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e-CFR data is current as of May 13, 2021

Title 17Chapter IIPart 270 → §270.18f-4


Title 17: Commodity and Securities Exchanges
PART 270—RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940


§270.18f-4   Exemption from the requirements of section 18 and section 61 for certain senior securities transactions.

(a) Definitions. For purposes of this section:

Absolute VaR test means that the VaR of the fund's portfolio does not exceed 20% of the value of the fund's net assets, or in the case of a closed-end company that has issued to investors and has then outstanding shares of a class of senior security that is a stock, that the VaR of the fund's portfolio does not exceed 25% of the value of the fund's net assets.

Derivatives exposure means the sum of the gross notional amounts of the fund's derivatives transactions described in paragraph (1) of the definition of the term “derivatives transaction” of this section, and in the case of short sale borrowings, the value of the assets sold short. If a fund's derivatives transactions include reverse repurchase agreements or similar financing transactions under paragraph (d)(1)(ii) of this section, the fund's derivatives exposure also includes, for each transaction, the proceeds received but not yet repaid or returned, or for which the associated liability has not been extinguished, in connection with the transaction. In determining derivatives exposure a fund may convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts and exclude any closed-out positions, if those positions were closed out with the same counterparty and result in no credit or market exposure to the fund.

Derivatives risk manager means an officer or officers of the fund's investment adviser responsible for administering the program and policies and procedures required by paragraph (c)(1) of this section, provided that the derivatives risk manager:

(1) May not be a portfolio manager of the fund, or if multiple officers serve as derivatives risk manager, may not have a majority composed of portfolio managers of the fund; and

(2) Must have relevant experience regarding the management of derivatives risk.

Derivatives risks means the risks associated with a fund's derivatives transactions or its use of derivatives transactions, including leverage, market, counterparty, liquidity, operational, and legal risks and any other risks the derivatives risk manager (or, in the case of a fund that is a limited derivatives user as described in paragraph (c)(4) of this section, the fund's investment adviser) deems material.

Derivatives transaction means:

(1) Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (“derivatives instrument”), under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payment or otherwise;

(2) Any short sale borrowing; and

(3) If a fund relies on paragraph (d)(1)(ii) of this section, any reverse repurchase agreement or similar financing transaction.

Designated index means an unleveraged index that is approved by the derivatives risk manager for purposes of the relative VaR test and that reflects the markets or asset classes in which the fund invests and is not administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used. In the case of a blended index, none of the indexes that compose the blended index may be administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used.

Designated reference portfolio means a designated index or the fund's securities portfolio. Notwithstanding paragraph (2) of the definition of designated index of this section, if the fund's investment objective is to track the performance (including a leverage multiple or inverse multiple) of an unleveraged index, the fund must use that index as its designated reference portfolio.

Fund means a registered open-end or closed-end company or a business development company, including any separate series thereof, but does not include a registered open-end company that is regulated as a money market fund under §270.2a-7.

Leveraged/inverse fund means a fund that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple (“leverage multiple”), or to provide investment returns that have an inverse relationship to the performance of a market index (“inverse multiple”), over a predetermined period of time.

Relative VaR test means that the VaR of the fund's portfolio does not exceed 200% of the VaR of the designated reference portfolio, or in the case of a closed-end company that has issued to investors and has then outstanding shares of a class of senior security that is a stock, that the VaR of the fund's portfolio does not exceed 250% of the VaR of the designated reference portfolio.

Securities portfolio means the fund's portfolio of securities and other investments, excluding any derivatives transactions, that is approved by the derivatives risk manager for purposes of the relative VaR test, provided that the fund's securities portfolio reflects the markets or asset classes in which the fund invests (i.e., the markets or asset classes in which the fund invests directly through securities and other investments and indirectly through derivatives transactions).

Unfunded commitment agreement means a contract that is not a derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a loan to a company or to invest equity in a company in the future, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund's general partner.

Value-at-risk or VaR means an estimate of potential losses on an instrument or portfolio, expressed as a percentage of the value of the portfolio's assets (or net assets when computing a fund's VaR), over a specified time horizon and at a given confidence level, provided that any VaR model used by a fund for purposes of determining the fund's compliance with the relative VaR test or the absolute VaR test must:

(1) Take into account and incorporate all significant, identifiable market risk factors associated with a fund's investments, including, as applicable:

(i) Equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk;

(ii) Material risks arising from the nonlinear price characteristics of a fund's investments, including options and positions with embedded optionality; and

(iii) The sensitivity of the market value of the fund's investments to changes in volatility;

(2) Use a 99% confidence level and a time horizon of 20 trading days; and

(3) Be based on at least three years of historical market data.

