FEBRUARY 1, 2016 SIDLEY UPDATE Q&A Addressing SEC Proposed New Rule Regulating Funds Use of Derivatives On December 11, 2015, the Securities and Exchange Commission (SEC) voted to propose Rule 18f-4 (Proposed Rule), a new rule under the Investment Company Act of 1940, as amended (the Act), intended to redress the ad hoc approach by which mutual funds, closed-end funds, exchange-traded funds and companies that elect to be treated as business development companies under the Act (collectively, Funds) and address issues raised by investments in derivatives transactions. The proposing release was published on December 28, 2015; the 90-day comment period expires on March 28, 2016. A copy of the proposing release is available at: http://federalregister.gov/a/2015-31704. The Proposed Rule is intended to limit Funds use of leverage and ensure that any Fund engaging in derivatives transactions has adequate assets available to meet its obligations under those transactions. The Proposed Rule also addresses requirements for financial commitment transactions (which include reverse repurchase agreements, short sale borrowings and any firm or standby commitment agreement) and imposes supplemental reporting and disclosure requirements to proposed Form N-PORT and proposed Form N-CEN. The Proposed Rule would supersede the confusing and sometimes inconsistent SEC guidance under Release 10666, multiple no-action letters and other SEC guidance issued over more than three decades. Below is a brief summary of key aspects of the proposal followed by Q&A section intended to address specific components of the Proposed Rule relevant to Funds and industry professionals. Limitations on Derivatives Transactions The Proposed Rule defines derivatives transactions broadly to include any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument under which a Fund is or may be required to make a payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination. Under the Proposed Rule, a Fund may invest in a derivatives transaction only if it: complies with one of two alternative portfolio limitations; maintains certain qualifying assets and segregates such assets on its books and records; and depending upon the extent of a Fund s derivatives usage, adopts a formal derivatives risk management program. Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.
Page 2 Portfolio Limitations. A Fund engaging in derivatives transactions would be required to comply with one of two alternative portfolio limitations that are intended to limit a Fund s overall exposure and limit speculation by constraining its use of leverage. Each portfolio limitation would be measured at the time the Fund enters into a derivatives transaction. Exposure-Based Portfolio Limitation. The exposure-based portfolio limitation would impose a ceiling on a Fund s exposure at 150 percent of its net assets. Exposure would be determined by aggregating the total notional amounts of the Fund s derivatives transactions, its total obligations under financial commitment transactions and its total amount of indebtedness and liquidation preference with respect to senior securities. Additionally, the notional amount for any derivatives transaction would be adjusted if: o o o enhanced leverage is embedded into such derivatives transaction; the underlying reference asset is a managed account or entity formed primarily for the purpose of investing or trading derivatives transactions; or it is a complex derivatives transaction in which the amount payable at maturity is variable. Risk-Based Portfolio Limitation. The risk-based portfolio limitation would impose a ceiling on a Fund s exposure at 300 percent of its net assets. A Fund would be permitted to utilize this portfolio limitation only if the derivatives transactions reduce the Fund s market risk. In making this determination, the Proposed Rule would require the Fund to analyze market risk using a value-at-risk (VaR) test designed to estimate its potential losses on an instrument or portfolio over a 10-to-20-day time horizon at a confidence level of 99 percent. Asset Coverage and Segregation Requirement. A Fund engaging in derivatives transactions would be required to maintain qualifying coverage assets and to identify and segregate such assets on its books and records on a daily basis. The amount of qualifying coverage assets is calculated based on the sum of two components: a mark-to-market coverage amount; and a risk-based coverage amount. The mark-to-market coverage amount is the amount payable by the Fund if it were to exit the transaction. This coverage amount would be reduced by an amount equal to any variation margin that the Fund has posted as collateral under the relevant derivatives transaction. Additionally, if the Fund were to have a netting agreement in place, the mark-to-market coverage amount for each derivatives transaction could also be netted. The risk-based asset coverage amount is a cushion above the mark-to-market coverage amount reflecting the amount payable by the Fund if it were to exit the transaction under stressed conditions. The risk-based coverage amount would be calculated in accordance with internal policies and procedures approved by the Fund s board of directors. Qualifying coverage assets would include cash and cash equivalents or, if the Fund may satisfy its obligations under a derivatives transaction by delivery of a particular asset, such asset.
