SEC Proposes New Exemptive Rule to Regulate Funds’ Use of Derivatives
At an open meeting of the U.S. Securities and Exchange Commission (SEC) today, the SEC by a three-to-one vote approved the proposal (Proposal) of new Rule 18f-4 under the Investment Company Act of 1940 (1940 Act) and amendments to certain proposed forms related to the use of derivatives by registered investment companies – open-end funds, closed-end funds, and exchange-traded funds – and business development companies (collectively, funds). This Proposal is the third of five significant SEC regulatory initiatives originally announced by SEC Chair Mary Jo White in December 2014.1
The proposed rule would provide funds with exemptive relief from the prohibition on issuing “senior securities” under Section 18 of the 1940 Act, subject to various requirements outlined below. Chair White stated at the meeting that “the current regulatory framework no longer achieves the statutory objectives of [the 1940 Act], which seeks to protect investors from the risks of excessive leverage and from funds being unable to meet payment obligations that can result from derivatives and other instruments.” Chair White further stated that the Proposal provides a “modernized, comprehensive regulatory framework” of regulation for funds’ use of derivatives.
As part of this modernization effort, the SEC proposed three categories of regulatory requirements applicable to the use of derivatives by funds relying on proposed Rule 18f-4: (1) portfolio limitations on derivatives transactions; (2) asset segregation requirements; and (3) derivatives risk management program requirements.
If adopted, the Proposal would represent significant changes to the way the SEC regulates funds’ use of derivatives and the obligations of boards of such funds. While presented as an “exemptive” rule, the Proposal in fact would restrict the manner in which many funds currently use derivatives based on existing SEC and no-action guidance. The Proposal is the first significant SEC or staff action relating to funds’ use of derivatives since the SEC’s issuance of its “Concept Release” in 2011.2
Notably, the Proposal addresses only compliance with Section 18 of the 1940 Act, and does not address other issues that arise under the 1940 Act with respect to the use of derivatives, such as the appropriate treatment of derivatives under the provisions of the 1940 Act governing issuer diversification, industry concentration and investments in securities-related issuers.
Regulation of Funds’ Use of Derivatives
Portfolio Limitations on Derivatives Transactions
The Proposal would require funds to comply with one of two alternative portfolio limitations:
- Exposure-Based Portfolio Limit. To rely on the limit, a fund would be required to limit its aggregate exposure to 150% of the fund’s net assets. “Exposure” would be calculated by adding the aggregate notional amount of the fund’s derivatives transactions with the fund’s other obligations under financial commitment transactions (defined below) and certain other transactions.
- Risk-Based Portfolio Limit. Under this limit, a fund would be permitted to obtain derivatives exposure up to 300% of the fund’s net assets, subject to the fund satisfying a risk-based test predicated on the fund’s “value-at-risk” (VAR). The risk-based test would require the fund to demonstrate that the fund’s portfolio VAR with the use of derivatives is less than the fund’s portfolio VAR without the use of derivatives. This comparison is intended to demonstrate that the fund’s use of derivatives does not expose the fund to additional market risk.
Chair White stated that the proposed portfolio limitations are designed to address risks related to leverage and “provide funds the ability to use various types of derivatives in different ways, while curbing a fund’s ability to engage in undue speculation, a principal concern underlying the [1940 Act].” The Staff of the SEC’s Division of Investment Management stated at the meeting that the use of the alternative methodology is designed to provide funds with “flexibility” in determining which limitation is appropriate for the fund’s use of derivatives.
Asset Segregation Requirements
Derivatives Transactions. The Proposal would require a fund to segregate with respect to its derivatives transactions an amount of “qualifying coverage assets” equal to a “mark-to-market coverage amount” plus a “risk-based coverage amount.”
- The mark-to-market coverage amount would mean the amount owed by the fund under its derivatives transactions at the time of determination.
- The risk-based coverage amount would mean a reasonable estimate of the amount that would be payable by the fund if it were to exit the derivatives transactions under “stressed conditions.”
