[Federal Register Volume 85, Number 16 (Friday, January 24, 2020)]
[Proposed Rules]
[Pages 4446-4567]
[FR Doc No: 2020-00040]

Vol. 85

Friday,

No. 16

January 24, 2020

Part III

Securities and Exchange Commission

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17 CFR Parts 239, 240, 249, et al.

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

Federal Register / Vol. 85 , No. 16 / Friday, January 24, 2020 /
Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

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

[Release No. 34-87607; IA-5413; IC-33704; File No. S7-24-15]
RIN 3235-AL60

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

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is
re-proposing rule 18f-4, a new exemptive rule under the Investment
Company Act of 1940 (the ``Investment Company Act'') designed to
address the investor protection purposes and concerns underlying
section 18 of the Act and to provide an updated and more comprehensive
approach to the regulation of funds' use of derivatives and the other
transactions addressed in the proposed rule. The Commission is also
proposing new rule 15l-2 under the Securities Exchange Act of 1934 (the
``Exchange Act'') and new rule 211(h)-1 under the Investment Advisers
Act of 1940 (``Advisers Act'') (collectively, the ``sales practices
rules''). In addition, the Commission is proposing new reporting
requirements and amendments to Form N-PORT, Form N-LIQUID (which we
propose to be re-titled as ``Form N-RN''), and Form N-CEN, which are
designed to enhance the Commission's ability to effectively oversee
funds' use of and compliance with the proposed rules, and for the
Commission and the public to have greater insight into the impact that
funds' use of derivatives would have on their portfolios. Finally, the
Commission is proposing to amend rule 6c-11 under the Investment
Company Act to allow certain leveraged/inverse ETFs that satisfy the
rule's conditions to operate without the expense and delay of obtaining
an exemptive order.

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

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

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an email to<EMAIL_ADDRESS>Please include
File No. S7-24-15 on the subject line.

Paper Comments

     Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-24-15. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method of submission. The Commission will post all
comments on the Commission's website (http://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549, on official business days between the hours of
10:00 a.m. and 3:00 p.m. All comments received will be posted without
change. Persons submitting comments are cautioned that we do not redact
or edit personal identifying information from comment submissions. You
should submit only information that you wish to make publicly
available.
    Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Asaf Barouk, Attorney-Adviser; Joel
Cavanaugh, Senior Counsel; John Lee, Senior Counsel; Sirimal Mukerjee,
Senior Counsel; Amanda Hollander Wagner, Branch Chief; Thoreau
Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson,
Assistant Director, at<PHONE_NUMBER>, Investment Company Regulation
Office, Division of Investment Management; and with respect to proposed
rule 15l-2, Kelly Shoop, Senior Counsel; or Lourdes Gonzalez, Assistant
Chief Counsel; Office of Chief Counsel, Division of Trading and
Markets; Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090.

SUPPLEMENTARY INFORMATION: Proposed rule 18f-4 would apply to mutual
funds (other than money market funds), exchange-traded funds
(``ETFs''), registered closed-end funds, and companies that have
elected to be treated as business development companies (``BDCs'')
under the Investment Company Act (collectively, ``funds''). It would
permit these funds to enter into derivatives transactions and certain
other transactions, notwithstanding the restrictions under sections 18
and 61 of the Investment Company Act, provided that the funds comply
with the conditions of the rule. The proposed sales practices rules
would require a broker, dealer, or investment adviser that is
registered with (or required to be registered with) the Commission to
exercise due diligence in approving a retail customer's or client's
account to buy or sell shares of certain ``leveraged/inverse investment
vehicles'' before accepting an order from, or placing an order for, the
customer or client to engage in these transactions.
    The Commission is proposing for public comment 17 CFR 270.18f-4
(new rule 18f-4) under the Investment Company Act, 17 CFR 240.15l-2
(new rule 15l-2) under the Exchange Act, 17 CFR 275.211(h)-1 (new rule
211(h)-1) under the Advisers Act; amendments to 17 CFR 270.6c-11 (rule
6c-11) under the Investment Company Act; amendments to Form N-PORT
[referenced in 17 CFR 274.150], Form N-LIQUID (which we propose to re-
title as ``Form N-RN'') [referenced in 17 CFR 274.223], Form N-CEN
[referenced in 17 CFR 274.101], and Form N-2 [referenced in 17 CFR
274.11a-1] under the Investment Company Act.

Table of Contents

I. Introduction
    A. Overview of Funds' Use of Derivatives
    B. Derivatives and the Senior Securities Restrictions of the
Investment Company Act
    1. Requirements of Section 18
    2. Evolution of Commission and Staff Consideration of Section 18
Restrictions as Applied to Funds' Use of Derivatives
    3. Need for Updated Regulatory Framework
    C. Overview of the Proposal
II. Discussion
    A. Scope of Proposed Rule 18f-4
    1. Funds Permitted To Rely on Proposed Rule 18f-4
    2. Derivatives Transactions Permitted Under Proposed Rule 18f-4
    B. Derivatives Risk Management Program
    1. Summary
    2. Program Administration
    3. Required Elements of the Program
    C. Board Oversight and Reporting
    1. Board Approval of the Derivatives Risk Manager
    2. Board Reporting
    D. Proposed Limit on Fund Leverage Risk

    1. Use of VaR
    2. Relative VaR Test
    3. Absolute VaR Test
    4. Choice of Model and Parameters for VaR Test
    5. Implementation
    6. Other Regulatory Approaches to Limiting Fund Leverage Risk
    E. Limited Derivatives Users
    1. Exposure-Based Exception
    2. Currency Hedging Exception
    3. Risk Management
    F. Asset Segregation
    G. Alternative Requirements for Certain Leveraged/Inverse Funds
and Proposed Sales Practices Rules for Certain Leveraged/Inverse
Investment Vehicles
    1. Background on Proposed Approach to Certain Leveraged/Inverse
Funds
    2. Proposed Sales Practices Rules for Leveraged/Inverse
Investment Vehicles
    3. Alternative Provision for Leveraged/Inverse Funds Under
Proposed Rule 18f-4
    4. Proposed Amendments to Rule 6c-11 Under the Investment
Company Act and Proposed Rescission of Exemptive Relief for
Leveraged/Inverse ETFs
    H. Amendments to Fund Reporting Requirements
    1. Amendments to Form N-PORT
    2. Amendments to Current Reporting Requirements
    3. Amendments to Form N-CEN
    4. BDC Reporting
    I. Reverse Repurchase Agreements
    J. Unfunded Commitment Agreements
    K. Recordkeeping Provisions
    L. Transition Periods
    M. Conforming Amendments
III. Economic Analysis
    A. Introduction
    B. Economic Baseline
    1. Fund Industry Overview
    2. Funds' Use of Derivatives
    3. Current Regulatory Framework for Derivatives
    4. Funds' Derivatives Risk Management Practices and Use of VaR
Models
    5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse
Funds
    C. Benefits and Costs of the Proposed Rules and Amendments
    1. Derivatives Risk Management Program and Board Oversight and
Reporting
    2. VaR-Based Limit on Fund Leverage Risk
    3. Limited Derivatives Users
    4. Reverse Repurchase Agreements and Similar Financing
Transactions
    5. Alternative Requirements for Certain Leveraged/Inverse Funds
and Proposed Sales Practices Rules for Certain Leveraged/Inverse
Investment Vehicles
    6. Proposed Amendments to Rule 6c-11 Under the Investment
Company Act and Proposed Rescission of Exemptive Relief for
Leveraged/Inverse ETFs
    7. Unfunded Commitment Agreements
    8. Recordkeeping
    9. Amendments to Fund Reporting Requirements
    10. Money Market Funds
    D. Effects on Efficiency, Competition, and Capital Formation
    1. Efficiency
    2. Competition
    3. Capital Formation
    E. Reasonable Alternatives
    1. Alternative Implementations of the VaR Tests
    2. Alternatives to the VaR Tests
    3. Stress Testing Frequency
    4. Alternative Exposure Limits for Leveraged/Inverse Funds
    5. No Sales Practices Rules and No Separate Exposure Limit for
Leveraged/Inverse Funds
    6. Enhanced Disclosure
    F. Request for Comments
IV. Paperwork Reduction Act Analysis
    A. Introduction
    B. Proposed Rule 18f-4
    1. Derivatives Risk Management Program
    2. Board Oversight and Reporting
    3. Disclosure Requirement Associated With Limit on Fund Leverage
Risk
    4. Disclosure Requirement for Leveraged/Inverse Funds
    5. Disclosure Changes for Money Market Funds
    6. Policies and Procedures for Limited Derivatives Users
    7. Recordkeeping Requirements
    8. Proposed Rule 18f-4 Total Estimated Burden
    C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers
    1. Due Diligence and Account Approval
    2. Policies and Procedures
    3. Recordkeeping
    4. Proposed Rule 15l-2 Total Estimated Burden
    D. Proposed Rule 211(h)-1: Sales Practices for Registered
Investment Advisers
    1. Due Diligence and Account Approval
    2. Policies and Procedures
    3. Recordkeeping
    4. Proposed Rule 211(h)-1 Total Estimated Burden
    E. Rule 6c-11
    F. Form N-PORT
    G. Form N-RN
    H. Form N-CEN
    I. Request for Comments
V. Initial Regulatory Flexbility Analysis
    A. Reasons for and Objectives of the Proposed Actions
    B. Legal Basis
    C. Small Entities Subject to Proposed Rules
    D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
    1. Proposed Rule 18f-4
    2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
    3. Proposed Sales Practices Rules
    4. Proposed Amendments to Rule 6c-11
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    1. Proposed Rule 18f-4
    2. Proposed Sales Practices Rules
    3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
    4. Rule 6c-11
    G. Request for Comment
VI. Consideration of Impact on the Economy
VII. Statutory Authority
VIII. Appendix A
IX. Appendix B

I. Introduction

    The fund industry has grown and evolved substantially in past
decades in response to various factors, including investor demand,
technological developments, and an increase in domestic and
international investment opportunities, both retail and
institutional.\1\ Funds today follow a broad variety of investment
strategies and provide diverse investment opportunities for fund
investors, including retail investors. As funds' strategies have become
increasingly diverse, funds' use of derivatives has grown in both
volume and complexity over the past several decades.\2\ Derivatives may
be broadly described as instruments or contracts whose value is based
upon, or derived from, some other asset or metric.\3\ Funds use
derivatives for a variety of purposes. For example, funds use
derivatives to seek higher returns through increased investment
exposure, to hedge risks in their investment portfolios, or to obtain
exposure to particular investments or markets more efficiently than may
be

