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More Work for the CCO in SEC’s Proposed Derivatives Rule


The SEC has once again proposed new derivatives rules for registered funds including mutual funds, ETFs, closed-end funds, and BDCs.  Funds that employ derivatives would be required to limit leverage to 150% of the value-at-risk of a designated referenced index.  The fund would also have to create a derivatives management program that would include a designated derivatives risk manager in addition to stress testing, backtesting, reporting and escalation procedures, and reviews.  Different rules would apply to levered or inverse funds, although any adviser or broker-dealer recommending or selling such funds would have to implement due diligence procedures for retail accounts.  A 60-day comment period will follow publication.

Here we go again.  The SEC tried derivatives reform back in 2015 but never adopted the rule in the face of industry objections.  The new proposal puts a lot of burden on the designated derivatives risk manager which, we expect, means more work for the Chief Compliance Officer.    

Portfolio Manager Blows Up His Firm With Swap Pricing Scheme

 A private fund portfolio manager was barred from the industry and ordered to pay $749,000 in disgorgement and fines for intentionally inflating swap valuations and concealing his activities.  According to the SEC, the PM, whose compensation was directly tied to fund performance, convinced management to use a discretionary valuation model for certain swaps and swaptions.  Without telling management, he then began using discretionary inputs rather than default values for pricing.  The SEC asserts that he used different discount curves to maximize valuations, fund performance, and his own compensation.  The SEC further alleges that he hid his activities by lying to the fund administrator and third party brokers.  Within 16 months after discovery of the mispricing, the firm reimbursed clients, shut down what had been a $375 Million fund, and ceased operations.

Firms should seriously re-consider tying portfolio management compensation directly to fund performance, especially where the PM is responsible for Level 3 (non-exchange traded) fair-valued securities.  For both the C-suite and compli-pros, this case shows how a failure to properly supervise one bad employee can blow up your firm.  As for the PM (and any other potential wrongdoer), the industry bar will make it difficult to find a job to get out of the six-figure hole resulting from the wrongdoing.