In late November 2019, the Securities and Exchange Commission checked another item off its ambitious rulemaking agenda with a rule proposal involving one of the more complex but increasingly relevant areas of fund regulation: the use of derivatives instruments by registered funds. Proposed rule 18f-4 under the Investment Company Act of 1940 is not, however, entirely new. The SEC initially proposed a derivatives rule in December 2015, and that version’s requirements that funds implement highly detailed and prescriptive rules governing their use of derivatives generated fairly widespread criticism during its comment period.

Chief among the concerns with the 2015 proposal was the role envisioned for fund directors. Under that proposal, the responsibilities imposed on the board—such as approving one of two alternative portfolio limitations on leverage—would have miscast them in a role seemingly closer to hands-on risk management than their traditional oversight position.

The SEC’s latest iteration of the derivatives rule proposal would impose substantially fewer onerous obligations on fund boards than the 2015 version. Still, there are new responsibilities for directors in this latest proposal and, importantly, embedded guidance aimed at fund boards that warrant attention. Various elements of the SEC’s proposal—including requiring applicable funds to implement a multi-part derivatives risk management program and associated compliance costs and administrative burdens—may rival the SEC’s liquidity risk management rule’s sweeping impact on the fund industry, particularly for funds that are unable to qualify for the limited derivatives user exception.

To fully appreciate the change in fortunes for fund directors under this latest proposal, as well as the proposal’s potential impact for fund sponsors generally, a brief refresher on the regulatory background is necessary.

The Backstory

SEC regulation of a fund’s use of derivatives is attributed to Section 18 of the 1940 Act, which places significant restrictions on the ability of registered funds to issue "senior securities," or instruments that evidence indebtedness. When the 1940 Act was enacted, the Congressional concern was that investment companies might borrow money without limit, either from banks or through issuing debt or preferred stock, potentially creating excessive leverage and/or leaving funds with inadequate assets and reserves. To protect investors from these risks, and to prevent abuses of purchasers of a fund’s senior securities, Section 18 functions as a protective measure to limit the leverage a registered fund can incur.

The lead up to the current regulatory framework governing funds' use of derivatives was gradual. The SEC was first concerned with certain investment techniques through which funds were obtaining de facto leverage, including (1) reverse repurchase agreements, (2) standby commitment agreements, and (3) firm commitment agreements. In 1979, the SEC issued Release 10666, which included seminal guidance for funds using these investment techniques and which the SEC said may be evidence of indebtedness that Section 18 was designed to prevent. Recognizing, however, that limited use of these transactions for certain purposes could benefit fund investors, the SEC said it would not consider funds in violation of Section 18 if funds segregate liquid assets to "cover" potential obligations resulting from these transactions. Notably, Release 10666 was not limited to these three trading practices and advised fund boards to consider other transactions that should be subject to this "cover" arrangement due to implicit leverage.

Taking the position that the use of certain derivatives may involve the issuance of senior securities, the SEC and its staff have since developed and expanded the concepts in Release 10666 and applied Section 18 limits to various derivatives instruments and short sale transactions. In more than 30 no-action letters and other guidance, the SEC and its staff have provided other ways for funds to "cover" their potential obligations. Under the current guidance, a registered fund generally may engage in derivatives transactions and financial commitment transactions without being subject to a limit to the level of these transactions, if the fund enters into offsetting transactions or segregates liquid assets in amounts sufficient to cover its potential liabilities under these transactions.

The foregoing, however, is a high-level simplification of a regulatory construct that is an amalgamation of SEC staff guidance. That guidance, over the years, often was delivered on an instrument-by-instrument basis, and the current situation is one that would seemingly benefit from regulatory clarity and consistency. The SEC has acknowledged that these factors have led to varied industry practices when funds use derivatives, including the calculation of the value of assets to be segregated or determination of what type of assets may be set aside for covering derivatives transactions; this is often driven by how industry participants (and/or their counsel) interpret SEC staff guidance. 

Version 1.0: The 2015 Proposal

With the growth in the volume and complexity of derivatives markets, and the increasing use of derivatives by funds, the SEC determined that a comprehensive regulatory overhaul was in order. Following a 2011 SEC concept release soliciting comments on various issues related to funds’ use of derivatives, the SEC took its first crack at a new derivatives rule in late December 2015, which would have imposed new constraints on the use of derivatives and new responsibilities on fund boards.

