Use of Derivatives by Investment Companies Under the Investment Company Act of 1940, 55237-55255 [2011-22724]
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Federal Register / Vol. 76, No. 173 / Wednesday, September 7, 2011 / Rules and Regulations
[FR Doc. 2011–22450 Filed 9–6–11; 8:45 am]
Paper Comments
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• Send paper comments in triplicate
to Elizabeth M. Murphy, Secretary,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–1090.
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Part 271
[Release No. IC–29776; File No. S7–33–11]
RIN 3235–AL22
Use of Derivatives by Investment
Companies Under the Investment
Company Act of 1940
Securities and Exchange
Commission.
ACTION: Concept release; request for
comments.
AGENCY:
The Securities and Exchange
Commission (the ‘‘Commission’’) and its
staff are reviewing the use of derivatives
by management investment companies
registered under the Investment
Company Act of 1940 (the ‘‘Investment
Company Act’’ or ‘‘Act’’) and companies
that have elected to be treated as
business development companies
(‘‘BDCs’’) under the Act (collectively,
‘‘funds’’). To assist in this review, the
Commission is issuing this concept
release and request for comments on a
wide range of issues relevant to the use
of derivatives by funds, including the
potential implications for fund leverage,
diversification, exposure to certain
securities-related issuers, portfolio
concentration, valuation, and related
matters. In addition to the specific
issues highlighted for comment, the
Commission invites members of the
public to address any other matters that
they believe are relevant to the use of
derivatives by funds. The Commission
intends to consider the comments to
help determine whether regulatory
initiatives or guidance are needed to
improve the current regulatory regime
for funds and, if so, the nature of any
such initiatives or guidance.
DATES: Comments should be received on
or before November 7, 2011.
ADDRESSES: Comments may be
submitted by any of the following
methods:
SUMMARY:
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Electronic Comments
• Use the Commission’s Internet
comment form (https://www.sec.gov/
rules/concept.shtml);
• Send an e-mail to rulecomments@sec.gov; or
• Use the Federal eRulemaking Portal
(https://www.regulations.gov). Follow the
instructions for submitting comments.
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All submissions should refer to File
Number S7–33–11. This file number
should be included on the subject line
if comments are submitted by e-mail. To
help us process and review your
comments more efficiently, please use
only one method. The Commission will
post all comments on the Commission’s
Internet Web site (https://www.sec.gov/
rules/concept.shtml). Comments are also
available for public inspection and
copying in the Commission’s Public
Reference Room, 100 F Street, NE.,
Washington, DC 20549, on official
business days between the hours of
10 a.m. and 3 p.m. All comments
received will be posted without change;
the Commission does not edit personal
identifying information from
submissions. Therefore, you should
only submit information that you wish
to make available publicly.
FOR FURTHER INFORMATION CONTACT:
Edward J. Rubenstein, Senior Special
Counsel, or Michael S. Didiuk, Senior
Counsel, at (202) 551–6825, Office of
Chief Counsel, Division of Investment
Management, Securities and Exchange
Commission, 100 F Street, NE.,
Washington, DC 20549–5030.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Purpose and Scope of the Concept
Release
B. Background Concerning the Use of
Derivatives by Funds
C. Request for Comment
II. Derivatives Under the Senior Securities
Restrictions of the Investment Company
Act
A. Purpose, Scope, and Application of the
Act’s Senior Securities Limitations
1. Statutory Restrictions on Senior
Securities and Related Commission
Guidance
2. Staff No-Action Letters Concerning the
Segregated Account Approach
B. Alternative Approaches to the
Regulation of Portfolio Leverage
1. The Current Asset Segregation Approach
2. Other Approaches
C. Request for Comment
1. Issues Concerning the Current Asset
Segregation Approach
2. Alternatives to the Current Asset
Segregation Approach
3. Related Matters
III. Derivatives Under the Investment
Company Act’s Diversification
Requirements
A. The Diversification Requirements
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55237
B. Application of the Diversification
Requirements to a Fund’s Use of
Derivatives
1. Valuation of Derivatives for Purposes of
Determining a Fund’s Classification as
Diversified or Non-Diversified
2. Identification of the Issuer of a
Derivative for Purposes of Determining a
Fund’s Classification as Diversified or
Non-Diversified
C. Request for Comment
IV. Exposure to Securities-Related Issuers
Through Derivatives
A. Investment Company Act Limitations on
Investing in Securities-Related Issuers
B. Counterparty to a Derivatives
Investment
C. Exposure to Other Securities-Related
Issuers Through Derivatives
D. Valuation of Derivatives for Purposes of
Rule 12d3–1 Under the Investment
Company Act
E. Request for Comment
V. Portfolio Concentration
A. Investment Company Act Provisions
Regarding Portfolio Concentration
B. Issues Relating to the Application of the
Act’s Concentration Provisions to a
Fund’s Use of Derivatives
C. Request for Comment
VI. Valuation of Derivatives
A. Investment Company Act Valuation
Requirements
B. Application of the Valuation
Requirements to a Fund’s Use of
Derivatives
C. Request for Comment
VII. General Request for Comment
*
*
*
*
*
I. Introduction
The activities of funds, including
their use of derivatives, are regulated
extensively under the Investment
Company Act,1 Commission rules, and
Commission guidance.2 Derivatives may
1 15 U.S.C. 80a. All statutory references to the
Investment Company Act are to 15 U.S.C. 80a, and,
unless otherwise stated, all references to rules
under the Investment Company Act are to Title 17,
Part 270 of the Code of Federal Regulations [17 CFR
270]. All references to the Securities Act of 1933
(the ‘‘Securities Act’’) are to 15 U.S.C. 77a, and,
unless otherwise stated, all references to rules
under the Securities Act are to Title 17, Part 230
of the Code of Federal Regulations [17 CFR 230]. All
references to the Securities Exchange Act of 1934
(the ‘‘Exchange Act’’) are to 15 U.S.C. 78a, and,
unless otherwise stated, all references to rules
under the Exchange Act are to Title 17, Part 240 [17
CFR 240].
2 The staff has also issued no-action and other
letters that relate to fund use of derivatives. In
addition to Investment Company Act provisions,
funds using derivatives must comply with all other
applicable statutory and regulatory requirements,
such as other Federal securities law provisions, the
Internal Revenue Code (the ‘‘IRC’’), Regulation T of
the Federal Reserve Board (‘‘Regulation T’’), and the
rules and regulations of the Commodity Futures
Trading Commission (the ‘‘CFTC’’). See also Title
VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, Public Law 111–203, 124
Stat. 1376 (2010) (the ‘‘Dodd-Frank Act’’), available
at https://www.sec.gov/about/laws/wallstreetreformcpa.pdf.
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be broadly described as instruments or
contracts whose value is based upon, or
derived from, some other asset or metric
(referred to as the ‘‘underlier,’’
‘‘underlying,’’ or ‘‘reference asset’’).3 As
detailed below,4 funds employ
derivatives for a variety of purposes,
including to increase leverage to boost
returns, gain access to certain markets,
achieve greater transaction efficiency,
and hedge interest rate, credit, and other
risks.5 At the same time, derivatives can
raise risk management issues for a fund
relating, for example, to leverage,
illiquidity (particularly with respect to
complex OTC derivatives), and
counterparty risk, among others.6
The dramatic growth in the volume
and complexity of derivatives
investments over the past two decades,
and funds’ increased use of derivatives,7
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3 See,
e.g., Board Oversight of Derivatives,
Independent Directors Council Task Force Report
(July 2008) (‘‘2008 IDC Report’’) at 1, 3, available
at https://www.ici.org/pdf/ppr_08_derivatives.pdf.
See also Mutual Funds and Derivative Instruments,
Division of Investment Management Memorandum
transmitted by Chairman Levitt to Representatives
Markey and Fields (Sept. 26, 1994) (‘‘1994 Report’’)
at text accompanying n. 1 (‘‘[t]he term ‘derivative’
is generally defined as an instrument whose value
is based upon, or derived from, some underlying
index, reference rate (e.g., interest rates or currency
exchange rates), security, commodity, or other
asset.’’), and at n. 2 (the ‘‘term ‘derivative’ generally
is used to embrace forward contracts, futures,
swaps, and options’’), available at https://
www.sec.gov/news/studies/deriv.txt; John C. Hull,
Options, Futures, and Other Derivatives (7th ed.
2009) (‘‘Hull’’) at 1, 779 (‘‘A derivative can be
defined as a financial instrument whose value
depends on (or derives from) the values of other,
more basic underlying variables,’’ and a derivative
is an ‘‘instrument whose price depends on, or is
derived from, the price of another asset’’) (italics in
original); rule 3b–13 under the Exchange Act,
which defines ‘‘eligible OTC derivative
instrument,’’ and rule 16a–1(c) under the Exchange
Act, which defines ‘‘derivative securities;’’ section
5200(b) of the Revised Statutes of the United States
[12 U.S.C. 84(b)] (as amended by section 610(a)(3)
of the Dodd-Frank Act, supra note 2), which defines
a ‘‘derivative transaction’’ to include ‘‘any
transaction that is a contract, agreement, swap,
warrant, note, or option that is based, in whole or
in part, on the value of, any interest in, or any
quantitative measure or the occurrence of any event
relating to, one or more commodities, securities,
currencies, interest or other rates, indices, or other
assets.’’
4 For a definition, and examples of types, of
derivatives, see infra Section I.B.
5 See 2008 IDC Report, supra note 3, at 8–11. See
also infra Section I.B.
6 See 2008 IDC Report, supra note 3, at 12–13. See
also Mutual Fund Derivative Holdings: Fueling the
Need for Improved Risk Management, JPMorgan
Thought Magazine (Summer 2008) (‘‘2008 JPMorgan
Article’’), available at https://www.jpmorgan.com/
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7 While complete data concerning the nature of
derivatives activities of funds is unavailable, for a
partial snapshot of derivatives activity by selected
fund complexes see Commodity Pool Operators and
Commodity Trading Advisors: Amendments to
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have led the Commission and its staff to
initiate a review of funds’ use of
derivatives under the Investment
Company Act.8 The staff generally has
been exploring the benefits, risks, and
costs associated with funds’ use of
derivatives. The staff also has been
exploring issues relating to the use of
derivatives by funds such as: whether
current market practices involving
derivatives are consistent with the
leverage, concentration, and
diversification provisions of the
Investment Company Act; whether
Compliance Obligations, Investment Company
Institute (‘‘ICI’’) Comment Letter to the CFTC at 18
(Apr. 12, 2011), available at https://www.ici.org/pdf/
25107.pdf. See also, e.g., Tim Adam and Andre
Guettler, The Use of Credit Default Swaps by U.S.
Fixed-Income Mutual Funds, FDIC Ctr. for Fin.
Research, Working Paper No. 2011–01, (Nov. 19,
2010) (‘‘Adam and Guettler Article’’), available at
https://www.fdic.gov/bank/analytical/cfr/2011/
wp2011/CFR_WP_2011_01.pdf (study of the use of
credit default swaps (‘‘CDS’’) by the largest 100 U.S.
corporate bond funds between 2004 and 2008
reflects an increase from about 20% of funds using
credit default swaps in 2004 to 60% of funds using
them in 2008; among CDS users, the average size
of CDS positions (measured by their notional
values) increased from 2% to almost 14% of a
fund’s NAV over the same period, with the CDS
positions representing less than 10% of NAV for
most funds, but with some funds exceeding this
level by a wide margin, particularly in 2008; CDS
are predominantly used to increase a fund’s
exposure to credit risks (net sellers of CDS) rather
than to hedge credit risk (net buyers); the frequency
of credit default swap usage by the largest bond
funds is comparable to that of most hedge funds),
available at https://www.fdic.gov/bank/analytical/
cfr/2011/wp2011/CFR_WP_2011_01.pdf; Assess the
Risks: Key Strategies for Overseeing Derivatives,
Board IQ at 1 (Jan. 15, 2008) (‘‘In recent years, the
use of derivatives by mutual funds has soared.’’),
available at https://www.interactivedata.com/
uploads/BoardIQ1207.pdf; 2008 JPMorgan Article,
supra note 6.
8 In a press release issued in March 2010, the
Commission announced that the staff was
conducting a review to evaluate the use of
derivatives by mutual funds, registered exchangetraded funds (‘‘ETFs’’), and other investment
companies. The press release indicated that the
review would examine whether and what
additional protections are necessary for those funds
under the Investment Company Act. The press
release further indicated that pending completion of
this review, the staff would defer consideration of
exemptive requests under the Act relating to ETFs
that would make significant investments in
derivatives. See SEC Press Release 2010–45, SEC
Staff Evaluating the Use of Derivatives by Funds
(Mar. 25, 2010) (‘‘2010 Derivatives Press Release’’),
available at https://www.sec.gov/news/press/2010/
2010-45.htm. As part of the staff’s review to
evaluate fund use of derivatives, and to further
enhance its knowledge of how funds are using, and
managing their use of, derivatives, the staff met
with industry groups as well as with some fund
complexes that use OTC derivatives. The staff also
reviewed fund disclosures relating to the use of
derivatives and their risks. In addition, the staff
considered The Report 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) (‘‘2010 ABA Derivatives Report’’), available at
https://meetings.abanet.org/webupload/
commupload/CL410061/sitesofinterest_files/
DerivativesTF_July_6_2010_final.pdf.
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funds that rely substantially upon
derivatives, particularly those that seek
to provide leveraged returns, maintain
and implement adequate risk
management and other procedures in
light of the nature and volume of their
derivatives investments; whether funds’
boards of directors are providing
appropriate oversight of the use of
derivatives by the funds; whether
existing rules sufficiently address
matters such as the proper procedures
for a fund’s pricing and liquidity
determinations regarding its derivatives
holdings; whether existing prospectus
disclosures adequately address the
particular risks created by derivatives;
and whether funds’ derivative activities
should be subject to any special
reporting requirements.
A. Purpose and Scope of the Concept
Release
The goal of the Commission’s and
staff’s review is to evaluate whether the
regulatory framework, as it applies to
funds’ use of derivatives, continues to
fulfill the purposes and policies
underlying the Act and is consistent
with investor protection. The purpose of
this concept release is to assist with this
review and solicit public comment on
the current regulatory regime under the
Act as it applies to funds’ use of
derivatives. We intend to use the
comments to help determine whether
regulatory initiatives or guidance are
needed to improve the current
regulatory regime and the specific
nature of any such initiatives.9
A fund that invests in derivatives
must take into consideration various
provisions of the Investment Company
Act and Commission rules under the
Act. The fund must consider the
leverage limitations of section 18 of the
Investment Company Act, which
governs the extent to which a fund may
issue ‘‘senior securities.’’ 10 A fund’s use
of derivatives also may raise issues
9 Section 2(c) of the Investment Company Act
provides that ‘‘[w]henever pursuant to this title the
Commission is engaged in rulemaking and is
required to consider or determine whether an action
is consistent with the public interest, the
Commission shall also consider, in addition to the
protection of investors, whether the action will
promote efficiency, competition, and capital
formation.’’
10 See sections 18(a)(1) and 18(f)(1) of the
Investment Company Act. See also Securities
Trading Practices of Registered Investment
Companies, Investment Company Act Release No.
10666 (Apr. 18, 1979) (‘‘Release 10666’’) [44 FR
25128 (Apr. 27, 1979)], and Registered Investment
Company Use of Senior Securities–Select
Bibliography (‘‘Senior Security Bibliography’’),
available at https://www.sec.gov/divisions/
investment/seniorsecurities-bibliography.htm
(prepared by the staff). See also discussion infra at
Section II. (Derivatives under the Senior Securities
Restrictions of the Investment Company Act).
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under Investment Company Act
provisions governing diversification,11
concentration,12 investing in certain
types of securities-related issuers,13
valuation,14 and accounting and
financial statement reporting,15 among
others,16 as well as under applicable
disclosure provisions.17
Derivatives generally entail the
potential for leveraged future gains and/
or losses that may significantly impact
the overall risk/reward profile of a fund.
Applying the Act’s provisions relating
to diversification, concentration, and
investments in securities-related issuers,
among others, may require determining
what value to assign to the derivative
and which of the derivative’s multiple
exposures should be measured for
purposes of the relevant provision. This
determination may be complex because
11 See sections 5(b)(1) and 13(a)(1) of the
Investment Company Act. See also infra discussion
at Section III. (Derivatives under the Investment
Company Act’s Diversification Requirements).
12 See sections 8(b)(1)(E) and 13(a)(3) of the
Investment Company Act. See also Form N–1A,
Item 4(a), instruction 4 to Item 9(b)(1), and Item
16(c)(1)(iv); Form N–2, Item 8.2.b (2), and Item
17.2.e. See also infra discussion at Section V.
(Portfolio Concentration).
13 See section 12(d)(3) of the Investment Company
Act and rule 12d3–1 thereunder. See also infra
discussion at Section IV. (Exposure to SecuritiesRelated Issuers Through Derivatives).
14 See section 2(a)(41) of the Investment Company
Act. See also Restricted Securities, Investment
Company Act Release No. 5847 (Oct. 21, 1969) [35
FR 19989 (Dec. 31, 1970)] (‘‘ASR 113’’), available
at https://www.sec.gov/rules/interp/1969/ic5847.pdf; Accounting for Investment Securities by
Registered Investment Companies, Investment
Company Act Release No. 6295 (Dec. 23, 1970) [35
FR 19986 (Dec. 31, 1970)] (‘‘ASR 118’’), available
at https://www.sec.gov/rules/interp/1970/ic6295.pdf. See also infra discussion at Section VI.
(Valuation of Derivatives).
15 See generally section 30(e) of the Investment
Company Act.
16 See, e.g., Investment Company Act provisions
relating to custody (section 17(f) and related rules),
and fund names (section 35(d) and rule 35d–1).
Also, an open-end fund should consider the effect
that the use of derivatives may have on the liquidity
of the fund’s portfolio. For general guidance on
liquidity and open-end funds, see, e.g., Resale of
Restricted Securities; Changes to Method of
Determining Holding Period of Restricted Securities
Under Rules 144 and 145, Investment Company Act
Release No. 17452 (Apr. 23, 1990) [55 FR 17933
(Apr. 30, 1990)], available at https://www.sec.gov/
rules/final/1990/33-6862.pdf. See also Revisions of
Guidelines, Investment Company Act Release No.
18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)],
available at https://www.sec.gov/rules/other/1992/
33-6927.pdf.
17 See, e.g., section 8(b) of the Investment
Company Act, and Items 4(a), 4(b), 9(b), 9(c), and
16(b) of Form N–1A. Certain derivatives-related
disclosure issues were discussed in a 2010 staff
letter to the ICI. See Derivatives-Related Disclosures
by Investment Companies, Letter from Barry D.
Miller, Associate Director, Division of Investment
Management, U.S. Securities and Exchange
Commission, to Karrie McMillan, General Counsel,
ICI (July 30, 2010) (‘‘2010 Staff Derivatives
Disclosure Letter’’), available at https://
www.sec.gov/divisions/investment/guidance/
ici073010.pdf.
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there are at least two potential measures
of the ‘‘value’’ 18 of a derivative for
purposes of applying various provisions
of the Act: the current market value or
fair value reflecting the price at which
the derivative could be expected to be
liquidated; and the notional amount
reflecting the contract size (number of
units per contract) multiplied by the
current unit price of the reference asset
on which payment obligations are
calculated.19 In addition, derivatives
18 The Bank for International Settlements (the
‘‘BIS’’) reports gross market values (positive and
negative) for open derivative contracts, which are
defined as ‘‘the sums of the absolute values of all
open contracts with either positive or negative
replacement values evaluated at market prices
prevailing at the reporting date. Thus, the gross
positive market value of a dealer’s outstanding
contracts is the sum of the replacement values of
all contracts that are in a current gain position to
the reporter at current market prices * * * The
gross negative market value is the sum of the values
of all contracts that have a negative value on the
reporting date * * *.’’ Guide to the International
Financial Statistics, Bank for International
Settlements (July 2009) (‘‘BIS Guide’’) at 31,
available at https://www.bis.org/statistics/
intfinstatsguide.pdf. See also Sarah Sharer Curley
and Elizabeth Fella, Where to Hide? How Valuation
of Derivatives Haunts the Courts—Even After
BAPCPA, 83 Am. Bankr. L.J. 297, 298–99 (Spring
2009) (‘‘In a simple interest rate swap * * * [t]he
value of the swap is the net difference between the
present value of the payments each party expects
to receive and the present value of the payments
each party expects to make. The value is generally
zero to each party at the inception of the swap, and
becomes positive to one party and negative to the
other depending on what direction the interest rates
move.’’); CFTC Glossary, Mark-to-Market Definition,
available at https://www.cftc.gov/Consumer
Protection/EducationCenter/CFTCGlossary/
index.htm (stating that marking to market is
accomplished for a futures or option contract by
‘‘calculating the gain or loss in each contract
position resulting from changes in the price of the
contracts at the end of each trading session. These
amounts are added or subtracted to each account
balance.’’).
19 The BIS describes ‘‘notional amounts
outstanding’’ as ‘‘a reference from which
contractual payments are determined in derivatives
markets.’’ BIS Guide, supra note 18, at 30.
‘‘Notional value’’ can be defined as ‘‘the value of
a derivative’s underlying assets at the spot price.’’
In the case of an options or futures contract, the
notional value is the number of units of an asset
underlying the contract, multiplied by the spot
price of the asset. See https://www.investorwords.
com/5930/notional-value.htm. The ‘‘spot price’’ of
a derivative’s underlying asset is the asset’s price
for immediate delivery, i.e., in the current market,
in contrast with the asset’s future or forward price.
See, e.g., Hull, supra note 3, at 789. ‘‘Notional
value’’ is also defined as ‘‘the underlying value
(face value), normally expressed in U.S. dollars, of
the financial instrument or commodity specified in
a futures or options on futures contract.’’ See CME
Group Glossary, available at https://
www.cmegroup.com/education/glossary.html.
‘‘ ‘Notional principal’ or ‘notional amount’ of a
derivative contract is a hypothetical underlying
quantity upon which interest rate or other payment
obligations are computed.’’ ISDA Online Product
Descriptions and Frequently Asked Questions at
https://www.isda.org/educat/faqs.html#7. See also
Hull, supra note 3, at 786 (‘‘Notional principal’’ is
the ‘‘principal used to calculate payments in an
interest rate swap. The principal is ‘notional’
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often create exposures to multiple
variables, such as the credit of a
counterparty as well as to a reference
asset on which the derivative is based.
The Commission or its staff, over the
years, has addressed a number of issues
relating to derivatives on a case-by-case
basis. The Commission now seeks to
take a more comprehensive and
systematic approach to derivativesrelated issues under the Investment
Company Act. In particular, in this
release the Commission discusses and
seeks comment on the following issues,
among others, relating to funds’ use of
derivatives: 20
• The attendant costs, benefits and
risks;
• The application of the Act’s
prohibitions and restrictions on senior
securities and leverage;
• The application of the Act’s
prohibition on investments in
securities-related issuers;
• The application of the Act’s
provisions concerning portfolio
diversification and concentration; and
• The application of the Act’s
provisions governing valuation of funds’
assets.
In addition to the specific issues
highlighted for comment, the
Commission invites members of the
public to address any other matters that
they believe are relevant to the use of
derivatives by funds.
B. Background Concerning the Use of
Derivatives by Funds
As noted above, derivatives may be
broadly defined to include instruments
or contracts whose value is based upon,
or derived from, some reference asset.
Reference assets can include, for
example, stocks, bonds, commodities,
currencies, interest rates, market
indices, currency exchange rates, or
other assets or interests, in virtually
endless variety.21
because it is neither paid nor received’’); Frank J.
