On October 28, 2020, the SEC adopted a new regulatory framework for derivatives use by registered investment companies. New Rule 18f-4 applies to mutual funds other than money market funds, exchange-traded funds (ETFs), closed-end funds, and business development companies (BDCs). The new rule permits such funds to enter into derivative transactions and certain other transactions notwithstanding statutory restrictions on the use of “senior securities” contained in Section 18 of the Investment Company Act of 1940 (the “1940 Act”). The new rule replaces prior guidance included in SEC releases and SEC staff no-action letters.
New Rule 18f-4 will be effective as of the date 60 days after publication of the adopting release in the Federal Register. Compliance with the new rule will be required 18 months after the effective date.
- Limit on Fund Leverage. Under Rule 18f-4, a fund will generally be subject to an outer limit on leverage based on value at risk (VaR) of 200% of a designated reference portfolio (DRP) or, alternatively, an absolute VaR test equal to 20% of the fund’s net assets. The DRP can be an index that meets certain requirements or the fund’s own securities portfolio (excluding derivative transactions). Closed-end funds that issue preferred stock are subject to a limit of 250% of the VaR of a DRP. If a fund is out of compliance with its VaR limit, it will need to come back into compliance “promptly,” in a manner that is in the best interests of the fund and its shareholders.
- Derivatives Risk Management Program. Under the new rule, funds that use derivatives to more than a limited extent must adopt a derivatives risk management program that is reasonably designed to manage a fund’s derivatives risks and to segregate the functions associated with such program from a fund’s portfolio management. The derivatives risk management program must address: (i) risk identification and assessment; (ii) risk guidelines; (iii) stress testing (at least weekly); (iv) backtesting (at least weekly); and (v) internal reporting and board escalation requirements.
- Board Oversight. A fund’s board is required to oversee the derivatives risk management program and designate a derivatives risk manager who has a direct reporting line to the board. The derivatives risk manager must report to the board at least annually regarding the program’s implementation and effectiveness and the results of the fund’s stress testing. Additionally, if the fund remains out of compliance with its VaR for more than five business days, the derivatives risk manager is required to analyze the circumstances that caused non-compliance and provide a written report to the board.
- Leveraged and inverse funds. The new rule allows any fund to offer leveraged/inverse products with a targeted daily return of up to 200% of the return (or inverse of the return) of the fund’s underlying index. In other words, leveraged/inverse funds will be required to operate in compliance with Rule 18f-4, except that leveraged/index funds in operation as of October 28, 2020 that seek a targeted return above 200% of the return (or inverse of the return) of the fund’s underlying index are grandfathered under the rule and will continue to be able to operate subject to the higher leverage limit. This is a departure from the proposed rule, which would have excepted all leveraged/inverse funds from the rule’s VaR-based leverage risk limit based on certain sales practices rules including requiring broker-dealers and investment advisers to engage in certain due diligence on retail investors prior to approving retail accounts for investments in leveraged/inverse products. The SEC determined not to impose such sales practice rules in the final rule because it agreed with a commenter’s arguments that investor protection concerns related to leveraged/inverse products are adequately addressed by the best interest standard of conduct for broker-dealers under Regulation Best Interest and the statutory fiduciary obligations of investment advisers.
- Exceptions for limited use of derivatives. A fund that limits its derivative exposure to 10% of its net assets (excluding derivatives transactions used to hedge certain currency and/or interest rate risks and positions closed out with the same counterparty) will be excepted from the VaR-based leverage limits and the requirements to adopt a derivatives risk management program. Such funds will, however, be required to adopt and implement written policies and procedures reasonably designed to manage the fund’s derivatives risks. The new rule also permits a fund to engage in reverse repurchase agreements and other similar transactions as long as it is subject to the asset coverage requirements of Section 18. A fund can also enter into an unfunded commitment agreement if the fund reasonably believes, at the time of entering into such agreement, that it will have sufficient assets to meet its obligations under the agreements as they come due.
A fund that relies on Rule 18f-4 must comply with VaR-based limits on fund leverage risk, adopt a derivatives risk management program (including an appointed derivatives risk manager), and comply with specific board oversight and reporting requirements, as set forth in more detail below.
