The Investment Lawyer

Transcription

1 The Investment Lawyer Covering Legal and Regulatory Issues of Asset Management VOL. 23, NO. 3 MARCH 2016 REGULATORY MONITOR SEC Update By Philip Hinkle and Matthew Kerfoot An Overview of the SEC s Derivatives and Senior Securities Transactions Rule Proposal Proposed Rule 18f-4 under the Investment Company Act of 1940 (1940 Act) would substantially limit the ability of registered investment funds and business development companies (BDCs) (collectively, funds) to invest in derivatives and incur other forms of leverage. In some cases, the proposed rule could cause certain types of funds, such as leveraged ETFs and managed futures mutual funds, to cease operations as currently structured or otherwise operate in a form other than as a registered investment fund. Under the proposed rule, a fund could enter into derivatives and certain financial commitment transactions only if three conditions are satisfied: (i) compliance with notional portfolio limitations, (ii) compliance with uniform asset segregation requirements, and (iii) implementation of board approved procedures and derivatives risk management programs for certain funds. The proposed rule s portfolio limitation and asset segregation conditions are designed to (i) limit the leverage a fund may obtain through certain transactions and thereby avoid undue speculation concerns, and (ii) require the fund to have assets available to meet its obligations under those transactions. The Securities and Exchange Commission (SEC) believes that these conditions would address the central investor protection purposes and concerns underlying Section 18. Background Section 18(f)(1) and Section 18(a)(1) of the 1940 Act restrict the ability of open-end and closedend funds to issue senior securities. BDCs are also subject to the limitations of Section 18(a) by virtue of Section 61(a) of the 1940 Act. Section 18(g) defines a senior security as any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness, and any stock of a class having priority over any other class as to distribution of assets or payment of dividends. Among other things, the Congressional concerns underlying Section 18 include (i) excessive borrowing and the issuance of excessive amounts of senior securities; 1 and (ii) funds operating without adequate assets and reserves. 2 The SEC and its Staff have historically taken positions that investments in derivatives and other transactions that have a leveraging impact fall within the definition of evidence of indebtedness and are potentially senior securities when they create leverage (that is, an obligation, or indebtedness, to someone other than the fund s shareholders [that enables] the fund to participate in gains and losses on an amount that exceeds its initial investment ). 3

2 2 THE INVESTMENT LAWYER In Release 10666, the SEC provided guidance that a fund could engage in transactions that may involve the issuance of senior securities if the fund maintained a segregated account of liquid assets to cover the transaction and limits the fund s risk of loss. 4 Since then, the Staff of the SEC s Division of Investment Management has provided guidance through no-action relief that allows funds to cover derivative transactions in a variety of ways, including through the use of offsetting transactions. 5 SEC s View on Current Cover Practices Currently, many funds apply a mark-to-market cover approach to certain derivatives, and some funds do so exclusively. 6 The SEC is concerned that this may not impose an effective limit on leverage or may fail to require a fund to have adequate assets to meet its obligations. 7 However, the SEC acknowledges that a cover amount equal to the full notional value may cause funds to hold liquid assets in excess of the fund s potential payment obligations because the notional amount of a derivative often exceeds the amount of cash or assets a fund would likely need to pay or deliver thereunder. 8 Proposed Rule Notional Limits The proposed rule would require funds engaging in derivatives to comply with one of two new portfolio limitations immediately after entering each derivative or other senior securities transaction. Exposure-based Portfolio Limit The aggregate exposure of a fund must not exceed 150% of the value of the fund s net assets. The Proposing Release clarifies that this limit would allow a fund to have 250% gross investment exposure, including the exposure of the net assets of the fund. Exposure would be calculated as the sum of: (i) the aggregate notional amounts of the fund s derivatives transactions; (ii) the aggregate obligations under the fund s financial commitment transactions, which are defined as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement; and (iii) the fund s aggregate indebtedness with respect to any senior securities transaction entered pursuant to Section 18 (such as bank borrowings or issuance of senior debt). The notional amount would mean the market value of an equivalent position in the underlying reference asset, or the principal amount on which payment obligations under a derivatives transaction are calculated (with certain adjustments). For purposes of calculating exposure, a fund would be permitted to net any directly offsetting derivatives transactions that are the same type of instrument and have the same underlying reference asset, maturity, and other material terms. Funds could net appropriate transactions with different counterparties. Risk-based Portfolio Limit This limit expands the permitted exposure amount if derivatives exposure reduces the fund s exposure to market risk. If a fund s full portfolio VaR is less than the fund s securities VaR (excluding derivatives), the fund s aggregate exposure must not exceed 300% of the value of the fund s net assets. The exposure and netting concepts noted above would also apply to the risk-based portfolio limit. Asset Segregation Under the proposed rule, a fund would have to segregate on its books an amount of qualifying coverage assets for its derivatives and financial commitment transactions. A fund would be required to determine whether segregated amounts are adequate at least once each business day. Asset Segregation for Derivatives Transactions For derivatives transactions, the required amount of qualifying coverage assets would be the sum of a mark-to-market coverage amount plus a risk-based coverage amount.

