SEC Continues Modernization Efforts, Adopts Rule 18f-4 – Use of Derivatives– November 03, 2020 by Lori Novak

This blog was updated 2/17/21

Last week, the Securities and Exchange Commission (SEC) continued its modernization plan, significantly altering the framework for derivatives used by registered investment companies (including mutual funds, ETFs, closed-end funds and business development companies). The new rule, Rule 18f-4, permits funds to invest in derivative transactions if they comply with certain conditions designed to protect investors.

The modifications provided by this multifaceted rule include:

  • The elimination of asset segregation requirements and rescission of the 1979 General Statement of Policy (Release 10666);
  • A requirement to appoint a derivatives risk manager and adopt a derivatives risk management program;
  • Limits on a fund’s value-at-risk (VaR); and,
  • A new requirement to combine reverse repurchase transactions with bank borrowings for purposes of calculating asset coverage under Section 18 of the Investment Company Act.

Included within the Rule is a limited derivative use exception that provides exemption from the derivatives risk management program requirements and the VaR-based limits. This exemption is available if the fund adopts and implements policies and procedures designed to manage the derivatives risks and limits its notional derivatives exposure (including the value of assets sold short) to either 10% of its net assets or to currency derivatives for hedging purposes.

Adoption of a Derivative Risk Management Program

Rule 18f-4 requires the adoption of a written derivatives risk management program to manage a fund’s derivatives risk. The program must include risk guidelines, as well as stress testing, frequent backtesting, internal reporting and escalation, and program review elements.

In addition, a board approved, appointed derivatives risk manager must administer the program. The appointee(s) is required to be an officer of the fund’s investment advisor (other than the fund’s portfolio manager), and to report to the board at least annually on the implementation of the program and its effectiveness.

Fund Leverage Risk Limits

Another aspect of the Rule is the required compliance with limits on the amount of leverage related risk based on VaR, an estimate of potential losses on an instrument or portfolio over a given period of time. The VaR-based limit replaces the current asset segregation requirements for purposes of limiting leverage risk. A fund generally can use either an index that meets certain requirements (relative VaR) or the fund’s own portfolio excluding derivatives transactions (absolute VaR) as its designated reference.

  • Relative VaR — With the relative VaR test, the fund’s portfolio may not exceed 200% of the VaR of a designated reference index. The designated reference index is an unleveraged index selected by the derivatives risk manager that is deemed to reflect the markets or asset classes in which the fund invests. This test allows for the assessment to the extent that the fund increased its leverage risk through its use of derivatives.

In addition, the Rule requires the fund to disclose the designated reference index in its annual report, as well as the fund’s performance relative to the designated reference index.

  • Absolute VaR — If the derivatives risk manager is unable to identify an appropriate designated reference index, the fund is required to comply with an absolute VaR test whereby the VaR of the registered fund’s portfolio cannot exceed 20% of its net assets.

Leveraged and inverse funds are also subject to Rule 18f-4, including the requirement to comply with the 200% relative VaR limit, effectively limiting their daily return to 200% (or inverse of return) of the underlying index. Such funds may seek an exemption to this requirement if they satisfy certain conditions.

Reverse Repurchase Agreements and Unfunded Commitments

The Rule adds an allowance for investing in reverse repurchase agreements and similar financing transactions provided they are treated as borrowings for Section 18 asset coverage requirements. Alternatively, funds have the option to treat these agreements as derivatives transactions rather than including them in the asset coverage calculation.

In addition, a fund can participate in unfunded commitment agreements, such as agreements to make a loan to a company or to invest in the equity of a company in the future, subject to certain conditions. Once such condition is if the conclusion can be made that the fund will have sufficient cash and cash equivalents to meet its obligations of its unfunded commitment agreements. Unfunded commitments are not included in the asset coverage calculation. Funds may also invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to certain conditions.

Other Provisions

The Rule has certain provisions requiring reporting to the SEC on Form-RN, on a confidential basis, if the fund is out of compliance with the VaR limits for more than five business days. Funds currently required to file reports on Forms N-PORT and N-CEN will be required to provide certain information regarding a fund’s derivatives use, including VaR and (for funds relying on the limited derivatives user exception to Rule 18f-4) other derivatives exposure information.

The SEC is rescinding Release 10666, which provided guidance on how funds may engage in certain trading practices in light of the Section 18 restrictions. Also, staff in the Division of Investment Management reviewed no-action letters and other guidance addressing funds’ use of derivatives as well as other transactions covered by rule 18f-4. Some but not all staff letters and guidance addressing fund derivatives usage covered by Rule 18f-4 will be withdrawn.

Our Take

The modifications to the regulatory regime provided by Rule 18f-4 are significant. This comprehensive approach to regulating the use of derivatives by funds certainly addresses concerns around investor protection, as well as levels the competitive landscape by requiring consistent limit calculations and reporting.

In addition, Rule 18f-4 allows all funds to use derivatives without exemptive relief, as long as they comply with this rule.

The new Rule is effective on February 19, 2021. However, given the significance of the revisions to the regulatory framework, compliance and related reporting requirements will be required beginning on August 19, 2022, which is 18 months after the effective date. The rescission of Release 10666 and withdrawal of staff letters and guidance will be effective concurrently with the compliance date.

>> Read the final rule in its entirety
 
Contact Lori Novak at lnovak@cohencpa.com or a member of your service team to discuss this topic further


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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.