SEC Adopts New Rules on Investment Company Use of Derivatives
The U.S. Securities and Exchange Commission (the “SEC”) recently adopted new rules and rule and form amendments under the Investment Company Act of 1940 (the “1940 Act”) relating to, among other things, use of derivatives and certain other types of instruments by investment companies and business development companies (BDCs). The purposes of the new rules, as described in the Adopting Release, are to (a) address certain investor protection concerns and (b) provide an updated and more comprehensive approach to the use of derivatives and certain other transactions by investment companies and BDCs. The final rules and rule and form amendments represent the culmination of a process that started in 2015.
The SEC published proposed rules on November 25, 2019. A copy of our Client Alert discussing the 2019 Proposing Release may be found here. In it, we discuss the current treatment of derivatives, the 2015 proposed rules addressing investment company use of derivatives, as well as the proposed rules and rule amendments made in the Proposing Release. In short, if adopted as proposed, the Proposing Release would have permitted the following:
- Proposed 1940 Act Rule 18f-4 – Investments companies would have been permitted to enter into derivative transactions without violating Section 18’s prohibition on issuing senior securities subject to (a) adopting a derivatives risk management program (DRMP), (b) complying with a limit on the amount of leverage-related risk based on “value at risk” (VaR), (c) special conditions relating to reverse repurchase agreements and similar financing agreements, as well as unfunded commitments, (d) new requirements for investment company boards of directors, (e) new reporting and recordkeeping requirements, and (f) a limited derivatives-user exemption.
- Proposed Amendment to 1940 Act Rule 6c-11. Leveraged/inverse ETFs would have been subject to alternative fund leverage risk requirements, as well as been able to rely on Rule 6c-11 under the 1940 Act, the SEC rule permitting ETFs to operate subject to conditions, rather than seek exemptive relief. In addition, registered brokers and investment advisers would have been subject to new sales practices relating to leveraged/inverse ETF shares.
For the most part, the adopted rules are similar to the 2019 proposed rules, retaining the same general framework and derivatives-program requirements. The principal differences between the adopted rules and the 2019 proposed rules are: (a) certain changes in the tests used to measure a fund’s derivatives exposure; (b) the adopted rules do not include the proposed rules on sales practices relating to leveraged/inverse funds; and (c) leveraged/inverse funds will be subject to the same VaR-based limits on leverage risk as other types of funds.
Summary of Adopted Rules
Rule 18f-4 permits a fund to enter into “derivatives transactions,” notwithstanding the prohibitions and restrictions on the issuance of senior securities under Section 18 of the 1940 Act. The rule imposes four principal conditions, which are discussed below: (1) limitations on the fund’s leverage risk; (2) adoption of a derivatives risk management program (“DRMP”); (3) oversight by and reporting to the fund’s board of directors or trustees (the “Board”), which includes the appointment of a derivatives risk manager (a “DRM”); and (4) satisfaction of certain recordkeeping requirements, including updates to Forms N-PORT, N-LIQUID, and N-CEN. In addition, Rule 18f-4 includes an exemption from certain requirements that would otherwise apply to funds that are limited users of derivatives, as well as “grandfathering” requirements for certain leveraged/inverse funds.
Derivatives Permitted by Rule 18f-4
Rule 18f-4 would define a “derivatives transaction” to mean one of three types of instruments. First, it would include any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (“derivative 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. In the Adopting Release, the SEC stressed the importance that there be a requirement to make an additional payment or deliver assets, not simply an obligation that is triggered at the option of the fund, e.g., a standard exchange-traded option, Second, it includes short sale borrowing. As explained in the Adopting Release, a short sale of a security provides the same economic exposure as a derivative instrument, and thus, short-sale borrowings should be treated similarly. Third, it specifically addresses reverse repurchase agreements, and it reflects that under the adopted rule, a fund may elect to treat a reverse repurchase agreement as a derivative or it may subject the transaction to Section 18’s asset-coverage requirements. This third type of instrument was not included in the proposed rule. Finally, unlike the proposed rule, the adopted rule would exclude from the definition of a derivatives transaction when-issued or forward-settling securities, or securities with a non-standard settlement cycle, provided (a) the fund actually intends to settle the transaction physically rather than enter into an offsetting transaction, and (b) the transaction must settle within 35 days. Moreover, while money market funds, that is, investment funds that meet the conditions of Rule 2a-7 under the 1940 Act, generally may not rely on Rule 18f-4, they may rely on the delayed-securities settlement provisions.
