Statement at Open Meeting
Chair Mary Jo White
Dec. 11, 2015
Good morning, everyone. This is an open meeting of the Securities and Exchange Commission on December 11, 2015 under the Government in the Sunshine Act.
The Commission will consider two separate recommendations from the staff today. First, we will consider and vote on a recommendation from the staff of the Division of Investment Management to propose an updated and more comprehensive approach to the use of derivatives by mutual funds and exchange-traded funds, closed-end funds, and business development companies.
Second, we will consider and vote on a recommendation from the staff of the Division of Corporation Finance to propose rules to require disclosure of certain payments made to governments by resource extraction issuers, as mandated by the Dodd-Frank Act.
* * *
We begin with derivatives. A critically important part of the Commission’s agenda is identifying and addressing, as appropriate, the risks in today’s asset management industry, which has more than $18 trillion in registered fund assets and $67 trillion in assets managed by registered investment advisers. A year ago today, I first outlined a five-part plan for regulating the risks arising from the portfolio composition of funds and the operations of funds and advisers in today’s markets. That plan encompasses a broad set of initiatives to address these risks, including enhanced data reporting, which the Commission proposed in May, and requirements to strengthen the management of fund liquidity, which the Commission proposed in September.
Today’s recommendation builds on that work by proposing enhanced protections that better address risks related to the use of derivatives by registered funds. Inadequate controls on the use of derivatives can create significant risks for funds themselves and investors, as well as raise questions about the potential impacts on the broader financial system.
This proposal would create a modernized, comprehensive regulatory framework to reflect the evolution of funds’ use of derivatives. That framework would require funds to meet certain conditions to monitor and manage their risk in order to rely on an exemption from certain statutory restrictions, and in some cases, would also limit a fund’s use of derivatives.
Addressing Risks in the Use of Derivatives by Funds
An analysis conducted by Division of Economic and Risk Analysis (DERA) economists shows that some funds use derivatives extensively, including funds with derivatives exposures as high as nearly 10 times net assets, while most mutual funds do not make extensive use of derivatives. Funds use derivatives for a variety of purposes, including to seek higher returns through increased investment exposures, to hedge risks in their investment portfolios, to gain access to certain markets, and to more efficiently adjust exposure to a market, sector or security. Derivatives can raise risks for a fund, including risks relating to leverage and the fund’s ability to meet future obligations. Funds can experience substantial and rapid losses from investments in derivatives, and can be forced to sell investments under adverse conditions and take other measures to meet derivatives-related obligations, which can harm investors.
I am concerned about the potential for such losses under the current regulatory framework. Today, funds can obtain high levels of exposure through the current practice of “mark-to-market segregation,” where a fund only segregates liquid assets equal to the current liability, if any, of a derivative transaction. And there is evidence that funds are using mark-to-market segregation for an increasingly wide range of cash-settled transactions, enabling a fund to incur much greater leverage. This practice also raises concerns that a fund may not have sufficient liquid assets to meet potential future losses because a fund may only maintain liquid assets to cover losses that the fund has already incurred.
Funds also currently segregate some types of liquid assets that may be more likely to decline in value at the same time that a fund experiences losses. For example, if a fund were to use listed equities as coverage assets for a swap on an equity index, the coverage assets might lose value at the same time the fund incurs losses on the swap, making it more likely that the fund would be forced to sell portfolio securities to meet derivatives payment obligations, potentially in stressed market conditions.
Enhancing Current Regulation of Use of Derivatives by Funds
The current regulatory framework for derivatives use by funds has developed on an instrument-by-instrument basis over many years. Indeed, the Commission last formally addressed issues related to Investment Company Act limits on financial transactions that create indebtedness more than three decades ago. Since then, the staff has issued more than 30 no-action letters and responded to numerous additional questions regarding the application of statutory and regulatory provisions to derivatives transactions.
In more recent years, the dramatic growth in the volume and complexity of the derivatives markets led the staff to initiate a review of funds’ use of derivatives, followed by a Commission concept release in 2011. The staff has also developed additional information about the use of derivatives by funds, including by reviewing funds’ disclosures, examinations, and extensive discussions with industry and derivatives experts. And our DERA economists and the data they assembled and analyzed on funds’ use of derivatives most recently were instrumental to the staff as they developed their recommendations to the Commission as we considered this proposal.
