Alert July 13, 2010

ABA Task Force Submits Report on Investment Company Use of Derivatives and Leverage to SEC

Formed in April 2009 in response to a request from the Director of the SEC’s Division of Investment Management, the Task Force on Investment Company Use of Derivatives and Leverage of the American Bar Association (“ABA”) submitted a report to the Division that evaluates regulation and practice relating to the use of derivatives and leverage by registered investment companies (“funds”) and makes recommendations on how the SEC and its staff can improve the regulatory framework in these areas.  The report provides an overview of different kinds of derivatives used by funds and how the SEC has historically regulated funds’ use of derivatives.  The report identifies a number of issues that funds have had to address in the absence of SEC guidance and describes common industry practices that have arisen to address these issues.  In addition to a general recommendation that regulation of derivative use by funds be principles-based, the report makes a number of specific recommendations, summarized as follows:


For purposes of Section 5(b) of the Investment Company Act of 1940 (the “1940 Act”), which divides management investment companies (generally consisting of mutual funds and closed-end funds) into diversified and non-diversified funds, the report recommends that a fund classify a derivative based on its reference asset, i.e., the asset to which the derivative provides exposure, unless the reference asset is a broad-based index, or a commodity or currency.


As with diversification, a fund’s determination of the effect of a derivative holding on compliance with its industry concentration policy should be based on the derivative’s reference asset.

Fund names

As with diversification and concentration, a fund should be able to comply with the requirement under Rule 35d-1 of the 1940 Act that a fund ordinarily invest at least 80% of its assets in securities consistent with a name that suggests a type of investment or industry, by looking through to a derivative’s reference asset.

Counterparty risk

The SEC should regulate the counterparty risk associated with derivatives using the framework created by Section 12(d)(3) of the 1940 Act, which generally limits a fund’s ability to invest in issuers in a securities-related business.  Under the report’s recommendations, Section 12(d)(3) based limits would also apply to counterparties that are not in a traditional securities-related business, and would be relaxed when a counterparty provides bankruptcy‑remote collateral.

Leverage and asset coverage

To address open issues and inconsistencies in SEC positions regarding the amount and type of assets that must be segregated to avoid a violation of the senior securities limitations of Section 18 of the 1940 Act, the report recommends that a fund using derivatives be required to develop policies that establish “Risk-Adjusted Segregated Amounts” (“RAS Amounts”) for the different derivative instruments it uses based on their individual risk profiles.  The determination of the amount to be segregated in each case would be based on consideration of factors such as the extent to which issuer or transaction-specific risk might result in a loss of the full notional amount of the derivative instrument or whether market practice and intra-day volatility suggest that the mark-to-market value of derivative is the more accurate measure of a fund’s exposure.  The report recommends that RAS Amounts also designate appropriate types of assets to be used to cover potential senior securities obligations created by derivatives and specify the types of transactions that may be used to offset derivative positions as an alternative to segregating assets.  The report recommends that the SEC not treat as subject to Section 18 fund investments in securities that do not result in obligations beyond the investment amount, but provide potential investment exposure in excess of what would be achieved by investing in a corresponding conventional security.  A fund should disclose its RAS Amounts in its statement of additional information.


The report recommends that funds provide additional disclosure designed to offer insight into how derivatives have affected fund performance, and points to the description of fund performance provided by portfolio management in the shareholder letters accompanying fund financial statements as an appropriate vehicle for this kind of disclosure, rather than the fund prospectus or statement of additional information.

Board oversight

The report emphasizes that a fund’s board should be viewed as acting in the same oversight role with respect to derivatives as it does with respect to any other fund activity.  The report provides examples of specific actions typically undertaken by fund directors in their oversight role with respect to derivatives, such as approving the use of new types of derivative instruments.  The report also discusses different types of reporting on derivatives use provided to fund boards.  The report recommends that the SEC or its staff consider proposing guidance for public comment on the proper role of fund directors in overseeing derivatives and leverage.