/>iIf adopted, the proposed requirements would significantly alter funds’ ability to enter into derivatives and other financial transactions, present new operational challenges, expand reporting requirements, and impose new and enhanced oversight responsibilities on funds’ boards of directors.
On December 11, the US Securities and Exchange Commission (SEC) voted three-to-one in favor of proposing a new rule—Rule 18f-4 under the Investment Company Act of 1940 (1940 Act)—that would significantly change the way the SEC regulates the use of derivatives and other financial transactions by registered investment companies (i.e., mutual funds, exchange-traded funds, and closed-end funds) and business development companies.[1]
This is the third significant proposed rulemaking for the registered fund industry this year[2]—as first outlined by SEC Chair Mary Jo White in December 2014—which together represent a significant departure from the SEC’s traditional approach to the regulation of not just derivatives, but funds generally.[3] This proposal comes more than four years after the SEC issued a Concept Release on funds’ investments in derivative instruments, and would effectively replace a patchwork of SEC Staff positions that has evolved over the last 35-plus years with a comprehensive approach of proactive oversight that is intended (among other things) to limit funds’ economic exposures that result from derivatives investments and other financial transactions.[4]
In support of its proposal, the SEC cited the need to protect investors and a concern for potential losses in funds that make extensive use of derivatives, as well as the desire to implement a more comprehensive approach to the regulation of funds’ use of derivative transactions. Comments on the proposal will be due sometime in March 2016—90 days after the proposal is published in the Federal Register.
Under the proposal, “derivatives transactions” would be broadly defined to include swaps, security-based swaps, futures contracts, forward contracts, and options, as well as any combination of those instruments and any similar instrument under which a fund is or may be required to make any payment or delivery of cash or other assets. In addition, the proposal would regulate funds’ “financial commitment transactions,” which would include reverse repurchase agreements, short sales, and any firm or standby commitment agreements or similar agreements (including promises to make a loan or capital commitments).
The proposal would regulate fund investments in derivatives in three ways: (i) by imposing certain portfolio limitations on leverage, which would act to limit the exposure a fund may obtain through derivatives, (ii) by requiring assets to be segregated and significantly limiting the types of assets that can be used for segregation, and (iii) by requiring certain funds to adopt a formal derivatives risk management program. Funds would also face new recordkeeping and reporting requirements.
Portfolio Limitations for Derivative Transactions
As proposed, funds would be required to comply with one of two alternative portfolio limitation tests that would limit the amount of leverage a fund can obtain through derivative transactions. A fund’s board of directors would have to approve the portfolio limitation test the fund would use. Compliance requirements and board oversight would be based on the test selected by the fund.
Exposure-Based Portfolio Limitation Test
The first test would be an exposure-based portfolio limitation, under which a fund would be required to limit its aggregate exposure to derivatives to 150% of its net assets, calculated immediately after entering into any senior securities transaction. Under this test, a fund’s exposure to derivatives would be calculated as the sum of (i) the aggregate notional amount of its derivative transactions (after netting any directly offsetting positions with the same type of instrument and same underlying reference assets, maturity, and other material terms),[5] (ii) the aggregate amount of cash or other assets that the fund is obligated to pay or deliver under its financial commitment transactions, and (iii) the aggregate indebtedness with respect to any senior securities transactions entered into by the fund pursuant to Section 18 of the 1940 Act (including involuntary liquidation preferences in the case of closed-end funds and business development companies).
Risk-Based Portfolio Limitation Test
The second test would be a risk-based portfolio limitation, under which a fund would be permitted to obtain derivatives exposure up to 300% of its net assets, provided that the fund satisfies a risk-based test that would be calculated using a value-at-risk (VaR) methodology. This second test would also be calculated immediately after entering into any senior securities transaction. VaR is a risk metric that would be defined under the proposed rule as an estimate of potential losses (of either a particular instrument or an entire portfolio) over a specified time horizon and at a given confidence interval, expressed in US dollars.