possible through direct investments.\4\ At the same time, derivatives
can introduce certain new risks and heighten certain risks to a fund
and its investors. These risks can arise from, for example, leverage,
liquidity, markets, operations, legal matters (e.g., contract
enforceability), and counterparties.
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    \1\ For example, the investment company industry consisted of
more than 3,500 investment companies, and held over $1.3 trillion in
assets, as of the end of 1991. See SEC Division of Investment
Management, Protecting Investors: A Half Century of Investment
Company Regulation (1992), available at https://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf. The assets held by
U.S.-registered investment companies grew to approximately $7.1
trillion as of the end of 1999, and from then until the end of 2018
grew over 200%, to approximately $21.4 trillion. See Investment
Company Institute, 2018 Investment Company Fact Book at 32,
available at https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf . Similarly, the number
of mutual funds, registered closed-end funds, and ETFs grew from
7,970, 512, and 30 (respectively) as of the end of 1999, to 9,599,
506, and 2,057 (respectively) as of the end of 2018. See id. at 50.
     The diversity of fund strategies has also increased over time,
including, more recently, the introduction of funds pursuing so-
called ``alternative strategies'' (which tend to use derivatives
more than other fund types). See Daniel Deli, Paul Hanouna, Christof
Stahel, Yue Tang & William Yost, Use of Derivatives by Registered
Investment Companies, Division of Economic and Risk Analysis (2015),
available at http://www.sec.gov/dera/staffpapers/white-papers/derivatives12-2015.pdf (``DERA White Paper'').
    \2\ See Use of Derivatives by Registered Investment Companies
and Business Development Companies, Investment Company Act Release
No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 28, 2015)], at n.6 and
accompanying text (``2015 Proposing Release'').
    \3\ The asset or metric on which the derivative's value is
based, or from which its value is derived, is commonly referred to
as the ``reference asset,'' ``underlying asset,'' or ``underlier.''
See id. at n.3 and accompanying text (citing Use of Derivatives by
Investment Companies under the Investment Company Act of 1940,
Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR
55237 (Sept. 7, 2011)], at n.3 (``2011 Concept Release'')). The
comment letters on the 2011 Concept Release (File No. S7-33-11) are
available at https://www.sec.gov/comments/s7-33-11/s73311.shtml.
    \4\ See, e.g., My Nguyen, Using Financial Derivatives to Hedge
Against Currency Risk, Arcada University of Applied Sciences (2012).
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    Funds using derivatives must consider requirements under the
Investment Company Act of 1940.\5\ These include sections 18 and 61 of
the Investment Company Act, which limit a fund's ability to obtain
leverage or incur obligations to persons other than the fund's common
shareholders through the issuance of ``senior securities.'' \6\ As we
discuss more fully in this release, as derivatives markets have
expanded and funds have increased their use of derivatives, the
Commission and its staff have issued guidance addressing the use of
specific derivatives instruments and practices, and other financial
instruments, under section 18. In determining how they will comply with
section 18, we understand that funds consider this Commission and staff
guidance, as well as staff no-action letters and the practices that
other funds disclose in their registration statements.\7\
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    \5\ 15 U.S.C. 80a (the ``Investment Company Act,'' or the
``Act''). Except in connection with our discussion of proposed rule
15l-2 under the Securities Exchange Act of 1934 and proposed rule
211(h)-1 under the Advisers Act or as otherwise noted, all
references to statutory sections are to the Investment Company Act,
and all references to rules under the Investment Company Act,
including proposed rule 18f-4, will be to title 17, part 270 of the
Code of Federal Regulations, 17 CFR part 270.
    \6\ See infra section I.B.1. Funds using derivatives must also
comply with all other applicable statutory and regulatory
requirements, such as other federal securities law provisions, the
Internal Revenue Code, Regulation T of the Federal Reserve Board,
and the rules and regulations of the Commodity Futures Trading
Commission (the ``CFTC''). See also Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act, Public Law 111-203, 124
Stat. 1376 (2010) (the ``Dodd-Frank Act''), available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.
    Section 61 of the Investment Company Act makes section 18 of the
Act applicable to BDCs, with certain modifications. See infra note
32 and accompanying text. Except as otherwise noted, or unless the
context dictates otherwise, references in this release to section 18
of the Act should be read to refer also to section 61 with respect
to BDCs.
    \7\ Any staff guidance or no-action letters discussed in this
release represent the views of the staff of the Division of
Investment Management. They are not a rule, regulation, or statement
of the Commission. Furthermore, the Commission has neither approved
nor disapproved their content. Staff guidance has no legal force or
effect; it does not alter or amend applicable law; and it creates no
new or additional obligations for any person.
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    In the absence of Commission rules and guidance that address the
current broad range of funds' derivatives use, inconsistent industry
practices have developed.\8\ We are concerned that certain of these
practices may not address investor protection concerns that underlie
section 18's limitations on funds' issuance of senior securities.
Specifically, certain fund practices can heighten leverage-related
risks, such as the risk of potentially significant losses and increased
fund volatility, that section 18 is designed to address. We are also
concerned that funds' disparate practices could create an un-level
competitive landscape and make it difficult for funds and our staff to
evaluate funds' compliance with section 18.\9\
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    \8\ See infra section I.B.2.b (discussing the asset segregation
practices funds have developed to ``cover'' their derivatives
positions, which vary based on the type of derivatives transaction
and with respect to the types of assets that funds segregate to
cover their derivatives positions).
    \9\ See, e.g., Comment Letter of the Investment Company
Institute on the 2011 Concept Release (Nov. 7, 2011) (File No. S7-
33-11) at n.19 (``ICI Concept Release Comment Letter'') (noting that
funds segregate the notional amount of physically-settled futures
contracts, while some funds disclose that they segregate only the
marked-to-marked obligation in respect of cash-settled futures and
agreeing with the concern reflected in the 2011 Concept Release that
this ``results in differing treatment of arguably equivalent
products'').
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    To address these concerns, in 2015 the Commission proposed new rule
18f-4 under the Investment Company Act, which would have permitted a
fund to enter into derivatives transactions and ``financial commitment
transactions,'' subject to certain conditions.\10\ We received
approximately 200 comment letters in response to the 2015 proposal.\11\
In developing this re-proposal we considered those comment letters, as
well as subsequent staff engagement with large and small fund complexes
and investor groups.\12\
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    \10\ For purposes of this release, we will refer to the version
of rule 18f-4 that the Commission proposed in the 2015 Proposing
Release as the ``2015 proposed rule.'' We will generally refer to
rule 18f-4 as we propose it here as the ``proposed rule.''
    The 2015 proposed rule included four principal elements for
funds entering into derivatives transactions: (1) A requirement to
comply with one of two alternative portfolio limitations designed to
limit the amount of leverage a fund may obtain through derivatives
and other senior securities transactions; (2) asset segregation for
derivatives transactions, designed to enable a fund to meet its
derivatives-related obligations; (3) a derivatives risk management
program requirement for funds that engage in more than limited
derivatives transactions or that use complex derivatives; and (4)
reporting requirements regarding a fund's derivatives usage.
    The 2015 proposed rule included different requirements for
derivatives transactions and ``financial commitment transactions''
(collectively, reverse repurchase agreements, short sale borrowings,
or any firm or standby commitment agreement or similar agreement).
Rule 18f-4 as we propose it here does not separately define
``financial commitment transactions,'' although the proposed rule
does address--either directly or indirectly--all of the types of
transactions that composed that defined term in the 2015 proposed
rule. See infra section II.
    \11\ The comment letters on the 2015 proposed rule (File No. S7-
24-15) are available at https://www.sec.gov/comments/s7-24-15/s72415.shtml.
    \12\ See also Division of Economic and Risk Analysis, Memorandum
re: Risk Adjustment and Haircut Schedules (Nov. 1, 2016), available
at https://www.sec.gov/comments/s7-24-15/s72415-260.pdf (``2016 DERA
Memo'').
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    We are re-proposing rule 18f-4, which is designed to address the
investor protection purposes and concerns underlying section 18 and to
provide an updated and more comprehensive approach to the regulation of
funds' use of derivatives transactions and certain other transactions.
The proposed rule would permit funds to enter into these transactions,
notwithstanding the restrictions under section 18 of the Investment
Company Act, provided that they comply with the conditions of the rule.
The proposed rule's conditions are designed to require funds to manage
the risks associated with their use of derivatives and to limit fund
leverage risk consistent with the investor protection purposes
underlying section 18. Our proposal also includes requirements designed
to address specific risks posed by certain registered investment
companies and exchange-listed commodity- or currency-based trusts or
funds that obtain leveraged or inverse exposure to an underlying index,
generally on a daily basis.\13\ The proposal also addresses funds' use
of reverse repurchase agreements and similar transactions and certain
so-called ``unfunded commitments.'' Finally, we propose to amend rule
6c-11 under the Investment Company Act to allow certain leveraged/
inverse ETFs that satisfy that rule's conditions to operate without the
expense and delay of obtaining an exemptive order. Together, the rules
we are proposing are designed to promote funds' ability to continue to
use derivatives in a broad variety of ways that serve investors, while
responding to the concerns underlying section 18 of the Investment
Company Act and promoting a more

modern and comprehensive framework for regulating funds' use of
derivatives and the other transactions addressed in the proposed rule.
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    \13\ As discussed in more detail in section II.G, the proposed
sales practices rules would cover transactions in ``leveraged/
inverse investment vehicles,'' which include registered investment
companies and certain exchange-listed commodity- or currency-based
trusts or funds that seek, directly or indirectly, to provide
investment returns that correspond to the performance of a market
index by a specified multiple, or to provide investment returns that
have an inverse relationship to the performance of a market index,
over a predetermined period of time. For purposes of this release,
we refer to leveraged, inverse, and leveraged inverse investment
vehicles collectively as ``leveraged/inverse.''
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A. Overview of Funds' Use of Derivatives

