accompanying text (discussing the proposed definition of
``derivatives risks'').
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    For example, a fund that uses derivatives solely to hedge currency
risks would not be introducing leverage risk, but could still introduce
other risks, including counterparty risk and the risk that a fund could
be required to sell its investments to meet margin calls. As another
example, certain derivatives, and particularly derivatives with non-
linear or path-dependent returns, may pose risks that require
monitoring even when the derivatives represent a small portion of net
asset value. For example, because of the non-linear payout profiles
associated with put and call options, changes in the value of the
option's underlying reference asset can increase the option's delta,
and thus the extent of the fund's derivatives exposure from the option.
An options transaction that represented a small percentage of a fund's
net asset value can rapidly increase to a larger percentage.
    The proposed rule would require funds relying on the limited
derivatives user exception to adopt and implement policies and
procedures reasonably designed to manage the funds' derivatives risks.
Because they would be reasonably designed to address each fund's
derivatives risks, these policies and procedures would reflect the
extent and nature of a fund's use of derivatives within the parameters
provided in the exception. For example, a fund that uses derivatives
only occasionally and for a limited purpose, such as to equitize cash,
could have limited policies and procedures commensurate with this
limited use. A fund that uses more complex derivatives with derivatives
exposure approaching 10% of net asset value, in contrast, would need to
have policies and procedures tailored to the risks these derivatives
could present. These policies and procedures could be more extensive
and could include elements similar to those required under the proposed
derivatives risk management program.
    The 2015 proposal would have required funds relying on that
proposal's exception to the derivatives risk management program
requirement to manage derivatives risks by determining (and maintaining
certain assets to cover) a ``risk-based coverage amount'' associated
with the fund's derivatives. This amount represented an estimate of the
amount the fund would expect to pay to exit the derivatives transaction
under stressed conditions.
    The approach we are proposing here is designed to require a fund
relying on the limited derivatives user exception to manage all of the
risks associated with its derivatives transactions, and not just the
risks that an asset segregation requirement could address.\296\
Moreover, our proposal is designed to limit derivatives risks by
limiting the extent to which a fund can use derivatives while relying
on the exception. As discussed above, the 2015 proposal would have
permitted funds to obtain substantially greater derivatives exposure--
up to 50% of net assets--without establishing a derivatives risk
management program. On balance, we believe that the proposed bases for
the limited derivatives user exception, together with the requirement
that a fund manage any risks its limited use of derivatives presents,
would provide both important investor protections and flexibility for
funds to use derivatives in a way that is consistent with the policy
concerns underlying section 18.
---------------------------------------------------------------------------

    \296\ We discuss the limitations of an asset segregation
requirement in section II.F below.
---------------------------------------------------------------------------

    We request comment on the proposed requirement that a fund relying
on the limited derivatives user exception manage the risks associated
with its derivatives transactions by adopting policies and procedures
that are reasonably designed to manage its derivatives risks.
    164. Is it appropriate to require funds relying on the limited
derivatives user exception to adopt policies and procedures that are
reasonably designed to manage their derivatives risks, in lieu of
requiring such a fund to adopt a derivatives risk management program
that includes all of the proposed program elements and comply with the
proposed VaR-based limit on fund leverage risk? Would this requirement
effectively address the risks entailed by the levels and types of
derivatives use in which a fund that qualifies for the proposed
exception might engage?
    165. Alternatively, should funds eligible for the proposed limited
derivatives user exception be subject to a tailored version of the
proposed program requirement (e.g., a program requirement that would
specify only certain elements, such as risk identification and
assessment, establishing risk guidelines, stress

testing, etc.)? If so, if so what should this entail?
    166. Either in addition to or in lieu of policies and procedures
reasonably designed to manage a fund's derivatives risk, should we
require funds relying on the limited derivatives user exception to
comply with an asset segregation requirement? Should we use the same
approach we proposed in 2015? Should we use that approach but allow
funds to segregate a broader range of assets, such as the assets with
corresponding haircuts analyzed in the 2016 DERA Memo?
    167. Should we require limited derivatives users to publicly
disclose that they are limited derivatives users in their prospectus,
annual report, or on their website? If so, should we require any
particular disclosure to enhance investors' understanding of, for
example: (1) The risks of investing in a fund that qualifies as a
limited derivatives user under the proposed rule, or (2) such a fund's
derivatives risk management practices?

F. Asset Segregation

    The Commission and staff have historically taken the position that
a fund may appropriately manage the risks that section 18 is designed
to address if the fund ``covers'' its obligations in connection with
various transactions by maintaining ``segregated accounts.'' \297\
Funds' practices regarding the amount of ``cover'' they segregate, and
the assets available for segregation, have evolved over time. In
addition, different funds have applied those practices in varying ways
to derivatives transactions with comparable economic exposures.
Moreover, regulatory and contractual margin requirements have developed
significantly since the adoption of Release 10666.
---------------------------------------------------------------------------

    \297\ See supra section I.B.2.
---------------------------------------------------------------------------

    The 2015 proposal drew on the Commission's historical approach--and
sought to primarily address the Investment Company Act's asset
sufficiency concern--by including an asset segregation requirement as
part of the 2015 proposed rule.\298\ Under the Commission's 2015
proposed approach, a fund relying on the proposed rule, in addition to
complying with one of two portfolio limitations, would have had to
maintain an amount of ``qualifying coverage assets'' designed to enable
a fund to meet its derivatives-related obligations. Under the 2015
proposed rule, a fund would not have been required to segregate a
derivative's full notional amount, but instead would have had to
segregate qualifying coverage assets (generally cash and cash
equivalents) equal to the sum of two amounts: (1) The amount that would
be payable by the fund if the fund were to exit the derivatives
transaction at the time of determination (the ``mark-to-market coverage
amount''), and (2) a reasonable estimate of the potential amount
payable by the fund if the fund were to exit the derivatives
transaction under stressed conditions (the ``risk-based coverage
amount'').\299\
---------------------------------------------------------------------------

    \298\ See 2015 Proposing Release supra note 2, at section III.C.
    \299\ See id. at section III.C.2 (discussing the composition of
qualifying coverage assets as either: (1) Cash and cash equivalents,
or (2) with respect to any derivatives transaction under which the
fund may satisfy its obligations under the transaction by delivering
a particular asset, that particular asset).
---------------------------------------------------------------------------

    Although commenters generally supported the overarching framework
of the 2015 proposed rule's asset segregation requirement, they
identified several operational complexities. For example, commenters
stated that additional clarity was necessary for funds to determine
risk-based coverage amounts, including how funds should determine
stressed conditions for this purpose.\300\ Commenters also raised
questions about how funds could reduce segregated amounts to account
for posted initial or variation margin and, more generally, how rule
provisions governing coverage amounts would apply to cleared
transactions (as opposed to OTC transactions covered by netting
agreements).\301\ A number of commenters also expressed concerns about
the proposed requirement that funds generally segregate cash and cash
equivalents.\302\ Commenters suggested alternatives to this proposed
requirement, including allowing funds to segregate a broader range of
assets subject to ``haircuts'' prescribed by the Commission based on
the relative volatility of different asset classes.\303\
---------------------------------------------------------------------------

    \300\ See, e.g., ICI Comment Letter I; BlackRock Comment Letter;
Dechert Comment Letter; FSR Comment Letter; Guggenheim Comment
Letter.
    \301\ See, e.g., SIFMA Comment Letter (stating that ``[i]n
practice, variation margin and initial margin are often calculated
in the aggregate, on a net basis, rather than separately'' and
recommending that funds ``be able to get credit for both initial and
variation margin posted on a net basis . . .'' rather than limiting
the type of coverage amount against which initial or variation
margin may be credited); BlackRock Comment Letter (stating that
initial and variation margin are used for cleared and OTC
derivatives transactions by the clearinghouse and counterparties,
respectively, when a derivatives transaction is exited and that
distinguishing between the uses of the two types of margin will
introduce complexity given that both forms of margin are available
to cover potential obligations under derivatives in the event of a
party's default).
    \302\ See, e.g., AIMA Comment Letter; AQR Comment Letter;
BlackRock Comment Letter; Dechert Comment Letter; Comment Letter of
Eaton Vance Management (Mar. 28, 2016) (``Eaton Vance Comment
Letter''); Guggenheim Comment Letter; Comment Letter of JPMorgan
(Mar. 28, 2016); Oppenheimer Comment Letter; PIMCO Comment Letter.
    \303\ See, e.g., Dechert Comment Letter; Eaton Vance Comment
Letter; IAA Comment Letter; SIFMA Comment Letter, Guggenheim Comment
Letter.
---------------------------------------------------------------------------

    Our proposal does not include a specific asset segregation
requirement because we do not believe that an asset segregation
requirement is necessary in light of the proposed rule's requirements,
including the requirements that funds establish risk management
programs and comply with the proposed VaR-based limit on fund leverage
risk. As discussed in more detail above, a fund relying on proposed
rule 18f-4 would be required to adopt and implement a written
derivatives risk management program that, among other things, would
require the fund to: Identify and assess its derivatives risks; put in
place guidelines to manage these risks; stress test the fund's
portfolio at least weekly; and escalate material risks to the fund's
portfolio managers and, as appropriate, the board of directors.\304\
These proposed requirements are designed to require a fund to manage
all of the risks associated with its derivatives transactions. These
include--but are not limited to--the risk that a fund may be required
to sell its investments to generate cash to pay derivatives
counterparties, which the 2015 proposal's asset segregation was
designed to address.
---------------------------------------------------------------------------

    \304\ Proposed rule 18f-4(c)(1). Funds that rely on the limited
derivatives user exception also would be required to manage the
risks associated with their more limited use of derivatives. See
supra section II.E.
---------------------------------------------------------------------------

    Moreover, the proposed rule would require that a fund's stress
testing for purposes of its derivatives management program specifically
take into account the fund's payments to derivatives counterparties
that could result from losses in stressed conditions. Rather than
require a fund to evaluate the amounts it would pay to exit derivatives
transactions under stressed conditions on a transaction-by-transaction
basis as in the 2015 proposal,\305\ our proposal would require funds to
conduct portfolio-wide stress tests, taking into account potential
payments to counterparties. Although counterparties often require funds
to post margin or collateral for individual transactions (or groups of
transactions) in order to cover potential loss exposure, the proposed

rule's stress testing requirement is designed to provide a portfolio-
wide assessment of how the fund may respond to stressed conditions and
any resulting payment obligations. This portfolio-wide assessment also
would be buttressed by the other provisions in the risk management
program and the proposed VaR-based limit on fund leverage risk, which
are designed to limit a fund's leverage risk and therefore the
potential for payments to derivatives counterparties. The 2015
proposal's derivatives risk management program, in contrast, did not
include such a portfolio-wide assessment. We believe that the proposed
rule's requirements, in their totality, would appropriately address the
asset sufficiency risks underlying section 18.
---------------------------------------------------------------------------

    \305\ In the 2015 proposal, funds were required to determine
qualifying coverage assets on a transaction-by-transaction basis,
with the exception that funds could determine the amount of
qualifying coverage assets on a net basis for derivatives
transactions covered by netting agreements. See 2015 proposed rule
18f-4(c)(6) and (9).
---------------------------------------------------------------------------

    A separate asset segregation requirement, in contrast, may be less
effective. As derivatives markets evolve, questions may arise about the
amount (and composition) of assets that funds must segregate for novel
types of transactions. Although the Commission in 2015 sought to take a
principles-based approach to the amount of assets that funds would
segregate, many commenters asserted that additional clarity would be
necessary to administer this approach. It would be difficult in this
context for the Commission to specify the amount of assets that funds
should segregate on a transaction-by-transaction basis and to keep any
specific requirements current as markets develop. And a principles-
based approach to asset segregation, if it does not provide sufficient
clarity, may contribute to the kinds of divergent asset segregation
practices that exist today, which in turn have led to situations in
which funds are not subject to a practical limit on potential leverage
that they may obtain through derivatives transactions.\306\ By building
on current risk management practices and techniques, including VaR and
stress testing, the proposed rule is designed to provide a framework
that we believe funds can apply to a broad variety of fund types and
derivatives uses without our having to specify the operational details
that an asset segregation requirement would entail.
---------------------------------------------------------------------------

    \306\ See supra sections I.B.2 and I.B.3.
---------------------------------------------------------------------------

    We request comment on our proposal not to include a specific asset
segregation requirement.
    168. Do commenters believe that the proposed rule's requirements
discussed above, in their totality, would appropriately address the
asset sufficiency risks underlying section 18? If not and commenters
believe rule 18f-4 should include an asset segregation requirement,
what should that requirement entail? What added benefits would an asset
segregation requirement provide that the current proposed rule
requirements would not?
    169. Should we require funds relying on the limited derivatives
user exposure-based exception to segregate assets for purposes of the
exception? Why or why not? Would an asset segregation requirement for
such limited derivatives users obviate any need for a policies and
procedures requirement? Why or why not?
    170. Commenters in the 2015 release requested further clarity about
the Commission's 2015 proposal to require a principles-based asset
segregation regime. What aspect of that proposal required further
clarity and why?

