By Amy Leisinger, J.D.
In comments on the SEC’s proposed rule governing registered funds’ use of derivatives, the Investment Company Institute (ICI) offered general support for the initiative but recommended certain changes to preserve the benefits of derivatives use. Specifically, the ICI opposed the proposed portfolio limits, arguing that the caps would harm funds and their shareholders by preventing the use of derivatives as an effective portfolio management tool.
In a press release, ICI President and CEO Paul Schott Stevens further noted that the proposed limits would disproportionately affect bond funds. “Nothing before the Commission or in its proposing release suggests that these bond funds are engaged in ‘undue speculation’ through their use of derivatives,” he said.
Derivatives use proposal. The SEC proposed rules to enhance regulation of the use of derivatives by registered investment companies. Specifically, the proposal would require each fund to comply with limitations on the amount of its leverage derivatives and other transactions and to manage risks associated with derivatives transactions by segregating assets in an amount sufficient to enable the fund to meet its obligations under stressed conditions. A fund that engages in more than a limited amount of derivatives transactions would also be required to establish a formalized derivatives risk management program under the rule. The proposed reforms would also address funds’ use of financial commitment transactions by requiring funds to segregate certain assets to cover their obligations.
ICI recommendations. In its comments, the ICI applauded the SEC efforts to modernize guidance for funds’ use of derivatives and to ensure that funds are not “unduly speculative,” but contended that aspects of the proposal go beyond what is necessary to achieve these purposes. Fund managers use derivatives to hedge risk, enhance liquidity, gain or reduce exposure, and reduce costs, and it is crucial to preserve these beneficial uses, the ICI stated.
The proposal’s requirement that a fund investing in derivatives transactions comply with one of two portfolio limits (the 150 percent notional exposure limit or the 300 percent risk-based limit) is based on limited data and an incomplete evaluation of the impact of the proposed restrictions, the ICI explained. The notional amounts on which the proposed limits are based are not an appropriate or reliable measure of economic exposure or risk, according to the ICI. A fund with high notional exposure may be equally risky as a fund with no derivatives exposure, the group stated, and the proposed limits would hamstring funds’ ability to use derivatives for the benefit of investors. Portfolio limits could also lead to deregistration of funds that cannot adjust to meet the restrictions or major strategy changes that could increase costs and risks for shareholders. If the SEC ultimately finds that portfolio limits are necessary, it should use them as a “backstop” and allow funds to adjust notional amounts based on underlying asset classes and consider raising the exposure limit to 200 percent. The group also recommended provision of a cure period for inadvertent exceeding of the notional threshold and an allowance for de minimis amounts of complex derivatives.
By contrast, the ICI offered support for the enhanced asset segregation requirements, particularly the risk-based coverage amounts for derivatives transactions, and stated that asset segregation risk-adjusted for the specific derivatives in a given fund’s portfolio is an effective tool for limiting leverage and ensuring ability to pay on obligations. However, the ICI recommended that the SEC go beyond allowing only cash and cash equivalents to be used as qualifying coverage assets. According to the ICI, the Commission should permit use of highly liquid assets to meet coverage requirements to avoid creation of a “cash drag” on fund performance and should apply risk adjustments to the value of non-cash assets in calculating total qualifying coverage assets.
The ICI also supported the implementation of derivatives risk management programs and enhanced board oversight. Formal programs coupled with asset segregation requirements will help to ensure that funds meet obligations and undue speculation, the group explained. However, the ICI advised the SEC to permit funds to appoint a committee to act as derivatives risk manager and to clarify that good faith decisions will not create liability. The ICI also asked the SEC to limit the proposed board duties to prevent requiring decisions that should be made by an investment adviser. As proposed, the rules would overly burden boards with the minutiae of general portfolio management activities, according to the ICI.
In conclusion, the ICI stated that, if the SEC adopts portfolio limits, it should confirm that funds need not look through other pooled investment vehicles in their calculations and that the Commission should exclude derivatives transactions that comply with the rulemaking from other asset coverage requirements. In addition, the ICI explained, if the proposed rule is adopted, the SEC should give funds a transition period of at least 30 months before rescinding existing guidance.