These regulatory actions include: (1) new Rule 18f‑4 under the Investment Company Act of 1940 (the Final Rule); (2) a related rule amendment under the 1940 Act pertaining to leveraged/inverse exchange-traded funds (ETFs); (3) related fund reporting rule and form and registration statement form amendments; and (4) a conforming amendment to Rule 22e-4 under the 1940 Act (collectively, the Final Rulemaking).
The Final Rulemaking represents the most significant change to the way the Commission regulates funds’ use of derivatives and other transactions and the obligations of fund boards with respect to such transactions since the Commission’s foundational Release 10666 was published in 1979. The Final Rulemaking was proposed in November 2019 and was a re-proposal of a 2015 Commission rulemaking effort. The 2015 proposed rulemaking was the first significant Commission or staff action relating to funds’ use of derivatives and certain other transactions that create leverage since the Commission’s issuance of a Concept Release in 2011.
The Final Rulemaking includes a number of significant changes from the 2019 Proposal. The Adopting Release highlights that many of the changes from the 2019 Proposal were made in response to industry comments, and that certain changes take into account in particular commenters’ experiences in managing funds’ derivatives risk through the period of market volatility following the 2020 outbreak of the COVID-19 coronavirus across the world.
In light of the Final Rule, and consistent with the approach identified under the Proposed Rule, the Commission is rescinding Release 10666 and the related “asset segregation” requirements articulated in that release, after an 18-month transition period to allow funds to prepare to come into compliance with the Final Rulemaking following its effective date, which will be 60 days after its publication in the Federal Register. The Commission staff also will withdraw related no-action letters and other guidance or portions thereof to the extent moot, superseded or otherwise inconsistent with the Final Rule. As a result, any fund will need to comply with the conditions set forth in the Final Rule in order to engage in the applicable transactions.
The Commission and its staff historically have taken positions that investments in many different types of derivatives (as well as other transactions) that represent a “contractual obligation to pay in the future for consideration presently received,” whether for speculative purposes or for leveraging, fall within the “functional meaning” of the term “evidence of indebtedness” for purposes of Section 18, and therefore potentially are senior securities.9 In Release 10666, the Commission took the position that a fund could engage in certain trading practices that may involve the issuance of senior securities, if the fund maintains a segregated account of liquid assets to “cover” the transaction. Since then, the staff of the Commission’s Division of Investment Management has provided guidance through no-action relief that allowed funds to cover derivatives transactions in a variety of ways, including through the use of offsetting transactions. Various industry practices based on Release 10666 and the Commission staff guidance have developed further over time. 10 Commission Views on Current Practices The Adopting Release states that the Commission continues to view trading practices that impose a contractual obligation on a fund to pay or deliver assets in the future to a counterparty as falling within the functional meaning of the term “evidence of indebtedness,” and therefore the Commission views these transactions as involving “the issuance of a senior security for purposes of section 18.” In the Adopting Release, the Commission highlights that funds have developed practices for covering derivatives transactions that are based “at least in part” on staff guidance and no-action letters. The Adopting Release discusses how funds’ asset segregation practices vary depending upon the type of derivatives transaction. Moreover, the Adopting Release notes that fund practices also vary with respect to the types of assets set aside for coverage. The Adopting Release expresses the Commission’s view that the practices regarding derivatives currently used by funds do not address the undue speculation and asset sufficiency concerns underlying Section 18, and “may involve risks that can result in significant losses to a fund.” In light of these concerns, the Adopting Release states that the Final Rule is intended to: provide an “updated, comprehensive approach to the regulation of funds’ use of derivatives”; limit the risks posed by funds’ derivatives use by creating a board oversight and compliance framework; and establish an outside limit on fund leverage risk. 8 See Provisions Of The Proposed Bill Related To Capital Structure (Sections 18, 19(B), And 21(C)), Introduced by L.M.C Smith, Associate Counsel, Investment Trust Study, Securities and Exchange Commission, Hearings on S.3580 Before a Subcommittee of the Senate Committee on Banking and Currency, 76th Congress, 3rd session (1940); Release 10666 at n. 8. See also Sections 1(b)(3), (7) and (8) of the 1940 Act. 9 See, e.g., Release 10666 at text accompanying n.14 (regarding reverse repurchase agreements, firm commitment agreements, and standby commitment agreements); see also Dreyfus Strategic Investing and Dreyfus Strategic Income, SEC No-Action Letter (June 22, 1987) (Dreyfus) (regarding short selling, futures, certain types of options, forward currency contracts). 