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

    \455\ See J.P. Morgan Comment Letter.
---------------------------------------------------------------------------

b. Remediation
    If a fund determines that it is not in compliance with the
applicable VaR test, then under the rule a fund must

come back into compliance promptly after such determination, in a
manner that is in the best interests of the fund and its
shareholders.\456\ If the fund is not in compliance within five
business days:
---------------------------------------------------------------------------

    \456\ See rule 18f-4(c)(2)(ii).
---------------------------------------------------------------------------

     The derivatives risk manager must provide a written report
to the fund's board of directors and explain how and by when (i.e., the
number of business days) the derivatives risk manager reasonably
expects that the fund will come back into compliance; \457\
---------------------------------------------------------------------------

    \457\ The final rule clarifies that this report must be in
writing. See rule 18f-4(c)(2)(iii)(A); proposed rule 18f-
4(c)(2)(iii)(A). The Commission did not receive comment on whether
this reporting requirement must be in writing.
---------------------------------------------------------------------------

     The derivatives risk manager must analyze the
circumstances that caused the fund to be out of compliance for more
than five business days and update any program elements as appropriate
to address those circumstances; \458\ and
---------------------------------------------------------------------------

    \458\ See rule 18f-4(c)(2)(iii)(B).
---------------------------------------------------------------------------

     The derivatives risk manager must provide a written report
within thirty calendar days of the exceedance to the fund's board of
directors explaining how the fund came back into compliance and the
results of the derivatives risk manager's analysis of the circumstances
that caused the fund to be out of compliance for more than five
business days and any updates to the program elements.\459\
---------------------------------------------------------------------------

    \459\ See rule 18f-4(c)(2)(iii)(C).

If the fund remains out of compliance with the applicable VaR test at
that time, the derivatives risk manager's written report must update
the report explaining how and by when he or she reasonably expects the
fund will come back into compliance, and the derivatives risk manager
must update the board of directors on the fund's progress in coming
back into compliance at regularly scheduled intervals at a frequency
determined by the board.\460\
---------------------------------------------------------------------------

    \460\ See id.; see also infra section II.G.2 (discussing the
requirement to submit a confidential report to the Commission if the
fund is out of compliance with the applicable VaR test for five
business days).
---------------------------------------------------------------------------

    The proposed rule would have required the derivatives risk manager
to satisfy the additional reporting and analysis requirements if the
fund was out of compliance for three consecutive business days.\461\
Additionally, the proposed rule would have prohibited a fund from
entering into any derivatives transactions (other than derivatives
transactions that, individually or in the aggregate, are designed to
reduce the fund's VaR) until the fund has been back in compliance with
the applicable VaR test for three consecutive business days (the
``proposed derivatives entry restriction''), among other
requirements.\462\ The Commission requested comment in the Proposing
Release on whether the remediation provision would exacerbate fund or
market instability and harm investors.\463\ The Commission also
requested comment on whether there was a more-effective means for the
remediation provision to balance investor protection concerns regarding
compliance with the VaR-based limit on fund leverage risk and not
forcing asset sales or unwinding transactions.
---------------------------------------------------------------------------

    \461\ See proposed rule 18f-4(c)(2)(iii).
    \462\ See proposed rule 18f-4(c)(2)(iii)(A) through (C).
    \463\ See Proposing Release, supra footnote 1, at section
II.D.5.b.
---------------------------------------------------------------------------

    Many commenters urged the Commission to extend the remediation
period from three business days to five business days or seven calendar
days.\464\ These commenters suggested that the proposed three business
days is too short to ensure an orderly process of getting back into
compliance.\465\ In particular, commenters raised concerns that during
periods of high market volatility and dislocation, funds would engage
in sales and other actions to get back into compliance with the VaR
test that may have adverse effects on a fund and its shareholders.\466\
Moreover, some commenters pointed out that a five-business-day
remediation period would align better with respect to over-the-counter
derivatives contracts' termination provisions that, based on industry
market practices, are often set at seven calendar days.\467\
---------------------------------------------------------------------------

    \464\ See, e.g., AQR Comment Letter I; Capital Group Comment
Letter; Dechert Comment Letter I; ICI Comment Letter; Franklin
Comment Letter; Putnam Comment Letter; SIFMA AMG Comment Letter; see
also ISDA Comment Letter (suggesting seven business days); Dechert
Comment Letter III (suggesting ten business days in light of
concerns relating to funds fire selling assets to avoid VaR test
compliance issues that may trigger reporting requirements to the
Commission).
    \465\ See, e.g., Franklin Comment Letter; Putnam Comment Letter;
T. Rowe Price Comment Letter.
    \466\ See, e.g., AQR Comment Letter I; Capital Group Comment
Letter; ICI Comment Letter.
    \467\ See, e.g., Dechert Comment Letter I; ICI Comment Letter;
MFA Comment Letter.
---------------------------------------------------------------------------

    Commenters similarly urged that the Commission eliminate or modify
the proposed derivatives entry restriction.\468\ Commenters urged that
this restriction could be disruptive to a fund's execution of its
strategy and could adversely affect a fund and its shareholders.\469\
Several commenters urged that it should be eliminated because the other
provisions requiring reporting to the fund's board of directors and to
the Commission under the rule provide sufficient incentives for funds
to come back into compliance promptly with the rule's VaR test.\470\ A
few commenters also expressed concerns with the proposed derivatives
entry restriction because of the challenges with predicting whether a
new derivatives transaction will be VaR reducing.\471\
---------------------------------------------------------------------------

    \468\ See, e.g., AQR Comment Letter I; Capital Group Comment
Letter; Dechert Comment Letter I; ICI Comment Letter; Franklin
Comment Letter; Putnam Comment Letter; SIFMA AMG Comment Letter;
Dechert Comment Letter III.
    \469\ See, e.g., AQR Comment Letter I; Franklin Comment Letter;
ISDA Comment Letter.
    \470\ See, e.g., SIFMA AMG Comment Letter; Nuveen Comment
Letter; Putnam Comment Letter. But see CFA Comment Letter (stating
that the proposed remediation provisions did not have enough
incentives for funds to comply with the rule's VaR-based test).
    \471\ See, e.g., Franklin Comment Letter; Dechert Comment Letter
I; ICI Comment Letter (suggesting that the implication is that a
fund must engage in pre-trade monitoring). But see J.P. Morgan
Comment Letter (suggesting pre-trade documentation by the portfolio
management team of the intended impact of the derivatives
transaction should satisfy this proposed requirement).
---------------------------------------------------------------------------

    After considering comments, we are making several modifications
from the proposal. We are extending from three business days to five
business days the time period during which a fund may be out of
compliance with its VaR test without being required to report to the
fund's board and confidentially to the Commission.\472\ We appreciate
that investigating a VaR breach and taking steps to remediate it may
take more time than reducing a fund's outstanding bank borrowings,
which was the basis for the three-day period at proposal.
---------------------------------------------------------------------------

    \472\ Under the rule, a fund that is not in compliance within
five business days also will be required to file a report to the
Commission on Form N-RN. See rule 18f-4(c)(7); infra section II.H.2.
---------------------------------------------------------------------------

    We also are modifying the rule to provide that a fund out of
compliance with its VaR test must reduce its VaR promptly, in a manner
that is in the best interests of the fund and its shareholders, which
may exceed this five-business day period. Although a fund remaining out
of compliance with the applicable VaR test raises investor protection
concerns related to fund leverage risk, if the rule were to force a
fund to exit derivatives transactions immediately or at the end of the
five-day period, this could result in greater harm to investors. For
example, it could require the fund to realize trading losses that could
have been avoided under a more-flexible approach. Requiring the fund to
come back into compliance promptly, in a manner that is in the best
interests of the fund and its shareholders, is designed to require a

fund to reduce its VaR promptly but without requiring the fund to
engage in deeply discounted transactions (sometimes known as ``fire
sales'') or otherwise incur trading losses that reasonably might be
avoided while coming back into compliance in a deliberate manner that
is in the best interests of the fund and its shareholders.\473\
---------------------------------------------------------------------------

    \473\ Cf. Dechert Comment Letter III (suggesting that the final
rule require a fund to reduce risk in the best interest of investors
and in line with an adviser's fiduciary responsibilities).
---------------------------------------------------------------------------

    If a fund does not come back into compliance within five business
days, the remediation provision requires the fund to satisfy three
additional requirements. First, the derivatives risk manager must
provide a written report to the fund's board of directors and explain
how and by when (i.e., the number of business days) the derivatives
risk manager reasonably expects that the fund will come back into
compliance.\474\ A few commenters expressed general support for this
remediation provision because it incentivizes funds to stay in
compliance or come back into compliance with the applicable VaR
limit.\475\ However, one commenter suggested eliminating the proposed
board reporting prong of the remediation provision and replacing it
with a rule requiring funds out of compliance with the VaR-based test
to ``reduce risk in the best interest of investors and in line with an
adviser's fiduciary responsibilities.'' \476\
---------------------------------------------------------------------------

    \474\ Rule 18f-4(c)(2)(iii)(A).
    \475\ See, e.g., T. Rowe Price Comment Letter; AQR Comment
Letter I.
    \476\ See, e.g., Dechert Comment Letter III.
---------------------------------------------------------------------------

    After considering the comments received, we are adopting this
requirement as proposed other than the change from three to five
business days discussed above and a modification to require that the
board report be in writing. This requirement is designed to facilitate
the fund coming back into compliance promptly by requiring the
derivatives risk manager to develop a specific remediation course of
action and to facilitate the board's oversight by requiring the
derivatives risk manager to report this information to the board.
    Second, the derivatives risk manager must analyze the circumstances
that caused the fund to be out of compliance for more than five
business days and update any program elements as appropriate to address
those circumstances.\477\ Commenters did not address this aspect of the
remediation provision. We are adopting this provision as proposed,
other than a conforming change from three to five business days
discussed above. This provision is designed to address any deficiencies
in the fund's program, which the fund's inability to come back into
compliance with the applicable VaR test within five business days may
suggest exist.
---------------------------------------------------------------------------

    \477\ Proposed rule 18f-4(c)(2)(iii)(B).
---------------------------------------------------------------------------

    Third, the derivatives risk manager, in a change from the proposal,
must provide a written report within thirty calendar days of the
exceedance (i.e., thirty calendar days of the fund's determination that
it is out of compliance with its applicable VaR test) to the fund's
board of directors explaining: (1) How the fund came back into
compliance; (2) the results of the derivatives risk manager's analysis
of the circumstances that caused the fund to be out of compliance for
more than five business days; and (3) any updates to the program
elements. Under the rule, if the fund remains out of compliance with
the applicable VaR test at that time, the derivatives risk manager's
written report must update the report that explained how and by when he
or she reasonably expects the fund will come back into compliance, and
the derivatives risk manager must update the board of directors on the
fund's progress in coming back into compliance at regularly scheduled
intervals at a frequency determined by the board.
    In the proposal, the Commission requested comment on whether the
remediation provision should include any changes that would distinguish
funds that have more frequent or longer periods of non-compliance with
the VaR test from other funds and potentially subject them to
additional remediation provisions.\478\ A few commenters addressed this
concern.\479\ For example, one commenter stated that because of the
proposed reporting requirements to the Commission and the fund's board
of directors, any fund that has more frequent or longer periods of non-
compliance would ``immediately stand apart as an outlier'' and the
fund's board and the Commission staff could address it.\480\ Another
commenter stated that it would be unlikely a fund would intentionally
exceed the VaR limits for a specific period because of the burdens and
``potentially costly and embarrassing consequences'' of exceeding the
VaR limit beyond the remediation period.\481\ A commenter also stated
that in lieu of the proposed restriction that may address this concern,
the Commission ``has many other tools'' that can address these types of
funds including requiring reporting to the fund's board of
directors.\482\
---------------------------------------------------------------------------

    \478\ See Proposing Release, supra footnote 1, at section
II.D.5.b.
    \479\ See, e.g., MFA Comment Letter; ISDA Comment Letter; AQR
Comment Letter I.
    \480\ See AQR Comment Letter I.
    \481\ See ISDA Comment Letter; but see CFA Comment Letter.
    \482\ See MFA Comment Letter.
---------------------------------------------------------------------------

