On December 11, 2015, the Securities and Exchange Commission (the “SEC”) proposed Rule 18f-4 (the “Rule”), a new exemptive rule under the Investment Company Act of 1940, as amended (the “1940 Act”), to govern the use of derivatives and other financial instruments by registered investment companies and business development companies (each, a “fund”). The Rule would permit a fund to enter into “derivatives transactions”1 and engage in “financial commitment transactions,”2 provided that the fund complies with the Rule’s requirements. If adopted, the Rule would supersede the guidance provided by the SEC in Release 106663 , as well as the guidance provided by the SEC staff through various no-action letters concerning a fund’s use of derivatives and financial commitment transactions.
The Rule would require a fund to:
(i) with respect to derivative transactions, comply with one of two alternative portfolio limitations;
(ii) maintain qualifying coverage assets;
(iii) with respect to derivative transactions, adopt and implement a written risk management program (unless a usage-based exemption applies);
(iv) adopt policies and procedures reasonably designed to provide for the fund’s maintenance of qualifying coverage assets; and
(v) maintain a variety of additional written records pertaining to the fund’s use of derivatives and/or financial commitment transactions.
Each of the foregoing conditions is summarized below.
Portfolio Limitations on Derivative Transactions
A fund engaging in derivative transactions pursuant to the Rule would be required to comply with either of the following two portfolio limitations intended to restrict the amount of leverage the fund may obtain through its use of derivatives:
- Exposure-Based Portfolio Limitation: A fund’s aggregate exposure under its derivatives transactions, financial commitment transactions and other transactions involving a senior security entered into by the fund pursuant to Section 18 of the 1940 Act (e.g., bank borrowings), may not, immediately after entering into any such transaction, exceed 150% of the fund’s net assets. The Rule specifies how a fund must determine its aggregate exposure, which is based on the notional amount (or adjusted notional amount) of the fund’s obligations under a derivative transaction, the amount of cash or other asset that the fund is obligated to pay under a financial commitment transaction (such amount, a “financial commitment obligation”), and the indebtedness with respect to any senior securities transaction entered into by the fund; or
- Risk-Based Portfolio Limitation: A fund’s exposure under its derivative transactions, financial commitment transactions and other senior securities transactions may not, immediately after entering into any such transaction, exceed 300% of the fund’s net assets. A fund that elects to comply with this risk-based limitation would be permitted to obtain exposure up to the 300% limitation, so long as the fund’s “full portfolio VaR” (as such term is defined in the Rule) is less than the fund’s “securities VaR” (as such term is defined in the Rule).4 The Rule sets certain requirements for any VaR model that a fund uses to determine its securities VaR and full portfolio VaR, including a minimum 99% confidence interval and a time horizon of not less than 10 and not more than 20 trading days.
The fund’s board of directors, including a majority of the directors who are not interested persons of the fund, would be required to approve the portfolio limitation selected for use by the fund.
Qualifying Coverage Assets for Derivative and Financial Commitment Transactions
Under the Rule, a fund engaging in derivative and/or financial commitment transactions must maintain “qualifying coverage assets.” The required amount and type of qualifying coverage assets differ by transaction type.
A. Derivative Transactions
Amount of Coverage Assets. For each derivatives transaction, a fund would be required to maintain qualifying coverage assets with a value equal to the amount that would be payable by the fund if the fund were to exit the transaction as of the time of determination (the “mark-to-market coverage amount”), plus an additional amount representing a reasonable estimate of the potential amount payable by the fund if the fund were to exit the transaction under stressed conditions (the “risk-based coverage amount”). The Rule does not define stressed conditions for this purpose.
Type of Coverage Assets. A fund’s qualifying coverage assets for its derivatives transactions generally would be required to consist of cash and cash equivalents. In addition, with respect to any derivatives transaction under which a fund may satisfy its obligations under the transaction by delivering a particular asset, the Rule would permit the fund to segregate that particular asset as a qualifying coverage asset. These coverage assets are more limiting than those currently permitted under applicable SEC staff guidance.
B. Financial Commitment Transactions
Amount of Coverage Assets. A fund that engages in a financial commitment transaction pursuant to the Rule would be required to maintain qualifying coverage assets equal in value to the fund’s full conditional and unconditional obligations under such transaction.
Type of Coverage Assets. A fund’s qualifying coverage assets for financial commitment transactions would be required to consist of cash and cash equivalents, and assets that are convertible to cash or that generate cash prior to the date on which the fund expects to be required to pay its obligations under the transaction. In addition, the Rule would permit a fund to maintain as qualifying coverage assets for a financial commitment transaction assets that have been pledged with respect to the financial commitment obligation and can be expected to satisfy such obligation.
