On December 11, 2015, the Securities and Exchange Commission (the “Commission”) proposed Rule 18f-4 (the “Proposed Rule”) under the Investment Company Act of 1940, as amended (the “1940 Act”).1 If adopted, the Proposed Rule represents a comprehensive overhaul of the current regulatory framework governing the use of derivatives and other trading practices that create leverage by registered investment companies. The Proposed Rule would supersede historical guidance provided by the Commission and its staff.
This bulletin provides a brief overview of the current regulatory framework and other developments that provided a foundation for the Proposed Rule and summarizes the key elements of the Proposed Rule. The Proposed Rule contains many complex definitions and provisions, and we and other industry participants continue to assess the potential impact of the Proposed Rule. While the Proposed Rule would have a greater impact on certain types of funds – particularly leveraged exchange-traded funds, managed futures funds and certain other alternative products – all registered investment companies that use derivatives or engage in other techniques that create leverage should carefully consider the implications of the Proposed Rule.
Existing Regulatory Framework. The 1940 Act, Commission rules and Commission guidance govern the use of derivatives by registered funds. A fund that engages in derivative transactions must consider, among other things, Section 18 of the 1940 Act, which addresses the capital structure of funds and the extent to which a fund may issue “senior securities.” The provisions of Section 18 seek to address Congress’s concerns regarding funds operating without adequate assets and reserves, and thus, are designed to prevent excessive borrowing, as well as limit the issuance of excessive amounts of senior securities by funds that increase the speculative character of their junior securities. To this end, Section 18(f)(1) of the 1940 Act prohibits an open-end fund from issuing senior securities, other than borrowings from a bank and subject to maintaining an asset coverage ratio of at least 300% (including the amount borrowed) at all times that the borrowing is outstanding. Section 18(a)(1) prohibits closed-end funds from issuing or selling a senior security that represent indebtedness unless it has 300% asset coverage immediately following such issuance, or issuing a senior security that represents equity unless it has an asset coverage of 200% immediately following the issuance of securities and incurrence of debt.
Section 18(g) of the 1940 Act defines senior security, in part, as “any bond, debenture, note or similar obligation or instrument constituting a security and evidencing indebtedness.” The seminal guidance on the application of Section 18 to trading practices that create leverage was issued by the Commission in 1979.2 In Release 10666, the Commission interpreted Section 18 broadly and stated that trading practices used by funds to “accomplish leveraging fall within the legislative purposes of Section 18” because these trading practices pose a risk of loss to funds “analogous to the danger caused by leverage.” In fact, the Commission noted, “[l]everaging without any significant limitation was identified in the Investment Trust Study of 1939 as one of the major abuses of investment companies prior to passage of the  Act by Congress.” In Release 10666, the Commission concluded that reverse repurchase agreements, firm commitment agreements and standby commitment agreements, although not securities for all purposes under the federal securities laws, fall within the functional meaning of the term “evidence of indebtedness” for purposes of Section 18 of the 1940 Act, and may constitute senior securities In Release 10666, the Commission stated that “if an investment company were to issue a security which affected its capital structure in a manner analogous to the agreements discussed [in the Release], and barring other material differences, the Commission believes it would view that transaction from a similar analytical posture.”
Following the Commission’s publication of Release 10666, the staff of the Division of Investment Management has issued more than twenty (20) no-action letters addressing interpretive questions with respect to whether certain investment techniques or instruments are senior securities under Section 18. In general, under a series of no-action letters, the staff provided guidance that the issue of compliance with Section 18 would not be raised if funds segregate liquid assets in an amount equal to a fund’s potential liabilities arising from the investment techniques or instrument. Alternatively, the staff did not object to funds “covering” the derivatives position by holding the actual security or instrument underlying the derivatives transaction or maintaining an offsetting position. Such guidance was generally provided on an instrument-by-instrument basis in response to specific questions presented to the staff. No formal guidance has been issued with respect to many commonly used derivatives techniques including, in particular, over-the-counter derivatives such as swaps, non-exchange traded options, forward swaps and swaptions.