    After considering the comments received, we are adopting this new
written reporting requirement. This provision is designed to facilitate
appropriate board engagement and oversight when a fund is out of
compliance with its VaR test. The rule provides for this follow-up
within thirty calendar days because we anticipate that funds generally
would have mitigated VaR breaches by that time and would be in a
position to report to the board regarding the process.
    For funds that are out of compliance beyond that time period, by
requiring the derivatives risk manager to update the initial board
report, the rule is designed to facilitate appropriate board oversight
and incentivize compliance with the rule's VaR-based fund leverage risk
limit. For the same reasons, the rule requires the fund's board of
directors to determine regularly scheduled intervals to meet with the
derivatives risk manager until the fund has come back into compliance
with its VaR-based test. If a fund is repeatedly out of compliance with
its applicable VaR test for more than five business days, we would
expect the fund and its board of directors to reconsider whether the
fund's derivatives risk management program is appropriately designed
and operating effectively.
    Finally, we are eliminating the proposed restrictions on a fund's
ability to enter into derivatives transactions while out of compliance
with the VaR test. We appreciate the concerns commenters raised about
the negative effects this could have on a fund's ability to pursue its
strategy, to the potential detriment of shareholders. We also believe
that the requirement that the fund report to the fund's board and the
Commission when a fund's VaR exceeds the limits in its VaR test for
five business days, as well as the other aspects of the remediation
provisions, will create a strong incentive for funds to come back into
compliance without the need for the final rule to limit a fund's
investment activities in ways that could be detrimental to
shareholders. We do not believe that additional mandatory Commission
reporting is necessary because Commission staff can determine whether
and how to follow up with a fund after receiving an initial report on
Form N-RN. The fund also must report confidentially to the Commission
on Form N-RN once it

comes back into compliance. This allows the Commission to monitor the
length of time that a fund has been out of compliance and the fund's
progress in coming back into compliance. We expect that this monitoring
would include staff outreach to a fund concerning its remediation plans
where the fund has remained out of compliance for a longer period of
time.
    Many commenters supported the Form N-RN reporting requirement as an
appropriate adjunct to the rule's remediation provision, facilitating
regulatory monitoring by the Commission.\483\ One commenter, however,
suggested removing the Form N-RN reporting requirement due to fund
sensitivities regarding having to immediately report to the
Commission.\484\ This commenter expressed concern that to avoid this
reporting requirement a fund may engage in ``fire sales'' during
stressed market conditions that may contribute to additional systemic
risk from portfolio managers selling into a volatile market and
realizing losses during a period where transaction costs may be higher.
---------------------------------------------------------------------------

    \483\ See, e.g., J.P. Morgan Comment Letter; Dechert Comment
Letter I; ICI Comment Letter; Invesco Comment Letter; SIFMA AMG
Comment Letter; Nuveen Comment Letter. But see ISDA Comment Letter
(suggesting that the board reporting requirement under the proposed
remediation provision is sufficient and SEC reporting on Form N-RN
is not necessary).
    \484\ See Dechert Comment Letter III (suggesting that some of
the proposed Form N-RN reporting information could be required on
Form N-PORT, which would provide this information to the Commission
on a more time delayed basis). Although this commenter stated that
it ``would eliminate the SEC reporting requirement on Form N-RN and
the board reporting requirement immediately post a [VaR] limit
breach,'' the commenter's concern appeared focused on filing Form N-
RN because the commenter later observed in its letter that ``[i]t is
the immediate SEC posting [on Form N-RN], not the [b]oard reporting
requirement, which creates the sense of urgency and may cause forced
selling not in the best interest of the fund.''
---------------------------------------------------------------------------

    After considering comments, the final rule, consistent with the
proposal, will require a fund that is not in compliance with the
applicable VaR test within five business days after determining it is
out of compliance to report this to the Commission on Form N-RN.\485\
We believe this requirement is important for facilitating appropriate
regulatory oversight of fund leverage risk and compliance with the
rule. This requirement is designed to provide the Commission with
current information regarding potential increased risks and stress
events (as opposed to delayed reporting on Form N-PORT), as discussed
in more detail below.\486\ We have modified the rule expressly to
require a fund that is promptly coming back into compliance with the
applicable VaR test to do so in a manner that is in the best interests
of the fund and its shareholders. A fund engaging in ``fire sales'' to
avoid filing a report on Form N-RN would violate the final rule.
---------------------------------------------------------------------------

    \485\ See infra section II.G.2 (discussing Form N-RN disclosure
reporting requirements).
    \486\ Id.
---------------------------------------------------------------------------

E. Limited Derivatives Users

    Consistent with the proposal, rule 18f-4 includes an exception from
the rule's requirements to adopt a derivatives risk management program,
comply with the VaR-based limit on fund leverage risk, and comply with
the related board oversight and reporting provisions for funds that use
derivatives in a limited manner (collectively, the ``VaR and program
requirements'').\487\ Requiring funds that use derivatives only in a
limited way to comply with these requirements could potentially require
funds (and therefore their shareholders) to incur costs and bear
compliance burdens that may be disproportionate to the resulting
benefits.\488\ We recognize that the risks and potential effect of
derivatives transactions on a fund's portfolio generally increase as
the fund's level of derivatives usage increases and when a fund uses
derivatives for speculative purposes. The rule's limited derivatives
user exception is designed to provide an objective standard to identify
funds that use derivatives in a limited manner.
---------------------------------------------------------------------------

    \487\ One commenter observed that if a limited derivatives user
is exempt from the rule's requirements to establish a derivatives
risk management program and comply with the VaR-based limit on fund
leverage risk, it seems implicit that the fund also would be exempt
from the related board oversight and reporting requirements that are
only relevant to funds that are required to establish a derivatives
risk management program. See NYC Bar Comment Letter. The final rule
clarifies this point by expressly providing that a limited
derivatives user is not subject to the related board oversight and
reporting requirements in rule 18f-4. See rule 18f-4(c)(4)(i).
    \488\ The cost burden concern extends to smaller funds as well,
which could experience an even more disproportionate cost than
larger funds.
---------------------------------------------------------------------------

    Commenters supported the proposed limited derivatives user
exception, and we are adopting it with certain modifications in
response to comments.\489\ Under the final rule, the exception will be
available to a fund that limits its derivatives exposure to 10% of its
net assets. A fund may exclude from the 10% threshold derivatives
transactions that are used to hedge certain currency and/or interest
rate risks and positions closed out with the same counterparty.\490\ A
fund that relies on the exception will be required to adopt policies
and procedures that are reasonably designed to manage its derivatives
risks.\491\ The rule also contains remediation provisions to address
instances in which a fund exceeds the 10% threshold.\492\ We discuss
each element of the exception below.
---------------------------------------------------------------------------

    \489\ See, e.g., ICI Comment Letter; Comment Letter of Gateway
Investment Advisers, LLC (Mar. 24, 2020) (``Gateway Comment
Letter''); SIFMA AMG Comment Letter; Comment Letter of TPG Specialty
Lending (Apr. 2, 2020) (``TPG Comment Letter''); T. Rowe Price
Comment Letter.
    \490\ See rule 18f-4(c)(4).
    \491\ See rule 18f-4(c)(4)(i).
    \492\ See rule 18f-4(c)(4)(ii).
---------------------------------------------------------------------------

1. Derivatives Exposure
    The final rule defines the term ``derivatives exposure'' to mean
the sum of: (1) The gross notional amounts of a fund's derivatives
transactions such as futures, swaps, and options; and (2) in the case
of short sale borrowings, the value of any asset sold short.\493\ We
are adopting this aspect of the rule as proposed, except with a
modification clarifying that derivatives instruments that do not
involve future payment obligations--and therefore are not a
``derivatives transaction'' under the rule--are not included in a
fund's derivatives exposure.\494\ Further, although commenters seemed
to assume that derivatives exposure was to be calculated on a gross
basis in the proposed rule, the final rule expressly requires
derivatives exposure to be based on ``gross'' notional amounts.\495\
This is designed to make clear that a fund's derivatives exposure must
include the sum of the absolute values of the notional amounts of the
fund's derivatives transactions, rather than a figure based on
calculations that net long and short positions. In addition, because
the final rule permits a fund to treat reverse repurchase agreements or
similar financing transactions as derivatives transactions under
certain circumstances, a fund treating these transactions as
derivatives transactions also must include in its derivatives exposure
the proceeds that the fund received but has not yet repaid or returned,
or for which the associated liability has not been extinguished, in
connection with each such transaction.\496\ The derivatives exposure
definition is designed to provide a measure of the market exposure
associated with a limited derivative user's derivatives transactions.
---------------------------------------------------------------------------

    \493\ See rule 18f-4(a).
    \494\ See rule 18f-4(a).
    \495\ Id.
    \496\ See rule 18f-4(a); see also rule 18f-4(d)(1)(ii); Item
B.9.e of Form N-PORT.
---------------------------------------------------------------------------

    Using gross notional amounts to measure market exposure could be

viewed as a relatively blunt measurement, as discussed in the Proposing
Release.\497\ The derivatives exposure threshold in the limited
derivatives user exception, however, is not designed to provide a
precise measure of a fund's market exposure or to serve as a risk
measure. Rather it is designed to serve as an efficient way to identify
funds that use derivatives in a limited way. Commenters supported
permitting the inclusion of an exception from the VaR and program
requirements for funds that engage in derivatives transactions to a
limited extent, based on a fund's derivatives exposure.\498\
---------------------------------------------------------------------------

    \497\ See Proposing Release supra footnote 1, at 149.
    \498\ See, e.g., Comment Letter of the Options Clearing
Corporation (Apr. 15, 2020) (``OCC Comment Letter''); T. Rowe Price
Comment Letter.
---------------------------------------------------------------------------

a. Adjustments for Interest Rate Derivatives and Options
    Like the proposed rule, the final rule permits funds to make two
adjustments designed to address certain limitations associated with
notional measures of market exposure. The commenters who addressed
these adjustments supported them.\499\ Specifically, the first
adjustment permits a fund to convert the notional amount of interest
rate derivatives to 10-year bond equivalents, and the second adjustment
permits a fund to delta adjust the notional amounts of options
contracts.\500\ Converting interest rate derivatives to 10-year bond
equivalents will provide for greater comparability of the notional
amounts of different interest rate derivatives that provide similar
exposure to changes in interest rates but that have different
unadjusted notional amounts. Absent this adjustment, short-term
interest rate derivatives in particular can produce large unadjusted
notional amounts that may not correspond to large exposures to interest
rate changes. Permitting funds to convert these and other interest rate
derivatives to 10-year bond equivalents is designed to result in
adjusted notional amounts that better represent a fund's exposure to
interest rate changes. Similarly, permitting delta adjusting of options
is designed to provide for a more tailored notional amount that better
reflects the exposure that an option creates to the underlying
reference asset. Further, providing these adjustments also would be
efficient for some funds because the adjustments are consistent with
the reporting requirements in Form PF and Form ADV.\501\
---------------------------------------------------------------------------

    \499\ See OCC Comment Letter (stating that ``allowing a fund to
delta-adjust the notional amount of a listed options contract allows
the fund to get a more accurate picture of its exposure to the
underlying security or index''); see also ISDA Comment Letter.
    \500\ Delta refers to the ratio of change in the value of an
option to the change in value of the asset into which the option is
convertible. A fund would delta adjust an option by multiplying the
option's unadjusted notional amount by the option's delta.
    \501\ See, e.g., General Instruction 15 to Form PF; Item B.30 of
Section 2b of Form PF; Glossary of Terms, Gross Notional Value of
Form ADV; Schedule D of Part 1A of Form ADV.
---------------------------------------------------------------------------

b. Closed-Out Derivatives Positions
    Several commenters stated that the rule should allow for netting of
offsetting derivatives transactions when calculating a fund's
derivatives exposure.\502\ They asserted that permitting a fund to
calculate its derivatives exposure by netting offsetting derivatives
positions is necessary to more accurately identify the fund's market
exposure through derivatives.\503\ Commenters stated that a derivatives
transaction previously executed by a fund is often exited through the
fund's execution of an identical but offsetting transaction and that
this process is a useful tool in controlling a fund's derivatives
exposure.\504\ Some commenters favored incorporating a broad use of
netting, for instance, allowing netting of offsetting derivatives
holdings with different counterparties.\505\ Other commenters suggested
that the rule should allow for netting only for offsetting transactions
with the same counterparty.\506\
---------------------------------------------------------------------------

