Remarks Before the PLI Investment Management Institute 2012
Eileen P. Rominger
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, NY
February 9, 2012
Thank you, Paul, for that kind introduction. Good morning to you and everyone in the audience both here in New York and those participating through groupcast and webcast. I am very excited to be here today to discuss the Division of Investment Management’s various priorities, and most importantly, listen to the views of my three distinguished predecessors in the panel immediately following my remarks. Each one of my predecessors has done an extraordinary job leading the Division at different points in time and I hope to learn from and emulate their successes.
I am honored to serve as the Director of the Division of Investment Management (the “Division”), particularly during this important — some might say historic — period of time. The complexity, scope, and importance of the various legal and policy issues before the Division are truly impressive. And I thoroughly enjoy the challenges these issues present.
In light of the panel that immediately follows my remarks, which will likely facilitate a discussion on a broad range of topics, I’ll try to be brief and limit my remarks to only a couple of topics. The first topic I’d like to discuss is the Division’s initiative to enhance its efficiency and effectiveness. I know, this probably sounds boring to most of you — but it is an initiative that I feel passionately about. And you should too because it should positively impact the way you do your job as counsels to investment advisers, funds, and funds’ boards. The second topic I’d like to discuss is the Division’s initiative to review the regulatory regime relating to funds’ use of derivatives.
However, before I go any further, let me give the standard disclaimer that the Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Therefore, my remarks this morning are my own, and do not necessarily represent the views of the Commission, individual Commissioners, or the staff of the Commission.
II. Enhancing the Division’s Efficiency and Effectiveness
As you know, the Division’s role is to help the Commission protect investors and facilitate capital formation. Its work seeks to minimize the financial risks to investors from fraud, mismanagement, self-dealing, and misleading or incomplete disclosure in the investment company and investment adviser segments of the financial services industry, without imposing unnecessary costs and burdens on regulated entities. This task has become more and more challenging over the last decade as the size, but more significantly, the complexity of the investment management industry increased exponentially. It is imperative that the Division conduct its business in the most efficient and effective manner possible.
Over the past year, the Division has made progress — and will continue to do so — in enhancing its internal efficiencies and regulatory effectiveness. This progress is evident through some Division initiatives I’d like to talk about today. These initiatives have already begun to positively impact the Division in numerous ways and I look forward to continued dividends. The progress the Division is making should positively affect your ability to work with us in solving day-to-day legal and business problems and comply with the regulations the Commission promulgates.
I understand that many of you rely on us for information and guidance that is critical to many aspects of your business, and your client’s business, including new products that may offer investors attractive benefits. With my staff, I am working on ways to improve our responsiveness. Although our response may not always be the one you were hoping for, we will work harder to respond in a timely manner at every step of the process.
a. Internal Efficiencies
As my predecessors on the next panel already know, the Division’s dedicated and talented staff is its most important resource. I know I certainly rely on its expert legal advice and thoughtful analysis every day to help me fulfill my responsibilities. That is why I feel a duty to ensure that the Division’s staff has the leadership, structure, and resources to effectively do its job. To that end, the Division has revisited how it accomplishes its goals and appropriately adapts to changes in the regulatory landscape. We are seeking closer alignment to the way our registrants function, and to developments in the securities markets, including new products and instruments.
This initiative has resulted in the creation of new offices, modification of our policy-making process, acquisition of specific expertise where needed, and continuing development of existing expertise. Most recently, the Division created a new private funds branch led by a seasoned hedge fund attorney to oversee the regulation of private fund advisers and the implementation of Form PF. We formed this new branch to address legal issues that may be relatively unique to these new Commission registrants and to develop and institutionalize this expertise as a resource for the Commission’s regulatory program. Some of you in the audience may be working on private fund advisers’ Form ADV and Form PF filings at this time and I want to let you know that this new branch is available should you need assistance.
The Division is also modifying its policy-making process by implementing a new approach to the way it conducts rulemaking and other policy initiatives. This new approach will increase the use of project teams in which subject matter experts in other offices within the Division are paired with experienced rule-writers to develop and draft rulemakings. This is a practice that has been successfully utilized by other divisions within the Commission and has, among other things, added significant value to the Commission’s policy-making function. It has also enhanced the professional experience of its staff. In the near future, the Division will also merge its two existing rulemaking offices to further enhance efficiencies in the rulemaking process.
The Division has also hired, or plans to hire, additional subject matter experts to augment its current expertise. We have recently hired an expert on exchange-traded funds and look forward to his valuable input. We also have plans to hire other specialized experts, such as one or more financial analyst to advise the Division and the Commission on novel and complex investment products and other projects. In addition, pursuant to the Dodd-Frank Act, we plan to hire exam staff that will work closely with our colleagues in the Office of Compliance Inspections and Examinations to support the Division’s policy role and enable us to better understand the impact of regulations in the marketplace.
