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(Article from Registered Funds Alert, May 2016)

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As discussed in our last Alert, the SEC recently proposed new Rule 18f-4 (the “Proposing Release”), which is intended to restrict the use of derivatives by registered funds. As proposed, Rule 18f-4 would, among other things, require registered funds to adhere to one of two limits on derivatives use—an exposure- or risk-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” (based on obligation amount) and (iii) any senior security (based on total indebtedness), totaling more than 150% of its net asset value. 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”). The Proposing Release also sets forth new asset segregation and risk management requirements. The SEC received more than 175 comment letters on the proposed rule, including a letter from Simpson Thacher.

This Alert summarizes notable themes presented in comments from industry participants. Similar to comments on the proposed liquidity rule, many industry commenters expressed support for the SEC as the appropriate regulator to address this issue (as opposed to the FSOC or another member of FSOC).[1] Commenters also generally expressed support for the consolidation and modernization of prior informal and formal guidance, such as Release 10666, into a single, uniform rule, noting that such a rule would bring more certainty, clarity and transparency to the obligations of registered funds.

Challenging the SEC’s Economic Analysis and Assumptions

As an initial matter, the industry raised serious questions regarding the SEC’s economic analysis and certain assumptions underpinning the proposed rule that arose from that analysis. The Investment Company Institute (the “ICI”), along with many others, urged the SEC to re-evaluate the impact of the proposed exposure- and risk-based limits in light of data submitted by commenters. While the SEC only analyzed approximately 10% of the industry in the Division of Economic and Risk Analysis white paper that accompanied the Proposing Release, the ICI analyzed data from 82 complexes with 6,661 funds and $13.6 trillion in assets under management (approximately 59% of the industry) and concluded that at least 369 funds, with $458 billion in assets under management either will have to de-register or substantially change their investment strategies to continue business as registered funds, with a particular disparate impact on alternative funds. Pointing to the ICI’s study, many commenters indicated that the exposure limits proposed by the SEC should be re-examined, as it appears that the SEC underestimated the potential significant impact of these limits on capital markets and capital formation. Moreover, many commenters, including the International Swaps and Derivatives Association, Inc., also argued that the proposed rule should be tabled until the SEC is able to finalize and observe the effects, both independently as well as the cumulative burdens, of other recently proposed rules, such as the data reporting modernization rule, the liquidity risk management rule and its Title VII security-based swaps rulemakings.

Number of registered funds the proposed rule would require to either de-register or substantially change their investment strategies, according to an ICI study

Proposed Alternatives and Revisions to the SEC’s Exposure-Based Limit

Commenters raised several issues with the SEC’s proposed exposure-based limit, including its reliance on notional amount and its seemingly arbitrary cap of 150% (or 300% in conjunction with the risk-based limit). A significant theme throughout the comments, including those submitted by Blackstone Alternative Investment Advisors LLC (“BAIA”), was that “notional exposure is an imperfect indicator of leverage and risk.” A number of commenters cited to a recent white paper by James Overdahl of Delta Strategy Group, which discusses numerous ways in which notional exposure is a poor measure of risk. Accordingly, commenters suggested a number of alternative exposure limits based on metrics other than notional exposure for the SEC’s consideration (which could be adopted in addition to the proposed 150% notional limit and make the proposed rule more appropriately tailored to funds that make significant use of derivatives). For example, BAIA recommended an exposure limit based on a fund’s Portfolio VaR versus a multiple (e.g., 1.5x) of the VaR of a benchmark, such as the S&P 500 Index. In the BAIA formulation, a fund would be able to choose a benchmark with a VaR lower than that of the S&P 500 Index but could not choose a benchmark with a higher VaR.

A significant number of commenters also suggested that, if the SEC proceeded with using notional values, notional values should be adjusted to reflect more accurately the risk of a derivative instrument’s underlying reference asset. Commenters pointed out that risk-adjusted notional amounts have gained wide-spread acceptance from U.S. and foreign regulators in other contexts, such as swap margin requirements. For interest rate derivatives, commenters suggested duration weighting as a method of adjusting notional amounts to account for risk.