3 VOL. 23, NO. 3 MARCH Mark-to-market coverage amount: The amount currently payable by the fund if the fund exits the derivatives transaction. The mark-to-market coverage amount would be reduced by the value of any variation margin but not initial margin. Variation margin or collateral in excess of a fund s current liability under the transaction would not reduce the fund s mark-to-market coverage amount for other transactions except as otherwise permitted under a netting agreement. 9 A fund would be permitted to calculate markto-market coverage on a net basis for derivative transactions for which the fund has entered into a netting agreement that allows the fund to net its payment obligations with respect to multiple derivatives transactions (that is, with the same counterparty). For this purpose, it would be important for funds to ensure that they have enabled or otherwise included netting provisions in their relevant derivatives documentation. Unlike portfolio limitation netting, this would not permit netting across different counterparties. Risk-based coverage amount: A reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions. This amount must be determined using boardapproved policies and procedures that take into account the structure, terms, and characteristics of the derivatives transaction and the underlying reference asset. A fund could use one or more financial models that take these factors into account to determine the risk-based coverage amount. The risk-based coverage amount would be reduced by the value of any assets that represent initial margin or collateral to cover the fund s potential payment amounts with respect to the transaction but not variation margin. This would only reduce the risk-based coverage amount for the transaction for which such assets were posted. 10 The fund could apply the same netting concept noted under mark-to-market coverage. Asset Segregation for Financial Commitment Transactions For financial commitment transactions, a fund would be required to maintain qualifying coverage assets with a value at least equal to the value of the fund s obligations under its financial commitment transactions. Assets that have been pledged with respect to the financial commitment transactions and can be expected to satisfy such obligation can be counted as qualifying coverage assets (similar to the way that initial and variation margin reduces the coverage amount for derivatives). Qualifying Coverage Assets Derivatives Transactions: Qualifying coverage assets would mean cash and cash equivalents. Cash equivalents would mean short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. If the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset could also be a qualifying coverage asset. This would not include an offsetting derivative allowing the fund to obtain the particular asset. Financial Commitment Transactions: Qualifying coverage assets would mean (i) cash and cash equivalents, (ii) the particular asset, and (iii) assets (a) convertible to cash or (b) that will generate cash equal to the financial commitment obligation prior to the expected payment date. This would include assets that have been pledged with respect to the financial commitment transaction and can be expected to satisfy such obligation, including collateral sold to counterparty in a reverse repurchase agreement transaction. 11

