SEC Issues Concept Release on Use of Derivatives by Investment Companies Under the Investment Company Act of 1940

September 07, 2011


On August 31, 2011, the U.S. Securities and Exchange Commission issued a concept release to seek public comment on a wide range of issues raised by the use of derivatives by investment companies regulated under the Investment Company Act of 1940, as amended.1 These investment companies include mutual funds, closed-end funds and exchange-traded funds (ETFs). The release is intended to assist the SEC and its staff in their ongoing review, announced in March 2010, of whether and how the regulatory regime surrounding the use of derivatives can be improved given the dramatic growth in the volume and complexity of derivative instruments and the increasing prevalence of derivatives in portfolio management strategies.According to SEC Chairman Mary Schapiro, the impetus for the review is that “fund investments in derivatives are not always wholly captured by the statutory limitations and requirements” contained in the Investment Company Act and that “[t]he controls in place to address fund investments in traditional securities can lose their effectiveness when applied to derivatives.”3  

Chairman Shapiro noted that “[t]he Commission’s approach to the regulation of funds’ use of derivatives has developed on an ad hoc basis as new derivative instruments were introduced and new derivative hedging strategies gained popularity.”4 The release states that the SEC “seeks to take a more comprehensive and systematic approach to derivatives-related issues under the Investment Company Act.”5 

The release is seeking broad public comment on a variety of issues relevant to the use of derivatives by funds, including the senior securities restrictions imposed by Section 18 of the Investment Company Act, diversification requirements, concentration limitations, restrictions on investments in securities-related businesses and valuation.

The SEC approved issuance of the release at an Open Meeting held on August 31, 2011. At the Open Meeting, the SEC also approved issuance of a pair of companion releases relating to the treatment under the Investment Company Act of asset-backed issuers and to the status under the Investment Company Act of companies engaged in the business of acquiring mortgages and mortgage-related instruments. We expect to issue client alerts on the companion releases in the near future.

Background and General Request for Comment

The release describes the current state of the regulatory framework, as well as the various types and uses of derivatives that have become common among funds. The SEC generally requests data and comment on the types of derivatives used by funds, the purposes for which funds use derivatives and whether the use of derivatives by funds has undergone or may be undergoing changes. The SEC is also requesting comment on a number of more specific questions, including questions concerning costs, benefits and risks associated with funds’ use of derivatives; the different types of derivatives used by different types of funds; and the manner in which they are used. The release also questions how ETFs use derivatives and whether an ETF’s use of derivatives raises unique investor protection concerns under the Investment Company Act.

The release then turns to specific provisions of the Investment Company Act and asks for comment on how they are implicated by the use of derivatives.

Section 18 and Limitations on the Issuance of Senior Securities

Section 18 of the Investment Company Act imposes various requirements on the capital structure of funds and governs the extent to which a fund may issue “senior securities.” “Senior security” has been broadly interpreted by the SEC and its staff to apply to transactions that expose a fund’s shareholders to potential leveraged losses. The release states that “the protection of investors against the potentially adverse effects of a fund’s issuance of senior securities is a core purpose of the Investment Company Act.”6 The release notes that Section 18 was enacted to prevent (i) potential abuse by the purchasers of senior securities, (ii) excessive borrowing and issuance of senior securities by funds, which increase the speculative character of junior securities, and (iii) funds operating without adequate assets and reserves to meet obligations.

The release describes the existing SEC guidance with respect to the application of Section 18 to investments in derivatives. Beginning with Release 10666,7 issued in 1979, and continuing in a series of subsequent no-action letters, the SEC and its staff developed a “segregated account approach,” which requires a fund to segregate liquid assets sufficient to meet potential obligations arising from the fund’s investment in a derivative instrument. The release notes that asset segregation practices with respect to a number of derivative instruments have not been specifically addressed by the SEC or its staff.

The release reviews the current segregated account approach, which serves both to limit a fund’s potential leverage and to provide a source of payment of future obligations arising from the leveraged transaction. The release notes that the segregated account approach has drawn criticism on several grounds. For example, some industry participants argue that the approach calls for an instrument-by-instrument assessment of the amount of cover required, which creates uncertainty about the treatment of new products. Others argue that, with respect to determining the amount to be segregated, use of the full notional amount and use of the mark-to-market amount both have their limitations.

The release goes on to describe some alternative approaches that have been suggested by industry participants or that have been adopted by regulators in other jurisdictions. One such approach, proposed in the 2010 ABA Derivatives Report,8 would be to require individual funds to establish their own asset segregation standards for derivative instruments that involve leverage within the meaning of Release 10666 and set minimum “risk adjusted segregated amounts” with respect to each type of derivative instrument. Under such an approach, funds could consider a variety of risk measures, including “value at risk” (taking into account, for example, the liquidity and duration of the instrument, price volatility of the reference asset, and creditworthiness of the counterparty), rather than the mark-to-market or notional amount, to determine the appropriate amount to segregate. These minimum asset segregation amounts would be reflected in policies and procedures that would be subject to approval by the fund’s board and disclosed (including the principles underlying the minimum amounts for different types of derivatives) in the fund’s statement of additional information.