Derivatives Risk Management Program
To rely on Rule 18f-4, a fund that uses derivatives is required to have a formal (written) derivatives risk management program (“DRMP”), which would include policies and procedures reasonably designed to manage the fund’s derivatives risks, as well as to reasonably segregate the functions associated with the DRMP from the portfolio management of the fund. To comply with Rule 18f-4, a DRMP also is required to have the following elements. These elements are substantially similar to those requirements included in the 2019 proposed rule:
- Risk Identification and Assessment. The DRMP must identify and assess a fund’s derivatives risks, considering the fund’s derivatives transactions and how they may interact with the fund’s other investments. Derivatives risk 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, the fund’s investment adviser) deems material.
- Risk Guidelines. The DRMP must to 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 related to a fund’s derivatives risks (“Guidelines”). Among other requirements, the Guidelines must specify levels of the given criteria, metric or threshold that a fund would not normally expect to exceed and the measures that would be taken if they were exceeded.
- Stress Testing. The DRMP must provide for stress testing of derivatives risks as a means of evaluating the potential for losses to a fund’s portfolio under stressed conditions. The stressed conditions that must be considered should be extreme, but plausible, conditions that could have a significant adverse effect on the fund’s portfolio. The stress tests also must consider correlations of market risk factors and resulting payments to derivatives counterparties. The frequency with which the stress testing is conducted must take into account the fund’s strategy and investments in current market conditions, provided that they are performed at least weekly.
- Backtesting. The DRMP must provide for backtesting – at least weekly - of the fund’s daily VaR calculation model, by comparing the fund’s gain or loss that occurred each day during the tested period with the corresponding VaR calculation.
- Internal Reporting and Escalation. The DRMP must identify the circumstances under which those persons responsible for portfolio management are informed of the operation of the DRMP. It also must specifiy when the “designated risk manager,” or DRM, who as discussed below is responsible for administering the DRMP, informs the fund’s board of the material risks of fund’s derivative use (discussed below), including the risks of the fund exceeding its Guidelines, as well as the results of the stress tests.
- DRMP Periodic Reviews. The DRM is required to review the DRMP at least annually to evaluate the DRMP’s effectiveness and to reflect changes in risk over time. This periodic review must also review the VaR calculation model and evaluate the continued appropriateness of the “designated reference portfolio” (discussed below).
Derivatives Risk Manager
Rule 18f-4 requires each fund to designate one or more officers of its investment adviser or, if applicable, sub-adviser, to serve as the fund’s derivatives risk manager (“DRM”). If more than one person is designated, the designees could act as a committee. A portfolio manager may not be designated as the sole DRM. Each designated person would have to be approved by the fund’s board, but the investment adviser or sub-adviser may submit a candidate for the board to consider. The DRM must have direct communication with the fund’s board.
Board Oversight and Reporting
The DRM must provide a written report to the fund’s board on the DRMP’s implementation and effectiveness. The report to the fund’s board must describe any instances when a fund exceeded its Guidelines and the results of its stress testing. It also must contain an analysis by the DRM with information reasonably necessary for the fund’s board to evaluate the fund’s responses to any instances when it exceeded its Guidelines and/or stress-testing results. These reports must be provided periodically, as determined by the fund’s board. The Adopting Release also notes that under Rule 38a-1 under the 1940 Act, a fund’s board will be required to oversee compliance with Rule 18f-4.
Limitations on Fund Leverage Risk
Rule 18f-4 requires that a fund comply with a value at risk (“VaR”) based limit on fund leverage when engaging in derivatives transactions, except for funds that are deemed to be limited derivatives users. VaR is an estimate of a portfolio’s potential losses over a given time horizon and at a specified confidence level. For example, if a fund’s VaR calculated at a 99 percent confidence level was $100, then that means that the fund’s VaR model estimates that 99 percent of the time, the fund would not be expected to lose more than $100 and 1 percent of the time the fund would be expected to lose more than $100. While Rule 18f-4 as a default requires a fund to comply with a “relative VaR test”, there is an alternative to comply with an “absolute VaR test” under certain conditions. Each is discussed in more detail below.
