The U.S. Securities and Exchange Commission on November 25, 2019 unanimously approved for publication a rule proposal related to the use of derivatives and certain other transactions by companies that have elected to be treated as business development companies under the Investment Company Act of 1940 and certain registered investment companies (collectively, funds).1 This OnPoint addresses the SEC proposal from the perspective of BDCs. For a more complete discussion of the proposal, please refer to Dechert OnPoint, Analysis of SEC’s Proposal to Update the Regulation of Funds’ Use of Derivatives and Other Transactions.
Among other things, the SEC proposal includes: new Rule 18f‑4 under 1940 Act (Proposed Rule); and related fund reporting form amendments and recordkeeping requirements. The Proposed Rule would permit BDCs to enter into derivatives transactions, reverse repurchase agreements and similar financing transactions, as well as unfunded commitment agreements, notwithstanding the restrictions under Sections 18 and 61 of the 1940 Act. As a result, BDCs that use any of these instruments must consider whether the Proposed Rule would create any issues for their continued use of such transactions.
Comments on the Proposed Rule will need to be submitted on or before 60 days following the publication of the Proposing Release in the Federal Register. As of the date of publication of this OnPoint, the Proposing Release had not been published in the Federal Register.
Separately, the Commodity Futures Trading Commission published in the Federal Register on December 10, 2019 several amendments to the regulatory framework applicable to commodity pool operators (CPOs) and commodity trading advisors (CTAs). Among other things, amendments to CFTC Rule 4.5 supersede CFTC Letter 12-40, which many BDCs and their investment advisers currently rely on in order to trade in derivatives that are commodity interests. As a result of these amendments, investment advisers to BDCs that trade commodity interests must file an electronic notice of exclusion with the National Futures Association “as soon as practicable after” January 9, 2019 in order to claim, and continue to rely upon, the exclusion from the definition of CPO previously available under CFTC Letter 12-40. Please refer to Dechert OnPoint, CFTC Finalizes Regulation Amendments: Certain Registered and Exempt CPOs and CTAs Need to Take Action, for further information regarding the changes to CFTC Rule 4.5 as applicable to BDCs.
The Proposed Rule
As noted above, the Proposed Rule would govern a BDC’s or other fund’s derivatives transactions,2 reverse repurchase agreements and other “similar financing transactions,” as well as unfunded commitment agreements, and would subject each category of transactions to different conditions. The Proposed Rule would rescind Release 106663 and the related “asset segregation” requirements articulated in that release, and the Proposing Release indicates that the staff also may withdraw related no-action letters and other guidance. As a result, a BDC would need to comply with the conditions set forth in the Proposed Rule in order to engage in the applicable transactions or otherwise comply with Section 18 of the 1940 Act.
Generally, the most relevant aspects of the Proposed Rule for BDCs will be: the exception for limited derivatives users; the treatment of reverse repurchase agreements and similar financing transactions; and the treatment of unfunded commitments. The following sections of this OnPoint provide a summary discussion of the Proposed Rule that focuses on issues most likely applicable to BDCs.
Treatment of Derivatives Transactions and Exception for Limited Derivatives Users
Standard Conditions for Derivatives Users
The Proposed Rule would require BDCs that use derivatives transactions above the thresholds for limited derivatives users discussed below to (1) establish a derivatives risk management program (that includes certain specified elements), (2) designate one or more officers of the BDC’s investment adviser as a derivatives risk manager, and (3) comply with a limit on the BDC’s total leverage whereby the BDC’s value at risk (VaR) could not exceed: 150% of the VaR of the BDC’s unleveraged designated reference index; or 15% of the value of the BDC’s net assets, if the derivatives risk manager is unable to identify an appropriate index. The BDC also would be subject to board oversight and reporting requirements.
Conditions to Exception for Limited Derivatives Users
A BDC would not be subject to the standard conditions for derivatives users discussed above, if it: (i)(a) limits its derivatives exposure to 10% of its net assets or (b) limits its derivatives usage to currency hedging with a notional value not exceeding the value of the hedged instruments; and (ii) adopts and implements policies and procedures reasonably designed to manage the BDC’s derivatives risks.
