initial sale transaction plus interest.\399\ A reverse repurchase

agreement is economically equivalent to a secured borrowing.\400\
---------------------------------------------------------------------------

    \398\ See section 18(f)(1) of the Investment Company Act.
    \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.
---------------------------------------------------------------------------

    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\
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    \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-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.
---------------------------------------------------------------------------

    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 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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \406\ See SIFMA Comment Letter.
---------------------------------------------------------------------------

    We request comment on our proposed approach to reverse repurchase
agreements and similar financing transactions under the proposed rule.
    227. 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?
    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?
    229. 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?
    230. 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?
    231. 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?
    232. 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?

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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 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 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.
---------------------------------------------------------------------------

    \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,
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.'').
    \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.
---------------------------------------------------------------------------

    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 agreements generally raise the
Investment Company Act's concerns regarding the risks of undue
speculation.\415\
---------------------------------------------------------------------------

    \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.'').
    \415\ See supra notes 45-47 and accompanying text.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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 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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 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 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.
---------------------------------------------------------------------------

    \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 408-412 (discussing
factors distinguishing unfunded commitment agreements from the
derivatives transactions covered by proposed rule 18f-4).
---------------------------------------------------------------------------

    We request comment on our proposed approach to unfunded commitment
agreements.
    233. Are unfunded commitment agreements distinguishable from
derivatives transactions? 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?
    234. 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?
    235. 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?
    236. 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?
    237. 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?
    238. 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 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?
    239. 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?
---------------------------------------------------------------------------

    \423\ See supra notes 29-32 and accompanying text.
---------------------------------------------------------------------------

    240. 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
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?
    241. 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?
    242. 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?
    243. Would any adverse market effects result from the proposed
treatment of unfunded 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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \428\ Proposed rule 18f-4(c)(6)(i)(C); see also supra section
II.K.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \429\ Proposed rule 18f-4(c)(6)(i)(D); see also supra section
II.K.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \430\ Proposed rule 18f-4(e)(2); see also supra section II.K.
    \431\ Id.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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 423
and 428 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).
---------------------------------------------------------------------------

    We request comment on the proposed rule's recordkeeping
requirements.
    244. 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?
---------------------------------------------------------------------------

    \435\ See, e.g., proposed rule 18f-4(c)(1)(ii), proposed rule
18f-4(c)(1)(v)(A).
---------------------------------------------------------------------------

    245. 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 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?
    246. 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\
---------------------------------------------------------------------------

    \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.

 Dreyfus Strategic Investing & Dreyfus Strategic Income (pub.
avail. June 22, 1987)
 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)
 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 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.
    247. 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?
    248. 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)?
    249. 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?
    250. 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 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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    We request comment on the proposed conforming amendment to Form N-
2, and other conforming amendments that commenters suggest would be
necessary or appropriate.
    251. 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?
    252. 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?
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    253. 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 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
derivatives use may entail risks relating to, for example, leverage,
markets, operations, liquidity, and counterparties, as well as legal
risks.\444\
---------------------------------------------------------------------------

    \443\ See supra section I.A.
    \444\ See, e.g., supra notes 16-17 and accompanying text.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \445\ See supra section I.B.1.
    \446\ See supra sections I.B.3.
---------------------------------------------------------------------------

    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 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\
---------------------------------------------------------------------------

    \447\ See supra sections I.C and II.E.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \448\ See supra section II.G.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 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\
---------------------------------------------------------------------------

    \452\ See supra sections II.C and II.H.
    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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
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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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 280.

---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \459\ See DERA White Paper, supra note 1.
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \460\ See supra note 279 and accompanying text.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \464\ See also supra note 145 and accompanying text.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \465\ See also supra note 179.
    \466\ See supra note 221 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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 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\
---------------------------------------------------------------------------

    \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.
    \470\ In statistical terms, the option returns and returns of
holding leveraged/inverse investment vehicles over longer holding
periods both exhibit positive skewness.

---------------------------------------------------------------------------

    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
options are therefore economically equivalent to a dynamically
rebalanced leveraged/inverse or inverse leveraged/inverse position in
the underlying asset or reference index.\473\
---------------------------------------------------------------------------

    \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.
    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \474\ See supra notes 307 and 356. 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 352-353 and accompanying text.
---------------------------------------------------------------------------

    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
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\
---------------------------------------------------------------------------

    \476\ See supra note 321.
    \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.
    \478\ See, e.g., Fiduciary Interpretation, supra note 308, 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.
---------------------------------------------------------------------------

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 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.
    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.
---------------------------------------------------------------------------

    \482\ See supra section III.B.4.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \483\ As a consequence of reducing risk, such funds may earn
reduced returns.
---------------------------------------------------------------------------

    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 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\
---------------------------------------------------------------------------

    \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
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).
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \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.
    \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'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \491\ See supra section II.B.3.d.
    \492\ See supra notes 150-151 and accompanying text.
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \493\ See supra section II.C.1.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \494\ See supra section II.C.2.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \495\ See supra section III.B.4.
---------------------------------------------------------------------------

    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 resources for the program, and fund
complexes may realize economies of scale in developing and implementing
derivatives risk management programs for several funds.\496\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \497\ This estimate is based on the following calculations: 0.65
x $70,000 = $45,500; 0.75 x $500,000 = $375,000.
---------------------------------------------------------------------------

    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 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\
---------------------------------------------------------------------------

    \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.
    \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 466.
    \502\ This estimate is based on the following calculation: 2,693
funds x ($70,000 + $45,500) = $311,041,500.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \503\ See supra section II.D.
    \504\ See supra sections II.E and II.G.3.
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \505\ See supra section II.D.2.
    \506\ See supra section II.D.2.a. The proposed definition of
``designated reference index'' also includes 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 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.
---------------------------------------------------------------------------

    \510\ See supra note 181 and accompanying text.
    \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.
---------------------------------------------------------------------------

    The details of the strategy are as follows. Assume a fund has
initial assets of $100 in cash. On day t, the manager of the portfolio
achieves the additional leverage by writing $ X worth of put options,
and then invests the proceeds from the sale of the options and the
initial cash balance, i.e., $(100 + X), 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 t is
normalized to $100. On day t + 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
[GRAPHIC] [TIFF OMITTED] TP24JA20.000

where RM is the gross one-day return of the S&P 500 index, and Rput =
P(t + 1)/P(t) is the gross one-day return of the put option, with the
price of the put option at time t denoted by P(t). The return of the
put option depends on the return of the underlying sset, 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 K = 92%, K = 96%,
and K = 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.
---------------------------------------------------------------------------

    \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.
    \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.

                             Table 1--Portfolio Composition, Returns and VAR Levels
----------------------------------------------------------------------------------------------------------------
                                                                      K = 92%         K = 96%        K = 100%
                                                                     Portfolio       Portfolio       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 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 (K = 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 (K = 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.
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    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 K = 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 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.
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    \514\ See supra note 183 and accompanying text.
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    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
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.
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    \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.
    \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.
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    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 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 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.
---------------------------------------------------------------------------

    \517\ See supra section III.C.5.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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 multiple types of derivatives, use derivatives more extensively, or
otherwise have more complicated derivatives portfolios, compared to
funds with less complicated derivatives portfolios.
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    \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, 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.
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    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 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\
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    \520\ We estimate that about 19% of all funds that would be