As a result of the lack of formal guidance, industry practice necessarily varies, although some trends have emerged. Generally two approaches are used with respect to the amount of assets that must be segregated. Under the first approach, the fund segregates assets in amount equal to the full amount of the fund’s potential obligation under the contract (i.e., the notional amount). Funds have applied this approach to physically settled futures, forwards and written options, as well as to certain swaps such as credit default swaps. For certain derivatives that are required to be net cash settled, funds often segregate an amount equal to the mark-to-market liability, if any. The staff has provided guidance with respect to the mark-to-market approach for certain instruments including interest rate swaps, cash settled futures and non-deliverable forwards. Through the disclosure process, it appears some funds have applied this approach to other cash settled instruments.
With respect to the types of assets that may be used for the segregation purposes, the staff has taken the position that a fund could maintain any liquid asset for segregation purposes, including equity securities and non-investment grade debt securities.3
As to the manner in which segregation may be effected, the staff has taken the position that a fund could segregate assets by designating such assets on its books, rather than establishing a segregated account at its custodian.4
Task Force Report (2010). In a report dated July 6, 2010 to the Commission’s Division of Investment Management, the Task Force on Investment Company Use of Derivatives and Leverage (the “Task Force”) addressed various challenges facing the regulation of derivatives and leverage when used by funds, and issued several recommendations.5 The Task Force undertook an examination of how the 1940 Act applies to the use of derivatives by funds, and studied industry practices in the context of regulatory interpretations of existing law. The Task Report recommended, among other things, that the Commission or its staff regulate compliance with Section 18 of the 1940 Act by applying a principles-based approach. The Task Report also introduced, among other things, a concept of maintaining a risk-adjusted segregated amount to cover potential liabilities under derivatives positions.
Concept Release (2011). In September 2011, the Commission sought public comment on the current regulatory framework, including the application of Section 18 to derivatives transactions.6 The comments received on the Concept Release shed some light on the various ways in which funds use derivatives, including, for example, to hedge risks associated with the fund’s securities investments, to equitize cash to gain exposure quickly, and to create synthetic positions. The Concept Release and comments also provided insight on industry practice regarding compliance with Section 18.
Proposed Regulatory Framework
The Proposing Release contains a comprehensive summary of the current regulatory framework and the staff’s observations regarding market developments and application of staff guidance to new types of derivatives. Among other things, the Proposing Release noted that historical guidance had been issued on an instrument-by-instrument basis, and that many types of instruments had developed in the market for which no formal guidance exists. The Proposing Release noted that the dramatic increase in the volume and complexity of derivatives instruments over the past two decades, and the increased use of derivatives by certain types of funds, led the Commission to evaluate whether the current regulatory framework continued to fulfill the purposes and policies of the 1940 Act.
The principal elements of the Proposed Rule, which are each discussed in detail below, include the following requirements:
- Portfolio Limits. A fund must limit its exposure to underlying reference assets through derivatives and other senior securities to either (i) 150% of net assets (“Exposure-Based Portfolio Limit”), or (2) 300% of net assets for funds that satisfy a “value-at-risk” (“VaR”) test (“Risk-Based Portfolio Limit”).
- Asset Coverage. A fund must maintain “qualifying coverage assets” in an amount equal to its current obligation (i.e., typically, a mark-to-market amount) plus a cushion, which represents a reasonable estimate of the potential obligations of the fund under stressed conditions.
- Risk Management Program. Except for funds that use derivatives to a limited extent, the Proposed Rule requires funds to adopt a formalized risk management program and appoint a board-approved derivatives risk manager.
The Proposed Rule would require a fund that engages in derivatives transactions in reliance on the Proposed Rule to comply with one of two alternative portfolio limits designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions.
Exposure-Based Portfolio Limit
A fund relying on this limitation generally would be required to limit its aggregate exposure (as defined below), measured immediately after entering into a covered transaction, to 150% of the fund’s net assets. Under this test, the Proposed Rule does not include any provision to permit a fund to reduce its exposure for purposes of the Proposed Rule’s portfolio limitations for particular derivatives transactions that may be entered into for hedging (or risk-mitigating) purposes or that may be “cover transactions,” as described below.
Risk-Based Portfolio Limit
A fund relying on this limitation would be required to limit its aggregate exposure to 300% of the fund’s net assets, measured immediately after entering into a covered transaction, if the fund can satisfy a risk-based test based on VaR. The Proposed Rule defines VaR as “an estimate of potential losses on an instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence level.”