Relative VaR Test. The relative VaR test requires a fund to calculate the VaR of its portfolio and compare it to the VaR of a “designated reference portfolio.” In determining what its designated reference portfolio is, a fund can either use: (i) an index that meets certain requirements (a “designated index”) or (ii) its own portfolio of securities and other investments, excluding any derivatives transactions (the fund’s “securities portfolio”). The designated reference portfolio is designed to create a baseline VaR that functions as the VaR of a fund’s unleveraged portfolio and, the relative VaR test is designed to identify the effects of any leveraging. Under Rule 18f-4, a fund would satisfy the relative VaR test if its portfolio VaR does not exceed 200% of its designated reference portfolio’s VaR (250% for closed-end funds that have issued and outstanding senior securities that is a stock).
Designated Index. A fund’s designated index must be an unleveraged index approved by the DRM for purposes of the relative VaR test, and it must reflect the markets or asset classes in which the fund invests. The designated index may not 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 such index is widely recognized and used. Rule 18f-4 does provide flexibility for an actively managed fund to use a blended index (including one blended by the fund’s investment adviser) as its designated index, so long as each constituent index meets the rule’s requirements. If a fund is passively managed and its investment objective is to track the performance (including a leverage multiple or inverse multiple) of an unleveraged index, then that fund must use that index as its designated reference portfolio, even if the index otherwise would be prohibited under Rule 18f-4.
Securities Portfolio. Under Rule 18f-4, an actively managed fund may use its securities portfolio as the designated reference portfolio for the relative VaR test. The fund’s securities portfolio includes all securities and other investments but excludes any derivatives transactions. The DRM would have to approve use of the securities portfolio as the designated reference portfolio for purposes of the relative VaR test and it must reflect the markets or asset classes in which the fund invests.
Absolute VaR Test. If a DRM 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, objectives and strategy, then the fund will have to comply with an absolute VaR test. In order to comply with the absolute VaR test, the VaR of a fund’s portfolio must not exceed 20 percent of the fund’s net assets (25 percent for closed-end funds that have issued and outstanding senior securities that is a stock).
Choice of Model and Parameters for Purposes of the VaR Test. Rule 18f-4 requires that the VaR model used by a fund for purposes of either the relative or absolute VaR test must take into account and incorporate all significant, identifiable market risk factors associated with that fund’s investments. A non-exhaustive list of the risk factors that a fund must take into account if applicable are:
- Equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk;
- Material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and
- The sensitivity of the market value of the fund’s investments to changes in volatility.
In choosing what VaR model to use, a fund must take into account its strategy, investments and other factors to determine which is best suited. The VaR model must also be based on a 99 percent confidence level and a time horizon of 20 trading days and be based on at least three years of historical market data. A fund is not required to apply its VaR calculations consistently (i.e., the same VaR model applied in the same way) when calculating (1) the VaR of its portfolio and (2) the VaR of its designated reference portfolio. However, any VaR calculations must comply with Rule 18f-4’s definition of VaR and its specified model requirements.
Implementation of the VaR Test. A fund would be required to ensure it was in compliance with its applicable VaR test at least once each business day. If it was determined that a fund was not in compliance with its applicable VaR test, then it would be required to come back into compliance promptly, in a manner that is in the best interests of the fund and its shareholders. If the fund was not back in compliance within five business days, then:
- The DRM must provide a written report to the board and explain how and by when the DRM reasonably expects the fund will come back into compliance;
- The DRM must analyze the circumstances that caused the fund to be out of compliance for more than five business days and update any elements of the DRMP as appropriate to address those circumstances; and
- The DRM must provide a written report within thirty calendar days of the exceedance to the fund’s board explaining how the fund came back into compliance and the results of the DRM’s analysis of the circumstances that caused the fund to be out of compliance for more than five business days and any updates to the DRMP.
If a fund would still be out of compliance thirty calendar days after the initial breach, then the DRM’s written report must be updated to explain how and by when he or she reasonably expects the fund will come back into compliance, and the DRM must update the fund’s board on the fund’s progress in coming back into compliance at regularly scheduled intervals at a frequency determined by the board.
