In an effort to modernize the regulatory framework to reflect the evolution of derivatives use and related investor protection concerns, a divided U.S. Securities and Exchange Commission (SEC) approved, by a 3-2 vote, Rule 18f-4 under the Investment Company Act (the Act). This long-awaited derivatives risk management rule, which applies to mutual funds (other than money market funds), exchange-traded funds (ETFs), registered closed-end funds, and business development companies (BDCs) (collectively, funds), pulls back from some of the more controversial aspects of the 2019 proposed rule (which was itself a reproposal of a version of the rule from 2015). Rule 18f-4 replaces the current decades-old approach, which Chairman Jay Clayton called “outdated and unclear.”
Our take. The long-awaited rules clarify decades of confusing and sometimes contradictory guidance. Investment advisers, fund trustees, lawyers, and compliance personnel will adapt to the new limitations, compliance obligations, and oversight expectations as the rule phases in. The SEC, for the time being, will allow leveraged/inverse funds to continue to operate as they were and will further study the issue.
Compliance dates. The rule takes effect 60 days after its publication in the Federal Register and provides for a further 18-month compliance transition period.
Derivatives transactions.1 The new rule is premised on the SEC’s longstanding view that derivatives transactions and certain other transactions are subject to the provisions in the Act governing “senior securities.” For decades, registered investment companies complied with the limitations under Section 18 of the Act by segregating assets or offsetting positions on a transaction-by-transaction basis. The rule, however, takes an entirely new approach to managing the risks presented by these transactions. The new rule switches to an approach in which risks are managed fundwide by a derivatives risk management program coupled with maximum value-at-risk (VaR) limits. In particular, the rule provides that registered investment companies (again, other than money market funds) may engage in derivatives transactions, notwithstanding the statutory “senior securities” restrictions, subject to the following conditions.
- Derivatives risk management program. A fund that uses derivatives in more than a limited manner (as described below) must adopt a risk management program tailored to its derivatives risk, taking into account the particular types of derivatives the fund uses and their related risks, as well as the fund’s investment objective, portfolio, and strategy.
The derivatives risk management program must be administered by the fund’s derivatives risk manager (DRM). The DRM must be an officer or officers (or person(s) with comparable authority and ability) of the fund’s investment adviser that have been approved by the fund’s board for the purpose of administering the program. The DRM may be a committee but cannot be an entity. Each person comprising the DRM must have relevant experience — as determined by the fund — in the management of derivatives risk. The DRM may not be a portfolio manager of the fund if a single person serves in that position; if multiple officers comprise the DRM, then a majority of those persons cannot be portfolio managers.
The program must account for the identification and assessment of the fund’s derivatives risks and must provide for the establishment, maintenance and enforcement of risk guidelines, stress testing of derivatives risks to evaluate potential losses under stressed conditions, and backtesting of the VaR calculation model that the fund uses under the rule. The DRM may reasonably rely on third-party service providers in carrying out these risk management policies. A fund’s program also must provide for internal reporting and escalation of specified matters related to a fund’s derivatives use to the fund’s portfolio managers and the fund’s board.
In a departure from the proposal, under the final rule a fund’s board is not specifically required to approve the derivatives risk management program but instead will carry out general oversight of the program through the appointment of, and active engagement with, the DRM. The derivatives risk program will be part of the fund’s overall compliance program, which is subject to board approval and oversight.
The DRM must have a direct reporting line to the fund’s board and must periodically (no less than annually) review and evaluate the program’s effectiveness and make any necessary updates. The DRM also must provide the board with regular written reports, at a frequency determined by the board, regarding the program’s implementation and effectiveness, including a summary of stress testing results, and an analysis of any “exceedances” (a somewhat odd phrase that appears intended to avoid referring to these as “breaches” or “violations”) of program guidelines. In another change from the proposal, the final rule does not require that these reports describe every single exceedance but instead contemplates an overall analysis. In another change from the proposal, the DRM will be required to include in reports to the board the basis for any change in the fund’s designated reference portfolio as well as the basis of the approval of a designated reference portfolio. The SEC views these as important inputs to understanding the fund’s VaR testing.
