Federal Register / Vol. 76, No. 173 / Wednesday, September 7, 2011 / Rules and Regulations 55237

[FR Doc. 2011–22450 Filed 9–6–11; 8:45 am] Paper Comments B. Application of the Diversification BILLING CODE 4910–13–P Requirements to a Fund’s Use of • Send paper comments in triplicate Derivatives to Elizabeth M. Murphy, Secretary, 1. of Derivatives for Purposes of Securities and Exchange Commission, Determining a Fund’s Classification as SECURITIES AND EXCHANGE 100 F Street, NE., Washington, DC Diversified or Non-Diversified COMMISSION 20549–1090. 2. Identification of the Issuer of a for Purposes of Determining a 17 CFR Part 271 All submissions should refer to File Fund’s Classification as Diversified or Number S7–33–11. This file number Non-Diversified C. Request for Comment [Release No. IC–29776; File No. S7–33–11] should be included on the subject line if comments are submitted by e-mail. To IV. Exposure to Securities-Related Issuers Through Derivatives RIN 3235–AL22 help us process and review your comments more efficiently, please use A. Investment Company Act Limitations on Investing in Securities-Related Issuers Use of Derivatives by Investment only one method. The Commission will B. Counterparty to a Derivatives Companies Under the Investment post all comments on the Commission’s Investment Company Act of 1940 Internet Web site (http://www.sec.gov/ C. Exposure to Other Securities-Related rules/concept.shtml). Comments are also Issuers Through Derivatives AGENCY: Securities and Exchange available for public inspection and D. Valuation of Derivatives for Purposes of Commission. copying in the Commission’s Public Rule 12d3–1 Under the Investment ACTION: Concept release; request for Reference Room, 100 F Street, NE., Company Act comments. Washington, DC 20549, on official E. Request for Comment business days between the hours of V. Portfolio Concentration SUMMARY: The Securities and Exchange A. Investment Company Act Provisions 10 a.m. and 3 p.m. All comments Regarding Portfolio Concentration Commission (the ‘‘Commission’’) and its received will be posted without change; staff are reviewing the use of derivatives B. Issues Relating to the Application of the the Commission does not edit personal Act’s Concentration Provisions to a by management investment companies identifying information from Fund’s Use of Derivatives registered under the Investment submissions. Therefore, you should C. Request for Comment Company Act of 1940 (the ‘‘Investment only submit information that you wish VI. Valuation of Derivatives Company Act’’ or ‘‘Act’’) and companies to make available publicly. A. Investment Company Act Valuation that have elected to be treated as Requirements business development companies FOR FURTHER INFORMATION CONTACT: B. Application of the Valuation (‘‘BDCs’’) under the Act (collectively, Edward J. Rubenstein, Senior Special Requirements to a Fund’s Use of ‘‘funds’’). To assist in this review, the Counsel, or Michael S. Didiuk, Senior Derivatives Commission is issuing this concept Counsel, at (202) 551–6825, Office of C. Request for Comment VII. General Request for Comment release and request for comments on a Chief Counsel, Division of Investment wide range of issues relevant to the use Management, Securities and Exchange * * * * * of derivatives by funds, including the Commission, 100 F Street, NE., I. Introduction potential implications for fund leverage, Washington, DC 20549–5030. diversification, exposure to certain SUPPLEMENTARY INFORMATION: The activities of funds, including securities-related issuers, portfolio their use of derivatives, are regulated concentration, valuation, and related Table of Contents extensively under the Investment 1 matters. In addition to the specific I. Introduction Company Act, Commission rules, and issues highlighted for comment, the A. Purpose and Scope of the Concept Commission guidance.2 Derivatives may Commission invites members of the Release public to address any other matters that B. Background Concerning the Use of 1 15 U.S.C. 80a. All statutory references to the they believe are relevant to the use of Derivatives by Funds Investment Company Act are to 15 U.S.C. 80a, and, C. Request for Comment unless otherwise stated, all references to rules derivatives by funds. The Commission under the Investment Company Act are to Title 17, intends to consider the comments to II. Derivatives Under the Senior Securities Restrictions of the Investment Company Part 270 of the Code of Federal Regulations [17 CFR help determine whether regulatory Act 270]. All references to the Securities Act of 1933 initiatives or guidance are needed to (the ‘‘Securities Act’’) are to 15 U.S.C. 77a, and, A. Purpose, Scope, and Application of the unless otherwise stated, all references to rules improve the current regulatory regime Act’s Senior Securities Limitations under the Securities Act are to Title 17, Part 230 for funds and, if so, the nature of any 1. Statutory Restrictions on Senior of the Code of Federal Regulations [17 CFR 230]. All such initiatives or guidance. Securities and Related Commission references to the Securities Exchange Act of 1934 DATES: Guidance (the ‘‘Exchange Act’’) are to 15 U.S.C. 78a, and, Comments should be received on unless otherwise stated, all references to rules or before November 7, 2011. 2. Staff No-Action Letters Concerning the Segregated Account Approach under the Exchange Act are to Title 17, Part 240 [17 ADDRESSES: Comments may be CFR 240]. B. Alternative Approaches to the 2 submitted by any of the following Regulation of Portfolio Leverage The staff has also issued no-action and other letters that relate to fund use of derivatives. In methods: 1. The Current Asset Segregation Approach addition to Investment Company Act provisions, 2. Other Approaches funds using derivatives must comply with all other Electronic Comments C. Request for Comment applicable statutory and regulatory requirements, • Use the Commission’s Internet 1. Issues Concerning the Current Asset such as other Federal securities law provisions, the comment form (http://www.sec.gov/ Segregation Approach Internal Revenue Code (the ‘‘IRC’’), Regulation T of 2. Alternatives to the Current Asset the Federal Reserve Board (‘‘Regulation T’’), and the rules/concept.shtml); rules and regulations of the Commodity Futures • Segregation Approach Send an e-mail to rule- 3. Related Matters Trading Commission (the ‘‘CFTC’’). See also Title [email protected]; or VII of the Dodd-Frank Wall Street Reform and • III. Derivatives Under the Investment Consumer Protection Act, Public Law 111–203, 124 Use the Federal eRulemaking Portal Company Act’s Diversification Stat. 1376 (2010) (the ‘‘Dodd-Frank Act’’), available (http://www.regulations.gov). Follow the Requirements at http://www.sec.gov/about/laws/wallstreetreform- instructions for submitting comments. A. The Diversification Requirements cpa.pdf.

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be broadly described as instruments or have led the Commission and its staff to funds that rely substantially upon contracts whose value is based upon, or initiate a review of funds’ use of derivatives, particularly those that seek derived from, some other asset or metric derivatives under the Investment to provide leveraged returns, maintain (referred to as the ‘‘underlier,’’ Company Act.8 The staff generally has and implement adequate risk ‘‘underlying,’’ or ‘‘reference asset’’).3 As been exploring the benefits, risks, and management and other procedures in detailed below,4 funds employ costs associated with funds’ use of light of the nature and volume of their derivatives for a variety of purposes, derivatives. The staff also has been derivatives investments; whether funds’ including to increase leverage to boost exploring issues relating to the use of boards of directors are providing returns, gain access to certain markets, derivatives by funds such as: whether appropriate oversight of the use of achieve greater transaction efficiency, current market practices involving derivatives by the funds; whether and hedge interest rate, credit, and other derivatives are consistent with the existing rules sufficiently address risks.5 At the same time, derivatives can leverage, concentration, and matters such as the proper procedures raise risk management issues for a fund diversification provisions of the for a fund’s pricing and liquidity relating, for example, to leverage, Investment Company Act; whether determinations regarding its derivatives illiquidity (particularly with respect to holdings; whether existing prospectus complex OTC derivatives), and Compliance Obligations, Investment Company disclosures adequately address the counterparty risk, among others.6 Institute (‘‘ICI’’) Comment Letter to the CFTC at 18 particular risks created by derivatives; The dramatic growth in the volume (Apr. 12, 2011), available at http://www.ici.org/pdf/ 25107.pdf. See also, e.g., Tim Adam and Andre and whether funds’ derivative activities and complexity of derivatives Guettler, The Use of Credit Default Swaps by U.S. should be subject to any special investments over the past two decades, Fixed-Income Mutual Funds, FDIC Ctr. for Fin. reporting requirements. and funds’ increased use of derivatives,7 Research, Working Paper No. 2011–01, (Nov. 19, 2010) (‘‘Adam and Guettler Article’’), available at A. Purpose and Scope of the Concept http://www.fdic.gov/bank/analytical/cfr/2011/ 3 Release See, e.g., Board Oversight of Derivatives, wp2011/CFR_WP_2011_01.pdf (study of the use of Independent Directors Council Task Force Report credit default swaps (‘‘CDS’’) by the largest 100 U.S. The goal of the Commission’s and (July 2008) (‘‘2008 IDC Report’’) at 1, 3, available corporate funds between 2004 and 2008 staff’s review is to evaluate whether the at http://www.ici.org/pdf/ppr_08_derivatives.pdf. reflects an increase from about 20% of funds using regulatory framework, as it applies to See also Mutual Funds and Derivative Instruments, credit default swaps in 2004 to 60% of funds using Division of Investment Management Memorandum them in 2008; among CDS users, the average size funds’ use of derivatives, continues to transmitted by Chairman Levitt to Representatives of CDS positions (measured by their notional fulfill the purposes and policies Markey and Fields (Sept. 26, 1994) (‘‘1994 Report’’) values) increased from 2% to almost 14% of a underlying the Act and is consistent at text accompanying n. 1 (‘‘[t]he term ‘derivative’ fund’s NAV over the same period, with the CDS with investor protection. The purpose of is generally defined as an instrument whose value positions representing less than 10% of NAV for is based upon, or derived from, some underlying most funds, but with some funds exceeding this this concept release is to assist with this index, reference rate (e.g., interest rates or currency level by a wide , particularly in 2008; CDS review and solicit public comment on exchange rates), , commodity, or other are predominantly used to increase a fund’s the current regulatory regime under the asset.’’), and at n. 2 (the ‘‘term ‘derivative’ generally exposure to credit risks (net sellers of CDS) rather Act as it applies to funds’ use of is used to embrace forward contracts, futures, than to hedge credit risk (net buyers); the frequency swaps, and options’’), available at http:// of credit default usage by the largest bond derivatives. We intend to use the www.sec.gov/news/studies/deriv.txt; John C. Hull, funds is comparable to that of most hedge funds), comments to help determine whether Options, Futures, and Other Derivatives (7th ed. available at http://www.fdic.gov/bank/analytical/ regulatory initiatives or guidance are 2009) (‘‘Hull’’) at 1, 779 (‘‘A derivative can be cfr/2011/wp2011/CFR_WP_2011_01.pdf; Assess the needed to improve the current defined as a financial instrument whose value Risks: Key Strategies for Overseeing Derivatives, depends on (or derives from) the values of other, Board IQ at 1 (Jan. 15, 2008) (‘‘In recent years, the regulatory regime and the specific more basic underlying variables,’’ and a derivative use of derivatives by mutual funds has soared.’’), nature of any such initiatives.9 is an ‘‘instrument whose price depends on, or is available at http://www.interactivedata.com/ A fund that invests in derivatives derived from, the price of another asset’’) (italics in uploads/BoardIQ1207.pdf; 2008 JPMorgan Article, original); rule 3b–13 under the Exchange Act, must take into consideration various supra note 6. provisions of the Investment Company which defines ‘‘eligible OTC derivative 8 In a press release issued in March 2010, the instrument,’’ and rule 16a–1(c) under the Exchange Commission announced that the staff was Act and Commission rules under the Act, which defines ‘‘derivative securities;’’ section conducting a review to evaluate the use of Act. The fund must consider the 5200(b) of the Revised Statutes of the United States derivatives by mutual funds, registered exchange- leverage limitations of section 18 of the [12 U.S.C. 84(b)] (as amended by section 610(a)(3) traded funds (‘‘ETFs’’), and other investment of the Dodd-Frank Act, supra note 2), which defines companies. The press release indicated that the Investment Company Act, which a ‘‘derivative transaction’’ to include ‘‘any review would examine whether and what governs the extent to which a fund may transaction that is a contract, agreement, swap, additional protections are necessary for those funds issue ‘‘senior securities.’’ 10 , note, or that is based, in whole or A fund’s use under the Investment Company Act. The press of derivatives also may raise issues in part, on the value of, any interest in, or any release further indicated that pending completion of quantitative measure or the occurrence of any event this review, the staff would defer consideration of relating to, one or more commodities, securities, exemptive requests under the Act relating to ETFs 9 Section 2(c) of the Investment Company Act currencies, interest or other rates, indices, or other that would make significant investments in provides that ‘‘[w]henever pursuant to this title the assets.’’ derivatives. See SEC Press Release 2010–45, SEC Commission is engaged in rulemaking and is 4 For a definition, and examples of types, of Staff Evaluating the Use of Derivatives by Funds required to consider or determine whether an action derivatives, see infra Section I.B. (Mar. 25, 2010) (‘‘2010 Derivatives Press Release’’), is consistent with the public interest, the 5 See 2008 IDC Report, supra note 3, at 8–11. See available at http://www.sec.gov/news/press/2010/ Commission shall also consider, in addition to the also infra Section I.B. 2010-45.htm. As part of the staff’s review to protection of investors, whether the action will 6 See 2008 IDC Report, supra note 3, at 12–13. See evaluate fund use of derivatives, and to further promote efficiency, competition, and capital also Derivative Holdings: Fueling the enhance its knowledge of how funds are using, and formation.’’ Need for Improved Risk Management, JPMorgan managing their use of, derivatives, the staff met 10 See sections 18(a)(1) and 18(f)(1) of the Thought Magazine (Summer 2008) (‘‘2008 JPMorgan with industry groups as well as with some fund Investment Company Act. See also Securities Article’’), available at http://www.jpmorgan.com/ complexes that use OTC derivatives. The staff also Trading Practices of Registered Investment cm/BlobServer?blobcol=urldata&blobtable= reviewed fund disclosures relating to the use of Companies, Investment Company Act Release No. MungoBlobs&blobkey=id& derivatives and their risks. In addition, the staff 10666 (Apr. 18, 1979) (‘‘Release 10666’’) [44 FR blobwhere=1158494213964& considered The Report of the Task Force on 25128 (Apr. 27, 1979)], and Registered Investment blobheader=application%2Fpdf& Investment Company Use of Derivatives and Company Use of Senior Securities–Select blobnocache=true&blobheadername1=Content. Leverage, Committee on Federal Regulation of Bibliography (‘‘Senior Security Bibliography’’), 7 While complete data concerning the nature of Securities, ABA Section of Business Law (July 6, available at http://www.sec.gov/divisions/ derivatives activities of funds is unavailable, for a 2010) (‘‘2010 ABA Derivatives Report’’), available at investment/seniorsecurities-bibliography.htm partial snapshot of derivatives activity by selected http://meetings.abanet.org/webupload/ (prepared by the staff). See also discussion infra at fund complexes see Commodity Pool Operators and commupload/CL410061/sitesofinterest_files/ Section II. (Derivatives under the Senior Securities Commodity Trading Advisors: Amendments to DerivativesTF_July_6_2010_final.pdf. Restrictions of the Investment Company Act).

