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Speech by SEC Staff:
Investment Company Act of 1940: Regulatory Gap between Paradigm and Reality?


Andrew J. Donohue1

Director, Division of Investment Management
U.S. Securities and Exchange Commission

American Bar Association Spring Meeting
Vancouver, Canada
April 17, 2009

I would like to start by thanking Jay Baris for inviting me to speak this morning. One of my recurring concerns has been investment companies' use of derivatives and what I perceive as the increasing gap between how the Investment Company Act of 1940(the "1940 Act" or "'40 Act") and investors look at fund portfolios versus how investment advisers look at them. Today I will discuss these concerns and challenge this group to devise an approach to address them. Before I continue, note that my remarks today represent my own views and not necessarily the views of the Commission, individuals Commissioners or my colleagues on the Commission staff.

As you know, the 1940 Act provides a comprehensive framework for the federal regulation of investment companies. This includes substantive protections beyond the disclosure requirements, including the safekeeping and proper valuation of fund assets, restrictions on transactions among affiliates, and governance requirements. Moreover, the '40 Act limits the amount of leverage that funds may bear, and the accompanying leverage that derivatives give to mutual funds are issues about which I am most concerned. Let me explain.

Thirty years ago the Commission announced a general policy on the economic effects and legal implications under the '40 Act of certain transactions that result in leverage.2 This release, commonly known as "ten-triple-six" in reference to its release number, represents the Commission's starting point in its policy addressing investment companies' leverage. Specifically, the Commission addressed Section 18(f) of the '40 Act,3 which generally prohibits an investment company from issuing a "senior security" except under certain circumstances. In a nutshell, a "senior security" is any security or obligation that creates a priority over any other class to a distribution of assets or payment of a dividend. Permissible "senior securities" include, among other things, a borrowing from a bank where the fund maintains an asset coverage ratio of at least 300% while the borrowing is outstanding.

Congress was concerned that abuses could result when funds leveraged without any significant limitations.4 This concern led to the protections contained in Section 18. The Commission stated in the ten-triple-six release that leverage 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."5 The Commission noted that the leveraging of an investment company portfolio by issuing senior securities and borrowing magnified the potential for gains or losses, thus increasing speculative investing. The Commission concluded that Congress intended "to limit increases in the speculative character of junior securities issued by investment companies."6

After interpreting Section 18 as limiting funds' ability to leverage, the Commission analyzed certain securities trading practices to determine whether and how far funds could go without violating Section 18. The Commission focused on reverse purchase agreements, firm commitment agreements, and standby commitment agreements, yet emphasized that it "intended to address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices" specifically discussed in the release.7 The Commission stated its belief that these agreements fell "within the functional meaning of the term 'evidence of indebtedness' for purposes of Section 18 of the Act."8 It did so not because these agreements were "inherently securities," but rather, because the trading practices were speculative and resulted in leverage. The Commission noted that the staff in analogous circumstances had determined that it would not raise with the Commission the issue of compliance withSection 18 if the investment company "'covers' the senior security by establishing and maintaining certain 'segregated accounts'."9 The Commission agreed that properly created and maintained segregated accounts would limit the investment company's risk of loss.10 The Commission explained that allocating assets into a segregated account would:1)function as a practical limit on both the amount of leverage undertaken by a fund and the potential increase in the speculative character of the fund's outstanding shares; and 2) assure the availability of adequate funds to meet the obligations arising from such activities.

Interestingly, ten-triple-six does not expressly use the word "derivatives." Its analysis, however, provides the foundation upon which the Commission has granted exemptive relief as well as no-action letters and other public statements from the Commission's staff recognizing that senior securities concerns can be addressed by offsetting exposure to derivatives positions. As an aside, I note that the Division recently added to its webpage a select bibliography of materials addressing investment companies' use of senior securities.11 This bibliography will help you find many of these orders, no-action letters and staff statements.

While acknowledging its critical role in enhancing investor protection, the Commission noted in ten-triple-six that the responsibility for managing an investment company's investments fall, in the first instance, on the fund's management and board of directors. The Commission cautioned fund directors to consider the "potential loss of flexibility" when determining the extent to which funds engage in leveraged transactions.12 Moreover, the Commission suggested that directors should review a fund's disclosure documents to "ensure complete disclosure," including:1) the potential risk of loss; 2) the identification of the securities trading practices as separate and distinct from the underlying securities; 3) the differing investment goals inherent in participating in the securities trading practices versus investing in the underlying securities; 4) whether the fund's name accurately reflects its portfolio investment policies and securities trading practices; and5) any other material information relating to such trading practices.13 This advice, while important then, is critical now and I will circle back to it in a few minutes.