    Funds today use a variety of derivatives. These derivatives can
reference a range of assets or metrics, such as: Stocks, bonds,
currencies, interest rates, market indexes, currency exchange rates, or
other assets or interests. Examples of derivatives that funds commonly
use include forwards, futures, swaps, and options. Derivatives are
often characterized as either exchange-traded or over-the-counter
(``OTC'').\14\
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    \14\ Exchange-traded derivatives--such as futures, certain
options, and options on futures--are standardized contracts traded
on regulated exchanges. See 2015 Proposing Release, supra note 2, at
nn.10-13 and accompanying text. OTC derivatives--such as certain
swaps, non-exchange-traded options, and combination products such as
swaptions and forward swaps--are contracts that parties negotiate
and enter into outside of an organized exchange. See id. at nn.14-16
and accompanying text. Unlike exchange-traded derivatives, OTC
derivatives may be significantly customized and may not be cleared
by a central clearing organization. Title VII of the Dodd-Frank Act
provides a comprehensive framework for the regulation of the OTC
swaps market. See supra note 6.
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    A common characteristic of most derivatives is that they involve
leverage or the potential for leverage. The Commission has stated that
``[l]everage exists when an investor achieves the right to a return on
a capital base that exceeds the investment which he has personally
contributed to the entity or instrument achieving a return.'' \15\ Many
fund derivatives transactions, such as futures, swaps, and written
options, involve leverage or the potential for leverage because they
enable the fund to magnify its gains and losses compared to the fund's
investment, while also obligating the fund to make a payment or deliver
assets to a counterparty under specified conditions.\16\ Other
derivatives transactions, such as purchased call options, provide the
economic equivalent of leverage because they can magnify the fund's
exposure beyond its investment but do not impose a payment obligation
on the fund beyond its investment.\17\
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    \15\ See Securities Trading Practices of Registered Investment
Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979)
[44 FR 25128 (Apr. 27, 1979)], at n.5 (``Release 10666'').
    \16\ The leverage created by such an arrangement is sometimes
referred to as ``indebtedness leverage.'' See 2015 Proposing
Release, supra note 2, at n.21 (citing 2011 Concept Release, supra
note 3, at n.31).
    \17\ This type of leverage is sometimes referred to as
``economic leverage.'' See id. at n.22 (citing 2011 Concept Release,
supra note 3, at n.32).
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    Funds use derivatives both to obtain investment exposures as part
of their investment strategies and to manage risk. A fund may use
derivatives to gain, maintain, or reduce exposure to a market, sector,
or security more quickly, and with lower transaction costs and
portfolio disruption, than investing directly in the underlying
securities.\18\ A fund also may use derivatives to obtain exposure to
reference assets for which it may be difficult or impractical for the
fund to make a direct investment, such as commodities.\19\ With respect
to risk management, funds may employ derivatives to hedge interest
rate, currency, credit, and other risks, as well as to hedge portfolio
exposures.\20\
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    \18\ See, e.g., id. at n.24 and accompanying text (citing 2011
Concept Release, supra note 3, at section I).
    \19\ See, e.g., Comment Letter of Stone Ridge Asset Management
LLC (Mar. 28, 2016) (``[I]t is not possible for AVRPX [a Stone Ridge
fund] to trade many of the physical assets underlying the
derivatives included in our portfolio--Stone Ridge does not maintain
facilities to store oil or live hogs, for example.''); Comment
Letter of Vanguard (Mar. 28, 2016) (``Vanguard Comment Letter'')
(stating that a fund may use a derivative, such as commodity
futures, when it is impractical to take delivery of physical
commodities).
    \20\ See 2015 Proposing Release, supra note 2, at n.25 and
accompanying text; see also 2011 Concept Release, supra note 3, at
section I.B.
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    At the same time, a fund's derivatives use may entail risks
relating to, for example, leverage, markets, operations, liquidity
(particularly with respect to complex OTC derivatives), and
counterparties, as well as legal risks.\21\ A fund's investment
adviser, therefore, must manage (and the board of directors oversee)
the fund's derivatives use, consistent with the fund's investment
objectives, policies, restrictions, and risk profile. Furthermore, a
fund's investment adviser and board of directors must bear in mind the
requirements of section 18 of the Investment Company Act, as well as
the Act's other requirements, when considering the use of derivatives.
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    \21\ See 2015 Proposing Release, supra note 2, at n.26 and
accompanying text (citing 2011 Concept Release, supra note 3, at
n.34).
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    Section 18 is designed to limit the leverage a fund can obtain or
incur through the issuance of senior securities. Although the leverage
limitations in section 18 apply regardless of whether the relevant fund
actually experiences significant losses, several recent examples
involving significant losses illustrate how a fund's use of derivatives
may raise the investor protection concerns underlying section 18. The
2015 proposal discussed several circumstances in which substantial and
rapid losses resulted from a fund's investment in derivatives.\22\ For
example, one of these cases shows that further losses can result when a
fund's portfolio securities decline in value at the same time that the
fund is required to make additional payments under its derivatives
contracts.\23\
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    \22\ See 2015 Proposing Release, supra note 2, at section
II.D.1.d. (discussing, among other things, the following settled
actions: In the Matter of OppenheimerFunds, Inc. and
OppenheimerFunds Distributor, Inc., Investment Company Act Release
No. 30099 (June 6, 2012) (settled action) (``OppenheimerFunds
Settled Action'') (involving two mutual funds that suffered losses
driven primarily by their exposure to certain commercial mortgage-
backed securities, obtained mainly through total return swaps); In
the Matter of Claymore Advisors, LLC, Investment Company Act Release
No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset
Management, LLC, Investment Company Act Release No. 30309 (Dec. 19,
2012) (settled actions) (involving a registered closed-end fund that
pursued an investment strategy involving written out-of-the-money
put options and short variance swaps, which led to substantial
losses for the fund); In the Matter of UBS Willow Management L.L.C.
and UBS Fund Advisor L.L.C., Investment Company Act Release No.
31869 (Oct. 16, 2015) (settled action) (involving a registered
closed-end fund that incurred significant losses due in part to
large losses on the fund's credit default swap portfolio)).
    See also In the Matter of Team Financial Asset Management, LLC,
Team Financial Managers, Inc., and James L. Dailey, Investment
Company Act Release No. 32951 (Dec. 22, 2017) (settled action)
(involving a mutual fund incurring substantial losses arising out of
speculative derivatives instruments, including losing $34.67 million
in 2013 from trading in derivatives such as futures, options, and
currency contracts); In the Matter of Mohammed Riad and Kevin
Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21,
2018) (settled action) (involving a registered closed-end fund
incurring substantial losses resulting from the implementation of a
new derivatives trading strategy); In the Matter of Top Fund
Management, Inc. and Barry C. Ziskin, Investment Company Act Release
No. 30315 (Dec. 21, 2012) (settled action) (involving a mutual fund
engaged in a strategy of buying options for speculative purposes
contrary to its stated investment policy, which permitted options
trading for hedging purposes, losing about 69% of its assets as a
result of this activity before liquidating).
    \23\ See OppenheimerFunds Settled Action, supra note 22.
---------------------------------------------------------------------------

    Similarly, last year the LJM Preservation and Growth Fund
liquidated after sustaining considerable losses (with its net asset
value declining approximately 80% in two days) when market volatility
spiked. The fund's principal investment strategy involved purchasing
and selling call and put options on the Standard & Poor's (``S&P'') 500
Futures Index.\24\ S&P 500 options prices are determined in part by
market volatility, and a volatility spike in early February 2018 caused
the fund to incur significant losses. The fund closed to new
investments on February 7, 2018 and announced on February 27,

2018 that it would liquidate its assets and dissolve on March 29,
2018.\25\
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    \24\ See Prospectus, LJM Preservation and Growth Fund (Feb. 28,
2017), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm.
    \25\ See Supplement to the Prospectus dated Feb. 28, 2017, LJM
Preservation and Growth Fund (Feb. 27, 2018), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064218001068/ljm497.htm.
---------------------------------------------------------------------------

    The losses suffered by this fund and in the other examples we
discuss above are extreme. Funds rarely suffer such large and rapid
losses. We note these examples to illustrate the rapid and extensive
losses that can result from a fund's investments in derivatives absent
effective derivatives risk management. In contrast, there are many
other instances in which funds, by employing derivatives, have avoided
losses, increased returns, and lowered risk.

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

1. Requirements of Section 18
    Section 18 of the Investment Company Act imposes various limits on
the capital structure of funds, including, in part, by restricting the
ability of funds to issue ``senior securities.'' Protecting investors
against the potentially adverse effects of a fund's issuance of senior
securities, and in particular the risks associated with excessive
leverage of investment companies, is a core purpose of the Investment
Company Act.\26\ ``Senior security'' is defined, in part, as ``any
bond, debenture, note, or similar obligation or instrument constituting
a security and evidencing indebtedness.'' \27\
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    \26\ See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of
the Investment Company Act; see also Provisions Of The Proposed Bill
Related To Capital Structure (Sections 18, 19(B), And 21(C)),
Introduced by L.M.C Smith, Associate Counsel, Investment Trust
Study, Securities and Exchange Commission, Hearings on S.3580 Before
a Subcommittee of the Senate Committee on Banking and Currency, 76th
Congress, 3rd session (1940), at 1028 (``Senate Hearings'')
(``Because of the leverage influence, a substantial swing of the
securities market is likely to deprive the common stock of a
leverage investment company of both its asset and market value. . .
. [H]ad investment companies been simple structure companies
exclusively, a very substantial part of the losses sustained by
investors in the common stock would have been avoided.'').
    \27\ See section 18(g) of the Investment Company Act. The
definition of ``senior security'' in section 18(g) also includes
``any stock of a class having priority over any other class as to
the distribution of assets or payment of dividends'' and excludes
certain limited temporary borrowings.
---------------------------------------------------------------------------

    Congress' concerns underlying the limits in section 18 focused on:
(1) Excessive borrowing and the issuance of excessive amounts of senior
securities by funds when these activities increase unduly the
speculative character of funds' junior securities; (2) funds operating
without adequate assets and reserves; and (3) potential abuse of the
purchasers of senior securities.\28\ To address these concerns, section
18 prohibits an open-end fund from issuing or selling any ``senior
security,'' other than borrowing from a bank (subject to a requirement
to maintain 300% ``asset coverage'').\29\ Section 18 similarly
prohibits a closed-end fund from issuing or selling any ``senior
security [that] represents an indebtedness'' unless it has at least
300% ``asset coverage,'' although closed-end funds' ability to issue
senior securities representing indebtedness is not limited to bank
borrowings.\30\ Closed-end funds also may issue senior securities that
are a stock, subject to the limitations of section 18.\31\ The
Investment Company Act also subjects BDCs to the limitations of section
18 to the same extent as registered closed-end funds, except the
applicable asset coverage amount for any senior security representing
indebtedness is 200% (and can be decreased to 150% under certain
circumstances).\32\
---------------------------------------------------------------------------

    \28\ For discussion of the excessive borrowing concern, see
section 1(b)(7) of the Investment Company Act; Release 10666, supra
note 15, at n.8; see also Senate Hearings, supra note 26, at 1028
(``The Commission believes that it has been clearly shown that it is
the leverage aspect of the senior-junior capital structure in
investment companies . . . which may be held accountable for a large
part of the losses which have been suffered by the investor who
purchases the common stock of a leverage company.'').
    For discussion of concerns regarding funds operating without
adequate assets and reserves, see section 1(b)(8) of the Investment
Company Act; Release 10666, supra note 15, at n.8.
    For discussion of, among other things, potential abuse of the
purchasers of senior securities, see Senate Hearings, supra note 26,
at 265-78; see also Mutual Funds and Derivative Instruments,
Division of Investment Management Memorandum transmitted by Chairman
Levitt to Representatives Markey and Fields (Sept. 26, 1994), at 23,
available at http://www.sec.gov/news/studies/deriv.txt (``1994
Letter to Congress'') (describing practices in the 1920s and 1930s
that gave rise to section 18's limits on leverage).
    \29\ See section 18(f)(1) of the Investment Company Act. ``Asset
coverage'' of a class of senior securities representing indebtedness
of an issuer generally is defined in section 18(h) of the Investment
Company Act as ``the ratio which the value of the total assets of
such issuer, less all liabilities and indebtedness not represented
by senior securities, bears to the aggregate amount of senior
securities representing indebtedness of such issuer.'' Take, for
example, an open-end fund with $100 in assets and with no
liabilities or senior securities outstanding. The fund could, while
maintaining the required coverage of 300% of the value of its
assets, borrow an additional $50 from a bank. The $50 in borrowings
would represent one-third of the fund's $150 in total assets,
measured after the borrowing (or 50% of the fund's $100 net assets).
    \30\ See section 18(a)(1) of the Investment Company Act.
    \31\ See section 18(a)(2) of the Investment Company Act. If a
closed-end fund issues or sells a class of senior securities that is
a stock, it must have an asset coverage of at least 200% immediately
after such issuance or sale. Id.
    \32\ See section 61(a)(1) of the Investment Company Act. BDCs,
like registered closed-end funds, also may issue a senior security
that is a stock (e.g., preferred stock), subject to limitations in
section 18. See sections 18(a)(2) and 61(a)(1) of the Investment
Company Act. In 2018, Congress passed the Small Business Credit
Availability Act, which, among other things, modified the statutory
asset coverage requirements applicable to BDCs (permitting BDCs that
meet certain specified conditions to elect to decrease their
effective asset coverage requirement from 200% to 150%). See section
802 of the Small Business Credit Availability Act, Public Law 115-
141, 132 Stat. 348 (2018).
---------------------------------------------------------------------------

2. Evolution of Commission and Staff Consideration of Section 18
Restrictions as Applied to Funds' Use of Derivatives
a. Investment Company Act Release 10666
    In a 1979 General Statement of Policy (Release 10666), the
Commission considered the application of section 18's restrictions on
the issuance of senior securities to reverse repurchase agreements,
firm commitment agreements, and standby commitment agreements.\33\ The
Commission concluded that these agreements fall within the ``functional
meaning of the term `evidence of indebtedness' for purposes of Section
18 of the Investment Company Act,'' noting ``the unique legislative
purposes and policies underlying Section 18 of the Act.'' \34\ The
Commission stated in Release 10666 that, for purposes of section 18,
``evidence of indebtedness'' would include ``all contractual
obligations to pay in the future for consideration presently
received.'' The Commission recognized that, while section 18 would
generally prohibit open-end funds' use of reverse repurchase
agreements, firm commitment agreements, and standby commitment
agreements, the Commission nonetheless permitted funds to use these and
similar arrangements subject to the constraints that Release 10666
describes.
---------------------------------------------------------------------------

    \33\ See Release 10666, supra note 15.
    \34\ See id.
---------------------------------------------------------------------------

    These constraints relied on funds' use of ``segregated accounts''
to ``cover'' senior securities, which ``if properly created and
maintained, would limit the investment company's risk of loss.'' \35\
The Commission also stated that the segregated account functions as ``a
practical limit on the amount of leverage which the investment company
may undertake and on the potential increase in the speculative
character of its outstanding common stock'' and that it ``[would]
assure the availability of adequate funds to meet the obligations
arising from such activities.'' \36\ The

