In a 3-to-1 vote, the SEC proposed a new rule that would restrict the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds and closed-end funds as well as business development companies that are subject to Investment Company Act Section 18 (“Capital Structure of Investment Companies”).
In support of the proposal, SEC Chair Mary Jo White said that funds use derivatives extensively for a variety of purposes, which can raise risks relating to leverage and the fund’s ability to meet future obligations. She remarked on the current practice of mark-to-market segregation, raising concerns that a fund may not have sufficient liquid assets to cover potential future losses. Chair White highlighted three elements that addressed these concerns: 1) new requirements that funds segregate assets to cover their mark-to-market liability, plus an additional risk-based coverage amount designed to address potential future losses on derivatives; 2) portfolio limitations based either on a fund’s aggregate derivatives exposure or on a risk-based analysis; and 3) the requirement that certain funds establish formalized risk management programs.
In presenting the proposal, SEC staff highlighted the following requirements for derivatives:
- Portfolio Limitations for Derivatives Transactions: A fund would be required to comply with one of two alternative portfolio limitations (“Exposure-Based Portfolio Limit” or “Risk-Based Portfolio Limit”) designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions. Under the exposure-based limitation, a fund would be required to limit its aggregate notional derivatives exposure to 150% of the fund’s assets. As an alternative, the risk-based limitation permits a fund to have aggregate notional derivatives exposure of up to 300% of the fund’s assets but only if the fund’s portfolio is subject to less market risk determined by a value-at-risk test.
- Asset Segregation for Derivatives Transactions: A fund would be required to manage the risks associated with derivatives by segregating certain assets (generally cash and cash equivalents) equal to the sum of “market-to-market coverage amount” and a “risk-based coverage amount.”
A fund would be required to segregate respectively:
(i) assets equal to the amount that the fund would pay if the fund exited the transaction at the time of the determination; and
(ii) an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the transaction under stressed conditions.
Derivatives Risk Management Program: Funds that engage in more than limited derivatives transactions or use complex derivatives would be required to establish a formalized derivatives risk management program consisting of certain components administered by a designated derivatives risk manager.
Requirements for Financial Commitment Transactions: A fund that enters into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under those transactions.
- Disclosure and Reporting: Two forms the SEC proposed in May 2015, Form N-PORT and Form N-CEN, would be amended respectively: (i) require a fund that is required to have a derivatives risk management program to disclose additional risk metrics related to a fund’s use of certain derivatives; and (ii) require that a fund disclose whether it relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund.
- Derivatives White Paper: The proposal refers to a white paper prepared by the SEC’s Division of Economic and Risk Analysis staff entitled, “Use of Derivatives by Registered Investment Companies.”
The majority of Commissioners relied on the white paper for evidence of the necessity for new regulation. They also referenced Section 1(b) of the Investment Company Act (which cites the Policy of the Investment Company Act) as evidence of the statutory need to eliminate undue leverage by registered funds.
Commissioner Aguilar supported the proposal but questioned whether the proposed rules place too large of a burden on fund boards. However, the Commissioner concluded that boards must be proactive in foreseeing the challenges in executing all of their fiduciary and regulatory responsibilities.
Commissioner Piwowar supported the asset segregation requirements but dissented from the portfolio limitations. He reasoned that asset segregation should be enough to address current derivative risks, therefore, absent data indicating that a separate specified leverage limit is warranted there is no justification for imposing any additional requirements or burdens on funds. In addition, the Commission has recently adopted other proposed rules that will either have a direct impact on the risks of derivatives positions held by funds, or will provide us with data that could be used to better understand how we should regulate.
Lofchie Comment: Commissioner Piwowar’s dissent from the proposal of the rule is well-reasoned. The SEC does not have adequate information needed for proper analysis of the proposal at the current time.
As the Commissioner argues, the SEC justifies the proposed derivatives framework as an “exemption” from Section 18 of the Investment Company Act (“Capital Structure of Investment Companies”), even though the SEC is in fact limiting behavior that it has previously sanctioned. It is not at all obvious that the conduct requires an exemption from Section 18; and the fact that the SEC had previously sanctioned the conduct would seem to indicate that no such exemption is required. If no exemption is required, it raises the question of the specific authority under which the SEC proposes to act.
The proposal also raises the question of whether the SEC acted appropriately in further restricting the activities of SEC-registered investment companies that have made appropriate disclosure of the risks involved in their investment strategies. The safety that SEC-registered investment companies provide to investors necessarily comes at a cost, whether it is the increased cost of managing the fund or the implicit cost to investors being denied investment opportunities. It is far from obvious that the subsequent costs that the SEC proposes here are justifiable.
As for the risk of derivatives, the idea that such risk may be judged based on a predetermined notional “size” measure is inherently inexact. Beyond that, the requirement of specified derivatives management procedures has the feel of more government-required formalities that have the potential to provide more benefits to consultants than to investors.