The Securities and Exchange Commission proposed a new rule aimed at limiting the leverage registered investment companies could obtain through the use of derivatives transactions.
In addition, the SEC’s proposed new rule would require investment companies to set aside in segregation qualifying assets to meet their mark-to-market liability as well as to cover potential future losses on derivatives transactions. Also, investment companies would be required to establish a formalized risk management program to manage the risks of derivatives transactions if they engaged in more than a limited number of transactions.
Investment companies would also be required to segregate certain assets in connection with other transactions that have a potential deferred financial obligation, such as repurchase agreements and short sales—termed “financial commitment transactions.” For such transactions, an investment company would be required to separately set aside qualifying assets with a value equal to the total amount of cash or other assets it must or conditionally might have to pay to satisfy its obligations.
Investment companies include mutual funds, exchange-traded funds—so-called ETFs—, and closed-end funds (collectively, "funds"). Derivatives include swaps, security-based swaps, futures contracts, forward contracts, options and similar type instruments where a fund is or might be required to make payments or deliver cash or other assets during the life of the instrument or at any future time, whether as margin, settlement or otherwise.
Under applicable law, a fund is limited in its ability to borrow money or issue senior securities. The SEC considers the use of derivatives as generally implicating this provision:
where [a] fund has entered into a derivatives transaction and has a future payment obligation—a conditional or unconditional contractual obligation to pay in the future—we believe that such a transaction involves an evidence of indebtedness that is a senior security for purposes of [applicable law].
(Click here to access the relevant law, Section 18 of the Investment Company Act, 15 US Code § 80a-18.)
SEC Chair Mary Jo White explained her unease regarding the status quo in approving issuance of the proposed new rule:
I am concerned about the potential for ...losses under the current regulatory framework. Today, funds can obtain high levels of exposure through the current practice of “mark-to-market segregation,” where a fund only segregates liquid assets equal to the current liability, if any, of a derivative transaction… This practice also raises concerns that a fund may not have sufficient liquid assets to meet potential future losses because a fund may only maintain liquid assets to cover losses that the fund has already incurred.
Under the SEC’s proposed new rules, a fund would have to comply with one of two leverage restrictions in connection with its derivatives transactions—an exposure-based position limit or a risk-based portfolio limit. Under the former limit, a fund would have to limit its aggregate exposure to 150 percent of its net assets (based on the notional amount of its derivatives transactions). Alternatively, a fund could obtain exposure to derivatives up to 300 percent of its assets provided the fund also satisfied a risk-based test. The greater potential leverage would be justified under this alternative test, said the SEC, because the fund’s portfolio would presumably be subject to less market risk by including derivatives than by not.
A fund would also have to separately segregate qualifying assets equal to an amount it would have to pay to exit the derivatives transaction at the time of the determination (so-called "mark-to-market coverage amount") plus an additional amount derived from a reasonable estimate of what the fund might have to pay to liquidate its derivatives transactions under stressed circumstances (so-called "risk-based coverage amount").
Finally, a fund that undertook more than a limited number of derivatives transactions or used complex derivatives would have to maintain a formalized risk management program under the oversight of a designated risk manager. The program would have to be “reasonably designed” to assess, manage and monitor the risks of derivatives transactions and to segregate functions of relevant personnel. Formalized risk programs would require annual updates and reviews.
Funds’ board of directors — including a majority of disinterested directors — would have to approve a registered fund’s risk management program and any material changes, as well as the designation of the derivatives risk manager.
The SEC also proposed amendments to funds’ reporting obligations that would require them to disclose to the Commission on a monthly and yearly basis certain information regarding their derivatives’ use.
In issuing a dissenting statement in connection with the Commission’s issuance of its proposed new rule, Commissioner Michael Piwowar claimed that the proposed limits on leverage were unnecessary. This is because, he said,
the proposed asset segregation requirements should function as a leverage limit on funds and ensure that funds have the ability to meet their obligations arising from derivatives. Therefore, absent data indicating that a separate specified leverage limit is warranted, there is no justification for imposing any additional requirements or burdens on funds.
The SEC will accept comments on its proposed new rule for 90 days after their publication in the Federal Register.