On October 28, 2020, the U.S. Securities and Exchange Commission (the SEC) voted 3-2 to adopt Rule 18f-4 (the Final Rule)1 under the Investment Company Act of 1940 (the 1940 Act), which establishes a comprehensive framework for derivatives investing by mutual funds (excluding money market funds), exchange-traded funds (ETFs), registered closed-end funds (CEFs) and business development companies (BDCs, and all the funds collectively, Funds). The 1940 Act limits the ability of Funds to engage in transactions that involve potential future payment obligations, including obligations under derivatives such as forward contracts, futures, swaps and written options. The Final Rule and related rule amendments permit Funds to enter into such derivatives transactions2, if they comply with certain conditions. In connection with the implementation of the Rule, the SEC will rescind its 1979 General Statement of Policy, commonly referred to as Release 106663, and related no-action letters, which, to date, have provided the guidance allowing Funds to engaged in derivative transactions in light of restrictions under Section 184 of the 1940 Act.5
The 1940 Act places specific restrictions on a Fund’s ability to issue senior securities and utilize leverage. Because they involve leverage, derivatives transactions are treated as senior securities under Section 18 of the 1940 Act. Absent relief from Section 18, it would be difficult for Funds to invest in derivatives. Historically, such relief has come from Release 10666 and related no-action letters and SEC guidance; these are now being replaced with Rule 18f-4. Subject to certain conditions, described in detail below, Rule 18f-4 will allows Funds to enter into derivatives transactions, notwithstanding the restrictions on the issuance of senior securities and the use of leverage imposed by Section 18 of the 1940 Act.
An overhaul of the derivatives rules and regulations has been on the SEC agenda for some time. In 2011, the SEC issued a Concept Release soliciting comments on a range of topics relating to the use of derivatives by Funds. In 2015, the SEC proposed Rule 18f-4 (the 2015 Proposed Rule) and received 200 comments in response, many of which criticized the 2015 Proposed Rule as being too onerous. After considerable engagement with fund complexes and investor groups, the SEC re-proposed a revised Rule 18f-4 in November 2019 (the 2019 Proposed Rule). The Final Rule largely tracks the 2019 Proposed Rule with one notable exception; the SEC did not adopt the sales practices rules for inverse and leveraged Funds, which would have applied to intermediaries recommending such Funds to retail investors.
Exception for limited derivatives use
The Final Rule provides a limited user exception to the conditions discussed in detail below. A Fund that limits its derivatives exposure to 10 percent of its net assets will only be required to adopt written policies and procedures that are reasonably designed to manage the Fund’s derivative risk exposure. The Final Rule generally defines “derivatives exposure” to mean the sum of the gross notional amounts of the Fund’s derivatives. Certain items, including any closed-out positions, may be excluded from the derivatives exposure calculation. During the rule-making process, the SEC sampled 48 of 99 BDCs and found that 59% did not report any derivatives holdings, and that another 31% had derivatives exposure that was less than 10% of their respective net assets. The SEC therefore expects that most BDCs that enter into derivatives transactions will qualify for this exception.
If a Fund’s derivative exposure exceeds 10 percent of its net assets for more than five business days, the Fund’s investment adviser must provide a written report to the Fund’s board of directors explaining either how (i) it plans to reduce the Fund’s derivatives exposure to be below the 10 percent threshold within 30 calendar days of the exceedance, or (ii) it plans to meet the full requirements of the Final Rule.
Guidance on unfunded commitments
In the Final Rule adopting release, the SEC makes it clear that it believes unfunded commitments should be treated differently from derivatives transactions because they are not used to leverage a Fund’s portfolio or create undue speculation, but still raise concerns regarding a Fund’s asset sufficiency. To address this concern, the Final Rule allows a Fund to enter into unfunded commitment agreements if the Fund reasonably believes, at the time it enters into such agreements, that it will have sufficient cash and cash equivalents to meets its obligations with respect to its unfunded commitment agreements as they come due. The Final Rule prescribes certain specific factors that a Fund should take into account when forming such reasonable belief. A Fund must consider its other obligations, including its senior securities and future redemptions. A Fund may take into account an issuance of debt and its borrowing capacity under existing lines of credit when reaching its determination, subject to asset coverage requirements. A Fund cannot, however, consider capital that may be available from the issuance of additional equity or from the sale or disposition of any investment at a price that deviates significantly from the market value of those investments.