Let me now fast-forward fifteen years to 1994. As some of you here today will recall, early that year we experienced a slow but steady rise in interest rates. The increase in the interest rates negatively affected the collateralized mortgage obligation ("CMO") market, including funds that invested in CMO securities. The general decline in the CMO market accelerated with the collapse of a large hedge fund manager at the end of March 1994 and resulted in the liquidation of hundreds of millions of dollars of CMO derivatives, further depressing the market and negatively impacting funds that had invested in them.14 Shortly thereafter, a congressional subcommittee requested that the Commission undertake a comprehensive study of the use of derivatives by mutual funds, with a particular emphasis on the adequacy of laws and regulations governing their disclosure and use. In response, on September 26, 1994, then-Chairman Arthur Levitt sent a Division of Investment Management staff study to the subcommittee.15

The study noted that mutual funds used derivatives for a wide variety of purposes, including hedging interest rate, currency and other market risks; substituting for a direct investment in the underlying instrument; or increasing returns. However, the study concluded that mutual funds' use of derivatives was limited. This conclusion had two bases:the Division's inspections to date which revealed limited usage and a contemporaneous survey conducted by the Investment Company Institute which also suggested that derivatives holdings constituted a small percentage of mutual fund portfolios.16

Although the study concluded that fund use of derivatives was limited, several funds had recently experienced significant losses from investments in mortgage derivatives. The study next analyzed derivatives and leverage, and the potential for increased volatility arising from such leverage to result in significant investor losses.

The staff study did not support a prohibition or restriction on the use of derivatives by mutual funds for three reasons. First, limiting or restricting derivatives could chill the use of instruments in a manner that is beneficial for mutual funds, such as hedging.Second, restrictions would be inconsistent with the general approach of the '40 Act, which imposes few substantive restrictions on mutual fund investments. Finally, and perhaps most important, the Division recognized that "it would be extremely difficult, if not impossible, to devise appropriate prohibitions or restrictions on the use of derivatives by mutual funds because of the wide variety of instruments that may be considered 'derivatives'."17 Instead, the study proposed improved risk disclosure as "one of the most effective means" for addressing the Division's concerns associated with derivatives leverage.18 Barely half a year later, the Commission published a concept release in which it solicited comments for improving descriptions of risk by mutual funds and other investment companies.19 The concept release sought comment on many issues, including whether the need for improved disclosure of risks associated with derivative usage was greater for fixed income funds.20 Ultimately, the Commission has not, to date, taken subsequent action vis--vis mutual fund derivative risk disclosure.

Now let me fast-forward again to the present. I believe it is fair to assume that investment companies today have increased their investment in derivatives since the ICI in 1994 conducted its only survey of this issue. I also believe it is fair to assume, as the Division's 1994 study foresaw, that the variety of derivative instruments has increased, creating more investment opportunities for investment companies. I would like to examine publicly available information to see whether funds have engaged in improved risk disclosures to address leverage concerns.

To begin this examination, let me identify certain requirements contained in the '40 Act and rules thereunder. This list is not a catalogue of every requirement, but rather, a highlight of items relevant to this discussion:

  • A mutual fund investing in derivatives must comply with the fund's name as required by Section 35(d);

  • A fund's derivative transactions must be consistent with its investment objectives and policies set forth in the fund's registration statement.

  • Consistent with ten-triple-six and its progeny, for purposes of Section 18 of the '40 Act a fund engaging in trading practices involving derivatives and leverage should cover its position with segregated assets or an offsetting hedge; and

  • A fund's portfolio must meet stringent diversification and liquidity standards.

Now let me share some sample disclosure language that might be found in the prospectus or statement of additional information of a mutual fund with derivatives in its portfolio. For purposes of this exercise, I have modified the language somewhat so as to provide anonymity to any particular fund.

  • Sample fund names include terms such as "income," "floating rate," "high yield," and "short term."

  • Sample investment objectives recite words to the effect that the fund's "primary objective is to seek high level current income mainly from a diversified portfolio not involving undue risk," "to realize an above-average return with reasonable market risk," or "high current income and capital appreciation."

  • Sample prospectus disclosures regarding the risks of investing in the fund, particularly risks associates with derivatives, include "the fund may use certain high-risk investments, including derivatives," and "derivatives may exhibit volatility and involve significant risk. "Fund statements of additional information, or SAIs, often contain more robust disclosures regarding derivatives investment risk. They generally note that derivatives could result in substantial loss for the fund.

  • Finally, the percentage of total assets that a fund may use to invest in derivatives varies from fund to fund, with funds exhibiting a wide range of possibilities.