Exception for Limited Users of Derivatives.
Limited users of derivatives would be exempt from the DRMP requirement, the VaR-based limit on fund leverage risk and the related board oversight and reporting provisions. A “limited user of derivatives” is defined as a fund that limits its derivatives exposure to 10 percent of its net assets. In calculating its derivatives exposure, a fund may exclude from the 10 percent threshold any derivatives transactions used to hedge certain currency and/or interest rate risks and positions closed out with the same counterparty. A limited user of derivatives would, however, still be required to adopt and implement policies and procedures reasonably designed to manage its derivatives risks. In designing their policies and procedures, a limited user of derivatives should tailor its program to the extent and nature of its derivatives use.
Specific Observations Related to the Calculation of Derivatives Exposure. Since Rule 18f-4 permits a fund to treat reverse repurchase agreements or similar financing transactions as derivatives under certain circumstances, a fund that determines to treat those transactions as derivatives transactions must include in its derivatives exposure calculation the proceeds that the fund received but has not yet repaid or returned, or for which the associated liability has not been closed out.
In addition, Rule 18f-4 allows funds to make two adjustments designed to address certain limitations associated with notional measures of market exposure. A fund is permitted to convert the notional amount of interest rate derivatives to 10-year bond equivalents. A fund also is permitted to delta adjust the notional amounts of options contracts.
In calculating its derivatives exposure, a fund may exclude any closed-out positions, so long as they are closed out with the same counterparty and result in no credit or market exposure for the fund. Rule 18f-4 also permits a fund to exclude currency and interest rate hedges from the 10 percent derivatives exposure threshold if those hedges are directly matched to particular investments held by the fund, or the principal amount of borrowings by the fund. Specifically, a fund may exclude currency and interest rate derivatives used to hedge the respective currency and interest rate risks associated with specific equity or fixed-income investments held by the fund or borrowings by the fund. With respect to currency hedges, the equity or fixed-income investments being hedged must be denominated in a foreign currency. The notional amounts of these 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 percent.
Exceeding 10-Percent Derivatives Exposure Threshold. If a limited user of derivatives exceeds the 10 percent derivatives exposure threshold, Rule 18f-4 includes two alternatives for remediation. If the fund’s exposure exceeds 10 percent for five business days, the fund’s investment adviser must provide a written report to the fund’s board informing it whether the investment adviser intends either to:
- Promptly, but within no more than thirty calendar days of the exceedance, reduce the fund’s derivatives exposure to be in compliance with the 10 percent threshold (“temporary exceedance”); or
- Establish a DRMP, comply with the VaR-based limit on fund leverage risk and comply with the related board oversight and reporting requirements as soon as reasonably practicable.
In either case, the fund’s next Form N-PORT filing must specify the number of business days, in excess of the five-business-day period that Rule 18f-4 provides for remediation, that the fund’s derivatives exposure exceeded 10 percent of its net assets during the applicable reporting period.
Although the initial five-business-day remediation period and the temporary exceedance remedy provides flexibility for a limited user of derivatives to come back into compliance with the 10 percent derivatives exposure threshold, if the fund exceeds the 10 percent threshold repeatedly, and particularly if those exceedances occurred over a long period of time and did not just correlate to extreme market events that may cause rapid and significant changes in a fund’s net asset value, the fund would not appear to be a limited user of derivatives. Therefore, the policies and procedures of a limited user of derivatives need to be reasonably designed to address compliance with the 10 percent threshold and support the fund’s reliance on the exclusion.
Leveraged and Inverse Funds
In connection with the adoption of Rule 18f-4, the SEC revised Rule 6c-11 (the “ETF Rule”) to allow leveraged/inverse ETFs that satisfy the requirements of Rule 18f-4 to operate without obtaining an exemption order from the SEC. Rule 6c-11 provides exemptions from certain sections of the 1940 Act to permit the operation of ETFs that satisfy certain conditions. Rule 6c-11, as adopted in 2019, excludes leveraged/inverse ETFs, meaning that leveraged/inverse ETFs currently must rely on SEC exemptive orders. The effect of the amendment to Rule 6c-11 to remove the exclusion of leveraged/inverse ETFs is to permit the operation of ETFs with leverage exposure of 200 percent without an exemptive order, in reliance on Rule 18f-4. The SEC will rescind the existing exemptive orders issued to leveraged/inverse ETFs, effective 18 months after Rule 18f-4’s effective date.
