(Article from Registered Funds Alert, February 2016)
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As we have discussed in previous Alerts, under pressure from the Financial Stability Oversight Council (“FSOC”), the Securities and Exchange Commission (“SEC”) is in the midst of proposing a series of rules affecting the asset management industry designed to minimize the alleged systemic risk posed to the financial system by mutual funds. The SEC had indicated that it plans to propose five new rules (data reporting, liquidity management, derivatives management, transition planning and third-party examinations of advisers), and the recently proposed derivatives rule is the third of these.
In December 2015, the SEC proposed new Rule 18f-4 under the 1940 Act (“Proposing Release”) aimed at restricting the use of derivatives by registered funds. Rule 18f-4 would be an exemptive rule, providing relief from the restrictions of Section 18 of the 1940 Act. Section 18 restricts the ability of registered funds to issue or sell senior securities.[1]
The Proposing Release is remarkable in several respects. First, the Proposing Release states that if Rule 18f-4 is adopted, the SEC will rescind all prior guidance regarding derivatives—including Investment Company Act Release 10666 and all no-action letters that have provided the foundation for the framework of funds’ use of derivatives for over 35 years. Second, the Proposing Release openly acknowledges that Rule 18f-4, as proposed, would make it impossible for registered managed futures funds, some leveraged exchange-traded funds (“ETFs”) and certain other types of registered alternative funds to continue to operate. To our knowledge, the SEC has never before proposed a rule that was designed to force specific types of funds to deregister, effectively putting them out of business or moving them into regulatory regimes other than the 1940 Act.
Rule 18f-4 would require registered funds to adhere to one of two limits on derivatives use—an exposure-based limit or a risk-based limit. The Proposing Release also sets forth new asset segregation and risk management requirements. This Alert will not explore all aspects of the proposed rule, instead focusing on several aspects of the proposal that are noteworthy for alternative funds. We expect that the SEC will receive comment letters addressing these points.
Exposure-Based Limit
The exposure-based limit would prevent a fund from having aggregate exposure to: (i) derivatives transactions (based on notional amount); (ii) “financial commitment transactions”[2] (based on obligation amount); and (iii) any senior security (based on total indebtedness), totaling more than 150% of its net asset value.
The Proposing Release states that the 150% limit is “designed to balance concerns about the limitations of an exposure measurement based on notional amounts with the benefits of using notional amounts.” There are at least three issues with the proposed limit: (i) it is not clear that notional amounts are the best metric for measuring risk or leverage in a fund portfolio; (ii) if the limit is based on notional amounts, 150% may not be the appropriate number; and (iii) the burdens of using notional amounts might outweigh the benefits.
Is Notional Amount the Best Metric For Measuring Derivatives Exposure?
By basing this limit on the notional amount of derivatives exposure, the SEC has proposed a one-size-fits-all limit that would curb derivatives use by registered funds. The SEC’s primary argument for using notional amount is that a limit based on notional amounts is the easiest way to administer an exposure limit. There is no doubt that the SEC is correct that it is a simple, administrable test, and for many funds will be easy to implement. But administrative ease is not sufficient to justify rule-making; instead it is one factor to consider when weighing various alternatives.
Notional exposure does not in and of itself measure the risk of a fund’s portfolio. This is true for a number of reasons. First, two different derivatives with the same notional exposure but different underlying assets have very different risk profiles; for example, an equity total return swap has a different risk profile than an interest rate swap. The SEC acknowledges this fact in the Proposing Release. Second, different derivative instruments may provide uncorrelated or inversely correlated returns to one another. A strategy using long equity derivatives and short equity derivatives may be designed to reduce risk, but by taking the absolute value of notional exposure for both, a fund using a notional exposure test will be treated as having greater risk than if it only held long or short positions.
In addition to not accurately measuring the risk of a fund’s portfolio, it is also not clear that a notional exposure limit necessarily measures the leverage in a fund’s portfolio. Take, for example, an equity total return swap. If there is a notional amount of $100, and the fund has no margin requirement, then the fund has leverage of $100. If the fund were to place $100 in a margin account, it would have no leverage; it would be the same as an investment in the underlying security. Whether the SEC views the purpose of Section 18 as a limit on risk or as a limit on leverage, notional exposure is at best an imperfect proxy for either such purpose. We expect significant industry comment that will, at a minimum, suggest that the SEC consider a more nuanced view of how to calculate a notional exposure limit.
Why is the Proposed Limit Set at 150%?