Under the 2015 proposal, a fund’s board would have been responsible for:

• Approving one of two alternative portfolio limitations—an exposure-based limit or a risk-based limit—with which the fund would comply;
• Approving policies and procedures reasonably designed to provide for the fund’s maintenance of qualifying coverage assets as required under the rule; and
• If relevant, approving the portfolio limitations necessary for a fund to be exempt from a derivatives risk management program (DRMP) requirement; or
• If the fund was subject to the DRMP requirement:
  • Providing initial approval of the fund’s DRMP and approval of any material changes to the program thereafter;
  • Approving the designation of an employee or officer of the fund or the fund’s investment adviser to be responsible for administering the fund’s DRMP—a derivatives risk manager (DRM); and
  • Reviewing, no less frequently than quarterly, a written report prepared by the DRM describing the adequacy of the DRMP and the effectiveness of its implementation.

What’s more, the 2015 proposal called for the board to approve policies and procedures reasonably designed to provide for a fund’s maintenance of qualifying coverage assets for those funds engaging in certain financial commitment transactions.

Management vs. Oversight: Despite assurances from the SEC staff in public statements that the 2015 proposal was not intended to impose management functions on fund boards, requiring the fund board to approve a particular portfolio limitation seemed to stretch beyond the reasonable bounds of the board’s oversight role. Moreover, as the Independent Directors Council and others pointed out in comment letters responding to the proposal, a fund’s use of derivatives should not require that a board include directors who are derivatives experts (although some boards may choose to do so). In general, the exercise of effective portfolio management oversight does not—and should not—require technical expertise, which assessing the relative merits and implications of two portfolio limitations—in addition to reviewing risk-based segregation procedures—would seem to require.

The 2015 proposal was shelved by the SEC and did not resurface until the spring of 2018, when it appeared on the SEC’s regulatory agenda as a re-proposal under consideration. In public remarks in October 2018, Division of Investment Management Director Dalia Blass acknowledged the critical feedback on the 2015 proposal and confirmed that the SEC staff was starting over with a "fresh look" at derivatives rulemaking, welcoming industry input in that process.

Version 2.0: The 2019 Proposal

On Nov. 25, 2019, the SEC took its second crack at derivatives rulemaking. As in 2015, the new draft would supersede historical guidance provided by the SEC and its staff and rescind Release 10666. This latest version contains several significant changes from the 2015 proposal.

The proposed rule would permit a fund to engage in derivatives transactions, notwithstanding the prohibitions and restrictions on the issuance of “senior securities” under Section 18, subject to the following conditions:

• Derivatives Risk Management Program. A fund would be required to adopt a written derivatives risk management program, including risk guidelines reflecting how the fund’s use of derivatives may affect its investment portfolio and overall risk profile. As was required under the 2015 proposal, a fund would also be required to appoint a derivatives risk manager (DRM) to administer the derivatives risk management program (DRMP).
• Limit on Fund Leverage Risk. A fund engaging in derivatives transactions would be required to comply with an outer limit on leverage based on a comparison of the fund’s value-at-risk to the VaR of a "designated reference index" for that fund. A fund would satisfy this test—referred to as a "relative VaR test"—if the VaR of its entire portfolio does not exceed 150% of the VaR of its designated reference index. If the fund’s DRM is unable to identify an appropriate designated reference index, the fund’s VaR could not exceed 15% of the value of the fund’s net assets—referred to as the "absolute VaR test." The applicable VaR limit must be tested at least once each business day (whereas the 2015 proposal required testing after each transaction) and additional requirements would be triggered if a fund determined that it was not in compliance with its applicable VaR test. The relative and absolute VaR tests differ significantly from the two alternative tests in the 2015 proposal, and the board plays no role in selecting the limit to be used. In another stark contrast to the 2015 proposal, the 2019 proposal does not include an asset segregation requirement for funds using derivatives and, by extension, the board does not need to approve policies and procedures concerning qualifying coverage assets as was required under the 2015 proposal.
• Board Oversight and Reporting. A fund's board of directors must approve the designation of the derivatives risk manager, "taking into account the derivatives risk manager’s relevant experience regarding the management of derivatives risk." The fund's DRM would be required to report to the fund’s board on the implementation and effectiveness of the DRMP and the results of the DRMP's required stress testing. Unlike the 2015 proposal, the rule would not require boards to approve the DRMP or any material changes to the program after its initial approval and implementation.