Commission stated that its expressed views were not limited to the
particular trading practices discussed, but that the Commission sought
to address the implications of comparable trading practices that could
similarly affect funds' capital structures.\37\
---------------------------------------------------------------------------

    \35\ See 2015 Proposing Release, supra note 2, at nn.45-47 and
accompanying text (discussing Release 10666's discussion of
segregated accounts).
    \36\ See Release 10666, supra note 15, at 25132; see also 2015
Proposing Release, supra note 2, at n.48 and accompanying text.
    \37\ See 2015 Proposing Release, supra note 2, at nn.49-50 and
accompanying text.
---------------------------------------------------------------------------

    We continue to view the transactions described in Release 10666 as
falling within the functional meaning of the term ``evidence of
indebtedness,'' for purposes of section 18.\38\ The trading practices
that Release 10666 describes, as well as short sales of securities for
which the staff initially developed the segregated account approach
that the Commission applied in Release 10666, all impose on a fund a
contractual obligation under which the fund is or may be required to
pay or deliver assets in the future to a counterparty. These
transactions therefore involve the issuance of a senior security for
purposes of section 18.\39\
---------------------------------------------------------------------------

    \38\ See Release 10666, supra note 15, at ``The Agreements as
Securities'' discussion. The Investment Company Act's definition of
the term ``security'' is broader than the term's definition in other
federal securities laws. See 2015 Proposing Release, supra note 2,
at n.61. Compare section 2(a)(36) of the Investment Company Act with
sections 2(a)(1) and 2A of the Securities Act of 1933 (15 U.S.C. 77a
et seq.) (``Securities Act'') and sections 3(a)(10) and 3A of the
Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) (``Exchange
Act''). See also 2011 Concept Release, supra note 3, at n.57 and
accompanying text (explaining that the Commission has interpreted
the term ``security'' in light of the policies and purposes
underlying the Investment Company Act).
    \39\ See Release 10666, supra note 15, at ``The Agreements as
Securities'' discussion; see also section 18(g) (defining the term
``senior security,'' in part, as ``any bond, debenture, note, or
similar obligation or instrument constituting a security and
evidencing indebtedness'').
    The Commission received several comments on the 2015 proposal
that objected to the Commission treating derivatives and financial
commitment transactions as involving senior securities where a fund
has ``appropriately'' covered its obligations under those
transactions. These comments generally argued that this approach is
not consistent with the Commission's views in Release 10666 and that
funds have for many years addressed senior security concerns raised
by these transactions by segregating assets or engaging in
offsetting, or ``cover,'' transactions that take into account
Release 10666 and staff guidance. See, e.g., Comment Letter of the
American Action Forum (Mar. 25, 2016) (``AAF Comment Letter'');
Comment Letter of Financial Services Roundtable (Mar. 28, 2016)
(``FSR Comment Letter''); Comment Letter of Franklin Resources, Inc.
(Mar. 28, 2016) (``Franklin Resources Comment Letter''); Comment
Letter of Dechert LLP (Mar. 28, 2016) (``Dechert Comment Letter'').
Whether a transaction involves the issuance of a senior security
will depend on whether that transaction involves a senior security
within the meaning of section 18(g). A fund's segregation of assets,
although one way to address policy concerns underlying section 18 as
the Commission described in Release 10666, does not, itself, affect
the legal question of whether a fund has issued a senior security.
---------------------------------------------------------------------------

    We apply the same analysis to all derivatives transactions that
create future payment obligations. This is the case where the fund has
a contractual obligation to pay or deliver cash or other assets to a
counterparty in the future, either during the life of the instrument or
at maturity or early termination.\40\ As was the case for trading
practices that Release 10666 describes, where the fund has entered into
a derivatives transaction and has such a future payment obligation, we
believe that such a transaction involves an evidence of indebtedness
that is a senior security for purposes of section 18.\41\
---------------------------------------------------------------------------

    \40\ These payments--which may include payments of cash, or
delivery of other assets--may occur as margin, as settlement
payments, or otherwise.
    \41\ As the Commission explained in Release 10666, we believe
that an evidence of indebtedness, for purposes of section 18,
includes not only a firm and un-contingent obligation, but also a
contingent obligation, such as a standby commitment or a ``put'' (or
call) option sold by a fund. See Release 10666, supra note 15, at
``Standby Commitment Agreements'' discussion. We understand it has
been asserted that a contingent obligation that a standby commitment
or similar agreement creates does not involve a senior security
under section 18, unless and until generally accepted accounting
principles (``GAAP'') would require the fund to recognize the
contingent obligation as a liability on the fund's financial
statements. The treatment of derivatives transactions under GAAP,
including whether the derivatives transaction constitutes a
liability for financial statement purposes at any given time or the
extent of the liability for that purpose, is not determinative with
respect to whether the derivatives transaction involves the issuance
of a senior security under section 18. This is consistent with the
Commission's analysis of a fund's obligation, and the corresponding
segregated asset amounts, under the trading practices that Release
10666 describes. See id.
---------------------------------------------------------------------------

    The express scope of section 18 supports this interpretation.
Section 18 defines the term ``senior security'' broadly to include
instruments and transactions that other provisions of the federal
securities laws might not otherwise consider to be securities.\42\ For
example, section 18(f)(1) generally prohibits an open-end fund from
issuing or selling any senior security ``except [that the fund] shall
be permitted to borrow from any bank.'' \43\ This statutory permission
to engage in a specific borrowing makes clear that such borrowings are
senior securities, which otherwise section 18 would prohibit absent
this specific permission.\44\
---------------------------------------------------------------------------

    \42\ Consistent with Release 10666, and as the Commission stated
in the 2015 Proposing Release, we are only expressing our views in
this release concerning the scope of the term ``senior security'' in
section 18 of the Investment Company Act. See also section 12(a) of
the Investment Company Act (prohibiting funds from engaging in short
sales in contravention of Commission rules or orders).
    \43\ Section 18(c)(2) similarly treats all promissory notes or
evidences of indebtedness issued in consideration of any loan as
senior securities except as section 18 otherwise specifically
provides.
    \44\ The Commission similarly observed in Release 10666 that
section 18(f)(1), ``by implication, treats all borrowings as senior
securities,'' and that ``[s]ection 18(f)(1) of the Act prohibits
such borrowings unless entered into with banks and only if there is
300% asset coverage on all borrowings of the investment company.''
See Release 10666, supra note 15, at ``Reverse Repurchase
Agreements'' discussion.
---------------------------------------------------------------------------

    This interpretation also is consistent with the fundamental policy
and purposes underlying the Investment Company Act expressed in
sections 1(b)(7) and 1(b)(8) of the Act.\45\ These respectively declare
that ``the national public interest and the interest of investors are
adversely affected'' when funds ``by excessive borrowing and the
issuance of excessive amounts of senior securities increase unduly the
speculative character'' of securities issued to common shareholders and
when funds ``operate without adequate assets or reserves.'' The
Commission emphasized these concerns in Release 10666, and we continue
to believe that the prohibitions and restrictions under the senior
security provisions of section 18 should ``function as a practical
limit on the amount of leverage which the investment company may
undertake and on the potential increase in the speculative character of
its outstanding common stock'' and that funds should not ``operate
without adequate assets or reserves.'' \46\ Funds' use of derivatives,
like the trading practices the Commission addressed in Release 10666,
may raise the undue speculation and asset sufficiency concerns in
section 1(b).\47\ First, funds' obtaining

leverage (or potential for leverage) through derivatives may raise the
Investment Company Act's undue speculation concern because a fund may
experience gains and losses that substantially exceed the fund's
investment, and also may incur a conditional or unconditional
obligation to make a payment or deliver assets to a counterparty.\48\
Not viewing derivatives that impose a future payment obligation on the
fund as involving senior securities, subject to appropriate limits
under section 18, would frustrate the concerns underlying section
18.\49\
---------------------------------------------------------------------------

    \45\ The Commission received several comments on the 2015
proposal asserting that the provisions in section 1(b) of the
Investment Company Act do not, themselves, provide us authority to
regulate senior securities transactions. See, e.g., AAF Comment
Letter; Franklin Resources Comment Letter; Comment Letter of the
Securities Industry and Financial Markets Association (Mar. 28,
2016) (``SIFMA Comment Letter'').
    The fundamental statutory policy and purposes underlying the
Investment Company Act, as expressed in section 1(b) of the Act,
inform our interpretation of the scope of the term ``senior
security'' in section 18, as we discuss in the paragraph
accompanying this note (and separately inform our consideration of
appropriate conditions for the exemption that proposed rule 18f-4
provides, as we discuss in sections II.B-II.G infra). The authority
under which we are proposing rules today is set forth in section VII
of this release and includes, among other provisions, section 6(c)
of the Act.
    \46\ See Release 10666, supra note 15, at ``Segregated Account''
discussion.
    \47\ As the Commission stated in Release 10666, leveraging an
investment company's portfolio through the issuance of senior
securities ``magnifies the potential for gain or loss on monies
invested and therefore results in an increase in the speculative
character of the investment company's outstanding securities'' and
``leveraging without any significant limitation'' was identified
``as one of the major abuses of investment companies prior to the
passage of the Act by Congress.'' Id.
    \48\ See, e.g., The Report of the Task Force on Investment
Company Use of Derivatives and Leverage, Committee on Federal
Regulation of Securities, ABA Section of Business Law (July 6,
2010), at 8 (``2010 ABA Derivatives Report'') (stating that
``[f]utures contracts, forward contracts, written options and swaps
can produce a leveraging effect on a fund's portfolio'' because
``for a relatively small up-front payment made by a fund (or no up-
front payment, in the case with many swaps and written options), the
fund contractually obligates itself to one or more potential future
payments until the contract terminates or expires''; noting, for
example, that an ``[interest rate] swap presents the possibility
that the fund will be required to make payments out of its assets''
and that ``[t]he same possibility exists when a fund writes puts and
calls, purchases short and long futures and forwards, and buys or
sells credit protection through [credit default swaps]'').
    \49\ One commenter on the 2011 Concept Release made this point
directly. See Comment Letter of Stephen A. Keen on the 2011 Concept
Release (Nov. 8, 2011) (File No. S7-33-11), at 3 (``Keen Concept
Release Comment Letter'') (``If permitted without limitation,
derivative contracts can pose all of the concerns that section 18
was intended to address with respect to borrowings and the issuance
of senior securities by investment companies.''); see also, e.g.,
ICI Concept Release Comment Letter, at 8 (``The Act is thus designed
to regulate the degree to which a fund issues any form of debt--
including contractual obligations that could require a fund to make
payments in the future.''). The Commission similarly noted in
Release 10666 that, given the potential for reverse repurchase
agreements to be used for leveraging and their ability to magnify
the risk of investing in a fund, ``one of the important policies
underlying section 18 would be rendered substantially nugatory'' if
funds' use of reverse repurchase agreements were not subject to
limitation. See 2015 Proposing Release, supra note 2, at text
preceding n.76.
---------------------------------------------------------------------------

    Second, with respect to the Investment Company Act's asset
sufficiency concern, a fund's use of derivatives with future payment
obligations also may raise concerns regarding the fund's ability to
meet those obligations. Many fund derivatives investments, such as
futures contracts, swaps, and written options, pose a risk of loss that
can result in payment obligations owed to the fund's
counterparties.\50\ Losses on derivatives therefore can result in
counterparty payment obligations that directly affect the capital
structure of a fund and the relative rights of the fund's
counterparties and shareholders. These losses and payment obligations
also can force a fund's adviser to sell the fund's investments to meet
its obligations. When a fund uses derivatives to leverage its
portfolio, this can amplify the risk of a fund having to sell its
investments, potentially generating additional losses for the fund.\51\
In an extreme situation, a fund could default on its payment
obligations.\52\
---------------------------------------------------------------------------

