December 16, 2019

SEC Re-Proposes Rule on Funds’ Derivatives Use

By Joshua B. Deringer and Bomi Lee

On November 25, 2019, the Securities and Exchange Commission (SEC) re-proposed Rule 18f-4 (Rule 18f-4) under the Investment Company Act of 1940, as amended (1940 Act). Rule 18f-4, if adopted, would alter the SEC’s regulation of the use of derivatives by registered investment companies and business development companies (collectively, funds).

Background

The SEC had previously proposed a different version of Rule 18f-4 in 2015, but that version of the proposal had received widespread industry criticism that led the SEC to re-work this new proposal. Rule 18f-4 would define a derivative as any swap, future, forward, option, or any similar instrument that creates future payment obligations and short sale borrowings. The rule would allow funds that meet its requirements to enter into derivatives transactions despite restrictions under section 18 of the 1940 Act. If enacted, funds would be permitted to use derivatives without the current asset segregation requirements imposed by existing SEC releases and staff guidance. Therefore, the proposal would rescind SEC Release 10666 (the seminal SEC release that created the current “cover or offset regime”), and the SEC has requested the staff review existing no-action letters to consider whether they should be withdrawn if Rule 18f-4 is adopted. The re-proposed rule, contrary to the 2015 proposal, treats reverse purchase agreements and unfunded commitment agreements as distinct from derivatives and thus allows funds to engage in such transactions subject to the rule’s conditions, as discussed below.

As a complement to Rule 18f-4, the SEC also proposed sales practice rules, which would establish due diligence requirements for broker-dealers and investment advisers that propose putting retail clients into certain leveraged vehicles. The proposals would require the broker-dealer or investment adviser to form a reasonable belief that the customer is capable of evaluating the risks associated with these products. As discussed below, the proposal would also expand the ability of leveraged and inverse exchange traded funds (ETFs) to rely on the SEC’s recently enacted ETF rule. Finally, the rule would provide for amendments to funds’ reporting and recordkeeping requirements.

Overview of the Proposed Rule

Rule 18f-4 includes the following requirements:

  • Derivatives Risk Management Program. Under the proposal, a fund generally would be required to adopt a written derivatives risk management program that contains policies and procedures reasonably designed to manage the fund’s derivatives use. The program would have to identify and assess the fund’s derivatives risks; establish and enforce measurable risk guidelines; provide for stress testing and backtesting; provide for internal reporting and escalation; and include program review elements. The program would be required to be overseen by a derivatives risk manager. The risk manager would be required to at least annually evaluate the program’s effectiveness. The proposal would require a fund adviser’s officer or officers to serve as the derivatives risk manager. Therefore, the proposal would not permit a third party to serve this role, but the derivatives risk manager could use a third party to assist in the administration of the program.
  • Board Oversight and Reporting. A fund’s board of directors would have to approve the fund’s designation of its derivatives risk manager. The board would be required to take into account the risk manager’s relevant experience. The derivatives risk manager would have to provide written reports to the board regarding the program’s implementation and effectiveness as well as the results of the fund’s stress testing and backtesting and any exceedances of the fund’s guidelines.
  • Limit on Fund Leverage Risk. Under the proposed rule, a fund generally would be required to comply with a value at risk (VaR) limit on fund leverage risk. The outer limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a designated reference index for that fund. The fund’s derivatives risk manager would be required to select a designated reference index that is unleveraged and reflects the markets or asset classes in which the fund invests. The fund’s VaR could not exceed 150% of the VaR of the fund’s designated reference index. If the derivatives risk manager is unable to identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test, under which the fund’s VaR could not exceed 15% of the value of the fund’s net assets. The fund would be required to determine its compliance with the applicable VaR test at least once each business day, and if the fund is not in compliance, it would have to come back into compliance within three business days.
  • Exception for Limited Derivatives Users. A fund would not be required to adopt a derivatives risk management program or satisfy the VaR test if it limits its derivatives exposure to 10% of its net assets or uses derivatives solely to hedge currency risks associated with specific foreign-currency-denominated equity or fixed-income investments. These limited derivatives users would still be required to adopt policies and procedures that are reasonably designed to manage its derivatives risks.
  • Alternative Conditions for Leveraged or Inverse Funds. The proposed sales practice rules would define leveraged or inverse investment vehicles as funds that seek returns that correspond to, or have an inverse relationship to, the performance of a market index by a specified multiple. In lieu of the VaR test, the proposed sales practice rules would require broker dealers and investment advisers to exercise due diligence on retail investors before approving retail investor accounts to invest in leveraged or inverse investment funds. Additionally, such a fund would have to limit the investment results it seeks to 300% of the return, or inverse of the return, of the underlying index and disclose in its prospectus that it is not subject to Rule 18f-4’s limit on fund leverage risk. Additionally, the rule would expand the recently adopted rule 6c-11, which currently does not apply to leveraged or inverse ETFs and commodity pools, to allow these investment vehicles to rely on rule 6c-11.
  • Reverse Repurchase Agreements and Unfunded Commitment Agreements. A fund may engage in reverse purchase agreements and other similar transactions as long as it is subject to the asset coverage requirements of section 18. A fund may enter into an unfunded commitment agreement if (1) the agreement does not fall into the rule’s definition of a derivative; and (2) the fund reasonably believes, at the time it enters into such an agreement, that it will have sufficient assets to meet its obligations under the agreements as they come due. A fund’s reasonable belief would take into account the fund’s unique facts and circumstances as well as the fund’s reasonable expectations with respect to its other obligations, its strategy, its assets’ liquidity, its borrowing capacity, and the contractual provisions of its unfunded commitment agreements. This is an important development for the growing segment of the registered fund industry that invests in private equity funds. Under the 2015 proposal, unfunded commitments would have been treated as leverage and would have required the full amount of the commitment to be segregated. The SEC was convinced that unfunded commitments are distinct from leverage and is instead proposing a more flexible approach.
  • Amendments to Reporting Requirements. The proposed rule would amend Form N-PORT and N-CEN to include information regarding a fund’s derivatives exposure and VaR. Form N-LIQUID, proposed to be renamed Form N-RN, would require that a fund subject to the VaR-based limit on fund leverage risk report to the SEC confidentially if it were to exceed its outer VaR limit for more than three consecutive days.
  • Recordkeeping. A fund would be required to maintain records of documents related to the fund’s derivatives risk management program and VaR tests and materials provided to the board. Limited derivatives users would be required to maintain records of its policies and procedures reasonably designed to manage its derivatives risks. A fund that enters into unfunded commitment agreements would be required to maintain a record of its reasonable belief for entering into such agreements. Records would have to be kept for at least five years.

The comment period will be open for 60 days after publication in the Federal Register.

Practice Points

  1. The rule proposal is specific as to the required experience and position of the derivatives risk manager. Advisers would have to ensure that they have the appropriate personnel and may need to hire additional people with relevant experience.
  2. While the proposed relative VaR test would ensure consistency across the industry, there are many types of derivatives that are used in a variety of manners. A more flexible approach to derivatives risk management may be appropriate.
  3. It will be helpful for the SEC to provide greater guidance on the sales practice requirements. Financial intermediaries may be reluctant to utilize these products if they do not have clear guidance as to their responsibilities.

Services and Industries

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