Fabbozzi, et al., Introduction to Structured Finance,
at 27 (2006) (‘‘[In an interest rate swap] [t]he dollar
amount of the interest payments exchanged is based
on some predetermined dollar principal, which is
called the notional amount.’’) (italics in original);
2010 ABA Derivatives Report, supra note 8, at n.11
(noting that the term ‘‘notional amount’’ is used
differently by different people in different contexts,
but is used, in the Report, to refer to ‘‘the nominal
or face amount that is used to calculate payments
made on a particular instrument, without regard to
whether its obligation under the instrument could
be netted against the obligation of another party to
pay the fund under the instrument.’’).
20 The Commission recognizes that there are other
significant derivatives-related issues under the
Investment Company Act that this release does not
address, such as disclosure-related issues, which
the Commission may consider at a later date.
21 For example, the reference asset of a Standard
& Poor’s (‘‘S&P’’) 500 futures contract is the S&P
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Derivatives are often characterized as
either exchange-traded or OTC.22
Exchange-traded derivatives—such as
futures, certain options,23 and options
on futures 24—are standardized
contracts traded on regulated exchanges,
such as the Chicago Mercantile
Exchange and the Chicago Board
Options Exchange. OTC derivatives—
such as swaps,25 non-exchange traded
options, and combination products such
as swaptions 26 and forward swaps 27—
500 index. 2008 IDC Report, supra note 3, at
Appendix C at C5.
22 See, e.g., Robert W. Kolb & James A. Overdahl,
Financial Derivatives, at 21 (2010) (‘‘Kolb &
Overdahl’’).
23 An option is the right to buy or sell an asset.
There are two basic types of options, a ‘‘call option’’
and a ‘‘put option.’’ A call option gives the holder
the right (but does not impose the obligation) to buy
the underlying asset by a certain date for a certain
price. The seller, or ‘‘writer,’’ of a call option has
the obligation to sell the underlying asset to the
holder if the holder exercises the option. A put
option gives the holder the right (but does not
impose the obligation) to sell the underlying asset
by a certain date for a certain price. The seller, or
‘‘writer’’, of a put option has the obligation to buy
from the holder the underlying asset if the holder
exercises the option. The price that the option
holder must pay to exercise the option is known as
the ‘‘exercise’’ or ‘‘strike’’ price. The amount that
the option holder pays to purchase an option is
known as the ‘‘option premium,’’ ‘‘price,’’ ‘‘cost,’’
or ‘‘fair value’’ of the option. For a basic
explanation of options, see, e.g., Hull, supra note
3, at 6–8, 179–236, and Kolb & Overdahl, supra note
22, at 13–16.
24 Options on futures generally trade on the same
exchange as the relevant futures contract. When a
call option on a futures contract is exercised, the
holder acquires from the writer a long position in
the underlying futures contract plus a cash amount
equal to the excess of the futures price over the
strike price. When a put option on a futures
contract is exercised, the holder acquires a short
position in the underlying futures contract plus a
cash amount equal to the excess of the strike price
over the futures price. See, e.g., Hull, supra note 3,
at 184, 341–54, and 782.
25 A ‘‘swap’’ is generally an agreement between
two counterparties to exchange periodic payments
based upon the value or level of one or more rates,
indices, assets, or interests of any kind. For
example, counterparties may agree to exchange
payments based on different currencies or interest
rates. See generally, e.g., Kolb & Overdahl, supra
note 22, at 11–13; Hull, supra note 3, at 147–73. See
also section 3(a)(69) of the Exchange Act for the
definition of ‘‘swap’’ (using the definition in section
1a of the Commodity Exchange Act, 7 U.S.C. 1a (the
‘‘CEA’’)); section 3(a)(68) of the Exchange Act for
the definition of ‘‘security-based swap;’’ section
721(a)(3) of the Dodd-Frank Act, supra note 2, for
the definition of ‘‘cleared swap;’’ and section
721(a)(12) of the Dodd-Frank Act for the definition
of ‘‘foreign exchange swap.’’ See also Further
Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and
‘‘Security-Based Swap Agreement;’’ Mixed Swaps;
Security-Based Swap Agreement Recordkeeping,
Securities Act Release No. 9204 (Apr. 29, 2011) [76
FR 29818 (May 23, 2011)] (‘‘Swap Definition
Release’’), available at https://www.sec.gov/rules/
proposed/2011/33-9204.pdf.
26 A ‘‘swaption’’ is an option to enter into an
interest rate swap where a specified fixed rate is
exchanged for a floating rate. See, e.g., Hull, supra
note 3, at 172, 658–62, 790.
27 A forward swap (or deferred swap) is an
agreement to enter into a swap at some time in the
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are contracts negotiated and entered
into outside of an organized exchange.
Unlike exchange-traded derivatives,
OTC derivatives may be significantly
customized, and may not be guaranteed
by a central clearing organization. OTC
derivatives that are not centrally
cleared, therefore, may involve greater
counterparty credit risk, and may be
more difficult to value, transfer, or
liquidate than exchange-traded
derivatives.28 The Dodd-Frank Act and
Commission rules thereunder seek to
establish a comprehensive new
regulatory framework for two broad
categories of derivatives—swaps and
security-based swaps—designed to
reduce risk, increase transparency, and
promote market integrity within the
financial system.29
A common characteristic of most
derivatives is that they involve
leverage.30 Certain derivatives
investments entered into by a fund,
such as futures contracts, swaps, and
written options, create obligations, or
potential indebtedness, to someone
other than the fund’s shareholders, and
enable the fund to participate in gains
and losses on an amount that exceeds
the fund’s initial investment.31 Other
derivatives entered into by a fund, such
as purchased call options, provide the
economic equivalent of leverage because
they convey the right to a gain or loss
on an amount in excess of the fund’s
investment but do not impose a
payment obligation on the fund above
its initial investment.32
Funds use derivatives to implement
their investment strategies, and to
manage risk.33 A fund may use
derivatives to gain, maintain, or reduce
exposure to a market, sector, or security
more quickly and/or with lower
transaction costs and portfolio
future. See Swap Definition Release, supra note 25,
at n. 147. See also, e.g., Hull, supra note 3, at 171,
779 (‘‘deferred swap’’).
28 An OTC derivative may be more difficult to
transfer or liquidate than an exchange-traded
derivative because, for example, an OTC derivative
may provide contractually for non-transferability
without the consent of the counterparty, or may be
sufficiently customized that its value is difficult to
establish or its terms too narrowly drawn to attract
transferees willing to accept assignment of the
contract, unlike most exchange-traded derivatives.
29 The Dodd-Frank Act, supra note 2, was signed
into law on July 21, 2010. The Dodd-Frank Act
mandates, among other things, substantial changes
in the OTC derivatives markets, including new
clearing, reporting, and trade execution mandates
for swaps and security-based swaps, and both
exchange-traded and OTC derivatives are
contemplated under the new regime. See DoddFrank Act sections 723 (mandating clearing of
swaps) and 763 (mandating clearing of securitybased swaps). Some of these changes will require
Commission action through rulemaking to become
effective. See Temporary Exemptions and Other
Temporary Relief, Together With Information on
Compliance Dates for New Provisions of the
Securities Exchange Act of 1934 Applicable to
Security-Based Swaps, Exchange Act Release No.
64678 (June 15, 2011) [76 FR 36287 (June 22,
2011)], available at https://www.sec.gov/rules/
exorders/2011/34-64678.pdf. For summaries of
other recent, pending, and future Commission and
staff initiatives relating to derivatives, see, e.g.,
Testimony on Enhanced Oversight after the
Financial Crisis: The Wall Street Reform Act at
One-Year, by Chairman Mary L. Schapiro,
Chairman, U.S. Securities and Exchange
Commission, before the United States Senate
Committee on Banking, Housing and Urban Affairs
(July 21, 2011), available at https://www.sec.gov/
news/testimony/2011/ts072111mls.htm. See also,
e.g., https://www.sec.gov/spotlight/dodd-frank/
accomplishments.shtml#derivatives; https://
www.sec.gov/spotlight/dodd-frank/dfactivityupcoming.shtml#07-12-12; https://www.sec.gov/
spotlight/dodd-frank/dfactivityupcoming.shtml#08-12-11; https://www.sec.gov/
spotlight/dodd-frank/dfactivityupcoming.shtml#01-06-12; https://www.sec.gov/
news/press/2011/2011-137.htm; https://
www.sec.gov/rules/other/2011/34-64926.pdf; and
https://www.sec.gov/spotlight/dodd-frank/
derivatives.shtml.
30 The Commission has stated that ‘‘[l]everage
exists when an investor achieves the right to a
return on a capital base that exceeds the investment
which he has personally contributed to the entity
or instrument achieving a return.’’ Release 10666,
supra note 10, at n. 5.
31 The leverage created by such an arrangement is
sometimes referred to as ‘‘indebtedness leverage.’’
1994 Report, supra note 3, at 22.
32 This type of leverage is sometimes referred to
as ‘‘economic leverage.’’ See 1994 Report, supra
note 3, at 23 (‘‘Other derivatives provide the
economic equivalent of leverage because they
display heightened price sensitivity to market
fluctuations * * * such as changes in stock prices
or interest rates. In essence, these derivatives
magnify a fund’s gain or loss from an investment
in much the same way that incurring indebtedness
does.’’). The 1994 Report gives a leveraged inverse
floating rate bond, with an interest rate that moves
inversely to a benchmark rate, as another example
of an instrument that displays economic leverage.
See also 2010 ABA Derivatives Report, supra note
8, at 20–21 (discussion of ‘‘implied’’ or ‘‘economic’’
leverage’’). For additional discussion of the
leveraging effects of derivatives (not limited to
‘‘economic leverage’’), see 2010 ABA Derivatives
Report, supra note 8, at 8–9. See also 2008 IDC
Report, supra note 3, at 3 (‘‘Market participants are
able to acquire exposure (either long or short) to a
large dollar amount of an asset (the notional value)
with only a small down payment, enabling parties
to shift risk more efficiently and with lower costs.
The leverage inherent in these instruments
magnifies the effect of changes in the value of the
underlying asset on the initial amount of capital
invested. For example, an initial 5% collateral
deposit on the total value of the commodity would
result in 20:1 leverage, with a potential 80% loss
(or gain) of the collateral in response to a 4%
movement in the market price of the underlying
commodity.’’).
33 2008 IDC Report, supra note 3, at 7–11. A fund
may also use derivatives to hedge current portfolio
exposures (for example, when a fund’s portfolio is
structured to reflect the fund’s long-term
investment strategy and its investment adviser’s
forecasts, interim events may cause the fund’s
investment adviser to seek to temporarily hedge a
portion of the portfolio’s broad market, sector, and/
or security exposures). Industry participants believe
that derivatives may also provide a more efficient
hedging tool than reducing exposure by selling
individual securities, offering greater liquidity,
lower round-trip transaction costs, lower taxes, and
reduced disruption to the portfolio’s longer-term
positioning. See id. at 11.
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disruption than investing directly
through the securities markets. At the
same time, use of derivatives may entail
risks relating, for example, to leverage,
illiquidity (particularly with respect to
complex OTC derivatives), and
counterparty risk, among others.34 A
fund’s use of derivatives presents
challenges for its investment adviser
and board of directors to ensure that the
derivatives are employed in a manner
consistent with the fund’s investment
objectives, policies, and restrictions, its
risk profile, and relevant regulatory
requirements, including those under
Federal securities laws. With respect to
some primary types of reference assets,
funds may use derivatives for the
following purposes, among others:
• Currency derivatives. 35 A fund may
use currency derivatives to increase or
decrease exposure to specific
currencies, to hedge against adverse
impacts on the fund’s portfolio caused
by currency fluctuations, and to seek
additional returns. For example,
currency derivatives can provide a
hedge against the risk that a fund’s
investment in a foreign debt security
will decline in value because of a
decline in the value of the foreign
currency in which the foreign debt
security is denominated.36 Funds also
may use currency derivatives to hedge
against a rise in the value of a foreign
currency, or may use ‘‘cross-currency’’
hedging or ‘‘proxy’’ hedging when, for
instance, it is difficult or expensive to
hedge a particular currency against the
U.S. dollar.37 Apart from hedging, funds
may use currency derivatives to seek
returns on the basis of anticipated
34 See, e.g., 2008 IDC Report, supra note 3, at 12–
13. See also 2008 JPMorgan Article, supra note 6.
35 See Swap Definition Release, supra note 25, at
II.C.1, for a description of certain currency
derivatives (foreign exchange swaps, foreign
exchange forwards, foreign currency options, nondeliverable forwards, currency swaps, and crosscurrency swaps). The 2010 ABA Derivatives Report,
supra note 8 at 6–7, gives as examples of currency
derivatives forward currency contracts, currency
futures contracts, currency swaps, and options on
currency futures contracts. As a general matter,
futures, forwards, swaps, and options can all be
used to increase or decrease exposures to reference
currencies. A fund’s investment adviser selects the
particular instrument based on the level and type
of exposure the adviser seeks to obtain and the costs
that are associated with the particular instrument.
36 For example, if a fund enters into a short
currency forward (which obligates the fund to sell
the currency at a future date, at a predetermined
price, and in the currency in which the foreign debt
security is denominated), the fund’s exposure to a
decline in the value of the currency is reduced. See
2010 ABA Derivatives Report, supra note 8, at 6.
37 For example, a fund may use a forward contract
on one foreign currency (or a basket of foreign
currencies) to hedge against adverse changes in the
value of another foreign currency (or basket of
currencies). See id.
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changes in the relative values of two
currencies.38
• Interest rate derivatives.39 A fund
may use interest rate derivatives to
modify its exposure to the gains or
losses arising from changes in interest
rates and to seek enhanced returns. For
example, a fund may use an interest rate
swap to hedge against the risk of a
decline in the prices of bonds owned by
a fund due to rising interest rates.
Similarly, a fund could shorten the
duration of its portfolio by selling
futures contracts on U.S. Treasury
bonds or notes, or Eurodollar futures.
Apart from hedging, a fund might use
interest rate derivatives to seek to
enhance its returns based on its
investment adviser’s views concerning
future movements in interest rates or
changes in the shape of the yield
curve.40
• Credit Derivatives.41 Credit
derivatives allow a fund to assume an
investment position concerning the
likelihood that a particular bond, or a
group of bonds, will be repaid in full
upon maturity. When a fund purchases
credit protection, it pays a premium to
a counterparty in return for which the
counterparty promises to pay the fund
if a bond or bonds default or experience
some other adverse credit event. When
a fund sells (or writes) credit protection,
the fund agrees to pay a counterparty if
a bond or bonds default or experience
some other adverse credit event, in
exchange for the receipt of a premium
from the protection purchaser. A fund
may purchase credit protection using
credit derivatives to hedge against
particular risks that are associated with
a bond that it owns, such as the risk that
the bond issuer will default, a rating
38 Id.
at 7.
39 Interest
rate derivatives include interest rate or
bond futures, Eurodollar futures, caps, floors,
overnight indexed swaps, interest rate swaps, and
options on futures and swaps. See, e.g., id. See also
Swap Definition Release, supra note 25, at III.B.1
(briefly describing interest and other monetary rate
swaps, and discussing that when payments
exchanged under a Title VII (of the Dodd-Frank Act)
instrument are based solely on the levels of certain
interest rates or other monetary rates that are not
themselves based on securities, the instrument
would be a swap but not a security-based swap).
40 For example, if a fund’s investment adviser
believes that the London Interbank Offered Rate
(‘‘LIBOR’’) will decrease compared to a Federal
funds rate, the adviser could enter into an interest
rate swap whereby the fund would be obligated to
make payments based upon the application of
LIBOR to an agreed notional amount in exchange
for payments from the counterparty based upon the
application of the Federal funds rate to the notional
amount. 2010 ABA Derivatives Report, supra note
8, at 7.
41 Credit derivatives include single-name and
index-linked (or basket) credit default swaps. See,
e.g., id. at 7–8. For additional description of CDS,
see Swap Definition Release, supra note 25, at
III.G.3.
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55241
agency will downgrade the bond or the
credit of the counterparty, or the risk
that credit ‘‘spread’’ will increase.42 A
fund may sell (or write) credit
protection to enhance its income and
return by the amount of the payment
that it receives for providing such
protection, or to obtain some investment
exposure to the reference asset (that is,
the underlying bond), without owning
the bond. The Commission understands
that selling protection may be more cost
effective than an outright purchase of a
bond.43
• Equity Derivatives.44 Funds may
use equity derivatives to enhance
investment opportunities (for example,
by using foreign index futures to obtain
exposure to a foreign equity market).
Equity derivatives also can be used by
funds as an income-producing strategy
by, for example, selling equity call
options on a particular security owned
by the fund.45 A fund also may use
equity derivatives (usually stock index
futures) to ‘‘equitize’’ cash.46
C. Request for Comment
The Commission generally requests
data and comment on the types of
derivatives used by funds, the purposes
for which funds use derivatives, and
whether funds’ use of derivatives has
undergone or may be undergoing
changes and, if so, the nature of such
changes. The Commission specifically
requests comment on the following:
• What are the costs and benefits to
funds from the use of derivatives? What
are the factors that influence those costs
and benefits? What are the risks to funds
42 See 2010 ABA Derivatives Report, supra note
8, at 7.
43 See id. at 8. The 2010 ABA Derivatives Report,
supra note 8, at 8, also observes that ‘‘a fund could
write a CDS, offering credit protection to its
counterparty. In doing so the fund gains the
economic equivalent of owning the security on
which it wrote the CDS, while avoiding the
transaction costs that would have been associated
with the purchase of the security.’’
44 Equity derivatives include equity futures
contracts, options on equity futures contracts,
equity options, and various kinds of equity-related
swaps (such as a total return swap on an equity
security). See, e.g., id. at 8.
45 By selling the options, a fund can earn income
(in the form of the premium received for writing the
option) while at the same time permitting the fund
to sell the underlying equity securities at a targeted
price set by the fund’s investment adviser. See, e.g.,
id.
46 As an example of ‘‘equitizing’’ cash, the 2010
ABA Derivatives Report, supra note 8, at 8, states
that:
[W]hen a fund has a large cash position for a
short amount of time, the fund can acquire long
futures contracts to retain (or gain) exposure to the
relevant equity market. When the futures contracts
are liquid (as is typically the case for broad market
indices), the fund can eliminate the position
quickly and frequently at lower costs than had the
fund actually purchased the reference equity
securities.
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from investing in derivatives? What role
does or could collateral used in
derivatives transactions play in
mitigating the concerns relating to the
use of derivatives? Please be specific
and provide data or statistics, if
possible.
• Do different types of funds use
different types of derivatives or use
derivatives for different purposes? If so,
what are the differences in the types of
funds that account for the differences in
their use of derivatives? For example, do
BDCs use derivatives in a manner
different from other funds and, if so,
how and what are the differences?
• How do ETFs use derivatives? Do
they use derivatives for the same
purposes that other open-end funds use
them? Does an ETF’s use of derivatives
raise unique investor protection
concerns under the Investment
Company Act?
II. Derivatives under the Senior
Securities Restrictions of the
Investment Company Act
In this section, the Commission
discusses the limitations on senior
securities imposed by section 18 of the
Investment Company Act, summarizes
related Commission and staff guidance,
discusses certain alternative
approaches, and highlights issues for
comment.
A. Purpose, Scope, and Application of
the Act’s Senior Securities Limitations
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1. Statutory Restrictions on Senior
Securities and Related Commission
Guidance
The protection of investors against the
potentially adverse effects of a fund’s
issuance of ‘‘senior securities’’ 47 is a
core purpose of the Investment
Company Act.48 Congress’ concerns
underlying the limitations in section 18
included, among others: (i) Potential
abuse of the purchasers of senior
securities; 49 (ii) excessive borrowing
and the issuance of excessive amounts
47 Section 18(g) of the Investment Company Act
defines ‘‘senior security,’’ in part, as ‘‘any bond,
debenture, note, or similar obligation or instrument
constituting a security and evidencing
indebtedness,’’ and ‘‘any stock of a class having
priority over any other class as to the distribution
of assets or payment of dividends.’’ The definition
excludes certain limited temporary borrowings.
48 See, e.g., Investment Company Act sections
1(b)(7), 1(b)(8), 18(a), and 18(f). See also, e.g., 1994
Report, supra note 3, at 20–22.
49 See Investment Trusts and Investment
Companies: Hearings on S. 3580 Before a Subcomm.
of the Senate Committee on Banking and Currency,
76th Cong., 3d Sess., pt. 1, 265–78 (1940) (‘‘Senate
Hearings’’). See also 1994 Report, supra note 3, at
21 (describing the practices in the 1920s and 1930s
that gave rise to section 18’s limitations on leverage,
and specifically discussing the potential abuse of
senior security holders).
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of senior securities by funds which
increased unduly the speculative
character of their junior securities; 50
and (iii) funds operating without
adequate assets and reserves.51 To
address these concerns, section 18(f)(1)
of the Investment Company Act
prohibits an open-end fund 52 from
issuing or selling any ‘‘senior security’’
other than borrowing from a bank, and
unless it maintains 300% ‘‘asset
coverage.’’ 53 Section 18(a)(1) of the
Investment Company Act prohibits a
closed-end fund 54 from issuing or
selling any ‘‘senior security that
represents an indebtedness’’ unless it
has at least 300% ‘‘asset coverage.’’ 55
In a 1979 General Statement of Policy
(Release 10666), the Commission
considered the application of section
18’s restrictions on the issuance of
senior securities to reverse repurchase
agreements, firm commitment
agreements, and standby commitment
agreements.56 The Commission
concluded that such agreements, while
50 See
section 1(b)(7) of the Investment Company
Act. See also, e.g., Release 10666, supra note 10, at
n. 8.
51 See section 1(b)(8) of the Investment Company
Act; Release 10666, supra note 10, at n. 8.
52 Section 5(a)(1) of the Investment Company Act
defines ‘‘open-end company’’ as ‘‘a management
company which is offering for sale or has
outstanding any redeemable security of which it is
the issuer.’’
53 ‘‘Asset coverage’’ of a class of securities
representing indebtedness of an issuer generally is
defined in section 18(h) of the Investment Company
Act as ‘‘the ratio which the value of the total assets
of such issuer, less all liabilities and indebtedness
not represented by senior securities, bears to the
aggregate amount of senior securities representing
indebtedness of such issuer.’’
54 Section 5(a)(2) of the Investment Company Act
defines ‘‘closed-end company’’ as ‘‘any
management company other than an open-end
company.’’
55 Section 18(a)(1)(A). A BDC is also subject to the
limitations of section 18(a)(1)(A) to the same extent
as if it were a closed-end investment company
except that the applicable asset coverage amount is
200%. See Investment Company Act section
61(a)(1).
56 As described in Release 10666, supra note 10,
in a typical reverse repurchase agreement, the fund
transfers possession of a debt security, often to a
broker-dealer or a bank, in return for a percentage
of the market value of the security (‘‘proceeds’’), but
retains record ownership of, and the right to receive
interest and principal payments on, the security. At
a stated future date, the fund repurchases the
security and remits to the counterparty the proceeds
plus interest. Id. at nn. 2–3 and accompanying text.
A firm commitment agreement (also known as a
‘‘when-issued security’’ or a ‘‘forward contract’’) is
a buy order for delayed delivery in which a fund
agrees to purchase a debt security from a seller
(usually a broker-dealer) at a stated future date,
price, and fixed yield. Id. at text accompanying n.
12. A standby commitment agreement is a delayed
delivery agreement in which a fund contractually
binds itself to accept delivery of a debt security
with a stated price and fixed yield upon the
exercise of an option held by the counterparty to
the agreement at a stated future date. Id. at
discussion of ‘‘Standby Commitment Agreements.’’
