On October 28, the Securities and Exchange Commission (the “SEC”) adopted Rule 18f-4 (the “Rule”) under the Investment Company Act of 1940 (the “1940 Act”) and amended related rules designed to provide a modernized, comprehensive approach to the regulation of derivative investments by mutual funds (other than money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, and business development companies (“BDCs”) (collectively, “funds”). This alert offers an overview of the Rule and related amendments.
A fund’s investment in derivatives creates leverage exposure, or the potential for leverage exposure, because derivatives allow the fund to achieve “the right to a return on a capital base that exceeds the investment which [the fund has] contributed to the entity or instrument achieving a return.” According to the SEC, a fund that is over-leveraged may struggle when markets are volatile, potentially causing a fund to experience trading, liquidity, and pricing disruptions, valuation challenges, counterparty issues, and issues relating to derivatives’ underlying assets.
The SEC generally classifies derivatives and short sale borrowings as senior securities, which are regulated by section 18 of the 1940 Act. The 1940 Act restricts the amount of leverage a fund may take on by limiting its ability to issue senior securities., Senior securities include any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness. Congress adopted the limitations in section 18 due to concerns of: (i) the excessive issuance of senior securities and borrowing by funds when these activities unduly increase the speculative character of funds’ junior securities; (ii) funds operating without adequate assets and reserves; and (iii) potential abuse of the purchasers of senior securities.
Over decades of market and industry developments, the SEC has taken a piecemeal approach to the regulation of derivatives. Such approach has created inconsistent risk management practices across the industry, generating SEC concerns over investor protection.
II. Summary of the New Regulatory Framework
In an effort to provide a harmonized regulatory framework for funds’ derivatives investments and other transactions, the SEC adopted the Rule, amended Rule 6c-11 under the 1940 Act, rescinded Release 10666, and updated related reporting requirements. Through the implementation of various controls, the new framework is intended to grant funds greater flexibility and certainty, while addressing concerns commonly associated with derivatives, such as over-speculation, volatility and asset sufficiency. The SEC’s new regulatory framework for funds’ use of derivatives is summarized below.
A. Rule 18f-4 under the 1940 Act
The Rule provides an exemption from the leverage limits provided by section 18 of the 1940 Act. Under the Rule, funds that invest in derivatives must comply with certain conditions. The Adopting Release requires the implementation of a derivatives risk management program (“Program”) reasonably designed to manage a fund’s derivatives risks and to segregate the functions associated with the Program from the portfolio management of the fund. Each Program must include the following components: (i) program administration; (ii) risk identification and assessment; (iii) stress testing and backtesting; (iv) internal reporting and escalation; and (v) periodic review. For funds whose derivatives exposure does not exceed 10% of net assets, the Rule provides a limited derivatives users exception from the condition to establish a Program; however, such funds are still required to adopt and implement policies and procedures reasonably designed to manage derivatives risks. A fund’s Program must be administered by a board-approved derivatives risk manager (“DRM”), and the DRM must provide regular written reports to the board of the fund(s) subject to the Program. Such reports must cover the Program’s implementation and effectiveness, stress testing results and any breaches of Program guidelines.
In addition to the Program requirements, the Rule imposes a limit on the amount of leverage-related risk that funds engaged in derivatives transactions may obtain based on value-at-risk (“VaR”). Funds may elect to use the relative VaR test or the absolute VaR test to perform its analysis.
- Under the relative VaR test, a fund’s VaR must not exceed 200% of the VaR of its designated reference portfolio, unless the fund is a closed-end fund that has outstanding shares of preferred stock, in which case the VaR must not exceed 250% of the VaR of the fund’s designated reference portfolio.
- Under the absolute VaR test, a fund’s VaR must not exceed 20% of the value of its net assets, unless the fund is a closed-end fund that has outstanding shares of preferred stock, in which case the VaR must not exceed 25% of the value of the fund’s net assets.
Additional details regarding the conditions of the Rule are provided in Section III below.