    \50\ Some derivatives transactions, like physically-settled
futures and forwards, can require the fund to deliver the underlying
reference assets regardless of whether the fund experiences losses
on the transaction.
    \51\ See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen,
Market Liquidity and Funding Liquidity, 22 The Review of Financial
Studies 6, 2201-2238 (June 2009), available at https://
www.princeton.edu/~markus/research/papers/liquidity.pdf (providing
both empirical support as well as a theoretical foundation for how
short-term leverage obtained through borrowings or derivative
positions can result in funds and other financial intermediaries
becoming vulnerable to tighter funding conditions and increased
margins, specifically during economic downturns (as in the recent
financial crisis), thus potentially increasing the need for the fund
or intermediary to de-lever and sell portfolio assets at a loss).
    \52\ See 2015 Proposing Release, supra note 2, at n.80.
---------------------------------------------------------------------------

b. Market and Industry Developments Following Release 10666
    Following the issuance of Release 10666, Commission staff issued
more than thirty no-action letters to funds concerning the maintenance
of segregated accounts or otherwise ``covering'' their obligations in
connection with various transactions otherwise restricted by section
18.\53\ In these letters (issued primarily in the 1970s through 1990s)
and through other staff guidance, Commission staff has addressed
questions--generally on an instrument-by-instrument basis--regarding
the application of the Commission's statements in Release 10666 to
various types of derivatives and other transactions.
---------------------------------------------------------------------------

    \53\ See id. at n.51 and accompanying text (citing 2011 Concept
Release, supra note 3, at section I).
---------------------------------------------------------------------------

    Funds have developed certain general asset segregation practices to
cover their derivatives positions, based at least in part on the
staff's no-action letters and guidance. Practices vary based on the
type of derivatives transaction. For certain derivatives, funds
generally segregate an amount equal to the full amount of the fund's
potential obligation under the contract, or the full market value of
the underlying reference asset for the derivative (``notional amount
segregation'').\54\ For certain cash-settled derivatives, funds often
segregate an amount equal to the fund's daily mark-to-market liability,
if any (``mark-to-market segregation'').\55\
---------------------------------------------------------------------------

    \54\ See id. at nn.54-55 and accompanying text.
    \55\ See id. at nn.56-58, 96-98 and accompanying text (stating
that funds initially applied the mark-to-market approach to
segregation to specific types of transactions addressed through
guidance by our staff (interest rate swaps, cash-settled futures,
non-deliverable forwards), but that funds now apply mark-to-market
segregation to a wider range of cash-settled instruments, with our
staff observing that some funds appear to apply the mark-to-market
approach to any derivative that is cash settled).
---------------------------------------------------------------------------

    Similarly, funds use different practices regarding the types of
assets that they segregate to cover their derivatives positions.
Release 10666 states that the assets eligible to be included in
segregated accounts should be ``liquid assets'' such as cash, U.S.
government securities, or other appropriate high-grade debt
obligations.\56\ However, a subsequent staff no-action letter stated
that the staff would not recommend enforcement action if a fund were to
segregate any liquid asset, including equity securities and non-
investment grade debt securities, to cover its senior securities-
related obligations.\57\
---------------------------------------------------------------------------

    \56\ See id. at n.47 and accompanying text.
    \57\ See id. at n.59 and accompanying text (citing Merrill Lynch
Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996),
available at https://www.sec.gov/divisions/investment/imseniorsecurities/merrilllynch070196.pdf).
---------------------------------------------------------------------------

    As a result of these asset segregation practices, funds'
derivatives use--and thus funds' potential leverage through derivatives
transactions--does not appear to be subject to a practical limit as the
Commission contemplated in Release 10666. Funds' mark-to-market
liability often does not reflect the full investment exposure
associated with their derivatives positions.\58\ As a result, a fund
that segregates only the mark-to-market liability could theoretically
incur virtually unlimited investment leverage.\59\
---------------------------------------------------------------------------

    \58\ For example, for derivatives where there is no loss in a
given day, a fund applying the mark-to-market approach might not
segregate any assets. This may be the case, for example, because the
derivative is currently in a gain position, or because the
derivative has a market value of zero (as will generally be the case
at the inception of a transaction). The fund may, however, still be
required to post collateral to comply with other regulatory or
contractual requirements.
    \59\ See, e.g., Comment Letter of Ropes & Gray LLC on the
Concept Release (Nov. 7, 2011) (File No. S7-33-11), at 4 (stating
that ``[o]f course, in many cases [a fund's daily mark-to-market
liability, if any] will not fully reflect the ultimate investment
exposure associated with the swap position'' and that, ``[a]s a
result, a fund that segregates only the market-to-market liability
could theoretically incur virtually unlimited investment leverage
using cash-settled swaps''); Keen Concept Release Comment Letter, at
20 (stating that the mark-to-market approach, as applied to cash
settled swaps, ``imposes no effective control over the amount of
investment leverage created by these swaps, and leaves it to the
market to limit the amount of leverage a fund may use'').
---------------------------------------------------------------------------

    These current asset segregation practices also may not assure the

availability of adequate assets to meet funds' derivatives obligations,
as the Commission contemplated in Release 10666. A fund using the mark-
to-market approach could segregate assets that only reflect the losses
(and corresponding potential payment obligations) that the fund would
then incur as a result of transaction termination. This practice
provides no assurances that future losses will not exceed the value of
the segregated assets or the value of all assets then available to meet
the payment obligations resulting from such losses.\60\ We also
recognize that when a fund segregates any liquid asset, rather than the
more narrow range of high-quality assets the Commission described in
Release 10666, the segregated assets may be more likely to decline in
value at the same time as the fund experiences losses on its
derivatives.\61\ In this case, or when a fund's derivatives payment
obligations are substantial relative to the fund's liquid assets, the
fund may be forced to sell portfolio securities to meet its derivatives
payment obligations. These forced sales could occur during stressed
market conditions, including at times when prudent management could
advise against such liquidation.\62\
---------------------------------------------------------------------------

    \60\ A fund's mark-to-market liability on any particular day, if
any, could be substantially smaller than the fund's ultimate
obligations under a derivative. See 2015 Proposing Release, supra
note 2, at n.113.
    \61\ See id. at n.115.
    \62\ The Commission noted in Release 10666 that ``in an extreme
case an investment company which has segregated all its liquid
assets might be forced to sell non-segregated portfolio securities
to meet its obligations upon shareholder requests for redemption.
Such forced sales could cause an investment company to sell
securities which it wanted to retain or to realize gains or losses
which it did not originally intend.'' See Release 10666, supra note
15, at ``Segregated Account'' discussion.
---------------------------------------------------------------------------

3. Need for Updated Regulatory Framework
    As the Commission observed in the 2015 proposal and for the reasons
discussed above, we continue to be concerned that funds' current
practices regarding derivatives use may not address the undue
speculation and asset sufficiency concerns underlying section 18.\63\
Additionally, as recent events demonstrate, a fund's derivatives use
may involve risks that can result in significant losses to a fund.\64\
Accordingly, we continue to believe that it is appropriate for funds to
address these risks and considerations relating to their derivatives
use. Nevertheless, we also recognize the valuable role derivatives can
play in helping funds to achieve their objectives efficiently or manage
their investment risks.
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    \63\ See 2015 Proposing Release, supra note 2, at sections
II.D.1.b and II.D.1.c; see also supra paragraphs accompanying notes
58-62.
    \64\ See supra paragraph accompanying notes 22-25.
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    We therefore believe funds that significantly use derivatives
should adopt and implement formalized programs to manage the risks
derivatives may pose. In addition, a more modern framework for
regulating funds' derivatives use would respond to our concern that
funds today are not subject to a practical limit on potential leverage
that they may obtain through derivatives transactions. The risk
management program requirement and limit on fund leverage risk we are
proposing are designed to address these considerations, in turn.
    A comprehensive approach to regulating funds' derivatives use also
would help address potential adverse results from funds' current,
disparate asset segregation practices. The development of staff
guidance and industry practice on an instrument-by-instrument basis,
together with growth in the volume and complexity of derivatives
markets over past decades, has resulted in situations in which
different funds may treat the same kind of derivative differently,
based on their own view of our staff's guidance or observation of
industry practice. This may unfairly disadvantage some funds.\65\ The
lack of comprehensive guidance also makes it difficult for funds and
our staff to evaluate and inspect for funds' compliance with section 18
of the Investment Company Act. Moreover, where there is no specific
guidance, or where the application of existing guidance is unclear or
applied inconsistently, funds may take approaches that involve an
extensive use of derivatives and may not address the purposes and
concerns underlying section 18.
---------------------------------------------------------------------------

    \65\ See, e.g., Comment Letter of Davis Polk on the 2011 Concept
Release (Nov. 11, 2011), at 1-2 (stating that ``funds and their
sponsors may interpret the available guidance differently, even when
applying it to the same instruments, which may unfairly disadvantage
some funds''); see also Comment Letter of Federated Investors, Inc.
(Mar. 23, 2016) (``Federated Comment Letter''); Comment Letter of
Salient Partners, L.P. (Mar. 25, 2016) (``Salient Comment Letter).
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C. Overview of the Proposal

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

    \67\ See proposed rule 18f-4(c)(1); infra section II.A.2.
---------------------------------------------------------------------------

     Limit on fund leverage risk.\68\ The proposed rule would
generally require funds when engaging in derivatives

transactions to comply with an outer limit on fund leverage risk based
on value at risk, or ``VaR.'' This outer limit would be based on a
relative VaR test that compares the fund's VaR to the VaR of a
``designated reference index'' for that fund. If the fund's derivatives
risk manager is unable to identify an appropriate designated reference
index, the fund would be required to comply with an absolute VaR test.
These proposed requirements are designed to limit fund leverage risk
consistent with the investor protection purposes underlying section 18
and to complement the proposed risk management program. Because VaR is
a commonly-known and broadly-used industry metric that enables risk to
be measured in a reasonably comparable and consistent manner across the
diverse instruments that may be included in a fund's portfolio, the
proposed VaR-based limit is designed to address leverage risk for a
variety of fund strategies.
---------------------------------------------------------------------------

    \68\ See proposed rule 18f-4(c)(2); infra section II.D.
---------------------------------------------------------------------------

     Board oversight and reporting.\69\ The proposed rule would
require a fund's board of directors to approve the fund's designation
of a derivatives risk manager, who would be responsible for
administering the fund's derivatives risk management program. The
fund's derivatives risk manager would have to report to the fund's
board on the derivatives risk management program's implementation and
effectiveness and the results of the fund's stress testing. The
derivatives risk manager would have a direct reporting line to the
fund's board. We believe requiring a fund's derivatives risk manager to
be responsible for the day-to-day administration of the fund's program,
subject to board oversight, is consistent with the way we understand
many funds currently manage derivatives risks and is key to
appropriately managing these risks.
---------------------------------------------------------------------------

    \69\ See proposed rule 18f-4(c)(5); infra section II.C.
---------------------------------------------------------------------------

     Exception for limited derivatives users.\70\ The proposed
rule would except limited derivatives users from the derivatives risk
management program requirement and the VaR-based limit on fund leverage
risk. This proposed exception would be available to a fund that either
limits its derivatives exposure to 10% of its net assets or uses
derivatives transactions solely to hedge certain currency risks and, in
either case, that also adopts and implements policies and procedures
reasonably designed to manage the fund's derivatives risks. Requiring a
derivatives risk management program that includes all of the program
elements specified in the rule for funds that use derivatives only in a
limited way could potentially require these funds to incur costs and
bear compliance burdens that are disproportionate to the resulting
benefits.
---------------------------------------------------------------------------

    \70\ See proposed rule 18f-4(c)(3); infra section II.E.
---------------------------------------------------------------------------

     Alternative requirements for certain leveraged/inverse
funds.\71\ The proposed rule would provide an exception from the limit
on fund leverage risk for certain leveraged/inverse funds in light of
the additional safeguards provided by the proposed requirements under
the sales practices rules that broker-dealers and investment advisers
exercise due diligence on retail investors before approving the
investors' accounts to invest in these funds.\72\ The conditions of
this exception are designed to address the investor protection concerns
that underlie section 18 of the Investment Company Act, while
preserving choice for investors the investment adviser or broker-dealer
reasonably believes have such financial knowledge and experience that
they may reasonably be expected to be capable of evaluating the risk of
these funds.
---------------------------------------------------------------------------

