SEC Staff Evaluating the Use of Derivatives by Registered Funds

March 29, 2010

On March 25, 2010, the U.S. Securities and Exchange Commission announced that its staff is conducting a review to evaluate the use of derivatives by mutual funds, exchange traded funds (ETFs) and other investment companies. In connection with the review, the staff will seek to determine whether and what additional regulation or guidance may be warranted. The SEC noted that, pending completion of the review, it will defer consideration of new and pending requests for exemptive relief by ETFs that would make significant investments in derivatives. The SEC noted, however, that this deferral does not affect existing ETFs or other types of fund applications.

In connection with the SEC’s decision to evaluate the use of derivatives by funds, SEC Chairman Mary Schapiro noted the “questions surrounding the risks associated with the derivative instruments underlying many funds.” Andrew “Buddy” Donohue, Director of the SEC’s Division of Investment Management, further noted, “[W]e want to be sure our regulatory protections keep up with the increasing complexity of these instruments and how they are used by fund managers.”

In connection with the review, the staff intends to explore, among other issues, whether:

  • current market practices involving derivatives are consistent with the leverage, concentration and diversification provisions of the Investment Company Act
  • funds that rely substantially on derivatives maintain adequate risk management procedures
  • boards of funds are providing appropriate oversight of the use of derivatives by funds
  • existing rules sufficiently address matters such as the proper procedure for pricing and liquidity determinations of derivative holdings
  • existing prospectus disclosures adequately address the risks created by derivatives
  • derivative activities by funds should be subject to special reporting requirements

The Investment Company Act of 1940 limits the amount of leverage that an investment company can bear. Section 18(f) generally prohibits a fund from issuing a “senior security” except under certain circumstances. Permissible senior securities include, among other things, a borrowing from a bank where the fund maintains an asset coverage ratio of at least 300 percent while the borrowing is outstanding. The SEC or its staff has, through a number of interpretive releases, no-action letters and other public statements, recognized that the concerns related to leverage created by a fund’s use of derivatives can be eliminated if the fund covers the exposure related to derivatives through, for example, segregated accounts or offsetting positions.

In recent years, the SEC staff has raised concerns about the use of derivatives by investment companies. In a speech to the American Bar Association on April 17, 2009, Mr. Donohue focused on the leverage that derivatives bring to funds and asked whether the “thirty year patchwork of stated Commission policy and staff positions regarding investment companies’ use of derivatives” is sufficient or whether regulatory and/or legislative action is necessary to address the leverage created by investment companies’ use of derivatives. Mr. Donohue referred to what he called the “increasing gap” between technical compliance with the existing leverage limitations under the Investment Company Act of 1940, on the one hand, and actual fund performance and investor expectations on the other hand. He noted that, despite risk disclosure contained in a fund’s offering documents, many investors in highly leveraged funds that suffered one-year losses in excess of 30 percent in 2008 “neither appreciated the potential magnitude of nor anticipated the actual diminution in value of these funds.”

It may take time for new rules or guidance to emerge. In the meantime, funds, advisers and boards may be well-served by reviewing their derivatives practices and procedures to ensure they conform to current law and interpretive guidance. Funds may also want to review their disclosures concerning derivatives to ensure that they are understandable to investors and adequately describe the ways they use derivatives and their attendant risks. In addition, boards may wish to ensure they are exercising adequate oversight of funds’ use of derivatives, including any embedded leverage.

For assistance, please contact the following lawyers:

Toby R. Serkin, Partner, Investment Management, 617.951.8760 

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

This article was originally published by Bingham McCutchen LLP.