The leveraged/inverse ETFs that rely on 6c-11 will be subject to the requirements of Rule 18f-4, including the VaR-based limit on leverage risk. This will effectively limit leveraged/inverse funds’ targeted daily return to 200 percent of the return (or inverse of the return) of the fund’s underlying index. Leveraged/inverse funds in operation as of October 28, 2020 that seek an investment return above 200 percent of the return (or inverse of the return) of the fund’s underlying index can continue to operate without satisfying the VaR-based limits. However, a grandfathered fund will not be permitted to change its reference index or increase or decrease the leveraged or inverse level of market exposure that it seeks to provide. Such funds will also be required to disclose in their prospectuses that they are not subject to Rule 18f-4’s limit on leverage risk.
Under proposed Rule 18f-4, any “leveraged/inverse investment vehicle” that meets certain conditions would not have to comply with the VaR-based limits on leverage risk. In conjunction with the proposed alternative regulation of leveraged/inverse funds, the SEC proposed new rules governing sales practices by broker-dealers and investment advisers that accept orders from retail investors to buy or sell shares of leveraged/inverse funds. In response to industry comments, Rule 18f-4, as adopted, does not include this alternative treatment of leveraged/inverse funds and the proposed sales practices rules ultimately were not adopted. In lieu of these rules, the SEC has directed its staff to review the effectiveness of the existing regulatory requirements in protecting investors who invest in leveraged/inverse products and other complex investment products. While the SEC recognized that the enhanced standard of conduct for broker-dealers under Regulation Best Interest and the fiduciary obligations of registered investment advisers will apply in the context of transactions with respect to leveraged/inverse investment vehicles, the SEC notes that these requirements do not address all of the investor protection issues raised in connection with complex investment products.
In connection with this review, the Chairman of the SEC, along with the Directors of the Division of Investment Management, Division of Corporation Finance and the Division of Trading and Markets, published in conjunction with the adoption of Rule 18f-4 a Joint Statement Regarding Complex Financial Products and Retail Investors. This Joint Statement solicits comments on issues presented by complex financial products for retail investors. The Joint Statement indicates that based on the staff’s review, it will make recommendations with respect to the regulation of these products.
Fund Reporting Requirements
In connection with the adoption of Rule 18f-4, the SEC is amending the requirements of Forms N-PORT, N-LIQUID and N-CEN.
The following sets forth new information that will be required to be reported on a fund’s Form N-PORT:
VaR Information. Funds that comply with the VaR-based limit on leverage risk will report (1) their median daily VaR or median VaR ratio, as applicable, for the reporting period, and (2) for funds subject to the relative VaR test during the reporting period, the name of the fund’s designated index and its index identifier.
Derivatives Exposure. A fund that relies on the limited derivatives user exception will report (1) its derivatives exposure; (2) its exposure from currency derivatives that hedge currency risks; (3) its exposure from interest rate derivatives that hedge interest rate risks; and (4) the number of business days, if any, in excess of the five-business-day remediation period that the fund’s derivatives exposure exceeded 10 percent of its net assets during the reporting period.
Backtesting Results. A fund complying with the VaR-based limit on leverage risk will report the number of exceptions it identified during the reporting period arising from backtesting the fund’s VaR calculation model. Only the required information with respect to a fund’s designated reference portfolio will be made public; all other information will be non-public.
Form N-LIQUID is to be re-named Form N-RN and is being amended to include new reporting events for funds that are subject to the VaR-based limit on fund leverage risk. If a fund’s portfolio violates the applicable VaR test for five business days, the fund will be required to file with the SEC a Form N-RN within one business day. The fund must report the dates on which the fund’s portfolio violated the applicable VaR test and the VaR of the portfolio for each pf those days. Funds that are subject to the absolute VaR test must also report the value of the fund’s net assets for each of these days, while fund’s that are subject to the relative VaR test must also report the VaR of its designated reference portfolio for each of the reporting days and the name of the fund’s designated index and its index identifier. Reports on Form N-RN will not be available to the public.