Limit on Fund Leverage Risk. The rule requires funds to comply with a VaR‑based outer limit on fund leverage risk. Generally, this outer limit is based on a relative VaR test that compares the fund’s VaR to the VaR of a DRP. Under the rule, a DRP is either a designated unleveraged index that reflects the markets or asset classes in which the fund invests or, in the case of an actively managed fund, the fund’s securities portfolio excluding any derivatives transactions. In general, a fund may not use a designated index as its DRP if the designated index was “created at the request of the fund or its investment adviser.”
If a fund’s derivatives risk manager reasonably determines that a DRP would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund must comply with an absolute VaR test. The VaR of a fund relying on the relative VaR test may not exceed 200% of the VaR of its DRP. A fund relying on the absolute VaR test cannot have a portfolio VaR of more than 20% of the value of the fund’s net assets.
While there has been much focus on this component of the rule, the VaR tests in rule 18f-4 are a single metric within the overall derivatives risk management program (described in detail below). Comparing a fund’s VaR to that of an unleveraged reference portfolio that reflects the markets or asset classes in which the fund invests can help the derivatives risk manager determine whether a fund is using derivatives transactions to leverage the fund’s portfolio, which can magnify its potential for losses and significant payment obligations to derivatives counterparties. A VaR test can also demonstrate whether a fund is using derivatives for reasons other than leveraging the fund’s portfolio, which may be less likely to raise the concerns underlying Section 18 of the 1940 Act. For example, a fund that uses derivatives extensively, but has a VaR that does not substantially exceed the VaR of an appropriate benchmark, would not be substantially leveraging its portfolio.
The SEC acknowledged that the relative VaR test differs from the asset coverage requirements included in Section 18. However, the SEC takes the view that section18, “like the relative VaR test, limits a fund’s potential leverage on a relative basis rather than an absolute basis.” According to the adopting release, the relative VaR test is likewise designed “to limit the extent to which a fund increases its market risk by leveraging its portfolio through derivatives, while not restricting a fund’s ability to use derivatives for other purposes.”
The rule requires that any VaR model used by a fund for purposes of either the relative or absolute VaR test take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments. Funds must also provide parameters for the VaR calculation’s confidence level, time horizon, and historical market data. The final rule does not require a fund to use the same VaR model for calculating its portfolio’s VaR and the VaR of its DRP.
The rule does not prescribe the modeling methodology that must be followed by a fund in calculating its VaR. However, it includes a non-exhaustive list of market risk factors that a fund must account for in its VaR model (if applicable). These include: (i) equity price risk, interest rate risk, credit spread risk, foreign currency risk, and commodity price risk; (ii) material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (iii) the sensitivity of the market value of the fund’s investments to changes in volatility. Additionally, the rule prescribes that a fund’s VaR model use a 99% confidence level and a time horizon of 20 trading days. Moreover, a fund’s chosen VaR model must be based on at least three years of historical market data.
Derivatives Risk Management Program. A fund’s derivatives risk management program must be reasonably designed to ensure that the fund’s use of derivatives aligns with the fund’s investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements. The derivatives risk management program should complement, but not replace, a fund’s other risk management activities, including its liquidity risk management program under Rule 22e-4. The derivatives risk management program should take into account the way a fund uses derivatives, e.g., whether to increase investment exposures and increase portfolio risks, or to reduce portfolio risks or facilitate efficient portfolio management. The program must include, at a minimum, the following elements:
Derivatives risk manager. The program must be administered by an officer or officers of a fund’s investment adviser who serves as a fund’s derivatives risk manager. The derivatives risk manager may not be the fund’s portfolio manager, and the fund must reasonably segregate the functions of the program from its portfolio management functions.
The derivatives risk manager must have relevant experience such that she can carry out her responsibilities under the rule, including not only administering the program and the related policies and procedures, but also making necessary internal and board reports. The person(s) serving in this role must have sufficient authority within the investment adviser to carry out these responsibilities. Additionally, although she is responsible for administration of the program, the derivatives risk manager may hire and rely on others, including third-party service providers, to carry out the activities associated with the program. The rule also does not preclude a derivatives risk manager from delegating to a sub-adviser specific derivatives risk management activities that are not specifically assigned to the derivatives risk manager in the rule, subject to appropriate oversight.
The SEC acknowledged that many commenters raised the concern that an individual appointed as the derivatives risk manager could be subjected to increased potential liability based on her administration of the program. The rule does not change the standards that the SEC will apply in determining whether a person is liable for aiding, abetting, or causing a violation of the federal securities laws. The SEC said, however, that is “recognize[s] that risk management necessarily involves judgment. That a fund suffers losses does not, itself, mean that a fund’s derivatives risk manager acted inappropriately.”