Page 3 Risk Management Program. A Fund would be required to have a formal derivatives risk management program if: its derivatives exposure exceeds 50 percent of the Fund s net assets; or it engages in any complex derivatives transactions (regardless of its exposure). The SEC notes in the release for the Proposed Rule that, at a minimum, the written derivatives risk management program would be required to address leverage risk, market risk, counterparty risk, liquidity risk and operational risk. A derivatives risk manager an employee appointed by the Fund s board of directors that is not a portfolio manager of the Fund would be required to administer the policies and procedures of the formal derivatives risk management program. The derivatives risk manager also would be required to provide a quarterly report for review and approval by the Fund s board of directors. Limitations on Financial Commitment Transactions Under the Proposed Rule, a Fund would be required to maintain qualifying coverage assets in an amount equal to its full obligations under a financial commitment transaction (i.e., both conditional and unconditional obligations). For purposes of financial commitment transactions, qualifying coverage assets include cash and cash equivalents, as well as assets that can be converted to cash on the date the obligation would become due, and securities or other assets pledged in connection with the transaction (e.g., securities held in connection with a short sale borrowing). Reporting Requirements The Proposed Rule imposes additional requirements to proposed Form N-PORT and proposed Form N-CEN. A Fund would be required to disclose its schedule of investments and specific information about the transactions on proposed Form N-PORT and it would be required to identify which of the two portfolio limitations the Fund is relying upon during the reporting period on proposed Form N-CEN. Questions and Answers Terms and Scope of the Proposed Rule Q 1: What types of transactions are covered by the Proposed Rule? The Proposed Rule covers three categories of transactions, collectively senior security transactions : 1) Derivatives transactions, which include any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument that may require payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination. 1 A subcategory of derivatives transactions, so-called complex derivatives transactions, are described in Question 2 below. 1 Proposed Rule 18f-4(c)(2).
Page 4 2) Financial commitment transactions, which include any short sale borrowing, reverse repurchase agreement, firm or standby commitment agreement, or similar agreement 2 ; and 3) Any other senior security entered into by a fund pursuant to Sections 18 or 61 of the Act, including borrowings from banks under the 300 percent asset coverage test and the issuance of debt or preferred stock by closed-end funds and business development companies. The Commission is requesting comment on whether purchased options and other derivatives that provide economic leverage should be added to the definition of derivatives. Q 2: What is a complex derivatives transaction for purposes of the Proposed Rule? A complex derivatives transaction is any derivatives transaction for which the amount payable by either party upon the settlement date, maturity or exercise is (i) dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction or (ii) a non-linear function for the value of the underlying reference asset. 3 Examples of complex derivatives transactions include knock-out or barrier trades (i.e., trades for the which the payout at maturity is dependent upon whether the price of the underlying asset reaches a specified level prior to maturity) and variance swaps (i.e., a swap for which the payout at maturity is determined by reference to a volatility measure of the underlying asset). Complex derivatives transactions do not include standard put or call options where optionality is dependent only upon a single strike price. Q 3: Are all transactions in listed or OTC securities options subject to the proposed limitations on derivatives transactions under the Proposed Rule? No. Under the Proposed Rule, only written options, which involve a potential for future payment obligations by a Fund, would be treated as derivatives transactions. Purchased options would not be treated as derivatives transactions for purposes of the Proposed Rule. Further, the Proposed Rule does not apply to any instrument for which the entire cost is paid up-front, even if the instrument derives its value from other assets, such as CDOs, CLOs and other asset-backed securities, and even if there is substantial leverage embedded in the instrument. Q 4: Are securities lending transactions entered into by Funds considered financial commitment transactions? No. However, the proposing release requests comments as to whether or not securities lending transactions should be covered by the Proposed Rule. 2 Proposed Rule 18f-4(c)(4). 3 Proposed Rule 18f-4(c)(1).
