Although we recognize that most funds that use 

derivatives do not use them solely to hedge currency risks, these currency hedges are not 

intended to leverage the fund’s portfolio, and conversely could mitigate potential losses.294  

                                                      
291  See proposed rule 18f-4(c)(3)(ii).  
292   Id. 
293  Many hedges are imperfect, which makes it difficult to distinguish purported hedges from 

leveraged or speculative exposures. See 2015 Proposing Release, supra 2, at n.238 and 
accompanying text. 

294  See infra section III.C.3 (discussing the number of funds whose current derivatives transactions 
practices would qualify them for the currency hedging exception). 



165 

We also recognize that certain funds hedge all of the foreign currency risk associated 

with their foreign securities investments. A fund that invests all or substantially all of its assets in 

foreign securities and currency derivatives to hedge currency risks associated with the foreign 

securities necessarily would have derivatives exposure exceeding 10% of net asset value. This is 

because such a fund could have derivatives exposure up to approximately 100% of the fund’s net 

assets to hedge the risks associated with all of its foreign security investments. We therefore are 

proposing a separate basis for the limited derivatives user exception for currency hedging 

because certain funds that hedge currency risks would be unable to qualify for the exposure-

based limited derivatives user exception discussed above. 

Rather than proposing two alternative bases to qualify for the limited derivatives user 

exception, we considered permitting a fund to qualify as a limited derivatives user if its 

derivatives exposure does not exceed 10% of net assets, excluding any currency hedges as 

discussed above. We are not taking this combined approach, however, to preclude a fund that is 

operating as a limited derivatives user from engaging in a broad range of derivatives transactions 

that may raise risks that we believe should be managed through a derivatives management 

program and subject to the proposed VaR-based limit on fund leverage risk.  

We request comment on the proposed currency hedging exception. 

 Is the proposed currency risk hedging exception appropriate? Why or why not? 

Should we modify the proposed exception in any way? Why or why not? For 

example, should we limit the derivatives exposure of a fund that relies on the 

currency hedging exception, and if so, what should be that exposure threshold? 

Should we prescribe the kinds of currency derivatives that a fund may use while 

relying on the exception? If so, which derivatives should be permitted and which 



166 

should be prohibited and why? Should the rule refer to other foreign-currency-

denominated assets in addition to equity or fixed-income investments? For example, 

do funds hedge holdings of foreign currencies themselves in addition to foreign-

currency-denominated investments?  

 Are there other types of derivatives that funds use that are less likely to raise the 

policy concerns underlying section 18? If so, which derivatives, and how do funds 

use them? For instance, we are aware that funds use interest rate derivatives to hedge 

interest rate risk arising from fixed income investments in their portfolios. Should we 

modify the proposed hedging-based exception to also include interest rate derivatives 

that funds use for hedging purposes? Why or why not? If so, what challenges could 

funds encounter in identifying interest rate derivatives that are used for hedging 

purposes (instead of for speculation or to accomplish leveraging)? How could we 

define interest rate hedging in rule 18f-4 in a way that would allow hedging 

transactions while not permitting transactions that simply are speculating on the 

direction of interest rates? How could conditions in the rule help identify interest rate 

derivatives that funds use for “true” hedging? For example, should we require that 

any interest rate derivative that is treated as a hedge be tied to specific fixed-income 

securities or groups of specific fixed-income securities in the fund’s portfolio? This 

would be analogous to the proposed nexus between a fund’s currency derivatives and 

the fund’s hedged foreign-currency-denominated investments. Should we similarly 

allow a fund to treat as a hedging transaction an interest rate derivative that converts a 

fund’s fixed rate borrowings to floating rate borrowings or vice versa? To what extent 

do funds engage in these transactions? For funds that do engage in these transactions, 



167 

how large are the notional amounts of these transactions, in ten-year bond 

equivalents, as a percentage of the fund’s net assets?  

 Should the rule address what happens if a fund using currency derivatives exceeds the 

notional amount of the value of the instruments denominated in a foreign currency by 

more than a negligible amount? If so, how should we address exceedances? Should 

we provide further guidance on what a negligible amount would be? For example, 

should we provide guidance or provide in rule 18f-4 that exceedances of 1% or 2%, 

for example, would be negligible?  

 Should we permit funds that rely on the first alternative set of limited derivatives user 

conditions (limiting their derivatives exposure to 10% of net assets) to deduct the 

notional amounts of their currency derivatives used for hedging purposes when 

calculating their derivatives exposure for purposes of the proposed exception? Why 

or why not? Should we allow funds to rely on both exceptions at the same time, 

instead of the exceptions being alternatives? If the exceptions were combined, could 

that result in funds relying on the limited derivatives user exception developing larger 

and potentially more complex derivatives portfolios that that may raise risks more 

appropriately managed through a derivatives management program and subject to the 

proposed VaR-based limit on fund leverage risk? Why or why not? 

3. Risk Management 

A fund relying on the limited derivatives user exception would be required to manage the 

risks associated with its derivatives transactions by adopting and implementing policies and 



168 

procedures that are reasonably designed to manage the fund’s derivatives risks.295 The 

requirement that funds relying on the exception manage their derivatives risks recognizes that 

even a limited use of derivatives can present risks that should be managed.  

For example, a fund that uses derivatives solely to hedge currency risks would not be 

introducing leverage risk, but could still introduce other risks, including counterparty risk and the 

risk that a fund could be required to sell its investments to meet margin calls. As another 

example, certain derivatives, and particularly derivatives with non-linear or path-dependent 

returns, may pose risks that require monitoring even when the derivatives represent a small 

portion of net asset value. For example, because of the non-linear payout profiles associated with 

put and call options, changes in the value of the option’s underlying reference asset can increase 

the option’s delta, and thus the extent of the fund’s derivatives exposure from the option. An 

options transaction that represented a small percentage of a fund’s net asset value can rapidly 

increase to a larger percentage. 

The proposed rule would require funds relying on the limited derivatives user exception 

to adopt and implement policies and procedures reasonably designed to manage the funds’ 

derivatives risks. Because they would be reasonably designed to address each fund’s derivatives 

risks, these policies and procedures would reflect the extent and nature of a fund’s use of 

derivatives within the parameters provided in the exception. For example, a fund that uses 

derivatives only occasionally and for a limited purpose, such as to equitize cash, could have 

limited policies and procedures commensurate with this limited use. A fund that uses more 

complex derivatives with derivatives exposure approaching 10% of net asset value, in contrast, 
                                                      
295  See proposed rule 18f-4(c)(3); see also proposed rule 18f-4(a) (definition of “derivatives risks”) 

and supra note 118 and accompanying text (discussing the proposed definition of “derivatives 
risks”). 



169 

would need to have policies and procedures tailored to the risks these derivatives could present. 

These policies and procedures could be more extensive and could include elements similar to 

those required under the proposed derivatives risk management program.  

The 2015 proposal would have required funds relying on that proposal’s exception to the 

derivatives risk management program requirement to manage derivatives risks by determining 

(and maintaining certain assets to cover) a “risk-based coverage amount” associated with the 

fund’s derivatives. This amount represented an estimate of the amount the fund would expect to 

pay to exit the derivatives transaction under stressed conditions.  

The approach we are proposing here is designed to require a fund relying on the limited 

derivatives user exception to manage all of the risks associated with its derivatives transactions, 

and not just the risks that an asset segregation requirement could address.296 Moreover, our 

proposal is designed to limit derivatives risks by limiting the extent to which a fund can use 

derivatives while relying on the exception. As discussed above, the 2015 proposal would have 

permitted funds to obtain substantially greater derivatives exposure—up to 50% of net assets—

without establishing a derivatives risk management program. On balance, we believe that the 

proposed bases for the limited derivatives user exception, together with the requirement that a 

fund manage any risks its limited use of derivatives presents, would provide both important 

investor protections and flexibility for funds to use derivatives in a way that is consistent with the 

policy concerns underlying section 18.  

We request comment on the proposed requirement that a fund relying on the limited 

derivatives user exception manage the risks associated with its derivatives transactions by 

adopting policies and procedures that are reasonably designed to manage its derivatives risks. 
                                                      
296  We discuss the limitations of an asset segregation requirement in section II.F below. 



170 

 Is it appropriate to require funds relying on the limited derivatives user exception to 

adopt policies and procedures that are reasonably designed to manage their 

derivatives risks, in lieu of requiring such a fund to adopt a derivatives risk 

management program that includes all of the proposed program elements and comply 

with the proposed VaR-based limit on fund leverage risk? Would this requirement 

effectively address the risks entailed by the levels and types of derivatives use in 

which a fund that qualifies for the proposed exception might engage?  

 Alternatively, should funds eligible for the proposed limited derivatives user 

exception be subject to a tailored version of the proposed program requirement (e.g., 

a program requirement that would specify only certain elements, such as risk 

identification and assessment, establishing risk guidelines, stress testing, etc.)? If so, 

if so what should this entail? 

 Either in addition to or in lieu of policies and procedures reasonably designed to 

manage a fund’s derivatives risk, should we require funds relying on the limited 

derivatives user exception to comply with an asset segregation requirement? Should 

we use the same approach we proposed in 2015? Should we use that approach but 

allow funds to segregate a broader range of assets, such as the assets with 

corresponding haircuts analyzed in the 2016 DERA Memo?  

 Should we require limited derivatives users to publicly disclose that they are limited 

derivatives users in their prospectus, annual report, or on their website? If so, should 

we require any particular disclosure to enhance investors’ understanding of, for 

example: (1) the risks of investing in a fund that qualifies as a limited derivatives user 

under the proposed rule, or (2) such a fund’s derivatives risk management practices? 



171 

F. Asset Segregation 

The Commission and staff have historically taken the position that a fund may 

appropriately manage the risks that section 18 is designed to address if the fund “covers” its 

obligations in connection with various transactions by maintaining “segregated accounts.”297 

Funds’ practices regarding the amount of “cover” they segregate, and the assets available for 

segregation, have evolved over time. In addition, different funds have applied those practices in 

varying ways to derivatives transactions with comparable economic exposures. Moreover, 

regulatory and contractual margin requirements have developed significantly since the adoption 

of Release 10666.  

The 2015 proposal drew on the Commission’s historical approach—and sought to 

primarily address the Investment Company Act’s asset sufficiency concern—by including an 

asset segregation requirement as part of the 2015 proposed rule.298 Under the Commission’s 

2015 proposed approach, a fund relying on the proposed rule, in addition to complying with one 

of two portfolio limitations, would have had to maintain an amount of “qualifying coverage 

assets” designed to enable a fund to meet its derivatives-related obligations. Under the 2015 

proposed rule, a fund would not have been required to segregate a derivative’s full notional 

amount, but instead would have had to segregate qualifying coverage assets (generally cash and 

cash equivalents) equal to the sum of two amounts: (1) the amount that would be payable by the 

fund if the fund were to exit the derivatives transaction at the time of determination (the “mark-

to-market coverage amount”), and (2) a reasonable estimate of the potential amount payable by 

                                                      
297  See supra section I.B.2. 
298  See 2015 Proposing Release supra note 2, at section III.C. 



172 

the fund if the fund were to exit the derivatives transaction under stressed conditions (the “risk-

based coverage amount”).299  

Although commenters generally supported the overarching framework of the 2015 

proposed rule’s asset segregation requirement, they identified several operational complexities. 

For example, commenters stated that additional clarity was necessary for funds to determine risk-

based coverage amounts, including how funds should determine stressed conditions for this 

purpose.300 Commenters also raised questions about how funds could reduce segregated amounts 

to account for posted initial or variation margin and, more generally, how rule provisions 

governing coverage amounts would apply to cleared transactions (as opposed to OTC 

transactions covered by netting agreements).301 A number of commenters also expressed 

concerns about the proposed requirement that funds generally segregate cash and cash 

equivalents.302 Commenters suggested alternatives to this proposed requirement, including 

                                                      
299  See id. at section III.C.2 (discussing the composition of qualifying coverage assets as either: (1) 

cash and cash equivalents, or (2) with respect to any derivatives transaction under which the fund 
may satisfy its obligations under the transaction by delivering a particular asset, that particular 
asset). 

300  See, e.g., ICI Comment Letter I; BlackRock Comment Letter; Dechert Comment Letter; FSR 
Comment Letter; Guggenheim Comment Letter.  

301  See, e.g., SIFMA Comment Letter (stating that “[i]n practice, variation margin and initial margin 
are often calculated in the aggregate, on a net basis, rather than separately” and recommending 
that funds “be able to get credit for both initial and variation margin posted on a net basis …” 
rather than limiting the type of coverage amount against which initial or variation margin may be 
credited); BlackRock Comment Letter (stating that initial and variation margin are used for 
cleared and OTC derivatives transactions by the clearinghouse and counterparties, respectively, 
when a derivatives transaction is exited and that distinguishing between the uses of the two types 
of margin will introduce complexity given that both forms of margin are available to cover 
potential obligations under derivatives in the event of a party’s default). 

302  See, e.g., AIMA Comment Letter; AQR Comment Letter; BlackRock Comment Letter; Dechert 
Comment Letter; Comment Letter of Eaton Vance Management (Mar. 28, 2016) (“Eaton Vance 
Comment Letter”); Guggenheim Comment Letter; Comment Letter of JPMorgan (Mar. 28, 
2016); Oppenheimer Comment Letter; PIMCO Comment Letter. 



173 

allowing funds to segregate a broader range of assets subject to “haircuts” prescribed by the 

Commission based on the relative volatility of different asset classes.303  

Our proposal does not include a specific asset segregation requirement because we do not 

believe that an asset segregation requirement is necessary in light of the proposed rule’s 

requirements, including the requirements that funds establish risk management programs and 

comply with the proposed VaR-based limit on fund leverage risk. As discussed in more detail 

above, a fund relying on proposed rule 18f-4 would be required to adopt and implement a written 

derivatives risk management program that, among other things, would require the fund to: 

identify and assess its derivatives risks; put in place guidelines to manage these risks; stress test 

the fund’s portfolio at least weekly; and escalate material risks to the fund’s portfolio managers 

and, as appropriate, the board of directors.304 These proposed requirements are designed to 

require a fund to manage all of the risks associated with its derivatives transactions. These 

include—but are not limited to—the risk that a fund may be required to sell its investments to 

generate cash to pay derivatives counterparties, which the 2015 proposal’s asset segregation was 

designed to address.  

Moreover, the proposed rule would require that a fund’s stress testing for purposes of its 

derivatives management program specifically take into account the fund’s payments to 

derivatives counterparties that could result from losses in stressed conditions. Rather than require 

a fund to evaluate the amounts it would pay to exit derivatives transactions under stressed 

                                                      
303  See, e.g., Dechert Comment Letter; Eaton Vance Comment Letter; IAA Comment Letter; SIFMA 

Comment Letter, Guggenheim Comment Letter. 
304  Proposed rule 18f-4(c)(1). Funds that rely on the limited derivatives user exception also would be 

required to manage the risks associated with their more limited use of derivatives. See supra 
section II.E.  



174 

conditions on a transaction-by-transaction basis as in the 2015 proposal,305 our proposal would 

require funds to conduct portfolio-wide stress tests, taking into account potential payments to 

counterparties. Although counterparties often require funds to post margin or collateral for 

individual transactions (or groups of transactions) in order to cover potential loss exposure, the 

proposed rule’s stress testing requirement is designed to provide a portfolio-wide assessment of 

how the fund may respond to stressed conditions and any resulting payment obligations. This 

portfolio-wide assessment also would be buttressed by the other provisions in the risk 

management program and the proposed VaR-based limit on fund leverage risk, which are 

designed to limit a fund’s leverage risk and therefore the potential for payments to derivatives 

counterparties. The 2015 proposal’s derivatives risk management program, in contrast, did not 

include such a portfolio-wide assessment. We believe that the proposed rule’s requirements, in 

their totality, would appropriately address the asset sufficiency risks underlying section 18. 

A separate asset segregation requirement, in contrast, may be less effective. As 

derivatives markets evolve, questions may arise about the amount (and composition) of assets 

that funds must segregate for novel types of transactions. Although the Commission in 2015 

sought to take a principles-based approach to the amount of assets that funds would segregate, 

many commenters asserted that additional clarity would be necessary to administer this 

approach. It would be difficult in this context for the Commission to specify the amount of assets 

that funds should segregate on a transaction-by-transaction basis and to keep any specific 

requirements current as markets develop. And a principles-based approach to asset segregation, 

                                                      
305  In the 2015 proposal, funds were required to determine qualifying coverage assets on a 

transaction-by-transaction basis, with the exception that funds could determine the amount of 
qualifying coverage assets on a net basis for derivatives transactions covered by netting 
agreements. See 2015 proposed rule 18f-4(c)(6) and (9). 



175 

if it does not provide sufficient clarity, may contribute to the kinds of divergent asset segregation 

practices that exist today, which in turn have led to situations in which funds are not subject to a 

practical limit on potential leverage that they may obtain through derivatives transactions.306 By 

building on current risk management practices and techniques, including VaR and stress testing, 

the proposed rule is designed to provide a framework that we believe funds can apply to a broad 

variety of fund types and derivatives uses without our having to specify the operational details 

that an asset segregation requirement would entail.  

We request comment on our proposal not to include a specific asset segregation 

requirement. 

 Do commenters believe that the proposed rule’s requirements discussed above, in 

their totality, would appropriately address the asset sufficiency risks underlying 

section 18? If not and commenters believe rule 18f-4 should include an asset 

segregation requirement, what should that requirement entail? What added benefits 

would an asset segregation requirement provide that the current proposed rule 

requirements would not? 

 Should we require funds relying on the limited derivatives user exposure-based 

exception to segregate assets for purposes of the exception? Why or why not? Would 

an asset segregation requirement for such limited derivatives users obviate any need 

for a policies and procedures requirement? Why or why not? 

 Commenters in the 2015 release requested further clarity about the Commission’s 

2015 proposal to require a principles-based asset segregation regime. What aspect of 

that proposal required further clarity and why?  
                                                      
306  See supra sections I.B.2 and I.B.3. 



176 

G. Alternative Requirements for Certain Leveraged/Inverse Funds and 
Proposed Sales Practices Rules for Certain Leveraged/Inverse 
Investment Vehicles 

1. Background on Proposed Approach to Certain 
Leveraged/Inverse Funds 

Proposed rule 18f-4 would include an alternative approach for certain funds that seek to 

provide leveraged or inverse exposure to an underlying index, generally on a daily basis. This 

alternative approach would be available for a registered investment company that is a 

“leveraged/inverse investment vehicle,” as that term is defined in proposed Exchange Act rule 

15l-2 and proposed Advisers Act rule 211(h)-1 (which we refer to collectively as the proposed 

“sales practices rules,” as noted above). As discussed below, the proposed sales practices rules 

would require broker-dealers and investment advisers to engage in due diligence before 

accepting or placing an order for a customer or client that is a natural person (“retail investor”) to 

trade a leveraged/inverse investment vehicle, or approving a retail investor’s account for such 

trading. The definition of the term “leveraged/inverse investment vehicle” in the proposed sales 

practices rules would include certain entities that seek, directly or indirectly, to provide 

investment returns that correspond to the performance of a market index by a specified multiple, 

or to provide investment returns that have an inverse relationship to the performance of a market 

index, over a predetermined period of time.307 The entities included in the proposed scope of the 

sales practices rules would include registered investment companies and certain exchange-listed 

commodity- or currency-based trusts or funds. In this release, we refer to the registered 

investment companies covered by the proposed sales practices rules as “leveraged/inverse funds” 

                                                      
307  See proposed rules 15l-2(d) and 211(h)-1(d) (defining the term “leveraged/inverse investment 

vehicle”); see also, e.g., ETFs Adopting Release, supra note 76, at section II.A.3; rule 6c-11(c)(3) 
under the Investment Company Act.  



177 

(which in turn would be subject to the proposed alternative approach under rule 18f-4). We use 

the proposed sales practices rules’ defined term “leveraged/inverse investment vehicle” to refer 

to both such leveraged/inverse funds and to the exchange-listed commodity- or currency-based 

trusts or funds covered by those rules. 

Leveraged/inverse funds, which today are structured primarily as leveraged/inverse 

ETFs, seek to amplify the returns of an underlying index by a specified multiple or to profit from 

a decline in the value of their underlying index over a predetermined period of time using 

financial derivatives.308 These funds reset periodically and are designed to hedge against or profit 

from short-term market movements without using margin, and, as such, are generally intended as 

short-term trading tools.309 To achieve their targeted returns, leveraged/inverse funds use 

derivatives extensively. In contrast to other funds that use derivatives as part of their broader 

investment strategy, leveraged/inverse funds’ strategies (and use of derivatives) are predicated on 

                                                      
308  See infra section III.B for baseline statistics regarding leveraged/inverse ETFs and mutual funds. 

Leveraged/inverse ETFs operate under Commission orders providing exemptive relief from 
certain provisions of the Investment Company Act. These orders, however, do not provide 
exemptive relief from section 18 of the Investment Company Act. Rather, like other funds that 
use derivative investments, leveraged/inverse ETFs rely upon Release 10666 and operate 
consistent with the conditions in staff no-action letters and other staff guidance on derivatives 
transactions. See infra section II.L (discussing our proposal to rescind Release 10666, and stating 
that staff in the Division of Investment Management is reviewing certain of its no-action letters 
and other guidance to determine which letters and other staff guidance should be withdrawn in 
connection with any adoption of this proposal).  

The Commission recently adopted rule 6c-11 under the Investment Company Act to permit ETFs 
that satisfy certain conditions to operate without obtaining an exemptive order from the 
Commission. Rule 6c-11 includes a provision excluding leveraged/inverse ETFs from the scope 
of that rule. See infra section II.G.4 (discussing proposed amendments to rule 6c-11 and proposed 
rescission of exemptive orders issued to leveraged/inverse ETFs). 

309  See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 
Investment Advisers Act Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at text 
preceding n.39 (“Fiduciary Interpretation”). 



178 

leverage. Accordingly, leveraged/inverse funds raise the issues that section 18 of the Investment 

Company Act is designed to address. 

Leveraged/inverse funds and certain commodity pools following the same strategy also 

present unique considerations because they rebalance their portfolios on a daily (or other 

predetermined) basis in order to maintain a constant leverage ratio. This reset, and the effects of 

compounding, can result in performance over longer holding periods that differs significantly 

from the leveraged or inverse performance of the underlying reference index over those longer 

holding periods.310 This effect can be more pronounced in volatile markets.311 As a result, buy-

and-hold investors in a leveraged/inverse fund who have an intermediate or long-term time 

horizon—and who may not evaluate their portfolios frequently—may experience large and 

unexpected losses or otherwise experience returns that are different from what they 

anticipated.312 

                                                      
310  For example, as a result of compounding, a leveraged/inverse fund can outperform a simple 

multiple of its index’s returns over several days of consistently positive returns, or underperform 
a simple multiple of its index’s returns over several days of volatile returns.  

311  See FINRA Regulatory Notice 09-31, Non-Traditional ETFs – FINRA Reminds Firms of Sales 
Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds (June 2009) 
(“FINRA Regulatory Notice 09-31”) (“Using a two-day example, if the index goes from 100 to 
close at 101 on the first day and back down to close at 100 on the next day, the two-day return of 
an inverse ETF will be different than if the index had moved up to close at 110 the first day but 
then back down to close at 100 on the next day. In the first case with low volatility, the inverse 
ETF loses 0.02 percent; but in the more volatile scenario the inverse ETF loses 1.82 percent. The 
effects of mathematical compounding can grow significantly over time, leading to scenarios such 
as those noted above.”). 

312  See id. (reminding member firms of their sales practice obligations relating to leveraged/inverse 
ETFs and stating that leveraged/inverse ETFs are typically not suitable for retail investors who 
plan to hold these products for more than one trading session). See also Fiduciary Interpretation, 
supra note 309 (stating that “leveraged exchange-traded products are designed primarily as short-
term trading tools for sophisticated investors … [and] require daily monitoring ....”); Securities 
Litigation and Consulting Group, Leveraged ETFs, Holding Periods and Investment Shortfalls, 
(2010), at 13 (“The percentage of investors that we estimate hold [leveraged/inverse ETFs] longer 
than a month is quite striking.”); ETFs Adopting Release, supra note 76, at n.78 (discussing 
comment letters submitted by Consumer Federation of America (urging the Commission to 

 



179 

The Commission’s Office of Investor Education and Advocacy and FINRA have issued 

alerts in the past decade to highlight issues investors should consider when investing in 

leveraged/inverse funds.313 In addition, some commenters to the 2015 proposal indicated that at 

least some segment of investors may hold leveraged/inverse funds for long periods of time, 

which can lead to significant losses under certain circumstances.314 FINRA has sanctioned a 

number of brokerage firms for making unsuitable sales of leveraged/inverse ETFs.315 More 

                                                      

consider additional investor protection requirements for leveraged/inverse ETFs) and by Nasdaq 
(stating that “there is significant investor confusion regarding existing leveraged/inverse ETFs’ 
daily investment horizon”)). 

313  SEC Investor Alert and Bulletins, Leveraged and Inverse ETFs: Specialized Products with Extra 
Risks for Buy-and-Hold Investors (Aug. 1, 2009), available at 
http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm. This investor alert, jointly issued by 
SEC staff and FINRA, followed FINRA’s June 2009 alert, which raised concerns about retail 
investors holding leveraged/inverse ETFs over periods of time longer than one day. See FINRA 
Regulatory Notice 9-31, supra note 311. 

314  See, e.g., CFA Comment Letter (“There is evidence that suggests investors are incorrectly using 
certain alternative investments that use derivatives extensively. For example, despite the fact that 
double and triple leveraged ETFs are short-term trading vehicles that are not meant to be held 
longer than one day, a significant number of shares are held for several days, if not weeks.”). But 
cf. Comment Letter of Rafferty Asset Management (Mar. 28, 2016) (asserting that there is no 
evidence that investors do not understand the leveraged/inverse ETF product, citing, for example, 
an analysis of eight of its leveraged/inverse ETFs between May 1, 2009 and July 31, 2015, and 
finding an average implied holding period ranging from 1.18 days to 4.03 days and suggesting, 
therefore, that investors understand the products are designed for active trading). We note, 
however, that the analysis relied upon in the Comment Letter of Rafferty Asset Management did 
not analyze shareholder-level trading activity or provide any information on the distribution of 
shareholder holding periods. 

315  See FINRA News Release, FINRA Sanctions Four Firms $9.1 Million for Sales of Leveraged and 
Inverse Exchange-Traded Funds (May 1, 2012), available at 
https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-
inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus and Century 
Securities to Pay Fines and Restitution Totaling More Than $1 Million for Unsuitable Sales of 
Leveraged and Inverse ETFs, and Related Supervisory Deficiencies (Jan. 9, 2014), available at 
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-
fines-and-restitution-totaling; FINRA News Release, FINRA Sanctions Oppenheimer & Co. $2.9 
Million for Unsuitable Sales of Non-Traditional ETFs and Related Supervisory Failures (June 8, 
2016), available at http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-
million-unsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of 
Acceptance, Waiver and Consent (“AWC”) No. 2014039418801 (Aug. 8, 2016), available at 
http://disciplinaryactions.finra.org/Search/ViewDocument/66461; Citigroup Global Markets Inc., 

 

https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-inverse-exchange-traded
https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-inverse-exchange-traded
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-fines-and-restitution-totaling
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-fines-and-restitution-totaling
http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs
http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs
http://disciplinaryactions.finra.org/Search/ViewDocument/66461


180 

recently, the Commission has brought enforcement actions against investment advisers for, 

among other things, soliciting advisory clients to purchase leveraged/inverse ETFs for their 

retirement accounts with long-term time horizons, and holding those securities in the client 

accounts for months or years.316 

Most leveraged/inverse funds could not satisfy the limit on fund leverage risk in proposed 

rule 18f-4 because they provide leveraged or inverse market exposure exceeding 150% of the 

return or inverse return of the relevant index.317 These funds therefore would fail the relative 

VaR test and would not be eligible to use the absolute VaR test.318 Requiring these funds to 

comply with the proposed VaR tests therefore effectively would preclude sponsors from offering 

the funds in their current form. Investors who are capable of evaluating these funds’ 

characteristics and their unique risks, however, may want to use them to meet specific short-term 

or other investment goals. We therefore are proposing a set of alternative requirements for 

leveraged/inverse funds designed to address the investor protection concerns that underlie 
                                                      

FINRA Letter of AWC No. 20090191134 (May, 1, 2012), available at 
http://disciplinaryactions.finra.org/Search/ViewDocument/31714. See also Regulation Best 
Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86031 (June 5, 
2019) [84 FR 33318 (July 12, 2019)], at paragraph accompanying nn.593-98 (“Regulation Best 
Interest: The Broker-Dealer Standard of Conduct”). 
 
See also, e.g., S.E.C. v. Hallas, No 1:17-cv-2999 (S.D.N.Y. Sept. 27, 2017) (default judgement); 
In the Matter of Demetrios Hallas, S.E.C. Release No. 1358 (Feb. 22, 2019) (initial decision), 
Exchange Act Release No 85926 (May 23, 2019) (final decision) (involving a former registered 
representative of registered broker-dealers purchasing and selling leveraged ETFs and exchange-
traded notes for customer accounts while knowingly or recklessly disregarding that they were 
unsuitable for these customers, in violation of section 17(a) of the Securities Act and 
section 10(b) and rule 10b-5 thereunder of the Exchange Act). 

316  See, e.g., In the Matter of Morgan Stanley Smith Barney, LLC, Investment Advisers Act Release 
No. 4649 (Feb. 14, 2017) (settled action).  

317  See supra section II.D (discussing the proposed VaR-based limit on fund leverage risk). 
318  See supra section II.D (discussing relative and absolute VaR tests under proposed rule 18f-4). In 

addition, we understand that even if leveraged/inverse funds were to apply the proposed absolute 
VaR test, many of those funds also would fail that test. 

https://www.sec.gov/alj/aljdec/2019/id1358jeg.pdf
https://www.sec.gov/alj/aljdec/2019/34-85926.pdf181 

section 18 of the Investment Company Act, while preserving choice for these investors. These 

requirements, discussed below, are designed to help ensure that retail investors in 

leveraged/inverse investment vehicles are limited to those who are capable of evaluating the 

risks these products present. They also would limit the amount of leverage that leveraged/inverse 

funds subject to rule 18f-4 can obtain to their current levels. 

2. Proposed Sales Practices Rules for Leveraged/Inverse 
Investment Vehicles 

As a complement to proposed rule 18f-4, we are proposing sales practices rules under the 

rulemaking authority provided in Exchange Act section 15(l)(2) and Advisers Act section 

211(h).319 The proposed sales practices rules would require broker-dealers and investment 

advisers to exercise due diligence on retail investors before approving retail investor accounts to 

invest in leveraged/inverse investment vehicles. Specifically, proposed rule 15l-2 under the 

Exchange Act would require a broker-dealer (or any associated person of the broker-dealer) to 

exercise due diligence to ascertain certain essential facts about a customer who is a retail investor 

before accepting the customer’s order to buy or sell shares of a leveraged/inverse investment 

vehicle, or approving the customer’s account to engage in those transactions.320 Similarly, 

proposed rule 211(h)-1 under the Advisers Act would require an investment adviser (or any 

supervised person of the investment adviser) to exercise due diligence to ascertain the same set 

of essential facts about a client who is a retail investor before placing an order for that client’s 

                                                      
319  These provisions provide the Commission with authority to “where appropriate, promulgate rules 

prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes 
for brokers, dealers, and investment advisers that the Commission deems contrary to the public 
interest and the protection of investors.”  

320  Proposed rule 15l-2(a). In this release, the term “firm,” which collectively refers to Commission-
registered broker-dealers and investment advisers, also includes associated persons of such 
broker-dealers.  



182 

account to buy or sell shares of a leveraged/inverse investment vehicle, or approving the client’s 

account to engage in those transactions.321 Under both of the proposed sales practices rules, a 

firm could approve the retail investor’s account to buy or sell shares of leveraged/inverse 

investment vehicles only if the firm had a reasonable basis to believe that the investor is capable 

of evaluating the risks associated with these products.  

The proposed sales practices rules are designed to establish a single, uniform set of 

enhanced due diligence and approval requirements for broker-dealers and investment advisers 

with respect to retail investors that engage in leveraged/inverse investment vehicle transactions, 

including transactions where no recommendation or investment advice is provided by a firm. 

These rules therefore would apply the same due diligence requirements to both broker-dealers 

and investment advisers.322 They are designed to help ensure that investors in these funds are 

limited to those who are capable of evaluating their characteristics—including that the funds 

would not be subject to all of the leverage-related requirements applicable to registered 

investment companies generally—and the unique risks they present. Compliance with the 

proposed rules would not supplant or by itself satisfy other broker-dealer or investment adviser 

obligations, such as a broker-dealer’s obligations under Regulation Best Interest or an investment 

adviser’s fiduciary duty under the Advisers Act.323 

                                                      
321  Proposed rule 211(h)-1(a). In this release, the term “firm,” which collectively refers to 

Commission-registered broker-dealers and investment advisers, also includes supervised persons 
of such investment advisers. 

322  Although we expect that the proposed sales practices rules would cover a significant percentage 
of the retail investors who invest in leveraged/inverse investment vehicles, we recognize that not 
every purchase or sale of a leveraged/inverse investment vehicle will involve a customer or client 
of a Commission-registered broker-dealer or investment adviser that would be subject to the 
proposed sales practices rules. 

323  See Regulation Best Interest: The Broker-Dealer Standard of Conduct, supra note 315 (discussing 
broker-dealer obligations when providing a recommendation to a retail customer of any securities 

 



183 

The approval and due diligence requirements under the proposed rules are modeled after 

current FINRA options account approval requirements for broker-dealers.324 Under the FINRA 

rules governing options, a broker-dealer may not accept a customer’s options order unless the 

broker-dealer has approved the customer’s account for options trading.325 Similarly, the 

proposed sales practices rules would require that a firm approve a retail investor’s account before 

the retail investor may invest in leveraged/inverse investment vehicles. As such, the proposed 

sales practices rules, like the FINRA rule, would not require firms to evaluate retail investors’ 

eligibility to transact in these products on a transaction-by-transaction basis. We have generally 

modeled the proposed rules after the FINRA options account framework in part because 

leveraged/inverse investment vehicles, when held over longer periods of time, may have certain 

similarities to options.326 The options account approval requirements also represent a current 

framework that can be used in connection with complex products generally.327 This approach 

may provide some efficiencies and reduced compliance costs for broker-dealers that already have 

                                                      

transaction or investment strategy involving securities based on the customer’s investment 
profile); Fiduciary Interpretation, supra note 309 (discussing an investment adviser’s fiduciary 
duty to its client, and stating that as fiduciaries, investment advisers owe their clients duties of 
care and loyalty). 

324  See, e.g., FINRA rule 2360(b)(16), (17) (requiring for options accounts, firm approval, diligence 
and recordkeeping). 

325  FINRA rule 2360(b)(16). The same requirements apply for transactions in index warrants, 
currency index warrants, and currency warrants. See FINRA rules 2352 and 2353. Similar 
requirements apply for transactions in security futures. See FINRA rule 2370(b)(16) (requiring 
broker-dealer approval and diligence regarding the opening of accounts to trade security futures). 

326  For example, both leveraged/inverse investment vehicles and options provide exposure that is 
economically equivalent to a dynamically rebalanced inverse or leveraged position in an 
underlying asset. As a result, both have return characteristics that are more complex than those of 
the underlying asset, particularly as a leveraged/inverse investment vehicle’s leverage multiple 
and/or holding period increase. See infra section III.B.5. 

327  See FINRA Regulatory Notice 12-03 (providing, among other things, that FINRA members 
“should consider prohibiting their sales force from recommending the purchase of some complex 
products to retail investors whose accounts have not been approved for options trading”).  



184 

compliance procedures in place for approving options accounts, although we recognize that these 

efficiencies and reduced compliance costs would not apply to investment advisers that are not 

dually registered as, or affiliated with, broker-dealers subject to FINRA rules.  

a. Definition of Leveraged/Inverse Investment Vehicle 

The proposed sales practices rules would define a “leveraged/inverse investment vehicle” 

to mean a registered investment company or an exchange-listed commodity- or currency-based 

trust or fund (a “listed commodity pool”), that seeks, directly or indirectly, to provide investment 

returns that correspond to the performance of a market index by a specified multiple, or to 

provide investment returns that have an inverse relationship to the performance of a market 

index, over a predetermined period of time.328 Although the scope of this definition extends 

beyond just ETFs (as defined in rule 6c-11), this definition otherwise is substantively identical to 

the provision in rule 6c-11 excluding leveraged/inverse ETFs from the scope of that rule. The 

substantive requirements in the proposed definition in the sales practices rules have the same 

meaning as the provision in rule 6c-11.329 

We believe it is appropriate for the scope of the proposed sales practices rules to include 

leveraged/inverse funds as well as listed commodity pools that follow a similar leveraged or 

inverse strategy. The same investor protection concerns regarding aligning firms’ transaction 

practices with investors’ capability of evaluating the risks of these trading tools apply to this 

broader category of leveraged/inverse investment vehicles, and not just leveraged/inverse funds 

                                                      
328  See proposed rule 15l-2(d) and proposed rule 211(h)-1(d). 
329  See rule 6c-11(c)(4) (providing that scope of rule 6c-11 does not include ETFs that “seek, directly 

or indirectly, to provide investment returns that correspond to the performance of a market index 
by a specified multiple, or to provide investment returns that have an inverse relationship to the 
performance of a market index, over a predetermined period of time.”). See also ETFs Adopting 
Release, supra note 76, at section II.A.3 (discussing rule 6c-11(c)(4)). 



185 

specifically.330 Indeed, we understand that leveraged/inverse funds and listed commodity pools 

following the same strategy can have virtually identical investment portfolios. Applying the 

proposed rule to all leveraged/inverse investment vehicles, as defined in the proposed rules, 

would avoid potential regulatory arbitrage that could result if we were to place different 

requirements on these products. 

We request comment on the definition of the term “leveraged/inverse investment vehicle” 

in the proposed sales practices rules. 

 Is the scope of the proposed definition of the term “leveraged/inverse investment 

vehicle” appropriate? The definition includes a fund that seeks to provide investment 

returns that have an inverse relationship to the performance of a market index. Do 

commenters agree that this is appropriate? Should the definition instead only include 

an inverse fund that seeks investment returns that exceed the inverse performance of a 

market index by a specified multiple (e.g., -1.5 or lower)? Why or why not? The 

definition also includes a fund that seeks to provide performance results “over a 

predetermined period of time.” Do commenters agree that this is appropriate? 

Generally, the extent to which a fund’s performance can be expected to deviate from 

the multiple or inverse multiple of the performance of its index when held over longer 

periods is larger for funds that track a multiple or inverse multiple of the performance 
                                                      
330 The definition of commodity- or currency-based trusts or funds that we propose to include in the 

leveraged/inverse investment vehicle definition tracks a definition recently provided by Congress 
in the Fair Access to Investment Research Act of 2017, Public Law No. 115-66, 131 Stat. 1196 
(2017) (the “FAIR Act”), which we understand includes the kinds of commodity pools that 
generally pursue leveraged or inverse investment strategies. Our proposed definition differs from 
the FAIR Act definition because it would not include a trust or fund that holds only commodities 
or currencies and does not hold derivatives. Because we believe that trusts or funds that seek to 
provide a leveraged or inverse return of an index generally would use derivatives to do so, we do 
not believe it is necessary to include trusts or funds that do not hold derivatives in the proposed 
definition in the sales practices rules. 



186 

of an index over shorter time intervals, as those funds typically rebalance their 

portfolios more frequently. Should we specify a time period in the definition and, if 

so, what time period would be appropriate? For example, should the definition only 

include a fund that seeks investment returns that correspond to a multiple or inverse 

multiple of an index over a fixed period of time that is less than a year, a quarter, or a 

month? Please explain.  

 Do commenters agree with our proposal to include listed commodity pools within the 

definition? Are we correct that the similarities between the investment strategies and 

return profiles of listed commodity pools and other leveraged/inverse investment 

vehicles, such as leveraged/inverse ETFs, warrant including listed commodity pools 

within the scope of this definition? 

 Are there other types of investments or products that we should include in the 

leveraged/inverse investment vehicle definition? For example, should we include 

exchange-traded notes within the scope of the proposed sales practices rules if they 

have the same or similar return profile as the leveraged/inverse funds and listed 

commodity pools included in the proposed definition?331 Are there additional 

complex financial products, such as those discussed in FINRA Regulatory Notice 12-

03 (including, among others, certain structured or asset-backed notes, unlisted REITs, 
                                                      
331  The Commission also recently brought and settled an enforcement action against a dually-

registered broker-dealer/investment adviser, certain of its supervisory personnel, and one of its 
registered representatives arising out of that representative’s recommending that his customers 
buy and hold leveraged and inverse exchange-traded funds and exchange traded notes (including 
allegations that the registered representative recommended that his customers hold a triple-
leveraged exchange-traded note for longer than the one-day holding period set forth in the 
product’s prospectus). See In the Matter of Cadaret Grant, et al., Exchange Act Release No. 
84074 (Sept. 11, 2018) (alleging, among other things, a violation of section 206(4) of the 
Advisers Act and rule 206(4)-7 thereunder and failure to supervise) (settled action). See In the 
Matter of Cadaret Grant, et al., Exchange Act Release No. 84074 (Sept. 11, 2018) (settled action). 



187 

securitized products, and products that offer exposure to stock market volatility), that 

commenters believe should be subject to the due diligence and account approval 

requirements that we are proposing for leveraged/inverse investment vehicles?332 

b. Required Approval and Due Diligence in Opening 
Accounts 

Under the proposed sales practices rules, no firm may accept an order from or place an 

order for a retail investor to buy or sell shares of a leveraged/inverse investment vehicle, or 

approve such a retail investor’s account to engage in those transactions, unless the firm has 

complied with certain conditions. Specifically, the proposed rules would require the firm to (1) 

approve the retail investor’s account for buying and selling shares of leveraged/inverse 

investment vehicles pursuant to a due diligence requirement; and (2) adopt and implement 

policies and procedures reasonably designed to achieve compliance with the proposed rules. 

The proposed due diligence requirement provides that a firm must exercise due diligence 

to ascertain the essential facts relative to the retail investor, his or her financial situation, and 

investment objectives. A firm must seek to obtain, at a minimum, certain information about its 

retail investor’s: 

• investment objectives (e.g., safety of principal, income, growth, trading profits, 

speculation) and time horizon; 

• employment status (name of employer, self-employed or retired); 

• estimated annual income from all sources; 

• estimated net worth (exclusive of family residence); 

• estimated liquid net worth (cash, liquid securities, other); 

                                                      
332  See FINRA Regulatory Notice 12-03, supra note 327. 



188 

• percentage of the retail investor’s liquid net worth that he or she intends to invest in 

leveraged/inverse investment vehicles; and 

• investment experience and knowledge (e.g., number of years, size, frequency and type of 

transactions) regarding leveraged/inverse investment vehicles, options, stocks and bonds, 

commodities, and other financial instruments.333 

Based on its evaluation of this information, the firm would be required specifically to approve or  

disapprove the retail investor’s account for buying or selling shares of leveraged/inverse 

investment vehicles. If the firm approves the account, the approval must be in writing. 

Under the proposed rules, to provide this approval a firm must have a reasonable basis for 

believing that the retail investor has the financial knowledge and experience to be reasonably 

expected to be capable of evaluating the risks of buying and selling leveraged/inverse investment 

vehicles. We are not proposing a bright-line test for this determination. Rather, the determination 

would be based on all of the relevant facts and circumstances.  

The information that a firm would collect includes information about the retail investor’s 

financial status (e.g., employment status, income, and net worth (including liquid net worth)); 

and information about his or her investment objectives generally and his or her anticipated 

investments in, and experience with, leveraged/inverse investment vehicles (e.g., general 

investment objectives, percentage of liquid net worth intended for investment in 

leveraged/inverse investment vehicles, and investment experience and knowledge). This 

information is designed to provide a comprehensive picture of the retail investor to allow a firm 

to evaluate whether the retail investor has the financial knowledge and experience to be 
                                                      
333  See proposed rule 15l-2(b)(2). For joint accounts, the firm must seek to obtain the information for 

all participants in joint retail investor accounts. 



189 

reasonably expected to be capable of evaluating the risks of buying and selling leveraged/inverse 

investment vehicles. 

While not required under the proposed rules, firms could consider establishing multiple 

levels of account approvals for a retail investor seeking to trade leveraged/inverse investment 

vehicles. We understand that broker-dealers set different levels of options account approval 

depending on the customer’s trading experience and financial sophistication.334 Similarly, a firm 

may determine that certain leveraged/inverse investment vehicles (e.g., those with lower leverage 

multiples or that invest in less-volatile asset classes) are more appropriate for a lower level of 

account approval, while other types of leveraged/inverse investment vehicles may be more 

appropriate for a higher level of account approval. Any such approaches generally should be 

addressed in the policies and procedures that the proposed sales practices rules would require a 

firm to adopt and implement.335  

The proposed rules’ scope with respect to a firm’s customer or client is limited to “a 

natural person” or “the legal representative of a natural person.”336 The rules include all natural 

persons—including high-net worth individuals—to provide the related investor protections to all 

natural persons. The proposed rules require firms to seek to obtain and to consider information 

related to a retail investor’s net worth as part of their consideration of whether to approve the 

investor’s account for trading in leveraged/inverse investment vehicles. We interpret “legal 

representative” of a natural person to mean non-professional legal representatives of a natural 

                                                      
334  These increasing levels generally track the riskiness of the product or trading strategy; for 

example, the initial option account approval may permit covered call writing of equity options but 
higher account approvals would be needed for writing uncovered index options. 

335  See proposed rules 15l-2(a) and 211(h)-1(a). 
336  See proposed rules 15l-2(a) and 211(h)-1(a). 



190 

person. 337 This interpretation would exclude institutions and certain professional fiduciaries, but 

it would include certain legal entities such as trusts that represent the assets of a natural 

person.338 This interpretation is designed to provide the protections of the sales practices rules 

where non-professional persons are acting on behalf of natural persons, but where such 

professional persons are not regulated financial services industry professionals retained by 

natural persons to exercise independent professional judgment.339 

In addition, we are proposing to specify in the sales practices rules that, although the 

rules would apply to transactions by broker-dealers and investment advisers for retail investors—

including those investors who have existing accounts before the rules’ compliance date—the 

sales practices rules would not apply to a position in a leveraged/inverse investment vehicle 

established before the rules’ compliance date. This provision is designed to allow existing 

investors in leveraged/inverse investment vehicles with open investments as of the rules’ 

compliance date to sell their holdings (or to purchase leveraged/inverse investment vehicles to 

close out short positions in the leveraged/inverse investment vehicle) without the additional steps 

we propose to require for their broker-dealer or investment adviser to determine whether to 

approve the retail investor’s account to trade in these products.340 Absent this provision, the sales 

                                                      
337  See, e.g., Form CRS Relationship Summary, Exchange Act Release No. 34-86032 (June 5, 2019) 

[84 FR 33492 (July 12, 2019)] (“Form CRS Release”), at n.629 and accompanying text. 
338  See Form CRS Release, supra note 337, at nn.645-647 and accompanying text (clarifying 

interpretation of “legal representative” of a natural person to cover only non-professional legal 
representatives (e.g., a non-professional trustee that represents the assets of a natural person and 
similar representatives such as executors, conservators, and persons holding a power of attorney 
for a natural person)); Regulation Best Interest: The Broker-Dealer Standard of Conduct, supra 
note 315, at n.237 and accompanying text (defining “retail customer”). 

339  See Form CRS Release, supra note 337, at nn.645-647 and accompanying text. 
340  This provision is designed to allow a retail investor to exit a legacy position in a 

leveraged/inverse investment vehicle, as discussed above, and does not reflect any view on 
whether any recommendation for these legacy positions was suitable when made.  



191 

practices rules could prevent or delay a retail investor’s ability to close or reduce a position in a 

leveraged/inverse investment vehicle that he or she entered into before firms were required to 

comply with the rules. 

We also do not believe it would be appropriate to apply the sales practices rules only to 

retail accounts established after the rules’ compliance date, because the investor protection 

concerns underlying the rules would apply equally to pre-existing retail investor accounts. 

Accordingly, the proposed rules would make clear that, even if a retail investor had already been 

trading leveraged/inverse investment vehicles, a firm would have to satisfy the due diligence and 

account approval requirements for that investor’s account before the investor could make 

additional investments in leveraged/inverse investment vehicles.341 

The proposed sales practices rules also would require firms to adopt and implement 

written policies and procedures addressing compliance with the applicable sales practices rule.342 

We are not proposing to impose specific requirements for these policies and procedures, 

provided that they are reasonably designed to achieve compliance with the applicable sales 

practices rule, including the due diligence and account approval requirements. This requirement, 

together with the proposed recordkeeping requirements discussed below, is designed to provide 

comparable policies and procedures and recordkeeping requirements for both broker-dealers and 

investment advisers.  

We request comment on the proposed approval and due diligence requirements for 

approving retail investors’ accounts to trade in shares of leveraged/inverse investment vehicles. 

                                                      
341  As discussed above, this evaluation would take into account, among other things, the investor’s 

experience with leveraged/inverse investment vehicles. See, e.g., proposed rules 211(h)-1(b)(2) 
and 15l-2(b)(2). 

342  See proposed rule 15l-2(a); proposed rule 211(h)-1(a). 



192 

 Is modeling these rules on FINRA’s options rule the appropriate approach? Why or 

why not?  

 Should the proposed sales practices rules apply to Commission-registered broker-

dealers and investment advisers? Why or why not? What challenges, if any, would 

broker-dealers or investment advisers face complying with the proposed rules, and 

what compliance burdens would the proposed rules create for broker-dealers and 

investment advisers? Would compliance burdens be substantially different for 

investment advisers than for broker-dealers (for example, because of any compliance 

efficiencies that might result to the extent broker-dealers are already complying with 

FINRA’s rules for approving options accounts), or vice versa? Should we apply 

proposed Advisers Act rule 211(h)-1 to investment advisers that are registered with 

one or more states but not registered with the Commission? Why or why not? Should 

the proposed rule for investment advisers apply equally to advisers with discretionary 

authority and with non-discretionary authority over client accounts? If the sales 

practices rule for investment advisers applies to both discretionary and non-

discretionary advisory accounts, should we apply different due diligence and account 

approval requirements based on whether an account is discretionary or non-

discretionary? Should the proposed sales practices rules apply to investment advisers, 

in light of their fiduciary duties to their clients? Why or why not? Should the sales 

practices rules apply to a broker-dealer if the broker-dealer does not effect 

transactions in leveraged investment vehicles for retail investors other than 

transactions resulting from recommendations that are subject to Regulation Best 

Interest? Why or why not? 



193 

 Should the proposed rules apply to transactions in leveraged/inverse investment 

vehicles that are directed by a retail investor without any recommendation or advice 

from a broker-dealer or investment adviser? Why or why not? 

 Should the proposed rules apply on a transaction-by-transaction basis rather than 

requiring an initial account approval to transact in leveraged/inverse investment 

vehicles? Why or why not? 

 As proposed, the sales practices rules would require that a firm could provide account 

approval only if the firm has a reasonable basis for believing that the investor has 

such knowledge and experience in financial matters that he or she may reasonably be 

expected to be capable of evaluating the risks of buying and selling leveraged/inverse 

investment vehicles. Is this account approval standard appropriate? Why or why not? 

If not, what should the account approval standard be? Should it be tied instead, for 

example, to an investor’s ability to absorb losses, and if so how should a firm assess 

this? 

 Is the investor information that the proposed rules would require firms to seek to 

obtain under the rules’ due diligence requirements appropriate, and would this 

information effectively assist in forming a reasonable basis for assessing the 

investor’s knowledge and experience in financial matters as required under the 

proposed account approval standard? Why or why not? What modifications, if any, 

should we make to the information items that the proposed rules would require a firm 

to seek to obtain? Are there any information items that we should remove from the 

proposed list, or any additional information items that we should include? For 

example, instead of tracking generally the information elements set forth under 



194 

FINRA’s option rule, should the proposed rules track generally the information set 

forth in the definition of “retail customer investment profile” under Regulation Best 

Interest (i.e., “age, other investments, financial situation and needs, tax status, 

investment objectives, investment experience, investment time horizon, liquidity 

needs, risk tolerance, and any other information the retail customer may disclose to 

the broker, dealer, or a natural person who is an associated person of a broker or 

dealer”)? As proposed, should the rules require firms to seek to obtain the percentage 

of the investments that the retail investor intends to invest in leveraged/inverse 

investment vehicles? Why or why not? 

 Should the sales practices rules require firms to obtain the specified information, 

rather than to seek to obtain it? Would a firm be able to form a reasonable basis for 

believing that a retail investor has such knowledge and experience in financial matters 

that he or she may reasonably be expected to be capable of evaluating the risks of 

buying and selling leveraged/inverse investment vehicles if the retail investor 

provides some, but not all, of the information specified in the sales practices rules? 

 What special procedures, if any, do firms currently undertake in permitting or not 

permitting retail investors to trade in leveraged/inverse investment vehicles? At 

account opening? With respect to specific transactions? With respect to concentration 

limits? Do firms already have approval processes in place designed to evaluate 

whether their retail investors are reasonably expected to be capable of evaluating the 

risks of buying and selling leveraged/inverse investment vehicles? If so, do firms 

distinguish between types of vehicles or trading strategies? Do these practices differ 

between broker-dealers and investment advisers? If so, please explain the differences.  



195 

 What special procedures, if any, do firms currently undertake in permitting or not 

permitting retail investors to trade in other types of complex products? Please explain 

in detail, including products to which such procedures apply and what the approval 

process entails. 

 The proposed sales practices rules would require that firms’ approvals of retail 

investors’ accounts for buying or selling shares of leveraged/inverse investment 

vehicles be in writing. The proposed rules would not require account disapprovals to 

be in writing. Should we require account disapprovals also to be in writing? Would 

such a requirement raise any practical concerns, or other concerns, for firms? In other 

investor approval contexts, do firms currently put both their approvals and 

disapprovals in writing? 

 How do broker-dealers apply the options eligibility requirement with respect to 

clients of investment advisers, if at all, when those advisers submit orders on behalf 

of their clients? Do broker-dealer practices differ with respect to orders submitted by 

other types of intermediaries? Please explain.  

 How do broker-dealers currently analyze the information they collect under FINRA 

rule 2360? Which data elements do broker-dealers find most important and which 

elements are less important? What standards do broker-dealers apply in determining 

whether to approve a customer’s account on the basis of the information collected?  

 Should the proposed rules require firms to provide specific disclosure as part of the 

approval process, similar to the options disclosure document that must be provided 

under FINRA rule 2360? If so, what information should it contain? Should the rules 

require that receipt of such disclosure be acknowledged? 



196 

 Should the rules require firms to provide retail investors a short, plain-English 

disclosure generally describing the risks associated with leveraged/inverse investment 

vehicles as part of the proposed account approval process? For example, before a firm 

approves a retail investor’s account for buying and selling shares of a 

leveraged/inverse investment vehicle, should the rules require a firm to incorporate 

and distill into a short disclosure the specific risk factors associated with 

leveraged/inverse investment vehicles (such as the risks related to compounding and 

other risks that leveraged/inverse funds disclose in their prospectuses)? 

 Should the rules apply to all customers or clients, and not just natural persons? 

Should they apply to a different subset of customers or clients and, if so, which ones 

and why? If the rule were to apply to all customers or clients, including institutional 

accounts, what changes should we make to the information that firms must collect or 

to the basis upon which a firm would approve or disapprove the account? Are there 

distinctions between institutional investors and natural persons that invest in 

leveraged/inverse investment vehicles that we should consider? For example, do 

commenters have data or information on the percentage of leveraged investment 

vehicles’ investors who are natural persons, and how natural persons use these 

investment products (e.g., how long do these investors hold the products)?  

 As discussed above, we understand that certain purchases or sales of 

leveraged/inverse investment vehicles do not involve a customer or client of a broker-

dealer or investment adviser that would be subject to the proposed sales practices 



197 

rules.343 Should the proposed rules apply to these transactions? For example, should 

the proposed sales practices rule for broker-dealers apply to a mutual fund principal 

underwriter’s transactions with any retail investor who is purchasing fund shares 

directly from the fund? 

 Should the sales practices rules include different account-approval conditions for 

different types of leveraged/inverse investment vehicles? For example, should the 

rules include different conditions for investment vehicles that seek to exceed the 

performance of a market index by a specified multiple, versus those that provide 

returns that have an inverse relationship to the performance of a market index? 

Should the rules include different levels of account approval, such as heightened 

requirements for investors to transact in leveraged/inverse investment vehicles with 

higher leverage multiples or that invest in more volatile asset classes? Similarly, 

should the rules include different levels of account-approval conditions based on a 

retail investor’s trading experience and financial sophistication? 