(b) Derivatives transactions. If a fund satisfies the conditions of paragraph (c) of this section, the fund may enter into derivatives transactions, notwithstanding the requirements of sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a-18(a)(1), 80a-18(c), 80a-18(f)(1), and 80a-60), and derivatives transactions entered into by the fund in compliance with this section will not be considered for purposes of computing asset coverage, as defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-18(h)).

(c) Conditions—(1) Derivatives risk management program. The fund adopts and implements a written derivatives risk management program (“program”), which must include policies and procedures that are reasonably designed to manage the fund's derivatives risks and to reasonably segregate the functions associated with the program from the portfolio management of the fund. The program must include the following elements:

(i) Risk identification and assessment. The program must provide for the identification and assessment of the fund's derivatives risks. This assessment must take into account the fund's derivatives transactions and other investments.

(ii) Risk guidelines. The program must provide for the establishment, maintenance, and enforcement of investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund's derivatives risks. These guidelines must specify levels of the given criterion, metric, or threshold that the fund does not normally expect to exceed, and measures to be taken if they are exceeded.

(iii) Stress testing. The program must provide for stress testing to evaluate potential losses to the fund's portfolio in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund's portfolio, taking into account correlations of market risk factors and resulting payments to derivatives counterparties. The frequency with which the stress testing under this paragraph is conducted must take into account the fund's strategy and investments and current market conditions, provided that these stress tests must be conducted no less frequently than weekly.

(iv) Backtesting. The program must provide for backtesting to be conducted no less frequently than weekly, of the results of the VaR calculation model used by the fund in connection with the relative VaR test or the absolute VaR test by comparing the fund's gain or loss that occurred on each business day during the backtesting period with the corresponding VaR calculation for that day, estimated over a one-trading day time horizon, and identifying as an exception any instance in which the fund experiences a loss exceeding the corresponding VaR calculation's estimated loss.

(v) Internal reporting and escalation—(A) Internal reporting. The program must identify the circumstances under which persons responsible for portfolio management will be informed regarding the operation of the program, including exceedances of the guidelines specified in paragraph (c)(1)(ii) of this section and the results of the stress tests specified in paragraph (c)(1)(iii) of this section.

(B) Escalation of material risks. The derivatives risk manager must inform in a timely manner persons responsible for portfolio management of the fund, and also directly inform the fund's board of directors as appropriate, of material risks arising from the fund's derivatives transactions, including risks identified by the fund's exceedance of a criterion, metric, or threshold provided for in the fund's risk guidelines established under paragraph (c)(1)(ii) of this section or by the stress testing described in paragraph (c)(1)(iii) of this section.

(vi) Periodic review of the program. The derivatives risk manager must review the program at least annually to evaluate the program's effectiveness and to reflect changes in risk over time. The periodic review must include a review of the VaR calculation model used by the fund under paragraph (c)(2) of this section (including the backtesting required by paragraph (c)(1)(iv) of this section) and any designated reference portfolio to evaluate whether it remains appropriate.

(2) Limit on fund leverage risk. (i) The fund must comply with the relative VaR test unless the derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, taking into account the fund's investments, investment objectives, and strategy. A fund that does not apply the relative VaR test must comply with the absolute VaR test.

(ii) The fund must determine its compliance with the applicable VaR test at least once each business day. If the fund determines that it is not in compliance with the applicable VaR test, the fund must come back into compliance promptly after such determination, in a manner that is in the best interests of the fund and its shareholders.

(iii) If the fund is not in compliance with the applicable VaR test within five business days:

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

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

(C) The derivatives risk manager must provide a written report within thirty calendar days of the exceedance to the fund's board of directors explaining how the fund came back into compliance and the results of the analysis and updates required under paragraph (c)(2)(iii)(B) of this section. If the fund remains out of compliance with the applicable VaR test at that time, the derivatives risk manager's written report must update the report previously provided under paragraph (c)(2)(iii)(A) of this section and the derivatives risk manager must update the board of directors on the fund's progress in coming back into compliance at regularly scheduled intervals at a frequency determined by the board.

