SEC Proposes Rule Changes Applicable to BDCs’ Use of Derivatives and Other Transactions

Dechert LLP
Contact

Dechert LLP

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.

Footnotes

1) Use 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 (Proposing Release), SEC Rel. Nos. 34-87607; IA-5413; IC-33704.

2) Derivatives transactions include: any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (each, a derivatives instrument), under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination whether as margin or settlement payment or otherwise; and any short sale borrowing.

3) Securities Trading Practices of Registered Investment Companies, SEC Release No. IC-10666 (Apr. 18, 1979).

4) Delta refers to the ratio of change in the value of an option to the change in value of the asset into which the option is convertible. A BDC would delta adjust an option by multiplying the option’s unadjusted notional amount by the option’s delta.

5) These are the risks outlined in the requirements for BDCs and other funds that are subject to a derivatives risk management program, and thus would be a good place to start when preparing policies and procedures.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Dechert LLP | Attorney Advertising

Written by:

Dechert LLP
Contact
more
less

Dechert LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
- hide

JD Supra Privacy Policy

Updated: May 25, 2018:

JD Supra is a legal publishing service that connects experts and their content with broader audiences of professionals, journalists and associations.

This Privacy Policy describes how JD Supra, LLC ("JD Supra" or "we," "us," or "our") collects, uses and shares personal data collected from visitors to our website (located at www.jdsupra.com) (our "Website") who view only publicly-available content as well as subscribers to our services (such as our email digests or author tools)(our "Services"). By using our Website and registering for one of our Services, you are agreeing to the terms of this Privacy Policy.

Please note that if you subscribe to one of our Services, you can make choices about how we collect, use and share your information through our Privacy Center under the "My Account" dashboard (available if you are logged into your JD Supra account).

Collection of Information

Registration Information. When you register with JD Supra for our Website and Services, either as an author or as a subscriber, you will be asked to provide identifying information to create your JD Supra account ("Registration Data"), such as your:

  • Email
  • First Name
  • Last Name
  • Company Name
  • Company Industry
  • Title
  • Country

Other Information: We also collect other information you may voluntarily provide. This may include content you provide for publication. We may also receive your communications with others through our Website and Services (such as contacting an author through our Website) or communications directly with us (such as through email, feedback or other forms or social media). If you are a subscribed user, we will also collect your user preferences, such as the types of articles you would like to read.

Information from third parties (such as, from your employer or LinkedIn): We may also receive information about you from third party sources. For example, your employer may provide your information to us, such as in connection with an article submitted by your employer for publication. If you choose to use LinkedIn to subscribe to our Website and Services, we also collect information related to your LinkedIn account and profile.

Your interactions with our Website and Services: As is true of most websites, we gather certain information automatically. This information includes IP addresses, browser type, Internet service provider (ISP), referring/exit pages, operating system, date/time stamp and clickstream data. We use this information to analyze trends, to administer the Website and our Services, to improve the content and performance of our Website and Services, and to track users' movements around the site. We may also link this automatically-collected data to personal information, for example, to inform authors about who has read their articles. Some of this data is collected through information sent by your web browser. We also use cookies and other tracking technologies to collect this information. To learn more about cookies and other tracking technologies that JD Supra may use on our Website and Services please see our "Cookies Guide" page.

How do we use this information?

We use the information and data we collect principally in order to provide our Website and Services. More specifically, we may use your personal information to:

  • Operate our Website and Services and publish content;
  • Distribute content to you in accordance with your preferences as well as to provide other notifications to you (for example, updates about our policies and terms);
  • Measure readership and usage of the Website and Services;
  • Communicate with you regarding your questions and requests;
  • Authenticate users and to provide for the safety and security of our Website and Services;
  • Conduct research and similar activities to improve our Website and Services; and
  • Comply with our legal and regulatory responsibilities and to enforce our rights.

How is your information shared?

  • Content and other public information (such as an author profile) is shared on our Website and Services, including via email digests and social media feeds, and is accessible to the general public.
  • If you choose to use our Website and Services to communicate directly with a company or individual, such communication may be shared accordingly.
  • Readership information is provided to publishing law firms and authors of content to give them insight into their readership and to help them to improve their content.
  • Our Website may offer you the opportunity to share information through our Website, such as through Facebook's "Like" or Twitter's "Tweet" button. We offer this functionality to help generate interest in our Website and content and to permit you to recommend content to your contacts. You should be aware that sharing through such functionality may result in information being collected by the applicable social media network and possibly being made publicly available (for example, through a search engine). Any such information collection would be subject to such third party social media network's privacy policy.
  • Your information may also be shared to parties who support our business, such as professional advisors as well as web-hosting providers, analytics providers and other information technology providers.
  • Any court, governmental authority, law enforcement agency or other third party where we believe disclosure is necessary to comply with a legal or regulatory obligation, or otherwise to protect our rights, the rights of any third party or individuals' personal safety, or to detect, prevent, or otherwise address fraud, security or safety issues.
  • To our affiliated entities and in connection with the sale, assignment or other transfer of our company or our business.