 Do commenters agree that we should apply the sales practices rules to all retail 

investors, including those who have opened accounts with an investment adviser or 

broker-dealer before the rules’ compliance date? Should the sales practices rules 

include exceptions from the due diligence and account approval requirements for 

retail investors that have already traded in leveraged/inverse investment vehicles as of 

the rules’ compliance date? Should the sales practices rules provide exceptions for 

retail investors who meet established criteria, such as retail investors who are 

accredited investors? Why or why not? 
                                                      
343  See supra note 322. 



198 

 The proposed rules also would not apply to, and therefore would not restrict a retail 

investor’s ability to close or reduce, a position in a leveraged/inverse investment 

vehicle established before the rules’ compliance date. Do commenters agree that this 

is appropriate? Are there modifications we should make to the rules so that they 

would not impede an investor’s ability to close or reduce an existing position in a 

leveraged/inverse investment vehicle? Which modifications and why? Alternatively, 

should the sales practices rules apply to retail investors with positions in 

leveraged/inverse investment vehicles established before the rules’ compliance date 

even if they do not seek to make additional purchases or sales of leveraged 

investment vehicles? If so, how would firms comply, in practice, with the due 

diligence and account approval requirements for these investors? 

 Do commenters agree with the proposed policies and procedures requirement? Should 

the rule provide specific requirements for firms’ policies and procedures relating to 

compliance with the sales practices rules? 

c. Recordkeeping 

Under the proposed sales practices rules, a firm would have to maintain a written record 

of the investor information that it obtained under the rules’ due diligence requirements, the 

firm’s written approval of the retail investor’s account for buying and selling shares of 

leveraged/inverse investment vehicles, and the versions of the firm’s policies and procedures that 

it adopted under the proposed rules that were in place when it approved or disapproved the 

account. We propose that firms be required to retain these records for a period of not less than 

six years (the first two years in an easily accessible place) after the date of the closing of the 



199 

investor’s account.344 We believe that it is appropriate for the proposed rules to include a 

recordkeeping provision to facilitate compliance, and regulatory oversight of a firm’s 

compliance, with the rules. Also, because an investor account that was approved to trade in 

leveraged/inverse investment vehicles could remain open with a firm for more than six years, we 

believe it is appropriate to require that records be preserved for a minimum of six years after the 

closing of the account, rather than six years after the creation of the records.345 We believe that 

this recordkeeping requirement would provide sufficient investor protection and, because it is 

generally consistent with recordkeeping requirements for broker-dealers and investment advisers, 

would not impose overly burdensome recordkeeping costs.346  

We request comment on the recordkeeping requirement in the proposed sales practices 

rules: 

 Is the proposed recordkeeping requirement appropriate? Why or why not?  

 What changes, if any, should we make to this proposed requirement (e.g., by 

modifying the types of records that a firm would have to keep)? 

 Does our proposal to apply the same recordkeeping requirement to both broker-

                                                      
344  See proposed rules 15l-2(c) and 211(h)-1(c). 
345  This is consistent with other Commission recordkeeping requirements relating to investor account 

documentation. See, e.g., rule 17a-4(c) under the Exchange Act (requiring broker-dealers to 
preserve for a period of not less than six years after the closing of any customer’s account any 
account cards or records relating to the terms and conditions with respect to the opening and 
maintenance of the account).  

346  See, e.g., id.; see also rule 204-2(e)(1) under the Investment Advisers Act (requiring investment 
advisers to preserve certain records in an easily accessible place for a period of not less than five 
years from the end of the fiscal year during which the last entry was made on such record, the 
first two years in an appropriate office of the investment adviser). While we recognize that our 
existing recordkeeping requirements generally require broker-dealers to preserve records for six 
years and investment advisers for five years, we believe it would be appropriate for the 
recordkeeping requirements under the proposed sales practices rule to be consistent, in part 
because many broker-dealers and investment advisers are dual-registered, and thus are proposing 
a six-year period for both rules. 



200 

dealers and investment advisers raise any specific recordkeeping concerns for either 

broker-dealers or investment advisers (e.g., do investment advisers believe it would 

be particularly burdensome to comply with a six-year recordkeeping period)? Should 

the proposed rules include different requirements for broker-dealers and investment 

advisers? 

 Is the proposed duration of the recordkeeping provision, including the proposed 

requirement that the records be maintained for a minimum of six years after the 

closing of the investor’s account, appropriate? Does using the closing of the 

investor’s account as the starting point for the recordkeeping period raise any 

practical difficulties for firms? Should we lengthen or shorten the required 

recordkeeping periods? Why or why not? 

3. Alternative Provision for Leveraged/Inverse Funds Under 
Proposed Rule 18f-4 

Under proposed rule 18f-4, a fund would not have to comply with the proposed VaR-

based leverage risk limit if it: (1) meets the definition of a “leveraged/inverse investment 

vehicle” in the proposed sales practices rules; (2) limits the investment results it seeks to 300% 

of the return (or inverse of the return) of the underlying index; and (3) discloses in its prospectus 

that it is not subject to proposed rule 18f-4’s limit on fund leverage risk. We refer to this set of 

proposed conditions collectively as the “alternative provision for leveraged/inverse funds.” A 

leveraged/inverse fund that satisfies these conditions still would be required to satisfy all of the 

additional conditions in proposed rule 18f-4 other than the VaR tests, including the proposed201 

conditions requiring a derivatives risk management program, board oversight and reporting, and 

recordkeeping.347  

First, the alternative provision for leveraged/inverse funds requires that a 

leveraged/inverse fund be a “leveraged/inverse investment vehicle” as defined in the proposed 

sales practices rules.348 As discussed above, the proposed sales practices rules are designed to 

help ensure that investors in leveraged/inverse investment vehicles are limited to those who are 

capable of evaluating their general characteristics and the unique risks they present.  

Second, the alternative provision for leveraged/inverse funds would limit a 

leveraged/inverse fund’s market exposure by providing that the fund must not seek or obtain, 

directly or indirectly, investment results exceeding 300% of the return (or inverse of the return) 

of the underlying index.349 This limitation reflects the highest leverage level currently permitted 

by our exemptive orders for leveraged/inverse ETFs.350 It therefore reflects the maximum 

amount of leverage in these funds with which investors and other market participants are 

familiar. To permit leveraged/inverse funds to use a higher level of leverage would heighten the 

investor protection concerns these funds present, notwithstanding their more limited investor 

base.351 Moreover, allowing leveraged/inverse funds to increase their leverage beyond current 

levels would result in a non-linear increase in the extent of leveraged/inverse funds’ rebalancing 

activity, which may have adverse effects on the markets for the constituent securities as 

                                                      
347  See proposed rule18f-4(c)(1), (5)-(6). 
348  See proposed rule 18f-4(c)(4)(i); proposed rules 15l-2(d) and 211(h)-1(d) (defining the term 

“leveraged/inverse investment vehicle”). 
349  See proposed rule 18f-4(c)(4)(iii). 
350  See ETFs Adopting Release, supra note 76, at n.75 and accompanying text. 
351  See also section III.C.5. 



202 

discussed in more detail in sections III.D.1 and III.E.4. For these reasons, and because the 

Commission does not have experience with leveraged/inverse funds that seek returns above 

300% of the return (or inverse of the return) of the underlying index, we are not proposing to 

permit higher levels of leveraged market exposure for leveraged/inverse funds in this rule.  

Third, the alternative provision for leveraged/inverse funds would require a 

leveraged/inverse fund to disclose in its prospectus that it is not subject to the condition of 

proposed rule 18f-4 limiting fund leverage risk.352 This requirement is designed to provide 

investors and the market with information to clarify that leveraged/inverse funds—which as 

discussed above, use derivatives extensively—are not subject to rule 18f-4’s limit on fund 

leverage risk. 

We request comment on the proposed alternative provision for leveraged/inverse funds. 

 Should the rule include an alternative set of requirements for leveraged/inverse 

funds? Should leveraged/inverse funds instead be required to meet the proposed 

requirements for all funds that use derivatives, including the VaR-based limit on fund 

leverage risk? If commenters agree that we should permit leveraged/inverse ETFs to 

rely on rule 18f-4 based on an alternative set of requirements, are there additional 

conditions—either relating to these funds’ derivatives risk management or 

otherwise—that we should consider requiring those funds to satisfy? To what extent 

would additional limitations or restrictions on leveraged investment vehicles’ 

advertising or marketing materials help to address the investor protection concerns 

discussed above? 

 Does our proposal to include within the scope of the rule only leveraged/inverse 
                                                      
352  See proposed rule 18f-4(c)(4)(ii). 



203 

funds that are covered by the proposed sales practices rules, along with the conditions 

comprising the alternative provision for leveraged/inverse funds, address the investor 

protection concerns related to leveraged/inverse funds? 

 If leveraged/inverse funds operate pursuant to the proposed alternative provision, 

should they nonetheless be subject to other requirements in the proposed rule (e.g., 

the proposed risk management program requirement, board oversight and reporting 

requirement, and recordkeeping requirement)?  

 Should leveraged/inverse funds relying on the alternative provision be required to 

disclose in their prospectuses that the fund is not subject to the proposed VaR-based 

limit on fund leverage risk, as proposed? If so, what would be the most appropriate 

method of disclosure? In addition to requiring this disclosure under rule 18f-4, should 

we also include this requirement in Form N-1A? Would it aid practitioners for a 

leveraged/inverse fund’s registration form to specify this requirement? 

 Should a leveraged/inverse fund relying on rule 18f-4 be required to limit the 

investment results it seeks or obtains to 300% of the return (or inverse of the return) 

of the underlying index? Would some other threshold be more appropriate? Should 

the threshold be higher, such as 400%, or lower, such as 150% or 200%? 

 Any registered investment company that operates as a leveraged/inverse fund would 

be eligible to comply with the proposed alternative provision for leveraged/inverse 

funds in rule 18f-4. Should we limit the scope of leveraged/inverse funds eligible for 

this provision to open-end funds, including ETFs?  



204 

4. Proposed Amendments to Rule 6c-11 under the Investment 
Company Act and Proposed Rescission of Exemptive Relief for 
Leveraged/Inverse ETFs  

Earlier this year, the Commission adopted rule 6c-11, which permits ETFs that satisfy 

certain conditions to operate without obtaining an exemptive order from the Commission.353 

Rule 6c-11 includes a provision excluding leveraged/inverse ETFs from the scope of ETFs that 

may rely on that rule.354 Leveraged/inverse ETFs, therefore, continue to rely on their 

Commission exemptive orders. In adopting rule 6c-11, the Commission stated that the particular 

section 18 concerns raised by leveraged/inverse ETFs’ use of derivatives distinguish those funds 

from the other ETFs permitted to rely on that rule, and that those section 18 concerns would be 

more appropriately addressed in a rulemaking addressing the use of derivatives by funds more 

broadly.355 The Commission further stated that leveraged/inverse ETFs are similar in structure 

and operation to the other types of ETFs that are within the scope of rule 6c-11.356 The rules we 

are proposing, rule 18f-4 under the Investment Company Act and the sales practices rules under 

the Exchange Act and the Advisers Act, would create an updated and more comprehensive 

regulatory framework for the use of derivatives by funds, including provisions specifically 

applicable to leveraged/inverse ETFs. Accordingly, we propose to amend rule 6c-11 to remove 

the provision excluding leveraged/inverse ETFs from the scope of that rule one year following 

the publication of the final amendments in the Federal Register. 

                                                      
353  See ETFs Adopting Release, supra note 76. 
354  See rule 6c-11(c)(4). 
355  See ETFs Adopting Release, supra note 76, at nn.72-75 and accompanying text.  
356  See id. at text following n.86. In addition, one sponsor of leveraged/inverse ETFs has stated that 

its ETFs would prefer to rely on rule 6c-11 over their exemptive orders and that leveraged/inverse 
ETFs would be able to comply with rule 6c-11 because they are structured and operated in the 
same manner as other ETFs that fall within the scope of that rule. See id. at n.83 and 
accompanying text. 



205 

In addition, because the proposed amendments to rule 6c-11 would permit 

leveraged/inverse ETFs to rely on that rule rather than their exemptive orders, we are proposing 

to rescind the exemptive orders we have previously issued to leveraged/inverse ETFs. The 

exemptive relief granted to leveraged/inverse ETFs has resulted in an uneven playing field 

among market participants because the Commission has permitted only three ETF sponsors to 

operate leveraged/inverse ETFs and has not granted any exemptive relief for leveraged/inverse 

ETFs since 2009.357 We believe that amending rule 6c-11 and rescinding these exemptive orders 

would promote a more level playing field and greater competition by allowing any sponsor to 

form and launch a leveraged/inverse ETF subject to the conditions in rules 6c-11 and proposed 

rule 18f-4, with transactions in the funds subject to the proposed sales practices rules. We 

propose to rescind these exemptive orders on the effective date of the proposed amendments to 

rule 6c-11 (one year following the publication of the final rule amendments in the Federal 

Register), to coincide with the compliance date for the sales practices rules and to allow time for 

broker-dealers and investment advisers to make any adjustments necessary to comply with the 

proposed sales practices rules. Providing a one-year period for existing leveraged/inverse ETFs 

also would provide time for them to prepare to comply with rule 6c-11 rather than their 

exemptive orders.358  

                                                      
357  There are currently two ETF sponsors that rely upon this exemptive relief today. See supra note 

308 and accompanying text; infra note 474 and accompanying text. We also discuss below in 
section III.E alternative approaches for leveraged/inverse funds, including an approach under 
which the Commission would rescind the exemptive orders issued to leveraged/inverse ETF 
sponsors, permit leveraged/inverse funds to operate under rule 6c-11, but require 
leveraged/inverse funds to comply with rule 18f-4’s VaR-based limit on fund leverage risk in lieu 
of adopting the proposed sales practices rules.  

358  See ETFs Adopting Release, supra note 76, at text following n.451. 



206 

We request comment on the proposed amendments to rule 6c-11 and rescission of 

leveraged/inverse ETF exemptive orders. 

 If leveraged/inverse funds are permitted to rely on rule 18f-4, should the Commission 

amend rule 6c-11 to permit leveraged/inverse funds to operate under that rule, as 

proposed? Do the requirements of proposed rule 18f-4, together with the proposed 

sales practices rules, adequately address the section 18 concerns relating to 

leveraged/inverse funds? Are there are other concerns regarding leveraged/inverse 

funds that we should consider in determining whether to allow such funds to rely on 

rule 6c-11? 

 In addition, do commenters agree with our proposal to rescind the existing 

leveraged/inverse ETF exemptive relief in view of our proposed treatment of 

leveraged/inverse funds under rule 18f-4 and proposed amendments to rule 6c-11? 

Are there other approaches to the existing leveraged/inverse ETF exemptive relief 

that we should consider in view of proposed rule 18f-4 and the proposed sales 

practices rules? 

H. Amendments to Fund Reporting Requirements 

We are proposing amendments to the reporting requirements for funds that would rely on 

proposed rule 18f-4—in particular, amendments to Forms N-PORT, N-LIQUID (which we 

propose to re-title as “Form N-RN”), and N-CEN.359 These proposed amendments are designed 

to enhance the Commission’s ability to oversee funds’ use of and compliance with the proposed 

rules effectively, and for the Commission and the public to have greater insight into the impact 

                                                      
359  17 CFR 274.150; 17 CFR 274.223; and 17 CFR 249.330 and 17 CFR 274.101. 



207 

that funds’ use of derivatives would have on their portfolios.360 They would allow the 

Commission and others to identify and monitor industry trends, as well as risks associated with 

funds’ investments in derivatives (including by requiring current, non-public reporting to the 

Commission when certain significant events related to a fund’s leverage risk occur). The 

proposed amendments also would aid the Commission in evaluating the activities of investment 

companies in order to better carry out its regulatory functions.  

                                                      
360  The funds that would rely on proposed rule 18f-4 other than BDCs generally are subject to 

reporting requirements on Form N-PORT. All registered management investment companies, 
other than registered money market funds and small business investment companies, are (or will 
be) required to electronically file with the Commission, on a quarterly basis, monthly portfolio 
investment information on Form N-PORT, as of the end of each month. See Investment Company 
Reporting Modernization Adopting Release, supra note 179. As of April 30, 2019, larger fund 
groups (defined as having $1 billion or more in net assets) have begun submitting reports on 
Form N-PORT for the period ending March 31, 2019. Smaller fund groups (less than $1 billion in 
net assets) will begin submitting reports on Form N-PORT by April 30, 2020. See Investment 
Company Reporting Modernization, Investment Company Act Release No. 32936 (Dec. 8, 2017) 
[82 FR 58731 (Dec. 14, 2017)]. Only information reported for the third month of each fund’s 
fiscal quarter on Form N-PORT will be publicly available (60 days after the end of the fiscal 
quarter). See Amendments to the Timing Requirements for Filing Reports on Form N-PORT, 
Investment Company Act Release No. 33384 (Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)].  

 Currently, only open-end funds that are not regulated as money market funds under rule 2a-7 
under the Investment Company Act are required to file current reports on Form N-LIQUID, under 
section 30(b) of the Investment Company Act and rule 30b1-10 under the Act. See Investment 
Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 
(Oct. 13, 2016) [81 FR 82142 (Nov. 18, 2016)], at section III.L.2 (“Liquidity Adopting Release”). 
Our proposal, including proposed amendments to Form N-LIQUID, rule 30b1-10 and proposed 
rule 18f-4(c)(7), would add new VaR-related items to the form, and would extend the requirement 
to file current reports with respect to these new items to any fund (including registered open-end 
funds, registered closed-end funds, and BDCs) that relies on rule 18f-4 and that is subject to the 
rule’s limit on leverage risk.  

The funds that would rely on proposed rule 18f-4 other than BDCs generally are subject to 
reporting requirements on Form N-CEN. Specifically, all registered investment companies, 
including money market funds but excluding face amount certificate companies, are currently 
required to file annual reports on Form N-CEN. See Investment Company Reporting 
Modernization Adopting Release, supra note 179. Form N-CEN requires these funds to report 
census-type information including reports on whether a fund relied upon certain enumerated rules 
under the Investment Company Act during the reporting period. See, e.g., Item C.7 of Form N-
CEN.  



208 

1. Amendments to Form N-PORT 

We are proposing to amend Form N-PORT to add new items to Part B (“Information 

About the Fund”), as well as to make certain amendments to the form’s General Instructions.  

a. Derivatives Exposure 

We are proposing to amend Form N-PORT to include a new reporting item on funds’ 

derivatives exposure.361 A fund would be required to provide its derivatives exposure as of the 

end of the reporting period.362 This information would be publicly available for the third month 

of each fund’s quarter and would provide market-wide insight into the levels of funds’ 

derivatives exposure to the Commission, its staff, and market participants.363 It also would allow 

                                                      
361  See proposed Item B.9 of Form N-PORT; see also proposed amendments to General Instruction E 

to Form N-PORT (adding a new definition for “derivatives exposure,” as defined in proposed rule 
18f-4(a),which would permit a fund to convert the notional amounts of interest rate derivatives to 
10-year bond equivalents and delta adjust the notional amounts of options contracts).  

362  See proposed Item B.9 of Form N-PORT. Just as the proposed definition of “derivatives 
transaction” in rule 18f-4 includes derivatives instruments as well as short sale borrowings, Form 
N-PORT would require a fund to report exposure associated with derivatives instruments and 
short sales. 

The proposed requirement to report derivatives exposure at the end of the reporting period 
reflects the form’s requirement to report information about funds’ portfolio holdings as of the last 
business day, or last calendar day, of each month. See General Instruction A to Form N-PORT. 
While we are proposing that funds report their highest daily VaR and median daily VaR during 
the reporting period (see infra section II.H.1.b), we are not also proposing that funds report their 
highest daily derivatives exposure (or median daily derivatives exposure) during the reporting 
period. This is because proposed rule 18f-4 requires daily calculation of a fund’s VaR but does 
not require a fund to calculate its derivatives exposure daily.  

363  We are not proposing to amend General Instruction F to Form N-PORT, which specifies the 
information that funds report on Form N-PORT that the Commission does not make publicly 
available. 

 While the information for the first two months of a fund’s quarter would be non-public, the 
information for the third month of a fund’s quarter would be publicly available. See supra note 
360. 



209 

the Commission and its staff to oversee and monitor compliance with the proposed rule’s 

exception for limited derivatives users.364 

We seek comment on the Commission’s proposed amendments to Form N-PORT 

requiring reporting of derivatives exposure: 

 Is the proposed requirement that funds report their derivatives exposure on 

Form N-PORT appropriate? Why or why not? Should we modify the proposed 

derivatives exposure reporting item in any way? If so, how should we modify this 

reporting item?  

 Our proposal would make public the information that a fund would report in response 

to the new derivatives exposure Form N-PORT item. Is there any reason why this 

information should not be publicly available?  

 Should we require this reporting only from certain funds—for example, those that 

qualify either as limited derivatives users or leveraged/inverse funds under proposed 

rule 18f-4—during the reporting period?  

 Should we require funds to report metrics tied to their daily notional amount 

calculation on Form N-PORT (for example, a fund’s highest daily derivatives 

exposure during the reporting period and the date of its highest exposure, and its 

median daily derivatives exposure during the reporting period)? Should we only 

require funds to report these types of metrics if we were also to modify proposed rule 

18f-4 to require funds to calculate their notional amounts daily? Would this type of 

reporting requirement help to mitigate any potential “window dressing” concerns 

                                                      
364  Under this proposal, a fund would have to indicate whether it is a limited derivatives user on 

Form N-CEN. See infra section II.H.3. 



210 

about funds’ reporting of their derivatives exposure, and/or provide additional 

beneficial transparency with respect to any particular type of funds (for example, 

leveraged/inverse funds)? If so, would these benefits outweigh related costs?  

b. VaR Information 

We are also proposing to amend Form N-PORT to include a new reporting item related to 

the proposed VaR tests.365 Information that a fund would report under this new reporting item 

would be made public for the third month of each fund’s quarter.366 The proposed item would 

apply to funds that were subject to the proposed VaR-based limit on fund leverage risk during 

the reporting period.  

Funds that are subject to the new VaR-related N-PORT item would have to report their 

highest daily VaR during the reporting period and its corresponding date, as well as their median 

daily VaR for the monthly reporting period.367 Funds subject to the relative VaR test during the 

reporting period would report the name of the fund’s designated reference index, and index 

identifier.368 These funds also would have to report the fund’s highest daily VaR ratio (that is, 

the value of the fund’s portfolio VaR divided by the VaR of the designated reference index) 

                                                      
365  See proposed Item B.10 of Form N-PORT. Proposed item B.10 would require that a fund provide 

the applicable VaR information in accordance with proposed rule 18f-4(c)(2)(ii), which requires a 
fund to determine compliance with its applicable VaR test at least once each business day. 

366 See supra note 363. While the information for the first two months of a fund’s quarter would be 
non-public, the information for the third month of a fund’s quarter would be publicly available. 
See supra note 360. 

367  See proposed Items B.10.a.-c of Form N-PORT. The proposed form amendments would require 
each of the reported metrics to be determined in accordance with the requirement under proposed 
rule 18f-4 to determine the fund’s compliance with the applicable VaR test at least once each 
business day. 

368  See proposed Item B.10.d.i.-ii of Form N-PORT. 



211 

during the reporting period and its corresponding date, as well as the fund’s median daily VaR 

ratio for the reporting period.369  

The proposed requirement for a fund to report highest daily VaR (and, for a fund that is 

subject to the relative VaR test, information about the fund’s VaR ratio) is designed to help 

assess compliance with the proposed rule. These requirements, and the proposed requirement for 

a fund to report its median daily VaR (and, for a fund that is subject to the relative VaR test, the 

median VaR ratio) are designed to help identify changes in a fund’s VaR over time, and to help 

identify trends involving a single fund or group of funds regarding their VaRs. The proposed 

requirement that a fund report information about its designated reference index is designed to 

help analyze whether funds are using designated reference indexes that meet the rule’s 

requirements, and also to assess any trends in the designated reference indexes that funds select.  

A fund also would have to report the number of exceptions the fund identified during the 

reporting period arising from backtesting the fund’s VaR calculation model.370 This proposed 

requirement is designed to help analyze whether a fund’s VaR model is effectively taking into 

account and incorporating all significant, identifiable market risk factors associated with a fund’s 

investments, as required by the proposed rule.371 This information would assist in monitoring for 

compliance with the proposed VaR tests and also would provide high-level information to 

market participants, as well as researchers and analysts, to help evaluate the extent to which 

                                                      
369 See proposed Item B.10.d.iii.-v of Form N-PORT.  
370  See proposed Item B.10.e of Form N-PORT; see also supra section II.B.3.d (discussing proposed 

backtesting requirement); ICI Comment Letter II (discussing UCITS funds being similarly 
required to report to their primary regulator, on a semi-annual basis, the number of VaR breaks 
that exceed a specified threshold (a VaR break occurs when the actual one-day loss exceeds that 
day’s VaR), and recommending the Commission require funds to report the number of VaR 
breaks and the dates on which they occurred).  

371  See supra note 151.  



212 

funds’ VaR models, used as part of the proposed VaR tests, are operating effectively. Because 

this information would be made publicly available on a delayed basis, and would not provide 

details about backtesting exceptions other than the number of exceptions, we do not believe that 

this proposed reporting requirement would produce adverse effects such that the reported 

information should be made non-public.372  

We seek comment on the Commission’s proposed amendments to Form N-PORT 

requiring reporting of VaR information: 

 Are the proposed requirements that funds report VaR information on Form N-PORT, 

and each of the elements that a fund would have to report under this requirement, 

appropriate? Why or why not? Should we modify the proposed VaR information 

reporting item in any way? If so, how should we modify this reporting item? 

 Our proposal would make public all of the information that a fund would report in 

response to the new VaR information item on Form N-PORT. Is there any reason 

why this information should not be publicly available? For example, would making 

this information public lead to harm arising from investor confusion, adverse 

competitive effects, or for any other reason? If we require that this reported 

information be made public, is there additional information we should require funds 

to report to provide contextualization or mitigate any adverse effects that could arise 

from public disclosure? Should we make non-public some of these disclosures (e.g., 

portfolio VaR or a fund’s designated reference index, or information about 
                                                      
372  See supra notes 363, 366. But see infra section II.H.2 (discussing adverse effects that might arise 

from the real-time public reporting of a fund’s VaR test breaches under the proposed amendments 
to Form N-LIQUID).  

Information reported for the third month of each fund’s fiscal quarter on Form N-PORT will be 
made publicly available 60 days after the end of the fiscal quarter. See supra note 360. 



213 

backtesting results) but not others? If so, which ones should we make non-public and 

why?  

 Would any of the proposed N-PORT reporting requirements be more appropriately 

structured as Form N-CEN reporting requirements, or items to be reported on a 

current basis on Form N-RN? 

 Is there any additional information related to funds’ derivatives exposure or 

derivatives risk management that we should require funds to report on Form N-

PORT? What information and why, and should this reported information be made 

public?  

2. Amendments to Current Reporting Requirements 

We are also proposing current reporting requirements for funds that are relying on 

proposed rule 18f-4. We are proposing to re-title Form N-LIQUID as Form N-RN and to amend 

this form to include new reporting events for funds that are subject to the proposed VaR-based 

limit on fund leverage risk.373 These funds would be required to determine their compliance with 

the applicable VaR test on at least a daily basis.374 We are proposing to require these funds to file 

Form N-RN to report information about VaR test breaches under certain circumstances. 

Proposed rule 18f-4 would require a fund that has determined that it is not in compliance with 

the applicable VaR test to come back into compliance promptly and within no more than three 

business days after such determination.375 We are therefore proposing that a fund that determines 

that it is out of compliance with the VaR test and has not come back into compliance within three 

                                                      
373   See proposed Parts E-G of Form N-RN. 
374   See supra section II.D; see also proposed rule 18f-4(c)(2). 
375   See supra section II.D.5.b. 



214 

business days after such determination would file a report on Form N-RN providing certain 

information regarding its VaR test breaches.376  

If the portfolio VaR of a fund subject to the relative VaR test were to exceed 150% of the 

VaR of its designated reference index for three business days, we are proposing to require that 

such a fund report: (1) the dates on which the fund portfolio’s VaR exceeded 150% of the VaR 

of its designated reference index; (2) the VaR of its portfolio for each of these days; (3) the VaR 

of its designated reference index for each of these days; (4) the name of the designated reference 

index; and (5) the index identifier.377 A fund would have to report this information within one 

business day following the third business day after the fund has determined that its portfolio VaR 

exceeds 150% of its designated reference index VaR.378 Such a fund also would have to file a 

report on Form N-RN when it is back in compliance with the relative VaR test.379 

If the portfolio VaR of a fund subject to the absolute VaR test were to exceed 15% of the 

value of the fund’s net assets for three business days, we are proposing to require that such a 

fund report: (1) the dates the on which the fund portfolio’s VaR exceeded 15% of the value of its 

net assets; (2) the VaR of its portfolio for each of these days; and (3) the value of the fund’s net 

                                                      
376   See proposed Parts E and F of Form N-RN. 
377   See proposed Part E of Form N-RN. 
378  For example, if the fund were to determine, on the evening of Monday, June 1, that its portfolio 

VaR exceeded 150% of the fund’s designated reference index VaR, and this exceedance were to 
persist through Tuesday (June 2), Wednesday (June 3), and Thursday (June 4), the fund would 
file Form N-RN on Friday, June 5 (because 3 business days following the determination on June 
1 is June 4, and 1 business day following June 4 is June 5). If the exceedance were to still persist 
on June 5 (the date that the fund would file Form N-RN), the fund’s report on Form N-RN would 
provide the required information elements for June 1, 2, 3, 4, and 5. 

379  See proposed Part G of Form N-RN. The report would include the dates on which the fund was 
not in compliance with the VaR test, and the current VaR of the fund’s portfolio on the date the 
fund files the report. See also proposed rule 18f-4(c)(2)(iii) (providing that a fund must meet 
specific requirements to be back in compliance). 



215 

assets for each of these days.380 A fund would have to report this information within one 

business day following the third business day that the fund determined that its portfolio VaR 

exceeds 15% of the value of its net assets. Such a fund also would have to file a report on Form 

N-RN when it is back in compliance with the absolute VaR test.381 

The data points, collectively, would aid the Commission in assessing funds’ compliance 

with the VaR tests. In addition, the information would provide staff the ability to assess how long 

a fund is precluded from entering into derivatives transactions as a consequence of its lack of 

compliance with its VaR test.  

Currently, only registered open-end funds (excluding money market funds) are required 

to file reports on Form N-LIQUID.382 We are proposing to amend this form, as well as rule 

30b1-10 under the Investment Company Act, to reflect the proposed 18f-4 requirement that all 

funds that are subject to the relative VaR test or absolute VaR test file current reports regarding 

VaR test breaches under the circumstances that Form N-RN specifies.383 The scope of funds that 

would be subject to the new VaR test breach current reporting requirements would thus include 

registered open-end funds as well as registered closed-end funds and BDCs. In addition to 

                                                      
380  See proposed Part F of Form N-RN. 
381   See supra note 379.  
382  See General Instruction A.(1) to Form N-LIQUID; see also rule 30b1-10 [17 CFR 270.30b1-10]. 
383  See proposed Form N-RN; see also proposed amendments to rule 30b1-10 under the Investment 

Company Act, and proposed rule 18f-4(c)(7) (requiring a fund that experiences an event specified 
in the parts of Form N-RN titled “Relative VaR Test Breaches,” “Absolute VaR Test Breaches,” 
or “Compliance with VaR Test” to file with the Commission a report on Form N-RN within the 
period and according to the instructions specified in that form).  



216 

extending the scope of funds required to respond to Form N-LIQUID, we are proposing to 

amend the general instructions to the form to reflect the expanded scope and application.384 

We are proposing to require funds to provide this information in a current report because 

we believe that the Commission should be notified promptly when a fund is out of compliance 

with the proposed VaR-based limit on fund leverage risk, which in turn we believe could indicate 

that a fund is experiencing heightened risks as a result of the fund’s use of derivatives 

transactions. VaR test breaches could indicate that a fund is using derivatives transactions to 

leverage the fund’s portfolio, magnifying its potential for losses and significant payments of fund 

assets to derivatives counterparties. Such breaches also could indicate market events that are 

drivers of potential derivatives risks or other risks across the fund industry. Either of these 

scenarios—increased fund-specific risks, or market events that affect funds’ risks broadly—may, 

depending on the facts and circumstances, require attention by the Commission. The proposed 

current reporting requirement is designed to provide the Commission current information 

regarding potential increased risks and stress events (as opposed to a requirement to report the 

same or similar information later, for example on Form N-PORT).385 The one-business-day time-

frame for submitting a report on Form N-RN regarding a fund’s VaR test breaches is designed to 

provide an appropriately early notification to the Commission of potential heightened risks, 

                                                      
384  See, e.g., proposed General Instruction A.(1) to Form N-RN (amending the defined term 

“registrant”); proposed General Instruction A.(2) to Form N-RN (amending the submission 
requirement to clarify application to the new VaR-test-breach-related items); proposed General 
Instruction A.(3) to Form N-RN (clarifying that only open-end funds required to comply with rule 
22e-4 under the Investment Company Act would be required to respond to events occurring in 
Parts B – D, as applicable, while funds required to comply with the limit on fund leverage risk in 
proposed rule 18f-4 would be required to respond to events specified in proposed Parts E-G, as 
applicable); and proposed General Instruction F to Form N-RN (clarifying that the terms used in 
proposed Parts E-G, unless otherwise specified, would have the same meaning as the terms in 
proposed rule 18f-4). 

385  See supra section II.H.1.b. 



217 

while at the same time providing sufficient time for a fund to compile and file its report on Form 

N-RN. This time-frame is also consistent with the current required timing for reporting other 

events on Form N-LIQUID.386  

We are cognizant that certain adverse effects might arise from real-time public reporting 

of a fund’s VaR test breaches. For example, publicly disclosing this information could lead to 

investor confusion. Investors might mistakenly assume that a fund that breached the applicable 

VaR test actually had suffered substantial losses or that substantial losses necessarily were 

imminent. Investors might also believe that a fund’s failing the VaR test suggests a sudden 

increase in fund risk when, in some cases, a fund can fail a VaR test—and especially an absolute 

VaR test—due to changes in market volatility generally. Investors also might believe that a 

fund’s real-time reporting of a VaR test breach necessarily meant that the fund was not 

complying with applicable regulations. Information about VaR breaches would therefore provide 

important information to the Commission and its staff for regulatory purposes but could confuse 

investors and lead them and other market participants to make incorrect assumptions about a 

fund’s relative riskiness. This could have potential adverse effects for funds if investors redeem 

or sell fund shares as a result. Other market participants also could react to real-time reporting of 

VaR breaches in ways that could adversely affect funds. For example, if market participants 

knew on a real-time basis that a fund had breached the applicable VaR test, market participants 

might seek to anticipate the trading activity the fund might undertake to come back into 

compliance and engage in predatory trading that could adversely affect the fund. Accordingly, 

we are proposing to make funds’ reports on Form N-RN regarding VaR test breaches (like their 

reports on this form regarding liquidity-related items) non-public, because we preliminarily 
                                                      
386   See General Instruction A of Form N-LIQUID. 



218 

believe that public disclosure of this information is neither necessary nor appropriate in the 

public interest or for the protection of investors.387 

We seek comment on the Commission’s proposed amendments to Form N-LIQUID 

requiring reporting of certain information regarding a fund’s VaR test breaches: 

 Is the proposed new current reporting requirement for funds that are subject to the 

VaR-based limit on fund leverage risk appropriate? Why or why not? If not, how 

should the scope of the proposed current reporting requirement be modified? Should 

we require additional current reporting requirements for funds to report other 

derivatives-risk-related information? For example, should funds that are limited 

derivatives users pursuant to the proposed exposure-based exception be required to 

file current reports if their derivatives exposure were to exceed 10% of their net 

assets?388 Should we require a fund to file a current report if it identifies a certain 

number of exceptions as a result of backtesting its VaR calculation model, and if so, 

what circumstances should trigger the requirement to file a current report?389  

 Is each of the pieces of information that we propose a fund would include in a report 

about a VaR test breach on proposed Form N-RN appropriate? Why or why not? 

Should we modify the required information in any way?  

 For a fund that is out of compliance with the VaR test, and is unable to come back 

                                                      
387  See proposed General Instruction A.(1) to Form N-RN; see also section 45(a) of the Investment 

Company Act (requiring information in reports filed with the Commission pursuant to the 
Investment Company Act to be made available to the public, unless we find that public disclosure 
is neither necessary nor appropriate in the public interest or for the protection of investors). 

388   See supra section II.E.1. 
389  See supra section II.B.3.d (discussing backtesting requirements in proposed rule 18f-4); see also 

supra section II.H.1.b (discussing proposed requirement to report backtesting results on Form N-
PORT). 



219 

into compliance within three business days after its initial determination, the proposed 

current reporting requirement would require that fund to file a report on Form N-RN 

providing certain information regarding its VaR test breaches. Is the proposed three-

business-day current reporting requirement appropriate? Why or why not? Should the 

rule require a shorter or longer period, such as one or seven days, before prompting a 

current reporting requirement? Which time period would be appropriate and why? 

 We are proposing that a fund’s reports regarding VaR test breaches on Form N-RN 

would not be made public. Would there be a benefit to publicly reporting this 

information, and would it be appropriate to make these disclosures public? Why or 

why not? Should we make public some of these disclosures but not others? If so, 

which ones should we make public and why?  

 As an alternative or an addition to the proposed current reporting requirement, should 

we require funds to report information regarding VaR test breaches on Form N-

PORT? Why or why not? If so, should we make public this information reported on 

Form N-PORT?  

 Should we modify the proposed current reporting requirement to require reporting by 

certain types of funds and not others? If so which types of funds, and why? For 

example, should we require BDCs also to report the information that we are 

proposing them to report on Form N-RN on Form 8-K? Why or why not?  

 As an alternative to amending Form N-LIQUID to require current reporting on VaR 

test breaches, should we provide a new, separate current reporting form for funds to 

use to report VaR test breaches (and/or any other current reporting items relating to 

their derivatives risk management programs under proposed rule 18f-4)? Why or why 



220 

not? 

3. Amendments to Form N-CEN 

Form N-CEN currently includes an item that requires a fund to indicate—in a manner 

similar to “checking a box”—whether the fund has relied on certain Investment Company Act 

rules during the reporting period.390 We are proposing amendments to this item to require a fund 

to identify whether it relied on proposed rule 18f-4 during the reporting period.391 We are also 

proposing amendments to require a fund to identify whether it relied on any of the exceptions 

from various requirements under the proposed rule, specifically: 

• Whether the fund is a limited derivatives user excepted from the proposed rule’s 

program requirement, under either the proposed exception for funds that limit 

their derivatives exposure to 10% of their net assets or under the exception for 

funds that limit their derivatives use to certain currency hedging;392 or 

• Whether the fund is a leveraged/inverse fund covered by the proposed sales 

practices rules that, under proposed rule 18f-4, would be excepted from the 

proposed limit on fund leverage risk.393  

Finally, a fund would have to identify whether it has entered into reverse repurchase agreements 

or similar financing transactions, or unfunded commitment agreements, as provided under the 

proposed rule.394 This information would assist the Commission and staff with our oversight 

functions by allowing us to identify which funds were excepted from certain of the proposed 
                                                      
390   See Item C.7 of Form N-CEN. 
391   See proposed Item C.7.l of Form N-CEN.  
392   See proposed Item C.7.l.i.-ii of Form N-CEN; see also supra section II.E. 
393  See proposed Item C.7.l.iii of Form N-CEN; see also supra section II.G. 
394  See proposed Item C.7.l.iv-v of Form N-CEN; see also infra sections II.I and II.J.221 

rule’s provisions or relied on the rule’s provisions regarding reverse repurchase agreements and 

unfunded commitment agreements. 

We seek comment on the Commission’s proposed amendments to Form N-CEN: 

 Should we require, as proposed, that funds identify that they relied on rule 18f-4, 

including whether they are limited derivatives users that are excepted from the 

proposed program requirement? Why or why not?  

 Should we require, as proposed, that funds identify that they are leveraged/inverse 

funds that are excepted from the proposed limit on fund leverage risk? Why or why 

not?  

 Should we require, as proposed, that funds identify that they entered into reverse 

repurchase agreements or similar financing transactions, or unfunded commitment 

agreements? Why or why not?  

 Are there other means that funds use to disclose or report information (e.g., 

prospectus or annual report disclosure in addition to the other disclosure requirements 

in this proposal) that would be more appropriate for reporting any of the information 

that the proposed amendments to Form N-CEN would require? Should any of the 

disclosures required in the proposed amendments to Form N-PORT above be made 

on Form N-CEN? Why or why not? 

4. BDC Reporting 

BDCs do not file reports on Form N-CEN or Form N-PORT. We considered proposing to 

require that BDCs provide the new information that we propose registered funds report on 

Form N-CEN, and the new information regarding derivatives exposure and VaR that we propose 



222 

to require funds to report on Form N-PORT, in their annual reports on Form 10-K. BDCs, 

however, generally do not enter into derivatives transactions or do so to a limited extent.395 We 

therefore believe that most BDCs that enter into derivatives transactions would qualify for the 

limited derivatives user exception (which would make the proposed VaR reporting items on 

Form N-PORT inapplicable to BDCs). In addition, and as noted above, we understand that even 

when BDCs do use derivatives more extensively, derivatives generally do not play as significant 

of a role in implementing the BDC’s strategy, as compared to many other types of funds that use 

derivatives extensively. BDCs are required under the Investment Company Act to invest at least 

70% of their total assets in “eligible portfolio companies,” which may limit the role that 

derivatives can play in a BDC’s portfolio relative to other kinds of funds that would generally 

execute their strategies primarily through derivatives transactions (e.g. a managed futures fund). 

BDCs that would not qualify as limited derivatives users under the proposed rule also would be 

subject to the proposed new requirement to file current reports regarding VaR test breaches on 

Form N-RN.396 Taking these factors into account, we are not proposing additional reporting 

requirements for BDCs because we believe that the reporting framework we are proposing for 

BDCs adequately addresses the Commission’s ability to monitor BDCs’ compliance with the 

proposed rules, as well as any competitive disparities that could result from disparate reporting 

requirements among funds that rely on proposed rule 18f-4.397 

                                                      
395   See supra section II.D.2.b. 
396  See supra section II.H.2.  
397  We have separately proposed to require BDCs to tag their financial statements using Inline 

XBRL, a structured, machine-readable format, which would provide structured data about BDCs’ 
derivatives and other investments. See Securities Offering Reform Proposing Release, supra note 
200, at section II.H.1. In addition, BDCs are currently required to disclose certain information 
about their exposures to market risks, including risks that may arise as a result of their 
derivatives-related activity. See, e.g., Items 303 and 305 of Regulation S-K [17 CFR 229.303 and 

 



223 

We seek comment on the Commission’s proposal to not require BDCs to report on Forms 

N-PORT or N-CEN: 

 Should we require BDCs to report any of the same information on Form 10-K (or 

elsewhere, such as in a BDC’s prospectus) that we are proposing to require registered 

investment companies to report on Forms N-CEN and N-PORT? Why or why not? 

Should we require, for example, that a BDC report its derivatives exposure, whether it 

is a limited derivatives user, and/or its designated reference index (if applicable)? If 

so, where? If a BDC uses derivatives and does not qualify as a limited derivatives 

user, should it have to report information about its derivatives exposure and portfolio 

VaR on Form N-PORT (or elsewhere)? 

 Should we require BDCs to report on Form 10-K or elsewhere whether they have 

relied on the rule’s provision regarding reverse repurchase agreements and similar 

financing transactions or unfunded commitment agreements? 

I. Reverse Repurchase Agreements 

Funds may engage in certain transactions that may involve senior securities primarily as a 

means of obtaining financing. For example, open-end funds are permitted to borrow money from 

a bank, provided they maintain a 300% asset coverage ratio.398 Another common method of 

obtaining financing is through the use of reverse repurchase agreements. In a reverse repurchase 

agreement, a fund transfers a security to another party in return for a percentage of the value of 

                                                      

229.305]. 

 See also infra section III.D.2 (discussing, among other things, potential competitive effects 
resulting from BDCs not being subject to the proposed additional reporting requirements on Form 
N-PORT and Form N-CEN). 

398  See section 18(f)(1) of the Investment Company Act.  



224 

the security. At an agreed-upon future date, the fund repurchases the transferred security by 

paying an amount equal to the proceeds of the initial sale transaction plus interest.399 A reverse 

repurchase agreement is economically equivalent to a secured borrowing.400  

We believe that reverse repurchase agreements and other similar financing transactions 

that have the effect of allowing a fund to obtain additional cash that can be used for investment 

purposes or to finance fund assets should be treated for section 18 purposes like a bank 

borrowing or other borrowing, as they achieve effectively identical results. Accordingly, we are 

proposing that a fund may engage in reverse repurchase agreements and other similar financing 

transactions so long as they are subject to the relevant asset coverage requirements of 

section 18.401 For example, this would have the effect of permitting an open-end fund to obtain 

financing by borrowing from a bank, engaging in a reverse repurchase agreement, or any 

combination thereof, so long as all sources of financing are included when calculating the fund’s 

asset coverage ratio.402  

                                                      
399  See Release 10666, supra note 15, at “Reverse Repurchase Agreements” discussion (stating that a 

reverse repurchase agreement may not have an agreed-upon repurchase date, and in that case the 
agreement would be treated as if it were reestablished each day). 

400  See, e.g., Office of Financial Research, Reference Guide to U.S. Repo and Securities Lending 
Markets (Sept. 9, 2015), available at https://www.financialresearch.gov/working-
papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-
Markets.pdf.  

401  Proposed rule 18f-4(d). Among other things, section 18 prescribes the required amount of asset 
coverage for a fund’s senior securities and provides certain consequences for a fund that fails to 
maintain this amount. See, e.g., section 18(a) (restrictions on dividend issuance). This provision 
in rule 18f-4 would not provide any exemptions from the requirements of section 61 for BDCs 
because that section does not limit a BDC’s ability to engage in reverse repurchase or similar 
transactions in parity with other senior security transactions permitted under that section.  

402  Section 18 states that certain borrowings that are made for temporary purposes (less than 60 days) 
and that do not exceed 5% of the total assets of the issuer at the time when the loan is made 
(temporary loans) are not senior securities for purposes of certain paragraphs in section 18. As we 
noted in Release 10666, reverse repurchase agreements and similar financing transactions could 
be designed to appear to fall within the temporary loans exception, and then could be “rolled-

 



225 

Reverse repurchase agreements and similar financing transactions are not treated as 

derivatives transactions under the proposed rule because they have the economic effects of a 

secured borrowing, and thus more closely resemble bank borrowings with a known repayment 

obligation rather than the more-uncertain payment obligations of many derivatives. However, 

such transactions can have the effect of introducing leverage into a fund’s portfolio if the fund 

were to use the proceeds of the financing transaction to purchase additional investments. In 

addition, such transactions impose a requirement to return assets at the termination of the 

agreement, which can raise section 18 asset sufficiency concerns to the extent the fund needs to 

sell less-liquid securities at a loss to obtain the necessary assets.  

Reverse repurchase agreements and similar financing transactions would not be included 

in calculating a fund’s derivatives exposure under the limited derivatives user provisions of the 

proposed rule. However, if a fund did not qualify as a limited derivatives user due to its other 

investment activity, any portfolio leveraging effect of reverse repurchase agreements or similar 

financing transactions would be included and restricted through the proposed VaR-based limit on 

fund leverage risk. This is because the proposed VaR tests estimate a fund’s risk of loss taking 

into account all of its investments, including the proceeds of reverse repurchase agreements and 

similar investments the fund purchased with those proceeds.  

Securities lending arrangements are structurally similar to reverse repurchase agreements 

in that, in both cases, a fund transfers a portfolio security to a counterparty in exchange for cash 

(or other assets). Although these arrangements are structurally similar, under our proposal we 

                                                      

over,” perhaps indefinitely, with such short-term transactions being entered into, closed out, and 
later re-entered. If substantially similar financing arrangements were being “rolled over” in any 
manner for a total period of 60 days or more, we would treat the later transactions as renewals of 
the earlier ones, and all such transactions would fall outside the exclusion for temporary loans. 



226 

would not view a fund’s obligation to return securities lending collateral as a “similar financing 

transaction” in the circumstances discussed below. In the 2015 Proposing Release, we sought 

comment on whether rule 18f-4 should address funds’ compliance with section 18 in connection 

with securities lending.403 Commenters stated that the staff’s current guidance on securities 

lending forms the basis for funds’ securities lending practices and effectively addresses the 

senior securities implications of securities lending, and thus securities lending practices need not 

be addressed in the final rule.404  

Currently, funds that engage in securities lending typically reinvest cash collateral in 

highly liquid, short-term investments, such as money market funds or other cash or cash 

equivalents, and funds generally do not sell or otherwise use non-cash collateral to leverage the 

fund’s portfolio.405 We believe a fund that engages in securities lending under these 

circumstances is limited in its ability to use securities lending transactions to increase leverage in 

its portfolio. Accordingly, the proposed rule does not treat a fund’s obligation to return securities 

lending collateral as a financing transaction similar to a reverse repurchase agreement, so long as 

                                                      
403  2015 Proposing Release, supra note 2, at paragraph accompanying n.149. 
404  See, e.g., ICI Comment Letter I; Guggenheim Comment Letter; SIFMA Comment Letter; 

Comment Letter of the Risk Management Association (Mar. 28, 2016). Staff guidance on 
Securities Lending by U.S. Open-End and Closed-End Investment Companies (Feb. 27, 2014), 
available at https://www.sec.gov/divisions/investment/securities-lending-open-closed-end-
investment-companies.htm (providing guidance on certain no-action letters that funds consider 
when engaging in securities lending and summarizing areas those letters address, including 
limitations on the amount that may be lent and collateralization for such loans).  

405  See ICI, Securities Lending by Mutual Funds, ETFs, and Closed-End Funds: The Basics (Sept. 
14, 2014), available at https://www.ici.org/viewpoints/view_14_sec_lending_01 (“[T]he 
collateral that funds can accept from borrowers must be highly liquid, such as cash, government 
securities, or bank letters of credit. U.S. regulated funds typically demand cash collateral. … In 
practice, U.S. regulated funds most often invest cash collateral in money market funds.”); 
SIFMA, Master Securities Lending Agreement, section 4.2 (2000), available at 
https://www.sifma.org/wp-content/uploads/2017/08/MSLA_Master-Securities-Loan-Agreement-
2000-Version.pdf (generally limiting lenders from re-hypothecating non-cash collateral).  

https://www.sec.gov/divisions/investment/securities-lending-open-closed-end-investment-companies.htm
https://www.sec.gov/divisions/investment/securities-lending-open-closed-end-investment-companies.htm
https://www.ici.org/viewpoints/view_14_sec_lending_01


227 

the obligation relates to an agreement under which a fund engages in securities lending, the fund 

does not sell or otherwise use non-cash collateral received for loaned securities to leverage the 

fund’s portfolio, and the fund invests cash collateral solely in cash or cash equivalents. If a fund 

were to engage in securities lending and to invest the cash collateral in securities other than cash 

or cash equivalents, this may result in leveraging of the fund’s portfolio, and we believe this 

activity would be a “similar financing transaction” and should thus be included when calculating 

a funds asset coverage ratio.  

We believe that a fund’s obligation with respect to a “tender option bond” (“TOB”) 

financing may be similar to a reverse repurchase agreement in some circumstances. One 

commenter on the 2015 proposal explained that TOB financings are economically similar to 

reverse repurchase agreements because a fund employing a TOB trust has in effect used the 

underlying bond as collateral to secure a borrowing analogous to a fund’s use of a security to 

secure a reverse repurchase agreement.406 We believe that determining whether a TOB is a 

similar financing transaction as a reverse repurchase agreement would depend on the facts and 

circumstances. To the extent a fund concludes that there are economic similarities between a 

TOB financing and a reverse repurchase agreement, the fund should treat obligations with 

respect to the TOB financing as a similar financing transaction under the proposed rule.  

We request comment on our proposed approach to reverse repurchase agreements and 

similar financing transactions under the proposed rule.  

 As proposed, should we treat reverse repurchase agreements and similar financing 

transactions as economically equivalent to bank borrowings under section 18, and 

subject them to the same asset coverage requirements? Why or why not?  
                                                      
406   See SIFMA Comment Letter.  



228 

 Should we not combine reverse repurchase agreements with bank borrowing and 

other senior securities under the provision, and instead treat them separately but with 

the same limit? For example, should we allow a fund to borrow from a bank subject 

to the 300% asset coverage limit and also separately use reverse repurchase 

agreements up to a 300% asset coverage limit?  

 Should we instead treat such reverse repurchase agreements and similar financing 

transactions as derivatives transactions under the proposed rule? Would this have any 

disparate effects on certain types of funds?  

 Is there a way to distinguish reverse repurchase agreements and similar financing 

transactions that funds use to leverage their portfolios from instances in which funds 

use those transactions for other purposes? If so, should we treat such transactions 

engaged in for leveraging purposes differently than transactions engaged in for other 

purposes?  

 Should we include securities lending transactions as a similar financing transaction 

(regardless of how the proceeds are invested) under the proposed provision? Why or 

why not? Should we define in rule 18f-4 the circumstances under which securities 

lending would not be treated as a similar financing transaction?  

 Are there other types of transactions that we should identify and treat as similar 

financing transactions to reverse repurchase agreements that we have not identified 

above? What are they and why should they be treated accordingly?  



229 

J. Unfunded Commitment Agreements 

Under unfunded commitment agreements, a fund commits, conditionally or 

unconditionally, to make a loan to a company or to invest equity in a company in the future.407 

They include capital commitments to a private fund requiring investors to fund capital 

contributions or to purchase shares upon delivery of a drawdown notice. The proposed rule 

would therefore define an unfunded commitment agreement to mean a contract that is not a 

derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a 

loan to a company or to invest equity in a company in the future, including by making a capital 

commitment to a private fund that can be drawn at the discretion of the fund’s general partner.408 

The Commission’s 2015 proposal would have treated these agreements as “financial 

commitment transactions.” As a result, a fund’s obligations under the agreements could not 

exceed the fund’s net asset value.409 Commenters on the 2015 proposal identified characteristics 

of these agreements that they believed distinguished unfunded commitments from the derivatives 

transactions and financial commitment transactions covered by that proposal, which are also 

covered by re-proposed rule 18f-4.410 First, commenters stated that a fund often does not expect 

                                                      
407  We understand that the types of funds that enter into unfunded commitment agreements typically 

include BDCs and registered closed-end funds. 
408  Proposed rule 18f-4(a). 
409  See 2015 proposed rule 18f-4(c)(4) (defining “financial commitment transactions”); 2015 

proposed rule 18f-4(b) (permitting funds to engage in financial commitment transactions if the 
fund maintains qualifying coverage assets with a value equal to at least the fund’s aggregate 
financial commitment obligations); 2015 proposed rule 18f-4(c)(5) (defining a fund’s “financial 
commitment obligations,” in part, to mean “the amount of cash or other assets that the fund is 
conditionally or unconditionally obligated to pay or deliver under a financial commitment 
transaction). 

410  Specifically, these commenters generally compared unfunded commitment agreements to firm 
and standby commitment agreements (which we would in turn interpret the phrase “or any similar 
instrument” in proposed rule 18f-4’s definition of “derivatives transaction” to include, see supra 
note 91 and accompanying paragraph). See, e.g., Letter of Ares Capital Corporation (Mar. 28, 

 



230 

to lend or invest up to the full amount committed. Second, commenters stated that a fund’s 

obligation to lend is commonly subject to conditions, such as a borrower’s obligation to meet 

certain financial metrics and performance benchmarks, which are not typically present under the 

types of agreements that the Commission described in Release 10666.411 Commenters also 

asserted that unfunded commitment agreements do not give rise to the risks that Release 10666 

identified and do not have a leveraging effect on the fund’s portfolio because they do not present 

an opportunity for the fund to realize gains or losses between the date of the fund’s commitment 

and its subsequent investment when the other party to the agreement calls the commitment.412 

These commenters contrasted firm and standby commitment agreements, under which a fund 

commits itself to purchase a security with a stated price and fixed yield without condition or 

                                                      

2016) (“Ares Comment Letter”); Comment Letter of the Small Business Investor Alliance (Mar. 
28, 2016) (“SBIA Comment Letter”); Comment Letter of the Center for Capital Markets 
Competitiveness, U.S. Chamber of Commerce (Mar. 28, 2016); Comment Letter of Skadden, 
Arps, Slate, Meagher & Flom LLP (Mar. 28, 2016) (“Skadden Comment Letter”); Dechert 
Comment Letter; Private Equity Growth Capital Council (Mar. 28, 2016) (“PEGCC Comment 
Letter”).  

411  See, e.g., SBIA Comment Letter; Comment Letter of Hercules Capital (Mar. 29, 2016); see also, 
e.g., Skadden Comment Letter (contingent loan commitments typically have “funding conditions 
that excuse the BDC from funding if the borrower does not continue to satisfy various 
representations, financial and non-financial metrics and performance conditions . . . [and] cannot 
result in substantial risk of loss prior to funding because the BDC is not required to fund the loan 
if the borrower’s credit or financial position degenerates meaningfully.”).  