G. Alternative Requirements for Certain Leveraged/Inverse Funds and
Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment
Vehicles

1. Background on Proposed Approach to Certain Leveraged/Inverse Funds
    Proposed rule 18f-4 would include an alternative approach for
certain funds that seek to provide leveraged or inverse exposure to an
underlying index, generally on a daily basis. This alternative approach
would be available for a registered investment company that is a
``leveraged/inverse investment vehicle,'' as that term is defined in
proposed Exchange Act rule 15l-2 and proposed Advisers Act rule 211(h)-
1 (which we refer to collectively as the proposed ``sales practices
rules,'' as noted above). As discussed below, the proposed sales
practices rules would require broker-dealers and investment advisers to
engage in due diligence before accepting or placing an order for a
customer or client that is a natural person (``retail investor'') to
trade a leveraged/inverse investment vehicle, or approving a retail
investor's account for such trading. The definition of the term
``leveraged/inverse investment vehicle'' in the proposed sales
practices rules would include certain entities that seek, directly or
indirectly, to provide investment returns that correspond to the
performance of a market index by a specified multiple, or to provide
investment returns that have an inverse relationship to the performance
of a market index, over a predetermined period of time.\307\ The
entities included in the proposed scope of the sales practices rules
would include registered investment companies and certain exchange-
listed commodity- or currency-based trusts or funds. In this release,
we refer to the registered investment companies covered by the proposed
sales practices rules as ``leveraged/inverse funds'' (which in turn
would be subject to the proposed alternative approach under rule 18f-
4). We use the proposed sales practices rules' defined term
``leveraged/inverse investment vehicle'' to refer to both such
leveraged/inverse funds and to the exchange-listed commodity- or
currency-based trusts or funds covered by those rules.
---------------------------------------------------------------------------

    \307\ See proposed rules 15l-2(d) and 211(h)-1(d) (defining the
term ``leveraged/inverse investment vehicle''); see also, e.g., ETFs
Adopting Release, supra note 76, at section II.A.3; rule 6c-11(c)(3)
under the Investment Company Act.
---------------------------------------------------------------------------

    Leveraged/inverse funds, which today are structured primarily as
leveraged/inverse ETFs, seek to amplify the returns of an underlying
index by a specified multiple or to profit from a decline in the value
of their underlying index over a predetermined period of time using
financial derivatives.\308\ These funds reset periodically and are
designed to hedge against or profit from short-term market movements
without using margin, and, as such, are generally intended as short-
term trading tools.\309\ To achieve their targeted returns, leveraged/
inverse funds use derivatives extensively. In contrast to other funds
that use derivatives as part of their broader investment strategy,
leveraged/inverse funds' strategies (and use of derivatives) are
predicated on leverage. Accordingly, leveraged/inverse funds raise the
issues that section 18 of the

Investment Company Act is designed to address.
---------------------------------------------------------------------------

    \308\ See infra section III.B for baseline statistics regarding
leveraged/inverse ETFs and mutual funds. Leveraged/inverse ETFs
operate under Commission orders providing exemptive relief from
certain provisions of the Investment Company Act. These orders,
however, do not provide exemptive relief from section 18 of the
Investment Company Act. Rather, like other funds that use derivative
investments, leveraged/inverse ETFs rely upon Release 10666 and
operate consistent with the conditions in staff no-action letters
and other staff guidance on derivatives transactions. See infra
section II.L (discussing our proposal to rescind Release 10666, and
stating that staff in the Division of Investment Management is
reviewing certain of its no-action letters and other guidance to
determine which letters and other staff guidance should be withdrawn
in connection with any adoption of this proposal).
    The Commission recently adopted rule 6c-11 under the Investment
Company Act to permit ETFs that satisfy certain conditions to
operate without obtaining an exemptive order from the Commission.
Rule 6c-11 includes a provision excluding leveraged/inverse ETFs
from the scope of that rule. See infra section II.G.4 (discussing
proposed amendments to rule 6c-11 and proposed rescission of
exemptive orders issued to leveraged/inverse ETFs).
    \309\ See Commission Interpretation Regarding Standard of
Conduct for Investment Advisers, Investment Advisers Act Release No.
5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at text preceding
n.39 (``Fiduciary Interpretation'').
---------------------------------------------------------------------------

    Leveraged/inverse funds and certain commodity pools following the
same strategy also present unique considerations because they rebalance
their portfolios on a daily (or other predetermined) basis in order to
maintain a constant leverage ratio. This reset, and the effects of
compounding, can result in performance over longer holding periods that
differs significantly from the leveraged or inverse performance of the
underlying reference index over those longer holding periods.\310\ This
effect can be more pronounced in volatile markets.\311\ As a result,
buy-and-hold investors in a leveraged/inverse fund who have an
intermediate or long-term time horizon--and who may not evaluate their
portfolios frequently--may experience large and unexpected losses or
otherwise experience returns that are different from what they
anticipated.\312\
---------------------------------------------------------------------------

    \310\ For example, as a result of compounding, a leveraged/
inverse fund can outperform a simple multiple of its index's returns
over several days of consistently positive returns, or underperform
a simple multiple of its index's returns over several days of
volatile returns.
    \311\ See FINRA Regulatory Notice 09-31, Non-Traditional ETFs--
FINRA Reminds Firms of Sales Practice Obligations Relating to
Leveraged and Inverse Exchange-Traded Funds (June 2009) (``FINRA
Regulatory Notice 09-31'') (``Using a two-day example, if the index
goes from 100 to close at 101 on the first day and back down to
close at 100 on the next day, the two-day return of an inverse ETF
will be different than if the index had moved up to close at 110 the
first day but then back down to close at 100 on the next day. In the
first case with low volatility, the inverse ETF loses 0.02 percent;
but in the more volatile scenario the inverse ETF loses 1.82
percent. The effects of mathematical compounding can grow
significantly over time, leading to scenarios such as those noted
above.'').
    \312\ See id. (reminding member firms of their sales practice
obligations relating to leveraged/inverse ETFs and stating that
leveraged/inverse ETFs are typically not suitable for retail
investors who plan to hold these products for more than one trading
session). See also Fiduciary Interpretation, supra note 308 (stating
that ``leveraged exchange-traded products are designed primarily as
short-term trading tools for sophisticated investors . . . [and]
require daily monitoring . . . .''); Securities Litigation and
Consulting Group, Leveraged ETFs, Holding Periods and Investment
Shortfalls, (2010), at 13 (``The percentage of investors that we
estimate hold [leveraged/inverse ETFs] longer than a month is quite
striking.''); ETFs Adopting Release, supra note 76, at n.78
(discussing comment letters submitted by Consumer Federation of
America (urging the Commission to consider additional investor
protection requirements for leveraged/inverse ETFs) and by Nasdaq
(stating that ``there is significant investor confusion regarding
existing leveraged/inverse ETFs' daily investment horizon'')).
---------------------------------------------------------------------------

    The Commission's Office of Investor Education and Advocacy and
FINRA have issued alerts in the past decade to highlight issues
investors should consider when investing in leveraged/inverse
funds.\313\ In addition, some commenters to the 2015 proposal indicated
that at least some segment of investors may hold leveraged/inverse
funds for long periods of time, which can lead to significant losses
under certain circumstances.\314\ FINRA has sanctioned a number of
brokerage firms for making unsuitable sales of leveraged/inverse
ETFs.\315\ More recently, the Commission has brought enforcement
actions against investment advisers for, among other things, soliciting
advisory clients to purchase leveraged/inverse ETFs for their
retirement accounts with long-term time horizons, and holding those
securities in the client accounts for months or years.\316\
---------------------------------------------------------------------------

    \313\ SEC Investor Alert and Bulletins, Leveraged and Inverse
ETFs: Specialized Products with Extra Risks for Buy-and-Hold
Investors (Aug. 1, 2009), available at http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm. This investor alert, jointly issued by
SEC staff and FINRA, followed FINRA's June 2009 alert, which raised
concerns about retail investors holding leveraged/inverse ETFs over
periods of time longer than one day. See FINRA Regulatory Notice 9-
31, supra note 310.
    \314\ See, e.g., CFA Comment Letter (``There is evidence that
suggests investors are incorrectly using certain alternative
investments that use derivatives extensively. For example, despite
the fact that double and triple leveraged ETFs are short-term
trading vehicles that are not meant to be held longer than one day,
a significant number of shares are held for several days, if not
weeks.''). But cf. Comment Letter of Rafferty Asset Management (Mar.
28, 2016) (asserting that there is no evidence that investors do not
understand the leveraged/inverse ETF product, citing, for example,
an analysis of eight of its leveraged/inverse ETFs between May 1,
2009 and July 31, 2015, and finding an average implied holding
period ranging from 1.18 days to 4.03 days and suggesting,
therefore, that investors understand the products are designed for
active trading). We note, however, that the analysis relied upon in
the Comment Letter of Rafferty Asset Management did not analyze
shareholder-level trading activity or provide any information on the
distribution of shareholder holding periods.
    \315\ See FINRA News Release, FINRA Sanctions Four Firms $9.1
Million for Sales of Leveraged and Inverse Exchange-Traded Funds
(May 1, 2012), available at https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus
and Century Securities to Pay Fines and Restitution Totaling More
Than $1 Million for Unsuitable Sales of Leveraged and Inverse ETFs,
and Related Supervisory Deficiencies (Jan. 9, 2014), available at
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-fines-and-restitution-totaling; FINRA
News Release, FINRA Sanctions Oppenheimer & Co. $2.9 Million for
Unsuitable Sales of Non-Traditional ETFs and Related Supervisory
Failures (June 8, 2016), available at http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of
Acceptance, Waiver and Consent (``AWC'') No.<PHONE_NUMBER>801 (Aug. 8,
2016), available at http://disciplinaryactions.finra.org/Search/ViewDocument/66461; Citigroup Global Markets Inc., FINRA Letter of
AWC No.<PHONE_NUMBER>4 (May, 1, 2012), available at http://disciplinaryactions.finra.org/Search/ViewDocument/31714. See also
Regulation Best Interest: The Broker-Dealer Standard of Conduct,
Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12,
2019)], at paragraph accompanying nn.593-98 (``Regulation Best
Interest: The Broker-Dealer Standard of Conduct''). See also, e.g.,
SEC. v. Hallas, No 1:17-cv-2999 (S.D.N.Y. Sept. 27, 2017) (default
judgement); In the Matter of Demetrios Hallas, SEC. Release No. 1358
(Feb. 22, 2019) (initial decision), Exchange Act Release No 85926
(May 23, 2019) (final decision) (involving a former registered
representative of registered broker-dealers purchasing and selling
leveraged ETFs and exchange-traded notes for customer accounts while
knowingly or recklessly disregarding that they were unsuitable for
these customers, in violation of section 17(a) of the Securities Act
and section 10(b) and rule 10b-5 thereunder of the Exchange Act).
    \316\ See, e.g., In the Matter of Morgan Stanley Smith Barney,
LLC, Investment Advisers Act Release No. 4649 (Feb. 14, 2017)
(settled action).
---------------------------------------------------------------------------

