Speech by SEC Staff:
Remarks before the Mutual Fund Directors Forum and the University of Maryland “Oversight of Derivatives” Conference
Director, Division of Investment Management
U.S. Securities and Exchange Commission
September 9, 2011
Good morning and thank you for that very kind introduction. Commissioner Chilton, I enjoyed hearing the CFTC's perspective on this important area. Derivatives today are widely used for a variety of investment purposes in a variety of investment company products. For us at the SEC in the Division of Investment Management, the regulatory issues surrounding funds' growing use of derivatives have been an area of significant focus. Before I get into the details, I need to let you know that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
Just last week the Securities and Exchange Commission approved my Division's recommendation to issue a Concept Release seeking broad public comment on the wide range of issues that mutual funds face under the Investment Company Act when investing in derivatives.2 The Commission requested information, analysis and opinion from all interested persons in order to assess our regulatory regime for funds' use of derivatives.
Let me also tell you that the Concept Release is 70 pages long and has 175 footnotes. Many of the issues it discusses are legal, technical, and detailed. But let's not lose the forest for the trees — figuring out the legal framework and complying with it is only a starting point. In my view, the fundamental issue, and what you care about as fund directors, is that mutual funds use derivatives responsibly, consistent with their investors' expectations, and with the backdrop of good risk management systems. Derivatives are not "bad," but they are potent and at times full of surprises. That is my "plain English" summary of the issue that the Concept Release is designed to address.
In your role as fund directors, you may be among the best positioned to see "the forest" when it comes to funds' use of derivatives. And as with other aspects of fund operations and investments, fund investors and the SEC expect you to see "the forest."
Let me explain. Although more mutual funds may be using derivatives now than before, or using them in more ways or for more purposes, I suspect that for most of you derivatives is not a new issue. In one way or another, the SEC and the staff have been talking to fund directors about derivatives for several decades now.
In 1979, when the SEC first expressed concerns about mutual funds' trading practices using reverse repurchase agreements, firm commitment agreements and standby commitment agreements, the SEC issued a Policy Statement a good part of which spoke to fund directors' responsibilities.3 The SEC was concerned about the leveraging of fund portfolios using these techniques, about funds' ability to meet redemptions, valuation and accounting issues, and about investor understanding of what the funds were doing. The SEC wanted fund directors to be concerned about the same things. Some examples of what the Commission said:4
[Directors should] “determine if [the fund] is involved in [any of the securities trading] practices under discussion, or in other trading practices with comparable effects on the capital structure of the [fund]."
"[I]n the exercise of their general fiduciary obligations under the [Investment Company] Act, [directors] should consider whether [the fund] has appropriately segregated assets in a manner which would satisfy the legislative purposes of [the asset coverage requirements of the Act]."
"Directors should note that, as asset segregation reaches certain levels, [a fund] may impair its ability to meet current obligations, to honor requests for redemption, and to manage properly the investment portfolio in a manner consistent with its stated investment objectives… . Therefore, directors should consider such potential loss of flexibility when determining the extent to which [the fund] should engage in such transactions."
"[D]irectors should review their current valuation procedures, accounting systems, and systems of internal accounting control to determine whether any inadequacies exist with regard to the valuation and accounting treatment of such securities trading practices."
"[Directors] should determine whether the securities trading practices of [the fund] are consistent with its [fundamental] policies."
Since 1979, the basic framework for looking at funds' leveraged trading practices and the use of derivatives has not changed much.
Fifteen years after the 1979 Policy Statement, in the wake of some significant derivatives-related losses by some mutual funds, in 1994 the SEC was again re-examining its role in enhancing investor protection in the area of mutual funds' derivative investments. The Commission also was reminding funds' managers to take steps to ensure proper understanding and effective management of derivatives risk.
And the Commission was reaching out to fund directors. The Commission's Chairman at the time, Arthur Levitt, spoke at great lengths urging fund boards to exercise meaningful oversight of fund derivative investments by becoming more involved in portfolio strategies, risk management, disclosure and pricing issues, accounting questions, and internal controls.5 In 1995, the SEC held a symposium for mutual fund directors, at which Chairman Levitt described his interactions with fund directors on the issue of derivatives:
"When I called upon directors more than a year ago to review derivatives policies, some people were skeptical. 'That's of concern to money managers, not directors,' they said. Some asserted that I was expecting too much of directors, asking them to get involved with something as technical as derivatives."6
And then he put it bluntly:
"If directors don't take the time to understand how derivatives work, how a fund is using them, how clearly they are described to shareholders, and what the exposure of shareholders is — well, if the investment portfolio begins to explode, those directors are likely to get burned along with the fund and its shareholders."7
Now fast forward to 2010 and you will find the same principles and framework that the SEC has been laying out for fund directors in the area of derivatives for decades, reflected in the Practical Guidance of your very own Mutual Funds Directors Forum. I am talking about the handbook, "Risk Principles for Fund Directors," that the Forum issued in April 2010.8 In many ways, that handbook is about helping fund directors to see "the forest" when it comes to evaluating their funds' use of derivatives or more broadly overseeing risk. You're probably well familiar with its contents.
And so, the issues surrounding mutual funds' use of derivatives, and fund directors' role in dealing with them, are both old and new. They are old, because in some form — starting in 1979 with reverse repurchase agreements — the issues have been around for decades, and directors have been urged to participate, and have participated, in addressing them just as long. They are new because derivatives are evolving, funds are evolving, and effective risk oversight cannot stand still.
For its part, the SEC is looking to keep up by comprehensively reviewing the use of derivatives by mutual funds, including ETFs, under the Investment Company Act. As the Commission noted in a press release in April of last year, my Division has been exploring a wide range of issues in this area, including whether fund boards are providing appropriate oversight of the use of derivatives by funds.9 As the SEC is looking to potentially improve its regulations as they apply to funds' use of derivatives, some of those improvements may go to helping fund directors be more effective in their role.
I urge you to express your opinions, views and concerns about your funds' experiences with derivatives and about your responsibilities in this area. If you think our rules should be clearer, please tell us so. If you think our rules allow funds to do something that goes against the best interests of fund investors, please tell us so. If you think we need to provide more guidance to fund managers or other service providers about certain aspects of funds' derivatives transactions, please tell us so. If you think we can be of assistance in helping you understand your responsibilities or better fulfill your role, please tell us so.
Commenting on our Concept Release is one of the ways that you may wish to communicate your ideas to us. But there is a multitude of other ways, through discussion and open forums, like this conference. I want to thank the Mutual Fund Directors Forum and the University of Maryland for putting together such a timely event, and for inviting me to participate. I am sure discussions throughout the day will be informative and thought-provoking.
1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
2 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
3 Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979).
5 See, e.g., Mutual Funds and Derivative Instruments, Memorandum from the Division of Investment Management to Chairman Levitt (transmitted to Chairman Markey and Representative Fields, Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce, U.S. House of Representatives) (Sept. 26, 1994) available at http://www.sec.gov/divisions/investment/imseniorsecurities/immemo092694.pdf
6 Mutual Fund Directors as Investor Advocates, Remarks by Chairman Levitt, U.S. Securities and Exchange Commission, The Second Annual Symposium for Mutual Fund Trustees and Directors, Washington, D.C. (Apr. 11, 1995).
8 Risk Principles for Fund Directors, Practical Guidance for Fund Directors on Effective Risk Management Oversight, Mutual Fund Directors Forum (Apr. 2010).
9 SEC Staff Evaluating the Use of Derivatives by Funds, U.S. Securities and Exchange Commission Press Release 2010-45 (Mar. 25, 2010).