Deriv User Funds and Board Oversight

On October 28, 2020, the Securities and Exchange Commission adopted a rule regarding derivatives usage by registered investment companies (including open-end funds other than money market funds; exchange-traded funds; closed-end funds; and business development companies).

The rule permits funds to invest in securities on a forward-settling basis or with non-standard settlement cycles, provided they intend to physically settle those transactions and do so within 35 days of their trade date.

Funds’ Derivatives Risk Management Program

Funds must create and implement a derivatives risk management program that includes (i) risk identification, assessment and evaluation; (iii) investment guidelines providing quantitative or otherwise measurable criteria, metrics or thresholds of the derivative risks; (iv) backtesting daily VaR test results; (v) internal reporting/escalation mechanisms; and (vi) periodic review. Furthermore, the program must contain risk guidelines tailored to reflect the fund's strategies as well as levels of derivative exposure.

The program must also ensure the derivatives risk manager and those accountable for portfolio management are kept informed of material risks arising from a fund's derivative transactions. If they determine that a fund has exceeded any criteria or threshold established by guidelines or stress testing as specified in those guidelines, they must immediately report this information to those in charge of portfolio management as well as to the board of directors of the fund.

Funds that fail to meet the criteria, metrics or threshold set out in the guidelines must submit a written report within thirty calendar days to portfolio management and the fund's Board of Directors outlining the extent of the failure and how it was corrected. If these exceedances continue or the fund remains out of compliance with applicable VaR tests, derivatives risk managers must update this report and update it periodically at a frequency determined by the board on progress towards becoming compliant.

The new Rule will have a different impact on funds depending on their level of derivatives usage. Generally, registered open-end and closed-end funds that utilize derivatives extensively will face more rigorous compliance obligations than those who don't - known as "limited derivatives users." Limited derivatives users do not need to create and follow an 18f-4 compliance operating model, yet they must still adopt written policies and procedures designed to manage the fund's derivative risk responsibly.

VaR-Based Limit on Fund Leverage Risk

Funds that invest in derivatives must adhere to a Value-at-risk ("VaR") test for leverage risk limits. Under the relative VaR test, funds must compare their VaR with that of an established reference portfolio (such as its securities portfolio) that accurately reflects market risks and asset classes where they invest. Conversely, under an absolute VaR test, funds may not exceed 150% of this designated reference portfolio's VaR (or 200% for closed-end funds).

The Rule requires funds to adopt and implement a derivatives risk management program that is reasonably designed to manage their "derivatives risks." Furthermore, it necessitates that the fund's board approve the designation of a Derivatives Risk Manager who would administer and report on its effectiveness as well as provide reports about stress test results, backtesting results, and breaches in program risk guidelines related to derivatives usage by the fund.

Furthermore, the Rule requires funds to maintain records pertaining to their program and adherence to VaR-based limits on leverage risk. These record-keeping requirements are intended to enable the SEC, board of directors, and compliance personnel of a fund to evaluate whether these provisions have been fulfilled.

If a fund's VaR exceeds that of its designated reference portfolio, it must inform the SEC and Commission by filing Form N-RN. This form must be filed confidentially on an ongoing basis and include information regarding the fund's highest VaR during the reporting period as well as the name and index identifier of its designated reference portfolio.

This disclosure requirement was designed to give the public insight into when a fund's VaR rises or drops over time. Unfortunately, the Commission's adopting release eliminates that public disclosure and ignores any benefit investors might gain from such transparency.

Furthermore, the Rule requires derivatives risk managers to submit quarterly and annual reports to the board regarding the effectiveness of their Program, including any stress tests or backtesting required under it. These periodic reviews must take into account changes in derivative risks a fund is exposed to over time such as regulatory, market or fund-specific developments.

Board Oversight and Reporting

A board of directors is often described as the "ultimate manager" or "ultimate overseer" of a corporation, with significant responsibilities to shareholders and stakeholders. As such, effective Board oversight necessitates adequate information flows to fulfill this role effectively.

Boards typically receive a substantial amount of financial information about an organization from management on a regular basis. This includes market and business strategy, measures of financial and operational performance, control structures, management processes, human resources issues as well as mandatory sustainability/ESG disclosures along with related systems and internal controls.

Boards also have other duties to fulfill, such as monitoring risk (i.e., complying with laws and regulations), assuring the company's business strategy aligns with its values, and giving approval to management plans to execute those strategies.

Typically, board oversight is delegated to several board committees that offer ongoing assistance to the full board in fulfilling its responsibilities. As such, standing committee structures must be carefully designed in order to promote effective board oversight of enterprise risks that affect core businesses and other mission-critical elements.

This task requires an in-depth knowledge of the risks an organization faces, its systems and processes for identifying and monitoring them, as well as how information about those risks is brought to the board and its committees. Furthermore, the board should establish a formal risk governance structure while periodically reviewing it according to changes in a company's risk landscape.

In addition, a Board's oversight of a company's financial reporting process is its primary responsibility. If necessary, they can demand explanations from management and audited reports for clarification purposes. Moreover, the board may want to assess its own information and control systems by engaging a third party to evaluate them. Furthermore, any corporate use of financial measures which have been challenged by regulators - such as free cash flow or net income excluding one-time charges - should be given special attention by the board.

Limited Derivatives User Exception

Under Rule 18f-4, funds that limit their derivatives exposure to 10% of net assets (excluding certain currency and interest rate hedging transactions) are exempted from the Program requirement and VaR-based limits. However, a fund using this Limited Derivatives User Exception must establish and implement written policies and procedures reasonably designed to manage its derivative risks in accordance with the Rule.

The Derivatives Risk Manager must include risk identification and management processes, such as those for leverage, market, counterparty, liquidity, operational, legal and operational risks that the fund's derivatives use presents. Furthermore, it should contain procedures for managing material risks arising from this use of derivatives back to the board for approval.

Funds that rely on the Limited Derivatives User exception for derivative exposure must treat it as a temporary breach and return to compliance within thirty calendar days after the initial breach. During this time, the Derivatives Risk Manager must submit a report to the fund's board outlining how and when it believes the fund will return to compliance; additionally, updates on progress towards coming back into compliance should be provided at regular intervals as determined by the board.

Additionally, if a fund remains out of compliance for more than five business days after an initial breach, its Derivatives Risk Manager must identify what caused them to fall out and adjust the program accordingly. Once back in compliance, they must continue monitoring and reporting on both their program and derivative exposure as of each reporting period's end.

Due to the intricate rules surrounding the Limited Derivatives Exception, it is essential that funds utilizing it comprehend its requirements and obligations. In particular, the Rule requires that a fund using this exception create a Derivatives Risk Manager (DRM) to manage its derivatives risks. Furthermore, regular reports must be provided by the DRM regarding its effectiveness as well as any material changes it might undergo.