SEC approves rule limiting use of derivatives in funds

A split Securities and Exchange Commission Wednesday approved a rule to limit the use of derivatives in investment funds that drew dissent from Democratic members who said it does not adequately protect investors.

In a related move, agency officials released a statement asking for public comment on whether the SEC should promulgate additional rules to safeguard investors who purchase leveraged, inverse and other complex products in self-directed accounts.

The agency approved, 3-2, the 458-page derivatives rule, which was first proposed in December 2015 and reproposed late last year. It applies to mutual funds, exchange-traded funds, close-end funds and business development companies.

The measure modernizes derivatives regulation to respond to increasingly sophisticated investment strategies without muzzling funds or making investors vulnerable, SEC Chairman Jay Clayton said at an open meeting.

The rule would amend Rule 18f-4 of the Investment Company Act. It sets an outer limit on the amount of leverage a fund can use based on value at risk, requires funds to implement a risk management program and establishes reporting and record-keeping requirements, among other changes.

The rule also allows leveraged and inverse ETFs that meet its conditions to operate without obtaining an exemptive order from the SEC.

 “Today’s action provides for a comprehensive framework for funds’ derivatives use that provides both meaningful protections for investors and regulatory certainty for funds and their advisers,” Clayton said in a statement.

He added at the open meeting, “[T]oday’s recommendation will undoubtedly enhance our investor protection efforts with respect to investment companies that invest in derivatives, including those that follow more complex strategies.’

DEMOCRATIC MEMBERS OBJECT

Democratic members Allison Herren Lee and Caroline Crenshaw voted against the rule. Lee supported the rule proposal last year, but said that important investor protections were removed from the final rule. For instance, Lee said the final rule scrapped reform of sales practices for inverse and leveraged ETFs.

“Unfortunately, this rule did not live up to the promise of the proposal,” Lee said at the open meeting. “In fact, it underwent a substantial overhaul — increasing risk, reducing transparency around that risk, and dropping basic sales practice rules for extremely complex products — all to the detriment of retail investors.”

Crenshaw said the final rule does not provide meaningful limits on leverage or address risks for retail investors.

“The majority of the commission is telling investors they are on their own,” she said at the open meeting.

The sales practice provision was taken out of the derivatives rule because it only applied to inverse and leveraged ETFs, the SEC said. The request for comment seeks public input on whether additional rules are needed for a whole range of complex product sales that also includes exchange-traded notes and products, and commodity pools, among other offerings.

But Lee said the follow-up examination of SEC rules on complex products should not dilute protections included in the derivatives rule.

“The fact that other products present similar dangers should not deter us from addressing the harm to retirees, middle-class savers, and other retail investors that is presently and squarely before us,” Lee said.

ADDITIONAL INVESTOR PROTECTIONS

The comment request focuses on protecting investors who buy complex products on their own through self-directed accounts. Clayton said Regulation Best Interest, the broker investment advice standard, and the fiduciary rule governing investment advisers help ensure investors using intermediaries are informed of the risks posed by complex products.  

In her statement, Lee pointed out that even brokers and advisers may not fully grasp opaque, complicated investments like derivatives.

“The staff may consider requirements that include, among other things, additional obligations for broker-dealers and investment advisers relating to complex products, as well as point-of-sale disclosures or policies and procedures tailored to the risks of complex products,” the joint statement says.

The derivatives rule proposal last year drew approximately 6,000 comments, the SEC said. Most of them focused on the sales practice provision.

The Investment Company Institute, which represents the investment fund industry, supports the SEC’s derivatives reform.

“ICI commends the SEC for adopting a final rule that enables funds to continue using derivatives to deliver strong performance and manage risks for investors, while providing robust shareholder protections,” ICI Chief Executive Paul Schott Stevens said in a statement.

Approximately 14% of mutual, exchange-traded and closed-end funds reported derivatives holdings at or above 50% of net assets as of September, the SEC rule states. They have combined net assets of $1.886 billion, which represents 8% of fund industry net assets. About 60% of funds report no derivatives holdings.

The derivatives rule will go into effect 60 days after it is published in the Federal Register. There will be an 18-month transition period before implementation.