Page 5 The Proposed Rule s Impact on Prior Guidance Q 5: If the Proposed Rule is adopted, may Funds continue to rely on Release 10666 and its line of no-action letters? No. If the Proposed Rule is adopted, the SEC will rescind Release 10666 and the line of letters discussing derivatives and financial commitment transactions 4. If the Proposed Rule is adopted, a Fund may only enter into derivatives transactions or financial commitment transactions if it complies with the Proposed Rule or with Sections 18 or 61 under the Act. The proposing release notes that a transition period is expected that would allow Funds to continue to rely on Release 10666 for a limited time. No guidance has been provided as to the duration of this transition period. Q 6: What are the Proposed Rule s implications for managed futures mutual funds, alternative mutual funds, leveraged ETFs and similar funds that significantly use derivatives? The Proposed Rule may significantly impact the operations and policies of some of these Funds. These Funds would be more limited in their use of derivatives transactions under the Proposed Rule than is currently the case. To the extent these Funds use derivatives for market exposure, exposure related to derivatives transactions (including complex derivatives transactions) would be limited to 150 percent of the Fund s net assets, unless the derivatives transactions reduce the Fund s market risk (as discussed below under Portfolio Limitations), in which case such exposure would be limited to 300 percent of the Fund s net assets. Q 7: How will the Proposed Rule affect a Fund s investment in financial commitment transactions? The Proposed Rule generally takes the same approach to financial commitment transactions as is currently followed in connection with Release 10666. However, under the Proposed Rule, since a Fund s qualifying coverage assets cannot exceed its net assets (i.e., the proceeds from a borrowing cannot be included among the qualifying coverage assets), financial commitment transactions cannot exceed a Fund s net assets. Q 8: What are the Proposed Rule s implications for tender option bond (TOB) trusts? If the TOB trust is non-recourse to the Fund, no asset segregation is required. If the TOB trust permits recourse to the Fund, then such recourse should be treated as a financial commitment transaction requiring the segregation of qualifying coverage assets to the extent of the Fund s obligation. This would limit the ability of the Fund to obtain leverage, since such a financial commitment transaction would be included in the Fund s calculation of exposure for purposes of determining if the Fund was in compliance with its portfolio limitations. 4 Proposing release p. 260.
Page 6 Portfolio Limitations Q 9: What are the alternative portfolio limitations that a Fund must comply with? If a Fund engages in any senior securities transactions in reliance upon the Proposed Rule, then the Fund s board of directors must elect to adhere to either an exposure-based portfolio limitation or a riskbased portfolio limitation. The exposure-based portfolio limitation would impose a ceiling on the Fund s exposure at 150 percent of its net assets. 5 The risk-based portfolio limitation would impose a higher ceiling on the Fund s exposure at 300 percent of its net assets, but a Fund would be permitted to utilize this portfolio limitation only if its derivatives transactions reduce the Fund s market risk. 6 In making this determination, the Proposed Rule would require the Fund to analyze market risk using a VaR model to estimate its potential losses on an instrument or portfolio. A Fund must determine its exposure based on a VaR model if electing the riskbased portfolio limitation, regardless of whether the Fund uses an alternative risk-based metric to analyze its portfolio for purposes of determining its risk-based coverage amount (described in Question 17 below), and regardless of the instruments invested in or the diversification of the portfolio. Q 10: How is exposure calculated? Under the Proposed Rule, exposure is calculated by aggregating the following: the notional amounts of a Fund s derivatives transactions; the Fund s obligations under financial commitment transactions; and the Fund s amount of indebtedness (and, with respect to closed-end Funds and business development companies, the involuntary liquidation preference of outstanding preferred stock) with respect to senior securities. 7 Consequently, if a Fund has bank loans outstanding, such loans will reduce, dollar-for-dollar, the availability of derivatives leverage (and likewise, if a Fund has outstanding derivatives leverage, it will reduce, dollar-for-dollar, the availability of bank loans). The notional amount for derivatives transactions is generally defined as the market value of an equivalent position in the underlying reference asset for the derivatives transaction 8, or the principal amount on which payment obligations under the derivatives transactions are calculated. 9 However, since the notional amount is intended to reflect the Fund s economic exposure to the underlying reference asset or metric, the Proposed Rule provides that exposure for certain types of 5 Proposing release p. 91. 6 Proposing release p. 115. 7 Proposed Rule 18f-4(c)(3). 8 Proposed Rule 18f-4(c)(7)(i). 9 Proposed Rule 18f-4(c)(7)(ii).