10 See, e.g., Dreyfus (permitting the use of offsetting positions); Merrill Lynch Asset Management, L.P., SEC No-Action Letter (July 2, 1996) (Merrill Lynch) (permitting the use of “any asset, including equity securities and non-investment grade debt ... so long as the asset is liquid and marked to market daily” when covering derivatives transactions). Dechert LLP November 2020 Page 4 Introduction to the Framework under the Final Rulemaking Derivatives Transactions The Final Rule provides that, if a fund satisfies the conditions described below, the fund may enter into derivatives transactions (defined below), notwithstanding the requirements of Sections 18(a)(1), 18(c), 18(f)(1) and 61 of the 1940 Act. Derivatives transactions entered into in compliance with the Final Rule will not be considered for purposes of computing asset coverage, as defined in Section 18(h) of the 1940 Act. A fund transacting in derivatives must comply with the following requirements, unless the fund is a limited derivatives user (as discussed below): Derivatives Risk Management Program. The fund must adopt and implement a written derivatives risk management program (Program), which includes policies and procedures that are reasonably designed to manage the fund’s derivatives risks and to reasonably segregate the functions associated with the Program from the portfolio management of the fund. The Program must include specific elements, which are described below. Board Oversight and Reporting. The fund’s board, including a majority of directors/trustees who are not interested persons of the fund, must approve the designation of a “derivatives risk manager,” which is discussed below. The derivatives risk manager must provide a written report to the board on or before implementation of the Program, and at least annually thereafter, regarding certain matters relating to the Program. The derivatives risk manager also will need to provide to the board regular written reports, at a frequency determined by the board, regarding the derivatives risk manager’s analysis of “exceedances” of “risk guidelines,” as well as the results of certain stress testing and backtesting required under the Program. Limit on Fund Leverage Risk. The fund must comply with an outer limit on fund leverage risk based on value-at-risk (VaR). Under this requirement, the fund must comply with a “relative VaR test” unless the fund’s derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for this purpose, taking into account the fund’s investments, investment objectives, and strategy. A fund that does not apply the relative VaR test must comply with an “absolute VaR test.” Under the relative VaR test, the fund’s VaR may not exceed 200% of the VaR of a designated reference portfolio (250%, for certain closed-end funds). Under the absolute VaR test, a fund’s VaR may not exceed 20% of the value of the fund’s net assets (25% for certain closed-end funds). The fund will need to determine its compliance with the applicable VaR test at least once each business day; additional requirements will be triggered if the fund determines that it is not in compliance with the applicable VaR test. Alternatively, a fund that enters into derivatives transactions is not required to adopt a Program or comply with the board oversight and reporting requirements or the limit on fund leverage risk, if the fund: (1) adopts and implements policies and procedures reasonably designed to manage the fund’s derivatives risks; and (2) limits its derivatives exposure to 10% of its net assets. For purposes of the 10% limit, derivatives exposure excludes certain currency and interest rate derivatives used for specified hedging purposes. Additional requirements will be triggered if a fund determines that it is not in compliance with the 10% limit. This aspect of the Final Rule is referred to as the “limited derivatives user exception.” Dechert LLP November 2020 Page 5 Reverse Repurchase Agreements, Similar Financing Transactions and Unfunded Commitments The Final Rule provides that a fund may enter into reverse repurchase agreements and similar financing transactions notwithstanding the requirements of Sections 18(a), 18(c) and 18(f)(1) of the 1940 Act, subject to certain requirements. To enter into reverse repurchase agreements and similar financing