    \71\ See proposed rule 18f-4(c)(4); infra section II.G.
    \72\ In our discussion in this release of the entities subject
to the proposed sales practices rules, we use ``broker-dealer'' to
refer to a broker-dealer that is registered with, or required to
register with, the Commission. Similarly, we use ``investment
adviser'' to refer to an investment adviser that is registered with,
or required to register with, the Commission.
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     Recordkeeping.\73\ The proposed rule would require a fund
to adhere to recordkeeping requirements that are designed to provide
the Commission's staff, and the fund's board of directors and
compliance personnel, the ability to evaluate the fund's compliance
with the proposed rule's requirements.
---------------------------------------------------------------------------

    \73\ See proposed rule 18f-4(c)(6); infra section II.K.
---------------------------------------------------------------------------

    Proposed rule 18f-4 would also permit funds to enter into reverse
repurchase agreements and similar financing transactions, as well as
``unfunded commitments'' to make certain loans or investments, subject
to conditions tailored to these transactions.\74\ A fund would be
permitted to engage in reverse repurchase agreements and similar
financing transactions so long as they meet the asset coverage
requirements under section 18. If the fund also borrows from a bank or
issues bonds, for example, these senior securities as well as the
reverse repurchase agreement would be required to comply with the asset
coverage requirements under the Investment Company Act. This approach
would provide the same asset coverage requirements under section 18 for
reverse repurchase agreements and similar financing transactions, bank
borrowings, and other borrowings permitted under the Investment Company
Act. A fund would be permitted to enter into unfunded commitment
agreements if the fund reasonably believes that its assets will allow
the fund to meet its obligations under these agreements. This approach
recognizes that, while unfunded commitment agreements do raise the risk
that a fund may be unable to meet its obligations under these
transactions, such unfunded commitments do not generally involve the
leverage and other risks associated with derivatives transactions.
---------------------------------------------------------------------------

    \74\ See proposed rule 18f-4(d) and (e); infra sections II.I and
II.J.
---------------------------------------------------------------------------

    The proposed sales practices rules are designed to address certain
specific considerations raised by certain leveraged/inverse funds and
listed commodity pools that obtain leveraged or inverse exposure to an
underlying index, on a periodic (generally, daily) basis.\75\ These
rules would require broker-dealers and investment advisers to exercise
due diligence in determining whether to approve a retail customer or
client's account to buy or sell these products. A broker-dealer or
adviser could only approve the account if it had a reasonable basis to
believe that the customer or client is capable of evaluating the risk
associated with these products. In this regard, the proposed sales
practices rules would complement the leveraged/inverse funds exception
from proposed rule 18f-4's limit on leverage risk by subjecting broker-
dealers or advisers to the proposed sales practices rules' due
diligence and approval requirements.
---------------------------------------------------------------------------

    \75\ See infra note 327 and accompanying text (defining ``listed
commodity pools'').
---------------------------------------------------------------------------

    In connection with proposed rules 15l-2, 211(h)-1, and 18f-4, we
are proposing amendments to rule 6c-11 under the Investment Company
Act. Rule 6c-11 generally permits ETFs to operate without obtaining a
Commission exemptive order, subject to certain conditions.\76\ The rule
currently excludes leveraged/inverse ETFs from relying on the rule,
however, to allow the Commission to consider the section 18 issues
raised by these funds' investment strategies as part of a broader
consideration of derivatives use by registered funds and BDCs.\77\ As
part of this further consideration, we are

proposing to remove this provision and permit leveraged/inverse ETFs to
rely on rule 6c-11 because the proposed sales practices rules and rule
18f-4 are designed to address these issues. In this regard, we are also
proposing to rescind the exemptive orders previously issued to the
sponsors of leveraged/inverse ETFs. Amending rule 6c-11 and rescinding
these exemptive orders would promote a level playing field by allowing
any sponsor (in addition to the sponsors currently granted exemptive
orders) to form and launch a leveraged/inverse ETF subject to the
conditions in rule 6c-11 and proposed rule 18f-4, with transactions in
the fund subject to the proposed sales practices rules.
---------------------------------------------------------------------------

    \76\ See generally Exchange-Traded Funds, Investment Company Act
Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24, 2019)]
(``ETFs Adopting Release'').
    \77\ See id. at nn.72-74 and accompanying text.
---------------------------------------------------------------------------

    The proposed amendments to Forms N-PORT, N-LIQUID, and N-CEN would
require a fund to provide information regarding: (1) The fund's
exposure to derivatives; (2) the fund's VaR (and, if applicable, the
fund's designated reference index) and backtesting results; (3) VaR
test breaches, to be reported to the Commission in a non-public current
report; and (4) certain identifying information about the fund (e.g.,
whether the fund is a limited derivatives user that is excepted from
certain of the proposed requirements, or whether the fund is a
``leveraged/inverse fund'').
    Finally, in view of our proposal for an updated, comprehensive
approach to the regulation of funds' derivative use, we are proposing
to rescind Release 10666. In addition, staff in the Division of
Investment Management is reviewing certain of its no-action letters and
other guidance addressing derivatives transactions and other
transactions covered by proposed rule 18f-4 to determine which letters
and other staff guidance, or portions thereof, should be withdrawn in
connection with any adoption of this proposal. Upon the adoption of any
final rule, some of these letters and other staff guidance, or portions
thereof, would be moot, superseded, or otherwise inconsistent with the
final rule and, therefore, would be withdrawn. We would expect to
provide funds a one-year transition period while they prepare to come
into compliance with rule 18f-4 before Release 10666 is withdrawn.

II. Discussion

A. Scope of Proposed Rule 18f-4

1. Funds Permitted To Rely on Proposed Rule 18f-4
    The proposed rule would apply to a ``fund,'' defined as a
registered open-end or closed-end company or a BDC, including any
separate series thereof. The rule would therefore apply to mutual
funds, ETFs, registered closed-end funds, and BDCs. The proposed rule's
definition of a ``fund'' would, however, exclude money market funds
regulated under rule 2a-7 under the Investment Company Act (``money
market funds''). Under rule 2a-7, money market funds seek to maintain a
stable share price or limit principal volatility by limiting their
investments to short-term, high-quality debt securities that fluctuate
very little in value under normal market conditions. As a result of
these and other requirements in rule 2a-7, we believe that money market
funds currently do not typically engage in derivatives transactions or
the other transactions permitted by rule 18f-4.\78\ We believe that
these transactions would generally be inconsistent with a money market
fund maintaining a stable share price or limiting principal volatility,
and especially if used to leverage the fund's portfolio.\79\ We
therefore believe that excluding money market funds from the scope of
the proposed rule is appropriate.
---------------------------------------------------------------------------

    \78\ See infra note 583.
    \79\ See Money Market Fund Reform; Amendments to Form PF,
Investment Company Act Release No. 31166 (July 23, 2014) [79 FR
47735 (Aug. 14, 2014)] (discussing (1) retail and government money
market funds, which seek to maintain a stable net asset value per
share and (2) institutional non-government money market funds whose
net asset value fluctuates, but still must stress test their ability
to minimize principal volatility given that ``commenters pointed out
investors in floating NAV funds will continue to expect a relatively
stable NAV'').
---------------------------------------------------------------------------

    Section 18 applies only to open-end or closed-end companies, i.e.,
to management investment companies. Proposed rule 18f-4 therefore also
would not apply to unit investment trusts (``UITs'') because they are
not management investment companies. In addition, as the Commission has
noted, derivatives transactions generally require a significant degree
of management, and a UIT engaging in derivatives transactions therefore
may not meet the Investment Company Act requirements applicable to
UITs.\80\
---------------------------------------------------------------------------

    \80\ See section 4(2) of the Investment Company Act; see also
Custody Of Investment Company Assets with Futures Commission
Merchants And Commodity Clearing Organizations, Investment Company
Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT
portfolios are generally unmanaged). See also ETFs Adopting Release,
supra note 76, at n.42.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's definition
of the term ``fund,'' including the following items.
    1. The proposed definition excludes money market funds. Should we
include money market funds in the definition? Why or why not?
    2. Do money market funds currently engage in any transactions that
might qualify as derivatives transactions under the rule or any of the
other transactions permitted by the rule? For example, do money market
funds engage in reverse repurchase agreements, ``to be announced''
dollar rolls, or ``when issued'' transactions? If so, which
transactions, to what extent, and for what purpose? For example, do
money market funds engage in reverse repurchase agreements for
liquidity management purposes but not to leverage the fund's portfolio?
If so, what effects would the proposed rule have on money market funds'
liquidity management if they are excluded from the rule's scope as
proposed? To the extent money market funds engage in any of the
transactions that the proposed rule would permit, how do money market
funds analyze them under rule 2a-7?
    3. Should we permit money market funds to engage in some of the
transactions that the rule would permit? If so, which transactions and
why, and how would the transactions be consistent with rule 2a-7? If we
were to include money market funds in the rule, or permit them to
engage in specific types of transactions, should the rule provide
specific conditions tailored to money market funds entering into those
transactions? What kinds of conditions and why? Should they be
permitted to engage in all (or certain types) of derivatives
transactions, or reverse repurchase or similar financing transactions,
for liquidity management or other purposes that do not leverage the
fund's portfolio? If money market funds were permitted to rely on the
rule for any transactions, should those transactions be limited in
scale? For example, should that limit be the same as the proposed
approach for limited derivatives users that limit the extent of their
derivatives exposure, as discussed below in section II.E.1? Would even
such limited use be consistent with funds that seek to maintain a
stable share price or limit principal volatility?
    4. If we were to include money market funds in the scope of rule
18f-4, should we revise Form N-MFP so that money market funds filing
reports on the form could select among the list of investment
categories set forth in Item C.6 of Form N-MFP derivatives and the
other transactions addressed in the proposed rule 18f-4? \81\ Why or
why not?
---------------------------------------------------------------------------

    \81\ See infra note 583.
---------------------------------------------------------------------------

2. Derivatives Transactions Permitted Under Proposed Rule 18f-4
    The proposed rule would permit funds to enter into derivatives

transactions, subject to the rule's conditions. The proposed rule would
define the term ``derivatives transaction'' to mean: (1) Any swap,
security-based swap, futures contract, forward contract, option, any
combination of the foregoing, or any similar instrument (``derivatives
instrument''), under which a fund is or may be required to make any
payment or delivery of cash or other assets during the life of the
instrument or at maturity or early termination, whether as margin or
settlement payment or otherwise; and (2) any short sale borrowing.\82\
---------------------------------------------------------------------------

    \82\ Proposed rule 18f-4(a). The 2015 proposal similarly defined
a derivatives transaction as including enumerated derivatives
instruments ``under which the fund is or may be required to make any
payment or delivery of cash or other assets during the life of the
instrument or at maturity or early termination, whether as a margin
or settlement payment or otherwise.'' 2015 proposed rule 18f-
4(c)(2). Most commenters did not address the proposed definition of
the term ``derivatives transaction,'' although those commenters who
did address the definition generally supported it. Some commenters
more generally supported the view, or sought confirmation, that a
derivative does not involve the issuance of a senior security if it
does not impose an obligation under which the fund is or may be
required to make a future payment (e.g., a standard purchased
option). See, e.g., Comment Letter of The Options Clearing
Corporation (Mar. 25, 2016); Comment Letter of Investment Adviser
Association (Mar. 28, 2016) (``IAA Comment Letter''); FSR Comment
Letter.
---------------------------------------------------------------------------