B. Amendments to Rule 6c-11; Rescission of Exemptive Orders
The SEC amended Rule 6c-11 under the 1940 Act to include leveraged/inverse ETFs within its scope, thereby negating the need for leveraged/inverse ETFs that comply with the Rule to seek separate exemptive relief in order to launch and operate (a requirement under the current regulatory regime). The SEC is rescinding exemptive orders previously issued to leveraged/inverse ETFs in connection with the amendments to Rule 6c-11 and the Rule.
In a key distinction from its initial proposal, the SEC did not adopt a proposed rule that would have banned the sale of leveraged/inverse ETFs to a retail investor, unless the selling broker-dealer or investment adviser (e.g., a private wealth manager) properly conducted sufficient due diligence to ascertain whether the retail investor had the financial knowledge and experience to evaluate the risks of buying and selling leveraged/inverse investment vehicles. The SEC explained that such rule was not necessary in light of broker-dealers’ and investment adviser’ general fiduciary duties and the obligations to their clients/customers imposed by Regulation Best Interest. For more on Regulation Best Interest, click here.
C. Rescission of Release 10666
The SEC is rescinding Release 10666, which provides guidance on how funds may engage in certain trading practices in light of the restrictions set forth in section 18 of the 1940 Act. No-action letters and staff guidance based on Release 10666 that are moot, superseded, or otherwise inconsistent with the Rule, will also be withdrawn.
D. Reporting Requirement Amendments
The SEC amended Forms N-PORT, N-LIQUID (renamed Form N-RN), and N-CEN to provide greater transparency with respect to funds’ use of derivatives and to allow for more effective regulatory oversight of funds’ reliance on, and compliance with, the Rule. In particular, these form amendments will require a fund to provide: (i) certain identifying information (e.g., identifying the provisions of the Rule that the fund is relying on to engage in derivatives transactions and the other transactions that the Rule addresses); (2) as applicable, information regarding the fund’s VaR, designated reference portfolio, and VaR backtesting results; (3) VaR test breaches (reported non-publicly); and (4) for a fund that is operating as a limited derivatives user, information about the fund’s derivatives exposure and the number of business days that its derivatives exposure exceeded 10% of net assets.
E. Effective Date
The Rule and related amendments will be effective 60 days after publication in the Federal Register. The SEC has provided an 18-month transition period after the effective date to allow for compliance with the Rule and related amendments.
Funds intending to rely on the exemption provided by the Rule must comply with various conditions that are designed to give investors protection from the risks associated with derivatives investments. Such conditions are discussed in detail below.
A. Derivatives Risk Management Program
The Rule requires the implementation of a Program designed to ensure that a fund’s derivatives investments are consistent with the fund’s investment objectives, policies, risk profile, and restrictions. The Program requirements are intended to complement a fund’s current risk management system, not replace it. The elements required to be included in a Program are discussed below.
1. Program Administration
A fund’s Program must be administered by a board-approved DRM. Contrary to the framework for liquidity risk management programs established under Rule 22e-4 under the 1940 Act, the administrator of a Program (i.e., the DRM) must be a natural person. Under the Rule, a fund’s DRM may be an officer, or officers, of the fund’s investment adviser. The Adopting Release notes that “investment advisers may have personnel who, although not designated as ‘officers’ in accordance with the adviser’s corporate bylaws, have a comparable degree of seniority and authority within the organization,” and that such personnel could be deemed an “officer” for purposes of selecting a DRM in accordance with the Rule. If the board selects a single individual to be the DRM, the position cannot be filled with the portfolio manager of the fund; however, if multiple individuals are selected to be the DRM, a majority of the DRM members may not be composed of the fund’s portfolio managers. The board’s consideration of a DRM candidate should take into account the candidate’s experience with respect to managing derivatives risk, among all other relevant factors.
The Adopting Release clarifies that a board’s Program oversight should be an “iterative” process; this does not require the board to engage in day-to-day management, but does require the board to have regular engagement with the Program to ensure proper oversight of the fund’s compliance with the Rule. The board is not required to approve the Program and, aside from its general oversight responsibilities, only engages with the Program through its selection of a DRM. It is the responsibility of the board to play an active role in engaging with the DRM, to stay abreast of matters involving material risks arising from the fund’s derivatives transactions, and to follow up on actions the fund has taken to address such risks.
