On November 25, 2019, the Securities and Exchange Commission voted to propose a new rule regarding the regulation of the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds (ETFs) and closed-end funds, as well as business development companies. See the Press Release.
Under the new proposed rule the General Statement of Policy (Release 10666) would be withdrawn after a one-year transition period.
The new rule is in some regards similar to the Commission proposal made in 2015 with respect to the use of derivatives by funds, particularly with respect to its Value at Risk or VaR approach.
The use of subscription lines to cover capital calls has evolved from short term bridge facilities (generally paid off within 90 days) into longer term facilities used by fund managers for cash management and greater flexibility in completing transactions, through the avoidance of the immediate need to call for capital from the fund’s limited investors. This expended use of subscription lines, however, has raised certain issues for limited partners in connection with and the alignment of their economic interests in subscription line use with the interests of the general partner. The Institutional Limited Partners Association (ILPA) recently published new guidance in this area: Subscription Lines of Credit and Alignment of Interests: Considerations and Best Practices for Limited and General Partners (June 2017).
Major areas of the ILPA’s concern with the use of subscription lines include:
Performance Comparability; Claw back Issues. The ability to delay the actual call for capital compresses the J-curve changing the calculation of the internal rate of return (IRR) and related preferred return thresholds. This makes it more difficult to compare fund performance across funds. Also, if the calculations are made from the time of the actual capital call rather than the time a draw is made on the line of credit, the IRR may be greater and preferred return hurdles may be achieved earlier. The early achievement of such hurdles may also lead to claw back issues if the general partner receives amounts which ultimately need to be returned due to poorer fund performance later on.
Expenses. A subscription line creates direct upfront expenses for the partnership. Poor performing funds may not be able to recoup some of those expenses.
Liquidity. An event of default on a subscription line related to a manager, or an event affecting the market generally, can result in there being multiple simultaneous capital calls, which may strain some limited partner resources. The expanded use of subscription lines can mask, to some extent, the aggregate exposure of some limited partners.
Ceding Control to Lenders. The terms of the subscription lines may cede control to lenders under certain circumstances on various fund decisions and assignments. Limited partners may have entered these investments based on their view of the manager, but now some of the manager’s discretion may have shifted to the lenders.
On June 22, the Alternative Reference Rates Committee (the “ARRC”) identified a broad Treasuries repo financing rate (the “Broad Treasuries Financing Rate”) that, according to the ARRC, in its consensus view represents best practice for use in certain new U.S. dollar derivatives and other financial contracts.
The work of the ARRC grew out of the past instances of manipulation of the LIBOR market which caused a loss of confidence in LIBOR – particularly as it had previously been determined and reported – as a reliable interest rate benchmark. That led the G20 to instruct the Financial Stability Board to review broadly-recognized interest rate benchmarks and devise a plan to ensure that the construction of these benchmarks are sound and used appropriately in the markets. According to the Working Group on Alternative Interest Rates initiated by the Federal Reserve in furtherance of the plan, the goals were two-fold: (1) strengthen the integrity of existing benchmark rates, and (2) develop alternative reference rates that would be free of many of the risks (including manipulation) associated with existing benchmarks. The Broad Treasuries Financing Rate would be one such alternative rate.
A recent decision of the European Court of Justice (“ECJ”), on a referral from the Latvian courts and which is binding on the English courts (although the UK has commenced steps to leave the EU, the UK’s formal exit is still some time away), will make it more difficult for the holder of an English floating charge to enjoy the benefit of the UK’s Financial Collateral Arrangements (No.2) Regulations 2003 (“FCARS”)
FCARS implement an EU directive whose purpose was to assist the taking of security over financial collateral, which includes securities and cash. When the FCARS apply, the collateral taker has certain advantages: a number of insolvency law provisions as well as some formalities will not apply. The FCARS can also permit the collateral taker to enforce its security by appropriating collateral without having to get a court order. Thus for a holder of security over financial collateral the applicability of the FCARS to its security can be very useful.
The English floating charge is used widely. It is a form of security whose creation in response to the needs of the emerging economic environment was endorsed by the English courts in the nineteenth century. It allows companies to grant security whilst at the same time still being able to carry on their business.
Lender Beware: The custody assets you are lending against may not actually be held in custody.
Lenders to funds and other borrowers often extend credit based on a security interest over assets that are held in custody. The lender is granted a security interest in the relevant custody account and all of the cash, securities and other assets therein, and then perfects the security interest by entering into a “control agreement” with the custodian. The lender may have made two big assumptions: (1) the custodian has “custody” of the assets, and (2) upon receipt of instructions from the lender after default, the custodian can readily transfer or otherwise dispose of the relevant assets. Upon closer examination, however, these assumptions may prove to be incorrect.
