In December 2015, the Securities and Exchange Commission (the SEC) proposed a new Rule 18f-4 under the Investment Company Act of 1940 (the 1940 Act) that would, if adopted, affect the ability of mutual funds, exchange-traded funds (ETFs), closed-end funds and business development companies (BDCs) (collectively, the Funds) to engage in derivative transactions and financial commitment transactions. The proposed rule would supersede prior SEC guidance underlying these practices, including the so-called “Release 10666”¹ and related SEC staff guidance, and would instead require compliance with a new comprehensive regulatory framework. If the proposed rule is adopted, Funds could only enter into derivatives transactions and financial commitment transactions in accordance with the proposed rule or in accordance with the asset coverage requirements currently applicable to them under the 1940 Act.

I. Background

Section 18 of the 1940 Act restricts the ability of Funds to issue “senior securities,” which are defined to include “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.”² Mutual funds are restricted from issuing or selling any senior security other than borrowing from a bank and must comply with a 300% asset coverage requirement in doing so.³ A closed-end fund, which is not confined to bank borrowings, must also comply with the 300% asset coverage requirement if it is to issue or sell a senior security representing indebtedness and a 200% asset coverage requirement if it is to issue or sell a senior security representing stock.⁴ A BDC is subject to the same restrictions as a closed-end fund, except that the applicable asset coverage requirement is 200% for both a senior security representing indebtedness and a senior security representing stock.⁵

Over the years, the SEC and its staff have asserted that an evolving list of investments made by Funds, such as derivatives, may fall within the “evidence of indebtedness” component of the definition of “senior securities” to the extent that they create leverage or similar risks and, as a result, may be subject to the limitations with respect thereto under the 1940 Act. However, in Release 10666, the SEC concluded that Funds could engage in these types of investments without complying with the asset coverage requirements under the 1940 Act so long as the Funds maintained a segregated account of liquid assets to “cover” the investments.⁶

As a recent example of the SEC staff’s evolving application of its “evidence of indebtedness” position, the SEC staff began in early 2015 to question, in connection with its review of BDC registration statements, whether an agreement under which a BDC is obligated to make a loan to, or an equity investment in, a company is a senior security under the 1940 Act and, thus, subject to the asset coverage requirement under the 1940 Act or the “covering” requirement contained in Release 10666. Although the SEC staff never reached a final determination with respect to this question in connection with its review of BDC registration statements, the proposed rule does so by treating these arrangements, which are commonly referred to as “unfunded commitments,” as “financial commitment transactions” under the rule.

II. Proposed Rule 18f-4

Proposed Rule 18f-4 would serve as an exemptive rule under Section 18 of the 1940 Act and supersede prior SEC guidance, including Release 10666, on “coverage” for senior securities obligations with respect to “derivatives transactions” and “financial commitment transactions.”

• A derivatives transaction is defined as “any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument” through which a Fund is or may be required to pay money or furnish cash assets to the Fund’s counterparty.
• A financial commitment transaction is defined as “any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement (such as an agreement under which a fund has obligated itself, conditionally or unconditionally, to make a loan to a company or to invest equity in a company, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner).”

A. Derivatives Transactions Requirements

Any Fund that wishes to enter into a derivatives transaction in reliance on the proposed rule would be required to satisfy three sets of conditions relating to (1) portfolio limitations, (2) asset segregation and (3) risk management program implementation.

1. Portfolio Limitations

A Fund’s board of directors (the Board), including a majority of independent directors, would be required to approve one of the two portfolio limitations on the Fund’s senior securities transactions, which include derivatives transactions, financial commitment transactions and other senior securities entered into pursuant to Section 18 of the 1940 Act, described below:

• The exposure-based portfolio limit requires that a Fund limit its aggregate “exposure” to 150% of the Fund’s net assets. This limit is designed to impose an overall limit on the amount of exposure, and thus the amount of potential leverage, that a Fund would be able to obtain through its use of derivatives and other senior securities transactions. A Fund’s “exposure” generally would be calculated as the aggregate notional amount of the Fund’s derivatives transactions, combined with its obligations under financial commitment transactions and other senior securities entered into pursuant to Section 18 of the 1940 Act. The proposed rule includes specific rules that Funds must follow in calculating the aggregate notional amount of the Fund’s derivatives transactions (such as the netting of certain offsetting derivatives transactions) and its obligations under financial commitment transactions.
• The risk-based portfolio limit allows a Fund to obtain “exposure” up to 300% of the Fund’s net assets if the Fund demonstrates through a value-at-risk (VaR) test that its use of derivatives decreases the Fund’s exposure to market risk; in other words, that the VaR of the Fund’s portfolio with derivatives transactions is less than the VaR without derivatives transactions. Thus, this limit expands the permitted exposure amount if the use of derivatives by the Fund reduces its market risk.