412  See, e.g., PEGCC Comment Letter (distinguishing the agreements that Release 10666 discusses 
because, while the value of the fund’s limited partnership interest may fluctuate based on the 
amount of capital it invests in the private fund, the fund has no profit or loss on the unfunded 
commitment); Ares Comment Letter (stating that, in general, unfunded loan commitments do not 
reflect a bet on interest rate movements because the yields for unfunded loan commitments are 
determined as a spread over a prevailing market interest rate); see also Altegris Comment Letter 
(explaining that unfunded commitment agreements do not have a potential for “pyramiding” 
because—in contrast to a reverse repurchase agreement—a fund “receives nothing from the 
underlying private equity funds in return for its capital commitments and, as a result, its gross 
assets remain unchanged.”).  



231 

upon the counterparty’s demand.413 They argued that the firm and standby commitment 

agreements that Release 10666 describes expose the fund to investment risk during the life of the 

transaction, because the value of the fund’s commitment agreement will change as interest rates 

change.  

We agree that these factors distinguish unfunded commitment agreements from the 

derivatives transactions covered by proposed rule 18f-4. The derivatives transactions covered by 

proposed rule 18f-4—including the firm and standby commitment agreements the Commission 

described in Release 10666—expose the fund to investment risk during the life of the transaction. 

Derivatives transactions therefore can be used to leverage a fund’s portfolio by enabling a fund 

to magnify its gains and losses compared to the fund’s investment, while also obligating the fund 

to make a payment to a counterparty. Based on the characteristics of unfunded commitment 

agreements commenters described, which we understand are typical of these agreements, we do 

not believe that such unfunded commitment agreements are undertaken to leverage a fund’s 

portfolio. For example, if the yield for an unfunded loan commitment is determined as a spread 

over a prevailing market interest rate, the agreement creates a risk that the fund would not have 

liquid assets to fund the loan, but the agreement would not reflect a speculative position on the 

direction of interest rates.414 We therefore do not believe that such unfunded commitment 

                                                      
413  See, e.g., SBIA Comment Letter; see also Altegris Comment Letter; Ares Comment Letter; 

Comment Letter of Dechert (Feb. 7, 2016); Skadden Comment Letter.  
414  Cf. Release 10666, supra note 15, at n.12 (“Commitments to purchase securities whose yields are 

determined on the date of delivery with reference to prevailing market interest rates are not 
intended to be included in this general statement of policy. Such commitments neither create nor 
shift the risk associated with interest rate changes in the marketplace, and in economic reality 
have no discernible potential for leverage.”). 



232 

agreements generally raise the Investment Company Act’s concerns regarding the risks of undue 

speculation.415  

Depending on the facts and circumstances, however, an unfunded commitment agreement 

could raise the asset sufficiency concerns underlying the Investment Company Act.416 A fund 

could be required to liquidate other assets to obtain the cash needed to satisfy its obligation under 

an unfunded commitment agreement if the fund did not have cash on hand to meet its obligation 

to provide a committed loan or make a committed equity investment. If the fund is unable to 

meet its obligations, the fund would be subject to default remedies available to its counterparty. 

For example, if a fund fails to fulfill its commitments to invest in a private fund when called to 

do so, the fund could be subject to the remedies specified in the limited partnership agreement 

(or similar document) relating to that private fund. These remedies can have the practical effect 

of forfeiture of some or all of the fund’s investment in the private fund.417 In these and other 

circumstances a fund’s investors could be harmed if the fund is unable to meet its obligations 

under an unfunded commitment agreement.  

Because unfunded commitment agreements can raise the asset sufficiency concern 

underlying section 18, but generally do not raise the undue speculation concern associated with 

derivatives transactions (and reverse repurchase agreements and similar financing transactions), 

we are proposing to permit a fund to enter into unfunded commitment agreements if it 

                                                      
415   See supra notes 45-47 and accompanying text. 
416   See id. 
417  See, e.g., Phyllis A. Schwartz & Stephanie R. Breslow, Private Equity Funds: Formation and 

Operation (June 2015 ed.), at 2-34 (remedies private equity funds may apply in event of investor 
default include, among other things, the right to charge high interest on late payments, the right to 
force a sale of the defaulting investor’s interest, the right to continue to charge losses and 
expenses to defaulting investors while cutting off their interest in future profits, and the right to 
take any other action permitted at law or in equity).  



233 

reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash 

and cash equivalents to meet its obligations with respect to all of its unfunded commitment 

agreements, in each case as they come due.418 While a fund should consider its unique facts and 

circumstances to have such a reasonable belief, the proposed rule would prescribe certain 

specific factors that a fund must take into account.419  

First, the proposed rule would require a fund to take into account its reasonable 

expectations with respect to other obligations (including any obligation with respect to senior 

securities or redemptions). This is because other obligations can place competing demands on 

cash a fund otherwise might intend to use to fund an unfunded commitment agreement. Second, 

the proposed rule would provide that a fund may not take into account cash that may become 

available from the sale or disposition of any investment at a price that deviates significantly from 

the market value of those investments. This provision is designed to address the risk that a fund 

could suffer losses by selling assets to raise cash to fund an unfunded commitment agreement, 

ultimately having an adverse impact on the fund’s investors. Finally, the proposed rule would 

provide that a fund may not consider cash that may become available from issuing additional 

equity. Whether a fund would be able to raise capital in the future and the amount of any 

additional capital would depend on a variety of factors, including future market conditions, that 

we believe are too speculative to support a fund’s reasonable belief that it could fund an 

                                                      
418  See proposed rule 18f-4(e)(1). Because this proposed condition is designed to provide an 

approach tailored to unfunded commitment agreements, the proposed rule would also provide that 
these transactions would not be considered for purposes of computing asset coverage under 
section 18(h). As with our approach to derivatives transactions, applying section 18(h) asset 
coverage to these transactions appears unnecessary in light of the tailored requirement we are 
proposing. See supra note 66. 

419  The proposed rule would also require the fund to make and maintain records documenting the 
basis for this belief. See proposed rule 18f-4(e)(2); see also infra section II.K. 



234 

unfunded commitment with the proceeds from future sales of the fund’s securities. The proposed 

rule would not preclude a fund from considering the issuance of debt to support a reasonable 

belief that it could fund an unfunded commitment, as we understand that funds often satisfy their 

obligations under unfunded commitments through borrowings. Moreover, such borrowings by 

funds would be limited by section 18’s asset coverage requirements, which would limit the 

extent to which a fund’s belief regarding its ability to borrow would allow the fund to enter into 

unfunded commitment agreements.  

To have a reasonable belief, a fund therefore could consider, for example, its strategy, its 

assets’ liquidity, its borrowing capacity under existing committed lines of credit, and the 

contractual provisions of its unfunded commitment agreements. A fund with unfunded loan 

commitments, for instance, could evaluate the likelihood that different potential borrowers would 

meet contractual “milestones” that the borrowers would have to satisfy as a condition to the 

obligation to fund a loan, as well as the amount of the anticipated borrowing. The fund’s 

historical experience with comparable obligations should inform this analysis. Whether a fund 

has a reasonable belief also could be informed by a fund’s assessment of the likeliness that 

subsequent developments could impair the fund’s ability to have sufficient cash and cash 

equivalents to meet its unfunded commitment obligations. 

This proposed approach for unfunded commitment agreements reflects the staff’s 

experience in reviewing and commenting on fund registration statements, which have disclosure 

regarding the funds’ unfunded commitments. These funds have generally represented, in 

substance, that they reasonably believe that their assets will provide adequate cover to allow 

them to satisfy all of their unfunded investment commitments, without taking into account any 



235 

projected securities offerings. In their responses to staff comments, funds also have provided a 

general explanation as to the process by which they reached this reasonable belief.  

Finally, the proposed rule would provide that an agreement that meets the rule’s 

definition of a derivatives transaction is not an unfunded commitment.420 This is because the 

proposed rule’s treatment of unfunded commitments is predicated on these agreements having 

characteristics that distinguish them from the derivatives transactions covered by the proposed 

rule, as discussed above. Because the proposed definition of the term “derivatives transaction” 

includes any instrument that is similar to certain listed derivatives instruments, a contract that is 

functionally similar to a listed derivatives instrument would be a derivatives transaction and 

therefore would not qualify for the proposed rule’s treatment of unfunded commitment 

agreements.421 For example, a fund that enters into a binding commitment to make a loan or 

purchase a note upon demand by the borrower, with stated principal and term and a fixed interest 

rate, would appear to have entered into an agreement that is similar to a standby commitment 

agreement or a written put option.422 This transaction would expose the fund to investment risk 

during the life of the transaction because the value of the fund’s commitment agreement will 

change as interest rates change. Such an agreement thus would fall within the proposed rule’s 

definition of “derivatives transaction” and would not be an unfunded commitment agreement 

under the proposed rule.  

We request comment on our proposed approach to unfunded commitment agreements.  

 Are unfunded commitment agreements distinguishable from derivatives transactions? 

                                                      
420   See proposed rule 18f-4(a) (defining the term “unfunded commitment agreement”).  
421   See supra section II.A (discussing proposed definition of “derivatives transaction”). 
422  See supra paragraph accompanying notes 409-413 (discussing factors distinguishing unfunded 

commitment agreements from the derivatives transactions covered by proposed rule 18f-4). 



236 

Can funds use unfunded commitment agreements for speculation or to accomplish 

leveraging? If so, how? What types of funds enter into unfunded commitment 

agreements, and for what purposes? 

 Does funds’ use of unfunded commitment agreements raise the undue speculation 

and/or the assets sufficiency concerns underlying section 18 of the Investment 

Company Act? Why or why not? 

 Is the proposed approach to unfunded commitment agreements appropriate? Would 

the proposed approach appropriately address any asset sufficiency concerns that 

funds’ use of unfunded commitment agreements might entail? Why or why not? 

 Is the proposed requirement that a fund must have a “reasonable belief” regarding its 

ability to meet its unfunded commitment obligations, at the time it enters into an 

unfunded commitment agreement, appropriate? Should the rule instead, or also, 

require a fund to reassess whether this belief remains reasonable at various points 

during the period of the unfunded commitment agreement? 

 Are the rule’s provisions regarding the factors that a fund must consider in 

determining whether it has the required “reasonable belief” appropriate? Why or why 

not? Are they sufficiently clear? Should we specify other factors that a fund could 

consider? Should the rule provide, for example, that a fund may consider potential 

borrowings only to the extent the fund has committed lines of credit or other 

committed borrowing capacity? If so, how should we define “committed” for this 

purpose? 

 Under the proposed rule, a fund’s reasonable belief that it has sufficient cash to 

satisfy its unfunded commitments may not be based on cash that may become 



237 

available from issuing additional equity. Do commenters agree that a fund’s ability to 

raise capital in the future, and the amount of any such additional capital, are based on 

factors that are too speculative to support a fund’s reasonable belief that it could use 

that capital to fund an unfunded commitment? Are there circumstances in which a 

fund can expect to raise capital in the future, such as expected inflows from 

retirement plan platforms, that would not raise the same concerns about supporting a 

reasonable belief under the proposed rule? Should the rule permit a fund to consider 

such additional capital as a basis for forming a reasonable belief?  

 Should the rule otherwise limit funds’ use of unfunded commitment agreements? If 

so, how? For example, should the rule specify that funds’ unfunded commitment 

agreements, in the aggregate, may not exceed the fund’s net asset value? Or should 

we adopt different requirements for unfunded commitment agreements for different 

types of funds, based on their ability to borrow money under the Investment 

Company Act?423 Should the rule limit the agreements’ counterparties or otherwise 

restrict the agreements’ terms in any way? If so, how? Should we adopt different 

requirements for unfunded loan commitments, which generally will be contingent 

upon a borrower meeting certain “milestones,” as compared to commitments to invest 

in a private fund due upon demand by the fund’s adviser? If so, which requirements 

should apply to each type of transaction and why?  

 Should the rule instead treat all—or a specified subset of—unfunded commitment 

agreements in the same way that it treats derivatives transactions? If a subset of these 

agreements, should the rule specify that certain characteristics of these agreements are 
                                                      
423   See supra notes 29-32 and accompanying text.  



238 

indicative that these agreements are “similar instruments” in the proposed rule’s 

definition of “derivatives transaction”? Should a fund that enters into unfunded 

commitment agreements, but that otherwise does not use derivatives (or that limits its 

derivatives exposure, either as the proposed rule specifies in the limited derivative 

user provisions or otherwise) be subject to the proposed VaR-based limit on fund 

leverage risk? Should such a fund be exempt from any of the proposed rule’s other 

requirements, and if so, which ones and why? 

 Is the proposed definition of “unfunded commitment agreement” clear and 

appropriate? If not, how should the Commission modify it? Should the Commission 

clarify any aspect of the definition (e.g., should the Commission further define or 

provide guidance regarding agreements that involve a commitment to “make a loan to 

a company” or to “invest equity in a company in the future”)? Would funds 

experience any challenges in practice differentiating between unfunded commitments, 

on the one hand, and firm or standby commitment agreements or other transactions 

included in the definition of “derivatives transaction,” on the other? If so, how should 

the Commission provide additional clarity?  

 Are there other types of transactions that we should identify and treat as similar to 

unfunded commitment agreements? What are they and why should they be treated 

accordingly? Are there any transactions that may be viewed as firm or standby 

commitment agreements, but that commenters believe should be given the same 

treatment as unfunded commitments under the proposed rule? What kinds of 

transactions and why? 

 Would any adverse market effects result from the proposed treatment of unfunded 



239 

commitment agreements? For example, would the proposal lead funds to restructure 

transactions as unfunded commitment agreements, and if so would this adversely 

affect investor protection? Would any modifications to the proposed rule, or 

additional Commission guidance, help mitigate potential adverse market effects?  

K. Recordkeeping Provisions 

Proposed rule 18f-4 also includes certain recordkeeping requirements. These proposed 

requirements are designed to provide our staff, and a fund’s compliance personnel, the ability to 

evaluate the fund’s compliance with the proposed rule’s requirements.  

First, the proposed rule would require the fund to maintain certain records documenting 

the fund’s derivatives risk management program. Specifically, for a fund subject to the proposed 

rule’s program requirements, the proposed rule would require the fund to maintain a written 

record of its policies and procedures that are designed to manage the fund’s derivatives risks.424 

The proposed rule would also require a fund to maintain a written record of the results of any 

stress testing of its portfolio, results of any VaR test backtesting it conducts, records 

documenting any internal reporting or escalation of material risks under the program, and records 

documenting any periodic reviews of the program.425 These records would allow our staff to 

understand a fund’s derivatives risk management program and how the fund administered it.  

Second, the proposed rule would require funds to keep records of any materials provided 

to the fund’s board of directors in connection with approving the designation of the derivatives 

                                                      
424  Proposed rule 18f-4(c)(6)(i)(A); see also supra section II.B.3. 

 Under proposed rule 18f-4(c)(4), leveraged/inverse funds would be subject to the proposed rule’s 
derivatives risk management program requirement. Such funds would therefore also be subject to 
the program-related recordkeeping provisions of the proposed rule. 

425 Proposed rule 18f-4(c)(6)(i)(A). 



240 

risk manager.426 The proposed rule would also require a fund to keep records of any written 

reports provided to the board of directors relating to the program, and any written reports 

provided to the board that the rule would require regarding the fund’s non-compliance with the 

applicable VaR test.427 These records would help our staff to understand what was provided to 

the fund’s board while overseeing the fund’s program.  

Third, for a fund that is required to comply with the proposed VaR-based limit on fund 

leverage risk, the fund would have to maintain records documenting the fund’s determination of: 

the VaR of its portfolio; the VaR of the fund’s designated reference index, as applicable; the 

fund’s VaR ratio (the value of the VaR of the fund’s portfolio divided by the VaR of the 

designated reference index), as applicable; and any updates to any VaR calculation models used 

by the fund, as well as the basis for any material changes made to those models.428 These records 

would provide information on the operation of a fund’s VaR test and, for example, would allow 

our staff to better understand how a fund (and funds generally) implement the proposed VaR 

tests. 

Fourth, the proposed rule would require a fund that is a limited derivatives user to 

maintain a written record of its policies and procedures that are reasonably designed to manage 

its derivatives risk.429 These records would help our staff to understand what policies and 

procedures that a limited derivatives user has adopted and implemented to address the risks 

associated with its use of derivatives.  

                                                      
426  Proposed rule 18f-4(c)(6)(i)(B); see also supra section II.C. 
427   Id.; see also supra section II.D.5.b. 
428  Proposed rule 18f-4(c)(6)(i)(C); see also supra section II.K. 
429   Proposed rule 18f-4(c)(6)(i)(D); see also supra section II.K.241 

Fifth, the proposed rule would require a fund that enters into unfunded commitment 

agreements to maintain a record documenting the basis for the fund’s belief regarding the 

sufficiency of its cash and cash equivalents to meet its obligations with respect to its unfunded 

commitment agreements.430 A fund must make such a record each time it enters into such an 

agreement.431 These records would allow our staff to understand and evaluate funds’ 

determinations regarding their ability to meet their obligations under their unfunded commitment 

agreements. 

Finally, the proposed rule would require funds to maintain the required records for a 

period of five years.432 In particular, a fund must retain a copy of its written policies and 

procedures under the rule that are currently in effect, or were in effect at any time within the past 

five years, in an easily accessible place.433 In addition, a fund would have to maintain all other 

records and materials that the rule would require the fund to keep for at least five years (the first 

two years in an easily accessible place).434 The proposed five-year retention period is consistent 

with the period provided in rule 38a-1(d) and rule 22e-4 under the Investment Company Act. We 

believe consistency in these retention periods is appropriate because funds currently have 

compliance-program-related recordkeeping procedures in place incorporating a five-year 

retention period, which we believe would lessen the proposed new recordkeeping compliance 

burden to funds, compared to choosing a different, longer retention period. 
                                                      
430   Proposed rule 18f-4(e)(2); see also supra section II.K. 
431   Id. 
432  Proposed rule 18f-4(c)(6)(ii); proposed rule 18f-4(e)(2).  
433  Proposed rule 18f-4(c)(6)(ii)(A); see also supra notes 424 and 429 and accompanying text. The 

retention requirement would apply to both funds that are required to implement a derivatives risk 
management program and funds that are limited derivatives users under proposed rule 18f-
4(c)(3). 

434  Proposed rule 18f-4(c)(6)(ii)(B); proposed rule 18f-4(e)(2). 



242 

We request comment on the proposed rule’s recordkeeping requirements.  

 Are the proposed recordkeeping provisions appropriate? Are there any other records 

relating to a fund’s derivatives transactions that a fund should be required to 

maintain? For example, should we also require a fund to maintain written records 

relating to any action the fund took after exceeding a risk guideline (or any internal 

reporting that occurred following the exceedance of a risk guideline)?435 Or, as 

another example, should we include a provision in the proposed rule that would 

require a fund that enters into reverse repurchase agreements under proposed rule 18f-

4(d) to maintain records documenting the fund’s compliance with the applicable asset 

coverage requirement of section 18? Why or why not? The proposed rule would 

require a fund to maintain records of the VaR of its portfolio, the VaR of its 

designated reference index (as applicable), and its VaR ratio. To what extent would 

the requirement to maintain records of the fund’s VaR ratio involve burdens in 

addition to the requirement to maintain the fund’s VaR and the VaR of the designated 

reference index? 

 Are there feasible alternatives to the proposed recordkeeping requirements that would 

minimize recordkeeping burdens, including the costs of maintaining the required 

records, while promoting the goals of providing the Commission and its staff, and a 

fund’s compliance personnel, sufficient information to understand: (1) a fund’s 

derivatives risk management program and how the fund had administered it, (2) how 

a fund’s board oversees the program, (3) the administration and effectiveness of a 

fund’s VaR test, (4) how a limited derivatives user’s policies and procedures are 
                                                      
435   See, e.g., proposed rule 18f-4(c)(1)(ii), proposed rule 18f-4(c)(1)(v)(A). 



243 

designed to address the risks associated with its use of derivatives, and (5) the basis 

for a fund’s determination regarding the sufficiency of its cash to meet its obligations 

with respect to unfunded commitment agreements?  

 Are the record retention time periods that we have proposed appropriate? Should we 

require records to be maintained for a longer or shorter period? If so, for how long?  

L. Transition Periods 

In view of our proposal for an updated, comprehensive approach to the regulation of 

funds’ derivatives use, we are proposing to rescind Release 10666.436 In addition, staff in the 

Division of Investment Management is reviewing its no-action letters and other guidance 

addressing derivatives transactions and other transactions covered by proposed rule 18f-4 to 

determine which letters and other staff guidance, or portions thereof, should be withdrawn in 

connection with any adoption of this proposal. Upon the adoption of any final rule, some of these 

letters and other staff guidance, or portions thereof, would be moot, superseded, or otherwise 

inconsistent with the final rule and, therefore, would be withdrawn. If interested parties believe 

that additional letters or other staff guidance, or portions thereof, should be withdrawn, they 

should identify the letter or guidance, state why it is relevant to the proposed rule, how it or any 

specific portion thereof should be treated, and the reason therefor. The staff review would 

include, but would not necessarily be limited to, all of the staff no-action letters and other staff 

guidance listed below, including our staff’s position regarding TOBs.437 

• Dreyfus Strategic Investing & Dreyfus Strategic Income (pub. avail. June 22, 1987) 
                                                      
436   See supra section I.C. 
437  See Investment Management Staff Issues of Interest, available at 

https://www.sec.gov/divisions/investment/issues-of-interest.shtml#tobfinancing; see also 
Registered Investment Company Use of Senior Securities — Select Bibliography, available at 
https://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.  

https://www.sec.gov/divisions/investment/issues-of-interest.shtml#tobfinancing


244 

• Merrill Lynch Asset Management, L.P. (pub. avail. July 2, 1996) 

• Robertson Stephens Investment Trust (pub. avail. Aug. 24, 1995) 

• Claremont Capital Corp (pub. avail. Sept. 16, 1979) 

• Emerald Mgt. Co. (pub. avail. Jan. 21, 1978) 

• Sanford C. Bernstein (pub. avail. June 25, 1990) 

• Hutton Options Trading, L.P. (pub. avail. Feb. 2, 1989) 

• Prudential-Bache IncomeVertible Plus Fund (pub. avail. Nov. 20, 1985) 

• State Street Income Fund, State Street Balanced Fund (pub. avail. Oct. 21, 1985) 

• New England Life Government Securities Trust (pub. avail. Sept. 26, 1985) 

• Putnam Option Income Trust II (pub. avail. Sept. 23, 1985) 

• Thomson McKinnon Government Securities Fund (pub. avail. Sept. 23, 1985) 

• GMO Core Trust (pub. avail. Aug. 19, 1985) 

• Bartlett Capital Trust (pub. avail. Aug. 19, 1985) 

• Continental Option Income Plus Fund (pub. avail. Aug. 12, 1985) 

• Colonial High Yield Securities Trust, Colonial Enhanced Mortgage Trust (pub. avail. 

July 25, 1985) 

• Putnam High Income Government Trust (pub. avail. June 3, 1985) 

• Bartlett Management Trust (pub. avail. May 17, 1985) 

• Drexel Series Trust — Government Securities Series (pub. avail. Apr. 25, 1985) 

• Koenig Tax Advantaged Liquidity Fund (pub. avail. Mar. 27, 1985) 

• Colonial Tax-Managed Trust (pub. avail. Dec. 31, 1984) 

• Monitrend Fund (pub. avail. Nov. 14, 1984) 

• Pilot Fund (pub. avail. Sept. 14, 1984) 



245 

• Colonial Government Securities Plus Trust (pub. avail. June 15, 1984) 

• Z-Seven Fund (pub. avail. May 21, 1984) 

• Pension Hedge Fund (pub. avail. Jan. 20, 1984) 

• Steinroe Bond Fund (pub. avail. Jan. 17, 1984) 

• IDS Bond Fund (pub. avail. Apr. 11, 1983) 

• Safeco Municipal Bond, Inc (pub. avail. Nov. 26, 1982) 

• “Dear Chief Financial Officer” Letter, from Lawrence A. Friend, Chief Accountant, 

Division of Investment Management (pub. avail. Nov. 7, 1997) 

Accordingly, following a one-year transition period to provide time for funds to prepare 

to come into compliance with the new rule, funds could only enter into derivatives transactions, 

reverse repurchase agreements and similar financing transactions, and unfunded commitments to 

the extent permitted by, and consistent with the requirements of, proposed rule 18f-4 or section 

18. At that time, Release 10666 would be rescinded and, as determined appropriate in connection 

with the staff’s review of no-action letters and other staff guidance described in this release, staff 

no-action letters and other staff guidance, or portions thereof, would be withdrawn. 

We similarly propose to provide a one-year compliance period for the sales practices 

rules to provide time for broker-dealers and investment advisers to bring their operations into 

conformity with the new rule. We also propose a one-year delay to the effective date of the 

amendments to rule 6c-11, which would permit leveraged/inverse ETFs to rely on that rule, and 

to rescind the exemptive orders we have provided to leveraged/inverse ETF sponsors on the 

effective date of the amendments to rule 6c-11.  

We propose that each of the transition periods discussed in this section would run from 

the date of the publication of any final rule in the Federal Register. Accordingly, one year after 



246 

that date: (1) any fund that enters into the transactions permitted by rule 18f-4 would do so 

relying on that rule; (2) broker-dealers and investment advisers would be required to comply 

with the sales practices rules; and (3) leveraged/inverse ETFs could operate under rule 6c-11 and 

the current leveraged/inverse ETF sponsors’ orders would be rescinded.  

We request comment on these transition periods. 

 Do commenters agree that a one-year transition period to provide time for funds to 

prepare to come into compliance with proposed rule 18f-4 is appropriate? Should the 

period be shorter or longer? 

 Should we adopt tiered transition periods for smaller entities? For example, should 

we provide an additional 6 months for smaller entities (or some other shorter or 

longer period) in any transition period that we provide? Should the transition period 

be the same for all funds that rely on proposed rule 18f-4 (for example 12 months 

after any adoption of proposed rule 18f-4, or any shorter or longer period)? 

 Is the proposed one-year compliance period for the sales practices rules appropriate? 

Why or why not? Is a longer or shorter compliance period necessary to allow 

investment advisers and broker-dealers to comply with the proposed sales practices 

rules? Why or why not? If we provide small and large funds a tiered transition period 

to comply with proposed rule 18f-4, should we similarly implement a tiered 

compliance period for investment advisers and broker-dealers to comply with the 

proposed sales practices rules? Why or why not? 

 Would our proposal to rescind the current leveraged/inverse ETF sponsors’ 

exemptive orders on the delayed effective date of the amendments to rule 6c-11 

provide sufficient time for the leveraged/inverse ETF sponsors to transition to 



247 

rule 6c-11? 

M. Conforming Amendments 

Form N-2 requires a closed-end fund to disclose a senior securities table with certain 

information about any senior securities it has issued.438 Outstanding senior securities may bear on 

the likelihood, frequency, and size of distributions from the fund to its investors because section 18 

prohibits distributions when a closed-end fund does not have the asset coverage required under that 

section. Proposed rule 18f-4 would provide that a fund’s derivatives transactions and unfunded 

commitments entered into under the proposed rule would not be considered for purposes of 

computing section 18 asset coverage.439 These transactions therefore would not affect a fund’s 

ability under section 18 to make distributions to investors. Registered closed-end funds are 

already required to disclose extensive information about their derivatives transactions on 

Form N-PORT. In light of this treatment under proposed rule 18f-4 and the information that is 

already available regarding registered closed-end funds’ derivatives transactions, we are 

proposing to amend Form N-2 to provide that funds relying on proposed rule 18f-4 would not be 

required to include their derivatives transactions and unfunded commitment agreements in the 

senior securities table on Form N-2.440 Commenters on the 2015 proposal that addressed this 

topic supported such a conforming amendment with respect to asset coverage calculations and 

disclosure.441 

We request comment on the proposed conforming amendment to Form N-2, and other 

conforming amendments that commenters suggest would be necessary or appropriate. 
                                                      
438  See Item 4.3 of Form N-2. 
439  See proposed rule 18f-4(b). 
440   See proposed amendment to Instruction 2 of Item 4.3 of Form N-2. 
441  See, e.g., Ares Comment Letter; ICI Comment Letter I. 



248 

 Is the proposed conforming amendment appropriate? We have not proposed to 

exclude reverse repurchase agreements and similar financing transactions from the 

senior securities table in Form N-2 because these transactions may bear on the 

likelihood, frequency, and size of distributions from a fund to its investors. Do 

commenters agree that this is appropriate? Why or why not? If commenters do not 

believe that these transactions should be included in the senior securities table, what 

other disclosure would be appropriate?  

 Rule 22e-4 requires funds subject to the rule, in classifying the liquidity of their 

portfolios and in determining whether a fund primarily holds highly liquid 

investments, to take into account the fund’s highly liquid investments that it has 

“segregated” to cover certain less liquid investments.442 Proposed rule 18f-4, 

however, does not include an asset segregation requirement, and would supersede 

Release 10666 and related staff guidance. Should we remove any references in rule 

22e-4 to “segregated” assets (while retaining rule 22e-4’s references to assets pledged 

to satisfy margin requirements)? Is there any other basis on which funds “segregate” 

assets that would warrant our retaining these references?  

 Are there other conforming amendments to any of our other rules or forms that we 

should make? If so, what rules or forms should be amended and why? 

III. ECONOMIC ANALYSIS 

We are mindful of the costs imposed by, and the benefits obtained from, our rules. 

Section 3(f) of the Exchange Act and section 2(c) of the Investment Company Act state that 

                                                      
442  See rule 22e-4(b)(1)(ii)(C); rule 22e-4(b)(1)(iii)(B). A fund would also have to take into account 

the percentage of its highly liquid investments that it has pledged to satisfy margin requirements. 
See id. 



249 

when the Commission is engaging in rulemaking under such titles and is required to consider or 

determine whether the action is necessary or appropriate in (or, with respect to the Investment 

Company Act, consistent with) the public interest, the Commission shall consider whether the 

action will promote efficiency, competition, and capital formation, in addition to the protection 

of investors. Further, section 23(a)(2) of the Exchange Act requires the Commission to consider, 

among other matters, the impact such rules would have on competition and states that the 

Commission shall not adopt any rule that would impose a burden on competition not necessary 

or appropriate in furtherance of the purposes of the Exchange Act. The following analysis 

considers, in detail, the potential economic effects that may result from the proposed rule, 

including the benefits and costs to investors and other market participants as well as the broader 

implications of the proposal for efficiency, competition, and capital formation. 

A. Introduction 

Funds today use a variety of derivatives, referencing a range of assets or metrics. Funds 

use derivatives both to obtain investment exposure as part of their investment strategies and to 

manage risks. A fund may use derivatives to gain, maintain, or reduce exposure to a market, 

sector, or security more quickly, or to obtain exposure to a reference asset for which it may be 

difficult or impractical for the fund to make a direct investment. A fund may use derivatives to 

hedge interest rate, currency, credit, and other risks, as well as to hedge portfolio exposures.443 

As funds’ strategies have become increasingly diverse, funds’ use of derivatives has grown in 

both volume and complexity over the past several decades. At the same time, a fund’s 

                                                      
443   See supra section I.A. 



250 

derivatives use may entail risks relating to, for example, leverage, markets, operations, liquidity, 

and counterparties, as well as legal risks.444 

Section 18 of the Investment Company Act is designed to limit the leverage a fund can 

obtain through the issuance of senior securities.445 As discussed above, a fund’s derivatives use 

may raise the investor protections concerns underlying section 18. In addition, funds’ asset 

segregation practices have developed such that funds’ derivatives use—and thus funds’ potential 

leverage through derivatives transactions—does not appear to be subject to a practical limit as 

the Commission contemplated in Release 10666. Accordingly, we continue to be concerned that 

certain fund asset segregation practices may not address the concerns underlying section 18.446  

Proposed rule 18f-4 is designed to provide an updated, comprehensive approach to the 

regulation of funds’ use of derivatives and certain other transactions. The proposed rule would 

permit a fund, subject to certain conditions, to enter into derivatives or other transactions, 

notwithstanding the prohibitions and restrictions on the issuance of senior securities under 

section 18 of the Investment Company Act. We believe that the proposed rule’s requirements, 

including the derivatives risk management program requirement and VaR-based limit on fund 

leverage risk, would benefit investors by mitigating derivatives-related risks, including those that 

may lead to unanticipated and potentially significant losses for investors. 

Certain funds use derivatives in a limited manner, which we believe presents a lower 

degree of risk or potential impact and generally a lower degree of leverage than permitted under 

section 18. The proposed rule would provide an exception from the proposed derivative risk 

                                                      
444   See, e.g., supra notes 16-17 and accompanying text. 
445   See supra section I.B.1. 
446   See supra sections I.B.3. 



251 

management program requirement and VaR-based limit on fund leverage risk for these limited 

derivatives users. Instead, the proposed rule would require a fund relying on this exception to 

adopt policies and procedures that are reasonably designed to manage its derivatives risks. Funds 

with limited derivatives exposure and funds that use derivatives transactions solely to hedge 

certain currency risk would therefore not be required to incur costs and bear compliance burdens 

that may be disproportionate to the resulting benefits, while still being required to manage the 

risks their limited use of derivatives may present.447  

The proposed rule would also provide an exception from the VaR-based limit on fund 

leverage risk for certain leveraged/inverse funds in light of the requirements under the proposed 

sales practices rules that broker-dealers and investment advisers exercise due diligence in 

approving the accounts of retail investors to invest in these funds, and other conditions for these 

funds that proposed rule 18f-4 includes.448 This would allow these funds, which generally could 

not currently satisfy the proposed VaR-based limit on fund leverage risk, to continue offering 

their current strategies. The proposed sales practices rules’ due diligence and account approval 

requirements also would apply to accounts of investors in certain exchange-listed commodity- or 

currency-based trusts or funds, which are not investment companies subject to section 18 but 

present similar investor protection concerns. We believe the proposed sales practices rules would 

enhance investor protection by helping to ensure that investors in these funds are limited to those 

who are capable of evaluating their characteristics—including that the funds would not be 

subject to all of the leverage-related requirements applicable to registered investment companies 

generally—and the unique risks they present.  

                                                      
447  See supra sections I.C and II.E. 
448  See supra section II.G. 



252 

Proposed rule 18f-4 also contains requirements for funds’ use of certain senior securities 

that are not derivatives. Specifically, the proposed rule would permit reverse repurchase 

agreements and other similar financing transactions if they comply with the asset coverage 

requirements of section 18; this approach would align the treatment of reverse repurchase 

agreements and similar financing transactions, for section 18 purposes, with the treatment of 

bank borrowings and other senior securities transactions subject to section 18’s asset coverage 

requirements.449 In addition, the proposed rule would permit a fund to enter into unfunded 

commitment agreements if it reasonably believes, at the time it enters into such an agreement, 

that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of 

its unfunded commitment agreements.450 This requirement is designed to address the concern 

that a fund may experience losses as a result of having insufficient assets to meet its obligations 

with respect to these transactions, and we believe that the requirement would benefit investors by 

mitigating such losses or other adverse effects if a fund is unable to satisfy an unfunded 

commitment agreement.451  

This proposal also includes certain recordkeeping requirements and reporting 

requirements for funds that use derivatives.452 We expect that the proposed recordkeeping 

requirements would benefit investors by facilitating fund compliance with the proposed rule and 

our staff’s review of funds’ compliance. In addition, we expect that the proposed amendments to 

                                                      
449  Similar financing transactions may include securities lending arrangements and TOBs, depending 

on the particular facts and circumstances of the individual transaction. See supra section II.I. 
450  See supra section II.J. 
451  We believe that the proposed treatment of unfunded commitment transactions is consistent with 

general market practices. Therefore, we believe that the proposed requirements for both types of 
senior securities would not have significant economic effects when measured against this 
baseline.  

452   See supra sections II.C and II.H. 



253 

Forms N-PORT, N-CEN, and N-RN would further benefit investors by enhancing the 

Commission’s and the public’s understanding of the impact of funds’ use of derivatives on fund 

portfolios, and by facilitating the Commission’s ability to oversee funds’ use of derivatives and 

compliance with the proposed rules.453  

B. Economic Baseline 

1. Fund Industry Overview 

The fund industry has grown and evolved substantially in past decades in response to 

various factors, including investor demand, technological developments, and an increase in 

domestic and international investment opportunities, both retail and institutional.454 As of 

September 2019, there were 9,788 mutual funds (excluding money market funds) with $21,333 

billion in total net assets, 1,910 ETFs organized as an open-end fund or as a share-class of an 

open-end fund with $3,081 billion in total net assets, 664 registered closed-end funds with 294 

billion in total net assets, and 13 variable annuity separate accounts registered as management 

investment companies on Form N-3 with $224 billion in total net assets. There also were 413 

money market funds with $3,392 billion in total net assets.455 Finally, as of June 2019, there 

were 99 BDCs with $63 billion in total net assets.456 

                                                      
453  Because leveraged/inverse funds would not be subject to the proposed VaR-based limit on fund 

leverage risk, these funds would not be subject to the related proposed reporting requirements on 
Forms N-PORT and N-RN. Leveraged/inverse funds would, however, be subject to the proposed 
new reporting requirements on funds’ derivatives exposure on form N-PORT as well as to the 
proposed new requirements on Form N-CEN.  

454  See supra note 1. 
455  Estimates of the number of registered investment companies and their total net assets are based 

on a staff analysis of Form N-CEN filings as of September 5, 2019. For open-end funds that have 
mutual fund and ETF share classes, we count each type of share class as a separate fund and use 
data from Morningstar to determine the amount of total net assets reported on Form N-CEN 
attributable to the ETF share class. Money market funds are excluded from the scope of proposed 
rule 18f-4 but may experience economic effects as a result of being excluded from the rule’s 
scope. We therefore report their number and net assets separately from those of other mutual 

 



254 

2. Funds’ Use of Derivatives 

DERA staff analyzed funds’ use of derivatives based on Form N-PORT filings as of 

September 2019. The filings covered 9,074 mutual funds with $19,590 billion in total net assets, 

1,711 ETFs with $3,317 billion in total net assets, 565 registered closed-end funds with $327 

billion in net assets, and 13 variable annuity separate accounts registered as management 

investment companies with $219 billion in total net assets.457 While only larger fund groups are 

currently required to file reports on Form N-PORT, existing filings nevertheless covered 89% of 

funds representing 94% of assets.458  

Based on this analysis, 59% of funds reported no derivatives holdings, and a further 27% 

of funds reported using derivatives with gross notional amounts below 50% of net assets. These 

results are comparable to and consistent with the findings of the DERA White Paper, which 

studied a random sample of 10% of funds in 2014.459 

BDCs do not file Form N-PORT. To help evaluate the extent to which BDCs use 

derivatives, our staff reviewed the most recent financial statements of 48 of the current 99 BDCs 

                                                      

funds.  
456  Estimates of the number of BDCs and their net assets are based on a staff analysis of Form 10-K 

and Form 10-Q filings as of June 30, 2019. Our estimate includes BDCs that may be delinquent 
or have filed extensions for their filings, and it excludes 6 wholly-owned subsidiaries of other 
BDCs.  

457  The analysis is based on each registrant’s latest Form N-PORT filing as of September 23, 2019. 
Money market funds are excluded from the analysis; they do not file monthly reports on Form N-
PORT and are excluded from the scope of proposed rule 18f-4. For open-end funds that have 
mutual fund and ETF share classes, we count each type of share class as a separate fund and use 
data from Morningstar to determine the amount of total net assets reported on Form N-PORT 
attributable to the ETF share class.  

458  See supra note 281. 
459  See DERA White Paper, supra note 1. 



255 

as of September 2019.460 Based on this analysis, we observe that most BDCs do not use 

derivatives extensively. Of the sampled BDCs, 54% did not report any derivatives holdings, and 

a further 29% reported using derivatives with gross notional amounts below 10% of net assets. 

3. Current Regulatory Framework for Derivatives  

Funds have developed certain general asset segregation practices to “cover” their 

derivatives positions, consistent with the conditions in staff no-action letters and guidance.461 

However, staff has observed that practices vary based on the type of derivatives transaction, and 

that funds use different practices regarding the types of assets that they segregate to cover their 

derivatives positions. For purposes of establishing the baseline, we assume that funds generally 

segregate sufficient assets to at least cover any mark-to-market liabilities on the funds’ 

derivatives transactions, with some funds segregating more assets for certain types of derivatives 

transactions (sufficient to cover the full notional amount of the transaction or an amount between 

the transaction’s full notional amount and any mark-to-market liability).462 As the mark-to-

market liability of a derivative can be much smaller than the full investment exposure associated 

with the position, funds’ current use of the mark-to-market asset segregation approach, and 

funds’ segregation of any liquid asset, do not appear to place a practical limit on their use of 

derivatives.463 

                                                      
460  See supra note 280 and accompanying text. 
461  See supra section II.B.2.b. 
462  See supra notes 54-55 and accompanying text. 
463  See supra section I.B.2.b.  



256 

4. Funds’ Derivatives Risk Management Practices and Use of 
VaR Models  

There is currently no requirement for funds that use derivatives to have a formalized 

derivatives risk management program. However, we understand that advisers to many funds 

whose investment strategies entail the use of derivatives, including leveraged/inverse funds, 

already assess and manage risks associated with their derivatives transactions to varying extents. 

In addition, we understand that funds engaging in derivatives transactions have increasingly used 

stress testing as a risk management tool over the past decade.464  

We also understand that VaR calculation tools are widely available, and many advisers 

that enter into derivatives transactions already use risk management or portfolio management 

platforms that include VaR tools.465 Advisers to funds that use derivatives more extensively may 

be particularly likely to currently use risk management or portfolio management platforms that 

include VaR capability. Moreover, advisers that manage (or that have affiliates that manage) 

UCITS funds may already be familiar with using VaR models in connection with European 

guidelines.466 One commenter submitted the results of a survey based on responses from 24 fund 

complexes with $13.8 trillion in assets.467 The results of this survey indicate that 73% of 

respondents used some form of both VaR and stress testing as derivatives risk management tools. 

                                                      
464  See also supra note 145 and accompanying text. 
465  See also supra note 180. 
466  See supra note 222 and accompanying text. 
467  See ICI Comment Letter III. The commenter also indicated that the surveyed ICI member firms 

accounted for 67% of mutual fund and ETF assets as of June 2019 and that survey responses were 
submitted by firms “whose assets under management spanned the spectrum from small to very 
large.” However, these representations alone do not provide sufficient information about whether 
the surveyed firms were representative of all mutual funds and ETFs in terms of the exact 
distribution of specific characteristics, such as firm size or type of investment strategy.  



257 

5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse 
Funds  

Leveraged/inverse investment vehicles, as defined in the proposed sales practices rules, 

include leveraged/inverse funds and certain exchange-listed commodity- or currency-based trusts 

or funds. Currently, there are 164 leveraged/inverse ETFs with $33.9 billion in total net assets; 

105 leveraged/inverse mutual funds with $4.9 billion in total net assets; and 17 exchange-listed 

commodity- or currency-based trusts or funds with $1.2 billion in total net assets.468  

Leveraged/inverse investment vehicles generally target a daily return (or a return over 

another predetermined time period) that is a multiple, inverse, or inverse multiple of the return of 

an underlying index; however over longer holding periods, the realized leverage multiple of the 

returns of an investment in a leveraged/inverse investment vehicle relative to the returns of its 

underlying index can vary substantially from the vehicle’s daily leverage multiple. 

In addition, the returns of leveraged/inverse investment vehicles over longer holding 

periods share certain features with the returns of holding an option.469 For example, a call option 

on an index with a strike price that is much higher than the current index price (i.e., the option is 

significantly “out of the money”) is likely to expire worthless. If the option expires worthless, an 

investor that holds the option until expiry receives no payoff in exchange for their initial 

investment (the option premium) and therefore experiences a return of -100%. Holding all other 

                                                      
468  Estimates of the number of leveraged/inverse mutual funds and leveraged/inverse ETFs and their 

total net assets are based on a staff analysis of Form N-CEN filings as of September 5, 2019. 
Estimates of the number of exchange-listed commodity- or currency-based trusts or funds and 
their total net assets are based on Bloomberg data as of September 20, 2019. 

469  For a technical analysis of the similarities between the returns of leveraged/inverse ETFs over 
longer holding periods and the returns of holding an option, see Division of Economic and Risk 
Analysis, Economics Note: The Distribution of Leveraged ETF Returns (Nov. 2019), available at 
https://www.sec.gov/files/DERA_LETF_Economics_Note_Nov2019.pdf. The results of that 
analysis also apply more generally to other types of leveraged/inverse investment vehicles. 



258 

factors fixed, the likelihood of this outcome increases with the strike price of the option, and the 

option is priced accordingly—options that are further out of the money, all else equal, will have 

lower premiums. At the same time, on the rare occasions when the index price exceeds the strike 

price at expiration, the investor will earn a high return on his or her initial investment because the 

initial price paid for a call option is lower when the strike price is higher. While the payoff to 

holding a leveraged/inverse investment vehicle over long periods generally lacks this strict 

discontinuous nature (expiring either in the money or out of the money), it is nevertheless similar 

to that of an option in the sense that, as the vehicle’s leverage multiple or investor’s holding 

period increases, the likelihood of experiencing a loss increases (analogous to the option expiring 

out of the money) while gains, when they do occur, tend to be larger (analogous to the option 

expiring in the money).470  

To achieve the stated leverage multiple, most leveraged/inverse investment vehicles 

rebalance their exposure to the underlying index daily.471 This is also similar to options, whose 

payoffs can be replicated by trading dynamically in the underlying asset and a low-risk bond. For 

example, call options are economically equivalent to holding a long position in the underlying 

asset and a short position in a low-risk bond.472 Both leveraged/inverse investment vehicles and 

                                                      
470  In statistical terms, the option returns and returns of holding leveraged/inverse investment 

vehicles over longer holding periods both exhibit positive skewness. 
471  Leveraged/inverse investment vehicles that track the returns of an underlying index over time 

periods that are longer than one day rebalance their portfolios at the end of each such period. 
Leveraged/inverse investment vehicles use derivatives to achieve their targeted returns.  

472  Conversely, put options are economically equivalent to holding a short position in the underlying 
and a long position in a low-risk bond—their replicating portfolio consists of an inverse leveraged 
position in the underlying. 



259 

options are therefore economically equivalent to a dynamically rebalanced leveraged/inverse or 

inverse leveraged/inverse position in the underlying asset or reference index.473 

The majority of assets held in leveraged/inverse funds are held in leveraged/inverse 

ETFs. There are currently two ETF sponsors that rely upon exemptive relief from the 

Commission that permits them to operate leveraged/inverse ETFs.474 Since 2009, the 

Commission has not granted leveraged/inverse exemptive relief to any additional sponsors. In 

addition, leveraged/inverse ETFs are currently excluded from the scope of rule 6c-11, which the 

Commission adopted earlier this year and which allows ETFs satisfying certain conditions to 

operate without obtaining an exemptive order from the Commission.475 

Retail investors predominantly purchase and sell shares of leveraged/inverse investment 

vehicles through broker-dealers and investment advisers.476 To the extent that broker-dealers or 

investment advisers recommend leveraged/inverse investment vehicles to their customers or 

clients, they should have processes in place to satisfy their obligations to make only suitable 

recommendations or provide best interest advice, respectively.477 For example, the basis for an 

investment adviser’s reasonable understanding generally would include, for retail clients of 

investment advisers, a reasonable inquiry into the client’s financial situation, level of financial 
                                                      
473  Option replication portfolios need to be rebalanced continuously throughout the day as the price 

of the underlying asset changes. While the implied rebalancing happens continuously during the 
trading day for options, leveraged/inverse investment vehicles perform rebalancing trades in the 
underlying less frequently (daily for most leveraged/inverse investment vehicles).  

474  See supra notes 308 and 357. The exemptive orders of the two sponsors that operate 
leveraged/inverse ETFs permit these sponsors to launch additional funds under the terms and 
conditions of those orders. 

475  See supra notes 353-354 and accompanying text. 
476  See supra note 322. 
477  Following the June 30, 2020 compliance date for Regulation Best Interest, broker-dealers will 

have to provide recommendations in the best interest of their retail customers. See Regulation 
Best Interest: The Broker-Dealer Standard of Conduct, supra note 308. 



260 

sophistication, investment experience, and financial goals.478 When an adviser is assessing 

whether complex or high-risk products—such as leveraged/inverse funds—are in a retail client’s 

best interest, the adviser should generally apply heightened scrutiny to whether such investments 

fall within the retail client’s risk tolerance and objectives.479 Broker-dealers also will be required 

to comply with Regulation Best Interest beginning on June 30, 2020.480 Broker-dealers 

complying with Regulation Best Interest will have to exercise reasonable diligence, care, and 

skill when making a recommendation to a retail customer, including by understanding potential 

risks, rewards, and costs associated with a recommendation in light of the customer’s investment 

profile.481 

C. Benefits and Costs of the Proposed Rules and Amendments  

The Commission is sensitive to the economic effects that may result from the proposed 

rules and rule and form amendments, including benefits and costs. Where possible, we have 

attempted to quantify the likely economic effects; however, we are unable to quantify certain 

economic effects because we lack the information necessary to provide reasonable estimates. In 

some cases, it is difficult to predict how market participants would act under the conditions of 

the proposed rules. For example, we are unable to predict whether the proposed derivatives risk 

management program requirement and VaR-based limit on fund leverage risk may make 

investors more or less likely to invest in funds that would be subject to these requirements or the 

                                                      
478  See, e.g., Fiduciary Interpretation, supra note 309, at text preceding n.36.  
479  See id. at text preceding n.39. The Commission further stated in the Fiduciary Interpretation that 

leveraged/inverse funds and other complex products “may not be in the best interest of a retail 
client absent an identified, short-term, client-specific trading objective and, to the extent that such 
products are in the best interest of a retail client initially, they would require daily monitoring by 
the adviser.” See id. 

480  See Regulation Best Interest: The Broker-Dealer Standard of Conduct, supra note 305. 
481  See id. at section II.C.2.261 

degree to which these requirements may affect the use of derivatives by these funds. 

Nevertheless, as described more fully below, we are providing both a qualitative assessment and 

quantified estimate of the economic effects, including the initial and ongoing costs of the 

additional reporting requirements, where feasible. 

Direct costs incurred by funds discussed below may, to some extent, be absorbed by the 

fund’s investment adviser or be passed on to investors in the form of increased management fees. 

The share of these costs borne by funds, their advisers, and investors depends on multiple 

factors, including the nature of competition between advisers, and investors’ relative sensitivity 

to changes in fund fees, the joint effects of which are particularly challenging to predict due to 

the number of assumptions that the Commission would need to make. 

1. Derivatives Risk Management Program and Board Oversight 
and Reporting  

Proposed rule 18f-4 would require funds that enter into derivatives transactions and are 

not limited derivatives users to adopt and implement a derivatives risk management program. 

The program would provide for the establishment of risk guidelines that must include certain 

elements, but that are otherwise tailored based on how the fund’s use of derivatives may affect 

its investment portfolio and overall risk profile. The program also would have to include stress 

testing, backtesting, internal reporting and escalation, and program review elements. The 

proposed rule would require a fund’s board of directors to approve the fund’s designation of a 

derivatives risk manager, who would be responsible for administering the derivatives risk 

management program. The fund’s derivatives risk manager would have to report to the fund’s 

board on the derivatives risk management program’s implementation and effectiveness and the 

results of the fund’s stress testing and backtesting. 



262 

We understand that advisers to many funds whose investment strategies entail the use of 

derivatives already assess and manage risks associated with their derivatives transactions.482 

However, proposed rule 18f-4’s requirement that funds establish written derivatives risk 

management programs would create a standardized framework for funds’ derivatives risk 

management by requiring each fund’s program to include all of the proposed program elements. 

To the extent that the resulting risk management activities are more comprehensive than funds’ 

current practices, this may result in more-effective risk management across funds. While the 

adoption of a derivatives risk management program requirement may not eliminate all 

derivatives-related risks, including that investors could experience large, unexpected losses from 

funds’ use of derivatives, we expect that investors would benefit from a decrease in leverage-

related risks.  

Some funds may reduce or otherwise alter their use of derivatives transactions to respond 

to risks identified after adopting and implementing their risk management programs. In 

particular, we expect that funds currently utilizing risk management practices that are not tailored 

to their use of derivatives may decide to make such changes to their portfolios.483  

The proposed rule would require a fund to reasonably segregate the functions of its 

derivatives risk management program from those of its portfolio management.484 This 

segregation requirement is designed to enhance the program’s effectiveness by promoting the 

objective and independent identification and assessment of derivatives risk.485 Segregating the 

                                                      
482  See supra section III.B.4. 
483  As a consequence of reducing risk, such funds may earn reduced returns. 
484  See supra section II.B.2. 
485  See supra note 112 and accompanying text. While some portfolio managers may find it 

burdensome to collaborate with a derivatives risk manager, to the extent that portfolio managers 
 



263 

functions of a fund’s derivatives risk management program from those of its portfolio 

management may also mitigate the risks of competing incentives between a fund’s portfolio 

managers and its investors.486 

Finally, to the extent that the periodic stress testing and backtesting requirements of the 

proposed derivatives risk management program result in fund managers developing a more 

complete understanding of the risks associated with their use of derivatives, we expect that funds 

and their investors will benefit from improved risk management.487 Such benefits would be in 

addition to benefits derived from the proposed VaR-based limit on fund leverage risk discussed 

below.488 VaR analysis, while yielding a simple yet general measure of a fund’s portfolio risk, 

does not provide a complete picture of a fund’s financial risk exposures.489 Complementing VaR 

analysis with stress testing would provide a more complete understanding of the fund’s potential 
                                                      

already consider the impact of trades on the fund’s portfolio risk, we believe that having the 
involvement of a derivatives risk manager may typically make a portfolio manager’s tasks more 
rather than less efficient. 

486 For example, portfolio managers of actively-managed funds that are underperforming competing 
funds may have an incentive to increase risk exposures through use of derivatives in an effort to 
increase returns. This behavior may result in a fund also increasing risk beyond investor 
expectations. (For theoretical motivation of such behaviors see, e.g., Keith C. Brown, W.V. 
Harlow, & Laura T. Starks, Of Tournaments and Temptations: An Analysis of Managerial 
Incentives in the Mutual Fund Industry, 51 Journal of Finance 85 (1996), available at 
https://www.onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1996.tb05203.x; Judith 
Chevalier & Glenn Ellison, Risk-Taking by Mutual Funds as a Response to Incentives, 105 
Journal of Political Economy 1167 (1997), available at 
https://www.jstor.org/stable/10.1086/516389?seq=1#metadata_info_tab_contents).  

487  See supra sections II.B.3.c and II.B.3.d; see also supra section II.C.2 (discussing the proposed 
requirements that a fund’s derivatives risk manager provide to the fund’s board: (1) a written 
report, at least annually, providing a representation that the program is reasonably designed to 
manage the fund’s derivatives risks and to incorporate the required elements of the program 
(including a review of the VaR calculation model used by the fund under proposed rule 18f-
4(c)(2), and the backtesting required by proposed rule 18f-4(c)(1)(iv)); and (2) a written report, at 
the frequency determined by the board, regarding any exceedances of the fund’s risk guidelines 
and the results of the fund’s stress tests).  

488   See infra section III.C.2. 
489   See id. 

https://www.jstor.org/stable/10.1086/516389?seq=1#metadata_info_tab_contents


264 

losses under different sets of market conditions. For example, simulating potential stressed 

market conditions not reflected in historical correlations between fund returns and asset prices 

observed in normal markets may provide derivatives risk managers with important information 

pertaining to derivatives risks in stressed environments.490 By incorporating the potential impact 

of future economic outcomes and market volatility in its stress test analysis, a fund may be able 

to analyze future potential swings in its portfolio that may impact the fund’s long-term 

performance. This forward-looking aspect of stress testing would supplement the proposed rule’s 

VaR analysis requirement, which would rely on historical data.  

In addition, requiring that a fund backtest the results of its VaR analysis each business 

day would assist funds in examining the effectiveness of the fund’s VaR model. The proposed 

rule would require that, each business day, the fund compare its actual gain or loss for that 

business day with the fund’s VaR calculated for that day.491 This comparison would help identify 

days where the fund’s portfolio losses exceed the VaR calculated for that day, as well as 

systematic over- or under-estimation of VaR suggesting that the fund may not be accurately 

measuring all significant, identifiable market risk factors.492  

Proposed rule 18f-4 would also require that a fund’s board of directors approve the 

designation of the fund’s derivatives risk manager, taking into account the derivatives risk 

                                                      
490  See supra section II.B.3.c (proposed rule 18f-4 would require the program to provide for stress 

testing to “evaluate potential losses to the fund’s portfolio in response to extreme but plausible 
market changes or changes in market risk factors that would have a significant adverse effect on 
the fund’s portfolio, taking into account correlations of market risk factors as appropriate and 
resulting payments to derivatives counterparties”). 

491  See supra section II.B.3.d. 
492  See supra notes 150-151 and accompanying text. 



265 

manager’s relevant experience.493 We anticipate that this requirement, along with the derivatives 

risk manager’s direct reporting line to the board, would result in effective communication 

between the board and the derivatives risk manager that would enhance oversight of the program 

to the benefit of the fund and its investors.  

