Use of Derivatives by Registered Investment Companies and Business Development Companies
The SEC has approved new Rule 18f-4 under the Investment Company Act to permit funds to use derivatives subject to certain conditions, serving 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. 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 (no more than 10% of net assets derivatives exposure) will not be required to have a 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.
For derivatives users, 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 (less common), 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. 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.
In a welcome change from the proposal, 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 rulemaking. 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.
The new rule will be effective February 19, 2021, and compliance will be required by August 19, 2022. For more information, including specific detailed requirements, registrants should review the SEC’s adopting release at the following link on the SEC’s website:
Good Faith Determination of Fair Value
The SEC approved new Rule 2a-5 under the Investment Company Act to clarify a fund board’s valuation duties, consolidate and eliminate a constellation of prior guidance, and explicitly permit a board to assign day-to-day valuation duties to the investment adviser (but not a subadviser). The new rule tracks closely to the rule proposal, which was designed to hew closely to well-established valuation practices and existing guidance. The final rule requires the board or its designee to periodically assess and manage risks, select valuation methodologies and monitor for circumstances that require fair valuation, test fair valuation methodologies, and provide oversight of third-party pricing services. If the board assigns valuation to the adviser, the rule requires some segregation between the portfolio manager and the valuation process, but advisers can continue to seek assistance from third parties (e.g., the administrator, pricing services). The final rule provides a bit more flexibility to board reporting than had been proposed. For example, the valuation designee now will have five (rather than three) business days to report “material” valuation matters, which includes significant deficiencies or material weaknesses in the fair value determination process or material errors in the NAV calculation. The final rule also eliminates the mandatory quarterly reporting to fund boards. The Commission simultaneously approved a new rule 31a-4 (splitting it out of proposed Rule 2a-5), which imposes new recordkeeping requirements with respect to fair valuations. Shifting this provision to a separate rule ensures that boards are not targeted for valuation enforcement actions just because record-keeping was deficient.
Importantly, Rule 2a-5’s definition of “readily available market quotations” (which is used to distinguish securities that will require fair valuation) will be applied to Rule 17a-7. Many in the industry have interpreted Rule 17a-7 to allow cross trading fixed-income securities. Under the new definition, however, securities that are not exchange-traded (e.g., most fixed income) would not qualify for Rule 17a-7’s exemption that otherwise permits cross trading in certain circumstances. SEC staff have confirmed that compliance with the new definition for Rule 17a-7 purposes is not required until compliance with Rule 2a-5 is required, but in the meantime, advisers would be well advised to proceed with caution given that the Commission evidently disfavors employing Rule 17a-7 to cross-trade fixed-income securities.
The new rule will be effective March 8, 2021, and compliance will be required by September 8, 2022. For more information, including specific detailed requirements, registrants should review the SEC’s adopting release at the following link on the SEC’s website:
Electronic Signatures in Regulation S-T Rule 302
The SEC amended (without notice or comment) Rule 302 of Reg. S-T to allow electronic signatures instead of “wet” signatures on filings as long as certain procedures are followed. Specifically, the rule allows electronic signatures on authentication documents required for EDGAR filings that are required to be signed. The current rule requires filers to manually sign a signature page or other document (“authentication document”) before or at the time of the electronic filing to “authenticate, acknowledge, or otherwise adopt the signature that appears in typed form within the electronic filing.” In order to use an electronic signature, you must satisfy the following conditions:
- Require the signatory to present a physical, logical, or digital credential that authenticates the signatory’s individual identity;
- Reasonably provide for non-repudiation of the signature;
- Provide that the signature be attached, affixed, or otherwise logically associated with the signature page or document being signed; and
- Include a timestamp to record the date and time of the signature.
Beware that you still must have a manual signature on file. Before using an electronic signature, the signatory must manually sign a document agreeing that the electronic constitutes the legal equivalent of that person’s manual signature. The electronic filer then must retain this manually signed document for as long as the electronic signature will be used, and a minimum of seven years after the date of the most recent electronically signed authentication document. The authentication document itself also must be maintained for five years, as currently required. The new rule was effective as of December 4, 2020. For more information, please review the SEC’s adopting release at the following link on the SEC’s website:
