On October 28, 2020, the Securities and Exchange Commission (Commission) adopted Rule 18f-4 (Rule), and rule and form amendments under the Investment Company Act of 1940, as amended (1940 Act), which are designed to provide a modernized and comprehensive approach to the regulation of the use of derivatives and other financial instruments by registered investment companies and business development companies (funds).1 The Release also includes amendments to Rule 6c-11 under the 1940 Act (which permits most exchange-traded funds (ETFs) to operate without obtaining an exemptive order) to cover certain leveraged or inverse ETFs.
The Rule becomes effective 60 days after publication in the Federal Register, which has not occurred as of the date of this client memorandum. Compliance with the Rule is required 18 months after the rule becomes effective.2
Key aspects of the new regulatory framework for derivatives that are addressed in the Release are summarized below.
The Rule permits a fund to enter into certain derivatives and financial commitment transactions notwithstanding the limitations of Section 18 of the 1940 Act,3 provided certain conditions are met. For derivatives transactions4, the Rule generally requires a fund to:
- adopt and implement a written derivatives risk management program (DRMP) (unless the limited derivatives user exception discussed below applies) and designate a derivatives risk manager (DRM);
- limit its leverage risk to a prescribed value-at-risk (VaR) limitation (unless the limited derivatives user exception applies) and report confidentially to the Commission on Form N-RN if certain events occur with respect to the VaR limitation;
- comply with certain reporting and disclosure requirements; and
- maintain a variety of written records pertaining to the fund’s use of derivatives transactions.
Each of the foregoing requirements is summarized below.
Reverse purchase agreements and unfunded commitment transactions are subject to different requirements than derivatives transactions under the Rule; these requirements are also highlighted below.
Derivatives Risk Management Program
Unless the fund is a “limited derivatives user” (as described below), the Rule requires a fund to adopt and implement a DRMP that includes policies and procedures reasonably designed to manage the fund’s derivatives risks and to reasonably segregate the functions associated with the DRMP from the portfolio management of the fund.
The Rule requires a fund to designate a DRM, who must be approved by the fund’s board of directors (board), including a majority of directors who are not interested persons of the fund, and is responsible for administering the DRMP. Under the Rule, an officer or officers of the fund’s investment adviser is required to serve as the fund’s DRM (the DRM may not be the investment adviser itself but rather must be one or more natural persons). The DRM may not be a third party or a portfolio manager of the fund (or, if the DRM consists of multiple persons, a majority of the fund’s portfolio managers) and must have relevant experience regarding the management of derivatives risk.
The Release notes that the Rule does not preclude a DRM from delegating to a sub-adviser specific derivatives risk management activities that are not specifically assigned to the DRM under the Rule, subject to appropriate oversight, but notes that the fund retains ultimate responsibility for compliance with the Rule, and that where risk management activities are delegated to a sub-adviser, the fund’s policies and procedures generally should address the oversight of any delegated activities.
While the DRMP must cover certain general elements, it must be tailored based on how the fund’s use of derivatives may affect the fund’s investment portfolio and overall risk profile. The Rule requires the DRMP to include the following elements:
- Risk identification and assessment. The DRMP must provide for the identification and assessment of a fund’s derivatives risks, which must take into account the fund’s derivatives transactions and other investments.
- Risk guidelines. The DRMP must provide for the establishment, maintenance and enforcement of investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to a fund’s derivatives risks. For example, a fund could establish investment size controls or lists of approved transactions for the fund.
- Stress Testing. The DRMP must provide for stress testing of derivatives risks to evaluate potential losses to a fund’s portfolio under stressed conditions.
- The DRMP must provide for backtesting to be conducted no less frequently than weekly of the VaR calculation model that the fund uses under the Rule.
- Internal reporting and escalation. The DRMP must provide for the reporting of certain matters relating to a fund’s derivatives use to the fund’s portfolio management and the fund’s board.