Page 7 derivatives transactions should be calculated using an adjusted notional amount as described in Question 11 below. Q 11: What types of trades require exposure to be calculated using an adjusted notional amount? The Proposed Rule identifies three categories of derivatives transactions for which exposure is to be determined by reference to an adjusted notional amount: 1) Enhanced leverage transactions: If a derivatives transaction provides a return based on the leveraged performance of an underlying asset, then the notional amount would be multiplied by the applicable leverage factor. 10 2) Managed account look-through : If the underlying reference asset is a managed account or entity formed primarily for the purpose of investing or trading derivatives transactions, or an index that reflects the performance of such managed account or entity, then the notional amount would be calculated by reference to the Fund s pro rata portion of the notional amounts of the derivatives transactions of the underlying reference vehicle. 11 3) Complex derivatives transactions: If a derivatives transaction is a complex derivatives transaction, then the notional amount of such transaction would be calculated by determining the aggregate notional amount(s) of non-complex derivatives transactions that replicate the market risk associated with the complex derivatives transaction at the time the Fund entered into such transaction. 12 Thus, to the extent possible, the complex derivatives transaction should be broken down into its constituent plain vanilla derivatives transactions, and the aggregate of the notional amounts for all such plain vanilla transactions would constitute the notional amount for the related complex derivatives transaction. It is understood that such constituent non-complex derivatives transactions would vary depending on the type of complex derivatives transaction for which a notional amount is being determined. Q 12: What methods may be used to calculate Value-at-Risk (VaR)? With respect to the risk-based portfolio limitation, the VaR measure is intended to determine if a Fund s derivatives investments, on the whole, will directionally increase or mitigate risk; it is not required, nor intended, to be the measure by which a Fund assesses its potential losses. 13 Under the Proposed Rule, the VaR method used in determining if a Fund is eligible to use the risk-based portfolio limitation examines the market risk of a Fund s portfolio by comparing the market risk of such Fund s portfolio exclusive of derivatives investments (the securities VaR) to the market risk of such Fund s portfolio inclusive of derivatives instruments (the full portfolio VaR). If the Fund s full portfolio VaR is less than its securities VaR, then such Fund may elect to use the risk-based portfolio limitation. 10 Proposed Rule 18f-4(c)(iii)(A). 11 Proposed Rule 18f-4(c)(iii)(B). 12 Proposed Rule 18f-4(c)(iii)(C). 13 Proposing release p. 127.
Page 8 The Proposed Rule defines VaR as an estimate of potential losses on an instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence level. 14 The Fund must apply the same VaR model to its full portfolio VaR and its securities VaR. 15 While VaR may be calculated using a wide range of models and parameters, the Proposed Rule would require a Fund to use a VaR model with a minimum 99 percent confidence interval and a time horizon of not less than 10 days and not more than 20 days. Additionally, the Proposed Rule would require that the VaR model selected by a Fund take into account all significant and identifiable market-risk factors associated with its investments. If a Fund elects to use a historical VaR model, it must have a minimum of three years historical market data. 16 Q 13: If a Fund s exposure exceeds the applicable exposure limit after entering into a derivatives transaction, would the Fund be required to terminate or unwind its derivatives transaction(s)? No. A Fund relying on the Proposed Rule would be required to comply with the applicable portfolio limitation immediately after entering into the transaction, but would not be required to terminate or unwind a transaction solely because the Fund s exposure subsequently increased. However, the Fund would not be permitted to enter into additional senior securities transactions in reliance upon the Proposed Rule unless the Fund would be in compliance with the applicable portfolio limitation immediately after entering into the transaction. 17 Thus, a Fund would not be allowed to enter into a riskreducing derivatives transaction subsequent to market movements that caused the Fund to exceed its relevant portfolio limitation unless such derivatives transaction brings the Fund below the applicable 150 percent or 300 percent threshold. The SEC has requested comment as to whether risk-reducing transactions should be permitted regardless of whether a Fund would be in compliance with the relevant portfolio limitation following such transaction. Asset Coverage and Segregation Requirement Q 14: What are the asset segregation requirements with respect to a Fund s derivatives transactions? The Proposed Rule would require a Fund to determine on a daily basis whether its segregated amounts are adequate. A Fund would be required to segregate on its books an amount of qualifying coverage assets equal to the aggregate coverage amounts with respect to its derivatives transactions and financial commitment transactions. A Fund s qualifying coverage assets may not exceed the Fund s net assets, and the same asset may not be used to cover a derivatives transaction and a financial commitment transaction at the same time. A Fund s board of directors, including a majority of its independent directors, would be required to approve policies and procedures reasonably designed to provide for the maintenance of the Fund s segregated qualifying coverage assets. 14 Proposed Rule 18f-4(c)(11). 15 Proposed Rule 18f-4(c)(11)(i). 16 Proposed Rule 18f-4(c)(11)(ii). 17 Proposing release p. 150.