(3) Board oversight and reporting—(i) Approval of the derivatives risk manager. A fund's board of directors, including a majority of directors who are not interested persons of the fund, must approve the designation of the derivatives risk manager.

(ii) Reporting on program implementation and effectiveness. On or before the implementation of the program, and at least annually thereafter, the derivatives risk manager must provide to the board of directors a written report providing a representation that the program is reasonably designed to manage the fund's derivatives risks and to incorporate the elements provided in paragraphs (c)(1)(i) through (vi) of this section. The representation may be based on the derivatives risk manager's reasonable belief after due inquiry. The written report must include the basis for the representation along with such information as may be reasonably necessary to evaluate the adequacy of the fund's program and, for reports following the program's initial implementation, the effectiveness of its implementation. The written report also must include, as applicable, the derivatives risk manager's basis for the approval of any designated reference portfolio or any change in the designated reference portfolio during the period covered by the report; or an explanation of the basis for the derivatives risk manager's determination that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test.

(iii) Regular board reporting. The derivatives risk manager must provide to the board of directors, at a frequency determined by the board, a written report regarding the derivatives risk manager's analysis of exceedances described in paragraph (c)(1)(ii) of this section, the results of the stress testing conducted under paragraph (c)(1)(iii) of this section, and the results of the backtesting conducted under paragraph (c)(1)(iv) of this section since the last report to the board. Each report under this paragraph must include such information as may be reasonably necessary for the board of directors to evaluate the fund's response to exceedances and the results of the fund's stress testing.

(4) Limited derivatives users. (i) A fund is not required to adopt a program as prescribed in paragraph (c)(1) of this section, comply with the limit on fund leverage risk in paragraph (c)(2) of this section, or comply with the board oversight and reporting requirements as prescribed in paragraph (c)(3) of this section, if:

(A) The fund adopts and implements written policies and procedures reasonably designed to manage the fund's derivatives risk; and

(B) The fund's derivatives exposure does not exceed 10 percent of the fund's net assets, excluding, for this purpose, currency or interest rate derivatives that hedge currency or interest rate risks associated with one or more specific equity or fixed-income investments held by the fund (which must be foreign-currency-denominated in the case of currency derivatives), or the fund's borrowings, provided that the currency or interest rate derivatives are entered into and maintained by the fund for hedging purposes and that the notional amounts of such derivatives do not exceed the value of the hedged investments (or the par value thereof, in the case of fixed-income investments, or the principal amount, in the case of borrowing) by more than 10 percent.

(ii) If a fund's derivatives exposure exceeds 10 percent of its net assets, as calculated in accordance with paragraph (c)(4)(i)(B) of this section, and the fund is not in compliance with that paragraph within five business days, the fund's investment adviser must provide a written report to the fund's board of directors informing them whether the investment adviser intends either:

(A) To reduce the fund's derivatives exposure to less than 10 percent of the fund's net assets promptly, but within no more than thirty calendar days of the exceedance, in a manner that is in the best interests of the fund and its shareholders; or

(B) For the fund to establish a program as prescribed in paragraph (c)(1) of this section, comply with the limit on fund leverage risk in paragraph (c)(2) of this section, and comply with the board oversight and reporting requirements as prescribed in paragraph (c)(3) of this section, as soon as reasonably practicable.

(5) Leveraged/inverse funds. A leveraged/inverse fund that cannot comply with the limit on fund leverage risk in paragraph (c) of this section is not required to comply with the limit on fund leverage risk if, in addition to complying with all other applicable requirements of this section:

(i) As of October 28, 2020, the fund is in operation; has outstanding shares issued in one or more public offerings to investors; and discloses in its prospectus a leverage multiple or inverse multiple that exceeds 200% of the performance or the inverse of the performance of the underlying index;

(ii) The fund does not change the underlying market index or increase the level of leveraged or inverse market exposure the fund seeks, directly or indirectly, to provide; and

(iii) The fund discloses in its prospectus that it is not subject to the limit on fund leverage risk in paragraph (c)(2) of this section.