The SEC describes the board’s role in a fund’s derivatives risk management program as one that involves regular engagement with the DRM, inquiry into material risks involving the fund’s derivatives transactions, requesting follow-up information when appropriate, and taking reasonable steps to ensure that any matters identified are addressed. The board’s role is one of oversight, not of day-to-day management of the program.
- VaR-based risk limits. Consistent with the proposal, funds that use derivatives in more than a limited manner are subject to an outer limit on risk under a set of VaR-based tests. The rule specifies that funds should apply a “relative VaR test” as the default measure while potentially permitting an alternative, “absolute VaR test,” under certain circumstances. In effect, the rule’s VaR tests do not limit the use of derivatives as such but rather are designed to limit their use only when they increase a fund’s risk exposure (as measured by VaR).
The SEC explains VaR in its rule release:
VaR is an estimate of an instrument’s or portfolio’s potential losses over a given time horizon and at a specified confidence level. VaR will not provide, and is not intended to provide, an estimate of an instrument’s or portfolio’s maximum loss amount. For example, if a fund’s VaR calculated at a 99% confidence level was $100, this means the fund’s VaR model estimates that, 99% of the time, the fund would not be expected to lose more than $100. However, 1% of the time, the fund would be expected to lose more than $100, and VaR does not estimate the extent of this loss.
The SEC acknowledges that “VaR is not itself a leverage measure” but goes on to say that the philosophy behind using VaR for this purpose is that
a VaR test, and especially one that compares a fund’s VaR to an unleveraged reference portfolio that reflects the markets or asset classes in which the fund invests, can be used to analyze whether a fund is using derivatives transactions to leverage the fund’s portfolio, magnifying its potential for losses ….
Under the relative VaR test, a fund will adopt a designated reference portfolio approved by the DRM against which to measure the fund’s exposure. The designated reference portfolio is intended to create a baseline VaR as a stand-in for the VaR of a fund’s unleveraged portfolio and may be either (i) a designated index that meets certain requirements, or (ii) in a change from the proposal and if the fund is actively managed, the fund’s own securities portfolio (excluding derivatives transactions). A fund will satisfy the relative VaR test if its portfolio VaR does not exceed 200% (rather than the proposed 150%) of the VaR of its designated reference portfolio. The relative VaR limit on leverage for closed-end funds with then-outstanding preferred stock is 250% (rather than the proposed 150%).
In most cases, the designated index may not be an index administered by an affiliate of the fund, its investment adviser or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used. In a change from the proposed rule, the final rule provides that if a fund’s investment objective is to track the performance of an unleveraged index, then the fund is required to use that index as its designated reference portfolio even if it would otherwise be a prohibited index under the rule. Also in a change from the proposal, a fund will not be required to disclose its designated reference portfolio in its annual reports.
If, however, the fund’s DRM reasonably determines, having considered the fund’s investments, investment objectives and strategy, that the fund’s designated reference portfolio is not an appropriate reference for the relative VaR test, the fund instead must comply with an absolute VaR test. The fund will satisfy the absolute VaR test if its portfolio VaR does not exceed 20% (rather than the proposed 15%) of the value of the fund’s net assets. The absolute VaR limit for closed-end funds with then-outstanding preferred stock is 25%.2
As to frequency of testing, a fund must determine its compliance with the applicable VaR test at least once each business day. If the fund determines it is not compliant with the VaR-based limits, it must come back into compliance promptly. If it fails to do so within five business days (rather than the proposed three), the fund’s DRM must provide certain written reports to the board and SEC and undertake additional analysis.