Proposed rule 18f-4 would require that the derivatives risk manager provide the fund’s 

board a written report at least once a year on the program’s effectiveness as well as regular 

written reports at a frequency determined by the board that analyze exceedances of the fund’s 

risk guidelines and present the results of the fund’s stress tests and backtests.494 The proposed 

board reporting requirements may facilitate the board’s oversight of the fund and the operation of 

the derivatives risk management program, to the extent the fund does not have such regular 

reporting mechanisms already in place. In the event the derivatives risk manager encounters 

material risks that need to be escalated to the fund’s board, the proposed provision that the 

derivatives risk manager may directly inform the board of these risks in a timely manner as 

appropriate may help prevent delays in resolving such risks.  

Funds today employ a range of different practices, with varying levels of 

comprehensiveness and sophistication, for managing the risks associated with their use of 

derivatives.495 We expect that compliance costs associated with the proposed derivatives risk 

management program requirement would vary based on the fund’s current risk management 

practices, as well as the fund’s characteristics, including in particular the fund’s investment 

strategy, and the nature and type of derivatives transactions used by the fund.  

                                                      
493   See supra section II.C.1. 
494  See supra section II.C.2. 
495  See supra section III.B.4. 



266 

We understand that VaR models are widely used in the industry and that backtesting is 

commonly performed in conjunction with VaR analyses. As a result, we believe that many funds 

that would be required to establish derivatives risk management programs already have VaR 

models with backtesting in place. Moreover, the proposed rule’s derivatives risk management 

program requirements, including stress testing and backtesting requirements are, generally, high-

level and principles-based. As a result, it is likely that many funds’ current risk management 

practices may already be in line with many of the proposed rule’s derivatives risk management 

program requirements or could be readily conformed without material change. Thus, the costs of 

adjusting funds current’ practices and procedures to comply with the parallel requirements of 

proposed rule 18f-4 may be minimal for such funds.  

Certain costs of the proposed derivatives risk management program may be fixed, while 

other costs may vary with the size and complexity of the fund and its portfolio allocation. For 

instance, costs associated with purchasing certain third-party data used in the program’s stress 

tests may not vary much across funds. On the other hand, certain third-party services may vary in 

terms of costs based on the portfolio positions to be analyzed. Further, the extent to which a cost 

corresponding to the program is fixed or variable may also depend on the third-party service 

provider.  

Larger funds or funds that are part of a large fund complex may incur higher costs in 

absolute terms but find it less costly, per dollar managed, to establish and administer a 

derivatives risk management program relative to a smaller fund or a fund that is part of a smaller 

fund complex. For example, larger funds may have to allocate a smaller portion of existing 



267 

resources for the program, and fund complexes may realize economies of scale in developing 

and implementing derivatives risk management programs for several funds.496  

For funds that do not already have a derivatives risk management program in place that 

could be readily adapted to meet the proposed rule’s requirements without significant additional 

cost, we estimate that the one-time costs to establish and implement a derivatives risk 

management program would range from $70,000 to $500,000 per fund, depending on the 

particular facts and circumstances, including whether a fund is part of a larger fund complex and 

therefore may benefit from economies of scale. These estimated costs are attributable to the 

following activities: (1) developing risk guidelines and processes for stress testing, backtesting, 

internal reporting and escalation, and program review; (2) integrating and implementing the 

guidelines and processes described above; and (3) preparing training materials and administering 

training sessions for staff in affected areas.  

For funds that do not already have a derivatives risk management program in place that 

could be readily adapted to meet the proposed rule’s requirements without significant additional 

cost, based on our understanding, we estimate that the ongoing annual program-related costs that 

a fund would incur range from 65% to 75% of the one-time costs to establish and implement a 

derivatives risk management program. Thus, a fund would incur ongoing annual costs that range 

                                                      
496  Although we believe that many funds have existing risk officers whose role extends to managing 

derivatives risks, we note that some funds, and in particular smaller funds or those that are part of 
a smaller fund complex, may not have existing personnel capable of fulfilling the responsibilities 
of the derivatives risk manager, or may choose to hire a new employee or employees to fulfill this 
role, rather than assigning that responsibility to a current employee or officer of the fund or the 
fund’s investment adviser. We expect that a fund that would hire new employees would likely 
incur larger costs compared to a fund that has existing employees that could serve as a fund’s 
derivatives risk manager.  



268 

from $45,500 to $375,000.497 These estimated costs are attributable to the following activities: 

(1) assessing, monitoring, and managing the risks associated with the fund’s derivatives 

transactions; (2) periodically reviewing and updating (A) the program including any models or 

measurement tools (including any VaR calculation models) to evaluate the program’s 

effectiveness and to reflect changes in risk over time, and (B) any designated reference index to 

evaluate its appropriateness; (3) providing written reports to the fund’s board on the derivatives 

risk management program’s implementation and effectiveness and the results of the fund’s stress 

testing; and (4) additional staff training. 

Under the proposed rule, a fund that is a limited derivatives user would not be required to 

establish a derivatives risk management program.498 Based on an analysis of Form N-PORT 

filings, as well as financial statements filed with the Commission by BDCs, we estimate that 

about 22% of funds that would be subject to the proposed rule, or 2,693 funds total, would be 

required to implement a risk management program.499 As many funds belong to a fund complex 

and are likely to experience economies of scale, we expect that the lower end of the estimated 

range of costs ($70,000 in one-time costs; $45,500 in annual costs) better reflects the total costs 

likely to be incurred by those funds.500 In addition, we believe that many funds already have a 

derivatives risk management program in place that could be readily adapted to meet the proposed 

                                                      
497  This estimate is based on the following calculations: 0.65 x $70,000 = $45,500; 0.75 x $500,000 

= $375,000. 
498  The estimates of the one-time and ongoing costs described in this section include the costs 

associated with determining whether a fund is a limited derivatives user.  
499  We estimate that about 22% of all funds that would be subject to the proposed rule hold some 

derivatives and would not qualify as a limited derivatives user under the proposed rule.  
500  A fund that uses derivatives in a complex manner, has existing risk management practices that are 

not commensurate with such use of derivatives, and may have to hire additional personnel to 
fulfill the role of derivatives risk manager would be particularly likely to experience costs at the 
upper end of this range. 



269 

rule’s requirements without significant additional cost. 501 However, as we do not have data to 

determine how many funds already have a program in place that would substantially satisfy the 

proposed rule’s requirements, we over-inclusively assume that all funds would incur a cost 

associated with this requirement. Based on these assumptions, we provide an upper-end estimate 

for total industry cost in the first year of $311,041,500.502 

2. VaR-Based Limit on Fund Leverage Risk 

The proposed rule would generally impose a VaR-based limit on fund leverage risk on 

funds relying on the rule to engage in derivatives transactions.503 This outer limit would be based 

on a relative VaR test or, if the fund’s derivatives risk manager is unable to identify an 

appropriate designated reference index, an absolute VaR test. In either case a fund would apply 

the test at least once each business day. The proposed rule would include an exception from the 

limit on fund leverage risk for limited derivatives users and also certain funds that are 

“leveraged/inverse investment vehicles,” as defined in the proposed sales practices rules.504 

The proposed relative VaR test would limit a fund’s VaR to 150% of the VaR of the 

fund’s designated reference index.505 The designated reference index would have to be 

unleveraged and reflect the markets or asset classes in which the fund invests.506 Therefore, the 

                                                      
501  One commenter indicated that implementing stress testing, which would be one of the required 

elements of the proposed derivatives risk management program, would be only slightly 
burdensome for 27% of respondents to a survey of ICI member firms and would be moderately 
burdensome for an additional 50% of respondents. See ICI Comment Letter III; see also supra 
note 467. 

502  This estimate is based on the following calculation: 2,693 funds x ($70,000 + $45,500) = 
$311,041,500. 

503  See supra section II.D. 
504  See supra sections II.E and II.G.3. 
505  See supra section II.D.2. 
506  See supra section II.D.2.a. The proposed definition of “designated reference index” also includes 

 



270 

relative VaR test restricts the incremental risk associated with a fund’s portfolio relative to a 

similar but unleveraged investment strategy. In this sense, the relative VaR test restricts the 

degree to which a fund can use derivatives to leverage its portfolio.  

We recognize that the derivatives risk managers of some funds may not be able to 

identify an appropriate designated reference index.507 As these funds would not be able to 

comply with the proposed relative VaR test, the proposed rule would require these funds to 

comply with the proposed absolute VaR test instead.508 To comply with the absolute VaR test, 

the VaR of the fund’s portfolio must not exceed 15% of the value of the fund’s net assets. The 

level of loss in the proposed absolute VaR test would provide approximately comparable 

treatment for funds that rely on the absolute VaR test and funds that rely on the relative VaR test 

and use the S&P 500 as their designated reference index during periods where the S&P 500’s 

VaR is approximately equal to the historical mean.509 

One common critique of VaR is that it does not reflect the conditional distribution of 

losses beyond the specified confidence level.510 In other words, the proposed VaR tests would 

not capture the size and relative frequency of losses in the “tail” of the distribution of losses 

                                                      

other requirements, as discussed above. See id. For example, a designated reference index could 
not be administered by an organization that is an affiliated person of the fund, its investment 
adviser, or principal underwriter, or created at the request of the fund or its investment adviser, 
unless the index is widely recognized and used. 

507  See supra section II.D.3. 
508  Whether a fund complies with the proposed relative or absolute VaR test would depend on 

whether the fund’s derivatives risk manager would be able to identify a designated reference 
index that is appropriate for the fund taking into account the fund’s investments, investment 
objectives, and strategy. See id. We therefore anticipate that industry norms that reflect the 
availability of an appropriate designated reference index would develop under which funds with 
similar strategies would generally comply with the same type of VaR test (that is, either the 
proposed relative VaR test or the proposed absolute VaR test). 

509   See supra section II.D.3. 
510  See supra note 182 and accompanying text.  



271 

beyond the measured confidence level.511 As a result, two funds with the same VaR level could 

differ significantly in the magnitude and relative frequency of extreme losses, even though the 

probability of a VaR breach would be the same for the two funds. To demonstrate this limitation 

of VaR, we construct a simplified portfolio with an equity investment that also achieves leverage 

through derivatives. By varying the type of derivatives included in the portfolio, we illustrate that 

the tail risk varies significantly across portfolios with equal VaR. 

The details of the strategy are as follows. Assume a fund has initial assets of $100 in 

cash. On day 𝑡𝑡, the manager of the portfolio achieves the additional leverage by writing $ 𝑋𝑋 

worth of put options, and then invests the proceeds from the sale of the options and the initial 

cash balance, i.e., $(100 + 𝑋𝑋), into the S&P 500 index.512 For simplicity, we further assume that 

the underlying asset of the shorted put options is also the S&P 500 index, so that the fund’s 

designated reference index is the S&P 500. The maturity of the put option is assumed to be one 

month, and the price of the S&P on day 𝑡𝑡 is normalized to $100. On day 𝑡𝑡 + 1, the manager buys 

back the put options and realizes the returns of the strategy. The one-day gross return of the fund 

can be described mathematically as 

𝑅𝑅𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 =
100 + 𝑋𝑋

100
𝑅𝑅𝑀𝑀 −

𝑋𝑋
100

𝑅𝑅𝑝𝑝𝑝𝑝𝑝𝑝, 

where 𝑅𝑅𝑀𝑀 is the gross one-day return of the S&P 500 index, and 𝑅𝑅𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑃𝑃(𝑡𝑡 + 1)/𝑃𝑃(𝑡𝑡) is the 

gross one-day return of the put option, with the price of the put option at time t denoted by 𝑃𝑃(𝑡𝑡). 

                                                      
511  The term “relative frequency” here refers to the frequency of loss outcomes in the tail of the 

distribution relative to other loss outcomes that are also in the tail of the distribution. This relative 
frequency of the loss outcomes together with the magnitude of the associated losses describe the 
conditional distribution of losses in the tail of the distribution.  

512  This strategy could be implemented by either investing in the constituent securities of the S&P 
500 directly or, for example, by investing in an ETF that tracks the S&P 500 index.  



272 

The return of the put option depends on the return of the underlying asset, and the money-ness of 

the put—the lower the strike price, the more out-of-the-money is the put. In our exercise, we 

look at three options with three different strike prices, ranging from more out-of-the-money to at-

the-money. The strike prices, denoted by K, are equal to 𝐾𝐾 = 92%,𝐾𝐾 = 96%, and 𝐾𝐾 = 100% of 

the current level of the S&P 500 index respectively.513 Assuming the portfolio manager wants to 

achieve as much leverage as possible with each of the three options, while still abiding by the 

proposed limit set by the relative VaR level of 150% at a 99% confidence level, we calculate the 

amount of puts she would short, the expected returns of the three portfolios, and the relative VaR 

for confidence levels of 95%, 99%, and 99.9%. In our calculation, the model is calibrated to 

approximately match the historical return distribution of the S&P 500. Returns are assumed to be 

normally distributed (for simplicity) with an annualized mean return of 6% and an annual 

standard deviation of roughly 16%. The latter implies a daily standard deviation of 1%. For 

simplicity, the risk-free rate is assumed to be zero. The results are in Table 1. 

 

TABLE 1: PORTFOLIO COMPOSITION, RETURNS AND VAR LEVELS 

 K=92% Portfolio K=96% Portfolio K=100% Portfolio 

Portfolio Weight -0.58% -0.93% -1.54% 

Number of Contracts -9.92  -2.05 -0.84 

Fund Expected Return 6.68% 7.00% 7.30% 

Fund Relative VaR (99%) 1.49 1.49 1.49 

Fund Relative VaR (99.9%) 2.14 2.07 2.03 

 
Relative VaR levels are identical and no greater than 150% for all three portfolios at the 

99% confidence level and, as expected, for each portfolio relative VaR is higher for higher 
                                                      
513  Given the historical volatility of the S&P 500 – approximately 16% annually, or 1% daily – an 

8% daily drop in the price is an 8 standard deviation event. Therefore, an option with a strike 
price of 92% of the current value of the S&P 500 index could be considered a deep out-of-the-
money option. 



273 

confidence levels. However, this example illustrates that relative VaR varies across these 

portfolio for confidence levels above 99%. The fund writing the more out-of-the-money option 

(𝐾𝐾 = 92%) is riskier in the tail of the S&P 500 return distribution (when the S&P 500 drops over 

the one-day period) than the fund writing the at-the-money option (𝐾𝐾 = 100%), but the relative 

VaR level at the 99% confidence level does not reflect this difference.  

Figure 1 shows the daily return profile of the three portfolios as a function of daily 

returns to the S&P 500 index. Along the x-axis are daily returns to the S&P 500 index, ranging 

from -8% to +8%. The dotted line represents the daily return profile of a portfolio that tracks 1.5 

times the returns of the S&P 500 index. The figure shows that the degree of tail risk differs 

across portfolios. While the returns to all portfolios are equal at the 150% relative VaR limit at a 

99% confidence level, returns beyond the 150% relative VaR limit are lower for portfolios that 

write puts that are further out-of-the-money.  

FIGURE 1: DAILY PORTFOLIO RETURNS 

 



274 

 
 

FIGURE 2: THREE-DAY RETURNS WITH DAILY REBALANCING 

 

We also considered the effect that a decline in the S&P 500 over three consecutive days 

would have on the fund that is short the put options with a 𝐾𝐾 = 92% strike price considered 

above. The proposed rule requires that a fund determine its compliance with the applicable VaR 

test at least once each business day. In computing three-day returns for the fund, we assume that, 

as the fund exceeds the relative VaR test each business day, the fund rebalances its portfolio, at 

the beginning of each day, to bring the fund back into compliance with the 150% relative VaR 

limit. The solid line in Figure 2 shows the three-day cumulative return of the fund as a function 

of the per-day returns of the S&P 500 on the x-axis, which is assumed to be the same for three 

consecutive days. The dashed curve in Figure 2 shows the corresponding first-day returns of the 

portfolio for comparison, which are the same as those denoted by the solid line in Figure 1. The 

figure shows that the three-day cumulative returns shown by the solid curve (in Figure 2) are less 



275 

than three times the single-day losses shown by the dashed curve. This is a result of the daily 

rebalancing of the portfolio, which, in this example, reduces the incremental downside risk over 

time.  

As discussed in more detail above, the proposed VaR tests are designed to address the 

concerns underlying section 18, but they are not a substitute for a fully-developed derivatives 

risk management program.514 Recognizing VaR’s limitations, the proposed rule also would 

require the fund to adopt and implement a derivatives risk management program that, among 

other things, would require the fund to establish risk guidelines and to stress test its portfolio in 

part because of concerns that VaR as a risk management tool may not adequately reflect tail 

risks. 

DERA staff analyzed the VaR levels of the portfolios of all funds that would be subject to 

the proposed rule and of certain benchmark indexes as of December 2018 in order to estimate 

how many of the funds that would be subject to the proposed VaR-based limit on fund leverage 

risk currently operate in exceedance of that limit.515 This analysis identified only six funds that 

would be subject to the proposed limit that DERA staff estimated may fail the relative VaR test. 

In the case of these six funds, DERA staff calculated the relative VaR test using the primary 

benchmark disclosed in the funds’ prospectuses. To the extent that these funds’ derivatives risk 

managers were to determine that a different index would be more appropriate for purposes of 
                                                      
514  See supra note 184 and accompanying text. 
515  This analysis is based on Morningstar data as of December 31, 2018. DERA staff computed the 

VaR of each fund and that of a reference index using historical simulation from three years of 
prior daily return data. Staff generally computed the relative VaR test based on a fund’s primary 
prospectus benchmark. In cases where historical return data for the primary prospectus 
benchmark was not available or where the primary prospectus benchmark did not appear to 
capture the markets or asset classes in which a fund invests, DERA staff instead used a broad-
based unleveraged index that captures a fund’s markets or asset classes or a broad-based U.S. 
equity index. 



276 

computing the relative VaR test or that no appropriate designated reference index were available, 

some or all of these funds could be compliant with the VaR-based limit on fund leverage risk 

either under the relative VaR test with a more appropriate index or under the absolute VaR 

test.516 As a result, we estimate that there would only be a very small number of funds, if any, 

that would have to adjust their portfolios in order to comply with the VaR-based limit on fund 

leverage risk. This is consistent with the VaR-based limit on fund leverage risk functioning as an 

outer bound on fund leverage risk. 

To the extent that there are funds that would have to adjust their portfolios to comply 

with the VaR-based limit on fund leverage risk, these funds would incur associated trading costs. 

If there were a fund that would have to adjust its portfolio so significantly that it could no longer 

pursue its investment strategy, such a fund may also lose investors or, if it chooses to cease 

operating, incur costs associated with unwinding the fund.  

In addition, funds could be required to adjust their portfolios to comply in the future and, 

if so, would incur associated trading costs. For example, as market conditions change, a fund’s 

VaR could exceed the proposed limits, especially if a fund relies on the absolute VaR test. The 

proposed VaR tests also would eliminate the flexibility that funds currently have to leverage their 

portfolios to a greater extent than the proposed VaR tests would permit. Although funds 

currently may not be exercising this flexibility, they may nevertheless value the ability to so 

increase leverage in the future. While, on the one hand, the proposed VaR tests impose costs on 

funds by restricting the strategies they may employ, the proposed limit on fund leverage risk 

would benefit fund investors, to the extent that it would prevent these investors from 

                                                      
516  Based on our analysis, we estimate that only one of the six funds that we identified may fail the 

proposed relative VaR test would also fail the proposed absolute VaR test.  



277 

experiencing unexpected losses from a fund’s increased risk exposure that are prevented by the 

proposed VaR-based limit on fund leverage risk.  

By establishing a bright-line limit on the amount of leverage risk that a fund can take on 

using derivatives, the proposed rule may make some funds and their advisers more comfortable 

with using derivatives. As a result, some funds that currently invest in derivatives to an extent 

that would result in the fund’s VaR being below the proposed limit may react by increasing the 

extent of their derivatives usage.  

The proposed requirement could also indirectly result in changing the amount of 

investments in funds. On the one hand, the proposed rule could attract additional investment, if 

investors become more comfortable with funds’ general level of riskiness as a result of funds’ 

compliance with an outside limit on fund leverage risk. On the other hand, to the extent that 

investors currently expect funds to limit their risk to levels below those which the proposed 

limits would produce (which investors could observe from the required VaR reporting 

requirements on form N-PORT for funds other than limited derivatives users and 

leveraged/inverse funds), or investors see funds’ general level of riskiness increasing after funds 

come into compliance with the proposed limits, the proposed limits may result in investors re-

evaluating how much risk they are willing to take and reducing their investments in funds. Due 

to a lack of data regarding current investor expectations about fund risk, however, we are unable 

to predict which of the two effects would more likely dominate the other.  

As the proposed requirements would prevent funds from offering investment strategies 

that exceed the proposed outer limit on fund leverage risk, those investors who prefer to invest in 

such funds because they value the increased potential for gains that is generally associated with 

riskier investment strategies may see their investment opportunities restricted by the proposed 



278 

rules. As a result, such investors may instead invest in alternative investment vehicles, exchange-

traded notes, or structured products, which can provide leveraged market exposure but would not 

be subject to the VaR-based limit on fund leverage risk of rule 18f-4.517 Alternatively, such 

investors, particularly institutional ones, may instead borrow themselves or trade on margin to 

achieve leverage.  

Funds that would be subject to the proposed VaR-based limit on fund leverage risk would 

incur the cost of determining their compliance with the applicable VaR test at least once each 

business day. Part of these costs would be associated with obtaining the necessary data required 

for the VaR calculation. Funds implementing the relative VaR test would likely incur larger data 

costs compared to funds implementing the absolute VaR test, as the absolute VaR test would 

require funds to obtain data only for the VaR calculation for the fund’s portfolio, whereas the 

relative VaR test also would require funds to obtain data for the VaR calculation for their 

designated reference index. In addition, some index providers may charge licensing fees to funds 

for including indexes in their disclosure documents or for access to information about the index’s 

constituent securities and weightings.518  

Funds that do not already have systems to perform the proposed VaR calculations in 

place would also incur the costs associated with setting up these systems or updating existing 

systems.519 Both the data costs and the systems costs would likely be larger for funds that use 

                                                      
517  See supra section III.C.5.  
518  We understand that industry practices around licensing indexes for regulatory purposes vary 

widely, with some providers not charging any fees and others charging fees in excess of $10,000 
per year.  

519  One commenter indicated that implementing a UCITS VaR test would be only slightly 
burdensome for 45% of respondents to a survey of ICI member firms and would be moderately 
burdensome for an additional 34% of respondents. The commenter also indicated that 
respondents commonly reported that the burden would increase, in some cases very substantially, 

 



279 

multiple types of derivatives, use derivatives more extensively, or otherwise have more 

complicated derivatives portfolios, compared to funds with less complicated derivatives 

portfolios.  

Larger funds or funds that are part of a large fund complex may incur higher costs in 

absolute terms but find it less costly, per dollar managed, to perform VaR tests relative to a 

smaller fund or a fund that is part of a smaller fund complex. For example, larger funds may 

have to allocate a smaller portion of existing resources for the VaR test and fund complexes may 

realize economies of scale in implementing systems to compute VaR. In particular, the costs 

associated with implementing or updating systems to calculate VaR would likely only be 

incurred once at the level of a fund complex, as such systems can be used to perform VaR tests 

for all funds in the complex that are subject to the VaR test requirement. Similarly, larger fund 

complexes may incur lower costs associated with purchasing data per fund, to the extent that the 

VaR calculations for multiple funds in the complex partially or completely require the same data.  

Under the proposed rule, a fund that holds derivatives that is either a limited derivatives 

user or a leveraged/inverse fund that complies with the alternative requirements for 

leveraged/inverse investment vehicles would not be subject to the proposed VaR-based limit on 

fund leverage risk. Based on an analysis of Form N-PORT filings and financial statements filed 

with the Commission by BDCs, we estimate that about 19% of funds that would be subject to the 

proposed rule, or 2,424 funds total, would be required to implement VaR tests.520 We estimate 

                                                      

if a VaR test has different parameters or is more prescriptive than UCITS VaR. See ICI Comment 
Letter III; see also supra note 451. As the requirements of the proposed VaR test are generally 
consistent with existing market practice, including that of UCITs funds, the results of this survey 
therefore support our view that many funds would likely experience efficiencies in implementing 
the proposed VaR test.  

520  We estimate that about 19% of all funds that would be subject to the proposed rule hold some 
 



280 

that the incremental annual cost associated with the VaR test would range from $5,000 to 

$100,000 per fund, depending on the particular facts and circumstances, including whether the 

fund currently computes VaR; whether the fund is implementing the relative or absolute VaR 

test; and whether a fund that is part of a larger complex may be able to realize economies of 

scale. Funds that currently already compute VaR would be particularly likely to experience costs 

at the very low end of this range. Assuming that the midpoint of this range reflects the cost to the 

average fund subject to the VaR requirement, we estimate a total additional annual industry cost 

of $127,260,000.521  

In addition, a fund that today or in the future may operate in a manner that would result in 

the fund’s portfolio VaR being just under the proposed limit on fund leverage risk may need to 

alter its portfolio during periods of increased market volatility in order to avoid falling out of 

compliance with the proposed limit. We would expect such a scenario to be more likely for a 

fund that would rely on the absolute VaR test, because the relative VaR test would allow a fund 

to operate with a higher portfolio VaR when the VaR of its designated reference index increases.  

A fund that were to eliminate some of its leverage risk associated with derivatives in 

order to comply with the proposed VaR-based limit on leverage risk might do so through 

unwinding or hedging its derivatives transactions or through some other means. These portfolio 

adjustments may be costly, particularly in conditions of market stress and reduced liquidity. The 
                                                      

derivatives, would not qualify as a limited derivatives user, and are not a leveraged/inverse fund 
that could comply with the alternative requirements for leveraged/inverse investment vehicles.  

521  This estimate is based on the following calculation: 2,424 funds x 0.5 x ($5,000 + $100,000) = 
$127,260,000. Some funds may find it more cost effective to restrict their use of derivatives in 
order to be able to rely on the proposed rule’s exception for limited derivatives users compared to 
complying with the proposed VaR-based limit on fund leverage risk. See supra section II.E; infra 
section III.C.3. As we do not have data that would allow us to quantify the costs and benefits that 
define the tradeoff for any particular fund of changing its use of derivatives in order to qualify for 
the limited user exception, we are unable to quantify how many funds would make this choice.281 

proposed rule would, however, give a fund the flexibility to mitigate these potential costs by not 

requiring the fund to exit positions or change its portfolio if it is out of compliance with the VaR 

test. Instead, the rule would provide that, if a fund has been out of compliance with the 

applicable VaR test for more than three business days, then: (1) the derivatives risk manager 

must report to the fund’s board of directors and explain how and by when (i.e., the number of 

business days) the derivatives risk manager reasonably expects that the fund will come back into 

compliance;522 (2) the derivatives risk manager must analyze the circumstances that caused the 

fund to be out of compliance for more than three business days and update any program elements 

as appropriate to address those circumstances; and (3) the fund may not enter into derivatives 

transactions other than derivatives transactions that, individually or in the aggregate, are 

designed to reduce the fund’s VaR, until the fund has been back in compliance with the 

applicable VaR test for three consecutive business days and satisfied the board reporting 

requirement and program analysis and update requirements.523 These provisions of the proposed 

rule collectively would provide some flexibility for a fund that is out of compliance with the VaR 

test to make any portfolio adjustments, which may allow funds to avoid some of the costs that 

otherwise could result from forced changes in the fund’s portfolio.  

3. Limited Derivatives Users 

Proposed rule 18f-4 includes an exception from the proposed risk management program 

requirement and VaR-based limit on fund leverage risk for limited derivatives users.524 The 

                                                      
522  Proposed rule 18f-4(c)(2)(iii)(A). See also infra section II.H.2 (discussing a report to the 

Commission regarding the fund being out of compliance with the applicable proposed VaR test 
for three business days). 

523  See proposed rule 18f-4(c)(2)(iii). 
524   See supra section II.E. 



282 

proposed exception would be available for a fund that either limits its derivatives exposure to 

10% of its net assets or uses derivatives transactions solely to hedge certain currency risks and 

that also adopts and implements policies and procedures reasonably designed to manage the 

fund’s derivative risks. We expect that the risks and potential impact of these funds’ derivatives 

use may not be as significant, compared to those of funds that do not qualify for the exception.525 

Therefore, we believe that a principles-based policies and procedures requirement would 

appropriately address these risks. 

We believe that investors in funds that use derivatives in a limited manner would benefit 

from the proposed requirement, which we anticipate would reduce, but not eliminate, the 

frequency and severity of derivatives-related losses for such funds. In addition, to the extent that 

the proposed framework is more comprehensive than funds’ current practices, the proposed 

requirement may result in more effective risk management across funds and increased fund 

industry stability. 

For funds that do not already have policies and procedures in place that could be readily 

adapted to meet the proposed rule’s requirements without significant additional cost, we estimate 

that the one-time costs would range from $1,000 to $100,000 per fund, depending on the 

particular facts and circumstances, including whether a fund is part of a larger fund complex; the 

extent to which the fund uses derivatives within the parameters of the limited user exception, 

including whether the fund uses more complex derivatives; and the fund’s current derivatives 

risk management practices. These estimated costs are attributable to the following activities: 

(1) assessing whether a fund is a limited derivatives user; (2) developing policies and procedures 

reasonably designed to manage a fund’s derivatives risks; (3) integrating and implementing the 
                                                      
525   See supra note 271 and accompanying and immediately-following text.  



283 

policies and procedures; and (4) preparing training materials and administering training sessions 

for staff in affected areas.  

For funds that do not already have policies and procedures in place that could be readily 

adapted to meet the proposed rule’s requirements without significant additional cost, we estimate 

that the ongoing annual costs that a fund that is a limited derivatives user would incur range from 

65% to 75% of the one-time costs to establish and implement the policies and procedures. Thus, 

a fund would incur ongoing annual costs that range from $650 to $75,000.526 These estimated 

costs are attributable to the following activities: (1) assessing, monitoring, and managing the 

risks associated with the fund’s derivatives transactions; (2) periodically reviewing and updating 

a fund’s policies and procedures; and (3) additional staff training. 

Based on an analysis of Form N-PORT filings, as well as financial statements filed with 

the Commission by BDCs, we estimate that about 19% of funds that would be subject to the 

proposed rule, or 2,398 funds total, would qualify as limited derivatives users. Almost all of 

these funds would be able to rely on the exposure-based exception. While some funds, about 1%, 

could rely on both the exposure-based exception and the currency hedging exception, only a 

fraction of 1% of funds would qualify as limited derivatives users solely based on the currency 

hedging exception.  

As many funds belong to a fund complex and are likely to experience economies of scale, 

we expect that the lower end of the estimated range of costs ($1,000 in one-time costs; $650 in 

annual costs) better reflects the total costs likely to be incurred by many funds. In addition, we 

believe that many funds already have policies and procedures in place that could be readily 

                                                      
526  This estimate is based on the following calculations: 0.65 x $1,000 = $650; 0.75 x $100,000 = 

$75,000.  



284 

adapted to meet the proposed rule’s requirements without significant additional cost. However, 

as we do not have data to determine how many funds already have such policies and procedures 

in place that would substantially satisfy the proposed rule’s requirements, we assume that all 

funds would incur a cost associated with this requirement. Based on these assumptions, we over-

inclusively estimate a lower bound for the total industry cost in the first year of $751,773.527 

Some funds may change how they use derivatives in order to qualify for the limited 

derivatives user exception and thereby avoid the potentially increased compliance cost associated 

with the proposed derivatives risk management program and VaR-based limit on fund leverage 

risk. Specifically, a fund with derivatives exposure just below 10% of its net assets may forego 

taking on additional derivatives positions, or a fund with derivatives exposure just above 10% of 

its net assets may close out some existing derivatives positions. Similarly, a fund that uses 

derivatives to hedge certain currency risks may forego or eliminate its use of derivatives for 

other purposes. As a result, the proposed exception for limited derivatives users may reduce the 

extent to which some funds use derivatives.528  

                                                      
527  This estimate is based on the following calculation: 2,398 funds x 0.19 x ($1,000 + $650) = 

$751,773. This cost estimate assumes that none of the funds that currently do not hold any 
derivatives would choose to establish and implement policies and procedures reasonably designed 
to manage the fund’s derivatives risks in anticipation of a future limited use of derivatives. 
Notwithstanding this assumption, we acknowledge some funds that currently do not use 
derivatives may still choose to establish and implement such policies and procedures 
prophylactically in order to preserve the flexibility to engage in a limited use of derivatives on 
short notice.  

528  As we do not have data that would allow us to quantify the costs and benefits that define the 
tradeoff for any particular fund of changing its use of derivatives in order to qualify for the 
limited user exception, we are unable to quantify how many funds would make this choice.  



285 

4. Reverse Repurchase Agreements and Similar Financing 
Transactions 

The proposed rule would allow funds to engage in reverse repurchase agreements and 

other similar financing transactions. However, as these transactions achieve economically 

identical results to other secured loans, the proposed rule would require that they be treated the 

same as bank borrowings and other borrowings under section 18. The proposal would therefore 

require a fund to combine any bank borrowings or other borrowings and reverse repurchase 

agreements when assessing compliance with the relevant asset coverage requirements of 

section 18.529  

Today, funds rely on the asset segregation approach that Release 10666 describes with 

respect to reverse repurchase agreements, which funds may view as separate from the limitations 

established on bank borrowings (and other senior securities that are evidence of indebtedness) by 

the asset coverage requirements of section 18.530 As a result, the degree to which funds could 

engage in reverse repurchase agreements may differ under the proposed rule from the baseline. A 

fund that engages solely in reverse repurchase agreements, or solely in bank borrowings (for 

example), would be unaffected by the proposed requirement.531 However, to the extent that a 

fund engages in both reverse repurchase agreements and bank borrowings (or similar 

transactions), because we believe these transactions are economically equivalent, they would be 

combined for purposes of analyzing whether a fund is in compliance with section 18’s asset 

coverage requirement. This may have the effect of limiting the overall scale of these transactions 

                                                      
529  See supra section II.I. 
530  See supra section I.B.2.a. 
531  For example, an open-end fund with no other senior securities outstanding could borrow an 

amount equivalent to 50% of its net assets using reverse repurchase agreements or bank 
borrowings under the baseline. 



286 

under the proposed requirement compared to the baseline, to the extent that funds today 

separately analyze their asset coverage requirements with respect to reverse repurchase 

agreements under Release 10666 and bank borrowings and similar senior securities under 

section 18.  

DERA staff analyzed funds’ use of reverse repurchase agreements and borrowings using 

Form N-PORT filings as well as financial statements filed with the Commission by BDCs. Based 

on our analysis of Form N-PORT filings, we estimate that about 0.36% of funds that would be 

subject to the proposed rule, or 45 funds total, used these transactions in combined amounts that 

exceeded the asset coverage requirement.532 These funds would have to adjust their use of 

reverse repurchase agreements, similar financing transactions, or borrowings in order to comply 

with the proposed rule and may incur associated transactions costs. 

In addition, under the proposed rule, if a fund did not qualify as a limited derivatives user 

due to its other investment activity, any portfolio leveraging effect of reverse repurchase 

agreements, similar financing transactions, and borrowings would also be restricted indirectly 

through the VaR-based limit on fund leverage risk. As a result, a fund could be restricted through 

the VaR-based limit on fund leverage risk from investing the proceeds of borrowings through 

reverse repurchase agreements to the full extent otherwise permitted by the asset coverage 

requirements in section 18 if the fund did not qualify as a limited derivatives user. 

                                                      
532  In our review of form N-PORT filings, we observed that several of the funds that used reverse 

repurchase agreements and similar financing transactions (bank borrowings and similar 
securities) in combined amounts that exceeded 50% of net assets already exceeded the 50% limit 
for either repurchase agreements, similar financing transactions (bank borrowings and similar 
securities, or both, when considered separately. In our review of financial statements filed by the 
Commission by BDCs, we observed that no BDCs exceeded the asset coverage requirement.  



287 

5. Alternative Requirements for Certain Leveraged/Inverse 
Funds and Proposed Sales Practices Rules for Certain 
Leveraged/Inverse Investment Vehicles  

The proposed sales practices rules would require a broker-dealer or investment adviser to 

(1) exercise due diligence in approving a retail investor’s account to buy or sell shares of 

leveraged/inverse investment vehicles before accepting an order from, or placing an order for, 

such an investor to engage in these transactions; and (2) adopt and implement policies and 

procedures reasonably designed to achieve compliance with the proposed rules.533 Additionally, 

a leveraged/inverse fund that meets the definition of a “leveraged/inverse investment vehicle” in 

the proposed sales practices rules would not have to comply with the VaR-based leverage risk 

limit under proposed rule 18f-4, provided the fund limits the investment results it seeks to 300% 

of the return (or inverse of the return) of the underlying index and discloses in its prospectus that 

it is not subject to the proposed VaR-based limit on fund leverage risk.534  

These due diligence and approval requirements are designed to address potential investor 

protection concerns with respect to leveraged/inverse investment vehicles by subjecting retail 

investors to specific due diligence and account approval requirements by broker-dealers and 

investment advisers. The proposed rules also are designed to help to ensure that investors in 

these funds are limited to those who are capable of evaluating their characteristics—including 

                                                      
533  See supra section II.G.2. The proposed sales practices rules define “leveraged/inverse investment 

vehicle” to mean a registered investment company or an exchange-listed commodity- or 
currency-based trust or fund that seeks, directly or indirectly, to provide investment returns that 
correspond to the performance of a market index by a specified multiple, or to provide investment 
returns that have an inverse relationship to the performance of a market index, over a 
predetermined period of time. See proposed rules 15l-2(d) and 211(h)-1(d). 

534  See supra section II.G.3. A leveraged/inverse fund that meets these requirements still would be 
required to satisfy all of the conditions in proposed rule 18f-4 other than the proposed VaR-based 
limit on fund leverage risk, including the proposed conditions requiring a derivatives risk 
management program, board oversight and reporting, and recordkeeping. 



288 

that the funds would not be subject to all of the leverage-related requirements applicable to 

registered investment companies generally—and the unique risks they present. There is a body of 

academic literature providing empirical evidence that retail investors may not fully understand 

the risks inherent in their investment decisions and not fully understand the effects of 

compounding returns over time.535 Retail investors could face additional burdens in investing in 

leveraged/inverse investment vehicles, to the extent that they do not currently possess the 

requisite capability of evaluating the risks of these products to satisfy the approval requirements 

implemented by broker-dealers and investment advisers in connection with the proposed rules’ 

due diligence and account approval obligations. However, we expect such retail investors would 

benefit from the proposed requirement, which we believe would help to ensure that investors in 

these funds are limited to those who are capable of evaluating the characteristics and unique risks 

of these products.536 We acknowledge that these benefits may be reduced, to the extent that they 

overlap with the effects of investment advisers’ or broker-dealers’ existing requirements or 

practices related to a retail investors’ suitability for investments in these produces as discussed in 

section III.B.5 above.  

                                                      
535  See, e.g., Annamaria Lusardi & Olivia S. Mitchell, The Economic Importance of Financial 

Literacy: Theory and Evidence, 52 Journal of Economic Literature 5 (2014), available at 
https://www.aeaweb.org/articles?id=10.1257/jel.52.1.5, which provides a literature review of 
recent survey-based work indicating that many retail investors have limited financial literacy and, 
for example, do not always understand the compounding of returns, which may directly apply in 
the context of the daily compounding feature of leveraged/inverse ETFs. The literature does not 
address retail investor’s inattention to investment risk or the unique dynamics of compounding of 
daily returns in the context of leveraged/inverse ETFs or other leveraged/inverse investment 
vehicles specifically, but studies investor inattention to financial products more generally. 

536  The sales practices rules would not apply to a position in a leveraged/inverse investment vehicle 
established before the rules’ compliance date. See supra note 340 and associated text. As a result, 
investors with such existing positions would only be affected by the proposed sales practices rules 
if they seek to increase an existing or add a new position in a leveraged/inverse investment 
vehicle. 



289 

Since the alternative provision for leveraged/inverse funds under proposed rule 18f-4 

includes a requirement that a leveraged/inverse fund disclose in its prospectus that it is not 

subject to the proposed limit on fund leverage risk, both investors and the market would benefit 

from transparency regarding which funds are exempt from rule 18f-4’s limit on fund leverage 

fund risk. Some investors may value this information to the extent that it helps them make better-

informed choices between funds.  

The costs that broker-dealers and investment advisers may incur as a result of the 

proposed sales practices rules would vary depending on the firm. For example, as the proposed 

requirements are generally modeled after the options account requirements, broker-dealers that 

already have compliance procedures in place for approving options accounts would likely have 

reduced compliance costs.537 In addition, some broker-dealers and investment advisers may incur 

costs associated with training customer-facing personnel and supervisory review of account 

approval decisions. Investment advisers’ and broker-dealers’ existing processes, as discussed 

above in section III.B.5, may reduce the costs that the proposed sales practices rules otherwise 

would involve to the extent that investment advisers or broker-dealers can build on existing 

processes in complying with the proposed sales practices rules. 

Broker-dealers and investment advisers would incur costs associated with the proposed 

sales practices rules. We estimate that one-time costs for a broker-dealer or investment adviser 

related to the due diligence and account approval requirements would range from $7,749 to 

$12,915538 and that one-time costs related to drafting the associated policies and procedures 

                                                      
537  These efficiencies and the resulting reduced compliance costs would not apply to investment 

advisers that are not also registered broker-dealers because they are not subject to FINRA rules. 
538  This estimated range is based on the following calculations: (6 hours x $365 (compliance 

attorney) + 9 hours x $284 (senior systems analyst) + 12 hours x $331 (senior programmer)) = 
 



290 

would range from $1,367 to $2,278.539 Thus, we estimate total one-time costs for a broker-dealer 

or investment adviser would range from $9,116 to $15,193.540  

In addition, we estimate that ongoing costs for a broker-dealer or investment adviser 

related to the due diligence and account approval requirements would range from $1,211 to 

$2,018 per year,541 that ongoing costs related to the associated policies and procedures 

requirement would range from $903 to $1,505 per year,542 and that ongoing costs related to the 

associated recordkeeping requirements would range from $157 to $393 per year.543 Thus, we 

                                                      

($2,190 + $2,556 + $3,972) = $8,718 for development and implementation of online client 
questionnaire; (3 hours x $365 (compliance attorney) + 3 hour x $70 (compliance clerk)) = 
$1,305 for customer due diligence; and 1 hour x $309 (compliance manager) = $309 for 
evaluation of client information for account approval/disapproval for a total of $10,332. 
Assuming a range of +/- 25% around the average total of $10,332 gives a range for one-time 
costs from $10,332 x 75% = $7,749 to $10,332 x 125% = $12,915. 

539  This estimated range is based on the following calculations: (3 hours x $309 (senior manager) + 1 
hour x $365 (compliance attorney) + 1 hour x $530 (chief compliance officer)) = ($927 + $365 + 
$530) = $1,822 for establishing and implementing rule 15l-2 policies and procedures. Assuming a 
range of +/- 25% around the average total of $1,822 gives a range for one-time costs from $1,822 
x 75% = $1,366.50 to $1,822 x 125% = $2,277.50. 

540  This estimated range is based on the following calculations: $7,749 + $1,366.50 = $9,115.50 for 
the minimum of the cost range and $12,915 + $2,277.50 = $15,192.50 for the maximum of the 
cost range.  

541  This estimated range is based on the following calculations: (3 hours x $365 (compliance 
attorney) + 3 hour x $70 (compliance clerk)) = $1,305 per year for customer due diligence; and 1 
hour x $309 (compliance manager) = $309 per year for evaluation of client information for 
account approval/disapproval for a total of $1,614 per year. Assuming a range of +/- 25% around 
the average total of $1,614 per year gives a range for ongoing costs from $1,614 x 75% = 
$1,210.50 per year to $1,614 x 125% = $2,017.50 per year. 

542  This estimated range is based on the following calculations: (1 hour x $309 (senior manager) + 1 
hour x $365 (compliance attorney) + 1 hour x $530 (chief compliance officer)) = $1,204 per year 
for reviewing and updating rule 15l-2 policies and procedures. Assuming a range of +/- 25% 
around the average total of $1,204 per year gives a range for ongoing costs from $1,204 x 75% = 
$903 per year to $1,204 x 125% = $1,505 per year. 

543  This estimated range is based on the following calculations: (1 hour x $62 (general clerk) + 1 
hour x $95 (senior computer operator)) = $157 per year for the minimum of the cost range and 
(2.5 hours x $62 (general clerk) + 2.5 hours x $95 (senior computer operator) = ($155 + 
$237.50)) = $392.50 per year for the maximum of the cost range.  



291 

estimate that total ongoing costs for a broker-dealer or investment adviser would range from 

$2,271 to $3,915 per year.544 

As of December 2018, there were 2,766 broker-dealers that reported some sales to retail 

customer investors.545 We estimate that 700 of these broker dealers with retail customer accounts 

(approximately 25%) have retail customer accounts that invest in leveraged/inverse investment 

vehicles. Our staff further estimates that 715,000 existing customer accounts with such broker-

dealers would require account approval for trading in leveraged/inverse investment vehicles and 

that 10,000 new customer accounts opened each year would require such approval. 546  

In addition, as of December 2018, there were 8,235 investment advisers registered with 

the Commission having some portion of their business dedicated to retail investors, including 

either individual high net worth clients or individual non-high net worth clients.547 We estimate 

that 2,000 of these investment advisers with retail client accounts (approximately 25%) have 

retail client accounts that invest in leveraged/inverse investment vehicles. We further estimate 

that 715,000 existing customer accounts with such investment advisers would require account 

                                                      
544  This estimated range is based on the following calculations: ($1,210.50 + $903 + $157) = 

$2,270.50 per year for the minimum of the cost range and ($2,017.50 + $1,505 + $392.50) = 
$3,915 per year for the maximum of the cost range.  

545  Our estimate of the number of broker-dealers with retail customers are based on data obtained 
from Form BD and Form BR as of December 31, 2018.  

546  The number of broker-dealers that have retail client accounts that invest in leveraged/inverse 
investment vehicles as well as the numbers of existing and new customer accounts with these 
broker-dealers that would require approval for trading in these products are based on staff 
experience, as we do not have data that would allow us to determine these numbers more 
precisely. 

547  Our estimate of the number of investment advisers with retail accounts are based on data obtained 
from responses to Item 5.D of Form ADV as of December 31, 2018.  



292 

approval for trading in leveraged/inverse investment vehicles, and that 10,000 new customer 

accounts opened each year would require such approval.548  

To the extent that many broker-dealers already have compliance procedures in place for 

approving options accounts, which is a common industry practice, these broker-dealers would 

likely have reduced costs associated with the proposed requirements of the sales practices rules. 

Thus, we estimate that many broker-dealers would incur one-time and ongoing costs that are 

closer to the low end of the provided ranges, while broker-dealers that cannot take advantage of 

such efficiencies and many investment advisors would likely experience costs closer to the high 

end of the provided ranges.549 We estimate that the total industry cost for the proposed 

requirements of the sales practice rule in the first year for both broker-dealers and investment 

advisers would equal $2,377,503,800, which is based on the midpoint of the sum of the ranges 

for both one-time and ongoing costs.550 Some broker-dealers and investment advisers may 

decide to pass these compliance costs on to their customers. 551  

                                                      
548  The number of investment advisors that have retail client accounts that invest in 

leveraged/inverse investment vehicles as well as the numbers of existing and new customer 
accounts with these investment advisers that would require approval for trading in these products 
are based on staff experience, as we do not have data that would allow us to determine these 
numbers more precisely.  

549   See supra notes 514 and 518. 
550  This estimate is based on the following calculations: (700 broker-dealers + 2,000 registered 

investment advisers having retail customer accounts that invest in leveraged/inverse investment 
vehicles) x ($8,718 + $1,822)) = $28,458,000 + ((2 x 715,000) existing customer accounts with 
broker-dealers and registered investment advisers requiring account approval for trading in 
leveraged/inverse investment vehicles) x ($1,305 + $309) = $2,308,020,000 for total one-time 
industry costs to broker-dealers and investment advisers of $2,336,478,000; and ((2 x 10,000) 
new customer accounts requiring account approval for trading in leveraged/inverse investment 
vehicles) x ($1,305 + $309) = $32,280,000 + (700 broker-dealers + 2,000 registered investment 
advisers having retail customer accounts that invest in leveraged/inverse investment vehicles) x 
$1,204) = $3,250,800 + (10,000 new customer accounts requiring account approval for trading in 
leveraged/inverse investment vehicles) x ($157 (broker-dealer recordkeeping costs) + $392.50 
(investment adviser recordkeeping costs)) = $5,495,000 for total ongoing annual industry costs to 
broker-dealers and investment advisers of $41,025,800 per year. Total industry cost for proposed 

 



293 

In addition, some leveraged/inverse investment vehicles may lose existing or potential 

investors as a result of some retail investors not being approved by their broker-dealer or 

investment adviser to transact in leveraged/inverse investment vehicles or some retail investors 

being deterred by the time costs and delay introduced by the account-opening procedures. 

Broker-dealers or investment advisers with a larger fraction of retail customers or clients that can 

no longer transact in leveraged/inverse investment vehicles as a result of the proposed sales 

practices rules may experience larger declines in their customer or client base and associated 

reductions in profits.552  

It is our understanding that no funds that would meet the definition of a 

“leveraged/inverse investment vehicle,” and that seek returns above 300% of the return (or 

inverse of the return) of the underlying index, currently exist. Therefore we do not expect any 

costs associated with existing funds having to alter their investment strategies or business 

practices to comply with proposed rule 18f-4’s alternative requirements for leveraged/inverse 

funds.  

Requiring a leveraged/inverse fund covered by the proposed sales practices rules to limit 

its exposure to 300% of the return (or inverse of the return) of the underlying index while 
                                                      

requirements of sales practice rule in the first year is $2,336,478,000 + $41,025,800 = 
$2,377,503,800, which is consistent with being the midpoint of the sum of the ranges for both 
one-time and ongoing costs discussed in preceding calculations.  

551  The share of these costs passed on to investors by investment advisers or broker-dealers would 
depend on multiple factors, including the nature of competition between investment advisers and 
broker-dealers as well as investors’ relative sensitivity to changes in fees, the joint effects of 
which are inherently impossible to predict. Some broker-dealers offer transactions in certain 
leveraged/inverse investment vehicles, such as some leveraged/inverse ETFs, without charging 
commissions. In these cases, broker-dealers may pass on some of the compliance costs associated 
with the proposed requirements by charging some amount of commission on these trades.  

552  Any such reduction in a broker-dealer’s or investment adviser’s customer base may be offset to 
the extent that clients transact in other products with the same broker dealer or investment adviser 
instead.  



294 

preventing a fund that does not qualify as a leveraged/inverse investment vehicle from offering 

investment strategies that exceed the proposed outer limit on fund leverage risk may also have 

competitive effects, which we discuss in section III.B.5 below. As an alternative to the proposed 

exposure limit for leveraged/inverse funds, we also discuss the effects of conditioning the 

exemption for leveraged/inverse funds on compliance with a higher or lower exposure limit in 

section III.D.1 below.  

6. Proposed Amendments to Rule 6c-11 under the Investment 
Company Act and Proposed Rescission of Exemptive Relief for 
Leveraged/Inverse ETFs 

Existing leveraged/inverse ETFs rely on exemptive relief, which the Commission has not 

granted to a leveraged/inverse ETF sponsor since 2009. We are proposing to amend rule 6c-11 to 

remove the provision excluding leveraged/inverse ETFs from its scope, which would permit fund 

sponsors to operate a leveraged/inverse ETF under that rule and without obtaining an exemptive 

order.  

The proposed amendments to rule 6c-11 would benefit any fund sponsors seeking to 

launch leveraged/inverse ETFs that did not obtain the required exemptive relief due to the 

Commission’s moratorium on granting such relief as well as fund sponsors seeking to launch 

leveraged/inverse ETFs in the future. A fund sponsor planning to seek exemptive relief from the 

Commission to form and operate a leveraged/inverse ETF would also no longer incur the cost 

associated with applying for an exemptive order.553 To the extent that the amendments result in 

                                                      
553  In the ETFs Adopting Release, we estimated that the direct cost of a typical fund’s application for 

ETF relief (associated with, for example, legal fees) is approximately $100,000. As exemptive 
applications for leveraged/inverse ETFs are significantly more complex than those of the average 
fund, we estimate that the direct costs of an application for leveraged/inverse ETF relief would 
amount to approximately $250,000. See ETFs Adopting Release, supra note 76, at nn.537-539 
and accompanying text.  



295 

new leveraged/inverse ETFs coming to market, the industry-wide assets under management of 

leveraged/inverse ETFs could increase and investors that would be eligible under the proposed 

sales practices rules to invest in leveraged/inverse ETFs could benefit from an increase in 

investment choices.554  

Because our proposed amendments to rule 6c-11 would permit leveraged/inverse ETFs to 

rely on that rule, we also are proposing to rescind the exemptive orders the Commission has 

previously granted to leveraged/inverse ETFs. As a result, existing and future leveraged/inverse 

ETFs would operate under a consistent regulatory framework. We believe that the costs to 

leveraged/inverse ETFs associated with rescinding their existing exemptive relief would be 

minimal, as we anticipate that all existing leveraged/inverse ETFs would be able to continue 

operating with only minor adjustments, other than being required to comply with the 

requirements in rule 6c-11 for additional website disclosures and basket asset policies and 

procedures.555  

Additional economic considerations that the proposed treatment of leveraged/inverse 

ETFs presents with regards to efficiency and competition are discussed below in section III.D. 

7. Unfunded Commitment Agreements 

The proposed rule would permit a fund to enter into unfunded commitment agreements if 

it reasonably believes, at the time it enters into such an agreement, that it will have sufficient 

                                                      
554  The increase in assets under management among leveraged/inverse ETFs could be attenuated, to 

the extent that proposed rule 15l-2’s and 211(h)-1’s due diligence requirements would lead to a 
reduction in the number of investors that invest in these funds. See infra section III.C.5. 

555  In this section as well as in section III.D below, we have accounted for the costs and benefits to 
leveraged/inverse ETFs as a result of the removal of the current exclusion of these funds from 
rule 6c-11. We believe that the additional considerations the Commission analyzed in the ETFs 
Adopting Release for ETFs other than leveraged/inverse ETFs that were included in the scope of 
rule 6c-11 at adoption would apply substantially similarly to leveraged/inverse ETFs. See ETFs 
Adopting Release, supra note 76. 



296 

cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment 

agreements, in each case as they come due.556 While a fund should consider its unique facts and 

circumstances, the proposed rule would prescribe certain specific factors that a fund must take 

into account in having such a reasonable belief. We believe that the proposed requirements are 

consistent with current market practices, based on the staff’s experience in reviewing and 

commenting on fund registration statements, which have disclosure regarding their unfunded 

commitments, as well as representations funds have made to the staff.557 As a result, we do not 

believe that the rule’s treatment of unfunded commitment agreements represents a change from 

the baseline, although we acknowledge that there may be some variation in the specific factors 

that funds consider today, as well as the potential for some variation between those factors and 

those prescribed in the proposed rule. Because we believe that the proposed approach is 

consistent with general market practices and we do not have specific granular information to 

identify differences in funds’ current practices relative to the proposed rule, we believe this 

proposed requirement would not lead to significant economic effects.  

8. Recordkeeping 

Proposed rule 18f-4 includes certain recordkeeping requirements.558 Specifically, the 

proposed rule would require a fund to maintain certain records documenting its derivatives risk 

management program’s written policies and procedures, along with its stress test results, VaR 

backtesting results, internal reporting or escalation of material risks under the program, and 

                                                      
556  See supra section II.J. 
557  See supra discussion in paragraph preceding note 420. 
558  See supra section II.K. 



297 

reviews of the program.559 It would also require a fund to maintain records of any materials 

provided to the fund’s board of directors in connection with approving the designation of the 

derivatives risk manager and any written reports relating to the derivatives risk management 

program.560 A fund that would be required to comply with the proposed VaR test would also 

have to maintain records documenting the determination of: its portfolio’s VaR; its designated 

reference index VaR, as applicable; its VaR ratio (the value of the VaR of the Fund’s portfolio 

divided by the VaR of the designated reference index), as applicable; and any updates to any of 

its VaR calculation models and the basis for any material changes to its VaR models.561 A fund 

that would be a limited derivatives user under the proposed rule would have to maintain a written 

record of its policies and procedures that are reasonably designed to manage derivatives risks.562 

Finally, a fund engaging in unfunded commitment agreements would be required to maintain 

records documenting the sufficiency of its funds to meet its obligations with respect to all 

unfunded commitment agreements.563  

We believe that these proposed requirements would increase the effectiveness of the 

Commission’s oversight of the fund industry, which will, in turn, benefit investors. Further, the 

requirement to keep records documenting the derivatives risk management program, including 

records documenting periodic review of the program and reports provided to the board of 

directors relating to the program, would help our staff evaluate a fund’s compliance with the 

proposed derivatives risk management program requirements. We anticipate that these 

                                                      
559  See proposed rule 18f-4(c)(i)(A). 
560  See proposed rule 18f-4(c)(6)(i)(B). 
561  See proposed rule 18f-4(c)(6)(i)(C). 
562  See proposed rule 18f-4(c)(6)(i)(D). 
563  See proposed rule 18f-4(c)(6)(i)(E). 