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not securities for all purposes,57 may
involve the issuance of senior securities
and ‘‘fall within the functional meaning
of the term ‘evidence of indebtedness’
for purposes of section 18 of the Act,’’
which generally would include ‘‘all
contractual obligations to pay in the
future for consideration presently
received.’’ 58 Further, the Commission
stated that ‘‘trading practices involving
the use by investment companies of
such agreements for speculative
purposes or to accomplish leveraging
fall within the legislative purposes of
Section 18.’’ 59 The Commission also
explained that:
[l]everage exists when an investor achieves
the right to a return on a capital base that
exceeds the investment which he has
personally contributed to the entity or
instrument achieving a return* * *. Through
a reverse repurchase agreement, an
investment company can achieve a return on
a very large capital base relative to its cash
contribution. Therefore, the reverse
repurchase agreement is a highly leveraged
transaction.60
Leveraging of a fund’s portfolio
through the issuance of senior securities
‘‘magnifies the potential for gain or loss
on monies invested and, therefore,
results in an increase in the speculative
character of the investment company’s
outstanding securities.’’ 61 Each of the
agreements discussed by the
Commission in Release 10666—the
reverse repurchase agreement, the firm
commitment agreement, and the
standby commitment agreement—‘‘may
be a substantially higher risk
investment’’ than direct investment in
57 Release 10666, supra note 10, at ‘‘The
Agreements as Securities’’ discussion. The
Commission notes, however, that the Investment
Company Act’s definition of the term ‘‘security’’ is
broader than the term’s definition in other Federal
securities laws. Compare section 2(a)(36) of the
Investment Company Act with sections 2(a)(1) and
2A of the Securities Act and sections 3(a)(10) and
3A of the Exchange Act. For example, the definition
of ‘‘security’’ in the Investment Company Act
includes any ‘‘evidence of indebtedness,’’ which is
not included in the definition of ‘‘security’’ in
section 3(a)(10) of the Exchange Act. Further, the
Commission has interpreted the term ‘‘security’’ in
light of the policies and purposes underlying the
Act. For example, the brief for the United States as
Amicus Curiae in Marine Bank v. Weaver, No. 80–
1562, 1980 U.S. Briefs 1562 (Oct. Term, 1980) (July
29, 1981) (‘‘Marine Bank v. Weaver Amicus Brief’’)
stated that the issue of whether a particular
instrument is a ‘‘security’’ depends on the context,
including the statute being applied, and further
stated that the Investment Company Act ‘‘presents
a significantly different context’’ (i.e., the regulation
of the operation and management of investment
companies) than the context of the Securities Act
and the Exchange Act (i.e., the issuance or trading
of such securities). Marine Bank v. Weaver Amicus
Brief at 38, 40.
58 Release 10666, supra note 10, at ‘‘The
Agreements as Securities’’ discussion.
59 Id.
60 Id. at n. 5 (citation omitted).
61 Id. at text accompanying n. 5.
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the underlying securities ‘‘because of
the additional risk of loss created by the
substantial leveraging in each
agreement, and in light of the volatility
of interest rates in the marketplace.’’ 62
In Release 10666, the Commission
further stated that, although reverse
repurchase agreements, firm
commitment agreements, and standby
commitment agreements are
functionally equivalent to senior
securities, these and similar
arrangements nonetheless could be used
by funds in a manner that would not
warrant application of the section 18
restrictions. The Commission noted that
in circumstances involving similar
economic effects, such as short sales of
securities by funds, our staff had
determined that the issue of section 18
compliance would not be raised if funds
‘‘cover’’ senior securities by maintaining
‘‘segregated accounts.’’ 63 The
Commission stated that the use of
segregated accounts ‘‘if properly created
and maintained, would limit the
investment company’s risk of loss.’’ 64
To avail itself of the segregated account
approach, a fund could establish and
maintain with the fund’s custodian a
segregated account containing liquid
assets, such as cash, U.S. government
securities, or other appropriate highgrade debt obligations, equal to the
indebtedness incurred by the fund in
connection with the senior security
(‘‘segregated account approach’’).65 The
amount of assets to be segregated with
respect to reverse repurchase
agreements lacking a specified
repurchase price would be the value of
the proceeds received plus accrued
62 Id. at discussion of ‘‘The Agreements as
Securities.’’ The Commission also stated that, ‘‘[t]he
gains and losses from the transactions can be
extremely large relative to invested capital; for this
reason, each agreement has speculative aspects.
Therefore, it would appear that the independent
investment decisions involved in entering into such
agreements, which focus on their distinct risk/
return characteristics, indicate that, economically as
well as legally, the agreements should be treated as
securities separate from the underlying Ginnie Maes
for purposes of Section 18 of the Act.’’ Id.
63 Release 10666, supra note 10, at text
accompanying n. 15.
64 Id. at discussion of ‘‘Segregated Account.’’
65 The Commission stated that, under the
segregated account approach, the value of the assets
in the segregated account should be marked to the
market daily, additional assets should be placed in
the segregated account whenever the total value of
the account falls below the amount of the fund’s
obligation, and assets in the segregated account
should be deemed frozen and unavailable for sale
or other disposition. See id. The Commission also
cautioned that as the percentage of a fund’s
portfolio assets that are segregated increases, the
fund’s ability to meet current obligations, to honor
requests for redemption, and to manage properly
the investment portfolio in a manner consistent
with stated its investment objective may become
impaired. Id.
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interest; for reverse repurchase
agreements with a specified repurchase
price, the amount of assets to be
segregated would be the repurchase
price; and for firm and standby
commitment agreements, the amount of
assets to be segregated would be the
purchase price.66 As the Commission
stated in Release 10666, the segregated
account functions as ‘‘a practical limit
on the amount of leverage which the
investment company may undertake
and on the potential increase in the
speculative character of its outstanding
common stock,’’ and ‘‘will assure the
availability of adequate funds to meet
the obligations arising from such
activities.’’ 67
2. Staff No-Action Letters Concerning
the Segregated Account Approach 68
Following the Commission’s issuance
of Release 10666, the Commission staff
issued more than twenty no-action
letters to funds concerning the
maintenance of segregated accounts or
otherwise ‘‘covering’’ their obligations
in connection with certain senior
securities, primarily interest rate
futures, stock index futures, and related
options.69
In a 1987 no-action letter issued to
two Dreyfus funds, the staff summarized
and expanded upon the methods by
which, in its view, obligations could be
covered by funds transacting in futures,
forwards, written options, and short
sales.70 The staff provided no-action
assurance that the Dreyfus funds could:
66 Id.
67 Id.
68 This release includes extensive discussion of
staff no-action letters; accordingly the Commission
notes that its discussion of staff statements is
provided solely for background and to facilitate
comment on issues that the Commission might
address. The discussion is in no way intended to
suggest that the Commission has adopted the
analysis, conclusions or any other portion of the
staff statements discussed here. Staff no-action
letters are issued by the Commission staff in
response to written requests regarding the
application of the Federal securities laws to
proposed transactions. Many of the staff no-action
letters are ‘‘enforcement-only’’ letters, in which the
staff states whether it will recommend enforcement
action to the Commission if the proposed
transaction proceeds in accordance with the facts,
circumstances and representations set forth in the
requester’s letter. Other staff no-action letters
provide the staff’s interpretation of a specific
statute, rule or regulation in the context of a specific
situation. See Informal Guidance Program for Small
Entities, Investment Company Act Release No.
22587 (Mar. 27, 1997).
69 See ‘‘No-Action Letters and Releases from
1982–1985 Regarding Covering Futures and
Options’’ at Senior Security Bibliography, supra
note 10. (Certain of these letters also addressed the
use of when-issued bonds, currency forwards, and
other senior securities).
70 Dreyfus Strategic Investing and Dreyfus
Strategic Income, SEC Staff No-Action Letter (June
22, 1987) (‘‘Dreyfus no-action letter’’ or ‘‘Dreyfus
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55243
• Cover a long position in a futures or
forward contract, or a written put
option, by establishing a segregated
account (not with a futures commission
merchant or broker) containing cash or
certain liquid assets equal to the
purchase price of the contract or the
strike price of the put option (less any
margin on deposit); and
• Cover short positions in futures or
forward contracts, sales of call options,
and short sales of securities by
establishing a segregated account (not
with a futures commission merchant or
broker) with cash or certain liquid assets
that, when added to the amounts
deposited with a futures commission
merchant or a broker as margin, equal
the market value of the instruments or
currency underlying the futures or
forward contracts, call options, and
short sales (but are not less than the
strike price of the call option or the
market price at which the short
positions or short sales were
established).71
The staff also provided no-action
assurance that the Dreyfus funds could
cover these transactions by owning, or
holding the right to obtain, the
instrument or cash that the fund has
obligated itself to deliver. For example:
• A fund could cover a long position
in a futures or forward contract by
purchasing a put option on the same
futures or forward contract with a strike
price as high or higher than the price of
the contract held by the fund; and
• A fund could cover a written put
option by selling short the instruments
or currency underlying the put option at
the same or higher price than the strike
price of the put option or, alternatively,
by purchasing a put option with the
strike price the same or higher than the
strike price of the put option written by
the fund.
The Commission staff has also
discussed the types of assets that may be
segregated and the manner in which, in
the staff’s view, segregation may be
effected. In Release 10666, the
Commission stated that the assets
eligible to be included in segregated
accounts should be ‘‘liquid assets,’’ such
as cash, U.S. government securities, or
Letter’’), available at https://www.sec.gov/divisions/
investment/seniorsecurities-bibliography.htm.
71 But see Robertson Stephens Investment Trust,
SEC Staff No-Action Letter (Aug. 24, 1995),
available at https://www.sec.gov/divisions/
investment/seniorsecurities-bibliography.htm (the
staff agreed not to recommend enforcement action
where the value of the segregated account, to cover
a short position in a security, was equal to the daily
(fluctuating) market price of the security sold short
(less certain amounts pledged with the broker as
collateral), even if the value of the segregated
account was less than the price at which the short
position was established).
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other appropriate high grade debt
obligations. In a 1996 staff no-action
letter issued to Merrill Lynch Asset
Management, the staff took the position
that a fund could cover its derivativesrelated obligations by depositing any
liquid asset, including equity securities
and non-investment grade debt
securities, in a segregated account.72 In
the Merrill Lynch no-action letter, the
staff explained that, in the staff’s view,
segregating any type of liquid asset
would be consistent with the purposes
underlying the asset segregation
approach because it would place a
practical limit on the amount of leverage
that a fund may undertake and on the
potential increase in the speculative
character of its outstanding shares.73
With respect to the manner in which
segregation may be effected, the
Commission staff took the position that
a fund could segregate assets by
designating such assets on its books,
rather than establishing a segregated
account at its custodian.74
Asset segregation practices with
respect to other derivatives investments
have not been addressed by the
Commission, or by the staff in no-action
letters.75 Certain swaps, for example,
that settle in cash on a net basis, appear
to be treated by many funds as requiring
segregation of an amount of assets equal
to the fund’s daily mark-to-market
liability, if any.76 Similarly, some funds
have disclosed that they segregate only
their daily, mark-to-market liability, if
any, with respect to futures and forward
contracts that are contractually required
to cash-settle.77
B. Alternative Approaches to the
Regulation of Portfolio Leverage
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1. The Current Asset Segregation
Approach
As noted above, the segregated
account approach serves both to limit a
72 Merrill Lynch Asset Management, L.P., SEC
Staff No-Action Letter (July 2, 1996) (‘‘Merrill
Lynch no-action letter’’ or ‘‘Merrill Lynch Letter’’),
available at https://www.sec.gov/divisions/
investment/seniorsecurities-bibliography.htm.
73 Id. The staff noted that ‘‘the type of asset placed
in the segregated account would have no effect on
the maximum amount of leverage that a fund can
assume.’’
74 See Dear Chief Financial Officer Letter from
Lawrence A. Friend, Chief Accountant, Division of
Investment Management (Nov. 7, 1997), available at
https://www.sec.gov/divisions/investment/
seniorsecurities-bibliography.htm.
75 Our discussion of current and past industry
practices is not intended to indicate any
Commission approval or disapproval of those
practices.
76 See, e.g., 2010 ABA Derivatives Report, supra
note 8, at 13–14.
77 For a discussion of asset segregation practices
involving futures and forwards that are
contractually required to cash-settle, see, e.g., id. at
14–15.
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fund’s potential leverage and to provide
a source of payment of future
obligations arising from the leveraged
transaction. In determining the amount
of assets required to be segregated to
cover a particular instrument, the
Commission and its staff have generally
looked to the purchase or exercise price
of the contract (less margin on deposit)
for long positions and the market value
of the security or other asset underlying
the agreement for short positions,
measured by the full amount of the
reference asset, i.e., the notional amount
of the transaction rather than the
unrealized gain or loss on the
transaction, i.e., its current mark-tomarket value.78
The segregated account approach has
drawn criticism on several grounds. For
example, we understand that some
industry participants argue that the
segregated account approach calls for an
instrument-by-instrument assessment of
the amount of cover required, further
arguing that this may create uncertainty
about the treatment of new products,
and that new product development will
inevitably lead to circumstances in
which available guidance does not
specifically address each new
instrument subject to section 18
constraints. Other industry participants
have argued that the staff’s application
of the segregated account approach
results in differing treatment of arguably
equivalent products.79
Others have argued that, with respect
to the amount to be segregated, both
notional amount and a mark-to-market
amount have their limitations.80 For
example, for many futures contracts, the
78 See Release 10666, supra note 10, at discussion
of ‘‘Segregated Account’’ (with regard to each
reverse repurchase agreement that lacks a specified
repurchase price, the fund should maintain in a
segregated account ‘‘liquid assets equal in value to
the proceeds received on any sale subject to
repurchase plus accrued interest. If the reverse
repurchase agreement has a specified repurchase
price, the investment company should maintain in
the segregated account an amount equal to the
repurchase price, which price will already include
interest charges.’’ With regard to each firm
commitment agreement, the fund should maintain
in a segregated account ‘‘liquid assets equal in value
to the purchase price due on the settlement date
under the * * * agreement.’’ With regard to each
standby commitment agreement, the fund should
maintain in a segregated account ‘‘liquid assets
equal in value to the purchase price under the
* * * agreement.’’).
79 They argue, for example, that a physicallysettled and a cash-settled future or forward are
equivalent products, and that segregation of the
delivery obligation amount for a physically-settled
future or forward, and segregation of the generally
smaller mark-to-market liability amount for a cashsettled future or forward, constitutes different
treatment of equivalent products. See the 2010 ABA
Derivatives Report, supra note 8, at 14–15 for a
discussion of cash-settled futures and forwards and
the asset segregation treatment of those products.
80 Id. at 16–17.
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notional amount may, as a practical
matter, exceed the maximum loss or
total risk on the contract.81
Consequently, it is argued with respect
to such derivatives that segregation of
assets equal to the notional amount may
limit the use of such derivative products
and strategies that could potentially
benefit funds and their investors.
Conversely, it is argued that segregation
of an amount equal to only the daily,
mark-to-market liability, if any, with
respect to cash-settled derivatives,82
may fail to take into account potential
future losses on such instruments.
Consequently, it is argued that
segregation of this amount may
understate the risk of loss to the fund,
permit the fund to engage in excessive
leveraging, fail to adequately set aside
sufficient assets to cover the fund’s
ultimate exposure, and, therefore,
perhaps not adequately fulfill the
purposes underlying the segregated
account approach and section 18.83
The significant disparity between
these two widely recognized measures—
notional amount and mark-to-market
amount—is illustrated by data relevant
to actual swap positions held by funds.
A recent study of the use of credit
default swaps (‘‘CDS’’) by a group of the
100 largest U.S. corporate bond funds
analyzed data relevant to the notional
amount and ‘‘book value,’’ i.e.,
unrealized gains and losses, of the
funds’ CDS positions during the period
2004 through 2008.84 Among the 65
funds in the sample group that used
CDS sometime between 2004 and 2008,
the total notional amount of CDS
positions increased from an average of
$103 million per fund in 2004 to an
81 See BIS Guide, supra note 18, at 30,
commenting in the context of OTC derivatives that
‘‘[n]ominal or notional amounts outstanding
provide a measure of market size and a reference
from which contractual payments are determined in
derivatives markets. However, with the partial
exception of credit default swaps, such amounts are
generally not those truly at risk. The amounts at risk
in derivatives contracts are a function of the price
level and/or volatility of the financial reference
index used in the determination of contract
payments, the duration and liquidity of contracts
and the creditworthiness of counterparties.’’
82 This is also a concern with respect to the
coverage of short sales.
83 See 2010 ABA Derivatives Report, supra note
8, at 15 (‘‘reducing the amount of assets subject to
segregation increased the practical ability of funds
to engage in derivatives on an increasing scale’’),
and at 16 (where only the mark-to-market liability,
if any, is segregated, ‘‘a fund’s exposure under a
derivative contract could increase significantly on
an intraday basis, resulting in the segregated assets
being worth less than the fund’s obligations (until
the fund is able to place additional assets in the
segregated account * * *.). To the extent that a
fund relying on the Merrill Lynch Letter segregates
assets whose prices are somewhat volatile, this
‘shortfall’ could be magnified.’’).
84 Adam and Guettler Article, supra note 7.
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average of $632 million in 2008. The
mean total notional amount of a fund’s
CDS positions relative to its net asset
value (‘‘NAV’’) increased from 2% to
almost 14%.85 At three funds, the
notional amounts of CDS positions held
in 2008 exceeded those funds’ NAVs.
During the same period, reported CDS
book losses (i.e., unrealized losses)
remained, on average, less than 1% of
a fund’s NAV.86
Critics of the notional and mark-tomarket standards often advocate use of
a more complex analysis of the risk of
a fund’s investments, including its
derivatives positions, such as Value at
Risk (‘‘VaR’’) or another methodology
for assessing the probability of portfolio
losses.87 VaR and other alternative
approaches are discussed in the
following section.
2. Other Approaches
The 2010 ABA Derivatives Report
observed that the ‘‘the basic framework
as articulated in Release 10666 has
worked very well’’ as applied to funds’
derivatives investments,88 but ‘‘there are
open issues and inconsistencies in the
current [Commission] and staff guidance
regarding the application of Section 18
of the 1940 Act to transactions in
derivatives.’’ 89 Accordingly, the 2010
ABA Derivatives Report states that the
Commission ‘‘should issue revised
guidance in this area, which would set
forth an approach to segregation that
would cover all types of derivative
instruments in a comprehensive
manner.’’ 90 The 2010 ABA Derivatives
Report, however, considers
comprehensive guidance unlikely to be
achievable, given that any generalized
approach will likely fail to take into
account significant variations in
individual transactions. Consequently,
85 Id.
at 12.
at 13.
87 See, e.g., 2010 ABA Derivatives Report, supra
note 8, at 18. As discussed infra, some non-U.S.
regulatory schemes have incorporated VaR or
comparable methodologies in their approach to
derivatives. See, e.g., CESR’s Guidelines on Risk
Measurement and the Calculation of Global
Exposure and Counterparty Risk for UCITS,
Committee of European Securities Regulators (July
28, 2010) (‘‘CESR’s Global Exposure Guidelines’’),
available at https://www.esma.europa.eu/
popup2.php?id=7000. See also Henry T.C. Hu, The
New Portfolio Society, SEC Mutual Fund Disclosure,
and the Public Corporation Model, 60 BUS. LAW.
1303 (2005) (advocating disclosure by funds of VaR
data). We note that the Commission has permitted
VaR to be used by certain registrants in other
circumstances. For example, the Commission
permits certain registered broker-dealers to use VaR
models to compute net capital charges. See, e.g.,
Exchange Act rule 15c3–1f.
88 2010 ABA Derivatives Report, supra note 8, at
16.
89 Id. at 15.
90 Id. at 17.
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86 Id.
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in lieu of comprehensive guidance
concerning the asset segregation
approach, the 2010 ABA Derivatives
Report proposes an alternative approach
pursuant to which individual funds
would establish their own asset
segregation standards for derivative
instruments that involve leverage within
the meaning of Release 10666. Under
this approach, each fund would be
required to adopt policies and
procedures that would include, among
other things, minimum asset segregation
requirements for each type of derivative
instrument, taking into account relevant
factors such as the specific context of
the transaction. In developing these
standards, fund investment advisers
could take into account a variety of risk
measures, including VaR and other
quantitative measures of portfolio risk,
and would not be limited to the notional
amount or mark-to-market standards.
These minimum ‘‘Risk Adjusted
Segregated Amounts’’ would be
reflected in policies and procedures that
would be subject to approval by the
fund’s board of directors and disclosed
(including the principles underlying the
Risk Adjusted Segregated Amounts for
different types of derivatives) in the
fund’s statement of additional
information.91
The challenge of designing a
regulatory standard by which leverage
can be measured and limited effectively
also has drawn the attention of
regulators in jurisdictions around the
globe. Internationally, limitations on
leveraged exposure take a variety of
forms, including maximum exposure
limitations, asset segregation
requirements, and other measures. In
the context of maximum exposure or
leverage limitations, the notional or
principal amount of the reference asset
underlying the derivative has commonly
been used as a conservative measure of
the exposure created by derivatives. In
addition to limitations on aggregate
positions or leveraged exposure, some
regulatory frameworks include
restrictions on concentrated exposures
to individual counterparties and some
provide for specialized funds that may
assume derivatives exposure exceeding
otherwise applicable limits.
The Committee of European
Securities Regulators (‘‘CESR’’) (which,
as of January 1, 2011, became the
European Securities and Markets
Authority, or ‘‘ESMA’’), conducted an
extensive review and consultation
concerning exposure measures for
derivatives used by Undertakings for
Collective Investment in Transferable
Securities (‘‘UCITS’’), investment
91 Id.
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vehicles authorized for sale to retail
investors. In 2010, CESR’s Global
Exposure Guidelines for UCITS were
issued,92 addressing implementation of
the European Commission’s 2009
revised UCITS Directive.93 Under the
revised UCITS Directive, UCITS are
permitted to engage in derivatives
investments subject to a ‘‘global
exposure’’ limitation, under which the
derivatives exposure of a UCITS may
not exceed the total net value of the
UCITS’ portfolio.94 CESR’s Global
Exposure Guidelines extensively
address the calculation of derivatives
exposure under the ‘‘global exposure’’
limit and define two permissible,
alternative methods for this purpose:
(i) The ‘‘commitment’’ approach; and
(ii) the advanced risk measurement
method to measure maximum potential
loss, such as the VaR approach.95
The commitment approach is a
method for standard derivatives that
uses the market value of the equivalent
position in the underlying asset but may
be ‘‘replaced by the notional value or
the price of the futures contract where
this is more conservative.’’ 96 CESR’s
Global Exposure Guidelines
incorporates a schedule of derivative
investments and their corresponding
conversion methods to be used in
calculating global exposure.97 The
conversion method to be used depends
on the derivative.98
92 See supra note 87. In order for CESR’s Global
Exposure Guidelines to be binding and operational
in a particular EU Member State, the Member State
must adopt them. To date, it appears that a few EU
Member States, e.g., Ireland and Luxembourg, have
adopted them.
93 See Directive 2009/65/EC of the European
Parliament and of the Council of 13 July 2009 on
the coordination of laws, regulations, and
administrative provisions relating to undertakings
for collective investment in transferable securities
(‘‘2009 Directive’’), available at https://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=
OJ:L:2009:302:0032:0096:en:PDF.
94 Id. at Article 51(3) at 62 (‘‘The exposure is
calculated taking into account the current value of
the underlying assets, the counterparty risk, future
market movements and the time available to
liquidate the positions’’).