    Most leveraged/inverse funds could not satisfy the limit on fund
leverage risk in proposed rule 18f-4 because they provide leveraged or
inverse market exposure exceeding 150% of the return or inverse return
of the relevant index.\317\ These funds therefore would fail the
relative VaR test and would not be eligible to use the absolute VaR
test.\318\ Requiring these funds to comply with the proposed VaR tests
therefore effectively would preclude sponsors from offering the funds
in their current form. Investors who are capable of evaluating these
funds' characteristics and their unique risks, however, may want to use
them to meet specific short-term or other investment goals. We
therefore are proposing a set of alternative requirements for
leveraged/inverse funds designed to address the investor protection
concerns that underlie section 18 of the Investment Company Act, while
preserving choice for these investors. These requirements, discussed
below, are designed to help ensure that retail investors in leveraged/
inverse investment vehicles are limited to those who are capable of
evaluating the risks these products present. They also would limit the
amount of leverage that leveraged/inverse funds subject to rule 18f-4
can obtain to their current levels.
---------------------------------------------------------------------------

    \317\ See supra section II.D (discussing the proposed VaR-based
limit on fund leverage risk).
    \318\ See supra section II.D (discussing relative and absolute
VaR tests under proposed rule 18f-4). In addition, we understand
that even if leveraged/inverse funds were to apply the proposed
absolute VaR test, many of those funds also would fail that test.
---------------------------------------------------------------------------

2. Proposed Sales Practices Rules for Leveraged/Inverse Investment
Vehicles
    As a complement to proposed rule 18f-4, we are proposing sales
practices rules under the rulemaking authority provided in Exchange Act
section 15(l)(2) and Advisers Act section

211(h).\319\ The proposed sales practices rules would require broker-
dealers and investment advisers to exercise due diligence on retail
investors before approving retail investor accounts to invest in
leveraged/inverse investment vehicles. Specifically, proposed rule 15l-
2 under the Exchange Act would require a broker-dealer (or any
associated person of the broker-dealer) to exercise due diligence to
ascertain certain essential facts about a customer who is a retail
investor before accepting the customer's order to buy or sell shares of
a leveraged/inverse investment vehicle, or approving the customer's
account to engage in those transactions.\320\ Similarly, proposed rule
211(h)-1 under the Advisers Act would require an investment adviser (or
any supervised person of the investment adviser) to exercise due
diligence to ascertain the same set of essential facts about a client
who is a retail investor before placing an order for that client's
account to buy or sell shares of a leveraged/inverse investment
vehicle, or approving the client's account to engage in those
transactions.\321\ Under both of the proposed sales practices rules, a
firm could approve the retail investor's account to buy or sell shares
of leveraged/inverse investment vehicles only if the firm had a
reasonable basis to believe that the investor is capable of evaluating
the risks associated with these products.
---------------------------------------------------------------------------

    \319\ These provisions provide the Commission with authority to
``where appropriate, promulgate rules prohibiting or restricting
certain sales practices, conflicts of interest, and compensation
schemes for brokers, dealers, and investment advisers that the
Commission deems contrary to the public interest and the protection
of investors.''
    \320\ Proposed rule 15l-2(a). In this release, the term
``firm,'' which collectively refers to Commission-registered broker-
dealers and investment advisers, also includes associated persons of
such broker-dealers.
    \321\ Proposed rule 211(h)-1(a). In this release, the term
``firm,'' which collectively refers to Commission-registered broker-
dealers and investment advisers, also includes supervised persons of
such investment advisers.
---------------------------------------------------------------------------

    The proposed sales practices rules are designed to establish a
single, uniform set of enhanced due diligence and approval requirements
for broker-dealers and investment advisers with respect to retail
investors that engage in leveraged/inverse investment vehicle
transactions, including transactions where no recommendation or
investment advice is provided by a firm. These rules therefore would
apply the same due diligence requirements to both broker-dealers and
investment advisers.\322\ They are designed to help ensure that
investors in these funds are limited to those who are capable of
evaluating their characteristics--including that the funds would not be
subject to all of the leverage-related requirements applicable to
registered investment companies generally--and the unique risks they
present. Compliance with the proposed rules would not supplant or by
itself satisfy other broker-dealer or investment adviser obligations,
such as a broker-dealer's obligations under Regulation Best Interest or
an investment adviser's fiduciary duty under the Advisers Act.\323\
---------------------------------------------------------------------------

    \322\ Although we expect that the proposed sales practices rules
would cover a significant percentage of the retail investors who
invest in leveraged/inverse investment vehicles, we recognize that
not every purchase or sale of a leveraged/inverse investment vehicle
will involve a customer or client of a Commission-registered broker-
dealer or investment adviser that would be subject to the proposed
sales practices rules.
    \323\ See Regulation Best Interest: The Broker-Dealer Standard
of Conduct, supra note 314 (discussing broker-dealer obligations
when providing a recommendation to a retail customer of any
securities transaction or investment strategy involving securities
based on the customer's investment profile); Fiduciary
Interpretation, supra note 308 (discussing an investment adviser's
fiduciary duty to its client, and stating that as fiduciaries,
investment advisers owe their clients duties of care and loyalty).
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    The approval and due diligence requirements under the proposed
rules are modeled after current FINRA options account approval
requirements for broker-dealers.\324\ Under the FINRA rules governing
options, a broker-dealer may not accept a customer's options order
unless the broker-dealer has approved the customer's account for
options trading.\325\ Similarly, the proposed sales practices rules
would require that a firm approve a retail investor's account before
the retail investor may invest in leveraged/inverse investment
vehicles. As such, the proposed sales practices rules, like the FINRA
rule, would not require firms to evaluate retail investors' eligibility
to transact in these products on a transaction-by-transaction basis. We
have generally modeled the proposed rules after the FINRA options
account framework in part because leveraged/inverse investment
vehicles, when held over longer periods of time, may have certain
similarities to options.\326\ The options account approval requirements
also represent a current framework that can be used in connection with
complex products generally.\327\ This approach may provide some
efficiencies and reduced compliance costs for broker-dealers that
already have compliance procedures in place for approving options
accounts, although we recognize that these efficiencies and reduced
compliance costs would not apply to investment advisers that are not
dually registered as, or affiliated with, broker-dealers subject to
FINRA rules.
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    \324\ See, e.g., FINRA rule 2360(b)(16), (17) (requiring for
options accounts, firm approval, diligence and recordkeeping).
    \325\ FINRA rule 2360(b)(16). The same requirements apply for
transactions in index warrants, currency index warrants, and
currency warrants. See FINRA rules 2352 and 2353. Similar
requirements apply for transactions in security futures. See FINRA
rule 2370(b)(16) (requiring broker-dealer approval and diligence
regarding the opening of accounts to trade security futures).
    \326\ For example, both leveraged/inverse investment vehicles
and options provide exposure that is economically equivalent to a
dynamically rebalanced inverse or leveraged position in an
underlying asset. As a result, both have return characteristics that
are more complex than those of the underlying asset, particularly as
a leveraged/inverse investment vehicle's leverage multiple and/or
holding period increase. See infra section III.B.5.
    \327\ See FINRA Regulatory Notice 12-03 (providing, among other
things, that FINRA members ``should consider prohibiting their sales
force from recommending the purchase of some complex products to
retail investors whose accounts have not been approved for options
trading'').
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a. Definition of Leveraged/Inverse Investment Vehicle
    The proposed sales practices rules would define a ``leveraged/
inverse investment vehicle'' to mean a registered investment company or
an exchange-listed commodity- or currency-based trust or fund (a
``listed commodity pool''), that seeks, directly or indirectly, to
provide investment returns that correspond to the performance of a
market index by a specified multiple, or to provide investment returns
that have an inverse relationship to the performance of a market index,
over a predetermined period of time.\328\ Although the scope of this
definition extends beyond just ETFs (as defined in rule 6c-11), this
definition otherwise is substantively identical to the provision in
rule 6c-11 excluding leveraged/inverse ETFs from the scope of that
rule. The substantive requirements in the proposed definition in the
sales practices rules have the same meaning as the provision in rule
6c-11.\329\
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    \328\ See proposed rule 15l-2(d) and proposed rule 211(h)-1(d).
    \329\ See rule 6c-11(c)(4) (providing that scope of rule 6c-11
does not include ETFs that ``seek, directly or indirectly, to
provide investment returns that correspond to the performance of a
market index by a specified multiple, or to provide investment
returns that have an inverse relationship to the performance of a
market index, over a predetermined period of time.''). See also ETFs
Adopting Release, supra note 76, at section II.A.3 (discussing rule
6c-11(c)(4)).
---------------------------------------------------------------------------

    We believe it is appropriate for the scope of the proposed sales
practices rules to include leveraged/inverse funds as well as listed
commodity pools that follow a similar leveraged or inverse

strategy. The same investor protection concerns regarding aligning
firms' transaction practices with investors' capability of evaluating
the risks of these trading tools apply to this broader category of
leveraged/inverse investment vehicles, and not just leveraged/inverse
funds specifically.\330\ Indeed, we understand that leveraged/inverse
funds and listed commodity pools following the same strategy can have
virtually identical investment portfolios. Applying the proposed rule
to all leveraged/inverse investment vehicles, as defined in the
proposed rules, would avoid potential regulatory arbitrage that could
result if we were to place different requirements on these products.
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    \330\ The definition of commodity- or currency-based trusts or
funds that we propose to include in the leveraged/inverse investment
vehicle definition tracks a definition recently provided by Congress
in the Fair Access to Investment Research Act of 2017, Public Law
115-66, 131 Stat. 1196 (2017) (the ``FAIR Act''), which we
understand includes the kinds of commodity pools that generally
pursue leveraged or inverse investment strategies. Our proposed
definition differs from the FAIR Act definition because it would not
include a trust or fund that holds only commodities or currencies
and does not hold derivatives. Because we believe that trusts or
funds that seek to provide a leveraged or inverse return of an index
generally would use derivatives to do so, we do not believe it is
necessary to include trusts or funds that do not hold derivatives in
the proposed definition in the sales practices rules.
---------------------------------------------------------------------------

    We request comment on the definition of the term ``leveraged/
inverse investment vehicle'' in the proposed sales practices rules.
    171. Is the scope of the proposed definition of the term
``leveraged/inverse investment vehicle'' appropriate? The definition
includes a fund that seeks to provide investment returns that have an
inverse relationship to the performance of a market index. Do
commenters agree that this is appropriate? Should the definition
instead only include an inverse fund that seeks investment returns that
exceed the inverse performance of a market index by a specified
multiple (e.g., -1.5 or lower)? Why or why not? The definition also
includes a fund that seeks to provide performance results ``over a
predetermined period of time.'' Do commenters agree that this is
appropriate? Generally, the extent to which a fund's performance can be
expected to deviate from the multiple or inverse multiple of the
performance of its index when held over longer periods is larger for
funds that track a multiple or inverse multiple of the performance of
an index over shorter time intervals, as those funds typically
rebalance their portfolios more frequently. Should we specify a time
period in the definition and, if so, what time period would be
appropriate? For example, should the definition only include a fund
that seeks investment returns that correspond to a multiple or inverse
multiple of an index over a fixed period of time that is less than a
year, a quarter, or a month? Please explain.
    172. Do commenters agree with our proposal to include listed
commodity pools within the definition? Are we correct that the
similarities between the investment strategies and return profiles of
listed commodity pools and other leveraged/inverse investment vehicles,
such as leveraged/inverse ETFs, warrant including listed commodity
pools within the scope of this definition?
    173. Are there other types of investments or products that we
should include in the leveraged/inverse investment vehicle definition?
For example, should we include exchange-traded notes within the scope
of the proposed sales practices rules if they have the same or similar
return profile as the leveraged/inverse funds and listed commodity
pools included in the proposed definition? \331\ Are there additional
complex financial products, such as those discussed in FINRA Regulatory
Notice 12-03 (including, among others, certain structured or asset-
backed notes, unlisted REITs, securitized products, and products that
offer exposure to stock market volatility), that commenters believe
should be subject to the due diligence and account approval
requirements that we are proposing for leveraged/inverse investment
vehicles? \332\
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    \331\ The Commission also recently brought and settled an
enforcement action against a dually-registered broker-dealer/
investment adviser, certain of its supervisory personnel, and one of
its registered representatives arising out of that representative's
recommending that his customers buy and hold leveraged and inverse
exchange-traded funds and exchange traded notes (including
allegations that the registered representative recommended that his
customers hold a triple-leveraged exchange-traded note for longer
than the one-day holding period set forth in the product's
prospectus). See In the Matter of Cadaret Grant, et al., Exchange
Act Release No. 84074 (Sept. 11, 2018) (alleging, among other
things, a violation of section 206(4) of the Advisers Act and rule
206(4)-7 thereunder and failure to supervise) (settled action). See
In the Matter of Cadaret Grant, et al., Exchange Act Release No.
84074 (Sept. 11, 2018) (settled action).
    \332\ See FINRA Regulatory Notice 12-03, supra note 326.
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b. Required Approval and Due Diligence in Opening Accounts
    Under the proposed sales practices rules, no firm may accept an
order from or place an order for a retail investor to buy or sell
shares of a leveraged/inverse investment vehicle, or approve such a
retail investor's account to engage in those transactions, unless the
firm has complied with certain conditions. Specifically, the proposed
rules would require the firm to (1) approve the retail investor's
account for buying and selling shares of leveraged/inverse investment
vehicles pursuant to a due diligence requirement; and (2) adopt and
implement policies and procedures reasonably designed to achieve
compliance with the proposed rules.
    The proposed due diligence requirement provides that a firm must
exercise due diligence to ascertain the essential facts relative to the
retail investor, his or her financial situation, and investment
objectives. A firm must seek to obtain, at a minimum, certain
information about its retail investor's:
     Investment objectives (e.g., safety of principal, income,
growth, trading profits, speculation) and time horizon;
     employment status (name of employer, self-employed or
retired);
     estimated annual income from all sources;
     estimated net worth (exclusive of family residence);
     estimated liquid net worth (cash, liquid securities,
other);
     percentage of the retail investor's liquid net worth that
he or she intends to invest in leveraged/inverse investment vehicles;
and
     investment experience and knowledge (e.g., number of
years, size, frequency and type of transactions) regarding leveraged/
inverse investment vehicles, options, stocks and bonds, commodities,
and other financial instruments.\333\
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    \333\ See proposed rule 15l-2(b)(2). For joint accounts, the
firm must seek to obtain the information for all participants in
joint retail investor accounts.