298 

recordkeeping requirements would generally not impose a large additional burden on funds, as 

most funds would likely choose to keep such records, even absent the proposed requirement to 

do so, in order to support their ongoing administration of the proposed derivatives risk 

management program and their compliance with the associated requirements. 

As discussed below in section IV.B.7, our estimated average one-time and ongoing 

annual costs associated with the recordkeeping requirements take into account the fact that 

certain funds can rely on the proposed rule’s limited derivatives user exception and may incur 

less extensive recordkeeping costs relative to those funds which may not rely on this exception. 

Of the estimated 5,091 funds that would be subject to the recordkeeping requirements, we 

estimate that 2,398 funds would be limited derivatives users. Assuming that both one-time and 

ongoing annual recordkeeping costs for limited derivatives users are 90% of those for funds that 

would not qualify as limited derivatives users, we estimate that, on average, each fund that could 

not rely on the limited user exception would incur a one-time cost of $2,047 564 and an ongoing 

cost of $330 per year565 and each fund that could rely on the exception would incur, a one-time 

                                                      
564  This estimate is based on the following derivations and calculations: 1.5 hours x $62 (general 

clerk) / ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $97.60; and 1.5 hours x $95 (senior 
computer operator) / ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $149.54 for a total of 
$97.60 + $149.54 + ($1,800 for initial external cost burden) = $2,047.14, where (2,398/5,091) is 
the share of funds that are limited derivatives users and (5,091 – 2,398)/5,091) is the share of 
funds that are not limited derivatives users.  

565  This estimate is based on the following derivations and calculations: 2 hours x $62 (general clerk) 
/ ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $130.13; and 2 hours x $95 (senior 
computer operator) / ( (2,398/5,091) x 90% + ((5,091 – 2,398)/5,091) ) = $199.39 for a total of 
$130.13 + $199.39 = $329.52, where (2,398/5,091) is the share of funds that are limited 
derivatives users and (5,091 – 2,398)/5,091) is the share of funds that are not limited derivatives 
users. 



299 

cost of $1,842566 and an ongoing cost of $297 per year.567 We thus estimate that the total 

industry cost for this requirement in the first year would equal $11,529,656.568 

9. Amendments to Fund Reporting Requirements 

a. Form N-PORT and Form N-CEN 

We are proposing to amend Form N-PORT to include a new reporting item on funds’ 

derivatives exposure, which would be publicly available for the third month of each fund’s 

quarter.569 In addition, we are proposing amendments that would require funds that are subject to 

the proposed VaR-based limit on fund leverage risk to report certain information related to their 

VaR.570 We are also proposing to amend Form N-CEN to require a fund to identify (1) whether it 

is a limited derivatives user (either under the proposed exception for funds that limit their 

derivatives exposure to 10% of their net assets or under the exception for funds that limit their 

derivatives use to certain currency hedging); (2) whether it is a leveraged/inverse investment 

vehicle as defined in proposed sales practices rules; and (3) whether it has entered into reverse 

repurchase agreements or similar financing transactions, or unfunded commitment 
                                                      
566  This estimate is based on the following calculations: $2,047.14 x 90% = $1,842.43. 
567  This estimate is based on the following calculations: $329.52 x 90% = $296.57. 
568  This estimate is based on the following calculations: (5,091 – 2,398 = 2,693 funds which cannot 

rely on the limited derivatives user exception) x ($2,047.14 + $329.52) = $6,400,347.32; and 
(2,398 funds which can rely on the limited derivatives user exception) x ($1,842.43 + $296.57) = 
$5,129,309.17 for a total of $11,529,656.48. 

569  See supra section II.H.1.While the information for the first two months of a fund’s quarter would 
be non-public, the information for the third month of a fund’s quarter would be publicly 
available. See supra note 360. 

570  Specifically, this information would include: (1) the fund’s highest daily VaR during the 
reporting period and its corresponding date; and (2) the fund’s median daily VaR for the reporting 
period. Funds subject to the relative VaR test during the reporting period also would have to 
report: (1) the name of the fund’s designated reference index; (2) the index identifier; (3) the 
fund’s highest daily VaR ratio during the reporting period and its corresponding date; and (4) the 
fund’s median daily VaR ratio for the reporting period. Finally, all funds that are subject to the 
proposed limit on fund leverage risk also would have to report the number of exceptions that the 
fund identified as a result of the backtesting of its VaR calculation model. See id. 



300 

agreements.571 These additional reporting requirements would not apply to BDCs, which do not 

file reports on Form N-CEN or Form N-PORT.572  

To the extent that measures of derivatives exposure, and the other information that we 

would require funds to report on Forms N-PORT and N-CEN, are not currently available, the 

proposed requirements that funds make such information available periodically on these forms 

would improve the ability of the Commission to oversee reporting funds. It also would allow the 

Commission and its staff to oversee and monitor reporting funds’ compliance with the proposed 

rule and help identify trends in reporting funds’ use of derivatives, portfolio VaRs, and their 

choice of designated reference indexes. The expanded reporting also would increase the ability 

of the Commission staff to identify trends in investment strategies and fund products in reporting 

funds as well as industry outliers.573  

Investors, third-party information providers, and other potential users would also 

experience benefits from the proposed amendments to Forms N-PORT and N-CEN. Investors 

and other potential users would have disclosure of additional information that is not currently 

available in any filings. We believe that the structured data format of this information in Forms 

N-PORT and N-CEN would allow investors and other potential users to more efficiently analyze 

portfolio investment information. The additional information, as well as the structure of that 

                                                      
571  We believe that many of these proposed new reporting items would be inapplicable to most 

BDCs. See supra section II.H.3. 
572  See supra section II.H.4. 
573  The structuring of the information in Form N-PORT would improve the ability of Commission 

staff to compile and aggregate information across all reporting funds, and to analyze individual 
funds or a group of funds, and would increase the overall efficiency of staff in analyzing the 
information.301 

information, would increase the transparency of a fund’s investment strategies and allow more 

efficient assessment of reporting funds’ potential leverage-related risks. 

The amendments to Forms N-PORT and N-CEN would also benefit investors, to the 

extent that they use the information, to better differentiate funds that are not limited derivatives 

users or leveraged/inverse funds based on their derivatives usage. For example, investors would 

be able to more efficiently identify the extent to which such funds use derivatives as part of their 

investment strategies. Investors, and in particular individual investors, could also indirectly 

benefit from the additional information in amended Forms N-PORT and N-CEN to the extent 

that third-party information providers and other interested parties obtain, aggregate, provide, 

analyze and report on the information. Investors could also indirectly benefit from the additional 

information in amended Forms N-PORT and N-CEN to the extent that other entities, including 

investment advisers and broker-dealers, utilize the information to help investors make more 

informed investment decisions related to funds that provide this information. 

As discussed below in section IV.F, our estimated average one-time and ongoing annual 

costs associated with the amendments to Forms N-PORT take into account the fact that certain 

funds that are not subject to the proposed VaR-based limit on fund leverage risk in proposed rule 

18f-4 would not have to report certain VaR-related information and may incur less extensive 

reporting costs relative to those funds subject to the limit, which are required to report such VaR-

related disclosure information. Of the estimated 5,091 funds that would be subject to the 

exposure-related disclosure requirement, we estimate that 2,424 funds would also be subject to 

the VaR-related disclosure requirements. We estimate that, on average, each fund that is not 



302 

subject to the VaR-related disclosure requirement would incur a one-time cost of $6,982 574 and 

an ongoing cost of $2,088 per year575 and each fund that is subject to the VaR-related disclosure 

requirement would incur a one-time cost of $8,374576 and an ongoing cost of $4,176 per year. 577 

We thus estimate that the total industry cost for this reporting requirement in the first year would 

equal $54,610,890.578 

As discussed below in section IV.H, we estimate that the average ongoing annual cost for 

a registered fund to prepare amendments to Form N-CEN is $6.96 per year. 579 We thus estimate 

that the total industry cost for all registered funds associated with this reporting requirement in 

the first year is $86,130.580 

                                                      
574  This estimate is based on the following derivations and calculations: (2 hours x $365 (compliance 

attorney) + 2 hours x $331 (senior programmer) + ($5,590 for initial external cost burden)) = 
$6,982 to comply with the new N-PORT requirements of derivatives exposure information in the 
first reporting quarter of the fiscal year.  

575  This estimate is based on the following derivations and calculations: (3 hours x $365 (compliance 
attorney) + 3 hours x $331 (senior programmer)) = $2,088 per year to comply with the new N-
PORT requirements of derivatives exposure information in the final three reporting quarters of 
the fiscal year. 

576  This estimate is based on the following derivations and calculations: (4 hours x $365 (compliance 
attorney) + 4 hours x $331 (senior programmer) + ($5,590 for initial external cost burden)) = 
$8,374 to comply with the new N-PORT requirements of derivatives exposure and VaR-related 
information in the first reporting quarter of the fiscal year. 

577  This estimate is based on the following derivations and calculations: (6 hours x $365 (compliance 
attorney) + 6 hours x $331 (senior programmer)) = $4,176 to comply with the new N-PORT 
requirements of derivatives exposure and VaR-related information in the final three reporting 
quarters of the fiscal year. 

578  This estimate is based on the following calculations: (5,091 – 2,424 = 2,667 funds which are not 
subject to the VaR-related disclosure agreements) x ($6,982 + $2,088) = $24,189,690; and (2,424 
funds which are subject to the VaR-related disclosure agreements) x ($8,374 + $4,176) = 
$30,421,200 for a total of ($24,189,690 + $30,421,200) = $54,610,890. 

579  This estimate is based on the following derivations and calculations: 0.01 hour x $365 
(compliance attorney) + 0.01 hour x $331 (senior programmer) = $3.65 + $3.31 = $6.96 per year 

580  This estimate is based on the following derivations and calculations: (12,375 registered funds 
required to prepare a report on Form N-CEN as amended) x $6.96 = $86,130. 



303 

b. Amendments to Current Reporting Requirements 

We are also proposing current reporting requirements for funds that are relying on 

proposed rule 18f-4 and subject to the proposed VaR-based limit on fund leverage risk. 

Specifically, a fund that is out of compliance with the VaR test for more than three business days 

would be required to file a non-public report on Form N-RN providing certain information 

regarding its VaR test breaches and a fund will also be required to file a report when it is back in 

compliance with its applicable VaR test.581  

We anticipate that the enhanced current reporting requirements could produce significant 

benefits. For example, when a fund is out of compliance with the proposed VaR-based limit on 

fund leverage risk, this may indicate that a fund is experiencing heightened risks as a result of a 

fund’s use of derivatives transactions. Such breaches also could indicate market events that are 

drivers of potential derivatives risks across the fund industry and therefore complement other 

sources of information related to such market events for the Commission. As a result, we believe 

that the proposed current reporting requirement would increase the effectiveness of the 

Commission’s oversight of the fund industry by providing the Commission and staff with current 

information regarding potential increased risks and stress events, which in turn would benefit 

investors.  

As discussed below in section IV.G, our estimated average cost burdens associated with 

the amendments to form N-RN are based on the assumption that, of the estimated 2,424 funds 

that would be required to comply with either of the VaR tests, the Commission would receive 

approximately 30 filings per year in response to each of the new VaR-related items proposed to 

be included in Form N-RN, as amended. We estimate such funds would incur an average cost of 
                                                      
581   See supra section II.H.2. 



304 

$3.49 per year on a per-fund basis582 to prepare amended Form N-RN. Thus, the estimated total 

industry cost for this reporting requirement in the first year for funds required to comply with 

either of the VaR tests is $8,460.583 

We do not believe there would be any potential indirect costs associated with filing Form 

N-RN, such as spillover effects or the potential for investor flight due to a VaR test breach (to 

the extent that investors would leave a fund if they believed a fund’s VaR test breaches indicate 

that a fund has a risk profile that is inconsistent with their investment goals and risk tolerance), 

because Form N-RN filings would not be publicly disclosed. Because the Form N-RN filing 

requirements would be triggered by events that are part of a fund’s proposed requirement to 

determine compliance with the applicable VaR test at least daily, any monitoring costs associated 

with Form N-RN are included in our estimates of the compliance costs for rule 18f-4 above. 

10. Money Market Funds 

Money market funds are excluded from the scope of proposed rule 18f-4. As we are 

proposing to rescind Release 10666, however, money market funds would not be able to enter 

into transactions covered by proposed rule 18f-4, including derivatives transactions and reverse 

repurchase agreements. As discussed above in section II.A.1, we believe that money market 

funds currently do not typically engage in derivatives transactions or the other transactions 

permitted by rule 18f-4.584 However, to the extent that there are money market funds that do 

                                                      
582  This estimate is based on the following derivations and calculations: 0.005 hour x $365 

(compliance attorney) + 0.005 hour x $331 (senior programmer) = $1.83 + $1.66 = $3.49 per year 
on a per-fund basis. 

583  This estimate is based on the following derivations and calculations: (30 filings per year 
fractionalized across the 2,424 funds per year required to comply with either of the VaR tests) x 
$3.49 = $8,460. 

584  Money market funds file monthly reports on Form N-MFP and disclose schedules of portfolio 
securities held on the form. For each security held, Form N-MFP requires money market funds to 

 



305 

engage in such transactions to increase the efficiency of their portfolio management, these funds 

would bear the costs associated with losing any such efficiencies. 

However, we believe any costs to money market funds that may currently enter into 

transactions covered by proposed rule 18f-4 would likely be small. Specifically, as discussed 

above in section II.A.1, we believe that these transactions would generally be inconsistent with a 

money market fund maintaining a stable share price or limiting principal volatility, and 

especially if used to leverage the fund’s portfolio. Therefore, we do not believe that any fund that 

may currently engage in these transactions would use them as an integral part of its investment 

strategy.  

D. Effects on Efficiency, Competition, and Capital Formation  

This section evaluates the impact of the proposed rules and amendments on efficiency, 

competition, and capital formation. However, we are unable to quantify the effects on efficiency, 

competition, and capital formation because we lack the information necessary to provide a 

reasonable estimate. For example, we are unable to predict how the proposed rules, amendments, 

and form amendments would change investors’ propensity to invest in funds and ultimately 

affect capital formation. Therefore, much of the discussion below is qualitative in nature, 

although where possible we attempt to describe the direction of the economic effects. 

1. Efficiency 

Proposed rule 18f-4 in conjunction with the proposed rescission of Release 10666 may 

make derivatives use more efficient for certain funds, particularly for those funds that would 

                                                      

disclose the investment category most closely identifying the instrument held from a list of 
investment categories. See Item C.6 of Form N-MFP. However, the form does not contemplate 
nor include data element categories for transactions covered by proposed rule 18f-4, including 
derivatives transactions and reverse repurchase agreements. We therefore do not estimate the 
extent to which money market funds currently rely on these transactions.  



306 

qualify as limited derivatives users. Specifically, funds’ current asset segregation practices may 

provide a disincentive to use derivatives for which notional amount segregation is the practice, 

even if such derivatives would otherwise provide a lower-cost method of achieving desired 

exposures than purchasing the underlying reference asset directly. For example, a fund seeking 

to sell credit default swaps to take a position in an issuer’s credit risk may currently choose not to 

do so because of the large notional amounts that the fund would segregate for that specific 

derivatives position. The proposed rule therefore could increase efficiency by mitigating current 

incentives for funds to avoid use of certain derivatives (even if foregoing the use of those 

derivatives would entail cost and operational efficiencies).  

In addition, the proposed rules and amendments may change the degree to which some 

funds choose to use derivatives generally or the degree to which funds use certain derivatives 

over others.585 Changes in the degree to which certain derivatives are used by funds could affect 

the liquidity and price efficiency of these derivatives. Although unaddressed in the academic 

literature, we expect an increase in the use of derivatives to correspond to an increase in 

derivatives market liquidity as more derivatives contracts may be easily bought or sold in 

markets in a given period, as well as an increase in price efficiency since information regarding 

                                                      
585  Specifically, (1) as discussed in the previous paragraph, funds may transact in more notional-

value based derivatives as a result of removing the incentive distortion of notional- vs. market-
value asset segregation under funds’ current asset segregation practices; (2) new potential funds 
may reduce their use of derivatives transactions to satisfy the proposed VaR-based limit on fund 
leverage risk (see supra section III.C.2); (3) existing funds may change their use of derivatives 
transactions to respond to risks identified after adopting and implementing their risk management 
programs (see supra section III.C.1); and (4) both existing and new potential funds may increase 
their use of derivatives transactions as a result of the exemptive rule’s bright-line limits on 
leverage risk (see supra section III.C.2). Overall, the effect of the proposed rules and amendments 
on funds use of derivatives transactions is ambiguous and depends on the type of derivatives 
transaction.  



307 

underlying securities (and other factors that affect derivatives prices) may be better reflected in 

the prices of derivative contracts. 

Changes in the degree to which certain derivatives are used could also affect the pricing 

efficiency and liquidity of securities underlying these derivatives and those of related securities. 

For example, one paper provides evidence that the introduction of credit default swap contracts 

decreases the liquidity and price efficiency of the equity security of the issuer referenced in the 

swap.586 Conversely, the paper also observes that the introduction of exchange-traded stock 

option contracts improves the liquidity and price efficiency of the underlying stocks. 

The proposed VaR-based limit on fund leverage risk would also establish a bright-line 

limit on the amount of leverage that a fund can take on using derivatives.587 To the extent that 

funds are more comfortable with managing their derivatives exposures to a clear outside limit, 

the proposed rule could improve the efficiency of fund’s portfolio risk management practices.  

In addition, the recordkeeping elements of proposed rule 18f-4 would facilitate more 

efficient evaluation of compliance with the rule while also providing the Commission with 

information that may be useful in assessing market risks associated with derivative products. 
                                                      
586  This paper analyzed NYSE-listed firms and observed that, all else equal, equity markets become 

less liquid and equity prices become less efficient when single-name credit default swap contracts 
are introduced, while the opposite results hold when equity options are listed on exchanges. 
Ekkehart Boehmer, Sudheer Chava, & Heather E. Tookes, Related Securities and Equity Market 
Quality: The Case of CDS, 50 Journal of Financial and Quantitative Analysis 509 (2015), 
available at https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-
analysis/article/related-securities-and-equity-market-quality-the-case-of-
cds/08DE66A250F9950FA486AE818D5E0341. The latter result, that traded equity options are 
associated with more liquid and efficient equity prices, is consistent with several other academic 
papers. See, e.g., Charles Cao, Zhiwu Chen, & John M. Griffin, Informational Content of Option 
Volume Prior to Takeovers, 78 Journal of Business 1073 (2005), as well as Jun Pan & Allen M. 
Poteshman, The Information in Option Volume for Future Stock Prices, 19 Review of Financial 
Studies 871 (2006). The effects described in the literature are based on studies of the introduction 
of derivative securities and may therefore apply differently to changes in the trading volume of 
derivatives securities that may occur as a result of the proposed rule.  

587  See supra section III.C.2. 



308 

Moreover, the proposed amendments to fund’s current reporting requirements could facilitate the 

Commission’s oversight of funds subject to proposed rule 18f-4 with fewer resources, thus 

making its supervision more efficient. 588  

The amendments to Forms N-PORT and N-CEN would allow investors, to the extent that 

they use the information, to better differentiate funds that are not limited derivatives users or 

leveraged/inverse funds based on their derivatives usage.589 As a result, investors would be able 

to more efficiently identify the extent to which such funds use derivatives as part of their 

investment strategies, allowing them to make better-informed investment decisions. 

The proposed sales practices rules could also reduce investments in leveraged/inverse 

investment vehicles, to the extent that some retail investors would not be approved by their 

broker-dealer or investment adviser to transact in leveraged/inverse investment vehicles or to the 

extent that some retail investors would be deterred by the time costs and delay introduced by the 

account-opening procedures.590 The proposed amendments to rule 6c-11, however, would likely 

outweigh these effects in the case of leveraged/inverse ETFs and lead to an overall increase in 

the number and assets under management for these types of funds.  

To the extent that the proposed rules would lead to a reduction in investment in 

leveraged/inverse commodity- or currency-based trusts or funds, the liquidity of these products 

may decline as a result. Conversely, to the extent that the proposed rules would lead to an overall 

increase in investments in leveraged/inverse ETFs, the liquidity of these funds may increase as a 

result. The likely increase in the number, and assets under management, of leveraged/inverse 

                                                      
588  See supra section III.C.8. 
589  See supra section III.C.9.a.  
590  See supra section III.B.5. 



309 

ETFs as a result of the proposed amendments to rule 6c-11 may affect the quality of the markets 

for underlying securities and derivatives. Specifically, the academic literature to date provides 

some evidence, albeit inconclusive, that leveraged/inverse ETFs’ rebalancing activity may have 

an impact on the price and volatility of the constituent assets that make up the ETFs. For 

example, one paper empirically tests whether the rebalancing activity of leveraged/inverse ETFs 

impacts the price and price volatility of underlying stocks.591 The authors find a positive 

association, suggesting that rebalancing demand may affect the price and price volatility of 

component stocks, and may reduce the degree to which prices reflect fundamental value of the 

component stocks. As leveraged/inverse ETFs commonly use derivatives to rebalance their 

portfolios, similar effects could also extend to underlying derivatives, although we are not aware 

of any academic literature that has examined the effects of leveraged/inverse ETFs’ rebalancing 

activity on derivatives markets. Conversely, another paper argues that the existing literature that 

studies the effect of leveraged/inverse ETFs’ rebalancing activity on the constituent asset prices 

does not control for the effect of the creation and redemption transactions (i.e., fund flows) by 

authorized participants.592 The paper presents evidence that positively leveraged/inverse ETFs 

tend to have capital flows in the opposite direction of the underlying index, and inverse 

leveraged/inverse ETFs tend to have capital flows in the same direction as the underlying index, 

suggesting that investor behavior may attenuate the effect of leveraged/inverse ETFs’ 

rebalancing activity on the prices of underlying securities and derivatives.593 

                                                      
591  See Qing Bai, Shaun A. Bond & Brian Hatch, The Impact of Leveraged and Inverse ETFs on 

Underlying Real Estate Returns, 43 Real Estate Economics 37 (2015). 
592  See Ivan T. Ivanov & Stephen Lenkey, Are Concerns About Leveraged ETFs Overblown?, FEDS 

Working Paper No. 2014-106 (2014). 
593  The literature we are aware of focuses on leveraged/inverse ETFs and does not study similar 

effects of leveraged/inverse mutual funds, although both types of funds generally engage in 
 



310 

2. Competition 

Certain aspects of the proposed rules and amendments may have an impact on 

competition. Certain of these potential competitive effects result from the proposed rule imposing 

differential costs on different funds. Specifically, (1) large fund complexes may find it less costly 

to comply per fund with the new requirements of proposed rule 18f-4;594 (2) funds that would 

qualify as limited derivatives users would generally incur lower compliance costs associated with 

the rule than funds that would not qualify for this exception;595 (3) funds that would comply with 

the relative VaR test would generally incur higher compliance costs than those that would 

comply with the absolute VaR test; (4) BDCs are not subject to the additional reporting 

requirements on Forms N-CEN or N-PORT and would therefore not incur the increased 

compliance costs that would be imposed on filers of these forms; and (5) leveraged/inverse funds 

are not subject to several of the additional reporting requirements on forms N-CEN or N-PORT 

and would therefore incur a reduced additional burden compared to other funds that are not 

limited users of derivatives.596 To the extent that investors believe that the funds that would incur 

lower compliance burdens and the funds that would incur a higher compliance burden under the 

rule are substitutes, the rule would result in a competitive advantage for funds with the lower 

compliance burden to the extent that a lower burden makes such funds materially less costly to 

operate.  

                                                      

similar rebalancing activity. To the extent that similar effects may be attributable to 
leveraged/inverse mutual funds and that any increase in leveraged/inverse ETF assets would be 
(at least partially) offset by a decrease in leveraged/inverse mutual fund assets, this may 
ameliorate the overall effect on the price and volatility of constituent assets.  

594  See supra section III.C.2. 
595  See supra section III.C.3. 
596  See supra section III.C.2. 



311 

To the extent that the proposed sales practices rules’ due diligence and account approval 

requirements limit certain customers or clients from buying or selling shares of certain 

leveraged/inverse investment vehicles, such investors may instead opt to invest in another 

product with a similar risk profile that is not subject to those requirements.597 Thus, the proposed 

sales practices rules may generate substitution spillover effects that increase competition 

between leveraged/inverse investment vehicles within the scope of the rule and other products 

outside the scope of the rule that provide similar exposures. 

Similarly, broker-dealers and investment advisers with a larger fraction of retail 

customers or clients that can no longer transact in leveraged/inverse investment vehicles as a 

result of the proposed sales practices rules’ due diligence and account approval requirements 

may experience larger declines in their customer or client base.598 As a result, broker-dealers and 

investment advisers that would see a larger reduction in customers or clients may be at a 

competitive disadvantage compared to broker-dealers and investment advisers that would see 

only a smaller reduction in customers or clients or no reduction at all. 

The Commission has not provided exemptive relief to new prospective sponsors of 

leveraged/inverse ETFs since 2009.599 The proposed amendments to rule 6c-11 would allow 

other leveraged/inverse ETFs to enter the leveraged/inverse ETF market, likely leading to more 

competition among leveraged/inverse ETFs and between leveraged/inverse ETFs and other 
                                                      
597  Some investors that are not approved to buy or sell leveraged/inverse investment vehicles may 

opt to move their capital into exchange-traded notes or other products with a similar risk profile. 
Conversely, some investors may transact in leveraged/inverse investment vehicles without 
involving a broker-dealer or investment adviser that would be subject to the proposed sales 
practices rules, although this is uncommon. See supra note 322. 

598  Any such reduction in a broker-dealer’s or investment adviser’s customer base may be offset to 
the extent that clients transact in other products with the same broker dealer or investment adviser 
instead. See supra section III.C.5. 

599  See supra text following note 474. 



312 

products that investors may perceive as substitutes, such as leveraged/inverse mutual funds. This 

increase in competition could be significant, as the leveraged/inverse ETF market is very 

concentrated; currently, only two fund sponsors operate leveraged/inverse ETFs.600 In addition, 

fees for leveraged/inverse ETFs and substitute products, such as leveraged/inverse mutual funds, 

could fall as a result of any such increase in competition.  

3. Capital Formation 

Certain aspects of the proposed rules and amendments may have an impact on capital 

formation. Certain of these effects may arise from a change in investors’ propensity to invest in 

funds. On the one hand, investors may be more inclined to invest in funds as a result of increased 

investor protection arising from any decrease in leverage-related risks. On the other hand, some 

investors may reduce their investments in certain funds that may increase their use of derivatives 

in light of the bright-line VaR-based limit on fund leverage risk.601 Additionally, some investors 

may re-evaluate their desire to invest in funds generally as a result of the increased disclosure 

requirements, with some investors deciding to invest more and other investors deciding to invest 

less. While we are unable to determine whether the proposed rules and amendments would lead 

to an overall increase or decrease in fund assets, to the extent the overall fund assets change, this 

may have an effect on capital formation.  

The proposed rule may also decrease the use of reverse repurchase agreements, similar 

financing transactions, or borrowings by some funds, or reduce some funds’ ability to invest the 

                                                      
600  The increase in competition among leveraged/inverse ETFs could be attenuated, to the extent that 

proposed rule 15l-2’s and 211(h)-1’s due diligence requirements would limit the number of 
investors that invest in these funds. See supra section III.C.5. 

601  See supra section III.C.2. 



313 

borrowings obtained through reverse repurchase agreements.602 To the extent that this restricts a 

fund’s ability to obtain financing to invest in debt or equity securities, capital formation may be 

reduced.  

In addition, the proposed sales practices rules may reduce capital formation in asset 

markets directly connected with covered leveraged/inverse investment vehicles. By restricting 

the accounts of customers or clients seeking to buy or sell shares of a leveraged/inverse 

investment vehicle, the proposed rules may produce net capital outflows from retail investors. 

However, the size of this effect would depend on the number of retail investors that would no 

longer be approved to buy or sell shares of leveraged/inverse investment vehicles and any other 

investments these retail investors would make in lieu of investing in leveraged/inverse 

investment vehicles.  

E. Reasonable Alternatives 

1. Alternative Implementations of the VaR Tests  

a. Different Confidence Level or Time Horizon 

Proposed rule 18f-4 would require that a fund’s VaR model use a 99% confidence level 

and a time horizon of 20 trading days.603 We could alternatively require a different confidence 

level and/or a different time horizon for the VaR test.  

As discussed above in section II.D.4, market participants calculating VaR most 

commonly use 95% or 99% confidence levels and often use time horizons of 10 or 20 days. The 

proposed VaR parameters therefore represent a confidence level and time horizon at the high end 

of what is commonly used. Compared to requiring a lower confidence level and a shorter time 

                                                      
602  See supra section III.C.4. 
603  See supra section II.D.4.  



314 

horizon, the proposed parameters result in a VaR test that is designed to measure, and therefore 

limit the severity of, less frequent but larger losses. The cost of calculating VaR does not vary 

based on how the model is parametrized, meaning the proposed confidence level and time 

horizon would not lead to larger compliance costs for funds compared to the alternatives we 

considered. A lower confidence level or shorter time horizon may be less effective at placing a 

VaR-based outer limit on fund leverage risk associated with larger losses and would not result in 

cost savings for funds. 

b. Absolute VaR Test Only 

To establish an outer limit for a fund’s leverage risk, the proposed rule would generally 

require a fund engaging in derivatives transactions to comply with a relative VaR test; the fund 

could instead comply with an absolute VaR test only if the derivatives risk manager is unable to 

identify an appropriate designated reference index for the fund. As an alternative, we could 

require all funds that would be subject to the proposed VaR-based limit on fund leverage risk to 

comply with an absolute VaR test.  

Use of an absolute VaR test would be less costly for some funds that would be required 

to comply with the relative VaR test under the proposed rule, including because the relative VaR 

test may require some funds to pay licensing costs associated with the use of the reference 

index.604 In addition, use of an absolute VaR test would reduce the compliance challenge for 

fund risk managers who have difficulty identifying a designated reference index; however, this 

benefit would be limited for funds that have an existing or easy-to-identify benchmark.  

On the other hand, the absolute VaR test is a static measure of fund risk in the sense that 

the implied limit on a fund’s VaR will not change with the VaR of its designated reference index. 
                                                      
604  See supra section III.C.2. 



315 

The absolute VaR test is therefore less suited for measuring leverage risk and limiting the degree 

to which a fund can use derivatives to leverage its portfolio, as measuring leverage inherently 

requires comparing a fund’s risk exposure to that of an unleveraged point of reference.605 An 

additional implication of this aspect of an absolute VaR test is that a fund may fall out of 

compliance with an absolute VaR test just because the market it invest in becomes more volatile 

even though the degree of leverage in the fund’s portfolio may not have changed. Overall, we 

believe that permitting funds to rely on an absolute VaR test only in those instances when a 

designated reference index is unavailable is justified.  

c. Choice of Absolute or Relative VaR Tests 

As another alternative, we could allow derivatives risk managers to choose between an 

absolute and a relative VaR limit, depending on their preferences and without regard to whether 

a designated reference index is available. Such an alternative would offer derivatives risk 

managers more flexibility than the proposed rule and could reduce compliance costs for funds, to 

the extent that derivatives risk managers would choose the VaR test that is cheaper to implement 

for their particular fund. However, this alternative may result in less uniformity in the outer limit 

on funds’ leverage risk across the industry, as individual derivatives risk managers would have 

the ability to choose between VaR-based tests that could provide for different limits on fund 

leverage risk. Funds that invest in assets with a low VaR, for example, could obtain significantly 

more leverage under an absolute VaR test because the VaR of the fund’s designated reference 

index would be low; as a result, investors in these funds would be less protected from leverage-

related risks compared to the proposed rule.  

                                                      
605  Id. 



316 

d. Optional Relative VaR Test Using a Fund’s “Securities 
VaR” 

As another alternative, we could allow funds relying on the relative VaR test to compare 

the fund’s VaR to its “securities VaR” (i.e., the VaR of the fund’s portfolio of securities and 

other investments, but excluding any derivatives transactions), rather than the VaR of the fund’s 

designated reference index, depending on the derivatives risk manager’s preferences and without 

regard to whether a designated reference index is available.606  

While such an alternative would offer derivatives risk managers more flexibility than the 

proposed rule, we believe that it would not be easier to implement or lead to cost savings for a 

significant number of funds. Conversely, the alternative VaR test based on a fund’s “securities 

VaR” would provide an incentive for some funds to invest in volatile, riskier securities that 

would increase the fund’s “securities VaR,” thereby reducing the test’s effectiveness at limiting 

fund leverage risk. As a result, investors in these funds would be less protected from leverage-

related risks compared to the proposed rule. 

e. Third-Party Validation of a Fund’s VaR Model 

The proposed rule does not require third-party validation of a fund’s chosen VaR model. 

As an alternative, we could require that a fund obtain third-party validation of its VaR model, 

either at inception or in connection with any material changes to the model, to independently 

confirm that the model is structurally sound and adequately captures all material risks.607 While 

such a requirement could help ensure funds’ compliance with the proposed VaR-based limit on 
                                                      
606  The 2015 Proposing Release also included a risk-based portfolio limit based on VaR, which 

provided that a fund would satisfy its risk-based portfolio limit condition if a fund’s full portfolio 
VaR was less than the fund’s “securities VaR.” See 2015 Proposing Release, supra note 2, at 
section III.B.2. 

 
607  See also supra note 244. 



317 

fund leverage risk, this incremental benefit may not justify the potentially significant additional 

costs to funds associated with third-party validation of the fund’s VaR model.608  

2. Alternatives to the VaR Tests 

a. Stress Testing 

As an alternative to the proposed VaR-based limit on fund leverage risk, we could require 

a stress testing approach. As discussed above in section II.D.6.a, we understand that many funds 

that use derivatives transactions already conduct stress testing for purposes of risk management. 

However, we do not believe that a stress testing approach would impose significantly lower costs 

on funds compared to a VaR-based approach, with the exception of those funds that already 

conduct stress testing but not VaR testing.609 

In addition, as also discussed in section II.D.6.a above, it would be challenging for the 

Commission to specify a set of asset class shocks, their corresponding shock levels, and, in the 

case of multi-factor stress testing, assumptions about the correlations of the shocks, in a manner 

that applies to all funds and does not become stale over time. While we could also prescribe a 

principles-based stress testing requirement, we believe that the flexibility such an approach 

would give to individual funds over how to implement the test would render it less effective than 

the proposed VaR test at establishing an outer limit on fund leverage risk.  

Finally, stress testing generally focuses on a narrower and more remote range of extreme 

loss events compared to VaR analysis. As a result, a limit on fund leverage risk based on stress 

                                                      
608  We note that the UCITS regime requires third-party validation of funds’ VaR models; as a result, 

these additional costs could be mitigated for fund that are part of a complex that also includes 
UCITS funds. See supra note 244. 

609  See also ICI Comment Letter III (stating that, “depending on the type of fund managed and 
whether the fund currently employs the test for risk management purposes, some respondents 
viewed a stress loss test as being more burdensome to implement, while others viewed a VaR test 
as being more burdensome to implement.”).  



318 

testing would likely be less effective at limiting fund leverage risk during more normal 

conditions and protecting investors from unexpected losses resulting from less extreme scenarios.  

b. Asset Segregation 

As another alternative, we could require an asset segregation approach in lieu of the 

proposed VaR-based limit on fund leverage risk. For example, we could consider an approach 

similar to the Commission’s position in Release 10666, under which a fund engaging in 

derivatives transactions would segregate cash and cash equivalents equal in value to the full 

amount of the conditional and unconditional obligations incurred by the fund (also referred to as 

“notional amount segregation”). Such an approach could also permit a fund to segregate a 

broader range of assets, subject to haircuts.610 Alternatively, we could require funds to segregate 

liquid assets in an amount equal to the fund’s daily mark-to-market liability plus a “cushion 

amount” designed to address potential future losses.  

As discussed above in section II.D.6.b, we believe that asset segregation approaches have 

several drawbacks as a means for limiting fund leverage risk, compared to the proposed VaR 

tests. For example, notional amount segregation is not risk-sensitive and could restrict 

derivatives transactions that would reduce portfolio risk. Similarly, segregation of liquid assets in 

an amount equal to the fund’s daily mark-to-market liability plus a “cushion amount” would be 

difficult to implement in a manner that is applied uniformly across all funds and types of 

derivatives. In addition, asset segregation approaches raise certain compliance complexities that 

                                                      
610  The 2016 DERA Memo, for example, analyzed different risk-based “haircuts” that could apply to 

a broader range of assets. See, e.g., 2016 DERA Memo, supra note 12. 



319 

may not make them significantly less costly to implement for funds than the proposed VaR 

tests.611  

In conjunction with the proposed VaR-based limit, we could also require a fund relying 

on the proposed rule to maintain an amount of “qualifying coverage assets” designed to enable a 

fund to meet its derivatives-related obligations. As discussed above, we believe that the proposed 

rule’s requirements, including the requirements that funds establish risk management programs 

and comply with the proposed VaR-based limit on fund leverage risk, would address the risk that 

a fund may be required to realize trading losses by selling its investments to generate cash to pay 

derivatives counterparties.  

c. Exposure-Based Test 

We alternatively considered proposing an exposure-based approach for limiting fund 

leverage risk in lieu of the proposed VaR test. An exposure-based test could limit a fund’s 

derivatives exposure, as defined in the proposed rule, to a specified percentage of the fund’s net 

assets. For example, we considered proposing that a fund limit its derivatives exposure to 50% of 

net assets. This would allow a fund to add to its portfolio an amount of derivatives exposure 

equal to the amount that an open-end fund could borrow from a bank. A similar approach would 

be to provide that the sum of a fund’s derivatives exposure and the value of its other investments 

cannot exceed 150% of its net asset value. This latter approach, and particularly if cash and cash 

equivalents were not included in the calculation, would allow a fund to achieve the level of 

market exposure permitted for an open-end fund under section 18 using any combination of 

derivatives and other investments.  

                                                      
611  See supra section II.D.6.b. 



320 

While an exposure-based test may be simpler and therefore less costly to implement for 

the typical fund than the proposed VaR tests, an exposure-based test has certain limitations 

compared to VaR tests, as discussed in detail in section above. One limitation is that measuring 

derivatives exposure based on notional amounts would not reflect how derivatives are used in a 

portfolio, whether to hedge or gain leverage, nor would it differentiate derivatives with different 

risk profiles. Various adjustments to the notional amount are available that may better reflect the 

risk associated with the derivatives transactions, although even with these adjustments the 

measure would remain relatively blunt. For example, an exposure-based limit could significantly 

limit certain strategies that rely on derivatives more extensively but that do not seek to take on 

significant leverage risk.  

Some of the limitations of an exposure-based approach could be addressed, however, if 

rule 18f-4 were to provide an exposure-based test as an optional alternative to the proposed VaR 

tests, rather than as the sole means of limiting fund leverage risk. Under this second alternative, 

funds with less complex portfolios might choose to rely on an exposure-based test because it 

would be simpler and impose lower compliance costs than the proposed VaR tests. Furthermore, 

if we provided that the sum of a fund’s derivatives exposure and the value of its other 

investments cannot exceed 150% of its net asset value, funds below this threshold would 

generally also pass the proposed relative VaR test.612 Conversely, funds with more complex 

portfolios that rely on derivatives more extensively but that do not seek to take on significant 

leverage risk might choose to rely on the proposed VaR test. As the proposed rule would already 

except limited derivatives users from the VaR-based limit on fund leverage risk, however, we do 
                                                      
612  A fund that limited the sum of its derivatives exposure and the value of its other investments to 

150% of its net asset value would generally also pass the proposed relative VaR test, provided 
that derivatives notionals are either not adjusted or only adjusted for delta in the case of options.321 

not believe that also giving funds the option of relying on an exposure-based limit on fund 

leverage risk would be necessary or that it would significantly reduce the compliance burden 

associated with the rule. 

3. Stress Testing Frequency 

Proposed rule 18f-4 would require funds that enter into derivatives transactions and are 

not limited derivatives users to adopt and implement a derivatives risk management program that 

includes stress testing, among other elements. The proposed rule would permit a fund to 

determine the frequency of stress tests, provided that the fund must conduct stress testing at least 

weekly.  

As an alternative to the weekly requirement, we considered both shorter and longer 

minimum stress testing frequencies. On the one hand, more frequent stress testing would reflect 

changes in risk for fund strategies that involve frequent and significant portfolio turnover. In 

addition, more frequent stress testing may reflect increases in market stress in a timelier manner. 

On the other hand, given the forward-looking nature of stress testing, we expect that most funds 

would take foreseeable changes in market conditions and portfolio composition into account 

when conducting stress testing. In addition, more frequent stress testing may impose an increased 

cost burden on funds, although we would expect any additional cost burden to be small, to the 

extent that funds perform stress testing in an automated manner. Overall, we preliminarily 

believe that the proposed minimum weekly stress testing appropriately balances the anticipated 

benefits of relatively frequent stress testing against the burdens of administering stress testing. 

Another alternative would be to permit a fund to determine its own stress testing 

frequency without the proposed rule prescribing a minimum stress testing frequency. This 

approach would provide maximum flexibility to funds regarding the frequency of their stress 

tests, and would reduce compliance costs for funds that determine that stress testing less 



322 

frequently than weekly is warranted in light of their own particular facts and circumstances. 

However, allowing funds to individually determine the frequency with which stress tests are 

conducted could result in some funds stress testing their portfolios too infrequently to provide 

timely information to the fund’s derivatives risk manager and board. Taking these considerations 

into account, we are proposing to require weekly stress tests, rather than less frequent testing, to 

provide for consistent and reasonably frequent stress testing by all funds that would be required 

to establish a derivatives risk management program.  

4. Alternative Exposure Limits for Leveraged/Inverse Funds 

A fund that meets the definition of a “leveraged/inverse investment vehicle” in the 

proposed sales practices rules would not have to comply with the VaR-based leverage risk limit 

under proposed rule 18f-4, provided the fund limits the investment results it seeks to 300% of the 

return (or inverse of the return) of the underlying index and discloses in its prospectus that it is 

not subject to the proposed limit on fund leverage risk.613 Alternatively, we could condition the 

exemption on compliance with a higher or lower exposure limit.  

Over longer holding periods, the realized leverage multiple of the returns of an 

investment in a leveraged/inverse fund relative to the returns of its underlying index can vary 

substantially from the fund’s daily leverage multiple.614 All else equal, this effect becomes 

stronger as the fund’s leverage multiple increases. The extent of a leveraged/inverse fund’s 

rebalancing activity likewise increases as the fund’s leverage multiple increases.615 Therefore, 

                                                      
613  See supra section II.G.3. 
614  See supra section III.B.5. 
615  The rebalancing demand of a leveraged/inverse fund is a function of the fund’s assets, the 

realized return of its reference index, and is proportional to the term (𝑥𝑥2 − 𝑥𝑥), where 𝑥𝑥 denotes 
the fund’s leverage multiple. (See, e.g., Minder Cheng & Ananth Madhavan, The dynamics of 
leveraged/inverse and inverse exchange-traded funds, 7 Journal of Investment Management 4 

 



323 

the effects of leveraged/inverse funds’ rebalancing activity on the constituent asset prices may be 

heightened if a significant number of leveraged/inverse funds were to increase their leverage 

beyond the levels currently observed in markets and, conversely, could be diminished if a 

significant number of leveraged/inverse funds were to reduce their leverage below current levels.  

While permitting a higher exposure limit may benefit fund sponsors to the extent that 

some sponsors would bring funds with higher leverage multiples to market, we are concerned 

that a higher exposure limit would heighten the investor protection concerns these funds present. 

Conversely, limiting leveraged/inverse funds’ exposure could reduce the concerns these funds 

present, but could reduce investor choice relative to the baseline given that leveraged/inverse 

funds today operate with levels of leverage up to the exposure limit we propose. Allowing funds 

to continue to obtain this level of leverage, subject to the additional requirements in proposed 

rule 18f-4 and in light of the proposed sales practices rules, is designed to address the investor 

protection concerns that underlie section 18, while preserving choice for retail investors who are 

capable of evaluating their characteristics and unique risks. For these reasons, and because the 

Commission does not have experience with leveraged/inverse funds that seek returns above 

300% of the return (or inverse of the return) of the underlying index, we are not proposing to 

permit higher levels of leveraged/inverse market exposure for leveraged/inverse funds in this 

rule. We also are not proposing a lower exposure limit for these funds in light of the investor 

protections that we believe proposed rule 18f-4 and the sales practices rules would provide.616  

                                                      

(2009).) As a result, increasing a fund’s leverage multiple increases its rebalancing demand more 
than linearly.  

616  See supra section II.G.3. 



324 

5. No Sales Practices Rules and No Separate Exposure Limit for 
Leveraged/Inverse Funds 

The proposed rules would require a leveraged/inverse fund that meets the definition of a 

“leveraged/inverse investment vehicle” to limit its investment results to 300% of the return (or 

inverse of the return) of the underlying index and would require a broker-dealer or investment 

adviser to exercise due diligence in approving a retail investor’s account to buy or sell shares of 

leveraged/inverse investment vehicles, as well as implement policies and procedures reasonably 

designed to achieve compliance with the proposed rules.617 In lieu of the proposed sales practices 

rules and associated exception from the VaR-based limit on fund leverage risk, we could 

alternatively require leveraged/inverse funds to comply with the proposed relative VaR test.  

Existing leveraged/inverse ETFs and mutual funds generally could comply with the 

proposed relative VaR test only if they restricted the investment results they seek to 150% of the 

return (or inverse of the return) of the underlying index. Therefore, under this alternative, 

leveraged/inverse funds that seek investment results in excess of this limit would either have to 

significantly change their investment strategy or liquidate. Given that existing fund sponsors 

frequently offer leveraged/inverse funds with various target multiples referencing the same 

index, we would expect that this alternative would reduce the number of leveraged/inverse funds.  

Compared to the proposal, this alternative would also restrict choice for investors that 

prefer to invest in leveraged/inverse funds that pursue investment results in excess of 150% of 

the return (or inverse of the return) of the underlying index and who would satisfy the due 

diligence and approval requirements adopted by their broker-dealer or investment adviser in 

connection with the proposed rule. 

                                                      
617  See supra sections II.G.3 and II.G.2.  



325 

At the same time, the alternative could result in increased investor protection for 

investors in these funds compared to the proposal. While investors’ access to leveraged/inverse 

funds would not be subject to the proposed sales practice rules under this alternative (and 

investment advisers and broker-dealers would not incur the associated compliance costs), these 

funds would be required to limit their exposure to 150% of the return (or inverse of the return) of 

the underlying index, thereby reducing the potential consequences for leveraged/inverse fund 

investors who are not capable of evaluating their return characteristics and ameliorating the 

associated investor protection concerns. Conversely, the alternative would reduce protection for 

investors in leveraged/inverse commodity- and currency-based trusts or funds, as those funds 

would be subject to neither the 150% exposure limit nor the proposed sales practices rules.  

Finally, because leveraged/inverse funds would no longer be able to offer exposures 

above 150% of the return (or inverse of the return) of the underlying index, the alternative may 

ameliorate the concerns associated with the rebalancing activity of leveraged/inverse ETFs, 

which decreases with the targeted leverage multiple of these funds.618 As discussed above in 

section D.1, however, while the literature observes that leveraged/inverse ETFs’ rebalancing 

activity may have an adverse impact on the prices and volatility of the constituent assets that 

make up leveraged/inverse ETFs, the literature, overall, is not definitive.  

Overall, we believe that preserving investor choice justifies providing leveraged/inverse 

funds an exemption from the proposed VaR-based limit on fund leverage risk, particularly in 

light of the proposed sales practices rules, which we believe would help to ensure that investors 

                                                      
618  See supra sections III.D.1 and III.E.4. While the literature focuses on leveraged/inverse ETFs, the 

results may apply similarly to leveraged/inverse mutual funds.  



326 

in these funds are limited to those who are capable of evaluating the characteristics and risks of 

these products.619 

6. Enhanced Disclosure 

As an alternative to the requirements in rule 18f-4, such as the proposed derivatives risk 

management program and the VaR-based limit on fund leverage risk, we could consider 

addressing the risks associated with funds’ use of derivatives through enhanced disclosures to 

investors with respect to a fund’s use of derivatives and the resulting derivatives-related risks.620 

While an approach focused on enhanced disclosures could result in greater fund investment 

flexibility, such an approach may be less effective than the proposed rule in addressing the 

purposes and concerns underlying section 18 of the Investment Company Act. Section 18 itself 

imposes a specific limit on the amount of senior securities that a fund may issue, regardless of 

the level of risk introduced or the disclosure that a fund provides regarding those risks. Absent 

additional requirements to limit leverage or potential leverage, requiring enhancement to 

derivatives disclosure alone would not appear to provide any limit on the amount of leverage a 

fund may obtain. Indeed, the degree to which funds use derivatives varies widely between funds. 

As a result, an approach focused solely on enhanced disclosure requirements may not provide a 

sufficient basis for an exemption from the requirements of section 18 of the Investment 

Company Act. 

                                                      
619  See also supra note 536. 
620  See, e.g., Comment Letter of the Fixed Income Market Structure Advisory Committee on 

proposed rule 6c-11 under the Investment Company Act (Oct. 29, 2018) (recommending that the 
Commission consider future rulemaking regarding “leveraged ETP” investor disclosure 
requirements). 



327 

F. Request for Comments 

The Commission requests comment on all aspects of this initial economic analysis, 

including whether the analysis has: (1) identified all benefits and costs, including all effects on 

efficiency, competition, and capital formation; (2) given due consideration to each benefit and 

cost, including each effect on efficiency, competition, and capital formation; and (3) identified 

and considered reasonable alternatives to the proposed new rules and rule amendments. We 

request and encourage any interested person to submit comments regarding the proposed rules, 

our analysis of the potential effects of the proposed rules and proposed amendments, and other 

matters that may have an effect on the proposed rules. We request that commenters identify 

sources of data and information as well as provide data and information to assist us in analyzing 

the economic consequences of the proposed rules and proposed amendments. We also are 

interested in comments on the qualitative benefits and costs we have identified and any benefits 

and costs we may have overlooked. In addition to our general request for comments on the 

economic analysis associated with the proposed rules and proposed amendments, we request 

specific comment on certain aspects of the proposal: 

 Are we correct that many funds already have a derivatives risk management program 

in place that could be readily adapted to meet the proposed rule’s requirements 

without significant additional cost? If so, for how many funds would this be true? 

 The proposed rule does not include any requirement for third-party validation of a 

fund’s chosen VaR model, either at inception or upon material changes, to confirm 

that the model is structurally sound and adequately captures all material risks.621 How 

costly would such a requirement be to funds? What would the benefits of such a 
                                                      
621  See also supra note 244. 



328 

requirement be? 

 Are we correct that many funds that use derivatives in a limited manner already have 

in place policies and procedures that are reasonably designed to address their 

derivatives that could be readily adapted to meet the proposed rule’s requirements 

without significant additional cost? If so, for how many funds would this be true? 

 How many broker-dealers provide customers the ability to buy or sell interests in 

leveraged/inverse investment vehicles? How many investment advisers place orders 

to buy or sell leveraged/inverse investment vehicles for their advisory clients? How 

many retail investor accounts with broker-dealers and investment advisers trade 

leveraged/inverse investment vehicles? 

 How many current investors in leveraged/inverse investment vehicles would likely 

not be approved to buy or sell these products under the proposed sales practices rules’ 

due diligence and account approval requirements?  

 If we provided that the sum of a fund’s derivatives exposure and the value of its other 

investments cannot exceed 150% of its net asset value, funds below this threshold 

would generally also pass the proposed relative VaR test. How many funds would be 

likely to rely on such an exposure-based test if exempted funds that satisfied this limit 

from the proposed VaR tests?  

IV. PAPERWORK REDUCTION ACT ANALYSIS  

A. Introduction 

Proposed rule 18f-4, proposed rule 15l-2, and proposed rule 211(h)-1 would result in new 

“collection of information” requirements within the meaning of the Paperwork Reduction Act of 



329 

1995 (“PRA”).622 In addition, the proposed amendments to rule 6c-11 under the Investment 

Company Act, as well as to Forms N-PORT, Form N-LIQUID (which would be renamed 

Form N-RN), and N-CEN would affect the collection of information burden under those rules 

and forms.623 

The titles for the existing collections of information are: “Form N-PORT” (OMB Control 

No. 3235-0731); “Form N-LIQUID” (OMB Control No. 3235-0754); “Form N-CEN” (OMB 

Control No. 3235-0730); and “Rule 6c-11 under the Investment Company Act of 1940, 

Exchange-traded funds” (OMB Control No. xxxx-xxxx). The titles for the new collections of 

information would be: “Rule 18f-4 under the Investment Company Act of 1940, Use of 

Derivatives by Registered Investment Companies and Business Development Companies,” “Rule 

15l-2 under the Securities Exchange Act of 1934, Broker and Dealer Sales Practices for 

Leveraged/Inverse Investment Vehicles,” and “Rule 211(h)-1 under the Investment Advisers Act 

of 1940, Investment Adviser Sales Practices for Leveraged/Inverse Investment Vehicles.” The 

Commission is submitting these collections of information to the Office of Management and 

Budget (“OMB”) for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. An 

agency may not conduct or sponsor, and a person is not required to respond to, a collection of 

information unless it displays a currently-valid control number. 

The Commission published notice soliciting comments on the collection of information 

requirements in the 2015 Proposing Release and submitted the proposed collections of 
                                                      
622  44 U.S.C. 3501-3520. 
623  We do not believe that the proposed conforming amendment to Form N-2, to reflect a 

clarification that funds do not have to disclose in their senior securities table the derivatives 
transactions and unfunded commitment agreements entered into in reliance on proposed rule 18f-
4, makes any new substantive recordkeeping or information collection within the meaning of the 
PRA. Accordingly, we do not revise any burden and cost estimates in connection with this 
proposed amendment. 



330 

information to OMB for review and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 

1320.11.624 The Commission received comments on the 2015 proposal’s collection of 

information burden regarding the 2015 proposal’s trade-by-trade determination of compliance 

with portfolio limits.625 These comments were considered but did not form the basis of our 

burden estimates because we do not propose a trade-by-trade determination of compliance with 

the proposed VaR-based tests. 

We discuss below the collection of information burdens associated with proposed 

rule 18f-4, proposed rule 15l-2, proposed rule 211(h)-1, as well as proposed amendments to 

rule 6c-11 and Forms N-PORT, N-LIQUID, and N-CEN. 

B. Proposed Rule 18f-4 

Proposed rule 18f-4 would permit a fund to enter into derivatives transactions, 

notwithstanding the prohibitions and restrictions on the issuance of senior securities under 

section 18 of the Investment Company Act. 

Proposed rule 18f-4 would generally require a fund that relies on the rule to enter into 

derivatives transactions to: adopt a derivatives risk management program; have its board of 

directors approve the fund’s designation of a derivatives risk manager and receive direct reports 

from the derivatives risk manager about the derivatives risk management program; and require a 

fund to comply with a VaR-based test designed to limit a fund’s leverage risk consistent with the 

investor protection purposes underlying section 18. Proposed rule 18f-4 includes an exception 

from the risk management program requirement and limit on fund leverage risk if a fund is a 

“limited derivatives user” that either limits its derivatives exposure to 10% of its net assets or it 
                                                      
624  See 2015 Proposing Release, supra note 2. 
625  See, e.g., Vanguard Comment Letter; Invesco Comment Letter; see also supra note 246 and 

accompanying text. 



331 

uses derivatives transactions solely to hedge certain currency risks. A fund relying on the 

proposed exception would be required to adopt policies and procedures that are reasonably 

designed to manage its derivatives risks. Proposed rule 18f-4 also includes alternative 

requirements for a leveraged/inverse fund not subject to the proposed VaR-based leverage risk 

limit, if such a fund: (1) meets the definition of a “leveraged/inverse investment vehicle” in the 

proposed sales practices rules; (2) limits the investment results it seeks to 300% of the return (or 

inverse of the return) of the underlying index; and (3) discloses in its prospectus that it is not 

subject to proposed rule 18f-4’s limit on fund leverage risk.626 Proposed rule 18f-4 also would 

require a fund to adhere to certain recordkeeping requirements that are designed to provide the 

Commission’s staff, and the fund’s board of directors and compliance personnel, the ability to 

evaluate the fund’s compliance with the proposed rule’s requirements.  

The respondents to proposed rule 18f-4 would be registered open- and closed-end 

management investment companies and BDCs.627 We estimate that 5,091 funds would likely rely 

on rule 18f-4.628 Compliance with proposed rule 18f-4 would be mandatory for all funds that 

seek to engage in derivatives transactions in reliance on the rule, which would otherwise be 

                                                      
626   See proposed rule 18f-4(c)(4); supra section II.G.3. 
627  See proposed rule 18f-4(a) (defining “fund”). 
628  See supra notes 468, 499 and accompanying text, and paragraph following note 526 (2,693 funds 

that would be subject to the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and 
complying with the related limited derivatives user requirements). 

