(Article from Registered Funds Alert, October 2018)
For more information, please visit the Registered Funds Alert Resource Center.
As our readers may recall, in 2015 the SEC proposed a rule that was intended to restrict the use of derivatives by registered funds (“Proposal”). We previously discussed this proposed rule at length in our February and May 2016 Alerts. As proposed, the derivatives rule would have, among other things, required registered funds to adhere to one of two limits on derivatives use—an exposure- or risk-based limit. The exposure-based limit would have prevented a fund from having aggregate exposure to (i) derivatives transactions (based on notional amount), (ii) “financial commitment transactions” (based on total indebtedness), totaling more than 150% of its net asset value. The proposed risk-based limit would have allowed a fund to have aggregate exposure of up to 300% of its net assets, so long as the fund’s derivatives positions reduced the fund’s overall value-at-risk (“VaR”). The Proposal also would have established new asset segregation and risk management requirements related to derivatives.
Generally speaking, the fund industry had a strong negative reaction to the Proposal. After receiving over 175 comment letters on the proposed rule, including a letter from Simpson Thacher, and undergoing a change in presidential administrations and SEC leadership, the derivatives rule was removed from the SEC’s Regulatory Flexibility Agenda (“Reg-Flex Agenda”), the formal agenda for SEC rulemaking. However, the derivatives rule recently reappeared on the Spring 2018 Reg-Flex Agenda, where it was noted that IM is “considering recommending that the Commission re-propose” the rule. Based on feedback from our clients, we understand that the Staff has begun actively reaching out to certain members of the industry who submitted comments on the Proposal for feedback as it considers a re-proposal of the derivatives rule.
This Alert lays out our predictions of, and suggestions for, the SEC’s re-proposal of the derivatives rule. Overall, we anticipate that the SEC will move away from relying on notional limits in light of the significant concerns expressed by the industry in the comment process that notional exposure is an “imperfect” indicator and “not an appropriate measure” of leverage, economic exposure and risk”[1] and the impact of the rule on the ability of certain types of registered funds to continue to operate. Instead, the SEC should focus on a derivatives rule that is flexible enough to account for variation in fund investment strategies and that incorporates asset segregation, which the industry supports. However, if the SEC remains focused on notional exposure, we suggest that the SEC use notional exposure as a nothing more than a potential trigger for a fund to implement a derivatives risk management program (as opposed to a hard cap on derivatives use).
Asset Segregation
We expect that the SEC will, at a minimum, retain its focus on asset segregation in the new rule. In the Proposal, the SEC had proposed that funds segregate assets based on mark-to-market derivatives exposure plus risk-based buffers, which generally received support from the industry as a method to minimize any risk posed by registered funds’ use of derivatives. Relying primarily on asset segregation is consistent with historical practices with respect to derivatives. The addition of a requirement to account for a risk-based buffer in segregating assets was a new concept, but the industry generally viewed this enhancement as a workable change. The main objection to the asset segregation requirements in the Proposal was that it would only allow funds to use cash and cash equivalents to count toward “qualifying coverage assets” that would satisfy the proposed asset segregation requirements.
A common theme in comment letters on the Proposal was that the SEC should expand the definition of qualifying coverage assets to be more in line with the range of assets that are permitted to be used for initial and variation margin for derivatives by U.S. and international regulators. This approach would allow funds to segregate a wide range of low-risk, low-volatility assets to cover derivatives transactions—specifically, high-quality government and central bank securities, high-quality corporate bonds and equities included in major stock market indicies. Industry comments also urged the SEC to follow internationally adopted guidelines that would allow highly liquid assets to count for segregation purposes after an appropriate haircut. Permitting a wider range of highly liquid assets to be used to meet coverage requirements would allow funds to continue to hold assets consistent with their investment strategy to minimize “cash drag” as discussed in the Investment Company Institute’s (ICI) comment letter, while also addressing the SEC’s concern that funds have sufficient assets available to meet their obligations even if their assets decline in value. We expect that the SEC will respond to the chorus of industry comments on this point and adjust the rule accordingly when re-proposed.
Reduced Reliance on Notional Limits
Funds use derivatives for a host of reasons—to achieve cost-effective exposure to investments, to provide non-correlated returns to traditional, long-only products and for hedging and risk management purposes. Given these uses, and the strong industry response to the suggestion of a notional exposure limit on such use of derivatives, we predict that the SEC will move away from a notional cap and focus primarily on asset segregation. There is a chance, however, that the SEC suggests retaining some sort of additional restraints on funds’ use of derivatives to prevent undue risk and speculation. The Staff may be grappling with the question of whether to impose a practical limit on leverage, which might require some degree of prudential regulation such as testing value at risk or stress testing.
While we would hope the SEC avoids incorporating notional amounts into a derivatives rule, as even the SEC has acknowledged that it is a “blunt measurement” that fails to account for differences in types of derivatives, if notional amounts are included in the re-proposal, we strongly suggest that the SEC avoid using notional amounts to impose a limit on the use of derivatives.
We propose instead that notional amounts only be used, if at all, as an indicator of when a fund is a sufficient user of derivatives to warrant the use of more sophisticated mechanisms to manage derivative risk effectively. For example, notional exposure might serve as a threshold that, if exceeded, would trigger the requirement to establish a derivatives risk management program with a derivatives risk manager who is independent from portfolio management. This approach, which only applies the risk management requirements to certain users, would be similar to the approach the SEC took in the liquidity risk management rule where funds that primarily hold highly liquid investments are subject to a reduced burden. A rule that mandates all funds that use derivatives to have a risk management program with a risk manager would be too over-inclusive and burdensome, so if the SEC feels compelled to retain some requirements tied to notional amounts, this might be an approach that could be workable in achieving the SEC’s regulatory aims without unduly burdening the entire industry.
Risk Management Program
With respect to risk management requirements, we believe that the SEC should make it clear in re-proposing a derivatives rule that a deviation from a derivatives risk management program will not be viewed as an automatic compliance violation by the SEC examination and enforcement staff. Many of the risk assessments that need to be made under such a program are inherently subjective, and therefore subject to second guessing (especially with the benefit of hindsight). It would provide significant comfort to the industry if the SEC made it clear, for example, that any person designated as derivative risk manager should not be personally liable (or the target of any SEC enforcement actions) for any good faith decisions he or she makes in such capacity. Similarly, the derivatives risk manager should not be liable for the performance of derivatives transactions or their effects on a portfolio in the event that a decision ultimately turns out to be wrong.
If the SEC re-proposes a derivatives rule, we expect that the SEC will receive a significant amount of comment from the industry and other interested parties. Simpson Thacher will be actively monitoring progress with regard to a potential derivatives re-proposal and will address any developments in future Alerts.
[1] See, e.g., comment letters submitted by Blackstone Alternative Investment Advisors LLC and the Investment Company Institute.