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
We promised a few posts back to discuss how a Limited Derivatives User should apply what we termed the “10% buffer” to determine whether currency and interest-rate derivatives may be excluded from its derivatives exposure. This post begins to tackle the question What is the 10% Buffer? and explain how it might work.
This post continues our examination of how a fund must treat hedges when calculating its derivatives exposure to qualify as a limited derivatives user. Commenters on proposed Rule 18f-4 suggested several types of derivatives hedges, in addition to currency derivatives, that the Commission might exclude from derivatives exposure. In the release adopting Rule 18f-4 (the “Adopting Release”), the Commission agreed to exclude interest rate derivatives from the calculation of derivatives exposure, but rejected the other suggestions. These other hedging strategies should therefore be included in a fund’s derivatives exposure.
We previously discussed covered call options and purchased option spreads, which are derivatives transactions and should be included in derivatives exposure. Other potential hedges that should be included in derivatives exposure include the following. Continue Reading Rule 18f-4: Trimming Hedges—Hedges Included in Derivatives Exposure
Our post on the derivatives exposure equation began with a separate equation concerning interest rate and currency hedges. This post explains the significance of this equation and what hedges should be excluded from a fund’s derivatives exposure. Our next post will address hedges included in derivatives exposures before we raise some interpretive questions about how the exclusion should be applied. Continue Reading Rule 18f-4: Trimming Hedges—Hedges Excluded from Derivatives Exposure
Given this week’s headlines, many emerging companies may be asking themselves: “Why am I holding so much cash?”
The Investment Company Act of 1940 (the 1940 Act) may be to blame.
“Inadvertent” Investment Companies
But I don’t have any intent of being an investment company. Aren’t those mutual funds or hedge funds? I’m an operating company that produces goods or provides services.”
The 1940 Act can apply to all companies, not just those with investment-related businesses. The term “investment company” under the 1940 Act has two primary meanings:
- A company that is or holds itself out as primarily engaged in the business of investing or trading in securities, which describes many investment funds; or
- A company whose total assets (exclusive of government securities and cash items) are comprised of at least 40% “investment securities” (which is more broadly defined under the 1940 Act than “securities” are defined under the Securities Act of 1933).
In other words, even if it doesn’t hold itself out as an investment-related business, an operating company that has 40% or more of its assets invested in stocks, bonds or other securities (even conservative corporate bonds held for cash preservation purposes) is an “investment company.” As such, the company will be subject to the registration and other requirements of the 1940 Act unless it meets a conditional exemption under Section 3 of the 1940 Act or another relevant provision or rule under the 1940 Act. Intent is not an element of the second primary meaning of “investment company,” and even a company that produces goods and services could inadvertently meet the definition simply by having a balance sheet comprised of too high a percentage of “investment securities” in relation to its total assets.
Generally, Government Securities and Cash Items are Out of the Equation
Importantly, along with government securities, “cash items,” such as cash, bank demand deposits and federally-regulated money market funds, are typically (but not always) removed from both the “investment securities” numerator and the total assets denominator when calculating the 40% test described above or similar tests under exemptive provisions. Holding corporate assets in cash as opposed to “investment securities” helps a company avoid investment company status if an exemption is not available. Even holding cash can complicate things, though, since excluding a large cash position from the 40% test can cause a company’s “investment security” holdings to disproportionately affect the results of that calculation.
Many start-up companies find themselves in the position of holding proceeds from fund raising but with relatively few other offsetting assets. Seeking to avoid becoming an inadvertent investment company, they may choose to hold the proceeds in cash items or government securities. Rule 3a-8 excludes certain research and development companies (and some other start-up companies) from the definition of an investment company if certain conditions are met, but many companies are not able to meet the conditions. This means that start-ups may be at particular risk from instability in the banking system as they may be limited in the choices they have to invest their fundraising proceeds.
What should I do if I am worried about holding cash but want to avoid an investment company status issue?”
Even if a regulator does not approach a company, many significant deals require a representation or even an outside legal opinion as to the company’s status under the 1940 Act. Significant securities holdings could delay a deal or even require restructuring the business. So, while it may be tempting to move your liquid holdings from bank accounts to securities or other assets in light of recent bank developments, careful planning can help prevent inadvertently jumping from the frying pan into the fire.
Contact a securities lawyer knowledgeable on investment company status issues should you have any questions.
On September 14, 2022, the SEC proposed amendments (the Proposal) to regulations for clearing agencies under the Securities Exchange Act of 1934 (the Exchange Act). The Proposal would increase the central clearing of U.S. Treasury securities, to be defined as “any security issued by the U.S. Department of the Treasury.” According to the SEC’s press release, “the proposal would require that clearing agencies in the U.S. Treasury market adopt policies and procedures designed to require their members to submit for clearing certain specified secondary market transactions.” Continue Reading Central Clearing of Treasury Trades—What the SEC Has Proposed
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
In our extensive examination of the requirements for Limited Derivatives Users under Rule 18f‑4(c)(4) we have tried to be conscientious in pointing out matters open to interpretation. While we have not been shy about arguing for interpretations that would reduce a fund’s derivatives exposure and thus ease compliance with these requirements, we acknowledge that these are just our informed opinions. Absent guidance from the SEC staff, chief compliance officers and counsel to fund directors and trustees will need to consider these matters and reach their own conclusions.
This post wraps up our examination of the Limited Derivatives User requirements with a list of these interpretive questions. While we are sure it is incomplete, at least it provides a starting point for consideration. Continue Reading A Limited Derivatives User Punch List
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