In addition to Program administration, the DRM holds certain responsibilities that are analogous to those of the fund’s chief compliance officer, including regular board reporting. The DRM must provide the board an annual written report regarding the effectiveness of the Program, and must provide additional written reports at a frequency determined by the board. The annual report must include a representation from the DRM that the Program is reasonably designed to manage the fund’s derivatives risks and to incorporate the elements required by the Rule, as well as the basis for that representation.
2. Risk Identification and Assessment
The Program must be designed to identify and assess a fund’s derivatives risks, including “assessing how a fund’s derivatives may interact with the fund’s other investments or whether the fund’s derivatives have the effect of helping the fund manage risk.” This includes an examination of the degree to which a fund’s derivatives exposures are speculative or bona fide hedges. Types of derivatives risks that must be identified and assessed include leverage, market, counterparty, liquidity, operational and legal risks, as well as any other risks the DRM deems material.
3. Risk Guidelines
Each fund must create a Program that establishes, maintains, and enforces risk management guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to a fund’s derivatives risks. The goal of implementing these risk guidelines is to assist the fund in monitoring derivatives risks, and identifying variances in those risks.
The guidelines must include threshold figures that a fund does not normally expect to surpass and set out remedial measures to be taken in the event that the thresholds are approached or exceeded. In such cases, the guidelines would have to establish who would have to be notified, how they would have to be notified, and what the next steps to be taken are for remediation. Risk and compliance alerts should also be implemented to identify instances in which risk thresholds are approached or exceeded.
The Rule does not impose specific requirements on how risk thresholds should be calculated; however, such thresholds should allow for proper monitoring and management of derivatives risks.
4. Stress Testing and Backtesting
The Program must provide for stress testing of derivatives risks to determine the potential losses to a fund’s portfolio under stressed conditions, during extreme market fluctuations, or as a result of changes in market risk factors. Under the Rule, stress testing must take into account correlations of market risk factors and resulting payments to derivatives counterparties. Stress test variables may differ between funds depending on their actual and intended derivatives exposures, as well as their disclosed investment objectives, strategies and policies. This principles-based approach provides funds with flexibility in designing and implementing their respective stress tests. At a minimum, stress testing on a fund’s portfolio must be conducted weekly; however, the frequency of stress testing should ultimately be determined in light of a fund’s strategy and investments, as well as prevailing and anticipated market conditions.
In addition to performing stress tests, funds will be required to backtest the results of the Rule’s required VaR calculation (discussed further below). Funds should perform backtesting of stress tests to measure the effectiveness of their VaR models and to determine whether any adjustments to such models are necessary.
The Rule requires a fund to evaluate compliance with the applicable VaR test at a consistent time at least once each business day, either in the morning prior to market open or in the evening after market close. In particular, a fund will be required to: (i) compare its actual daily gain or loss with the VaR calculated for that day; and (ii) document instances where the fund’s losses exceed the corresponding VaR calculation. At a minimum, backtesting must be performed on a weekly basis; however, the DRM may determine that a higher frequency of testing is appropriate.
5. Internal Reporting and Escalation
The Program must establish an internal reporting system and an escalation process (tailored based on fund size, sophistication, and needs) that keeps portfolio managers and boards well-informed of circumstances regarding Program operations. This includes a DRM’s responsibility of informing, in a timely manner, the board of material risks regarding the fund’s derivatives transactions, stress testing results, and instances of non-compliance with the Program’s risk guidelines. The internal reporting and escalation condition is intended to bridge any communication gap between risk and portfolio management relating to Program operations. The Adopting Release notes that portfolio managers should have sufficient insight into a fund’s derivatives risk management so they may properly manage a fund’s individual derivative transactions and overall derivatives risk and exposures.
