Wednesday, August 31, 2011

SEC Will Use Concept Release as Part of Broad Review of Derivatives Use by Investment Companies

The SEC will issue a Concept Release to solicit public comment on the use of derivatives by investment companies and on the current regulatory regime under the Investment Company Act as it applies to the use of derivatives by investment companies.. The Commission will use the comments to help determine whether regulatory initiatives or guidance is needed that would continue to protect investors and fulfill the purposes underlying the 1940 Act.

Subject to the various safeguards contained in the Investment Company Act as well as SEC rules and guidance, funds are permitted to invest in derivatives . A common characteristic of most derivatives, which are among a panoply of investments that a fund may make in managing its portfolio, is that they involve leverage. When the Investment Company Act was enacted in 1940, it did not contemplate funds investing in derivatives as they may do today.

The Concept Release asks for information on how different types of funds use various types of derivatives as well as the benefits, risks and costs of using derivatives. It also asks for comment on several specific issues under the Investment Company Act implicated by funds’ use of derivatives.

The Investment Company Act restricts the manner and extent to which funds may incur indebtedness and leverage their portfolios. The Concept Release discusses the treatment of derivatives under these restrictions. The Concept Release asks, among other things, how to measure the amount of leverage that a fund incurs when it invests in a derivative. While the 1940 Act does not require the portfolios of funds to be diversified, it does require them to disclose in their registration statements whether they are diversified or not. The Act also prohibits a fund from changing its classification from diversified to non-diversified without shareholder approval. The Concept Release asks how a fund should value a derivative to determine the percentage of the fund's assets that' are invested in a particular company for diversification purposes.

While the 1940 Act prohibits funds from acquiring any security issued by, or any other interest in, the business of a broker, dealer, underwriter or investment adviser, funds that meet certain conditions may acquire some securities issued by companies engaged in such business. The Concept Release asks how investing in a derivative issued by a broker-dealer may be different from, or similar to, investing in the broker-dealer's stock or bond.

Similarly, although the 1940 Act does not prohibit funds from concentrating their investments in a particular industry, it does require funds to disclose their industry concentration policies in their registration statements. It also prohibits funds from deviating from those policies without shareholder approval. The Concept Release queries how funds determine the industry or industries to which they may be exposed through a derivative investment.

Also, the Investment Company Act specifies how funds must determine the value of their assets. The Concept Release asks whether the SEC should issue guidance on how funds should value derivatives in their portfolios.

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