A significant portion of the Proposing Release attempts to justify the SEC’s choice of 150% as the appropriate limit for derivatives exposure. There is not, however, any clear statutory basis that supports that particular number, as opposed to 167.3% (or any other number). The Proposing Release states that the SEC believes that using “an appropriate exposure limit” is important, and that the SEC has determined that 150% is appropriate. The statutory bases cited to support the 150% limit are (i) Sections 1(b)(7) and 1(b)(8) of the 1940 Act, which state that the national public interest and interest of investors are harmed when excessive borrowing and the issuance of excessive amounts of senior securities increase unduly the speculative character of funds’ junior securities and when funds operate without adequate assets or reserves, and (ii) Section 18 of the 1940 Act, which allows a fund to borrow amounts equaling up to 50% of its net assets. Prior to the Proposing Release, the SEC staff had taken the view that derivatives should not even be considered senior securities if funds had adequate assets or reserves to meet their obligations under the derivatives contracts. The Proposing Release turns that on its head, and states that not only do open derivatives positions—even when covered by adequate reserves—constitute senior securities, they are tantamount to borrowings regardless of the effect on leverage in a fund’s portfolio and should be treated as such.
Do the Potential Burdens of Using Notional Amounts Outweigh the Benefits?
The Proposing Release states that the benefits of using notional amounts are that they are easy to determine and generally serve as a measure of a fund’s exposure to underlying reference assets. This would allow smaller, “plain vanilla” fund complexes to adhere to the proposed rule. In addition to the legal arguments, the SEC also goes to great lengths to justify the 150% notional limit on a cost-benefit basis through an extensive economic analysis.
The Proposing Release states that, based on its economic analysis, approximately 32% of all funds utilize derivatives and therefore would be impacted by the proposed rule. The SEC estimates that approximately 4% of all funds (and 27% of all alternative funds), 479 in total, would fail the 150% notional limit, and therefore seek to rely on the risk-based limit instead. For reasons discussed in more detail below, we do not believe that funds that fail the exposure-based limit are likely to find any relief in the risk-based limit. Even if one were to assume that the economic analysis is accurate, it would still appear to be unprecedented for the SEC to justify a rule by saying that only 27% of an industry segment will be adversely affected. Presumably the SEC believes that 27% is a low number, essentially incidental to the broader regulatory goals of the proposal. It is not patently obvious to us that 27% is a low number, nor does the record demonstrate that alternatives to an exposure limit based on notional amounts that might affect fewer funds were considered carefully.
Furthermore, there would appear to be two additional burdens that have not been addressed in detail, but should be, given that the proposed test effectively puts some funds out of business. First, what about the financial commitment made by sponsors of those funds in creating such products? Has the cost of shutting down those funds, including the lost investment in starting those funds, been fully considered? What about the expectations of the investors in those funds, who presumably sought particular strategies and who also might reasonably have expected to benefit from the protections of the 1940 Act? Second, has the burden on future product development and the impact on the U.S. advisory business been fully contemplated? By pushing products outside the 1940 Act and potentially to the more favorable regulatory regime in Europe (not a phrase one hears very often), it is not inconceivable that future development, investment and talent will migrate away from U.S. registered fund products. Again, it is not clear that the record demonstrates that the SEC considered alternatives that would not have these effects on U.S. sponsors and investors.
Risk-Based Limit
The proposed risk-based limit would allow a fund to have aggregate exposure of up to 300% of its net assets, so long as the fund’s derivatives positions reduce the fund’s overall “value-at-risk” (“VaR”). Generally speaking, VaR is a method of estimating potential loss. In order to rely on the risk-based limit, the VaR of a fund’s entire portfolio (including derivatives) must be less than the VaR of the fund’s non-derivatives holdings. This effectively reserves the risk-based limit for funds that use derivatives almost exclusively for hedging purposes to reduce risk, and is therefore unlikely to be available to alternative funds. Furthermore, the limit as proposed is designed to apply only to funds that have securities positions that are hedged by derivatives to reduce risk. There are many funds designed to hedge risk vis-à-vis broad market measures but that do not have substantial securities holdings, as they primarily use derivatives, backed by cash and cash equivalents, to achieve that hedged exposure. Because the proposed limit requires that derivatives reduce the VaR of a fund compared to the VaR of the securities held by the fund, many funds that pursue objectives of reducing risk compared to equity markets will be precluded from using the risk-based limit.