95 See CESR’s Global Exposure Guidelines, supra
note 87. The CESR’s Global Exposure Guidelines
note that the ‘‘use of a commitment approach or
VaR approach or any other methodology to
calculate global exposure does not exempt UCITS
from the requirement to establish appropriate
internal risk management measures and limits.’’ Id.
at 5. In addition, with respect to the selection of the
methodology used to measure global exposure,
CESR’s Global Exposure Guidelines note that the
‘‘commitment approach should not be applied to
UCITS using, to a large extent and in a systematic
way, financial derivative instruments as part of
complex investment strategies.’’ Id. at 6.
96 See id. at 7.
97 See id. at 7–12.
98 Id. at 8. For example, for bond futures, the
applicable conversion method is the number of
contracts multiplied by the notional contract size
at 18.
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The second method is VaR or a
comparably sophisticated risk
measurement method, designed to
measure the maximum potential loss
due to market risk rather than
leverage.99 When using the VaR
approach to calculate global exposure,
either the relative VaR approach or the
absolute VaR approach may be used.100
Under the relative VaR approach, the
VaR of the portfolio cannot be greater
than twice the VaR of an unleveraged
reference portfolio.101 The absolute VaR
approach limits the maximum VaR that
a UCITS can have relative to its NAV,
and as a general matter, the absolute
VaR is limited to 20 percent of the
UCITS NAV.102
In addition to the global exposure
limitation, CESR’s Global Exposure
Guidelines subject UCITS to ‘‘cover
rules’’ for investments in financial
derivatives.103 Under these cover rules,
UCITS should, at any given time, be
capable of meeting all its payment and
delivery obligations incurred by
financial derivatives’ investments, and
cover should form part of the UCITS’
risk management process.104 More
specifically, in the case of a derivative
that provides, automatically or at the
multiplied by the market price of the cheapest-todeliver reference bond. For plain vanilla fixed/
floating interest rate and inflation swaps, the
applicable conversion method is the market value
of the underlier (though the notional value of the
fixed leg may also be applied). Id. For foreign
exchange forwards, the prescribed conversion
method is the notional value of the currency leg(s).
Id. at 9. With respect to non-standard derivatives,
where it is not possible to convert the derivative
into the market value or notional value of the
equivalent underlying asset, CESR’s Global
Exposure Guidelines note that ‘‘an alternative
approach may be used provided that the total
amount of the derivatives represent a negligible
portion of the UCITS portfolio.’’ Id. at 7.
99 Id. at 22 (‘‘More particularly, the VaR approach
measures the maximum potential loss at a given
confidence level (probability) over a specific time
period under normal market conditions.’’).
100 Id. at 23. A global exposure calculation using
the VaR approach should consider all the positions
in the UCITS’ portfolio. Id. at 22. The VaR approach
measures the probability of risk of loss rather than
the amount of leverage in portfolio. Id. at 22. The
absolute VaR of a UCITS cannot be greater than
20% of its NAV. Id. at 26. For both VaR approaches,
the calculation must have a ‘‘one-tailed confidence
interval of 99%,’’ a holding period of one month (20
business days), an observation period of risk factors
of at least one year (unless a shorter observation
period is justified by a significant increase in price
volatility), at least quarterly updates, and at least
daily calculation. Id. at 26. UCITS employing the
VaR approach are required to conduct a ‘‘rigorous,
comprehensive and risk-adequate stress testing
program.’’ Id. at 30–34.
101 CESR’s Global Exposure Guidelines note that
the relative VaR approach does not measure
leverage of the UCITS’ strategies but instead allows
the UCITS to double the risk of loss under a given
VaR model. Id. at 24.
102 Id. at 25–26.
103 Id. at 40.
104 Id.
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counterparty’s choice, for physical
delivery of the underlier, the UCITS
should hold: (i) the underlier in its
portfolio, or, if the underlier is deemed
to be sufficiently liquid, (ii) cash or
other liquid assets on the condition that
these other assets (after applying
appropriate haircuts), held in sufficient
quantities, may be used at any time to
acquire the underlier that is to be
delivered.105 In the case of a derivative
that provides, automatically or at the
UCITSs choice, for cash settlement, the
UCITS should hold enough liquid assets
after appropriate haircuts to allow the
UCITS to make the contractually
required payments.106
Singapore has adopted a bifurcated
approach similar to that applicable
under CESR’s Global Exposure
Guidelines for UCITS. The Monetary
Authority of Singapore (the ‘‘MAS’’)
requires that the risks of derivatives
used by investment companies are
‘‘duly measured, monitored and
managed on an ongoing basis.’’ 107 An
investment company’s exposure to
derivatives is limited to 100% of its
NAV, and global exposure is calculated
using the commitment approach as the
default method. Under the commitment
approach, which is similar to the
commitment approach in CESR’s Global
Exposure Guidelines, global exposure is
calculated by converting the investment
company’s derivatives positions into
equivalent positions in the underlying
assets and then is quantified as the sum
of the absolute values of the individual
positions.108 The investment company’s
exposure to the counterparty of an OTC
derivative is limited to 10% of its NAV
and is measured on a maximum
potential loss basis that may be incurred
by the investment company if the
counterparty defaults.109 Cash or money
market instruments and bonds issued by
a government with a rating of AAA may
be tendered as collateral to reduce
counterparty exposure.110
Other jurisdictions have adopted
approaches to investment companies’
use of derivatives that limit aggregate
exposure and/or require maintaining
liquid assets equal to the notional or
‘‘exercise’’ value of derivatives
contracts. For example, the Central Bank
of Ireland, in addressing non-UCITS
investment companies offered to the
public generally, has issued guidelines
that provide standards analogous to a
‘notional amount’ or commitment
approach and generally limits the
maximum potential exposure to 25% of
the investment company’s NAV.111
Separately, the Central Bank of Ireland
permits the use of techniques and
instruments by investment companies
for the purposes of ‘‘efficient portfolio
management,’’ subject to certain
conditions. These include a requirement
that an investment company selling a
futures contract must own the security
that is the subject of the contract.
Alternatively, the investment company’s
assets, or a proportion of its assets at
least equal to the exercise value of the
futures contracts sold, must reasonably
be expected to behave in terms of price
movement in the same manner as the
futures contract.112
A similar approach is followed by the
Canadian Securities Administrators,
which permits investment companies
sold to the general public to use
derivatives for hedging and non-hedging
purposes but limits the derivatives
exposure and requires certain ‘‘cash
cover’’ intended to limit leverage.113 For
109 Id.
at Appendix 1, sections 5.2 and 5.4.
at Appendix 1, sections 5.7 and 5.8.
111 Central Bank of Ireland, NU SERIES OF
NOTICES: Conditions Imposed in Relation to
Collective Investment Schemes Other than UCITS
(July 2011) at 13.12, available at https://
www.centralbank.ie/regulation/industry-sectors/
funds/non-ucits/Documents/
Non%20UCITS%20Notices.pdf
112 Id. at 16.10. In addition, certain requirements
are imposed on the use of OTC derivatives. Id. at
16.10.
113 National Instrument 81–102 Mutual Funds
(Jan. 2011) at sections 2.7 and 2.8, available at
https://www.bcsc.bc.ca/uploadedFiles/securitieslaw/
policy8/81102%20Mutual%20Funds%20%5BNI%5D%20Jan1-11.pdf. In addition, for periods when the
investment company would be required to make
payments under the swap, the investment company
is required to hold an equivalent quantity of the
reference asset of the swap, a right or obligation to
acquire an equivalent quantity of the reference asset
of the swap and cash cover that, together with the
margin on account for the swap, have a value at
least equal to the aggregate amount of the
obligations of the investment company under the
swap, or a combination of the positions, without
recourse to other assets of the investment company,
110 Id.
105 Id.
106 Id. On April 14, 2011, ESMA published a final
report on the guidelines on risk measurement and
the calculation of the global exposure for certain
types of structured UCITS. See Guidelines to
Competent Authorities and UCITS Management
Companies on Risk Measurement and the
Calculation of Global Exposure for Certain Types of
Structured UCITS (final report) (Apr. 14, 2011) (ref.:
ESMA/2011/112), available at https://
www.esma.europa.eu/popup2.php?id=7542 (these
guidelines, which will need to be adopted and
implemented by Member States, propose for certain
types of structured UCITS, an optional regime for
the calculation of the global exposure).
107 The Monetary Authority of Singapore, Code
on Collective Investment Schemes, Chapter 3,
section 3.1(f) (April 2011) at 7, available at
https://www.mas.gov.sg/resource/
legislation_guidelines/securities_futures/
sub_legislation/
110408%20Revised%20Code_8%20April_final.pdf.
108 MAS allows for the use of a VaR approach,
with prior approval and submission of specific
information on the investment company manager’s
risk management process. Id. at Appendix 1, section
3.2(b).
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example, an investment company may
enter into a swap if, among other things,
the investment company holds cash
cover in an amount that, together with
margin on account for the swap and the
market value of the swap, is not less
than the underlying market exposure of
the swap.114
The Hong Kong Securities and
Futures Commission (the ‘‘SFC’’)
applies a differentiated approach,
limiting investment companies
generally to the use of derivatives for
non-hedging positions that are capped
at 15% of NAV for options and warrants
and 20% for futures.115 For investment
companies that may acquire financial
derivative instruments extensively for
investment purposes, the investment
companies’ global exposure relating to
the financial derivative instruments
should not exceed 100% of the total net
asset value of the investment
companies. For purposes of calculating
global exposure, investment companies
must use the commitment approach.
This approach requires that derivative
positions be converted into the
equivalent position in the underlying
assets of the derivative, taking into
account the prevailing value of the
underlying assets, counterparty risk,
futures market movements, and the time
available to liquidate the positions.
There are also requirements for: (a) the
over-the-counter derivative
counterparties (or their guarantors, if
applicable) of these investment
companies to be substantial financial
institutions (as defined in the Code on
Unit Trusts and Mutual Funds); (b) the
net exposure for these investment
companies to a single over-the-counter
derivative counterparty to be no greater
than 10% of NAV; and (c) the
acceptability criteria of collateral as
provided by the over-the-counter
derivative counterparties.116
to enable it to satisfy its obligations under the swap.
Id. at sections 2.7 and 2.8.
114 Id. at section 2.8.
115 Hong Kong Securities and Futures
Commission, Code on Unit Trusts and Mutual
Funds (June 2010), Chapter 7, available at https://
www.sfc.hk/sfc/doc/EN/intermediaries/products/
handBooks/Eng_UT.pdf. See also Hong Kong
Securities and Futures Commission Handbook for
Unit Trusts and Mutual Funds, Investment-Linked
Assurance Schemes and Unlisted Structured
Investment Products.
116 Hong Kong Securities and Futures
Commission, Code on Unit Trusts and Mutual
Funds (June 2010), Chapter 8, available at https://
www.sfc.hk/sfc/doc/EN/intermediaries/products/
handBooks/Eng_UT.pdf.
Other requirements include a restriction on
premium paid to acquire identical options
exceeding 5% of the NAV of the investment
company, open positions in any futures contract
month or option series may not be held if the
combined margin requirement represents 5% or
more of the NAV of the investment company, and
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C. Request for Comment
The Commission requests comment
concerning the current approach to the
application of the senior securities
limitations of section 18 of the Act to
funds’ use of derivatives. The
Commission seeks views concerning the
appropriateness and effectiveness of the
asset segregation approach as a basis for
section 18 compliance, and ways in
which the approach might be improved
to better serve the statutory purposes
and protect investors. The Commission
also seeks views concerning potential
alternative approaches under which
funds could capture the benefits of
using derivatives that would meet these
same important goals. Commenters are
requested to consider these broad
questions as well as the specific
questions that follow:
1. Issues Concerning the Current Asset
Segregation Approach
• Is the definition of leverage
articulated by the Commission in
Release 10666—that is, the right to a
return on a capital base that exceeds a
fund’s investment in the instrument
producing the return—sufficiently
precise, and appropriate to limit the
risks addressed by the senior security
prohibition of section 18? Are other
measures of leverage equally pertinent
to, and sufficiently objective, precise,
and transparent to achieve the investor
protection purposes of section 18? Do
funds make use of any leverage
measurements as part of their own
portfolio oversight procedures? Are
leveraged transactions involving
derivatives subject to any special
approval or review procedures?
the investment company may not hold open
positions in futures or options contracts concerning
a single commodity or a single underlying financial
instrument for which the combined margin
requirement represents 20% or more of the NAV of
the investment company. Id.
Futures and options investments companies are
subject to still different requirements, including
that at least 30% of the investment company’s NAV
be held on deposit in short-term debt instruments
and may not be used for margin requirements and
no more than 70% of the NAV of the investment
company may be committed as margin for futures
or option contracts and/or premium paid for
options purchased. Other requirements applicable
to futures and options investment companies
include a restriction on premium paid to acquire
options outstanding with identical characteristics
exceeding 5% of the NAV of the investment
company, open positions in any futures contract
month or option series may not be held if the
combined margin requirement represents 5% or
more of the net asset value of the investment
company, and the investment company may not
hold open positions in futures or options contracts
concerning a single commodity or a single
underlying financial instrument for which the
combined margin requirement represents 20% or
more of the net asset value of the investment
company. Id.
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• Does the segregated account
approach adequately address the
investor protection purposes and
concerns underlying section 18 of the
Act? What are the benefits and the
shortcomings of the segregated account
approach? What benefits may be lost
under an approach that is more
restrictive than the current segregated
account approach?
• Derivatives can raise risk
management issues for funds, such as
leverage, illiquidity (particularly with
respect to complex OTC derivatives),
and counterparty risk, among others.117
The segregated account approach
addresses leverage, but may not address
liquidity and counterparty concerns.
Should funds that use derivatives be
required to consider and address these
concerns? For example, should funds be
required to undertake an ongoing credit
analysis of their derivatives
counterparties, and an ongoing analysis
of the liquidity of the derivatives, and
to take action should the
creditworthiness of the derivatives
counterparties and the liquidity of the
derivatives themselves decline below a
certain point? Should diversification
among counterparties be a requirement?
Are there other risk considerations that
funds engaged in derivatives
investments should be required to take
into account?
• What is the optimal amount of
assets that should be segregated for
purposes of complying with the leverage
limitations of section 18? In general,
should a fund segregate assets in an
amount equal to the notional amount of
a derivative contract? In what situations,
if any, would a lesser amount satisfy the
purposes and concerns underlying
section 18’s leverage limitations and
why? Since futures, swaps, and similar
derivatives generally have zero market
value at inception and subsequent markto-market amounts may fluctuate
widely, how effectively does segregating
an amount equal to the daily, mark-tomarket amount serve the Act’s objective
of limiting leverage and assuring the
availability of adequate assets to cover
a fund’s ultimate obligations? To what
extent do funds rely upon the mark-tomarket standard to determine the
amount of assets to be segregated? Are
CDS, or some subset thereof, generally
covered based on their notional amount,
their mark-to-market value, or some
other measure? Does it depend on
whether the CDS cash-settles or
involves physical delivery of the
underlier?
117 See 2008 IDC Report, supra note 3, at 12–13.
See also 2008 JPMorgan Article, supra note 6, at
page 25.
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• To what extent does the asset
segregation approach cause funds to
refrain from derivatives investments or
strategies that could benefit investors?
Please describe specific scenarios in
which a fund might be deterred from
engaging in derivatives activities for this
reason. Does the asset segregation
approach create particular impediments
for certain types of funds or strategies?
Please also provide any information
relevant to assessing the impact upon
the funds of asset segregation as
contemplated by Release 10666.
• In Release 10666, the Commission
stated that it believed that only liquid
assets should be placed in the
segregated accounts. The Commission
listed cash, U.S. Government securities,
or other appropriate high-grade debt
obligations as examples of liquid assets
that could be placed in a segregated
account.118 Subsequently, in the Merrill
Lynch no-action letter, the staff took the
position that ‘‘cash or liquid securities
(regardless of type)’’ may be segregated
for section 18 purposes. Should the
Commission permit funds to segregate
any liquid asset? Or should the
Commission further limit the types of
assets that may be placed in a segregated
account? The 2010 ABA Derivatives
Report has observed that the practical
effect of segregating ‘‘any liquid asset’’
rather than segregating only the assets
specifically noted as examples in
Release 10666 ‘‘greatly increase[s] the
degree to which funds [may] * * * use
derivatives.’’ 119 Is segregation of ‘‘any
liquid asset’’ for purposes of section 18
consistent with the purposes and
concerns underlying section 18’s
limitations on leverage? Should any
restrictions be placed on the types of
liquid assets that may be used for asset
cover, e.g., excluding assets that
replicate the fund’s exposure under the
covered obligation?
• What types of liquid assets are
currently used by funds for asset
segregation purposes? Do funds
commonly include equities among the
liquid assets that they segregate? If so,
what types of equities?
• Is owning, or having the right to
obtain, the cash or other assets that a
fund obligates itself to deliver in
connection with senior securities an
adequate substitute for segregation of
liquid assets? To what extent do funds
rely on this cover approach rather than
asset segregation? Are cover methods
that do not involve asset segregation as
effective as asset segregation in terms of
118 See Release 10666, supra note 10, at
discussion of ‘‘Segregated Account.’’
119 2010 ABA Derivatives Report, supra note 8, at
14.
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limiting a fund’s ability to engage in
leverage, limiting a fund’s risk of loss,
and making sure that a fund has set
aside sufficient assets to cover its
obligations under derivatives and other
senior securities?
• Should the Commission revise its
position in Release 10666 to provide
expressly for cover methods in addition
to asset segregation? If so, should the
Commission take the position that a
fund may only enter into such non-asset
segregation cover methods with the
same counterparty to the senior security
being covered? If so, what conditions, if
any, should be imposed on such cover
methods?
• The Commission also requests
comment on the different treatment
afforded conventional bank borrowings
under section 18, which generally
require 300% asset coverage, and other
transactions, such as reverse repurchase
agreements, that may be functionally
equivalent to borrowings but, under
Release 10666, may be covered by
segregation of assets equal to 100% of
the fund’s obligations. Why, if at all,
should other senior securities be treated
differently from bank borrowings for
purposes of the amount of cover
required? Should the Commission revise
its position in Release 10666 so that all
borrowings and their functional
equivalents are subject to the same asset
segregation requirements?
2. Alternatives to the Current Asset
Segregation Approach
• What alternatives to the segregated
account approach, if any, should the
Commission consider to fulfill the
investor protection purposes of section
18 of the Act? Please identify any
alternative measures that would assure
adequate coverage of the fund’s ongoing
exposures under a derivative
investment, and provide a cushion to
cover future exposure.
• What benefits would be lost, and/or
what costs would increase, if an
alternative approach to the segregated
account were to limit funds’ use of
derivatives?
• As discussed above, the 2010 ABA
Derivatives Report recommends a more
flexible approach to section 18
compliance, under which funds would
specify a Risk Adjusted Segregated
Amount (‘‘RASA’’) for each derivative
investment used by the fund.120 Under
this recommended approach, the
amount of assets to be segregated would
be determined by each fund, based on
the risk profiles of the derivative
instruments (including issuer- and
120 2010 ABA Derivatives Report, supra note 8, at
1, 17–18.
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transaction-specific risk) and its
assessment of risk based upon
consideration of relevant risk measures,
such as VaR, potentially subject to
Commission guidance of a general
nature.121 What benefits would accrue
to funds and investors from the ABA’s
RASA approach? What would be the
costs of this approach? In what respects
would fund-determined asset
segregation policies be expected to
deviate from the current segregated
account approach? Would such policies
be likely to incorporate VaR or other
risk methodologies? Do boards, as
currently constituted, have sufficient
expertise to oversee an alternative
approach to leverage and derivatives
management such as RASA and/or VaR?
If funds were permitted to determine the
cover amount for their derivatives
investments, should the Commission
give guidance concerning minimum
requirements for cover amounts or
methodologies for determining cover
amounts? If funds were permitted to
determine the cover amount for their
derivatives investments, would the
result be that different funds would
likely reach different determinations,
resulting in different cover amounts, for
the same derivatives?
• Should the Commission consider a
bifurcated approach to funds’ use of
derivatives, similar to that set out in
CESR’s Global Exposure Guidelines
(which provides two methodologies, the
commitment approach or an advanced
risk measurement method such as VaR)?
If the Commission were to pursue a
bifurcated approach, should funds be
permitted to elect to use notional
amount (or similar reference) or a
quantitative risk assessment such as
VaR, or should funds with different
levels of derivatives activities be
required to choose one or the other
measure based upon their level of
derivatives activities or other factors?
• If funds are permitted to choose
which quantitative risk assessment
approach to use, under what
circumstances, if any, should they be
allowed to switch to a different
assessment? Should a fund’s proposed
change in assessment require
consideration and approval of its board
of directors? Should shareholder
approval of a fund’s proposed change in
assessment be required? For what
reason(s) should a fund be permitted to
change assessments, if any?
• We note that bank capital standards
incorporate methodologies by which the
current exposure and potential future
exposure created by derivative
investments are calculated. The
121 Id.
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potential future exposure calculation is
based upon application of a specified
multiplier, varying with the type and
maturity of the derivative, to the
notional amount of the investment.122
Would a formula combining the current
mark-to-market value of a fund’s
derivative investments with a measure
of potential future exposure based upon
a percentage of the notional amount of
its derivative contracts provide a more
robust measure of risk than the notional
amount or mark-to-market value of the
derivative? If so, are bank capital
standards a relevant reference point for
our consideration of the potential future
exposure and asset segregation amount?
If not, are there other preferable
standards for measuring the potential
future exposure of a derivative
investment? How, if at all, would such
an approach address the leverage
concerns underlying section 18 of the
Act? What would be the costs and
benefits of employing an asset
segregation calculation that reflects both
current mark-to-market values and a
potential future exposure approximation
calculated by reference to notional
amount? Given the purposes of section
18, should an additional cushion
amount be considered in addition to
current mark-to-market value and
potential future exposure?
• The Commission also requests
comment concerning the desirability of
incorporating a VaR approach or other
comparable risk measurement
methodology in the segregated account
approach to section 18. To what extent
do funds currently employ VaR or a
comparable risk measure as part of their
routine portfolio oversight procedures?
Would a VaR measure, potentially
supplemented by stress testing and a
leverage measure, provide an adequate
methodology for addressing leverage
risks in fund portfolios? What
procedures would be required so that
any VaR methodology chosen by a fund
would be implemented in a way that
adequately captures any additional risks
associated with the use of leverage and
derivatives by a fund? What other
quantitative criteria might be employed
in lieu of, or as a supplement to, VaR?
Would adoption of VaR or a comparable
risk standard require review by the
Commission or Commission staff of
particular risk measurement
methodologies in order to establish an
appropriate level of investor protection?
What would be the costs and benefits of
adopting a VaR standard in lieu of an
122 See 12 CFR 3 at Appendix C to Part 3 (2011)
(Capital Adequacy Guidelines for Banks: InternalRatings-Based and Advanced Measurement
Approaches).
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asset segregation approach in addressing
the treatment of derivatives under
section 18?
• UCITS using VaR approaches to
measure global exposure limits are
required to disclose in their prospectus
their expected level of leverage and the
possibility of higher leverage.123 In the
event that the Commission were to
accept a VaR approach in connection
with funds’ use of derivatives, should
funds be required to disclose their
expected and/or actual leverage levels?
• UCITS using VaR approaches to
comply with global exposure limits are
also required to maintain ‘‘a rigorous,
comprehensive and risk-adequate stress
testing program.’’ 124 Should a stress
testing requirement be imposed upon
funds that use derivatives, at least
where a risk-based methodology is used
to determine the required asset
segregation value? What standards, if
any, should the Commission establish
for stress testing if such a requirement
were to be imposed?