Additionally, commenters asked that the exposure limit of 150% be increased (e.g., the ICI suggested raising the limit to 200%) to provide funds with greater flexibility and mitigate the need for some funds to deregister or drastically modify their investment strategies. In this connection, it was pointed out that funds are likely to self-impose a lower exposure limit to avoid breaching the SEC’s exposure limit.

Commenters also urged the SEC to expand the definition of netting when calculating the exposure-based limit. Under the proposed rule, funds would be permitted to net notional amounts of any offsetting derivatives transactions of the same type, with the same underlying reference asset, maturity and other material terms. For instance, Stone Ridge Asset Management LLC (“Stone Ridge”) proposed that funds be permitted to net directly offsetting transactions that fall into certain specifically delineated categories. Finally, many commenters also recommended that the SEC allow for daily rather than time-of-transaction compliance monitoring. The proposed rule’s real-time requirement would be especially problematic for multi-manager funds, where sub-advisers would be required to report portfolio limits or VaR in real time.

Alternatives to the SEC’s Risk-Based Limit

Many commenters expressed the opinion that, as proposed, the risk-based limit is too narrow and would not serve as a realistic option for funds that use derivatives to gain market exposure. Among the alternatives proposed by commenters, OppenheimerFunds, Inc. suggested revising the risk-based limit by setting a VaR limit for a fund’s overall portfolio based on a multiple of the fund’s securities VaR (i.e., the degree to which portfolio VaR can be increased through derivatives rather than looking at how portfolio VaR is reduced by derivatives). Under OppenheimerFunds’s approach, a fund could have aggregate exposure of up to 300% of its net assets so long as its full portfolio VaR did not exceed 150% of its securities VaR—i.e., the fund’s derivatives transactions could not create an additional risk of loss greater than 50% of the risk of loss without those derivatives transactions. The ICI submitted a different alternative, which would allow a fund to have up to 300% aggregate exposure (or 350% if the exposure-based limit is raised to 200%, as the ICI suggested), so long as the derivatives that make up the additional 150% serve to reduce the VaR of the rest of the fund’s portfolio, including the derivatives that comprise the initial 150/200% of exposure. Thus, a fund could use derivatives for market exposure up to 150/200%, and any additional derivatives use would need to reduce risk.

Asset Segregation

A major theme throughout the comments was that the proposed exposure- and risk-based limits were unnecessary, and that the risks associated with a fund’s derivatives use would be more appropriately addressed through asset segregation, in conformity with past SEC practice. 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. 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.

A significant theme in comments, including those from the Investment Adviser Association, was that the definition of “qualifying coverage assets,” which generally limits qualifying coverage assets to cash and cash equivalents, should be expanded to include highly liquid assets with haircuts, noting that other U.S. and international financial regulators have blessed the approach. As argued by the ICI and many others, “restricting qualifying coverage assets to cash and cash equivalents can penalize investors by creating a ‘cash drag’ on the performance of a fund that otherwise would be fully invested.” Further, many commenters also suggested revising the proposed rule to allow for netting derivatives transactions with offsetting exposures, with respect to both derivatives and financial commitment transactions.

BDC and Fund of Private Fund Issues

As proposed, Rule 18f-4 would apply equally to business development companies (“BDCs”) and closed-end funds as to other types of funds, such as mutual funds. As noted in comments from the U.S. Chamber of Commerce, BDCs are a significant source of financing for small- and medium-sized companies in the United States, and it is well documented that financing for such companies has generally become less available in recent periods from banks for a variety of reasons, including regulatory changes. The proposed rule would drastically limit the ability of BDCs and certain closed-end funds (including real estate closed-end funds that make similar types of loan commitments with respect to underlying assets) to provide such crucial financing because it would treat revolving lines of credit provided by such funds as financial commitment transactions under the theory that they are unfunded commitments. In particular, Ares Capital Corporation (“Ares”), a specialty finance company that has elected to be regulated as a BDC, urged the SEC to exclude conditional loan obligations from the definition of a financial commitment transaction. Ares also suggested that, in the event that the SEC adopts the rule as proposed, it should expand the definition of “qualifying coverage assets” to include available capacity under a fund’s revolving line of credit, which is typically balanced against a fund’s unfunded commitments.

