United States: Special Update On Proposed Derivatives Rules For Registered Funds And BDCs

At an open meeting on December 11, 2015, the Securities and Exchange Commission ("SEC") proposed a new "exemptive" rule, Rule 18f-4, which addresses investment company use of derivatives and other leveraging arrangements. It would require most funds that use derivatives to implement a derivative risk management program (including appointing a derivatives management officer). The proposed rule applies to mutual funds, ETFs, closed-end funds and BDCs.

The rule is intended to modernize and harmonize funds' treatment of derivatives under Section 18 of the Investment Company Act of 1940, as amended (the "1940 Act"), by updating and modifying previous guidance issued in 1979 in Investment Company Act Release 10666 and more than 30 no-action letters in which SEC staff permitted fund practices involving specific types of derivatives.1

According to the SEC, Section 18, which restricts funds' capital structures, was designed to address abuses that existed before the enactment of the 1940 Act: excessive borrowing and levered securities issuances. The SEC views a fund's obligation to pay money or deliver assets to a counterparty as implicating Section 18. Proposed Rule 18f-4 would clarify that the limitations of Section 18 apply to most derivatives (forwards, futures, swaps and written options) and financial commitments (reverse repurchase agreements, short sale borrowings, firm or standby commitments, and other similar agreements) and would provide that funds could enter into derivative transactions only if their portfolios satisfy certain conditions, including a portfolio-level limit on derivative investments and asset segregation requirements developed from the Release 10666 model.

Asset Segregation

Following the model described in Release 10666, most funds that use derivatives or financial commitment transactions in their portfolios would be required to abide by asset segregation requirements. A fund that uses derivatives would have to segregate by maintaining "qualifying coverage assets" (identified on the books and records of the fund at least once daily) in an amount equal to the sum of:

The Market Coverage Amount: The amount the fund would pay if the fund exited the derivative transaction; and
The Risk-Based Coverage Amount: A reasonable estimate of the amount the fund would pay if it exited the transaction under stressed conditions.

The sum of these two amounts would reflect the overall exposure of the fund to the ongoing risk incurred in holding a particular derivative investment. It covers both the "mark-to-market" exposure, as well as potential future losses. The Market Coverage Amount would be reduced by the value of assets posted as variation margin (but not initial margin or the "independent amount") or collateral with respect to a transaction, because the variation margin or collateral is a security for the mark-to-market exposure of a particular transaction. The Risk-Based Coverage Amount would be reduced by the value of assets representing initial margin or the "independent amount" because those amounts are posted to cover potential future amounts payable in a specific transaction. Thus, a fund using derivatives would receive "credit" for security posted in relation to the transaction when calculating the amount of coverage needed.

Unlike under existing practice, segregation requirements for derivative transactions would have to be satisfied exclusively in cash and cash equivalents, or, if the fund can satisfy its obligation by delivering a specific asset, the specific asset. Currently, many funds use "any liquid asset" to meet segregation requirements.

Cash equivalents include:

  • U.S. Treasury and agency securities
  • Bank deposits
  • Commercial paper
  • Shares of money market funds

If the fund enters into "financial commitment transactions," it would be required to segregate assets that equal the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver. Generally, "financial commitment transactions" include reverse repurchase agreements, short sale borrowings, firm or standby commitment agreements and comparable agreements, and can include uncalled capital commitments to private funds. For financial commitment transactions, a fund could meet the segregation requirement by identifying cash or cash equivalents, specific assets, or assets that are convertible to cash or will generate cash equal to the amount of the financial commitment obligation before the date on which the fund would be expected to pay.

A fund's board of directors, including a majority of the independent directors, would be required to approve a fund's policies and procedures for asset segregation.

Overall Limit — Two Alternatives

Funds would have to limit overall exposure to derivatives and other senior securities, tested immediately after their acquisition, by applying one of two alternative limitations.