Risk identification and assessment. The program must include procedures to identify and assess a fund’s derivatives risk in the context of its derivatives transactions and other investments. Moreover, the SEC said that an appropriate assessment of derivatives risks “generally involves assessing how a fund’s derivatives may interact with the fund’s other investments or whether the fund’s derivatives have the effect of helping the fund manage risks.” Under the rule, the following derivatives risks must be identified, assessed, and managed:
- leverage risk – the risk that derivatives transactions can magnify a fund’s gains and losses;
- market risk – the risk from potential adverse market movements in relation to the fund’s derivatives positions, or the risk that markets could experience a change in volatility that adversely impacts fund returns and the fund’s obligations and exposures;
- counterparty risk – the risk that a counterparty on a derivatives transaction may not be willing or able to perform its obligations under the derivatives contract, and the related risks of a fund having concentrated exposure to such a counterparty;
- liquidity risk – the risk related to liquidity demands that derivatives can create to make payments of margin, collateral, or settlement payments to counterparties;
- operational risk – risks related to potential operational issues, including documentation issues, settlement issues, systems failures, inadequate controls, and human error; and
- legal risk – the risk of insufficient documentation, insufficient capacity or authority of counterparty, or legality or enforceability of a contract.
Importantly, however, the rule does not limit a fund’s identification and assessment of derivatives risks to only those specified in the rule but specifically includes any other risks a fund’s derivatives risk manager deems material.
- Risk guidelines. The program will have to 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. These guidelines must be tailored to a particular fund’s investment strategy and objectives and specify metrics or thresholds that a fund does not normally expect to exceed and the measures to be taken if they are exceeded. According to the SEC, this requirement is “designed to address the derivatives risks that a fund would be required to monitor routinely as part of its program, and to help the fund identify when it should respond to changes in those risks.” A fund should keep in mind, when developing these guidelines, that they should complement, and not duplicate, other aspects of the derivatives risk management program including, specifically, the fund’s stress testing procedures.
Stress testing. The program will have to provide for stress testing of derivatives risks to evaluate potential losses to a fund’s portfolio under stressed conditions. Stress tests must “evaluate potential losses in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund’s portfolio.” Additionally, stress tests must take into account correlations of market risk factors and resulting payments to derivatives counterparties and address the frequency with which stress testing will occur in light of the fund’s strategy and investments and current market conditions, provided that stress tests must be conducted no less frequently than weekly.
Although not required by the rule itself, the SEC identified six factors—liquidity, volatility, yield curve shifts, sector movements, or changes in the price of the underlying reference security or asset—that could be considered for stress testing. Importantly, however, the SEC acknowledged that there are factors other than these that should be considered for stress testing, and the specific factors will vary from fund to fund based on the judgment of fund risk professionals designing the stress tests.
As noted above, stress testing must occur at least weekly. However, the scope of stress testing may vary. For example, a fund may conduct more-detailed scenario analyses monthly and conduct more-focused weekly stress tests. In short, hypothetical scenarios involved in stress testing should be tailored to the particular fund.
- Backtesting. The program must provide for backtesting a fund’s VaR calculation model on at least a weekly basis, taking into account the fund’s gain and loss on each business day during the backtesting period. Thus, the fund must compare its actual gain or loss for each business day during the week with the VaR the fund calculated for that day, and identify as an exception any instance in which the fund experiences a loss exceeding the corresponding VaR calculation’s estimated loss. The backtesting data will be used by the derivatives risk manager to assess when a fund’s VaR model should be adjusted.
Internal reporting and escalation. The program must provide for the reporting of certain matters relating to a fund’s derivatives use to the fund’s portfolio management and board of directors. The internal reporting and escalation components of the program must identify the circumstances under which persons responsible for portfolio management will be informed regarding the operation of the program (for example, when identified risk guidelines are exceeded) and the results of the fund’s stress testing. The program should also clarify when the derivatives risk manager must inform the fund’s board of material risks arising from the fund’s derivatives use. While the rule requires the derivatives risk manager to “timely” inform portfolio managers of material risks arising from the fund’s derivatives transactions, the derivatives risk manager has flexibility to inform the board about such material risks “as appropriate.” Moreover, a fund’s escalation requirements should be tailored based on its size, sophistication, and needs.