- Qualifying coverage assets would mean cash and cash equivalents.
A fund would not be permitted to avoid senior security concerns by entering into offsetting transactions. Limiting qualifying coverage assets to cash and cash equivalents, and not permitting offsetting transactions to avoid the issuance of senior securities, represents a significant departure from applicable no-action relief from the Staff of the Division of Investment Management and current practice by many funds.3
Financial Commitment Transactions. In addition, the Proposal would impose a different asset segregation limit on “financial commitment transactions” such as short sales, reverse repurchase agreements and firm commitments. A fund would be required to segregate the amount of cash or other assets the fund would be required to pay or deliver under such a transaction.
- Qualifying coverage assets would be expanded for purposes of financial commitment transactions to also include assets convertible to cash prior to the future payment date and the assets required to be delivered under the transaction.
Chair White stated that the proposed asset segregation requirements “are designed to address concerns relating to a fund’s ability to meet its obligation” under a derivatives transaction.
Derivatives Risk Management Programs
The Proposal would impose certain requirements related to derivatives risk management and asset segregation that would apply to all funds engaging in derivatives transactions in reliance on proposed Rule 18f-4.
In addition, a fund that (1) engages in “more than limited derivatives transactions” or (2) uses “certain complex derivatives” would be required to adopt a formalized “derivatives risk management program.” The Proposal would require that the derivatives risk management program (1) be approved by the fund’s board, (2) consist of several components and (3) be reasonably designed to assess risks created by a fund’s derivatives transactions and maintain appropriate coverage amounts. In addition, the Proposal would require the board to approve a “derivatives risk manager” to administer the program. Statements of the Commissioners at the meeting suggested that the Proposal would impose additional quarterly reporting to the board by the derivatives risk manager, as well as annual updates to the derivatives risk management program.
“More than limited derivatives transactions” would be defined to mean a fund holding derivatives transactions with notional exposure equal to 50% or more of the fund’s net assets.
Amendments to Proposed Reporting Forms (Form N-PORT and Form N-CEN)
The Proposal would also amend proposed Form N-PORT and Form N-CEN, new fund reporting forms proposed by the SEC in May 2015. The amendments would require a fund to disclose (1) certain risk metrics relating to the fund’s use of derivatives (proposed Form N-PORT) and (2) whether the fund relied on proposed Rule 18f-4 during the reporting period and the portfolio limitation relied upon by the fund for the period (Form N-CSR).
SEC DERA Staff White Paper
The Proposal is based in part on information and analysis detailed in a white paper prepared by the SEC Division of Economic and Risk Analysis (DERA) Staff. The paper analyzes 10% of the fund industry using a random sample of funds. The paper reports that some funds use derivatives extensively, with notional exposures ranging up to approximately 950% of net assets, while most funds either do not use derivatives or do not use a substantial amount. The SEC plans to publish the white paper in connection with the rulemaking.
The comment period for the Proposal will be 90 days after publication in the Federal Register. The SEC has released a “fact sheet” and a copy of the SEC’s proposing release that relates to the Proposal. The information herein is a summary based on statements at the open meeting and the SEC’s fact sheet.
The Proposal represents the next step, and a notable increase in the SEC’s role, in the regulation of derivatives markets. The SEC and its staff are increasing their focus on, and the staff is ramping up its capabilities in, the area of derivatives regulation for funds. An upcoming Dechert OnPoint will provide further analysis on the Proposal, as well as potential issues for funds and their boards to consider.
1) The SEC has already adopted rule proposals related to enhanced fund and adviser reporting and liquidity risk management requirements. The two remaining initiatives relate to transition planning and stress testing.
2) For more information on the SEC’s 2011 “Concept Release,” please see Dechert OnPoint, SEC Issues “Concept Release” on Funds’ Use of Derivatives.
3) See, e.g Dreyfus; Merrill Lynch Asset Management, L.P., SEC No-Action Letter (July 2, 1996) (permitting the use of “any asset, including equity securities and non-investment grade debt . . . so long as the asset is liquid and marked to market daily.”).