On December 11, 2015, the Securities and Exchange Commission proposed a new rule under the Investment Company Act of 1940 that would govern the use of derivatives (defined to include any swap, security-based swap, futures contract, forward contract, option or any similar instrument) by business development companies (“BDCs”). Under the proposed rule, a BDC would be required to comply with one of two alternative portfolio limitations and manage the risks associated with derivatives transactions by segregating certain assets. In addition, a BDC that engages in more than a limited amount of derivatives transactions or that uses complex derivatives would be required to establish a formalized derivatives risk management program.
Portfolio Limitations. Under the proposed rule, a BDC would need to comply with one of two alternative portfolio limitations designed to limit the amount of leverage that the BDC may obtain through derivatives and certain other transactions:
- Exposure-Based Limit. Under the exposure-based portfolio limit, a BDC would be required to limit its aggregate exposure to 150% of the BDC’s net assets. A BDC would generally calculate its “exposure” by adding the aggregate notional amount of its derivatives transactions with its obligations under financial commitment transactions (see below) and certain other transactions.
- Risk-Based Limit. Under the risk-based portfolio limit, a BDC would be permitted to obtain exposure up to 300% of its net assets, provided that it satisfies a risk-based test (based on valueat-risk (VaR)). The risk-based portfolio limit is designed to indicate whether a BDC’s derivatives transactions, in the aggregate, have the effect of reducing its exposure to market risk, as measured by the VaR test.
Asset Segregation. The proposed rule would require a BDC to manage the risks associated with its derivatives transactions by segregating a certain amount of “qualifying coverage assets” (cash and cash equivalents) designed to enable the BDC to meet its obligations arising from derivatives transactions. The amount a BDC would be required to segregate would equal the sum of two amounts:
- Mark-to-Market Coverage Amount. The amount the BDC would pay if it exited the derivatives transaction at the time of the determination.
- Risk-Based Coverage Amount. An additional risk-based coverage amount representing a reasonable estimate of the potential amount the BDC would pay if it exited the derivatives transaction under stressed conditions.
Financial Commitment Transactions. The proposed rule would impose a different asset segregation limit on “financial commitment transactions” (defined as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement). A BDC that engages in financial commitment transactions would be required to segregate an amount equal to the full notional amount of the instrument. For this purpose, “qualifying coverage assets” would be expanded to also include assets convertible to cash prior to the future payment date and the assets required to be delivered under the transaction if applicable.
Derivative Risk Management Program. Under the proposed rule, a BDC that engages in more than a limited amount of derivatives transactions (in excess of 50% of its net assets) or uses complex derivatives (as defined) would be required to establish and maintain a formalized derivatives risk management program. Among other things, the proposed rule would require the risk management program to be approved by the BDC’s board of directors (including a majority of disinterested directors) and to be administered by a designated derivatives risk manager (who must be an employee of the BDC or its investment adviser, but cannot be a portfolio manager of the BDC).
Comments on the proposed rule will be due 90 days after its publication in the Federal Register. The SEC’s release on the proposed rule may be accessed here.