Page 9 Q 15: Are the requirements for asset segregation different for physically settled derivatives and cash settled derivatives? No. The requirements of the Proposed Rule are the same whether the derivatives transaction is physically settled or cash settled. Q 16: What are the asset segregation requirements with respect to a Fund s financial commitment transactions? Under the Proposed Rule, a Fund would be required to maintain qualifying coverage assets in an amount equal to its full obligations under a financial commitment transaction (i.e., both conditional and unconditional obligations). Q 17: How are qualifying coverage assets for derivatives transactions and financial commitment transactions calculated? For derivatives transactions, the required amount of qualifying coverage assets would be the sum of (i) a mark-to-market coverage amount, plus (ii) a risk-based coverage amount. The mark-to-market coverage amount is the amount currently payable by the Fund if the Fund were to exit the derivatives transaction at that time. 18 The mark-to-market coverage amount would be reduced by the value of any assets that represent variation margin or posted collateral (other than initial margin) under a derivatives transaction. Variation margin or collateral in excess of a Fund s current liability under the derivatives transaction would not reduce the Fund s mark-to-market coverage amount for other derivatives transactions except as otherwise permitted under a netting agreement. 19 The Proposed Rule permits a Fund to calculate mark-to-market coverage on a net basis for derivatives transactions for which it has entered into a netting agreement allowing payment netting with respect to multiple derivatives transactions with the same counterparty (e.g., derivatives transactions governed by an ISDA Master Agreement), but would not permit netting across different counterparties. The risk-based asset coverage amount reflects the amount payable by a Fund if it were to exit the derivatives transaction under stressed conditions, providing a cushion in excess of the mark-to-market coverage amount. 20 The risk-based coverage amount for a derivatives transaction would be reduced by the value of any assets that represent initial margin or posted collateral (but not variation margin) for the purpose of covering the Fund s potential payment amounts with respect to such transaction. The Fund can apply the same netting concept noted above with respect to the mark-to-market coverage amount. A Fund could use one or more financial models that take these factors into account to determine the riskbased coverage amount and, unlike for purposes of determining if a Fund is eligible to use the risk-based portfolio limitation, a Fund is not required to use a VaR model for determining its risk-based coverage amount. 18 Proposed Rule 18f-4(c)(6). 19 Proposing release pp. 157-162. 20 Proposed Rule 18f-4(c)(9).
Page 10 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. 21 A Fund can count as qualifying coverage assets those assets that have been pledged as collateral with respect to its financial commitment transactions that can be expected to satisfy such obligations. Q 18: Are qualifying coverage assets the same for derivatives transactions and financial commitment transactions? No. Qualifying coverage assets for derivatives transactions include cash and cash equivalents or, if the Fund may satisfy its obligations under a derivatives transaction by delivery of a particular asset, such asset. Examples of items the SEC considers to be cash equivalents include certain Treasury bills, agency securities, bank deposits, commercial paper and shares of money market funds. 22 For purposes of financial commitment transactions, qualifying coverage assets also include cash and cash equivalents, and additionally include assets that can be converted to cash on the date the obligation would become due, securities, the particular asset that the Fund may deliver to satisfy its obligations under the transaction, or other assets pledged in connection with the transaction (e.g., securities held in connection with a short sale borrowing). 23 If a payment obligation under a financial commitment transaction is expected on a short-term basis, the qualifying coverage assets would also need to be convertible to cash or be able to generate cash on a short-term basis. Q 19: Can a Fund use an offsetting cover transaction in determining if it has qualifying coverage assets for a derivatives transaction? No. Under the Proposed Rule, the particular asset that the Fund may deliver to satisfy its obligation under the derivatives transaction would be a qualifying asset. However, in a departure from Release 10666 and related prior SEC guidance, a derivative providing offsetting exposure would not be a qualifying coverage asset for a derivatives transaction. 24 Thus, if a Fund has written a call option on a security that the Fund owns, such security would be considered a qualifying coverage asset. However, if a Fund has written a CDS on a bond, a purchased CDS on the same bond would not be considered a qualifying coverage asset. 25 Q 20: Can a Fund use equity securities or non-government debt securities to cover its derivatives mark-to-market coverage and risk-based coverage amounts? Generally not. Non-government debt securities and equity securities (other than shares of money market funds) would not qualify as cash or a cash equivalent. The one exception would be in the case of a derivatives transaction under which the fund may satisfy its obligation by delivering a particular equity 21 Proposing release p. 231. 22 Proposing release p. 179. 23 Proposing release p. 238. 24 Proposing release p. 182. 25 Proposed Rule 18f-4(c)(8)(ii).