2. Asset Segregation

A Fund would be required to segregate “qualifying coverage assets,” which generally include cash and cash equivalents, for each derivatives transaction pursuant to a policy approved by the Board. The amount to be segregated for each derivatives transaction, whether physical or cash-settled, would be computed as the sum of (i) the mark-to-market coverage amount, which would be calculated as the payment due by the Fund if it exited the derivatives transaction at the time of the determination, subject to certain adjustments contained in the proposed rule and (ii) the risk-based coverage amount, which would include a reasonable estimate of the potential amount, in addition to the derivative transaction’s mark-to-market coverage amount, the Fund would be required to pay if it exited the derivatives transaction under stressed conditions at the time of the determination date, subject to certain adjustments contained in the rule (including the reduction of the risk-based coverage amount by the value of assets posted as initial margin or collateral in connection with the derivatives transaction). Qualifying coverage assets would be identified on the books and records of the Funds at least once each business day. In addition, the total amount of a Fund’s qualifying coverage assets cannot exceed the Fund’s net assets and assets of the Fund maintained as qualifying coverage assets cannot be used to cover both a derivatives transaction and a financial commitment transaction. The limitation that a Fund’s qualifying coverage assets cannot exceed the Fund’s net assets would prevent a Fund from using other forms of leverage such as borrowings to cover the leverage created by its use of derivatives transactions.

3. Derivatives Risk Management Program

A Fund that either engages in complex derivatives transactions⁷ or that has substantial derivatives exposure (i.e., the aggregate notional amounts of a Fund’s derivatives transactions exceed 50% of the value of a Fund’s net assets) would be required to establish and implement a formal derivatives risk management program (the Risk Management Program) to be overseen by a designated derivatives risk manager (the Risk Manager). The Board, including a majority of independent directors, would be required to approve (i) the Risk Management Program, (ii) the Risk Manager’s appointment and (ii) any material changes to the program. The Risk Management Program would need to be reasonably designed to assess and manage risks associated with derivatives transactions and inform portfolio management of any material risks associated with engaging in such transactions. In addition, the Risk Manager would be required to provide the Board with a written report evaluating the Risk Management Program’s effectiveness on at least a quarterly basis.

B. Financial Commitment Transactions Requirements

Any Fund that wishes to enter into a financial commitment transaction in reliance on the proposed rule would be required to satisfy an asset segregation requirement. In this regard, the proposed rule would require a Fund to segregate qualifying coverage assets with respect to its financial commitment transactions (including unfunded commitments) and to assess daily whether such assets are adequate. In contrast to the proposed coverage amounts for derivative transactions, the proposed rule would require a Fund to maintain qualifying coverage assets equal to the full value of the Fund’s obligations under the financial commitment transaction. The SEC believes that this distinction is appropriate because a Fund is more likely to be required to fulfill its full obligation under a financial commitment transaction as compared to a derivatives transaction. The proposed rule provides that qualifying coverage assets would include:

• Cash and cash equivalents;
• The particular asset that a Fund may deliver to satisfy its obligation pursuant to the commitment, if applicable;
• Assets that are (i) convertible to cash or (ii) that will generate cash equal to the financial commitment obligation prior to the expected payment date; or
• Assets that have been pledged with respect to the financial commitment transaction and can be expected to satisfy such obligation.

As is the case for covering derivative transactions, the total amount of a Fund’s qualifying coverage assets cannot exceed the Fund’s net assets and assets of the Fund maintained as qualifying coverage assets cannot be used to cover both a derivatives transaction and a financial commitment transaction. The limitation that a Fund’s qualifying coverage assets cannot exceed the Fund’s net assets would prevent a Fund from using other forms of leverage such as borrowings to cover the leverage created by its use of financial commitment transactions.

