Compliance Matters - New Derivatives Rule (18f-4)

Nov 30, 2020

As we approach the Thanksgiving holiday, it is time to reflect on (and give thanks for?) the bounty of new rules and regulations the SEC has adopted.

Foremost among them, as you no doubt know, is the new derivatives rule, Rule 18f-4 of the Investment Company Act, recently adopted by a 3-2 vote at the Commission after years in the making. The new Rule functions as an exemption to Section 18’s restriction on funds’ use of senior securities. Rule 18f-4 replaces a patchwork of prior guidance concerning asset segregation in favor of “new value at risk” (VaR) limits coupled with derivatives risk management requirements. The Rule applies to mutual funds (but not money market funds), ETFs, closed-end funds, and BDCs. What follows is (a) a summary of the key features of the Rule, and (b) a discussion of what this means for boards, funds, and advisers. Rest assured, we are working diligently to implement the new Rule and expect to have new policies and procedures in place well before the deadline for implementation (likely summer of 2022, or 18 months after it the Rule is published in the Federal Register).

Rule Summary

Rule 18f-4 will permit funds to use derivatives subject to certain conditions. Fundamentally, the Rule limits leverage by confining a fund’s use of derivative (swaps, futures, forwards, options, short sales, borrowings, and similar transactions) to a prescribed VaR limit and requiring funds using derivatives to adopt a derivatives risk management program (DRMP), administered by a derivatives risk manager (DRM), overseen by the board. Funds that make only limited use of derivatives – which will be most funds (as discussed further below) – will not be required to have a full-blown DRMP or DRM, but such funds still will have to adopt and implement policies and procedures reasonably designed to manage the fund’s derivatives risks. The Rule also amends certain forms and requires additional reporting about funds’ use of derivatives, and it imposes recordkeeping requirements. Key elements of the Rule are described below:

  • VaR Limits. The Rule imposes limits on funds’ leverage risk based on a VaR calculation to measure the overall derivatives exposure of the portfolio. (The VaR limit replaces the prior asset segregation requirements.) The Rule’s default VaR test requires that a fund’s VaR be measured relative to the VaR of the fund’s “designated reference portfolio,” which is either a reference index selected by the DRM or the fund’s own portfolio excluding derivatives transactions. Under this relative VaR test, the fund’s VaR is not permitted to exceed 200% (250% for certain closed-end funds) of the VaR of the designated reference portfolio. Alternatively, if the DRM reasonably determines that no designated reference portfolio can be identified (likely uncommon), the fund instead would calculate an absolute VaR and may not exceed 20% (25% for certain closed-end funds) of the fund’s net assets. A fund must measure its compliance with the applicable VaR test at least once each business day.
  • DRMP. Derivatives users will be required to adopt a formal DRMP that includes policies and procedures to manage derivatives risk. While there is some flexibility to tailor the program to the particular portfolio, every fund’s program must provide for risk identification and assessment, risk guidelines, weekly stress testing, weekly back-testing, internal reporting and escalation, and periodic reviews of the DRMP. Risk guidelines must be quantitative, but the Rule does not prescribe particular criteria or limits. The program must be administered by a DRM, who is an officer or officers of the fund’s investment adviser, who is responsible for reporting to the Board about the program’s effectiveness and stress testing. The Rule requires that the fund “reasonably segregate” the risk management from portfolio management. To that end, if a single person serves as the DRM, that person cannot be a portfolio manager; likewise, the Rule forbids using a committee if the majority is composed of portfolio managers.
  • Board Oversight. The Board is not required to approve the DRMP, but the board must approve the fund’s DRM and review an initial report and at least annual reports concerning the DRMP’s effectiveness. The DRM also must report on stress testing and back-testing results, as well as report any breach of the program’s guidelines. If a fund is out of compliance for more than five business days, the DRM must report to the board and explain how and when the DRM reasonably expects the fund will return to compliance, and then provide an update within 30 days.
  • Reporting and Recordkeeping. Funds will be required to report confidentially to the Commission on Form N-RN (which also replaces Form N-LIQUID) if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than five business days. There also will be additional reporting required on the Forms N-CEN and N-PORT. In addition to written policies and procedures required of all funds, funds derivatives users also must maintain written records concerning (i) VaR-related determinations and calculations, (ii) testing, (iii) internal reporting, (iv) periodic reviews, (v) materials provided to the Board, (vi) sufficiency of cash obligations for unfunded commitments, and (vii) treatment of reverse repurchase agreements.
  • Limited Derivatives User Exception. Importantly, limited derivatives users – those that limit VaR to 10% of net assets (excluding certain currency and interest rate hedging transactions) – are excepted from the DRMP and DRM requirements provided that such funds have adopted policies and procedures to manage their derivatives risks. The SEC estimates that 80% of funds will qualify for this exception. The currency or interest rate hedges can be excluded if they for bona fide hedging purposes and the notional amounts of such derivatives do not exceed the value of the hedged investments (or the par value of fixed-income investments, or the principal amount of borrowings) by more than 10%. If a fund is out of compliance for more than five business days, the adviser must report to the board how it will get back into compliance within 30 days in a manner in the best interest of shareholders, or it must establish a DRMP and comply with the VaR limits.
Impact on Boards, Funds, and Advisers