6. Periodic Review of the Program
The DRM must review the Program at least annually to evaluate the Program’s effectiveness and to reflect changes in risk over time. The review should assist the DRM in determining whether the Program should be revised and must include a review of the VaR calculation model and any designated reference portfolio to evaluate whether it remains appropriate (discussed further below).
B. Limit on Fund Leverage Risk
The Rule requires funds engaged in derivatives transactions to comply with a VaR-based limit on fund leverage risk. The limit should be based on a relative VaR test that compares the fund’s VaR to the VaR of a designated reference portfolio. According to the SEC, “[a] fund will satisfy the relative VaR test if its portfolio VaR does not exceed 200% of the VaR of its designated reference portfolio.” If, however, the fund is a closed-end fund with outstanding shares of preferred stock issued to investors, the VaR must not exceed 250% of the VaR of the fund’s designated reference portfolio.
The SEC adopted two ways in which a fund can establish its designated reference portfolio. The first option allows an actively-managed fund to use its own portfolio of securities, excluding any derivatives exposures, as its designated reference portfolio. The second option allows the fund to use an index (“designated index”). The designated index must be an unleveraged index that is approved and reviewed periodically by the DRM for purposes of the relative VaR test, and that reflects the markets or asset classes in which the fund invests., Generally, index-tracking funds are required to use the index it tracks as its designated reference portfolio. However, unless an index is widely recognized and used, the designated index may not be an index that is administered by an entity that is an affiliate of the fund, the fund’s investment adviser, or principal underwriter, nor may it be an index that was created at the request of the fund or its investment adviser. The Rule does not prohibit the use of a blended index for the designated index if it is more consistent with the fund’s investment program, and each index meets the requirements of the Rule. The DRM is responsible for providing the board a written report explaining its basis for approving the designated index. The fund must also disclose its designated index to the SEC on Form N-PORT.
If the DRM concludes a designated reference portfolio for a particular fund does not exist in light of the fund’s investments, objectives or strategy, the fund does not have to apply the relative VaR test; rather, it must comply with an absolute VaR test. The absolute VaR test is satisfied if the fund’s portfolio VaR does not exceed 20% of the value of the fund’s net assets, unless the fund is a closed-end fund that has outstanding preferred stock, in which case the VaR must not exceed 25% of the value of the fund’s net assets.
The VaR calculation model, whether for the relative or absolute VaR test, must take into account and incorporate all significant market risk factors “associated with a fund’s investments and provide parameters for the VaR calculation’s confidence level, time horizon, and historical market date.” In an effort to focus on more extreme, but less-frequent losses, the Rule requires VaR models to use a 99% confidence level and a time horizon of 20 trading days. In addition, VaR models must be based on at least three years of historical market data.
If a fund determines that it is not in compliance with the applicable VaR test, the fund must reduce its VaR promptly in a manner that is in the best interests of the fund and its shareholders (i.e., without engaging in deeply discounted transactions or “fire sales”). If the fund is not back in compliance within five business days: (i) the DRM must provide the board a written report and explain how and by when (i.e., the number of business days) the DRM expects the fund will be in compliance, and the DRM must update the board on the fund’s progress in coming back into compliance at regularly scheduled intervals determined by the board; (ii) the DRM must analyze the circumstances that caused the fund to be out of compliance and update Program elements to address those circumstances; and (iii) the DRM must provide the board with a written report within 30 calendar days of being out of compliance, explaining how the fund came back into compliance, the circumstances that caused the fund to be out of compliance, and any updates to Program elements.
A fund that is not in compliance within five business days after determining it is out of compliance, must report this information to the SEC on Form N-RN. If a fund is repeatedly out of compliance with its applicable VaR test for more than five business days, the SEC noted that it would expect the fund and its board to reconsider whether the fund’s Program is appropriately designed and operating effectively.
C. Exception for Limited Derivatives Users
To protect funds with limited derivatives exposure from incurring costs and burdens that are disproportionate to the intended benefits of the Rule, the SEC created an exception for limited derivatives users (the “Limited Use Exception”). A fund that limits its derivatives exposure to 10% of its net assets (“10% Limit”) is exempt from having to comply with Program requirements, including VaR-based limits and the Rule’s board oversight and reporting provisions. However, a fund that relies on the Limited Use Exception must adopt policies and procedures that are reasonably designed to manage risks associated with its derivatives transactions. Such policies and procedures should be tailored to the extent and nature of the fund’s derivatives use.