There are two broad categories of assets that are capable of being held in custody:
(1) Assets such as a bearer bond, a stock certificate in the name of the borrower (together with an undated stock power in blank), or gold bullion. This is referred to as “on premises custody” or “direct custody”; the custodian has physical custody of the asset. In each of these cases, the custodian has the power to transfer title to the asset by delivery thereof – it may not have the right vis-à-vis the borrower (i.e., the custodian may be liable for breach of its duty to the borrower), but it does have the power.
(2) Assets that are held in an indirect holding system. This is referred to as “off premises custody” or “indirect custody.” One typical example of how an indirect holding system works: a clearing company (such as Depository Trust Company) holds a master share certificate for 500 million shares of an S&P 500 publicly‑traded company. The clearing company identifies on its books and records 10 million of such shares as being held for the account of the custodian (in its capacity as a member of the clearing company) and, in turn, the custodian identifies on its books and records 100,000 of such shares as being held for the account of the borrower. In this case, the custodian has the power to (a) “move” some or all of those 100,000 shares on its books and records to another of its custody clients, or (b) advise the clearing company that some or all of such shares have been transferred to a third party that does not maintain an account with the custodian (in which case the clearing company would revise its books and records to reflect that such shares are held by or through another member of such clearing company). In any event, as a general rule, the custodian has the power to transfer the borrower’s interests in these shares.
2017 is proving to be a stressful and costly year for asset managers. The terms of the UK’s exit from the EU will continue to be the subject of extensive debate, both politically and in the press. At the same time, MiFID II is just around the corner, coming into force in January 2018 after having been put back a year due to the complexity of its implementation.
MiFID II recasts and broadens MiFID (the EU’s Markets in Financial Instruments Directive) in response to the financial crisis. It will change the way asset managers operate and not just in terms of enhanced investor protection. The new rules affecting allocation of costs for research, the impact on the fixed income market, the prohibition on payments to financial advisers and the new significantly more onerous reporting requirements are all major issues for the industry players to deal with. One commentator has estimated that MiFID II will cost the financial services industry more than EUR 2.5 billion to implement. And smaller players will be hit hardest, having less ability to absorb these hefty costs.
As for the UK’s proposed exit from the EU (the UK has yet to formally pull that trigger) we can expect the UK’s financial services industry to be significantly impacted. However, quite what that impact will be is as yet unknown and will depend on what model is eventually negotiated for the relationship between the UK and the EU in place of the UK’s current position as a full member of the EU. Of particular relevance for asset managers will be what the UK’s access to EU markets will look like. Currently, asset managers along with other UK authorised firms have full access to EU markets under passporting rights, which allow them to carry on business in another EEA state whether or not through a branch.
It’s clear to anyone paying attention that the market for initial public offerings of closed‑end funds has fallen off dramatically over the last few years. Undoubtedly, the primary cause of this fall off has been the gaping average trading discount of existing closed‑end funds (i.e., on average these funds have been trading at steep discounts to net asset values). That made it difficult, if not a practical impossibility, for asset managers to sell shares of a new closed-end fund when investors could simply purchase shares of a similar, existing closed-end fund at a significant discount.
Also contributing somewhat to this fall off has been the relative increase in the cost of leverage as a result of the phasing in of new capital rules for banks. Many closed-end funds employ leverage to deliver additional returns to investors; these increased costs (which correspondingly reduce returns to investors) have made it incrementally more difficult for asset managers looking to launch new closed-end funds to make their case to investors.
On top of all of this, according to many industry observers the so-called “fiduciary rule” (finalized on April 6, 2016) would make it nearly impossible for financial advisors to recommend to investors that they purchase shares of a closed‑end fund at the IPO stage. The key problem for closed-end fund IPOs under the fiduciary rule is not necessarily inherent; it arises out of the fact that, at times, while many closed-end funds trade at a premium at and shortly after the initial offering, thereafter they begin to trade at a discount. This can have the effect of creating at best a short-term paper loss, and at worst a short-term actual loss, for investors.
If you have any questions regarding anything discussed on this blog, the attorneys and other professionals of the Financial Institutions Group of Bryan Cave LLP are available to answer your questions. Please click here for a list of our Professionals or fill out the contact request form below.
Thank you for reaching out to us.
First, though, we have to tell you a couple of things:
Your email will not create an attorney-client relationship between you and us. Attorney-client relationships can only be created in writing, signed by both you and us.
Until you become a client:
You will not tell us anything you would not want made public.
We cannot respond to any question about the law or legal options.
We may represent a party adverse to you, now or in the future.
The attorneys of Bryan Cave Leighton Paisner make this site available to you only for the educational purposes of imparting general information and a general understanding of the law. This site does not offer specific legal advice. Your use of this site does not create an attorney-client relationship between you and Bryan Cave LLP or any of its attorneys. Do not use this site as a substitute for specific legal advice from a licensed attorney. Much of the information on this site is based upon preliminary discussions in the absence of definitive advice or policy statements and therefore may change as soon as more definitive advice is available. Please review our full disclaimer.