    \502\ See, e.g., Angel Oak Comment Letter; Dechert Comment
Letter I; Guggenheim Comment Letter; T. Rowe Price Comment Letter.
    \503\ See, e.g., Guggenheim Comment Letter; ICI Comment Letter;
Invesco Comment Letter; ISDA Comment Letter; Angel Oak Comment
Letter; Dechert Comment Letter I.
    \504\ See, e.g., T. Rowe Price Comment Letter; Invesco Comment
Letter; Guggenheim Comment Letter.
    \505\ See, e.g., ICI Comment Letter; Invesco Comment Letter.
    \506\ Guggenheim Comment Letter; SIFMA AMG Comment Letter.
---------------------------------------------------------------------------

    We recognize that, in certain circumstances, funds seeking to exit
a derivatives position may enter into a directly offsetting position to
eliminate the fund's market exposure. Accordingly, we are modifying the
proposed ``derivatives exposure'' definition in the final rule to allow
a fund to exclude from its derivatives exposure any closed-out
positions. These positions must be closed out with the same
counterparty and must result in no credit or market exposure to the
fund.\507\
---------------------------------------------------------------------------

    \507\ Rule 18f-4(a). In addition, the final rule's approach to
offsetting positions is consistent with the way advisers report
derivatives exposures on Form PF, which may provide some
efficiencies where these advisers also manage funds that are limited
derivatives users.
---------------------------------------------------------------------------

    The final rule does not, however, permit a fund to exclude offset
positions across different counterparties. This could result in the
fund having a large volume of open derivatives positions subject to
their own margin and other requirements with various counterparties.
For example, when a fund must make margin or collateral payments on a
derivatives transaction to one counterparty, and has not yet received
payments from an offsetting transaction from a different counterparty,
the fund might have to sell investments to raise cash for these
purposes. This could result from differences in the timing of required
payments, effects of margin thresholds or minimum transfer amounts for
the exchange of margin or collateral, or other reasons. These
transactions could involve a scale of derivatives positions and related
operational and counterparty risks that we believe should be managed as
part of a fund's derivatives risk management program.
2. Limited Derivatives User Threshold
    A fund will qualify as a limited derivatives user under the rule if
its derivatives exposure does not exceed 10% of its net assets. As
discussed in more detail above, a fund's derivatives exposure is based
primarily on the gross notional amounts of a fund's derivatives
transactions such as futures, swaps, and options, subject to certain
adjustments. In addition, and in a change from the proposal, the final
rule permits a fund to exclude certain currency and interest rate
hedges from the 10% threshold. This threshold is designed to provide an
objective standard to identify funds that use derivatives in a limited
manner.
a. 10% Derivatives Exposure Threshold
    The Commission proposed a 10% derivatives exposure threshold based
in part on staff analysis of funds' practices regarding derivatives use
based on Form N-PORT filings. Specifically, DERA staff's analysis in
connection with the proposal showed that 78% of funds had adjusted
notional amounts below 10% of NAV; 80% of funds had adjusted notional
amounts below 15% of NAV; 81% of funds had adjusted notional amounts
below 20% of NAV; and 82% of funds had adjusted notional amounts below
25% of NAV.\508\ One commenter conducted a survey of funds' derivatives

exposure and found similar results.\509\ Although BDCs are not required
to file reports on Form N-PORT, our staff separately analyzed a
sampling of 48 BDCs and found that of the sampled BDCs, 54% did not
report any derivatives holdings and a further 29% reported using
derivatives with gross notional amounts below 10% of net assets.\510\
Commenters did not provide alternative data regarding the extent to
which BDCs use derivatives in the context of the limited derivatives
user exception.
---------------------------------------------------------------------------

    \508\ See Proposing Release supra footnote 1, at 151 (citing
data based on Form N-PORT filings from September 2019). These
figures, as well as the updated figures provided below, include
funds that did not report any derivatives transactions.
    \509\ See ICI Comment Letter (asserting that ``75 percent of
respondents (3,940 out of 5,228 funds) indicated that, as of
December 31, 2019, they would have qualified as limited derivative
users'').
    \510\ See Proposing Release supra footnote 1, at 151-52.
---------------------------------------------------------------------------

    The 10% threshold the Commission proposed took these findings into
account, including the Commission's observation that setting the
threshold at 10%, 15%, 20%, or 25%, for example, seemed likely to
result in nearly the same percentages of funds qualifying for the
exception. Since the proposal, DERA staff updated their analysis of
funds' use of derivatives based on September 2020 Form N-PORT filings.
The results of the updated analysis are similar to the findings at
proposal, with the updated analysis reflecting that 79% of funds had
adjusted notional amounts below 10% of NAV; 81% of funds had adjusted
notional amounts below 15% of NAV; 82% of funds had adjusted notional
amounts below 20% of NAV; and 83% of funds had adjusted notional
amounts below 25% of NAV. Similarly, our staff updated their analysis
of the use of derivatives by BDCs. Of the 48 BDCs sampled at proposal
(or their successor funds), updated data reflects that 59.1% did not
report any derivatives holdings, and a further 31.8% reported using
derivatives with gross notional amounts below 10% of net assets. Four
of the BDCs sampled used derivatives more extensively, when measured on
a gross notional basis, mainly due to their use of currency forwards
and/or interest rate swaps. However, as proposed, the final rule
permits a fund to convert the notional amount of interest rate
derivatives to 10-year bond equivalents.\511\ Further, as discussed in
more detail below, and in a change from the proposal, a fund may
exclude currency and interest rate derivatives from the 10% derivatives
exposure threshold if these transactions meet certain criteria for
hedging under the final rule. Most commenters generally supported the
limited derivatives user exception but did not comment specifically on
the proposed 10% threshold. One commenter, however, suggested that a
fund with derivatives exposure up to 20% or 25% of net assets should be
permitted to rely on this exception absent data indicating harm would
result from a higher threshold.\512\ This commenter stated that
distressed or volatile market conditions could make it difficult for
funds to consistently maintain a derivatives exposure of less than 10%.
---------------------------------------------------------------------------

    \511\ See rule 18f-4(a); see also supra section II.E.1.a. Our
staff did not have access to sufficient information to adjust the
notional amounts of the BDCs' interest rate derivatives.
    \512\ See ISDA Comment Letter.
---------------------------------------------------------------------------

    We are adopting the proposed 10% derivatives exposure threshold
rather than a higher figure, like 25%, because we believe the 10%
exposure level is likely to result in nearly the same percentage of
funds qualifying for the exception based on current practices. The 10%
threshold will provide greater investor protections than a 25%
threshold, for example, without a materially greater compliance burden
on funds, since only 4% more funds would be subject to the derivatives
risk management program at the 25% threshold. Further, we believe that
a fund that maintains derivatives exposure at 10% or below is using
derivatives in a limited manner, whereas a fund that has derivatives
exposure near 20% or 25% of its net assets is more likely to present
risks that we believe should be managed as part of a derivatives risk
management program. For instance, we believe that it is important that
a fund with derivatives exposure near 20% or 25% is subject to the
periodic stress testing requirement of the derivatives risk management
program.\513\ For example, although the final rule permits a fund to
delta adjust options because we believe this provides for a more
tailored notional amount, delta-adjusting options also creates the risk
that the size of a fund's investment exposure can increase quickly as
market conditions change, including in times of stress. The final
rule's stress testing requirement will result in the fund manager
developing a more complete understanding of the fund's potential losses
during distressed or volatile market conditions, such as those related
to the recent COVID-19 global health pandemic.
---------------------------------------------------------------------------

    \513\ See infra section II.B.2.c (discussing the stress testing
requirements of the derivatives risk management program).
---------------------------------------------------------------------------

b. The 10% Derivatives Exposure Threshold Excludes Certain Hedging
Transactions
    In a modification of the proposal, the final rule allows a fund to
exclude certain hedging transactions from the 10% derivatives exposure
threshold. The proposed rule, in contrast, included two mutually-
exclusive bases for relying on the limited derivatives user exception.
The first prong of the proposed exception would have excluded funds
when their derivatives exposure is less than 10% of net assets. The
second prong would have excluded funds that limited their derivatives
use solely to certain currency hedging transactions. The Commission
observed that using currency derivatives solely to hedge currency risk
does not raise the policy concerns underlying section 18.
    Commenters urged the Commission to combine the proposed exposure-
based and currency hedging exceptions by allowing a fund to exclude
currency hedges from the derivatives exposure calculation.\514\
Commenters stated that requiring a limited derivatives user to choose
between these exceptions could require funds that use derivatives in a
limited way nevertheless to incur the costs and compliance burdens of
complying with the VaR and program requirements.\515\ For example,
several commenters were concerned that, under the proposal, a fund with
currency derivatives exposure exceeding 10% of the fund's net assets
would be unable to use a single derivative for any other purpose while
remaining a limited derivatives user.\516\ The fund would have to
either leave its foreign-currency denominated investments unhedged or,
if it hedged its currency risk, forgo even a limited use of non-
currency hedging derivatives.\517\ Commenters also stated that, because
they believed that currency hedging derivatives permitted in the
proposed exception do not raise section 18 policy concerns, excluding
currency hedging derivatives from the 10% derivatives exposure
threshold would not raise additional risks that need to be managed
under a derivatives risk management program.\518\
---------------------------------------------------------------------------

    \514\ See, e.g., ICI Comment Letter; Dechert Comment Letter I;
TPG Comment Letter.
    \515\ See, e.g., ICI Comment Letter; Calamos Comment Letter.
    \516\ See, e.g., ICI Comment Letter; T. Rowe Price Comment
Letter; TPG Comment Letter.
    \517\ Dechert Comment Letter I; ICI Comment Letter (stating that
this ``is inefficient and likely detrimental to a fund's returns and
could create more risk for the fund'').
    \518\ See, e.g., Vanguard Comment Letter; ICI Comment Letter.
---------------------------------------------------------------------------

    Several commenters also suggested broadening the scope of the
exclusion to

include interest rate hedging that corresponds directly to a specific
cash-market instrument held by the fund.\519\ Some commenters stated
that they routinely enter into fixed-to-floating interest rate swaps
(or vice versa) and that these transactions are matched to the notional
amount and maturity of a specific security in the fund's
portfolio.\520\ These commenters asserted that such matched interest
rate hedging is conceptually the same as the currency hedging that the
proposed exception would permit because the transactions are easily
identified as a hedge, offset a single risk (interest rate risk), and
are tied to a specific instrument in a fund's portfolio.\521\
---------------------------------------------------------------------------

    \519\ See, e.g., SIFMA AMG Comment Letter; ISDA Comment Letter.
    \520\ See, e.g., SIFMA AMG Comment Letter; TPG Comment Letter.
    \521\ See, e.g., Guggenheim Comment Letter; TPG Comment Letter.
---------------------------------------------------------------------------

    After considering comments, we are permitting funds to exclude
certain currency and interest rate hedges from the 10% derivatives
exposure threshold, in the final rule.\522\ While distinguishing most
hedging transactions from leveraged or speculative derivatives
transactions is challenging, the rule limits this exclusion to interest
rate or currency hedging transactions directly matched to particular
investments held by the fund, or the principal amount of borrowings by
the fund. We believe these currency and interest rate derivatives are
appropriate for limited derivatives users because they will predictably
and mechanically provide the anticipated hedging exposure without
giving rise to basis risks or other potentially complex risks that
should be managed as part of a derivatives risk management program.
---------------------------------------------------------------------------

    \522\ See rule 18f-4(c)(4)(i)(B).
---------------------------------------------------------------------------

    Accordingly, under the final rule a fund may exclude currency and
interest rate derivatives used to hedge the respective currency and
interest rate risks associated with specific equity or fixed-income
investments held by the fund or borrowings by the fund. In the case of
currency hedges, the equity or fixed-income investments being hedged
must be foreign-currency-denominated. These derivatives must be entered
into and maintained by the fund for hedging purposes. The notional
amounts of such derivatives may not exceed the value of the hedged
instruments (or the par value thereof, in the case of fixed-income
investments, or the principal amount, in the case of borrowings) by
more than 10%. These requirements are substantially similar to the
proposal's currency hedging exception, except the proposal provided
that the derivative's notional amount could not exceed the value of the
hedged investment by more than a ``negligible amount'' instead of
10%.\523\
---------------------------------------------------------------------------