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under Investment Company Act there are at least two potential measures often create exposures to multiple provisions governing diversification,11 of the ‘‘value’’ 18 of a derivative for variables, such as the credit of a concentration,12 investing in certain purposes of applying various provisions counterparty as well as to a reference types of securities-related issuers,13 of the Act: the current market value or asset on which the derivative is based. valuation,14 and accounting and fair value reflecting the price at which The Commission or its staff, over the financial statement reporting,15 among the derivative could be expected to be years, has addressed a number of issues others,16 as well as under applicable liquidated; and the notional amount relating to derivatives on a case-by-case disclosure provisions.17 reflecting the contract size (number of basis. The Commission now seeks to Derivatives generally entail the units per contract) multiplied by the take a more comprehensive and potential for leveraged future gains and/ current unit price of the reference asset systematic approach to derivatives- or losses that may significantly impact on which payment obligations are related issues under the Investment the overall risk/reward profile of a fund. calculated.19 In addition, derivatives Company Act. In particular, in this Applying the Act’s provisions relating release the Commission discusses and to diversification, concentration, and 18 The Bank for International Settlements (the seeks comment on the following issues, investments in securities-related issuers, ‘‘BIS’’) reports gross market values (positive and among others, relating to funds’ use of negative) for open derivative contracts, which are among others, may require determining 20 defined as ‘‘the sums of the absolute values of all derivatives: what value to assign to the derivative open contracts with either positive or negative • The attendant costs, benefits and and which of the derivative’s multiple replacement values evaluated at market prices risks; exposures should be measured for prevailing at the reporting date. Thus, the gross • The application of the Act’s purposes of the relevant provision. This positive market value of a dealer’s outstanding contracts is the sum of the replacement values of prohibitions and restrictions on senior determination may be complex because all contracts that are in a current gain position to securities and leverage; the reporter at current market prices * * * The • The application of the Act’s 11 See sections 5(b)(1) and 13(a)(1) of the gross negative market value is the sum of the values prohibition on investments in Investment Company Act. See also infra discussion of all contracts that have a negative value on the securities-related issuers; at Section III. (Derivatives under the Investment reporting date * * *.’’ Guide to the International • Company Act’s Diversification Requirements). Financial Statistics, Bank for International The application of the Act’s 12 See sections 8(b)(1)(E) and 13(a)(3) of the Settlements (July 2009) (‘‘BIS Guide’’) at 31, provisions concerning portfolio Investment Company Act. See also Form N–1A, available at http://www.bis.org/statistics/ diversification and concentration; and Item 4(a), instruction 4 to Item 9(b)(1), and Item intfinstatsguide.pdf. See also Sarah Sharer Curley • The application of the Act’s 16(c)(1)(iv); Form N–2, Item 8.2.b (2), and Item and Elizabeth Fella, Where to Hide? How Valuation 17.2.e. See also infra discussion at Section V. of Derivatives Haunts the Courts—Even After provisions governing valuation of funds’ (Portfolio Concentration). BAPCPA, 83 Am. Bankr. L.J. 297, 298–99 (Spring assets. 13 See section 12(d)(3) of the Investment Company 2009) (‘‘In a simple * * * [t]he In addition to the specific issues Act and rule 12d3–1 thereunder. See also infra value of the swap is the net difference between the highlighted for comment, the discussion at Section IV. (Exposure to Securities- present value of the payments each party expects Related Issuers Through Derivatives). to receive and the present value of the payments Commission invites members of the 14 See section 2(a)(41) of the Investment Company each party expects to make. The value is generally public to address any other matters that Act. See also Restricted Securities, Investment zero to each party at the inception of the swap, and they believe are relevant to the use of Company Act Release No. 5847 (Oct. 21, 1969) [35 becomes positive to one party and negative to the derivatives by funds. FR 19989 (Dec. 31, 1970)] (‘‘ASR 113’’), available other depending on what direction the interest rates at http://www.sec.gov/rules/interp/1969/ic- move.’’); CFTC Glossary, Mark-to-Market Definition, B. Background Concerning the Use of 5847.pdf; Accounting for Investment Securities by available at http://www.cftc.gov/Consumer Derivatives by Funds Registered Investment Companies, Investment Protection/EducationCenter/CFTCGlossary/ Company Act Release No. 6295 (Dec. 23, 1970) [35 index.htm (stating that marking to market is As noted above, derivatives may be FR 19986 (Dec. 31, 1970)] (‘‘ASR 118’’), available accomplished for a futures or option contract by broadly defined to include instruments at http://www.sec.gov/rules/interp/1970/ic- ‘‘calculating the gain or loss in each contract 6295.pdf. See also infra discussion at Section VI. position resulting from changes in the price of the or contracts whose value is based upon, (Valuation of Derivatives). contracts at the end of each trading session. These or derived from, some reference asset. 15 See generally section 30(e) of the Investment amounts are added or subtracted to each account Reference assets can include, for Company Act. balance.’’). example, , bonds, commodities, 16 19 The BIS describes ‘‘notional amounts See, e.g., Investment Company Act provisions currencies, interest rates, market relating to custody (section 17(f) and related rules), outstanding’’ as ‘‘a reference from which and fund names (section 35(d) and rule 35d–1). contractual payments are determined in derivatives indices, currency exchange rates, or Also, an open-end fund should consider the effect markets.’’ BIS Guide, supra note 18, at 30. other assets or interests, in virtually that the use of derivatives may have on the liquidity ‘‘Notional value’’ can be defined as ‘‘the value of endless variety.21 of the fund’s portfolio. For general guidance on a derivative’s underlying assets at the spot price.’’ liquidity and open-end funds, see, e.g., Resale of In the case of an options or , the Restricted Securities; Changes to Method of notional value is the number of units of an asset because it is neither paid nor received’’); Frank J. Determining Holding Period of Restricted Securities underlying the contract, multiplied by the spot Fabbozzi, et al., Introduction to , Under Rules 144 and 145, Investment Company Act price of the asset. See http://www.investorwords. at 27 (2006) (‘‘[In an interest rate swap] [t]he dollar Release No. 17452 (Apr. 23, 1990) [55 FR 17933 com/5930/notional-value.htm. The ‘‘spot price’’ of amount of the interest payments exchanged is based (Apr. 30, 1990)], available at http://www.sec.gov/ a derivative’s underlying asset is the asset’s price on some predetermined dollar principal, which is rules/final/1990/33-6862.pdf. See also Revisions of for immediate delivery, i.e., in the current market, called the notional amount.’’) (italics in original); Guidelines, Investment Company Act Release No. in contrast with the asset’s future or . 2010 ABA Derivatives Report, supra note 8, at n.11 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)], See, e.g., Hull, supra note 3, at 789. ‘‘Notional (noting that the term ‘‘notional amount’’ is used available at http://www.sec.gov/rules/other/1992/ value’’ is also defined as ‘‘the underlying value differently by different people in different contexts, 33-6927.pdf. (face value), normally expressed in U.S. dollars, of but is used, in the Report, to refer to ‘‘the nominal 17 See, e.g., section 8(b) of the Investment the financial instrument or commodity specified in or face amount that is used to calculate payments Company Act, and Items 4(a), 4(b), 9(b), 9(c), and a futures or options on futures contract.’’ See CME made on a particular instrument, without regard to 16(b) of Form N–1A. Certain derivatives-related Group Glossary, available at http:// whether its obligation under the instrument could disclosure issues were discussed in a 2010 staff www.cmegroup.com/education/glossary.html. be netted against the obligation of another party to letter to the ICI. See Derivatives-Related Disclosures ‘‘ ‘Notional principal’ or ‘notional amount’ of a pay the fund under the instrument.’’). by Investment Companies, Letter from Barry D. derivative contract is a hypothetical underlying 20 The Commission recognizes that there are other Miller, Associate Director, Division of Investment quantity upon which interest rate or other payment significant derivatives-related issues under the Management, U.S. Securities and Exchange obligations are computed.’’ ISDA Online Product Investment Company Act that this release does not Commission, to Karrie McMillan, General Counsel, Descriptions and Frequently Asked Questions at address, such as disclosure-related issues, which ICI (July 30, 2010) (‘‘2010 Staff Derivatives http://www.isda.org/educat/faqs.html#7. See also the Commission may consider at a later date. Disclosure Letter’’), available at http:// Hull, supra note 3, at 786 (‘‘Notional principal’’ is 21 For example, the reference asset of a Standard www.sec.gov/divisions/investment/guidance/ the ‘‘principal used to calculate payments in an & Poor’s (‘‘S&P’’) 500 futures contract is the S&P ici073010.pdf. interest rate swap. The principal is ‘notional’ Continued

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Derivatives are often characterized as are contracts negotiated and entered investments entered into by a fund, either exchange-traded or OTC.22 into outside of an organized exchange. such as futures contracts, swaps, and Exchange-traded derivatives—such as Unlike exchange-traded derivatives, written options, create obligations, or futures, certain options,23 and options OTC derivatives may be significantly potential indebtedness, to someone on futures 24—are standardized customized, and may not be guaranteed other than the fund’s shareholders, and contracts traded on regulated exchanges, by a central clearing organization. OTC enable the fund to participate in gains such as the Chicago Mercantile derivatives that are not centrally and losses on an amount that exceeds Exchange and the Chicago Board cleared, therefore, may involve greater the fund’s initial investment.31 Other Options Exchange. OTC derivatives— counterparty credit risk, and may be derivatives entered into by a fund, such such as swaps,25 non-exchange traded more difficult to value, transfer, or as purchased call options, provide the options, and combination products such liquidate than exchange-traded economic equivalent of leverage because as 26 and forward swaps 27— derivatives.28 The Dodd-Frank Act and they convey the right to a gain or loss Commission rules thereunder seek to on an amount in excess of the fund’s 500 index. 2008 IDC Report, supra note 3, at establish a comprehensive new investment but do not impose a Appendix C at C5. regulatory framework for two broad payment obligation on the fund above 22 See, e.g., Robert W. Kolb & James A. Overdahl, categories of derivatives—swaps and its initial investment.32 Financial Derivatives, at 21 (2010) (‘‘Kolb & Overdahl’’). security-based swaps—designed to Funds use derivatives to implement 23 An option is the right to buy or sell an asset. reduce risk, increase transparency, and their investment strategies, and to There are two basic types of options, a ‘‘’’ promote market integrity within the manage risk.33 A fund may use and a ‘‘.’’ A call option gives the holder financial system.29 derivatives to gain, maintain, or reduce the right (but does not impose the obligation) to buy A common characteristic of most the underlying asset by a certain date for a certain exposure to a market, sector, or security price. The seller, or ‘‘writer,’’ of a call option has derivatives is that they involve more quickly and/or with lower the obligation to sell the underlying asset to the leverage.30 Certain derivatives transaction costs and portfolio holder if the holder exercises the option. A put option gives the holder the right (but does not future. See Swap Definition Release, supra note 25, return on a capital base that exceeds the investment impose the obligation) to sell the underlying asset at n. 147. See also, e.g., Hull, supra note 3, at 171, which he has personally contributed to the entity by a certain date for a certain price. The seller, or 779 (‘‘deferred swap’’). or instrument achieving a return.’’ Release 10666, ‘‘writer’’, of a put option has the obligation to buy 28 An OTC derivative may be more difficult to supra note 10, at n. 5. from the holder the underlying asset if the holder transfer or liquidate than an exchange-traded 31 exercises the option. The price that the option The leverage created by such an arrangement is derivative because, for example, an OTC derivative holder must pay to the option is known as sometimes referred to as ‘‘indebtedness leverage.’’ may provide contractually for non-transferability the ‘‘exercise’’ or ‘‘strike’’ price. The amount that 1994 Report, supra note 3, at 22. without the consent of the counterparty, or may be the option holder pays to purchase an option is 32 This type of leverage is sometimes referred to sufficiently customized that its value is difficult to known as the ‘‘option premium,’’ ‘‘price,’’ ‘‘cost,’’ as ‘‘economic leverage.’’ See 1994 Report, supra establish or its terms too narrowly drawn to attract or ‘‘fair value’’ of the option. For a basic note 3, at 23 (‘‘Other derivatives provide the transferees willing to accept assignment of the economic equivalent of leverage because they explanation of options, see, e.g., Hull, supra note contract, unlike most exchange-traded derivatives. 3, at 6–8, 179–236, and Kolb & Overdahl, supra note display heightened price sensitivity to market 29 The Dodd-Frank Act, supra note 2, was signed 22, at 13–16. fluctuations * * * such as changes in prices into law on July 21, 2010. The Dodd-Frank Act 24 or interest rates. In essence, these derivatives Options on futures generally trade on the same mandates, among other things, substantial changes exchange as the relevant futures contract. When a magnify a fund’s gain or loss from an investment in the OTC derivatives markets, including new in much the same way that incurring indebtedness call option on a futures contract is exercised, the clearing, reporting, and trade execution mandates does.’’). The 1994 Report gives a leveraged inverse holder acquires from the writer a long position in for swaps and security-based swaps, and both floating rate bond, with an interest rate that moves the underlying futures contract plus a cash amount exchange-traded and OTC derivatives are inversely to a benchmark rate, as another example equal to the excess of the futures price over the contemplated under the new regime. See Dodd- of an instrument that displays economic leverage. . When a put option on a futures Frank Act sections 723 (mandating clearing of contract is exercised, the holder acquires a swaps) and 763 (mandating clearing of security- See also 2010 ABA Derivatives Report, supra note position in the underlying futures contract plus a based swaps). Some of these changes will require 8, at 20–21 (discussion of ‘‘implied’’ or ‘‘economic’’ cash amount equal to the excess of the strike price Commission action through rulemaking to become leverage’’). For additional discussion of the over the futures price. See, e.g., Hull, supra note 3, effective. See Temporary Exemptions and Other leveraging effects of derivatives (not limited to at 184, 341–54, and 782. Temporary Relief, Together With Information on ‘‘economic leverage’’), see 2010 ABA Derivatives 25 A ‘‘swap’’ is generally an agreement between Compliance Dates for New Provisions of the Report, supra note 8, at 8–9. See also 2008 IDC two counterparties to exchange periodic payments Securities Exchange Act of 1934 Applicable to Report, supra note 3, at 3 (‘‘Market participants are based upon the value or level of one or more rates, Security-Based Swaps, Exchange Act Release No. able to acquire exposure (either long or short) to a indices, assets, or interests of any kind. For 64678 (June 15, 2011) [76 FR 36287 (June 22, large dollar amount of an asset (the notional value) example, counterparties may agree to exchange 2011)], available at http://www.sec.gov/rules/ with only a small down payment, enabling parties payments based on different currencies or interest exorders/2011/34-64678.pdf. For summaries of to shift risk more efficiently and with lower costs. rates. See generally, e.g., Kolb & Overdahl, supra other recent, pending, and future Commission and The leverage inherent in these instruments note 22, at 11–13; Hull, supra note 3, at 147–73. See staff initiatives relating to derivatives, see, e.g., magnifies the effect of changes in the value of the also section 3(a)(69) of the Exchange Act for the Testimony on Enhanced Oversight after the underlying asset on the initial amount of capital definition of ‘‘swap’’ (using the definition in section Financial Crisis: The Wall Street Reform Act at invested. For example, an initial 5% collateral 1a of the Commodity Exchange Act, 7 U.S.C. 1a (the One-Year, by Chairman Mary L. Schapiro, deposit on the total value of the commodity would ‘‘CEA’’)); section 3(a)(68) of the Exchange Act for Chairman, U.S. Securities and Exchange result in 20:1 leverage, with a potential 80% loss the definition of ‘‘security-based swap;’’ section Commission, before the United States Senate (or gain) of the collateral in response to a 4% 721(a)(3) of the Dodd-Frank Act, supra note 2, for Committee on Banking, Housing and Urban Affairs movement in the market price of the underlying the definition of ‘‘cleared swap;’’ and section (July 21, 2011), available at http://www.sec.gov/ commodity.’’). 721(a)(12) of the Dodd-Frank Act for the definition news/testimony/2011/ts072111mls.htm. See also, 33 2008 IDC Report, supra note 3, at 7–11. A fund of ‘‘.’’ See also Further e.g., http://www.sec.gov/spotlight/dodd-frank/ may also use derivatives to hedge current portfolio Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and accomplishments.shtml#derivatives; http:// exposures (for example, when a fund’s portfolio is ‘‘Security-Based Swap Agreement;’’ Mixed Swaps; www.sec.gov/spotlight/dodd-frank/dfactivity- structured to reflect the fund’s long-term Security-Based Swap Agreement Recordkeeping, upcoming.shtml#07-12-12; http://www.sec.gov/ investment strategy and its investment adviser’s Securities Act Release No. 9204 (Apr. 29, 2011) [76 spotlight/dodd-frank/dfactivity- forecasts, interim events may cause the fund’s FR 29818 (May 23, 2011)] (‘‘Swap Definition upcoming.shtml#08-12-11; http://www.sec.gov/ investment adviser to seek to temporarily hedge a Release’’), available at http://www.sec.gov/rules/ spotlight/dodd-frank/dfactivity- portion of the portfolio’s broad market, sector, and/ proposed/2011/33-9204.pdf. upcoming.shtml#01-06-12; http://www.sec.gov/ or security exposures). Industry participants believe 26 A ‘‘’’ is an option to enter into an news/press/2011/2011-137.htm; http:// that derivatives may also provide a more efficient interest rate swap where a specified fixed rate is www.sec.gov/rules/other/2011/34-64926.pdf; and hedging tool than reducing exposure by selling exchanged for a floating rate. See, e.g., Hull, supra http://www.sec.gov/spotlight/dodd-frank/ individual securities, offering greater liquidity, note 3, at 172, 658–62, 790. derivatives.shtml. lower round-trip transaction costs, lower taxes, and 27 A forward swap (or deferred swap) is an 30 The Commission has stated that ‘‘[l]everage reduced disruption to the portfolio’s longer-term agreement to enter into a swap at some time in the exists when an investor achieves the right to a positioning. See id. at 11.