How We Protect Your Information

JD Supra takes reasonable and appropriate precautions to insure that user information is protected from loss, misuse and unauthorized access, disclosure, alteration and destruction. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. You should keep in mind that no Internet transmission is ever 100% secure or error-free. Where you use log-in credentials (usernames, passwords) on our Website, please remember that it is your responsibility to safeguard them. If you believe that your log-in credentials have been compromised, please contact us at privacy@jdsupra.com.

Children's Information

Our Website and Services are not directed at children under the age of 16 and we do not knowingly collect personal information from children under the age of 16 through our Website and/or Services. If you have reason to believe that a child under the age of 16 has provided personal information to us, please contact us, and we will endeavor to delete that information from our databases.

Links to Other Websites

Our Website and Services may contain links to other websites. The operators of such other websites may collect information about you, including through cookies or other technologies. If you are using our Website or Services and click a link to another site, you will leave our Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We are not responsible for the data collection and use practices of such other sites. This Policy applies solely to the information collected in connection with your use of our Website and Services and does not apply to any practices conducted offline or in connection with any other websites.

Information for EU and Swiss Residents

JD Supra's principal place of business is in the United States. By subscribing to our website, you expressly consent to your information being processed in the United States.

  • Our Legal Basis for Processing: Generally, we rely on our legitimate interests in order to process your personal information. For example, we rely on this legal ground if we use your personal information to manage your Registration Data and administer our relationship with you; to deliver our Website and Services; understand and improve our Website and Services; report reader analytics to our authors; to personalize your experience on our Website and Services; and where necessary to protect or defend our or another's rights or property, or to detect, prevent, or otherwise address fraud, security, safety or privacy issues. Please see Article 6(1)(f) of the E.U. General Data Protection Regulation ("GDPR") In addition, there may be other situations where other grounds for processing may exist, such as where processing is a result of legal requirements (GDPR Article 6(1)(c)) or for reasons of public interest (GDPR Article 6(1)(e)). Please see the "Your Rights" section of this Privacy Policy immediately below for more information about how you may request that we limit or refrain from processing your personal information.
  • Your Rights
    • Right of Access/Portability: You can ask to review details about the information we hold about you and how that information has been used and disclosed. Note that we may request to verify your identification before fulfilling your request. You can also request that your personal information is provided to you in a commonly used electronic format so that you can share it with other organizations.
    • Right to Correct Information: You may ask that we make corrections to any information we hold, if you believe such correction to be necessary.
    • Right to Restrict Our Processing or Erasure of Information: You also have the right in certain circumstances to ask us to restrict processing of your personal information or to erase your personal information. Where you have consented to our use of your personal information, you can withdraw your consent at any time.

You can make a request to exercise any of these rights by emailing us at privacy@jdsupra.com or by writing to us at:

Privacy Officer
JD Supra, LLC
10 Liberty Ship Way, Suite 300
Sausalito, California 94965

You can also manage your profile and subscriptions through our Privacy Center under the "My Account" dashboard.

We will make all practical efforts to respect your wishes. There may be times, however, where we are not able to fulfill your request, for example, if applicable law prohibits our compliance. Please note that JD Supra does not use "automatic decision making" or "profiling" as those terms are defined in the GDPR.

  • Timeframe for retaining your personal information: We will retain your personal information in a form that identifies you only for as long as it serves the purpose(s) for which it was initially collected as stated in this Privacy Policy, or subsequently authorized. We may continue processing your personal information for longer periods, but only for the time and to the extent such processing reasonably serves the purposes of archiving in the public interest, journalism, literature and art, scientific or historical research and statistical analysis, and subject to the protection of this Privacy Policy. For example, if you are an author, your personal information may continue to be published in connection with your article indefinitely. When we have no ongoing legitimate business need to process your personal information, we will either delete or anonymize it, or, if this is not possible (for example, because your personal information has been stored in backup archives), then we will securely store your personal information and isolate it from any further processing until deletion is possible.
  • Onward Transfer to Third Parties: As noted in the "How We Share Your Data" Section above, JD Supra may share your information with third parties. When JD Supra discloses your personal information to third parties, we have ensured that such third parties have either certified under the EU-U.S. or Swiss Privacy Shield Framework and will process all personal data received from EU member states/Switzerland in reliance on the applicable Privacy Shield Framework or that they have been subjected to strict contractual provisions in their contract with us to guarantee an adequate level of data protection for your data.

California Privacy Rights

Pursuant to Section 1798.83 of the California Civil Code, our customers who are California residents have the right to request certain information regarding our disclosure of personal information to third parties for their direct marketing purposes.

You can make a request for this information by emailing us at privacy@jdsupra.com or by writing to us at:

Privacy Officer
JD Supra, LLC
10 Liberty Ship Way, Suite 300
Sausalito, California 94965

Some browsers have incorporated a Do Not Track (DNT) feature. These features, when turned on, send a signal that you prefer that the website you are visiting not collect and use data regarding your online searching and browsing activities. As there is not yet a common understanding on how to interpret the DNT signal, we currently do not respond to DNT signals on our site.

