Join the Conversation on the SEC's New Derivatives Rule- 11 Things You Need to Know

Posted by Richard Wagner on Jan 12, 2021 9:41:15 AM

On October 28, 2020, the SEC adopted a new Rule designed to address the investor protection purposes and concerns underlying Section 18 of the Investment Company Act of 1940. More specifically, Rule 18f-4 provides an updated and more comprehensive approach to the regulation of funds’ use of derivatives. This Rule is effective for all funds February 19, 2021, with a compliance date of August 19, 2022.

11 DerivativesThe final Rule offers a more than 450-page comprehensive framework for funds utilizing derivatives.
Below, we’ve noted 11 key highlights that you should consider about this new Rule, particularly if your funds utilize derivatives.

1. Derivatives Risk Managers – The Rule requires an officer or officers of the fund’s investment advisor with relevant experience regarding the management of derivatives risk to serve as the fund’s derivatives risk manager. The derivatives risk manager may not be a portfolio manager of the fund if the derivatives risk manager is a single person. If multiple officers serve as a derivatives risk manager, a majority of the individuals may not be composed of portfolio managers. The Rule does allow for some flexibility if the designated individual is not an officer of the advisor but has a comparable degree of seniority and authority within the organization, meets the qualification for being a derivatives risk manager and is approved by the fund’s board. 

2. Sub-Advisors as Derivatives Risk Managers – The Rule provides flexibility for funds to involve sub-advisors in derivatives risk management. Pursuant to the Rule, a group of individuals are able to serve as a fund’s risk manager, and the group could include officers of both the fund’s primary advisor and the sub-advisor(s). A fund that has a single sub-advisor which manages the entire portfolio (as opposed to a portion, or “sleeve” of the fund’s assets), could have the officer(s) of the sub-advisor serve as the derivatives risk manager, if approved by the fund’s Board. 

3. Liability Risks of the Derivatives Risk Manager – The Rule utilizes the same standards that apply in determining whether a person is liable for aiding or abetting or causing a violation of the federal securities laws. The SEC has recognized that risk management necessarily involves judgement and that a fund that suffers losses does not itself mean that a fund’s derivatives risk manager acted inappropriately. 

4. Value-at-Risk (“VaR”) TestThere are multiple ways to calculate the VaR. The Rule requires a fund to use the relative VaR test as a default method unless the fund’s derivatives risk manager determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test. The derivatives risk manager needs to take into account the fund’s investments, investment objectives, and strategy.  A fund that does not apply the relative VaR test must comply with the absolute VaR test. The absolute VaR test may be appropriate for managed futures funds, market-neutral funds, long-short funds, multi-alternative funds/non-correlated strategy funds, and funds that invest in unique asset classes that may not have a broad-based index. The VaR test should be performed each day. 

5. Leverage / Inverse Funds and VaR – These funds are required to comply with the VaR-based leverage limit in Rule 18f-4, although there is an exception for the leveraged/inverse funds that were in operation as of October 28, 2020 that seek an investment result above 200% of the return (or inverse of the return) of an underlying index and satisfy certain additional criteria. 

6. Funds Limited to Certain Investors and VaR – Funds that limit their investors to “qualified clients” as defined in Rule 205-3 under the Advisers Act, and/or are sold exclusively to “qualified clients,” “accredited investors,” or “qualified purchasers” are not exempted from the VaR-based limit of the Rule. All funds registered under the Investment Company Act of 1940 or regulated under the Act, as in the case of business development companies, are subject to the Rule. 

7. Funds Out of Compliance With the VaR test – If a fund is not back in compliance with the applicable VaR test within five business days after determining it is out of compliance, it is required to file Form N-RN with the Commission. The fund is required to return to compliance in a manner that is in the best interest of the fund and its shareholders. A fund engaging in “fire sales” to avoid filing a report on Form N-RN would violate the Rule. 

8. Board Oversight – The Rule will require: (1) a fund’s Board of Directors to approve the designation of the fund’s derivatives risk manager; and (2) the derivatives risk manager to provide regular written reports to the Board regarding the program’s implementation and effectiveness, and analyzing exceedances of the fund’s guidelines and the results of the fund’s stress testing. The Board should have an active role in the oversight of the derivatives utilized by the fund. This includes inquiry into 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 change over time. 

9. Reporting to the Board – The derivatives risk manager will provide a written report on the effectiveness of the program at least annually. Regular written reports are also required to be provided to the Board at their discretion.  The reports are required to facilitate the Board’s oversight role, including its role under Rule 38a-1.

10. Compliance With the Rule – 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. Under Rule 38a-1, the fund’s CCO will be required to report the following related to the Derivatives Rule to the Board:

  • The operation of the policies and procedures of the fund
  • Any material changes to the policies and procedures since the last report
  • Any recommendations for material changes to the policies and procedures as a result of the annual review
  • Any material compliance matters since the date of the last report

11. Fund Reporting Requirements – The Rule includes requirements to report specified information to the Commission on Forms N-PORT, N-RN, and N-CEN. Form N-PORT will provide more information about the fund, including its derivatives exposure and VaR information, if applicable. Form N-RN is used to report instances of VaR test breaches, and it’s important to note that this form is the amended and re-titled Form N-LIQUID. Form N-CEN will be utilized to report if a fund relied on Rule 18f-4 during the period and whether it relied on any of the exceptions from various requirement under the Rule. 

Bottom Line: This Rule is going to create additional work and expenses for all funds in the form of legal and compliance fees, whether they are utilizing derivatives or not.   It is clear that there will be more data to perform enhanced oversight of derivatives use by each fund’s Board and the SEC. Time will tell if the Rule will fulfill its intended purpose of addressing the enhanced shareholder protections and concerns underlying Section 18 of the Investment Company Act of 1940.

Contact Us