Option 1: Exposure-Based Limit Option 2: Risk-Based Portfolio Limit
150 percent of Net Assets

A fund could limit aggregate exposure to 150 percent of the fund's net assets. A fund's exposure is the aggregate notional amount of its derivatives transactions (as opposed to mark-to-market exposure) together with its obligations under financial commitment transactions and certain other transactions. There would be a "look-through" to obligations underlying separately managed accounts, Cayman blockers, index funds and similar investments.
300 percent of Net Assets and VaR Test

A fund could obtain exposure to up to 300 percent of the fund's net assets, so long as the fund satisfies a risk-based test based on value-at-risk ("VaR"), which is an amount expressed in U.S. dollars representing the estimate of potential losses on an instrument or portfolio, over a specified time horizon and at a given confidence interval based on a fund's VaR model. The risk-based test is designed to determine whether the fund's derivative or senior securities transactions, in aggregate, have effectively reduced the fund's market risk (in other words, the portfolio would have less market risk after a derivatives transaction than if the fund did not use derivatives). Under this risk-based limit, the fund's full portfolio VaR would have to be less than the fund's securities VaR (which is the VaR of the fund's holdings in securities and other investments but not derivatives).

A fund's particular limit would have to be approved by its board of directors, including a majority of its independent directors. This requirement suggests that in order to adopt the risk-based model, a board would have to gain a basic understanding of value-at-risk and the specific models used by the adviser to evaluate value-at-risk.

Derivatives Risk Management Program

Funds that have portfolio-level derivatives with notional exposure of more than 50 percent of their assets, or funds using any complex derivatives, would be required to implement a Derivatives Risk Management Program (DRMP) designed to identify and assess the risks associated with the fund's derivative transactions, and manage and monitor these risks. The DRMP would need to address the potential risks posed by the investments, and monitor derivatives investing activity to ensure that it is consistent with a fund's investment guidelines, relevant portfolio limitations and relevant disclosure to investors. The DRMP would be composed of policies and procedures including models (such as VaR calculation models), as well as other measurement tools that address potential leverage, market, counterparty, liquidity and operational risks. The DRMP would be reviewed periodically and updated at least annually to reflect changes in risk over time, and changes in policies, measurement tools or models. A fund would also need to segregate personnel involved in derivative risk management from personnel involved in portfolio management and appoint a derivatives risk manager. The proposal does not discuss whether the risk manager function can be outsourced in the same way that some funds use chief compliance officers who are employed by separate compliance organizations.

The fund's board of directors, including a majority of the fund's independent directors, would have to review and approve the DRMP and any material changes to the DRMP, and the appointment of the risk manager. The fund's board would also have to receive regular reports from the risk manager, at least quarterly, and review the adequacy and efficacy of the program. In the adopting release, the SEC specifically suggested that boards should consider the adequacy of a fund's DRMP in light of past experience (of the fund and markets in general) and recent compliance experience.

Reporting Changes

The Commission is also proposing amendments to its recently proposed reporting forms, Form N-PORT and Form N-CEN. As we have previously reported to you, these new forms, proposed in May 2015, are part of the Commission's effort to modernize investment company regulation and reporting.

Form N-PORT Form N-CEN
Form N-PORT would require funds to provide information about the fund's investment portfolio on a monthly basis. The SEC now proposes to add to Form N-PORT additional risk metrics relating to some derivatives, but only for funds that are required to adopt a DRMP. Form N-CEN would replace current Form N-SAR and would be filed annually to reflect certain census information about funds. The SEC proposes to add to Form N-CEN additional disclosures about whether a fund relied on the new Rule 18f-4 during a period, and the particular limitations that applied to the fund's use of derivatives.

The comment period for the proposed rule is 90 days from publication in the Federal Register.

Footnote

1. The proposal developed after the director of the Division of Investment Management in 2009 challenged the Subcommittee on Investment Companies and Investment Advisers of the American Bar Association Section of Business Law's Committee on Federal Regulation of Securities to suggest enhancements to the SEC's approaches to derivatives, resulting in the formation of the Task Force on Investment Company Use of Derivatives and Leverage (the "ABA Task Force"), on which Kramer Levin participated, and a July 2010 report by the ABA Task Force seeking enhanced regulation or guidance on certain outstanding issues and concerns. In response, the SEC issued a concept release in August 2011 seeking further comment. Kramer Levin continues to participate on the ABA Task Force and will participate in its drafting of a comment letter on the current proposal.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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