    The first prong of this proposed definition is designed to describe
those derivatives transactions that involve the issuance of a senior
security, because they involve a contractual future payment
obligation.\83\ When a fund engages in these transactions, the fund
will have an obligation (or potential obligation) to make payments or
deliver assets to the fund's counterparty. This prong of the definition
incorporates a list of derivatives instruments that, together with the
proposed inclusion in the definition of ``any similar instrument,''
covers the types of derivatives that funds currently use and that the
requirements of section 18 would restrict. This list is designed to be
sufficiently comprehensive to include derivatives that may be developed
in the future. We believe that this approach is clearer than a more
principles-based definition of the term ``derivatives transaction,''
such as defining this term as an instrument or contract whose value is
based upon, or derived from, some other asset or metric.
---------------------------------------------------------------------------

    \83\ See supra note 27 and accompanying text, and text following
note 34 (together, noting that ``senior security'' is defined in
part as ``any . . . similar obligation or instrument constituting a
security and evidencing indebtedness,'' and that the Commission has
previously stated that, for purposes of section 18, ``evidence of
indebtedness'' would include ``all contractual obligations to pay in
the future for consideration presently received''); see also infra
notes 85-87 (recognizing that not every derivative instrument will
involve the issuance of a senior security).
---------------------------------------------------------------------------

    This prong of the definition also provides that a derivatives
instrument, for purposes of the proposed rule, must involve a future
payment obligation.\84\ This aspect of the definition recognizes that
not every derivatives instrument imposes an obligation that may require
the fund to make a future payment, and therefore not every derivatives
instrument will involve the issuance of a senior security.\85\ A
derivative that does not impose any future payment obligation on a fund
generally resembles a securities investment that is not a senior
security, in that it may lose value but will not require the fund to
make any payments in the future.\86\ Whether a transaction involves the
issuance of a senior security will depend on the nature of the
transaction. The label that a fund or its counterparty assigns to the
transaction is not determinative.\87\
---------------------------------------------------------------------------

    \84\ Under the proposed rule, a derivatives instrument is one
where the fund ``is or may be required to make any payment or
delivery of cash or other assets during the life of the instrument
or at maturity or early termination, whether as margin or settlement
payment or otherwise.''
    \85\ See 2015 Proposing Release, supra note 2, at paragraph
accompanying nn.82-83. A fund that purchases a standard option
traded on an exchange, for example, generally will make a non-
refundable premium payment to obtain the right to acquire (or sell)
securities under the option. However, the option purchaser generally
will not have any subsequent obligation to deliver cash or assets to
the counterparty unless the fund chooses to exercise the option.
    \86\ See id. at n.82.
    \87\ For example, the Commission received a comment on the 2015
proposal addressing a type of total return swap, asserting that
``[t]he Swap operates in a manner similar to a purchased option or
structure, in that the fund's losses under the Swap cannot exceed
the amount posted to its tri-party custodian agreement for purposes
of entering into the Swap,'' and that, in the commenter's view, the
swap should be ``afforded the same treatment as a purchased option
or structured note'' because ``[a]lthough the Swap involves interim
payments through the potential posting of margin from the custodial
account, the payment obligations cannot exceed the [amount posted
for purposes of entering into the Swap].'' See Comment Letter of
Dearborn Capital Management (Mar. 24, 2016) (``Dearborn Comment
Letter''). Unlike a fund's payment of a one-time non-refundable
premium in connection with a standard purchased option or a fund's
purchase of a structured note, this transaction appears to involve a
fund obligation to make interim payments of fund assets posted as
margin or collateral to the fund's counterparty during the life of
the transaction in response to market value changes of the
underlying reference asset, as this commenter described. The fund
also must deposit additional margin or collateral to maintain the
position if the fund's losses deplete the assets that the fund
posted to initiate the transaction; if a fund effectively pursues
its strategy through such a swap, or a small number of these swaps,
the fund may as a practical matter be required to continue
reestablishing the trade or refunding the collateral account in
order to continue to offer the fund's strategy. The transaction
therefore appears to involve the issuance of a senior security as
the fund may be required to make future payments.
    See also infra section II.J (discussing the characterization of
``unfunded commitment'' agreements for purposes of the proposed
rule, and as senior securities).
---------------------------------------------------------------------------

    Unlike the 2015 proposal, this proposal does not include references
to, or a definition of, ``financial commitment transaction'' in
addition to the proposed definition of ``derivatives transaction.'' The
2015 proposal defined a ``financial commitment transaction'' as any
reverse repurchase agreement, short sale borrowing, or any firm or
standby commitment agreement or similar agreement.\88\ Because our
proposal addresses funds' use of reverse repurchase agreements and
unfunded commitment agreements separately from funds' use of
derivatives, the proposed definition of ``derivatives transaction''
does not include reverse repurchase agreements and unfunded commitment
agreements.\89\
---------------------------------------------------------------------------

    \88\ See 2015 Proposing Release, supra note 2, at section
III.A.2; 2015 proposed rule 18f-4(c)(4); see also supra note 10.
    \89\ See infra section II.I.
---------------------------------------------------------------------------

    Short sale borrowings, however, are included in the second prong of
the proposed definition of ``derivatives transaction.'' We appreciate
that short sales of securities do not involve derivatives instruments
such as swaps, futures, and options. The value of a short position is,
however, derived from the price of another asset, i.e., the asset sold
short. A short sale of a security provides the same economic exposure
as a derivatives instrument, like a future or swap, that provides short
exposure to the same security. The proposed rule therefore treats short
sale borrowings and derivatives instruments identically for purposes of
funds' reliance on the rule's exemption.\90\
---------------------------------------------------------------------------

    \90\ See proposed rule 18f-4(b).
---------------------------------------------------------------------------

    While this proposal does not specifically list firm or standby
commitment agreements in the definition of ``derivatives transaction,''
we interpret the definitional phrase ``or any similar instrument'' to
include these agreements. A firm commitment agreement has the same
economic characteristics as a forward contract.\91\ Similarly, a
standby commitment agreement has the same economic characteristics as
an option contract, and the Commission has previously stated that such
an agreement is economically equivalent to the issuance

of a put option.\92\ To the extent that a fund engages in transactions
similar to firm or standby commitment agreements, they may fall within
the ``any similar instrument'' definitional language, depending on the
facts and circumstances.\93\
---------------------------------------------------------------------------

    \91\ Indeed, the Commission noted in Release 10666 that a firm
commitment is known by other names such as a ``forward contract.''
See Release 10666, supra note 15, at nn.10-12 and accompanying text.
    \92\ See id. at ``Standby Commitment Agreements'' (``The standby
commitment agreement is a delayed delivery agreement in which the
investment company contractually binds itself to accept delivery of
a Ginnie Mae with a stated price and fixed yield upon the exercise
of an option held by the other party to the agreement at a stated
future date. . . . The Commission believes that the standby
commitment agreement involves, in economic reality, the issuance and
sale by the investment company of a `put.' '').
    \93\ See, e.g., infra paragraph accompanying notes 419-420
(discussing agreements that would not qualify for the proposed
rule's treatment of unfunded commitment agreements because they are
functionally similar to derivatives transactions).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule's definition
of the term ``derivatives transaction,'' including the following items.
    5. Is the definition of ``derivatives transaction'' sufficiently
clear? Are there additional types of derivatives instruments, or other
transactions, that we should include or exclude? Adding additional
transactions to the definition would permit a fund to engage in those
transactions by complying with the proposed rule, rather than section
18. Are there transactions that we should exclude from the definition
so that funds must comply with the limits of section 18 (to the extent
permitted under section 18) with respect to these transactions, rather
than the proposed rule's conditions?
    6. The proposed rule's definition of the term ``derivatives
transaction'' is designed to describe those derivatives transactions
that would involve the issuance of a senior security. Do commenters
agree that derivatives transactions that involve obligations to make a
payment or deliver assets involve the issuance of a senior security
under section 18 of the Act? Does the rule effectively describe all of
the types of derivatives transactions that would involve the issuance
of a senior security? Conversely, are there any types of transactions
that are included in the proposed definition of ``derivatives
transaction'' that should not be considered to involve the issuance of
a senior security? If so, which types of transactions and why?
    7. Is it appropriate that the proposed rule's definition of
``derivatives transaction'' incorporates a list of derivatives
instruments plus ``any similar instrument,'' rather than a principles-
based definition, such as an instrument or contract whose value is
based upon, or derived from, some other asset or metric? Why or why
not? Is the reference to ``any similar instrument'' in the proposed
definition sufficiently clear to address transactions that may be
developed in the future? If not, how should we modify the rule to
provide additional clarity?
    8. Should the proposed definition of ``derivatives transaction''
include short sale borrowings? Would this approach cause any confusion
because short sales are not typically understood as derivatives
instruments? If the latter, what alternative approach would be
preferable?
    9. Should we specifically list firm or standby commitments in the
proposed definition of ``derivatives transaction''? Would funds
understand the phrase ``or any similar instrument'' in the proposed
definition to include these agreements? Do funds currently use the
terms ``firm commitment agreement'' or ``standby commitment agreement''
to describe any of their transactions?
    10. Are there any transactions similar to firm or standby
commitments that we should specifically address, either in the proposed
definition of ``derivatives transaction'' or otherwise as guidance? Are
there any other types of transactions that the Commission should
address--either in the proposed definition or as guidance--as
transactions that fall within the ``any similar instrument''
definitional language?

B. Derivatives Risk Management Program

1. Summary
    Fund investments in derivatives transactions can pose a variety of
risks, and poor risk management can cause significant harm to funds and
their investors. Derivatives can raise potential risks such as market,
counterparty, leverage, liquidity, and operational risk. Although many
of these risks are not limited to derivatives, the complexity and
character of certain derivatives--such as their multiple contingencies
and optionality, path dependency, and non-linearity--may heighten these
risks.\94\ Even simple derivatives without multiple contingencies and
optionality, for example, can present additional risks beyond a fund's
investment in the underlying reference assets, such as the risk that a
fund must have margin-eligible assets on hand to meet margin or
collateral calls. We also recognize the valuable role derivatives can
play in helping funds to achieve their objectives efficiently or manage
their investment risks.
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    \94\ See European Securities and Markets Authority (formerly
Committee of European Securities Regulators), Guidelines on Risk
Measurement and the Calculation of Global Exposure and Counterparty
Risk for UCITS, CESR/10-788 (July 28, 2010), at 12, available at
https://www.esma.europa.eu/sites/default/files/library/2015/11/10_788.pdf (``CESR Global Guidelines'').
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    An investment adviser of a fund that uses derivatives therefore
should manage this use to ensure alignment with the fund's investment
objectives, policies, and restrictions, its risk profile, and relevant
regulatory requirements. In addition, a fund's board of directors is
responsible for overseeing the fund's activities and the adviser's
management of risks, including any derivatives risks.\95\ Given the
dramatic growth in the volume and complexity of the derivatives markets
over the past two decades, and the increased use of derivatives by
certain funds and their related risks, we believe that requiring funds
that are users of derivatives (other than limited derivatives users) to
have a formalized risk management program with certain specified
elements (a ``program'') supports exempting these transactions from
section 18.
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    \95\ See, e.g., Interpretive Matters Concerning Independent
Directors of Investment Companies, Investment Company Act Release
No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role of
Independent Directors of Investment Companies, Investment Company
Act Release No. 24816 (Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)];
Independent Directors Council, Fund Board Oversight of Risk
Management (Sept. 2011), available at http://www.ici.org/pdf/pub_11_oversight_risk.pdf (``2011 IDC Report'').
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    Under the proposed program requirement, a fund would have to adopt
and implement a written derivatives risk management program, which
would include policies and procedures reasonably designed to manage the
fund's derivatives risks.\96\ A fund's risk management program should
take into the account the way the fund uses derivatives, whether to
increase investment exposures in ways that increase portfolio risks or,
conversely, to reduce portfolio risks or facilitate efficient portfolio
management.\97\
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    \96\ Proposed rule 18f-4(c)(1).
    \97\ See supra note 4 and accompanying text; infra section
II.B.3.a.
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    The program requirement is designed to result in a program with
elements that are tailored to the particular types of derivatives that
the fund uses and their related risks, as well as how those derivatives
impact the fund's investment portfolio and strategy. The proposal would
require a fund's program to include the following elements:
     Risk identification and assessment.\98\ The program would
have to provide for the identification and assessment of a fund's
derivatives risks,

which would take into account the fund's derivatives transactions and
other investments.
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    \98\ Proposed rule 18f-4(c)(1)(i); see also infra section
II.B.3.a.
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     Risk guidelines.\99\ The program would have to provide for
the establishment, maintenance, and enforcement of investment, risk
management, or related guidelines that provide for quantitative or
otherwise measurable criteria, metrics, or thresholds related to a
fund's derivatives risks.
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    \99\ Proposed rule 18f-4(c)(1)(ii); see also infra section
II.B.3.b.
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     Stress testing.\100\ The program would have to provide for
stress testing of derivatives risks to evaluate potential losses to a
fund's portfolio under stressed conditions.
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    \100\ Proposed rule 18f-4(c)(1)(iii); see also infra section
II.B.3.c.
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     Backtesting.\101\ The program would have to provide for
backtesting of the VaR calculation model that the fund uses under the
proposed rule.
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    \101\ Proposed rule 18f-4(c)(1)(iv); see also infra section
II.B.3.d.
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     Internal reporting and escalation.\102\ The program would
have to provide for the reporting of certain matters relating to a
fund's derivatives use to the fund's portfolio management and board of
directors.
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    \102\ Proposed rule 18f-4(c)(1)(v); see also infra section
II.B.3.e.
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     Periodic review of the program.\103\ A fund's derivatives
risk manager would be required to periodically review the program, at
least annually, to evaluate the program's effectiveness and to reflect
changes in risk over time.
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    \103\ Proposed rule 18f-4(c)(1)(vi); see also infra section
II.B.3.f.