transactions, the fund must: (1) (a) comply with the asset coverage requirements under Section 18; and (b) combine the aggregate amount of indebtedness associated with such transactions with the aggregate amount of any other senior securities representing indebtedness when calculating the asset coverage ratio; or (2) treat all such agreements and transactions as derivatives transactions for all purposes under the Final Rule. The Final Rule provides that a fund may enter into unfunded commitment agreements notwithstanding the requirements of Sections 18(a), 18(c), 18(f)(1) and 61 of the 1940 Act, subject to certain requirements. To enter into an unfunded commitment agreement, the fund must reasonably believe, at the time it enters into such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements as they come due. Leveraged/Inverse Funds A leveraged/inverse fund (as defined below) generally is subject to all of the provisions of the Final Rule, including the relative VaR test. However, the Final Rule includes an exception from the limit on fund leverage risk for leveraged/inverse funds that were in operation as of October 28, 2020 and seek an investment result above 200% of the return (or inverse of the return) of an underlying index, provided such a fund satisfies certain additional conditions. Other Requirements The Commission adopted amendments that would permit leveraged/inverse funds to operate as ETFs pursuant to Rule 6c-11 under the 1940 Act. The Commission also is rescinding the exemptive orders previously issued to sponsors of leveraged/inverse ETFs upon which those funds currently rely. In addition, the Commission adopted conforming amendments to Rule 22e-4 under the 1940 Act as part of the Final Rulemaking. The Commission also adopted related recordkeeping requirements and amendments to Form N-PORT, Form NLIQUID (which will be re-titled as Form N-RN), and Form N-CEN, as well as certain related reporting requirements under the 1940 Act, “to enhance the Commission’s ability to oversee funds’ use of and compliance with the proposed rules effectively, and for the Commission and the public to have greater insight into the impact that funds’ use of derivatives would have on their portfolios.” Repeal of Existing Commission Guidance As noted above, the Commission is rescinding Release 10666, and the Commission’s staff will withdraw certain related no-action letters and guidance in conjunction with the adoption of the Final Rule. * * * The key components of the Final Rulemaking are discussed in further detail below. As appropriate, the text of each of the following sections sets forth a description of the Final Rulemaking, and Dechert’s analysis of and observations regarding the Commission’s guidance provided in the Adopting Release are set forth in bullet points following the description of the Final Rulemaking. Dechert LLP November 2020 Page 6 Scope of the Final Rule Funds Subject to the Final Rule The Final Rule applies to registered open-end and closed-end investment companies and BDCs, including any separate series thereof, but does not apply to any registered open-end investment company that is regulated as a money market fund under Rule 2a-7 under the 1940 Act (with a limited exception for certain when-issued, forwardsettling and non-standard settlement cycle securities transactions, discussed below).11 In addition, unit investment trusts (UITs) are not permitted to rely on the Final Rule. Fund Transactions Subject to the Final Rule The Final Rule defines as a “derivatives transaction”: 1. Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (“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; 2. Any short sale borrowing; and 3. Any reverse repurchase agreement or similar financing transactions (each as defined below), if a fund relies on Rule 18f-4(d)(1)(ii) and therefore is required to treat its reverse repurchase agreements and similar financing transactions as derivatives transactions (as discussed below).12 Separately, the Final Rule provides that a fund or a money market fund may invest in a security on a when-issued or forward-settling basis, or with a non-standard settlement cycle, and the transaction will be deemed not to involve a senior security, provided that: (i) the fund intends to physically settle the transaction; and (ii) the transaction will settle within 35 days of its trade date.13 The treatment of such when-issued, forward-settling and non-standard settlement cycle securities transactions represents a significant deviation from the 2019 Proposed Rule, which might not have permitted certain money market funds to continue investing in these products. The Adopting Release notes that this provision will allow money market funds to continue to be able to invest in when-issued Treasury securities “notwithstanding that these investments trade on a forward basis involving a temporary delay between the transaction’s trade date and settlement date.”