All of these efforts and the associated public comments have led me to conclude that the current regulatory framework no longer effectively achieves the statutory objectives of the Investment Company Act, which seeks to protect investors from the risks of excessive leverage and from funds being unable to meet payment obligations that can result from derivatives and other instruments. A new approach is needed, which today’s proposal provides.
Proposed New Framework for Regulating Use of Derivatives by Funds
As an initial matter, the proposal would clarify the application of Section 18 of the Investment Company Act to derivatives transactions with a future payment obligation, such as forwards, futures, swaps and written options, and financial commitment transactions, such as reverse repurchase agreements, short sale borrowings, and firm and standby commitment agreements. The proposal would permit a fund to enter into these types of transactions notwithstanding the restrictions in section 18 of the Act, but only provided that certain conditions are met.
In a moment, the staff will discuss the recommendations in detail, but there are three important elements I would like to highlight.
First, the proposal would impose new asset segregation requirements designed to address concerns relating to a fund’s ability to meet its obligations. Funds would be required to segregate assets to cover their mark-to-market liability, plus an additional risk-based coverage amount designed to address potential future losses on derivatives. The proposal also would generally require funds to use cash and cash equivalents for coverage of their derivatives transactions.
Asset segregation requirements by themselves, however, may not in all instances provide a sufficient limitation on the amount of leverage that a fund could obtain through derivatives. And in order for asset segregation requirements alone to result in an effective limit on leverage, we would need to require funds to segregate a much greater amount of assets -- for example, a derivatives transaction’s full notional amount. This kind of approach would be over-restrictive for derivatives transactions in some circumstances, leading funds to hold more coverage assets than likely would be necessary for the fund to meet its obligations.
As a result, the proposal contains a second critical element that would require funds to comply with one of two alternative portfolio limitations on derivatives and similar transactions. One limitation would be based on a fund’s aggregate exposures and the other limitation would be based primarily on a risk-based test. This framework is designed to provide funds the ability to use various types of derivatives in different ways, while curbing a fund’s ability to engage in undue speculation, a principal concern underlying the Investment Company Act.
The proposal addresses the concerns related to a fund’s ability to obtain excessive leverage through derivatives transactions primarily through the proposed portfolio limitations by limiting the amount of derivatives that the fund can use. The proposal separately addresses the concerns related to a fund’s ability to meet its derivatives obligations primarily through the proposed asset segregation requirements by requiring the fund to cover its mark-to-market liability and an additional risk-based amount. This proposed framework is designed to address each concern more directly and effectively than would reliance on portfolio limitations or asset segregation alone.
Finally, a third element of the proposal would require funds that engage in more than a limited amount of derivatives transactions or that use certain complex derivatives transactions to establish formalized risk management programs to manage the associated risks.
Taken together, these and the other elements of this proposal are designed to modernize the regulation of funds’ use of derivatives and safeguard both investors and our financial system. I want to highly commend the staff’s exceptional work on this rulemaking, and I look forward to reviewing the comments we receive related to these critical reforms.
I would like to specifically thank a number of the Commission staff for applying their deep expertise of investment companies and investment advisers to this rulemaking. First, thank you to Dave Grim, the Director of the Division of Investment Management, and his team: Diane Blizzard, Dan Townley, Brian Johnson, Thoreau Bartmann, Aaron Schlaphoff, Jamie Walter, Erin Loomis, Adam Bolter, Sara Cortes, and Jacob Krawitz.
Throughout this process, SEC economists from DERA provided economic analyses, data, and invaluable input related to funds’ use of derivatives. And I thank Director Mark Flannery, Jennifer Marietta-Westberg, Christof Stahel, Yue Tang, Daniel Deli, Paul Hanouna, William Yost, and John Cook for their work.
As always, thanks to Annie Small, Meridith Mitchell, Lori Price, Robert Bagnall, and Kevin Christy from the Office of the General Counsel.
I would also like to express gratitude to my fellow Commissioners and all of our counsels for their engagement, support and comments on these recommendations, which were improved by the process of their engagement. These reforms address a very important subject in the heart of the SEC’s mission, which we have all been focused on for quite some time.