Page 11 security or non-government debt security. In that case, that particular security would qualify as a coverage asset. Q 21: Can a Fund use equity securities or non-government debt securities to cover its financial commitment transaction obligations? Yes, subject to liquidity. In addition to cash, cash equivalents and deliverable assets, Funds may cover financial commitment transaction obligations using any assets that are convertible to cash or that will generate cash prior to the date on which the Fund can be expected to be required to pay such obligation. 26 An equity or non-government debt security position that is convertible to cash or matures in time for the Fund to use the cash proceeds to complete the financial commitment transaction may be used as qualifying coverage. Any portion of such position that could not be converted to cash by such time could not be used as qualifying coverage. In addition, the Fund may use as qualifying coverage any assets pledged by the Fund with respect to the financial commitment obligation that can be expected to satisfy such obligation, as determined in accordance with policies and procedures approved by the Fund s board of directors. 27 Risk Management Program Q 22: What are the implications of the Proposed Rule for independent directors of Funds? A Fund s board of directors, including a majority of the non-interested directors, must determine which of the two portfolio limitations will apply to the Fund. Funds engaging in more than a limited amount of derivatives transactions (i.e., the aggregate exposure of a Fund s derivatives transactions exceeds 50 percent of its net assets) or Funds that use complex derivatives transactions, must adopt and implement a formalized derivatives risk management program (periodically updated at least annually) administered by a designated derivatives risk manager. 28 The Fund s board of directors, including a majority of independent directors, must approve any material changes to the derivatives risk management program. The board of directors must, on at least a quarterly basis, review a written report of the derivatives risk manager assessing the adequacy of the derivatives risk management program. 29 Under the Proposed Rule, the Fund s board of directors, including a majority of the independent directors, would be required to approve policies and procedures reasonably designed to provide for the maintenance of qualifying coverage assets. Q 23: Must a Fund have a formal derivatives risk management program? No. A Fund is only required to have a formal derivatives risk management program if the Fund s aggregate exposure exceeds 50 percent of its net assets or if it engages in any complex derivatives transactions (regardless of exposure). 26 Proposed Rule 18f-4(c)(8)(iii). 27 Proposed Rule 18f-4(c)(8)(iii). 28 Proposing release p. 226. 29 Proposed Rule 18f-4(a)(3)(iii).
Page 12 Q 24: Can an Employee of the Fund s Investment Adviser act as the derivatives risk manager? Yes. The derivatives risk manager must be an individual designated by the Fund, which can be an employee or officer of the Fund or the Fund s investment adviser, but cannot be a portfolio manager of the Fund. The derivatives risk manager would be required to administer the policies and procedures of the formal derivatives risk management program. The derivatives risk manager would also be required to provide a quarterly report evaluating the derivatives risk management program for review and approval by the Fund s board of directors. 30 Recordkeeping and Disclosure Requirements Q 25: Are there new recordkeeping requirements? Yes. The Proposed Rule requires that the Fund maintain, for a period of at least five years, (i) written records of each determination made by the board of directors with respect to the portfolio limitation applicable to the Fund; (ii) a written copy of all policies and procedures approved by the board of directors for the Fund s ongoing compliance with the Proposed Rule, including but not limited to the Fund s maintenance of qualifying coverage assets and, immediately after entering into any senior securities transaction, compliance with the Fund s portfolio limitation; (iii) copies of all policies and procedures relating to the Fund s adopting and implementing any required derivatives risk management program and the materials provided to the board in connection with its approval of the derivatives risk management program, including any material changes to the derivatives risk management program and any written reports relating to the derivatives risk management program; (iv) records documenting the periodic reviews and updates to the derivatives risk management program, including any VaR calculation models, measurement tools, and policies and procedures used to evaluate the derivatives risk management program s effectiveness and to reflect changes in risks over time; and (v) records demonstrating that immediately after the Fund entered into a senior securities transaction it complied with the applicable portfolio limitation and asset coverage requirements with respect to each senior securities transaction, showing the Fund s aggregate exposure, the value of the Fund s net assets and, if applicable, the Fund s full portfolio VaR and securities VaR. 31 The Proposed Rule requires that the Fund maintain, for a period of at least five years, (i) a written copy of the policies and procedures approved by the board that are reasonably designed to provide for the Fund s maintenance of qualifying coverage assets and (ii) a written record reflecting the amount of each financial transaction commitment obligation entered into by the Fund and identifying the qualifying coverage assets maintained by the Fund with respect to each financial commitment obligation, as determined by the Fund at least once each business day. 32 30 Proposing Rule 18f-4(a)(3)(ii). 31 Proposed Rule 18f-4(a)(6). 32 Proposed Rule 18f-4(b)(3).