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disruption than investing directly changes in the relative values of two agency will downgrade the bond or the through the securities markets. At the currencies.38 credit of the counterparty, or the risk same time, use of derivatives may entail • Interest rate derivatives.39 A fund that credit ‘‘spread’’ will increase.42 A risks relating, for example, to leverage, may use interest rate derivatives to fund may sell (or write) credit illiquidity (particularly with respect to modify its exposure to the gains or protection to enhance its income and complex OTC derivatives), and losses arising from changes in interest return by the amount of the payment counterparty risk, among others.34 A rates and to seek enhanced returns. For that it receives for providing such fund’s use of derivatives presents example, a fund may use an interest rate protection, or to obtain some investment challenges for its investment adviser swap to hedge against the risk of a exposure to the reference asset (that is, and board of directors to ensure that the decline in the prices of bonds owned by the underlying bond), without owning derivatives are employed in a manner a fund due to rising interest rates. the bond. The Commission understands consistent with the fund’s investment Similarly, a fund could shorten the that selling protection may be more cost objectives, policies, and restrictions, its duration of its portfolio by selling effective than an outright purchase of a risk profile, and relevant regulatory futures contracts on U.S. Treasury bond.43 • 44 requirements, including those under bonds or notes, or Eurodollar futures. Equity Derivatives. Funds may Federal securities laws. With respect to Apart from hedging, a fund might use use equity derivatives to enhance some primary types of reference assets, interest rate derivatives to seek to investment opportunities (for example, funds may use derivatives for the enhance its returns based on its by using foreign index futures to obtain following purposes, among others: investment adviser’s views concerning exposure to a foreign equity market). future movements in interest rates or Equity derivatives also can be used by • 35 Currency derivatives. A fund may changes in the shape of the funds as an income-producing strategy use currency derivatives to increase or curve.40 by, for example, selling equity call decrease exposure to specific • Credit Derivatives.41 Credit options on a particular security owned currencies, to hedge against adverse derivatives allow a fund to assume an by the fund.45 A fund also may use impacts on the fund’s portfolio caused investment position concerning the equity derivatives (usually stock index by currency fluctuations, and to seek likelihood that a particular bond, or a futures) to ‘‘equitize’’ cash.46 additional returns. For example, group of bonds, will be repaid in full currency derivatives can provide a upon maturity. When a fund purchases C. Request for Comment hedge against the risk that a fund’s credit protection, it pays a premium to The Commission generally requests investment in a foreign debt security a counterparty in return for which the data and comment on the types of will decline in value because of a counterparty promises to pay the fund derivatives used by funds, the purposes decline in the value of the foreign if a bond or bonds default or experience for which funds use derivatives, and currency in which the foreign debt some other adverse credit event. When whether funds’ use of derivatives has security is denominated.36 Funds also a fund sells (or writes) credit protection, undergone or may be undergoing may use currency derivatives to hedge the fund agrees to pay a counterparty if changes and, if so, the nature of such against a rise in the value of a foreign a bond or bonds default or experience changes. The Commission specifically currency, or may use ‘‘cross-currency’’ some other adverse credit event, in requests comment on the following: • hedging or ‘‘proxy’’ hedging when, for exchange for the receipt of a premium What are the costs and benefits to instance, it is difficult or expensive to from the protection purchaser. A fund funds from the use of derivatives? What hedge a particular currency against the may purchase credit protection using are the factors that influence those costs U.S. dollar.37 Apart from hedging, funds credit derivatives to hedge against and benefits? What are the risks to funds may use currency derivatives to seek particular risks that are associated with returns on the basis of anticipated a bond that it owns, such as the risk that 42 See 2010 ABA Derivatives Report, supra note 8, at 7. the bond issuer will default, a rating 43 See id. at 8. The 2010 ABA Derivatives Report, 34 See, e.g., 2008 IDC Report, supra note 3, at 12– supra note 8, at 8, also observes that ‘‘a fund could 13. See also 2008 JPMorgan Article, supra note 6. 38 Id. at 7. write a CDS, offering credit protection to its 35 See Swap Definition Release, supra note 25, at 39 Interest rate derivatives include interest rate or counterparty. In doing so the fund gains the II.C.1, for a description of certain currency bond futures, Eurodollar futures, caps, floors, economic equivalent of owning the security on derivatives (foreign exchange swaps, foreign overnight indexed swaps, interest rate swaps, and which it wrote the CDS, while avoiding the exchange forwards, foreign currency options, non- options on futures and swaps. See, e.g., id. See also transaction costs that would have been associated deliverable forwards, currency swaps, and cross- Swap Definition Release, supra note 25, at III.B.1 with the purchase of the security.’’ currency swaps). The 2010 ABA Derivatives Report, (briefly describing interest and other monetary rate 44 Equity derivatives include equity futures supra note 8 at 6–7, gives as examples of currency swaps, and discussing that when payments contracts, options on equity futures contracts, derivatives forward currency contracts, currency exchanged under a Title VII (of the Dodd-Frank Act) equity options, and various kinds of equity-related futures contracts, currency swaps, and options on instrument are based solely on the levels of certain swaps (such as a on an equity currency futures contracts. As a general matter, interest rates or other monetary rates that are not security). See, e.g., id. at 8. futures, forwards, swaps, and options can all be themselves based on securities, the instrument 45 By selling the options, a fund can earn income used to increase or decrease exposures to reference would be a swap but not a security-based swap). (in the form of the premium received for writing the currencies. A fund’s investment adviser selects the 40 For example, if a fund’s investment adviser option) while at the same time permitting the fund particular instrument based on the level and type believes that the London Interbank Offered Rate to sell the underlying equity securities at a targeted of exposure the adviser seeks to obtain and the costs (‘‘LIBOR’’) will decrease compared to a Federal price set by the fund’s investment adviser. See, e.g., that are associated with the particular instrument. funds rate, the adviser could enter into an interest id. 36 For example, if a fund enters into a short rate swap whereby the fund would be obligated to 46 As an example of ‘‘equitizing’’ cash, the 2010 currency forward (which obligates the fund to sell make payments based upon the application of ABA Derivatives Report, supra note 8, at 8, states the currency at a future date, at a predetermined LIBOR to an agreed notional amount in exchange that: price, and in the currency in which the foreign debt for payments from the counterparty based upon the [W]hen a fund has a large cash position for a security is denominated), the fund’s exposure to a application of the Federal funds rate to the notional short amount of time, the fund can acquire long decline in the value of the currency is reduced. See amount. 2010 ABA Derivatives Report, supra note futures contracts to retain (or gain) exposure to the 2010 ABA Derivatives Report, supra note 8, at 6. 8, at 7. relevant equity market. When the futures contracts 37 For example, a fund may use a 41 Credit derivatives include single-name and are liquid (as is typically the case for broad market on one foreign currency (or a basket of foreign index-linked (or basket) credit default swaps. See, indices), the fund can eliminate the position currencies) to hedge against adverse changes in the e.g., id. at 7–8. For additional description of CDS, quickly and frequently at lower costs than had the value of another foreign currency (or basket of see Swap Definition Release, supra note 25, at fund actually purchased the reference equity currencies). See id. III.G.3. securities.

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from investing in derivatives? What role of senior securities by funds which not securities for all purposes,57 may does or could collateral used in increased unduly the speculative involve the issuance of senior securities derivatives transactions play in character of their junior securities; 50 and ‘‘fall within the functional meaning mitigating the concerns relating to the and (iii) funds operating without of the term ‘evidence of indebtedness’ use of derivatives? Please be specific adequate assets and reserves.51 To for purposes of section 18 of the Act,’’ and provide data or statistics, if address these concerns, section 18(f)(1) which generally would include ‘‘all possible. of the Investment Company Act contractual obligations to pay in the • Do different types of funds use prohibits an open-end fund 52 from future for consideration presently different types of derivatives or use issuing or selling any ‘‘senior security’’ received.’’ 58 Further, the Commission derivatives for different purposes? If so, other than borrowing from a bank, and stated that ‘‘trading practices involving what are the differences in the types of unless it maintains 300% ‘‘asset the use by investment companies of funds that account for the differences in coverage.’’ 53 Section 18(a)(1) of the such agreements for speculative their use of derivatives? For example, do Investment Company Act prohibits a purposes or to accomplish leveraging BDCs use derivatives in a manner closed-end fund 54 from issuing or fall within the legislative purposes of different from other funds and, if so, selling any ‘‘senior security that Section 18.’’ 59 The Commission also how and what are the differences? represents an indebtedness’’ unless it explained that: • How do ETFs use derivatives? Do has at least 300% ‘‘asset coverage.’’ 55 [l]everage exists when an investor achieves they use derivatives for the same In a 1979 General Statement of Policy the right to a return on a capital base that purposes that other open-end funds use (Release 10666), the Commission exceeds the investment which he has them? Does an ETF’s use of derivatives considered the application of section personally contributed to the entity or instrument achieving a return* * *. Through raise unique investor protection 18’s restrictions on the issuance of a reverse repurchase agreement, an concerns under the Investment senior securities to reverse repurchase investment company can achieve a return on Company Act? agreements, firm commitment a very large capital base relative to its cash agreements, and standby commitment contribution. Therefore, the reverse II. Derivatives under the Senior agreements.56 The Commission repurchase agreement is a highly leveraged Securities Restrictions of the concluded that such agreements, while transaction.60 Investment Company Act Leveraging of a fund’s portfolio In this section, the Commission 50 See section 1(b)(7) of the Investment Company through the issuance of senior securities discusses the limitations on senior Act. See also, e.g., Release 10666, supra note 10, at ‘‘magnifies the potential for gain or loss securities imposed by section 18 of the n. 8. 51 See section 1(b)(8) of the Investment Company on monies invested and, therefore, Investment Company Act, summarizes Act; Release 10666, supra note 10, at n. 8. results in an increase in the speculative related Commission and staff guidance, 52 Section 5(a)(1) of the Investment Company Act character of the investment company’s discusses certain alternative defines ‘‘open-end company’’ as ‘‘a management outstanding securities.’’ 61 Each of the approaches, and highlights issues for company which is offering for sale or has outstanding any redeemable security of which it is agreements discussed by the comment. the issuer.’’ Commission in Release 10666—the A. Purpose, Scope, and Application of 53 ‘‘Asset coverage’’ of a class of securities reverse repurchase agreement, the firm the Act’s Senior Securities Limitations representing indebtedness of an issuer generally is commitment agreement, and the defined in section 18(h) of the Investment Company standby commitment agreement—‘‘may 1. Statutory Restrictions on Senior Act as ‘‘the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness be a substantially higher risk Securities and Related Commission not represented by senior securities, bears to the investment’’ than direct investment in Guidance aggregate amount of senior securities representing The protection of investors against the indebtedness of such issuer.’’ 57 Release 10666, supra note 10, at ‘‘The 54 Section 5(a)(2) of the Investment Company Act Agreements as Securities’’ discussion. The potentially adverse effects of a fund’s defines ‘‘closed-end company’’ as ‘‘any Commission notes, however, that the Investment 47 issuance of ‘‘senior securities’’ is a management company other than an open-end Company Act’s definition of the term ‘‘security’’ is core purpose of the Investment company.’’ broader than the term’s definition in other Federal Company Act.48 Congress’ concerns 55 Section 18(a)(1)(A). A BDC is also subject to the securities laws. Compare section 2(a)(36) of the limitations of section 18(a)(1)(A) to the same extent Investment Company Act with sections 2(a)(1) and underlying the limitations in section 18 as if it were a closed-end investment company 2A of the Securities Act and sections 3(a)(10) and included, among others: (i) Potential except that the applicable asset coverage amount is 3A of the Exchange Act. For example, the definition abuse of the purchasers of senior 200%. See Investment Company Act section of ‘‘security’’ in the Investment Company Act securities; 49 (ii) excessive borrowing 61(a)(1). includes any ‘‘evidence of indebtedness,’’ which is not included in the definition of ‘‘security’’ in 56 As described in Release 10666, supra note 10, and the issuance of excessive amounts section 3(a)(10) of the Exchange Act. Further, the in a typical reverse repurchase agreement, the fund Commission has interpreted the term ‘‘security’’ in transfers possession of a debt security, often to a 47 light of the policies and purposes underlying the Section 18(g) of the Investment Company Act broker-dealer or a bank, in return for a percentage Act. For example, the brief for the United States as defines ‘‘senior security,’’ in part, as ‘‘any bond, of the market value of the security (‘‘proceeds’’), but Amicus Curiae in Marine Bank v. Weaver, No. 80– , note, or similar obligation or instrument retains record ownership of, and the right to receive 1562, 1980 U.S. Briefs 1562 (Oct. Term, 1980) (July constituting a security and evidencing interest and principal payments on, the security. At 29, 1981) (‘‘Marine Bank v. Weaver Amicus Brief’’) indebtedness,’’ and ‘‘any stock of a class having a stated future date, the fund repurchases the stated that the issue of whether a particular priority over any other class as to the distribution security and remits to the counterparty the proceeds instrument is a ‘‘security’’ depends on the context, of assets or payment of dividends.’’ The definition plus interest. Id. at nn. 2–3 and accompanying text. including the statute being applied, and further excludes certain limited temporary borrowings. A firm commitment agreement (also known as a stated that the Investment Company Act ‘‘presents 48 See, e.g., Investment Company Act sections ‘‘when-issued security’’ or a ‘‘forward contract’’) is a significantly different context’’ (i.e., the regulation 1(b)(7), 1(b)(8), 18(a), and 18(f). See also, e.g., 1994 a buy order for delayed delivery in which a fund of the operation and management of investment Report, supra note 3, at 20–22. agrees to purchase a debt security from a seller companies) than the context of the Securities Act 49 See Investment Trusts and Investment (usually a broker-dealer) at a stated future date, and the Exchange Act (i.e., the issuance or trading Companies: Hearings on S. 3580 Before a Subcomm. price, and fixed yield. Id. at text accompanying n. of such securities). Marine Bank v. Weaver Amicus of the Senate Committee on Banking and Currency, 12. A standby commitment agreement is a delayed Brief at 38, 40. 76th Cong., 3d Sess., pt. 1, 265–78 (1940) (‘‘Senate delivery agreement in which a fund contractually 58 Hearings’’). See also 1994 Report, supra note 3, at binds itself to accept delivery of a debt security Release 10666, supra note 10, at ‘‘The 21 (describing the practices in the 1920s and 1930s with a stated price and fixed yield upon the Agreements as Securities’’ discussion. that gave rise to section 18’s limitations on leverage, exercise of an option held by the counterparty to 59 Id. and specifically discussing the potential abuse of the agreement at a stated future date. Id. at 60 Id. at n. 5 (citation omitted). senior security holders). discussion of ‘‘Standby Commitment Agreements.’’ 61 Id. at text accompanying n. 5.