Based on its evaluation of this information, the firm would be required
specifically to approve or disapprove the retail investor's account for
buying or selling shares of leveraged/inverse investment vehicles. If
the firm approves the account, the approval must be in writing.
    Under the proposed rules, to provide this approval a firm must have
a reasonable basis for believing that the retail investor has the
financial knowledge and experience to be reasonably expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles. We are not proposing a bright-line test for this
determination. Rather, the determination would be based on all of the
relevant facts and circumstances.
    The information that a firm would collect includes information
about the retail investor's financial status (e.g.,

employment status, income, and net worth (including liquid net worth));
and information about his or her investment objectives generally and
his or her anticipated investments in, and experience with, leveraged/
inverse investment vehicles (e.g., general investment objectives,
percentage of liquid net worth intended for investment in leveraged/
inverse investment vehicles, and investment experience and knowledge).
This information is designed to provide a comprehensive picture of the
retail investor to allow a firm to evaluate whether the retail investor
has the financial knowledge and experience to be reasonably expected to
be capable of evaluating the risks of buying and selling leveraged/
inverse investment vehicles.
    While not required under the proposed rules, firms could consider
establishing multiple levels of account approvals for a retail investor
seeking to trade leveraged/inverse investment vehicles. We understand
that broker-dealers set different levels of options account approval
depending on the customer's trading experience and financial
sophistication.\334\ Similarly, a firm may determine that certain
leveraged/inverse investment vehicles (e.g., those with lower leverage
multiples or that invest in less-volatile asset classes) are more
appropriate for a lower level of account approval, while other types of
leveraged/inverse investment vehicles may be more appropriate for a
higher level of account approval. Any such approaches generally should
be addressed in the policies and procedures that the proposed sales
practices rules would require a firm to adopt and implement.\335\
---------------------------------------------------------------------------

    \334\ These increasing levels generally track the riskiness of
the product or trading strategy; for example, the initial option
account approval may permit covered call writing of equity options
but higher account approvals would be needed for writing uncovered
index options.
    \335\ See proposed rules 15l-2(a) and 211(h)-1(a).
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    The proposed rules' scope with respect to a firm's customer or
client is limited to ``a natural person'' or ``the legal representative
of a natural person.'' \336\ The rules include all natural persons--
including high-net worth individuals--to provide the related investor
protections to all natural persons. The proposed rules require firms to
seek to obtain and to consider information related to a retail
investor's net worth as part of their consideration of whether to
approve the investor's account for trading in leveraged/inverse
investment vehicles. We interpret ``legal representative'' of a natural
person to mean non-professional legal representatives of a natural
person.\337\ This interpretation would exclude institutions and certain
professional fiduciaries, but it would include certain legal entities
such as trusts that represent the assets of a natural person.\338\ This
interpretation is designed to provide the protections of the sales
practices rules where non-professional persons are acting on behalf of
natural persons, but where such professional persons are not regulated
financial services industry professionals retained by natural persons
to exercise independent professional judgment.\339\
---------------------------------------------------------------------------

    \336\ See proposed rules 15l-2(a) and 211(h)-1(a).
    \337\ See, e.g., Form CRS Relationship Summary, Exchange Act
Release No. 34-86032 (June 5, 2019) [84 FR 33492 (July 12, 2019)]
(``Form CRS Release''), at n.629 and accompanying text.
    \338\ See Form CRS Release, supra note 336, at nn.645-647 and
accompanying text (clarifying interpretation of ``legal
representative'' of a natural person to cover only non-professional
legal representatives (e.g., a non-professional trustee that
represents the assets of a natural person and similar
representatives such as executors, conservators, and persons holding
a power of attorney for a natural person)); Regulation Best
Interest: The Broker-Dealer Standard of Conduct, supra note 314, at
n.237 and accompanying text (defining ``retail customer'').
    \339\ See Form CRS Release, supra note 336, at nn.645-647 and
accompanying text.
---------------------------------------------------------------------------

    In addition, we are proposing to specify in the sales practices
rules that, although the rules would apply to transactions by broker-
dealers and investment advisers for retail investors--including those
investors who have existing accounts before the rules' compliance
date--the sales practices rules would not apply to a position in a
leveraged/inverse investment vehicle established before the rules'
compliance date. This provision is designed to allow existing investors
in leveraged/inverse investment vehicles with open investments as of
the rules' compliance date to sell their holdings (or to purchase
leveraged/inverse investment vehicles to close out short positions in
the leveraged/inverse investment vehicle) without the additional steps
we propose to require for their broker-dealer or investment adviser to
determine whether to approve the retail investor's account to trade in
these products.\340\ Absent this provision, the sales practices rules
could prevent or delay a retail investor's ability to close or reduce a
position in a leveraged/inverse investment vehicle that he or she
entered into before firms were required to comply with the rules.
---------------------------------------------------------------------------

    \340\ This provision is designed to allow a retail investor to
exit a legacy position in a leveraged/inverse investment vehicle, as
discussed above, and does not reflect any view on whether any
recommendation for these legacy positions was suitable when made.
---------------------------------------------------------------------------

    We also do not believe it would be appropriate to apply the sales
practices rules only to retail accounts established after the rules'
compliance date, because the investor protection concerns underlying
the rules would apply equally to pre-existing retail investor accounts.
Accordingly, the proposed rules would make clear that, even if a retail
investor had already been trading leveraged/inverse investment
vehicles, a firm would have to satisfy the due diligence and account
approval requirements for that investor's account before the investor
could make additional investments in leveraged/inverse investment
vehicles.\341\
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    \341\ As discussed above, this evaluation would take into
account, among other things, the investor's experience with
leveraged/inverse investment vehicles. See, e.g., proposed rules
211(h)-1(b)(2) and 15l-2(b)(2).
---------------------------------------------------------------------------

    The proposed sales practices rules also would require firms to
adopt and implement written policies and procedures addressing
compliance with the applicable sales practices rule.\342\ We are not
proposing to impose specific requirements for these policies and
procedures, provided that they are reasonably designed to achieve
compliance with the applicable sales practices rule, including the due
diligence and account approval requirements. This requirement, together
with the proposed recordkeeping requirements discussed below, is
designed to provide comparable policies and procedures and
recordkeeping requirements for both broker-dealers and investment
advisers.
---------------------------------------------------------------------------

    \342\ See proposed rule 15l-2(a); proposed rule 211(h)-1(a).
---------------------------------------------------------------------------

    We request comment on the proposed approval and due diligence
requirements for approving retail investors' accounts to trade in
shares of leveraged/inverse investment vehicles.
    174. Is modeling these rules on FINRA's options rule the
appropriate approach? Why or why not?
    175. Should the proposed sales practices rules apply to Commission-
registered broker-dealers and investment advisers? Why or why not? What
challenges, if any, would broker-dealers or investment advisers face
complying with the proposed rules, and what compliance burdens would
the proposed rules create for broker-dealers and investment advisers?
Would compliance burdens be substantially different for investment
advisers than for broker-dealers (for example, because of any
compliance efficiencies that might result to the extent broker-dealers
are already complying with FINRA's

rules for approving options accounts), or vice versa? Should we apply
proposed Advisers Act rule 211(h)-1 to investment advisers that are
registered with one or more states but not registered with the
Commission? Why or why not? Should the proposed rule for investment
advisers apply equally to advisers with discretionary authority and
with non-discretionary authority over client accounts? If the sales
practices rule for investment advisers applies to both discretionary
and non-discretionary advisory accounts, should we apply different due
diligence and account approval requirements based on whether an account
is discretionary or non-discretionary? Should the proposed sales
practices rules apply to investment advisers, in light of their
fiduciary duties to their clients? Why or why not? Should the sales
practices rules apply to a broker-dealer if the broker-dealer does not
effect transactions in leveraged investment vehicles for retail
investors other than transactions resulting from recommendations that
are subject to Regulation Best Interest? Why or why not?
    176. Should the proposed rules apply to transactions in leveraged/
inverse investment vehicles that are directed by a retail investor
without any recommendation or advice from a broker-dealer or investment
adviser? Why or why not?
    177. Should the proposed rules apply on a transaction-by-
transaction basis rather than requiring an initial account approval to
transact in leveraged/inverse investment vehicles? Why or why not?
    178. As proposed, the sales practices rules would require that a
firm could provide account approval only if the firm has a reasonable
basis for believing that the investor has such knowledge and experience
in financial matters that he or she may reasonably be expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles. Is this account approval standard appropriate? Why
or why not? If not, what should the account approval standard be?
Should it be tied instead, for example, to an investor's ability to
absorb losses, and if so how should a firm assess this?
    179. Is the investor information that the proposed rules would
require firms to seek to obtain under the rules' due diligence
requirements appropriate, and would this information effectively assist
in forming a reasonable basis for assessing the investor's knowledge
and experience in financial matters as required under the proposed
account approval standard? Why or why not? What modifications, if any,
should we make to the information items that the proposed rules would
require a firm to seek to obtain? Are there any information items that
we should remove from the proposed list, or any additional information
items that we should include? For example, instead of tracking
generally the information elements set forth under FINRA's option rule,
should the proposed rules track generally the information set forth in
the definition of ``retail customer investment profile'' under
Regulation Best Interest (i.e., ``age, other investments, financial
situation and needs, tax status, investment objectives, investment
experience, investment time horizon, liquidity needs, risk tolerance,
and any other information the retail customer may disclose to the
broker, dealer, or a natural person who is an associated person of a
broker or dealer'')? As proposed, should the rules require firms to
seek to obtain the percentage of the investments that the retail
investor intends to invest in leveraged/inverse investment vehicles?
Why or why not?
    180. Should the sales practices rules require firms to obtain the
specified information, rather than to seek to obtain it? Would a firm
be able to form a reasonable basis for believing that a retail investor
has such knowledge and experience in financial matters that he or she
may reasonably be expected to be capable of evaluating the risks of
buying and selling leveraged/inverse investment vehicles if the retail
investor provides some, but not all, of the information specified in
the sales practices rules?
    181. What special procedures, if any, do firms currently undertake
in permitting or not permitting retail investors to trade in leveraged/
inverse investment vehicles? At account opening? With respect to
specific transactions? With respect to concentration limits? Do firms
already have approval processes in place designed to evaluate whether
their retail investors are reasonably expected to be capable of
evaluating the risks of buying and selling leveraged/inverse investment
vehicles? If so, do firms distinguish between types of vehicles or
trading strategies? Do these practices differ between broker-dealers
and investment advisers? If so, please explain the differences.
    182. What special procedures, if any, do firms currently undertake
in permitting or not permitting retail investors to trade in other
types of complex products? Please explain in detail, including products
to which such procedures apply and what the approval process entails.
    183. The proposed sales practices rules would require that firms'
approvals of retail investors' accounts for buying or selling shares of
leveraged/inverse investment vehicles be in writing. The proposed rules
would not require account disapprovals to be in writing. Should we
require account disapprovals also to be in writing? Would such a
requirement raise any practical concerns, or other concerns, for firms?
In other investor approval contexts, do firms currently put both their
approvals and disapprovals in writing?
    184. How do broker-dealers apply the options eligibility
requirement with respect to clients of investment advisers, if at all,
when those advisers submit orders on behalf of their clients? Do
broker-dealer practices differ with respect to orders submitted by
other types of intermediaries? Please explain.
    185. How do broker-dealers currently analyze the information they
collect under FINRA rule 2360? Which data elements do broker-dealers
find most important and which elements are less important? What
standards do broker-dealers apply in determining whether to approve a
customer's account on the basis of the information collected?
    186. Should the proposed rules require firms to provide specific
disclosure as part of the approval process, similar to the options
disclosure document that must be provided under FINRA rule 2360? If so,
what information should it contain? Should the rules require that
receipt of such disclosure be acknowledged?
    187. Should the rules require firms to provide retail investors a
short, plain-English disclosure generally describing the risks
associated with leveraged/inverse investment vehicles as part of the
proposed account approval process? For example, before a firm approves
a retail investor's account for buying and selling shares of a
leveraged/inverse investment vehicle, should the rules require a firm
to incorporate and distill into a short disclosure the specific risk
factors associated with leveraged/inverse investment vehicles (such as
the risks related to compounding and other risks that leveraged/inverse
funds disclose in their prospectuses)?
    188. Should the rules apply to all customers or clients, and not
just natural persons? Should they apply to a different subset of
customers or clients and, if so, which ones and why? If the rule were
to apply to all customers or clients, including institutional accounts,
what changes should we make to the information that firms must collect
or to the basis upon which a firm would approve or disapprove the
account? Are