- Exception for limited derivatives users. Funds that make limited use of derivatives are excepted from the requirements to adopt a derivatives risk management program and comply with the VaR-based limits as well as the related board oversight and reporting requirements. This exception is available to a fund that limits its derivatives exposure to 10% of its net assets. For purposes of this exception, “derivatives exposure” means the sum of (i) the gross notional amounts of a fund’s derivatives transactions, such as futures, swaps and options, and (ii) in the case of short borrowings, the value of any assets sold short. Transactions that are used to hedge certain currency and/or interest rate risks are excluded from the calculation. These funds instead are required to adopt and implement written policies and procedures reasonably designed to manage their level of derivatives risk (i.e., written policies and procedures are still required, but their form and content are not specified).
The final rule, unlike the proposal, provides two routes for remediation in the event that a fund relying on the limited derivatives user exception exceeds the 10% exposure threshold. When the threshold has been exceeded for five business days, the fund must provide the board with a written report indicating whether the adviser intends to (i) reduce exposure promptly (but within no more than 30 days) or (ii) establish a derivatives risk management program and come into compliance with the applicable VaR-based limit and related board oversight and reporting requirements as soon as practicable. In either case, the fund’s next Form N-PORT must specify the number of business days, in excess of the five-day remediation period, during which the fund’s exposure exceeded 10% of its net assets.
Leveraged and inverse funds. The SEC did not adopt controversial proposed sales practices rules that would have required a broker-dealer or investment adviser to assess the ability of an investor in leveraged and inverse funds to understand the risks of investing in those funds. Leveraged/inverse funds instead will be subject to all provisions of the final rule, including the VaR-based limits, subject to certain grandfathering terms.
Effectively, a leveraged/inverse fund’s targeted daily return is limited to 200% of the return (or inverse of the return) of the fund’s underlying index. The SEC grandfathered existing leveraged/inverse funds (that is, funds that seek to provide returns of three times the return of a benchmark index, positive or inverse), exempting them from the VaR limits, but will not allow any new funds that have limits of more than 200%. Under the grandfathering terms, a leveraged/inverse fund that was in operation as of October 28, 2020 and cannot comply with the VaR-based risk threshold may continue to operate under certain conditions and if the fund otherwise complies with all other requirements of the final rule.
The SEC notes that the enhanced standard of conduct for broker-dealers under Regulation Best Interest and fiduciary obligations of registered investment advisers help to address some of the concerns at which the proposed sales practice rules were aimed. In a statement on leveraged/inverse funds, the SEC required the staff to further study complex derivatives products, as described below.
The SEC also is amending Rule 6c-11 (the SEC’s principal ETF rule) to include leveraged/inverse ETFs so that they can operate without obtaining or relying on an exemptive order from the SEC, provided they comply with Rule 18f-4 as applicable. Leveraged/inverse funds had been excluded from Rule 6c-11, pending completion of the current rulemaking. With leveraged/inverse ETFs now covered by Rule 6c-11 and either fully under Rule 18f-4 or under the rule but grandfathered from the VaR tests, the SEC rescinded all previously issued leveraged/inverse fund exemptive orders.
Reverse repurchase agreements and similar financing transactions. The rule will allow funds to enter into reverse repurchase agreements (reverse repos) and similar financing transactions so long as they meet the Section 18 asset coverage (“senior security”) requirements. In a change from the proposal, funds have the option of treating reverse repos as derivatives transactions rather than including them in the fund’s asset coverage calculations. The election must apply to all of a fund’s reverse repos and similar financing transactions.
Unfunded commitment agreements. The rule will allow funds to enter into unfunded commitment agreements if the fund reasonably believes, at the time of entering into these agreements, that it will have sufficient cash and cash equivalents to meet its obligations under the agreement. A fund should consider specific factors when forming its reasonable belief, including existing obligations related to senior securities or redemptions. A fund may consider its strategy, assets, liquidity and borrowing capacity under existing committed lines of credit. A fund cannot, however, consider any cash that may become available from a sale or disposition of any investment at a price not reflected in the market or from issuing additional equity.
