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(Article from Registered Funds Alert, May 2020)

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The SEC re-proposed Rule 18f-4 under the 1940 Act last year.[1] The proposal provides a conditional exemption from the asset coverage requirements under Sections 18 and 61 of the 1940 Act for registered funds and business development companies (collectively, “Regulated Funds”) when entering into derivatives, short sale borrowings, unfunded commitments and reverse repurchase agreements or similar financing transactions.

The comment period for the proposal expired last month. Commenters generally viewed the framework of the rule as an improvement over the SEC’s prior proposal, but certain modifications are necessary. We expect the SEC to adopt a final rule before the end of the year.

This Alert provides background on the current regulation of these transactions under the 1940 Act and an overview of how that would change under the proposed rule. This article then examines potential issues with the proposed rule in its current form and suggests potential revisions for the SEC staff to consider prior to adopting a final rule.

Background

Section 18 of the 1940 Act limits a Regulated Fund’s ability to obtain leverage or incur obligations to persons other than its common shareholders through the issuance of senior securities.[2] Section 18 itself does not answer the question of how it applies to derivatives and other types of instruments that may be characterized as providing portfolio leverage. The answer to this question has significant implications for how much structural leverage a fund may utilize.

Regulated Funds use derivatives, reverse repurchase agreements and similar instruments in reliance on highly fragmented guidance from the SEC and its staff that has evolved over many decades. In the SEC’s Release 10666,[3] issued in 1979, the Commission issued a general statement of policy concluding that reverse repurchase agreements and similar arrangements meet the “functional meaning” of the term “evidence of indebtedness” for purposes of Section 18 of the 1940 Act. The Commission stated that a Regulated Fund’s use of reverse repurchase agreements and similar arrangements will not be subject to the asset coverage requirements in Section 18 if the Regulated Fund “covers” its obligation under the reverse repurchase agreement or similar arrangement by segregating and maintaining liquid assets equal to the Regulated Fund’s obligation under the arrangement.

The SEC staff, after Release 10666 was issued, sought to clarify the application of Section 18 to instruments other than reverse repurchase agreements. The staff, for example, extended the policy statement in Release 10666 to futures, forwards, written options and similar derivative instruments. The staff subsequently issued a no-action letter that many interpret as allowing Regulated Funds the ability to “cover” their obligations under derivatives, reverse repurchase agreements and similar transactions with cash or other highly liquid instrument.[4]

Over the years, advisers to Regulated Funds have taken various interpretations of the permitted use of derivatives and similar instruments under this guidance when operating Regulated Funds and developing new registered products. Without a clear set of rules to reference, somewhat predictably, the Regulated Funds industry became more governed by lore than law with respect to the use of derivatives, short sales, unfunded commitments, reverse repurchase agreements and similar instruments.

Recognizing this reality, over the last decade, the SEC has taken steps to codify its position on how Regulated Funds may use derivatives and other instruments. The process kicked off with an ABA Task Force Report in 2010 and the subsequent issuance of an SEC concept release seeking input from the industry and other interested commentators in 2011. In 2015, the SEC, by proposing Rule 18f-4, made a first attempt at a rule to codify the regulation of the use of derivatives and similar instruments by Regulated Funds. To say the least, this proposal was highly controversial and, if it had been adopted, would have resulted in adverse impacts to certain Regulated Funds, in particular those with a fixed income investment strategy. This is because the proposal included a blunt notional cap on a Regulated Fund’s use of derivatives that would have forced certain funds to limit their use of less volatile derivatives for risk mitigation, hedging and investment purposes. The 2015 proposed rule also would have treated unfunded commitments in the same manner as reverse repurchase agreements, without accounting for the differences in their use by Regulated Funds.

The SEC’s more recent re-proposal of Rule 18f-4 implements lessons learned from the response to the 2015 proposal. The re-proposal provides a more comprehensive and more sophisticated approach to codifying how Regulated Funds may utilize derivatives and similar instruments in compliance with the 1940 Act, although certain modifications, including to the VaR test calculations, are necessary to mitigate the risk of market disruption. Most significantly, the re-proposed rule would eliminate the current asset segregation requirement for the use of derivatives by Regulated Funds and would rescind and replace prior staff guidance on this topic. We summarize the highlights of the proposed rule below.