The release also devotes substantial attention to the approaches adopted by regulators in other jurisdictions. For example, the European Securities and Markets Authority (formerly, the Committee of European Securities Regulators) has issued Global Exposure Guidelines to govern the use of derivatives by investment vehicles that are authorized for sale to retail investors (known as “Undertakings for Collective Investment in Transferable Securities” or “UCITS”). The Global Exposure Guidelines permit two alternative methods for determining exposure. The first is the “commitment approach,” in which a fund’s derivatives positions are converted into equivalent positions in the underlying assets and the total exposure from such conversions is limited to 100% of the total net value of the UCITS’ portfolio. The Global Exposure Guidelines provide a schedule of derivative investments that indicates the appropriate conversion method to use for various types of derivatives (e.g., market value, notional amount or some risk-adjusted alternative) in determining a fund’s global exposure. The Global Exposure Guidelines also permit UCITS to determine global exposure using value at risk (or a comparably sophisticated risk measurement method). Global exposure based on value at risk is limited to either twice the value at risk of an unleveraged reference portfolio (“relative value at risk”) or 20% of the UCITS’ NAV (“absolute value at risk”). 

Other jurisdictions have taken similar approaches. For example, the Monetary Authority of Singapore requires investment companies to calculate global exposure based on a commitment approach, similar to that described above (or, with prior approval, using the value at risk approach). Total global exposure may not exceed 100% of the investment company’s NAV. Singapore also prohibits an investment company from having exposure to any single counterparty that exceeds 10% of its NAV, although cash or AAA government bonds may be tendered as collateral to reduce counterparty exposure for purposes of this limitation.

The release also describes the approach to coverage requirements taken in certain jurisdictions, such as Ireland and Canada. For example, in Ireland a non-UCITS investment company is permitted to sell a futures contract only if it holds the underlying reference asset or maintains a proportion of assets that is at least equal to the exercise value of the futures contract and is reasonably expected to behave in the same manner, in terms of price movement, as the futures contract. Similarly, the Canadian Securities Administrators require an investment company to maintain cash cover that, for example with respect to a swap, is not less than the underlying market exposure of the swap plus any margin on account and the market value of the swap. 

Finally, the release notes that the Hong Kong Securities and Futures Commission differentiates between authorized unit trusts and mutual funds that use derivatives extensively for investment purposes and unit trusts and mutual funds that do not engage in such use of derivatives in regulating their use of derivatives. For example, authorized unit trusts and mutual funds in Hong Kong are generally limited to investing 15% of NAV in options and 15% of NAV in warrants when these instruments are used for non-hedging purposes. By contrast, for collective investment schemes that are non-UCITS, which do not meet certain criteria and use derivative instruments extensively for investment purposes, global exposure is limited to 100% of NAV. The Hong Kong Securities and Futures Commission requires authorized unit trusts and mutual funds to use a version of the commitment approach in determining global exposure, which takes into account the prevailing value of the underlying assets, counterparty risk, futures market movements and liquidity concerns in converting derivatives positions into equivalent positions in the underlying reference assets.

The SEC requests comment on the application of the senior securities limitations imposed by Section 18 to funds’ use of derivatives. The SEC is also seeking views concerning the appropriateness and effectiveness of the current segregated account approach and potential ways to improve the approach to better address the investor protection concerns underlying Section 18. The SEC also asks a number of other specific questions concerning the current approach and alternative approaches.

Section 5(b) and Diversification Requirements

The next section of the release addresses diversification requirements, the purpose of those requirements and the application of those requirements to a fund’s use of derivatives. 

Funds are required to disclose in their registration statements whether they are classified as diversified or non-diversified. Under Section 5(b) of the Investment Company Act, a diversified fund is a fund that, with respect to 75% of the value of its total assets, has (among other things) no more than 5% of the value of its total assets invested in the securities of any one issuer. The release notes that, because Section 5(b) requires a diversified fund to calculate the 75% bucket and the percentage of the fund’s total assets that is invested in the securities of a single issuer, it implicates the manner in which the fund values its derivative instruments. Pursuant to Section 2(a)(41) of the Investment Company Act, a fund must use the market value (or fair value) to value derivatives. The release questions whether these valuation methods are adequate to achieve Section 5(b)’s purpose of preventing a fund that holds itself out as being diversified from being overly exposed to a single issuer, given that the market or fair value of a derivative instrument may not reflect the true extent of the fund’s exposure to the underlying reference asset.