The 10% limitation under the exception for limited derivatives users is based on the sum of the notional amounts of the BDC’s derivatives transactions and the value of assets sold short. For purposes of the 10% limitation, a BDC may convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust4 the notional amounts of options contracts. However, a BDC cannot exclude derivatives used for currency hedging from the derivatives measured for purposes of the 10% limitation, as currency hedging is an alternative basis to comply with the limited derivatives user exception.
As noted above, if a BDC uses derivatives in compliance with the exception for limited derivatives users, the BDC also is required to implement policies and procedures. These are principles-based policies and procedures that must reflect “the extent and nature” of the BDC’s use of derivatives and be reasonably designed to manage all of the BDC’s derivatives risks that the BDC’s investment adviser believes to be material for the BDC (e.g., leverage risk, market risk, counterparty risk, liquidity risk, operational risk and legal risk).5
The SEC notes in the Proposing Release that, based on a review of filings, it appears that most BDCs would fall within the limited derivatives users exception.
Possible Change to SEC Approach to BDCs’ Use of Total Return Swaps
Previously, certain BDCs have agreed, in correspondence addressed to the SEC’s disclosure review staff, to “look through” a total return swap (TRS) held by the BDC as if the BDC had acquired the reference assets (i.e., the loans underlying the TRS) with debt financing provided by the TRS counterparty. Under this approach, for purposes of the asset coverage requirements of Sections 18(a) and 61 of the 1940 Act, the BDC would treat: the fair value of the underlying loans as assets of the BDC; and the BDC’s “deemed borrowing” under the TRS (i.e., the notional amount of loans less cash collateral posted by the BDC under the TRS) as a senior security. In addition, for purposes of Section 55(a) of the 1940 Act, the BDC would treat each of the underlying loans as a qualifying or non-qualifying asset according to the character of the obligor (e.g., if the obligor were an eligible portfolio company, then the loan would be a qualifying asset).
If the Proposed Rule were adopted, it appears unlikely that that the staff would “look through” a TRS held by a BDC. A BDC utilizing a TRS to obtain exposure to loans would no longer need to treat the TRS as a “deemed borrowing.” Instead, the BDC would comply with the applicable conditions of the Proposed Rule with respect to such holdings in TRS. As a result, the notional value of such TRS would need to be below 10% of the BDC’s net assets, or the BDC would be subject to the full requirements of the Proposed Rule summarized above. It also appears unlikely that the staff would continue to “look through” the TRS for purposes of Section 55(a).
Requirements for Reverse Repurchase Agreements and Similar Financing Transactions
The Proposed Rule would permit a BDC to enter into reverse repurchase agreements or similar financing transactions if: the BDC complies with the asset coverage requirements of Section 18 (and Section 61) of the 1940 Act; and combines the aggregate indebtedness from such reverse repurchase agreements or similar financing transactions with the aggregate amount of any other senior securities representing indebtedness (e.g., bank borrowings and notes issued by the BDC) when calculating the applicable asset coverage ratio for the BDC.
While most registered funds use the asset segregation approach, originally outlined in Release 10666, for reverse repurchase agreements, most BDCs do not have sufficient liquid assets to cover their obligations in this manner, so many BDCs already use the approach that would be required under the Proposed Rule. In addition, the SEC disclosure review staff has recently commented to certain BDCs and closed-end funds that reverse repurchase agreements should be subject to the asset coverage test, consistent with the requirements under the Proposed Rule.
Requirements for Unfunded Commitment Agreements
The Proposed Rule would permit a BDC to enter into an unfunded commitment agreement that is not a derivatives transaction (e.g., an agreement to provide financing to a portfolio company) if the BDC has a reasonable belief, 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, in each case as it becomes due.
In forming a reasonable belief, the BDC would need to take into account its reasonable expectations with respect to other obligations (including with respect to senior securities and redemptions). The BDC would not be able to take into account cash to be raised through the issuance of additional equity or cash that may become available from the sale of an investment at a price that deviates significantly from the market value of the investment. The BDC also would be required to document the basis for its reasonable belief. If a BDC could not meet this test, it would be required to treat unfunded commitments as a derivatives transaction subject to the above requirements (as opposed to reverse repurchase agreements).
This approach is generally consistent with current practice and SEC disclosure review staff comment letters with respect to whether a BDC needs to segregate assets to cover its unfunded commitments.