SEC Adopts New Regulatory Framework For Use Of Derivatives By Registered Funds – Finance and Banking

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”).¹ 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.

Summary

• 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.

Detailed Requirements

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.”²

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.³

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.⁴

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.

SEC Reporting

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.

Conclusion

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.

Footnotes

1 Section 18 of the 1940 Act imposes limits on a
fund’s capital structure. Among other things, Section 18
restricts a fund’s ability to issue “senior
securities.” A senior security is defined, in part, as
“any bond, debenture, note, or similar obligation or
instrument constituting a security and evidencing
indebtedness.”

2 A fund with the investment objective to track the
performance (including a leveraged multiple or inverse multiple) of
an unleveraged index must use the unleveraged index it is tracking
as its DRP. Additionally, an actively managed fund may use a
blended index as its designated index, provided that each
constituent index meets the rule’s requirements.

3 Under the final rule, closed-end funds that have issued
to investors and have outstanding shares of a senior security that
is a stock are subject to relative and absolute VaR limits of 250%
and 25%, respectively. A closed-end fund that does not obtain
equity-based structural leverage would, however, be subject to the
same 200% relative VaR limit as other funds.

4 A fund also may obtain the VaR of its DRP from a
third-party vendor instead of analyzing it in-house.

Because of the generality of this update, the information
provided herein may not be applicable in all situations and should
not be acted upon without specific legal advice based on particular
situations.

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