there distinctions between institutional investors and natural persons
that invest in leveraged/inverse investment vehicles that we should
consider? For example, do commenters have data or information on the
percentage of leveraged investment vehicles' investors who are natural
persons, and how natural persons use these investment products (e.g.,
how long do these investors hold the products)?
    189. As discussed above, we understand that certain purchases or
sales of leveraged/inverse investment vehicles do not involve a
customer or client of a broker-dealer or investment adviser that would
be subject to the proposed sales practices rules.\343\ Should the
proposed rules apply to these transactions? For example, should the
proposed sales practices rule for broker-dealers apply to a mutual fund
principal underwriter's transactions with any retail investor who is
purchasing fund shares directly from the fund?
---------------------------------------------------------------------------

    \343\ See supra note 321.
---------------------------------------------------------------------------

    190. Should the sales practices rules include different account-
approval conditions for different types of leveraged/inverse investment
vehicles? For example, should the rules include different conditions
for investment vehicles that seek to exceed the performance of a market
index by a specified multiple, versus those that provide returns that
have an inverse relationship to the performance of a market index?
Should the rules include different levels of account approval, such as
heightened requirements for investors to transact in leveraged/inverse
investment vehicles with higher leverage multiples or that invest in
more volatile asset classes? Similarly, should the rules include
different levels of account-approval conditions based on a retail
investor's trading experience and financial sophistication?
    191. Do commenters agree that we should apply the sales practices
rules to all retail investors, including those who have opened accounts
with an investment adviser or broker-dealer before the rules'
compliance date? Should the sales practices rules include exceptions
from the due diligence and account approval requirements for retail
investors that have already traded in leveraged/inverse investment
vehicles as of the rules' compliance date? Should the sales practices
rules provide exceptions for retail investors who meet established
criteria, such as retail investors who are accredited investors? Why or
why not?
    192. The proposed rules also would not apply to, and therefore
would not restrict a retail investor's ability to close or reduce, a
position in a leveraged/inverse investment vehicle established before
the rules' compliance date. Do commenters agree that this is
appropriate? Are there modifications we should make to the rules so
that they would not impede an investor's ability to close or reduce an
existing position in a leveraged/inverse investment vehicle? Which
modifications and why? Alternatively, should the sales practices rules
apply to retail investors with positions in leveraged/inverse
investment vehicles established before the rules' compliance date even
if they do not seek to make additional purchases or sales of leveraged
investment vehicles? If so, how would firms comply, in practice, with
the due diligence and account approval requirements for these
investors?
    193. Do commenters agree with the proposed policies and procedures
requirement? Should the rule provide specific requirements for firms'
policies and procedures relating to compliance with the sales practices
rules?
c. Recordkeeping
    Under the proposed sales practices rules, a firm would have to
maintain a written record of the investor information that it obtained
under the rules' due diligence requirements, the firm's written
approval of the retail investor's account for buying and selling shares
of leveraged/inverse investment vehicles, and the versions of the
firm's policies and procedures that it adopted under the proposed rules
that were in place when it approved or disapproved the account. We
propose that firms be required to retain these records for a period of
not less than six years (the first two years in an easily accessible
place) after the date of the closing of the investor's account.\344\ We
believe that it is appropriate for the proposed rules to include a
recordkeeping provision to facilitate compliance, and regulatory
oversight of a firm's compliance, with the rules. Also, because an
investor account that was approved to trade in leveraged/inverse
investment vehicles could remain open with a firm for more than six
years, we believe it is appropriate to require that records be
preserved for a minimum of six years after the closing of the account,
rather than six years after the creation of the records.\345\ We
believe that this recordkeeping requirement would provide sufficient
investor protection and, because it is generally consistent with
recordkeeping requirements for broker-dealers and investment advisers,
would not impose overly burdensome recordkeeping costs.\346\
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    \344\ See proposed rules 15l-2(c) and 211(h)-1(c).
    \345\ This is consistent with other Commission recordkeeping
requirements relating to investor account documentation. See, e.g.,
rule 17a-4(c) under the Exchange Act (requiring broker-dealers to
preserve for a period of not less than six years after the closing
of any customer's account any account cards or records relating to
the terms and conditions with respect to the opening and maintenance
of the account).
    \346\ See, e.g., id.; see also rule 204-2(e)(1) under the
Investment Advisers Act (requiring investment advisers to preserve
certain records in an easily accessible place for a period of not
less than five years from the end of the fiscal year during which
the last entry was made on such record, the first two years in an
appropriate office of the investment adviser). While we recognize
that our existing recordkeeping requirements generally require
broker-dealers to preserve records for six years and investment
advisers for five years, we believe it would be appropriate for the
recordkeeping requirements under the proposed sales practices rule
to be consistent, in part because many broker-dealers and investment
advisers are dual-registered, and thus are proposing a six-year
period for both rules.
---------------------------------------------------------------------------

    We request comment on the recordkeeping requirement in the proposed
sales practices rules:
    194. Is the proposed recordkeeping requirement appropriate? Why or
why not?
    195. What changes, if any, should we make to this proposed
requirement (e.g., by modifying the types of records that a firm would
have to keep)?
    196. Does our proposal to apply the same recordkeeping requirement
to both broker-dealers and investment advisers raise any specific
recordkeeping concerns for either broker-dealers or investment advisers
(e.g., do investment advisers believe it would be particularly
burdensome to comply with a six-year recordkeeping period)? Should the
proposed rules include different requirements for broker-dealers and
investment advisers?
    197. Is the proposed duration of the recordkeeping provision,
including the proposed requirement that the records be maintained for a
minimum of six years after the closing of the investor's account,
appropriate? Does using the closing of the investor's account as the
starting point for the recordkeeping period raise any practical
difficulties for firms? Should we lengthen or shorten the required
recordkeeping periods? Why or why not?
3. Alternative Provision for Leveraged/Inverse Funds Under Proposed
Rule 18f-4
    Under proposed rule 18f-4, a fund would not have to comply with the
proposed VaR-based leverage risk limit if it: (1) Meets the definition
of a ``leveraged/inverse investment vehicle'' in the proposed sales
practices rules; (2) limits the investment results it seeks to

300% of the return (or inverse of the return) of the underlying index;
and (3) discloses in its prospectus that it is not subject to proposed
rule 18f-4's limit on fund leverage risk. We refer to this set of
proposed conditions collectively as the ``alternative provision for
leveraged/inverse funds.'' A leveraged/inverse fund that satisfies
these conditions still would be required to satisfy all of the
additional conditions in proposed rule 18f-4 other than the VaR tests,
including the proposed conditions requiring a derivatives risk
management program, board oversight and reporting, and
recordkeeping.\347\
---------------------------------------------------------------------------

    \347\ See proposed rule 18f-4(c)(1), (5)-(6).
---------------------------------------------------------------------------

    First, the alternative provision for leveraged/inverse funds
requires that a leveraged/inverse fund be a ``leveraged/inverse
investment vehicle'' as defined in the proposed sales practices
rules.\348\ As discussed above, the proposed sales practices rules are
designed to help ensure that investors in leveraged/inverse investment
vehicles are limited to those who are capable of evaluating their
general characteristics and the unique risks they present.
---------------------------------------------------------------------------

    \348\ See proposed rule 18f-4(c)(4)(i); proposed rules 15l-2(d)
and 211(h)-1(d) (defining the term ``leveraged/inverse investment
vehicle'').
---------------------------------------------------------------------------

    Second, the alternative provision for leveraged/inverse funds would
limit a leveraged/inverse fund's market exposure by providing that the
fund must not seek or obtain, directly or indirectly, investment
results exceeding 300% of the return (or inverse of the return) of the
underlying index.\349\ This limitation reflects the highest leverage
level currently permitted by our exemptive orders for leveraged/inverse
ETFs.\350\ It therefore reflects the maximum amount of leverage in
these funds with which investors and other market participants are
familiar. To permit leveraged/inverse funds to use a higher level of
leverage would heighten the investor protection concerns these funds
present, notwithstanding their more limited investor base.\351\
Moreover, allowing leveraged/inverse funds to increase their leverage
beyond current levels would result in a non-linear increase in the
extent of leveraged/inverse funds' rebalancing activity, which may have
adverse effects on the markets for the constituent securities as
discussed in more detail in sections III.D.1 and III.E.4. For these
reasons, and because the Commission does not have experience with
leveraged/inverse funds that seek returns above 300% of the return (or
inverse of the return) of the underlying index, we are not proposing to
permit higher levels of leveraged market exposure for leveraged/inverse
funds in this rule.
---------------------------------------------------------------------------

    \349\ See proposed rule 18f-4(c)(4)(iii).
    \350\ See ETFs Adopting Release, supra note 76, at n.75 and
accompanying text.
    \351\ See also section III.C.5.
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    Third, the alternative provision for leveraged/inverse funds would
require a leveraged/inverse fund to disclose in its prospectus that it
is not subject to the condition of proposed rule 18f-4 limiting fund
leverage risk.\352\ This requirement is designed to provide investors
and the market with information to clarify that leveraged/inverse
funds--which as discussed above, use derivatives extensively--are not
subject to rule 18f-4's limit on fund leverage risk.
---------------------------------------------------------------------------

    \352\ See proposed rule 18f-4(c)(4)(ii).
---------------------------------------------------------------------------