Although the rule specifies that a fund’s portfolio manager may not be the fund’s derivatives risk manager, the internal reporting and escalation requirements of the rule contemplate communication between a fund’s risk management and portfolio management regarding the operation of the program. According to the SEC, “[p]roviding portfolio managers with the insight of a fund’s derivatives risk manager is designed to inform portfolio managers’ execution of the fund’s strategy and recognize that portfolio managers will generally be responsible for transactions that could mitigate or address derivatives risks as they arise.”
- Periodic review of the program. A fund’s derivatives risk manager must review the program at least annually to evaluate the program’s effectiveness and to reflect changes in a fund’s derivatives risks over time. This review must include a review of the fund’s VaR calculation model and any DRP to evaluate whether it remains appropriate. Moreover, the SEC takes the view that a derivatives risk manager should periodically evaluate regulatory, market-wide, and fund-specific developments affecting the fund’s program so that she is well positioned to evaluate the program’s effectiveness. The minimum annual period for this review mirrors the minimum period in which the fund’s derivatives risk manager would be required to provide a written report on the effectiveness of the program to the board.
Board Oversight and Reporting. Under Rule 18f-4, the board is required to approve the designation of a fund’s derivatives risk manager with relevant experience in the management of derivatives risk. The board is not required to approve the derivatives risk management program itself. The SEC said that it anticipates that a fund’s adviser will, at the request of the board, carry out due diligence on appropriate candidates and articulate the qualifications of the candidate(s) that it puts forward to the board. However, “requiring the board to designate the derivatives risk manager is important to establish the foundation for an effective relationship and line of communication between a fund’s board and its derivatives risk manager.”
The rule requires the derivatives risk manager to provide a fund’s board with a written report at or before the implementation of the fund’s derivatives risk management program and at least annually thereafter. Among other things, such report must provide the board with information about the effectiveness and implementation of the program so that the board may appropriately exercise its oversight responsibilities, including its role under rule 38a-1. The derivatives risk manager should include in such report her representation that the program is reasonably designed to manage the fund’s derivatives risks and to incorporate the required elements of the program. The report must include the basis for such representation, which may be the derivatives risk manager’s reasonable belief after due inquiry.
The written report must also include, as applicable, the fund’s derivatives risk manager’s basis for the approval of the DRP (or any change in the DRP) used under the relative VaR test or, alternatively, explain why the derivatives risk manager determined it was not appropriate to use a DRP for purposes of the relative VaR test such that the fund relied on the absolute VaR test instead. In addition to the required annual report, the derivatives risk manager should provide the board (at a frequency determined by the board) with reports that analyze circumstances when the fund exceeded its risk guidelines and the results of the fund’s stress testing and backtesting.
Although it is the derivatives risk manager who must have relevant experience regarding the management of derivatives risk, the SEC said in the adopting release that the board should “understand the program and the derivatives risks it is designed to manage. They also should ask questions and seek relevant information regarding the adequacy of the program[.]” Among other things, this means that a board should inquire about material risks arising from a fund’s derivatives transactions and follow up regarding the steps the fund takes to address such risks and any change in those risks over time. Finally, the board is expected to take reasonable steps to see that matters identified through the derivatives risk management program are appropriately addressed.
Notwithstanding the level of expected involvement of the board, the SEC confirmed that the board’s role is one of “general oversight.” Consistent with that obligation, the SEC clarified that directors should “exercise their reasonable business judgment in overseeing the program on behalf of [a] fund’s investors.” The SEC also clarified its characterization of the process as “iterative,” meaning that the board’s oversight role requires regular engagement with the derivatives risk management program rather than a one-time assessment.
Exception for Funds with Limited Use of Derivatives
As noted above, a fund that limits its derivatives exposure to 10% of its net assets will be excepted from the rule’s requirements to adopt a derivatives risk management program, comply with the VaR-based limit on fund leverage risk, and comply with the related board oversight and reporting provisions. For purposes of this calculation, “derivatives exposure” means the sum of: (1) the gross notional amounts of a fund’s derivatives transactions such as futures, swaps, and options; and (2) in the case of short sale borrowings, the value of any asset sold short. A fund may exclude from the 10% threshold derivatives transactions that are used to hedge certain currency and/or interest rate risks and positions closed out with the same counterparty, but may not exclude offset positions across different counterparties.