The proposed program requirement is drawn from existing fund best
practices. We believe it would enhance practices for funds that have
not already implemented a derivatives risk management program, while
building off practices of funds that already have one in place.\104\
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    \104\ See, e.g., Aviva Comment Letter (discussing the
implementation of formalized derivatives risk management programs);
Vanguard Comment Letter.
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    Most commenters generally supported the 2015 proposal's derivatives
risk management program requirement, which had many similar
foundational elements to those of the program we are proposing here.
These commenters stated that the use of derivatives transactions by a
fund should be subject to a comprehensive and appropriate written risk
management program, which would benefit investors.\105\ Our proposal
includes elements from the 2015 proposal's derivatives risk management
program framework, and adds elements that take into account our
analysis of the comments we received.
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    \105\ See, e.g., Comment Letter of AFG-French Asset Management
Association (Mar. 25, 2016) (``AFG Comment Letter''); Comment Letter
of American Beacon Advisors (Mar. 28, 2016) (``American Beacon
Comment Letter''); Comment Letter of AQR Capital Management (Mar.
28, 2016) (``AQR Comment Letter''); Federated Comment Letter;
Comment Letter of Fidelity (Mar. 28, 2016) (``Fidelity Comment
Letter''); Comment Letter of AFL-CIO (Mar. 28, 2016); Comment Letter
of Alternative Investment Management Association (Mar. 28, 2016)
(``AIMA Comment Letter''); Comment Letter of Aviva (Mar. 28, 2016)
(``Aviva Comment Letter''); Comment Letter of BlackRock (Mar. 28,
2016) (``BlackRock Comment Letter''); Comment Letter of Capital
Research and Management Company (Mar. 28, 2016) (``CRMC Comment
Letter'').
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2. Program Administration
    The proposed rule would require a fund adviser's officer or
officers to serve as the fund's derivatives risk manager.\106\ This
requirement is designed to centralize derivatives risk management and
to promote accountability. The designation of the derivatives risk
manager must be approved by the fund's board of directors, and the
derivatives risk manager must have direct communication with the fund's
board of directors. Allowing multiple officers of the fund's adviser
(including any sub-advisers) to serve as the fund's derivatives risk
manager is designed to allow funds with differing sizes, organizational
structures, or investment strategies to more effectively tailor the
programs to their operations.\107\ We understand that many advisers
today involve committees or groups of officers in the vetting and
analysis of portfolio risk and other types of risk.\108\ Although the
proposed rule would not permit a third party to serve as a fund's
derivatives risk manager, the derivatives risk manager could obtain
assistance from third parties in administering the program. For
example, third parties could provide data relevant to the
administration of a fund's program or other analysis that may inform
the fund's derivatives risk management.
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    \106\ Proposed rule 18f-4(a).
    \107\ The term ``adviser'' as used in this release and rule 18f-
4 generally refers to any person, including a sub-adviser, that is
an ``investment adviser'' of an investment company as that term is
defined in section 2(a)(20) of the Investment Company Act.
    \108\ See, e.g., IAA Comment Letter.
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    The proposed rule would also require that the fund's derivatives
risk manager have relevant experience regarding derivatives risk
management.\109\ This requirement is designed to reflect the potential
complex and unique risks that derivatives can pose to funds and promote
the selection of a derivatives risk manager who is well-positioned to
manage these risks. As discussed below, under the proposed rule, a
fund's board must approve the designation of the fund's derivatives
risk manager, taking into account the derivatives risk manager's
relevant experience regarding derivatives risk management.\110\
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    \109\ Proposed rule 18f-4(a).
    \110\ See infra section II.C.1.
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    The proposed rule would require a fund to reasonably segregate the
functions of the program from its portfolio management.\111\
Segregating derivatives risk management from portfolio management is
designed to promote objective and independent identification,
assessment, and management of the risks associated with derivatives
use. Accordingly, this element is designed to enhance the
accountability of the derivatives risk manager and other risk
management personnel and, therefore, to enhance the program's
effectiveness.\112\ We understand that funds today often segregate risk
management from portfolio management. Many have observed that
independent oversight of derivatives activities by compliance and
internal audit functions is valuable.\113\ Because a fund may
compensate its portfolio management personnel in part based on the
returns of the fund, the incentives of portfolio managers may not
always be consistent with the restrictions that a risk management
program would impose. Keeping the functions separate in the context of
derivatives risk management should help mitigate the possibility that
these competing incentives diminish the program's effectiveness.
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    \111\ Proposed rule 18f-4(c)(1).
    \112\ See, e.g., Comptroller of the Currency Administrator of
National Banks, Risk Management of Financial Derivatives:
Comptroller's Handbook (Jan. 1997), at 9 (discussing the importance
of independent risk management functions in the banking context).
    \113\ See, e.g., Kenneth K. Marshall, Internal Control and
Derivatives, The CPA Journal (Oct. 1995), available at http://archives.cpajournal.com/1995/OCT95/f461095.htm.
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    Separation of functions creates important checks and balances, and
funds could institute this proposed requirement through a variety of
methods, such as independent reporting chains, oversight arrangements,
or separate monitoring systems and personnel. The proposed rule would
require reasonable segregation of functions, rather than taking a more
prescriptive approach, such as requiring funds to implement strict
protocols regarding communications between specific fund personnel, to
allow funds to structure their risk management and portfolio management
functions in ways that are tailored to each fund's facts and
circumstances, including the size and

resources of the fund's adviser. In this regard, the reasonable
segregation requirement is not meant to indicate that the derivatives
risk manager and portfolio management must be subject to a
communications ``firewall.'' We recognize the important perspective and
insight regarding the fund's use of derivatives that the portfolio
manager can provide and generally understand that the fund's
derivatives risk manager would work with the fund's portfolio
management in implementing the program requirement.
    For similar reasons, the proposed rule would also prohibit the
derivatives risk manager position from being filled solely by the
fund's portfolio manager, if a single fund officer serves in the
position.\114\ The proposed rule also would prohibit a majority of the
officers who compose the derivatives risk manager position from being
portfolio managers, if multiple fund officers serve in the position.
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    \114\ Proposed rule 18f-4(a).
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    Commenters generally supported the 2015 proposal's requirement that
a fund's derivatives risk management program be administered by a
derivatives risk manager and that the fund's derivatives risk
management be segregated from the fund's portfolio management.\115\
Commenters did, however, express concern about the 2015 proposal's
requirement that there be a single derivatives risk manager and urged
that the Commission permit a fund's portfolio managers to provide some
input into the fund's derivatives risk management function.\116\ This
re-proposal addresses these concerns by permitting a group or committee
to serve as a fund's derivatives risk manager, a portion of whom could
be portfolio managers.
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    \115\ See, e.g., BlackRock Comment Letter.
    \116\ See, e.g., BlackRock Comment Letter; Comment Letter of
Morningstar (Mar. 28, 2016) (``Morningstar Comment Letter'');
Comment Letter of the Investment Company Institute (Mar. 28, 2016)
(``ICI Comment Letter I''); Comment Letter of WisdomTree (Mar. 28,
2016).
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    We request comment on the proposed requirements that a fund's
derivatives risk manager administer the fund's program, and that the
derivatives risk management function be reasonably segregated from the
fund's portfolio management.
    11. Is the proposed definition of ``derivatives risk manager''
sufficiently clear? Why or why not? Should the rule, as proposed,
require that a fund's derivatives risk manager be an officer or
officers of the fund's adviser, and would this requirement further the
goals of centralizing derivatives risk management and promoting
accountability? Why or why not? Should the rule, as proposed, permit a
fund's derivatives risk manager to be an officer or officers of the
fund's sub-advisers? Why or why not? If so, should the rule require
that at least one of the officers be an officer of the adviser or
otherwise limit the number of sub-adviser officers? Why or why not?
Would a fund's program be more effective if we required the derivatives
risk manager to be a single individual? Why or why not? If so, should
this individual be required to be an officer of a fund's adviser?
    12. Should the rule, as proposed, require that a fund's derivatives
risk manager have relevant experience regarding derivatives risk
management? Why or why not? Is the proposed requirement that the
derivatives risk manager have ``relevant experience regarding the
management of derivatives risk'' sufficiently clear? Would this raise
questions about whether portfolio management experience, or experience
outside of formal derivatives risk management, would suffice for
purposes of the rule? Should the rule, instead, require that a fund's
derivatives risk manager simply have ``relevant experience''? Should
the rule specify that the derivatives risk manager must have relevant
experience as determined by the fund's board, to allow a board to
determine the experience that would be appropriate? Or should the rule
identify specific qualifications, training, or experience of a fund's
derivatives risk manager? Why or why not? If so, what should they be
and why?
    13. Should the rule, as proposed, require a fund to segregate
derivatives risk management functions from portfolio management? Why or
why not? If we were not to require independence between a fund's
derivatives risk manager and the fund's portfolio managers, how could
we ensure that a fund's portfolio management personnel, who may have
conflicting incentives, do not unduly influence the fund's program
management?
    14. Should we provide any additional clarification regarding the
proposed reasonable segregation requirement? If so, what changes should
we make? Should we add any specific requirements? For example, should
we limit the extent to which fund risk management personnel can be
compensated in part based on fund performance?
    15. Is our understanding that many funds already segregate
functions correct? If so, how and why do current approaches differ from
the proposed rule's requirement to segregate functions?
    16. Are there other ways to facilitate objective and independent
risk assessment of portfolio strategies that we should consider? If so,
what are they and how would these alternatives be more effective than
the proposed rule's requirement to reasonably segregate functions?
    17. Rule 22e-4 under the Investment Company Act, similar to the
proposed rule, requires certain funds to implement a risk management
program. In particular, rule 22e-4 requires person(s) designated to
administer a fund's liquidity risk management program to be the fund's
investment adviser, officer, or officers (which may not be solely
portfolio managers of the fund) (the ``liquidity risk manager'').
Should we amend rule 22e-4 to more closely align the definition of
``liquidity risk manager'' with the proposed definition of
``derivatives risk manager'' by prohibiting a fund's adviser from
serving as a liquidity risk manager? Why or why not? Conversely, should
we align the standard for derivatives risk manager with the liquidity
risk manager standard under rule 22e-4?