• Are there any alternative measures
that would provide adequate coverage of
a fund’s future obligations throughout
the life of a derivative instrument as
well as the availability of resources to
cover unanticipated price movements?
• During the recent credit crisis, did
funds that used derivatives and leverage
demonstrate the ability to foresee and
manage the risks that manifested
themselves in connection with
derivatives and leverage? Are there
examples during the credit crisis where
funds incurred losses or experienced
gains specifically attributable to their
derivatives usage?
• Is it the case that most futures
contracts are highly liquid, and that this
facilitates rapid liquidation of a losing
position, enabling funds to minimize
losses? Are there futures contracts that
are not highly liquid? Have there been
instances where futures contracts, that
may typically be considered liquid,
have become less liquid, or illiquid? If
so, please describe. Could there be
instances in the future where
derivatives that have historically been
considered to be liquid become less
liquid, or illiquid? If so, please describe.
3. Related Matters
• Do derivatives that create economic
leverage, but that do not impose future
payment obligations on funds, such as
purchased options or commodity-linked
notes, raise the same or similar concerns
as derivatives that create indebtedness
leverage? Do such derivatives present
123 See CESR’s Global Exposure Guidelines, supra
note 87, at 35.
124 Id. at 31.
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55249
any other material concerns to funds or
their investors, or raise other concerns
under the Investment Company Act? If
so, how should the Commission address
them?
• Please comment on these, or any
other, alternative approaches to the
regulation of leverage under the Act.
The Commission requests comment on
whether any other regulatory
frameworks provide relevant and useful
approaches that the Commission should
consider.
• Are there special considerations
that need to be taken into account for
smaller funds? How might taking such
considerations into account impact
investor protection?
III. Derivatives Under the Investment
Company Act’s Diversification
Requirements
In this section of the release, the
Commission discusses the
diversification requirements of the
Investment Company Act. The
Commission also explores, and requests
comment on, issues that arise in the
course of applying those requirements
to funds’ use of derivatives.
A. The Diversification Requirements
Funds are required to disclose in their
registration statements whether they are
classified as diversified or nondiversified.125 A fund that discloses in
its registration statement that it is
classified as diversified is prohibited
from changing its classification to nondiversified without first obtaining
shareholder approval.126 A diversified
fund is a fund that, with respect to 75%
of the value of its total assets (the ‘‘75%
bucket’’),127 has (among other things) no
more than 5% of the value of its total
assets invested in the securities of any
one issuer.128 A non-diversified fund is
125 Section 8(b)(1)(A) of the Act; Form N–1A,
Items 16, 4(a) and 4(b)(1); Form N–2, Item 17.
126 Section 13(a)(1) of the Act.
127 Rule 5b–1 under the Investment Company Act
generally defines ‘‘total assets,’’ when used in
computing values for purposes of sections 5 and 12
of the Act, as ‘‘the gross assets of the company with
respect to which the computation is made, taken as
of the end of the fiscal quarter of the company last
preceding the date of computation.’’
128 Section 5(b)(1) of the Act. The term ‘‘issuer’’
is defined in sections 2(a) and 2(a)(22) of the Act
as ‘‘unless the context otherwise requires, * * *
every person who issues or proposes to issue any
security, or has outstanding any security which it
has issued.’’ In addition, a diversified fund, with
respect to the 75% bucket, may not own more than
10% of the outstanding voting securities of any one
issuer. See Section 5(b)(1) of the Act. A fund
seeking to qualify as a ‘‘regulated investment
company’’ must comply with the diversification
requirements of section 851 of the IRC, even if the
fund is not diversified under the Investment
Company Act. The diversification requirements
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any fund that does not meet these
requirements.129
The purpose of the diversification
requirements is to prevent a fund that
holds itself out as diversified from being
too closely tied to the success of one or
a few issuers or controlling portfolio
companies.130 As one commentator has
noted, the requirements are designed to
ensure that investors receive a clear
statement of the character of the
portfolio of the fund in which they have
invested,131 and are intended to prevent
any diversified fund from becoming
non-diversified without the prior
approval of its shareholders.132
For purposes of determining whether
a fund is diversified or non-diversified,
the value of the fund’s ‘‘total assets’’ is
generally determined as of the end of
the fund’s last preceding fiscal quarter
and includes the value of derivatives
held by the fund. Under the Investment
Company Act’s definition of ‘‘value,’’ 133
the appropriate valuation methodology
to be used by a fund generally depends
upon: (a) Whether market quotations for
the fund’s portfolio securities 134 are
readily available; and (b) whether the
fund owned the particular portfolio
securities or other assets at the end of
its last preceding fiscal quarter.
under the IRC are similar, but not identical, to the
diversification requirements of the Investment
Company Act. See 26 U.S.C. 851(b)(3)(2010).
129 Section 5(b)(2) of the Act.
130 Senate Hearings, supra note 49, at 188
(Statement of David Schenker, Chief Counsel,
Investment Trust Study, SEC, commenting on a
version of section 5(b)(1) that was similar, but not
identical, to the current version) (‘‘a diversified
company must have at least several different
securities in its portfolio, and cannot make
investments which will put them in a controlling
position * * *.’’).
131 See, e.g., Alfred Jaretzki, Jr., The Investment
Company Act of 1940, 26 Wash. U. L. Q. 303, 314
n. 34 (Apr. 1941) (‘‘Jaretzki’’) (the ‘‘distinction
between diversified and non-diversified companies
is due in large part, it is believed, to a desire to
inform stockholders of the character of the portfolio
of the company in which they have invested.’’)
132 Id. at 316–17.
133 ‘‘Value’’ is defined in section 2(a)(41) of the
Act.
134 Sections 2(a) and 2(a)(36) of the Act provide
that, ‘‘unless the context otherwise requires,’’ the
term ‘‘security’’ includes, among other things, any
‘‘note’’ or ‘‘evidence of indebtedness.’’ As discussed
supra note 57, the definition of the term ‘‘security’’
in the Act is broader than the definitions of that
term in the other Federal securities laws and the
Commission has interpreted the term ‘‘security’’ in
light of the policies and purposes underlying the
Act. As a general matter, most derivatives appear
to be notes or evidences of indebtedness and thus
securities for purposes of the diversification
requirements. Treating derivatives as securities for
diversification classification purposes appears to be
consistent with the policies and purposes
underlying the diversification requirements,
including the concern that funds that classify
themselves as diversified indeed have diverse
portfolios of investments, the performance of which
is not tied too closely to the success of one or a few
issuers.
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Specifically, the Act states that, ‘‘unless
the context otherwise requires,’’ the
value of a fund’s assets for purposes of
the diversification requirements is as
follows:
• For each portfolio security owned at
the end of the fund’s last preceding
fiscal quarter for which market
quotations are readily available, the
value of the security is the market value
of the security at the end of such
quarter;
• For any other portfolio security or
asset owned at the end of the fund’s last
preceding fiscal quarter, the value of the
security or asset is the fair value of the
security or asset at the end of such
quarter, as determined in good faith by
the fund’s board of directors; and
• For any security or asset acquired
by the fund after the last preceding
fiscal quarter, the cost thereof.135
B. Application of the Diversification
Requirements to a Fund’s Use of
Derivatives
A diversified fund that contemplates
investing in derivatives must consider
how to value these instruments for
purposes of calculating the 75% bucket
based upon its ‘‘total assets’’ and for
purposes of calculating whether the
fund has invested 5% of the value of its
total assets in the securities of any one
‘‘issuer.’’ In addition, the fund must
determine the identity of the issuer of
each such derivative.
1. Valuation of Derivatives for Purposes
of Determining a Fund’s Classification
as Diversified or Non-Diversified
When determining the value of a
fund’s total assets for purposes of
determining the fund’s classification as
diversified or non-diversified, the fund
must calculate the value of any
derivative held by the fund. Under the
Act, ‘‘unless the context otherwise
requires,’’ derivatives (and all other
assets) held by a fund must be valued
for diversification purposes using
market values and fair values, at the end
of the fund’s last preceding fiscal
quarter, or, if subsequently acquired,
their cost.136
For purposes of calculating NAV
under the Act’s valuation provisions,
derivatives are generally valued using a
‘‘market value’’ measure for exchangetraded derivatives and a ‘‘fair value’’
135 Sections 2(a)(41)(A)(i), (ii), and (iii) of the Act.
Market value and fair value are discussed infra at
Section VI. (Valuation of Derivatives). See also
Adoption of Rules Relating to the Classification of
Management Investment Companies as either
Diversified or Non-Diversified, Investment
Company Act Release No. 178 (Aug. 6, 1941) [6 FR
3966 (Aug. 8, 1941)].
136 See section 2(a)(41)(A) of the Act.
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measure for OTC derivatives; under
either measure, the value of a derivative
would appear to be the value at which
the derivative could be sold or
otherwise transferred at the relevant
time.137 Compliance with the valuation
provisions of the Act helps to ensure,
among other things, that the prices at
which fund shares are purchased and
redeemed are fair and do not result in
dilution of shareholder interests or other
harm to shareholders.138
The diversification requirements are
designed to prevent a fund that holds
itself out as diversified from having
heightened exposure to one or a few
issuers and help to accurately inform
investors about the nature of the fund.
Given that derivatives generally are
designed to convey a leveraged return
based on a reference asset over a period
of time, their mark-to-market values at
a given point do not reflect the asset
base on which future gains and losses
will be based or otherwise represent the
potential future exposure of the fund
under the derivatives investment. Use of
a mark-to-market value for derivatives
held by a fund could thus permit a fund
to maintain an ongoing exposure to a
single issuer or group of issuers in
excess of 5% of the fund’s assets on a
notional basis, while continuing to
classify itself as diversified.139
Should the Commission consider
whether application of the
diversification requirements to
derivatives is a ‘‘context [that] otherwise
requires’’ a different measure of value
than the statutory definition of ‘‘value?’’
The value at which the derivative can be
sold or otherwise transferred will reflect
the gains or losses on that investment at
a point in time. Would the use of the
notional amount of the derivative, rather
than its liquidation value, better achieve
the purposes of the diversification
provisions of the Act? The Commission
requests comment on these issues and
related questions set forth below.
137 For additional discussion of valuation
requirements and guidance, see infra Section VI.
(Valuation of Derivatives).
138 Compliance Programs of Investment
Companies and Investment Advisers, Investment
Company Act Release No. 26299 (Dec. 17, 2003) [68
FR 74714 (Dec. 24, 2003)] available at https://
www.sec.gov/rules/final/ia-2204.pdf.
139 For example, a fund that holds itself out as
diversified may have invested four percent of its
assets in securities of an issuer to which it has
additional exposure through a total return swap that
creates exposure equal to another four percent of its
assets on a notional basis, yielding a combined
exposure to the issuer of eight percent of the fund’s
total assets. The current mark-to-market value of the
total return swap would likely be sufficiently low
to enable the fund to calculate its investments in
the issuer at less than five percent of its total assets,
but, its total exposure to that issuer is over five
percent of its total assets.
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2. Identification of the Issuer of a
Derivative for Purposes of Determining
a Fund’s Classification as Diversified or
Non-Diversified
The diversification requirements
restrict a fund that is classified as
diversified from investing, with respect
to its 75% bucket, more than 5% of the
value of its total assets in the securities
of any one issuer. The Act defines the
term ‘‘issuer’’ as ‘‘every person who
issues or proposes to issue any security,
or has outstanding any security which it
has issued,’’ 140 unless the context
otherwise requires.141 In general, the
‘‘issuer’’ of an OTC derivative entered
into by a fund would appear to be the
fund’s counterparty, and the ‘‘issuer’’ of
an exchange-traded derivative would
appear to be the clearinghouse due to
the novation.142 However, a derivative
may have a reference asset that also has
an issuer, e.g., a total return swap on the
common stock of a corporate issuer. In
such a case, the potential exposure of
the fund created by the derivative is to
both the counterparty to the contract
and the issuer of the reference security.
C. Request for Comment
The Commission requests comment
concerning the application of the Act’s
diversification requirements to
derivatives held in fund portfolios,
including the following specific issues:
• Valuation of Derivatives for
Purposes of the Diversification
Requirements. As discussed above, the
diversification requirements are
designed to preclude a fund that has
classified itself as ‘‘diversified’’ from
concentrating its portfolio investments
in the securities of any single issuer. In
light of this purpose, how should a
derivative be valued for purposes of
applying the diversification tests? Could
investors be misled by a fund’s
disclosure that it is diversified when it
has ongoing exposure to a single issuer
or group of issuers in excess of 5% of
the fund’s assets on a notional basis? In
what circumstances, if any, would
mark-to-market value provide an
adequate measure of a fund’s exposure
to an issuer such that the purposes of
the diversification requirements would
be fulfilled? If a current market value
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140 Section
2(a)(22) of the Act.
141 Section 2(a) of the Act.
142 See Exemptions for Security-Based Swaps
Issued by Certain Clearing Agencies, Securities Act
Release No. 9222 (June 9, 2011) [76 FR 34920 (June
15, 2011)] at n. 18 and accompanying text, available
at https://www.sec.gov/rules/proposed/2011/33–
9222.pdf (also describing ‘‘novation’’ as a process
through which the original obligation between a
buyer and seller is discharged through the
substitution of the central counterparty as seller to
buyer and buyer to seller, creating two new
contracts).
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measure is appropriate for this purpose,
should any additional safeguards be
adopted to address circumstances in
which a derivative’s potential future
exposure may materially exceed its
current market value? For example,
should the ‘‘diversification’’
classification be qualified or
supplemented to reflect the impact on
the fund’s diversification of the notional
exposures created by derivatives? The
Commission also requests comment
concerning the potential for derivatives
exposures to be understated. Further, if
derivatives exposures are potentially
understated, how should the issue be
addressed? For example, should funds
be required to provide additional
information to investors? Also, if markto-market values are ascribed to
derivatives for purposes of the
diversification requirements, how
should negative values for derivatives
be treated?
• Alternative Diversification
Standards. Should different or
additional diversification standards be
developed that would better address the
types of exposures attainable through
derivatives?
• Treatment of Counterparty Issues
under the Diversification Requirements.
In light of the statutory purpose of
preventing a fund from holding itself
out as diversified even though it is
dependent upon the performance of a
small number of issuers, should
counterparties to derivatives
investments with funds be considered
issuers of securities for purposes of the
diversification requirements? If
counterparty obligations under a
derivative investment are considered
securities of an issuer for purposes of
the diversification requirements, how
should such obligations be measured for
this purpose? The 2010 ABA Derivatives
Report recommends that, for purposes
of determining a fund’s classification as
diversified or non-diversified, a fund
should be able to disregard its exposures
to its derivative investment
counterparties and that counterparty
exposures should be addressed
separately under section 12(d)(3) of the
Act, in part to assure that counterparty
exposures would be addressed for nondiversified as well as diversified
funds.143 Would it be preferable to
address counterparty exposures under
section 12(d)(3)? 144 If so, should
143 2010 ABA Derivatives Report, supra note 8, at
27–28.
144 Under section 12(d)(3) of the Investment
Company Act, funds generally may not purchase or
otherwise acquire any security issued by, or any
other interest in, the business of a broker, dealer,
underwriter, or investment adviser (‘‘securitiesrelated issuer’’). See infra discussion in Section IV.
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55251
diversification issues relating to
counterparties that are not securitiesrelated issuers continue to be addressed
under the Act’s diversification
provisions?
• Relevance of Reference Assets
Under Derivatives to Diversification
Requirements. Under the 2010 ABA
Derivatives Report’s suggested
approach, a derivative’s reference asset
would be considered a security issued
by an issuer for purposes of the
diversification requirements, an
approach that the 2010 ABA Derivatives
Report indicates is already followed by
many funds when calculating ‘‘long
exposures’’ to the fund.145 Should the
issuer of reference assets underlying a
derivative entered into by a fund be
considered to be the issuer of a security
for purposes of the diversification
requirements in lieu of, or in addition
to, the counterparty? If not, how, if at
all, should exposure to the issuer of a
reference asset be disclosed to investors
and the potential inconsistency of such
exposure with diversification
categorization be addressed?
• Are there special considerations
that need to be taken into account for
smaller funds? How might taking such
considerations into account impact
investor protection?
IV. Exposure to Securities-Related
Issuers Through Derivatives
Funds engaging in derivatives
investments may also confront issues
under the Act’s restrictions upon
acquisition of interests in securitiesrelated issuers. In this section of the
release, the Commission discusses the
application of section 12(d)(3) and rule
12d3–1, which address a fund’s
exposure to securities-related issuers, to
funds’ use of derivatives. The
Commission seeks comment on the
manner in which the Act’s prohibition
on such acquisitions and the
Commission’s exemptive rule granting
limited relief from that prohibition
should apply in the context of
derivatives.
A. Investment Company Act Limitations
on Investing in Securities-Related
Issuers
Under section 12(d)(3) of the
Investment Company Act, funds
generally may not purchase or otherwise
acquire any security issued by, or any
other interest in, the business of a
broker, dealer, underwriter, or
investment adviser (‘‘securities-related
(Exposure to Securities-Related Issuers Through
Derivatives).
145 2010 ABA Derivatives Report, supra note 8, at
26.
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issuer’’).146 There are two reasons for
this prohibition. First, it limits a fund’s
exposure to the entrepreneurial risks of
securities-related issuers, including the
fund’s potential inability to extricate
itself from an illiquid investment in a
securities-related issuer.147 Second, it is
one of several Investment Company Act
provisions which, taken together,
prohibit fund sponsors, which include
broker-dealers, underwriters, and
investment advisers, from taking
advantage of the funds that they
sponsor.148 Specifically, the prohibition
has the effect of limiting the possibility
of abusive reciprocal practices 149
146 Section 12(d)(3) of the Act. See also Statement
of the Commission Advising All Registered
Investment Companies to Divest Themselves of
Interest and Securities Acquired in Contravention of
the Provisions of Section 12(d)(3) of the Investment
Company Act of 1940 within a Reasonable Period
of Time, Investment Company Act Release No. 3542
(Sept. 21, 1962) [27 FR 9652 (Sept. 29, 1962)]
(‘‘1962 Statement’’) (stating that ‘‘prohibited
purchases or acquisitions occur not only when a
security or interest is originally purchased or
acquired, but also when investment companies
* * * hold an interest in a portfolio company
which thereafter by merger, consolidation,
reorganization * * * or otherwise, acquires an
interest in a dealer, broker, underwriter or
investment adviser’’); Exemption for Acquisition by
Registered Investment Companies of Securities
Issued by Persons Engaged Directly or Indirectly in
Securities Related Businesses, Investment Company
Act Release No. 13725 (Jan. 17, 1984) [49 FR 2912
(Jan. 24, 1984)] (‘‘1984 Proposing Release’’) at n.2
and accompanying text (discussing the 1962
Statement).
147 See 1984 Proposing Release, supra note 146,
at n. 7 and accompanying text (discussing that ‘‘[i]n
1940, securities related businesses, for the most
part, were organized as private partnerships. By
investing in such businesses, investment companies
would expose their shareholders to potential losses
which were not present in other types of
investments; if the business failed, the investment
company as a general partner would be held
accountable for the partnership’s liabilities; if the
business floundered, the investment company
would be locked into its investment.’’). Rule 12d3–
1 under the Act has, since 1984, provided a limited
exemption from section 12(d)(3) for acquisitions of
certain securities and, until 1993, addressed the
liquidity concern underlying section 12(d)(3) by
limiting the equity securities of a securities-related
issuer that a fund may acquire to ‘‘margin
securities,’’ as defined in Regulation T of the Board
of Governors of the Federal Reserve System, and
generally limiting the permissible debt securities to
‘‘investment grade securities,’’ as determined by at
least one nationally recognized statistical rating
organization. See, e.g., 1984 Proposing Release,
supra note 146, at nn. 24–25 and accompanying
text. The rule has never permitted a fund to acquire
a general partnership interest in a securities-related
business.
148 See id. at n. 8 and accompanying text.
149 See, e.g., id. at n. 9 and accompanying text
(‘‘Such reciprocal practices include the possibility
that an investment company might purchase
securities or other interests in a broker-dealer to
reward that broker-dealer for selling fund shares,
rather than solely on investment merit. Similarly,
the staff has expressed concern that an investment
company might direct brokerage to a broker-dealer
in which the company has invested to enhance the
broker-dealer’s profitability or to assist it during
financial difficulty, even though that broker-dealer
may not offer the best price and execution.’’)
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B. Counterparty to a Derivatives
Investment
When a fund invests in an OTC
derivative, the fund receives the
obligation of its counterparty to perform
under the contract. If the counterparty is
a securities-related issuer, a fund’s
acquisition of that obligation may
constitute an acquisition of a security or
another interest in a securities-related
issuer within the scope of section
12(d)(3) of the Investment Company
Act.153 As noted above, in the case of
exchange-traded derivatives that are
cleared, the issuer of the derivative
typically is the clearinghouse. In a noaction letter, the staff did not object to
the assertion that, in acquiring an
exchange-traded option, a fund
generally would not appear to be
acquiring securities issued by, or an
interest in, a securities-related issuer.154
In the case of OTC derivatives, if a
fund’s counterparty is a securitiesrelated issuer, the fund’s transaction
with the counterparty may represent the
acquisition of a security issued by, or an
interest in, that issuer.155
If an OTC derivative with a securitiesrelated issuer as the counterparty is a
security issued by that counterparty,
then the fund may be able to rely on
rule 12d3–1 to engage in the
transaction.156 If such a derivative is not
a security issued by the counterparty,
but the transaction may be deemed to be
the fund’s acquisition of ‘‘an interest in’’
a securities-related issuer (the
counterparty), then rule 12d3–1 would
not be available because it exempts only
acquisitions of securities, and the
transaction would be prohibited under
the Investment Company Act. There is
no bright-line test distinguishing
transactions that may or may not
150 The rule defines ‘‘securities related activities’’
as ‘‘activities as a broker, a dealer, an underwriter,
an investment adviser registered under the
Investment Advisers Act of 1940, as amended, or
as an investment adviser to a registered investment
company.’’
151 Under these limits, a fund may not acquire
more than 5% of that class of the issuer’s
outstanding equity securities or more than 10% of
the outstanding principal amount of the issuer’s
debt securities, and may not have more than 5% of
the value of the fund’s total assets invested in the
securities of the issuer. Rule 12d3–1 defines ‘‘equity
security’’ in accordance with rule 3a11–1 under the
Exchange Act, which in turn includes ‘‘any stock
or similar security, certificate of interest or
participation in any profit sharing agreement,
preorganization certificate or subscription,
transferable share, voting trust certificate or
certificate of deposit for an equity security, limited
partnership interest, interest in a joint venture, or
certificate of interest in a business trust; any
security future on any such security; or any security
convertible, with or without consideration into
such a security, or carrying any warrant or right to
subscribe to or purchase such a security; or any
such warrant or right; or any put, call, straddle, or
other option or privilege of buying such a security
from or selling such a security to another without
being bound to do so.’’ Rule 12d3–1 under the Act
defines ‘‘debt security’’ as ‘‘all securities other than
equity securities.’’
152 Rule 12d3–1 also does not permit the
acquisition of a security issued by the fund’s
promoter, principal underwriter, or investment
adviser, or an affiliated person of the promoter,
principal underwriter, or investment adviser,
subject to an exception for certain subadvisory
relationships.
153 If the counterparty is not a securities-related
issuer, the fund may enter into the transaction
without being limited by section 12(d)(3). The fund
will need to monitor the status of its counterparty
during the term of the transaction to ensure that the
counterparty remains a non-securities-related
issuer. See 1962 Statement, supra note 146.