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the underlying securities ‘‘because of interest; for reverse repurchase • Cover a long position in a futures or the additional risk of loss created by the agreements with a specified repurchase forward contract, or a written put substantial leveraging in each price, the amount of assets to be option, by establishing a segregated agreement, and in light of the segregated would be the repurchase account (not with a futures commission of interest rates in the marketplace.’’ 62 price; and for firm and standby merchant or broker) containing cash or In Release 10666, the Commission commitment agreements, the amount of certain liquid assets equal to the further stated that, although reverse assets to be segregated would be the purchase price of the contract or the repurchase agreements, firm purchase price.66 As the Commission strike price of the put option (less any commitment agreements, and standby stated in Release 10666, the segregated margin on deposit); and commitment agreements are account functions as ‘‘a practical limit • Cover short positions in futures or functionally equivalent to senior on the amount of leverage which the forward contracts, sales of call options, securities, these and similar investment company may undertake and short sales of securities by arrangements nonetheless could be used and on the potential increase in the establishing a segregated account (not by funds in a manner that would not speculative character of its outstanding with a futures commission merchant or warrant application of the section 18 common stock,’’ and ‘‘will assure the broker) with cash or certain liquid assets restrictions. The Commission noted that availability of adequate funds to meet that, when added to the amounts in circumstances involving similar the obligations arising from such deposited with a futures commission economic effects, such as short sales of activities.’’ 67 merchant or a broker as margin, equal securities by funds, our staff had the market value of the instruments or 2. Staff No-Action Letters Concerning determined that the issue of section 18 currency underlying the futures or the Segregated Account Approach 68 compliance would not be raised if funds forward contracts, call options, and ‘‘cover’’ senior securities by maintaining Following the Commission’s issuance short sales (but are not less than the ‘‘segregated accounts.’’ 63 The of Release 10666, the Commission staff strike price of the call option or the Commission stated that the use of issued more than twenty no-action market price at which the short segregated accounts ‘‘if properly created letters to funds concerning the positions or short sales were and maintained, would limit the maintenance of segregated accounts or established).71 investment company’s risk of loss.’’ 64 otherwise ‘‘covering’’ their obligations The staff also provided no-action To avail itself of the segregated account in connection with certain senior assurance that the Dreyfus funds could approach, a fund could establish and securities, primarily interest rate cover these transactions by owning, or maintain with the fund’s custodian a futures, stock index futures, and related holding the right to obtain, the segregated account containing liquid options.69 instrument or cash that the fund has assets, such as cash, U.S. government In a 1987 no-action letter issued to obligated itself to deliver. For example: securities, or other appropriate high- two Dreyfus funds, the staff summarized • A fund could cover a long position grade debt obligations, equal to the and expanded upon the methods by in a futures or forward contract by indebtedness incurred by the fund in which, in its view, obligations could be purchasing a put option on the same connection with the senior security covered by funds transacting in futures, futures or forward contract with a strike (‘‘segregated account approach’’).65 The forwards, written options, and short price as high or higher than the price of 70 amount of assets to be segregated with sales. The staff provided no-action the contract held by the fund; and respect to reverse repurchase assurance that the Dreyfus funds could: • A fund could cover a written put agreements lacking a specified option by selling short the instruments 66 repurchase price would be the value of Id. or currency underlying the put option at 67 Id. the same or higher price than the strike the proceeds received plus accrued 68 This release includes extensive discussion of staff no-action letters; accordingly the Commission price of the put option or, alternatively, 62 Id. at discussion of ‘‘The Agreements as notes that its discussion of staff statements is by purchasing a put option with the Securities.’’ The Commission also stated that, ‘‘[t]he provided solely for background and to facilitate strike price the same or higher than the gains and losses from the transactions can be comment on issues that the Commission might strike price of the put option written by extremely large relative to invested capital; for this address. The discussion is in no way intended to reason, each agreement has speculative aspects. suggest that the Commission has adopted the the fund. Therefore, it would appear that the independent analysis, conclusions or any other portion of the The Commission staff has also investment decisions involved in entering into such staff statements discussed here. Staff no-action discussed the types of assets that may be agreements, which focus on their distinct risk/ letters are issued by the Commission staff in segregated and the manner in which, in return characteristics, indicate that, economically as response to written requests regarding the the staff’s view, segregation may be well as legally, the agreements should be treated as application of the Federal securities laws to securities separate from the underlying Ginnie Maes proposed transactions. Many of the staff no-action effected. In Release 10666, the for purposes of Section 18 of the Act.’’ Id. letters are ‘‘enforcement-only’’ letters, in which the Commission stated that the assets 63 Release 10666, supra note 10, at text staff states whether it will recommend enforcement eligible to be included in segregated accompanying n. 15. action to the Commission if the proposed accounts should be ‘‘liquid assets,’’ such 64 transaction proceeds in accordance with the facts, Id. at discussion of ‘‘Segregated Account.’’ as cash, U.S. government securities, or 65 The Commission stated that, under the circumstances and representations set forth in the segregated account approach, the value of the assets requester’s letter. Other staff no-action letters in the segregated account should be marked to the provide the staff’s interpretation of a specific Letter’’), available at http://www.sec.gov/divisions/ market daily, additional assets should be placed in statute, rule or regulation in the context of a specific investment/seniorsecurities-bibliography.htm. the segregated account whenever the total value of situation. See Informal Guidance Program for Small 71 But see Robertson Stephens Investment Trust, the account falls below the amount of the fund’s Entities, Investment Company Act Release No. SEC Staff No-Action Letter (Aug. 24, 1995), obligation, and assets in the segregated account 22587 (Mar. 27, 1997). available at http://www.sec.gov/divisions/ should be deemed frozen and unavailable for sale 69 See ‘‘No-Action Letters and Releases from investment/seniorsecurities-bibliography.htm (the or other disposition. See id. The Commission also 1982–1985 Regarding Covering Futures and staff agreed not to recommend enforcement action cautioned that as the percentage of a fund’s Options’’ at Senior Security Bibliography, supra where the value of the segregated account, to cover portfolio assets that are segregated increases, the note 10. (Certain of these letters also addressed the a short position in a security, was equal to the daily fund’s ability to meet current obligations, to honor use of when-issued bonds, currency forwards, and (fluctuating) market price of the security sold short requests for redemption, and to manage properly other senior securities). (less certain amounts pledged with the broker as the investment portfolio in a manner consistent 70 Dreyfus Strategic Investing and Dreyfus collateral), even if the value of the segregated with stated its investment objective may become Strategic Income, SEC Staff No-Action Letter (June account was less than the price at which the short impaired. Id. 22, 1987) (‘‘Dreyfus no-action letter’’ or ‘‘Dreyfus position was established).

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other appropriate high grade debt fund’s potential leverage and to provide notional amount may, as a practical obligations. In a 1996 staff no-action a source of payment of future matter, exceed the maximum loss or letter issued to Merrill Lynch Asset obligations arising from the leveraged total risk on the contract.81 Management, the staff took the position transaction. In determining the amount Consequently, it is argued with respect that a fund could cover its derivatives- of assets required to be segregated to to such derivatives that segregation of related obligations by depositing any cover a particular instrument, the assets equal to the notional amount may liquid asset, including equity securities Commission and its staff have generally limit the use of such derivative products and non-investment grade debt looked to the purchase or exercise price and strategies that could potentially securities, in a segregated account.72 In of the contract (less margin on deposit) benefit funds and their investors. the Merrill Lynch no-action letter, the for long positions and the market value Conversely, it is argued that segregation staff explained that, in the staff’s view, of the security or other asset underlying of an amount equal to only the daily, segregating any type of liquid asset the agreement for short positions, mark-to-market liability, if any, with would be consistent with the purposes measured by the full amount of the respect to cash-settled derivatives,82 underlying the asset segregation reference asset, i.e., the notional amount may fail to take into account potential approach because it would place a of the transaction rather than the future losses on such instruments. practical limit on the amount of leverage unrealized gain or loss on the Consequently, it is argued that that a fund may undertake and on the transaction, i.e., its current mark-to- segregation of this amount may potential increase in the speculative market value.78 understate the risk of loss to the fund, character of its outstanding shares.73 The segregated account approach has permit the fund to engage in excessive With respect to the manner in which drawn criticism on several grounds. For leveraging, fail to adequately set aside segregation may be effected, the example, we understand that some sufficient assets to cover the fund’s Commission staff took the position that industry participants argue that the ultimate exposure, and, therefore, a fund could segregate assets by segregated account approach calls for an perhaps not adequately fulfill the designating such assets on its books, instrument-by-instrument assessment of purposes underlying the segregated rather than establishing a segregated the amount of cover required, further account approach and section 18.83 account at its custodian.74 arguing that this may create uncertainty The significant disparity between Asset segregation practices with about the treatment of new products, these two widely recognized measures— respect to other derivatives investments and that new product development will notional amount and mark-to-market have not been addressed by the inevitably lead to circumstances in amount—is illustrated by data relevant Commission, or by the staff in no-action which available guidance does not to actual swap positions held by funds. letters.75 Certain swaps, for example, specifically address each new A recent study of the use of credit that settle in cash on a net basis, appear instrument subject to section 18 default swaps (‘‘CDS’’) by a group of the to be treated by many funds as requiring constraints. Other industry participants 100 largest U.S. funds segregation of an amount of assets equal have argued that the staff’s application analyzed data relevant to the notional to the fund’s daily mark-to-market of the segregated account approach amount and ‘‘book value,’’ i.e., liability, if any.76 Similarly, some funds results in differing treatment of arguably unrealized gains and losses, of the have disclosed that they segregate only equivalent products.79 funds’ CDS positions during the period their daily, mark-to-market liability, if Others have argued that, with respect 2004 through 2008.84 Among the 65 any, with respect to futures and forward to the amount to be segregated, both funds in the sample group that used contracts that are contractually required notional amount and a mark-to-market CDS sometime between 2004 and 2008, to cash-settle.77 amount have their limitations.80 For the total notional amount of CDS example, for many futures contracts, the B. Alternative Approaches to the positions increased from an average of $103 million per fund in 2004 to an Regulation of Portfolio Leverage 78 See Release 10666, supra note 10, at discussion of ‘‘Segregated Account’’ (with regard to each 1. The Current Asset Segregation 81 reverse repurchase agreement that lacks a specified See BIS Guide, supra note 18, at 30, Approach repurchase price, the fund should maintain in a commenting in the context of OTC derivatives that As noted above, the segregated segregated account ‘‘liquid assets equal in value to ‘‘[n]ominal or notional amounts outstanding the proceeds received on any sale subject to provide a measure of market size and a reference account approach serves both to limit a repurchase plus accrued interest. If the reverse from which contractual payments are determined in repurchase agreement has a specified repurchase derivatives markets. However, with the partial 72 Merrill Lynch Asset Management, L.P., SEC price, the investment company should maintain in exception of credit default swaps, such amounts are Staff No-Action Letter (July 2, 1996) (‘‘Merrill the segregated account an amount equal to the generally not those truly at risk. The amounts at risk Lynch no-action letter’’ or ‘‘Merrill Lynch Letter’’), repurchase price, which price will already include in derivatives contracts are a function of the price available at http://www.sec.gov/divisions/ interest charges.’’ With regard to each firm level and/or volatility of the financial reference investment/seniorsecurities-bibliography.htm. commitment agreement, the fund should maintain index used in the determination of contract 73 Id. The staff noted that ‘‘the type of asset placed in a segregated account ‘‘liquid assets equal in value payments, the duration and liquidity of contracts in the segregated account would have no effect on to the purchase price due on the date and the creditworthiness of counterparties.’’ the maximum amount of leverage that a fund can under the * * * agreement.’’ With regard to each 82 This is also a concern with respect to the assume.’’ standby commitment agreement, the fund should coverage of short sales. 74 See Dear Chief Financial Officer Letter from maintain in a segregated account ‘‘liquid assets 83 See 2010 ABA Derivatives Report, supra note Lawrence A. Friend, Chief Accountant, Division of equal in value to the purchase price under the 8, at 15 (‘‘reducing the amount of assets subject to Investment Management (Nov. 7, 1997), available at * * * agreement.’’). segregation increased the practical ability of funds http://www.sec.gov/divisions/investment/ 79 They argue, for example, that a physically- to engage in derivatives on an increasing scale’’), seniorsecurities-bibliography.htm. settled and a cash-settled future or forward are and at 16 (where only the mark-to-market liability, 75 Our discussion of current and past industry equivalent products, and that segregation of the if any, is segregated, ‘‘a fund’s exposure under a practices is not intended to indicate any delivery obligation amount for a physically-settled derivative contract could increase significantly on Commission approval or disapproval of those future or forward, and segregation of the generally an intraday basis, resulting in the segregated assets practices. smaller mark-to-market liability amount for a cash- being worth less than the fund’s obligations (until 76 See, e.g., 2010 ABA Derivatives Report, supra settled future or forward, constitutes different the fund is able to place additional assets in the note 8, at 13–14. treatment of equivalent products. See the 2010 ABA segregated account * * *.). To the extent that a 77 For a discussion of asset segregation practices Derivatives Report, supra note 8, at 14–15 for a fund relying on the Merrill Lynch Letter segregates involving futures and forwards that are discussion of cash-settled futures and forwards and assets whose prices are somewhat volatile, this contractually required to cash-settle, see, e.g., id. at the asset segregation treatment of those products. ‘shortfall’ could be magnified.’’). 14–15. 80 Id. at 16–17. 84 Adam and Guettler Article, supra note 7.

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average of $632 million in 2008. The in lieu of comprehensive guidance vehicles authorized for sale to retail mean total notional amount of a fund’s concerning the asset segregation investors. In 2010, CESR’s Global CDS positions relative to its net asset approach, the 2010 ABA Derivatives Exposure Guidelines for UCITS were value (‘‘NAV’’) increased from 2% to Report proposes an alternative approach issued,92 addressing implementation of almost 14%.85 At three funds, the pursuant to which individual funds the European Commission’s 2009 notional amounts of CDS positions held would establish their own asset revised UCITS Directive.93 Under the in 2008 exceeded those funds’ NAVs. segregation standards for derivative revised UCITS Directive, UCITS are During the same period, reported CDS instruments that involve leverage within permitted to engage in derivatives book losses (i.e., unrealized losses) the meaning of Release 10666. Under investments subject to a ‘‘global remained, on average, less than 1% of this approach, each fund would be exposure’’ limitation, under which the a fund’s NAV.86 required to adopt policies and derivatives exposure of a UCITS may Critics of the notional and mark-to- procedures that would include, among not exceed the total net value of the market standards often advocate use of other things, minimum asset segregation UCITS’ portfolio.94 CESR’s Global a more complex analysis of the risk of requirements for each type of derivative Exposure Guidelines extensively a fund’s investments, including its instrument, taking into account relevant address the calculation of derivatives derivatives positions, such as Value at factors such as the specific context of exposure under the ‘‘global exposure’’ Risk (‘‘VaR’’) or another methodology the transaction. In developing these limit and define two permissible, for assessing the probability of portfolio standards, fund investment advisers alternative methods for this purpose: losses.87 VaR and other alternative could take into account a variety of risk (i) The ‘‘commitment’’ approach; and approaches are discussed in the measures, including VaR and other (ii) the advanced risk measurement following section. quantitative measures of portfolio risk, method to measure maximum potential and would not be limited to the notional loss, such as the VaR approach.95 2. Other Approaches amount or mark-to-market standards. The commitment approach is a The 2010 ABA Derivatives Report These minimum ‘‘Risk Adjusted method for standard derivatives that observed that the ‘‘the basic framework Segregated Amounts’’ would be uses the market value of the equivalent as articulated in Release 10666 has reflected in policies and procedures that position in the underlying asset but may worked very well’’ as applied to funds’ would be subject to approval by the be ‘‘replaced by the notional value or derivatives investments,88 but ‘‘there are fund’s board of directors and disclosed the price of the futures contract where open issues and inconsistencies in the (including the principles underlying the this is more conservative.’’ 96 CESR’s current [Commission] and staff guidance Risk Adjusted Segregated Amounts for Global Exposure Guidelines regarding the application of Section 18 different types of derivatives) in the incorporates a schedule of derivative of the 1940 Act to transactions in fund’s statement of additional investments and their corresponding derivatives.’’ 89 Accordingly, the 2010 information.91 conversion methods to be used in ABA Derivatives Report states that the The challenge of designing a calculating global exposure.97 The Commission ‘‘should issue revised regulatory standard by which leverage conversion method to be used depends guidance in this area, which would set can be measured and limited effectively on the derivative.98 forth an approach to segregation that also has drawn the attention of would cover all types of derivative regulators in jurisdictions around the 92 See supra note 87. In order for CESR’s Global globe. Internationally, limitations on Exposure Guidelines to be binding and operational instruments in a comprehensive in a particular EU Member State, the Member State manner.’’ 90 The 2010 ABA Derivatives leveraged exposure take a variety of must adopt them. To date, it appears that a few EU Report, however, considers forms, including maximum exposure Member States, e.g., Ireland and Luxembourg, have comprehensive guidance unlikely to be limitations, asset segregation adopted them. 93 achievable, given that any generalized requirements, and other measures. In See Directive 2009/65/EC of the European the context of maximum exposure or Parliament and of the Council of 13 July 2009 on approach will likely fail to take into the coordination of laws, regulations, and account significant variations in leverage limitations, the notional or administrative provisions relating to undertakings individual transactions. Consequently, principal amount of the reference asset for collective investment in transferable securities underlying the derivative has commonly (‘‘2009 Directive’’), available at http://eur- lex.europa.eu/LexUriServ/LexUriServ.do?uri= 85 been used as a conservative measure of Id. at 12. OJ:L:2009:302:0032:0096:en:PDF. 86 Id. at 13. the exposure created by derivatives. In 94 Id. at Article 51(3) at 62 (‘‘The exposure is 87 See, e.g., 2010 ABA Derivatives Report, supra addition to limitations on aggregate calculated taking into account the current value of note 8, at 18. As discussed infra, some non-U.S. positions or leveraged exposure, some the underlying assets, the counterparty risk, future regulatory schemes have incorporated VaR or regulatory frameworks include market movements and the time available to comparable methodologies in their approach to restrictions on concentrated exposures liquidate the positions’’). derivatives. See, e.g., CESR’s Guidelines on Risk 95 See CESR’s Global Exposure Guidelines, supra Measurement and the Calculation of Global to individual counterparties and some note 87. The CESR’s Global Exposure Guidelines Exposure and Counterparty Risk for UCITS, provide for specialized funds that may note that the ‘‘use of a commitment approach or Committee of European Securities Regulators (July assume derivatives exposure exceeding VaR approach or any other methodology to 28, 2010) (‘‘CESR’s Global Exposure Guidelines’’), otherwise applicable limits. calculate global exposure does not exempt UCITS available at http://www.esma.europa.eu/ from the requirement to establish appropriate popup2.php?id=7000. See also Henry T.C. Hu, The The Committee of European internal risk management measures and limits.’’ Id. New Portfolio Society, SEC Mutual Fund Disclosure, Securities Regulators (‘‘CESR’’) (which, at 5. In addition, with respect to the selection of the and the Public Corporation Model, 60 BUS. LAW. as of January 1, 2011, became the methodology used to measure global exposure, 1303 (2005) (advocating disclosure by funds of VaR European Securities and Markets CESR’s Global Exposure Guidelines note that the data). We note that the Commission has permitted ‘‘commitment approach should not be applied to VaR to be used by certain registrants in other Authority, or ‘‘ESMA’’), conducted an UCITS using, to a large extent and in a systematic circumstances. For example, the Commission extensive review and consultation way, financial derivative instruments as part of permits certain registered broker-dealers to use VaR concerning exposure measures for complex investment strategies.’’ Id. at 6. models to compute net capital charges. See, e.g., derivatives used by Undertakings for 96 See id. at 7. Exchange Act rule 15c3–1f. 97 Collective Investment in Transferable See id. at 7–12. 88 2010 ABA Derivatives Report, supra note 8, at 98 Id. at 8. For example, for bond futures, the 16. Securities (‘‘UCITS’’), investment applicable conversion method is the number of 89 Id. at 15. contracts multiplied by the notional contract size 90 Id. at 17. 91 Id. at 18. Continued