* * *
Section 1504 of the Dodd-Frank Act requires issuers of securities who are involved in the commercial development of natural resources to report annually the payments they — and subsidiaries and entities they control — make to a foreign government or to the federal government for the purpose of the commercial development of oil, natural gas, or minerals. Section 1504 reflects the U.S. foreign policy interest in reducing corruption in resource-rich countries, supporting the federal government’s commitment to global efforts to improve transparency in the extractive industries. The proposed rulemaking carries out the statutory mandate by the Commission to further this policy choice.
The Commission previously adopted rules to implement this particular mandate in 2012, which were subsequently vacated. Since that earlier effort, significant developments have occurred in global efforts to promote the transparency of resource extraction payments. For example, the European Union and Canada have adopted transparency initiatives largely based on the rules the Commission adopted in 2012. During this time, the Commission staff has continued to engage with numerous stakeholders and government agencies on key international developments and continued study the governmental interests that Section 1504 — and the rulemaking it requires — are designed to serve, and to determine the best way to structure the Commission’s rules so as to further those governmental interests.
Drawing on the experience developed during that process, the recommendation before us today is intended to further the policy goals of Section 1504 by requiring resource extraction issuers to file annually a Form SD disclosing information about payments to the U.S. federal government and foreign national and subnational governments related to the commercial development of oil, natural gas, or minerals.
In the course of this rulemaking, commenters have expressed concern about the potential that the proposed disclosures could be prohibited under a host country’s laws or could cause competitive harm. We have responded to that concern in this proposal. The Commission has the authority, under the Exchange Act, to consider exemptive relief in such circumstances on a case-by-case basis. Also, in light of the international developments and the progress made by the U.S. Extractive Industries Transparency Initiative (USEITI), the proposed approach would allow issuers to use a report prepared for foreign regulatory requirements to comply with the Commission’s rules if the Commission determines such requirements are substantially similar to its own rules.
I am very interested in receiving comments on the specifics of the proposal we are considering today, as well as the questions raised in the release about whether these rules would support international transparency efforts and further the U.S. foreign policy objective of combatting global corruption, while being sensitive to the potential costs of this proposal. I am particularly interested in views about how smaller reporting companies would be impacted by these recommendations. This rulemaking is being conducted under an expedited schedule submitted to the court, and I urge interested parties to submit their views promptly.
Before I turn the proceedings over to Barry Summer, Associate Director in the Division of Corporation Finance, to discuss the recommendations, I would like to thank the staff for their hard and careful work on this proposal.
Specifically, I would like to thank Barry Summer, Elizabeth Murphy, Shehzad Niazi, Elliot Staffin, Eduardo Aleman, Jennifer Riegel, John Hodgin, Kwame Awuah-offei, Ryan Milne, and Ada Sarmento in the Division of Corporation Finance; Annie Small, Michael Conley, Rich Levine, Bryant Morris, Brooks Shirey, Ted Weiman, Uzma Wahhab, and Connor Raso in the Office of the General Counsel; Mark Flannery, Scott Bauguess, Vanessa Countryman, Simona Mola Yost, Mike Willis, Vladimir Ivanov, Igor Kozhanov, Walter Hamscher, and Tristan Chiappetti in the Division of Economic and Risk Analysis; Michael Pawluk, Diane Blizzard, and Sarah ten Siethoff in the Division of Investment Management; and Jeff Minton, Jenifer Minke-Girard, Jonathan Duersch, Jonathan Wiggins, and Sviatlana Phelan in the Office of Chief Accountant. I would also like to thank my fellow Commissioners and their counsels for their engagement and work on this rulemaking.
 See In the matter of OppenheimerFunds, Inc. and OppenheimerFunds Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action); In the matter of Claymore Advisors, LLC, Investment Company Act Release No. 30308 (Dec. 19, 2012) (settled action); In the matter of Fiduciary Asset Management, LLC, Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled action); In the Matter of UBS Willow Management L.L.C. and UBS Fund Advisor L.L.C., Investment Company Act Release No. 31869 (Oct. 16, 2015) (settled action). See also Ludwig B. Chincarini, A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors L.L.C., 18 J. OF APPLIED FIN. 152 (Spring/Summer 2008), available at http://ludwigbc.com/pubs/pub9.pdf (a private fund was forced to liquidate its portfolio and close in 2006).