Page 13 Q 26: Are there new disclosure requirements? Yes. The Proposed Rule imposes additional disclosure requirements under proposed Form N-PORT and proposed Form N-CEN. A Fund would be required to disclose its schedule of investments and specific information about the transactions on proposed Form N-PORT. Additionally the Fund would be required to disclose risk metrics, including the delta for derivatives instruments with optionality, interest rate risk and credit risk spread. Further, if the Fund were required to implement a derivatives risk management program under the Proposed Rule, then it would also be required to report the vega and gamma for its investments. 33 The Fund would be required to identify which of the two portfolio limitations the Fund is relying upon during the reporting period on proposed Form N-CEN. 33 Proposing release p. 254.
Page 14 If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or John A. MacKinnon Partner jmackinnon@sidley.com +1 212 839 5534 Frank P. Bruno Partner fbruno@sidley.com +1 212 839 5540 James C. Munsell Partner jmunsell@sidley.com +1 212 839 5609 Laurin Blumenthal Kleiman Partner lkleiman@sidley.com +1 212 839 5525 Michael S. Sackheim Partner msackheim@sidley.com +1 212 839 5503 Sara N. Shouse Associate sshouse@sidley.com +1 212 839 5331 Investment Funds, Advisers and Derivatives Practice Sidley has a premier, global practice in structuring and advising investment funds and advisers. We advise clients in the formation and operation of all types of alternative investment vehicles, including hedge funds, fund-of-funds, commodity pools, venture capital and private equity funds, private real estate funds and other public and private pooled investment vehicles. We also represent clients with respect to more traditional investment funds, such as closed-end and open-end registered investment companies (i.e., mutual funds) and exchange-traded funds (ETFs). Our advice covers the broad scope of legal and compliance issues that are faced by funds and their boards, as well as investment advisers to funds and other investment products and accounts, under the laws and regulations of the various jurisdictions in which they may operate. In particular, we advise our clients regarding complex federal and state laws and regulations governing securities, commodities, funds and advisers, including the Dodd-Frank Act, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act, the USA PATRIOT Act and comparable laws in non-u.s. jurisdictions. Our practice group consists of approximately 120 lawyers in New York, Chicago, London, Hong Kong, Singapore, Shanghai, Tokyo, Los Angeles and San Francisco. Derivatives Practice Sidley s derivatives lawyers in numerous worldwide offices advise clients on a broad range of domestic and international derivatives transactions involving swaps, commodity futures contracts and options. Our clients, located in the U.S. and outside the U.S., include commercial banks, investment banks, insurance companies, hedge funds and mutual funds and their advisers, commodity and options exchanges, clearing organizations and other participants in the OTC and exchange-traded derivatives markets. In serving our derivatives clients, our internationally-based group utilizes the extensive experience of lawyers in Sidley s other practice areas, including tax, banking, insurance, investment funds, litigation, bankruptcy, employee benefits, securitization and financial regulatory practices. We act for our clients in a wide variety of settings, including initial transaction and product structuring, negotiation and execution; post-trade operation, modification, work-out, dispute resolution, remedies and recovery; practice before regulatory authorities; and general consultation. To receive Sidley Updates, please subscribe at www.sidley.com/subscribe. BEIJING BOSTON BRUSSELS CENTURY CITY CHICAGO DALLAS GENEVA HONG KONG HOUSTON LONDON LOS ANGELES NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer. www.sidley.com