    \523\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------

    Several commenters urged that we replace a ``negligible amount''
with a fixed numerical value to provide greater clarity and facilitate
compliance.\524\ Many commenters suggested that a 10% numerical value
would be consistent with the limited derivatives user exception's 10%
derivatives exposure threshold.\525\ Commenters stated that there are
situations, such as shareholder redemptions or fluctuations in the
market value of a hedged investment, that can temporarily cause the
notional amounts of the hedges to exceed the value of the hedged
investments by more than a negligible amount.\526\
---------------------------------------------------------------------------

    \524\ See, e.g., BlackRock Comment Letter; Dechert Comment
Letter I.
    \525\ See, e.g., BlackRock Comment Letter; ICI Comment Letter.
    \526\ See Invesco Comment Letter.
---------------------------------------------------------------------------

    After considering these comments, we have modified the proposal to
replace ``negligible amount'' with a 10% threshold in the final rule.
We are not taking the position that this threshold reflects a
negligible amount. Rather, this change is designed to provide an
unambiguous numerical value to facilitate compliance. Setting the level
at 10%, as opposed to a lower value like 5% or 3%, also will avoid
funds frequently trading (and incurring the attendant costs) to resize
their hedges in response to small changes in value of the hedged
investments. If the notional amount of a derivatives transaction
exceeds the value of the hedged investments by more than 10%, however,
it will no longer qualify as a hedge under the limited derivatives user
exception.
    One commenter urged that the final rule refer simply to foreign-
currency denominated ``investments,'' rather than ``foreign-currency-
denominated equity or fixed-income investments.'' \527\ The commenter
stated that certain investments, such as foreign currency itself, may
not constitute an equity or fixed-income investment. We have not made
this modification because we understand, based on our staff's analysis
of Form N-PORT filings, that funds rarely hold foreign currency in such
significant amounts, and for an extended period, that they would hedge
this currency risk. Moreover, we believe that a rule that refers
specifically to ``equity or fixed-income investments'' is appropriate
because, absent this limitation, a fund could enter into derivatives
transactions to hedge the risks associated with other derivatives
transactions. We view using derivatives to hedge the risks of a fund's
cash-market investments, in contrast, as more consistent with
``limited'' derivatives use.
---------------------------------------------------------------------------

    \527\ Invesco Comment Letter. This commenter also asserted that,
although denominated in U.S. dollars, investors in American
depositary receipts (``ADRs'') are exposed to currency risk
equivalent to that incurred by investing directly in the foreign
security held in the ADR and that it would therefore be appropriate
to ``look through'' the ADR to the underlying foreign security for
purposes of identifying currency hedges under the rule. We agree.
---------------------------------------------------------------------------

c. Certain Suggested Transactions Not Excluded From the 10% Derivatives
Exposure Threshold
    We have not further expanded the limited derivatives user exception
as some commenters urged to include additional hedging or other
transactions. We understand that certain other derivatives strategies
could mitigate funds' portfolio risks. The exception is not meant to
provide parameters for hedging generally or to provide a comprehensive
list of transactions that may pose more limited or defined risks. The
final rule's limited derivatives user exception, however, is designed
to provide an objective standard to identify funds that use derivatives
in a limited manner and help facilitate compliance with the rule.\528\
Unlike the currency and interest rate hedges discussed above, other
transactions commenters suggested may not always predictably and
mechanically provide the anticipated hedging exposure without giving
rise to basis risks or many other potentially complex risks that we
believe should be managed as part of a derivatives risk management
program. Moreover, if we were to permit funds to engage in some or all
of these transactions, as some commenters suggested, that could result
in a fund obtaining derivatives exposure up to the 10% threshold while
also engaging in a range of other transactions. We do not believe this
would represent a limited use of derivatives that should be exempted
from the rule's derivatives

risk management program and VaR requirements. We discuss commenters'
specific suggestions below.
---------------------------------------------------------------------------

    \528\ The challenges of distinguishing between hedging and
speculative activity have been considered in numerous regulatory and
financial contexts. For example, the exemption for certain risk-
mitigating hedging activities from the prohibition on proprietary
trading by banking entities in the rules implementing section 13 of
the Bank Holding Company Act (commonly known as the ``Volcker
Rule''). See Prohibitions and Restrictions on Proprietary Trading
and Certain Interests in, and Relationships With, Hedge Funds and
Private Equity Funds, Release No. BHCA-1 (Dec. 10, 2013) 79 FR 5536
(Jan. 31, 2014), at 5629, 5627. The complexity of distinguishing
hedging from speculation in this context is notable because the
exemption is designed for entities that would not otherwise be
engaged in speculative activity.
---------------------------------------------------------------------------

    Some commenters stated that certain derivatives transactions used
for hedging purposes but not directly matched to a particular
instrument in the fund's portfolio should be excluded from a fund's 10%
derivatives exposure threshold. For instance, a few commenters
requested an exclusion for duration hedging, which is used primarily by
fixed-income funds to manage their exposure to interest rate
fluctuations.\529\ We are not including duration hedging and similar
transactions in the rule because, in contrast to the currency and
interest rate hedging permitted under the exclusion, duration hedging
is not directly matched to a particular instrument in a fund's
portfolio, but rather seeks to modify a portfolio's general interest
rate exposure. Duration hedging can involve more complex hedging
activities than the hedging transactions permitted under the final
rule, which are tied to specific securities held by the fund. Duration
hedging therefore can require a degree of sophistication to implement
and manage.\530\ For these reasons, we believe that a fund that engages
in these transactions, to a sufficient degree, should address these
transactions as part of the fund's derivatives risk management program
and in its compliance with the final rule's VaR requirements.
---------------------------------------------------------------------------

    \529\ For example, if a portfolio has a duration of five
(meaning that for every 1% increase in interest rates, the value of
the portfolio will decline by 5%), interest rate derivatives could
be used to reduce that sensitivity to a lower rate (for example, 2%
or 3%). See Guggenheim Comment Letter; see also SIFMA AMG Comment
Letter.
    \530\ See, e.g., Robert Daigler, Mark Copper, A Futures
Duration-Convexity Hedging Method, 33 The Financial Review 61 (1998)
(discussing the limitations and complexities of duration hedging).
---------------------------------------------------------------------------

    Further, several commenters requested that purchased single-name
credit default swaps be excluded.\531\ Commenters asserted that these
swaps are used to hedge a single risk factor, credit risks.\532\
Although these derivatives transactions may be tied to a particular
reference asset held by the fund, we are not excluding these
transactions from a fund's 10% derivatives exposure threshold. Market
value changes in the fund's investment in the reference asset may not
be offset precisely by changes in value of, or payment amounts under,
the credit default swap. Further, credit default swaps are typically
administered and governed by procedures and documents established by
the International Swaps and Derivatives Association (``ISDA''), a third
party separate from the parties to the transaction. The ISDA procedures
may determine whether the issuer has experienced a credit event that
triggers a payment from the seller of protection. These determinations
will affect whether a fund receives a payment from the protection
seller in the event of a possible credit event. The specific credit
events for a given credit default swap also can affect the swap's value
or its payment amount and, accordingly, can introduce basis risk
between the swap and an investment held by the fund. These mismatches
can occur particularly if the fund holds a security issued by the
entity referenced in the credit default swap but not the exact
reference obligation used by the relevant ISDA procedure. A credit
default swap therefore will not always predictably and mechanically
provide the anticipated hedging exposure without giving rise to basis
risks or other risks that, if incurred in sufficient size, should be
managed as part of a derivatives risk management program.
---------------------------------------------------------------------------

    \531\ See, e.g., ICI Comment Letter, ISDA Comment Letter; SIFMA
AMG Comment Letter.
    \532\ See, e.g., SIFMA AMG Comment Letter; see also Guggenheim
Comment Letter.
---------------------------------------------------------------------------

    Separately, one commenter asserted that after the initial premium,
a purchased single-name credit default swap only obligates a fund to
pay a regularly-scheduled coupon at a rate fixed on trade date.\533\
The commenter urged treating this transaction as an unfunded commitment
agreement under the rule. We are not taking this approach. We believe
that purchased single-name credit default swaps are derivatives
instruments and are distinguishable from unfunded commitment
agreements. For example, they involve investment risks during the life
of the transaction as the value of the swap changes as perceptions of
the credit risk of the entity that the swap references change.\534\
Credit default swaps, including purchased credit default swaps, provide
the ability to take unfunded positions in an issuer's credit risk with
a future payment obligation that can create leverage and other
risks.\535\ We therefore are not excluding purchased credit default
swaps from a fund's 10% derivatives exposure threshold the final rule.
---------------------------------------------------------------------------

    \533\ See Guggenheim Comment Letter (further stating that if
``the reference issuer fails during the term of the trade, an
auction settlement process will unfold pursuant to which the fund
will receive a cash payment equal to the difference (if greater than
zero) between the par value of the reference issuer's debt and the
auction-determined price of such debt'').
    \534\ See footnote 751 and accompanying text for further
discussion of the differences between derivatives transactions and
unfunded commitment agreements.
    \535\ See, e.g., In the Matter of UBS Willow Management L.L.C.
and UBS Fund Advisor L.L.C., Investment Company Act Release No.
31869 (Oct. 16, 2015) (settled action) (involving a registered
closed-end fund that incurred significant losses due in part to
large losses on the fund's purchased credit default swap portfolio).
---------------------------------------------------------------------------

    Additionally, commenters suggested that covered call options and
certain purchased option spreads should be excluded from a fund's 10%
derivatives exposure threshold.\536\ Commenters asserted that for these
transactions, the potential future payment obligation is fully covered
either by shares the fund already owns, in the case of a covered call
option, or by offsetting purchased options, in the case of a purchased
option spread.\537\ Although these transactions have a defined risk
tied to an investment held by the fund, they may be used for
speculative purposes, which makes it difficult to categorically
classify these derivatives transactions as hedges. Further, we do not
believe that it is appropriate or feasible for the limited derivatives
user exception to identify all derivatives instruments or combinations
of derivatives instruments that may mitigate a defined risk in the fund
or a fund position considered in isolation. We therefore have not
modified the rule as these commenters suggested.
---------------------------------------------------------------------------

    \536\ See, e.g., Dechert Comment Letter I; Franklin Templeton
Comment Letter; ICI Comment Letter.
    \537\ See Franklin Templeton Comment Letter.
---------------------------------------------------------------------------

    Similarly, one commenter expressed the view that the Commission
should exclude any derivatives transactions from the 10% derivatives
exposure threshold if a fund earmarks liquid assets equal to the
derivatives' full notional obligations.\538\ The commenter suggested
that this approach would allow funds to engage in hedging transactions
while keeping fund leverage ratios low, at 200% or below. The approach
suggested by the commenter would allow a fund to engage in a
potentially significant amount of derivatives transactions while
remaining a limited derivatives user. Although these transactions may
be ``unelaborate'' in some cases, as described by the commenter,\539\
these transactions could be used to leverage a fund's portfolio and
could be used to introduce significant risk. We believe that funds
engaging in such a level of derivatives activity should comply with the
VaR and program requirements. We therefore have not modified the rule
as the commenter suggested.
---------------------------------------------------------------------------

    \538\ Keen Comment Letter.
    \539\ Id.
---------------------------------------------------------------------------

    One commenter also requested that the exclusion include synthetic
positions where a fund holds cash with

a value equal to the notional amount of derivatives held by the fund,
less any posted margin.\540\ This commenter asserted that a fund's use
of synthetic derivatives should be excluded because they do not create
leverage. We understand that funds may use derivatives to create
synthetic positions to replicate a cash-market exposure in a given
security or group of securities. However, based on Commission staff's
experience, we understand that there could be events that cause these
synthetic positions to behave differently than the equivalent cash-
market position. For instance, an equity swap may contain a complex
merger event or potential adjustment event where the consequences
diverge from the desired consequences available to a cash-market
investor. For example, a swap contract may terminate upon a valid
tender offer for the underlying stock. A swap dealer also may terminate
a transaction due to the dealer's inability to continue to hedge its
market exposure under the swap or due to increased hedging costs. These
kinds of events could lead to an early termination of a synthetic
position prior to the desired liquidation of the related cash-market
investment. Further, the ability to adjust a fund's position in such a
swap may be more limited than its adjustment of cash-market
investments.
---------------------------------------------------------------------------

    \540\ Fidelity Comment Letter (stating that these synthetic
positions are ``routinely used by funds to fully invest shareholder
funds where access to a particular market may be limited at any
given time, or to manage large flows into a fund'').
---------------------------------------------------------------------------