(6) Recordkeeping—(i) Records to be maintained. A fund must maintain a written record documenting, as applicable:

(A) The fund's written policies and procedures required by paragraph (c)(1) of this section, along with:

(1) The results of the fund's stress tests under paragraph (c)(1)(iii) of this section;

(2) The results of the backtesting conducted under paragraph (c)(1)(iv) of this section;

(3) Records documenting any internal reporting or escalation of material risks under paragraph (c)(1)(v)(B) of this section; and

(4) Records documenting the reviews conducted under paragraph (c)(1)(vi) of this section.

(B) Copies of any materials provided to the board of directors in connection with its approval of the designation of the derivatives risk manager, any written reports provided to the board of directors relating to the program, and any written reports provided to the board of directors under paragraphs (c)(2)(iii)(A) and (C) of this section.

(C) Any determination and/or action the fund made under paragraphs (c)(2)(i) and (ii) of this section, including a fund's determination of: The VaR of its portfolio; the VaR of the fund's designated reference portfolio, as applicable; the fund's VaR ratio (the value of the VaR of the fund's portfolio divided by the VaR of the designated reference portfolio), as applicable; and any updates to any VaR calculation models used by the fund and the basis for any material changes thereto.

(D) If applicable, the fund's written policies and procedures required by paragraph (c)(4) of this section, along with copies of any written reports provided to the board of directors under paragraph (c)(4)(ii) of this section.

(ii) Retention periods. (A) A fund must maintain a copy of the written policies and procedures that the fund adopted under paragraph (c)(1) or (4) of this section that are in effect, or at any time within the past five years were in effect, in an easily accessible place.

(B) A fund must maintain all records and materials that paragraphs (c)(6)(i)(A)(1) through (4) and (c)(6)(i)(B) through (D) of this section describe for a period of not less than five years (the first two years in an easily accessible place) following each determination, action, or review that these paragraphs describe.

(7) Current reports. A fund that experiences an event specified in the parts of Form N-RN [referenced in 17 CFR 274.223] titled “Relative VaR Test Breaches,” “Absolute VaR Test Breaches,” or “Compliance with VaR Test” must file with the Commission a report on Form N-RN within the period and according to the instructions specified in that form.

(d) Reverse repurchase agreements. (1) A fund may enter into reverse repurchase agreements or similar financing transactions, notwithstanding the requirements of sections 18(c) and 18(f)(1) of the Investment Company Act, if the fund:

(i) Complies with the asset coverage requirements of section 18, and combines the aggregate amount of indebtedness associated with all reverse repurchase agreements or similar financing transactions with the aggregate amount of any other senior securities representing indebtedness when calculating the asset coverage ratio; or

(ii) Treats all reverse repurchase agreements or similar financing transactions as derivatives transactions for all purposes under this section.

(2) A fund relying on paragraph (d) of this section must maintain a written record documenting whether the fund is relying on paragraph (d)(1)(i) or (ii) of this section for a period of not less than five years (the first two years in an easily accessible place) following the determination.

(e) Unfunded commitment agreements. (1) A fund may enter into an unfunded commitment agreement, notwithstanding the requirements of sections 18(a), 18(c), 18(f)(1), and 61 of the Investment Company Act, if the fund reasonably believes, at the time it enters into such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as they come due. In forming a reasonable belief, the fund must take into account its reasonable expectations with respect to other obligations (including any obligation with respect to senior securities or redemptions), and may not take into account cash that may become available from the sale or disposition of any investment at a price that deviates significantly from the market value of those investments, or from issuing additional equity. Unfunded commitment agreements entered into by the fund in compliance with this section will not be considered for purposes of computing asset coverage, as defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-18(h)).

(2) For each unfunded commitment agreement that a fund enters into under paragraph (e)(1) of this section, a fund must document the basis for its reasonable belief regarding the sufficiency of its cash and cash equivalents to meet its unfunded commitment agreement obligations, and maintain a record of this documentation for a period of not less than five years (the first two years in an easily accessible place) following the date that the fund entered into the agreement.

(f) When issued, forward-settling, and non-standard settlement cycle securities transactions. Notwithstanding the requirements of sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a-18(a)(1), 80a018(c), 80a-18(f)(1), and 80a-60), a fund or registered open-end company that is regulated as a money market fund under §270.2a-7 may invest in a security on a when-issued or forward-settling basis, or with a non-standard settlement cycle, and the transaction will be deemed not to involve a senior security, provided that: The fund intends to physically settle the transaction; and the transaction will settle within 35 days of its trade date.

[85 FR 83291, Dec. 21, 2020]

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