This test would be an alternative to the exposure-based test and would permit a fund to obtain exposure in excess of the limitations set forth in the exposure-based test, provided the fund complies with the VaR-based limitations. The SEC recognized that it may be appropriate for a fund to be able to obtain exposure in excess of what would be permitted under the exposure-based portfolio limitations if the fund’s derivatives transactions have the effect of reducing the fund’s exposure to market risk. VaR models will vary from fund to fund, but must incorporate all identifiable market risks, including equity price risk, interest rate risk, credit spread risk, foreign currency risk, and commodity price risk. VaR models also need to address sensitivity to changes in volatility and non-linear price characteristics. To satisfy the VaR test, a fund’s full portfolio VaR (i.e., the VaR of the fund’s entire portfolio, including securities, derivatives transactions, and other transactions) would have to be less than the fund’s securities VaR (i.e., the VaR of the fund’s securities and other investments, excluding any derivatives transactions) immediately after the fund enters into any senior security transaction.
Asset Segregation for Derivatives Transactions
The proposed rule would also require a fund to manage the risks associated with its derivatives transactions by, among other things, segregating assets to ensure that the fund has sufficient assets to meet its obligations under those transactions. Funds would be required to implement board-approved policies and procedures through which they would maintain a required amount of qualifying coverage assets. The amount of qualifying coverage assets would be determined by a two-part test. The first amount would be a “marked-to-market coverage amount,” equal to the amount that would be payable by the fund if it were to exit the derivatives transaction as of the time of determination. The second amount would be a “risk-based coverage amount,” equal to a reasonable estimate of the potential amount payable by the fund if it were to exit under stressed conditions. This risk-based coverage amount, if applicable, would be in addition to the marked-to-market amount, and not an alternative.
“Qualifying coverage assets” generally would be limited to cash and cash equivalents, with certain exceptions. For derivative transactions and financial commitment transactions under which a fund is required to deliver a particular asset, then that particular asset would be a qualifying coverage asset for that position. Funds would need to identify qualifying coverage assets on their books and records at least once each business day, and the timing of the marked-to-market and risk-based amounts would be required to be consistent with one another so as to provide the fund with a reasonably current estimate of the potential amounts payable.
Derivatives Risk Management Program
In most cases, a fund would also be required to adopt and implement a written derivatives risk management program that is reasonably designed to assess and manage the risks associated with its derivatives transactions.
The written risk management program would be required to
(i) assess the risks associated with the fund’s investments (including an evaluation of the potential leverage, market, counterparty, liquidity, and operational risks);
(ii) manage associated risks by monitoring whether investments are consistent with the fund’s investment guidelines, disclosures to investors, and communications with the fund’s portfolio managers and board of directors;
(iii) be segregated from the portfolio management of the fund; and
(iv) be reviewed and updated at least once annually, including updating models or risk measurement tools used as part of the program (such as VaR models).
A fund’s board of directors (including a majority of the independent directors) would be required to initially approve the written risk management program and to approve any material changes to the program. The fund would be required to designate an employee or officer of the fund (or the fund’s adviser) as a “derivatives risk manager” who would be responsible for administering the policies and procedures set forth in the written derivatives risk management program. The derivatives risk manager would not be permitted to be a portfolio manager and would have to be approved by the board of directors (including a majority of the independent directors). The board would also be required to review, at least quarterly, a written report prepared by the derivatives risk manager that assesses the adequacy and effectiveness of the fund’s program.
A fund that has aggregate exposure to derivatives transactions of less than 50% of the value of the fund’s net assets and that does not use complex derivatives transactions would not be required to adopt a written risk management program. As proposed, a “complex derivative transaction” would be any instrument where the amount payable (i) depends on the value of an underlying reference asset at multiple points in time, or (ii) is a non-linear function of the value of the underlying reference asset.[6]
Financial Commitment Transactions
As noted above, the proposal would also regulate funds’ “financial commitment transactions,” which would include reverse repurchase agreements, short sales, and any firm or standby commitment agreements or similar agreements (including promises to make a loan or capital commitments). Funds that enter into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund would be obligated to pay or deliver under those transactions. These coverage assets would have to be identified on the books of the fund at least once each business day. A fund’s board (including a majority of its independent directors) would also have to approve policies and procedures reasonably designed to comply with these coverage requirements.
