The Securities and Exchange Commission (the “Commission”) today voted, by a three-to-one margin, to propose rules that would limit the amount of leverage that mutual funds may obtain through derivatives. The proposals also require funds and business development companies (BDCs) to manage the risks of investing in derivatives by clarifying requirements to segregate liquid assets to “cover” their potential exposure to derivatives. We will prepare a more detailed analysis shortly after the Commission publishes the text of the proposals.

The proposals would clarify how Section 18 of the Investment Company Act of 1940, as amended (the “1940 Act”) would apply to derivatives transactions with future payment obligations, such as forwards, futures, swaps, and written options, as well as “financial commitment” transactions, like reverse repurchase agreements. Section 18 generally prohibits funds from issuing “senior securities,” which can be thought of as transactions that create a preference in a bankruptcy proceeding. The proposals would allow funds to enter into derivatives transactions despite the Section 18 prohibitions, if they comply with certain conditions. These conditions would codify some existing Commission guidance, but would impose some significant new ones.