    We request comment on the proposed alternative provision for
leveraged/inverse funds.
    198. Should the rule include an alternative set of requirements for
leveraged/inverse funds? Should leveraged/inverse funds instead be
required to meet the proposed requirements for all funds that use
derivatives, including the VaR-based limit on fund leverage risk? If
commenters agree that we should permit leveraged/inverse ETFs to rely
on rule 18f-4 based on an alternative set of requirements, are there
additional conditions--either relating to these funds' derivatives risk
management or otherwise--that we should consider requiring those funds
to satisfy? To what extent would additional limitations or restrictions
on leveraged investment vehicles' advertising or marketing materials
help to address the investor protection concerns discussed above?
    199. Does our proposal to include within the scope of the rule only
leveraged/inverse funds that are covered by the proposed sales
practices rules, along with the conditions comprising the alternative
provision for leveraged/inverse funds, address the investor protection
concerns related to leveraged/inverse funds?
    200. If leveraged/inverse funds operate pursuant to the proposed
alternative provision, should they nonetheless be subject to other
requirements in the proposed rule (e.g., the proposed risk management
program requirement, board oversight and reporting requirement, and
recordkeeping requirement)?
    201. Should leveraged/inverse funds relying on the alternative
provision be required to disclose in their prospectuses that the fund
is not subject to the proposed VaR-based limit on fund leverage risk,
as proposed? If so, what would be the most appropriate method of
disclosure? In addition to requiring this disclosure under rule 18f-4,
should we also include this requirement in Form N-1A? Would it aid
practitioners for a leveraged/inverse fund's registration form to
specify this requirement?
    202. Should a leveraged/inverse fund relying on rule 18f-4 be
required to limit the investment results it seeks or obtains to 300% of
the return (or inverse of the return) of the underlying index? Would
some other threshold be more appropriate? Should the threshold be
higher, such as 400%, or lower, such as 150% or 200%?
    203. Any registered investment company that operates as a
leveraged/inverse fund would be eligible to comply with the proposed
alternative provision for leveraged/inverse funds in rule 18f-4. Should
we limit the scope of leveraged/inverse funds eligible for this
provision to open-end funds, including ETFs?
4. Proposed Amendments to Rule 6c-11 Under the Investment Company Act
and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs
    Earlier this year, the Commission adopted rule 6c-11, which permits
ETFs that satisfy certain conditions to operate without obtaining an
exemptive order from the Commission.\353\ Rule 6c-11 includes a
provision excluding leveraged/inverse ETFs from the scope of ETFs that
may rely on that rule.\354\ Leveraged/inverse ETFs, therefore, continue
to rely on their Commission exemptive orders. In adopting rule 6c-11,
the Commission stated that the particular section 18 concerns raised by
leveraged/inverse ETFs' use of derivatives distinguish those funds from
the other ETFs permitted to rely on that rule, and that those section
18 concerns would be more appropriately addressed in a rulemaking
addressing the use of derivatives by funds more broadly.\355\ The
Commission further stated that leveraged/inverse ETFs are similar in
structure and operation to the other types of ETFs that are within the
scope of rule 6c-11.\356\ The rules we are proposing, rule 18f-4 under
the

Investment Company Act and the sales practices rules under the Exchange
Act and the Advisers Act, would create an updated and more
comprehensive regulatory framework for the use of derivatives by funds,
including provisions specifically applicable to leveraged/inverse ETFs.
Accordingly, we propose to amend rule 6c-11 to remove the provision
excluding leveraged/inverse ETFs from the scope of that rule one year
following the publication of the final amendments in the Federal
Register.
---------------------------------------------------------------------------

    \353\ See ETFs Adopting Release, supra note 76.
    \354\ See rule 6c-11(c)(4).
    \355\ See ETFs Adopting Release, supra note 76, at nn.72-75 and
accompanying text.
    \356\ See id. at text following n.86. In addition, one sponsor
of leveraged/inverse ETFs has stated that its ETFs would prefer to
rely on rule 6c-11 over their exemptive orders and that leveraged/
inverse ETFs would be able to comply with rule 6c-11 because they
are structured and operated in the same manner as other ETFs that
fall within the scope of that rule. See id. at n.83 and accompanying
text.
---------------------------------------------------------------------------

    In addition, because the proposed amendments to rule 6c-11 would
permit leveraged/inverse ETFs to rely on that rule rather than their
exemptive orders, we are proposing to rescind the exemptive orders we
have previously issued to leveraged/inverse ETFs. The exemptive relief
granted to leveraged/inverse ETFs has resulted in an uneven playing
field among market participants because the Commission has permitted
only three ETF sponsors to operate leveraged/inverse ETFs and has not
granted any exemptive relief for leveraged/inverse ETFs since
2009.\357\ We believe that amending rule 6c-11 and rescinding these
exemptive orders would promote a more level playing field and greater
competition by allowing any sponsor to form and launch a leveraged/
inverse ETF subject to the conditions in rules 6c-11 and proposed rule
18f-4, with transactions in the funds subject to the proposed sales
practices rules. We propose to rescind these exemptive orders on the
effective date of the proposed amendments to rule 6c-11 (one year
following the publication of the final rule amendments in the Federal
Register), to coincide with the compliance date for the sales practices
rules and to allow time for broker-dealers and investment advisers to
make any adjustments necessary to comply with the proposed sales
practices rules. Providing a one-year period for existing leveraged/
inverse ETFs also would provide time for them to prepare to comply with
rule 6c-11 rather than their exemptive orders.\358\
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    \357\ There are currently two ETF sponsors that rely upon this
exemptive relief today. See supra note 307 and accompanying text;
infra note 473 and accompanying text. We also discuss below in
section III.E alternative approaches for leveraged/inverse funds,
including an approach under which the Commission would rescind the
exemptive orders issued to leveraged/inverse ETF sponsors, permit
leveraged/inverse funds to operate under rule 6c-11, but require
leveraged/inverse funds to comply with rule 18f-4's VaR-based limit
on fund leverage risk in lieu of adopting the proposed sales
practices rules.
    \358\ See ETFs Adopting Release, supra note 76, at text
following n.451.
---------------------------------------------------------------------------

    We request comment on the proposed amendments to rule 6c-11 and
rescission of leveraged/inverse ETF exemptive orders.
    204. If leveraged/inverse funds are permitted to rely on rule 18f-
4, should the Commission amend rule 6c-11 to permit leveraged/inverse
funds to operate under that rule, as proposed? Do the requirements of
proposed rule 18f-4, together with the proposed sales practices rules,
adequately address the section 18 concerns relating to leveraged/
inverse funds? Are there are other concerns regarding leveraged/inverse
funds that we should consider in determining whether to allow such
funds to rely on rule 6c-11?
    205. In addition, do commenters agree with our proposal to rescind
the existing leveraged/inverse ETF exemptive relief in view of our
proposed treatment of leveraged/inverse funds under rule 18f-4 and
proposed amendments to rule 6c-11? Are there other approaches to the
existing leveraged/inverse ETF exemptive relief that we should consider
in view of proposed rule 18f-4 and the proposed sales practices rules?

H. Amendments to Fund Reporting Requirements

    We are proposing amendments to the reporting requirements for funds
that would rely on proposed rule 18f-4--in particular, amendments to
Forms N-PORT, N-LIQUID (which we propose to re-title as ``Form N-RN''),
and N-CEN.\359\ These proposed amendments are designed to enhance the
Commission's ability to oversee funds' use of and compliance with the
proposed rules effectively, and for the Commission and the public to
have greater insight into the impact that funds' use of derivatives
would have on their portfolios.\360\ They would allow the Commission
and others to identify and monitor industry trends, as well as risks
associated with funds' investments in derivatives (including by
requiring current, non-public reporting to the Commission when certain
significant events related to a fund's leverage risk occur). The
proposed amendments also would aid the Commission in evaluating the
activities of investment companies in order to better carry out its
regulatory functions.
---------------------------------------------------------------------------

    \359\ 17 CFR 274.150; 17 CFR 274.223; and 17 CFR 249.330 and 17
CFR 274.101.
    \360\ The funds that would rely on proposed rule 18f-4 other
than BDCs generally are subject to reporting requirements on Form N-
PORT. All registered management investment companies, other than
registered money market funds and small business investment
companies, are (or will be) required to electronically file with the
Commission, on a quarterly basis, monthly portfolio investment
information on Form N-PORT, as of the end of each month. See
Investment Company Reporting Modernization Adopting Release, supra
note 178. As of April 30, 2019, larger fund groups (defined as
having $1 billion or more in net assets) have begun submitting
reports on Form N-PORT for the period ending March 31, 2019. Smaller
fund groups (less than $1 billion in net assets) will begin
submitting reports on Form N-PORT by April 30, 2020. See Investment
Company Reporting Modernization, Investment Company Act Release No.
32936 (Dec. 8, 2017) [82 FR 58731 (Dec. 14, 2017)]. Only information
reported for the third month of each fund's fiscal quarter on Form
N-PORT will be publicly available (60 days after the end of the
fiscal quarter). See Amendments to the Timing Requirements for
Filing Reports on Form N-PORT, Investment Company Act Release No.
33384 (Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)].
     Currently, only open-end funds that are not regulated as money
market funds under rule 2a-7 under the Investment Company Act are
required to file current reports on Form N-LIQUID, under section
30(b) of the Investment Company Act and rule 30b1-10 under the Act.
See Investment Company Liquidity Risk Management Programs,
Investment Company Act Release No. 32315 (Oct. 13, 2016) [81 FR
82142 (Nov. 18, 2016)], at section III.L.2 (``Liquidity Adopting
Release''). Our proposal, including proposed amendments to Form N-
LIQUID, rule 30b1-10 and proposed rule 18f-4(c)(7), would add new
VaR-related items to the form, and would extend the requirement to
file current reports with respect to these new items to any fund
(including registered open-end funds, registered closed-end funds,
and BDCs) that relies on rule 18f-4 and that is subject to the
rule's limit on leverage risk.
    The funds that would rely on proposed rule 18f-4 other than BDCs
generally are subject to reporting requirements on Form N-CEN.
Specifically, all registered investment companies, including money
market funds but excluding face amount certificate companies, are
currently required to file annual reports on Form N-CEN. See
Investment Company Reporting Modernization Adopting Release, supra
note 178. Form N-CEN requires these funds to report census-type
information including reports on whether a fund relied upon certain
enumerated rules under the Investment Company Act during the
reporting period. See, e.g., Item C.7 of Form N-CEN.
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1. Amendments to Form N-PORT
    We are proposing to amend Form N-PORT to add new items to Part B
(``Information About the Fund''), as well as to make certain amendments
to the form's General Instructions.
a. Derivatives Exposure
    We are proposing to amend Form N-PORT to include a new reporting
item on funds' derivatives exposure.\361\ A fund would be required to
provide its derivatives exposure as of the end of the reporting
period.\362\ This information

would be publicly available for the third month of each fund's quarter
and would provide market-wide insight into the levels of funds'
derivatives exposure to the Commission, its staff, and market
participants.\363\ It also would allow the Commission and its staff to
oversee and monitor compliance with the proposed rule's exception for
limited derivatives users.\364\
---------------------------------------------------------------------------

    \361\ See proposed Item B.9 of Form N-PORT; see also proposed
amendments to General Instruction E to Form N-PORT (adding a new
definition for ``derivatives exposure,'' as defined in proposed rule
18f-4(a),which would permit a fund to convert the notional amounts
of interest rate derivatives to 10-year bond equivalents and delta
adjust the notional amounts of options contracts).
    \362\ See proposed Item B.9 of Form N-PORT. Just as the proposed
definition of ``derivatives transaction'' in rule 18f-4 includes
derivatives instruments as well as short sale borrowings, Form N-
PORT would require a fund to report exposure associated with
derivatives instruments and short sales.
    The proposed requirement to report derivatives exposure at the
end of the reporting period reflects the form's requirement to
report information about funds' portfolio holdings as of the last
business day, or last calendar day, of each month. See General
Instruction A to Form N-PORT. While we are proposing that funds
report their highest daily VaR and median daily VaR during the
reporting period (see infra section II.H.1.b), we are not also
proposing that funds report their highest daily derivatives exposure
(or median daily derivatives exposure) during the reporting period.
This is because proposed rule 18f-4 requires daily calculation of a
fund's VaR but does not require a fund to calculate its derivatives
exposure daily.
    \363\ We are not proposing to amend General Instruction F to
Form N-PORT, which specifies the information that funds report on
Form N-PORT that the Commission does not make publicly available.
    While the information for the first two months of a fund's
quarter would be non-public, the information for the third month of
a fund's quarter would be publicly available. See supra note 359.
    \364\ Under this proposal, a fund would have to indicate whether
it is a limited derivatives user on Form N-CEN. See infra section
II.H.3.
---------------------------------------------------------------------------

