Proposed Rule on Registered Funds’ Use of Derivatives

David C. Sullivan is partner in the Investment Management practice at Ropes & Gray LLP. This post is based on a Ropes & Gray publication by Mr. Sullivan, Tim Diggins, George Raine and Sarah Clinton.

On December 11, 2015, the SEC issued its long-anticipated release (the “Release”) proposing Rule 18f-4 (“the “Proposed Rule”) under the 1940 Act regarding the use of derivatives and certain related instruments by registered investment companies (collectively, “funds”). The stated objective of the Release is to “address the investor protection purposes and concerns underlying section 18 [of the 1940 Act] and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives” in light of the increased participation by funds in today’s large and complex derivatives markets.

We provide an executive summary of the Proposed Rule and other aspects of the Release below and, in the Appendix of the complete publication, we discuss the Proposed Rule in more detail.

Some Early Thoughts

  • The Proposed Rule is something of a blunt instrument. In many respects, it does not distinguish among the reasons investment companies may use derivatives—a forward currency hedge is for all intents and purposes treated the same as a speculative equity total return swap. We expect that industry commentary will seek greater levels of nuance because different types and uses of derivatives create very different risks.
  • Some early client feedback has focused on the Proposed Rule’s hard 150% limit on notional exposure. In conjunction with the Release, the SEC published a report by its Division of Economic and Risk Analysis (“DERA”), based on a random sample of roughly 10% of funds, that indicated that relatively few funds will be affected by the limit—but this remains to be seen as the broader universe of funds applies the limit to particular portfolios. For example, a broader sampling of bond funds that manage duration, currency and credit risks through derivatives may show that a significantly greater percentage of more traditional funds would have to alter their investment programs to comply with the 150% limit than the DERA study suggests.
  • The SEC’s recognition of a “value-at-risk” (“VaR”) tool is an important development, although its application may be seen as too limited (note—the Proposed Rule would allow an exception to the 150% notional exposure limit, to 300%, if a VaR analysis shows that the effect of all of a fund’s derivatives transactions in effect at a particular time is to reduce overall portfolio risk). Some market participants may suggest that the VaR analysis should be applied separately to different types of derivatives activities—so that, for example, a fund’s currency or interest rate hedging transactions that reduce portfolio risk should not count against any limit on other derivatives use by the fund.
  • The Proposed Rule’s asset segregation requirements are complicated and not especially clear. A number of our clients have expressed concern about the effort and expense that will be required to monitor a fund’s ongoing compliance with the proposed new requirements.
  • Like other recent rulemakings, the Proposed Rule will impose significant new responsibilities on fund directors/trustees and on fund personnel (most notably, the Proposed Rule’s required individual who serves as derivatives risk manager). Many funds will be required to adopt detailed, board-approved policies and procedures designed to assess and manage the risks associated with the funds’ derivatives transactions.
  • Depending on how the comment process proceeds, there is at least some chance of a legal challenge to the Proposed Rule. Although the SEC went to some length to find support for its authority, principally under Section 18 of the 1940 Act, that position may be weakened by the SEC’s proposed approach to the regulation of derivatives, finding “senior securities” even in transactions where portfolio risk is clearly reduced and where the risks commonly associated with senior securities—leverage, preferential claims on fund assets and increases in a fund’s speculative character—are minimal.

Executive Summary

Proposed Rule 18f-4 would supplant a significant volume of SEC no-action and other guidance on derivatives use by funds, and would introduce a range of specific, technical restrictions:

  • The Proposed Rule defines and distinguishes between derivatives transactions [1] and a newly defined category of “financial commitment transactions” (consisting of reverse repurchase agreements, short sale borrowings, firm or standby commitments, and similar agreements).
  • Each fund that utilizes any derivatives transactions would have to comply with one of two alternative portfolio limitations designed to impose a limit on the aggregate amount of leverage the fund may obtain through all derivatives transactions, financial commitment transactions, and other senior securities transactions (such as permitted borrowings).
    • Under an exposure-based portfolio limit, the fund would be subject to a limit of 150% (relative to its net assets) on its aggregate notional “exposure” to senior securities transactions, measured after each transaction in accordance with a prescribed calculation methodology.
    • Alternatively, under a risk-based portfolio limit, the fund could have exposure of up to 300%, provided it also meets a value at risk (VaR) test intended to ensure that the fund’s use of derivatives reduces, rather than magnifies, the fund’s overall exposure to market risk.
  • In addition, each fund would have to maintain a specified value of “qualifying coverage assets” identified on its books and records (i.e., “earmarked”) to manage the risks associated with its derivatives transactions and financial commitment transactions.
    • For derivatives transactions, the required amount of qualifying coverage assets would be based on mark-to-market value of derivatives transactions, plus an additional risk-based amount, but could only consist of cash and cash equivalents and particular assets that may be delivered by a fund to satisfy its obligations (e.g., if the fund has written a call option on a particular security that the fund owns, then the security would be considered qualifying coverage assets for that transaction).
    • For financial commitment transactions, the required amount of qualifying coverage assets would be calculated based on the fund’s full notional financial commitment obligations but, unlike derivatives transactions, may also include assets that (i) are convertible to cash or that will generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund is required to pay the obligation, or (ii) have been pledged with respect to the financial commitment obligation and can be expected to satisfy the obligation.
  • Depending on the extent and complexity of its derivatives usage, a fund may be required to adopt and implement a board-approved written derivatives risk management program reasonably designed to assess and manage the risks associated with the fund’s derivatives transactions.
    • The program would include, among other things, an assessment of specified risks, the designation of an individual as derivatives risk manager and oversight by the fund’s board.
  • The Release also would amend (i) proposed Form N-PORT to require funds that must implement a derivatives risk management program to report certain portfolio- and position-level risk metrics; and (ii) proposed Form N-CEN to require funds engaging in derivatives transactions to identify the portfolio limitation category (i.e., the 150% exposure-based limitation or the 300% risk-based limitation) on which the fund has relied.

Each of these requirements is discussed in more detail in the Appendix of the complete publication.

Existing Guidance and Compliance Dates

If proposed Rule 18f-4 is adopted, the SEC would rescind Release IC-10666 and the staff’s no-action letters addressing derivatives transactions and financial commitment transactions. Funds would only be permitted to enter into derivatives transactions and financial commitment transactions to the extent consistent with the requirements of Rule 18f-4 or Sections 18 or 61 of the 1940 Act. However, prior to Rule 18f-4’s effective date, a fund may still rely on Release IC-10666 and existing no-action letters. The Release does not propose a compliance date or transition period, but requests comments on whether a proposed compliance period of 18 months for larger entities (30 total months for smaller entities) would provide sufficient time for funds to transition to operation under the Proposed Rule.

* * *

We expect a significant number of comments on the Release and Proposed Rule from various industry participants and other interested parties. Comments must be filed with the SEC no later than March 28, 2016.

The complete publication, including Appendix, is available here.


[1] “Derivatives transaction” means any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (“derivatives instrument”) under which the 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 a margin or settlement payment or otherwise. Derivatives, such as purchased options, that do not obligate a fund to make future payments or to deliver a fund asset, are not “derivatives transactions” under the Proposed Rule.
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