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Comment Round-Up: The SEC’s Concept Release on the Use of Derivatives by Mutual Funds

December 1, 2011

Photo by scott*eric. Some rights reserved.

On August 31, 2011, the SEC issued a concept release requesting comment on issues relevant to the use of derivatives by mutual funds, including the potential implications for fund leverage, diversification, exposure to certain securities-related issuers, portfolio concentration, valuation, and related matters. The comment period closed on November 7, 2011 (although the Securities Industry and Financial Markets Association submitted its comments last week).

The fund industry used the comment period to blast the Investment Management Division’s de facto moratorium on the use of derivatives by new exchange-traded funds (“ETFs”). Dechert LLP, on behalf of a number of investment advisers, noted that although the Commission appears to contemplate the continued use of derivatives by ETFs, provided they do not make a “significant” investment in derivatives, Investment Management Division staff will not process an actively managed ETF exemptive application unless the applicant represents that it will not invest in options, futures or swaps.

Dechert, and its clients, complain the moratorium has created an uneven competitive playing field among ETF market participants. Those who received exemptive relief prior to the moratorium can continue to launch new ETFs without the derivatives restriction, while later entrants cannot.

Even BlackRock, which has been critical of European funds’ use of derivatives and which possesses the aforementioned competitive advantage, objected to the blanket moratorium. It noted:

If there is concern with ETFs that do not track an index seeking to employ highly derivative-based strategies similar to leveraged and inverse ETFs, we believe the Commission could address this through other means…. A complete ban on the use of derivatives by ETFs, however, does not appear justified by any facts of which we are aware.

BlackRock also reiterated its concern over a fund’s undisclosed use of synthetic investments. Citing Rule 35d-l, which generally requires a registered investment company to adopt a policy to invest at least 80% of its assets (including any borrowings for investment purposes) in the securities suggested by the company’s name, it asked the SEC to “clarify that actual economic exposure through reference assets should be used for purposes of determining compliance with the … Rule.”

Industry commenters were broadly supportive of the July 6, 2010 recommendations presented by the ABA’s Task Force on Investment Company Use of Derivatives and Leverage. Excepting the ETF moratorium, industry commenters generally would like to preserve the status quo with minor modifications. The need for clarifying, principles-based guidance on valuation, the use of leverage, and asset segregation was noted by many.

In what may prove to be a more controversial (and in practice, contentious) area, a few commenters weighed in on the subject of fund board oversight. The ABA’s Federal Regulation of Securities Committee reminded the SEC that:

the role of the fund board with respect to a fund’s use of derivatives and leverage is one of oversight, rather than micromanagement…. While the Concept Release notes that the Commission’s staff has been exploring issues such as ‘whether funds’ boards of directors are providing appropriate oversight of the use of derivatives by the funds,’ the Concept Release does not discuss what constitutes the appropriate level of oversight by a fund board…. [F]rom our collective experience, a number of fund directors have indicated that they would welcome guidance confirming the scope of their oversight (rather than micromanagement) role in this area.

The Mutual Fund Directors Forum agrees, cautioning the Commission against a regulatory system that places a core management function in the hands of a fund’s board.

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