In truth, the statements of additional information that I have reviewed are quite extensive in their discussion of the risks posed by investing in derivatives. Clearly, funds need to disclose such risks to limit potential liability. Extensive risk disclosure, however, may not equal a discussion readily understandable by investors. As the Commission noted in its 1995 concept release, "lengthy and highly technical descriptions of permissible policies and investments that are often used in meeting existing requirements may make it difficult for investors to understand the total risk level of a fund."21 After all, while a fund's SAI may include a laundry list of potential risks, including substantial losses, how does an investor synthesize that information with a fund's stated investment objective of investing with "reasonable market risk" or "without undue risk?"

This dichotomy — or gap between technical compliance with the '40 Act versus actual performance — is precisely the issue I am concerned about today. As an example, consider the recent performance of fixed income funds in 2008 when a number of funds suffered one-year losses in excess of 30%. Unquestionably, some of this performance is due to adverse results from investment decisions concerning security selection, industry or sector concentration, or to the negative impact in a down market of old fashioned bank borrowing-type leverage. Some of the explanation, however — and for some funds a lot of the explanation — likely may rest with the use of derivatives to magnify the economic exposure of the portfolio. To be clear, I am not suggesting that the fund disclosures were legally deficient. Rather, I submit that many investors in these funds, particularly at the retail level, neither appreciated the potential magnitude of nor anticipated the actual diminution in value of these funds.

In my view, this demonstrates that the Commission's concerns expressed thirty years ago are just as important today. Specifically, the Commission advised the directors to review a fund's disclosure documents to "ensure complete disclosure" associated with the fund's participation in the types of trading practices at issue, including: the potential risk of loss; the identification of the securities trading practices as separate and distinct from the underlying securities; the differing investment goals inherent in participating in the trading practices versus investing in the underlying securities; whether the fund's name accurately reflects its portfolio investment policies and securities trading practices; and any other material information relating to such trading practices.22

At the beginning of my remarks I stated that I would challenge this group to address the concerns that I have discussed this morning. Broadly speaking, here are three concerns regarding investment companies' use of derivatives for your consideration:

  • Funds should have a means to deal effectively with derivatives outside of disclosure;

  • A fund's approach to leverage should address both implicit and explicit leverage; and

  • A fund should address diversification from investment exposures taken on versus the amount of money invested.

Like layers of an onion, underlying these three concerns are a gamut of issues. For example, should the application of '40 Act leverage restrictions to derivatives held by investment companies be re-examined?Is the thirty year patchwork of stated Commission policy and staff positions regarding investment companies' use of derivatives sufficient or is regulatory and/or legislative action necessary to address the leverage created by investment companies' use of derivatives? If you believe action is necessary, what do you recommend?Do existing rules sufficiently address matters such as the proper procedure for investment company pricing and liquidity determinations of derivatives holdings?Are investment company boards exercising meaningful oversight of funds' use of derivatives, including risk management, proper accounting and internal controls?

I think you get the point so let me stop now before I start sounding too much like a law school professor. Let me conclude by stating that I look forward to obtaining your insight and greatly appreciate the input. Thank you for allowing me to participate this morning and I welcome your questions.


1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the staff of the Commission.

2 Investment Company Act Release No. 10666 (Apr. 18, 1979), 44 Fed. Reg. 25128 (Apr. 27, 1979).

3 15 U.S.C. 80a-18(f)(1).

4 Id., 44 Fed. Reg. at 25129-30.

5 Id. at 25129, n. 5.

6Id. at 25129, nn. 4 & 5 and accompanying text.

7 Id. at 25129 (emphasis added).

8 Id. at text accompanying nn. 14 & 15.

9 Id. at 25131-32.

10 Id.

11 See Registered Investment Company Use of Senior Securities — Select Bibliography, available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.

12 44 Fed. Reg. at 25132.

13 Id. at 25133.

14 For a general discussion of CMO market events in 1994 and the negative impact on mutual funds, see Commission Opinion: Piper Capital Management, Inc., Marijo A. Goldstein, Robert H. Nelson, Amy K. Johnson, and Molly J. Destro; Investment Company Act Release No. 26167 (August 26, 2003).

15 Mutual Fund Derivative Instruments (Sept. 26, 1994), available at http://www.sec.gov/news/studies/deriv.txt

16 See, Investment Company Institute, Investment in Derivatives by Registered Investment Companies (Aug. 1994), available at http://www.ici.org/pdf/wht_derivatives.pdf.

17 Mutual Fund Derivative Instruments at p. 27.

18 Id.

19 Investment Company Act Release No. 20974 (Mar. 29, 1995), 60 Fed. Reg. 17172 (Apr. 4, 1995).

20 Id. at 17174.

21 Id. at 17172.

22 44 Fed. Reg. at 25133.



Modified: 04/17/2009