154 See, e.g., Institutional Equity Fund, SEC Staff
No-Action Letter (Feb. 27, 1984).
155 The Commission has stated, for example, that
in entering into a repurchase agreement, a fund may
be acquiring an interest in the counterparty that is
prohibited by section 12(d)(3). See, e.g., Treatment
of Repurchase Agreements and Refunded Securities
as an Acquisition of the Underlying Securities,
Investment Company Act Release No. 25058 (July
5, 2001) at n. 5 and accompanying text [66 FR
36156 at note 5 (July 11, 2001)].
156 A derivative is likely to be categorized as a
debt security subject to the 10% limitation of rule
12d3–1. Rule 12d3–1 defines ‘‘debt security’’ as ‘‘all
securities other than equity securities.’’ The
Commission also by order has exempted certain
transactions from section 12(d)(3) that may have
involved a fund’s acquisition of a security from a
securities-related issuer. See, e.g., the following
orders issued by the Commission involving
principal-protected funds: AIG SunAmerica Asset
Management Corp., et al., Investment Company Act
Release Nos. 26725 (notice) (Jan. 21, 2005) [70 FR
3946 (Jan. 27, 2005)] and 26760 (Feb. 16, 2005)
(order) (by virtue of entering into a protection
arrangement with an AIG affiliate that is a broker,
dealer, underwriter, investment adviser to a
registered investment company, or an investment
adviser registered under the Investment Advisers
Act, a fund may be deemed to have acquired a
security from the AGI affiliate); Merrill Lynch
Principal Protected Trust, et al., Investment
Company Act Release Nos. 26164 (Aug. 20, 2003)
(notice) [68 FR 51602 (Aug. 27, 2003)] and 26180
(Sept. 16, 2003) (order) (by virtue of entering into
a protection arrangement with a Merrill Lynch
affiliate that is a broker, dealer, underwriter,
investment adviser to a registered investment
company, or an investment adviser registered under
the Investment Advisers Act of 1940, a fund may
be deemed to have acquired a security from the
Merrill Lynch affiliate).
between funds and securities-related
issuers.
Rule 12d3–1 under the Act provides
funds with a limited exception from this
prohibition. Under the rule, a fund may
acquire securities of any person that (a)
derives 15 percent or less of its gross
revenues from ‘‘securities related
activities,’’ 150 as long as the fund does
not control such person after the
acquisition, or (b) derives more than 15
percent of its gross revenues from
‘‘securities related activities,’’ subject to
limits on the percentage of the issuer’s
securities that may be acquired by a
fund.151 The rule does not permit a fund
to acquire a general partnership interest
in a securities-related issuer.152
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constitute a fund’s acquisition of an
‘‘interest in’’ a securities-related issuer.
However, a fund’s acquisition of a
general partnership interest in a
securities-related issuer, whether or not
the interest is a security, is not
permitted by rule 12d3–1.157
by, or an interest in, the credit support
provider that is a securities-related
issuer.158 If it does, then the fund would
need to analyze the derivative
transaction under section 12(d)(3) with
respect to the credit support provider as
well.
C. Exposure to Other Securities-Related
Issuers Through Derivatives
D. Valuation of Derivatives for Purposes
of Rule 12d3–1 Under the Investment
Company Act
As noted above, if a derivative
transaction involves an acquisition by
the fund of a security issued by a
securities-related issuer, the fund may
be able to rely on rule 12d3–1 under the
Investment Company Act, which
provides a conditional exemption to the
prohibition in section 12(d)(3). For
purposes of the conditions of rule 12d3–
1, if the securities-related issuer, in its
most recent fiscal year, derived more
than 15% of its gross revenues from
securities-related activities, as defined
in the rule, the fund would need to
determine whether such derivative is an
equity or debt security and apply the
percentage limitations in the rule
accordingly.159 Among other things, the
fund would need to determine whether,
immediately after the acquisition of
such derivative, the fund has invested
not more than five percent of the value
of its total assets in the securities of the
issuer. For purposes of this calculation,
the exposure of the fund to its
counterparty or its exposure to the
issuer of a reference security may be
understated were the current market or
fair value of the derivative the
appropriate measure. The potential
future exposure of the fund to the
securities-related issuer is, in each case,
likely to be unaccounted for by a current
mark-to-market standard. Neither the
Commission nor the staff has addressed
this point. The Commission
understands that many funds perform
the calculation under rule 12d3–1 based
upon the notional amounts of
derivatives transactions, although this
practice is not uniform.
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The issue of whether an OTC
derivative transaction is prohibited
under the Investment Company Act as
an impermissible acquisition of a
security issued by, or an interest in, a
securities-related issuer, also may
require analysis of a fund’s exposure to
a reference asset underlying the
derivative. If the derivative transaction
is based upon the price or value of
securities issued by, or interests in, a
securities-related issuer, the fund’s
relationship to the issuer of the
reference asset may raise both of the
concerns underlying section 12(d)(3)—
the fund’s exposure to the risks of that
securities-related issuer and the
potential for reciprocal practices. For
example, if the issuer of the reference
asset is a broker-dealer, and the fund’s
position in the derivative transaction
benefits from increases in the market
price of the reference asset, the fund
might direct brokerage or other business
to that broker-dealer to enhance the
broker-dealer’s profitability.
Consequently, the fund could be
considered to have assumed an
exposure to a securities-related issuer
that is in violation of section 12(d)(3). In
that event, the fund would need to
consider the availability and conditions
of rule 12d3–1 with respect to that
entity before determining whether the
fund may, and if so, to what extent,
enter into the derivative transaction.
Certain OTC derivative transactions
involve credit support providers or
entities performing similar roles. These
entities also may be securities-related
issuers. In that case, the fund would
need to determine whether the
provision of credit support or similar
protection for the fund’s benefit in the
derivative transaction constitutes the
fund’s acquisition of a security issued
157 In addition, section 12(d)(3) of the Act
prohibits a fund’s acquisition of any security issued
by ‘‘or any other interest in’’ a securities-related
issuer. The Commission has noted that, in enacting
section 12(d)(3), Congress was particularly
concerned with funds investing as general partners
in securities-related issuers. See Exemption of
Acquisitions of Securities Issued by Persons
Engaged in Securities-Related Business, Investment
Company Act Release No. 19204 (Jan. 4, 1993) [58
FR 3243 (Jan. 8, 1993)] at n. 10 and accompanying
text. Rule 12d3–1(c) provides that ‘‘this section
does not exempt the acquisition of: (1) a general
partnership interest[.]’’
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E. Request for Comment
The Commission asks for comment on
all aspects of the application of section
12(d)(3) and rule 12d3–1 to funds’
derivative transactions.
• Do commenters believe that OTC
derivative transactions between funds
and securities-related issuers implicate
the purposes of section 12(d)(3), i.e.,
protection against the entrepreneurial
risks of securities-related issuers and the
potential for reciprocal practices that
disadvantage fund investors? If so, in
what respects? If not, on what basis
should a fund’s exposure to a securitiesrelated issuer in a derivatives
transaction be distinguished from other
types of investments to which section
12(d)(3) applies?
• Do commenters believe that a
fund’s exposure to price movements or
performance of a reference security
issued by a securities-related issuer
implicates the purposes of section
12(d)(3)? If not, on what basis would
such exposure be distinguished from
other types of investments subject to
section 12(d)(3)?
• Should the extent to which the
securities-related issuer’s obligations are
secured by collateral provided by the
issuer affect this analysis? If so, what
specific effect should collateral
arrangements be accorded and by what
criteria should qualifying collateral
arrangements be defined?
• The 2010 ABA Derivatives Report
suggests that section 12(d)(3) ‘‘provides
an appropriate framework for dealing
with fund counterparty exposures.’’ 160
The 2010 ABA Derivatives Report states
that the counterparties to fund
derivative transactions generally fall
within the categories of securitiesrelated issuers addressed by section
12(d)(3) and that, unlike the
diversification requirements discussed
above, section 12(d)(3) applies to all
registered investment companies,
regardless of diversification status. The
2010 ABA Derivatives Report also
suggests that the Commission or the
staff issue guidance concerning the
manner in which the various provisions
of rule 12d3–1 under the Act should
apply to derivatives.161 Is rule 12d3–1
the appropriate framework for
exempting certain derivatives
transactions from section 12(d)(3)? Are
the existing percentage limitations in
rule 12d3–1 appropriate in the context
of derivatives? Should there be
additional limitations or conditions to
an exemption from section 12(d)(3) for
derivative transactions? If so, what types
of conditions or limitations? The
Commission also asks commenters to
identify and discuss the interpretive
issues that may arise when rule 12d3–
1 is applied to funds’ use of derivatives.
158 See rule 12d3–1(d)(7)(v) under the Act,
deeming an acquisition of demand features or
guarantees as not being the acquisition of securities
of a securities-related issuer provided certain
conditions are met.
159 See supra discussion at note 151.
160 2010 ABA Derivatives Report, supra note 8, at
33. The Report states that ‘‘counterparty exposure’’
presents ‘‘the concern that a counterparty cannot
pay a fund the amount that the fund is due under
the derivative instrument * * *.’’ Id.
161 Id. at 34–35.
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Federal Register / Vol. 76, No. 173 / Wednesday, September 7, 2011 / Rules and Regulations
V. Portfolio Concentration
In this section, the Commission
discusses the Investment Company
Act’s provisions regarding portfolio
‘‘concentration’’ and the application of
these provisions to a fund’s use of
derivatives.
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A. Investment Company Act Provisions
Regarding Portfolio Concentration
Funds are required to disclose in their
registration statements their policy
concerning ‘‘concentrating investments
in a particular industry or group of
industries.’’ 162 This requirement
reflects the view that such a policy is
likely to be central to a fund’s ability to
achieve its investment objectives, and
that a fund that concentrates its
investments will be subject to greater
risks than funds that do not follow the
policy.163 The concentration
requirements also are intended to
prevent funds from substantially
changing the nature and character of
their businesses without shareholder
approval.164 Funds are prohibited from
deviating from their policy concerning
‘‘concentration of investments in any
particular industry or groups of
industries’’ as recited in their
registration statements without
obtaining shareholder approval.165 The
Investment Company Act does not
include definitions of the terms
‘‘concentration’’ and ‘‘industry or
groups of industries.’’ The Commission
has stated generally that a fund is
concentrated in a particular industry or
group of industries if the fund invests or
proposes to invest more than 25% of the
value of its net assets in a particular
industry or group of industries.166 The
162 See Section 8(b)(1)(E) of the Act; Form N–1A,
Items 4, 9 (instruction 4) and 16(c)(1)(iv); and Form
N–2, Items 8.2.b(2) and 17.2.e.
163 Registration Form Used by Open-End
Management Investment Companies, Investment
Company Act Release No. 23064 (Mar. 13, 1998)
(‘‘Release 23064’’) [63 FR 13916 (Mar. 23, 1998)] at
nn. 98–99 and accompanying text.
164 See Jaretzki, supra note 131, at 317. The
concentration requirements focus on all of the
funds’ investments, and not solely on their
investments in securities.
165 Section 13(a)(3) of the Act. See also Securities
and Exchange Commission’s Brief Amicus Curiae
dated March 25, 2010, In re: Charles Schwab Corp.
Securities Litigation, Master File No. C–08–01510–
WHA (N.D. Cal.) (‘‘SEC Schwab Amicus Brief’’) at
2–3; In re: Charles Schwab Corp. Securities
Litigation, No. C 08–01510 WHA, 2010 U.S. Dist.
LEXIS 32113 (N.D. Cal. Mar. 30, 2010) (‘‘Schwab
Opinion’’) at *3–*4.
166 See also Form N–1A, Item 9, instruction 4
(defining industry concentration for Form N–1A
disclosure purposes as ‘‘investing more than 25%
of a Fund’s net assets in a particular industry or
group of industries’’); but compare Form N–2, Item
8.2.b (instruction) (defining industry concentration
for Form N–2 purposes as ‘‘25 percent or more of
the value of Registrant’s total assets invested or
proposed to be invested in a particular industry or
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Commission also has stated that, in
determining industry classifications, a
fund may select its own industry
classifications, but such classifications
must be reasonable and should not be so
broad that the primary economic
characteristics of the companies in a
single class are materially different.167
B. Issues Relating to the Application of
the Act’s Concentration Provisions to a
Fund’s Use of Derivatives
When a fund enters into a derivatives
transaction, the fund may gain exposure
to more than one industry or group of
industries. For example, if a fund and a
bank enter into a total return swap on
stock issued by a corporation in the
pharmaceuticals industry, the fund will
have gained exposure to the banking
industry (i.e., the industry associated
with the fund’s counterparty) as well as
exposure to the pharmaceuticals
industry (i.e., the industry associated
with the issuer of the reference asset).
As noted above, the Commission has
stated that generally a fund is
concentrated in a particular industry or
group of industries if the fund invests or
proposes to invest more than 25% of the
value of its net assets in a particular
industry or group of industries. This
standard does not, by its terms, address
derivative transactions by which a fund
obtains exposure to a particular industry
or group of industries, whether through
exposure to the counterparty to the
transaction or through its contractual
exposure to a reference asset.
Another issue relevant to determining
industry concentration is whether a
fund values its derivatives using
notional amount or market value. The
2010 ABA Derivatives Report states that
‘‘using the notional value, rather than
the market value, of a derivative
instrument may inflate an industry
position relative to the fund’s current
economic exposure.’’ 168 The 2010 ABA
Derivatives Report further states that
‘‘funds typically comply with their
group of industries’’). See also, e.g., Release No.
23064, supra note 163, (‘‘The Commission’s staff
has taken the position for purposes of the
concentration disclosure requirement that a fund
investing more than 25% of its assets in an industry
is concentrating in that industry.’’).
167 See SEC Schwab Amicus Brief, supra note
165, at 8 and 9. See also Schwab Opinion, supra
note 165, at *20 (‘‘This order agrees * * * that a
promoter is free to define an industry in any
reasonable way when it establishes a fund and
assumes for sake of argument that the promoter may
unilaterally, even after the fund is up and running,
clarify in a reasonable way a definitional line that
may otherwise be vague. But once the promoter has
drawn a clear line and thereafter gathers in the
savings of investors, the promoter must adhere to
the stated limitation unless and until changed by
a stockholder vote.’’)
168 2010 ABA Derivatives Report, supra note 8, at
n. 57.
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concentration policies by looking to the
reference asset and not any counterparty
to the derivative instrument. Funds
typically use market values for these
calculations * * *.’’ 169
C. Request for Comment
The Commission requests comment
on the application of concentration
requirements to funds’ investments in
derivatives, including the following
questions.
• How do funds apply the
concentration requirements to their
investments in derivatives? Do they
consider current market value or the
notional amount of a derivative (or some
other measure) for purposes of
determining whether they have invested
25% or more of the value of their net
assets in a particular industry or group
of industries? Do funds focus solely
upon the exposures to the industries
with which their derivatives
counterparties are associated, or do they
also take into account their exposures to
the industry or industries (if any) of the
reference assets underlying those
derivatives?
• Is it consistent with the policies and
purposes underlying the concentration
requirements for funds to focus on the
industry of the issuer of the reference
asset and disregard the exposure to the
industry or industries with which the
derivatives counterparty is associated?
Should this depend on the level of
collateral (if any) posted by the
counterparty?
• Should the Commission provide
guidance to funds on how they should
comply with the concentration
requirements when they use
derivatives? If so, what should that
guidance entail?
• Are there special considerations
that need to be taken into consideration
for smaller funds? How might taking
such considerations into account impact
investor protection?
VI. Valuation of Derivatives
In this section, the Commission
discusses, and requests comment on, the
valuation of derivatives used by funds
for purposes of applying the various
provisions of the Investment Company
Act.
A. Investment Company Act Valuation
Requirements
When calculating their NAVs, funds
must determine the value of their assets,
including the value of the derivatives
that they hold. The Investment
Company Act specifies how funds must
determine the value of their assets.
169 Id.
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Federal Register / Vol. 76, No. 173 / Wednesday, September 7, 2011 / Rules and Regulations
Under the Act, all funds (other than
money market funds),170 whether openend or closed-end, must calculate their
NAVs by using the market values of
their portfolio securities when market
quotations for those securities are
‘‘readily available.’’ 171 When market
quotations for a fund’s portfolio
securities or other assets are not readily
available, the fund must calculate its
NAV by using the fair value of those
securities or assets, as determined in
good faith by the fund’s board of
directors.172
There is no single methodology for
determining the fair value of a security
or other asset because fair value
depends upon the facts and
circumstances of each situation.173 As a
general principle, however, the fair
value of a security or other asset held by
a fund would be the amount that the
fund might reasonably expect to receive
for the security or other asset upon its
current sale.174 When determining the
fair value of a security or other asset
held by a fund, all indications of value
that are available must be taken into
account.175
jlentini on DSK4TPTVN1PROD with RULES
B. Application of the Valuation
Requirements to a Fund’s Use of
Derivatives
For many derivatives that are
securities, such as exchange-traded
options, market quotations typically are
readily available. As a result, a fund
generally must use market values to
value such derivatives. For many other
derivatives, however, market quotations
are not readily available, and a fund that
holds such derivatives is required to
value those derivatives at their fair
values as determined by the fund’s
board of directors.
Valuation of some derivatives may
present special challenges for funds.
Some derivatives may have customized
170 Money market funds that comply with the
provisions of rule 2a–7 under the Act [17 CFR
270.2a–7], however, may value their portfolio
securities on the basis of amortized cost. In
addition, under certain circumstances, open-end
funds may value certain of their portfolio securities
on the basis of amortized cost. See Valuation of
Debt Instruments by Money Market Funds and
Certain Other Open-End Investment Companies,
Investment Company Act Release No. 9786 (May
31, 1977) [42 FR 28999 (June 7, 1977)], available at
https://www.sec.gov/rules/interp/1977/ic-9786.pdf.
171 Section 2(a)(41)(B) of the Act. See also ASR
118 and ASR 113, supra note 14. ‘‘Readily
available’’ refers to public market quotations that
are current, i.e., ‘‘[r]eadily available market
quotations refers to reports of current public
quotations for securities similar in all respects to
the securities in question.’’ ASR 113, supra note 14,
at 2.
172 ASR 113, supra note 14.
173 ASR 118, supra note 14.
174 ASR 113 and ASR 118, supra note 14.
175 ASR 118, supra note 14.
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terms, including contractual restrictions
on their transferability. Some
derivatives also may restrict a fund’s
ability to close out the contract or to
enter into an offsetting transaction. For
some derivatives, there may be no
quotations available from independent
sources, and for some derivatives the
fund’s counterparty may be the only
available source of pricing information.
C. Request for Comment
The Commission requests comment
on funds’ valuation of derivatives,
including the following questions:
• How do funds determine the fair
values of derivatives that they hold? To
what extent do valuation determinations
depend upon the type of derivative,
reference asset, trading venue, and other
factors?
• How do funds, when fair valuing
derivatives, assess the accuracy and
reliability of pricing information that is
obtained from their counterparties or
from other sources?
• How do funds take into account,
when valuing derivatives, contractual
restrictions on transferability, and
restrictions on their ability to close out
the transactions or to enter into
offsetting transactions?
• Some derivatives held by funds
may have negative values due to, among
other things, changes in the value of the
reference assets underlying the
derivatives. Do funds calculate the
values of such derivatives in the same
manner as they value derivatives that
have positive values? If not, why not?
• Should the Commission issue
guidance on the fair valuation of
derivatives under the Investment
Company Act? If so, what issues should
be addressed by that guidance?
• Are there special considerations
that need to be taken into consideration
for smaller funds? How might taking
such considerations into account impact
investor protection?
VII. General Request for Comment
In addition to the specific issues
highlighted for comment, the
Commission invites members of the
public to address any other matters that
they believe are relevant to the use of
derivatives by funds.
Dated: August 31, 2011.
By the Commission.
Elizabeth M. Murphy,
Secretary.
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9546]
RIN 1545–BD04
Definition of Solid Waste Disposal
Facilities for Tax-Exempt Bond
Purposes; Correction
Internal Revenue Service (IRS),
Treasury.
ACTION: Correcting amendment.
AGENCY:
This document contains
corrections to final regulations (TD
9546) that were published in the
Federal Register on Friday, August 19,
2011, on the definition of solid waste
disposal facilities for purposes of the
rules applicable to tax-exempt bonds
issued by State and local governments.
These regulations provide guidance to
State and local governments that issue
tax-exempt bonds to finance solid waste
disposal facilities and to taxpayers that
use those facilities.
DATES: This correction is effective on
September 7, 2011 and is applicable
beginning October 18, 2011.
FOR FURTHER INFORMATION CONTACT:
Timothy Jones, (202) 622–3980 (not a
toll free number).
SUPPLEMENTARY INFORMATION:
SUMMARY:
Background
The final regulations that are the
subject of this document are under
section 142 of the Internal Revenue
Code.
Need for Correction
As published August 19, 2011 (76 FR
51879), the final regulations (TD 9546)
contain errors that may prove to be
misleading and are in need of
clarification.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
Correction of Publication
Accordingly, 26 CFR part 1 is
corrected by making the following
correcting amendments:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 continues to read in part as
follows:
■
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.142(a)(6)–1 is
amended by revising paragraph (c)(2)(v),
and the first sentence of paragraph (h),
Example 9 (ii) to read as follows:
■
[FR Doc. 2011–22724 Filed 9–6–11; 8:45 am]
BILLING CODE 8011–01–P
55255
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]]>Agencies
[Federal Register Volume 76, Number 173 (Wednesday, September 7, 2011)]
[Rules and Regulations]
[Pages 55237-55255]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-22724]
=======================================================================
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 271
[Release No. IC-29776; File No. S7-33-11]
RIN 3235-AL22
Use of Derivatives by Investment Companies Under the Investment
Company Act of 1940
AGENCY: Securities and Exchange Commission.
ACTION: Concept release; request for comments.
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SUMMARY: The Securities and Exchange Commission (the ``Commission'')
and its staff are reviewing the use of derivatives by management
investment companies registered under the Investment Company Act of
1940 (the ``Investment Company Act'' or ``Act'') and companies that
have elected to be treated as business development companies (``BDCs'')
under the Act (collectively, ``funds''). To assist in this review, the
Commission is issuing this concept release and request for comments on
a wide range of issues relevant to the use of derivatives by funds,
including the potential implications for fund leverage,
diversification, exposure to certain securities-related issuers,
portfolio concentration, valuation, and related matters. In addition to
the specific issues highlighted for comment, the Commission invites
members of the public to address any other matters that they believe
are relevant to the use of derivatives by funds. The Commission intends
to consider the comments to help determine whether regulatory
initiatives or guidance are needed to improve the current regulatory
regime for funds and, if so, the nature of any such initiatives or
guidance.