Overview of Proposed Rule 18f-4

In lieu of complying with the asset coverage requirements under Sections 18 and 61, as applicable, the proposed rule includes a number of conditions that a Regulated Fund must comply with to rely on the exemption in Rule 18f-4 when it uses derivatives, short sale borrowings, unfunded commitments, reverse repurchase agreements and similar financing transactions.

• Derivatives Risk Management Program. The proposed rule requires that a Regulated Fund (other than a limited derivatives user) that enters into derivatives transactions adopt and implement a written derivatives risk management program designed to manage the risks that arise when entering into such transactions. The program will be administered by a derivatives risk manager (“DRM”), which may be a committee or an individual, and must be approved by the fund’s board of directors. If an individual, the DRM cannot be a portfolio manager and, if a committee, a majority of the committee cannot be comprised of portfolio management. The derivatives risk management program should be tailored to the particular types of derivatives that the Regulated Fund routinely uses and their related risks, and must address the following elements:

1. Risk identification and assessment;
2. Risk guidelines that provide for quantitative and measurable criteria;
3. Stress testing to evaluate potential losses to a Regulated Fund’s portfolio under stress conditions;
4. Backtesting of the value at risk (“VaR”) calculation model that the Regulated Fund uses each business day;
5. Internal reporting and escalation of certain derivative matters to the fund’s portfolio management and board of directors; and
6. A periodic review of the program, at least annually, to evaluate the program’s effectiveness.

• Proposed VaR-Based Limit. The proposed rule generally requires that a Regulated Fund (other than a limited derivatives user) that engages in derivatives transactions comply with a VaR-based limit on fund leverage risk. VaR is an estimate of an instrument’s or portfolio’s potential losses over a given period of time and at a specific confidence level.

  Under the proposed rule, a fund’s portfolio VaR will not be permitted to exceed 150% of the VaR of a designated reference index specific to that fund, as selected by the DRM (the “Relative VaR Test”). The designated reference index must be unleveraged and reflect the markets or asset classes in which the fund invests. If the DRM is unable to identify an appropriate designated reference index, the fund must use an absolute VaR test in which the VaR of the fund’s portfolio cannot exceed 15% of the value of the fund’s net assets (the “Absolute VaR Test”). The VaR model that a fund uses must take into account all significant and identifiable market risk factors associated with its investments. The Relative VaR Test or the Absolute VaR Test must be conducted at a consistent time at least once each business day, take into account and incorporate all significant and identifiable market risk factors associated with a Regulated Fund’s investments, use a 99% confidence level and a time horizon of 20 trading days and be based on at least three years of historical data.

• Limited Derivative Users. The proposed rule provides an exception from the derivatives risk management program and VaR test requirements for certain Regulated Funds, known as “limited derivatives users.” This exception is available if a fund adopts and implements procedures reasonably designed to manage the fund’s derivative risk and the fund either (1) limits its derivatives exposure to 10% of its net assets (with adjustments solely to convert the notional amount of interest rate derivatives into 10-year bond equivalents and to delta adjust the notional amounts of options contracts) or (2) uses derivatives solely to hedge certain currency risks.
• Reverse Repurchase Agreements. Reverse repurchase agreements and similar financing transactions will be treated separately from derivatives transactions under the proposed rule, as the SEC believes that such transactions have economic effects similar to secured borrowings. Under the proposed rule, a fund may engage in reverse repurchase agreements or similar financing transactions if the fund includes the aggregate amount of indebtedness associated with such transactions when calculating its asset coverage ratio under Section 18 of the 1940 Act.
• Unfunded Commitments. The SEC believes that unfunded commitments are distinguishable from derivatives transactions. Therefore, under the proposed rule, a Regulated Fund may enter into unfunded commitment agreements if it reasonably believes, at the time it enters into such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements as they come due. The Regulated Fund must document the basis for this belief, and the proposed rule includes certain specific factors that the fund must take into account.
• Board Oversight and Reporting. The proposed rule requires a fund’s board to approve the designation of the fund’s DRM. The board must take into account the manager’s relevant experience regarding the management of derivatives risk. At least annually, the DRM must provide regular written reports to the board regarding the program’s implementation and effectiveness and the results of any stress testing. The board is also responsible for ensuring the fund’s compliance with the proposed rule.

The proposed rule would replace the asset coverage requirements that currently apply to Regulated Funds under Release 10666 and related staff guidance. Importantly, the proposed rule would not impose notional limits on a Regulated Fund’s use of derivatives, a significant improvement over the prior proposal.

