On December 11, 2015, the Securities and Exchange Commission (the “SEC”) proposed a new rule that would regulate the use of derivatives by investment companies registered under the Investment Company Act of 1940, as amended (the “ICA”), and business development companies (“Funds”). Many liquid alternative mutual funds, which are ICA-registered funds that follow non-traditional hedge-fund like strategies and invest in non-traditional asset classes such as derivatives, would be affected significantly by the adoption of the proposed rule.
The SEC has previously expressed concern with transactions that impose obligations on Funds to pay or deliver assets in the future to a counterparty because it deems those transactions to involve the issuance of a “senior security” restricted by Section 18 of the ICA. In prior ICA releases and no-action letters issued by the SEC or its staff, the SEC addressed the application of Section 18’s restrictions to certain transactions involving senior securities and concluded that the use of segregated accounts containing certain liquid assets equal to the obligation incurred by the Fund would limit the Fund’s risk of loss. Some of those no-action letters and other SEC staff guidance addressed derivatives transactions, but the guidance to date has been on an instrument-by-instrument basis.
In its release proposing the rule, the SEC explained that it was applying, on a comprehensive basis, the analysis expressed in past instrument-by-instrument guidance to those derivatives transactions where a Fund is or may be required to make any payment or to deliver cash or other assets during the life of the instrument or at maturity or early termination (whether as a margin or as settlement payment or otherwise).
Under the proposed rule, a Fund would be required to comply with one of two alternative portfolio limitations in connection with its derivatives transactions. One limitation (150% of net assets) is based on a Fund’s exposure to derivatives calculated by the aggregate notional amount of its derivatives and its obligations under financial commitment and certain other transactions. The other limitation (300% of net assets) is based on a Fund’s risk calculated by its Value at Risk (“VaR”) which is a statistical estimate of the market risk of the Fund’s portfolio. A Fund would also have to manage the risks associated with its derivatives by using certain segregated accounts based on mark-to-market and risk-based coverage amounts. Funds that engage in more than limited derivatives transactions or use complex derivatives would additionally be required to establish a formal derivatives risk management program administered by a designated derivatives risk manager both of which must be approved and reviewed by the Fund’s board of directors.
 See Investment Company Act Release No. 7221 (June 9, 1972) regarding the use of segregated accounts for put and call options written by funds.
 See Investment Company Act Release No. 10666 (Apr. 18, 1979) regarding the use of segregated accounts for reverse repurchase agreements, firm and standby commitment agreements.