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The second method is VaR or a counterparty’s choice, for physical counterparty defaults.109 Cash or money comparably sophisticated risk delivery of the underlier, the UCITS market instruments and bonds issued by measurement method, designed to should hold: (i) the underlier in its a government with a rating of AAA may measure the maximum potential loss portfolio, or, if the underlier is deemed be tendered as collateral to reduce due to market risk rather than to be sufficiently liquid, (ii) cash or counterparty exposure.110 leverage.99 When using the VaR other liquid assets on the condition that Other jurisdictions have adopted approach to calculate global exposure, these other assets (after applying approaches to investment companies’ either the relative VaR approach or the appropriate haircuts), held in sufficient use of derivatives that limit aggregate absolute VaR approach may be used.100 quantities, may be used at any time to exposure and/or require maintaining Under the relative VaR approach, the acquire the underlier that is to be liquid assets equal to the notional or VaR of the portfolio cannot be greater delivered.105 In the case of a derivative ‘‘exercise’’ value of derivatives than twice the VaR of an unleveraged that provides, automatically or at the contracts. For example, the Central Bank reference portfolio.101 The absolute VaR UCITSs choice, for cash settlement, the of Ireland, in addressing non-UCITS approach limits the maximum VaR that UCITS should hold enough liquid assets investment companies offered to the a UCITS can have relative to its NAV, after appropriate haircuts to allow the public generally, has issued guidelines and as a general matter, the absolute UCITS to make the contractually that provide standards analogous to a VaR is limited to 20 percent of the required payments.106 ‘notional amount’ or commitment UCITS NAV.102 Singapore has adopted a bifurcated approach and generally limits the In addition to the global exposure approach similar to that applicable maximum potential exposure to 25% of limitation, CESR’s Global Exposure under CESR’s Global Exposure the investment company’s NAV.111 Guidelines subject UCITS to ‘‘cover Guidelines for UCITS. The Monetary Separately, the Central Bank of Ireland rules’’ for investments in financial Authority of Singapore (the ‘‘MAS’’) permits the use of techniques and derivatives.103 Under these cover rules, requires that the risks of derivatives instruments by investment companies UCITS should, at any given time, be used by investment companies are for the purposes of ‘‘efficient portfolio capable of meeting all its payment and ‘‘duly measured, monitored and management,’’ subject to certain delivery obligations incurred by managed on an ongoing basis.’’ 107 An conditions. These include a requirement financial derivatives’ investments, and investment company’s exposure to that an investment company selling a cover should form part of the UCITS’ derivatives is limited to 100% of its futures contract must own the security 104 risk management process. More NAV, and global exposure is calculated that is the subject of the contract. specifically, in the case of a derivative using the commitment approach as the Alternatively, the investment company’s that provides, automatically or at the default method. Under the commitment assets, or a proportion of its assets at approach, which is similar to the least equal to the exercise value of the multiplied by the market price of the cheapest-to- commitment approach in CESR’s Global futures contracts sold, must reasonably deliver reference bond. For plain vanilla fixed/ be expected to behave in terms of price floating interest rate and inflation swaps, the Exposure Guidelines, global exposure is applicable conversion method is the market value movement in the same manner as the calculated by converting the investment 112 of the underlier (though the notional value of the company’s derivatives positions into futures contract. fixed leg may also be applied). Id. For foreign A similar approach is followed by the equivalent positions in the underlying exchange forwards, the prescribed conversion Canadian Securities Administrators, assets and then is quantified as the sum method is the notional value of the currency leg(s). which permits investment companies Id. at 9. With respect to non-standard derivatives, of the absolute values of the individual sold to the general public to use where it is not possible to convert the derivative positions.108 The investment company’s into the market value or notional value of the derivatives for hedging and non-hedging exposure to the counterparty of an OTC equivalent underlying asset, CESR’s Global purposes but limits the derivatives derivative is limited to 10% of its NAV Exposure Guidelines note that ‘‘an alternative exposure and requires certain ‘‘cash approach may be used provided that the total and is measured on a maximum cover’’ intended to limit leverage.113 For amount of the derivatives represent a negligible potential loss basis that may be incurred portion of the UCITS portfolio.’’ Id. at 7. 99 Id. at 22 (‘‘More particularly, the VaR approach by the investment company if the 109 Id. at Appendix 1, sections 5.2 and 5.4. measures the maximum potential loss at a given 110 Id. at Appendix 1, sections 5.7 and 5.8. confidence level (probability) over a specific time 105 Id. 111 Central Bank of Ireland, NU SERIES OF period under normal market conditions.’’). 106 Id. On April 14, 2011, ESMA published a final NOTICES: Conditions Imposed in Relation to 100 Id. at 23. A global exposure calculation using report on the guidelines on risk measurement and Collective Investment Schemes Other than UCITS the VaR approach should consider all the positions the calculation of the global exposure for certain (July 2011) at 13.12, available at http:// in the UCITS’ portfolio. Id. at 22. The VaR approach types of structured UCITS. See Guidelines to www.centralbank.ie/regulation/industry-sectors/ measures the probability of risk of loss rather than Competent Authorities and UCITS Management funds/non-ucits/Documents/ the amount of leverage in portfolio. Id. at 22. The Companies on Risk Measurement and the Non%20UCITS%20Notices.pdf absolute VaR of a UCITS cannot be greater than Calculation of Global Exposure for Certain Types of 112 Id. at 16.10. In addition, certain requirements 20% of its NAV. Id. at 26. For both VaR approaches, Structured UCITS (final report) (Apr. 14, 2011) (ref.: are imposed on the use of OTC derivatives. Id. at the calculation must have a ‘‘one-tailed confidence ESMA/2011/112), available at http:// 16.10. interval of 99%,’’ a holding period of one month (20 www.esma.europa.eu/popup2.php?id=7542 (these 113 National Instrument 81–102 Mutual Funds business days), an observation period of risk factors guidelines, which will need to be adopted and (Jan. 2011) at sections 2.7 and 2.8, available at of at least one year (unless a shorter observation implemented by Member States, propose for certain http://www.bcsc.bc.ca/uploadedFiles/securitieslaw/ period is justified by a significant increase in price types of structured UCITS, an optional regime for policy8/81- volatility), at least quarterly updates, and at least the calculation of the global exposure). 102%20Mutual%20Funds%20%5BNI%5D%20Jan- daily calculation. Id. at 26. UCITS employing the 107 The Monetary Authority of Singapore, Code 1-11.pdf. In addition, for periods when the VaR approach are required to conduct a ‘‘rigorous, on Collective Investment Schemes, Chapter 3, investment company would be required to make comprehensive and risk-adequate stress testing section 3.1(f) (April 2011) at 7, available at payments under the swap, the investment company program.’’ Id. at 30–34. http://www.mas.gov.sg/resource/ is required to hold an equivalent quantity of the 101 CESR’s Global Exposure Guidelines note that legislation_guidelines/securities_futures/ reference asset of the swap, a right or obligation to the relative VaR approach does not measure sub_legislation/ acquire an equivalent quantity of the reference asset leverage of the UCITS’ strategies but instead allows 110408%20Revised%20Code_8%20April_final.pdf. of the swap and cash cover that, together with the the UCITS to double the risk of loss under a given 108 MAS allows for the use of a VaR approach, margin on account for the swap, have a value at VaR model. Id. at 24. with prior approval and submission of specific least equal to the aggregate amount of the 102 Id. at 25–26. information on the investment company manager’s obligations of the investment company under the 103 Id. at 40. risk management process. Id. at Appendix 1, section swap, or a combination of the positions, without 104 Id. 3.2(b). recourse to other assets of the investment company,

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example, an investment company may C. Request for Comment • Does the segregated account enter into a swap if, among other things, The Commission requests comment approach adequately address the the investment company holds cash concerning the current approach to the investor protection purposes and cover in an amount that, together with application of the senior securities concerns underlying section 18 of the margin on account for the swap and the limitations of section 18 of the Act to Act? What are the benefits and the market value of the swap, is not less funds’ use of derivatives. The shortcomings of the segregated account than the underlying market exposure of Commission seeks views concerning the approach? What benefits may be lost 114 the swap. appropriateness and effectiveness of the under an approach that is more The Hong Kong Securities and asset segregation approach as a basis for restrictive than the current segregated Futures Commission (the ‘‘SFC’’) account approach? section 18 compliance, and ways in • applies a differentiated approach, which the approach might be improved Derivatives can raise risk limiting investment companies to better serve the statutory purposes management issues for funds, such as generally to the use of derivatives for and protect investors. The Commission leverage, illiquidity (particularly with non-hedging positions that are capped also seeks views concerning potential respect to complex OTC derivatives), at 15% of NAV for options and warrants and counterparty risk, among others.117 115 alternative approaches under which and 20% for futures. For investment funds could capture the benefits of The segregated account approach companies that may acquire financial using derivatives that would meet these addresses leverage, but may not address derivative instruments extensively for same important goals. Commenters are liquidity and counterparty concerns. investment purposes, the investment requested to consider these broad Should funds that use derivatives be companies’ global exposure relating to questions as well as the specific required to consider and address these the financial derivative instruments questions that follow: concerns? For example, should funds be should not exceed 100% of the total net required to undertake an ongoing credit asset value of the investment 1. Issues Concerning the Current Asset analysis of their derivatives companies. For purposes of calculating Segregation Approach counterparties, and an ongoing analysis global exposure, investment companies • Is the definition of leverage of the liquidity of the derivatives, and must use the commitment approach. articulated by the Commission in to take action should the This approach requires that derivative Release 10666—that is, the right to a creditworthiness of the derivatives positions be converted into the return on a capital base that exceeds a counterparties and the liquidity of the equivalent position in the underlying fund’s investment in the instrument derivatives themselves decline below a assets of the derivative, taking into producing the return—sufficiently certain point? Should diversification account the prevailing value of the precise, and appropriate to limit the among counterparties be a requirement? underlying assets, counterparty risk, risks addressed by the senior security Are there other risk considerations that futures market movements, and the time prohibition of section 18? Are other funds engaged in derivatives available to liquidate the positions. measures of leverage equally pertinent investments should be required to take There are also requirements for: (a) the to, and sufficiently objective, precise, into account? • over-the-counter derivative and transparent to achieve the investor What is the optimal amount of counterparties (or their guarantors, if protection purposes of section 18? Do assets that should be segregated for applicable) of these investment funds make use of any leverage purposes of complying with the leverage companies to be substantial financial measurements as part of their own limitations of section 18? In general, institutions (as defined in the Code on portfolio oversight procedures? Are should a fund segregate assets in an Unit Trusts and Mutual Funds); (b) the leveraged transactions involving amount equal to the notional amount of net exposure for these investment derivatives subject to any special a derivative contract? In what situations, companies to a single over-the-counter approval or review procedures? if any, would a lesser amount satisfy the derivative counterparty to be no greater purposes and concerns underlying than 10% of NAV; and (c) the the investment company may not hold open section 18’s leverage limitations and acceptability criteria of collateral as positions in futures or options contracts concerning why? Since futures, swaps, and similar provided by the over-the-counter a single commodity or a single underlying financial derivatives generally have zero market derivative counterparties.116 instrument for which the combined margin value at inception and subsequent mark- requirement represents 20% or more of the NAV of the investment company. Id. to-market amounts may fluctuate to enable it to satisfy its obligations under the swap. Futures and options investments companies are widely, how effectively does segregating Id. at sections 2.7 and 2.8. subject to still different requirements, including an amount equal to the daily, mark-to- 114 Id. at section 2.8. that at least 30% of the investment company’s NAV market amount serve the Act’s objective 115 Hong Kong Securities and Futures be held on deposit in short-term debt instruments Commission, Code on Unit Trusts and Mutual and may not be used for margin requirements and of limiting leverage and assuring the Funds (June 2010), Chapter 7, available at http:// no more than 70% of the NAV of the investment availability of adequate assets to cover www.sfc.hk/sfc/doc/EN/intermediaries/products/ company may be committed as margin for futures _ a fund’s ultimate obligations? To what handBooks/Eng UT.pdf. See also Hong Kong or option contracts and/or premium paid for extent do funds rely upon the mark-to- Securities and Futures Commission Handbook for options purchased. Other requirements applicable Unit Trusts and Mutual Funds, Investment-Linked to futures and options investment companies market standard to determine the Assurance Schemes and Unlisted Structured include a restriction on premium paid to acquire amount of assets to be segregated? Are Investment Products. options outstanding with identical characteristics CDS, or some subset thereof, generally 116 Hong Kong Securities and Futures exceeding 5% of the NAV of the investment covered based on their notional amount, Commission, Code on Unit Trusts and Mutual company, open positions in any futures contract Funds (June 2010), Chapter 8, available at http:// month or option series may not be held if the their mark-to-market value, or some www.sfc.hk/sfc/doc/EN/intermediaries/products/ combined margin requirement represents 5% or other measure? Does it depend on handBooks/Eng_UT.pdf. more of the net asset value of the investment whether the CDS cash-settles or Other requirements include a restriction on company, and the investment company may not involves physical delivery of the premium paid to acquire identical options hold open positions in futures or options contracts exceeding 5% of the NAV of the investment concerning a single commodity or a single underlier? company, open positions in any futures contract underlying financial instrument for which the month or option series may not be held if the combined margin requirement represents 20% or 117 See 2008 IDC Report, supra note 3, at 12–13. combined margin requirement represents 5% or more of the net asset value of the investment See also 2008 JPMorgan Article, supra note 6, at more of the NAV of the investment company, and company. Id. page 25.

