Recently, Andrew J. Donohue, Director of the SEC's Division of Investment Management, wrote an article for The Harvard Law School Forum on Corporate Governance and Financial Regulation. The blog post, based on his April 8, 2010 address before the Practicing Law Institute's Investment Management Institute 2010, outlined areas about which he and his division are concerned, and how his division seeks to "create a more dynamic regulatory scheme – one that will be effective in increasing investor protection even as the investment company landscape continues to change and evolve at a rapid pace."
Derivatives. The Commission has made no secret of its concerns about funds' use of derivatives, and it's worries "that these instruments, while affording the opportunity for efficient portfolio management and risk mitigation, also can present potentially significant additional risk as well as raise issues of investor protection." According to Donohue, the 1940 Act body of regulation contemplated a different world of investment companies from the growing range of funds that mimic hedge fund strategies, absolute return funds, commodity return funds, alternative investment funds, long-short funds, leveraged funds, inverse index funds, etc. In response, as we have reported earlier, Donohue's division has launched a comprehensive review of the way in which funds use derivatives, and how regulations should be changed to keep pace. Donohue stated that his key concerns about funds' use of derivatives are:
- Leverage, and how funds may be exposing themselves to impermissible amounts of leverage through use of derivatives and the use of various structures and offshore or special purpose vehicles.
- Diversification, and how funds may become unintentionally (or intentionally) concentrated through the use of derivatives, thereby underestimating the exposure and associated risk. In addition, Donohue points out that "utilizing derivative instruments introduces another dimension to the equation, in addition to the exposure sought from the derivative instrument, the fund frequently has now exposed the fund to the credit and other risks associated with the issuing of the derivative instrument and its issuer."
Donohue also stated that he is worried about how funds' use of derivatives also exposes them to systematic risks.
Thinking about how interconnected our markets can be daunting. For this reason, the Division is also looking at how funds are addressing risk in this area and asking whether funds that rely heavily on the use of derivatives, particularly those that seek leveraged returns, have appropriate expertise and maintain robust risk management systems and procedures in light of their investments. In addition, the Division is looking at how fund derivative investments are being regulated and overseen. Do existing regulations sufficiently address whether funds' procedures for pricing and liquidity determinations of their derivatives holdings are appropriate and do the current disclosure requirements adequately address the risks created by derivatives? Has the Commission provided adequate guidance on how much leverage is permissible, how it should be measured and "covered" for purposes of the Act?
Of note to fund directors, Donohue also announced that the Commission will look into the role of directors in overseeing derivatives and their associated risks. He also emphasized that, while the Division examines the regulatory framework for funds' use of derivatives, board oversight is even more important.
In addition, the staff, in its review, is looking at whether boards of directors are providing sufficient oversight of the use of derivatives by funds and how the Commission might assist directors in this important area. As we are refining the appropriate regulatory framework for derivatives usage by funds, effective Board oversight in this area, in the meantime, is critically important. As funds' use of derivatives presents concerns and risks on many levels, fund boards' oversight of the use of these instruments by advisers also requires a multi-faceted approach, an approach that not only considers the more obvious risks these instruments present - such as market, liquidity, leverage, counterparty, legal and structure risks - but some less obvious risks as well. For example, certain derivative-based investment products, such as collateralized debt obligations, collateralized mortgage obligations and swaps are potentially difficult to price, directors should ensure that the fund's procedures to price such securities are appropriate. Does the fund have the necessary expertise (other than the portfolio manager) to understand the impact on the fund's portfolio of the derivatives and to properly determine their price and liquidity?
It is clear from Mr. Donohue's remarks that the Commission expects board oversight of their fund's use of derivatives to to keep pace with the kinds of instruments and increased sophistication of the derivatives employed. As boards reexamine their role in oversight of their funds' risk management function, they should bear Donohue's remarks in mind.
Money Market Funds. Though the Commission has already amended rule 2a-7, tightening restrictions on money funds and aimed at increasing their stability and preventing the kind of sudden vulnerability they suffered last fall due to liquidity problems and market events, Donohue outlined the second phase of money market reform. Commencing "later this year," following the release of the President's Working Group report on money market funds, Donohue's division will examine ways in which the risk of runs on money funds can be reduced and managed. Donohue mentioned the idea of a private liquidity bank for money market funds to turn to should they exhaust their own liquidity; however, he criticized the idea as ineffective:
This facility would operate to augment the recent rule changes with respect to liquidity, but it would not prevent funds from breaking the dollar and thus would not fully resolve systemic risk concerns. Institutional investors would still have an incentive to run if the marked to market value of a money market fund is below a dollar.
Rather, Mr. Donohue suggested that the second phase of money market reform would focus on ways in which the incentive for institutional investors to run on money market funds in times of market stress could be reduced, and how systematic and liquidity risks can be managed for the money market fund industry as whole.
Collective Investment Trusts. Donohue expressed concern about whether collective investment trusts, exempt from the Investment Company Act, are properly protecting investors. He stated that, in certain cases, the exemption from the rules governing investment companies may not be appropriate, and some of these investment vehicles should be subject to the regulatory scheme applicable to mutual funds. Donohue's division will be looking into this area, and considering regulatory recommendations as well.
The full text of Andrew J. Donohue's blog post is available at: http://blogs.law.harvard.edu/corpgov/2010/05/08/creating-a-dynamic-investment-management-regulatory-scheme/