ICI Files Comment Letter on SEC's Proposed Rules on Funds' Use of Derivatives and Sales Practices for Transactions in Leveraged/Inverse Investment Vehicles
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April 20, 2020 TO: ICI MembersInvestment Company Directors SUBJECTS: Closed-End Funds
Compliance
Disclosure
Distribution
Exchange-Traded Funds (ETFs)
Intermediary Oversight
Investment Advisers
Money Market Funds
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Risk Oversight
Systemic Risk RE: ICI Files Comment Letter on SEC's Proposed Rules on Funds' Use of Derivatives and Sales Practices for Transactions in Leveraged/Inverse Investment Vehicles
As previously reported, the Securities and Exchange Commission reproposed a rule that would provide an updated approach to the regulation of derivatives and similar instruments used by mutual funds, exchange-traded funds, closed-end funds, and business development companies (“funds”).[1] The rulemaking also sets forth proposed new rules governing the sale of leveraged and inverse investment vehicles.
ICI today submitted the attached comment letter strongly supporting the reproposed rule.[2] ICI’s letter is divided into four sections reflecting the three main parts of the proposal—the reproposed rule (Proposed Rule 18f-4), public reporting requirements, and the sales practices requirements—as well as a discussion on compliance dates. Most of our comments relate to Proposed Rule 18f-4, focusing mainly on the scope of the rule and its proposed leverage limits. With respect to board-related issues, ICI endorsed the letter that the Independent Directors Council filed.[3] We summarize below a number of the key points that we raise in our letter.
I. Proposed Rule 18f-4
Our discussion on Proposed Rule 18f-4 is divided into subsections covering: the scope of the rule; the leverage limits; the derivatives risk management program; the limited derivatives user exceptions; reverse repurchase agreements and similar financing transactions; and unfunded commitment agreements.
Scope of the rule. We recommend that the Commission exclude certain firm and standby commitment agreements (and similar instruments) from the “derivatives transaction” and “senior securities” definitions. Those agreements—that have a relatively short-settlement period and create a fixed and known obligation for a fund or whose yields are determined on the date of delivery with reference to prevailing interest rates—do not create leverage (e.g., when-issued Treasury Securities) and should not be treated like derivatives that do. For the remaining firm and standby commitment agreements (and similar instruments), we recommend that the Commission permit funds to treat them as derivatives transactions under the rule or to except them from being treated as derivatives transactions under a modified asset segregation regime. That regime would require funds to set aside “highly liquid” or “moderately liquid” investments to cover the fund’s obligations under such agreements, marked-to-market on a daily basis.[4] Finally, we recommend that the Commission permit money market funds to continue to invest in certain instruments covered by the rule because those funds already are subject to the requirements and strong investor protections of Rule 2a-7 under the Investment Company Act.
Leverage limits. The letter supports leverage limits based on a value-at-risk test but recommends several modifications. First, we recommend modifying the proposed relative VaR standard. The standard should require that a fund compare its VaR to the VaR of a “designated reference index” that reflects the fund’s investment strategies instead of just the markets or asset classes in which the fund invests. This approach is better aligned with an investor’s expectation that a fund will have volatility and risk similar to its designated reference index and aligns with other major jurisdictions. We also recommend that the Commission provide additional guidance to derivatives risk managers to evaluate and make changes to designated reference indexes and permit an index fund that tracks an affiliated index to select that index as its designated reference index.
Second, we recommend changes to the proposed leverage limits. We strongly urge increasing the leverage limits to a 200 percent relative VaR limit and a 20 percent absolute VaR limit, as VaR-based limits do not isolate leverage attributable only to derivatives. The Commission also underestimated the effect of the proposed limits. It estimated, based on year-end 2018 data, that only 0.04 percent of the funds that would be subject to the proposed rule would fail the proposed VaR tests. In contrast, based on an ICI survey, 6.7 percent of respondents over the course of 2019 and 9.3 percent of respondents during a stressed period would exceed the proposed VaR limits. More recently, during the midst of the COVID-19 crisis, 15.7 percent of respondents in a smaller sample would have exceeded the proposed VaR limits. For closed-end funds, we strongly recommend that the Commission increase the limits to reflect the increased leverage they can obtain. In this regard, we suggest that the Commission increase the leverage limits based on the maximum amount of structural leverage a closed-end fund intends to attain from its preferred stock issuance.
Third, we ask the Commission to clarify that a fund can scale its VaR results from a 95 percent confidence level to a 99 percent confidence level, when appropriate. This would enable a risk manager to use a wider set of negative outcomes in the VaR calculation rather than being limited to the most extreme and unlikely losses.
Finally, we ask the Commission to ease the impact of VaR test breaches on funds. The Commission should extend the period of a fund’s VaR test breach to five business days before requiring remedial action to give funds sufficient time to return to compliance. In addition, the Commission should eliminate the “timeout” restricting a fund from engaging in derivatives transactions (unless the derivatives are designed to reduce the fund’s VaR) immediately after a VaR test breach. The concerns the Commission raises for the timeout already are addressed, and such transactions are important to managing a fund consistent with its investment objective and protecting investors.