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• To what extent does the asset limiting a fund’s ability to engage in transaction-specific risk) and its segregation approach cause funds to leverage, limiting a fund’s risk of loss, assessment of risk based upon refrain from derivatives investments or and making sure that a fund has set consideration of relevant risk measures, strategies that could benefit investors? aside sufficient assets to cover its such as VaR, potentially subject to Please describe specific scenarios in obligations under derivatives and other Commission guidance of a general which a fund might be deterred from senior securities? nature.121 What benefits would accrue engaging in derivatives activities for this • Should the Commission revise its to funds and investors from the ABA’s reason. Does the asset segregation position in Release 10666 to provide RASA approach? What would be the approach create particular impediments expressly for cover methods in addition costs of this approach? In what respects for certain types of funds or strategies? to asset segregation? If so, should the would fund-determined asset Please also provide any information Commission take the position that a segregation policies be expected to relevant to assessing the impact upon fund may only enter into such non-asset deviate from the current segregated the funds of asset segregation as segregation cover methods with the account approach? Would such policies contemplated by Release 10666. same counterparty to the senior security be likely to incorporate VaR or other • In Release 10666, the Commission being covered? If so, what conditions, if risk methodologies? Do boards, as stated that it believed that only liquid any, should be imposed on such cover currently constituted, have sufficient assets should be placed in the methods? expertise to oversee an alternative segregated accounts. The Commission • The Commission also requests approach to leverage and derivatives listed cash, U.S. Government securities, comment on the different treatment management such as RASA and/or VaR? or other appropriate high-grade debt afforded conventional bank borrowings If funds were permitted to determine the obligations as examples of liquid assets under section 18, which generally cover amount for their derivatives that could be placed in a segregated require 300% asset coverage, and other investments, should the Commission account.118 Subsequently, in the Merrill transactions, such as reverse repurchase give guidance concerning minimum Lynch no-action letter, the staff took the agreements, that may be functionally requirements for cover amounts or position that ‘‘cash or liquid securities equivalent to borrowings but, under methodologies for determining cover (regardless of type)’’ may be segregated Release 10666, may be covered by amounts? If funds were permitted to for section 18 purposes. Should the segregation of assets equal to 100% of determine the cover amount for their Commission permit funds to segregate the fund’s obligations. Why, if at all, derivatives investments, would the any liquid asset? Or should the should other senior securities be treated result be that different funds would Commission further limit the types of differently from bank borrowings for likely reach different determinations, assets that may be placed in a segregated purposes of the amount of cover resulting in different cover amounts, for account? The 2010 ABA Derivatives required? Should the Commission revise the same derivatives? • Report has observed that the practical its position in Release 10666 so that all Should the Commission consider a effect of segregating ‘‘any liquid asset’’ borrowings and their functional bifurcated approach to funds’ use of rather than segregating only the assets equivalents are subject to the same asset derivatives, similar to that set out in specifically noted as examples in segregation requirements? CESR’s Global Exposure Guidelines Release 10666 ‘‘greatly increase[s] the (which provides two methodologies, the 2. Alternatives to the Current Asset commitment approach or an advanced degree to which funds [may] * * * use Segregation Approach derivatives.’’ 119 Is segregation of ‘‘any risk measurement method such as VaR)? • liquid asset’’ for purposes of section 18 What alternatives to the segregated If the Commission were to pursue a consistent with the purposes and account approach, if any, should the bifurcated approach, should funds be concerns underlying section 18’s Commission consider to fulfill the permitted to elect to use notional limitations on leverage? Should any investor protection purposes of section amount (or similar reference) or a restrictions be placed on the types of 18 of the Act? Please identify any quantitative risk assessment such as liquid assets that may be used for asset alternative measures that would assure VaR, or should funds with different cover, e.g., excluding assets that adequate coverage of the fund’s ongoing levels of derivatives activities be replicate the fund’s exposure under the exposures under a derivative required to choose one or the other covered obligation? investment, and provide a cushion to measure based upon their level of • What types of liquid assets are cover future exposure. derivatives activities or other factors? • • If funds are permitted to choose currently used by funds for asset What benefits would be lost, and/or which quantitative risk assessment segregation purposes? Do funds what costs would increase, if an approach to use, under what commonly include equities among the alternative approach to the segregated circumstances, if any, should they be liquid assets that they segregate? If so, account were to limit funds’ use of derivatives? allowed to switch to a different what types of equities? • • Is owning, or having the right to As discussed above, the 2010 ABA assessment? Should a fund’s proposed obtain, the cash or other assets that a Derivatives Report recommends a more change in assessment require fund obligates itself to deliver in flexible approach to section 18 consideration and approval of its board connection with senior securities an compliance, under which funds would of directors? Should shareholder adequate substitute for segregation of specify a Risk Adjusted Segregated approval of a fund’s proposed change in liquid assets? To what extent do funds Amount (‘‘RASA’’) for each derivative assessment be required? For what 120 rely on this cover approach rather than investment used by the fund. Under reason(s) should a fund be permitted to asset segregation? Are cover methods this recommended approach, the change assessments, if any? • We note that bank capital standards that do not involve asset segregation as amount of assets to be segregated would incorporate methodologies by which the effective as asset segregation in terms of be determined by each fund, based on the risk profiles of the derivative current exposure and potential future exposure created by derivative 118 See Release 10666, supra note 10, at instruments (including issuer- and discussion of ‘‘Segregated Account.’’ investments are calculated. The 119 2010 ABA Derivatives Report, supra note 8, at 120 2010 ABA Derivatives Report, supra note 8, at 14. 1, 17–18. 121 Id. at 17.

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potential future exposure calculation is asset segregation approach in addressing any other material concerns to funds or based upon application of a specified the treatment of derivatives under their investors, or raise other concerns multiplier, varying with the type and section 18? under the Investment Company Act? If maturity of the derivative, to the • UCITS using VaR approaches to so, how should the Commission address notional amount of the investment.122 measure global exposure limits are them? Would a formula combining the current required to disclose in their prospectus • Please comment on these, or any mark-to-market value of a fund’s their expected level of leverage and the other, alternative approaches to the derivative investments with a measure possibility of higher leverage.123 In the regulation of leverage under the Act. of potential future exposure based upon event that the Commission were to The Commission requests comment on a percentage of the notional amount of accept a VaR approach in connection whether any other regulatory its derivative contracts provide a more with funds’ use of derivatives, should frameworks provide relevant and useful robust measure of risk than the notional funds be required to disclose their approaches that the Commission should amount or mark-to-market value of the expected and/or actual leverage levels? consider. derivative? If so, are bank capital • UCITS using VaR approaches to • Are there special considerations standards a relevant reference point for comply with global exposure limits are that need to be taken into account for our consideration of the potential future also required to maintain ‘‘a rigorous, smaller funds? How might taking such exposure and asset segregation amount? comprehensive and risk-adequate stress considerations into account impact If not, are there other preferable testing program.’’ 124 Should a stress investor protection? standards for measuring the potential testing requirement be imposed upon future exposure of a derivative funds that use derivatives, at least III. Derivatives Under the Investment investment? How, if at all, would such where a risk-based methodology is used Company Act’s Diversification an approach address the leverage to determine the required asset Requirements concerns underlying section 18 of the segregation value? What standards, if In this section of the release, the Act? What would be the costs and any, should the Commission establish Commission discusses the benefits of employing an asset for stress testing if such a requirement diversification requirements of the segregation calculation that reflects both were to be imposed? Investment Company Act. The current mark-to-market values and a • Are there any alternative measures Commission also explores, and requests potential future exposure approximation that would provide adequate coverage of comment on, issues that arise in the calculated by reference to notional a fund’s future obligations throughout course of applying those requirements amount? Given the purposes of section the life of a derivative instrument as to funds’ use of derivatives. 18, should an additional cushion well as the availability of resources to A. The Diversification Requirements amount be considered in addition to cover unanticipated price movements? current mark-to-market value and • During the recent credit crisis, did Funds are required to disclose in their potential future exposure? funds that used derivatives and leverage registration statements whether they are • The Commission also requests demonstrate the ability to foresee and classified as diversified or non- comment concerning the desirability of manage the risks that manifested diversified.125 A fund that discloses in incorporating a VaR approach or other themselves in connection with its registration statement that it is comparable risk measurement derivatives and leverage? Are there classified as diversified is prohibited methodology in the segregated account examples during the credit crisis where from changing its classification to non- approach to section 18. To what extent funds incurred losses or experienced diversified without first obtaining do funds currently employ VaR or a gains specifically attributable to their shareholder approval.126 A diversified comparable risk measure as part of their derivatives usage? fund is a fund that, with respect to 75% routine portfolio oversight procedures? • Is it the case that most futures of the value of its total assets (the ‘‘75% Would a VaR measure, potentially contracts are highly liquid, and that this bucket’’),127 has (among other things) no supplemented by stress testing and a facilitates rapid liquidation of a losing more than 5% of the value of its total leverage measure, provide an adequate position, enabling funds to minimize assets invested in the securities of any methodology for addressing leverage losses? Are there futures contracts that one issuer.128 A non-diversified fund is risks in fund portfolios? What are not highly liquid? Have there been procedures would be required so that instances where futures contracts, that 125 Section 8(b)(1)(A) of the Act; Form N–1A, any VaR methodology chosen by a fund may typically be considered liquid, Items 16, 4(a) and 4(b)(1); Form N–2, Item 17. 126 would be implemented in a way that have become less liquid, or illiquid? If Section 13(a)(1) of the Act. 127 Rule 5b–1 under the Investment Company Act adequately captures any additional risks so, please describe. Could there be generally defines ‘‘total assets,’’ when used in associated with the use of leverage and instances in the future where computing values for purposes of sections 5 and 12 derivatives by a fund? What other derivatives that have historically been of the Act, as ‘‘the gross assets of the company with quantitative criteria might be employed considered to be liquid become less respect to which the computation is made, taken as of the end of the fiscal quarter of the company last in lieu of, or as a supplement to, VaR? liquid, or illiquid? If so, please describe. preceding the date of computation.’’ Would adoption of VaR or a comparable 3. Related Matters 128 Section 5(b)(1) of the Act. The term ‘‘issuer’’ risk standard require review by the is defined in sections 2(a) and 2(a)(22) of the Act • Commission or Commission staff of Do derivatives that create economic as ‘‘unless the context otherwise requires, * * * particular risk measurement leverage, but that do not impose future every person who issues or proposes to issue any payment obligations on funds, such as security, or has outstanding any security which it methodologies in order to establish an has issued.’’ In addition, a diversified fund, with appropriate level of investor protection? purchased options or commodity-linked respect to the 75% bucket, may not own more than What would be the costs and benefits of notes, raise the same or similar concerns 10% of the outstanding voting securities of any one adopting a VaR standard in lieu of an as derivatives that create indebtedness issuer. See Section 5(b)(1) of the Act. A fund leverage? Do such derivatives present seeking to qualify as a ‘‘regulated investment company’’ must comply with the diversification 122 See 12 CFR 3 at Appendix C to Part 3 (2011) requirements of section 851 of the IRC, even if the (Capital Adequacy Guidelines for Banks: Internal- 123 See CESR’s Global Exposure Guidelines, supra fund is not diversified under the Investment Ratings-Based and Advanced Measurement note 87, at 35. Company Act. The diversification requirements Approaches). 124 Id. at 31. Continued

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any fund that does not meet these Specifically, the Act states that, ‘‘unless measure for OTC derivatives; under requirements.129 the context otherwise requires,’’ the either measure, the value of a derivative The purpose of the diversification value of a fund’s assets for purposes of would appear to be the value at which requirements is to prevent a fund that the diversification requirements is as the derivative could be sold or holds itself out as diversified from being follows: otherwise transferred at the relevant too closely tied to the success of one or • For each portfolio security owned at time.137 Compliance with the valuation a few issuers or controlling portfolio the end of the fund’s last preceding provisions of the Act helps to ensure, companies.130 As one commentator has fiscal quarter for which market among other things, that the prices at noted, the requirements are designed to quotations are readily available, the which fund shares are purchased and ensure that investors receive a clear value of the security is the market value redeemed are fair and do not result in statement of the character of the of the security at the end of such dilution of shareholder interests or other portfolio of the fund in which they have quarter; harm to shareholders.138 invested,131 and are intended to prevent • For any other portfolio security or The diversification requirements are any diversified fund from becoming asset owned at the end of the fund’s last designed to prevent a fund that holds non-diversified without the prior preceding fiscal quarter, the value of the itself out as diversified from having approval of its shareholders.132 security or asset is the fair value of the heightened exposure to one or a few For purposes of determining whether security or asset at the end of such issuers and help to accurately inform a fund is diversified or non-diversified, quarter, as determined in good faith by investors about the nature of the fund. the value of the fund’s ‘‘total assets’’ is the fund’s board of directors; and Given that derivatives generally are generally determined as of the end of • For any security or asset acquired designed to convey a leveraged return the fund’s last preceding fiscal quarter by the fund after the last preceding based on a reference asset over a period and includes the value of derivatives fiscal quarter, the cost thereof.135 of time, their mark-to-market values at held by the fund. Under the Investment a given point do not reflect the asset 133 B. Application of the Diversification Company Act’s definition of ‘‘value,’’ base on which future gains and losses Requirements to a Fund’s Use of the appropriate valuation methodology will be based or otherwise represent the Derivatives to be used by a fund generally depends potential future exposure of the fund upon: (a) Whether market quotations for A diversified fund that contemplates 134 under the derivatives investment. Use of the fund’s portfolio securities are investing in derivatives must consider a mark-to-market value for derivatives readily available; and (b) whether the how to value these instruments for held by a fund could thus permit a fund fund owned the particular portfolio purposes of calculating the 75% bucket to maintain an ongoing exposure to a securities or other assets at the end of based upon its ‘‘total assets’’ and for single issuer or group of issuers in its last preceding fiscal quarter. purposes of calculating whether the excess of 5% of the fund’s assets on a fund has invested 5% of the value of its notional basis, while continuing to under the IRC are similar, but not identical, to the 139 diversification requirements of the Investment total assets in the securities of any one classify itself as diversified. Company Act. See 26 U.S.C. 851(b)(3)(2010). ‘‘issuer.’’ In addition, the fund must Should the Commission consider 129 Section 5(b)(2) of the Act. determine the identity of the issuer of whether application of the 130 Senate Hearings, supra note 49, at 188 each such derivative. diversification requirements to (Statement of David Schenker, Chief Counsel, derivatives is a ‘‘context [that] otherwise Investment Trust Study, SEC, commenting on a 1. Valuation of Derivatives for Purposes version of section 5(b)(1) that was similar, but not of Determining a Fund’s Classification requires’’ a different measure of value identical, to the current version) (‘‘a diversified as Diversified or Non-Diversified than the statutory definition of ‘‘value?’’ company must have at least several different The value at which the derivative can be securities in its portfolio, and cannot make When determining the value of a investments which will put them in a controlling sold or otherwise transferred will reflect position * * *.’’). fund’s total assets for purposes of the gains or losses on that investment at 131 See, e.g., Alfred Jaretzki, Jr., The Investment determining the fund’s classification as a point in time. Would the use of the Company Act of 1940, 26 Wash. U. L. Q. 303, 314 diversified or non-diversified, the fund notional amount of the derivative, rather n. 34 (Apr. 1941) (‘‘Jaretzki’’) (the ‘‘distinction must calculate the value of any than its liquidation value, better achieve between diversified and non-diversified companies derivative held by the fund. Under the is due in large part, it is believed, to a desire to the purposes of the diversification inform stockholders of the character of the portfolio Act, ‘‘unless the context otherwise provisions of the Act? The Commission of the company in which they have invested.’’) requires,’’ derivatives (and all other requests comment on these issues and 132 Id. at 316–17. assets) held by a fund must be valued related questions set forth below. 133 ‘‘Value’’ is defined in section 2(a)(41) of the for diversification purposes using Act. market values and fair values, at the end 137 134 Sections 2(a) and 2(a)(36) of the Act provide For additional discussion of valuation that, ‘‘unless the context otherwise requires,’’ the of the fund’s last preceding fiscal requirements and guidance, see infra Section VI. term ‘‘security’’ includes, among other things, any quarter, or, if subsequently acquired, (Valuation of Derivatives). ‘‘note’’ or ‘‘evidence of indebtedness.’’ As discussed their cost.136 138 Compliance Programs of Investment Companies and Investment Advisers, Investment supra note 57, the definition of the term ‘‘security’’ For purposes of calculating NAV in the Act is broader than the definitions of that Company Act Release No. 26299 (Dec. 17, 2003) [68 term in the other Federal securities laws and the under the Act’s valuation provisions, FR 74714 (Dec. 24, 2003)] available at http:// Commission has interpreted the term ‘‘security’’ in derivatives are generally valued using a www.sec.gov/rules/final/ia-2204.pdf. light of the policies and purposes underlying the ‘‘market value’’ measure for exchange- 139 For example, a fund that holds itself out as Act. As a general matter, most derivatives appear diversified may have invested four percent of its to be notes or evidences of indebtedness and thus traded derivatives and a ‘‘fair value’’ assets in securities of an issuer to which it has securities for purposes of the diversification additional exposure through a total return swap that requirements. Treating derivatives as securities for 135 Sections 2(a)(41)(A)(i), (ii), and (iii) of the Act. creates exposure equal to another four percent of its diversification classification purposes appears to be Market value and fair value are discussed infra at assets on a notional basis, yielding a combined consistent with the policies and purposes Section VI. (Valuation of Derivatives). See also exposure to the issuer of eight percent of the fund’s underlying the diversification requirements, Adoption of Rules Relating to the Classification of total assets. The current mark-to-market value of the including the concern that funds that classify Management Investment Companies as either total return swap would likely be sufficiently low themselves as diversified indeed have diverse Diversified or Non-Diversified, Investment to enable the fund to calculate its investments in portfolios of investments, the performance of which Company Act Release No. 178 (Aug. 6, 1941) [6 FR the issuer at less than five percent of its total assets, is not tied too closely to the success of one or a few 3966 (Aug. 8, 1941)]. but, its total exposure to that issuer is over five issuers. 136 See section 2(a)(41)(A) of the Act. percent of its total assets.

