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Not content with Steve’s detour into the relationship between Rule 2a-7 and re-proposed Rule 18f-4, we would also like to point out a set of rules under which the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) have wrestled with the distinctions between “swaps, security-based swaps and security-based swap agreements” and non-derivative transactions. Release No. 33-9938 (the “Release”) not only adopted regulations distinguishing swaps from other types of derivatives instruments (such as securities forwards) and securities, but also included interpretive guidance for distinguishing swaps from consumer and commercial agreements, contracts, and transactions. Several of the commercial transactions discussed in this Release correspond to the type of loan commitments the SEC proposes to include in the definition of “unfunded commitment agreement” in Rule 18f‑4. We suggest that some factors used to distinguish one type of derivative instrument (a swap) from commercial lending transactions may also help distinguish these transactions from derivatives instruments more generally.

This post continues my consideration of why certain “unfunded commitment agreements” should be carved out of the valuation at risk limitations of re-proposed Rule 18f-4. My previous post explained why two of the justifications offered for this carve out do not bear scrutiny. My current view is that the scope of the carve out depends on the third proposed justification: that some commitments may not have “leveraging effects.” This requires an understanding of the leveraging effects regulated by Section 18 of the Investment Company Act.

I will use the example of money market funds to explore “leveraging effects” because (a) it allows me to answer a question raised in the proposing release and (b) it illustrates another means of limiting leverage.

This post continues my assessment of the proposed treatment of unfunded commitments under re-proposed Rule 18f-4. My previous post questioned whether the proposed definition of an “unfunded commitment agreement” successfully carved these transactions out of the definition of “derivatives transactions.” This post begins my evaluation of why such a carve out may be warranted.

The SEC’s release cites three factors offered by commenters that the SEC agreed “distinguish unfunded commitment agreements from … derivatives transactions.” Unfortunately, the first two of these factors do not provide a sound basis for drawing such a distinction.

My initial posts on re-proposed Rule 18f-4 reflect my generally favorable reactions to the SEC’s attempt to develop a practical, hence imperfect, means of implementing the limitations on senior securities required by Section 18 of the Investment Company Act of 1940. My initial series of post written at the time Rule 18f-4 was first proposed attempted to explain some of the inherent difficulties of this task.

I will now turn to a more problematic matter: the proposed treatment of so-called “unfunded commitment agreements.” While I basically agree with the proposed approach of limiting commitments by requiring a reasonable means of meeting the fund’s obligations, I have reservations about how and why the rule proposes to implement this approach.

In my initial post on the SEC’s reproposed rules for regulating the use of derivatives by investment companies (“funds”), I noted favorably that the regulations would extend beyond funds to registered broker/dealers and investment advisers. I think this reflects a more comprehensive, less piecemeal, approach to these proposed rules. I also appreciate the coordination of the Divisions of Investment Management and Trading and Markets in drafting the proposed rules.

There are other praiseworthy aspects of the general approach taken in developing the revised proposals. Chief among these is the SEC’s willingness to take a fresh look at the means of regulating the risks of derivatives usage. Historically, the SEC’s principal means for regulating these risks was to require funds to “segregate” liquid assets to cover a fund’s potential obligations for derivative transactions. The revised proposals would eliminate asset segregation in favor of more direct limits on potential volatility resulting from derivative transactions. Risks posed by payment or delivery obligations would represent just one, no longer paramount, component of a comprehensive risk management program.

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Release No. IC-10666 (“Release 10666”), issued in 1979 under the direction of my partner Marty Lybecker, was the starting point for the SEC’s regulation of derivatives under Section 18 of the Investment Company Act. This release would provide the basis for proposed Rule 18f‑4’s regulation of “financial commitment transactions.” Many of the comment letters on the proposed rule refer to Release 10666, and many of these assert that subsequent no-action letters extended Release 10666 to derivatives. Their assertion underestimates the original scope of Release 10666, which extended to all derivative contracts commonly used at the time.