When calculating the 10% Limit to determine if the Limited Use Exception is available, a fund may exclude currency and interest rate risk hedging transactions. The SEC noted that “[t]he notional amounts of such derivatives may not exceed the value of the hedged instruments (or the par value thereof, in the case of fixed-income investments, or the principal amount, in the case of borrowings) by more than 10%.” However, funds must include equity, credit and commodity derivative hedging transactions when determining compliance with the 10% Limit.
If a fund exceeds its 10% Limit for five business days, the Rule provides two alternative paths for remediation. The investment adviser must inform the board in a written report that the adviser intends to promptly: (i) but within no more than 30 calendar days of the breach, reduce the fund’s derivatives exposure to be in compliance with the 10% Limit; or (ii) create a Program, and comply with the VaR-based limit as well as the related board oversight and reporting provisions as soon as reasonably practicable. The fund’s subsequent filing of Form N-PORT must specify the number of business days, in excess of the five business day remediation period, that the fund’s exposure exceeded the 10% Limit.
D. Alternative Requirements for Certain Leveraged/Inverse Funds
Under the Rule, a leveraged/inverse fund must use the index it tracks as its designated reference portfolio (“designated index”). In the Adopting Release, the SEC recognized that, for a leveraged/inverse fund that seeks, directly or indirectly, to provide investment returns that correspond to 200% of the performance or inverse performance of an index (“2X Funds”), there may be minor deviations between the VaR of the fund and 200% of the VaR of its designated index due to (i) financing costs embedded in the fund’s derivatives and (ii) valuation differences between the fund’s portfolio and designated index. The SEC explains that such deviations would be expected to cause the fund’s VaR to exceed 200% of the VaR of its designated index by a de minimis amount from time to time, and that it would not view such deviations as a breach of the relative VaR test in such circumstances because they do not reflect an increase in the fund’s leveraged or inverse market exposure. The SEC further explains that it would not view such deviations, alone, as giving rise to the remediation requirements in the Rule for funds that are not in compliance with their respective VaR tests, or the requirement for funds to file Form N-RN to report information about VaR test breaches to the SEC.
Leveraged/inverse funds are generally subject to all of the Rule’s provisions, with the exception that 2X Funds that satisfy certain conditions listed below do not need to comply with the 200% VaR-based limit requirements of the Rule and may continue operating at their current leverage levels. To qualify for this exception, a 2X Fund must, as of October 28, 2020: (i) be in operation; (ii) have outstanding shares issued in one or more public offerings to investors; and (iii) disclose 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. 2X Funds that rely on this exception may not change the underlying market index or increase the level of leveraged or inverse market exposure the fund seeks to provide. Existing 2X Funds must disclose in their prospectuses that they are not subject to the Rule’s condition limiting fund leverage risk. Reliance on this exception will not give rise to the remediation requirements in the Rule, or require the filing of Form N-RN for VaR test breaches.
E. Reverse Repurchase Agreements
Under the Rule, funds are permitted to enter into reverse repurchase agreements and similar financing transactions, subject to the full asset coverage requirements of section 18 of the 1940 Act. In addition, the Rule gives funds the option to treat reverse repurchase agreements or similar financing transactions as derivatives transactions, providing funds flexibility to choose the approach best suited to its investment strategy. As a result, a fund may choose to either: (i) limit its reverse repurchase and other similar financing transactions to the asset coverage limits of section 18 for senior securities representing indebtedness; or (ii) treat the transactions as derivatives transactions.
Each fund is required to document on its books and records which option it uses to manage its reverse repurchase agreements and similar transactions, as well as any decisions to switch between such elections and the corresponding time periods.