    We seek comment on the Commission's proposed amendments to Form N-
PORT requiring reporting of derivatives exposure:
    206. Is the proposed requirement that funds report their
derivatives exposure on Form N-PORT appropriate? Why or why not? Should
we modify the proposed derivatives exposure reporting item in any way?
If so, how should we modify this reporting item?
    207. Our proposal would make public the information that a fund
would report in response to the new derivatives exposure Form N-PORT
item. Is there any reason why this information should not be publicly
available?
    208. Should we require this reporting only from certain funds--for
example, those that qualify either as limited derivatives users or
leveraged/inverse funds under proposed rule 18f-4--during the reporting
period?
    209. Should we require funds to report metrics tied to their daily
notional amount calculation on Form N-PORT (for example, a fund's
highest daily derivatives exposure during the reporting period and the
date of its highest exposure, and its median daily derivatives exposure
during the reporting period)? Should we only require funds to report
these types of metrics if we were also to modify proposed rule 18f-4 to
require funds to calculate their notional amounts daily? Would this
type of reporting requirement help to mitigate any potential ``window
dressing'' concerns about funds' reporting of their derivatives
exposure, and/or provide additional beneficial transparency with
respect to any particular type of funds (for example, leveraged/inverse
funds)? If so, would these benefits outweigh related costs?
b. VaR Information
    We are also proposing to amend Form N-PORT to include a new
reporting item related to the proposed VaR tests.\365\ Information that
a fund would report under this new reporting item would be made public
for the third month of each fund's quarter.\366\ The proposed item
would apply to funds that were subject to the proposed VaR-based limit
on fund leverage risk during the reporting period.
---------------------------------------------------------------------------

    \365\ See proposed Item B.10 of Form N-PORT. Proposed item B.10
would require that a fund provide the applicable VaR information in
accordance with proposed rule 18f-4(c)(2)(ii), which requires a fund
to determine compliance with its applicable VaR test at least once
each business day.
    \366\ See supra note 362. While the information for the first
two months of a fund's quarter would be non-public, the information
for the third month of a fund's quarter would be publicly available.
See supra note 359.
---------------------------------------------------------------------------

    Funds that are subject to the new VaR-related N-PORT item would
have to report their highest daily VaR during the reporting period and
its corresponding date, as well as their median daily VaR for the
monthly reporting period.\367\ Funds subject to the relative VaR test
during the reporting period would report the name of the fund's
designated reference index, and index identifier.\368\ These funds also
would have to report the fund's highest daily VaR ratio (that is, the
value of the fund's portfolio VaR divided by the VaR of the designated
reference index) during the reporting period and its corresponding
date, as well as the fund's median daily VaR ratio for the reporting
period.\369\
---------------------------------------------------------------------------

    \367\ See proposed Items B.10.a.-c of Form N-PORT. The proposed
form amendments would require each of the reported metrics to be
determined in accordance with the requirement under proposed rule
18f-4 to determine the fund's compliance with the applicable VaR
test at least once each business day.
    \368\ See proposed Item B.10.d.i.-ii of Form N-PORT.
    \369\ See proposed Item B.10.d.iii.-v of Form N-PORT.
---------------------------------------------------------------------------

    The proposed requirement for a fund to report highest daily VaR
(and, for a fund that is subject to the relative VaR test, information
about the fund's VaR ratio) is designed to help assess compliance with
the proposed rule. These requirements, and the proposed requirement for
a fund to report its median daily VaR (and, for a fund that is subject
to the relative VaR test, the median VaR ratio) are designed to help
identify changes in a fund's VaR over time, and to help identify trends
involving a single fund or group of funds regarding their VaRs. The
proposed requirement that a fund report information about its
designated reference index is designed to help analyze whether funds
are using designated reference indexes that meet the rule's
requirements, and also to assess any trends in the designated reference
indexes that funds select.
    A fund also would have to report the number of exceptions the fund
identified during the reporting period arising from backtesting the
fund's VaR calculation model.\370\ This proposed requirement is
designed to help analyze whether a fund's VaR model is effectively
taking into account and incorporating all significant, identifiable
market risk factors associated with a fund's investments, as required
by the proposed rule.\371\ This information would assist in monitoring
for compliance with the proposed VaR tests and also would provide high-
level information to market participants, as well as researchers and
analysts, to help evaluate the extent to which funds' VaR models, used
as part of the proposed VaR tests, are operating effectively. Because
this information would be made publicly available on a delayed basis,
and would not provide details about backtesting exceptions other than
the number of exceptions, we do not believe that this proposed
reporting requirement would produce adverse effects such that the
reported information should be made non-public.\372\
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    \370\ See proposed Item B.10.e of Form N-PORT; see also supra
section II.B.3.d (discussing proposed backtesting requirement); ICI
Comment Letter II (discussing UCITS funds being similarly required
to report to their primary regulator, on a semi-annual basis, the
number of VaR breaks that exceed a specified threshold (a VaR break
occurs when the actual one-day loss exceeds that day's VaR), and
recommending the Commission require funds to report the number of
VaR breaks and the dates on which they occurred).
    \371\ See supra note 151.
    \372\ See supra notes 362, 365. But see infra section II.H.2
(discussing adverse effects that might arise from the real-time
public reporting of a fund's VaR test breaches under the proposed
amendments to Form N-LIQUID).
    Information reported for the third month of each fund's fiscal
quarter on Form N-PORT will be made publicly available 60 days after
the end of the fiscal quarter. See supra note 359.
---------------------------------------------------------------------------

    We seek comment on the Commission's proposed amendments to

Form N-PORT requiring reporting of VaR information:
    210. Are the proposed requirements that funds report VaR
information on Form N-PORT, and each of the elements that a fund would
have to report under this requirement, appropriate? Why or why not?
Should we modify the proposed VaR information reporting item in any
way? If so, how should we modify this reporting item?
    211. Our proposal would make public all of the information that a
fund would report in response to the new VaR information item on Form
N-PORT. Is there any reason why this information should not be publicly
available? For example, would making this information public lead to
harm arising from investor confusion, adverse competitive effects, or
for any other reason? If we require that this reported information be
made public, is there additional information we should require funds to
report to provide contextualization or mitigate any adverse effects
that could arise from public disclosure? Should we make non-public some
of these disclosures (e.g., portfolio VaR or a fund's designated
reference index, or information about backtesting results) but not
others? If so, which ones should we make non-public and why?
    212. Would any of the proposed N-PORT reporting requirements be
more appropriately structured as Form N-CEN reporting requirements, or
items to be reported on a current basis on Form N-RN?
    213. Is there any additional information related to funds'
derivatives exposure or derivatives risk management that we should
require funds to report on Form N-PORT? What information and why, and
should this reported information be made public?
2. Amendments to Current Reporting Requirements
    We are also proposing current reporting requirements for funds that
are relying on proposed rule 18f-4. We are proposing to re-title Form
N-LIQUID as Form N-RN and to amend this form to include new reporting
events for funds that are subject to the proposed VaR-based limit on
fund leverage risk.\373\ These funds would be required to determine
their compliance with the applicable VaR test on at least a daily
basis.\374\ We are proposing to require these funds to file Form N-RN
to report information about VaR test breaches under certain
circumstances. Proposed rule 18f-4 would require a fund that has
determined that it is not in compliance with the applicable VaR test to
come back into compliance promptly and within no more than three
business days after such determination.\375\ We are therefore proposing
that a fund that determines that it is out of compliance with the VaR
test and has not come back into compliance within three business days
after such determination would file a report on Form N-RN providing
certain information regarding its VaR test breaches.\376\
---------------------------------------------------------------------------

    \373\ See proposed Parts E-G of Form N-RN.
    \374\ See supra section II.D; see also proposed rule 18f-
4(c)(2).
    \375\ See supra section II.D.5.b.
    \376\ See proposed Parts E and F of Form N-RN.
---------------------------------------------------------------------------

    If the portfolio VaR of a fund subject to the relative VaR test
were to exceed 150% of the VaR of its designated reference index for
three business days, we are proposing to require that such a fund
report: (1) The dates on which the fund portfolio's VaR exceeded 150%
of the VaR of its designated reference index; (2) the VaR of its
portfolio for each of these days; (3) the VaR of its designated
reference index for each of these days; (4) the name of the designated
reference index; and (5) the index identifier.\377\ A fund would have
to report this information within one business day following the third
business day after the fund has determined that its portfolio VaR
exceeds 150% of its designated reference index VaR.\378\ Such a fund
also would have to file a report on Form N-RN when it is back in
compliance with the relative VaR test.\379\
---------------------------------------------------------------------------

    \377\ See proposed Part E of Form N-RN.
    \378\ For example, if the fund were to determine, on the evening
of Monday, June 1, that its portfolio VaR exceeded 150% of the
fund's designated reference index VaR, and this exceedance were to
persist through Tuesday (June 2), Wednesday (June 3), and Thursday
(June 4), the fund would file Form N-RN on Friday, June 5 (because 3
business days following the determination on June 1 is June 4, and 1
business day following June 4 is June 5). If the exceedance were to
still persist on June 5 (the date that the fund would file Form N-
RN), the fund's report on Form N-RN would provide the required
information elements for June 1, 2, 3, 4, and 5.
    \379\ See proposed Part G of Form N-RN. The report would include
the dates on which the fund was not in compliance with the VaR test,
and the current VaR of the fund's portfolio on the date the fund
files the report. See also proposed rule 18f-4(c)(2)(iii) (providing
that a fund must meet specific requirements to be back in
compliance).
---------------------------------------------------------------------------

    If the portfolio VaR of a fund subject to the absolute VaR test
were to exceed 15% of the value of the fund's net assets for three
business days, we are proposing to require that such a fund report: (1)
The dates the on which the fund portfolio's VaR exceeded 15% of the
value of its net assets; (2) the VaR of its portfolio for each of these
days; and (3) the value of the fund's net assets for each of these
days.\380\ A fund would have to report this information within one
business day following the third business day that the fund determined
that its portfolio VaR exceeds 15% of the value of its net assets. Such
a fund also would have to file a report on Form N-RN when it is back in
compliance with the absolute VaR test.\381\
---------------------------------------------------------------------------

    \380\ See proposed Part F of Form N-RN.
    \381\ See supra note 378.
---------------------------------------------------------------------------

    The data points, collectively, would aid the Commission in
assessing funds' compliance with the VaR tests. In addition, the
information would provide staff the ability to assess how long a fund
is precluded from entering into derivatives transactions as a
consequence of its lack of compliance with its VaR test.
    Currently, only registered open-end funds (excluding money market
funds) are required to file reports on Form N-LIQUID.\382\ We are
proposing to amend this form, as well as rule 30b1-10 under the
Investment Company Act, to reflect the proposed 18f-4 requirement that
all funds that are subject to the relative VaR test or absolute VaR
test file current reports regarding VaR test breaches under the
circumstances that Form N-RN specifies.\383\ The scope of funds that
would be subject to the new VaR test breach current reporting
requirements would thus include registered open-end funds as well as
registered closed-end funds and BDCs. In addition to extending the
scope of funds required to respond to Form N-LIQUID, we are proposing
to amend the general instructions to the form to reflect the expanded
scope and application.\384\
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    \382\ See General Instruction A.(1) to Form N-LIQUID; see also
rule 30b1-10 [17 CFR 270.30b1-10].
    \383\ See proposed Form N-RN; see also proposed amendments to
rule 30b1-10 under the Investment Company Act, and proposed rule
18f-4(c)(7) (requiring a fund that experiences an event specified in
the parts of Form N-RN titled ``Relative VaR Test Breaches,''
``Absolute VaR Test Breaches,'' or ``Compliance with VaR Test'' to
file with the Commission a report on Form N-RN within the period and
according to the instructions specified in that form).
    \384\ See, e.g., proposed General Instruction A.(1) to Form N-RN
(amending the defined term ``registrant''); proposed General
Instruction A.(2) to Form N-RN (amending the submission requirement
to clarify application to the new VaR-test-breach-related items);
proposed General Instruction A.(3) to Form N-RN (clarifying that
only open-end funds required to comply with rule 22e-4 under the
Investment Company Act would be required to respond to events
occurring in Parts B-D, as applicable, while funds required to
comply with the limit on fund leverage risk in proposed rule 18f-4
would be required to respond to events specified in proposed Parts
E-G, as applicable); and proposed General Instruction F to Form N-RN
(clarifying that the terms used in proposed Parts E-G, unless
otherwise specified, would have the same meaning as the terms in
proposed rule 18f-4).