A fund relying on the limited derivatives user exception will nonetheless be expected to manage the risks associated with its derivatives transactions by adopting and implementing written policies and procedures that are reasonably designed to manage such risks. The rule also contains remediation provisions to address instances in which a fund exceeds the 10% threshold. Thus, if a fund’s derivatives exposure exceeds the 10% derivatives exposure threshold for five business days, the fund’s investment adviser must provide a written report to the fund’s board of directors informing it whether the investment adviser intends either to: (i) promptly, but within no more than 30 calendar days, reduce the fund’s derivatives exposure to be in compliance with the 10% threshold; or (ii) adopt the requirements of Rule 18f-4, including establishing a derivatives risk management program, complying with the VaR-based limit on fund leverage risk, and complying with the related board oversight and reporting requirements as soon as reasonably practicable. In either case, the fund’s next filing on Form N-PORT must specify the number of business days, in excess of five business days, that the fund’s derivatives exposure exceeded 10% of its net assets during the applicable reporting period.
The SEC adopted certain amendments to the reporting requirements for funds that rely on Rule 18f-4, as set forth below.
Form N-PORT. Form N-PORT is amended to add new items to Part B (“Information about the Fund”). A fund that relies on the exception to the rule available to limited users of derivatives must report its aggregate derivatives exposure as of the end of each reporting period. Such a fund will also be required to break out certain aspects of its derivatives exposure, including exposure from currency and interest rate derivatives that hedge related risks, and report the number of business days (in excess of the five-business-day remediation period provided in Rule 18f-4) that derivatives exposure exceeded 10% of its net assets. The derivatives exposure information reported by funds that rely on exception for limited derivatives users will be confidentially reported and not publicly disclosed.
Funds that rely on Rule 18f-4 will be required to report their median daily VaR for the monthly reporting period. Funds subject to the relative VaR test will report, as applicable, the name of the fund’s designated index or a statement that the fund’s DRP is the fund’s securities portfolio, as well as their median VaR during the reporting. Funds subject to the absolute VaR test will report their median daily VaR during the reporting period. A fund’s median VaR information will not be publicly available.
A fund also must report the number of identified exceptions during the reporting period arising from backtesting the fund’s VaR calculation model, but this information will not be made publicly available.
- Form N-RN. Form N-LIQUID is renamed “Form N-RN,” and is amended to require a fund to file a Form N-RN to report that it is out of compliance with applicable VaR-based limits and has not come back into compliance within five business days of discovering the breach. Such fund must file a report within one business day following the fifth business day after the fund determined that it was out of compliance. The fund also is required to file a report on Form N-RN when it is back in compliance with the applicable VaR-based limit. This information will not be made public.
- Form N-CEN. Form N-CEN is amended to require a fund to identify whether it relied on Rule 18f-4 during the reporting period and whether it relied on any of the exceptions the rule’s requirements. A fund also has to identify whether it entered into reverse repurchase agreements or similar financing transactions, unfunded commitment agreements, or investments in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle. A fund is not required to publicly disclose its designated index in its annual report to shareholders.
New Rule 18f-4 creates a level playing field for registered funds that use more than a limited amount of derivatives. It recognizes that a fund may appropriately use derivatives for the benefit of a fund and its shareholders, provided that any resulting risks are understood and managed. Moreover, it facilitates the ability of fund sponsors to bring new leveraged/inverse funds to market.
For any fund that seeks to rely on Rule 18f-4, however, the rule creates another required risk-management program and meaningfully increases the oversight obligations of the board. Commenters on the proposal also argued that the rule unnecessarily inserts the board more firmly into management of a fund’s adviser by requiring that the derivatives risk manager, who must be an officer of the adviser, have a direct reporting relationship with the fund’s board. In recognition of this concern, the Commission clarified that a fund’s board will not be responsible for the day-to-day management of the fund’s derivatives risk.
Nonetheless, the Commission anticipates that the board of a fund relying on Rule 18f-4 will regularly engage with the derivatives risk management program (presumably through interactions with the derivatives risk manager) and actively inquire into material risks arising from the fund’s derivatives transactions and the steps the fund takes to address such risks. Boards should therefore expect to spend significant time over the next 18 months to come up to speed on a fund’s use of derivatives and their related risks. Boards should also expect to spend a meaningful amount of time reviewing derivatives and their associated risks on a going forward basis.