The Commission’s estimates of the relevant wage rates in the tables below are based on salary 
information for the securities industry compiled by the Securities Industry and Financial Markets 
Association’s Office Salaries in the Securities Industry 2013. The estimated wage figures are 
modified by Commission staff to account for an 1,800-hour work-year and multiplied by 2.93 to 
account for bonuses, firm size, employee benefits, overhead, and adjusted to account for the 
effects of inflation. See Securities Industry and Financial Markets Association, Report on 
Management & Professional Earnings in the Securities Industry 2013 (“SIFMA Report”). 



332 

subject to the restrictions of section 18. To the extent that records required to be created and 

maintained by funds under the rule are provided to the Commission in connection with 

examinations or investigations, such information would be kept confidential subject to the 

provisions of applicable law.  

1. Derivatives Risk Management Program 

Proposed rule 18f-4 would require certain funds relying on the rule to adopt and 

implement a written derivatives risk management program, which would include policies and 

procedures reasonably designed to manage the fund’s derivatives risks. The proposal would 

require a fund’s program to include the following elements: (1) risk identification and 

assessment; (2) risk guidelines; (3) stress testing; (4) backtesting; (5) internal reporting and 

escalation; and (6) periodic review of the program.629 Under the proposed rule, the derivatives 

risk manager is responsible for administering the derivatives risk management program and its 

policies and procedures. Certain funds relying on the proposed rule would not be subject to the 

program requirement.630 We estimate that 2,693 funds would likely be subject to the program 

requirement.631 Below we estimate the initial and annual ongoing burdens associated with initial 

documentation of the program, and any revision (and related documentation) of the derivatives 

risk management program arising from the periodic review of the program. In addition to the 

initial burden to document the program, including policies and procedures reasonably designed 

to manage the fund’s derivatives risks, we estimate that a fund relying on the proposed rule 
                                                      
629  See proposed rule 18f-4(c)(1)(i)-(vi); supra section II.A.2 (discussing the proposed derivatives 

risk management program requirement). 
630  A fund that is a limited derivatives user would not be required to comply with the proposed 

program requirement. Funds that are limited derivatives users would be required to adopt policies 
and procedures that are reasonably designed to manage its derivatives risks. See proposed rule 
18f-4(c)(3); infra section IV.B.6 (discussing limited derivatives users). 

631  See supra notes 499, 628 and accompanying text. 



333 

would have an ongoing burden associated with the proposed periodic review requirements to 

evaluate the program’s effectiveness and to reflect changes in the fund’s derivatives risks over 

time. Below we estimate the initial and annual ongoing burdens associated with documentation 

and any review and revision of funds’ programs including their policies and procedures. 

Table 2 below summarizes the proposed PRA initial and ongoing annual burden 

estimates associated with the derivatives risk management program requirement under proposed 

rule 18f-4. We do not estimate that there will be any initial or ongoing external costs associated 

with the derivatives risk management program requirement. 



334 

 

Table 2: Derivatives Risk Management Program PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours1  Wage rate2 Internal time costs 

PROPOSED ESTIMATES 

Written derivatives risk management 
program development 

12 hours 4 hours × $357 (derivatives risk 
manager) $1,428 

12 hours 4 hours × $466 (assistant general 
counsel) 

$1,864 

12 hours 4 hours × $365 (compliance attorney) $1,460 

 

Periodic review and revisions of the 
program 

 

0 hours 2 hours × 
$357 (derivatives risk 

manager) 
$714 

0 hours 2 hours × 
$466 (assistant general 

counsel) $932 

0 hours 2 hours × $365 (compliance attorney) $730 

Total annual burden per fund  18 hours   $7,128 

Number of funds  × 2,693   × 2,693 

Total annual burden  48,474 hours   $19,195,704 

Notes: 
1. For “Written Derivatives Risk Management Program Development,” these 
estimates include initial burden estimates annualized over a three-year period. 
2. See supra note 628.  
 



 

335 

2. Board Oversight and Reporting 

The proposed rule would require: (1) a fund’s board of directors to approve the 

designation of the fund’s derivatives risk manager,632 (2) the derivatives risk manager to provide 

written reports to the board regarding the program’s implementation and effectiveness,633 and 

(3) the derivatives risk manager to provide written reports describing any exceedances of the 

fund’s guidelines and the results of the fund’s stress testing and backtesting.634 We estimate that 

2,693 funds would be subject to these requirements.635 

Table 3 below summarizes the proposed PRA initial and ongoing annual burden 

estimates associated with the board oversight and reporting requirements under proposed 

rule 18f-4. We do not estimate that there will be any initial or ongoing external costs associated 

with the board oversight and reporting requirements. 

                                                      
632  See proposed rule 18f-4(c)(5)(i); supra section II.C (discussing the proposed board oversight and 

reporting requirements). 
633  See proposed rule 18f-4(c)(5)(ii); supra section II.C.  
634  See proposed rule 18f-4(c)(5)(iii); supra section II.C. Burdens associated with reports to the 

fund’s board of directors of material risks arising from the fund’s derivatives transactions, as 
described in proposed rule 18f-4(c)(1)(v), are discussed above in supra section IV.B.1. 

635   See supra notes 499, 628 and accompanying text. 



336 

Table 3: Board Oversight and Reporting PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours1  Wage rate2 Internal time costs 

PROPOSED ESTIMATES 

Approving the designation of the 
derivatives risk manager 

3 hours 1 hour × 
$17,860 (combined rate for 4 

directors)2 $17,860 

Derivatives risk manager written 
reports3 

 8 hours × 
$357 (derivatives risk 

manager) $2,856 

 1 hour × $17,860 (combined rate for 4 
directors) $17,860 

Total annual burden per fund  10 hours   $11,786 

Number of funds  × 2,693   × 2,693 

Total annual burden  26,930 hours   $31,739,698 

Notes: 
1. For “Approving the Designation of the Derivatives Risk Manager,” this estimate 
includes initial burden estimates annualized over a three-year period. 
2. See supra notes 628. 
3. See supra notes 632-633 and accompanying text. 



 

337 

3. Disclosure Requirement Associated with Limit on Fund 
Leverage Risk 

The proposed rule would also generally require funds relying on the rule to comply with 

an outer limit on fund leverage risk based on VaR. This outer limit would be based on a relative 

VaR test that compares the fund’s VaR to the VaR of a “designated reference index.” If the 

fund’s derivatives risk manager is unable to identify an appropriate designated reference index, 

the fund would be required to comply with an absolute VaR test.636 Under the proposed rule, a 

fund must disclose its designated reference index in its annual report.637 We estimate that 2,424 

funds would be subject to this disclosure requirement.638 

Table 4 below summarizes the proposed PRA initial and ongoing annual burden 

estimates associated with the disclosure requirement associated with the proposed limit on fund 

leverage risk. We do not estimate that there will be any paperwork-related initial or ongoing 

external costs associated with this proposed disclosure requirement.  

                                                      
636  The collections of information burdens for disclosure requirements associated with the proposed 

limit on fund leverage risk are reflected in the PRA for proposed rule 18f-4 and not in the funds’ 
applicable disclosure forms because the burden arises from the proposed rule. The Paperwork 
Reduction Act analysis for the funds’ applicable disclosure forms will not reflect the collections 
of information burdens for disclosure requirements associated with the proposed limit on fund 
leverage risk. 

A fund that is a leveraged/inverse investment vehicle, as defined in the proposed sales practices 
rules, would not be required to comply with the proposed VaR-based limit on fund leverage risk. 
Broker-dealers and investment advisers would be required to approve retail investors’ accounts to 
purchase or sell shares in these funds. See infra sections IV.C and IV.D (discussing 
leveraged/inverse investment vehicles and leveraged/inverse funds covered by the sales practices 
rules). The proposed rule also would provide an exception from the proposed VaR tests for funds 
that use derivatives to a limited extent or only to hedge currency risks. See infra sections IV.B.5 
(discussing the proposed rule’s provisions regarding limited derivatives users). 

VaR test burdens related to recordkeeping and reporting are reflected in the recordkeeping section 
below, and also in the Forms N-PORT, N-CURRENT, and N-CEN burdens discussed below. See 
infra sections IV.F, IV.G, and IV.H. 

637  See proposed rule 18f-4(c)(2)(iv). 
638   See supra notes 520-521 and accompanying text. 



338 

Table 4: Disclosure Requirement Associated with Limit on Fund Leverage Risk PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours  Wage rate1 Internal time costs 

PROPOSED ESTIMATES 

Disclosure of designated reference 
index 

0 hours .5 hours × $309 (compliance manager) $154.50 

0 hours .5 hours × $365 (compliance attorney) $182.50 

Total annual burden per fund  1 hour   $337 

Number of funds  × 2,424   × 2,424 

Total annual burden  2,424 hours   $816,888 

 
Notes: 
1. See supra note 628. 
 



 

339 

4. Disclosure Requirement for Leveraged/Inverse Funds 

Under the proposed rule, a fund would not have to comply with the proposed VaR-based 

leverage risk limit if it: (1) meets the definition of a “leveraged/inverse investment vehicle” in 

the proposed sales practices rules; (2) limits the investment results it seeks to 300% of the return 

(or inverse of the return) of the underlying index; and (3) discloses in its prospectus that it is not 

subject to proposed rule 18f-4’s limit on fund leverage risk.639 We estimate that 269 funds would 

be subject to the proposed prospectus disclosure requirement for leveraged/inverse funds.640 

Table 5 below summarizes the proposed PRA initial and ongoing annual burden 

estimates associated with the disclosure requirement in the proposed rule’s alternative provision 

for leveraged/inverse funds. We do not estimate that there will be any initial or ongoing external 

costs associated with this proposed disclosure requirement.  

                                                      
639  See proposed rule 18f-4(c)(4); supra section II.G (discussing the alternative requirements for 

leveraged/inverse funds). 
640  See supra note 468 and accompanying text (164 leveraged/inverse ETFs + 105 leveraged mutual 

funds). 



 

340 

Table 5: Disclosure Requirement Associated with Leveraged/Inverse Funds PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours  Wage rate1 Internal time costs 

PROPOSED ESTIMATES 

Leveraged/inverse fund prospectus 
disclosure 

0 hours .25 hours × $309 (compliance manager) $77 

0 hours .25 hours × $365 (compliance attorney) $91 

Total annual burden per fund  1 hour   $168 

Number of funds  × 269   × 269 

Total annual burden  269 hours   $45,192 

 
Notes: 
1. See supra note 628.341 

5. Disclosure Changes for Money Market Funds 

Money market funds are excluded from the scope of the rule and could not rely on 

proposed rule 18f-4 to enter into derivatives transactions or other transactions addressed in the 

proposed rule.641 To the extent a money market fund currently discloses in its prospectus that it 

may use any of these transactions—even if it is not currently entering into these transactions—

money market funds would be subject to the burdens associated with making disclosure changes 

to their prospectuses. We estimate that 413 funds could be subject to such disclosure changes on 

account of money market funds’ exclusion from the proposed rule.642 

Table 6 below summarizes the proposed PRA initial and ongoing annual burden 

estimates associated with disclosure changes that money market funds could make because of 

their exclusion from proposed rule 18f-4.643 We do not estimate that there will be any initial or 

ongoing external costs associated with this disclosure change requirement.  

                                                      
641  See proposed rule 18f-4(a) (defining the term “Fund” to “…not include a registered open-end 

company that is regulated as a money market fund”); supra section II.A.1 (discussing the 
exclusion of money market funds from the scope of the proposed rule). 

642  See supra note 455 and accompanying text. This likely overestimates the total number of funds 
subject to these disclosure changes, because we believe that money market funds currently do not 
typically engage in derivatives transactions or the other transactions addressed by proposed 
rule 18f-4. See supra section II.A.1. 

643  These per-fund burden estimates likely overestimate the total burden associated with these 
disclosure changes. See supra note 642. 



 

342 

Table 6: Disclosure Changes for Money Market Funds PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours  Wage rate1 Internal time costs 

PROPOSED ESTIMATES 

Money market prospectus disclosure 
changes 

.75 hours .25 hours × $309 (compliance manager) $77 

.75 hours .25 hours × $365 (compliance attorney) $91 

Total annual burden per fund  .5 hour   $168 

Number of funds  × 413   × 413 

Total annual burden  207 hours   $69,384 

 
Notes: 
1. See supra note 628. 
 



 

343 

6. Policies and Procedures for Limited Derivatives Users 

Proposed rule 18f-4 would require funds relying on the limited derivatives user 

provisions to adopt and implement written policies and procedures reasonably designed to 

manage the fund’s derivatives risks.644 Only funds that limit their derivatives exposure to 10% of 

their net assets or that use derivatives transactions solely to hedge certain currency risks would 

be permitted to rely on these provisions. We estimate that 2,398 funds would be subject to the 

limited derivatives users requirements.645 In addition to the initial burden to document the 

policies and procedures, we estimate that limited derivatives users would have an ongoing 

burden associated with any review and revisions to its policies and procedures to ensure that they 

are “reasonably designed” to manage the fund’s derivatives risks. Below we estimate the initial 

and annual ongoing burdens associated with documentation and any review and revision of the 

limited derivatives users’ policies and procedures. 

Table 7 below summarizes the proposed PRA initial and ongoing annual burden 

estimates associated with the policies and procedures requirement for limited derivatives users 

under proposed rule 18f-4. We do not estimate that there will be any initial or ongoing external 

costs associated with the policies and procedures requirement for limited derivatives users. 

                                                      
644  See proposed rule 18f-4(c)(3); supra section II.E (discussing the proposed policies and 

procedures requirement for limited derivatives users). 
645  See supra paragraph following note 526. 



344 

Table 7: Policies and Procedures for Limited Derivatives Users PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours1  Wage rate2 Internal time costs 

PROPOSED ESTIMATES 

Written policies and procedures 
3 hours 1 hour × $329 (senior manager) 4 $329 

3 hours 1 hour × $365 (compliance attorney) 4 $365 

Review of policies and procedures 
0 hours .25 hours  $329 (senior manager) 4 $82.25 

0 hours .25 hours  $365 (compliance attorney) 4 $91.25 

Total annual burden per fund  2.5 hours   $867.50 

Number of funds  × 2,398   × 2,398 

Total annual burden  5,995 hours   $2,080,265 

Notes: 
1. For “Written Policies and Procedures,” these estimates include initial burden 
estimates annualized over a three-year period. 
2. See supra note 628. 
 



 

345 

7. Recordkeeping Requirements 

Proposed rule 18f-4 would require a fund to maintain certain records documenting its 

derivatives risk management program’s written policies and procedures, along with its stress test 

results, VaR backtesting results, internal reporting or escalation of material risks under the 

program, and reviews of the program.646 The proposed rule would also require a fund to maintain 

records of any materials provided to the fund’s board of directors in connection with approving 

the designation of the derivatives risk manager and any written reports relating to the derivatives 

risk management program.647 A fund that is required to comply with the proposed VaR test 

would also have to maintain records documenting the determination of: its portfolio VaR; the 

VaR of its designated reference indexes, as applicable; its VaR ratio (the value of the VaR of the 

Fund’s portfolio divided by the VaR of the designated reference index), as applicable; and any 

updates to any of its VaR calculation model and the basis for any material changes to its VaR 

model.648 A fund that is a limited derivatives users under the proposed rule would have to 

maintain a written record of its policies and procedures that are reasonably designed to manage 

derivatives risks.649 A fund engaging in unfunded commitment agreements would be required to 

maintain records documenting the sufficiency of its funds to meet its obligations with respect to 

all unfunded commitment agreements.650  

                                                      
646  See proposed rule 18f-4(c)(6)(i)(A); supra section II.K (discussing the proposed recordkeeping 

requirements). 
647  See proposed rule 18f-4(c)(6)(i)(B). 
648  See proposed rule 18f-4(c)(6)(i)(C). 
649   See proposed rule 18f-4(c)(6)(i)(D). 
650   See proposed rule 18f-4(e)(2). 



346 

We estimate that 5,091 funds would be subject to the recordkeeping requirements.651 

Below we estimate the average initial and ongoing annual burdens associated with the 

recordkeeping requirements. This average takes into account that some funds such as limited 

derivatives users may have less extensive recordkeeping burdens than other funds that use 

derivatives more substantially. 

Table 8 below summarizes the proposed PRA estimates associated with the 

recordkeeping requirements in rule 18f-4. 

                                                      
651  See supra notes 468, 499 and accompanying text, and paragraph following note 526 (2,693 funds 

that would be subject to the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and 
complying with the related limited derivatives user requirements). 



347 

Table 8: Recordkeeping PRA Estimates 

 Internal 
initial 

burden 
hours 

Internal 
annual burden 

hours1  Wage rate2 
Internal time 

costs 
Initial external 

cost burden 

Annual 
external cost 

burden 

PROPOSED ESTIMATES 

Establishing recordkeeping 
policies and procedures 

1.5 .5  $62 (general clerk) $31 
$1,800 $600 

1.5 .5  $95 (senior computer operator) $47.50 

Recordkeeping 0 hours 2 hours × $62 (general clerk) $31 
$0 $0 

 0 hours 2 hours × $95 (senior computer operator) $47.50 

Total annual burden per 
fund 

 5 hours   $157  $600 

Number of funds  × 5,091   × 5,091  5,091 

Total annual burden  25,455 hours   $799,287  $3,054,600 

  

Notes: 
1. For “Establishing Recordkeeping Policies and Procedures,” these estimates 
include initial burden estimates annualized over a three-year period. 
2. See supra note 628. 

 
 



 

348 

8. Proposed Rule 18f-4 Total Estimated Burden 

As summarized in Table 9 below, we estimate that the total hour burdens and time costs 

associated with proposed rule 18f-4, including the burden associated with documenting the 

derivatives risk management program, board oversight and reporting, disclosure requirements 

associated with the proposed VaR tests, disclosure requirements associated with the alternative 

requirements for leveraged/inverse funds, policies and procedures development for limited 

derivatives users, and recordkeeping, amortized over three years, would result in an average 

aggregate annual burden of 109,754 hours and an average aggregate annual monetized time cost 

of $54,761,797. We also estimate that, amortized over three years, there would be external costs 

of $3,054,600 associated with this collection of information. Therefore, each fund that relies on 

the rule would incur an average annual burden of approximately 20.56 hours, at an average 

annual monetized time cost of approximately $10,757, and an external cost of $600 to comply 

with proposed rule 18f-4.652 

                                                      
652  These per-fund burden estimates likely overestimate the total burden of proposed rule 18f-4 

because not all funds (e.g., limited derivatives users) would incur the various burdens set forth in 
the table.  



349 

Table 9: Proposed Rule 18f-4 Total PRA Estimates 

 Internal 
hour burden 

Internal  
burden time cost 

External  
cost burden 

Derivatives risk management program 48,474 hours $19,195,704 $0 

Board oversight and reporting 26,930 hours $31,739,698 $0 

Disclosure requirement associated 
with limit on fund leverage risk 2,424 hours $816,888 $0 

Disclosure requirement associated 
with alternative requirements for 

leveraged/inverse funds 
269 hours $45,192 $0 

Disclosure changes for money market 
funds 207 hours $69,384 $0 

Policies and procedures for limited 
derivatives users 5,995 hours $2,080,265 $0 

Recordkeeping requirements 25,455 hours $799,287 $3,054,600 

Total annual burden 109,754 $54,746,418 $3,054,600 

Number of funds ÷ 5,091 ÷ 5,091 ÷ 5,091 

Average annual burden per fund 20.56 hours $10,754 $600 

 

C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers 

Proposed rule 15l-2 would impose burdens on registered broker-dealers relating to 

investments in leveraged/inverse investment vehicles by their retail customers.653 The proposed 

rule is designed to address investor protection concerns relating to leveraged/inverse investment 

vehicles by helping to ensure that retail investors in these products are capable of evaluating their 

characteristics and the unique risks they present. The collections of information under proposed 

rule 15l-2, discussed below, would assist the Commission with its accounting, auditing and 

oversight functions. The respondents to the proposed rule would be broker-dealers registered 

under the Exchange Act with retail customers that transact in leveraged/inverse investment 

vehicles. Compliance with proposed rule 15l-2 would be mandatory for all such broker-dealers. 

                                                      
653  Specifically, the proposed sales practices rules (proposed rule 15l-2, as well as proposed rule 

211(h)-1 under the Advisers Act), would require broker-dealers and investment advisers to 
engage in due diligence before accepting or placing an order for a retail investor to trade a 
leveraged/inverse investment vehicle or approving an investor’s account for such trading. See 
supra section II.G.2.  



350 

To the extent that records required to be created and maintained by broker-dealers under the 

proposed rule are provided to the Commission in connection with examinations or investigations, 

such information would be kept confidential subject to the provisions of applicable law. 

We estimate that, as of December 31, 2018, there were approximately 2,766 broker-

dealers registered with the Commission that reported some sales to retail customer investors.654 

We further estimate that 700 of those broker dealers with retail customer accounts 

(approximately 25%) have retail customer accounts that invest in leveraged/inverse investment 

vehicles. 

1. Due Diligence and Account Approval 

Under proposed rule 15l-2, before accepting an order from a customer that is a natural 

person (or the legal representative of a natural person) to buy or sell shares of a leveraged/inverse 

investment vehicle, or approve such a customer’s account to engage in those transactions, the 

broker-dealer must approve the customer’s account to engage in those transactions in accordance 

with the proposed rule.655 To make this determination, the broker-dealer must exercise due 

diligence to ascertain certain facts about the customer, his or her financial situation, and 

investment objectives. To comply with this due diligence requirement, the broker-dealer must 

seek to obtain certain information described in the proposed rule. This proposed rule is modeled, 

in large part, after the FINRA rule requiring due diligence and account approval for retail 

investors to trade in options. Based on our understanding of how broker-dealers comply with the 

FINRA options account requirements, we believe that a common way for broker-dealers to 

comply with this due diligence obligation would be to utilize in-house legal and compliance 
                                                      
654 Our estimates relating to retail sales by broker-dealers are based on data obtained from Form BD 

and Form BR. See also supra note 544 and accompanying text. 
655  See supra section II.G.2.b. 



351 

counsel, as well as in-house computer and website specialists, to create an online form for 

customers to provide the required information for approval of their accounts to trade in 

leveraged/inverse investment vehicles. We also believe that a portion of the due diligence would 

be performed by individuals associated with a broker-dealer or by telephone or in-person 

meetings with investors. Based on our understanding of current broker-dealer practices, we do 

not believe there would be any initial or ongoing external costs associated with the proposed 

broker-dealer due diligence requirement. 

Currently, there are 105 leveraged/inverse mutual funds, 164 leveraged/inverse ETFs, 

and 17 exchange-listed commodity- or currency-based trusts or funds that meet the definition of 

“leveraged/inverse investment vehicle” under the proposed rule.656 Accordingly, there are 286 

leveraged/inverse investment vehicles in total for which a broker-dealer would be required to 

approve a retail customer’s account before the customer could transact in the shares of those 

vehicles. Based on our experience with broker-dealers and leveraged/inverse investment 

vehicles, we estimate that each of these leveraged/inverse investment vehicles is held by 

approximately 2,500 separate retail investor accounts held by registered broker dealers, for a 

total of 715,000 existing accounts requiring approval to trade in leveraged/inverse investment 

vehicles. We further estimate that approximately 10,000 new retail accounts will be opened each 

year requiring approval to trade in leveraged/inverse investment vehicles.657 

Table 10 below summarizes our initial and ongoing PRA burden estimates associated 

with the due diligence and account approval requirements in proposed rule 15l-2. Based on our 

understanding of current broker-dealer practices, we do not estimate that there will be any initial 

                                                      
656  See supra note 468 and accompanying text. 
657  See supra note 546 and accompanying text. 



352 

or ongoing external costs associated with the proposed due diligence and account approval 

requirements. 



 

353 

Table 10: Proposed Rule 15l-2 Due Diligence and Account Approval PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours1  Wage rate2 

Internal time 
costs 

Initial external cost 
burden 

Annual external cost 
burden 

PROPOSED ESTIMATES 

Development and implementation of 
customer due diligence  

6 hours 2 hours × $365 (compliance 
attorney) $730 

  9 hours 3 hours × $284 (senior systems 
analyst) 

$852 

12 hours 4 hours × $331 (senior 
programmer) 

$1324 

Annual burden per broker-dealer  9 hours   $2906   

Estimated number of affected  
broker- dealers  700   700   

Total burden (I)  6300 hours   $2,034,200   

Customer due diligence 
3 hours 1 hour × $365 (compliance 

attorney) 
$365 

  
3 hours 1 hour × 

$70 (compliance 
clerk) $70 

Evaluation of customer information for 
account approval/disapproval 1 hour .33 hours × $309 (compliance 

manager) $101.97   

Total annual burden per customer account 7 hours 2.33 hours   $536.97   

Estimated number of affected customer 
accounts  × 248,333.333   × 248,333.33 × 248,333.33 × 248,333.33 

Total burden (II)  578,616.66 hours   $133,347,548   

Total annual burden (I+II)  584,916.66 hours   $135,381,748 $0 $0 

 
 
Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. 
3. We estimate that 715,000 existing customer accounts with broker-dealers would require the proposed rule 15l-2 account approval for trading in leveraged/inverse investment 
vehicles, and that 10,000 new customer accounts opened each year would require such approval. Accordingly, we believe that over a three-year period, a total of 745,000 accounts will 
require approval, which when annualized over a three-year period, equals 248,333.33 accounts per year. 



 

354 

 
2. Policies and Procedures 

Proposed rule 15l-2 requires broker-dealers to adopt and implement policies and 

procedures reasonably designed to achieve compliance with the proposed rule’s provisions.658 

We believe that broker-dealers likely would establish these policies and procedures by adjusting 

their current systems for implementing and enforcing compliance policies and procedures. While 

broker-dealers already have policies and procedures in place to address compliance with other 

Commission rules (among other obligations), they would need to update their existing policies 

and procedures to account for rule 15l-2. To comply with this obligation, we believe that broker-

dealers would use in-house legal and compliance counsel to update their existing policies and 

procedures to account for the requirements of rule 15l-2. For purposes of these PRA estimates, 

we assume that broker-dealers would review the policies and procedures that they would adopt 

under proposed rule 15l-2 annually (for example, to assess whether the policies and procedures 

continue to be “reasonably designed” to achieve compliance with the proposed rule). We 

therefore have estimated initial and ongoing burdens associated with the proposed policies and 

procedures requirement. As discussed above, we estimate that approximately 700 broker dealers 

have retail customer accounts that invest in leveraged/inverse investment vehicles. We do not 

estimate that there will be any initial or ongoing external costs associated with the proposed 

policies and procedures requirement. 

Table 11 below summarizes our initial and ongoing annual PRA burden estimates 

associated with the policies and procedures requirement in proposed rule 15l-2.

                                                      
658   See supra section II.G.2.b. 



 

355 

Table 11: Proposed Rule 15l-2 Policies and Procedures PRA Estimates 

 Internal 
initial 

burden 
hours 

Internal annual 
burden hours1  Wage rate2 

Internal time 
costs 

PROPOSED ESTIMATES 

Establishing and implementing rule 
15l-2 policies and procedures 

3 hours 1 hour × $309 (compliance manager) $309.00 

1 hours 0.33 hours × $365 (compliance attorney) $120.45 

1 hour 0.33 hours × $530 (chief compliance officer) $174.90 

Reviewing and updating rule 15l-2 
policies and procedures 

 1 hour × $309 (compliance manager) $309.00 

 1 hour × $365 (compliance attorney) $365.00 

 1 hour × $530 (chief compliance officer) $530.00 

Total annual burden per broker-dealer  4.66 hours   $1,808.35 
Number of affected broker-dealers  × 700   × 700 

Total annual burden  3,262 hours   $1,265,845 

Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. 

 



 

356 

3. Recordkeeping 

Under proposed rule 15l-2, a broker-dealer would have to maintain a written record of the 

information that it obtained under the rule 15l-2 due diligence requirement and its written 

approval of the customer’s account, as well as the firm’s policies and procedures, for a period of 

not less than six years (the first two years in an easily accessible place) after the date of the 

closing of the client’s account.659 To comply with this obligation, we believe that broker-dealers 

would use in-house personnel to compile and maintain the relevant records. We do not estimate 

that there will be any initial or ongoing external costs associated with this requirement. 

Table 12 below summarizes our PRA initial and ongoing annual burden estimates 

associated with the recordkeeping requirement in proposed rule 15l-2. 

  

                                                      
659   See supra section II.G.2.c. 



357 

Table 12: Proposed Rule 15l-2 Recordkeeping PRA Estimates 

 Internal initial burden 
hours 

Internal annual burden 
hours  Wage rate1 

Internal time 
costs 

PROPOSED ESTIMATES 

Recordkeeping 0 hours 1 hour × $62 (general clerk) $62 

 0 hours 1 hour × $95 (senior computer 
operator) 

$95 

Total annual burden per broker-
dealer 0 hours 2 hours   $157 

Number of affected broker-
dealers × 700 × 700   × 700 

Total annual burden 0 hours 1,400 hours   $109,900 

Notes: 
1. See supra note 628.  
 

 

4. Proposed Rule 15l-2 Total Estimated Burden 

As summarized in Table 13 below, we estimate that the total hour burdens and time costs 

associated with proposed rule 15l-2, including the burden associated with the due diligence and 

account approval requirement, the policies and procedures requirement, and the recordkeeping 

requirement, would result in an average aggregate annual burden of 589,578.66 hours and an 

average aggregate time cost of $136,757,493. Therefore, each broker-dealer would incur an 

annual burden of approximately 842.26 hours, at an average time cost of approximately 

$195,367.85, to comply with proposed rule 15l-2. 

  



358 

Table 13: Proposed Rule 15l-2 Total PRA Estimates 

 Internal initial 
burden hours 

Internal burden 
time cost 

External  
cost burden 

Due diligence and account approval  
 584,916.66 

hours 
$135,381,748 $0 

Policies and procedures 3,262 hours $1,265,845 $0 

Recordkeeping 1,400 hours $109,900 $0 

Total annual burden 589,578.66 hours $136,757,493 $0 

Number of affected broker-dealers  ÷ 700 ÷ 700 ÷ 700 

Average annual burden per affected 
broker-dealer 

 842.26 hours $195,367.85 $0 

 
D. Proposed Rule 211(h)-1: Sales Practices for Registered Investment 

Advisers 

Proposed 211(h)-1 would impose burdens on registered investment advisers relating to 

investments in leveraged/inverse investment vehicles by their retail clients.660 Proposed rule 

211(h)-1 is designed to address investor protection concerns relating to leveraged/inverse 

investment vehicles by helping to ensure that retail investors in these products are capable of 

evaluating their characteristics and the unique risks they present. The Commission also believes 

that the collections of information under proposed rule 211(h)-1, discussed below, would assist 

the Commission with its accounting, auditing and oversight functions. 

The respondents to the proposed rule would be investment advisers registered under the 

Advisers Act that place orders for retail clients to invest in leveraged/inverse investment 

vehicles. Compliance with proposed rule 211(h)-1 would be mandatory for all such investment 

advisers. To the extent that records required to be created and maintained by investment advisers 

under the proposed rule are provided to the Commission in connection with examinations or 

investigations, such information would be kept confidential subject to the provisions of 

applicable law. 

                                                      
660   See supra note 653. 



359 

We estimate that, as of December 31, 2018, approximately 8,235 investment advisers 

registered with the Commission have some portion of their business dedicated to retail investors, 

including either individual high net worth clients or individual non-high net worth clients.661 

Based on our experience with registered investment advisers, we further estimate that 2,000 of 

these investment advisers with retail client accounts (approximately 25%) have retail client 

accounts that invest in leveraged/inverse investment vehicles. As such, the investment advisers 

for those client accounts would be subject to the requirements of proposed rule 211(h)-1.662 

1. Due Diligence and Account Approval 

Under proposed rule 211(h)-1, before placing an order for the account of a client that is a 

natural person (or the legal representative of a natural person) to buy or sell shares of a 

leveraged/inverse investment vehicle, or approving such a client’s account to engage in those 

transactions, the investment adviser must approve the client’s account to engage in those 

transactions in accordance with the proposed rule.663 To make this determination, the adviser 

must exercise due diligence to ascertain certain facts about the client, his or her financial 

situation, and investment objectives. To comply with this due diligence requirement, the 

investment adviser must seek to obtain certain information described in the proposed rule. Based 

on our understanding of how broker-dealers comply with the FINRA options account 

requirements, as discussed above (which we assume, for purposes of this PRA estimate, that 

investment advisers could model their compliance programs after), we believe that investment 

advisers likely would comply with this due diligence obligation by utilizing in-house legal and 

                                                      
661  Based on responses to Item 5.D of Form ADV. 
662  See supra note 548 and accompanying paragraph. 
663  See proposed rule 211(h)-1; supra section II.G.2. 



360 

compliance counsel, as well as in-house computer and website specialists, to create an online 

form for clients to complete with the required information for approval of their accounts to trade 

in leveraged/inverse investment vehicles.664 We also believe that a portion of the due diligence 

would be performed by individuals associated with an investment adviser by telephone or in-

person meetings with investors. 

Currently, there are 105 leveraged/inverse mutual funds, 164 leveraged/inverse ETFs, 

and 17 exchange-listed commodity- or currency-based trusts or funds that meet the definition of 

“leveraged/inverse investment vehicle” under the proposed rule.665 Accordingly, there are 286 

leveraged/inverse investment vehicles in total for which an investment adviser would be required 

to approve a retail client’s account before the client could transact in the shares those vehicles. 

Based on our experience with registered investment advisers, we estimate that each of these 

leveraged/inverse investment vehicles is held by approximately 2,500 separate retail investor 

accounts held by investment advisers, for a total of 715,000 existing accounts requiring approval 

to trade in leveraged/inverse investment vehicles. Based on our experience, we further estimate 

that approximately 10,000 new retail accounts will be opened each year requiring approval to 

trade in leveraged/inverse investment vehicles.666 

Table 14 below summarizes our initial and ongoing PRA burden estimates associated 

with the due diligence requirement in proposed rule 211(h)-1. We do not estimate that there will 

be any initial or ongoing external costs associated with the proposed due diligence and approval 

requirements.

                                                      
664   See supra paragraph accompanying note 655. 
665  See supra note 468 and accompanying text. 
666  See supra note 548 and accompanying text.361 

Table 14: Proposed Rule 211(h)-1 Due Diligence and Account Approval PRA Estimates 

 Internal 
initial 

burden 
hours 

Internal annual 
burden hours1  Wage rate2 

Internal time 
costs 

Initial 
external 

cost 
burden 

Annual external 
cost burden 

PROPOSED ESTIMATES 

Development and implementation of  
client due diligence   

6 hours 2 hours × $365 (compliance attorney) $730 

$0 $0 9 hours 3 hours × $284 (senior systems analyst) $852 

12 hours 4 hours × $331 (senior programmer) $1324 

Annual burden per investment adviser  9 hours   $2906   

Estimated number of affected  
investment advisers  2000   2000   

Total burden (I)  18,000 hours   $5,812,000   

Client due diligence 
3 hours 1 hour × $365 (compliance attorney) $365 

  
3 hours 1 hour ×  $70 (compliance clerk) $70 

Evaluation of client information for 
account approval/disapproval 1 hour .33 hours  $309 (compliance manager)  $101.97   

Total annual burden per client 
account 7 hours 2.33 hours   $536.97   

Estimated number of affected client 
accounts  × 248,333.333   × 248,333.33   

Total burden (II)  578,616.66 hours   $133,347,548   

Total annual burden (I+II)  596,616.66 hours   $139,159,548 $0 $0 

 
 
Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. 
3. We estimate that 715,000 existing client accounts with registered investment advisers would require the proposed rule 211(h)-1 account approval for trading in leveraged/inverse 
investment vehicles, and that 10,000 new client accounts opened each year would require such approval. Accordingly, we believe that over a three-year period, a total of 745,000 client 
accounts would require approval, which when annualized over a three-year period, is 248,333.33 accounts per year.



 

362 

 
2. Policies and Procedures 

Proposed rule 211(h)-1 requires investment advisers to adopt and implement policies and 

procedures reasonably designed to achieve compliance with the proposed rule’s provisions.667 

We believe that investment advisers likely would establish these policies and procedures by 

adjusting their current systems for implementing and enforcing compliance policies and 

procedures. While investment advisers already have policies and procedures in place to address 

compliance with other Commission rules (among other obligations), they would need to update 

their existing policies and procedures to account for rule 211(h)-1. To comply with this 

obligation, we believe that investment advisers would use in-house legal and compliance counsel 

to update their existing policies and procedures to account for the requirements of rule 211(h)-1. 

For purposes of these PRA estimates, we assume that investment advisers would review the 

policies and procedures that they would adopt under proposed rule 211(h)-1 annually (for 

example, to assess whether the policies and procedures continue to be “reasonably designed” to 

achieve compliance with the proposed rule, and in compliance with Advisers Act rule 206(4)-

7(b)). We therefore have estimated initial and ongoing burdens associated with the proposed 

policies and procedures requirement. We do not estimate that there will be any initial or ongoing 

external costs associated with the proposed policies and procedures requirement. 

Table 15 below summarizes our PRA estimates associated with the policies and 

procedures requirement in proposed rule 211(h)-1. 

 

                                                      
667   See supra section II.G.2.b. 



 

363 

Table 15: Proposed Rule 211(h)-1 Policies and Procedures PRA Estimates 

 Internal 
initial 

burden 
hours 

Internal annual 
burden hours1  Wage rate2 

Internal time 
costs 

PROPOSED ESTIMATES 

Establishing and implementing rule 
211(h)-1 policies and procedures 

3 hours 1 hour x $309 (compliance manager) $309 

1 hours 0.33 hours x $365 (compliance attorney) $120.45 

1 hour 0.33 hours x $530 (chief compliance officer) $174.90 

Reviewing and updating rule 211(h)-1 
policies and procedures 

 1 hour  $309 (compliance manager) $309 

 1 hour  $365 (compliance attorney) $365 

 1 hour  $530 (chief compliance officer) $530 

Total annual burden per investment 
adviser  4.66 hours   $1808.35 

Number of affected investment 
advisers  × 2,000   × 2,000 

Total annual burden  9,320 hours   $3,616,700 

Notes: 
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628.  
 

 



 

364 

3. Recordkeeping 

Under the proposed rule, a registered investment adviser would have to maintain a 

written record of the information that it obtained under the rule 211(h)-1 due diligence 

requirement and its written approval of the client’s account for buying or selling shares of 

leveraged/inverse investment vehicles, as well as the firm’s policies and procedures, for a period 

of not less than six years (the first two years in an easily accessible place) after the date of the 

closing of the client’s account.668 To comply with this obligation, we believe that investment 

advisers would use in-house personnel to compile and maintain the relevant records. We do not 

estimate that there will be any initial or ongoing external costs associated with this requirement. 

Table 16 below summarizes our PRA estimates associated with the recordkeeping 

requirement in proposed rule 211(h)-1.  

                                                      
668   See supra section II.G.2.c. 



365 

Table 16: Proposed Rule 211(h)-1 Recordkeeping PRA Estimates 

 Internal 
initial 

burden 
hours 

Internal 
annual burden 

hours1  Wage rate2 
Internal time 

costs 

PROPOSED ESTIMATES 

Recordkeeping 0 hours 2.5 hours × $62 (general clerk) $155 

 0 hours 2.5 hours × $95 (senior computer operator) $237.50 

Total annual burden per 
investment adviser 0 hours 5 hours   $392.50 

Number of affected 
investment advisers × 2000 × 2000   × 2000 

Total annual burden 0 hours 10,000   $785,000 

Notes:  
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628.  
 

 

4. Proposed Rule 211(h)-1 Total Estimated Burden 

As summarized in Table 17 below, we estimate that the total hour burdens and time costs 

associated with proposed rule 211(h)-1, including the burden associated with the due diligence 

and account approval requirement, the policies and procedures requirement, and the 

recordkeeping requirement, would result in an average aggregate annual burden of 615,936.66 

hours and an average aggregate time cost of $143,561,248. Therefore, each investment adviser 

would incur an annual burden of approximately 307.97 hours, at an average time cost of 

approximately $71,780.62 to comply with proposed rule 211(h)-1. 

Table 17: Proposed Rule 211(h)-1 Total Estimated PRA Burden 

 
Internal initial 
burden hours 

Internal  
burden time cost 

External  
cost burden 

Due diligence and account approval 596,616.66 $139,159,548 $0 

Policies and procedures  9,320 $3,616,700 $0 

Recordkeeping 10,000 $785,000 $0 

Total annual burden 615,936.66 $143,561,248 $0 

Number of affected investment 
advisers 

÷ 2000 ÷ 2000 ÷ 2000 

Average annual burden per 
investment adviser 307.97 $71,780.62 $0 

 



366 

E. Rule 6c-11 

We recently adopted rule 6c-11, which permits ETFs that satisfy certain conditions to 

operate without first obtaining an exemptive order from the Commission.669 The rule is designed 

to create a consistent, transparent, and efficient regulatory framework for such ETFs and 

facilitate greater competition and innovation among ETFs. Rule 6c-11 includes a provision 

excluding leveraged/inverse ETFs from the scope of ETFs that may rely on that rule. To promote 

a level playing field among ETFs, and in view of the other conditions we are proposing to place 

on leveraged/inverse ETFs under proposed rule 18f-4 and on transactions in leveraged/inverse 

ETFs’ securities under proposed rule 15l-2 and 211(h)-1, we are proposing to amend rule 6c-11 

to permit leveraged/inverse ETFs to rely on that rule. Because we believe this proposed 

amendment would increase the number of funds relying on rule 6c-11, we are updating the PRA 

analysis for rule 6c-11 to account for any burden increases that would result from this increase in 

respondents to that rule. We are not updating the rule 6c-11 PRA analysis in any other respect. 

Rule 6c-11 requires an ETF to disclose certain information on its website, to maintain 

certain records, and to adopt and implement certain written policies and procedures. The purpose 

of these collections of information is to provide useful information to investors who purchase 

and sell ETF shares in secondary markets and to allow the Commission to better monitor reliance 

on rule 6c-11 and will assist the Commission with its accounting, auditing and oversight 

functions. 

The respondents to rule 6c-11 will be ETFs registered as open-end management 

investment companies other than share class ETFs and non-transparent ETFs. This collection 

will not be mandatory, but will be necessary for those ETFs seeking to operate without 
                                                      
669  See supra notes 353-356 and accompanying text.  



367 

individual exemptive orders, including all ETFs whose existing exemptive orders will be 

rescinded. Information provided to the Commission in connection with staff examinations or 

investigations will be kept confidential subject to the provisions of applicable law. 

Under current PRA estimates, 1,735 ETFs would be subject to these requirements. The 

current PRA estimates for rule 6c-11 include 74,466.2 total internal burden hours, 

$24,771,740.10 in internal time costs, and $1,735,000 in external time costs. 

We continue to believe that the current annual burden and cost estimates for rule 6c-11 

are appropriate, but estimate that the proposed amendment to rule 6c-11 would result in an 

increase in the number of respondents. Specifically, we estimate that an additional 164 ETFs (all 

leveraged/inverse ETFs) would rely on rule 6c-11, resulting in an increase in the number of 

respondents to 1,899 ETFs.670 Table 18 below summarizes these revisions to the estimated 

annual responses, burden hours, and burden-hour costs based on the proposed amendment to rule 

6c-11. 

                                                      
670 See supra note 468 and accompanying text. 



 

368 

Table 18: Rule 6c-11 PRA Estimates 

 
Previously estimated 
annual internal hour 

burden1 

Updated estimated 
annual internal hour 

burden2 

Previously estimated 
annual internal burden 

time cost 

Updated estimated 
annual internal time 

burden cost 

Previously estimated 
annual external cost 

burden 

Updated estimated 
annual external cost 

burden 

Website disclosure 33,398.75 hours 36,555.75 hours $10,717,945.15 $11,731,053.51 $1,735,000 $1,899,000 

Recordkeeping 8,675 hours 9,495 hours $680,987.50 $745,357.50 $0 $0 

Policies and 
procedures 32,392.45 hours 35,454.33 hours $13,372,807.45 $14,636,865.33 $0 $0 

Total annual burden 74,466.2 hours 81,505.08 hours $24,771,740.10 $27,113,276.34 $1,735,000 $1,899,000 

Number of affected 
ETFs ÷ 1,735 ÷ 1,899 ÷ 1,735 ÷ 1,899 ÷ 1,735 ÷ 1,899 

Average annual 
burden per ETF 42.92 hours 42.92 hours $14,277.66 $14,277.66 $1,000 $1,000 

Notes:  
1. The previously estimated burdens and costs in this table are based on an estimate of 1,735 ETFs relying on rule 6c-11. 
2. The updated estimated burdens and costs in this table are based on an estimate of 164 leveraged/inverse ETFs that would rely on rule 6c-11 pursuant to the proposed amendment to that 
rule, for a total estimate of 1,899 ETFs that would rely on rule 6c-11. 



 

369 

F. Form N-PORT 

We are proposing to amend Form N-PORT to add new items to Part B (“Information 

About the Fund”), as well as to make certain amendments to the form’s General Instructions.  

Form N-PORT, as amended, would require funds to provide information about their 

derivatives exposure.671 We estimate that 5,091 funds would be subject to this exposure-related 

disclosure requirement.672  

In addition, funds that are subject to the limit on fund leverage risk in proposed rule 18f-4 

would have to report certain VaR-related information, including: (1) the fund’s highest daily 

VaR during the reporting period and its corresponding date; and (2) the fund’s median daily VaR 

for the reporting period. Funds subject to the relative VaR test during the reporting period also 

would have to report: (1) the name of the fund’s designated reference index, (2) the index 

identifier, (3) the fund’s highest daily VaR ratio during the reporting period and its 

corresponding date; and (4) the fund’s median daily VaR ratio for the reporting period.673 

Finally, all funds that are subject to the proposed limit on fund leverage risk also would have to 

report the number of exceptions that the fund identified as a result of the backtesting of its VaR 

calculation model.674 We estimate that 2,424 funds would be subject to these VaR-related 

disclosure requirements.675 

                                                      
671   See proposed Item B.9 of Form N-PORT; supra section II.H.1.a. 
672  See supra notes 468, 499 and accompanying text, and paragraph following note 526 (2,693 funds 

that would be subject to the proposed derivatives risk management program and limit on fund 
leverage risk requirements + 2,398 funds relying on the limited derivatives user exception and 
complying with the related limited derivatives user requirements). 

673   See proposed Item B.10 of Form N-PORT; supra section II.H.1.b. 
674  See id. 
675   See supra paragraph following note 526. 



370 

Preparing reports on Form N-PORT is mandatory for all management investment 

companies (other than money market funds and small business investment companies) and UITs 

that operate as ETFs and is a collection of information under the PRA. The information required 

by Form N-PORT must be data-tagged in XML format. Responses to the reporting requirements 

will be kept confidential, subject to the provisions of applicable law, for reports filed with 

respect to the first two months of each quarter; the third month of the quarter will not be kept 

confidential, but made public sixty days after the quarter end. Form N-PORT is designed to 

assist the Commission its regulatory, disclosure review, inspection, and policymaking roles, and 

to help investors and other market participants better assess different fund products.676 

Based on current PRA estimates, we estimate that funds prepare and file their reports on 

Form N-PORT either by (1) licensing a software solution and preparing and filing the reports in 

house, or (2) retaining a service provider to provide data aggregation, validation and/or filing 

services as part of the preparation and filing of reports on behalf of the fund. We estimate that 

35% of funds subject to the proposed N-PORT filing requirements would license a software 

solution and file reports on Form N-PORT in house, and the remainder would retain a service 

provider to file reports on behalf of the fund. 

Table 19 below summarizes our PRA initial and ongoing annual burden estimates 

associated with the proposed amendments to Form N-PORT. 

                                                      
676  The specific purposes for each of the new proposed reporting items are discussed in section II.H.1 

supra. 



371 

Table 19: Form N-PORT PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours1  Wage rate2 

Internal time 
costs 

Initial external 
cost burden 

Annual external 
cost burden 

PROPOSED ESTIMATES 

Report derivatives exposure 
information 

2 hours 4.33 hours3 × $365 (compliance attorney) $1,580 

$5,590 $4,210 

2 hours 4.33 hours × $331 (senior programmer) $1,433 

Total new burden for derivatives 
exposure information  8.66 hours   $3,013 

Number of funds for derivatives 
exposure information  × 5,091   × 5,091 

Total new annual burden for 
derivatives exposure information (I)  44,088 hours   $15,339,183 

Report VaR-related information 
2 hours 4.33 hours × $365 (compliance attorney) $1,580 

2 hours 4.33 hours × $331 (senior programmer) $1,433 

Total new burden for VaR-related 
information  

 

8.66 hours 

× 2,424 

 

 

 

 

$3,013 

× 2,424 Number of funds for VaR-related 
information 

Total new annual burden for VaR-
related information (II)  20,992 hours   $7,303,512 

Total new annual burden (I + II)  65,080 hours   $22,642,695  $21,433,1104 

Current burden estimates  1,803,826 hours     $103,776,240 

Revised burden estimates  1,868,906 hours     $125,209,350 

Notes:  
1. Includes initial burden estimates annualized over a three-year period. 
2. See supra note 628. These PRA estimates assume that the same types of 
professionals would be involved in the proposed reporting requirements that we 
believe otherwise would be involved in preparing and filing reports on Form N-PORT. 
3. This estimate assumes that, annually after the initial 2 hours to comply with the 
new N-PORT requirements, each of a compliance attorney and a senior programmer 
would incur 1 burden hours per filing associated with the new reporting 
requirements. The estimate of 4.33 hours is based on the following calculation: ((2 
hours for the first filing x 1 = 2) + (3 additional filings in year 1 x 1 hour for each of 
the additional 3 filings in year 1 = 3) + (4 filings in years 2 and 3 x 1 hour per filing x 
2 years) = 8) / 3 = 4.33. 
4. This estimate is based on the following calculation: $4,210 (average costs for 
funds reporting the proposed information on Form N-PORT) * 5,091 funds (which 
includes funds reporting derivative exposure information and VaR-related 
information). 



 

372 

G. Form N-RN 

We are proposing to amend Form N-LIQUID (which we propose to re-title as “Form N-

RN”) to add new current reporting requirements for funds subject to the proposed VaR-based 

limit on fund leverage risk pursuant to proposed rule 18f-4.677 Specifically, a fund that 

determines that it is out of compliance with the VaR test and has not come back into compliance 

within three business days after such determination would have to file a non-public report on 

Form N-RN providing certain information regarding its VaR test breaches.678 If the portfolio 

VaR of a fund subject to the relative VaR test were to exceed 150% of the VaR of its designated 

reference index for three business days, a fund would have to report: (1) the dates on which the 

fund portfolio’s VaR exceeded 150% of the VaR of its designated reference index; (2) the VaR 

of its portfolio for each of these days; (3) the VaR of its designated reference index for each of 

these days; (4) the name of the designated reference index; and (5) the index identifier. If the 

portfolio VaR of a fund subject to the absolute VaR test were to exceed 10% of the value of the 

fund’s net assets for three business days, a fund would have to report: (1) the dates on which the 

fund portfolio’s VaR exceeded 10% of the value of its net assets; (2) the VaR of its portfolio for 

each of these days; and (3) the value of the fund’s net assets for each of these days.  

In addition, if a fund that has filed Part E or Part F of Form N-RN to report it has 

breached its applicable VaR test, has come back into compliance with either the relative VaR test 

or the absolute VaR test, as applicable, it must file a report on Form N-RN to indicate that. 679 

                                                      
677   See supra section II.H.2. 
678  This requirement would be implemented through the proposed amendments to rule 30b1-10 under 

the Investment Company Act, and proposed rule 18f-4(c)(7). For purposes of this PRA analysis, 
the burden associated with the proposed amendments to rule 30b1-10 and proposed rule 18f-
4(c)(7) is included in the collection of information requirements for Form N-RN. 

679   See proposed Part G of Form N-RN. 



373 

Specifically, a fund must report the dates on which its portfolio VaR exceeded, as applicable, 

150% of the VaR of its designated reference index (if the fund is subject to the relative VaR test 

under proposed rule 18f-4(c)(2)(i)) or exceeded 15% of the value of its net assets (if the fund is 

subject to the absolute VaR test under proposed rule 18f-4(c)(2)(ii)).680 Furthermore, a fund must 

also report the current VaR of its portfolio.681  

A fund would have to report information for either VaR test breach, within one business 

day following the third business day after the fund has determined that its portfolio VaR exceeds 

either of the VaR test thresholds, as applicable. Similarly, a fund that has come back into 

compliance with its applicable VaR test would have to file such a report within one business day. 

We estimate that 2,424 funds per year would be required to comply with either of the VaR tests, 

and the Commission would receive approximately 30 filing(s) per year in response to each of the 

new VaR-related items that we proposed to include on Form N-RN, as amended.682 

Under the proposed amendments to Form N-RN, preparing a report on this form would 

be mandatory for any fund that is out of compliance with its applicable VaR test for more than 

three business days, as described above, and for any fund that has come back into compliance 

with its applicable VaR test. A report on Form N-RN is a collection of information under the 

PRA. The VaR test breach information provided on Form N-RN, as well as the information a 

fund provides when it has come back into compliance, would enable the Commission to receive 

information on events that could impact funds’ leverage-related risk more uniformly and 

                                                      
680   Id.  
681   Id. 
682  This estimate is similar to the Commission’s estimates of the number of reports that funds, in the 

aggregate, would submit annually in response to the liquidity-related items of Form N-LIQUID. 
See Liquidity Adopting Release, supra note 360, at nn.1281-1283 and accompanying paragraph. 
See also supra paragraph following note 526. 



374 

efficiently and would enhance the Commission’s oversight of funds when significant fund and/or 

market events occur. The Commission would be able to use the newly required information that 

funds would provide on Form N-RN in its regulatory, disclosure review, inspection, and 

policymaking roles. Responses to the reporting requirements and this collection of information 

would be kept confidential, subject to provisions of applicable law. 

Table 20 below summarizes our PRA initial and ongoing annual burden estimates 

associated with the proposed amendments to funds’ current reporting requirement. Staff 

estimates there will be no external costs associated with this collection of information. We 

further assume similar hourly and cost burdens, as well as similar response rates, for responses to 

either a breach of the absolute VaR test or the relative VaR test. 



375 

Table 20: Form N-RN PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours  Wage rate1 

Internal time 
costs 

PROPOSED ESTIMATES 

Relative or absolute VaR test breach 
reports 

0 hour 0.005 hours2 × $365 (compliance attorney) $1.83 

0 hour 0.005 hours × $331 (senior programmer) $1.66 

Total new annual burden per fund  0.01 hours   $3.49 

Number of funds  × 2,424   × 2,424 

Total new annual burden  24 hours   $8,460 

Current burden estimates  941 hours    

Revised burden estimates  965 hours    

Notes:  
1. See supra note 628. These PRA estimates assume that the same types of 
professionals would be involved in the proposed reporting requirements that we 
believe otherwise would be involved in preparing and filing reports on Form N-
LIQUID. 
2. This estimate is based on the assumption that, of the 2,424 funds that would be 
required to comply with either of the VaR tests, on average the Commission would 
receive 30 reports regarding a relative or absolute VaR test breach and that 
compliance attorney and senior programmer would each spend 30 minutes as part 
of preparing and submitting this report.  

 



 

376 

H. Form N-CEN 

We are proposing to amend Form N-CEN to require a fund to identify whether it relied 

on proposed rule 18f-4 during the reporting period.683 Form N-CEN is a structured form that 

requires registered funds to provide census-type information to the Commission on an annual 

basis. The proposed amendments also would require a fund to identify whether it relied on any of 

the exemptions from various requirements under the proposed rule, specifically: (1) whether the 

fund is a limited derivatives user excepted from the proposed rule’s program requirement, under 

either of the proposed exception’s alternatives (either a funds that limits its derivatives exposure 

to 10% of its net assets, or a fund that uses derivatives transactions solely to hedge certain 

currency risks); or (2) whether it is a leveraged/inverse investment fund covered by the proposed 

sales practices rules that, under proposed rule 18f-4, would be excepted from the proposed limit 

on fund leverage risk. Finally, a fund would have to identify whether it has entered into reverse 

repurchase agreements or similar financing transactions, or unfunded commitment agreements, 

as provided under the proposed rule.  

Preparing a report on Form N-CEN, as amended, would be mandatory for all registered 

funds. Responses would not be kept confidential. We estimate that 12,375 funds would be 

subject to these disclosure requirements.684 

The purpose of Form N-CEN is to satisfy the filing and disclosure requirements of 

section 30 of the Investment Company Act, and of amended rule 30a-1 thereunder. The 

information required to be filed with the Commission assures the public availability of the 

                                                      
683  See supra section II.H.3. 
684  See supra section III.B.1 (9,788 mutual funds + 1,910 ETFs organized as an open-end fund or as 

a share-class of an open-end fund + 664 registered closed-end funds + 13 variable annuity 
separate accounts registered as management investment companies on Form N-3). 



377 

information and is designed to facilitate the Commission’s oversight of registered funds and its 

ability to monitor trends and risks. 

Table 21 below summarizes our PRA initial and ongoing annual burden estimates 

associated with the proposed amendments to Form N-CEN based on current Form N-CEN 

practices and burdens associated with minor amendments to the form. Staff estimates there will 

be no external costs associated with this collection of information.



