By August 19, 2022, registered investment companies must comply with Rule 18f-4 of the U.S. Investment Company Act of 1940, as amended (“Investment Company Act”). The new regulatory framework for the use of derivatives creates a set of rules and requirements that will significantly impact how investment advisers and fund Boards evaluate a fund’s use of derivatives. In combination with Rule 18f-4, the U.S. Securities and Exchange Commission (SEC) will rescind Investment Company Act Release No. 10666, as well as subsequent SEC staff no-action letters, which have governed the use of derivatives and certain other financing transactions in registered funds for over 40 years.
Rule 18f-4 will require a Board’s heightened attention to and oversight of a fund’s derivatives usage and material risks. The Board must approve the designation of an officer or officers to serve as the fund’s derivatives risk manager (“DRM”), and it must review the DRM’s initial and annual written report on the derivatives risk management program. In addition, the Board is expected to review periodic written reports describing information related to the implementation of the derivatives risk management program.
Additionally, Rule 18f-4 mandates a VaR test (either the default of relative VaR or, if the conditions are met, absolute VaR). The relative VaR test is intended to measure the VaR of the fund relative to the VaR of a designated reference portfolio. The designated reference portfolio can generally be either (i) an index selected by the fund’s DRM, or (ii) the fund’s own securities portfolio (excluding derivative transactions).
Another key component of Rule 18f-4 is a written derivatives risk management program. While Rule 18f-4 allows funds to tailor their derivatives risk management programs to suit their derivatives usage, each program must include the following elements: (1) risk identification and assessment, (2) risk guidelines, (3) stress testing on at least a weekly basis, (4) weekly backtesting, (5) internal reporting and escalation, and (6) periodic reviews of the derivatives risk management program.
Finally, Rule 18f-4 contains several exceptions specific to certain fund types and financial instruments. For example, funds limiting their derivatives exposure to 10% of net assets (excluding certain currency and interest rate hedging transactions) are excepted from the VaR testing, derivatives risk management program requirements, and Board oversight requirements, provided that such funds implement written policies and procedures reasonably designed to manage their derivatives risks. Rule 18f-4 also contains detailed provisions regarding the definition of “derivatives transactions” and special treatment for leveraged/inverse funds, reverse repos and similar financing transactions, delayed-settlement securities, and unfunded commitment agreements, as well as expanded reporting and recordkeeping requirements.
While funds have until next August to comply with Rule 18f-4’s requirements, investment advisers and Boards should begin planning and ensuring all of Rule 18f-4’s requirements can be satisfied prior to the August compliance date. We hope that this Guide will provide a practical resource for AIMA members seeking to achieve compliance with Rule 18f-4. It is intended to provide a summary of key portions of Rule 18f-4, as well as notable exceptions and alternatives.
Partner, K&L Gates
Partner, K&L Gates
Partner, K&L Gates
Partner, K&L Gates
Associate, K&L Gates
Time to get started...
Every in scope fund will need to comply with Rule 18f-4 by no later than August 19, 2022. This may seem to be a long way away still but there is a lot to do before then. The Guide helps to break down the principal tasks into a manageable set of steps. However, investment advisers should also consider whether the changes in process might drive the need to make other less obvious changes. Does the fund's fundamental policy regarding senior securities need to be adjusted? Do arrangements with custodians and prime brokers need to be adjusted? Do new instructions need to be given to any of the fund's service providers? Be sure to consider the possibility of these type of lateral impacts and leave sufficient time for dealing with them.
The following is a summary checklist of steps for the investment adviser or sub-adviser (except where indicated) and an indication where each step is discussed in the guide:
- Determine whether Rule 18f-4 applies and, if so, to what extent (chapter 1)
- Determine whether the fund qualifies as a “limited derivatives user” (chapter 2)
- Establish the fund’s status as a limited derivatives user
- Monitor the 10% limit
- Report exceedances to the board and to the SEC as required
- Start developing the derivatives risk management program by identifying and assessing the fund’s derivatives risks (chapter 3)
- Identify a qualified and eligible nominee to serve as derivatives risk manager (“DRM”) (chapter 4)
- Nominate the candidate for the board to consider designation as DRM (chapter 4)
- Board to designate the DRM (chapter 4)
- Complete the derivatives risk management and the relevant policies and procedures (chapter 5), which should include policies and procedures related to:
- Risk guidelines (chapter 5.A)
- Leverage risk limits and related monitoring (chapter 5.B)
- Determine whether the fund qualifies for the leveraged/inverse fund exception
- Operationalize the relative VaR test including choosing a designated reference portfolio, unless not applicable
- Operationalize the absolute VaR test if applicable
- Include VaR related escalation and board reporting policies and procedures
- Perform required regulatory reporting
- Stress testing (chapter 5.C)
- Backtesting (chapter 5.D)
- Internal reporting and escalation (chapter 5.E)
- Treatment of specific types of instruments:
- Reverse repurchase agreements/similar financing transactions (chapter 5.F)
- Unfunded commitment agreements (chapter 5.G)
- When-issued, forward-settling and non-standard settlement cycle securities transactions (chapter 5.H)
- Approval of the derivatives risk management program by the investment adviser (or sub-adviser) (chapter 5.I)
- Review and assessment of the derivatives risk management program by the DRM (chapter 6)
- Board consideration and approval of the derivatives risk management program (chapter 7)
- Annual review of the program by the DRM (chapter 8.A)
- Annual and periodic reporting from the DRM to the board (chapter 8.B)
- Recordkeeping and retention (chapter 8.C)
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Watch the webinar replay
Click below to watch the replay of Derivatives risk management programs for liquid alts strategies, a discussion of the practical aspects of implementing the new rule’s requirements and the challenges for derivatives risk management programs for liquid alts strategies.