Special treatment for reverse repurchase agreements
Because reverse repurchase agreements and similar financing transactions are common methods of obtaining financing and are economically equivalent to bank borrowings, the SEC determined that reverse repurchase agreements may be treated equally to bank borrowing. This position is a departure from the asset segregation approach of Release 10666, which viewed reverse repurchase agreements as separate from the limitations established on bank borrowings by the asset coverage requirements of Section 18. To provide flexibility, the Final Rule allows a Fund to either (i) comply with the asset coverage requirements of Section 18 when engaging in reverse repurchase agreements or (ii) chose to treat such agreements as derivatives transactions under the Final Rule. Whichever treatment a Fund chooses, the election will apply to all of its reverse repurchase agreements or similar financing transactions. Which choice a Fund elects will likely depend on the extent to which the Fund is engaged in borrowings under Section 18 or otherwise uses derivatives. A Fund can change the approach it takes, but is required to memorialize that choice and any changes on its books and records.
Conditions for derivatives use above the limited amount
The Final Rule establishes conditions that must be met in order for a Fund to enter into derivatives transactions in excess of 10 percent of its net assets. The Final Rule is intended to be fluid so fund complexes of various sizes and structures may mold a framework that suits their structure and will allow the regulation of derivatives use to evolve along with the derivatives markets. Under the Final Rule, Funds engaged in derivatives use will generally be subject to the following conditions:
Derivatives Risk Management Program
In order to engage in transactions covered by the Final Rule, a Fund must develop and implement a Derivatives Risk Management Program (DRM). The Final Rule establishes a number of elements that a Fund’s DRM should include, but otherwise encourages Funds to tailor its DRM to its particular risks. In addition to establishing internal reporting and escalation procedures and conducting periodic reviews, the required elements of the DRM are as follows:
(1) Derivatives Risk Manager. A Fund’s board of directors is not required to approve a Fund’s DRM but rather must engage with the Fund’s DRM through the appointment of a derivatives risk manager (the Manager) who will oversee the Fund’s DRM. The Manager must be an officer or officers of a Fund’s investment adviser and must have experience in derivatives risk management. The Manager is required to provide written reports to the Fund’s board of directors on the implementation of the Fund’s DRM and then provide regular updates at least annually thereafter. The Manager must also provide the Fund’s board of directors with regular updates on the status of the Fund’s stress testing and backtesting (as discussed below).
(2) Risk Identification and Assessment. A Fund’s DRM must provide for the regular identification and assessment of the Fund’s derivatives risks. Such assessment should review how the Fund’s derivative transactions interact with the Fund’s other investments, and should take into account, at a minimum, risks related to leverage, liquidity, and operations.
(3) Risk Guidelines. A Fund must establish, maintain and enforce guidelines that provide quantitative or otherwise measurable criteria or metrics related to a Fund’s derivatives risks, such as investment size limits or lists of approved counterparties.
(4) Stress Testing. A DRM program must include stress testing designed to evaluate a portfolio’s potential losses resulting from extreme (but plausible) market conditions or changes. The Final Rule requires that this stress testing occur, at minimum, weekly, but the SEC notes that the frequency of stress testing may be impacted by market conditions and/or a Fund’s investment strategy.
(5) Backtesting. A Fund’s DRM program must backtest the results of the Value-at-Risk (VaR) calculation model used by the Fund. The Final Rule requires that a Fund backtest, at least weekly, its VaR calculation model by comparing its actual gain or loss for each business day with the VaR calculated for that day.
Limit on fund leverage risk
The Final Rule requires that Funds generally comply with an outer limit on fund leverage based on VaR. VaR is an estimate of a portfolio’s potential loss over a given period of time and at a specified confidence level. The outer leverage limit is based on one of two tests: (i) a relative VaR test or (ii) an absolute VaR test. The relative VaR test, the default, compares the Fund’s VaR to the VaR of a “designated reference portfolio” for that Fund. Generally, a Fund is permitted to use either an index that meets certain requirements or its own securities portfolio (excluding derivatives transactions) as its designated reference portfolio. Under the relative VaR test, a Fund’s VaR is generally not permitted to exceed 200% of the VaR of its designated reference portfolio. The SEC granted additional VaR flexibility to CEFs that have outstanding preferred stock. Such CEF’s VaR must not exceed 250% of the VaR of its designed reference portfolio. The purpose of the relative VaR test is to measure how much additional risk a Fund takes on when using derivatives, compared to a similar Fund with no derivatives exposure.
If the Fund’s Manager reasonably determines that a reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test—because, for example, the unique nature of a Fund’s portfolio—the Fund instead must comply with an absolute VaR test, which compares the portfolio’s VaR to the value of the Fund’s net assets. Under the absolute VaR test, a Fund’s VaR is not permitted to exceed 20% of the Fund’s net assets (or 25% for those CEFs with preferred stock outstanding).
Board oversight and reporting
As discussed above, the Final Rule establishes a direct line between a Fund’s DRM and a Fund’s board of directors via the Manager. The board of directors must appoint the Manager and must review regular written reports from the Manager regarding a Fund’s DRM and its risk exposure relating to the use of derivatives. During the implementation of the DRM, the Manager must provide a report to the Fund’s board of directors regarding the structure of the DRM. Such report must include the Manager’s determination that the DRM is reasonably designed to manage the Fund’s derivatives risks and the basis for the Manager’s determination. The Manager must also identify the designated reference portfolio to be used for VaR testing (or an explanation as to why no reference portfolio meets the needs) and the Manager’s basis for selecting that portfolio. Finally, the Manager must provide regular reports regarding stress testing, backtesting and the Fund’s internal controls and reporting regarding derivatives use. In the Final Rule, the SEC stressed that board oversight of a Fund’s DRM should not be passive, rather a board of directors should ask questions and seek additional information regarding the management of a Fund’s derivative risk exposure.
Reporting requirements for registered investment companies
In connection with the adoption of the Final Rule, the SEC is also adopting corresponding changes to Forms N-PORT, N-LIQUID (to be renamed Form N-RN), and N-CEN to increase disclosure regarding derivatives exposure. Form N-PORT will be amended to require Funds to confidentially disclose to the SEC information regarding derivatives exposure, a Fund’s median VaR, number of days of non-compliance with the 10 percent limitation beyond the five-business day period (as applicable for those Funds relying on the limited user exception) and backtesting results. N-PORT will also require Funds to publicly disclose information regarding its designated reference portfolio for its relative VaR testing purposes. Form N-RN (N-LIQUID) will be amended to require Funds to confidentially disclose to the SEC certain items relating to VaR test breaches. Finally, Funds will need to “check the box” on Form N-CEN if they are relying on the Final Rule. BDCs will not be subject to these additional disclosure requirements.
The Final Rule will become effective 60 days following its publication in the Federal Register, which had not yet occurred as of the date of this Legal Alert. Funds will have 18 months following the date of effectiveness to come into compliance with the Final Rule. At that time, the SEC will rescind Release 10666 and any other guidance it deems moot, superseded by, or inconsistent with the Final Rule.
Though Funds will likely not need to be compliant with the Final Rule until at least mid-2022, the requirements of the Final Rule will require significant work to ensure compliance by that date. Funds should first determine if they are eligible to rely on the limited user exception, or if they could become eligible with moderate adjustments. For Funds that exceed the 10 percent limitation, investment advisers and boards of directors should begin coordinating and organizing the resources necessary to select a Manager and establish a DRM, in addition to the other requirements.
The full text of the Final Rule is available at the following link: https://www.sec.gov/rules/final/2020/ic-34084.pdf
The Final Rule defines “derivatives transactions” as any swap, security-based swap, future contract, forward contract, option, any combination of the foregoing, or any similar 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, as well as any short sale or borrowing.
Final Rule also gives Funds the choice of treating reverse repurchase agreements and similar financial transactions as derivatives transactions and, thus, being subject to the Rule, or as senior securities.
The full text of Release 10666 is available at the following link: https://www.sec.gov/divisions/investment/imseniorsecurities/ic-10666.pdf
Section 61 of the 1940 Act places similar leverage restrictions on BDCs. Though this Legal Alert refers to Section 18, this framework applies equally to BDCs.
The Final Rule also permits the operation of certain inverse and leveraged ETFs. The operation of inverse and leveraged ETFs is outside the scope of this Legal Alert.