“If at first you don’t succeed, try, try again.”
– Thomas Palmer, American educator
In 2015, the Securities and Exchange Commission (SEC) proposed a new rule 18f-4 under the Investment Company Act of 1940 (1940 Act) to regulate the use of derivatives by investment companies and business development companies, other than money market funds (collectively, funds). That proposal generated approximately 200 comment letters. On November 25, 2019, the SEC reproposed a revamped rule 18f-4 (Fund Derivatives Rule) to govern funds’ use of derivatives.1 The SEC also proposed new sales practice rules – rule 15l-2 under the Securities Exchange Act of 1934 (Exchange Act) and rule 211(h)-1 under the Investment Advisers Act of 1940 (Advisers Act) – that would require broker-dealers and investment advisers to exercise due diligence on retail investors before approving retail investor accounts to invest in leveraged/inverse exchange-traded funds (ETFs) and other leveraged investment vehicles. Finally, the SEC is proposing to amend rule 6c-11 under the 1940 Act (ETF Rule)2 – to allow certain leveraged/inverse ETFs that meet the ETF rule’s conditions to operate without the need to obtain an exemptive order.
The Fund Derivatives Rule would require a fund to implement a derivatives risk management program tailored to the risks of the derivatives used by the fund, limit its leverage risk relative to the risk of an unleveraged index (or blend of indices) that can serve as an appropriate benchmark for the fund and appoint a derivative risk manager with a degree of independence from the fund’s portfolio manager(s). However, a fund that used derivatives to a limited extent or solely to hedge currency risks would be exempt from these requirements and would be required only to adopt policies and procedures tailored to its own derivatives use.
Proposed Rule 18f-4 Under the 1940 Act
The SEC has expressed concern that, because different fund groups interpret SEC staff guidance on derivatives differently and because there may not be any guidance on how to treat particular derivatives: (a) different fund groups will treat investments in the same types of derivatives differently; and (b) some of these treatments may not address the purposes and concerns underlying section 18. Proposed rule 18f-4 is intended to impose a uniform set of conditions and provide certain exemptions from the 1940 Act.
b. Application to Funds:
It is important to note that the Fund Derivatives Rule in its entirety would apply only to a small subset of funds. In particular, a fund would not need to implement a derivatives risk management program with all of the elements required by the proposed rule or limit its leverage risk to a percentage of value-at-risk (VaR) if its adjusted derivatives risk exposure is ten percent (10%) or less of its net assets or if it uses derivatives solely to hedge certain currency risks (Limited Derivatives Users). These requirements are discussed in section c.(v), below.
The SEC estimates that 22% of funds that would be subject to proposed rule 18f-4 would be required to implement a derivatives risk management program and comply with the VaR limits. Funds that are Limited Derivatives Users would instead be required only to implement policies and procedures reasonably designed to manage their derivatives risks. However, once a fund in a fund complex becomes subject to the Fund Derivatives Rule in its entirety, a complex could decide that it is more efficient to operate a single derivatives risk management program covering all of its funds than to run a full-blown program and a derivatives-lite program side-by-side.
It is also important to note that the Fund Derivatives Rule would not capture all types of derivatives. The proposed rule distinguishes between those derivatives that cause a fund to incur a payment obligation or deliver assets to a counterparty under specified conditions – such as futures, swaps, and written options – and those derivatives that do not impose a payment obligation on a fund beyond its initial investment, such as purchased call options. The Fund Derivatives Rule would apply only to derivatives that cause a fund to incur a payment obligation or deliver assets to a counterparty under specified conditions. See section c.(v), below.
c. Proposed Requirements:
Under proposed rule 18f-4, a fund would become subject to the rule’s requirements in their entirety, as specified below, if its activities regarding certain types of derivatives exceed specified thresholds:.
i. Derivatives Risk Management Program.
The Fund Derivatives Rule would generally require a fund to implement a written derivatives risk management program, including policies and procedures reasonably designed to manage the fund’s derivatives risks. The program would institute a standardized risk management framework for funds, while requiring principles-based tailoring by each fund to the fund’s particular risks. Required elements of the program would include:
- risk identification and assessment – taking into account the fund’s derivative transactions and how they interact with the fund’s other investments, including:
- leverage risk – the risk that derivatives transactions can magnify the fund’s gains and losses;
- market risk – risk from potential adverse market movements in relation to the fund’s derivatives positions, or the risk that markets could experience a change in volatility that adversely affects fund returns and the fund’s obligations and exposures;
- counterparty risk – the risk that a fund’s counterparty may be unwilling or unable to perform its obligations under the derivatives contract, and the related risk of having concentrated exposure to such a counterparty;
- liquidity risk – risk involving liquidity demands created by derivatives to make payments of margin, collateral or settlement payments to counterparties;
- operational risk – can include documentation issues, settlement issues, systems failures, inadequate controls and human error; and
- legal risk – can include insufficient documentation, insufficient capacity or authority of counterparty, or legality or enforceability of a contract.