Key Issues We Hope the SEC Will Reconsider

We generally support the SEC’s adoption of the proposed rule, but some aspects of the proposal warrant further consideration and revision.

The DRM should be able to choose which VaR test to comply with regardless of its ability to identify an appropriate “designated reference index”.

We believe the DRM should be permitted to choose the more appropriate VaR test for each Regulated Fund. Under the proposed rule, a DRM must either identify an appropriate designated reference index when conducting the daily VaR test or, if a designated reference index is unavailable, the DRM must ensure that the fund complies with an Absolute VaR Test.

Requiring a Regulated Fund to use a Relative VaR Test unless the DRM is “unable to identify” a designated reference index would create an ambiguous standard that could be applied arbitrarily. Neither the proposing release nor the proposed rule clearly defines what “unavailable” means in the context of identifying a designated reference index. This lack of a definition would put the DRM in a difficult position of needing to determine the point at which an appropriate reference index is (or becomes) unavailable for use and could lead to potential second guessing of the DRM’s decision. Moreover, the definition of “designated reference index” in the proposed rule is overly broad. The proposed rule states that a designated reference index must either be an appropriate broad-based securities market index or an “additional index” within the meaning of Form N-1A. For funds that seek absolute return, an additional index may exist that reflects markets or asset classes in which the fund invests, but such an index may not be an appropriate index for the fund due to differences in volatility, asset class weightings, short exposures and/or capacity constraints, among other factors. A DRM should be permitted to select the VaR test that is most appropriate for a fund’s investment objective, policies and risks.

Permitting a DRM to choose which VaR test to comply with for each Regulated Fund under the DRM’s supervision would allow a global asset manager to more closely align risk testing across its product line. As a practical matter, many asset managers operate global businesses that must comply with various regulatory regimes. In the European Union, the Committee of European Securities Regulators Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS govern the risk measurement and the calculation of global exposure and counterparty risk for public investment companies offered in Europe (the “UCITS Guidelines”). The UCITS Guidelines recognize that the effectiveness of a VaR test depends on various factors, such as a fund’s investment objective, which the fund’s adviser is best positioned to determine. The UCITS Guidelines make the UCITS responsible for deciding which VaR approach is the most appropriate methodology given the risk profile and investment strategy of the UCITS. The UCITS must be able to demonstrate that the VaR approach it utilizes is appropriate and must fully document its underlying assumptions. If the SEC were to adopt a similar approach, it would allow global asset managers to streamline their risk management programs and more closely tailor their VaR tests to the risks and objectives of each Regulated Fund. The SEC should consider the experience of these global fund managers in adopting and finalizing this proposed rule.

The proposed leverage limits should be increased to a 200% relative VaR limit and a 20% absolute VaR limit.

We agree with the many commenters who strongly support increasing the proposed Relative VaR Test to a 200% limit and the proposed Absolute VaR Test to a 20% limit. These limits would be in line with the UCITS Guidelines, which global asset managers have operated under for many years, including during the current COVID-19 crisis. Such an approach would allow global asset managers to streamline their risk management programs in a manner that has proven effective during the current market crisis. Moreover, the rule should allow a DRM to choose a 95% VaR confidence level in order to obtain additional observations to produce a more robust and stable measure of risk, the results of which could then be rescaled to a 99% confidence level equivalent. This would further align the rule with the UCITS Guidelines under which global asset managers currently operate. Certain commenters provided data supporting the conclusion that, without these and other enhancements to the VaR tests, a potentially large number of funds that were not otherwise stressed would have had to substantially alter their investment strategies during the COVID-19 crisis in order to comply with the rule. We urge the SEC to modify the final rule to address these concerns.

The “limited derivatives user” definition in the proposed rule should be revised to modify the 10% derivatives exposure limit.

We support the exception in the proposed rule that excludes “limited derivatives users” from the requirements to adopt a risk management program and implement VaR-based testing, but it should be revised to make currency hedging derivatives a global exception rather than a standalone one. Under the proposed rule, limited derivatives users must fall into one of two categories: those that limit their overall use of derivatives to 10% of their net assets with certain limited adjustments or those that exclusively use derivatives for currency hedging. We believe, however, that the two alternatives should be collapsed into one set of criteria; in other words, the rule should permit a Regulated Fund to qualify as a limited derivatives user if its derivatives exposure does not exceed 10% of net assets, excluding any currency hedges.