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2. Identification of the Issuer of a measure is appropriate for this purpose, diversification issues relating to Derivative for Purposes of Determining should any additional safeguards be counterparties that are not securities- a Fund’s Classification as Diversified or adopted to address circumstances in related issuers continue to be addressed Non-Diversified which a derivative’s potential future under the Act’s diversification The diversification requirements exposure may materially exceed its provisions? • restrict a fund that is classified as current market value? For example, Relevance of Reference Assets diversified from investing, with respect should the ‘‘diversification’’ Under Derivatives to Diversification to its 75% bucket, more than 5% of the classification be qualified or Requirements. Under the 2010 ABA value of its total assets in the securities supplemented to reflect the impact on Derivatives Report’s suggested of any one issuer. The Act defines the the fund’s diversification of the notional approach, a derivative’s reference asset term ‘‘issuer’’ as ‘‘every person who exposures created by derivatives? The would be considered a security issued issues or proposes to issue any security, Commission also requests comment by an issuer for purposes of the or has outstanding any security which it concerning the potential for derivatives diversification requirements, an has issued,’’ 140 unless the context exposures to be understated. Further, if approach that the 2010 ABA Derivatives otherwise requires.141 In general, the derivatives exposures are potentially Report indicates is already followed by ‘‘issuer’’ of an OTC derivative entered understated, how should the issue be many funds when calculating ‘‘long into by a fund would appear to be the addressed? For example, should funds exposures’’ to the fund.145 Should the fund’s counterparty, and the ‘‘issuer’’ of be required to provide additional issuer of reference assets underlying a an exchange-traded derivative would information to investors? Also, if mark- derivative entered into by a fund be appear to be the clearinghouse due to to-market values are ascribed to considered to be the issuer of a security the novation.142 However, a derivative derivatives for purposes of the for purposes of the diversification may have a reference asset that also has diversification requirements, how requirements in lieu of, or in addition an issuer, e.g., a total return swap on the should negative values for derivatives to, the counterparty? If not, how, if at be treated? all, should exposure to the issuer of a common stock of a corporate issuer. In • such a case, the potential exposure of Alternative Diversification reference asset be disclosed to investors the fund created by the derivative is to Standards. Should different or and the potential inconsistency of such both the counterparty to the contract additional diversification standards be exposure with diversification and the issuer of the reference security. developed that would better address the categorization be addressed? types of exposures attainable through • Are there special considerations C. Request for Comment derivatives? • that need to be taken into account for The Commission requests comment Treatment of Counterparty Issues smaller funds? How might taking such concerning the application of the Act’s under the Diversification Requirements. considerations into account impact diversification requirements to In light of the statutory purpose of investor protection? derivatives held in fund portfolios, preventing a fund from holding itself including the following specific issues: out as diversified even though it is IV. Exposure to Securities-Related • Valuation of Derivatives for dependent upon the performance of a Issuers Through Derivatives Purposes of the Diversification small number of issuers, should Funds engaging in derivatives Requirements. As discussed above, the counterparties to derivatives investments may also confront issues diversification requirements are investments with funds be considered under the Act’s restrictions upon designed to preclude a fund that has issuers of securities for purposes of the acquisition of interests in securities- classified itself as ‘‘diversified’’ from diversification requirements? If related issuers. In this section of the concentrating its portfolio investments counterparty obligations under a release, the Commission discusses the in the securities of any single issuer. In derivative investment are considered application of section 12(d)(3) and rule light of this purpose, how should a securities of an issuer for purposes of 12d3–1, which address a fund’s derivative be valued for purposes of the diversification requirements, how exposure to securities-related issuers, to applying the diversification tests? Could should such obligations be measured for funds’ use of derivatives. The investors be misled by a fund’s this purpose? The 2010 ABA Derivatives Commission seeks comment on the disclosure that it is diversified when it Report recommends that, for purposes manner in which the Act’s prohibition has ongoing exposure to a single issuer of determining a fund’s classification as on such acquisitions and the or group of issuers in excess of 5% of diversified or non-diversified, a fund Commission’s exemptive rule granting the fund’s assets on a notional basis? In should be able to disregard its exposures limited relief from that prohibition what circumstances, if any, would to its derivative investment should apply in the context of mark-to-market value provide an counterparties and that counterparty derivatives. adequate measure of a fund’s exposure exposures should be addressed to an issuer such that the purposes of separately under section 12(d)(3) of the A. Investment Company Act Limitations the diversification requirements would Act, in part to assure that counterparty on Investing in Securities-Related be fulfilled? If a current market value exposures would be addressed for non- Issuers diversified as well as diversified Under section 12(d)(3) of the 140 Section 2(a)(22) of the Act. funds.143 Would it be preferable to Investment Company Act, funds 141 Section 2(a) of the Act. address counterparty exposures under generally may not purchase or otherwise 142 See Exemptions for Security-Based Swaps section 12(d)(3)? 144 If so, should Issued by Certain Clearing Agencies, Securities Act acquire any security issued by, or any Release No. 9222 (June 9, 2011) [76 FR 34920 (June other interest in, the business of a 15, 2011)] at n. 18 and accompanying text, available 143 2010 ABA Derivatives Report, supra note 8, at broker, dealer, underwriter, or 27–28. at http://www.sec.gov/rules/proposed/2011/33– investment adviser (‘‘securities-related 9222.pdf (also describing ‘‘novation’’ as a process 144 Under section 12(d)(3) of the Investment through which the original obligation between a Company Act, funds generally may not purchase or buyer and seller is discharged through the otherwise acquire any security issued by, or any (Exposure to Securities-Related Issuers Through substitution of the central counterparty as seller to other interest in, the business of a broker, dealer, Derivatives). buyer and buyer to seller, creating two new underwriter, or investment adviser (‘‘securities- 145 2010 ABA Derivatives Report, supra note 8, at contracts). related issuer’’). See infra discussion in Section IV. 26.

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issuer’’).146 There are two reasons for between funds and securities-related exchange-traded derivatives that are this prohibition. First, it limits a fund’s issuers. cleared, the issuer of the derivative exposure to the entrepreneurial risks of Rule 12d3–1 under the Act provides typically is the clearinghouse. In a no- securities-related issuers, including the funds with a limited exception from this action letter, the staff did not object to fund’s potential inability to extricate prohibition. Under the rule, a fund may the assertion that, in acquiring an itself from an illiquid investment in a acquire securities of any person that (a) exchange-traded option, a fund securities-related issuer.147 Second, it is derives 15 percent or less of its gross generally would not appear to be one of several Investment Company Act revenues from ‘‘securities related acquiring securities issued by, or an provisions which, taken together, activities,’’ 150 as long as the fund does interest in, a securities-related issuer.154 prohibit fund sponsors, which include not control such person after the In the case of OTC derivatives, if a broker-dealers, underwriters, and acquisition, or (b) derives more than 15 fund’s counterparty is a securities- investment advisers, from taking percent of its gross revenues from related issuer, the fund’s transaction advantage of the funds that they ‘‘securities related activities,’’ subject to with the counterparty may represent the sponsor.148 Specifically, the prohibition limits on the percentage of the issuer’s acquisition of a security issued by, or an has the effect of limiting the possibility securities that may be acquired by a interest in, that issuer.155 of abusive reciprocal practices 149 fund.151 The rule does not permit a fund If an OTC derivative with a securities- to acquire a general partnership interest related issuer as the counterparty is a 146 Section 12(d)(3) of the Act. See also Statement in a securities-related issuer.152 security issued by that counterparty, of the Commission Advising All Registered then the fund may be able to rely on Investment Companies to Divest Themselves of B. Counterparty to a Derivatives Interest and Securities Acquired in Contravention of rule 12d3–1 to engage in the Investment 156 the Provisions of Section 12(d)(3) of the Investment transaction. If such a derivative is not Company Act of 1940 within a Reasonable Period When a fund invests in an OTC a security issued by the counterparty, of Time, Investment Company Act Release No. 3542 derivative, the fund receives the but the transaction may be deemed to be (Sept. 21, 1962) [27 FR 9652 (Sept. 29, 1962)] obligation of its counterparty to perform (‘‘1962 Statement’’) (stating that ‘‘prohibited the fund’s acquisition of ‘‘an interest in’’ purchases or acquisitions occur not only when a under the contract. If the counterparty is a securities-related issuer (the security or interest is originally purchased or a securities-related issuer, a fund’s counterparty), then rule 12d3–1 would acquired, but also when investment companies acquisition of that obligation may not be available because it exempts only * * * hold an interest in a portfolio company which thereafter by merger, consolidation, constitute an acquisition of a security or acquisitions of securities, and the reorganization * * * or otherwise, acquires an another interest in a securities-related transaction would be prohibited under interest in a dealer, broker, underwriter or issuer within the scope of section the Investment Company Act. There is investment adviser’’); Exemption for Acquisition by 12(d)(3) of the Investment Company no bright-line test distinguishing Registered Investment Companies of Securities 153 Issued by Persons Engaged Directly or Indirectly in Act. As noted above, in the case of transactions that may or may not Securities Related Businesses, Investment Company Act Release No. 13725 (Jan. 17, 1984) [49 FR 2912 150 The rule defines ‘‘securities related activities’’ counterparty remains a non-securities-related (Jan. 24, 1984)] (‘‘1984 Proposing Release’’) at n.2 as ‘‘activities as a broker, a dealer, an underwriter, issuer. See 1962 Statement, supra note 146. and accompanying text (discussing the 1962 an investment adviser registered under the 154 See, e.g., Institutional Equity Fund, SEC Staff Statement). Investment Advisers Act of 1940, as amended, or No-Action Letter (Feb. 27, 1984). 147 See 1984 Proposing Release, supra note 146, as an investment adviser to a registered investment 155 The Commission has stated, for example, that at n. 7 and accompanying text (discussing that ‘‘[i]n company.’’ in entering into a repurchase agreement, a fund may 1940, securities related businesses, for the most 151 Under these limits, a fund may not acquire be acquiring an interest in the counterparty that is part, were organized as private partnerships. By more than 5% of that class of the issuer’s prohibited by section 12(d)(3). See, e.g., Treatment investing in such businesses, investment companies outstanding equity securities or more than 10% of of Repurchase Agreements and Refunded Securities would expose their shareholders to potential losses the outstanding principal amount of the issuer’s as an Acquisition of the Underlying Securities, which were not present in other types of debt securities, and may not have more than 5% of Investment Company Act Release No. 25058 (July investments; if the business failed, the investment the value of the fund’s total assets invested in the 5, 2001) at n. 5 and accompanying text [66 FR company as a general partner would be held securities of the issuer. Rule 12d3–1 defines ‘‘equity accountable for the partnership’s liabilities; if the 36156 at note 5 (July 11, 2001)]. security’’ in accordance with rule 3a11–1 under the 156 business floundered, the investment company A derivative is likely to be categorized as a Exchange Act, which in turn includes ‘‘any stock would be locked into its investment.’’). Rule 12d3– debt security subject to the 10% limitation of rule or similar security, certificate of interest or 1 under the Act has, since 1984, provided a limited 12d3–1. Rule 12d3–1 defines ‘‘debt security’’ as ‘‘all participation in any profit sharing agreement, exemption from section 12(d)(3) for acquisitions of securities other than equity securities.’’ The certain securities and, until 1993, addressed the preorganization certificate or subscription, Commission also by order has exempted certain liquidity concern underlying section 12(d)(3) by transferable , voting trust certificate or transactions from section 12(d)(3) that may have limiting the equity securities of a securities-related certificate of deposit for an equity security, limited involved a fund’s acquisition of a security from a issuer that a fund may acquire to ‘‘margin partnership interest, interest in a joint venture, or securities-related issuer. See, e.g., the following securities,’’ as defined in Regulation T of the Board certificate of interest in a business trust; any orders issued by the Commission involving of Governors of the Federal Reserve System, and security future on any such security; or any security principal-protected funds: AIG SunAmerica Asset generally limiting the permissible debt securities to convertible, with or without consideration into Management Corp., et al., Investment Company Act ‘‘investment grade securities,’’ as determined by at such a security, or carrying any warrant or right to Release Nos. 26725 (notice) (Jan. 21, 2005) [70 FR least one nationally recognized statistical rating subscribe to or purchase such a security; or any 3946 (Jan. 27, 2005)] and 26760 (Feb. 16, 2005) organization. See, e.g., 1984 Proposing Release, such warrant or right; or any put, call, , or (order) (by virtue of entering into a protection supra note 146, at nn. 24–25 and accompanying other option or privilege of buying such a security arrangement with an AIG affiliate that is a broker, text. The rule has never permitted a fund to acquire from or selling such a security to another without dealer, underwriter, investment adviser to a a general partnership interest in a securities-related being bound to do so.’’ Rule 12d3–1 under the Act registered investment company, or an investment business. defines ‘‘debt security’’ as ‘‘all securities other than adviser registered under the Investment Advisers 148 See id. at n. 8 and accompanying text. equity securities.’’ Act, a fund may be deemed to have acquired a 149 See, e.g., id. at n. 9 and accompanying text 152 Rule 12d3–1 also does not permit the security from the AGI affiliate); Merrill Lynch (‘‘Such reciprocal practices include the possibility acquisition of a security issued by the fund’s Principal Protected Trust, et al., Investment that an investment company might purchase promoter, principal underwriter, or investment Company Act Release Nos. 26164 (Aug. 20, 2003) securities or other interests in a broker-dealer to adviser, or an affiliated person of the promoter, (notice) [68 FR 51602 (Aug. 27, 2003)] and 26180 reward that broker-dealer for selling fund shares, principal underwriter, or investment adviser, (Sept. 16, 2003) (order) (by virtue of entering into rather than solely on investment merit. Similarly, subject to an exception for certain subadvisory a protection arrangement with a Merrill Lynch the staff has expressed concern that an investment relationships. affiliate that is a broker, dealer, underwriter, company might direct brokerage to a broker-dealer 153 If the counterparty is not a securities-related investment adviser to a registered investment in which the company has invested to enhance the issuer, the fund may enter into the transaction company, or an investment adviser registered under broker-dealer’s profitability or to assist it during without being limited by section 12(d)(3). The fund the Investment Advisers Act of 1940, a fund may financial difficulty, even though that broker-dealer will need to monitor the status of its counterparty be deemed to have acquired a security from the may not offer the best price and execution.’’) during the term of the transaction to ensure that the Merrill Lynch affiliate).