All funds will be required to adopt and implement written policies and procedures to manage derivatives risks. The SEC recognized that such policies should be tailored to the fund’s derivatives use and thus some funds may have “limited” policies. We anticipate that most funds will qualify as “limited derivatives users” exempt from the more onerous DRMP requirements, but at least some funds may be subject to the Rule’s full requirements, which, in a series trust complex, will require comprehensive trust-level policies. Advisers that manage portfolios that rely on derivatives transactions should evaluate whether their portfolio strategy can satisfy the VaR limits. Advisers also must identify a person or persons with relevant experience who can serve as DRM for such funds, and they will need to tailor their own adviser policies to address derivatives risk management. This may require a significant investment of resources. Implementing a DRMP may be onerous, particularly for smaller advisers that may have limited in-house resources to appoint a DRM. The Rule does not allow outsourcing the DRM role except to a sub-adviser that manages the entire portfolio, and the DRM must be a natural person or persons (unlike the Liquidity Rule, which permits appointing the adviser as the liquidity program administrator). Thus, Boards and advisers must consider whether pursuing a derivatives strategy is worth the added burden and expense of implementing the required risk management program.

The determination whether a full DRMP is required will hinge on a VaR calculation. While that is a familiar concept to more experienced derivatives users, it may be a foreign concept to others (and it is, in any case, a new regulatory obligation for everyone). The Rule does not prescribe a specific VaR method, so careful consideration must be given to methodologies that can be implemented effectively and consistently, and calculation may require hiring third-party vendors or implementation of new software. VaR also must be back-tested at least weekly using a one-day time horizon at a 99% confidence level. Thus, funds will need to closely monitor back-testing results and update the DRMP as needed. Importantly, VaR is not intended to replace other models and testing that advisers employ to manage portfolio risk (particularly tail risk); other testing (e.g., historical simulations, parametric models) may continue to inform decisions about risk and may be incorporated as elements of the fund’s DRMP.

Boards will have substantial new oversight responsibilities with the new Rule. Although not required to approve the DRMP, they are responsible for approving the DRM and reviewing initial, annual, and other periodic reports about the DRMP’s effectiveness. This will require that boards be reasonably conversant in the elements of derivatives risk management, and they may wish to consider forming a special committee or consult an outside expert for help in fulfilling its obligations. Boards should assess whether D&O insurance, as well as the adviser’s E&O policy, covers potential liability for losses associated with the use of derivatives.

In a welcome change from the proposed rule, the final Rule scrapped a proposal that would have required certain sales practices requirements for distributing leveraged or inverse funds that seek a return greater than 200% of the return (or its inverse) of a reference index. Such funds instead will be subject to the derivates rule (effectively limiting new leveraged funds to 2x), and likely a separate future rule making. Existing 3x funds (i.e., those in operation by October 28, 2020) can continue to operate, but new funds will not be permitted to exceed 200% VaR (except for de minimis deviations). The SEC also amended Rule 6c-11 to permit leveraged or inverse ETFs to operate without exemptive relief provided they satisfy Rule 6c-11. Notably, in a separate statement, the SEC reiterated concerns that retail investors may not understand how leveraged and inverse funds operate and perform. Recent enforcement actions in this area reflect that concern and, hence, we anticipate there will be rulemaking in this area.

Rule 18f-4 has many more detailed provisions and requirements, including provisions addressing reverse repos, securities lending, short sales, and unfunded commitments. We welcome your questions about these or any of the provisions discussed above. In the meantime, we are working to develop trust-level policies and procedures to comport with the new Rule’s requirements for both limited and full derivatives users. We also are exploring whether a software solution can be implemented as an additional compliance testing tool. We plan to consult you as we design new compliance policies to implement the Rule, and you CCO will provide periodic updates as we make significant progress toward that end. Please feel to reach out to your trust CCO or me if you have questions or would like to discuss further.

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