This is a particular concern for alternative credit managers managing Regulated Funds that provide capital to small and mid-size businesses. Many of these Regulated Funds will use interest rate swaps and credit default swaps to hedge exposures in their portfolios, along with currency derivatives to hedge any non-U.S. investments. These Regulated Funds do, in fact, use derivatives for limited purposes, but it is quite possible the cumulative notional amount of derivatives used will exceed 10% of net assets when including currency derivatives and, therefore, these Regulated Funds will not qualify as limited derivative users under the rule as proposed.

The proposed rule would force many Regulated Funds who have very limited use of derivative outside of currency hedging to adopt derivatives risk management programs and conduct VaR tests that are burdensome and not necessary when compared to the volatility of their portfolios, which are generally comprised of loans and bonds.

This should not be the case. The goal of the limited derivatives user exception should be to exclude Regulated Funds whose use of derivatives does not raise the concerns that Section 18 is meant to address. We urge the Commission to combine the separate parts of the proposed limited derivatives user exception into one test in the final rule, and to allow a DRM to risk adjust the notional amounts of derivatives when calculating the percentage of net assets test.

Reverse repurchase agreements are not analogous to bank borrowings and should not be subject to the 300% asset coverage requirement.

We do not agree with the proposed rule’s treatment of reverse repurchase agreements as the functional equivalent of bank borrowings. The Commission and the staff have maintained a long-standing policy that they will not object to Regulated Funds engaging in reverse repurchase agreements without complying with the asset coverage and other requirements of Section 18, provided that such investment companies segregate assets, or otherwise “cover” their obligations under the instruments. The framework set forth in Release 10666 has been functioning appropriately for more than 40 years and should continue to be applied to these types of arrangements.

Bank borrowings and reverse repurchase agreements are two unique transactions that do not warrant the same type of treatment under Section 18 of the 1940 Act. A key distinction between the two is that one creates an unequivocal monetary liability while the other only creates a future contractual liability that might not actually result in a financial liability. A bank borrowing involves an extension of credit to a fund, creating a financial liability that the fund must repay by a certain date. Reverse repurchase agreements and similar financing transactions create a potential liability to pay a fixed sum of money at a future date, but because the underlying securities to be repurchased may have appreciated in the time since the parties entered into the repurchase agreement, reacquiring the securities may well be accretive to the fund. A Regulated Fund has the ability to adequately address the potential, but not the certainty, of future liability by setting aside and marking to market liquid assets that cover the fund’s exposure to the potential liability. The guidance in Release 10666 reached the correct conclusion and should continue to be applied to reverse repurchase agreements and similar arrangements.

If, however, the SEC determines that it must repeal the guidance under Release 10666, then reverse repurchase agreements and similar financing transactions would be better treated in the same manner as derivatives under the proposed rule. As the SEC acknowledges in the proposing release, any portfolio leveraging effects of reverse repurchase agreements or similar financing transactions for Regulated Funds subject to the VaR test would be included and restricted in the VaR-based limit, which covers all of a fund’s investments. There is no reason why the Section 18 limitations on senior securities need to apply directly to reverse repurchase agreements when funds that utilize them extensively would become subject to a VaR-based limit on fund leverage risk. Any portfolio leveraging effect of reverse repurchase agreements or similar transactions would be included and restricted through the VaR-based limit, which estimates a fund’s risk of loss after taking into account all of the fund’s investments.

Next Steps

The proposed rule is a positive step in providing a clearer, modern regulatory framework for how Regulated Funds use derivatives and similar arrangements. Nonetheless, there are components of the proposed rule that we believe the SEC should reconsider. If these concerns are addressed in a final rule, the new regulatory regime will be a welcome improvement to the regulation of the use of derivatives, unfunded commitments and reverse repurchase agreements or similar financing transactions by Regulated Funds.

[1] At the same time it re-proposed Rule 18f-4, it also proposed new rules under the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 that govern sales practices for leveraged/inverse ETFs and similar investment vehicles.

[2] Section 61 of the 1940 Act modifies the asset coverage requirements under Section 18 that apply to BDCs. The general principles discussed in this article apply equally to the asset coverage requirements that apply to a BDC under Sections 18 and 61.

[3] See Investment Company Act Release No. 10666 (Apr. 27, 1979).

[4] See Merrill Lynch Asset Management, L.P., SEC No-Action Letter (July 2, 1996).