    Moreover, although we believe that a derivatives transaction's
notional amount is an appropriate means of measuring derivatives
exposure for purposes of the limited derivatives user exception, the
notional amount is not a risk measure and may not appropriately reflect
the derivative's market exposure in all cases, such as with respect to
certain complex derivatives.\541\ This commenter's suggestion would
permit a fund to obtain substantially more derivatives exposure than
permitted under the 10% threshold--with exposure theoretically up to
100% of the fund's net assets--increasing the likelihood that the fund
could incur substantial derivatives risks without establishing a
derivatives risk management program or complying with the rule's VaR
test requirements. We do not believe this would be a sufficiently
limited use of derivatives that it should not be subject to those
requirements. For these reasons we are not excluding synthetic
positions from the 10% derivatives exposure threshold in the exception.
---------------------------------------------------------------------------

    \541\ See, e.g., 2015 Proposing Release, supra footnote 1, at
n.175 and accompanying discussion.
---------------------------------------------------------------------------

    One commenter suggested calculating each derivatives transaction's
impact on VaR as an alternative method for identifying hedging
transactions that a fund would exclude from its 10% derivatives
exposure threshold. If the incremental VaR calculation is negative, the
derivatives transaction reduces the fund's risk profile and should
therefore be deemed to fall within the hedging-based exclusion.\542\ As
we discuss above, VaR can be used to analyze whether a fund is using
derivatives transactions to leverage the fund's portfolio. VaR is just
one risk management tool, however, and we believe that it is more
effective if supplemented with other measures.\543\ This commenter's
suggestion could involve funds taking on substantial derivatives
exposure based on VaR calculations without complying with the other
aspects of the rule, like stress testing, that are designed to
complement VaR. This is because an approach based solely on VaR could
identify derivatives transactions as reducing a fund's risk based on
historical correlations that could break down, including in periods of
market stress or the trading days during which the greatest losses
occur (i.e., the ``tail risks'' that VaR does not measure).
---------------------------------------------------------------------------

    \542\ Angel Oak Comment Letter (stating that the ``risk of [the]
overall portfolio should be reduced after the hedging transactions
are executed'').
    \543\ See supra section II.D.1, at footnotes 297-299 and the
accompanying paragraph.
---------------------------------------------------------------------------

    Finally, one commenter urged that we expand the limited derivatives
user exception to exclude commodity hedging from a fund's derivatives
exposure.\544\ Funds typically do not invest directly in commodities,
however, and this suggestion could, for example, involve funds hedging
the exposure created from investments in commodity derivatives with
other commodity derivatives. We recognize that the parties to certain
commodity derivatives transactions (like commodity futures and options
on those futures) may view these transactions as hedged in that they
may be delta neutral.\545\ If these positions remain delta neutral,
losses on one of the positions will be offset by gains on the other.
However, these transactions continue to pose risks that may be
significant. For instance, as certain factors change over time, such as
the price of the underlying asset and/or the interest rate, the
underlying delta can change quickly, introducing risk that will no
longer be offset by the other position. Accordingly, we believe these
transactions, if incurred in sufficient size, should be addressed
through the rule's derivatives risk management program and VaR test
requirements.
---------------------------------------------------------------------------

    \544\ See Guggenheim Comment Letter.
    \545\ As an example, if a fund sells a put option on natural gas
futures and also sells those same futures contracts, and the amount
of the sold futures contracts equals the delta of the sold option,
these positions will be ``delta neutral.''
---------------------------------------------------------------------------

3. Risk Management
    A fund relying on the limited derivatives user exception, as
proposed, will be required to manage the risks associated with its
derivatives transactions by adopting and implementing written policies
and procedures that are reasonably designed to manage the fund's
derivatives risks.\546\ The requirement that funds relying on the
exception manage their derivatives risks recognizes that even a limited
use of derivatives can present risks that a fund should manage.
---------------------------------------------------------------------------

    \546\ See rule 18f-4(c)(4)(i)(A). We are adopting the definition
of derivatives risks as proposed, including the requirement that, in
addition to the enumerated risks, a fund's derivatives risks include
any other risks a fund's investment adviser deems material in the
case of a limited derivatives user. See supra section II.B.2.a
(discussing the derivatives risks definition).
---------------------------------------------------------------------------

    For example, a fund that uses derivatives to hedge currency risks
would not be introducing leverage risk, but could still introduce other
risks, including counterparty risk and a risk of selling investments to
meet margin calls. As another example, certain derivatives, and
particularly derivatives with non-linear or path-dependent returns, may
pose risks that require monitoring even when the derivatives' delta-
adjusted notional amount represents a small portion of net asset value.
In such case, because of the non-linear payout profiles associated with
put and call options, changes in the value of the option's underlying
reference asset can increase the option's delta, and thus a fund's
derivatives exposure from the option. An options transaction that
represents a small percentage of a fund's net asset value can rapidly
increase to a larger percentage.
    The policies and procedures that a fund relying on the limited
derivatives user exception adopts should be tailored to the extent and
nature of the fund's derivatives use. For example, a fund that uses
derivatives only occasionally and for a limited purpose, such as to
equitize cash, is likely to have limited policies and procedures
commensurate with this limited use. A fund that uses more complex
derivatives with derivatives exposure approaching 10% of net asset
value, in contrast, should

have more extensive policies and procedures.
    Commenters generally supported the proposed requirement that a fund
relying on the limited derivatives user exception should adopt and
implement written policies and procedures reasonably designed to manage
the funds' derivatives risks.\547\ One commenter requested that the
Commission provide further guidance on the contents of these required
policies and procedures.\548\ This commenter specifically requested
additional clarity on the minimum frequency of testing for continued
compliance with the exception.
---------------------------------------------------------------------------

    \547\ See, e.g., Gateway Comment Letter; Franklin Comment
Letter.
    \548\ See SIFMA AMG Comment Letter.
---------------------------------------------------------------------------

    The final rule is designed to require a fund relying on the limited
derivatives user exception to manage all risks associated with its
derivatives transactions. Moreover, this approach allows funds to scale
their policies and procedures to address the different strategies funds
may pursue, the different level of derivatives exposure they may seek
(so long as they remain below the 10% derivatives exposure threshold),
and the different risks associated with their derivatives transactions.
In contrast, although a more prescriptive approach regarding a fund's
policies and procedures, such as a minimum frequency of testing as one
commenter suggested, would provide clearer guidelines to facilitate
compliance, this approach may be over- or under-inclusive considering
the breadth of funds' use of derivatives and the derivatives'
particular risks.
4. Exceedances of the Limited Derivatives User Exception
    In the Proposing Release, the Commission stated that if a fund's
derivatives exposure were to exceed the 10% threshold for any reason,
the fund would have to reduce its derivatives exposure promptly or
establish a derivatives risk management program and comply with the
VaR-based limit on fund leverage risk as soon as reasonably
practicable.\549\ The Commission also requested comment on whether the
rule should otherwise address exceedances and remediation.
---------------------------------------------------------------------------

    \549\ See Proposing Release supra footnote 1, at 155.
---------------------------------------------------------------------------

    Many commenters requested further clarity on issues related to
exceedances and remediation of the exception in the final rule,
including to prevent confusion and divergent practices.\550\ As
discussed in more detail below, commenters sought additional clarity
and made suggestions regarding cases where a fund's derivatives
exposure were to exceed the 10% threshold temporarily, as well as cases
where a fund exceeded the derivatives exposure threshold and determined
to come into compliance with the VaR and program requirements rather
than reduce the fund's derivatives exposure.
---------------------------------------------------------------------------

    \550\ See, e.g., BlackRock Comment Letter; Nuveen Comment
Letter; Invesco Comment Letter; Dechert Comment Letter I; see also
ICI Comment Letter (urging that further confusion could result
without clear guidance in situations in which the Commission's exam
staff questions whether a fund's remediation activities were
timely).
---------------------------------------------------------------------------

    To address commenters' concerns, we have determined to modify the
final rule to address exceedances of the 10% derivatives exposure
threshold. The final rule includes two alternative paths for
remediation. If a fund's derivatives exposure exceeds the 10%
derivatives exposure threshold for five business days, the fund's
investment adviser must provide a written report to the fund's board of
directors informing it whether the investment adviser intends either
to: (1) Promptly, but within no more than thirty calendar days of the
exceedance, reduce the fund's derivatives exposure to be in compliance
with the 10% threshold (``temporary exceedance''); or (2) establish a
derivatives risk management program, comply with the VaR-based limit on
fund leverage risk, and comply with the related board oversight and
reporting requirements as soon as reasonably practicable (``derivatives
risk management program adoption'').\551\ In either case the fund's
next filing on Form N-PORT must specify the number of business days, in
excess of the five-business-day period that the final rule provides for
remediation, that the fund's derivatives exposure exceeded 10% of its
net assets during the applicable reporting period.\552\
---------------------------------------------------------------------------

    \551\ See rule 18f-4(c)(4)(ii). A fund with derivatives exposure
exceeding the 10% threshold that complies with the remediation
provision and other requirements of rule 18f-4 applicable to a
limited derivatives user will still qualify as a limited derivatives
user. Under these circumstances the fund's derivatives transactions
therefore will not affect a fund's computation of asset coverage, a
concern that one commenter raised. See Calamos Comment Letter. This
is because the final rule provides that a fund's derivatives
transactions entered into in compliance with the rule will not be
considered for purposes of computing asset coverage under section
18(h). See rule 18f-4(b).
    \552\ See section II.G.1.a. For example, if a fund relying on
the limited derivatives user exception were to determine, on the
evening of Monday, June 1, that its derivatives exposure exceeded
10% of its net assets, and this exceedance were to persist through
Tuesday (June 2), Wednesday (June 3), Thursday (June 4), Friday
(June 5), Monday (June 8), and Tuesday (June 9), the fund would
specify on its next Form N-PORT filing that it had exceeded the 10%
derivatives exposure threshold for 1 day (because five business days
following the determination on June 1 is June 8, and the fund is
required to report the number of business days in excess of the
five-business-day remediation period, therefore the fund will only
report the exceedance on Tuesday, June 9). Information provided in
response to this new Form N-PORT reporting item will not be made
public.
---------------------------------------------------------------------------

    The two paths that the final rule permits for remediation are
designed to balance providing a clear framework for addressing
exceedances that persist beyond five business days with investor
protection concerns related to fund leverage risk and potential harm to
a fund if it were required to sell assets or exit positions quickly to
remain a limited derivatives user. We discuss each of the two paths for
remediation below.
a. Temporary Exceedance
    Several commenters who addressed temporary exceedances urged that
we provide greater clarity by including in the final rule a specific
cure period for a fund to remediate a breach.\553\ A commenter also
urged us to consider including an exception for temporary exceedances
that result from certain ``routine'' fund events, such as large
redemptions and fund rebalancings.\554\ This commenter suggested that
the investment adviser would determine the appropriate duration of the
fund's exceedance based on the fund's risk guidelines and market
convention.
---------------------------------------------------------------------------

    \553\ See ICI Comment Letter (requesting a 14-calendar-day cure
period for a temporary breach, stating that such cure period ``is a
sufficient and reasonable period of time for funds to unwind, close
out, or terminate such transactions in order to come back into
compliance with the exception''); see also Invesco Comment Letter
(requesting a 7-calendar-day cure period); SIFMA AMG Comment Letter
(requesting a 5-business-day cure period).
    \554\ Fidelity Comment Letter.
---------------------------------------------------------------------------

    After considering comments, we are providing an initial five-
business-day period for a fund to address any temporary exceedance of
the threshold.\555\ We recognize that there can be circumstances that
could cause a fund's derivatives exposure temporarily to exceed the 10%
threshold. These might include circumstances that are consistent with
the fund generally using derivatives in a limited way, for example, a
decrease in the fund's net asset value while its derivatives' notional
amounts remain relatively constant. This could happen more frequently
during periods of volatile market conditions. The five-business-day
remediation period is designed to provide funds with some flexibility
in coming back into compliance with the limited derivatives user
exception without triggering an obligation to inform the fund's board
of directors or a Form N-PORT reporting requirement.