378 

Table 21: Form N-CEN PRA Estimates 

 Internal initial 
burden hours 

Internal annual 
burden hours  Wage rate1 

Internal time 
costs 

PROPOSED ESTIMATES 

Reporting derivatives-related fund 
census information 

0 hour 0.01 hours × $365 (compliance attorney) $3.7 

0 hour 0.01 hours × $331 (senior programmer) $3.3 

Total new annual burden per fund  0.02 hours   $7 

Number of funds  × 12,375    × 12,375  

Total new annual burden  248 hours   $86,625 

Current burden estimates  74,425 hours    

Revised burden estimates  74,673 hours    

Notes:  
1. See supra note 628. These PRA estimates assume that the same types of 
professionals would be involved in the proposed reporting requirements that we 
believe otherwise would be involved in preparing and filing reports on Form N-CEN. 
2. This estimate assumes each fund reporting on Form N-CEN would spend 1 to 2 
minutes reporting these new data elements. 



 

379 

I. Request for Comments 

We request comment on whether these estimates are reasonable. Pursuant to 44 U.S.C. 

3506(c)(2)(B), the Commission solicits comments in order to: (1) evaluate whether the proposed 

collections of information are necessary for the proper performance of the functions of the 

Commission, including whether the information will have practical utility; (2) evaluate the 

accuracy of the Commission’s estimate of the burden of the proposed collections of information; 

(3) determine whether there are ways to enhance the quality, utility, and clarity of the 

information to be collected; and (4) determine whether there are ways to minimize the burden of 

the collections of information on those who are to respond, including through the use of 

automated collection techniques or other forms of information technology. 

Persons wishing to submit comments on the collection of information requirements of the 

proposed rules and amendments should direct them to the OMB, Attention Desk Officer for the 

Securities and Exchange Commission, Office of Information and Regulatory Affairs, 

Washington, DC 20503, and should send a copy to, Vanessa Countryman, Secretary, Securities 

and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090, with reference to 

File No. S7-24-15. OMB is required to make a decision concerning the collections of 

information between 30 and 60 days after publication of this release; therefore a comment to 

OMB is best assured of having its full effect if OMB receives it within 30 days after publication 

of this release. Requests for materials submitted to OMB by the Commission with regard to these 

collections of information should be in writing, refer to File No. S7-24-15, and be submitted to 

the Securities and Exchange Commission, Office of FOIA Services, 100 F Street, NE, 

Washington, DC 20549- 2736. 

V. INITIAL REGULATORY FLEXBILITY ANALYSIS 

This Initial Regulatory Flexibility Analysis has been prepared in accordance with 



380 

section 3 of the Regulatory Flexibility Act.685 It relates to proposed rules 18f-4, 15l-2, 211(h)-1, 

and proposed amendments to Forms N-PORT, N-LIQUID (which we propose to re-title as 

“Form N-RN”), and N-CEN.686  

A. Reasons for and Objectives of the Proposed Actions 

The Commission is proposing new rules 18f-4, 211(h)-1, and 15l-2, amendments to rule 

6c-11, as well as amendments to Forms N-PORT, N-LIQUID, and N-CEN. These proposed rules, 

and proposed rule and form amendments, are designed to address the investor protection 

purposes and concerns underlying section 18 of the Investment Company Act and to provide an 

updated and more comprehensive approach to the regulation of funds’ use of derivatives and the 

other transactions covered by proposed rule 18f-4.687  

Proposed rule 18f-4 is designed to provide an updated, comprehensive approach to the 

regulation of funds’ use of derivatives and certain other transactions, generally through the 

implementation of a derivatives risk management program, limits on fund leverage risk, board 

oversight and reporting, and related recordkeeping requirements.688 The proposed sales practices 

rules are designed to address certain specific considerations raised by certain leveraged/inverse 

investment vehicles by requiring registered broker-dealers and investment advisers to satisfy due 

diligence and account approval requirements.689 Finally, the proposed amendments to 

                                                      
685  5 U.S.C. 603.  
686  As discussed above, the proposed conforming amendment to Form N-2 does not change the Form 

N-2 collection of information. See supra note 623. We also do not believe there to be any 
reporting, recordkeeping, or compliance burden associated with this proposed conforming 
amendment.  

687  See supra section I.B (discussing the requirements of section 18, and as well as Congress’ 
concerns underlying the limits of section 18). 

688  See supra section II.A.2. 
689   See supra section II.G.381 

Forms N-PORT, N-LIQUID, and N-CEN are designed to enhance the Commission’s ability to 

effectively oversee the use by funds, broker-dealers and investment advisers of the proposed 

rules and to provide the Commission and the public with greater insight into the impact that 

funds’ use of derivatives may have on their portfolios.690  

All of these requirements are discussed in detail in section II of this release. The costs 

and burdens of these requirements on small funds, investment advisers, and broker-dealers are 

discussed below as well as above in our Economic Analysis and Paperwork Reduction Act 

Analysis, which discuss the applicable costs and burdens on all funds, investment advisers, and 

broker-dealers.691  

B. Legal Basis 

The Commission is proposing new rule 18f-4 under the authority set forth in sections 6(c), 

12(a), 18, 31(a), 38(a), and 61 of the Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-

12(a), 80a-18, 80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing amendments to 

rule 6c-11 under the authority set forth in sections 6(c), 22(c), and 38(a) of the Investment 

Company Act [15 U.S.C. 80a-6(c), 22(c), and 80a-37(a)]. The Commission is proposing new 

rule 15l-2 under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 17, 23(a), and 36 of 

the Securities Exchange Act of 1934 [15 U.S.C. 78c, 78c(b), 78c-5, 78j, 78o(l), 78o-10, 78q, 

78w(a), and 78mm]. The Commission is proposing new rule 211(h)-1 under the authority set 

forth in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment Advisers Act of 1940 

[15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and 80b-11(h)]. The Commission is proposing 

amendments to Form N-PORT, Form N-LIQUID (which we propose to re-title as “Form N-RN”), 
                                                      
690   See supra section II.H. 
691  See supra sections III and IV. These sections also discuss the professional skills that we believe 

compliance with the proposed rules, and proposed rule and form amendments would entail. 



382 

Form N-CEN, and Form N-2 under the authority set forth in sections 8, 18, 30, and 38 of the 

Investment Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 80a-29, 80a-37, 80a-63], sections 6, 

7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C. 77f, 77g(a), 77j, 77s(a)], and sections 

10, 13, 15, 23, and 35A of the Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and 78ll]. 

C. Small Entities Subject to Proposed Rules 

For purposes of Commission rulemaking in connection with the Regulatory Flexibility 

Act, an investment company is a small entity if, together with other investment companies in the 

same group of related investment companies, it has net assets of $50 million or less as of the end 

of its most recent fiscal year (a “small fund”).692 Commission staff estimates that, as of June 

2019, approximately 42 registered open-end mutual funds, 8 registered ETFs, 33 registered 

closed-end funds, and 16 BDCs (collectively, 99 funds) are small entities.693  

For purposes of Commission rulemaking in connection with the Regulatory Flexibility 

Act, a broker-dealer is a small entity if it: (1) had total capital (net worth plus subordinated 

liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited 

financial statements were prepared pursuant to rule 17a-5(d) under the Exchange Act, or, if not 

required to file such statements, had total capital (net worth plus subordinated liabilities) of less 

than $500,000 on the last business day of the preceding fiscal year (or in the time that it has been 

in business, if shorter); and (2) it is not affiliated with any person (other than a natural person) 

that is not a small business or small organization.694 Commission staff estimates that, as of June 

                                                      
692  See rule 0-10(a) under the Investment Company Act [17 CFR 270.0-10(a)].  
693  This estimate is derived an analysis of data obtained from Morningstar Direct as well as data 

reported to the Commission for the period ending June 2019.  
694   See rule 0-10(c)(1)-(2) under the Exchange Act [17 CFR 240.0-10(c)(1)(2)]. 



383 

30, 2019, there are approximately 942 broker-dealers that may be considered small entities.695  

Under Commission rules, and for the purposes of the Advisers Act and the Regulatory 

Flexibility Act, a registered investment adviser generally is a small entity if it: (1) has assets 

under management having a total value of less than $25 million; (2) did not have total assets of 

$5 million or more on the last day of the most recent fiscal year; and (3) does not control, is not 

controlled by, and is not under common control with another investment adviser that has assets 

under management of $25 million or more, or any person (other than a natural person) that had 

total assets of $5 million or more on the last day of its most recent fiscal year.696 We believe that 

proposed rule 211(h)-1 would not affect most investment advisers that are small entities (“small 

advisers”). Many small advisers would not be affected because they are registered with one or 

more state securities authorities and not with the Commission. Under section 203A of the 

Advisers Act, many small advisers are prohibited from registering with the Commission and are 

regulated by state regulators.697 Of those advisers that are registered with the Commission, we 

estimate based on IARD data that as of June 30, 2019, approximately 470 SEC-registered 

investment advisers are small entities under the RFA.698 Of these, we estimate that 171 registered 

investment advisers are small entities that provide advice to individual clients.699  

                                                      
695  This estimate is derived from an analysis of data for the period ending June 30, 2019 obtained 

from Financial and Operational Combined Uniform Single (FOCUS) Reports that broker-dealers 
generally are required to file with the Commission and/or SROs pursuant to rule 17a-5 under the 
Exchange Act [17 CFR 240.17a-5]. 

696   See rule 0-7(a) under the Advisers Act [17 CFR 275.0-7(a)]. 
697   15 U.S.C. 80b-3a. 
698   Based on SEC registered investment adviser responses to Item 12 of Form ADV. 
699  Based on SEC-registered investment adviser responses to Items 5.D.(1)(a)-(b), 5.D.(3)(a)-(b), 5.F 

and 12 of Form ADV. These responses indicate that: the investment adviser has clients that are 
high net worth individuals and/or individuals other than high net worth individuals; the 
investment adviser has regulatory assets under management attributable to clients that are high 

 



384 

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements 

1. Proposed Rule 18f-4 

a. Derivatives Risk Management Program, and Board 
Oversight and Reporting 

Proposed rule 18f-4 would generally require a fund relying on the rule—including small 

entities, but not including funds that are limited derivatives users—to adopt and implement a 

derivatives risk management program.700 This risk management program would include policies 

and procedures reasonably designed to assess and manage the risks of the fund’s derivatives 

transactions.701 The program requirement is designed to permit a fund to tailor the program’s 

elements to the particular types of derivatives that the fund uses and related risks, as well as how 

those derivatives impact the fund’s investment portfolio and strategy. The proposal would 

require a fund’s program to include the following elements: (1) risk identification and 

assessment; (2) risk guidelines; (3) stress testing; (4) backtesting; (5) internal reporting and 

escalation; and (6) periodic review of the program. The proposed rule also would require: (1) a 

fund’s board of directors to approve the designation of the fund’s derivatives risk manager and 

(2) the derivatives risk manager to provide written reports to the board regarding the program’s 

implementation and effectiveness, including describing any exceedances of the fund’s guidelines 

                                                      

net worth individuals and/or individuals other than high net worth individuals; and that the 
investment adviser is a small entity. Firms that are registered as a broker-dealer and an investment 
adviser are counted in both the total number of small investment advisers and small broker-
dealers that would be subject to the new requirements. We believe that counting these firms twice 
is appropriate because of any additional burdens of complying with the rules with respect to both 
their advisory and brokerage businesses. 

700  See supra section II.A.2; proposed rule 18f-4(c)(1).  
701  See proposed rule 18f-4(a).  



385 

and the results of the fund’s stress testing and backtesting.702 

As discussed above, we estimate that the one-time operational costs necessary to 

establish and implement a derivatives risk management program would range from $70,000 to 

$500,000 per fund, depending on the particular facts and circumstances and current derivatives 

risk management practices of the fund.703 We also estimate that each fund would incur ongoing 

program-related costs that range from 65% to 75% of the one-time costs necessary to establish 

and implement a derivatives risk management program.704 Thus, we estimate that a fund would 

incur ongoing annual costs associated with proposed rule 18f-4 that would range from $45,500 to 

$375,000.705 We estimate that approximately 22% of funds would be required to implement a 

derivatives risk management program, including board oversight.706 We similarly estimate—

applying to small funds the same estimated percentage of funds that would implement a 

derivatives risk management program—that approximately 22% of small funds (approximately 

22 small funds) would establish a derivatives risk management program.707  

There are different factors that would affect whether a smaller fund incurs program-

related costs that are on the higher or lower end of the estimated range. For example, we would 

expect that smaller funds—and more specifically, smaller funds that are not part of a fund 

                                                      
702  See supra sections II.C and III.C.1. 
703  See supra section III.C.1. This section, along with sections IV.B.1 and IV.B.2, also discusses the 

professional skills that we believe compliance with this aspect of the proposal would entail. 
704   Id. 
705   Id. 
706  These are funds that would not be considered limited derivatives users under the proposed rule. 

See supra sections II.E, III.C.1, IV.B.1 and IV.B.2; infra section V.D.1.c. 
707  See supra sections III.C.1 and V.C. We estimate that there are 99 small funds that meet the small 

entity definition. See supra note 693 and accompanying text. 99 small funds x 22% = 
approximately 22 funds that are small entities.  



386 

complex—may not have existing personnel capable of fulfilling the responsibilities of the 

proposed derivatives risk manager, or may choose to hire a derivatives risk manager rather than 

assigning that responsibility to a current officer (or officers) of the fund’s investment adviser 

who is not a portfolio manager. Also, while we would expect larger funds or funds that are part 

of a large fund complex to incur higher program-related costs in absolute terms relative to a 

smaller fund or a fund that is part of a smaller fund complex, we would expect a smaller fund to 

find it more costly, per dollar managed, to comply with the proposed program requirement 

because it would not be able to benefit from a larger fund complex’s economies of scale.708 

b. Limit on Fund Leverage Risk 

Proposed rule 18f-4 would also generally require a fund relying on the rule—including 

small entities, but not including funds that are limited derivatives users or that are certain 

leveraged/inverse funds that the rule describes—to comply with an outer limit on fund leverage 

risk based on VaR.709 This outer limit would be based on a relative VaR test that compares the 

fund’s VaR to the VaR of a designated reference index. If the fund’s derivatives risk manager is 

unable to identify an appropriate designated reference index, the fund would be required to 

comply with an absolute VaR test.710 Under the proposed rule, a fund must disclose its 

designated reference index in its annual report.711 This proposed requirement is designed to limit 

fund leverage risk consistent with the investor protection purposes underlying section 18.  

As discussed above, we estimate that the one-time operational costs necessary to 

establish and implement a VaR calculation model consistent with the proposed limit on fund 
                                                      
708   See supra section III.C.1. 
709   See supra sections II.D, II.E, and II.G. 
710  See supra sections II.D.2, II.D.3. 
711  Proposed rule 18f-4(c)(2)(iv). 



387 

leverage risk would range from $5,000 to $100,000 per fund, depending on the particular facts 

and circumstances and current derivatives risk management practices of the fund.712 We estimate 

that approximately 19% of funds would be required to comply with the proposed limit on fund 

leverage risk.713 We similarly estimate—applying to small funds the same estimated percentage 

of funds overall that would comply with this requirement—that approximately 19% of small 

funds (approximately 19 small funds) would be required to comply with the proposed limit on 

fund leverage risk.714  

There are multiple factors that could affect whether the costs that smaller funds would 

incur in complying with the proposed limit on fund leverage risk would be on the lower versus 

higher end of this estimated range. To the extent that funds (including smaller funds) have 

already established and implemented portfolio VaR testing practices and procedures, these funds 

would incur fewer costs relative to those funds that have not already established and 

implemented VaR-based analysis in their risk management. If as a result of fewer resources, a 

smaller fund, and more specifically a smaller fund not part of a fund complex, hired a third-party 

vendor to comply with the VaR-based limit on fund leverage risk, this could increase costs of 

complying with the proposed limit for those funds. Finally, costs would vary based on factors 

such as whether the fund uses multiple types of derivatives or uses derivatives more extensively, 

whether the fund would be implementing the absolute VaR test versus the relative VaR test, and 

                                                      
712  See supra section III.C.2. This section, along with section IV.B.3, also discusses the professional 

skills that we believe compliance with this aspect of the proposal would entail. 
713  See supra section III.C.2. This estimate excludes both: (1) limited derivatives users, and (2) funds 

that are leveraged/inverse investment vehicles under the proposed sales practices rules. Id.; see 
also supra sections II.E, II.G, III.C.2, III.C.3, III.C.5, and IV.B.3; infra section V.D.1.c. 

714  See supra sections III.C.2 and V.C. We estimate that there are 99 small funds that meet the small 
entity definition. See supra note 693 and accompanying text. 99 small entities x 19% = 
approximately 19 funds that are small entities.  



388 

whether (for a fund that uses the relative VaR test) the fund uses a designated reference index for 

which the index provider charges a licensing fee.715  

c. Requirements for Limited Derivatives Users 

Proposed rule 18f-4 includes an exception from the proposed rule’s risk management 

program requirement and limit on fund leverage risk for “limited derivatives users.”716 The 

proposed exception would be available to a fund that either limits its derivatives exposure to 

10% of its net assets, or that uses derivatives transactions solely to hedge certain currency risks. 

Any fund that relies on the proposed exception—small funds as well as large funds—would also 

be required to adopt policies and procedures that are reasonably designed to manage its 

derivatives risks. We expect that the risks and potential impact of these funds’ derivatives use 

may not be as significant, compared to those of funds that do not qualify for the exception, and 

that a principles-based policies and procedures requirement would appropriately address these 

risks. These “reasonably designed” policies and procedures would have a scope that that reflects 

the extent and nature of a fund’s use of derivatives within the parameters that the proposed 

exception provides. 

As discussed above, we estimate that the one-time costs to establish and implement 

policies and procedures reasonably designed to manage a fund’s derivative risks would range 

from $1,000 to $100,000 per fund, depending on the particular facts and circumstances and 

current derivatives risk management practices of the fund.717 We also estimate that the ongoing 

                                                      
715  See supra note 203 and accompanying paragraph; note 518 and accompanying sentence. 
716   See supra section II.E; proposed rule 18f-4(c)(3)(i)-(ii). 
717  See supra section III.C.3 (discussing the one-time range of costs for implementing the limited 

derivatives user requirements under proposed rule18f-4 and the variables impacting a fund 
incurring costs at the lower or higher end of the estimated cost range). This section, along with 

 



389 

annual costs that a fund that is a limited derivatives user would incur range from 65% to 75% of 

the one-time costs to establish and implement the policies and procedures. Thus, we estimate that 

a fund would incur ongoing annual costs associated with the proposed limited derivatives user 

exception that would range from $650 to $75,000.718 We anticipate that larger funds that are 

limited derivatives users—or limited derivatives user funds that are part of a large fund 

complex—would likely experience economies of scale in complying with the proposed 

requirements for limited derivatives users that smaller funds would not necessarily experience.719 

Thus, smaller funds that are limited derivatives users could incur costs on the higher end of the 

estimated range. However, a smaller fund whose derivatives use is limited could benefit from the 

proposed limited derivatives user exception, because it would not be required to adopt a 

derivatives risk management program (including all of the proposed program elements), and 

therefore such a fund could potentially avoid incurring costs and bearing compliance burdens 

that may be disproportionate to any benefits.720 

We estimate that approximately 19% of funds that use derivatives would qualify for the 

limited derivatives user exception.721 We would expect some small funds to fall within the 

proposed limited derivatives user exception.722 However, not all small funds that use derivatives 

                                                      

section IV.B.6, also discusses the professional skills that we believe compliance with this aspect 
of the proposal would entail. 

718  Id. 
719  See supra note 708 and accompanying text.  
720   See supra section II.E. 
721  Id. This estimate excludes both: (1) funds that would comply with the derivatives risk 

management program, and (2) funds that would be leveraged/inverse investment vehicles under 
proposed rule 15l-2. See also supra sections II.A.2, II.E, II.G, III.C.1, III.C.3, III.C.5, IV.B.4, and 
V.D.1.a. 

722  Id.; see also supra section III.C.3. 



390 

would necessarily qualify as limited derivatives users. We estimate—applying to small funds the 

same estimated percentage of funds overall that would qualify as limited derivatives users—that 

approximately 19% of small funds that use derivatives (approximately 19 small funds) would 

comply with the proposed requirements for limited derivatives users under the proposed rule.723  

d. Reverse Repurchase Agreements and Unfunded 
Commitment Agreements 

Proposed rule 18f-4 would permit a fund to engage in reverse repurchase agreements and 

other similar financing transactions so long as they are subject to the relevant asset coverage 

requirements of section 18.724 Because funds are required to rely on the asset segregation 

approach in Release 10666, the degree to which funds could engage in reverse repurchase 

agreements under the proposal would generally be the same as under current practice. Therefore 

we do not estimate a significant compliance burden—either for small funds that engage in 

reverse repurchase agreements or for larger funds—associated with the proposed provisions 

regarding reverse repurchase agreements in rule 18f-4.725 For large and small funds subject to the 

proposed limit on fund leverage risk, any portfolio leveraging effect of reverse repurchase 

agreements or similar financing transactions would be included and restricted through the 

proposed VaR-based limits, and therefore would incrementally affect the costs associated with 

complying with these limits.726  

                                                      
723  Id.; see also supra sections III.C.3 and V.C. We estimate that there are 99 small funds that meet 

the small entity definition. See supra note 693 and accompanying text. 99 small entities x 19% = 
approximately 19 funds that are small entities.  

724  See supra section II.I.  
725   See supra section III.C.4. 
726   See supra section II.I. 



391 

The proposed rule also includes a provision that codifies an approach for funds’ 

participation in unfunded commitment agreements in light of the concerns underlying section 

18.727 Proposed rule 18f-4 would permit a fund to enter into unfunded commitment agreements if 

it reasonably believes, at the time it enters into such agreement, that it will have sufficient cash 

and cash equivalents to meet its obligations with respect to all of its unfunded commitment 

agreements, in each case as they come due. The proposed rule would prescribe factors that a fund 

must consider in forming such a reasonable belief. If a fund enters into unfunded comment 

agreements in compliance with this requirement, the proposed rule specifies that unfunded 

commitment agreements will not be considered for purposes of computing asset coverage, as 

defined in section 18(h) of the Investment Company Act. This proposed approach for unfunded 

commitment agreements reflects the staff’s experience in reviewing and commenting on fund 

registration statements, as discussed above.728 We therefore do not expect that the proposed 

approach would result in significant costs to small or large funds because we believe the 

proposed approach is generally consistent with the current practices of funds that enter into 

unfunded commitment agreements.  

e. Recordkeeping 

Proposed rule 18f-4 includes certain recordkeeping provisions that are designed to 

provide the Commission’s staff, and the fund’s board of directors and compliance personnel, the 

ability to evaluate the fund’s compliance with the proposed rule’s requirements.729 The proposed 

rule would require a fund to maintain certain records documenting its derivatives risk 

                                                      
727   See supra section II.J.  
728  See id. 
729   See supra section II.K. 



392 

management program, including a written record of: (1) its policies and procedures designed to 

manage the fund’s derivatives risks, (2) the results of any stress testing of its portfolio, (3) the 

results of any VaR test backtesting it conducts, (4) records documenting any internal reporting or 

escalation of material risks under the program, and (5) records documenting any periodic reviews 

of the program.730  

Second, the proposed rule would also require a fund to maintain a written record of any 

materials provided to the fund’s board of directors in connection with approving the designation 

of the derivatives risk manager. The proposed rule would also require a fund to keep records of 

any written reports provided to the board of directors relating to the program, and any written 

reports provided to the board that the rule would require regarding the fund’s non-compliance 

with the applicable VaR test.731  

Third, a fund that is required to comply with the proposed VaR test would also have to 

maintain written records documenting the determination of: its portfolio VaR; the VaR of its 

designated reference index, as applicable; its VaR ratio (the value of the VaR of the Fund’s 

portfolio divided by the VaR of the designated reference index), as applicable; and any updates 

to the VaR calculation models used by the fund, as well as the basis for any material changes 

made to those models.732  

                                                      
730  See proposed rule 18f-4(c)(6)(i)(A). 
731  See proposed rule 18f-4(c)(6)(i)(B). 
732  See proposed rule 18f-4(c)(6)(i)(C). 



393 

Fourth, the proposed rule would require a fund that is a limited derivatives user to 

maintain a written record of its policies and procedures that are reasonably designed to manage 

its derivatives risks.733  

Finally, a fund that enters into unfunded commitment agreements would be required to 

maintain a records documenting the basis for the fund’s belief regarding the sufficiency of its 

cash and cash equivalents to meet its obligations with respect to its unfunded commitment 

agreements.734 A record must be made each time a fund enters into such an agreement.735 

As discussed above, we estimate that the average one-time recordkeeping costs for funds 

that would not qualify as limited derivatives users would be $2,047 per fund, depending on the 

particular facts and circumstances and current derivatives risk management practices of the 

fund.736 We also estimate that such a fund would incur an average ongoing annual recordkeeping 

costs of $330.737 We further estimate that the one-time and ongoing annual recordkeeping costs 

for a limited derivatives user to be 90% of those for funds that do not qualify as limited 

derivatives users.738 Thus, for each fund that could rely on the limited derivatives user exception, 

we estimate a one-time cost of $1,842 and an ongoing cost of $297 per year.739 To the extent that 

we estimate that small funds would be subject to the various provisions of the proposed rule that 

would necessitate recordkeeping requirements, as discussed above, these small funds also would 

                                                      
733   See proposed rule 18f-4(c)(6)(i)(D). 
734   See proposed rule 18f-4e)(2); see also supra note 430 and accompanying text. 
735   Id.; see also supra note 431 and accompanying text. 
736  See supra section III.C.8. This section, along with section IV.B.7, also discusses the professional 

skills that we believe compliance with this aspect of the proposal would entail. 
737   Id.  
738   Id.  
739   Id. 



394 

be subject to the associated proposed recordkeeping requirements. Therefore, we estimate that: 

22% of small funds (approximately 22 small funds) would have to comply with the program-

related recordkeeping requirements and requirements regarding materials provided to the fund’s 

board; 19% of small funds (approximately 19 small funds) would have to comply with 

requirements to maintain records of compliance with the proposed VaR test; and 19% of small 

funds (approximately 19 funds) would have to comply with the recordkeeping requirements for 

limited derivatives users.740  

A fund’s recordkeeping-related costs will vary, depending on the provisions of proposed 

rule 18f-4 that the fund relies on. For example, funds that are required to adopt derivatives risk 

management programs, versus funds that are limited derivatives users under the proposed rule, 

would be subject to different recordkeeping requirements. However, while small funds’ 

recordkeeping burdens would vary based on the provisions of the proposed rule that a fund relies 

on, their recordkeeping burdens would not vary solely because they are small funds. We do not 

anticipate that larger funds, or funds that are part of a large fund complex, would experience any 

significant economies of scale related to the proposed recordkeeping requirements. 

2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-
CEN 

a. Proposed Amendments to Form N-PORT  

The proposed amendments to Form N-PORT would require funds to report information 

about their derivatives exposure, and also—as applicable for funds that are subject to the 

proposed rule 18f-4 VaR-based limit on fund leverage risk—to report certain VaR-related 

                                                      
740  See supra sections III.C.1, III.C.2, III.C.3, V.D.1.a, V.D.1.b, and V.D.1.c. 



395 

information.741 These proposed amendments would provide market-wide insight into the levels 

of reporting funds’ derivatives exposure to the Commission, its staff, and market participants at 

the specific points in time covered by the reporting. They also would help the Commission and 

its staff assess compliance with proposed rule 18f-4.  

All funds that file Form N-PORT would have to provide information regarding their 

derivatives exposure on this form. We estimate that 41% of small funds that file Form N-PORT 

(approximately 34 small funds) use derivatives, and thus only these funds would have 

substantive information to report in response to this new exposure-related disclosure 

requirement.742  

In addition, funds that are subject to the proposed limit on fund leverage risk would have 

to report: (1) the fund’s highest daily VaR during the reporting period and its corresponding date; 

and (2) the fund’s median daily VaR for the reporting period. Funds subject to the relative VaR 

test during the reporting period also would have to report: (1) the name of the fund’s designated 

reference index, (2) the index identifier, (3) the fund’s highest daily VaR ratio during the 

reporting period and its corresponding date; and (4) the fund’s median daily VaR ratio for the 

                                                      
741  See supra section II.H.1; see also proposed Items B.9 and B.10 of Form N-PORT. 
742  See supra sections V.C, V.D.1.a, and V.D.1.c. Because BDCs do not file reports on Form N-

PORT, we deduct the number of BDCs from the total number of small funds that we estimate (99 
small funds – 16 BDCs that are small entities = 83 small funds that file reports on Form N-
PORT). See supra note 693 and accompanying text.  

We estimate that approximately 22% of funds would be subject to the proposed rule’s derivatives 
risk management program requirements and approximately 19% of funds would be subject to 
either of the limited derivatives user exceptions, with funds from both groups subject to reporting 
requirements on Form N-PORT. See supra notes 707, 721, and accompanying text. Although 
both of these estimated percentages include BDCs, we note that the total number of BDCs 
relative to the number of registered open- and closed-end funds is small, and therefore our 
estimates do not adjust these percentages to reflect the fact that BDCs do not file Forms N-PORT. 
See supra section III.B.1. Therefore, we estimate the total number of small funds subject to the 
proposed Form N-PORT requirements as follows: 83 small funds that file reports on Form N-
PORT x (22% + 19% = 41%) = 34 small funds. 



396 

reporting period. A fund would be required to determine its compliance with its applicable VaR 

test once each business day.743  

All funds that are subject to the proposed limit on fund leverage risk also would have to 

report the number of exceptions that the fund identified as a result of the backtesting of its VaR 

calculation model. We estimate that 19% of small funds (approximately 16 small funds) would 

be subject to these VaR-related disclosure requirements.744 

We estimate that each fund that reports information in response to the proposed VaR-

related disclosure requirements on Form N-PORT would incur a one-time cost of $2,784 and an 

ongoing cost of $4,176 per year, and each fund that is not subject to the VaR-related disclosure 

requirement would incur a one-time cost of $1,392 and an ongoing cost of $2,088 per year.745 

Notwithstanding the economies of scale experienced by large versus small funds, we would not 

expect the costs of compliance associated with the new Form N-PORT requirements to be 

meaningfully different for small versus large funds. The costs of compliance would vary only 

based on fund characteristics tied to their derivatives use. For example, a fund that uses 

derivatives extensively would incur more costs to calculate its derivatives exposure than a fund 

                                                      
743   See supra note 365. 
744  We estimate 83 small funds that file reports on Form N-PORT. See supra note 742.  

 We estimate that approximately 19% of funds would be subject to the proposed limit on fund 
leverage risk. See supra note 713 and accompanying text. Although this estimated percentage 
include BDCs, we note that the total number of BDCs relative to the number of registered open- 
and closed-end funds is small, and therefore our estimate does not adjust this percentage to reflect 
the fact that BDCs do not file Forms N-PORT. See supra section III.B.1. Therefore, we estimate 
the total number of small funds that would make VaR-related disclosures on Form N-PORT as 
follows: 83 small funds that file reports on Form N-PORT x 19% = approximately 16 small 
funds. 

745  See supra section III.C.9.a.; see also supra section IV.F (discussing the professional skills that we 
believe compliance with this aspect of the proposal would entail). 



397 

that does not use derivatives extensively.746 And a fund that is a limited derivatives user, or that 

otherwise is not subject to the proposed VaR test, would not incur any costs to comply with the 

proposed new VaR-related N-PORT items.747 

b. Proposed Amendments to Form N-LIQUID 

We are proposing to re-title Form N-LIQUID as Form N-RN, and amend this form to 

include new reporting events for funds that are subject to proposed rule 18f-4’s limit on fund 

leverage risk.748 The proposed amendments would require funds subject to the limit on fund 

leverage risk to report information about VaR test breaches under certain circumstances. These 

proposed current reporting requirements are designed to aid the Commission in assessing funds’ 

compliance with the VaR tests, and to provide staff the ability to assess how long a fund is 

precluded from entering into derivatives transactions as a consequence of its lack of compliance 

with its VaR test. We are proposing to require funds to provide this information in a current 

report because we believe that the Commission should be notified promptly when a fund is out of 

compliance with the proposed VaR-based limit on fund leverage risk (and also when it has come 

back into compliance with its applicable VaR test). We believe this information could indicate 

that a fund is experiencing heightened risks as a result of a fund’s use of derivatives transactions, 

as well as provide the Commission insight about the duration and severity of those risks, and 

whether those heightened risks are fund-specific or industry-wide. 

As discussed above, we estimate that each fund subject to the proposed new current 

reporting requirements would incur an average cost of $10 per year to prepare amended Form N-

                                                      
746   See supra note 715. 
747   See proposed Item B.10 to Form N-PORT. 
748   See supra section II.H.2. 



398 

RN.749 We estimate that approximately 19 registered open- and closed-end funds, and BDCs, are 

small entities that would be required to report VaR test related information on Form N-RN.750 

Because the proposed amendments to Form N-RN would require both large and small funds to 

report VaR test breaches, the burden to report is not associated with fund size, and consequently, 

we would not expect the costs of compliance with the new Form N-RN requirements to be 

meaningfully different for small versus large funds.  

c. Proposed Amendments to Form N-CEN 

The proposed amendments to Form N-CEN would require a fund to identify whether it 

relied on proposed rule 18f-4 during the reporting period.751 The proposed amendments also 

would require a fund to identify whether it relied on any of the exemptions from various 

requirements under the proposed rule, specifically: (1) whether the fund is a limited derivatives 

user excepted from the proposed rule’s program requirement, under either of the proposed 

exception’s alternatives (either a funds that limits its derivatives exposure to 10% of its net assets, 

or a fund that uses derivatives transactions solely to hedge certain currency risks); or (2) whether 

it is a leveraged/inverse fund covered by the proposed sales practices rules that, under proposed 

rule 18f-4, would be excepted from the proposed limit on fund leverage risk. Finally, a fund 

would have to identify whether it has entered into reverse repurchase agreements or similar 

financing transactions, or unfunded commitment agreements, as provided under the proposed 
                                                      
749  See supra section III.C.9.b; see also supra section IV.G (discussing the professional skills that we 

believe compliance with this aspect of the proposal would entail). 
750  This estimate is based on an estimate that 16 small registered open- and closed-end funds would 

make VaR-related disclosures on Form N-PORT (see supra note 744 and accompanying text), 
plus 3 BDCs (16 total small BDCs (see supra note 693 and accompanying text) x 19% (our 
estimate of the percentage of funds subject to a VaR-based limit on fund leverage risk, see supra 
note 713 and accompanying text) = approximately 3 BDCs). Thus, 16 small registered open- and 
closed-end funds + 3 BDCs = 19 funds. 

751   See supra section II.H.3. 



399 

rule.752 The proposed amendments to Form N-CEN are designed to assist the Commission and 

staff with our oversight functions by allowing us to identify which funds were excepted from 

certain of the proposed rule’s provisions or relied on the rule’s provisions regarding reverse 

repurchase agreements and unfunded commitment agreements.  

As discussed above, we estimate that each fund subject to the proposed new Form N-

CEN reporting requirements would incur on average an ongoing annual cost of $6.96 per year.753 

We estimate that approximately 34 registered open- and closed-end funds are small entities that 

would be subject to the proposed new Form N-CEN reporting requirements.754 Notwithstanding 

any economies of scale experienced by large versus small funds, we would not expect the costs 

of compliance with the new Form N-CEN requirements to be meaningfully different for small 

versus large funds. 

                                                      
752  See proposed Item C.7.l.iv-v of Form N-CEN; see also supra section II.I and II.J; proposed rule 

18f-4(d); and proposed rule 18f-4(e). 
753  See supra section III.C.9.a; see also supra section IV.H (discussing the professional skills that we 

believe compliance with this aspect of the proposal would entail). 
754  Because BDCs do not file reports on Form N-CEN, we deduct the number of BDCs from the total 

number of small funds that we estimate (99 small funds – 16 BDCs that are small entities = 83 
small funds that file reports on Form N-CEN). See supra note 693 and accompanying text.  

The estimate of 34 funds is based on the percentage of funds we believe would be subject to the 
proposed derivatives risk management program requirement (22% of funds, see supra note 499 
and accompanying text) plus the percentage of funds we believe would qualify as limited 
derivatives users (19% of funds, see supra note 721 and accompanying text). We estimate that 83 
small funds that file reports on Form N-CEN (99 total small funds less 16 small BDCs) x 41% 
(22% + 19%) = 34 small funds subject to the proposed Form N-CEN reporting requirements. To 
the extent that there are funds that either (1) would not adopt a derivatives risk management 
program or (2) would not qualify as limited derivatives user, but that would rely on the rule’s 
provisions with respect to reverse repurchase agreements or unfunded commitment agreements, 
this analysis might underestimate the number of funds that would be subject to the new Form N-
CEN reporting requirements. 



400 

3. Proposed Sales Practices Rules  

The proposed sales practices rules under the Exchange Act and the Advisers Act would 

require a firm to exercise due diligence in determining whether to approve the account of a retail 

investor to buy or sell shares of a leveraged/inverse investment vehicle before accepting an order 

from, or placing an order for, the retail investor to engage in these transactions.755 Under the 

proposed sales practices rules, no firm may accept an order from or place an order for a retail 

investor to buy or sell shares of a leveraged/inverse investment vehicle, or approve such an 

investor’s account to engage in those transactions, unless the firm has complied with certain 

conditions.  

Specifically, the proposed sales practices rules would require the firm to: (1) approve the 

retail investor’s account for buying and selling shares of leveraged/inverse investment vehicles 

pursuant to a due diligence requirement; and (2) adopt and implement policies and procedures 

reasonably designed to achieve compliance with the proposed rules.756 The proposed sales 

practices rules’ due diligence requirements provide that a firm must exercise due diligence to 

ascertain the essential facts relative to the retail investor, his or her financial situation, and 

investment objectives. A firm must seek to obtain, at a minimum, certain specified information 

about the retail investor. The proposed sales practices rules also include recordkeeping 

requirements relating to the information that the firm obtained through its due diligence, the 

firm’s approval or disapproval of the retail investor’s account for buying and selling shares of 

                                                      
755   See supra section II.G.1. 
756   See supra section II.G.2.b.401 

leveraged/inverse investment vehicles (account approvals must be in writing), and the firm’s 

policies and procedures that it adopted pursuant to those rules.757  

The proposed sales practices rules are designed to establish a uniform set of enhanced 

due diligence and account approval requirements for all leveraged/inverse investment vehicle 

transactions, including transactions where no recommendation or investment advice is provided 

by a firm. They also are designed in part to help to ensure that investors in these funds are 

limited to those who understand their characteristics—including that these funds would not be 

subject to all of the leverage-related requirements applicable to registered investment companies 

generally—and the unique risks they present. 

As discussed above, we estimate that each broker-dealer subject to proposed rule 15l-2, 

and each investment adviser subject to proposed rule 211(h)-1, would incur total one-time costs 

that would range from $9,115.50 to $15,192.50 to comply with the proposed rules, and total 

ongoing costs that would range from $2,270.50 to $3,915 per year to comply with the proposed 

rules.758 We estimate that approximately 236 broker-dealers and 43 registered investment 

advisers are small entities that would be subject to the proposed sales practices rules.759 

                                                      
757   See supra section II.G.2.c. 
758  See supra notes 540 and 544 and accompanying text. This discussion, along with sections IV.C 

and IV.D supra, also discusses the professional skills that we believe compliance with this aspect 
of the proposal would entail. 

759  We estimate there are currently 942 small broker-dealers. See supra note 695 and accompanying 
text. We further estimate that 700 broker-dealers (or 25% of all 2,766 broker-dealers registered 
with the Commission) have retail customer accounts that invest in leveraged/inverse investment 
vehicles. See supra section III.C.5. Our estimate of 236 broker-dealers is based on the following 
calculation: 942 small broker dealers x 25% = approximately 236 small broker-dealers that have 
retail customer accounts that invest in leveraged/inverse investment vehicles. 

We estimate that there are currently 470 SEC-registered investment advisers that are small 
entities. See supra note 698 and accompanying text. Of these, we estimate that 171 provide 
advice to individual clients, and could therefore be subject to the proposed new sales practices 
rules under the Advisers Act. See supra note 699 and accompanying text. We further estimate 

 



402 

The costs that broker-dealers and investment advisers may incur as a result of the 

proposed sales practices rules would vary depending on the firm and the due diligence 

requirements that the firm adopts as a result of the proposed rules’ requirements.760 We expect 

that economies of scale among larger firms could result in cost reductions for larger firms. 

Compliance costs could, however, be different across firms with relatively smaller or larger 

numbers of retail investors as customers or clients.761  

4. Proposed Amendments to Rule 6c-11  

We are proposing to amend rule 6c-11 to remove the provision excluding 

leveraged/inverse ETFs from the scope of that rule and to newly permit leveraged/inverse ETFs 

to rely on that rule.762 Rule 6c-11 permits ETFs that satisfy certain conditions to operate without 

obtaining an exemptive order from the Commission.763 The rule is designed to create a consistent, 

transparent, and efficient regulatory framework for such ETFs and facilitate greater competition 

and innovation among ETFs. As a consequence of our proposed amendment to rule 6c-11, and 

proposal to rescind the exemptive orders we have previously issued to leveraged/inverse ETFs, 

                                                      

that 2,000 investment advisers (or approximately 25% of the 8,235 investment advisers that are 
registered with the Commission and offer some part of their business to retail investors) have 
retail client accounts that invest in leveraged/inverse investment vehicles. See supra sections 
III.C.5 and IV.D. Our estimate of 43 investment advisers is based on the following calculation: 
171 small investment advisers that provide advice to individual clients x 25% = approximately 43 
small investment advisers that have retail client accounts that invest in leveraged/inverse 
investment vehicles. 

760   See supra section III.C.5 (discussing costs and benefits of proposed sales practices rules). 
761  See supra section II.G.2.b (discussing required approval and due diligence for retail investors’ 

accounts to trade shares of leveraged/inverse investment vehicles under the proposed sales 
practices rules). 

762   See supra section II.G.4. 
763  Id. 



403 

these proposed amendments would newly permit leveraged/inverse ETFs to come within scope 

of the rule’s exemptive relief.  

Currently, there are 73 leveraged/inverse ETFs.764 As a result of the proposed 

amendments, we would expect the number of funds relying on rule 6c-11 to increase, and we 

estimate that all 73 leveraged/inverse ETFs would newly seek to use rule 6c-11. We also 

estimate, for purposes of this Regulatory Flexibility Act analysis, that approximately 1 of these 

leveraged/inverse ETFs would be a small leveraged/inverse ETF that would seek to rely on rule 

6c-11.765 We do not estimate our amendments to rule 6c-11 would change the estimated per-fund 

cost burden associated with rule 6c-11, but we do believe the number of funds using the rule, as a 

result of our amendment, would now increase.766 The costs associated with complying with rule 

6c-11 are discussed in the ETFs Adopting Release.767 

E. Duplicative, Overlapping, or Conflicting Federal Rules 

Commission staff has not identified any federal rules that duplicate, overlap, or conflict 

with proposed Investment Company Act rule 18f-4, proposed Exchange Act rule 15l-2, proposed 

Advisers Act rule 211(h)-1, or the proposed amendments to Form N-PORT, Form N-LIQUID, 

and Form N-CEN. 

We recognize that other broker-dealer or investment adviser obligations require these 

entities to engage in due diligence with respect to transactions they recommend to customers or 

clients. The proposed sales practices rules, in contrast, would apply regardless of whether a 
                                                      
764   See supra note 468. 
765  This estimate is based on the following calculation: 8 small ETFs / 1,190 total ETFs = 

approximately 0.67% of ETFs that are small ETFs. See supra sections III.B.1 and V.C. 0.67% of 
73 leveraged/inverse ETFs = approximately 1 leveraged/inverse ETF.  

766   See supra section IV.E. 
767  See ETFs Adopting Release, supra note 76, at section IV. 



404 

broker-dealer or investment adviser recommends that a customer or client buy or sell 

leveraged/inverse investment vehicles. We therefore do not believe that the sales practices rules 

would conflict with existing broker-dealer or investment adviser obligations, and believe that any 

overlap or duplication should be limited because a broker-dealer or investment adviser could 

consider the information it collects in connection with the sales practices rules in connection with 

the due diligence the broker-dealer or investment adviser conducts in connection with other, 

existing obligations for recommended transactions. 

F.  Significant Alternatives 

The Regulatory Flexibility Act directs the Commission to consider significant 

alternatives that would accomplish our stated objectives, while minimizing any significant 

economic impact on small entities. We considered the following alternatives for small entities in 

relation to our proposal: (1) exempting funds, broker-dealers, and registered investment advisers 

that are small entities from the proposed reporting, recordkeeping, and other compliance 

requirements, to account for resources available to small entities; (2) establishing different 

reporting, recordkeeping, and other compliance requirements or frequency, to account for 

resources available to small entities; (3) clarifying, consolidating, or simplifying the compliance 

requirements under the proposal for small entities; and (4) using performance rather than design 

standards. 

1. Proposed Rule 18f-4 

We do not believe that exempting small funds from the provisions in proposed rule 18f-4 

would permit us to achieve our stated objectives. Because proposed rule 18f-4 is an exemptive 

rule, it would require funds to comply with new requirements only if they wish to enter into 



405 

derivatives or certain other transactions.768 Therefore, if a small entity does not enter into 

derivatives or such other transactions as part of its investment strategy, then the small entity 

would not be subject to the provisions of proposed rule 18f-4. In addition, a small fund whose 

derivatives use is limited could benefit from the proposed limited derivatives user exception, 

because it would not be required to adopt a derivatives risk management program (including all 

of the proposed program elements). 

We estimate that 59% of all funds do not have any exposure to derivatives or such other 

transactions.769 This estimate indicates that many funds, including many small funds, would be 

unaffected by the proposed rule. However, for small funds that would be affected by our 

proposed rule, providing an exemption for them could subject investors in small funds that invest 

in derivatives or engage in such other transactions to a higher degree of risk than investors to 

large funds that would be required to comply with the proposed elements of the rule. 

The undue speculation concern expressed in section 1(b)(7) of the Investment Company 

Act, and the asset sufficiency concern reflected in section 1(b)(8) of the Act—both of which the 

proposed rule is designed to address—apply to both small as well as large funds. As discussed 

throughout this release, we believe that the proposed rule would result in investor protection 

benefits, and these benefits should apply to investors in smaller funds as well as investors in 

larger funds. We therefore do not believe it would be appropriate to exempt small funds from the 

proposed rule’s program requirement or VaR-based limit on fund leverage risk, or to establish 

different requirements applicable to funds of different sizes under these provisions to account for 

resources available to small entities. We believe that all of the proposed elements of rule 18f-4 

                                                      
768  See supra sections II.D.6 and III.E. 
769   See supra note 459 and accompanying paragraph. 



406 

should work together to produce the anticipated investor protection benefits, and therefore do not 

believe it is appropriate to except smaller funds because we believe this would limit the benefits 

to investors in such funds. 

We also do not believe that it would be appropriate to subject small funds to different 

reporting, recordkeeping, and other compliance requirements or frequency. Similar to the 

concerns discussed above, if the proposal included different requirements for small funds, it 

could raise investor protection concerns for investors in small funds including subjecting small 

fund investors to a higher degree of risk if the small fund uses derivatives transactions. We also 

believe that all fund investors will benefit from enhanced Commission monitoring and oversight 

of the fund industry, which we anticipate will result from the disclosure and reporting 

requirements.  

We do not believe that clarifying, consolidating, or simplifying the compliance 

requirements under the proposal for small funds would permit us to achieve our stated 

objectives. Again, this approach would raise investor protection concerns for investors in small 

funds using derivatives transactions. However, as discussed above, the proposed rule contains an 

exception for limited derivatives users that we anticipate would subject funds that qualify for this 

exception to fewer compliance burdens. We recognize that the risks and potential impact of 

derivatives transactions on a fund’s portfolio generally increase as the fund’s level of derivatives 

usage increases and when funds use derivatives for speculative purposes. Therefore the proposed 

rule would entail a less significant compliance burden for funds—including small funds—that 

choose to limit their derivatives usage in the manner that the proposed exception specifies. The 

proposal, therefore, does include provisions designed to consider the requirement burdens based 

on the fund’s use of derivatives (rather than the size of the fund).  



407 

The costs associated with proposed rule 18f-4 would vary depending on the fund’s 

particular circumstances, and thus the proposed rule could result in different burdens on funds’ 

resources. In particular, we expect that a fund that pursues an investment strategy that involves 

greater derivatives risk may have greater costs associated with its derivatives risk management 

program. For example, a fund that qualifies as a limited derivatives user under the proposed rule 

would be exempt from the proposed requirements to adopt and implement a derivatives risk 

management program, and to adhere to the proposed rule’s VaR-based limit on fund leverage 

risk. The costs of compliance with the proposed rule would vary even for limited derivatives 

users, as these funds would be required to adopt policies and procedures that are “reasonably 

designed” to manage their derivatives risks. Thus, to the extent a fund that is a small entity faces 

relatively little derivatives risk, we believe it would incur relatively low costs to comply with the 

proposed rule. However, we believe that it is appropriate to correlate the costs associated with 

the proposed rule with the level of derivatives risk facing a fund, and not necessarily with the 

fund’s size in light of our investor protection objectives. 

Finally, with respect to the use of performance rather than design standards, the proposed 

rule generally uses performance standards for all funds relying on the proposed rule, regardless 

of size. We believe that providing funds with the flexibility with respect to investment strategies 

and use of derivatives transactions is appropriate, as well as the derivatives risk management 

program design. However, the proposed rule also uses design standards with respect to certain 

requirements such as complying with the VaR-based limit on fund leverage risk and the specified 

program elements in the derivatives risk management program. For the reasons discussed above, 

we believe that this use of design standards is appropriate to address investor protection concerns, 

particularly the concerns expressed in sections 1(b)(7), 1(b)(8), and 18 of the Investment 



408 

Company Act. 

2. Proposed Sales Practices Rules 

Similarly, we do not believe that exempting any subset of broker-dealers or registered 

investment advisers, including those firms that are small entities, from the provisions in the 

proposed sales practices rules would permit us to achieve our stated investor protection 

objectives. We also do not believe that it would be desirable to establish different requirements 

applicable to firms of different sizes under the proposed sales practices rules to account for 

resources available to small entities, to consolidate or simplify the compliance requirements 

under the proposal for small entities, or to use performance standards rather than design 

standards for small entities.  

We do not believe exempting small broker-dealers and investment advisers from the 

proposed sales practices rules would serve the interest of investors. As we discussed above, 

leveraged/inverse investment vehicles present unique considerations, and the proposed sales 

practices rules are designed in part to address the investor protection concerns leveraged/inverse 

funds present.770 The proposed sales practices rules would permit broker-dealers and investment 

advisers to accept or place orders to buy or sell shares of a “leveraged/inverse investment vehicle” 

only for investors that they have approved for those transactions, based on certain required 

criteria.771 Exempting smaller broker-dealer and investment adviser firms would create a 

regulatory gap, whereby larger funds would be required to comply with the proposed sales 

practices rules’ due diligence requirements to determine whether to approve the account of retail 

investor to buy or sell shares of a leveraged/inverse investment vehicle, and small entities would 

                                                      
770   See supra section II.G. 
771  See proposed rule 15l-2(b). 



409 

not need to conduct this same diligence.  

As discussed above, we believe that this limitation on leveraged/inverse investment 

vehicles’ investor base would help provide that investors in these vehicles understand the 

characteristics of these vehicles and the unique risks they present.772 Providing different 

requirements or simplifying the requirements for small entities would dilute these investor 

protection benefits for customers or clients of small entities. We do not believe that the investor 

protection benefits of the proposed sales practices rules should depend on whether an investor is 

transacting through a small or a large firm. Furthermore, a broker-dealer or investment adviser 

would have to comply with the applicable proposed rule’s requirements only if it transacts with 

retail investors in the shares of leveraged/inverse investment vehicles.773 

Finally, we are not proposing performance standards rather than design standards for 

smaller entities. We believe that subjecting smaller entities to different standards under the 

proposed rules could lead to inconsistency in how investors would transact in leveraged/inverse 

investment vehicles, depending on whether the investor has a relationship with a large or small 

broker-dealer or investment adviser. This would be inconsistent with the regulatory and investor 

protections purposes of the proposed rules and could subject investors who interact with small 

firms to a higher degree of risk than investors who interact with larger firms. It could also 

circumvent the proposed rules’ ability to establish a uniform set of enhanced due diligence and 

                                                      
772  See supra section II.G.  
773  We estimate that approximately 236 broker-dealers and 43 registered investment advisers are 

small entities that would be subject to the proposed sales practices rules. See supra note 759 and 
accompanying text. 

 Broker-dealers and investment advisers that would have to comply with the proposed sales 
practices rules also might currently have processes in place that would provide efficiencies in 
complying with the proposed rules. See supra note 537 and accompanying text. 



410 

approval requirements for all leveraged/inverse investment vehicle transactions, and to address 

the investor protection concerns underlying section 18 for leveraged/inverse funds by limiting 

their investor base. 

3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-
CEN 

We do not believe that the interests of investors would be served by exempting funds that 

are small entities from the proposed disclosure and reporting requirements. We believe that the 

form amendments are necessary to help identify and provide the Commission, staff, investors, 

and other market participants timely information about funds that comply with proposed rule 

18f-4, and to realize the anticipated benefits of the proposed reporting requirements.774 

Exempting small funds from coverage under all or any part of the proposed form amendments 

could compromise the effectiveness of the required disclosures, which the Commission believes 

would not be consistent with its goals of industry oversight and investor protection. We believe 

that all fund investors, including investors in small funds, would benefit from disclosure and 

reporting requirements that would permit them to make investment choices that better match 

their risk tolerances. We also believe that all fund investors would benefit from enhanced 

Commission monitoring and oversight of the fund industry, which we anticipate would result 

from the proposed disclosure and reporting requirements.  

For similar reasons, we do not believe that the interests of investors would be served by 

establishing different reporting, recordkeeping, or other compliance requirements for small 

funds. We considered providing small funds simplified compliance or disclosure requirements. 

However, we believe this too would subject investors in small funds that invest in derivatives to 

                                                      
774   See supra section III.C.9. 



411 

a higher degree of risk and information asymmetry than investors to large funds that would be 

required to comply with the proposed disclosure requirements. We also note that registered open- 

and closed-end management investment companies, including those that are small entities, have 

already updated their systems and have established internal processes to prepare, validate, and 

file reports on Forms N-PORT and N-CEN (or will do so shortly).775 For funds that will be 

required to file reports on Form N-RN, the vast majority of them are open-end funds, which 

already are required to submit the form upon specified events. With respect to the additional 

registered closed-end funds and BDCs newly required to file reports on Form N-RN, we do not 

believe they would need more time to comply with the new reporting requirements, given the 

limited set of reporting requirements they would be subject to and the relatively low burden we 

estimate of filing reports on Form N-RN. 

We also do not believe that the interests of investors would be served by clarifying, 

consolidating, or simplifying the compliance requirements under the proposal for small funds. 

Small funds are as vulnerable to the same potential risks associated with their derivatives use as 

larger funds are, and therefore we believe that simplifying or consolidating the proposed 

reporting requirements for small funds would not allow us to meet our stated objectives. 

Moreover, we believe many of the proposed disclosure requirements involve minimal burden. 

For example, the Form N-CEN “checking a box” reporting requirement is completed on an 

annual basis.  

Finally, we did not prescribe performance standards rather than design standards for 

                                                      
775  See supra note 360 (discussing, among other things, Form N-PORT compliance dates and noting 

that the funds that would rely on proposed rule 18f-4 (if adopted) other than BDCs generally are 
subject to reporting requirements on Form N-CEN); see also Investment Report Modernization 
Adopting Release supra note 179, at section II.H. 



412 

small funds because we believe this too could diminish the ability of the proposed rules to 

achieve their intended regulatory purpose by creating inconsistent reporting requirements 

between small and large funds, and weakening the benefits of the proposed reporting 

requirement for investors in small funds. 

4. Rule 6c-11 

Rule 6c-11 is designed to modernize the regulatory framework for ETFs and to create a 

consistent, transparent, and efficient regulatory framework.776 The Commission’s full Regulatory 

Flexibility Act Analysis regarding rule 6c-11, including analysis of significant alternatives, 

appears in the 2019 ETFs Adopting Release and the 2018 ETFs Proposing Release.777 Our 

analysis of alternatives for small leveraged/inverse ETFs here is consistent with the 

Commission’s analysis of alternatives for small ETFs in those releases.  

We do not believe that permitting or requiring different treatment for any subset of 

leveraged/inverse ETFs, including small leveraged/inverse ETFs, under the proposed 

amendments to rule 6c-11, and the rule’s related recordkeeping, disclosure and reporting 

requirements, would permit us to achieve our stated objectives. Similarly, we do not believe that 

we can establish simplified or consolidated compliance requirements for small leveraged/inverse 

ETFs under the proposed amendments to rule 6c-11 without compromising our objectives. The 

Commission discussed the bases for this determination (with respect to ETFs other than 

leveraged/inverse ETFs) in more detail in the ETFs Proposing Release and the ETFs Adopting 

Release, and we are extending that analysis to leveraged/inverse ETFs in this Initial Regulatory 

Flexibility Act Analysis. In addition, we do not believe it would be appropriate to exempt small 
                                                      
776   See ETFs Adopting Release, supra note 76, at section I. 
777  See id. at section VI; see also Exchange-Traded Funds, Investment Company Act Release No. 

