At an open meeting on Dec. 11, the SEC proposed Rule 18f-4, a new "exemptive" rule regarding registered investment companies' use of derivatives and other leveraging arrangements. If adopted, it would require asset segregation, limit the use of derivatives and other leveraging arrangements, and require hosts of funds that use derivatives to implement a "derivative risk management program," including the appointment of 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 ("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.
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, including 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. The proposed rule 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 allow funds to 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.
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:
- Exposure-Based Limit – Under this test, a fund could limit aggregate exposure to 150% 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.
- Risk-Based Portfolio Limit – Under this test, a fund could obtain exposure to up to 300% 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 its 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).
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 both the Market Coverage Amount, which is the amount the fund would pay if it exited the derivative transaction, and the Risk-Based Coverage Amount, a reasonable estimate of the amount it 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.
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 their segregation requirements. If the fund enters into "financial commitment transactions," it could also segregate assets that are convertible to, or will generate sufficient, cash equal to the full amount that the fund is conditionally or unconditionally obligated to pay or deliver before the date on which the fund would be expected to pay.
Derivatives Risk Management Program
Under the proposed rules, funds that have portfolio-level derivatives with notional exposure of more than 50% 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. A fund would also need to separate 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 external chief compliance officers.
Role of Board of Directors
The proposed rule would require a fund's board to approve policies and procedures designed to assure compliance with the rule, including, when a derivatives risk management program is required, the components of the program and the appointment of the required risk manager.
The SEC specifically suggested that boards should consider the adequacy of a fund's DRMP in light of past experience – both of the fund and the markets in general – and recent compliance experience.
Finally, the SEC is also proposing amendments to its recently proposed reporting forms, Form N-PORT and Form N-CEN. These new forms, proposed in May 2015, are part of the commission's effort to modernize investment company regulation and reporting. 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 the 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 proposed Rule 18f-4 during a period, and the particular limitations that applied to the fund's use of derivatives.
Comments on the proposed rule are due by March 28, 2016.
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