This time period is consistent with the time period that the final rule
permits for a fund to come back into compliance with the VaR test
before the fund reports a breach to its board and the Commission.
---------------------------------------------------------------------------

    \555\ See rule 18f-4(c)(4)(ii).
---------------------------------------------------------------------------

    This provision also provides some flexibility for a fund that
cannot reduce its exposure within five business days in a manner that
is in the best interests of the fund and its shareholders.\556\ For
example, a fund with derivatives exposure that exceeds the 10%
threshold because of rebalancing activities as identified by one
commenter would have flexibility either to reduce derivatives exposure
below 10% within five business days, or to take more time to reduce
exposure (up to thirty calendar days of the fund's determination that
it is out of compliance with the 10% threshold) if the adviser reports
to the fund's board.\557\
---------------------------------------------------------------------------

    \556\ See Fidelity Comment Letter (identifying certain events
that could cause a fund's derivatives exposure to exceed the 10%
threshold temporarily).
    \557\ Id.
---------------------------------------------------------------------------

    Although this provision provides flexibility, if a fund were to
exceed the 10% threshold repeatedly, and particularly if those
exceedances occurred over a long period of time and did not occur in
connection with extreme market events that may cause rapid and
significant changes in a fund's net asset value, the fund would not
appear to be using derivatives in a limited manner. In order for a
fund's compliance policies and procedures under rule 38a-1 to be
reasonably designed to achieve compliance with the final rule, they
should be designed to prevent such repeated exceedances. The fund's
policies and procedures likewise should be reasonably designed
generally to address the fund's compliance with the 10% threshold and
support the fund's reliance on the exclusion.
b. Derivatives Risk Management Program Adoption
    The alternate path will require a fund to establish a derivatives
risk management program and comply with the related requirements as
soon as reasonably practicable. Commenters requested greater clarity of
the meaning of ``reasonably practicable'' in the Proposing Release's
discussion of the timing to establish a derivatives risk management
program and comply with the rule's VaR requirements after an
exceedance.\558\ Some commenters requested that we provide a particular
remediation period to allow a fund to implement a derivatives risk
management program.\559\ One commenter suggested that instead of
providing more definitive regulatory guidance, the Commission should
provide assurances that it will not second-guess reasonable actions and
interpretations.\560\
---------------------------------------------------------------------------

    \558\ See, e.g., BlackRock Comment Letter; Dechert Comment
Letter I; SIFMA AMG Comment Letter.
    \559\ See ICI Comment Letter (requesting a 90-calendar-day
period); see also SIFMA AMG Comment Letter (requesting a 60-
calendar-day period); T. Rowe Price Comment Letter (requesting a 45-
calendar-day period).
    \560\ Dechert Comment Letter I.
---------------------------------------------------------------------------

    We understand that there are practical considerations that would
prevent a fund that is no longer a limited derivatives user from coming
into immediate compliance with the VaR and program requirements.
Compliance with the rule requires a fund to adopt a written derivatives
risk management program that a board-approved derivatives risk manager
administers. The program includes mandatory stress testing,
backtesting, internal reporting and escalation, and program review
elements, among other requirements. We recognize that some funds may be
able to comply with the VaR and program requirements relatively
quickly. Their ability to comply quickly would vary based on a variety
of factors, including the complexity of a fund's derivatives use. Other
funds may require additional time. For these reasons, the final rule
provides, as the Commission stated in the proposal, that a fund
transitioning from a limited derivatives user to full compliance with
the rule's other requirements must do so as soon as reasonably
practicable.\561\ We continue to believe this standard is more
appropriate than specifying in the rule the specific time periods
commenters suggested or some other period. Any prescribed period might
provide more or less time than a particular fund may need.
---------------------------------------------------------------------------

    \561\ A fund transitioning from a limited derivatives user to
full compliance with the rule's other requirements may be able to
reduce its exposure below the 10% threshold. If the fund were able
to resume operating below the 10% threshold as a limited derivatives
user, the fund could do so rather than finalizing the fund's
derivatives risk management program and complying with the rule's
VaR test. As noted above, however, if a fund were to exceed the 10%
threshold repeatedly, and particularly if those exceedances occurred
over a long period of time and did not occur in connection with
extreme market events that may cause rapid and significant changes
in a fund's net asset value, the fund would not appear to be using
derivatives in a limited manner. See supra discussion following
footnote 557.
---------------------------------------------------------------------------

F. Approach to Leveraged/Inverse Funds

    Proposed rule 18f-4 included an alternative set of requirements for
leveraged/inverse funds. Under the proposal, a leveraged/inverse fund
would not have been required to comply with rule 18f-4's VaR-based
leverage risk limit if: (1) Transactions in the fund's shares would be
subject to the proposed sales practices rules, discussed below; (2) the
fund limited the investment results it seeks to 300% of the return (or
inverse of the return) of the underlying index; and (3) the fund
disclosed in its prospectus that it was not subject to rule 18f-4's
leverage risk limit.\562\ As discussed in more detail below, after
considering comments, we are not adopting the proposed sales practices
rules or the proposed exception from the VaR-based limit on leverage
risk that was predicated on those rules. Leveraged/inverse funds will
be subject to all of the provisions of rule 18f-4, including the
relative VaR test. Rule 18f-4 will provide, however, an exception from
the VaR test requirement for leveraged/inverse funds in operation as of
October 28, 2020 that seek an investment result above 200% of the
return (or inverse of the return) of an underlying index and satisfy
certain additional conditions.
---------------------------------------------------------------------------

    \562\ See Proposing Release, supra footnote 1, at section
II.G.3.
---------------------------------------------------------------------------

1. Proposed Alternative Requirements for Leveraged/Inverse Funds
    As the Commission stated in the Proposing Release, leveraged/
inverse funds present unique considerations. In contrast to other funds
that use derivatives as part of their broader investment strategy, the
strategy of a leveraged/inverse fund is predicated on the use of
derivatives to amplify the returns (or to correspond to the inverse of
the returns) of an underlying index by a specified multiple.\563\
---------------------------------------------------------------------------

    \563\ Proposing Release, supra footnote 1, at section II.G.1.
The term ``multiple'' as used in rule 18f-4 has the same meaning as
in rule 6c-11. See ETFs Adopting Release, supra footnote 76, at
section II.A.3. As such, leveraged/inverse funds that seek returns
over a predetermined time period that are not evenly divisible by
100 (e.g., 150% of the performance of an index), or that seek
returns within a specified range of an index's performance (e.g.,
200% to 300% of an index's performance or -200% to -300% of an
index's performance), are ``leveraged/inverse funds'' for the
purposes of rule 18f-4.
---------------------------------------------------------------------------

    Leveraged/inverse funds also rebalance their portfolios on a daily
(or other predetermined) basis in order to maintain a constant leverage
ratio. This reset, and the effects of compounding, can result in
performance over longer holding periods that differs significantly from
the leveraged or inverse performance of the underlying reference index
over those longer holding periods.\564\ This effect can be more

pronounced in volatile markets.\565\ As a result, buy-and-hold
investors in a leveraged/inverse fund who have an intermediate or long-
term time horizon--and who may not evaluate their portfolios
frequently--may experience large and unexpected losses or otherwise
experience returns that are different from what they anticipated.\566\
---------------------------------------------------------------------------

    \564\ For example, as a result of compounding, a leveraged/
inverse fund can outperform a simple multiple of its index's returns
over several days of consistently positive returns, or underperform
a simple multiple of its index's returns over several days of
volatile returns.
    \565\ See supra footnotes 23-26 and accompanying text
(discussing effects of market volatility caused by COVID-19 pandemic
on issues related to funds' use of derivatives). See also FINRA
Regulatory Notice 09-31, Non-Traditional ETFs-FINRA Reminds Firms of
Sales Practice Obligations Relating to Leveraged and Inverse
Exchange-Traded Funds (June 2009) (``FINRA Regulatory Notice 09-
31'') (``Using a two-day example, if the index goes from 100 to
close at 101 on the first day and back down to close at 100 on the
next day, the two-day return of an inverse ETF will be different
than if the index had moved up to close at 110 the first day but
then back down to close at 100 on the next day. In the first case
with low volatility, the inverse ETF loses 0.02 percent; but in the
more volatile scenario the inverse ETF loses 1.82 percent. The
effects of mathematical compounding can grow significantly over
time, leading to scenarios such as those noted above.'').
    \566\ See Regulation Best Interest Adopting Release, supra
footnote 12, at discussion following n.597 (stating leveraged and
inverse exchange-traded products ``may not be in the best interest
of a retail customer absent an identified, short-term, customer-
specific trading objective''); see also FINRA Regulatory Notice 09-
31, supra footnote 565 (reminding member firms of their sales
practice obligations relating to leveraged/inverse ETFs and stating
that leveraged/inverse ETFs are typically not suitable for retail
investors who plan to hold these products for more than one trading
session); see also Fiduciary Interpretation, infra footnote 564
(stating that ``leveraged exchange-traded products are designed
primarily as short-term trading tools for sophisticated investors .
. . [and] require daily monitoring . . . .''); Securities Litigation
and Consulting Group, Leveraged ETFs, Holding Periods and Investment
Shortfalls (2010), at 13 (``The percentage of investors that we
estimate hold [leveraged/inverse ETFs] longer than a month is quite
striking.''); ETFs Adopting Release, supra footnote 76, at n.78
(discussing comment letters submitted by Consumer Federation of
America (urging the Commission to consider additional investor
protection requirements for leveraged/inverse ETFs) and by Nasdaq
(stating that ``there is significant investor confusion regarding
existing leveraged/inverse ETFs' daily investment horizon'')).
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the Commission's Office of
Investor Education and Advocacy and FINRA have issued alerts in the
past decade to highlight issues investors should consider when
investing in leveraged/inverse funds.\567\ In addition, some commenters
on the 2015 proposal indicated that at least some segment of investors
may hold leveraged/inverse funds for long periods of time, which can
lead to significant losses under certain circumstances.\568\ FINRA has
sanctioned a number of brokerage firms for making unsuitable sales of
leveraged/inverse ETFs.\569\ More recently, the Commission has brought
enforcement actions against investment advisers for, among other
things, soliciting advisory clients to purchase leveraged/inverse ETFs
for their retirement accounts with long-term time horizons, and holding
those securities in the client accounts for months or years.\570\
---------------------------------------------------------------------------

    \567\ SEC Investor Alert and Bulletins, Leveraged and Inverse
ETFs: Specialized Products with Extra Risks for Buy-and-Hold
Investors (Aug. 1, 2009), available at http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm. This investor alert, jointly issued by
SEC staff and FINRA, followed FINRA's June 2009 alert, which raised
concerns about retail investors holding leveraged/inverse ETFs over
periods of time longer than one day. See FINRA Regulatory Notice 09-
31, supra footnote 565.
    \568\ See, e.g., Comment Letter of the Consumer Federation of
America (Mar. 28, 2016) (``There is evidence that suggests investors
are incorrectly using certain alternative investments that use
derivatives extensively. For example, despite the fact that double
and triple leveraged ETFs are short-term trading vehicles that are
not meant to be held longer than one day, a significant number of
shares are held for several days, if not weeks.''). But cf. Comment
Letter of Rafferty Asset Management (Mar. 28, 2016) (asserting that
there is no evidence that investors do not understand the leveraged/
inverse ETF product, citing, for example, an analysis of eight of
its leveraged/inverse ETFs between May 1, 2009 and July 31, 2015,
and finding an average implied holding period ranging from 1.18 days
to 4.03 days and suggesting, therefore, that investors understand
the products are designed for active trading). We note, however,
that the analysis relied upon in the Comment Letter of Rafferty
Asset Management did not analyze shareholder-level trading activity
or provide any information on the distribution of shareholder
holding periods.
    \569\ See FINRA News Release, FINRA Sanctions Four Firms $9.1
Million for Sales of Leveraged and Inverse Exchange-Traded Funds
(May 1, 2012), available at https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus
and Century Securities to Pay Fines and Restitution Totaling More
Than $1 Million for Unsuitable Sales of Leveraged and Inverse ETFs,
and Related Supervisory Deficiencies (Jan. 9, 2014), available at
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-fines-and-restitution-totaling; FINRA
News Release, FINRA Sanctions Oppenheimer & Co. $2.9 Million for
Unsuitable Sales of Non-Traditional ETFs and Related Supervisory
Failures (June 8, 2016), available at http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of
Acceptance, Waiver and Consent (``AWC'') No.<PHONE_NUMBER>801 (Aug. 8,
2016), available at http://disciplinaryactions.finra.org/Search/ViewDocument/66461; Citigroup Global Markets Inc., FINRA Letter of
AWC No.<PHONE_NUMBER>4 (May, 1, 2012), available at http://disciplinaryactions.finra.org/Search/ViewDocument/31714. See also
Regulation Best Interest Adopting Release, supra footnote 12, at
paragraph accompanying nn.593-98.
    See also, e.g., SEC. v. Hallas, No 1:17-cv-2999 (S.D.N.Y. Sept.
27, 2017) (default judgement); In the Matter of Demetrios Hallas,
SEC. Release No. 1358 (Feb. 22, 2019) (initial decision), Exchange
Act Release No 85926 (May 23, 2019) (final decision) (involving a
former registered representative of registered broker-dealers
purchasing and selling leveraged ETFs and exchange-traded notes for
customer accounts while knowingly or recklessly disregarding that
they were unsuitable for these customers, in violation of section
17(a) of the Securities Act and section 10(b) and rule 10b-5
thereunder of the Exchange Act).
    \570\ See, e.g., In the Matter of Wells Fargo Clearing Services,
LLC, et al., Investment Advisers Act Release No. 5451 (Feb. 27,
2020) (settled action); In the Matter of Morgan Stanley Smith
Barney, LLC, Investment Advisers Act Release No. 4649 (Feb. 14,
2017) (settled action).
---------------------------------------------------------------------------