- Periodic review of the DRMP.A fund’s DRM is required to review the DRMP, periodically but no less frequently than annually, to evaluate the DRMP’s effectiveness and to reflect changes in derivatives risk over time.
Limits on the Fund’s Leverage Risk
Unless the fund is a limited derivatives user, the Rule generally requires a fund engaging in derivatives transactions to comply with an outer limit on fund leverage risk based on value at risk, or “VaR.” VaR is an estimate of an instrument’s or portfolio’s potential losses over a given time horizon and at a specified confidence level.5 The outer limit on fund leverage risk is based on a relative VaR test that limits the VaR of the fund’s portfolio to 200% of the VaR of a designated reference portfolio – either an index that meets certain requirements (Designated Index) or the fund’s own securities portfolio (excluding derivatives transactions), as selected by the DRM, to be measured at least once each business day. A Designated Index must be unleveraged and reflect the markets or asset classes in which the fund invests.
If the DRM reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for the relative VaR test, the Rule requires the fund to comply with an absolute VaR test. A fund satisfies the absolute VaR test if its portfolio VaR does not exceed 20% of the value of the fund’s net assets.
The Rule provides relative and absolute VaR limits of 250% and 25%, respectively, for closed-end funds that have issued and have outstanding shares of preferred stock.
The Rule also provides for a remediation period of five business days during which a fund may be out of compliance with its VaR test without being required to report to the fund’s board and confidentially to the Commission.
Board Oversight and Reporting
Unless the fund is a limited derivatives user, the fund’s board, including a majority of its independent directors, must approve the designation of the DRM, who is responsible for administering the DRMP, as indicated above.
On or before the implementation of the DRMP, and at least annually thereafter, the DRM must provide to the fund’s board a written report providing, among other things, a representation that the DRMP is reasonably designed to manage the fund’s derivatives risks and to incorporate the elements of the DRMP. The written report must include the basis for the representation along with such information as may be reasonably necessary to evaluate the adequacy of the DRMP and, for reports following the DRMP’s initial implementation, the effectiveness of its implementation. In addition, the DRM must provide to the fund’s board, at a frequency determined by the board, written reports analyzing exceedances of the fund’s risk guidelines and the results of the fund’s stress tests and backtesting.
Under the Rule, the fund’s board is not required to specifically approve the DRMP or any material changes thereto, but the board is responsible for overseeing the fund’s compliance with the Rule, in connection with the board’s role under Rule 38a-1 under the 1940 Act, which provides for oversight of compliance by the fund’s adviser and other service providers. The Commission indicated in the Release that it believed that the board should view oversight as an “iterative process,” requiring regular engagement with the DRMP rather than an one-time assessment. In this regard, the Commission indicated that the board’s role should be an active one that involves inquiry into material risks arising from the fund’s derivatives transactions and follow-up regarding the steps the fund has taken to address such risks.
Fund Reporting and Disclosure Requirements
The Commission adopted amendments to the reporting requirements for funds that will rely on the Rule, notably amendments to Forms N-PORT, N-LIQUID (re-titled as “Form N-RN,” to reflect that funds will use this form to file risk notices), and Form N-CEN. The amendments are designed to enhance the Commission’s ability to oversee funds’ use of and compliance with the Rule, and to provide the Commission and the public additional information regarding funds’ use of derivatives. Certain information filed with the Commission will not be publicly available, such as median VaR information and backtesting results, derivatives exposure of limited derivative users, and fund reports filed on Form N-RN.
Exception for Limited Derivatives Users
The Rule provides an exception from the DRMP requirements and the VaR-based limit(s) on fund leverage risk, and the related board oversight and reporting requirements, for those funds that qualify as a “limited derivatives user.” The exception is available for a fund if its derivatives exposure does not exceed 10% of the fund’s net assets.6 In calculating derivatives exposure to determine eligibility for the exception, a fund is permitted to exclude currency or interest rate derivatives that hedge certain currency and interest rate risks associated with specific equity or fixed-income investments held by the fund, or the fund’s borrowings, subject to certain conditions. Furthermore, the Rule provides for a remediation period of five business days during which a fund may be out of compliance with the 10% threshold requirement without being required to report to the fund’s board and confidentially to the Commission. A fund that relies on the limited user exception is required to adopt written policies and procedures that are reasonably designed to manage its derivatives risks.