DATES: Comments should be received on or before November 7, 2011.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (https://www.sec.gov/rules/concept.shtml);
Send an e-mail to rule-comments@sec.gov; or
Use the Federal eRulemaking Portal (https://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-33-11. This file number
should be included on the subject line if comments are submitted by e-
mail. To help us process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (https://www.sec.gov/rules/concept.shtml). Comments are also available for public inspection and
copying in the Commission's Public Reference Room, 100 F Street, NE.,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. All comments received will be posted without change;
the Commission does not edit personal identifying information from
submissions. Therefore, you should only submit information that you
wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Edward J. Rubenstein, Senior Special
Counsel, or Michael S. Didiuk, Senior Counsel, at (202) 551-6825,
Office of Chief Counsel, Division of Investment Management, Securities
and Exchange Commission, 100 F Street, NE., Washington, DC 20549-5030.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Purpose and Scope of the Concept Release
B. Background Concerning the Use of Derivatives by Funds
C. Request for Comment
II. Derivatives Under the Senior Securities Restrictions of the
Investment Company Act
A. Purpose, Scope, and Application of the Act's Senior
Securities Limitations
1. Statutory Restrictions on Senior Securities and Related
Commission Guidance
2. Staff No-Action Letters Concerning the Segregated Account
Approach
B. Alternative Approaches to the Regulation of Portfolio
Leverage
1. The Current Asset Segregation Approach
2. Other Approaches
C. Request for Comment
1. Issues Concerning the Current Asset Segregation Approach
2. Alternatives to the Current Asset Segregation Approach
3. Related Matters
III. Derivatives Under the Investment Company Act's Diversification
Requirements
A. The Diversification Requirements
B. Application of the Diversification Requirements to a Fund's
Use of Derivatives
1. Valuation of Derivatives for Purposes of Determining a Fund's
Classification as Diversified or Non-Diversified
2. Identification of the Issuer of a Derivative for Purposes of
Determining a Fund's Classification as Diversified or Non-
Diversified
C. Request for Comment
IV. Exposure to Securities-Related Issuers Through Derivatives
A. Investment Company Act Limitations on Investing in
Securities-Related Issuers
B. Counterparty to a Derivatives Investment
C. Exposure to Other Securities-Related Issuers Through
Derivatives
D. Valuation of Derivatives for Purposes of Rule 12d3-1 Under
the Investment Company Act
E. Request for Comment
V. Portfolio Concentration
A. Investment Company Act Provisions Regarding Portfolio
Concentration
B. Issues Relating to the Application of the Act's Concentration
Provisions to a Fund's Use of Derivatives
C. Request for Comment
VI. Valuation of Derivatives
A. Investment Company Act Valuation Requirements
B. Application of the Valuation Requirements to a Fund's Use of
Derivatives
C. Request for Comment
VII. General Request for Comment
* * * * *
I. Introduction
The activities of funds, including their use of derivatives, are
regulated extensively under the Investment Company Act,\1\ Commission
rules, and Commission guidance.\2\ Derivatives may
[[Page 55238]]
be broadly described as instruments or contracts whose value is based
upon, or derived from, some other asset or metric (referred to as the
``underlier,'' ``underlying,'' or ``reference asset'').\3\ As detailed
below,\4\ funds employ derivatives for a variety of purposes, including
to increase leverage to boost returns, gain access to certain markets,
achieve greater transaction efficiency, and hedge interest rate,
credit, and other risks.\5\ At the same time, derivatives can raise
risk management issues for a fund relating, for example, to leverage,
illiquidity (particularly with respect to complex OTC derivatives), and
counterparty risk, among others.\6\
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\1\ 15 U.S.C. 80a. All statutory references to the Investment
Company Act are to 15 U.S.C. 80a, and, unless otherwise stated, all
references to rules under the Investment Company Act are to Title
17, Part 270 of the Code of Federal Regulations [17 CFR 270]. All
references to the Securities Act of 1933 (the ``Securities Act'')
are to 15 U.S.C. 77a, and, unless otherwise stated, all references
to rules under the Securities Act are to Title 17, Part 230 of the
Code of Federal Regulations [17 CFR 230]. All references to the
Securities Exchange Act of 1934 (the ``Exchange Act'') are to 15
U.S.C. 78a, and, unless otherwise stated, all references to rules
under the Exchange Act are to Title 17, Part 240 [17 CFR 240].
\2\ The staff has also issued no-action and other letters that
relate to fund use of derivatives. In addition to Investment Company
Act provisions, funds using derivatives must comply with all other
applicable statutory and regulatory requirements, such as other
Federal securities law provisions, the Internal Revenue Code (the
``IRC''), Regulation T of the Federal Reserve Board (``Regulation
T''), and the rules and regulations of the Commodity Futures Trading
Commission (the ``CFTC''). See also Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act, Public Law 111-203, 124
Stat. 1376 (2010) (the ``Dodd-Frank Act''), available at https://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.
\3\ See, e.g., Board Oversight of Derivatives, Independent
Directors Council Task Force Report (July 2008) (``2008 IDC
Report'') at 1, 3, available at https://www.ici.org/pdf/ppr_08_derivatives.pdf. See also Mutual Funds and Derivative Instruments,
Division of Investment Management Memorandum transmitted by Chairman
Levitt to Representatives Markey and Fields (Sept. 26, 1994) (``1994
Report'') at text accompanying n. 1 (``[t]he term `derivative' is
generally defined as an instrument whose value is based upon, or
derived from, some underlying index, reference rate (e.g., interest
rates or currency exchange rates), security, commodity, or other
asset.''), and at n. 2 (the ``term `derivative' generally is used to
embrace forward contracts, futures, swaps, and options''), available
at https://www.sec.gov/news/studies/deriv.txt; John C. Hull, Options,
Futures, and Other Derivatives (7th ed. 2009) (``Hull'') at 1, 779
(``A derivative can be defined as a financial instrument whose value
depends on (or derives from) the values of other, more basic
underlying variables,'' and a derivative is an ``instrument whose
price depends on, or is derived from, the price of another asset'')
(italics in original); rule 3b-13 under the Exchange Act, which
defines ``eligible OTC derivative instrument,'' and rule 16a-1(c)
under the Exchange Act, which defines ``derivative securities;''
section 5200(b) of the Revised Statutes of the United States [12
U.S.C. 84(b)] (as amended by section 610(a)(3) of the Dodd-Frank
Act, supra note 2), which defines a ``derivative transaction'' to
include ``any transaction that is a contract, agreement, swap,
warrant, note, or option that is based, in whole or in part, on the
value of, any interest in, or any quantitative measure or the
occurrence of any event relating to, one or more commodities,
securities, currencies, interest or other rates, indices, or other
assets.''
\4\ For a definition, and examples of types, of derivatives, see
infra Section I.B.
\5\ See 2008 IDC Report, supra note 3, at 8-11. See also infra
Section I.B.
\6\ See 2008 IDC Report, supra note 3, at 12-13. See also Mutual
Fund Derivative Holdings: Fueling the Need for Improved Risk
Management, JPMorgan Thought Magazine (Summer 2008) (``2008 JPMorgan
Article''), available at https://www.jpmorgan.com/cm/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1158494213964&blobheader=application%2Fpdf&blobnocache=true&blobheadername1=Content.
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The dramatic growth in the volume and complexity of derivatives
investments over the past two decades, and funds' increased use of
derivatives,\7\ have led the Commission and its staff to initiate a
review of funds' use of derivatives under the Investment Company
Act.\8\ The staff generally has been exploring the benefits, risks, and
costs associated with funds' use of derivatives. The staff also has
been exploring issues relating to the use of derivatives by funds such
as: whether current market practices involving derivatives are
consistent with the leverage, concentration, and diversification
provisions of the Investment Company Act; whether funds that rely
substantially upon derivatives, particularly those that seek to provide
leveraged returns, maintain and implement adequate risk management and
other procedures in light of the nature and volume of their derivatives
investments; whether funds' boards of directors are providing
appropriate oversight of the use of derivatives by the funds; whether
existing rules sufficiently address matters such as the proper
procedures for a fund's pricing and liquidity determinations regarding
its derivatives holdings; whether existing prospectus disclosures
adequately address the particular risks created by derivatives; and
whether funds' derivative activities should be subject to any special
reporting requirements.
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\7\ While complete data concerning the nature of derivatives
activities of funds is unavailable, for a partial snapshot of
derivatives activity by selected fund complexes see Commodity Pool
Operators and Commodity Trading Advisors: Amendments to Compliance
Obligations, Investment Company Institute (``ICI'') Comment Letter
to the CFTC at 18 (Apr. 12, 2011), available at https://www.ici.org/pdf/25107.pdf. See also, e.g., Tim Adam and Andre Guettler, The Use
of Credit Default Swaps by U.S. Fixed-Income Mutual Funds, FDIC Ctr.
for Fin. Research, Working Paper No. 2011-01, (Nov. 19, 2010)
(``Adam and Guettler Article''), available at https://www.fdic.gov/bank/analytical/cfr/2011/wp2011/CFR_WP_2011_01.pdf (study of the
use of credit default swaps (``CDS'') by the largest 100 U.S.
corporate bond funds between 2004 and 2008 reflects an increase from
about 20% of funds using credit default swaps in 2004 to 60% of
funds using them in 2008; among CDS users, the average size of CDS
positions (measured by their notional values) increased from 2% to
almost 14% of a fund's NAV over the same period, with the CDS
positions representing less than 10% of NAV for most funds, but with
some funds exceeding this level by a wide margin, particularly in
2008; CDS are predominantly used to increase a fund's exposure to
credit risks (net sellers of CDS) rather than to hedge credit risk
(net buyers); the frequency of credit default swap usage by the
largest bond funds is comparable to that of most hedge funds),
available at https://www.fdic.gov/bank/analytical/cfr/2011/wp2011/CFR_WP_2011_01.pdf; Assess the Risks: Key Strategies for
Overseeing Derivatives, Board IQ at 1 (Jan. 15, 2008) (``In recent
years, the use of derivatives by mutual funds has soared.''),
available at https://www.interactivedata.com/uploads/BoardIQ1207.pdf;
2008 JPMorgan Article, supra note 6.
\8\ In a press release issued in March 2010, the Commission
announced that the staff was conducting a review to evaluate the use
of derivatives by mutual funds, registered exchange-traded funds
(``ETFs''), and other investment companies. The press release
indicated that the review would examine whether and what additional
protections are necessary for those funds under the Investment
Company Act. The press release further indicated that pending
completion of this review, the staff would defer consideration of
exemptive requests under the Act relating to ETFs that would make
significant investments in derivatives. See SEC Press Release 2010-
45, SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25,
2010) (``2010 Derivatives Press Release''), available at https://www.sec.gov/news/press/2010/2010-45.htm. As part of the staff's
review to evaluate fund use of derivatives, and to further enhance
its knowledge of how funds are using, and managing their use of,
derivatives, the staff met with industry groups as well as with some
fund complexes that use OTC derivatives. The staff also reviewed
fund disclosures relating to the use of derivatives and their risks.
In addition, the staff considered The Report 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) (``2010 ABA Derivatives Report''), available at https://meetings.abanet.org/webupload/commupload/CL410061/sitesofinterest_files/DerivativesTF_July_6_2010_final.pdf.
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A. Purpose and Scope of the Concept Release
The goal of the Commission's and staff's review is to evaluate
whether the regulatory framework, as it applies to funds' use of
derivatives, continues to fulfill the purposes and policies underlying
the Act and is consistent with investor protection. The purpose of this
concept release is to assist with this review and solicit public
comment on the current regulatory regime under the Act as it applies to
funds' use of derivatives. We intend to use the comments to help
determine whether regulatory initiatives or guidance are needed to
improve the current regulatory regime and the specific nature of any
such initiatives.\9\
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\9\ Section 2(c) of the Investment Company Act provides that
``[w]henever pursuant to this title the Commission is engaged in
rulemaking and is required to consider or determine whether an
action is consistent with the public interest, the Commission shall
also consider, in addition to the protection of investors, whether
the action will promote efficiency, competition, and capital
formation.''
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A fund that invests in derivatives must take into consideration
various provisions of the Investment Company Act and Commission rules
under the Act. The fund must consider the leverage limitations of
section 18 of the Investment Company Act, which governs the extent to
which a fund may issue ``senior securities.'' \10\ A fund's use of
derivatives also may raise issues
[[Page 55239]]
under Investment Company Act provisions governing diversification,\11\
concentration,\12\ investing in certain types of securities-related
issuers,\13\ valuation,\14\ and accounting and financial statement
reporting,\15\ among others,\16\ as well as under applicable disclosure
provisions.\17\
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\10\ See sections 18(a)(1) and 18(f)(1) of the Investment
Company Act. See also Securities Trading Practices of Registered
Investment Companies, Investment Company Act Release No. 10666 (Apr.
18, 1979) (``Release 10666'') [44 FR 25128 (Apr. 27, 1979)], and
Registered Investment Company Use of Senior Securities-Select
Bibliography (``Senior Security Bibliography''), available at https://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm
(prepared by the staff). See also discussion infra at Section II.
(Derivatives under the Senior Securities Restrictions of the
Investment Company Act).
\11\ See sections 5(b)(1) and 13(a)(1) of the Investment Company
Act. See also infra discussion at Section III. (Derivatives under
the Investment Company Act's Diversification Requirements).
\12\ See sections 8(b)(1)(E) and 13(a)(3) of the Investment
Company Act. See also Form N-1A, Item 4(a), instruction 4 to Item
9(b)(1), and Item 16(c)(1)(iv); Form N-2, Item 8.2.b (2), and Item
17.2.e. See also infra discussion at Section V. (Portfolio
Concentration).
\13\ See section 12(d)(3) of the Investment Company Act and rule
12d3-1 thereunder. See also infra discussion at Section IV.
(Exposure to Securities-Related Issuers Through Derivatives).
\14\ See section 2(a)(41) of the Investment Company Act. See
also Restricted Securities, Investment Company Act Release No. 5847
(Oct. 21, 1969) [35 FR 19989 (Dec. 31, 1970)] (``ASR 113''),
available at https://www.sec.gov/rules/interp/1969/ic-5847.pdf;
Accounting for Investment Securities by Registered Investment
Companies, Investment Company Act Release No. 6295 (Dec. 23, 1970)
[35 FR 19986 (Dec. 31, 1970)] (``ASR 118''), available at https://www.sec.gov/rules/interp/1970/ic-6295.pdf. See also infra discussion
at Section VI. (Valuation of Derivatives).
\15\ See generally section 30(e) of the Investment Company Act.
\16\ See, e.g., Investment Company Act provisions relating to
custody (section 17(f) and related rules), and fund names (section
35(d) and rule 35d-1). Also, an open-end fund should consider the
effect that the use of derivatives may have on the liquidity of the
fund's portfolio. For general guidance on liquidity and open-end
funds, see, e.g., Resale of Restricted Securities; Changes to Method
of Determining Holding Period of Restricted Securities Under Rules
144 and 145, Investment Company Act Release No. 17452 (Apr. 23,
1990) [55 FR 17933 (Apr. 30, 1990)], available at https://www.sec.gov/rules/final/1990/33-6862.pdf. See also Revisions of
Guidelines, Investment Company Act Release No. 18612 (Mar. 12, 1992)
[57 FR 9828 (Mar. 20, 1992)], available at https://www.sec.gov/rules/other/1992/33-6927.pdf.
\17\ See, e.g., section 8(b) of the Investment Company Act, and
Items 4(a), 4(b), 9(b), 9(c), and 16(b) of Form N-1A. Certain
derivatives-related disclosure issues were discussed in a 2010 staff
letter to the ICI. See Derivatives-Related Disclosures by Investment
Companies, Letter from Barry D. Miller, Associate Director, Division
of Investment Management, U.S. Securities and Exchange Commission,
to Karrie McMillan, General Counsel, ICI (July 30, 2010) (``2010
Staff Derivatives Disclosure Letter''), available at https://www.sec.gov/divisions/investment/guidance/ici073010.pdf.
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Derivatives generally entail the potential for leveraged future
gains and/or losses that may significantly impact the overall risk/
reward profile of a fund. Applying the Act's provisions relating to
diversification, concentration, and investments in securities-related
issuers, among others, may require determining what value to assign to
the derivative and which of the derivative's multiple exposures should
be measured for purposes of the relevant provision. This determination
may be complex because there are at least two potential measures of the
``value'' \18\ of a derivative for purposes of applying various
provisions of the Act: the current market value or fair value
reflecting the price at which the derivative could be expected to be
liquidated; and the notional amount reflecting the contract size
(number of units per contract) multiplied by the current unit price of
the reference asset on which payment obligations are calculated.\19\ In
addition, derivatives often create exposures to multiple variables,
such as the credit of a counterparty as well as to a reference asset on
which the derivative is based.
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\18\ The Bank for International Settlements (the ``BIS'')
reports gross market values (positive and negative) for open
derivative contracts, which are defined as ``the sums of the
absolute values of all open contracts with either positive or
negative replacement values evaluated at market prices prevailing at
the reporting date. Thus, the gross positive market value of a
dealer's outstanding contracts is the sum of the replacement values
of all contracts that are in a current gain position to the reporter
at current market prices * * * The gross negative market value is
the sum of the values of all contracts that have a negative value on
the reporting date * * *.'' Guide to the International Financial
Statistics, Bank for International Settlements (July 2009) (``BIS
Guide'') at 31, available at https://www.bis.org/statistics/intfinstatsguide.pdf. See also Sarah Sharer Curley and Elizabeth
Fella, Where to Hide? How Valuation of Derivatives Haunts the
Courts--Even After BAPCPA, 83 Am. Bankr. L.J. 297, 298-99 (Spring
2009) (``In a simple interest rate swap * * * [t]he value of the
swap is the net difference between the present value of the payments
each party expects to receive and the present value of the payments
each party expects to make. The value is generally zero to each
party at the inception of the swap, and becomes positive to one
party and negative to the other depending on what direction the
interest rates move.''); CFTC Glossary, Mark-to-Market Definition,
available at https://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/index.htm (stating that marking to market is
accomplished for a futures or option contract by ``calculating the
gain or loss in each contract position resulting from changes in the
price of the contracts at the end of each trading session. These
amounts are added or subtracted to each account balance.'').
\19\ The BIS describes ``notional amounts outstanding'' as ``a
reference from which contractual payments are determined in
derivatives markets.'' BIS Guide, supra note 18, at 30. ``Notional
value'' can be defined as ``the value of a derivative's underlying
assets at the spot price.'' In the case of an options or futures
contract, the notional value is the number of units of an asset
underlying the contract, multiplied by the spot price of the asset.
See https://www.investorwords.com/5930/notional-value.htm. The ``spot
price'' of a derivative's underlying asset is the asset's price for
immediate delivery, i.e., in the current market, in contrast with
the asset's future or forward price. See, e.g., Hull, supra note 3,
at 789. ``Notional value'' is also defined as ``the underlying value
(face value), normally expressed in U.S. dollars, of the financial
instrument or commodity specified in a futures or options on futures
contract.'' See CME Group Glossary, available at https://www.cmegroup.com/education/glossary.html. `` `Notional principal' or
`notional amount' of a derivative contract is a hypothetical
underlying quantity upon which interest rate or other payment
obligations are computed.'' ISDA Online Product Descriptions and
Frequently Asked Questions at https://www.isda.org/educat/faqs.html#7. See also Hull, supra note 3, at 786 (``Notional
principal'' is the ``principal used to calculate payments in an
interest rate swap. The principal is `notional' because it is
neither paid nor received''); Frank J. Fabbozzi, et al.,
Introduction to Structured Finance, at 27 (2006) (``[In an interest
rate swap] [t]he dollar amount of the interest payments exchanged is
based on some predetermined dollar principal, which is called the
notional amount.'') (italics in original); 2010 ABA Derivatives
Report, supra note 8, at n.11 (noting that the term ``notional
amount'' is used differently by different people in different
contexts, but is used, in the Report, to refer to ``the nominal or
face amount that is used to calculate payments made on a particular
instrument, without regard to whether its obligation under the
instrument could be netted against the obligation of another party
to pay the fund under the instrument.'').
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The Commission or its staff, over the years, has addressed a number
of issues relating to derivatives on a case-by-case basis. The
Commission now seeks to take a more comprehensive and systematic
approach to derivatives-related issues under the Investment Company
Act. In particular, in this release the Commission discusses and seeks
comment on the following issues, among others, relating to funds' use
of derivatives: \20\
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\20\ The Commission recognizes that there are other significant
derivatives-related issues under the Investment Company Act that
this release does not address, such as disclosure-related issues,
which the Commission may consider at a later date.
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The attendant costs, benefits and risks;
The application of the Act's prohibitions and restrictions
on senior securities and leverage;
The application of the Act's prohibition on investments in
securities-related issuers;
The application of the Act's provisions concerning
portfolio diversification and concentration; and
The application of the Act's provisions governing
valuation of funds' assets.
In addition to the specific issues highlighted for comment, the
Commission invites members of the public to address any other matters
that they believe are relevant to the use of derivatives by funds.
B. Background Concerning the Use of Derivatives by Funds
As noted above, derivatives may be broadly defined to include
instruments or contracts whose value is based upon, or derived from,
some reference asset. Reference assets can include, for example,
stocks, bonds, commodities, currencies, interest rates, market indices,
currency exchange rates, or other assets or interests, in virtually
endless variety.\21\
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\21\ For example, the reference asset of a Standard & Poor's
(``S&P'') 500 futures contract is the S&P 500 index. 2008 IDC
Report, supra note 3, at Appendix C at C5.
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[[Page 55240]]
Derivatives are often characterized as either exchange-traded or
OTC.\22\ Exchange-traded derivatives--such as futures, certain
options,\23\ and options on futures \24\--are standardized contracts
traded on regulated exchanges, such as the Chicago Mercantile Exchange
and the Chicago Board Options Exchange. OTC derivatives--such as
swaps,\25\ non-exchange traded options, and combination products such
as swaptions \26\ and forward swaps \27\--are contracts negotiated and
entered into outside of an organized exchange. Unlike exchange-traded
derivatives, OTC derivatives may be significantly customized, and may
not be guaranteed by a central clearing organization. OTC derivatives
that are not centrally cleared, therefore, may involve greater
counterparty credit risk, and may be more difficult to value, transfer,
or liquidate than exchange-traded derivatives.\28\ The Dodd-Frank Act
and Commission rules thereunder seek to establish a comprehensive new
regulatory framework for two broad categories of derivatives--swaps and
security-based swaps--designed to reduce risk, increase transparency,
and promote market integrity within the financial system.\29\
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\22\ See, e.g., Robert W. Kolb & James A. Overdahl, Financial
Derivatives, at 21 (2010) (``Kolb & Overdahl'').
\23\ An option is the right to buy or sell an asset. There are
two basic types of options, a ``call option'' and a ``put option.''
A call option gives the holder the right (but does not impose the
obligation) to buy the underlying asset by a certain date for a
certain price. The seller, or ``writer,'' of a call option has the
obligation to sell the underlying asset to the holder if the holder
exercises the option. A put option gives the holder the right (but
does not impose the obligation) to sell the underlying asset by a
certain date for a certain price. The seller, or ``writer'', of a
put option has the obligation to buy from the holder the underlying
asset if the holder exercises the option. The price that the option
holder must pay to exercise the option is known as the ``exercise''
or ``strike'' price. The amount that the option holder pays to
purchase an option is known as the ``option premium,'' ``price,''
``cost,'' or ``fair value'' of the option. For a basic explanation
of options, see, e.g., Hull, supra note 3, at 6-8, 179-236, and Kolb
& Overdahl, supra note 22, at 13-16.
\24\ Options on futures generally trade on the same exchange as
the relevant futures contract. When a call option on a futures
contract is exercised, the holder acquires from the writer a long
position in the underlying futures contract plus a cash amount equal
to the excess of the futures price over the strike price. When a put
option on a futures contract is exercised, the holder acquires a
short position in the underlying futures contract plus a cash amount
equal to the excess of the strike price over the futures price. See,
e.g., Hull, supra note 3, at 184, 341-54, and 782.