Form N-CEN is being amended to require funds to “check a box” to identify whether they rely on Rule 18f-4. Funds also are required to identify whether they rely on any of the exceptions from the various requirements of Rule 18f-4 and whether they have entered into any of the transactions covered by Rule 18f-4. This information reported on Form N-CEN will be available to the public.
Reverse Repurchase Agreements
Rule 18f-4 permits funds to enter into reverse repurchase agreements or similar financing transactions so long as they meet the relevant asset coverage requirements of Section 18 of the 1940 Act. For purposes of calculating compliance with Section 18’s asset coverage ratios, funds would be required to combine the aggregate amount of indebtedness associated with reverse repurchase agreements and other similar financing transactions with bank borrowings and other senior securities representing indebtedness. Under this approach, reverse repurchase agreements and similar financing transactions would not be treated as derivative transactions for purposes of Rule 18f-4.
Rule 18f-4 also allows funds to treat reverse repurchase agreements or similar financing transactions as derivatives transactions if they choose to do so and comply with the other requirements of Rule 18f-4. In that case, such transactions would not be included in a fund’s asset coverage calculations. The SEC stated that this alternative is “designed to provide a fund flexibility to choose the approach that is best suited to its investment strategy or operational needs, while still addressing [S]ection 18’s asset sufficiency and leverage concerns.” A fund’s election will apply to all of its reverse repurchase agreements and similar financing transactions. A fund can also change its election, but it must maintain a record of its election and any changes.
Unfunded Commitment Agreements
Rule 18f-4 allows funds to enter into unfunded commitment agreements to make certain loans or investments 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 its unfunded commitment agreements. Because these agreements do not generally involve leverage, Rule 18f-4 does not treat them as derivative transactions. Rule 18f-4 provides factors to be considered in assessing the sufficiency of a fund’s cash and cash equivalents to meet its obligations under any unfunded commitment agreements.
Effective and Compliance Dates
The Effective and Compliance Dates have not yet been established. The Effective Date will be 60 days after the Adopting Release’s publication in the Federal Register, and the Compliance Date will be 18 months after the Effective Date.
For Additional Information
This memorandum was prepared by John Hunt (617.338.2961; firstname.lastname@example.org), Eric Simanek (202.775.1232; email@example.com), and Rachael Schwartz (212.660.3069; firstname.lastname@example.org). If you have any questions or would like to discuss these proposals, please contact any of the above Sullivan lawyers, or any other Sullivan lawyer with whom you regularly work.
The information in this document is made available only for general informational purposes. It is not intended to constitute specific legal advice or to be a substitute for advice from qualified counsel.
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 “Use of Derivatives by Registered Investment Companies and Business Development Companies,” Release No. IC-34078 (October 28, 2020) [hereinafter, the “Adopting Release”].
 “Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles,” Release No. IC-33704 (November 25, 2019) [hereinafter, the “Proposing Release”].
 “Use of Derivatives by Registered Investment Companies and Business Development Companies,” Release No. IC-31933 (December 11, 2015).
 Section 18 generally prohibits investments companies from issuing “senior securities,” except in limited circumstances, and it defines a senior security to include an “obligation or instrument constituting a security and evidencing indebtedness.” In the Adopting Release, the SEC stated that it still considers certain transactions (e.g., reverse repurchase agreements and unfunded commitments, as well as short sales) to create evidence of indebtedness, and thus, constitute a senior security for purposes of Section 18.
 The Adopting Release notes that “derivatives exposure” means the sum of: (1) the gross notional amounts of the fund’s derivatives instruments such as futures, swaps and options; and (2) in the case of short sale borrowings, the value of any asset sold short.
 Delta refers to the ratio of change in the value of an option to the change in value of the asset into which the option is convertible. A fund would delta adjust an option by multiplying the option’s unadjusted notional amount by the option’s delta.
 Rule 18f-4 defines “leveraged/inverse fund” as “a fund 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.”
 Currently, only two ETF sponsors currently rely on exemptive relief permitting them to operate leveraged/inverse ETFs. The SEC currently has in place a moratorium on considering new applications for the exemptions necessary to operate leveraged/inverse ETFs.
 Rule 18f-4 defines an “unfunded commitment agreement” as “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.”