4 4 THE INVESTMENT LAWYER A fund s qualifying coverage assets could not exceed the fund s net assets. This means the fund could not cover with borrowed assets or assets owed to other counterparties. In addition, assets may not be used to cover both a derivatives transaction and a financial commitment transaction at the same time. Board Oversight and Derivatives Risk Management Program For any fund entering into derivatives transactions, the board, including a majority of its independent directors, would be required to approve (i) the particular portfolio limitations under which the fund will operate (that is, (a) the 150% limit, (b) the 300% limit, or (c) the 50% plus no complex derivatives transactions limit (discussed below)); and (ii) policies and procedures reasonably designed to provide for the maintenance of qualifying coverage assets. In addition, any fund that enters derivatives transactions would be required to adopt a tailored written derivatives risk management program (DRM Program) unless the fund complies, and monitors compliance with, the following portfolio limitation: (i) immediately after entering into any derivatives transaction the aggregate exposure associated with the fund s derivatives transactions does not exceed 50% of the value of the fund s net assets; and (ii) the fund does not enter into complex derivatives transactions. The proposed rule defines a complex derivatives transaction as any transaction for which the amount payable by either party upon settlement date, maturity, or exercise (i) is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction, or (ii) is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price. A fund s DRM Program would consist of written policies and procedures reasonably designed to: assess risks associated with a fund s derivatives transactions, including an evaluation of potential (i) leverage risk; (ii) market risk; (iii) counterparty risk; (iv) liquidity risk; (v) operational risk; and (vi) other risks considered relevant; manage risks associated with a fund s derivatives transactions, including by (i) monitoring consistency with investment guidelines, portfolio limitations and disclosure; and (ii) informing portfolio management or the Board, as appropriate, regarding material risks arising from the fund s derivatives transactions ; reasonably segregate DRM Program functions from portfolio management; and provide for periodic (at least annual) review and update of the DRM Program. The DRM Program would also be required to include procedures to reasonably segregate the DRM Program functions from portfolio management. In addition, the fund would be required to designate an employee or officer of the fund or its adviser or sub-adviser that is not a portfolio manager of the fund, called a derivatives risk manager, responsible for administering the DRM Program. Finally, the fund s Board, including a majority of its independent directors, would be required to: approve the DRM Program initially and approve any material changes; review, no less frequently than quarterly, a written report prepared by the derivatives risk manager describing the DRM Program s adequacy and effectiveness; and approve the fund s designation of the derivatives risk manager. Request for Comments The SEC invites comments on the proposed rule, which must be submitted on or before March 28, Mr. Hinkle is a partner in the Washington, DC office, and Mr. Kerfoot is a partner in the New York City office, of Dechert LLP.

5 VOL. 23, NO. 3 MARCH NOTES 1 Use of Derivatives by Registered Investment Companies and Business Development Companies, 80 Fed. Reg. 80,884 (Dec. 28, 2015) (Proposing Release) at 80,887 n.30 (citing Section 1(b)(7) of the 1940 Act and Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No (Apr. 18, 1979) (Release 10666) n.8). 2 Id. at 80,887 n.31 (citing Section 1(b)(8) of the 1940 Act and Release n.8). 3 See, e.g., Release at text accompanying n.14; Dreyfus Strategic Investing and Dreyfus Strategic Income, SEC No-Action Letter (June 22, 1987) (Dreyfus). 4 See Release at n See, e.g., Dreyfus (permitting the use of offsetting positions); Merrill Lynch Asset Management, L.P., SEC No-Action Letter (July 2, 1996) (Merrill Lynch) (permitting the use of any asset, including equity securities and non-investment grade debt so long as the asset is liquid and marked to market daily ). 6 The Proposing Release notes that industry practices with respect to the appropriate cover amount whether the notional amount or the mark-to-market amount currently due and type of cover assets for various transactions have developed over time based at least in part on no-action letters and staff guidance. Proposing Release at 80, Id. at 80,893 and 80, Id. at 80, Proposing Release at 80,923 n Id. at 80, Id. at 80,949. Copyright 2016 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer, March 2016, Volume 23, Number 3, pages 37 41, with permission from Wolters Kluwer, New York, NY, ,