    The proposal, as well as market volatility following the onset of
COVID-19, each elicited feedback from investors in leveraged/inverse
funds. As discussed below, the Commission received many comments on the
proposal from individual investors asserting they understand the risks
involved in these funds,\571\ as well as some comments suggesting that
retail investors do not understand the unique risks of leveraged/
inverse funds.\572\ The Commission's Office of Investor Education and
Advocacy has received complaints and other communications from
investors following the onset of the market volatility related to
COVID-19 expressing concerns that these funds did not behave as these
investors had expected, with some of these investors experiencing
significant losses. Furthermore, several leveraged/inverse funds with
3x leverage or inverse multiples recently reduced their leverage
multiples to 2x due to the increased market volatility caused by COVID-
19.\573\
---------------------------------------------------------------------------

    \571\ See, e.g., Comment Letter of Kerry Copple (Apr. 17, 2020);
Comment Letter of Praveen Lobo (Apr. 7, 2020); Comment Letter of
Arlene Hellman (Mar. 25, 2020); Comment Letter of Sean Ward (Apr.
27, 2020); Comment Letter of Stephen Cecchini (Apr. 22, 2020).
    \572\ See, e.g., Comment Letter of Steve Woeste (Mar. 17, 2020);
Comment Letter of James Reichl (Mar. 17, 2020); Comment Letter of
Steven Bell (Mar. 18, 2020); Comment Letter of Richard Herber (Mar.
17, 2020); Comment Letter of Daniel P. Smith (Jan. 29, 2020).
    \573\ See, e.g., Direxion Press Release, supra footnote 24; see
also paragraph accompanying supra footnotes 23-26 (discussing
effects of COVID-19 related volatility on funds' use of
derivatives).
---------------------------------------------------------------------------

    As the Commission recognized in the Proposing Release, most
leveraged/inverse funds provide leveraged or inverse market exposure
that exceeds 150% of the return or inverse return of the relevant
index.\574\ Such funds would not have been able to comply with the
proposed limitation on leverage risk under rule 18f-4 because they
would not have been able to satisfy the proposed relative VaR test, and
would not have been eligible to use the proposed absolute VaR test. As
such, requiring these funds to comply with the proposed limit on
leverage risk

effectively would have precluded sponsors from offering the funds in
their current form.
---------------------------------------------------------------------------

    \574\ See Proposing Release, supra footnote 1, at nn.317-318 and
accompanying text.
---------------------------------------------------------------------------

    The Commission proposed a set of alternative requirements for
leveraged/inverse funds that, if satisfied, would have excepted such
funds from the leverage risk limit in proposed rule 18f-4. These
proposed alternative requirements were designed to address the investor
protection concerns that underlie section 18 of the Investment Company
Act, in part, by helping to ensure that retail investors in leveraged/
inverse funds are limited to those investors who are capable of
evaluating the risks these products present. They also would have
limited the amount of leverage that leveraged/inverse funds subject to
rule 18f-4 can obtain to 300% of the return (or inverse of the return)
of the underlying index.
    Proposed rule 15l-2 under the Exchange Act and rule 211(h)-1 under
the Advisers Act would have required broker-dealers and investment
advisers, respectively, to exercise due diligence on retail investors
before approving retail investor accounts to invest in ``leveraged/
inverse investment vehicles.'' As defined in the proposed sales
practices rules, leveraged/inverse investment vehicles include
leveraged/inverse funds and certain exchange-listed commodity- or
currency-based trusts or funds that use a similar leveraged/inverse
strategy.\575\
---------------------------------------------------------------------------

    \575\ See Proposing Release, supra footnote 1, at section
II.G.2.
---------------------------------------------------------------------------

    The proposed due diligence requirements provided that a broker-
dealer or investment adviser must exercise due diligence to ascertain
the essential facts relative to the retail investor, his or her
financial situation, and investment objectives before approving his or
her account to invest in leveraged/inverse investment vehicles. This
requirement would have required the broker-dealer or investment adviser
to seek to obtain certain information about the retail investor,
including, at a minimum, information about his or her financial status
(e.g., employment status, income, and net worth (including liquid net
worth)); and information about his or her investment objectives
generally and his or her anticipated investments in, and experience
with, leveraged/inverse investment vehicles (e.g., general investment
objectives, percentage of liquid net worth intended for investment in
leveraged/inverse investment vehicles, and investment experience and
knowledge).
    The proposed due diligence requirement was designed to provide the
broker-dealer or investment adviser with a comprehensive picture of the
retail investor on which to evaluate whether the retail investor has
the financial knowledge and experience to be reasonably expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles.\576\
---------------------------------------------------------------------------

    \576\ In addition, the proposed sales practices rules would have
required broker-dealers and investment advisers to adopt and
implement written policies and procedures addressing compliance with
the applicable sales practices rule, and would have required broker-
dealers and investment advisers to retain certain records arising
from the due diligence and account approval requirements. See
Proposing Release, supra footnote 1, at sections II.G.2.b-c.
---------------------------------------------------------------------------

    The proposed sales practices rules were generally modeled after
current FINRA options account approval requirements for broker-dealers,
in part based on the Commission's belief that leveraged/inverse
investment vehicles, when held over longer periods of time, may have
certain similarities to options.\577\ Under the FINRA rules for
options, a broker-dealer may not accept a customer's options order
unless the broker-dealer has approved the customer's account for
options trading.\578\ This account-approval requirement applies to all
customers who wish to trade options, including self-directed investors
who do not receive advice or recommendations from the broker-dealer.
---------------------------------------------------------------------------

    \577\ See, e.g., FINRA rule 2360(b)(16)-(17) (requiring firm
approval, diligence and recordkeeping for options accounts); see
also Proposing Release, supra footnote 1, at nn.325-327 and
accompanying text.
    \578\ FINRA rule 2360(b)(16).
---------------------------------------------------------------------------

    The Commission received significant comment on the proposed
alternative requirements for leveraged/inverse funds. Most commenters
categorically opposed the adoption of the proposed sales practices
rules. These commenters provided numerous reasons for their opposition,
including:
     The proposed sales practices rules would restrict investor
choice because retail investors who wish to invest or continue to
invest in leveraged/inverse investment products, including investors
who understand their unique risks, might not be approved for trading in
those products by a broker-dealer or investment adviser.\579\
---------------------------------------------------------------------------

    \579\ See, e.g., Comment Letter of Nathaniel Reynolds (Apr. 28,
2020); Comment Letter of Steve Ludwig (Apr. 22, 2020); Comment
Letter of Jesse Underwood (Apr. 17, 2000); Comment Letter of Angie
Hall (Apr. 17, 2020); Comment Letter of Barbara Kalib (Mar. 22,
2020).
---------------------------------------------------------------------------

     The proposed sales practices rules would provide few
additional protections for investors because their requirements are
duplicative of existing Commission requirements for the activities of
broker-dealers and investment advisers in the recommended transaction
context, including rule 15l-1 under the Exchange Act (``Regulation Best
Interest'') and investment advisers' fiduciary obligations to their
clients.\580\
---------------------------------------------------------------------------

    \580\ See, e.g., Comment Letter of TD Ameritrade (May 4, 2020)
(``TD Ameritrade Comment Letter''); SIFMA Comment Letter. See also
Regulation Best Interest Adopting Release, supra footnote 12;
Commission Interpretation Regarding Standard of Conduct for
Investment Advisers, Investment Advisers Act Release No. 5248 (June
5, 2019) [84 FR 33669 (July 12, 2019)] (``Fiduciary
Interpretation'').
---------------------------------------------------------------------------

     The Commission should not address the investor protection
concerns underlying section 18 of the Investment Company Act by
imposing sales practice requirements on financial intermediaries rather
than placing requirements on leveraged/inverse funds themselves.\581\
---------------------------------------------------------------------------

    \581\ See Direxion Comment Letter; see also Comment Letter of
Charles Schwab & Co., Inc. (Mar. 24, 2020) (``Schwab Comment
Letter'').
---------------------------------------------------------------------------

     The operational burden and expense of implementing the due
diligence and account approval requirements, as well as the potential
legal liability arising from the performance of those requirements,
could cause broker-dealers and investment advisers simply to stop
offering leveraged/inverse investment vehicles to retail investors,
causing harm to leveraged/inverse fund sponsors and restricting
investor choice.\582\
---------------------------------------------------------------------------

    \582\ See, e.g., Comment Letter of Americans for Limited
Government (Mar. 24, 2020) (``Americans for Limited Government
Comment Letter''); SIFMA Comment Letter; Direxion Comment Letter;
ProShares Comment Letter; Schwab Comment Letter.
---------------------------------------------------------------------------

     The FINRA options account-approval framework is not well
suited as a model for leveraged/inverse investment vehicles because
options trading strategies are significantly more complex and have
significantly more risk, including the risk that an investor could lose
more than the amount invested, than investments in leveraged/inverse
investment vehicles.\583\
---------------------------------------------------------------------------

    \583\ See, e.g., Schwab Comment Letter; SIFMA Comment Letter.
Several commenters stated that the FINRA options rule, unlike the
proposed sales practices rules, applies only to transactions for
which there is a broker-dealer recommendation. See, e.g., Direxion
Comment Letter. Although the proposed sales practice rules
incorporated one element from the FINRA rule that applies to
recommended options transactions, FINRA rule 2360(b)(19), the FINRA
rule on which the proposed sales practices rules principally were
based, rule 2360(b)(16), applies regardless of whether the broker-
dealer has made a recommendation.
---------------------------------------------------------------------------

     The proposed sales practices rules, because they would
apply to only two categories of leveraged/inverse products--leveraged/
inverse funds and

listed commodity pools that use leveraged/inverse strategies--would not
sufficiently advance the Commission's investor protection goals.
Exchange-traded notes (``ETNs''), for example, would not be subject to
the proposed sales practices rules, but can use leveraged/inverse
strategies with a nearly identical risk/return profile to leveraged/
inverse investment vehicles, and can present additional risks,
including the risk of issuer default. Accordingly, the proposed sales
practices rules, if adopted, could cause: (1) Sponsors of leveraged/
inverse investment vehicles to offer leveraged/inverse strategies as
ETNs rather than funds or listed commodity pools; and (2) retail
investors to seek out leveraged/inverse strategies through ETNs or
other products that would not be subject to the requirements of the
proposed sales practices rules.\584\
---------------------------------------------------------------------------

    \584\ See, e.g., Direxion Comment Letter; Comment Letter of Mark
J. Flannery, Ph.D. (Mar. 31, 2020) (``Flannery Comment Letter'').
---------------------------------------------------------------------------

     Commenters questioned whether the proposed sales practices
rules regulate ``sales practices'' and therefore the Commission's
authority to promulgate the proposed rules.\585\
---------------------------------------------------------------------------

    \585\ See, e.g., Direxion Comment Letter; ProShares Comment
Letter; Comment Letter of Virtu Financial (Apr. 24, 2020).
---------------------------------------------------------------------------

    Some commenters expressed support for the proposed sales practices
rules on the basis that additional investor protections are warranted
in light of the unique characteristics and risks of leveraged/inverse
investment vehicles.\586\ In addition, several commenters stated that
many retail investors do not understand the risks associated with
investing in leveraged/inverse investment vehicles.\587\
---------------------------------------------------------------------------