The Commission adopted certain recordkeeping requirements designed to provide the Commission, and a fund’s compliance personnel, the ability to evaluate the fund’s compliance with the Rule, including requirements for records documenting the DRMP and its implementation, and for materials provided to the fund’s board. The Rule requires funds to maintain the required records for a period of five years.
Treatment of Reverse Repurchase and Unfunded Commitment Agreements
The Rule permits a fund to engage in reverse repurchase agreements (reverse repos) and similar financing transactions so long as the reverse repo or other transaction is subject to the relevant asset coverage requirements of Section 18 of the 1940 Act.7 A fund would also be permitted to enter into these transactions if it treats them as derivatives transactions under the Rule. This alternative approach allows funds to apply a consistent set of requirements to its derivatives transactions and any reverse repurchase agreements or similar financing transactions.
In addition, a fund is permitted under the Rule to enter into unfunded commitment agreements when the fund “reasonably believes” at the time the fund enters into such agreement that it will have sufficient cash and cash equivalents to meet its obligations under all of its unfunded commitment agreements as they come due. A fund is required to document the basis for its reasonable belief and retain this documentation as part of the fund’s records.
The Rule also includes a provision that permits funds, as well as money market funds,8 to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to certain conditions.
Amendments to Rule 6c-11 – Leveraged/Inverse Funds and ETFs
Leveraged/inverse funds are generally subject to the Rule, including the VaR-based limit on fund leverage risk, effectively limiting leveraged/inverse funds’ targeted daily return to 200% of the return (or inverse of the return) of the fund’s underlying index. The Rule, however, provides an exception from the VaR-based limit for leveraged/inverse funds in operation as of October 28, 2020 that seek to exceed the 200% threshold, provided they satisfy certain conditions. In connection with the adoption of the Rule, the Commission has amended Rule 6c-11 under the 1940 Act to permit leveraged/inverse ETFs to rely on Rule 6c-11 if they comply with all applicable provisions of the Rule, permitting new leverage/inverse funds to come to market without first being required to receive separate ETF exemptive orders.
Proposed Sales Practice Rules. The 2019 Commission re-proposal for Rule 18f-4 included proposals for new sales practice rules, Rule 15l-5 under the Securities Exchange Act of 1934, as amended, and Rule 211(h)-1 under the Investment Advisers Act of 1940, as amended (Proposed Sales Practice Rules), which would have required brokers, dealers and registered advisers to exercise due diligence in approving certain clients to transact in shares of certain leveraged or inverse funds and certain commodity or currency pools. The Commission did not adopt the Proposed Sales Practice Rules and will spend additional time reviewing the effectiveness of existing regulatory requirements in protecting investors investing in leveraged/inverse products and other complex investment products. The Release noted that the enhanced standard of conduct for broker-dealers under Regulation Best Interest and the fiduciary obligations of registered investment advisers also apply to broker-dealer recommendations and advice from investment advisers, respectively, in connection with leveraged/inverse funds.
The new derivative regulatory framework effectively eliminates the Commission’s and Staff’s long-standing requirements for funds to maintain segregated accounts or otherwise “cover” their obligations in connection with various transactions, including derivatives transactions, otherwise restricted by Section 18 of the 1940 Act. The new DRMP requirements, however, are fairly substantial and may affect the degree of use of derivatives by certain funds, including funds that may only want to be treated as “limited derivative users” under the Rule. In addition, firms, particularly smaller ones, may not have a current officer who can serve as a DRM and may have to incur costs in appointing and training one, in addition to other costs of implementing a DRMP, such as performing VaR calculations, stress testing and backtesting.
At the same time, the new requirements may be more comprehensive than the existing practices for some funds and thus may enhance their risk management with respect to derivatives.