F. Unfunded Commitment Agreements
The Rule permits funds “to enter into unfunded commitment agreements if the fund reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to its unfunded commitment agreements, in each case as they come due.” In forming a reasonable belief, the SEC noted that a fund should consider its unique circumstances, including its strategy, asset liquidity and borrowing capacity. In addition, the Rule provides specific parameters for what a fund should consider or disregard in making its determination: (i) a fund must take into account its reasonable expectations with respect to other obligations; (ii) a fund must not consider the cash that might arise from a sale of an investment at a price that significantly varies from the market value of such investment; and (iii) a fund may not consider cash that could arise from the issuance of additional equity. A fund is obligated to reassess its “reasonable belief” of its asset sufficiency prior to entering into additional unfunded commitment agreements. Such commitments would not be included in or subject to the asset coverage requirements under sections 18 or 61 of the 1940 Act.
G. When-Issued and Forward-Settling Transactions
The Rule includes a provision that will permit a fund, as well as money market funds, to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, without having to deem such investments senior securities, if: (i) the fund intends to physically settle such transactions; and (ii) the transactions will settle within 35 days of their respective trade dates. This provision will allow money market funds to continue to be able to invest in when-issued U.S. Treasury securities, notwithstanding that these investments trade on a forward basis involving a temporary delay between the transaction’s trade date and settlement date.
The SEC is requiring funds to maintain certain records designed to provide the SEC the ability to evaluate funds’ compliance with the Rule.
- A fund is expected to document information regarding its Program, including policies and procedures designed to manage derivatives risks, stress testing and backtesting results, reports of material risks, and any periodic reviews of the Program.
- A fund must keep records of any materials provided to its board relating to DRM appointments, its Program and VaR non-compliance issues.
- For a fund with a VaR-based limit, records documenting the VaR of its portfolio, the VaR of its designated reference portfolio, the VaR ratio, and any updates to any of the VaR calculation models, must be maintained.
- A fund utilizing the limited derivatives user exception is required to maintain written records of its policies and procedures that are designed to manage derivatives risk. Records of written reports provided to the board in situations where the fund exceeds its 10% Limit must be maintained.
- A fund that enters into unfunded commitment agreements must have a record explaining the basis for the fund’s finding that a “reasonable belief” exists regarding asset sufficiency. A record must be made each time the fund enters into a new unfunded commitment agreement.
- A fund that enters into reverse repurchase agreements or similar financing transactions must have a written record stating whether the fund is treating such transactions under an asset coverage approach or a derivatives transactions approach.
All of a fund’s written policies and procedures that currently are in effect, or were in effect within the past five years, must be maintained in an easily accessible. All other records must be maintained for a period of five years, with the first two years in an easily accessible place.
 Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 34084 (Oct. 28, 2020) (“Adopting Release”).
 See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979), at n.5 (“Release 10666”).
 With the exception of bank borrowings, an open-end fund is prohibited from issuing or selling any senior security. Open-end funds must maintain 300% asset coverage with respect to its aggregate bank borrowings. A closed-end fund is prohibited from issuing or selling any senior security that represents an indebtedness, unless it maintains 300% asset coverage; however, if the closed-end fund issues or sells stock classified as senior securities (i.e., preferred stock), the asset coverage requirement is 200%, calculated immediately after such issuance or sale. “Asset coverage” generally refers to the ratio of a fund’s net assets relative to its debt exposure. See sections 18(f)(1) and 18(a) of the 1940 Act.
 BDCs are prohibited from issuing or selling any senior security that represents an indebtedness, unless it maintains 200% asset coverage (or 150% asset coverage under certain circumstances). See section 61(a) of the 1940 Act.
 Section 18(g) of the 1940 Act. “Evidence of indebtedness” includes all contractual obligations to pay in the future for consideration presently received (e.g., swaps, written options and futures contracts). See Release 10666 at 25131.
 See Adopting Release at 16.
 “Derivatives” include “(1) any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar 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) reverse repurchase agreements and similar financing transactions, for those funds that choose to treat these transactions as derivatives transactions under the rule.” See Rule 18f-4(a) under the 1940 Act.