10515 (June 28, 2018) [83 FR 37332 (July 31, 2018)] (“ETFs Proposing Release”), at section V.  



413 

leveraged/inverse ETFs from the proposed amendments to rule 6c-11 (or to establish different 

disclosure, reporting, or recordkeeping requirements, or simplified or consolidated compliance 

requirements under rule 6c-11 for these entities) because of the particular risks that 

leveraged/inverse ETFs may present.778 We also do not think it would be appropriate to establish 

different requirements under rule 6c-11 for small leveraged/inverse ETFs, which could produce a 

competitive advantage for these funds compared to larger leveraged/inverse ETFs (and compared 

to other ETFs that rely on the rule). This would conflict with our goals of creating a consistent, 

transparent, and efficient regulatory framework for ETFs and to facilitate greater competition 

and innovation among ETFs.  

G. Request for Comment 

The Commission requests comments regarding this analysis. We request comment on the 

number of small entities that would be subject to our proposal and whether our proposal would 

have any effects that have not been discussed. We request that commenters describe the nature of 

any effects on small entities subject to our proposal and provide empirical data to support the 

nature and extent of such effects. We also request comment on the estimated compliance burdens 

of our proposal and how they would affect small entities. 

VI. CONSIDERATION OF IMPACT ON THE ECONOMY 

For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996 

(“SBREFA”), the Commission must advise OMB whether a proposed regulation constitutes a 

“major” rule. Under SBREFA, a rule is considered “major” where, if adopted, it results in or is 

likely to result in:  

• An annual effect on the economy of $100 million or more;  

                                                      
778   See supra section II.G.1. 



414 

• A major increase in costs or prices for consumers or individual industries; or  

• Significant adverse effects on competition, investment, or innovation.  

We request comment on whether our proposal would be a “major rule” for purposes of 

SBREFA. We solicit comment and empirical data on:  

• The potential effect on the U.S. economy on an annual basis;  

• Any potential increase in costs or prices for consumers or individual industries; and  

• Any potential effect on competition, investment, or innovation.  

Commenters are requested to provide empirical data and other factual support for their 

views to the extent possible. 

VII. STATUTORY AUTHORITY 

The Commission is proposing new rule 18f-4 under the authority set forth in sections 

6(c), 12(a), 18, 31(a), 38(a), and 61 of the Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 

80a-12(a), 80a-18, 80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing 

amendments to rule 6c-11 under the authority set forth in sections 6(c), 22(c), and 38(a) of the 

Investment Company Act [15 U.S.C. 80a-6(c), 22(c), and 80a-37(a)]. The Commission is 

proposing new rule 15l-2 under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F, 17, 

23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C. 78c, 78c(b), 78c-5, 78j, 78o(l), 

78o-10, 78q, 78w(a), and 78mm]. The Commission is proposing new rule 211(h)-1 under the 

authority set forth in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment 

Advisers Act of 1940 [15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and 80b-11(h)]. The 

Commission is proposing amendments to Form N-PORT, Form N-LIQUID (which we propose 

to re-title as “Form N-RN”), Form N-CEN, and Form N-2 under the authority set forth in 

sections 8, 18, 30, and 38 of the Investment Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 

80a-29, 80a-37, 80a-63], sections 6, 7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C. 



415 

77f, 77g(a), 77j, 77s(a)], and sections 10, 13, 15, 23, and 35A of the Exchange Act [15 U.S.C. 

78j, 78m, 78o, 78w, and 78ll]. 

TEXT OF RULES AND FORMS  

List of Subjects  

17 CFR Parts 240 and 249 

 Brokers, Fraud, Reporting and recordkeeping requirements, Securities. 

17 CFR Parts 270 and 274  

Investment companies, Reporting and recordkeeping requirements, Securities.  

17 CFR Part 275 

 Reporting and recordkeeping requirements, Securities. 

For the reasons set out in the preamble, title 17, chapter II of the Code of Federal 

Regulations is proposed to be amended as follows:  

* * * * * 

PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT 
OF 1934 
 

1. The authority citation for part 240 is amended by adding a subauthority 

for Section 240.15l-2 to read as follows: 

 
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 77eee, 77ggg, 77nnn, 77sss, 

77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f, 78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 

78o-4, 78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 

80a-37, 80b-3, 80b-4, 80b-11, and 7201 et seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 

5221(e)(3); 18 U.S.C. 1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-106, 

sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted. 



416 

* * * * * 

Section 240.15l-2 is also issued under Pub. L. 111-203, sec. 913, 124 Stat. 1376, 1827 

(2010). 

* * * * * 

2. Section 240-15l-2 is added to read as follows: 

§ 240.15l-2   Broker and dealer sales practices for leveraged/inverse investment vehicles. 

(a) Required approval of customer account. No broker or dealer registered or 

required to be registered under the Securities Exchange Act of 1934, or any associated person of 

the broker or dealer, may accept an order from a customer that is a natural person (or the legal 

representative of a natural person) to buy or sell shares of a leveraged/inverse investment vehicle 

unless the broker or dealer has approved such a customer’s account to engage in those 

transactions and has adopted and implemented policies and procedures reasonably designed to 

achieve compliance with this section. Any approval of a customer’s account for buying or selling 

leveraged/inverse investment vehicles must be effected as provided in paragraph (b). 

(b) Diligence in approving accounts. (1) In determining whether to approve a 

customer’s account to buy or sell leveraged/inverse investment vehicles, the broker or dealer 

must exercise due diligence to ascertain the essential facts relative to the customer, his or her 

financial situation, and investment objectives, including, at a minimum, the information specified 

in paragraph (b)(2) of this section (and must seek to obtain information for all participants in a 

joint account). Based upon this information, the broker or dealer must specifically approve or 

disapprove the customer’s account for buying and selling shares of leveraged/inverse investment 

vehicles. An approval of a customer account must be in writing. A broker or dealer may provide 

this approval if the broker or dealer has a reasonable basis for believing that the customer has 



417 

such knowledge and experience in financial matters that he or she may reasonably be expected to 

be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. 

(2) A broker or dealer must seek to obtain the following information at a minimum 

regarding the customer: 

(i) Investment objectives (e.g., safety of principal, income, growth, trading 

profits, speculation) and time horizon; 

(ii) Employment status (name of employer, self-employed or retired); 

(iii) Estimated annual income from all sources; 

(iv) Estimated net worth (exclusive of family residence); 

(v) Estimated liquid net worth (cash, liquid securities, other); 

 (vi) Percentage of the customer’s estimated liquid net worth that he or she 

intends to invest in leveraged/inverse investment vehicles; and 

(vii) Investment experience and knowledge (e.g., number of years, size, 

frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, 

stocks and bonds, commodities, and other financial instruments. 

(c) Recordkeeping. A broker or dealer must maintain a written record of the 

information that it obtained under paragraph (b) of this section and, if applicable, its written 

approval of the customer’s account, as well as the versions of the firm’s policies and procedures 

required under paragraph (a) that were in place when it approved or disapproved the customer’s 

account, for a period of not less than six years (the first two years in an easily accessible place) 

after the date of the closing of the customer’s account.  

(d) Definitions. For purposes of this section: 



418 

Associated person of the broker dealer means any partner, officer, director, or branch 

manager of such broker or dealer (or any person occupying a similar status or performing similar 

functions), any person directly or indirectly controlling, controlled by, or under common control 

with such broker or dealer, or any employee of such broker or dealer, except that any person 

associated with a broker or dealer whose functions are solely clerical or ministerial shall not be 

included in the meaning of such term for purposes of section 15(b) of the Exchange Act (other 

than paragraph (6) thereof). 

Commodity- or Currency-Based Trust or Fund means a trust or other person: 

(1) Issuing securities in an offering registered under the Securities Act of 

1933 (15 U.S.C. 77a et seq.) and which class of securities is listed for trading on a national 

securities exchange; 

(2) The assets of which consist primarily of derivative instruments that 

reference commodities or currencies, or interests in the foregoing; and 

(3) That provides in its registration statement under the Securities Act of 1933 

(15 U.S.C. 77a et seq.) that a class of its securities are purchased or redeemed, subject to 

conditions or limitations, for a ratable share of its assets. 

Leveraged/inverse investment vehicle means a registered investment company (including 

any separate series thereof), or commodity- or currency-based trust or fund, that seeks, directly 

or indirectly, to provide investment returns that correspond to the performance of a market index 

by a specified multiple, or to provide investment returns that have an inverse relationship to the 

performance of a market index, over a predetermined period of time. 

(e) Transition. This section applies to all customers of the broker or dealer, including 

customers who have opened accounts with the broker or dealer before the compliance date for 



419 

this section, provided that this section does not apply to, and therefore will not restrict a 

customer’s ability to close or reduce, a position in a leveraged/inverse investment vehicle that a 

customer established before the compliance date of this section. 

 
PART 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940  

3. The authority citation for part 270 continues to read, in part, as follows: 

 
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39, and Pub. L. 111-203, sec. 

939A, 124 Stat. 1376 (2010), unless otherwise noted.  

* * * * * 
 

Section 270.6c-11 is also issued under 15 U.S.C. 80a-6(c) and 80a-37(a). 
 

* * * * * 
 

4. Amend §6c-11 by removing paragraph (c)(4). 
 
 

5. Section 270.18f-4 is added to read as follows: 
 
§ 270.18f-4 Exemption from the requirements of section 18 and section 61 for certain 

senior securities transactions. 

(a) Definitions. For purposes of this section: 

Absolute VaR test means that the VaR of the fund’s portfolio does not exceed 15% of the 

value of the fund’s net assets. 

Derivatives exposure means the sum of the notional amounts of the fund’s derivatives 

instruments and, in the case of short sale borrowings, the value of the asset sold short. In 

determining derivatives exposure a fund may convert the notional amount of interest rate 

derivatives to 10-year bond equivalents and delta adjust the notional amounts of options 

contracts. 



420 

Derivatives risks means the risks associated with a fund’s derivatives transactions or its 

use of derivatives transactions, including leverage, market, counterparty, liquidity, operational, 

and legal risks and any other risks the derivatives risk manager (or, in the case of a fund that is a 

limited derivatives user as described in paragraph (c)(3) of this section, the fund’s investment 

adviser) deems material. 

Derivatives risk manager means an officer or officers of the fund’s investment adviser 

responsible for administering the program and policies and procedures required by paragraph 

(c)(1) of this section, provided that the derivatives risk manager: 

(1) May not be a portfolio manager of the fund, or if multiple officers serve as 

derivatives risk manager, may not have a majority composed of portfolio managers of the fund; 

and 

(2) Must have relevant experience regarding the management of derivatives 

risk. 

Derivatives transaction means:  

(1) Any swap, security-based swap, futures contract, forward contract, option, 

any combination of the foregoing, or any similar instrument (“derivatives instrument”), under 

which a fund is or may be required to make any payment or delivery of cash or other assets 

during the life of the instrument or at maturity or early termination, whether as margin or 

settlement payment or otherwise; and 

(2) Any short sale borrowing. 

Designated reference index means an unleveraged index that: (1) is selected by the 

derivatives risk manager and that reflects the markets or asset classes in which the fund invests; 

(2) is not administered by an organization that is an affiliated person of the fund, its investment421 

adviser, or principal underwriter, or created at the request of the fund or its investment adviser, 

unless the index is widely recognized and used; and (3) is an “appropriate broad-based securities 

market index” or an “additional index,” as defined in the instruction to Item 27 in Form N-1A 

[17 CFR 274.11A]. In the case of a blended index, none of the indexes that compose the blended 

index may be administered by an organization that is an affiliated person of the fund, its 

investment adviser, or principal underwriter, or created at the request of the fund or its 

investment adviser, unless the index is widely recognized and used. 

Fund means a registered open-end or closed-end company or a business development 

company, including any separate series thereof, but does not include a registered open-end 

company that is regulated as a money market fund under § 270.2a-7. 

Relative VaR test means that the VaR of the fund’s portfolio does not exceed 150% of the 

VaR of the designated reference index. 

Unfunded commitment agreement means a contract that is not a derivatives transaction, 

under which a fund commits, conditionally or unconditionally, to make a loan to a company or to 

invest equity in a company in the future, including by making a capital commitment to a private 

fund that can be drawn at the discretion of the fund’s general partner. 

Value-at-risk or VaR means an estimate of potential losses on an instrument or portfolio, 

expressed as a percentage of the value of the portfolio’s net assets, over a specified time horizon 

and at a given confidence level, provided that any VaR model used by a fund for purposes of 

determining the fund’s compliance with the relative VaR test or the absolute VaR test must: 

(1) Take into account and incorporate all significant, identifiable market risk 

factors associated with a fund’s investments, including, as applicable: 



422 

(i) Equity price risk, interest rate risk, credit spread risk, foreign 

currency risk and commodity price risk; 

(ii) Material risks arising from the nonlinear price characteristics of a 

fund’s investments, including options and positions with embedded optionality; and 

(iii) The sensitivity of the market value of the fund’s investments to 

changes in volatility;  

(2) Use a 99% confidence level and a time horizon of 20 trading days; and 

(3) Be based on at least three years of historical market data. 

(b) Derivatives transactions. If a fund satisfies the conditions of paragraph (c) of this 

section, the fund may enter into derivatives transactions, notwithstanding the requirements of 

sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a-

18(a)(1), 80a-18(c), 80a-18(f)(1), and 80a-60), and derivatives transactions entered into by the 

fund in compliance with this section will not be considered for purposes of computing asset 

coverage, as defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-18(h)). 

(c) Conditions. (1) Derivatives risk management program. The fund adopts and 

implements a written derivatives risk management program (“program”), which must include 

policies and procedures that are reasonably designed to manage the fund’s derivatives risks and 

to reasonably segregate the functions associated with the program from the portfolio 

management of the fund. The program must include the following elements: 

(i) Risk identification and assessment. The program must provide for the 

identification and assessment of the fund’s derivatives risks. This assessment must take into 

account the fund’s derivatives transactions and other investments. 



423 

(ii) Risk guidelines. The program must provide for the establishment, 

maintenance, and enforcement of investment, risk management, or related guidelines that 

provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s 

derivatives risks. These guidelines must specify levels of the given criterion, metric, or threshold 

that the fund does not normally expect to exceed, and measures to be taken if they are exceeded. 

(iii) Stress testing. The program must provide for stress testing to evaluate 

potential losses to the fund’s portfolio in response to extreme but plausible market changes or 

changes in market risk factors that would have a significant adverse effect on the fund’s 

portfolio, taking into account correlations of market risk factors and resulting payments to 

derivatives counterparties. The frequency with which the stress testing under this paragraph is 

conducted must take into account the fund’s strategy and investments and current market 

conditions, provided that these stress tests must be conducted no less frequently than weekly. 

(iv) Backtesting. The program must provide for backtesting of the results of 

the VaR calculation model used by the fund in connection with the relative VaR test or the 

absolute VaR test by, each business day, comparing the fund’s gain or loss with the 

corresponding VaR calculation for that day, estimated over a one-trading day time horizon, and 

identifying as an exception any instance in which the fund experiences a loss exceeding the 

corresponding VaR calculation’s estimated loss. 

(v) Internal reporting and escalation. (A) Internal reporting. The program 

must identify the circumstances under which persons responsible for portfolio management will 

be informed regarding the operation of the program, including exceedances of the guidelines 

specified in paragraph (c)(1)(ii) of this section and the results of the stress tests specified in 

paragraph (c)(1)(iii) of this section. 



424 

(B) Escalation of material risks. The derivatives risk manager must 

inform in a timely manner persons responsible for portfolio management of the fund, and also 

directly inform the fund’s board of directors as appropriate, of material risks arising from the 

fund’s derivatives transactions, including risks identified by the fund’s exceedance of a criterion, 

metric, or threshold provided for in the fund’s risk guidelines established under paragraph 

(c)(1)(ii) of this section or by the stress testing described in paragraph (c)(1)(iii) of this section.  

(vi) Periodic review of the program. The derivatives risk manager must review 

the program at least annually to evaluate the program’s effectiveness and to reflect changes in 

risk over time. The periodic review must include a review of the VaR calculation model used by 

the fund under paragraph (c)(2) of this section (including the backtesting required by paragraph 

(c)(1)(iv) of this section) and any designated reference index to evaluate whether it remains 

appropriate. 

(2) Limit on fund leverage risk. (i) The fund must comply with the relative VaR test 

or, if the derivatives risk manager is unable to identify a designated reference index that is 

appropriate for the fund taking into account the fund’s investments, investment objectives, and 

strategy, the absolute VaR test.  

(ii) The fund must determine its compliance with the applicable VaR test at 

least once each business day. If the fund determines that it is not in compliance with the 

applicable VaR test, the fund must come back into compliance promptly and within no more than 

three business days after such determination. 

(iii) If the fund is not in compliance with the applicable VaR test within three 

business days: 



425 

(A) The derivatives risk manager must report to the fund’s board of 

directors and explain how and by when (i.e., number of business days) the derivatives risk 

manager reasonably expects that the fund will come back into compliance; 

(B) The derivatives risk manager must analyze the circumstances that 

caused the fund to be out of compliance for more than three business days and update any 

program elements as appropriate to address those circumstances; and 

(C) The fund may not enter into any derivatives transactions (other 

than derivatives transactions that, individually or in the aggregate, are designed to reduce the 

fund’s VaR) until the fund has been back in compliance with the applicable VaR test for three 

consecutive business days and has satisfied the requirements set forth in paragraphs (c)(2)(iii)(A) 

and (B) of this section. 

(iv) If the fund is complying with the relative VaR test, an open-end fund must 

disclose in its annual report the fund’s designated reference index as the fund’s “appropriate 

broad-based securities market index” or an “additional index,” as defined in the instruction to 

Item 27 in Form N-1A [17 CFR 274.11A], and a registered closed-end fund or business 

development company must disclose its designated reference index in the annual report, together 

with a presentation of the fund’s performance relative to the designated reference index. A fund 

is not required to include this disclosure in an annual report if the fund is a “New Fund,” as 

defined in Form N-1A [17 CFR 274.11A], or would meet that definition if it were filing on Form 

N-1A [17 CFR 274.11A], at the time the fund files the annual report. 

(3) Limited derivatives users. A fund is not required to adopt a program as prescribed 

in paragraph (c)(1) of this section, or comply with the limit on fund leverage risk in paragraph 



426 

(c)(2) of this section, if the fund adopts and implements policies and procedures reasonably 

designed to manage the fund’s derivatives risks and: 

(i) The fund’s derivatives exposure does not exceed 10 percent of the fund’s 

net assets; or  

(ii) The fund limits its use of derivatives transactions to currency derivatives 

that hedge the currency risks associated with specific foreign-currency-denominated equity or 

fixed-income investments held by the fund, provided that the currency derivatives are entered 

into and maintained by the fund for hedging purposes and that the notional amounts of such 

derivatives do not exceed the value of the hedged instruments denominated in the foreign 

currency (or the par value thereof, in the case of fixed-income investments) by more than a 

negligible amount. 

(4) Leveraged/inverse funds. A fund is not required to comply with the limit on fund 

leverage risk in paragraph (c)(2) of this section if: 

(i) The fund is a leveraged/inverse investment vehicle as defined in § 

240.15l-2 and § 275.211(h)-1;  

(ii) The fund discloses in its prospectus that it is not subject to the limit on 

fund leverage risk in paragraph (c)(2) of this section; and  

(iii) The fund does not seek or obtain, directly or indirectly, investment results 

exceeding 300% of the return (or inverse of the return) of the underlying index. 

(5) Board oversight and reporting. (i) Approval of the derivatives risk manager. A 

fund’s board of directors, including a majority of directors who are not interested persons of the 

fund, must approve the designation of the derivatives risk manager, taking into account the 

derivatives risk manager’s relevant experience regarding the management of derivatives risk. 



427 

(ii) Reporting on program implementation and effectiveness. On or before the 

implementation of the program, and at least annually thereafter, the derivatives risk manager 

must provide to the board of directors a written report providing a representation that the 

program is reasonably designed to manage the fund’s derivatives risks and to incorporate the 

elements provided in paragraphs (c)(1)(i)–(vi) of this section. The representation may be based 

on the derivatives risk manager’s reasonable belief after due inquiry. The written report must 

include the basis for the representation along with such information as may be reasonably 

necessary to evaluate the adequacy of the fund’s program and, for reports following the 

program’s initial implementation, the effectiveness of its implementation. The written report also 

must include the derivatives risk manager’s basis for the selection of the designated reference 

index or, if applicable, an explanation of why the derivatives risk manager was unable to identify 

a designated reference index appropriate for the fund. 

(iii) Regular board reporting. The derivatives risk manager must provide to 

the board of directors, at a frequency determined by the board, a written report regarding the 

derivatives risk manager’s analysis of any exceedances described in paragraph (c)(1)(ii) of this 

section, the results of the stress testing conducted under paragraph (c)(1)(iii) of this section, and 

the results of the backtesting conducted under paragraph (c)(1)(iv) of this section since the last 

report to the board. Each report under this paragraph must include such information as may be 

reasonably necessary for the board of directors to evaluate the fund’s response to any 

exceedances and the results of the fund’s stress testing. 

(6) Recordkeeping. (i) Records to be maintained. A fund must maintain a written 

record documenting, as applicable: 



428 

(A) The fund’s written policies and procedures required by paragraph 

(c)(1) of this section, along with: 

(1) The results of the fund’s stress tests under paragraph 

(c)(1)(iii) of this section; 

(2) The results of the backtesting conducted under paragraph 

(c)(1)(iv) of this section; 

(3) Records documenting any internal reporting or escalation 

of material risks under paragraph (c)(1)(v)(B) of this section; and  

(4) Records documenting the reviews conducted under 

paragraph (c)(1)(vi) of this section. 

(B) Copies of any materials provided to the board of directors in 

connection with its approval of the designation of the derivatives risk manager, any written 

reports provided to the board of directors relating to the program, and any written reports 

provided to the board of directors under paragraph (c)(2)(iii)(A) of this section. 

(C) Any determination and/or action the fund made under paragraphs 

(c)(2)(i)-(ii) of this section, including a fund’s determination of: the VaR of its portfolio; the VaR 

of the fund’s designated reference index, as applicable; the fund’s VaR ratio (the value of the 

VaR of the Fund’s portfolio divided by the VaR of the designated reference index), as 

applicable; and any updates to any VaR calculation models used by the fund and the basis for 

any material changes thereto. 

(D) If applicable, the fund’s written policies and procedures required 

by paragraph (c)(3) of this section.  



429 

(ii) Retention periods. (A) A fund must maintain a copy of the written policies 

and procedures that the fund adopted under paragraphs (c)(1) or (c)(3) of this section that are in 

effect, or at any time within the past five years were in effect, in an easily accessible place. 

(B) A fund must maintain all records and materials that paragraphs 

(c)(6)(i)(A)(1)-(4) and (c)(6)(i)(B)-(D) of this section describe for a period of not less than five 

years (the first two years in an easily accessible place) following each determination, action, or 

review that these paragraphs describe.  

(7) Current reports. A fund that experiences an event specified in the parts of Form 

N-RN [referenced in 17 CFR 274.223] titled “Relative VaR Test Breaches,” “Absolute VaR Test 

Breaches,” or “Compliance with VaR Test” must file with the Commission a report on Form N-

RN within the period and according to the instructions specified in that form. 

(d) Reverse repurchase agreements. A fund may enter into reverse repurchase 

agreements or similar financing transactions, notwithstanding the requirements of sections 18(c), 

and 18(f)(1) of the Investment Company Act, if the fund complies with the asset coverage 

requirements of section 18 and combines the aggregate amount of indebtedness associated with 

the reverse repurchase agreement or similar financing transaction with the aggregate amount of 

any other senior securities representing indebtedness when calculating the asset coverage ratio.  

(e) Unfunded commitment agreements. (1) A fund may enter into an unfunded 

commitment agreement, notwithstanding the requirements of sections 18(a), 18(c), 18(f)(1), and 

61 of the Investment Company Act, if the fund reasonably believes, at the time it enters into such 

agreement, that it will have sufficient cash and cash equivalents to meet its obligations with 

respect to all of its unfunded commitment agreements, in each case as they come due. In forming 

a reasonable belief, the fund must take into account its reasonable expectations with respect to 



430 

other obligations (including any obligation with respect to senior securities or redemptions), and 

may not take into account cash that may become available from the sale or disposition of any 

investment at a price that deviates significantly from the market value of those investments, or 

from issuing additional equity. Unfunded commitment agreements entered into by the fund in 

compliance with this section will not be considered for purposes of computing asset coverage, as 

defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-18(h)). 

(2) For each unfunded commitment agreement that a fund enters into under paragraph 

(e)(1) of this section, a fund must document the basis for its reasonable belief regarding the 

sufficiency of its cash and cash equivalents to meet its unfunded commitment agreement 

obligations, and maintain a record of this documentation for a period of not less than five years 

(the first two years in an easily accessible place) following the date that the fund entered into the 

agreement. 

* * * * * 

6. Revise §270.30b1-10 to read as follows: 
 
§270.30b1-10   Current report for open-end and closed-end management 

investment companies. 

Every registered open-end management investment company, or series thereof, and every 

registered closed-end management investment company, but not a fund that is regulated as a 

money market fund under §270.2a-7, that experiences an event specified on Form N-RN, must 

file with the Commission a current report on Form N-RN within the period and according to the 

instructions specified in that form. 

 
PART 274 - FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 
1940 
 



431 

7. The general authority for part 274 continues to read as follows: 
 
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 78n, 78o(d), 80a-8, 80a-

24, 80a-26, 80a-29, and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless otherwise 

noted. 

* * * * * 

8. Amend Form N-2 (referenced in §§ 239.14 and 274.11a-1) by revising 

instruction 2. to sub-item “3. Senior Securities” of “Item 4. Financial Highlights” to 

read as follows: 

Note: The text of Form N-2 does not, and this amendment will not, appear in the Code of 
Federal Regulations.  
 

Form N-2 
 

* * * * * 
 

Item 4. Financial Highlights 
 

* * * * * 
 

3. Senior Securities 
 

* * * * * 
 

Instructions 
 

* * * * * 
 

2. Use the method described in section 18(h) of the 1940 Act [15 U.S.C. 80a-18(h)] to calculate 

the asset coverage to be set forth in column (3). However, in lieu of expressing asset coverage in 

terms of a ratio, as described in section 18(h), express it for each class of senior securities in 

terms of dollar amounts per share (in the case of preferred stock) or per $1,000 of indebtedness 

(in the case of senior indebtedness). A fund should not consider any derivatives transactions, or 



432 

any unfunded commitment agreements, that it enters into in compliance with rule 18f-4 under the 

Investment Company Act [17 CFR 270.18f-4] for purposes of computing asset coverage.  

* * * * * 
 

9. Amend Form N-CEN (referenced in §§249.330 and 274.101) by adding 

new Item C.7.l. to read as follows: 

 
Note: The text of Form N-CEN does not, and this amendment will not, appear in the Code of 
Federal Regulations.  
 
 

FORM N-CEN 
 

ANNUAL REPORT FOR REGISTERED INVESTMENT COMPANIES 
 

* * * * * 
 

Item C.7. * * * 
 

l. Rule 18f-4 (17 CFR 270.18f-4):  _____ 

i. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4) program 
requirement under rule 18f-4(c)(3)(i) (17 CFR 270.18f-4(c)(3)(i))?   _____ 

ii. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4) program 
requirement under rule 18f-4(c)(3)(ii) (17 CFR 
270.18f-4(c)(3)(ii))?   _____ 

iii. Is the Fund a leveraged/inverse fund covered by rule 15l-2 under the 
Exchange Act (17 CFR 240.15l-2) or rule 211(h)-1 under the Investment 
Advisers Act of 1940 (17 CFR 275.211(h)-1) that, under rule 18f-4(c)(4) 
(17 CFR 270.18f-4(c)(4)), is excepted from the requirement to comply 
with the limit on leverage risk described in rule 18f-4(c)(2) (17 CFR 
270.18f-4(c)(2))?   ____ 

iv. Has the Fund entered into any reverse repurchase agreements or similar 
financing transactions under rule 18f-4(d) (17 CFR 270.18f-4(d))?   ____ 

v. Has the Fund entered into any unfunded commitment agreements under 
rule 18f-4(e) (17 CFR 270.18f-4(e))?   ____ 

 
* * * * * 



433 

 
10. Amend Form N-PORT (referenced in §274.150) by: 

a. Adding to General Instruction E. “Definitions” in alphabetical order, the 

following definitions: 

i. “Absolute VaR Test”; 

ii. “Designated Reference Index”; 

iii. “Derivatives Exposure”; 

iv. “Relative VaR Test”; 

v. “Value-at-risk”; 

vi. “VaR Ratio”; and  

b. Adding Items B.9 and B.10. 

The additions read as follows: 
 
Note: The text of Form N-PORT does not, and this amendment will not, appear in the Code of 
Federal Regulations. 
 

 
 

Form N-PORT 
MONTHLY PORTFOLIO INVESTMENTS REPORT 

 
* * * * * 

 
GENERAL INSTRUCTIONS 

 
* * * * * 

 
E. Definitions 
 

* * * * * 
 

 “Absolute VaR Test” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)].  
 

* * * * * 
 

“Derivatives Exposure” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 



434 

 
* * * * * 

 
“Designated Reference Index” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 

 
* * * * * 

 
“Relative VaR Test” has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 

 
* * * * * 

 
 “Value-at-risk” or VaR has the meaning defined in rule 18f-4(a) [17 CFR 270.18f-4(a)]. 
 

* * * * * 
“VaR Ratio” means the value of the Fund’s portfolio VaR divided by the VaR of the Designated 
Reference Index. 
 

* * * * * 
 

PART B. * * * 
 

Item B.9 Derivatives Exposure. Report as a percentage of the Fund’s net asset value: 

a. Derivatives Exposure. 

i. Exposure from derivatives instruments. 

ii. Exposure from short sales. 

Item B.10 VaR Information. For Funds subject to the limit on fund leverage risk in rule 18f-
4(c)(2) [17 CFR 270.18f-4(c)(2)], provide the following information, as 
determined in accordance with the requirement under rule 18f-4(c)(2)(ii) to 
determine the fund’s compliance with the applicable VaR test at least once each 
business day:  

a. Highest daily VaR during the reporting period. 

b. Date of highest daily VaR during the reporting period. 

c. Median daily VaR during the reporting period. 

d. For Funds that were subject to the Relative VaR Test during the reporting period, 
provide: 

i. Name of the Fund’s Designated Reference Index. 

ii. Index Identifier for the Fund’s Designated Reference Index. 

iii. Highest VaR Ratio during the reporting period. 



435 

iv. Date of highest VaR Ratio during the reporting period. 

v. Median VaR Ratio during the reporting period. 

e. Backtesting Results. Number of exceptions that the Fund identified as a result of its 
backtesting of its VaR calculation model (as described in rule 18f-4(c)(1)(iv) [17 CFR 
270.18f-4(c)(1)(iv)] during the reporting period. 

 
* * * * * 

 
11. Revise §274.223, its sectional heading, and Form N-LIQUID (referenced 

in §274.223) and its title to read as follows: 

§274.223   Form N-RN, Current report, open- and closed-end investment company 

reporting. 

This form shall be used by registered open-end management investment companies, or 

series thereof, and closed-end management investment companies, or series thereof, to file 

reports pursuant to §270.18f-4(c)(7) and §270.30b1-10 of this chapter. 

 
Note: The text of Form N-RN does not, and this amendment will not, appear in the Code of 
Federal Regulations.  
 
 

UNITED STATES  
SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON, D.C. 20549  
 

FORM N-RN 
CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT 

COMPANIES AND BUSINESS DEVELOPMENT COMPANIES 
 

Form N-RN is to be used by a registered open-end management investment company or 

series thereof, but not including a fund that is regulated as a money market fund under rule 2a-7 

under the Act (17 CFR 270.2A-7) (a “registered open-end fund”), a registered closed-end 

management investment company (a “registered closed-end fund”), or a closed-end management 

investment company that has elected to be regulated as a business development company (a 



436 

“business development company”), to file current reports with the Commission pursuant to rule 

18f-4 and rule 30b1-10 under the Investment Company of 1940 Act [15 U.S.C. 80a] (“Act”) (17 

CFR 270.18f-4; 17 CFR 270.30b1-10). The Commission may use the information provided on 

Form N-RN in its regulatory, disclosure review, inspection, and policymaking roles. 

GENERAL INSTRUCTIONS  

A. Rules as to Use of Form N-RN. 

(1) Form N-RN is the reporting form that is to be used for current reports of registered open-

end funds (not including funds that are regulated as money market funds under rule 2a-7 under 

the Act), registered closed-end funds, and business development companies (together, 

“registrants”) required by, as applicable, section 30(b) of the Act and rule 30b1-10 under the Act, 

as well as rule 18f-4 under the Act. The Commission does not intend to make public information 

reported on Form N-RN that is identifiable to any particular registrant, although the Commission 

may use Form N-RN information in an enforcement action. 

(2) Unless otherwise specified, a report on this Form N-RN is required to be filed, as 

applicable, within one business day of the occurrence of the event specified in Parts B – G of this 

form. If the event occurs on a Saturday, Sunday, or holiday on which the Commission is not 

open for business, then the one business day period shall begin to run on, and include, the first 

business day thereafter. 

(3)  For registered open-end funds required to comply with rule 22e-4 under the Investment 

Company Act [17 CFR 270.22e-4], complete Parts B – D of this form, as applicable. For 

registrants that rely on rule 18f-4 of the Act [17 CFR 270.18f-4], complete Parts E – G of this 

form, as applicable. 



437 

B. Application of General Rules and Regulations 

The General Rules and Regulations under the Act contain certain general requirements 

that are applicable to reporting on any form under the Act. These general requirements should be 

carefully read and observed in the preparation and filing of reports on this form, except that any 

provision in the form or in these instructions shall be controlling. 

C. Information to Be Included in Report Filed on Form N-RN 

Upon the occurrence of the event specified in Parts B – G of Form N-RN, as applicable, a 

registrant must file a report on Form N-RN that includes information in response to each of the 

items in Part A of the form, as well as each of the items in the applicable Parts B – G of the Form. 

D. Filing of Form N-RN  

A registrant must file Form N-RN in accordance with rule 232.13 of Regulation S-T (17 

CFR Part 232). Form N-RN must be filed electronically using the Commission’s Electronic Data 

Gathering, Analysis and Retrieval System (“EDGAR”). 

E. Paperwork Reduction Act Information 

A registrant is not required to respond to the collection of information contained in Form 

N-RN unless the form displays a currently valid Office of Management and Budget (“OMB”) 

control number. Please direct comments concerning the accuracy of the information collection 

burden estimate and any suggestions for reducing the burden to the Secretary, Securities and 

Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. The OMB has reviewed 

this collection of information under the clearance requirements of 44 U.S.C. 3507. 

F. Definitions 



438 

(1) References to sections and rules in this Form N-RN are to the Investment Company Act 

(15 U.S.C 80a), unless otherwise indicated. Terms used in this Form N-RN have the same 

meaning as in the Investment Company Act, rule 22e-4 under the Investment Company Act (for 

Parts B-D of the Form), or rule 18f-4 under the Investment Company Act (for Part E – G of the 

Form), unless otherwise indicated. In addition, as used in this Form N-RN, the term registrant 

means the registrant or a separate series of the registrant, as applicable. 

 
UNITED STATES  

SECURITIES AND EXCHANGE COMMISSION 
WASHINGTON, D.C. 20549  

 
FORM N-RN 

CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT 
COMPANIES AND BUSINESS DEVELOPMENT COMPANIES 

PART A.  General Information 

Item A.1. Report for [mm/dd/yyyy].  

Item A.2. CIK Number of registrant.  

Item A.3. EDGAR Series Identifier.  

Item A.4. Securities Act File Number, if applicable.  

Item A.5. Provide the name, e-mail address, and telephone number of the person authorized 

to receive information and respond to questions about this Form N-RN. 

PART B.  Above 15% Illiquid Investments 

If more than 15 percent of the registrant’s net assets are, or become, illiquid investments 

that are assets as defined in rule 22e-4, then report the following information:  

Item B.1. Date(s) on which the registrant’s illiquid investments that are assets exceeded 15 

percent of its net assets. 



439 

Item B.2. The current percentage of the registrant’s net assets that are illiquid investments 

that are assets. 

Item B.3. Identification of illiquid investments. For each investment that is an asset that is 

held by the registrant that is considered illiquid, disclose (1) the name of the 

issuer, the title of the issue or description of the investment, the CUSIP (if any), 

and at least one other identifier, if available (e.g., ISIN, Ticker, or other unique 

identifier (if ticker and ISIN are not available)) (indicate the type of identifier 

used), and (2) the percentage of the fund’s net assets attributable to that 

investment. 

PART C.  At or Below 15% Illiquid Investments 

 If a registrant that has filed Part B of Form N-RN determines that its holdings in illiquid 

investments that are assets have changed to be less than or equal to 15 percent of the registrant’s 

net assets, then report the following information: 

Item C.1. Date(s) on which the registrant’s illiquid investments that are assets fell to or 

below 15 percent of net assets. 

Item C.2. The current percentage of the registrant’s net assets that are illiquid investments 

that are assets. 

PART D.  Assets that are Highly Liquid Investments Below the Highly Liquid Investment 

Minimum 



440 

If a registrant’s holdings in assets that are highly liquid investments fall below its highly 

liquid investment minimum for more than 7 consecutive calendar days, then report the following 

information: 

Item D.1. Date(s) on which the registrant’s holdings of assets that are highly liquid 

investments fell below the fund’s highly liquid investment minimum. 

PART E.  Relative VaR Test Breaches 

 If a registrant is subject to the relative VaR test under rule 18f-4(c)(2)(i) [17 CFR 

270.18f-4(c)(2)(i)], and the fund determines that it is not in compliance with the relative VaR test 

and has not come back into compliance within 3 business days after such determination, provide: 

Item E.1. The dates on which the VaR of the registrant’s portfolio exceeded 150% of the 

VaR of its designated reference index. 

Item E.2. The VaR of the registrant’s portfolio on the dates each exceedance occurred. 

Item E.3. The VaR of the registrant’s designated reference index on the dates each 

exceedance occurred. 

Item E.4. The name of the registrant’s designated reference index. 

Item E.5. The index identifier for the registrant’s designated reference index. 

PART F.  Absolute VaR Test Breaches 

If a registrant is subject to the absolute VaR test under rule 18f-4(c)(2)(i) [17 CFR 

270.18f-4(c)(2)(i)], and the fund determines that it is not in compliance with the absolute VaR441 

test and has not come back into compliance within 3 business days after such determination, 

provide: 

Item F.1. The dates on which the VaR of the registrant’s portfolio exceeded 15% of the 

value of the registrant’s net assets. 

Item F.2. The VaR of the registrant’s portfolio on the dates each exceedance occurred. 

Item F.3. The value of the registrant’s net assets on the dates each exceedance occurred. 

 
PART G.  Compliance with VaR Test 

 If a registrant that has filed Part E or Part F of Form N-RN has come back into 

compliance with either the relative VaR test or the absolute VaR test, as applicable, then report 

the following information: 

Item G.1. Dates on which the VaR of the registrant’s portfolio exceeded, as applicable, 

150% of the VaR of its designated reference index (if the registrant is subject to 

the relative VaR test under rule 18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]) or 

15% of the value of the registrant’s net assets (if the registrant is subject to the 

absolute VaR test under rule 18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]). 

Item G.2. The current VaR of the registrant’s portfolio.  

PART H.  Explanatory Notes (if any) 

 A registrant may provide any information it believes would be helpful in understanding 

the information reported in response to any Item of this Form.  



442 

SIGNATURES  

Pursuant to the requirements of the Investment Company Act of 1940, the registrant has duly caused 
this report to be signed on its behalf by the undersigned hereunto duly authorized. 

______________________________________  

(Registrant)  

Date ______________________________  

________________________________________  

(Signature)*  

*Print name and title of the signing officer under his/her signature. 

 
* * * * * 

 
 
PART 275 - RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940 

 
12. The authority citation for part 275 continues to read, in part, and the 

subauthority for Section 275.211h-1 is added to read as follows: 

 
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-2(a)(17), 80b-3, 80b-4, 

80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted. 

* * * * * 

Section 275.211(h)-1 is also issued under sec. 913, Pub. L. 111-203, 124 Stat. 1827-28 

(2010). 

* * * * * 

13. Section 275.211(h)-1 is added to read as follows: 
 



443 

§ 275.211(h)-1   Investment adviser sales practices for leveraged/inverse investment 

vehicles. 

(a) Required approval of client account. No investment adviser registered or required 

to be registered under the Advisers Act, or any supervised person of the investment adviser, may 

place an order for the account of an advisory client that is a natural person (or the legal 

representative of a natural person) to buy or sell shares of a leveraged/inverse investment vehicle 

unless the investment adviser has approved such a client’s account to engage in those 

transactions and has adopted and implemented policies and procedures reasonably designed to 

achieve compliance with this section. Any approval of a client’s account for buying or selling 

leveraged/inverse investment vehicles must be effected as provided in paragraph (b). 

(b) Diligence in approving accounts. (1) In determining whether to approve a client’s 

account to buy or sell leveraged/inverse investment vehicles, the investment adviser must 

exercise due diligence to ascertain the essential facts relative to the client, his or her financial 

situation, and investment objectives, including, at a minimum, the information specified in 

paragraph (b)(2) of this section (and must seek to obtain information for all participants in a joint 

account). Based upon this information, the investment adviser must specifically approve or 

disapprove the client’s account for buying and selling shares of leveraged/inverse investment 

vehicles. An approval of a client account must be in writing. An investment adviser may provide 

this approval if the investment adviser has a reasonable basis for believing that the client has 

such knowledge and experience in financial matters that he or she may reasonably be expected to 

be capable of evaluating the risks of buying and selling leveraged/inverse investment vehicles. 

(2) An investment adviser must seek to obtain the following information at a 

minimum regarding the client: 



444 

(i) Investment objectives (e.g., safety of principal, income, growth, trading 

profits, speculation) and time horizon; 

(ii) Employment status (name of employer, self-employed or retired); 

(iii) Estimated annual income from all sources; 

(iv) Estimated net worth (exclusive of family residence); 

(v) Estimated liquid net worth (cash, liquid securities, other); 

(vi) Percentage of the client’s estimated liquid net worth that he or she intends 

to invest in leveraged/inverse investment vehicles; and 

(vii) Investment experience and knowledge (e.g., number of years, size, 

frequency and type of transactions) regarding leveraged/inverse investment vehicles, options, 

stocks and bonds, commodities, and other financial instruments. 

(c) Recordkeeping. An investment adviser must maintain a written record of the 

information that it obtained under paragraph (b) of this section and, if applicable, its written 

approval of the client’s account, as well as the versions of the firm’s policies and procedures 

required under paragraph (a) that were in place when it approved or disapproved the client’s 

account, for a period of not less than six years (the first two years in an easily accessible place) 

after the date of the closing of the client’s account.  

(d) Definitions. For purposes of this section: 

Commodity- or currency-based trust or fund means a trust or other person: 

(1) Issuing securities in an offering registered under the Securities Act of 

1933 (15 U.S.C. 77a et seq.) and which class of securities is listed for trading on a national 

securities exchange; 



445 

(2) The assets of which consist primarily of derivative instruments that 

reference commodities or currencies, or interests in the foregoing; and 

(3)  That provides in its registration statement under the Securities Act of 1933 

(15 U.S.C. 77a et seq.) that a class of its securities are purchased or redeemed, subject to 

conditions or limitations, for a ratable share of its assets. 

Leveraged/inverse investment vehicle means a registered investment company (including 

any separate series thereof), or commodity- or currency-based trust or fund, that seeks, directly 

or indirectly, to provide investment returns that correspond to the performance of a market index 

by a specified multiple, or to provide investment returns that have an inverse relationship to the 

performance of a market index, over a predetermined period of time. 

Supervised person means any partner, officer, director (or other person occupying a 

similar status or performing similar functions), or employee of an investment adviser, or other 

person who provides investment advice on behalf of the investment adviser. 

(e) Transition. This section applies to all clients of the investment adviser, including 

clients who have opened accounts with the investment adviser before the compliance date for 

this section, provided that this section does not apply to, and therefore will not restrict the ability 

to close or reduce, a client’s position in a leveraged/inverse investment vehicle that a client 

established before the compliance date of this section. 



446 

 

By the Commission. 

Dated: November 25, 2019 

 

 

Eduardo A. Aleman  
Deputy Secretary 

 

VIII. APPENDIX A 

Note: Appendix A will not appear in the Code of Federal Regulations.  

Feedback Flier: Funds’ Use of Derivatives 

We are proposing a new regulatory approach for funds’ use of derivatives. This includes 

proposed rule 18f-4 under the Investment Company Act of 1940, a new exemptive rule designed 

to address the investor protection purposes and concerns underlying section 18 of the Act and to 

provide an updated and more comprehensive approach to the regulation of funds’ use of 

derivatives. The proposal also includes certain new proposed reporting requirements relating to 

funds’ derivatives use. More information about our proposal is available at 

https://www.sec.gov/rules/proposed/2019/34-87607.pdf. 

We are particularly interested in learning what small funds think about the requirements 

of proposed new rule 18f-4 and the proposed new reporting requirements. Hearing from small 

funds could help us learn how the proposed rule and new reporting requirements would affect 

these entities, and evaluate how we could address any unintended consequences resulting from 

the cost and effort of regulatory compliance while still promoting investor protection. We would 

appreciate your feedback on any or all of the following questions.  

https://www.sec.gov/rules/proposed/2019/34-87458.pdf


447 

All of the following questions are optional, including any questions that ask about 

identifying information. Please note that responses to these questions – including any other 

general identifying information you provide – will be made public. 

Item 1: General Identifying Information  
 

Instructions: At your option, you may include general identifying information that would 
help us contextualize your other feedback on the proposal. This information could include 
responses to the following questions, as well as any other general identifying information you 
would like to provide. Responses to these items—like responses to the other items on this 
Feedback Flier—will be made public. 

a. How big is the fund in terms of net asset value? (This may be expressed in a 

range, for example, $40 million - $50 million.) 

b.  What is/are the principal investment strategy/strategies of the fund? 

c. Does the fund use derivatives transactions (as defined in the proposed rule) to 

pursue the fund’s principal investment strategy/strategies? [Y/N] 

d. Is the fund part of a fund complex? [Y/N] 

e. Please include any additional general identifying information that you wish to 

provide, that could add context for your other feedback on the proposal. 

Item 2: Derivatives Risk Management Program  

Instructions: If you believe the fund would be required to adopt and implement a derivatives 
risk management program under the proposed rules, please answer the following questions. If 
you do not believe so, please proceed to Item 4. 

a. The proposed derivatives risk management program requirement would include 

the following seven elements. In the following chart, please indicate which of the 

proposed program elements you think would be the most expensive for the fund 

to implement and which would be least expensive to implement, by ranking the 

following elements from one (1) – most expensive – through seven (7) – least 



448 

expensive – using each number only once. If you have any comments about the 

factors informing your analysis, please include.  

Derivatives Risk Management 
Program Elements 

Rank by Cost 
(1 – most expensive; 7 – 

least expensive) 
Use each number once 

Comments 

a) Risk identification and 
assessment 

  

b) Risk guidelines   

c) Stress testing   

d) Backtesting   

e) Internal reporting and 
escalation 

  

f) Periodic review of the 
program 

  

g) Board reporting and 
oversight 

  

 

b. Implementation timing. 

1.) How many months do you think it would take the fund to adopt and 

implement a derivatives risk management program (check one box)?  

6 months – 12 
months 

12 months – 18 
months 

18 months – 24 
months 

> 24 months 

[  ] [  ] [  ] [  ] 

 

2.) If the response above is more than 12 months, what would help to shorten 

that time period? 

3.) Please provide any explanatory notes that you would like to include. 

c. Implementation cost. 



449 

1.) Approximately how much do you think it would cost the fund to 

implement a derivatives risk management program (in terms of combined 

internal and external costs) (check one box)?  

 

2.) Please include any explanatory notes that you would like to provide. These 

could describe, for example, how a fund that is part of a fund complex 

might share these costs, any particular cost considerations for a fund that 

uses sub-advisers, or the extent to which the estimated costs would arise 

from internal versus external costs (such as those associated with third-

party service providers). 

d. To the extent that the fund is a sub-advised fund, would any of the proposed 

program elements present any particular challenges for the fund to implement in 

light of its advisory structure? If so please explain. 

Item 3: Limit on Fund Leverage Risk  

Instructions: The proposed rule would require certain funds to comply with a limit on fund 
leverage risk based on value at risk (“VaR”). The following questions relate to this proposed 
requirement. 

a. Does the fund currently use VaR testing? [Y/N] 

b. Implementation cost. 

1.) If you anticipate that, if the proposed rules were adopted, the fund would 

have to comply with the VaR testing requirement, approximately how 

Estimated cost ($) 

$0 - $150,000 $150,001 - $350,000 $350,001 - $500,000 > $500,000 

[  ] [  ] [  ] [  ] 



450 

much do you think it would cost the fund to implement the proposed VaR 

test requirements (in terms of combined internal and external costs) (check 

one box)?  

 

2.) Please include any explanatory notes that you would like to provide. These 

could describe, for example, how a fund that is part of a fund complex 

might share these costs, any particular cost considerations for a fund that 

uses sub-advisers, or the extent to which the estimated costs would arise 

from internal versus external costs (such as those associated with third-

party service providers). 

c. Use of relative VaR test and absolute VaR test. 

1.) Would the fund anticipate that it would use the proposed relative VaR 

test or the proposed absolute VaR test (check one box)?  

Relative VaR test Absolute VaR test 

[  ] [  ] 

 

2.) If you anticipate that you would use the proposed relative VaR test, and 

you already disclose a benchmark index for performance disclosure, do 

you anticipate that the index would also qualify as a designated reference 

index under the proposed rule? [Y/N] 

Estimated cost ($) 

$0 - $25,000 $25,001 - $50,000 $50,001 - $75,000 > $75,000 

[  ] [  ] [  ] [  ] 



451 

d. To the extent that the fund is a sub-advised fund, would the proposed limit on 

fund leverage risk present any particular challenges for the fund to implement in 

light of its advisory structure? If so please explain. 

Item 4: Limited Derivatives Users  

Instructions: If you believe the fund would qualify as a limited derivatives user under the 
proposed rule, please answer the following questions. If you do not believe so, please 
proceed to question 5. 

a. Please state which basis for the proposed limited derivatives user exception you 

think the fund would seek to rely on (check one box):  

Exposure-based test 
(The fund’s derivatives exposure 

does not exceed 10% of the fund’s 
net asset value) 

Currency hedging exception 
(The fund only uses derivatives for 

currency hedging purposes as 
specified in the proposed rule) 

[  ] [  ] 

 

b. Should the rule include any other bases for a fund to qualify as a limited 

derivatives user? What alternative approach and why?  

c. Implementation cost. 

1.) Approximately how much do you think it would cost the fund to adopt and 

implement policies and procedures reasonably designed to manage its 

derivatives risks (in terms of combined internal and external costs) (check 

one box)?  

Estimated cost ($) 

$0 - $25,000 $25,001 - $50,000 $50,001 - $75,000 $75,001 - $100,000 > $100,000 

[  ] [  ] [  ] [  ] [  ] 



452 

 

2.) Please include any explanatory notes that you would like to provide. 

Item 5: Recordkeeping 

a. Approximately how much would it cost the fund to comply with the proposed 

recordkeeping requirements associated with rule 18f-4 (in terms of combined 

internal and external costs)? 

b. Should we modify any of the proposed recordkeeping requirements, and if so, 

how? 

Item 6: Reporting Requirements 

a. Approximately how much would it cost the fund to comply with the proposed 

new requirements for reporting on Form N-PORT, Form N-CEN, and Form N-

RN (in terms of combined internal and external costs)? 

b. Should we modify any of the proposed reporting requirements, and if so, how? 

Item 7: Other Feedback on Proposed Rule 18f-4 and Proposed New Reporting 
Requirements  
 

Instructions: Please include any other additional suggestions or comments about proposed 
rule 18f-4, and/or the proposed new reporting requirements, that you would like to provide. 

 

We will post your feedback on our website. Your submission will be posted without change; we 
do not redact or edit personal identifying information from submissions. You should only make 
submissions that you wish to make available publicly. 

If you are interested in more information on the proposal, or want to provide feedback on 
additional questions, click here. Comments should be received on or before March 24, 2020. 

Thank You! 

 
Other Ways to Submit Your Feedback 

https://www.sec.gov/rules/proposed/2019/34-87607.pdf


453 

You also can send us feedback in the following ways (include the file number S7-24-15 in your 
response): 

 
Print Your Responses and Mail 

Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090 

 
Print a PDF of Your Responses and Email 

Use the printer friendly page and select a PDF printer to create a file you can email to: rule-
[email protected] 

 
Print a Blank Copy of This Flier, Fill it Out, and Mail 

Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090

 

IX. APPENDIX B 

Note: Appendix B will not appear in the Code of Federal Regulations. 

Feedback Flier: Sales Practices Rules for Transacting in Shares of Leveraged/Inverse 

Investment Vehicles 

We are proposing two new sales practices rules—rule 15l-2 under the Securities 

Exchange Act of 1934, and Rule 211(h)-1 under the Investment Advisers Act of 1940—that 

would require a broker, dealer, or registered investment adviser to exercise due diligence in 

approving a retail customer’s or client’s account to buy or sell shares of certain 

“leveraged/inverse investment vehicles.” More information about our proposal is available at 

https://www.sec.gov/rules/proposed/2019/34-87607.pdf. 

We are particularly interested in learning what small broker-dealers and investment 

advisers think about the proposed new sales practices rules’ requirements. Hearing from these 

javascript:Clickheretoprint()
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https://www.sec.gov/rules/proposed/2019/34-87458.pdf


454 

smaller firms could help us learn how our proposed rules would affect them, and evaluate how 

we could address any unintended consequences resulting from the cost and effort of regulatory 

compliance while still promoting investor protection. We would appreciate your feedback on any 

or all of the following questions.  

All of the following questions are optional, including any questions that ask about 

identifying information. Please note that responses to these questions – including any other 

general identifying information you provide – will be made public. 

Item 1: General Identifying Information 
 

Instructions: At your option, you may include general identifying information that would 
help us contextualize your other feedback on the proposal. This information could include 
responses to the following questions, as well as any other general identifying information you 
would like to provide. Responses to these items—like responses to the other items on this 
Feedback Flier—will be made public. 
 

a. Is the firm a Commission-registered investment adviser or a broker-dealer? 

b. What is the size of the firm in terms of: 

1.) The number of retail investors (as defined in the release)? 

2.) For Investment Advisers, regulatory assets under management? 

3.) For broker-dealers, regulatory net capital? 

4.) Other (please specify)? 

c. Please include any additional general identifying information that you wish to 

provide, that could add context to your other feedback on the proposal. 

d. Does the firm accept orders from or place orders for the accounts of retail 

investors to buy or sell shares of leveraged/inverse investment vehicles (as 

defined in the proposed sales practices rules)? 



455 

Item 2: Cost to Comply with the Proposed Due Diligence and Account Approval 
Requirements 
 
a. What do you expect the cost to your firm would be in order to comply with these 

proposed requirements (in terms of combined internal and external costs)?  

1.) For an investment adviser (check one box): 

Estimated cost ($) 

$0 - $5,000 $5,001 - $10,000 > $10,000 

[  ] [  ] [  ] 

 

2.) For a broker-dealer (check one box): 

Estimated cost ($) 

$0 - $25,000 $25,001 - $50,000 > $50,000 

[  ] [  ] [  ] 

 

b. Are there any less expensive alternatives to the proposed requirements you can 

suggest that would still preserve the proposed rules’ intended investor protection 

safeguards? 

Item 3: Other Feedback on Proposed Sales Practices Rules 
 
Instructions: Please include any other additional suggestions or comments about the 
proposed sales practices rules that you would like to provide. 

 

We will post your feedback on our website. Your submission will be posted without change; we 
do not redact or edit personal identifying information from submissions. You should only make 
submissions that you wish to make available publicly. 



456 

If you are interested in more information on the proposal, or want to provide feedback on 
additional questions, click here. Comments should be received on or before March 24, 2020. 

Thank You! 

 
Other Ways to Submit Your Feedback 

You also can send us feedback in the following ways (include the file number S7-24-15 in your 
response): 

 
Print Your Responses and Mail 

Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090 

 
Print a PDF of Your Responses and Email 

Use the printer friendly page and select a PDF printer to create a file you can email to: rule-
[email protected] 

 
Print a Blank Copy of This Flier, Fill it Out, and Mail 

Secretary 
Securities and Exchange Commission 
100 F Street, NE 
Washington, DC 20549-1090

 
 

https://www.sec.gov/rules/proposed/2019/34-87607.pdf
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mailto:[email protected]?subject=S7-08-18
mailto:[email protected]?subject=S7-08-18
https://www.sec.gov/rules/proposed/2018/34-83063-appendix-f.pdf