(Article from Registered Funds Alert, October 2018)
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SEC Chairman Jay Clayton issued a statement last month reiterating the Commission’s longstanding position that “all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties.” Staff of the Division of Investment Management (“IM”) followed Chairman Clayton’s lead by withdrawing letters[1] the Staff issued in 2004 related to proxy advisory firms. We discuss these curious developments below.
SEC Staff Guidance Is Not Law
While unusual to see in writing from the SEC, Chairman Clayton’s statement highlights a well-known legal principle – communications by the Staff are not law, nor are they rules, regulations or statements of the SEC. Rather, such statements represent the views of the Staff, which can evolve over time. The timing of Chairman Clayton’s statement corresponds with similar statements by other federal agencies, indicating a broader communications effort by leaders of federal agencies.
The Chairman’s position applies to all Staff communications, including letters, speeches, responses to frequently asked questions and responses to specific requests for assistance.[2] The statement explains that Chairman Clayton recently instructed the directors of the Division of Enforcement and the Office of Compliance Inspections and Examinations to further emphasize to their staff the distinction between the Commission’s rules and regulations, on the one hand, and Staff views on the other. Chairman Clayton encouraged engagement on Staff statements and documents, “with the recognition that it is the Commission and only the Commission that adopts rules and regulations that have the force and effect of law.”
Likely the most significant news arising from Chairman Clayton’s statement was his revelation that he recently instructed the directors of the enforcement and examination units to emphasize to their staff the legal distinctions between laws and rules, on the one hand, and Staff guidance, on the other hand. As market participants are well aware, SEC examiners routinely cite to Staff no-action letters and informal Staff positions when communicating purported deficiencies they identify in the course of an examination. If followed, Chairman Clayton’s instruction should lead examiners to change practice and cite either to an actual law, rule or regulation for a particular deficiency or, in the absence of relevant law, refrain from finding deficiencies based on Staff positions. Perhaps we are overly optimistic, but another potential salutary effect of the statement could be a change of practice by IM’s disclosure examiners. Many in the registered funds industry have received disclosure comments that have no source in any law or regulation. Effectively, disclosure examiners have made rules informally through the registration statement review process. This practice should change. The disclosure review process requires more centralized oversight to ensure compliance with the policies expressed in Chairman Clayton’s statement.
Withdrawal of Proxy Advisory Letters
The proxy advisory letters withdrawn by IM were first issued in response to requests for guidance from two proxy advisory firms during the first proxy voting season following the compliance date of Rule 206(4)-6 under the Advisers Act. That rule addresses an investment adviser’s fiduciary obligation to its clients when the adviser has authority to vote their proxies. The rule requires, in relevant part, an investment adviser that exercises voting authority over client proxies to adopt policies and procedures reasonably designed to ensure that the adviser votes proxies in the best interest of clients. An adviser’s policies and procedures under the Rule must address how the adviser resolves material conflicts of interest with its clients. To this end, the Rule’s adopting release states:
An adviser that votes securities based on a pre-determined voting policy could demonstrate that its vote was not a product of a conflict of interest if the application of the policy to the matter presented to shareholders involved little discretion on the part of the adviser. Similarly, an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party. . . . Other policies and procedures are also available; their effectiveness (and the effectiveness of any policies and procedures) will turn on how well they insulate the decision on how to vote client proxies from the conflict.[3]
The proxy advisory firms sought clarity from the Staff regarding how an adviser should assess a proxy advisory firm’s recommendation of a vote in light of a conflict of interest the proxy advisory firm may have with respect to an issuer. The letters provided guidance – not traditional no-action relief – stating that a proxy advisory firm’s receipt of compensation from an issuer generally would not affect the proxy advisory firm’s independence from an investment adviser for purposes of making voting recommendations concerning the issuer’s proxies for the investment adviser’s clients. Taken together, the letters indicated that an investment adviser could view a proxy advisory firm’s recommendation not to be conflicted even though that firm received compensation from an issuer. This determination would be made on a case-by-case evaluation of the proxy voting firm’s relationship with issuers, a thorough review of the proxy voting firm’s conflict procedures, and/or other means reasonably designed to ensure the integrity of the proxy voting process.
Subsequent to the withdrawal of the letters, the Director of IM explained to a Congressional oversight committee that the withdrawal of the letters was intended to facilitate discussion at an upcoming SEC roundtable on the proxy process. In developing the agenda for that roundtable, the Staff determined to withdraw the proxy advisory letters immediately in light of developments since 2004, when the letters were first issued. The Director of IM further elaborated that the roundtable discussion about investment advisers’ responsibilities in voting client proxies, and about potential conflicts of interest in voting recommendations made by the proxy advisory firms, would best be facilitated if the letters were withdrawn.
Importantly, IM did not withdraw Staff Legal Bulletin No. 20, which provides guidance on the retention of proxy advisory firms.[4] This legal bulletin states that, when retaining a proxy advisory firm, an investment adviser could consider the robustness of the proxy advisory firm’s policies and procedures regarding its ability to identify and address any conflicts of interest and any other considerations that the investment adviser believes would be appropriate in considering the nature and quality of the services provided by the proxy advisory firm. At the Congressional committee hearing, the IM director expressed her view that the legal bulletin provides guidance that is more consistent with Rule 206(4)-6 than the guidance contained in the now-withdrawn letters.
What is the key takeaway from the withdrawal of the letters? In our view, not much has changed. Investment advisers that currently engage in appropriate diligence of proxy advisory firm conflicts in accordance with Rule 206(4)-6 and Staff Legal Bulletin No. 20 should not be adversely affected by the withdrawal of the Proxy Advisory Letters. Investment advisers that rely on proxy advisory firms should continue to consider whether a proxy adviser is providing conflicted advice. This could continue to take the form of a consideration of the robustness of a proxy advisory firm’s conflicts policies and procedures.
SEC Considers Derivatives Rule Re-Proposal
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” [5] 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] Egan-Jones Proxy Services, SEC Staff Letter (May 27, 2004) (Withdrawn); Institutional Shareholder Services, Inc., SEC Staff Letter (Sept. 15, 2004) (Withdrawn).
[2] The statement specifically identifies guidance updates from the Division of Investment Management as an example of a nonbinding statement.
[3] Proxy Voting by Investment Advisers, SEC Release No. IA-2106 (Jan. 31, 2003).
[4] See Staff Legal Bulletin No. 20 (June 30, 2014).
[5] See, e.g., comment letters submitted by Blackstone Alternative Investment Advisors LLC and the Investment Company Institute.