Program requirements. Our letter states that the Commission should adopt the derivatives risk management program requirements with adjustments. In particular, the Commission should clarify certain statements made in the proposing release indicating that fund directors should engage more actively in the day-to-day management of the fund’s derivatives risk management program. Directors typically provide general oversight with respect to a fund’s derivatives use, and the Commission should affirm that it expects directors to continue in this traditional oversight role. We also recommend that the Commission expand the entities eligible to serve as derivatives risk manager to include a fund’s investment adviser and eliminate the requirement that the board consider the manager’s relevant experience regarding the management of derivatives risk. Permitting the fund’s investment adviser to serve as derivatives risk manager is consistent with the Commission’s approach to the fund liquidity rule and would enable the investment adviser to appropriately designate employees to staff the program’s administration functions. Eliminating the “relevant experience” requirement also would be consistent with the Commission’s approach to the fund liquidity rule and would alleviate concerns about what “relevant experience” means in the derivatives risk management context.
To assist funds in implementing their programs and to eliminate unnecessary burdens, we ask the Commission to clarify the scope of stress testing correlations and permit a fund to conduct stress testing and backtesting on at least a monthly basis. To assist derivatives risk managers with their obligations, we recommend that the Commission clarify that they can delegate their responsibilities to subadvisers.
Limited derivatives user exceptions. We recommend that the Commission combine the “currency hedging exception” with the “exposure-based exception.” Doing so would enable funds to exclude the hedging and offsetting transactions permitted in the currency hedging exception from the exposure-based exception calculation. The Commission notes that transactions in the currency hedging exception do not raise the policy concerns underlying Section 18, so the Commission should exclude those transactions when determining whether a fund should be subject to additional derivatives restrictions. In addition, we recommend that the Commission expand the currency hedging exception to exclude additional hedging and offsetting transactions that, like the currency hedging transactions, do not raise the policy concerns underlying Section 18 (e.g., written call options on securities held by the fund). To assist funds in complying with the currency hedging exception, we ask the Commission to clarify that the “negligible amounts” standard in the exception includes differences of 10 percent or less of the value of hedged instruments. Finally, we ask the Commission to define the cure period for exceedances or breaches of the limited derivatives user exceptions to give funds at least 14 calendar days to return to compliance or at least 90 days to adopt and implement a derivatives risk management program and adhere to the leverage limits.
Reverse repurchase agreements and similar financing transactions. We agree with the Commission’s proposed approach to treat reverse repurchase agreements and similar financing transactions as fund borrowings and indebtedness subject to statutory asset coverage requirements. In addition, we ask the Commission to permit funds that engage in those transactions to have the option to comply with the statutory asset coverage requirements or cover the obligations from those transactions under a modified asset segregation regime. The Commission has permitted funds to fully cover these transactions with known payment obligations using liquid assets for decades without issue. For funds engaging in securities lending transactions, we ask the Commission to permit them to invest any non-cash collateral received in highly liquid, short-term instruments, consistent with the current framework.
Unfunded commitment agreements. We agree with the Commission’s proposed definition and approach concerning unfunded commitment agreements.[5] That approach would permit funds to enter into unfunded commitment agreements as long as a fund reasonably believes it has sufficient cash and cash equivalents to meet its obligations under such agreements when they become due.
II. Public Reporting Requirements
We agree with the Commission’s proposed reporting requirements. We ask the Commission, however, to keep disclosure of derivatives exposures and information related to a fund’s VaR calculation model non-public, because such information may be misleading and is neither necessary nor appropriate in the public interest. In addition, the information could reveal sensitive proprietary information about a fund’s risk management model. Additionally, we recommend that the Commission amend the liquidity rule, Form N-PORT, and related guidance, if necessary, to be consistent with final rules.
III. Sales Practices Requirements
Subjecting certain registered investment companies to different sales practices requirements than any other registered investment company is a novel and untested regulatory approach. We caution the Commission that such an approach must be strongly justified with a demonstrated purpose and need, as registered funds already are subject to a robust regulatory regime under the federal securities laws.
IV. Compliance Dates
We urge a transition period of at least 24 months before rescinding the Commission and the staff’s existing guidance. A 24-month period is necessary to make wholesale changes to the way funds invest in, administer, account for, and treat derivatives and the other instruments covered in the rulemaking.
Kenneth Fang
Assistant General Counsel
Shelly Antoniewicz
Senior Director, Industry and Financial Analysis
endnotes
[1] See Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 33704 (Nov. 25, 2019), available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf. For a summary of the proposing release, see ICI Memorandum No. 32083, available at https://www.ici.org/my_ici/memorandum/memo32083.
[2] See Letter from Paul Schott Stevens, President and CEO, ICI, to Vanessa A. Countryman, Secretary, SEC, dated April 20, 2020. While the initial comment period ended on March 24, 2020, the Commission posted a notice that, due to the challenges associated with COVID-19, it would not take final action on the proposal until May 1, 2020 to allow commenters additional time to submit comments if needed.
[3] See Letter from Thomas T. Kim, Managing Director, Independent Directors Council, to Vanessa A. Countryman, Secretary, SEC, dated April 20, 2020.
[4] Funds would determine whether an investment is “highly liquid” or “moderately liquid” based on the fund liquidity rule. See Rule 22e-4 under the Investment Company Act.
[5] The proposal would define an “unfunded commitment agreement” as “a contract that is not a derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a loan to a company or to invest equity in a company in the future, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner.” See Proposed Rule 18f-4(a).