- risk guidelines – incorporating quantitative or otherwise measurable criteria, metrics or thresholds related to a fund’s derivatives risks:
- the guidelines would be required to specify:
- levels of the given criterion, metric, or threshold that a fund does not normally expect to exceed; and
- the measures to be taken if they are exceeded.
- the proposed guidelines requirement seeks to:
- address the derivatives risks that a fund would be required to monitor routinely as part of its program; and
- help the fund identify when it should respond to changes in those risks.
- funds would be able to establish their own risk limits; and
- funds would be required to adopt quantitative or otherwise measurable criteria, metrics, or thresholds of the fund’s derivatives risks.
- stress testing – to evaluate potential losses to a fund’s portfolio under stressed conditions.
- stress tests would be required to evaluate potential losses to the fund’s portfolio in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund’s portfolio; and
- a fund would be required to stress test its portfolio at least weekly.
- backtesting – of the VaR calculation model used by the fund:
- each business day, a fund would be required to compare its actual gain or loss for that business day with the VaR the fund had previously calculated for that day;
- for purposes of the backtesting requirement, the VaR would be estimated over a one-trading day time horizon; and
- a fund would have to identify as an exception each instance in which a fund’s actual loss exceeds the corresponding VaR estimated loss.
- internal reporting and escalation:
- communication between a fund’s risk management and portfolio management regarding the operation of the program; and
- communication between a fund’s derivatives risk manager and the fund’s board of certain matters relating to a fund’s derivatives use.
- program review elements – the fund’s board must approve a fund’s derivatives risk manager, who would be required to review the program (including each specific program element) at least annually in order to evaluate the program’s effectiveness and to reflect changes in risk over time. The requirement is intended to facilitate the board’s oversight of the fund’s derivative management program.
- the guidelines would be required to specify:
ii. Program Administration.
The Fund Derivatives Rule would require that a fund’s derivatives risk manager be one or more officers of the fund’s adviser (or sub-adviser). The rule would require that the fund’s board approve the fund’s derivatives risk manager. The derivatives risk manager would be required to have relevant experience regarding derivatives risk management. However, the SEC also seeks to ensure “a reasonable segregation of functions” as between the derivatives risk manager and the fund’s portfolio managers. Consequently, if a fund were to employ a sole derivatives risk manager, the rule would prohibit the manager from also serving as the fund’s portfolio manager. Similarly, if a fund were to employ multiple individuals to serve as its derivatives risk manager, a majority of those individuals could not also be portfolio managers of the fund.
PRACTUS NOTE: The Proposing Release notes that the SEC’s recently adopted mutual fund liquidity rule, unlike the Fund Derivatives Rule, permits investment advisers to serve as liquidity risk managers. The SEC specifically solicits comment on whether this aspect of the Fund Derivatives Rule should be conformed to the mutual fund liquidity rule, or whether this aspect of the mutual fund liquidity rule should be conformed to the Fund Derivatives Rule.
iii. Board Oversight.
The Proposing Release discusses the SEC’s expectations with respect to board oversight. The SEC states that:[D]irectors should understand the program and the derivatives risks it is designed to manage as well as participate in determining who should administer the program. They also should ask questions and seek relevant information regarding the adequacy of the program and the effectiveness of its implementation. The board should view oversight as an iterative process. Therefore, the board should inquire about material risks arising from the fund’s derivatives transactions and follow up regarding the steps the fund has taken to address such risks, including as those risks may change over time.
PRACTUS NOTE: Statements such as “directors should . . . participate in determining who should administer the program” imply a level of engagement that may go beyond oversight and into day-to-day management. Commenters may wish to address the level of engagement that the SEC seeks from boards, and whether this level of engagement should take place from the Board as a whole, or from a Committee that has the requisite expertise.
In addition, the proposed Fund Derivatives Rule seeks to facilitate board oversight by requiring that the periodic report that the derivatives risk manager provides the board include: (i) a representation that the program is reasonably designed to manage the fund’s derivatives risks; (ii) the basis for the manager’s representation; and (ii) such information as may be reasonably necessary to evaluate the adequacy of the fund’s program and the effectiveness of its implementation. The proposed Fund Derivatives Rule would also require the periodic report to specifically address why the manager selected the particular designated reference index used under the proposed relative VaR test (discussed below) or, if applicable, why the manager was unable to identify a designated reference index appropriate for the fund such that the fund relied on the proposed absolute VaR test (discussed below) instead.
