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ABA Publishes Recommendations for IC Use of Derivatives

At the 2009 Spring Meeting of the Business Law Section of the American Bar Association in Vancouver, Andrew J. Donohue, Director of the SEC's Division of Investment Management, challenged the ABA's Subcommittee on Investment Companies and Investment Advisers to address some specific concerns about investment company use of derivatives and leverage.  Donohue asked for the ABA  to consider whether:

  1. investment companies should have a means to deal effectively with derivatives outside of disclosure;
  2. a fund's approach to leverage should address both implicit and explicit leverage; and
  3. a fund should address diversification from investment exposures taken on versus the amount of money invested. 

To address these questions, the ABA put together a task force consisting of leading investment company lawyers who are members of the Subcommittee on Investment Companies and Investment Advisers.  The Task Force studied current industry practices in the context of existing laws and regulatory interpretations, and evaluated whether the current regulatory scheme was adequate in view of current issues confronting the derivatives market.  In response to this effort, the Task Force determined to suggest to the Mr. Donohue and the SEC alternative approaches to dealing with the complicated set of legal issues presented by the use of derivatives by investment companies.

The Task Force formally submitted its report and recommendations to the SEC, and has made the full text of its report publicly available.  In summary, the Task force recommends the following:

  • Principles-based approach. The Task Force favors a principles-based approach to the regulation ofderivatives. The Task Force recommends that the Securities and Exchange Commission (the "SEC")or its staff adopt new rules and/or issue new interpretive guidance to implement and facilitate thoseprinciples, coupled with enhanced disclosure.
  • Diversification. The Task Force recommends a bifurcated approach to regulating diversification.That is, funds should measure diversification for purposes of Section 5(b) of the Investment CompanyAct of 1940 (the "1940 Act") by looking at reference assets, when applicable.
  • Broad-based indices, or reference assets such as commodities or currencies, should be excluded.
  • Counterparties. The Task Force recommends that the SEC should regulate counterparty risk underSection 12(d)(3) of the 1940 Act, including counterparties that are not in a traditional securities related business.
  • The need for counterparty diversification would be limited to the extent that a fund holdsbankruptcy-remote collateral from a particular counterparty.
  • Limits on leverage. The Task Force recommends that the SEC or its staff regulate compliance withSection 18 of the 1940 Act by applying a principles-based approach:• The SEC or its staff should require funds to develop and maintain "Risk-Adjusted SegregatedAmounts" ("RAS Amounts"). Funds would establish minimum amounts of required segregatedassets based on the risk profiles of derivative instruments.
  • Funds should establish policies and procedures that cover both the value of assets and the typesof assets that are appropriate for RAS Amounts.
  • Fund policies and procedures should also describe what will constitute an "offsetting transaction"for purposes of coverage requirements.
  • Concentration. The Task Force observes that many funds measure concentration based on referenceassets and believes that this measurement is appropriate.
  • Fund names. The Task Force recommends that the SEC or its staff clarify that Rule 35d-1 under the1940 Act should be interpreted like Section 5(b) as noted above. Specifically, funds would invest inaccordance with their name by looking to the reference assets.
  • Disclosure. The Task Force recommends that funds enhance disclosure of how derivative instrumentsaffect actual investment results.
  • Director oversight. The Task Force recommends that the SEC or its staff emphasize that the role ofthe fund board with respect to a fund's use of derivatives and leverage is one of oversight, rather than micro-management. The SEC or its staff should consider proposing guidance for public commenton the proper role of fund directors in overseeing derivatives and leverage.
  • Additional insight. The Task Force suggests that the SEC or its staff consider additional means tobetter develop insight into current practices of investment company use of derivatives and leverageand the appropriate level of regulatory oversight. For example, an SEC roundtable would give theSEC and its staff the opportunity to learn how portfolio managers, traders, operations personnel andcompliance officers manage the risks of derivatives and leverage. 

The full text of the Task Force Report is available at: