Securities Regulation Daily SEC adopts rule on registered investment company derivative use
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Wednesday, October 28, 2020

SEC adopts rule on registered investment company derivative use

By Jay Fishman, J.D.

Complex investment company derivatives rule finally materializes after years of SEC brainstorming but two of the five commissioners are not satisfied.

The SEC adopted a November 2019-proposed rule to better mitigate the risks to retail investors who invest in registered investment company funds comprising derivatives. Chairman Jay Clayton commended the Commission’s Investment Management Division staff led by Dalia Blass and the Economic and Risk Analysis Division staff led by S.P. Kothari, as well as the SEC’s general counsel and his fellow commissioners for their efforts to bring a 10-year regulatory framework to fruition. Investment company fund derivatives were previously regulated by a patchwork of inconsistent guidance and no-action letters, which grew unwieldy over time.

The first attempt at a rule in 2015 failed to gain consensus that led to the 2019 proposal, on which 6000 persons submitted comments. The final rule was adopted 3-2, with Chairman Clayton and commissioners Hester Peirce and Elad Roisman voting in favor while commissioners Allison Herren Lee and Carolina Crenshaw dissented. Lee and Crenshaw found the final rule to be a watered-down version of the initial proposal they considered a much stronger investor protector. The final rule left out the initial version’s sales practice provisions and relaxed some of the leverage restrictions.

Effective dates and rescissions. The new rule and its related rule and form amendments (see below) will be published on the Commission’s website and in the Federal Register, with all taking effect 60 days after Federal Register publication. Further, funds will have 18 months after the effective date to comply with the new rule. Lastly, the first document on this subject, a 1979 General Policy Statement (Release 10666) will be rescinded 18 months after the effective date, along with the staffs’ 1979-followup no-action letters and other guidance.

Joint Statement. Chairman Clayton, Director Blass, and Corporate Finance Division Director William Hinman and Trading and Markets Division Director Brett Redfearn simultaneously released a Joint Statement Regarding Complex Financial Products and Retail Investors. The joint statement addresses the follow factors for these complex products: (1) the structural differences that may impact regulatory protections; (2) the potential impact of volatility and market stress; (3) the increase in self-directed trading; and (4) the disclosure requirements for these products, along with Regulation Best Interest and the investment adviser’s fiduciary duty. The Joint Statement ends with a request for engagement.

Investment Company Act rules 18f-4 and 6c-11. The new rule, specifically Investment Company (1940 Act) Rule 18f-4, is an exemptive rule that permits mutual funds (other than money market funds), along with exchange-traded funds (ETFs), registered closed-end funds, and business development companies to enter into derivatives transactions (and certain other transactions), bypassing the 1940 Act restrictions associated with the rule. Simultaneously, the Commission amended 1940 Act Rule 6c-11 to allow leveraged or inverse ETFs to operate without obtaining an exemptive order. Lastly, the Commission adopted new reporting requirements and amendments to disclosure Forms N-PORT and N-CEN.

The final rule basically mandates funds under Rule 18f-4 to:

  1. Implement a written derivatives risk management program made up of both a standardized risk management framework for all funds and a principles-based tailoring of each fund’s particular risks.
  2. Comply with an outer limit on fund leverage risk based on value-at-risk (VaR) that compares the VaR to the VaR of a "designated reference portfolio (DRP);" funds must, alternatively, comply with an absolute VaR test if the fund’s derivatives risk manager reasonably determines that a DRP is not appropriate for a fund; generally, a VaR must not exceed 200 percent of the fund’s DRP under the relative VaR test or 20 percent under the absolute VaR test.

NOTE that this VaR requirement does not apply to funds whose derivative exposure is 10 percent or less of its net assets (excluding certain currency and interest rate hedging transactions).

Leveraged/inverse funds. Leveraged/inversed funds must also comply with the above requirements, by limiting their targeted daily returns to 200 percent of the return (or inverse of the return) of the fund’s underlying index. But funds with higher returns will be excepted under certain conditions.

Reverse repurchase agreements and unfunded commitment agreements. The rule permits funds to enter into reverse repurchase and unfunded commitment agreements, subject to conditions tailored to the transactions.

Recordkeeping. The rule requires funds to comply with certain recordkeeping requirements.

Rule approvers. Chairman Clayton, voting to approve the rule, remarked that "Derivatives have come to play an important role for many funds in portfolio strategy and risk management, but the regulatory approach for derivatives use has been inconsistent and outdated."

Commissioner Roisman found that the rule strikes the right balance of restricting particular funds that use derivatives while simultaneously providing less restrictions on, and exceptions for, funds overall. He was also glad the final rule left out the sales practice provisions, which he considered unduly burdensome for fund managers trying to comply with the rule.

Commissioner Peirce also voted for the rule but had a few reservations. While agreeing that the rule is a vast improvement over the 2015 proposal and the vast patchwork of guidance and no-action letters stemming from the 1979 policy statement, she thought that the sales practice provisions should have been left in, stating that personnel issues should be left to advisers. Also, she liked that the rule is principles-based, but indicated that the principles-based approach should have encompassed more than the rule prescribes.

Rule dissenters. Commissioner Lee voted against the rule, believing that it does not strike the correct balance mentioned above. She said that leaving out the sales practice provisions will render the rule much more harmful to investors, declaring that fund managers, unlike advisers, often do not understand the risks these recommended complex products pose to retirees, middle income, and other retail investors. But her primary concern with the final rule is that fund managers will use the relaxed limit on non-derivative based funds to manipulate the derivative fund restriction in ways that subject retail investors to significantly more risk that they would have been subject to under the initial proposal.

Commissioner Crenshaw said that the final rule would leave investors to fend for themselves, proclaiming that she would have preferred the 2015 proposal. In dissenting, she said that: (1) the final rule’s VaR [requirement #2] for determining leverage is an unreliable test because it looks backward rather than forward; (2) the final rule actually creates double leverage rather than less; (3) the risk management program [requirement #1] undermines the rule’s ability to limit risk; and (3) eliminating the sales practice provisions will result in retail investors buying these complex funds without sufficient adviser guidance, thereby facilitating the investors’ purchase of funds alarmingly contrary to their investment objectives.

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