C. Identification of Coverage Assets and Related Procedures
The Rule would require a fund to identify on its books the qualifying coverage assets in accordance with the Rule, and determine such assets at least once each business day. In addition, the fund would be required to adopt policies and procedures reasonably designed to provide for the fund’s maintenance of qualifying coverage assets, which policies and procedures must be approved by the fund’s board of directors, including a majority of its independent directors. For derivative transactions, the fund would be required to maintain a written record of, among other things, the mark-to-market coverage amount and risk-based coverage amount for each derivative transaction, and records identifying the qualifying coverage assets maintained by the fund with respect to its aggregate mark-to-market and risk-based coverage amounts. For financial commitment transactions, the fund would be required to maintain a written record of, among other things, the amount of each financial commitment obligation and records identifying the qualifying coverage assets maintained by the fund with respect to such obligation.
Derivatives Risk Management Program
Unless the proposed “limited use” exemption described below applies, a fund entering into derivatives transactions would be required to adopt and implement a written derivatives risk management program that is (i) reasonably designed to assess and manage risks associated with the fund’s derivatives transactions; and (ii) administered by a designated derivatives risk manager who must be an employee of the fund or its investment adviser, but may not be a portfolio manager of the fund.
The fund’s board of directors, including a majority of its independent directors, must initially approve the risk management program and any material changes thereto, and approve the designation of the risk manager. The fund’s board would also be required, at least quarterly, to review written reports prepared by the risk manager regarding the program’s adequacy and effectiveness.
In addition, a fund required to adopt a written risk management program must also adopt and implement written policies and procedures reasonably designed to:
- assess the risks associated with the fund’s derivative transactions, including an evaluation of potential leverage, market, counterparty, liquidity and operational risks, and any other relevant risks;
- manage risks associated with the fund’s use of derivatives, including by monitoring such use and informing the fund’s portfolio manager or board regarding material risks arising from such transactions;
- reasonably segregate the functions associated with the program from the portfolio management of the fund; and
- periodically (but at least annually) review and update the program, including any models (e.g., VaR calculation models used during the review period), measurement tools, and policies and procedures used in connection with the program.
A fund would not be required to adopt a formal derivatives risk management program under the Rule if:
(i) the fund makes only “limited use” of derivatives (i.e., immediately after entering into any derivative transaction, the fund’s aggregate exposure to derivative transactions does not exceed 50% of the value of the fund’s net assets)5; and
(ii) the fund does not enter into “complex derivatives transactions”6.
Role of Fund Boards
As indicated above, a fund’s board would be required to, among other things:
- with respect to derivative transactions, approve the particular portfolio limitation(s) to be used by the fund in accordance with the Rule, including, if applicable, the limited use test;
- approve written policies and procedures reasonably designed to provide for the fund’s maintenance of qualifying coverage assets for derivative transactions and for financial commitment transactions; and
- if the fund is required to have a derivatives risk management program, approve the risk management program and any material amendments thereto, approve the designated risk manager responsible for administering the program, and review quarterly reports prepared by the risk manager regarding the program’s adequacy and effectiveness.
The Rule would require a fund entering into transactions pursuant to the Rule to maintain certain additional written records, including:
- a record of every portfolio limitation determination made by the fund’s board;
- copies of the policies and procedures relating to the fund’s derivatives risk management program, materials given to the fund’s board of directors in connection with its approval of the program and records documenting periodic reviews of the program;
- records demonstrating the fund’s compliance with applicable portfolio limitations, which records must reflect, among other things, the fund’s aggregate exposure and the value of the fund’s net assets; and
- records relating to the qualifying coverage assets maintained by the fund.
In the proposing release relating to the Rule, the SEC also proposed amendments to proposed Forms N-PORT and N-CEN that would require reporting and disclosure of certain information regarding a fund’s use of derivatives.
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Comments on the proposal are due 90 days after it is published in the Federal Register.
1 “Derivatives transaction” is defined in the Rule as any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar 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 a margin or settlement payment or otherwise.
2 “Financial commitment transaction” is defined in the Rule as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement (such as an agreement under which a fund has obligated itself, conditionally or unconditionally, to make a loan to a company or to invest equity in a company, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner).
3 Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979). Release 10666 would be rescinded if the Rule is adopted.
4 The VaR test is intended to provide an indication of whether a fund’s aggregate use of derivatives will effectively reduce the fund’s exposure to market risk.
5 This 50% limitation applies only to derivative transactions; a fund would not need to take into account its exposures from financial commitment transactions or other senior securities transactions entered into by the fund pursuant to Section 18 of the 1940 Act.
6 “Complex derivatives transaction” is defined in the Rule as any derivatives transaction for which the amount payable by either party upon settlement date, maturity or exercise is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction, or is a non-linear function of the underlying reference asset’s value, other than due to optionality arising from a single strike price.
If you have any questions regarding the matters covered in this memo, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Investment Management Group.