Other key elements of the proposal include:

• Exception of Limited Derivatives Users. Limited derivatives users—i.e., a fund that either (1) limits its derivatives exposure to 10% of its net assets or (2) uses derivatives transactions solely to hedge certain currency risks—would be excepted from the DRMP requirement and from the VaR-based limit on fund leverage risk. A limited derivatives user would, however, still be required to adopt and implement policies and procedures that are reasonably designed to manage the fund’s derivatives risks.
• Alternative Requirements for Certain Leveraged/Inverse Funds. Certain leveraged/inverse funds would be excepted from the limit on fund leverage risk because of proposed new sales practices rules that would require broker-dealers and investment advisers to exercise due diligence on retail investors before permitting transactions in these types of funds. This is a significant change from the 2015 proposal which had no accommodation for these funds.

While requiring a DRMP for funds that are derivatives users—other than limited derivatives users—is not new, there are several new required program features, including: 

• Risk guidelines with discrete metrics
• At least weekly stress testing
• Daily backtesting

Other required features of the DRMP generally reflected in both the 2015 and 2019 proposals include:

• Risk identification and assessment covering specified risk factors
• Reporting and escalation
• Periodic program review

DRM Qualifications. As noted above, the 2019 proposal would require a fund’s board to approve the designation of the fund’s DRM, taking into account the DRM's "relevant experience regarding the management of derivatives risk." The DRM feature of the proposal is not new, but the "relevant experience" piece is. The proposing release explains that "[t]his requirement is designed to reflect the potential complex and unique risks that derivatives can pose to funds and promote the selection of a [DRM] who is well-positioned to manage these risks." The question left for fund boards: What constitutes "relevant experience"?

The proposing release explains the SEC’s thinking on this matter:

"The requirement that the board consider the [DRM's] relevant experience is designed to provide flexibility for a fund’s board to take into account a [DRM's] specific experience, rather than the rule taking a more prescriptive approach in identifying a specific amount or type of experience that a [DRM] must have. Detailing a [DRM's] required experience in the rule would not be practical, given the numerous ways in which a person could obtain experience with derivatives or risk management. Any specification in the rule of the specific experience required to serve as a [DRM] likely would be over- or under-inclusive and would not take into account the way that any particular fund uses derivatives. We believe that a fund’s board, in its oversight role, is best-positioned to consider a prospective [DRM's] experience based on all the facts and circumstances relevant to the fund in considering whether to approve the [DRM's] designation."  

The Board’s Role: Oversight and Reporting

The 2019 proposal includes a multi-faceted board reporting component to enable the board to exercise its oversight role as follows:

• Initial and Annual Reports on DRMP Implementation and Effectiveness. The DRM would be required to provide to the fund’s board, on or before the implementation of the DRMP and at least annually thereafter, a written report including a representation that the DRMP is reasonably designed to manage the fund’s derivatives risk and to incorporate the required elements of the program as well as the basis for the representation.
• Required Elements of the Initial and Annual Written Reports. The proposed rule would require that the reports include:
  • The basis for the DRM's representation and information reasonably necessary to evaluate the adequacy of the fund’s DRMP and—for reports following the initial implementation of the program—the effectiveness of its implementation; and
  • The basis for the DRM's selection of the designated reference index used under the proposed relative VaR test or, if applicable, an explanation of why the DRM was unable to identify a designated reference index appropriate for the fund such that the fund relied on the proposed absolute VaR test instead.
• Regular Board Reporting and Required Elements. The proposed rule would also require a DRM to provide to the fund’s board, at a frequency determined by the board, a written report analyzing where a fund’s risk guidelines were exceeded and the results of the fund's stress testing and backtesting. The report must include such information as may be reasonably necessary for the board to evaluate the fund's responses to any breaches of risk guidelines and the stress testing and backtesting results.