To satisfy this test, a fund’s “full portfolio VaR” must be less than its “securities VaR.” The Proposed Rule defines “full portfolio VaR” as the VaR of the fund’s entire portfolio, including securities, derivatives transactions and other investments. A fund’s “securities VaR” would be defined as the VaR of the fund’s portfolio of securities and other investments, but excluding any derivatives transactions. The policy rationale for this test is the Commission’s belief that, if a fund’s full portfolio VaR is less than its securities VaR, such determination would be an appropriate indication that the fund’s derivatives use, in the aggregate, decreases the fund’s overall exposure to market risk.
The Proposed Rule gives funds some flexibility in the selection of a VaR model for use in the risk-based test for purposes of the risk-based portfolio limit, but the VaR model must meet certain minimum requirements. The Proposed Rule requires a fund’s VaR model to take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments. In addition, the Proposed Rule would require a fund to use a minimum 99% confidence interval, a time horizon of not less than 10 and not more than 20 trading days, and a minimum of three years of historical data to estimate historical VaR. A fund would also be required to apply its VaR model consistently when calculating its securities VaR and full portfolio VaR.
For the purposes of both portfolio limits described above, aggregate exposure is the sum of:
- The aggregate notional amount of the fund’s derivatives transactions, subject to certain adjustments discussed below;
- The amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under any financial commitment transactions, such as short sales, reverse repurchase agreements, firm commitment agreements and standby commitment agreements;7 and
- The aggregate indebtedness (and with respect to any closed-end fund or business development company, or involuntary liquidation preference of preferred shares) with respect to any other senior securities transactions entered into by the fund pursuant to Section 18 or 61 of the 1940 Act.
While it was thought that an exposure test that focuses on limiting the aggregate notional amounts of funds’ derivatives transactions is the appropriate means of limiting leverage, in some cases, the notional amount of a derivatives transaction may not be the most meaningful measure of exposure that the Commission believes would be appropriate for purposes of the proposed rule’s exposure limitations. Therefore, the Proposed Rule requires an adjustment to the notional amount in three circumstances:
- For derivatives that provide a return based on the leveraged performance of an underlying reference asset, the Proposed Rule would require the notional amount to be multiplied by the applicable leverage factor. Thus, for example, the Proposed Rule would require a total return swap that has a notional amount of $1 million and that provides a return equal to three times the performance of an equity index to be treated as having a notional amount of $3 million.
- The Proposed Rule includes a “look-through” for calculating the notional amount in respect of derivatives transactions for which the underlying reference asset is a managed account or entity formed or operated primarily for the purpose of investing in or trading derivatives transactions, or an index that reflects the performance of such a managed account or entity. For such derivatives transactions, the Proposed Rule would require a fund to calculate the notional amount by reference to the fund’s pro rata portion of the notional amounts of the derivatives transactions of the underlying reference vehicle, which, in turn, must be calculated in a manner consistent with the requirements of the Proposed Rule.
- The Proposed Rule contains specific provisions for calculating the notional amount for certain defined “complex derivatives transactions.” The Proposed Rule defines a complex derivatives transaction as any derivatives transaction for which the amount payable by either party upon settlement date, maturity or exercise: (i) is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction; or (ii) is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price.8
The Proposed Rule includes a netting provision that would permit a fund, in determining its aggregate notional exposure, to net any directly offsetting derivatives transactions that are the same type of instrument and have the same underlying reference asset, maturity and other material terms.9
Asset Coverage Requirements
The Proposed Rule would require a fund to manage the risks associated with its derivatives transactions by maintaining a certain amount of “qualifying coverage assets” for each derivatives transaction, determined pursuant to policies and procedures approved by the fund’s board of directors. Under the Proposed Rule, “qualifying coverage assets” in respect of a derivatives transaction would be fund assets that either: (i) are cash and cash equivalents, or (ii) are with respect to any derivatives transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset. Notably, qualifying coverage assets do not include other types of liquid assets such as equities or investment grade bonds.