Asset Segregation Requirements
In order to rely on Rule 18f-4 to engage in derivatives and financial commitment transactions, funds must comply with new asset segregation requirements in addition to the portfolio limitations discussed above. The proposed rule requires that funds segregate “qualifying coverage assets,” which involves different requirements for derivatives and financial commitment transactions.
With respect to derivatives transactions, funds would need to maintain assets on a daily basis with a value equal to the mark-to-market value on that day, plus an additional “risk-based coverage amount” that reflects an estimate of any additional amount the fund might owe if it were to exit the transaction under stressed conditions. Funds could not “net” derivatives positions unless such positions are subject to a netting agreement, but would be allowed to consider margin that had been posted as counting toward its qualifying coverage amount.
With respect to financial commitment transactions, funds would need to maintain qualifying coverage assets equal to the amount of the obligations under such transactions, whether conditional or unconditional. The mark-to-market approach would not be available with respect to financial commitment transactions.
As proposed, the rule only allows cash and cash equivalents to count toward a fund’s qualifying coverage assets (compared to existing SEC staff guidance that permits the use of any liquid securities). If a fund is obligated to deliver a particular asset pursuant to a derivative or financial commitment transaction, a fund can also count that asset toward its qualifying coverage assets. The proposed asset coverage requirements, by focusing on mark-to-market measures of exposure, are in many ways more realistic than current requirements, although current requirements are not necessarily clear or uniformly applied. The requirement for a risk-based buffer is also unlikely to draw significant comment other than with respect to a board’s role in evaluating the buffer, and it is helpful that the level of required buffers was not prescribed in the rule and treated in a “one-size-fits-all” manner. We expect comment, however, on the limitation of assets that can be used for segregation to cash and cash equivalents, which could lead to drags on performance. In many regulatory regimes, including for other U.S. securities law purposes, “haircuts” are used to give credit towards collateral requirements for different types of instruments (e.g., cash is treated as 100 cents on the dollar but equities are treated as 50 cents on the dollar), and we expect that commenters will at a minimum suggest similar adjustments to the current proposal. We also note that the treatment of unfunded capital commitments under the asset segregation limits may have significant effects on certain types of products. For example, funds of private equity funds may choose to avoid primary commitments to underlying funds to avoid having to maintain the entire capital commitment in cash, if the rule is adopted as proposed.
Derivatives Risk Management Program Requirements
If a fund has more than 50% notional exposure to derivatives transactions, or engages in any “complex derivatives transactions,”[3] it would be required to adopt a tailored derivatives risk management program. A fund would be required to adopt certain policies and procedures reasonably designed to assess and manage the fund’s derivatives transactions, and to ensure appropriate asset segregation. Additionally, a “derivatives risk manager” must be designated to administer the program. The SEC estimates that approximately 52% of alternative funds would be required to implement a derivatives risk management program.
The requirement for a derivatives risk manager is characteristic of recent SEC rulemaking initiatives, reflecting a trend towards what has been called “prudential oversight.” One could imagine several approaches to potential rulemaking in this area. The SEC could craft intricate rules that prescribe and proscribe certain behaviors, such as the money market fund rule. An alternative would be to permit funds some flexibility, but to place burdens on fund boards to serve as checks on conflicts of interest that may arise, such as the SEC’s rule with respect to affiliated brokerage. Still another approach would be prudential oversight, tasking individuals with overseeing risk and reporting on such risk, including to the regulator. In proposing Rule 18f-4, the SEC has decided to employ all three approaches simultaneously.
Significant Industry Response Expected
The new proposed rule would have far-reaching effects on the fund industry. If adopted as proposed, the management of many products, especially alternative funds, would be affected. Some funds would need to become commodity pools or private funds or move offshore and certain types of strategies may migrate to non-1940 Act products such as structured notes. As noted, we expect that the SEC will receive a significant amount of comment from the industry and other interested parties on proposed Rule 18f-4, including from Simpson Thacher. We will be monitoring comments and other developments regarding this rule proposal carefully, and intend to address them further in future Alerts.
[1] “Senior security” is defined in Section 18(g) as any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.
[2] The Proposing Release defines “financial commitment transaction” as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement (or similar agreement). Any unfunded capital commitment to a private fund would also be deemed to be a financial commitment transaction.
[3] The Proposing Release defines a “complex derivatives transaction” as
any derivatives transaction for which the amount payable by either party upon settlement date, maturity or exercise: (i) is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction; or (ii) is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price.