This is the ninth installment of our review of the compliance requirements of new Rule 18f‑4. Our last post explained why unfunded commitment agreements present asset sufficiency risk but did not create leverage risk. In this post, we will explain how paragraph (e) of the new rule controls asset sufficiency risk, tracing its origins back to Release No. IC-10666 (“Release 10666”).
Continue Reading Unfunded Commitment Agreements under Rule 18f-4: The Last Vestige of Release 10666

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?”
Continue Reading Rule 18f-4 Still Has Commitment Issues

This post is the third installment of our discussion of the compliance requirements of new Rule 18f‑4. From this point forward, we will be dealing with exemptions that apply only to business development companies (“BDCs”), closed-end funds and open-end funds other than money market funds (collectively, “Funds”). We first consider paragraph (d) of Rule 18f‑4, relating to reverse repurchase agreements (“reverse repos”).
Continue Reading Reverse Repos and Rule 18f-4—The Easy and the Hard Ways

This post is the second installment of our discussion of the compliance requirements of new Rule 18f-4.

The comments on proposed Rule 18f-4 revealed a significant lacuna in the rule resulting from two unrelated changes to current regulations. First, the SEC will rescind Investment Company Act Release No. 10666 (“Release 10666”) as of August 19, 2022, the same day funds must comply with Rule 18f-4. Second, money market funds are excluded from the exemptions for derivatives transactions provided by Rule 18f-4. This post will explain why this was a problem and how the final rule addresses it.
Continue Reading Exclusion of Non-Standard Settlements—Something for Every Fund in Rule 18f-4

Following onto our recent podcast discussing new Rule 18f-4 at a very high level, we thought it would help to post a series of blogs that go into more detail and point out some open questions. We begin with the most basic elements:

  • What is Rule 18f-4?
  • What alternatives are available for compliance?
  • When must funds comply with Rule 18f-4?


Continue Reading Dealing with the New Derivatives Rule—Definition of Derivatives Transactions and Classifications of Funds

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.
Continue Reading Re-Proposed Rule 18f-4: Commitment Agreements—Putting it all Together

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.
Continue Reading Re-Proposed Rule 18f-4: Features of Loan Commitments that May Prevent “Leveraging Effects”

Our last post used a comparison of loan commitments, which re-proposed Rule 18f-4 would treat as “unfunded commitment agreement,” and “to be announced” (“TBA”) mortgage-backed securities trades and put options for bonds, which Rule 18f-4 would treat as “derivative transactions,” to isolate features that could be used to delineate these commitments based on their leveraging effects. Our next post will continue this analysis by considering whether each unique feature of a loan commitment mitigates its potential “leveraging effects.” Before proceeding, however, we will consider one feature shared by loan commitments and TBAs to illustrate why even seemingly common features may have different leveraging effects.
Continue Reading Re-Proposed Rule 18f-4: What Features of Loan Commitments May Preclude “Leveraging Effects”—Prepayments

Our last post began to consider why some firm and standby commitments entered into by investment companies (including business development companies) may have “leveraging effects” while others do not. The Securities and Exchange Commission (“SEC”) needs to identify the essential differences between these commitments to delineate when re-proposed Rule 18f-4 should treat a commitment as an “unfunded commitment agreement” rather than a “derivatives transaction.” Our last post showed that loan commitments share, at a minimum, the same interest rate risks as other types of commitments, so any absence of leveraging effects must depend on other factors.
Continue Reading Re-Proposed Rule 18f-4: Using Morphology to Delineate Commitment Agreements

This post continues our consideration of a carveout from the proposed Value at Risk (“VaR”) limitations of Rule 18f-4 for unfunded commitment agreements “because they do not present an opportunity for the fund to realize gains or losses between the date of the fund’s commitment and its subsequent investment ….” Our last post dealt with commitments to invest in a company’s equity. But the definition of “unfunded commitment agreement” would also include a contract “to make a loan to a company.” Commenters on the original Rule 18f-4 proposal contrasted these loan commitments with:

firm and standby commitment agreements, under which a fund commits itself to purchase a security with a stated price and fixed yield without condition or upon the counterparty’s demand.”

We do not believe the contrast is as stark as these commenters suggest. If our view is correct, we will need to search for additional factors to distinguish these loan commitments from commitment agreements that should be treated as derivatives transactions.
Continue Reading Re-Proposed Rule 18f-4: Unfunded Loan Commitments