For each derivatives transaction, the Proposed Rule requires a fund to maintain qualifying coverage assets with a value equal to the sum of: (i) the amount that would be payable by the fund if the fund were to exit the derivatives transaction as of the time of determination (the “mark-to-market coverage amount”), and (ii) an additional amount that represents a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions (the “risk-based coverage amount”). The Proposed Rule requires the fund to identify qualifying coverage assets for derivatives transactions on the books and records of the fund at least once each business day, and the total amount of a fund’s qualifying coverage assets could not exceed the fund’s net assets.
The Proposed Rule would also allow a fund to reduce the mark-to-market coverage amount for a derivatives transaction by the value of any assets that represent variation margin or collateral to cover the fund’s mark-to-market loss with respect to the transaction.10
Under the Proposed Rule, the fund must determine the risk-based coverage amount for each derivatives transaction in accordance with policies and procedures approved by the fund’s board of directors. At a minimum, these policies and procedures should take into account, as relevant, the structure, terms and characteristics of the derivatives transaction and the underlying reference asset. If a fund elects to conduct stress testing for other purposes, and such stress tests incorporate factors other than those specified under the Proposed Rule, the fund should consider incorporating the results of such stress testing into the determination of its risk-based coverage amount.
Financial Commitment Transactions
The Proposed Rule would require a fund that engages in financial commitment transactions to maintain qualifying coverage assets equal in value to the amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under each of its financial commitment transactions. Under the Proposed Rule, “qualifying coverage assets” in respect of a financial commitment transaction would be fund assets that: (1) are cash and cash equivalents; (2) are, with respect to any financial commitment transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset; or (3) are assets that are convertible to cash or that will 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 or that have been pledged with respect to the financial commitment obligation and can be expected to satisfy such obligation, determined in accordance with policies and procedures approved by the fund’s board of directors.
A fund’s qualifying coverage assets for its financial commitment transactions, like the qualifying coverage assets for the fund’s derivatives transactions, would be required to be identified on the fund’s books and records, and determined at least once each business day.
Risk Management Program
Funds that engage in more than a limited amount of derivatives transactions, or that use complex derivatives transactions as defined in the Proposed Rule, must also have a formalized derivatives risk management program that includes policies and procedures reasonably designed to assess and manage the particular risks presented by the fund’s use of derivatives. The program’s requirements would be in addition to the requirements related to derivatives risk management that would apply to every fund that enters into derivatives transactions (e.g., portfolio limits and asset segregation).
Funds Subject to the Risk Management Program Condition
Funds that have aggregate exposure to derivatives transactions exceeding 50% of its net asset value, or that use complex derivatives, must adopt and implement a formalized risk management program. The 50% exposure condition would include exposures from derivatives transactions entered into by a fund, but would not include exposure from financial commitment transactions or other senior securities transactions entered into by the fund pursuant to Section 18 or 61 of the 1940 Act.
Required Elements of Formalized Risk Management Program
First, the formalized derivatives risk management program requires that the fund have policies and procedures reasonably designed to evaluate certain identified potential risks that are common to most derivatives transactions, as appropriate. The potential risks explicitly included in the Proposed Rule are, as applicable: (i) leverage risk, (ii) market risk, (iii) counterparty risk, (iv) liquidity risk, (v) operational risk, and (vi) any other risks considered relevant.
Second, the formalized derivatives risk management program requires that the fund have policies and procedures reasonably designed to manage the risks of its derivatives transactions, including by monitoring: (i) whether those risks continue to be consistent with any investment guidelines established by the fund or the fund’s investment adviser, (ii) the fund’s portfolio limitation established under the Proposed Rule, and (iii) relevant disclosure to investors. In addition, the formalized derivatives risk management program also requires policies and procedures reasonably designed to inform persons responsible for portfolio management of the fund or the fund’s board of directors, as appropriate, regarding material risks arising from the fund’s derivatives transactions. This element would not require a fund to impose particular risk limits.
Third, the formalized derivatives risk management program requires that the fund have policies and procedures reasonably designed to segregate the functions associated with the program from the portfolio management of the fund. However, the proposed rule’s segregation of functions is not meant to indicate that the derivatives risk manager and portfolio management should be subject to a communications “firewall.” Indeed, as discussed above, the derivatives risk management program would require that risk management personnel monitor the risks associated with the fund’s derivatives transactions and inform portfolio management (or the fund’s board) regarding those risks, as appropriate.