In applying the diversification requirements, a fund also must determine the identity of the issuer of each derivative. The release also seeks comment on whether funds should look to the issuer of the underlying reference asset or to the counterparty to the derivative instrument, or both, in making this determination. The release notes that a derivative, such as a total return swap on the common stock of a corporate issuer, may have a reference asset that also has an issuer. In such a case, the derivative creates potential exposure for the fund to both the counterparty to the contract and the issuer of the reference asset. 

Section 12(d)(3) and Investments in Securities-Related Issuers

The release next addresses how funds’ use of derivatives implicates the general prohibition contained in Section 12(d)(3) of the Investment Company Act (which general prohibition is subject to certain exceptions reflected in Rule 12d3-1) against a fund’s acquisition of interests in securities-related issuers. To the extent these entities are counterparties to a derivative transaction with a fund, the SEC questions whether the counterparty relationship raises the same concerns about over-exposure to securities-related issuers that Section 12(d)(3) is intended to address. The SEC also asks whether investment in a derivative instrument in which the reference asset is a security or other interest issued by a securities-related issuer raises similar concerns.

The release notes that the restriction on investments in securities-related issuers raises the same valuation issues discussed in the context of diversification because of the limited exception provided in Rule 12d3-1 to the prohibition contained in Section 12(d)(3), which is based in part on limiting the percentage of a fund’s total assets that may be invested in the securities of a securities-related issuer. The release seeks comments on all aspects of the application of Section 12(d)(3) and Rule 12d3-1 to funds’ derivatives transactions. 

Section 8(b)(1) and Concentration Limitations

The release then addresses the implications of derivatives for portfolio concentration. Pursuant to Section 8(b)(1) of the Investment Company Act, each fund must declare a policy concerning whether and how it concentrates its investments in the securities of issuers within a particular industry or group of industries. The release notes that derivative instruments may entail exposure to a reference asset as well as to the counterparty to the instrument, and consequently may cause a fund to gain exposure to more than one industry or group of industries. The release also notes that another relevant issue in determining industry concentration is how the fund values its derivatives.

The release seeks comments on the application of concentration requirements to funds’ investments in derivatives. For example, the release questions whether funds should account for the counterparty exposure in determining whether they are concentrated in a particular industry. 


The last section of the release addresses the valuation of derivative instruments. The release notes that market quotations are not readily available for many derivatives and acknowledges that the valuation of certain derivatives may present special challenges for funds. The SEC requests comment on funds’ valuation of derivatives, including how funds fair value the derivatives they hold and how they assess the accuracy and reliability of pricing information.


The SEC has posed numerous questions on a wide range of issues relating to the use of derivatives by funds, and seeks broad public comment to inform its review. According to Chairman Schapiro, the SEC “want[s] input from those who use derivatives, input from those who invest in funds, and input from those who manage funds with derivatives strategies” to ensure that the SEC “get[s] it right.” The SEC will use the comments received to help determine whether and what regulatory initiatives or guidance may be needed.9 Industry participants who use derivatives as part of their investment strategies, therefore, may wish to consider submitting comments. Bingham will continue to closely monitor the issues raised by the release and any related developments.


For assistance, please contact the following lawyers in the Financial Services Area:

Investment Management Partners:

Marion Giliberti Barish, 617.951.8801

David C. Boch, 617.951.8485

Lea Anne Copenhefer, 617.951.8515

Steven M. Giordano, 617.951.8205

Michael Glazer, 213.680.6646

Anne-Marie Godfrey, +852.3182.1705

Richard A. Goldman, 617.951.8851

Barry N. Hurwitz, 617.951.8267

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

Amy Natterson Kroll, 202.373.6118

Michael P. O’Brien, 617.951.8302

Nancy M. Persechino, 202.373.6185

Paul B. Raymond, 617.951.8567

Toby R. Serkin, 617.951.8760

L. Kevin Sheridan Jr., 212.705.7738

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

Joshua B. Sterling, 202.373.6556

Stephen C. Tirrell, 617.951.8833

1Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Release No. IC-29776 (Aug. 31, 2011) (“Concept Release”), available at
2The SEC announced the staff’s review of the use of derivatives by investment companies in a press release issued in March 2010. The press release also indicated that pending completion of this review, the staff would defer consideration of exemptive requests under the Investment Company Act relating to ETFs that would make significant investments in derivatives. SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25, 2010), available at
3Speech by SEC Chairman: Opening Statement at SEC Open Meeting Item 1 — Use of Derivatives by Funds (Aug. 31, 2011) (“Chairman’s Opening Statement”), available at
5Concept Release at 10.
6Id. at 19.
7Securities Trading Practices of Registered Investment Companies, Release No. IC-10666 (April 18, 1979). 
8Report of the Task Force on Investment Company Use of Derivatives and Leverage, Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6, 2010), available at
9Chairman’s Opening Statement.

This article was originally published by Bingham McCutchen LLP.