Rescind and withdraw existing guidance. The SEC rescinded Release 10666, which since 1979 has provided guidance with respect to senior securities, upon the effective date of Rule 18f-4. The SEC is also withdrawing other guidance, including certain derivatives-related no-action letters, upon the effective date of the recession of Release 10666.
Remediation for violations. The new rule eased limits on a fund’s ability to remediate violations and eliminated a proposed limitation on the ability of a fund to enter into new derivatives transactions while out of compliance.
Amendments to fund reporting requirements. With certain modifications to the proposal, the SEC is adopting amendments to Forms N-PORT, N-LIQUID (to be retitled Form N-RN) and N-CEN.
Form N-PORT is amended to include an item for certain funds’ derivatives exposure. The amendments will not require all funds to report their aggregate derivatives exposure as proposed; instead only a fund that relies on the limited derivatives exception will be required to do so. Also in a change from the proposed rule, a limited derivatives user will be required to report information regarding instances when the fund’s derivatives exposure exceeded the 10% exposure threshold. Reporting on exceedances will not be made publicly available. Also to be reported but not publicly available is information on a fund’s median daily VaR, median VaR ratio (a percentage of the VaR of the fund’s designated reference portfolio) and VaR backtesting.
Form N-LIQUID, retitled Form N-RN, will reflect new reporting items for funds that are subject to the VaR-based risk limits under the new rule. Although only registered open-end funds were required to file reports on Form N-RN, now all funds subject to the new rule will file Forms N-RN to report VaR test breaches under certain circumstances. As was proposed, this information will not be made publicly available.
Form N-CEN is amended to require a fund to indicate its reliance on the new rule (and any exceptions) during the reporting period. A fund also must identify on Form N-CEN whether it has entered into any reverse repos or similar financing transactions and will indicate whether the fund has entered into these transactions in compliance with Section 18’s asset coverage requirements or as derivatives transactions in compliance with the new rule. A fund also must identify whether it has entered into unfunded commitment agreements.
Recordkeeping. A fund will be subject to certain new recordkeeping requirements, including to maintain, for a period of five years, records including those documenting its derivatives risk management program, testing results, materials provided to its board in connection with the approval and designation of a DRM, written reports provided to the fund’s board and VaR testing-related documents. A fund that is a limited derivatives user must maintain records of its derivatives risk management policies and any reports related to exceedances of the exposure threshold. Funds also are subject to recordkeeping requirements related to their treatment of reverse repos.
Statement on Complex Financial Products. In a separate statement, the SEC expressed concern that retail investors “may not fully appreciate” how complex products, including leveraged/inverse funds, operate and the associated risks of these investments. The statement noted that the concerns are heightened during times of market stress, when these complex products are disproportionately affected and may not perform as expected. The statement noted that self-directed investors, who are increasingly making investment decisions without the assistance of financial professionals, may not have the required protections that they would have when they receive advice from broker-dealers and investment advisers. In light of these concerns, the SEC directed its staff to review the effectiveness and adequacy of the existing investor protection requirements, particularly with respect to self-directed accounts that invest in leveraged/inverse funds.
The dissenting Commissioners. The two dissenting Commissioners, Allison Herren Lee and Caroline A. Crenshaw, objected to the final rule, generally because they believe it did not go far enough to address investor protection concerns. Commissioner Crenshaw said she believes that the rule “fails to provide a meaningful limit on registered funds’ ability to take on leverage.” Commissioner Lee expressed disapproval of the SEC’s decisions to remove a significant amount of the proposed required disclosure around a fund’s VaR and to reject the proposed sales practice rules. She said that while she supported the rule as proposed, the final rule “abandons much of what made it a reasonable balanced approach.”
The final rule can be found here.
The Joint Statement Regarding Complex Financial Products and Retail Investors is available here.