Several commenters, including the Private Equity Growth Capital Council (the “PEGCC”), raised concerns that the proposed rule’s treatment of unfunded commitments to private funds as financial commitment transactions would unnecessarily diminish the ability of funds to invest in private funds. The SEC has allowed funds of private equity funds, for example, to operate so long as their investors meet certain sophistication criteria. Under the proposed rule, such funds would be required to segregate the full amount of all unfunded commitments to private equity funds, even if there is little to no chance that some of the commitments would be called. To illustrate this point, commenters compared two general types of investments that funds of private equity funds typically make—primary commitments to private equity funds that are in earlier stages of their life cycles and are more likely to call commitments to make new investments and secondary investments in later-stage private equity funds that are past their investment period and are highly unlikely to call any outstanding commitments. The PEGCC suggested that funds be required to segregate an amount based on a reasonable estimation of the amount of unfunded commitments expected to be called in the next calendar quarter instead of the full amount of the outstanding obligation.

Role of Board

The proposed rule would also impose on fund boards three primary new responsibilities: (i) approving one of the two portfolio limitations; (ii) approving asset segregation policies and procedures; and (iii) approving a derivatives risk management program (and any material changes thereto) and if applicable to the fund, approving the designation of a derivatives risk manager and reviewing quarterly reports regarding the program. A significant theme throughout the comments addressed concerns of the board’s role exceeding typical oversight responsibilities. For instance, the Independent Directors Council (the “IDC”) suggested that the board’s approval of the particular limitation is not an appropriate board role, indicating that the adviser, if anyone, would be in the best position to make such a decision. Moreover, the IDC and Mutual Fund Directors Forum (“the MFDF”) questioned the need for specific board approval requirements under the proposed rule when Rule 38a-1 already requires the board to approve compliance policies and procedures, including those related to derivatives. The MFDF and IDC both expressed concern that the approval of specific asset segregation policies and procedures might require board members to develop in-depth knowledge of VaR or other technical concepts beyond the scope of their typical oversight responsibilities. Finally, many also urged the SEC to decrease the frequency of the derivatives reports from at least quarterly to at least annually and to eliminate the requirement that a fund board approve any material changes to the fund’s risk management program, especially given that Rule 38a-1 requires the fund’s CCO report to address such changes.

Risk Management Program

Under the proposed rule, if a fund has more than 50% notional exposure to derivatives transactions, or engages in any “complex derivatives transactions” 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.

Generally, most commenters did not oppose the SEC’s proposal, but noted several modifications, including a cure period, a de minimis exception and the ability to appoint a committee or an individual as the fund’s derivatives risk manager. Many commenters agreed that a cure period, for example the five-day period suggested by Guggenheim Investments, would be helpful for a fund that seeks to limit its exposure to derivatives to 50% or less of the net assets of the fund, but temporarily exceeds that threshold. The ICI also suggested a de minimis exception, whereby a fund would be allowed to use a de minimis amount of complex derivatives transactions without giving rise to the risk management program requirements. Many commenters, including BlackRock, also urged the SEC to allow firms to delegate the responsibilities of the derivatives risk manager to a group of people, such as a risk committee, noting that doing so “would allow firms some flexibility to incorporate the risk management program into their existing compliance and oversight structures.”

Further, many commenters also asked the SEC to clarify that a fund’s derivative risk manager will 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.

Other Comments

Several commenters, including Simpson Thacher and Stone Ridge, asserted that “grandfathering” provisions should be incorporated into the rule for certain funds currently in operation, pointing to the significant startup capital and resources that have been expended by fund managers. Stone Ridge also urged the SEC to “embrace its ability to issue exemptive orders,” arguing that any final rule should include specific exemptive authority by which a fund may be exempted from some or all of the requirements of the proposed rule. Noting that it is unlikely that any final rule would work for all funds, these commenters argued that a fund should be exempt from such requirements if it can demonstrate that its strategy does not implicate the SEC’s concerns regarding excessive borrowing and undue speculation.

Simpson Thacher will be actively monitoring progress with regard to the derivatives and other proposals (including data reporting and liquidity management proposals) and will address any developments in future Alerts.

[1] Notably, FSOC released an update on its review of asset management products and activities on April 18, 2016, in which it acknowledged the SEC’s recent data reporting, liquidity and derivatives rulemaking proposals and appeared inclined to defer to the SEC’s expertise in these areas.