Finally, the proposed Fund Derivatives Rule would require the manager to provide the board with a separate periodic written report addressing each instance that the fund’s risk guidelines were exceeded, as well as the results of the fund’s stress tests and backtesting. This report would also be required to include such information as may be reasonably necessary for the board to evaluate the fund’s response to any instances that the guidelines were exceeded, as well as the stress testing and backtesting results.
iv. Limit on Fund Leverage Risk.
If a fund were to rely upon the Fund Derivatives Rule, it would generally have to comply with an outer limit on fund leverage risk based on VaR. Generally, a fund would first be required to select a “designated reference index” for the fund – an unleveraged index selected by the derivatives risk manager, and that reflects the markets or asset classes in which the fund invests. The designated reference index would also be required to be an appropriate broad-based securities market index or a narrowly based index that reflects the market sectors in which the fund invests – a fund would be required to disclose its designated reference index in its annual report. The fund’s VaR could not exceed 150% of the VaR of the fund’s designated reference index. If a fund cannot identify an appropriate “designated reference index”, it would instead be required to comply with an absolute VaR test, under which the VaR of its portfolio would not be permitted to exceed 15% of the value of the fund’s net assets.
In order to prevent funds from selecting an inappropriate designated reference index comprised of more volatile securities to enable the fund to take on more leverage, the proposed Fund Derivatives Rule would require: (1) the derivatives risk manager to select the designated reference index and to periodically review it; (2) the fund to disclose the designated reference index, relative to its performance, in its annual report; and (3) the fund’s board to receive a written report providing the derivatives risk manager’s basis for selecting the designated reference index.
The Fund Derivatives Rule would require that any VaR model a fund uses for purposes of the relative or absolute VaR test take into account and incorporate all significant, identifiable market risk factors associated with the fund’s investments. These market risk factors would include: (1) equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk; (2) material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (3) the sensitivity of the market value of the fund’s investments to changes in volatility.
The Proposing Release indicates that the SEC views VaR as one component of a fund’s derivatives risk management program. The SEC views VaR as providing funds with an estimate of the magnitude of a fund’s potential losses over a 20 trading day time frame and at a 99% confidence level. It notes that “VaR will not provide, and is not intended to provide, an estimate of an instrument or portfolio’s maximum loss amount.” Instead, stress testing is intended to be the component of a fund’s derivatives management program that is intended to assess losses not captured by VaR testing.
The Fund Derivatives Rule would require that if a fund falls out of compliance with its applicable VaR test (whether relative or absolute), it must act promptly to come back into compliance, with an outer limit of three business days. If a fund cannot bring itself back into compliance within three business days, then (1) the derivatives risk manager would be required to report to the fund’s board and explain how and by when (i.e., the number of business days) the derivatives risk manager reasonably expects that the fund would come back into compliance; (2) the derivatives risk manager must analyze the circumstances that caused the fund to fall out of compliance for more than three business days and update any program elements as appropriate to address those circumstances; and (3) the fund would not be able to enter into derivatives transactions (other than derivatives transactions that, individually or in the aggregate, are designed to reduce the fund’s VaR) until the fund has been back in compliance with the applicable VaR test for three consecutive business days and satisfied the board reporting requirement and program analysis and update requirements.
v. Exception for Limited Users of Derivatives.
Rule 18f-4 would provide an exception from the program requirement and the VaR-based limit on fund leverage risk for a fund that either: (1) limits its derivatives exposure to 10% of its net assets, or (2) uses derivatives only to hedge certain currency risks. As noted above, a fund relying upon this exception would still need to adopt and implement policies and procedures tailored to manage the fund’s derivatives risks.
The Fund Derivatives Rule would generally define the term “derivatives exposure” as the sum of the notional amounts of the fund’s derivatives instruments and, for short sale borrowings, the value of any asset sold short. However, the proposed rule would permit a fund to convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts, to more closely reflect the exposure that the derivative creates to the underlying reference asset.
The currency hedging exception would enable a fund to use currency derivatives, but only to hedge currency risk associated with particular foreign currency-denominated equity or fixed-income investments held by the fund. Moreover, the notional amount of the currency derivatives held by the fund could not exceed the value of the instruments denominated in the foreign currency by more than a trivial amount.
vi. Alternative Conditions for Certain Leveraged or Inverse Funds.
Rule 18f-4 would include a set of alternative conditions for certain leveraged or inverse funds. A leveraged or inverse fund would be excepted from the proposed limit on fund leverage risk, provided that, among other things, it:
- limits the investment results it seeks to 300% of the return (or inverse of the return) of the underlying index;
- discloses in its prospectus that it is not subject to the proposed limit on fund leverage risk, and
- is a fund to which the new proposed sales practices rules (discussed below) would apply, prohibiting a retail investor from trading through a broker-dealer or investment adviser unless the broker-dealer or investment adviser were to approve the investor’s account for such trading.
vii. Reverse Repurchase Agreements and Unfunded Commitment Agreements.