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constitute a fund’s acquisition of an by, or an interest in, the credit support risks of securities-related issuers and the ‘‘interest in’’ a securities-related issuer. provider that is a securities-related potential for reciprocal practices that However, a fund’s acquisition of a issuer.158 If it does, then the fund would disadvantage fund investors? If so, in general partnership interest in a need to analyze the derivative what respects? If not, on what basis securities-related issuer, whether or not transaction under section 12(d)(3) with should a fund’s exposure to a securities- the interest is a security, is not respect to the credit support provider as related issuer in a derivatives permitted by rule 12d3–1.157 well. transaction be distinguished from other C. Exposure to Other Securities-Related D. Valuation of Derivatives for Purposes types of investments to which section Issuers Through Derivatives of Rule 12d3–1 Under the Investment 12(d)(3) applies? Company Act • The issue of whether an OTC Do commenters believe that a derivative transaction is prohibited As noted above, if a derivative fund’s exposure to price movements or under the Investment Company Act as transaction involves an acquisition by performance of a reference security an impermissible acquisition of a the fund of a security issued by a issued by a securities-related issuer security issued by, or an interest in, a securities-related issuer, the fund may implicates the purposes of section securities-related issuer, also may be able to rely on rule 12d3–1 under the 12(d)(3)? If not, on what basis would require analysis of a fund’s exposure to Investment Company Act, which such exposure be distinguished from a reference asset underlying the provides a conditional exemption to the other types of investments subject to derivative. If the derivative transaction prohibition in section 12(d)(3). For section 12(d)(3)? is based upon the price or value of purposes of the conditions of rule 12d3– • Should the extent to which the securities issued by, or interests in, a 1, if the securities-related issuer, in its securities-related issuer’s obligations are securities-related issuer, the fund’s most recent fiscal year, derived more secured by collateral provided by the relationship to the issuer of the than 15% of its gross revenues from issuer affect this analysis? If so, what reference asset may raise both of the securities-related activities, as defined specific effect should collateral in the rule, the fund would need to concerns underlying section 12(d)(3)— arrangements be accorded and by what determine whether such derivative is an the fund’s exposure to the risks of that criteria should qualifying collateral equity or debt security and apply the securities-related issuer and the arrangements be defined? potential for reciprocal practices. For percentage limitations in the rule 159 • The 2010 ABA Derivatives Report example, if the issuer of the reference accordingly. Among other things, the suggests that section 12(d)(3) ‘‘provides asset is a broker-dealer, and the fund’s fund would need to determine whether, immediately after the acquisition of an appropriate framework for dealing position in the derivative transaction 160 benefits from increases in the market such derivative, the fund has invested with fund counterparty exposures.’’ price of the reference asset, the fund not more than five percent of the value The 2010 ABA Derivatives Report states might direct brokerage or other business of its total assets in the securities of the that the counterparties to fund to that broker-dealer to enhance the issuer. For purposes of this calculation, derivative transactions generally fall broker-dealer’s profitability. the exposure of the fund to its within the categories of securities- Consequently, the fund could be counterparty or its exposure to the related issuers addressed by section considered to have assumed an issuer of a reference security may be 12(d)(3) and that, unlike the exposure to a securities-related issuer understated were the current market or diversification requirements discussed fair value of the derivative the that is in violation of section 12(d)(3). In above, section 12(d)(3) applies to all appropriate measure. The potential that event, the fund would need to registered investment companies, future exposure of the fund to the consider the availability and conditions regardless of diversification status. The securities-related issuer is, in each case, of rule 12d3–1 with respect to that 2010 ABA Derivatives Report also likely to be unaccounted for by a current entity before determining whether the suggests that the Commission or the mark-to-market standard. Neither the fund may, and if so, to what extent, staff issue guidance concerning the Commission nor the staff has addressed enter into the derivative transaction. manner in which the various provisions this point. The Commission Certain OTC derivative transactions of rule 12d3–1 under the Act should understands that many funds perform involve credit support providers or apply to derivatives.161 Is rule 12d3–1 the calculation under rule 12d3–1 based entities performing similar roles. These the appropriate framework for upon the notional amounts of entities also may be securities-related exempting certain derivatives derivatives transactions, although this issuers. In that case, the fund would transactions from section 12(d)(3)? Are practice is not uniform. need to determine whether the the existing percentage limitations in provision of credit support or similar E. Request for Comment rule 12d3–1 appropriate in the context protection for the fund’s benefit in the The Commission asks for comment on of derivatives? Should there be derivative transaction constitutes the all aspects of the application of section additional limitations or conditions to fund’s acquisition of a security issued 12(d)(3) and rule 12d3–1 to funds’ an exemption from section 12(d)(3) for derivative transactions. derivative transactions? If so, what types 157 In addition, section 12(d)(3) of the Act • Do commenters believe that OTC of conditions or limitations? The prohibits a fund’s acquisition of any security issued Commission also asks commenters to by ‘‘or any other interest in’’ a securities-related derivative transactions between funds issuer. The Commission has noted that, in enacting and securities-related issuers implicate identify and discuss the interpretive section 12(d)(3), Congress was particularly the purposes of section 12(d)(3), i.e., issues that may arise when rule 12d3– concerned with funds investing as general partners protection against the entrepreneurial 1 is applied to funds’ use of derivatives. in securities-related issuers. See Exemption of Acquisitions of Securities Issued by Persons Engaged in Securities-Related Business, Investment 158 See rule 12d3–1(d)(7)(v) under the Act, 160 2010 ABA Derivatives Report, supra note 8, at Company Act Release No. 19204 (Jan. 4, 1993) [58 deeming an acquisition of demand features or 33. The Report states that ‘‘counterparty exposure’’ FR 3243 (Jan. 8, 1993)] at n. 10 and accompanying guarantees as not being the acquisition of securities presents ‘‘the concern that a counterparty cannot text. Rule 12d3–1(c) provides that ‘‘this section of a securities-related issuer provided certain pay a fund the amount that the fund is due under does not exempt the acquisition of: (1) a general conditions are met. the derivative instrument * * *.’’ Id. partnership interest[.]’’ 159 See supra discussion at note 151. 161 Id. at 34–35.

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V. Portfolio Concentration Commission also has stated that, in concentration policies by looking to the In this section, the Commission determining industry classifications, a reference asset and not any counterparty discusses the Investment Company fund may select its own industry to the derivative instrument. Funds Act’s provisions regarding portfolio classifications, but such classifications typically use market values for these ‘‘concentration’’ and the application of must be reasonable and should not be so calculations * * *.’’ 169 broad that the primary economic these provisions to a fund’s use of C. Request for Comment derivatives. characteristics of the companies in a single class are materially different.167 The Commission requests comment A. Investment Company Act Provisions on the application of concentration Regarding Portfolio Concentration B. Issues Relating to the Application of requirements to funds’ investments in the Act’s Concentration Provisions to a derivatives, including the following Funds are required to disclose in their Fund’s Use of Derivatives registration statements their policy questions. • concerning ‘‘concentrating investments When a fund enters into a derivatives How do funds apply the in a particular industry or group of transaction, the fund may gain exposure concentration requirements to their industries.’’ 162 This requirement to more than one industry or group of investments in derivatives? Do they reflects the view that such a policy is industries. For example, if a fund and a consider current market value or the likely to be central to a fund’s ability to bank enter into a total return swap on notional amount of a derivative (or some achieve its investment objectives, and stock issued by a corporation in the other measure) for purposes of that a fund that concentrates its pharmaceuticals industry, the fund will determining whether they have invested investments will be subject to greater have gained exposure to the banking 25% or more of the value of their net risks than funds that do not follow the industry (i.e., the industry associated assets in a particular industry or group policy.163 The concentration with the fund’s counterparty) as well as of industries? Do funds focus solely requirements also are intended to exposure to the pharmaceuticals upon the exposures to the industries prevent funds from substantially industry (i.e., the industry associated with which their derivatives changing the nature and character of with the issuer of the reference asset). counterparties are associated, or do they their businesses without shareholder As noted above, the Commission has also take into account their exposures to approval.164 Funds are prohibited from stated that generally a fund is the industry or industries (if any) of the deviating from their policy concerning concentrated in a particular industry or reference assets underlying those ‘‘concentration of investments in any group of industries if the fund invests or derivatives? particular industry or groups of proposes to invest more than 25% of the • Is it consistent with the policies and industries’’ as recited in their value of its net assets in a particular purposes underlying the concentration registration statements without industry or group of industries. This requirements for funds to focus on the obtaining shareholder approval.165 The standard does not, by its terms, address industry of the issuer of the reference Investment Company Act does not derivative transactions by which a fund asset and disregard the exposure to the include definitions of the terms obtains exposure to a particular industry industry or industries with which the ‘‘concentration’’ and ‘‘industry or or group of industries, whether through derivatives counterparty is associated? groups of industries.’’ The Commission exposure to the counterparty to the Should this depend on the level of has stated generally that a fund is transaction or through its contractual collateral (if any) posted by the concentrated in a particular industry or exposure to a reference asset. counterparty? group of industries if the fund invests or Another issue relevant to determining • Should the Commission provide proposes to invest more than 25% of the industry concentration is whether a guidance to funds on how they should value of its net assets in a particular fund values its derivatives using comply with the concentration industry or group of industries.166 The notional amount or market value. The requirements when they use 2010 ABA Derivatives Report states that derivatives? If so, what should that 162 See Section 8(b)(1)(E) of the Act; Form N–1A, ‘‘using the notional value, rather than guidance entail? Items 4, 9 (instruction 4) and 16(c)(1)(iv); and Form the market value, of a derivative • Are there special considerations N–2, Items 8.2.b(2) and 17.2.e. instrument may inflate an industry that need to be taken into consideration 163 Registration Form Used by Open-End position relative to the fund’s current for smaller funds? How might taking Management Investment Companies, Investment economic exposure.’’ 168 The 2010 ABA Company Act Release No. 23064 (Mar. 13, 1998) such considerations into account impact (‘‘Release 23064’’) [63 FR 13916 (Mar. 23, 1998)] at Derivatives Report further states that investor protection? nn. 98–99 and accompanying text. ‘‘funds typically comply with their 164 See Jaretzki, supra note 131, at 317. The VI. Valuation of Derivatives concentration requirements focus on all of the group of industries’’). See also, e.g., Release No. In this section, the Commission funds’ investments, and not solely on their 23064, supra note 163, (‘‘The Commission’s staff investments in securities. has taken the position for purposes of the discusses, and requests comment on, the 165 Section 13(a)(3) of the Act. See also Securities concentration disclosure requirement that a fund valuation of derivatives used by funds and Exchange Commission’s Brief Amicus Curiae investing more than 25% of its assets in an industry for purposes of applying the various dated March 25, 2010, In re: Charles Schwab Corp. is concentrating in that industry.’’). provisions of the Investment Company Securities Litigation, Master File No. C–08–01510– 167 See SEC Schwab Amicus Brief, supra note Act. WHA (N.D. Cal.) (‘‘SEC Schwab Amicus Brief’’) at 165, at 8 and 9. See also Schwab Opinion, supra 2–3; In re: Charles Schwab Corp. Securities note 165, at *20 (‘‘This order agrees * * * that a A. Investment Company Act Valuation Litigation, No. C 08–01510 WHA, 2010 U.S. Dist. promoter is free to define an industry in any LEXIS 32113 (N.D. Cal. Mar. 30, 2010) (‘‘Schwab reasonable way when it establishes a fund and Requirements Opinion’’) at *3–*4. assumes for sake of argument that the promoter may When calculating their NAVs, funds 166 See also Form N–1A, Item 9, instruction 4 unilaterally, even after the fund is up and running, (defining industry concentration for Form N–1A clarify in a reasonable way a definitional line that must determine the value of their assets, disclosure purposes as ‘‘investing more than 25% may otherwise be vague. But once the promoter has including the value of the derivatives of a Fund’s net assets in a particular industry or drawn a clear line and thereafter gathers in the that they hold. The Investment group of industries’’); but compare Form N–2, Item savings of investors, the promoter must adhere to Company Act specifies how funds must 8.2.b (instruction) (defining industry concentration the stated limitation unless and until changed by for Form N–2 purposes as ‘‘25 percent or more of a stockholder vote.’’) determine the value of their assets. the value of Registrant’s total assets invested or 168 2010 ABA Derivatives Report, supra note 8, at proposed to be invested in a particular industry or n. 57. 169 Id. at 29.

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Under the Act, all funds (other than terms, including contractual restrictions DEPARTMENT OF THE TREASURY money market funds),170 whether open- on their transferability. Some end or closed-end, must calculate their derivatives also may restrict a fund’s Internal Revenue Service NAVs by using the market values of ability to close out the contract or to their portfolio securities when market enter into an offsetting transaction. For 26 CFR Part 1 quotations for those securities are some derivatives, there may be no [TD 9546] ‘‘readily available.’’ 171 When market quotations available from independent quotations for a fund’s portfolio sources, and for some derivatives the RIN 1545–BD04 securities or other assets are not readily fund’s counterparty may be the only Definition of Solid Waste Disposal available, the fund must calculate its available source of pricing information. NAV by using the fair value of those Facilities for Tax-Exempt Bond securities or assets, as determined in C. Request for Comment Purposes; Correction good faith by the fund’s board of The Commission requests comment AGENCY: Internal Revenue Service (IRS), directors.172 on funds’ valuation of derivatives, Treasury. There is no single methodology for ACTION: Correcting amendment. determining the fair value of a security including the following questions: or other asset because fair value • How do funds determine the fair SUMMARY: This document contains depends upon the facts and values of derivatives that they hold? To corrections to final regulations (TD circumstances of each situation.173 As a what extent do valuation determinations 9546) that were published in the general principle, however, the fair depend upon the type of derivative, Federal Register on Friday, August 19, value of a security or other asset held by reference asset, trading venue, and other 2011, on the definition of solid waste a fund would be the amount that the factors? disposal facilities for purposes of the fund might reasonably expect to receive • How do funds, when fair valuing rules applicable to tax-exempt bonds for the security or other asset upon its derivatives, assess the accuracy and issued by State and local governments. current sale.174 When determining the reliability of pricing information that is These regulations provide guidance to fair value of a security or other asset obtained from their counterparties or State and local governments that issue held by a fund, all indications of value from other sources? tax-exempt bonds to finance solid waste that are available must be taken into disposal facilities and to taxpayers that • account.175 How do funds take into account, use those facilities. when valuing derivatives, contractual DATES: This correction is effective on B. Application of the Valuation restrictions on transferability, and Requirements to a Fund’s Use of September 7, 2011 and is applicable restrictions on their ability to close out beginning October 18, 2011. Derivatives the transactions or to enter into FOR FURTHER INFORMATION CONTACT: For many derivatives that are offsetting transactions? Timothy Jones, (202) 622–3980 (not a securities, such as exchange-traded • Some derivatives held by funds options, market quotations typically are toll free number). may have negative values due to, among SUPPLEMENTARY INFORMATION: readily available. As a result, a fund other things, changes in the value of the generally must use market values to reference assets underlying the Background value such derivatives. For many other derivatives. Do funds calculate the The final regulations that are the derivatives, however, market quotations values of such derivatives in the same subject of this document are under are not readily available, and a fund that manner as they value derivatives that section 142 of the Internal Revenue holds such derivatives is required to have positive values? If not, why not? Code. value those derivatives at their fair values as determined by the fund’s • Should the Commission issue Need for Correction board of directors. guidance on the fair valuation of As published August 19, 2011 (76 FR Valuation of some derivatives may derivatives under the Investment 51879), the final regulations (TD 9546) present special challenges for funds. Company Act? If so, what issues should contain errors that may prove to be Some derivatives may have customized be addressed by that guidance? misleading and are in need of • Are there special considerations clarification. 170 Money market funds that comply with the that need to be taken into consideration provisions of rule 2a–7 under the Act [17 CFR List of Subjects in 26 CFR Part 1 270.2a–7], however, may value their portfolio for smaller funds? How might taking securities on the basis of amortized cost. In such considerations into account impact Income taxes, Reporting and addition, under certain circumstances, open-end investor protection? recordkeeping requirements. funds may value certain of their portfolio securities on the basis of amortized cost. See Valuation of VII. General Request for Comment Correction of Publication Debt Instruments by Money Market Funds and Accordingly, 26 CFR part 1 is Certain Other Open-End Investment Companies, In addition to the specific issues Investment Company Act Release No. 9786 (May corrected by making the following 31, 1977) [42 FR 28999 (June 7, 1977)], available at highlighted for comment, the correcting amendments: http://www.sec.gov/rules/interp/1977/ic-9786.pdf. Commission invites members of the 171 Section 2(a)(41)(B) of the Act. See also ASR public to address any other matters that PART 1—INCOME TAXES 118 and ASR 113, supra note 14. ‘‘Readily they believe are relevant to the use of available’’ refers to public market quotations that derivatives by funds. ■ Paragraph 1. The authority citation are current, i.e., ‘‘[r]eadily available market for part 1 continues to read in part as quotations refers to reports of current public Dated: August 31, 2011. quotations for securities similar in all respects to follows: By the Commission. the securities in question.’’ ASR 113, supra note 14, Authority: 26 U.S.C. 7805 * * * at 2. Elizabeth M. Murphy, ■ 172 ASR 113, supra note 14. Par. 2. Section 1.142(a)(6)–1 is Secretary. 173 ASR 118, supra note 14. amended by revising paragraph (c)(2)(v), 174 ASR 113 and ASR 118, supra note 14. [FR Doc. 2011–22724 Filed 9–6–11; 8:45 am] and the first sentence of paragraph (h), 175 ASR 118, supra note 14. BILLING CODE 8011–01–P Example 9 (ii) to read as follows:

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