\25\ A ``swap'' is generally an agreement between two
counterparties to exchange periodic payments based upon the value or
level of one or more rates, indices, assets, or interests of any
kind. For example, counterparties may agree to exchange payments
based on different currencies or interest rates. See generally,
e.g., Kolb & Overdahl, supra note 22, at 11-13; Hull, supra note 3,
at 147-73. See also section 3(a)(69) of the Exchange Act for the
definition of ``swap'' (using the definition in section 1a of the
Commodity Exchange Act, 7 U.S.C. 1a (the ``CEA'')); section 3(a)(68)
of the Exchange Act for the definition of ``security-based swap;''
section 721(a)(3) of the Dodd-Frank Act, supra note 2, for the
definition of ``cleared swap;'' and section 721(a)(12) of the Dodd-
Frank Act for the definition of ``foreign exchange swap.'' See also
Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement;'' Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, Securities Act Release No. 9204 (Apr. 29,
2011) [76 FR 29818 (May 23, 2011)] (``Swap Definition Release''),
available at https://www.sec.gov/rules/proposed/2011/33-9204.pdf.
\26\ A ``swaption'' is an option to enter into an interest rate
swap where a specified fixed rate is exchanged for a floating rate.
See, e.g., Hull, supra note 3, at 172, 658-62, 790.
\27\ A forward swap (or deferred swap) is an agreement to enter
into a swap at some time in the future. See Swap Definition Release,
supra note 25, at n. 147. See also, e.g., Hull, supra note 3, at
171, 779 (``deferred swap'').
\28\ An OTC derivative may be more difficult to transfer or
liquidate than an exchange-traded derivative because, for example,
an OTC derivative may provide contractually for non-transferability
without the consent of the counterparty, or may be sufficiently
customized that its value is difficult to establish or its terms too
narrowly drawn to attract transferees willing to accept assignment
of the contract, unlike most exchange-traded derivatives.
\29\ The Dodd-Frank Act, supra note 2, was signed into law on
July 21, 2010. The Dodd-Frank Act mandates, among other things,
substantial changes in the OTC derivatives markets, including new
clearing, reporting, and trade execution mandates for swaps and
security-based swaps, and both exchange-traded and OTC derivatives
are contemplated under the new regime. See Dodd-Frank Act sections
723 (mandating clearing of swaps) and 763 (mandating clearing of
security-based swaps). Some of these changes will require Commission
action through rulemaking to become effective. See Temporary
Exemptions and Other Temporary Relief, Together With Information on
Compliance Dates for New Provisions of the Securities Exchange Act
of 1934 Applicable to Security-Based Swaps, Exchange Act Release No.
64678 (June 15, 2011) [76 FR 36287 (June 22, 2011)], available at
https://www.sec.gov/rules/exorders/2011/34-64678.pdf. For summaries
of other recent, pending, and future Commission and staff
initiatives relating to derivatives, see, e.g., Testimony on
Enhanced Oversight after the Financial Crisis: The Wall Street
Reform Act at One-Year, by Chairman Mary L. Schapiro, Chairman, U.S.
Securities and Exchange Commission, before the United States Senate
Committee on Banking, Housing and Urban Affairs (July 21, 2011),
available at https://www.sec.gov/news/testimony/2011/ts072111mls.htm.
See also, e.g., https://www.sec.gov/spotlight/dodd-frank/accomplishments.shtml#derivatives; https://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#07-12-12; https://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#08-12-11; https://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#01-06-12;
https://www.sec.gov/news/press/2011/2011-137.htm; https://www.sec.gov/rules/other/2011/34-64926.pdf; and https://www.sec.gov/spotlight/dodd-frank/derivatives.shtml.
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A common characteristic of most derivatives is that they involve
leverage.\30\ Certain derivatives investments entered into by a fund,
such as futures contracts, swaps, and written options, create
obligations, or potential indebtedness, to someone other than the
fund's shareholders, and enable the fund to participate in gains and
losses on an amount that exceeds the fund's initial investment.\31\
Other derivatives entered into by a fund, such as purchased call
options, provide the economic equivalent of leverage because they
convey the right to a gain or loss on an amount in excess of the fund's
investment but do not impose a payment obligation on the fund above its
initial investment.\32\
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\30\ The Commission has stated that ``[l]everage exists when an
investor achieves the right to a return on a capital base that
exceeds the investment which he has personally contributed to the
entity or instrument achieving a return.'' Release 10666, supra note
10, at n. 5.
\31\ The leverage created by such an arrangement is sometimes
referred to as ``indebtedness leverage.'' 1994 Report, supra note 3,
at 22.
\32\ This type of leverage is sometimes referred to as
``economic leverage.'' See 1994 Report, supra note 3, at 23 (``Other
derivatives provide the economic equivalent of leverage because they
display heightened price sensitivity to market fluctuations * * *
such as changes in stock prices or interest rates. In essence, these
derivatives magnify a fund's gain or loss from an investment in much
the same way that incurring indebtedness does.''). The 1994 Report
gives a leveraged inverse floating rate bond, with an interest rate
that moves inversely to a benchmark rate, as another example of an
instrument that displays economic leverage. See also 2010 ABA
Derivatives Report, supra note 8, at 20-21 (discussion of
``implied'' or ``economic'' leverage''). For additional discussion
of the leveraging effects of derivatives (not limited to ``economic
leverage''), see 2010 ABA Derivatives Report, supra note 8, at 8-9.
See also 2008 IDC Report, supra note 3, at 3 (``Market participants
are able to acquire exposure (either long or short) to a large
dollar amount of an asset (the notional value) with only a small
down payment, enabling parties to shift risk more efficiently and
with lower costs. The leverage inherent in these instruments
magnifies the effect of changes in the value of the underlying asset
on the initial amount of capital invested. For example, an initial
5% collateral deposit on the total value of the commodity would
result in 20:1 leverage, with a potential 80% loss (or gain) of the
collateral in response to a 4% movement in the market price of the
underlying commodity.'').
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Funds use derivatives to implement their investment strategies, and
to manage risk.\33\ A fund may use derivatives to gain, maintain, or
reduce exposure to a market, sector, or security more quickly and/or
with lower transaction costs and portfolio
[[Page 55241]]
disruption than investing directly through the securities markets. At
the same time, use of derivatives may entail risks relating, for
example, to leverage, illiquidity (particularly with respect to complex
OTC derivatives), and counterparty risk, among others.\34\ A fund's use
of derivatives presents challenges for its investment adviser and board
of directors to ensure that the derivatives are employed in a manner
consistent with the fund's investment objectives, policies, and
restrictions, its risk profile, and relevant regulatory requirements,
including those under Federal securities laws. With respect to some
primary types of reference assets, funds may use derivatives for the
following purposes, among others:
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\33\ 2008 IDC Report, supra note 3, at 7-11. A fund may also use
derivatives to hedge current portfolio exposures (for example, when
a fund's portfolio is structured to reflect the fund's long-term
investment strategy and its investment adviser's forecasts, interim
events may cause the fund's investment adviser to seek to
temporarily hedge a portion of the portfolio's broad market, sector,
and/or security exposures). Industry participants believe that
derivatives may also provide a more efficient hedging tool than
reducing exposure by selling individual securities, offering greater
liquidity, lower round-trip transaction costs, lower taxes, and
reduced disruption to the portfolio's longer-term positioning. See
id. at 11.
\34\ See, e.g., 2008 IDC Report, supra note 3, at 12-13. See
also 2008 JPMorgan Article, supra note 6.
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Currency derivatives. \35\ A fund may use currency
derivatives to increase or decrease exposure to specific currencies, to
hedge against adverse impacts on the fund's portfolio caused by
currency fluctuations, and to seek additional returns. For example,
currency derivatives can provide a hedge against the risk that a fund's
investment in a foreign debt security will decline in value because of
a decline in the value of the foreign currency in which the foreign
debt security is denominated.\36\ Funds also may use currency
derivatives to hedge against a rise in the value of a foreign currency,
or may use ``cross-currency'' hedging or ``proxy'' hedging when, for
instance, it is difficult or expensive to hedge a particular currency
against the U.S. dollar.\37\ Apart from hedging, funds may use currency
derivatives to seek returns on the basis of anticipated changes in the
relative values of two currencies.\38\
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\35\ See Swap Definition Release, supra note 25, at II.C.1, for
a description of certain currency derivatives (foreign exchange
swaps, foreign exchange forwards, foreign currency options, non-
deliverable forwards, currency swaps, and cross-currency swaps). The
2010 ABA Derivatives Report, supra note 8 at 6-7, gives as examples
of currency derivatives forward currency contracts, currency futures
contracts, currency swaps, and options on currency futures
contracts. As a general matter, futures, forwards, swaps, and
options can all be used to increase or decrease exposures to
reference currencies. A fund's investment adviser selects the
particular instrument based on the level and type of exposure the
adviser seeks to obtain and the costs that are associated with the
particular instrument.
\36\ For example, if a fund enters into a short currency forward
(which obligates the fund to sell the currency at a future date, at
a predetermined price, and in the currency in which the foreign debt
security is denominated), the fund's exposure to a decline in the
value of the currency is reduced. See 2010 ABA Derivatives Report,
supra note 8, at 6.
\37\ For example, a fund may use a forward contract on one
foreign currency (or a basket of foreign currencies) to hedge
against adverse changes in the value of another foreign currency (or
basket of currencies). See id.
\38\ Id. at 7.
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Interest rate derivatives.\39\ A fund may use interest
rate derivatives to modify its exposure to the gains or losses arising
from changes in interest rates and to seek enhanced returns. For
example, a fund may use an interest rate swap to hedge against the risk
of a decline in the prices of bonds owned by a fund due to rising
interest rates. Similarly, a fund could shorten the duration of its
portfolio by selling futures contracts on U.S. Treasury bonds or notes,
or Eurodollar futures. Apart from hedging, a fund might use interest
rate derivatives to seek to enhance its returns based on its investment
adviser's views concerning future movements in interest rates or
changes in the shape of the yield curve.\40\
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\39\ Interest rate derivatives include interest rate or bond
futures, Eurodollar futures, caps, floors, overnight indexed swaps,
interest rate swaps, and options on futures and swaps. See, e.g.,
id. See also Swap Definition Release, supra note 25, at III.B.1
(briefly describing interest and other monetary rate swaps, and
discussing that when payments exchanged under a Title VII (of the
Dodd-Frank Act) instrument are based solely on the levels of certain
interest rates or other monetary rates that are not themselves based
on securities, the instrument would be a swap but not a security-
based swap).
\40\ For example, if a fund's investment adviser believes that
the London Interbank Offered Rate (``LIBOR'') will decrease compared
to a Federal funds rate, the adviser could enter into an interest
rate swap whereby the fund would be obligated to make payments based
upon the application of LIBOR to an agreed notional amount in
exchange for payments from the counterparty based upon the
application of the Federal funds rate to the notional amount. 2010
ABA Derivatives Report, supra note 8, at 7.
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Credit Derivatives.\41\ Credit derivatives allow a fund to
assume an investment position concerning the likelihood that a
particular bond, or a group of bonds, will be repaid in full upon
maturity. When a fund purchases credit protection, it pays a premium to
a counterparty in return for which the counterparty promises to pay the
fund if a bond or bonds default or experience some other adverse credit
event. When a fund sells (or writes) credit protection, the fund agrees
to pay a counterparty if a bond or bonds default or experience some
other adverse credit event, in exchange for the receipt of a premium
from the protection purchaser. A fund may purchase credit protection
using credit derivatives to hedge against particular risks that are
associated with a bond that it owns, such as the risk that the bond
issuer will default, a rating agency will downgrade the bond or the
credit of the counterparty, or the risk that credit ``spread'' will
increase.\42\ A fund may sell (or write) credit protection to enhance
its income and return by the amount of the payment that it receives for
providing such protection, or to obtain some investment exposure to the
reference asset (that is, the underlying bond), without owning the
bond. The Commission understands that selling protection may be more
cost effective than an outright purchase of a bond.\43\
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\41\ Credit derivatives include single-name and index-linked (or
basket) credit default swaps. See, e.g., id. at 7-8. For additional
description of CDS, see Swap Definition Release, supra note 25, at
III.G.3.
\42\ See 2010 ABA Derivatives Report, supra note 8, at 7.
\43\ See id. at 8. The 2010 ABA Derivatives Report, supra note
8, at 8, also observes that ``a fund could write a CDS, offering
credit protection to its counterparty. In doing so the fund gains
the economic equivalent of owning the security on which it wrote the
CDS, while avoiding the transaction costs that would have been
associated with the purchase of the security.''
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Equity Derivatives.\44\ Funds may use equity derivatives
to enhance investment opportunities (for example, by using foreign
index futures to obtain exposure to a foreign equity market). Equity
derivatives also can be used by funds as an income-producing strategy
by, for example, selling equity call options on a particular security
owned by the fund.\45\ A fund also may use equity derivatives (usually
stock index futures) to ``equitize'' cash.\46\
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\44\ Equity derivatives include equity futures contracts,
options on equity futures contracts, equity options, and various
kinds of equity-related swaps (such as a total return swap on an
equity security). See, e.g., id. at 8.
\45\ By selling the options, a fund can earn income (in the form
of the premium received for writing the option) while at the same
time permitting the fund to sell the underlying equity securities at
a targeted price set by the fund's investment adviser. See, e.g.,
id.
\46\ As an example of ``equitizing'' cash, the 2010 ABA
Derivatives Report, supra note 8, at 8, states that:
[W]hen a fund has a large cash position for a short amount of
time, the fund can acquire long futures contracts to retain (or
gain) exposure to the relevant equity market. When the futures
contracts are liquid (as is typically the case for broad market
indices), the fund can eliminate the position quickly and frequently
at lower costs than had the fund actually purchased the reference
equity securities.
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C. Request for Comment
The Commission generally requests data and comment on the types of
derivatives used by funds, the purposes for which funds use
derivatives, and whether funds' use of derivatives has undergone or may
be undergoing changes and, if so, the nature of such changes. The
Commission specifically requests comment on the following:
What are the costs and benefits to funds from the use of
derivatives? What are the factors that influence those costs and
benefits? What are the risks to funds
[[Page 55242]]
from investing in derivatives? What role does or could collateral used
in derivatives transactions play in mitigating the concerns relating to
the use of derivatives? Please be specific and provide data or
statistics, if possible.
Do different types of funds use different types of
derivatives or use derivatives for different purposes? If so, what are
the differences in the types of funds that account for the differences
in their use of derivatives? For example, do BDCs use derivatives in a
manner different from other funds and, if so, how and what are the
differences?
How do ETFs use derivatives? Do they use derivatives for
the same purposes that other open-end funds use them? Does an ETF's use
of derivatives raise unique investor protection concerns under the
Investment Company Act?
II. Derivatives under the Senior Securities Restrictions of the
Investment Company Act
In this section, the Commission discusses the limitations on senior
securities imposed by section 18 of the Investment Company Act,
summarizes related Commission and staff guidance, discusses certain
alternative approaches, and highlights issues for comment.
A. Purpose, Scope, and Application of the Act's Senior Securities
Limitations
1. Statutory Restrictions on Senior Securities and Related Commission
Guidance
The protection of investors against the potentially adverse effects
of a fund's issuance of ``senior securities'' \47\ is a core purpose of
the Investment Company Act.\48\ Congress' concerns underlying the
limitations in section 18 included, among others: (i) Potential abuse
of the purchasers of senior securities; \49\ (ii) excessive borrowing
and the issuance of excessive amounts of senior securities by funds
which increased unduly the speculative character of their junior
securities; \50\ and (iii) funds operating without adequate assets and
reserves.\51\ To address these concerns, section 18(f)(1) of the
Investment Company Act prohibits an open-end fund \52\ from issuing or
selling any ``senior security'' other than borrowing from a bank, and
unless it maintains 300% ``asset coverage.'' \53\ Section 18(a)(1) of
the Investment Company Act prohibits a closed-end fund \54\ from
issuing or selling any ``senior security that represents an
indebtedness'' unless it has at least 300% ``asset coverage.'' \55\
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\47\ Section 18(g) of the Investment Company Act defines
``senior security,'' in part, as ``any bond, debenture, note, or
similar obligation or instrument constituting a security and
evidencing indebtedness,'' and ``any stock of a class having
priority over any other class as to the distribution of assets or
payment of dividends.'' The definition excludes certain limited
temporary borrowings.
\48\ See, e.g., Investment Company Act sections 1(b)(7),
1(b)(8), 18(a), and 18(f). See also, e.g., 1994 Report, supra note
3, at 20-22.
\49\ See Investment Trusts and Investment Companies: Hearings on
S. 3580 Before a Subcomm. of the Senate Committee on Banking and
Currency, 76th Cong., 3d Sess., pt. 1, 265-78 (1940) (``Senate
Hearings''). See also 1994 Report, supra note 3, at 21 (describing
the practices in the 1920s and 1930s that gave rise to section 18's
limitations on leverage, and specifically discussing the potential
abuse of senior security holders).
\50\ See section 1(b)(7) of the Investment Company Act. See
also, e.g., Release 10666, supra note 10, at n. 8.
\51\ See section 1(b)(8) of the Investment Company Act; Release
10666, supra note 10, at n. 8.
\52\ Section 5(a)(1) of the Investment Company Act defines
``open-end company'' as ``a management company which is offering for
sale or has outstanding any redeemable security of which it is the
issuer.''
\53\ ``Asset coverage'' of a class of securities representing
indebtedness of an issuer generally is defined in section 18(h) of
the Investment Company Act as ``the ratio which the value of the
total assets of such issuer, less all liabilities and indebtedness
not represented by senior securities, bears to the aggregate amount
of senior securities representing indebtedness of such issuer.''
\54\ Section 5(a)(2) of the Investment Company Act defines
``closed-end company'' as ``any management company other than an
open-end company.''
\55\ Section 18(a)(1)(A). A BDC is also subject to the
limitations of section 18(a)(1)(A) to the same extent as if it were
a closed-end investment company except that the applicable asset
coverage amount is 200%. See Investment Company Act section
61(a)(1).
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In a 1979 General Statement of Policy (Release 10666), the
Commission considered the application of section 18's restrictions on
the issuance of senior securities to reverse repurchase agreements,
firm commitment agreements, and standby commitment agreements.\56\ The
Commission concluded that such agreements, while not securities for all
purposes,\57\ may involve the issuance of senior securities and ``fall
within the functional meaning of the term `evidence of indebtedness'
for purposes of section 18 of the Act,'' which generally would include
``all contractual obligations to pay in the future for consideration
presently received.'' \58\ Further, the Commission stated that
``trading practices involving the use by investment companies of such
agreements for speculative purposes or to accomplish leveraging fall
within the legislative purposes of Section 18.'' \59\ The Commission
also explained that:
\56\ As described in Release 10666, supra note 10, in a typical
reverse repurchase agreement, the fund transfers possession of a
debt security, often to a broker-dealer or a bank, in return for a
percentage of the market value of the security (``proceeds''), but
retains record ownership of, and the right to receive interest and
principal payments on, the security. At a stated future date, the
fund repurchases the security and remits to the counterparty the
proceeds plus interest. Id. at nn. 2-3 and accompanying text. A firm
commitment agreement (also known as a ``when-issued security'' or a
``forward contract'') is a buy order for delayed delivery in which a
fund agrees to purchase a debt security from a seller (usually a
broker-dealer) at a stated future date, price, and fixed yield. Id.
at text accompanying n. 12. A standby commitment agreement is a
delayed delivery agreement in which a fund contractually binds
itself to accept delivery of a debt security with a stated price and
fixed yield upon the exercise of an option held by the counterparty
to the agreement at a stated future date. Id. at discussion of
``Standby Commitment Agreements.''
\57\ Release 10666, supra note 10, at ``The Agreements as
Securities'' discussion. The Commission notes, however, that the
Investment Company Act's definition of the term ``security'' is
broader than the term's definition in other Federal securities laws.
Compare section 2(a)(36) of the Investment Company Act with sections
2(a)(1) and 2A of the Securities Act and sections 3(a)(10) and 3A of
the Exchange Act. For example, the definition of ``security'' in the
Investment Company Act includes any ``evidence of indebtedness,''
which is not included in the definition of ``security'' in section
3(a)(10) of the Exchange Act. Further, the Commission has
interpreted the term ``security'' in light of the policies and
purposes underlying the Act. For example, the brief for the United
States as Amicus Curiae in Marine Bank v. Weaver, No. 80-1562, 1980
U.S. Briefs 1562 (Oct. Term, 1980) (July 29, 1981) (``Marine Bank v.
Weaver Amicus Brief'') stated that the issue of whether a particular
instrument is a ``security'' depends on the context, including the
statute being applied, and further stated that the Investment
Company Act ``presents a significantly different context'' (i.e.,
the regulation of the operation and management of investment
companies) than the context of the Securities Act and the Exchange
Act (i.e., the issuance or trading of such securities). Marine Bank
v. Weaver Amicus Brief at 38, 40.
\58\ Release 10666, supra note 10, at ``The Agreements as
Securities'' discussion.
\59\ Id.
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[l]everage exists when an investor achieves the right to a
return on a capital base that exceeds the investment which he has
personally contributed to the entity or instrument achieving a
return* * *. Through a reverse repurchase agreement, an investment
company can achieve a return on a very large capital base relative
to its cash contribution. Therefore, the reverse repurchase
agreement is a highly leveraged transaction.\60\
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\60\ Id. at n. 5 (citation omitted).
Leveraging of a fund's portfolio through the issuance of senior
securities ``magnifies the potential for gain or loss on monies
invested and, therefore, results in an increase in the speculative
character of the investment company's outstanding securities.'' \61\
Each of the agreements discussed by the Commission in Release 10666--
the reverse repurchase agreement, the firm commitment agreement, and
the standby commitment agreement--``may be a substantially higher risk
investment'' than direct investment in
[[Page 55243]]
the underlying securities ``because of the additional risk of loss
created by the substantial leveraging in each agreement, and in light
of the volatility of interest rates in the marketplace.'' \62\
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\61\ Id. at text accompanying n. 5.
\62\ Id. at discussion of ``The Agreements as Securities.'' The
Commission also stated that, ``[t]he gains and losses from the
transactions can be extremely large relative to invested capital;
for this reason, each agreement has speculative aspects. Therefore,
it would appear that the independent investment decisions involved
in entering into such agreements, which focus on their distinct
risk/return characteristics, indicate that, economically as well as
legally, the agreements should be treated as securities separate
from the underlying Ginnie Maes for purposes of Section 18 of the
Act.'' Id.
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In Release 10666, the Commission further stated that, although
reverse repurchase agreements, firm commitment agreements, and standby
commitment agreements are functionally equivalent to senior securities,
these and similar arrangements nonetheless could be used by funds in a
manner that would not warrant application of the section 18
restrictions. The Commission noted that in circumstances involving
similar economic effects, such as short sales of securities by funds,
our staff had determined that the issue of section 18 compliance would
not be raised if funds ``cover'' senior securities by maintaining
``segregated accounts.'' \63\ The Commission stated that the use of
segregated accounts ``if properly created and maintained, would limit
the investment company's risk of loss.'' \64\ To avail itself of the
segregated account approach, a fund could establish and maintain with
the fund's custodian a segregated account containing liquid assets,
such as cash, U.S. government securities, or other appropriate high-
grade debt obligations, equal to the indebtedness incurred by the fund
in connection with the senior security (``segregated account
approach'').\65\ The amount of assets to be segregated with respect to
reverse repurchase agreements lacking a specified repurchase price
would be the value of the proceeds received plus accrued interest; for
reverse repurchase agreements with a specified repurchase price, the
amount of assets to be segregated would be the repurchase price; and
for firm and standby commitment agreements, the amount of assets to be
segregated would be the purchase price.\66\ As the Commission stated in
Release 10666, the segregated account functions as ``a practical limit
on the amount of leverage which the investment company may undertake
and on the potential increase in the speculative character of its
outstanding common stock,'' and ``will assure the availability of
adequate funds to meet the obligations arising from such activities.''
\67\
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