The Division is also taking significant steps to provide its talented and dedicated staff with the resources and tools it needs to work more efficiently. One important step — and one that I am particularly interested in — is the Division’s newly created Task Force on Knowledge Management. This Task Force exists to assist senior management in identifying and implementing technology, processes, and procedures that will enable the Division to better manage its knowledge assets and workflow. Its goal is to create a knowledge management system that will increase productivity by improving the Division’s ability to share information internally, track workflow, and access information relevant to specific projects.
b. Regulatory Effectiveness
As the Division intensifies its focus on facilitating internal efficiencies to enhance the policy-making process, it must also ensure that its existing rules are effective in meeting their intended goals. Our rules must be the product of a careful consideration of empirical evidence, appropriate data, knowledge of investment and business practices, and feedback from investors and market participants. Our rules should be informed by a thoughtful consideration of the various costs and benefits associated with policy options. And we must continue to acquire this type of information in new and innovative ways, as demonstrated by our current investor testing initiative to evaluate the effectiveness of various types of disclosure.
Most companies providing products or services to the public routinely conduct focus groups or consumer testing, and realize the importance of this feedback. I think it is extraordinarily valuable to have this kind of information as we work on our disclosure policy and I hope we will be able to do much more of it in the future. After all, providing information in a clear and useful manner to investors is central to our mission.
The Division also has a responsibility to ensure that its rules continue to be effective years after adoption. Put simply, we need to make sure that our existing rules actually work the way we originally intended for them to work. We will work closely with the Office of Compliance Inspections and Examinations in this endeavor.
III. Review of Funds' Use of Derivatives
Although I could talk all morning about the Division’s initiatives to enhance operations, I can tell by the increased BlackBerry usage in the audience that you would rather I didn’t. So I will respectfully move on to a topic that may be of more direct interest to you and which also happens to exemplify the Division’s commitment to the new approach to the policy-making process that I just described - that topic is the review of funds' use of derivatives and the related Concept Release that the Commission issued last August.1 The collaborative approach the Division has taken on this project has allowed it to utilize the expertise within the Division as well as across the Commission. I am confident that this collaboration will ultimately lead to a much better product.
a. Concept Release on the Use of Derivatives by Funds
The Overview for this Conference on the website intriguingly refers to "the continuing saga of the use by funds of derivatives." It has indeed been a "saga," both for funds that use derivatives and for those of us who have been involved in taking a fresh look at the regulatory framework that surrounds it.
The recent Concept Release on the use of derivatives by funds was both a culmination and a beginning of efforts for the Division staff. It was a culmination in the sense that the Concept Release reflected and put into focus for public comment, several decades of regulatory and policy developments that have sought to balance the extraordinary innovation taking place in derivatives with the Commission's investor protection mandate. To think that it all began in 1979 with the famous "Commission Release Ten-Triple-Six" that tackled plain-vanilla reverse repos! And today - or last August in the Concept Release - we are talking about a multitude of "instruments whose value is based upon, or derived from, some reference asset," which asset itself may be of a virtually endless variety. The innovation that has taken place in the fund industry, in part driven by derivative usage, is quite evident. What I think the Concept Release made equally evident was the regulatory effort that has accompanied that innovation.
Experience suggests that the controls in place to address fund investments in traditional securities can lose their effectiveness when applied to derivatives. This is particularly the case because a relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss — or to an outsized exposure to an individual counterparty. The Commission’s and the Division's historical approach to the regulation of funds’ use of derivatives developed on an ad hoc basis as new derivative instruments were introduced and new derivative hedging strategies gained popularity.
We have now taken the opportunity - centered around the Concept Release - to re-think our approach to the regulation of funds’ use of derivatives. It is a review that takes a holistic perspective, in the wake of a financial crisis, and in light of a new comprehensive regulatory regime for swaps and security-based swaps being developed under the Dodd-Frank Act. The Division staff has also, since March 2010, deferred consideration of exemptive requests under the Investment Company Act relating to ETFs intending to make significant investments in derivatives, pending this review.
The primary purpose of the Concept Release was to enrich this review by soliciting broad public comment on a wide variety of issues relevant to funds' use of derivatives. The Concept Release requested comment on over one hundred fifty questions. The questions were both specific and spanned a number of broad areas, such as: the costs, benefits, and risks of fund use of derivatives, including any special considerations for ETFs; the application to derivatives of the Act's restrictions on leverage and portfolio diversification and concentration requirements; considerations relating to investment in securities-related issuers and to counterparty exposure; and valuation issues.