 VaR is a measure of the risk of loss for investments over a given time horizon and at a specified confidence level.
 Notable withdrawn no-action letters and staff guidance include, among others: Dreyfus Strategic Investing & Dreyfus Strategic Income, SEC Staff No-Action Letter (June 22, 1987); Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996); Robertson Stephens Investment Trust, SEC Staff No-Action Letter (Aug. 24, 1995); and “Dear Chief Financial Officer” Letter, from Lawrence A. Friend, Chief Accountant, Division of Investment Management (pub. avail. Nov. 7, 1997).
 See Adopting Release at 56.
 Id. at 65.
 Id. at 67.
 Id. at 69-70.
 Id. at 74 (“While a fund must run stress tests on a weekly basis, the scope of stress testing may vary. Funds may, for example, conduct more-detailed scenario analyses on a less-frequent basis—such as the monthly frequency suggested by some commenters—while conducting more-focused weekly stress tests under rule 18f-4.”).
 See Adopting Release at 80. The internal reporting and escalation requirement is principles-based, providing funds with flexibility when structuring Program requirements.
 The standard for “timely” is not defined in the Adopting Release. Rather, the SEC noted that it believes that a fund’s DRM is best positioned to determine when it is appropriate to inform the fund’s portfolio management and board of material risks based on the fund’s size, sophistication and needs. See id. at 81-82.
 Id. at 81. The DRM has discretion to determine what material risks it escalates to the fund’s board and portfolio management.
 Id. at 154. The Rule does not apply to funds whose only derivatives exposure comes through investments in other funds or BDCs. However, if a fund enters into derivatives transactions indirectly through a foreign subsidiary, such transactions are treated as direct investments of the fund for purposes of this Rule.
 Id. at 97.
 Id. at 122.
 See id. at 115. An index would be leveraged if, for example, the derivatives included in the index multiply the returns of the index or index constituents.
 Rule 18f-4(a).
 Id. (providing an exception to prohibited indexes when a fund’s investment objective is to track the performance of an unleveraged index, the fund must use that index as its designated reference portfolio even if the index would otherwise be prohibited by the Rule).
 See Adopting Release at 146. (“The rule includes a non-exhaustive list of common market risk factors that a fund must account for in its VaR model, if applicable. These market risk factors are: (1) equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk; (2) material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (3) the sensitivity of the market value of the fund’s investments to changes in volatility.”).
 Id. at 161 (explaining that the coming back into compliance may take more than five business days if it is in the best interests of the fund and its shareholders).
 Id. at 164-165.
 Id. at 168-170 (defining derivatives exposure as: (1) the gross notional amounts of a fund’s derivatives transactions such as futures, swaps, and options; and (2) in the case of short sale borrowings, the value of any asset sold short); (“[T]he final rule permits funds to make two adjustments designed to address certain limitations associated with notional measures of market exposure … the first adjustment permits a fund to convert the notional amount of interest rate derivatives to 10-year bond equivalents, and the second adjustment permits a fund to delta adjust the notional amounts of options contracts.”).
 Id. at 177-178. (“In the case of currency hedges, the equity or fixed-income investments being hedged must be foreign-currency-denominated.”).
 Id. at 178.
 Id. at 206.
 See Adopting Release at 213.
 Id. at 248-251 (clarifying that securities lending transactions will not be considered “similar financing transactions” unless a fund were to invest the cash collateral in securities other than cash or cash equivalents).
 Id. at 245 (stating that a funds election, whether to apply the asset coverage limits or identify the transactions as derivatives, must subject all of its reverse repurchase agreements or similar transactions to the same election, it cannot elect to mix and match transaction types).
 See Rule 18f-4(e)(1).
 Rule 18f-4(e)(1) (stating that funds are required to document the basis for this reasonable belief).
 See Adopting Release at 261 (explaining that the VaR ratio is the value of the VaR of the fund’s portfolio divided by the VaR of the designated reference portfolio).
Marco E. AdelfioPartnerChair, Investment Management
Paul J. DelligattiPartnerDC Business Law Leader