SEC Proposes New Derivatives Rules For Registered Funds

A rule proposed by the US Securities and Exchange Commission would provide for new limits on the use of derivatives—together with new risk management measures—for SEC-registered investment companies. All funds registered under the US Investment Company Act of 1940 would be covered, including mutual funds, exchange-traded funds (ETFs), closed-end funds, and business development companies.

New proposed Rule 18f-4 would rescind a patchwork of SEC and SEC staff guidance that developed over almost 40 years and, for the first time, would set hard ceilings on market exposures obtained through derivatives. Here are the highlights:

150% Exposure Ceiling. This would be wholly new. Gross notional exposure through derivatives, together with leverage undertaken by the fund through bank borrowings and debt or preferred stock issuances plus exposures under the fund's so-called "financial commitment transactions," would be capped at 150% of a fund's net asset value. 300% Exposure Ceiling. This also would be wholly new. As an alternative to the 150% ceiling, the same exposures could be capped at 300% of net asset value, if the fund can demonstrate that its full portfolio is less risky (measured on a value-at-risk or "VaR" basis) than is its securities portfolio standing alone without taking into account derivative positions. New Asset Segregation Rules. This would be partially new. Under existing guidance, a fund assesses its exposure on a transaction by transaction basis and segregates on its books liquid assets (often called "cover") sufficient to match the fund's liabilities under each derivative. That approach continues, but with three proposed adjustments. First, it is proposed that cover consist only of cash and cash equivalents (today a fund may cover with any liquid assets, including liquid equities). Second, there would no longer be uncertainty as to whether the required cover amount for a given position should be assessed on a notional versus mark-to-market basis, as it is proposed to look only to mark-to-market liabilities. But it also is proposed that a fund should maintain a separate "cushion" of additional risk-based cover (also in cash or cash equivalents) in an amount of its choosing, which must be a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivative transaction under stressed conditions. The rules would, however, credit against the mark-to-market and risk-based requirements any variation or initial margin, respectively, posted by the fund. Third, these cover practices now would be applied in parallel with the proposed exposure ceilings; in other words, if a transaction breaches a ceiling, it is barred even if sufficient cover is available. Risk Management Programs. This would be either partially or wholly new depending on your perspective. Funds making more than limited use of derivatives would be required to have a formal derivatives risk management program. While presumably many firms have such a program in some form today, the required version would include independent board oversight, separation of functions between risk and portfolio management and elements such as policies and procedures reasonably designed to assess the risks associated with the fund's derivative transactions. The proposed rule is the first concrete SEC action regarding funds' use of derivatives since the agency issued its "Concept Release" that presaged the current rulemaking in 2011.1 The SEC is soliciting comment on the proposal through March 28, 2016 (so for 90 days following publication in the Federal Register). SEC Policy Interests and Prospective Public Reaction

In putting forward this proposal, the SEC is reacting to concern that its existing framework—developed around a 40-year old interpretation of a 75-year old statute—has become severely outdated. Given dramatic growth in the volume and complexity of the derivatives market over that period, the SEC says that it now believes that some funds are using derivatives to obtain leverage that is "excessive" relative to policy expectations for regulated investment funds sold to the public.

Nor should the fact of the current rulemaking be a surprise. The agency has been signaling its interest in a comprehensive overhaul since at least 2010 and, as noted, published a detailed concept release in 2011. More recently, the SEC Chair Mary Jo White announced that derivatives rulemaking was an agency priority in a series of speeches starting in December 2014.

That said, elements of the current rulemaking—notably the proposed ceilings and the restriction of permitted cover to cash and cash equivalents—represent a direct reversal of longstanding agency positions and are certain to draw a broad array of public comment. Some commenters will focus on incremental suggested improvements. Given the commercial impact, however, some commenters are likely to be highly critical, asking the agency to specify, for example, a concrete basis for the new rules that is sufficiently clear and quantifiable so as to justify its divergence from longstanding practice. Others might suggest alternative approaches altogether, such as creating a class of registered funds available only to accredited investors that would continue to operate under the current framework.

Historical Perspective

Since derivatives as we know them today are modern financial instruments, the industry's governing statute, the Investment Company Act of 1940, neither referred to nor prohibited their use by funds. The closest analog is that Section 18 of the Act aimed to protect investors from excessive leverage by prohibiting funds from issuing "senior securities." A "senior security" is defined, in part, as "any bond, debenture, note or similar obligation or instrument constituting a security and evidencing indebtedness"2—a definition that may or may not reach derivatives since many derivatives will not "constitute a security."

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