But if one issue had to be identified that occupied a central position both in the Concept Release and in the public comments that the Commission received in response, it was the issue of the leverage that funds incur when using derivatives. The Investment Company Act draws a bright line limiting leverage, generally out of concern for the holders of both the senior and the junior securities of a fund. The current approach of segregating assets to cover a fund's obligation in a derivative transaction, draws another bright line, with a similar goal of preventing excessive leverage. The Concept Release essentially asked whether the overall picture makes sense from a policy standpoint, and how it could be improved.
b. Comments on the Concept Release
The Commission has received almost fifty comment letters in response to the Concept Release from individual investors, fund groups, investment advisers, fund service providers, industry groups, stock exchanges, law firms, and academics. The comments included some expressing impassioned views pro and con, some providing technical statutory interpretation and detailed legal analysis, and others suggesting financial risk management techniques. Many commenters urged the Commission to defer adopting any new rules for funds' use of derivatives until the regulatory framework for swaps and security-based swaps under the Dodd-Frank Act is developed.
Some individual investors wrote about the derivatives market as "a giant casino." Other commenters, while not as colorful in their descriptions, expressed concerns about the extent of derivatives use by some funds, and the potential negative implications of broadening derivatives use generally for the markets. But a significant number of commenters felt that funds should have greater flexibility in using derivatives, and in determining the amounts of assets that they need to segregate to cover their derivatives obligations. Many of these commenters also suggested that funds be given the ability to determine for themselves how and where to set their leverage limits in the context of derivatives.
This suggestion is one of several that the Division is examining more closely as it begins to analyze the comments on the Concept Release. We are trying to imagine a regulatory world in which funds essentially set their own asset coverage and leverage limits in using derivatives. Would this approach lead to excessive leverage and raise the concerns that led Congress to limit funds’ leverage in the first place? How would a fund go about deciding on its derivatives leverage limits? Would there be a "race to the bottom" if leverage drives performance and performance drives sales of fund shares? Are fund directors or chief compliance officers in a position to guard against abuses in this area? If they are, what tools do they have at their disposal and how would they use them?
These are the types of questions that we in the Division are confronting as we think about the next steps in the "saga" of funds' use of derivatives. These types of questions are at the base of any future efforts to help ensure that the regulatory framework, as it applies to funds' use of derivatives, continues to fulfill the purposes and policies underlying the Investment Company Act.
c. Next Steps
Keep in mind that, although the issues discussed in the Concept Release took on an almost encyclopedic scope, they were not exhaustive. Many issues relating to funds' use of derivatives not discussed in the Concept Release are no less important for that fact, and are receiving the Division's and the Commission's attention in other ways. Custody-related issues and broader risk management concerns are two examples. Another example is the Division's ongoing efforts to monitor and improve funds' disclosure about leverage generally and about the implications of using derivatives in particular. We are continuously on the look-out, for example, for funds that appear to have significant derivatives exposure in their financial statements, but have limited or no discussion in their annual reports of the effect of those derivatives on the funds’ performance.
You clearly see that, when it comes to derivatives in a fund's portfolio, the list of relevant issues is long - leverage, valuation, diversification and concentration, counterparty exposure, custody, oversight, internal controls and risk management, as well as disclosure and investor understanding. In addition, we must assess the costs and benefits of the various potential measures that could be considered to address all of the above. In a fund group that uses derivatives and worries about these issues, there is likely to be coordination and input from many sources - portfolio managers, fund directors, the chief compliance officer, risk management committee, auditors, custodians, legal counsel, to name a few. We in the Division are looking at these issues - most of which were discussed in the Concept Release - with coordination and input from sources with similar expertise within the Commission. This means that the staff who contribute to the funds' use of derivatives initiative are not just the legal and policy experts in the Division, but also disclosure reviewers, accountants, financial analysts, examiners, and members of the Commission's Division of Risk, Strategy, and Financial Innovation, to name a few.
As the "saga" of funds' use of derivatives continues, we in the Division are striving towards a comprehensive, coordinated, and informed analysis that should serve well the Commission, the investing public, and funds themselves. We are cognizant of the need to act in a timely and expeditious manner, and in particular of the inconvenience that our deferred review of ETF exemptive requests may be causing some industry participants. But we are also mindful of the parallel regulatory developments on derivatives taking place under the Dodd-Frank Act. And, of course, we're always open to constructive criticism and helpful suggestions, so my fellow former Division directors, don't be shy.
Although I’ve only covered two current Division priorities in these remarks, I can assure you that we continue to focus on many Dodd-Frank Act related implementation issues as well as numerous existing rulemaking initiatives. Also, given the energetic innovation in the investment management industry, I’m sure a variety of new issues will pop up in the near future to keep us, and you, busy.
Thank you for the opportunity to speak here today.
1 Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011), available at http://www.sec.gov/rules/concept/2011/ic-29776.pdf.