The Fund Derivatives Rule would also permit a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, if the fund complied with conditions governing those types of transactions. The proposed rule would not treat reverse repurchase agreements as derivatives transactions because the SEC believes they more closely resemble bank borrowings with known repayment obligations than derivative transactions which often have more uncertain payment obligations. However, a fund that could not rely upon the limited derivatives user exception would be required to take into account leverage created by reverse repurchase agreements in determining compliance with VaR limits.
An unfunded commitment agreement would be defined under the Fund Derivatives Rule as a contract that is not a derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a loan to a company or to invest equity in a company in the future, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner. The SEC notes that a fund often does not expect to lend or invest up to the full amount committed under an unfunded commitment agreement. In addition, a fund’s obligation to lend under an unfunded commitment agreement often is conditioned upon a borrower’s obligation to meet certain financial metrics and performance benchmarks. The SEC notes that unfunded commitment agreements do not have a leveraging effect on the fund’s portfolio because they do enable the fund to realize gains or losses between the date of the fund’s commitment and its subsequent investment when the other party to the agreement calls the commitment. The SEC states that while unfunded commitment agreements do not raise leverage concerns, they can raise concerns that a fund would need to liquidate other assets to satisfy its obligation if it did not have enough cash on hand to meet its commitment. Consequently, the SEC proposes to permit a fund to enter into unfunded commitment agreements if the fund reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, when each obligation is triggered.
viii. Proposed Sales Practice Rules and Amendments to Rule 6c-11.
The SEC’s proposed sales practice rules seek to establish a set of customized due diligence and approval requirements for broker-dealers and SEC-registered investment advisers with respect to trades in shares of certain leveraged investment vehicles. Note that these rules would be in addition to newly-enacted Regulation BI with respect to broker-dealers and the existing fiduciary duty of investment advisers.
The proposed rules would require a broker-dealer or investment adviser to exercise due diligence in determining whether to approve a retail customer or client’s account to buy or sell leveraged investment vehicles. A broker-dealer or investment adviser could approve the account only if it had a reasonable basis to believe that its customer or client is capable of evaluating the risks associated with these products.
The proposed amendments to rule 6c-11 under the 1940 Act would permit certain leveraged or inverse ETFs to rely on the rule (currently, a leveraged or inverse ETF must obtain an exemptive order in order to operate). The SEC proposes to rescind the exemptive orders previously issued to the sponsors of leveraged or inverse ETFs in connection with any adoption of the proposed amendments.
The proposal would require a fund to report confidentially to the SEC on a current basis on Form N-LIQUID (to be renamed Form N-RN) if the fund falls out of compliance with the VaR-based limit on fund leverage risk for more than three consecutive business days. The proposal also would amend Forms N-PORT and N-CEN to require funds that are currently required to file these forms to provide certain information regarding a fund’s derivatives exposure and, as applicable, information regarding the fund’s VaR. The SEC would make this information publicly available. However, the SEC is not proposing to require BDCs to report this information on Form N-PORT or N-CEN.
Review of Relevant Staff Guidance
The SEC believes that rule 18f-4, if adopted, would supersede past SEC guidance on derivatives and other transactions generating leverage, and therefore would rescind a 1979 General Statement of Policy (Release 10666). In addition, staff in the Division of Investment Management (IM) is reviewing its no-action letters and other guidance addressing funds’ use of derivatives and other transactions covered by proposed rule 18f-4 to determine which letters and staff guidance, or portions thereof, should be withdrawn in connection with any adoption of the proposal. The proposal has been published on SEC.gov, but has yet to be published in the Federal Register. The public comment period will remain open for 60 days after publication in the Federal Register.
The SEC’s second attempt to regulate fund use of derivatives appears to be more narrowly-tailored to the funds that make extensive use of derivatives than its first attempt. However, it is unclear why it believes that there was a need to promulgate specialized sales practice rules before broker-dealers were required to comply with Regulation BI and when investment advisers are already subject to a fiduciary duty. Moreover, to the extent that the SEC was attempting to create a uniform playing field for users of derivatives, its determination to require the vast majority of fund derivatives users to adopt only policies and procedures addressing fund derivatives use may well mean that funds continue to treat similar derivative transactions differently. If you are interested in commenting on the Proposed Rules, we encourage you to contact a Practus attorney, who can assist you in drafting a comment letter to the SEC.
1Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Rel. No. 33704 (Nov. 25, 2019) (“Proposing Release”).
2 Practus’ Legal Insight post examining the ETF Rule is available at https://practus.com/sec-issues-new-etf-rule-and-adopts-form-amendments/.