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    We are proposing to require funds to provide this information in a
current report because we believe that the Commission should be
notified promptly when a fund is out of compliance with the proposed
VaR-based limit on fund leverage risk, which in turn we believe could
indicate that a fund is experiencing heightened risks as a result of
the fund's use of derivatives transactions. VaR test breaches could
indicate that a fund is using derivatives transactions to leverage the
fund's portfolio, magnifying its potential for losses and significant
payments of fund assets to derivatives counterparties. Such breaches
also could indicate market events that are drivers of potential
derivatives risks or other risks across the fund industry. Either of
these scenarios--increased fund-specific risks, or market events that
affect funds' risks broadly--may, depending on the facts and
circumstances, require attention by the Commission. The proposed
current reporting requirement is designed to provide the Commission
current information regarding potential increased risks and stress
events (as opposed to a requirement to report the same or similar
information later, for example on Form N-PORT).\385\ The one-business-
day time-frame for submitting a report on Form N-RN regarding a fund's
VaR test breaches is designed to provide an appropriately early
notification to the Commission of potential heightened risks, while at
the same time providing sufficient time for a fund to compile and file
its report on Form N-RN. This time-frame is also consistent with the
current required timing for reporting other events on Form N-
LIQUID.\386\
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    \385\ See supra section II.H.1.b.
    \386\ See General Instruction A of Form N-LIQUID.
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    We are cognizant that certain adverse effects might arise from
real-time public reporting of a fund's VaR test breaches. For example,
publicly disclosing this information could lead to investor confusion.
Investors might mistakenly assume that a fund that breached the
applicable VaR test actually had suffered substantial losses or that
substantial losses necessarily were imminent. Investors might also
believe that a fund's failing the VaR test suggests a sudden increase
in fund risk when, in some cases, a fund can fail a VaR test--and
especially an absolute VaR test--due to changes in market volatility
generally. Investors also might believe that a fund's real-time
reporting of a VaR test breach necessarily meant that the fund was not
complying with applicable regulations. Information about VaR breaches
would therefore provide important information to the Commission and its
staff for regulatory purposes but could confuse investors and lead them
and other market participants to make incorrect assumptions about a
fund's relative riskiness. This could have potential adverse effects
for funds if investors redeem or sell fund shares as a result. Other
market participants also could react to real-time reporting of VaR
breaches in ways that could adversely affect funds. For example, if
market participants knew on a real-time basis that a fund had breached
the applicable VaR test, market participants might seek to anticipate
the trading activity the fund might undertake to come back into
compliance and engage in predatory trading that could adversely affect
the fund. Accordingly, we are proposing to make funds' reports on Form
N-RN regarding VaR test breaches (like their reports on this form
regarding liquidity-related items) non-public, because we preliminarily
believe that public disclosure of this information is neither necessary
nor appropriate in the public interest or for the protection of
investors.\387\
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    \387\ See proposed General Instruction A.(1) to Form N-RN; see
also section 45(a) of the Investment Company Act (requiring
information in reports filed with the Commission pursuant to the
Investment Company Act to be made available to the public, unless we
find that public disclosure is neither necessary nor appropriate in
the public interest or for the protection of investors).
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    We seek comment on the Commission's proposed amendments to Form N-
LIQUID requiring reporting of certain information regarding a fund's
VaR test breaches:
    214. Is the proposed new current reporting requirement for funds
that are subject to the VaR-based limit on fund leverage risk
appropriate? Why or why not? If not, how should the scope of the
proposed current reporting requirement be modified? Should we require
additional current reporting requirements for funds to report other
derivatives-risk-related information? For example, should funds that
are limited derivatives users pursuant to the proposed exposure-based
exception be required to file current reports if their derivatives
exposure were to exceed 10% of their net assets? \388\ Should we
require a fund to file a current report if it identifies a certain
number of exceptions as a result of backtesting its VaR calculation
model, and if so, what circumstances should trigger the requirement to
file a current report? \389\
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    \388\ See supra section II.E.1.
    \389\ See supra section II.B.3.d (discussing backtesting
requirements in proposed rule 18f-4); see also supra section
II.H.1.b (discussing proposed requirement to report backtesting
results on Form N-PORT).
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    215. Is each of the pieces of information that we propose a fund
would include in a report about a VaR test breach on proposed Form N-RN
appropriate? Why or why not? Should we modify the required information
in any way?
    216. For a fund that is out of compliance with the VaR test, and is
unable to come back into compliance within three business days after
its initial determination, the proposed current reporting requirement
would require that fund to file a report on Form N-RN providing certain
information regarding its VaR test breaches. Is the proposed three-
business-day current reporting requirement appropriate? Why or why not?
Should the rule require a shorter or longer period, such as one or
seven days, before prompting a current reporting requirement? Which
time period would be appropriate and why?
    217. We are proposing that a fund's reports regarding VaR test
breaches on Form N-RN would not be made public. Would there be a
benefit to publicly reporting this information, and would it be
appropriate to make these disclosures public? Why or why not? Should we
make public some of these disclosures but not others? If so, which ones
should we make public and why?
    218. As an alternative or an addition to the proposed current
reporting requirement, should we require funds to report information
regarding VaR test breaches on Form N-PORT? Why or why not? If so,
should we make public this information reported on Form N-PORT?
    219. Should we modify the proposed current reporting requirement to
require reporting by certain types of funds and not others? If so which
types of funds, and why? For example, should we require BDCs also to
report the information that we are proposing them to report on Form N-
RN on Form 8-K? Why or why not?
    220. As an alternative to amending Form N-LIQUID to require current
reporting on VaR test breaches, should we provide a new, separate
current reporting form for funds to use to report VaR test breaches
(and/or any other current reporting items relating to their derivatives
risk management programs under proposed rule 18f-4)? Why or why not?
3. Amendments to Form N-CEN
    Form N-CEN currently includes an item that requires a fund to
indicate--in a manner similar to ``checking a

box''--whether the fund has relied on certain Investment Company Act
rules during the reporting period.\390\ We are proposing amendments to
this item to require a fund to identify whether it relied on proposed
rule 18f-4 during the reporting period.\391\ We are also proposing
amendments to require a fund to identify whether it relied on any of
the exceptions from various requirements under the proposed rule,
specifically:
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    \390\ See Item C.7 of Form N-CEN.
    \391\ See proposed Item C.7.l of Form N-CEN.
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     Whether the fund is a limited derivatives user excepted
from the proposed rule's program requirement, under either the proposed
exception for funds that limit their derivatives exposure to 10% of
their net assets or under the exception for funds that limit their
derivatives use to certain currency hedging; \392\ or
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    \392\ See proposed Item C.7.l.i.-ii of Form N-CEN; see also
supra section II.E.
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     Whether the fund is a leveraged/inverse fund covered by
the proposed sales practices rules that, under proposed rule 18f-4,
would be excepted from the proposed limit on fund leverage risk.\393\
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    \393\ See proposed Item C.7.l.iii of Form N-CEN; see also supra
section II.G.
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    Finally, a fund would have to identify whether it has entered into
reverse repurchase agreements or similar financing transactions, or
unfunded commitment agreements, as provided under the proposed
rule.\394\ This information would assist the Commission and staff with
our oversight functions by allowing us to identify which funds were
excepted from certain of the proposed rule's provisions or relied on
the rule's provisions regarding reverse repurchase agreements and
unfunded commitment agreements.
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    \394\ See proposed Item C.7.l.iv-v of Form N-CEN; see also infra
sections II.I and II.J.
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    We seek comment on the Commission's proposed amendments to Form N-
CEN:
    221. Should we require, as proposed, that funds identify that they
relied on rule 18f-4, including whether they are limited derivatives
users that are excepted from the proposed program requirement? Why or
why not?
    222. Should we require, as proposed, that funds identify that they
are leveraged/inverse funds that are excepted from the proposed limit
on fund leverage risk? Why or why not?
    223. Should we require, as proposed, that funds identify that they
entered into reverse repurchase agreements or similar financing
transactions, or unfunded commitment agreements? Why or why not?
    224. Are there other means that funds use to disclose or report
information (e.g., prospectus or annual report disclosure in addition
to the other disclosure requirements in this proposal) that would be
more appropriate for reporting any of the information that the proposed
amendments to Form N-CEN would require? Should any of the disclosures
required in the proposed amendments to Form N-PORT above be made on
Form N-CEN? Why or why not?
4. BDC Reporting
    BDCs do not file reports on Form N-CEN or Form N-PORT. We
considered proposing to require that BDCs provide the new information
that we propose registered funds report on Form N-CEN, and the new
information regarding derivatives exposure and VaR that we propose to
require funds to report on Form N-PORT, in their annual reports on Form
10-K. BDCs, however, generally do not enter into derivatives
transactions or do so to a limited extent.\395\ We therefore believe
that most BDCs that enter into derivatives transactions would qualify
for the limited derivatives user exception (which would make the
proposed VaR reporting items on Form N-PORT inapplicable to BDCs). In
addition, and as noted above, we understand that even when BDCs do use
derivatives more extensively, derivatives generally do not play as
significant of a role in implementing the BDC's strategy, as compared
to many other types of funds that use derivatives extensively. BDCs are
required under the Investment Company Act to invest at least 70% of
their total assets in ``eligible portfolio companies,'' which may limit
the role that derivatives can play in a BDC's portfolio relative to
other kinds of funds that would generally execute their strategies
primarily through derivatives transactions (e.g., a managed futures
fund). BDCs that would not qualify as limited derivatives users under
the proposed rule also would be subject to the proposed new requirement
to file current reports regarding VaR test breaches on Form N-RN.\396\
Taking these factors into account, we are not proposing additional
reporting requirements for BDCs because we believe that the reporting
framework we are proposing for BDCs adequately addresses the
Commission's ability to monitor BDCs' compliance with the proposed
rules, as well as any competitive disparities that could result from
disparate reporting requirements among funds that rely on proposed rule
18f-4.\397\
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    \395\ See supra section II.D.2.b.
    \396\ See supra section II.H.2.
    \397\ We have separately proposed to require BDCs to tag their
financial statements using Inline XBRL, a structured, machine-
readable format, which would provide structured data about BDCs'
derivatives and other investments. See Securities Offering Reform
Proposing Release, supra note 199, at section II.H.1. In addition,
BDCs are currently required to disclose certain information about
their exposures to market risks, including risks that may arise as a
result of their derivatives-related activity. See, e.g., Items 303
and 305 of Regulation S-K [17 CFR 229.303 and 229.305].
     See also infra section III.D.2 (discussing, among other things,
potential competitive effects resulting from BDCs not being subject
to the proposed additional reporting requirements on Form N-PORT and
Form N-CEN).
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    We seek comment on the Commission's proposal to not require BDCs to
report on Forms N-PORT or N-CEN:
    225. Should we require BDCs to report any of the same information
on Form 10-K (or elsewhere, such as in a BDC's prospectus) that we are
proposing to require registered investment companies to report on Forms
N-CEN and N-PORT? Why or why not? Should we require, for example, that
a BDC report its derivatives exposure, whether it is a limited
derivatives user, and/or its designated reference index (if
applicable)? If so, where? If a BDC uses derivatives and does not
qualify as a limited derivatives user, should it have to report
information about its derivatives exposure and portfolio VaR on Form N-
PORT (or elsewhere)?
    226. Should we require BDCs to report on Form 10-K or elsewhere
whether they have relied on the rule's provision regarding reverse
repurchase agreements and similar financing transactions or unfunded
commitment agreements?

I. Reverse Repurchase Agreements

    Funds may engage in certain transactions that may involve senior
securities primarily as a means of obtaining financing. For example,
open-end funds are permitted to borrow money from a bank, provided they
maintain a 300% asset coverage ratio.\398\ Another common method of
obtaining financing is through the use of reverse repurchase
agreements. In a reverse repurchase agreement, a fund transfers a
security to another party in return for a percentage of the value of
the security. At an agreed-upon future date, the fund repurchases the
transferred security by paying an amount equal to the proceeds of the