Recordkeeping, Disclosure, and Reporting
Funds would be required to maintain numerous records under the proposed rule, including a written record of certain determinations made by the board, copies of the policies and procedures, materials provided to the board in connection with the approval of the written derivatives risk management program, records documenting periodic reviews of the program, and portfolio records evidencing compliance with applicable portfolio limitations and coverage requirements, including records that must be created on a per-transaction basis.
In conjunction with proposed Rule 18f-4, the SEC also proposed amendments to two reporting forms that were first proposed in May 2015. First, Form N-PORT (which was proposed in May to be a monthly filing of portfolio-wide and position-level data and would replace current Form N-Q) would now also require funds to disclose, on a monthly basis, certain risk metrics about their use of certain derivatives. Second, Form N-CEN (which was proposed in May to be an annual filing that would replace Form N-SAR) would now also require disclosure of whether a fund relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund (i.e., exposure-based or risk-based). This requirement is designed to prevent funds from selectively changing between the portfolio limitations as one becomes preferable to the other.
Comments on the Proposal and Effect on Existing Guidance
Comments on the proposed reforms are due 90 days after the Proposing Release is published in the Federal Register. This publication process typically takes less than two weeks, so we expect comments will be due during the second half of March 2016.
The SEC noted that if proposed Rule 18f-4 is adopted, then the SEC would rescind its release on Securities Trading Practices of Registered Investment Companies from April 1979,[7] as well as the SEC Staff’s no-action letters addressing derivatives and financial commitment transactions. If the proposed reforms are adopted, then funds would only be permitted to enter into derivatives transactions and financial commitment transactions to the extent permitted by Rule 18f-4, or Section 18 or 61 of the 1940 Act.
The SEC noted that until the proposed changes are adopted, its current guidance, including all related no-action letters, will remain in place. A fund would be able to rely on the proposed rule after its effective date as soon as the fund can comply with the rule’s conditions. The SEC also noted that it would expect to provide a transition period during which funds would move from the current regulatory framework to the effective rule. The SEC has requested comment on whether a transition period would be appropriate and, if so, how long such a period should be.
Upcoming Information
These proposed changes would substantially affect how registered investment companies and business development companies use derivatives and other financial transactions, particularly those funds that rely on such instruments as a primary component of their investment strategies. Financial entities that provide derivatives and other financial transactions to the marketplace likely will be indirectly affected by these changes as well. Fund compliance professionals and boards of directors would also face new challenges as a result of the reforms.
[1] See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Rel. No. 31,933 (Dec. 11, 2015) (hereinafter, Proposing Release). The proposal relies significantly on a white paper from the SEC’s Division of Economic and Risk Analysis titled “Use of Derivatives by Registered Investment Companies,” which was released in tandem. A draft copy of Rule 18f-4 is based on the text set forth in the Proposing Release.
[2] See Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Rel. No. 31,835 (Sep. 22, 2015); See also Investment Company Reporting Modernization, Investment Company Act Rel. No. 31,610 (May 20, 2015);
[3] See Speech by SEC Chair Mary Jo White, Enhancing Risk Monitoring and Regulatory Safeguards for the Asset Management Industry (Dec. 11, 2014).
[4] See Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Rel. No. 29,776 (Aug. 31, 2011).
[5] The SEC noted in the Proposing Release that a fund would be able to net directly offsetting derivatives transactions even if those transactions are entered into with different counterparties and without regard to whether those transactions are subject to a netting agreement. See Proposing Release, supra note 1 at n. 374.
[6] In the Proposing Release, the SEC notes that a variance swap would be an example of a complex derivative transaction where the amount payable is a non-linear function based on the value of the underlying reference asset. In a variance swap, investors profit from the current implied volatility and future realized volatility of an asset, but payments based on variance are the square of volatility.
[7] See Investment Company Act Rel. No. 10,666 (Apr. 18, 1979).