Unlike derivatives transactions, however, Funds have greater latitude with respect to the types of assets with which they may cover their financial commitment transactions. In particular, the proposed rule provides that where the timing of a Fund’s payment obligations under such commitments can be reasonably predicted, the Fund can cover with assets that are quickly convertible to cash or have a reasonable expectation of generating sufficient cash prior to the payment due date under the financial commitment obligation. The following passages from the SEC proposing release are fairly instructive with respect to the SEC’s intent relating to “convertibility to cash or the ability to generate cash” provision:

“For example, if a fund enters into a firm commitment agreement whereby the fund agrees to purchase a security from a counterparty at a future date and at a stated price, the fund would know at the outset of the transaction the date on which the obligation is due and the full amount of the obligation. Rather than being required to maintain cash and cash equivalents equal in value to the amount of this obligation—which the fund may not be required to pay for some time—the proposed rule would permit the fund to maintain assets that are convertible to cash or that will generate cash prior to the date on which the fund can be expected to be required to pay such obligation, determined in accordance with board-approved policies and procedures.

In this example, if the purchase price of the firm commitment is $100 and the transaction will be completed on a fixed date, the fund, if consistent with its policies and procedures relating to qualifying coverage assets, could segregate a fixed-income security with a value of $100 or more that would pay $100 or more upon maturity and would mature in time for the fund to use the principal payment to complete the firm commitment transaction. As another example, the fund could, if consistent with its policies and procedures relating to qualifying coverage assets, segregate a fixed-income security with a value of $100 or more that would generate $100 or more in interest payments that the fund could use to complete the firm commitment agreement.

Where the fund can be expected to pay the obligation on a short-term basis, the assets maintained by the fund as qualifying coverage assets also would have to be convertible to cash or able to generate cash on a short-term basis. For example, if the fund has entered into a standby commitment agreement and the fund could be expected to be required to pay the purchase price under the agreement on a short-term basis, the fund would need to segregate assets that could be convertible to cash or able to generate cash in a short period of time to enable the fund to meet its expected obligation. We would expect these assets to be highly liquid assets given the short-term nature of the fund’s obligation under the transaction and the proposed rule’s requirement that qualifying coverage assets be convertible to cash or generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to be required to pay such obligation.”

An asset’s convertibility to cash or the ability to generate cash in relation to the expected date of the financial commitment obligation would have to be determined in accordance with policies and procedures approved by the Fund’s Board for such purpose.

In addition, the Board, including a majority of its independent directors, of a Fund that intends to enter into financial commitment transactions would be required to approve policies and procedures reasonably designed to provide for the maintenance of qualifying coverage assets. The SEC believes that this requirement would appropriately focus the Board’s attention on the Fund’s management of its obligations under financial commitment transactions and the Fund’s reliance on the exemption under the proposed rule.

III. Form N-PORT and Form N-CEN

The SEC also proposed amendments to two reporting forms – Form N-PORT and Form N-CEN – for mutual funds, ETFs and other registered investment companies (collectively, Registered Funds) that were proposed in May 2015.

Form N-PORT, which would require Registered Funds other than money market funds to file portfolio-wide and position level holdings data with the SEC on a monthly basis, would be amended to require any Registered Fund with a Risk Management Program to disclose supplementary risk metrics with respect to the Registered Fund’s use of derivatives.

Form N-CEN, which would require Registered Funds to annually report census-type information with the SEC (instead of on Form N-SAR), would be amended to require a Registered Fund to disclose its reliance on Rule 18f-4 during the reporting period and specify its use of either the exposure-based portfolio limit or the risk-based portfolio limit, as described above.

IV. Next Steps

Funds should determine the impact the proposed rule will have on their operations and business and consider submitting a comment letter to the SEC expressing their views on the proposed rule, including any concerns identified or recommendations developed in connection with any such assessment, if the proposed rule will negatively impact them. Comments on the proposed rule are due by March 28, 2016.

                                                 

¹ Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (April 18, 1979) (Release 10666).

² A senior security, as defined in Section 18(g) of the 1940 Act, also includes “any stock of a class having priority over any other class as to the distribution of assets or payment of dividends.” Section 18 of the 1940 Act is made applicable to BDCs by Section 61 of the 1940 Act, with the modifications contained therein.

³ See Section 18(f)(1) of the 1940 Act.

⁴ See Section 18(a)(1) of the 1940 Act.

⁵ See Section 61(a)(1) of the 1940 Act.

⁶ Under this approach, the segregated account would include certain liquid assets (i.e., cash, U.S. government securities, etc.) equal to the obligation incurred with respect to the investment.

⁷ A complex derivatives transaction is defined as any derivatives transaction where the amount payable depends on the value of the underlying reference asset at multiple points in time or is a non-linear function of the underlying reference asset’s value.