Fourth, the formalized derivatives risk management program requires that the fund have policies and procedures reasonably designed to review periodically (at least annually) and update the formalized derivatives risk management program, including any models (including any VaR calculation models used during the covered period), measurement tools, or policies and procedures that are part of, or used in, the program to evaluate their effectiveness and reflect changes in risks over time. Beyond these requirements, the Proposed Rule would not include prescribed review procedures or incorporate specific developments that a fund must consider as part of its review.
Administration of the Program
The Proposed Rule would expressly require a fund to designate an employee or officer of the fund or the fund’s investment adviser responsible for administering the policies and procedures of the formalized derivatives risk management program, whose designation must be approved by the fund’s board of directors, including a majority of the directors who are not interested persons of the fund.
The derivatives risk manager also may have other roles, including, for example, serving as the fund’s chief compliance office or chief risk manager (if it has one). Under the Proposed Rule, the derivatives risk manager must be an employee of the fund or its investment adviser, but may not be a portfolio manager of the fund.
Unlike the requirements concerning a fund’s chief compliance officer set forth in Rule 38a-1 under the 1940 Act, the Proposed Rule would neither require that a derivatives risk manager be removable only by the fund’s board of directors nor require the board’s approval of the derivatives risk manager's compensation.
Board Approval and Oversight
Under the Proposed Rule, the fund’s derivatives risk management program would be administered by the derivatives risk manager, with oversight provided by the fund’s board of directors. In addition, the Proposed Rule would require each fund to obtain initial approval of its written derivatives risk management program, and any material changes to the program thereafter, from the fund’s board of directors, including a majority of independent directors.
The fund’s board would be required under the Proposed Rule to review a written report from the fund’s derivatives risk manager, provided no less frequently than quarterly, that reviews the adequacy of the fund’s derivatives risk management program and the effectiveness of its implementation.
The Proposed Rule would also include certain recordkeeping requirements such as: (i) a record of each determination made by the fund’s board that the fund will comply with one of the portfolio limitations; (ii) a copy of the policies and procedures approved by the board regarding qualifying coverage assets; (iii) a record demonstrating compliance with the applicable portfolio limitation immediately after entering into the senior securities transaction; (iv) a record reflecting the fund’s aggregate mark-to-market and aggregate risk-based coverage amounts, and the qualifying coverage assets maintained to cover these aggregate amounts; (v) a record reflecting the fund’s financial commitment obligations and the qualifying coverage assets maintained for each specific financial commitment; (vi) fund’s financial commitment obligations (and the qualifying coverage assets maintained to cover these amounts); (vii) a copy of the policies and procedures approved by the fund’s board; (viii) records of any materials provided to the board in connection with the approval of the risk management program; and (ix) records documenting periodic updates and reviews required as part of the risk management program.
All of the stipulated records would be required to be kept for five years (the first two years in an easily accessible place).
The Commission proposed to amend Form N-PORT to require funds subject to the derivatives risk management program requirement to disclose additional risk metrics (i.e., gamma, which measures the sensitivity of delta in response to price changes, and vega, which measures the amount that an option contract’s price changes in relation to a one percent change in the volatility of an underlying asset) related to a fund’s use of options and warrants, including options on a derivative (e.g., swaptions). The Commission also proposed to amend Form N CEN to require that a fund disclose whether it relied on the Proposed Rule during the reporting period and the particular portfolio limitation (i.e., exposure-based or risk-based) applicable to the fund.
Comments on the Proposed Rule are due 90 days after publication in the Federal Register. We expect this to be sometime in the second half of March 2016. The Commission noted that, until the Proposed Rule is adopted, its current guidance will remain in place.11
The Proposed Rule represents a comprehensive overhaul of the regulatory framework for the use of derivatives by registered investment companies. Some funds will be unable to satisfy the elements of the Proposed Rule at all or without significant modification to their investment strategies. The Proposed Rule would substantially affect how registered investment companies use derivatives and engage in other financial transactions that create leverage. In addition, the requirements would present new operational challenges, expand reporting requirements, and impose new oversight responsibilities on a fund’s board of directors. We, along with others across the industry, continue to assess the impact of the Proposed Rule and we expect that industry participants will actively engage in the comment process and engage in active dialogue with the staff of the Commission throughout the comment period.