Access/Correct/Update/Delete Personal Information

For non-EU/Swiss residents, if you would like to know what personal information we have about you, you can send an e-mail to privacy@jdsupra.com. We will be in contact with you (by mail or otherwise) to verify your identity and provide you the information you request. We will respond within 30 days to your request for access to your personal information. In some cases, we may not be able to remove your personal information, in which case we will let you know if we are unable to do so and why. If you would like to correct or update your personal information, you can manage your profile and subscriptions through our Privacy Center under the "My Account" dashboard. If you would like to delete your account or remove your information from our Website and Services, send an e-mail to privacy@jdsupra.com.

Changes in Our Privacy Policy

We reserve the right to change this Privacy Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our Privacy Policy will become effective upon posting of the revised policy on the Website. By continuing to use our Website and Services following such changes, you will be deemed to have agreed to such changes.

Contacting JD Supra

If you have any questions about this Privacy Policy, the practices of this site, your dealings with our Website or Services, or if you would like to change any of the information you have provided to us, please contact us at: privacy@jdsupra.com.

JD Supra Cookie Guide

As with many websites, JD Supra's website (located at www.jdsupra.com) (our "Website") and our services (such as our email article digests)(our "Services") use a standard technology called a "cookie" and other similar technologies (such as, pixels and web beacons), which are small data files that are transferred to your computer when you use our Website and Services. These technologies automatically identify your browser whenever you interact with our Website and Services.

How We Use Cookies and Other Tracking Technologies

We use cookies and other tracking technologies to:

  1. Improve the user experience on our Website and Services;
  2. Store the authorization token that users receive when they login to the private areas of our Website. This token is specific to a user's login session and requires a valid username and password to obtain. It is required to access the user's profile information, subscriptions, and analytics;
  3. Track anonymous site usage; and
  4. Permit connectivity with social media networks to permit content sharing.

There are different types of cookies and other technologies used our Website, notably:

  • "Session cookies" - These cookies only last as long as your online session, and disappear from your computer or device when you close your browser (like Internet Explorer, Google Chrome or Safari).
  • "Persistent cookies" - These cookies stay on your computer or device after your browser has been closed and last for a time specified in the cookie. We use persistent cookies when we need to know who you are for more than one browsing session. For example, we use them to remember your preferences for the next time you visit.
  • "Web Beacons/Pixels" - Some of our web pages and emails may also contain small electronic images known as web beacons, clear GIFs or single-pixel GIFs. These images are placed on a web page or email and typically work in conjunction with cookies to collect data. We use these images to identify our users and user behavior, such as counting the number of users who have visited a web page or acted upon one of our email digests.

JD Supra Cookies. We place our own cookies on your computer to track certain information about you while you are using our Website and Services. For example, we place a session cookie on your computer each time you visit our Website. We use these cookies to allow you to log-in to your subscriber account. In addition, through these cookies we are able to collect information about how you use the Website, including what browser you may be using, your IP address, and the URL address you came from upon visiting our Website and the URL you next visit (even if those URLs are not on our Website). We also utilize email web beacons to monitor whether our emails are being delivered and read. We also use these tools to help deliver reader analytics to our authors to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

Analytics/Performance Cookies. JD Supra also uses the following analytic tools to help us analyze the performance of our Website and Services as well as how visitors use our Website and Services:

  • HubSpot - For more information about HubSpot cookies, please visit legal.hubspot.com/privacy-policy.
  • New Relic - For more information on New Relic cookies, please visit www.newrelic.com/privacy.
  • Google Analytics - For more information on Google Analytics cookies, visit www.google.com/policies. To opt-out of being tracked by Google Analytics across all websites visit http://tools.google.com/dlpage/gaoptout. This will allow you to download and install a Google Analytics cookie-free web browser.

Facebook, Twitter and other Social Network Cookies. Our content pages allow you to share content appearing on our Website and Services to your social media accounts through the "Like," "Tweet," or similar buttons displayed on such pages. To accomplish this Service, we embed code that such third party social networks provide and that we do not control. These buttons know that you are logged in to your social network account and therefore such social networks could also know that you are viewing the JD Supra Website.

Controlling and Deleting Cookies

If you would like to change how a browser uses cookies, including blocking or deleting cookies from the JD Supra Website and Services you can do so by changing the settings in your web browser. To control cookies, most browsers allow you to either accept or reject all cookies, only accept certain types of cookies, or prompt you every time a site wishes to save a cookie. It's also easy to delete cookies that are already saved on your device by a browser.

The processes for controlling and deleting cookies vary depending on which browser you use. To find out how to do so with a particular browser, you can use your browser's "Help" function or alternatively, you can visit http://www.aboutcookies.org which explains, step-by-step, how to control and delete cookies in most browsers.

Updates to This Policy

We may update this cookie policy and our Privacy Policy from time-to-time, particularly as technology changes. You can always check this page for the latest version. We may also notify you of changes to our privacy policy by email.

Contacting JD Supra

If you have any questions about how we use cookies and other tracking technologies, please contact us at: privacy@jdsupra.com.

- hide

This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.