In Andrew Cross and my series on Rule 18f-4, we noted that the SEC was rescinding Release 10666 and related no-action letters as of the compliance date for the rule (August 19, 2022). The release adopting 18f-4 also promised that the Division of Investment Management would review prior guidance and reconcile the guidance to the new rule. In March 2021, the Division issued an information update listing staff letters that have been withdrawn or modified in connection with Rule 18f-4. I’m posting this link as a convenient resource for readers of our series (who have been plentiful and we thank you).
This post will bring to a close, for now, our survey of the requirements of new Rule 18f-4, which investment companies must comply with by August 19, 2022. This post considers whether a Chief Compliance or Risk Officer should seek to treat some or all of their funds as Limited Derivatives Users and how that choice, in turn, relates to the decision about whether to treat reverse repurchase agreements as derivatives transactions. But first, we review the compliance procedures required by Rule 18f-4 for (nearly) every fund. We also provide links to compliance checklists provided in earlier posts. Continue Reading Rule 18f-4 Wrap-Up
As with Fund-of-Funds, the release adopting Rule 18f-4 (the “Adopting Release”) devotes a section to sub-advised funds. We again consider three types of funds:
- VaR Funds in which a sub-adviser manages their entire portfolio (“Single Sub-Adviser Funds”);
- VaR Funds in which one or more sub-advisers manage a portion or “sleeve” of their portfolio (“Sleeve Funds”); and
- Sub-advised funds that seek to qualify as Limited Derivatives Users.
The Adopting Release discusses the first two circumstances but is silent on the third. Continue Reading Compliance with Rule 18f-4 by a Sub-Advised Fund
The release adopting Rule 18f-4 (the “Adopting Release”) devotes an entire section to discussing how “a fund that invests in other registered investment companies (‘underlying funds’)” should comply with the value-at-risk (“VaR”) requirements of the rule. This post considers three circumstances in which a fund investing in underlying funds:
- Does not invest in any derivatives transactions (a “Non-User Fund-of-Funds”);
- Allows its derivatives exposure to exceed 10% of its net assets (a “VaR Fund-of-Funds”) ; and
- Limits its derivatives exposure to 10% of its net assets (a “Limited Derivatives User Fund-of-Funds”).
We use the term “Fund-of-Funds” for convenience, meaning to include funds that hold both direct investments and underlying funds in compliance with Rule 12d1-4 or other exemptions. Continue Reading Compliance with Rule 18f-4 by a Fund-of-Funds
Our last post explained why the Limited Derivatives User provisions of Rule 18f‑4(c)(4) may not “provide [the] objective standard to identify funds that use derivatives in a limited manner” anticipated by the SEC. Inconsistencies in methods of determining the notional amounts of derivatives transactions may cause funds that use such transactions in the same manner and to the same extent to be treated differently under the rule. The previous post also questioned whether requiring Limited Derivatives Users to perform the complex calculations required to determine their derivatives exposure each day might “incur costs and bear compliance burdens that may be disproportionate to the resulting benefits.”
This post points out some alternatives that would address our concerns, although it may be too late to implement one of them. Continue Reading Improving the Limited Derivatives User Provisions of Rule 18f-4
This post continues our assessment of whether the Limited Derivative User requirements of Rule 18f-4(c)(4) effectively and efficiently accomplish the SEC’s aim of providing “an objective standard to identify funds that use derivatives in a limited manner.” Here we question whether the “gross notional amount” of a derivatives transaction measures the means and consequences, rather than the extent, of its use. Continue Reading Assessing the Limited Derivatives User Requirements of Rule 18f-4—Notional Amounts
Our last series of posts on Rule 18f-4 have struggled to understand how its Limited Derivatives User requirements are supposed to work. We have done the best we could to explain the process for calculating a fund’s derivatives exposure, including determining the gross notional amount of derivatives transactions and adjustments thereto, excluding closed-out positions and currency and interest-rate derivatives entered into for hedging purposes, and applying the “10% buffer” for these hedges. In this series of posts, we shift our perspective to assessing whether these requirements effectively and efficiently accomplish the SEC’s objectives. Continue Reading Assessing the Limited Derivatives User Requirements of Rule 18f-4—Costs
This post will address another ambiguity in the “10% buffer” Rule 18f-4 provides for excluding the notional amount of derivative transactions that hedge currency or interest rate risks (“Hedging Derivatives”) when calculating the Derivatives Exposure of a Limited Derivatives User. The ambiguity is whether, once the notional amount of a Hedging Derivative exceeds the 10% buffer, a fund should add back to its Derivatives Exposure (a) the entire notional amount of the Hedging Derivative or (b) only the notional amount in excess of the 10% buffer. We chose answer (b) in our post on The 10% Buffer and Changes in Hedged Investments. This post explains why. Continue Reading Hedging Derivatives under Rule 18f-4: Not an “All or None” Exclusion
This post continues our examination of the “10% buffer” for Hedging Derivatives, which refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value, par or principal amount of the hedged equity and fixed-income investments. In this post we consider whether funds should apply the 10% buffer to Hedging Derivatives in the aggregate or on a “hedge-by-hedge” basis. Continue Reading Rule 18f-4: One 10% Buffer or Many?
This post continues our examination of the “10% buffer” for Hedging Derivatives, which refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value of hedged equity investments, par amount of hedged fixed-income investments or principal amount of hedged borrowings. In this post we examine what it means for Hedging Derivatives to exceed the 10% buffer. Continue Reading Rule 18f-4: The 10% Buffer and Changes in Hedged Investments