In the blitz of regulatory and financial developments that have made headlines throughout the first quarter of 2023, a recent FINRA enforcement action serves as a reminder to both broker-dealers and their representatives that Regulation Best Interest (Reg BI) remains an area of focus for FINRA. This action underscores how important it is for broker-dealers
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…
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.
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.
As has been our practice in this series on new Rule 18f-4, we end our survey of its Limited Derivatives User requirements with a compliance checklist. This checklist reiterates much of our earlier post on Derivatives Exposure: Why It Matters And How To Calculate It, but provides more details and includes required…
Yesterday, the Investment Adviser Association published our article on “Dealing with the New Derivatives Rule: A Guide of Legal and Compliance Professionals” in the “Compliance Corner” of its September 2021 IAA Newsletter.
At a high level, the article:
- Provides a background on the limitations on senior securities under the Investment Company Act of
Having completed our review of derivatives transactions, we now consider the risks such transactions may pose. Rule 18f-4(a) defines “derivatives risks” to include “leverage, market, counterparty, liquidity, operational, and legal risks and any other [material] risks.” The adopting release (the “Release”) provides helpful descriptions of these risks and some examples.
This is the seventh installment of Andrew Cross and my review of the compliance requirements of new Rule 18f‑4 and the first to deal with “unfunded commitment agreements.” Before plunging into the substance of paragraph (e) of Rule 18f-4, which regulates unfunded commitment agreements, I want to revisit a problem I have with the definition. My problem stems from trying to answer a basic question: Is a binding commitment to make a loan upon demand by the borrower, with stated principal and term and a fixed interest rate, an “unfunded commitment agreement?”
This post ends our series critiquing the proposed definition of “unfunded commitment agreement” in re-proposed Rule 18f-4. This definition is important because it would create an exception from the Value at Risk (“VaR”) limitations the proposed rule would impose on “derivatives transactions” by investment companies. This post will recap the problems with the proposed definition and the approach we would recommend for addressing these shortcomings.
In a previous post, we compared loan commitments, which re-proposed Rule 18f-4 would treat as “unfunded commitment agreements,” and “to be announced” (“TBA”) mortgage-backed securities (“MBS”) trades and put options, which Rule 18f-4 would treat as “derivative transactions,” to identify features that may be unique to loan commitments. Our last post showed how one feature, greater uncertainty as to the term of eventual loans as compared to the average life of the mortgages that underlie TBAs (in each case resulting from prepayments of the loans and mortgages, respectively), could prevent loan commitments from fluctuating in value. If the value of the commitment does not fluctuate substantially, the commitment cannot “present an opportunity for the fund to realize gains or losses between the date of the fund’s commitment and its subsequent investment” and thus will not have a leveraging effect on the fund.
Gauging the probability of drawings and prepayments is not a practical approach to regulating commitments by investment companies, so we will continue analyzing the potential leveraging effects of the unique features of loan commitments we previously identified. Two features, the right to terminate the commitment and the expectation that the commitment would be drawn, were uniquely present in loan commitments. Two other features, the availability of offsetting transactions and posting margin to secure the commitment, were uniquely absent.