    \586\ See, e.g., Herber Comment Letter; Comment Letter of Tom
Antony (Apr. 9, 2020); Comment Letter of Thomas Garman (Mar. 6,
2020); Comment Letter of Patrick Oberman (Feb. 20, 2020); NASAA
Comment Letter. One commenter supported the sales practices rules as
proposed, but suggested that the Commission not amend rule 6c-11 to
include leveraged/inverse funds within that rule's scope (as
proposed), without first implementing additional identification and
categorization requirements for exchange-traded products generally.
See BlackRock Comment Letter (also discussed at infra footnote 618
and accompanying text).
    \587\ See supra footnote 572.
---------------------------------------------------------------------------

    Several commenters recommended alternatives to the proposed sales
practices rules that they believed would address investor protection
concerns associated with leveraged/inverse funds. Commenters suggested
that we should place additional disclosure-based requirements on
intermediaries offering leveraged/inverse investment vehicles to retail
investors, rather than due diligence and account approval
requirements.\588\ Some commenters suggested we require broker-dealers
to: (1) Provide their self-directed customers with short, plain-English
disclosures of the potential risks of trading leveraged/inverse
investment vehicles, both at the point of sale and periodically
thereafter; and (2) require such customers to provide an
acknowledgement of receipt of these disclosures.\589\ Another commenter
suggested that we require broker-dealers and investment advisers to
adopt and implement policies and procedures designed to protect
investors in leveraged/inverse investment vehicles.\590\ This commenter
stated that such policies and procedures could include, among other
things, procedures for reviewing purchases of leveraged/inverse
investment vehicles and monitoring accounts that hold positions in
leveraged/inverse investment vehicles for extended time periods.
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    \588\ See, e.g., Direxion Comment Letter; Schwab Comment Letter.
    \589\ See, e.g., Schwab Comment Letter; TD Ameritrade Comment
Letter; see also NASAA Comment Letter.
    \590\ See Comment Letter of Cambridge Investment Research, Inc.
(May 1, 2020) (``Cambridge Investment Research Comment Letter'').
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    Commenters also suggested that we allow leveraged/inverse funds
with a stated target multiple that is equal to or below the VaR-based
limit on leveraged risk in rule 18f-4 (e.g., a fund that seeks 100%
inverse exposure to the relevant index) to comply with all the
requirements of rule 18f-4, including the VaR-based risk limitation,
rather than requiring broker-dealers or investment advisers to comply
with the proposed sales practices rules with respect to transactions in
these funds. According to these commenters, leveraged/inverse funds
that do not exceed the VaR-based risk limit (and thus would not require
an exception to the VaR limit) should not be subject to the proposed
sales practices rules.\591\
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    \591\ See, e.g., Direxion Comment Letter; ProShares Comment
Letter. See also Comment Letter of Innovator Capital Management (May
8, 2020) (``Innovator Comment Letter'').
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2. Treatment of Leveraged/Inverse Funds Under Rule 18f-4
    After considering the comments discussed above, we have determined
not to adopt the proposed sales practices rules or the proposed
exception from the leverage risk limit that was predicated on broker-
dealers' and investment advisers' compliance with the sales practices
rules. Leveraged/inverse funds, like funds generally, will be required
to comply with the VaR-based limit on fund leverage risk in rule 18f-4,
as adopted, with the exception of certain existing funds discussed in
section II.F.3 below.
    We recognize, as commenters suggested, that our proposal to address
the investor protection concerns underlying section 18 by placing
requirements on the activities of broker-dealers and investment
advisers that offer leveraged/inverse funds, rather than on the
leveraged/inverse funds themselves, presents unique challenges. These
challenges include, as commenters stated, that broker-dealers and
investment advisers would be required to carry out new due diligence
requirements designed to address concerns under section 18, and that
section 18 does not apply to the broker-dealers and investment advisers
that would be subject to those new requirements.\592\ We also recognize
that many leveraged/inverse funds can comply with final rule 18f-4,
particularly given the adjustments to the relative VaR test. We believe
the approach we are adopting addresses many of the concerns raised by
commenters regarding the proposed sales practices rules. We believe the
final approach will preserve meaningful choice for investors by
permitting a substantial number of leveraged/inverse funds to continue
to operate under rule 18f-4, subject to the rule's requirements.
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    \592\ Some commenters also expressed the concern that a
leveraged/inverse fund sponsor would not be able to ensure that a
broker-dealer or investment adviser complied with the sales
practices rules. See, e.g., Direxion Comment Letter. The alternative
requirements in proposed rule 18f-4 would have applied to leveraged/
inverse funds that were within the scope of the proposed sales
practices rules. Broker-dealers and investment advisers would have
been responsible for their own compliance with the sales practices
rules.
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    Leveraged/inverse funds generally will be subject to the
requirements of rule 18f-4 on the same basis as other funds that are
subject to that rule, including the VaR-based leverage risk limit.\593\
Leveraged/inverse funds, because they provide a leveraged return of an
index, will be subject to the rule's relative VaR and, under the rule,
a leveraged/inverse fund must use the index it tracks as its designated
reference portfolio.\594\ For a leveraged/inverse fund that seeks,
directly or indirectly, to provide investment returns that correspond
to 200% of the performance or inverse performance of an index, we
recognize that there may

be minor deviations between the VaR of the fund and 200% of the VaR of
its designated index. These are attributable to financing costs
embedded in the fund's derivatives and valuation differences between
the fund's portfolio and the index it tracks.\595\ These minor
differences would be expected to cause a fund's VaR to exceed 200% of
the VaR of its designated index by a de minimis amount from time to
time where the fund is seeking to provide investment exposure equal to
200% of the return, or inverse of the return, of an index. We would not
view these de minimis deviations by a leveraged/inverse fund as
exceedances of the relative VaR test under these circumstances because
they do not reflect an increase in the fund's leveraged or inverse
market exposure. Therefore, we would not view these deviations, alone,
as giving rise to the remediation requirements in rule 18f-4 for funds
that are not in compliance with the VaR test, or the requirements for
funds to file Form N-RN to report information about VaR test breaches
to the Commission.
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    \593\ The Commission considered and requested comment on this
alternative in section III.E.5 of the Proposing Release.
    \594\ As discussed above, if a fund's investment objective is to
track the performance of an unleveraged index--as we understand to
be the case for leveraged/inverse funds--the fund will be required
under the final rule to use that index as the fund's designated
reference portfolio. See supra section II.D.2.b.
    \595\ See, e.g., ProShares Comment Letter.
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    In addition, where a fund's investment strategy is to provide the
inverse performance, or a multiple of the inverse performance, of an
index, we anticipate the fund would calculate the VaR of the index
based upon the index's inverse performance for purposes of the relative
VaR test. This is because, for inverse funds, the potential for losses
that VaR seeks to measure is driven by the potential for increases in
the index.
3. Standards of Conduct for Broker-Dealers and Registered Investment
Advisers
    Although the final rules we are adopting will not include the
proposed sales practices rules, we agree with commenters that, in the
context of recommended transactions, certain of the investor protection
concerns the Commission articulated in the Proposing Release regarding
leveraged/inverse investment vehicles are addressed by the best
interest standard of conduct for broker-dealers under Regulation Best
Interest. Further, in the context of advisory relationships, the
fiduciary obligations of investment advisers, as the Commission
discussed in the Fiduciary Interpretation, address many of the same
concerns. The best interest standard of conduct for broker-dealers and
the fiduciary obligations of investment advisers apply to transactions
in all exchange-traded products where the transaction is recommended by
a broker-dealer or pursuant to the advice of an investment adviser.
These include transactions in leveraged/inverse funds and listed
commodity pools that the proposed sales practices rules covered, as
well as transactions in products such as ETNs that the proposed rules
did not address.
    The Commission's adoption of Regulation Best Interest enhanced the
standard of conduct for broker-dealers beyond the then-existing
suitability obligations by requiring broker-dealers to act in the best
interest of a retail customer when recommending a securities
transaction or investment strategy involving securities to a retail
customer.\596\ To meet this best interest standard, a broker-dealer
must, among other things, satisfy its care obligation. The care
obligation requires the broker dealer to exercise reasonable diligence,
care, and skill to understand the potential risks, rewards, and costs
associated with the recommendation, and have a reasonable basis to
believe that the recommendation could be in the best interest of at
least some retail customers. This requirement is especially important
where broker-dealers recommend products that are particularly complex
or risky, including leveraged/inverse funds and other products that
follow a similar leveraged or inverse strategy. Broker-dealers
recommending such products should understand that leveraged/inverse
products that are reset daily may not be suitable for, and as a
consequence also not in the best interest of, retail customers who plan
to hold them for longer than one trading session, particularly in
volatile markets. A broker-dealer cannot establish a reasonable basis
to recommend leveraged/inverse products to retail customers without
understanding the terms, features, and risks of these products.\597\
The care obligation also requires a broker-dealer to have a reasonable
basis to believe that a recommendation provided to a retail customer is
in the customer's best interest. Leveraged/inverse products may not be
in the best interest of a retail customer absent an identified, short-
term, customer-specific trading objective.
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    \596\ Regulation Best Interest Adopting Release, supra footnote
12.
    \597\ Id. at nn.593-597 and accompanying text.
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    Similarly, as the Commission stated in the Fiduciary
Interpretation, a reasonable belief that investment advice is in the
best interest of a client requires that an adviser conduct a reasonable
investigation into the investment sufficient not to base its advice on
materially inaccurate or incomplete information. An investment adviser
also must have a reasonable belief that the advice it provides is in
the best interest of the client based on the client's investment
objectives.\598\ Complex products, such as leveraged/inverse products
that are designed primarily as short-term trading tools for
sophisticated investors, may not be in the best interest of a retail
client absent an identified, short-term, client-specific trading
objective.\599\ Moreover, to the extent that such products are in the
best interest of a retail client initially, they would require daily
monitoring by the adviser.
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    \598\ See Fiduciary Interpretation, supra footnote 580.
    \599\ Id. at n.39 and accompanying text.
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    To satisfy their respective obligations in making recommendations
or giving investment advice to retail investors, broker-dealers and
investment advisers need to ascertain certain information about their
customer or client, which can include the same kinds of information the
Commission proposed that firms would collect under the sales practices
rules' due diligence requirement.\600\ Broker-dealers must develop an
investment profile for a retail customer based on the customer's age,
other investments, financial situation and needs, tax status,
investment objectives, investment experience, investment time horizon,
liquidity needs, risk tolerance, and any other information the retail
customer may disclose to the broker-dealer.\601\ Similarly, investment
advisers are required to develop a reasonable understanding of a retail
client's objectives, which should, at a minimum, include a reasonable
inquiry into the client's financial situation, level of financial
sophistication, investment experience, and financial goals.\602\
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    \600\ The proposed sales practices rules would have required
broker-dealers and investment advisers to seek to obtain information
about the retail investor, including, at a minimum, his or her
investment objectives (e.g., safety of principal, income, growth,
trading profits, speculation) and time horizon; employment status
(name of employer, self-employed or retired); estimated annual
income from all sources; estimated net worth (exclusive of family
residence); estimated liquid net worth (cash, liquid securities,
other); percentage of the customer's estimated liquid net worth that
he or she intends to invest in leveraged/inverse investment
vehicles; and investment experience and knowledge (e.g., number of
years, size, frequency and type of transactions) regarding
leveraged/inverse investment vehicles, options, stocks and bonds,
commodities, and other financial instruments. See Proposing Release,
supra footnote 1, at n.333 and accompanying text.
    \601\ See Regulation Best Interest Adopting Release, supra
footnote 12, at paragraph (a)(2).
    \602\ See Fiduciary Interpretation, supra footnote 580, at
section II.B.1.

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4. Staff Review of Regulatory Requirements Relating to Complex
Financial Products
    We recognize that while Regulation Best Interest applies to all
exchange-traded products, including products that the proposed sales
practices rules did not cover, it applies only where a broker-dealer
recommends a transaction or an investment strategy involving securities
to a retail customer. Similarly, rule 18f-4 does not address the
universe of potential investor protection issues related to
transactions in complex products, as it applies only to registered
investment companies and business development companies, and its
requirements for leveraged/inverse funds specifically address the
section 18 concerns that these funds raise. As such, neither Regulation
Best Interest nor rule 18f-4 applies where a retail investor with a
self-directed account invests in ETNs or other complex financial
products that use leveraged/inverse strategies with a nearly identical
risk/return profile to leveraged/inverse funds or in other complex
investment products.