The Board’s Role: Guidance from the SEC

Aside from making a judgment regarding the relevancy of a prospective DRM's experience—and deciding the frequency of certain reports directors receive—the 2019 proposal generally avoids imposing discrete responsibilities on fund boards. Instead, directors are expected to exercise their customary oversight responsibilities. The SEC's proposing release offers instructive guidance about its expectations as to how directors should exercise these oversight responsibilities:

"The proposed rule's requirements regarding board oversight and reporting are designed to further facilitate the board's oversight of the fund's derivatives risk management. Board oversight should not be a passive activity. Consistent with that view, we believe that directors should understand the program and the derivatives risks it is designed to manage as well as participate in determining who should administer the program. They should also ask questions and seek relevant information regarding the adequacy of the program and the effectiveness of its implementation. The board should view oversight as an iterative process. Therefore, the board should inquire about material risks arising from the fund’s derivatives transactions and follow up regarding the steps the fund has taken to address such risks, including as those risks may change over time. To facilitate the board's oversight, the proposed rule...would require the fund’s derivatives risk manager to provide reports to the board.

"A fund's board would also be responsible for overseeing a fund's compliance with proposed rule 18f-4. Rule 38a-1 under the Investment Company Act requires a fund’s board, including a majority of its independent directors, to approve policies and procedures reasonably designed to prevent violation of the federal securities laws by the fund and its service providers. Rule 38a-1 provides for oversight of compliance by the fund's adviser and other service providers through which the fund conducts its activities. Rule 38a-1 would encompass a fund’s compliance obligations with respect to proposed rule 18f-4." (Emphasis added.)

TAKEAWAYS FOR FUND DIRECTORS

A Significant Improvement from Version 1.0...

Although the board is tasked with determining whether a prospective DRM has "relevant experience" to administer the fund’s DRMP, the requirement that the board approve the designation of the DRM is at least consistent with the liquidity risk management rule’s requirement that the board approve that program's administrator, as well as with the component of the fund compliance rule—Rule 38a-1—requiring board appointment of the fund’s chief compliance officer. Certainly, removing the board from decisions about portfolio leverage limitations is a welcome change from the 2015 proposal, which would have required board involvement in management or operational matters.

...But Caution Ahead.

While the fortunes seemingly have improved for fund boards, the rule proposal is far from perfect and will impose substantial additional operational and compliance duties on fund managers that are derivatives users. Those funds must develop, implement and maintain a multi-faceted derivatives risk management program, involving daily VaR testing, daily backtesting, and at least weekly stress testing, that may strain resources and require outside expertise and/or additional third-party resources and data. Moreover, the proposed rule includes various recordkeeping requirements relating to a fund’s compliance with the rule, as well as new SEC reporting requirements regarding a fund’s derivatives risks and any exceedances of the VaR-based limits.

What You See is What You Get?

In developing the latest derivatives rule proposal, the SEC considered the approximately 200 comment letters received in response to the 2015 proposal, as well as subsequent SEC staff engagement with various fund complexes and investor groups. This regulatory history, and the staff’s efforts to address various concerns with the 2015 proposal, suggest that the contours of a final rule, if adopted, may largely align with this proposal. Still, industry participants should not hesitate to engage in the comment process, which ends on March 24.

The SEC is Talking to You; It Would be Prudent to Listen.

Finally, directors should heed the guidance directed to their attention and actively engage fund management to develop an understanding of their funds' use of derivatives, the material risks presented and the manner in which those risks are addressed. Directors are not expected to have an in-depth, technical understanding of how derivatives operate. However, the SEC expects directors have an understanding of the risks associated with a fund’s use of derivatives so that they can make an informed evaluation of the adequacy of the DRMP and the effectiveness of its implementation.

Nathaniel Segal serves as counsel at Vedder Price and is a member of the firm's Investment Services group. Based in Chicago, he counsels investment companies, investment advisers, and boards of directors on a broad range of regulatory, compliance, corporate and transactional matters arising under U.S. federal securities laws. He also advises the independent board members of investment companies on corporate governance matters and best practices, including with their review of investment advisory and distribution contracts.