UK: ABA Task Force Report and SEC Letter Regarding Investment Company Use of Derivatives and Leverage

Last Updated: 17 August 2010
Article by Douglas P. Dick, Megan C. Johnson and Jeanette Wingler

At the 2009 Spring Meeting of the Business Law Section of the American Bar Association ("ABA"), Andrew "Buddy" Donohue, Director of the Division of Investment Management of the Securities and Exchange Commission ("SEC"), challenged the ABA Subcommittee on Investment Companies and Investment Advisers to address concerns about investment company use of derivatives and leverage.1 In response to this challenge, on July 6, 2010, the Task Force on Investment Company Use of Derivatives and Leverage (the "Task Force") of the Committee on Federal Regulation of Securities (the "Committee") of the ABA's Section of Business Law submitted its Report to the Division of Investment Management (the "ABA Paper"). The ABA Paper identifies common approaches to compliance with the Investment Company Act of 1940 (the "1940 Act") and regulations thereunder. The ABA Paper also identifies potential improvements to the existing regulatory framework regarding fund use of derivatives (e.g., forwards, futures, options and swaps) and leverage.

In addition, on July 30, 2010, the SEC staff publicly issued a letter regarding derivativesrelated disclosures by investment companies in registration statements, shareholder reports and financial statements.2 The SEC Letter contains observations on derivatives-related disclosures, which may provide investment companies with "immediate guidance to provide investors with more understandable disclosures related to derivatives, including the risks associated with them."3

The ABA Paper

Substantive Regulation of Fund Use of Derivatives

The use of derivatives by investment companies implicates a number of regulatory provisions of the 1940 Act; however, the SEC and its staff have generally provided only limited guidance concerning how these provisions apply to derivatives. The ABA Paper suggests modifications to certain regulatory provisions by the SEC or its staff.

Section 18 – Limits on Leverage

The ABA Paper identifies certain open issues and inconsistencies in the current SEC and staff guidance regarding the application of Section 18 of the 1940 Act to transactions in derivatives. While the Task Force believes that the basic regulatory framework4 has worked well, the Task Force recommends that: (i) the SEC issue guidance and/or rulemaking; and (ii) funds adopt policies and procedures to address certain open issues and inconsistencies.

Amount to be Segregated

The Task Force recommends SEC guidance, as well as the adoption of policies and procedures by funds that invest in derivative instruments, with respect to the amount to be segregated. In the case of certain instruments, funds are expected to segregate assets that are equivalent in value to the notional value of the instrument; in other cases, however, it is sufficient to segregate only an amount equal to the daily marked-tomarket value of the obligations. Also problematic is that asset segregation practices for certain instruments (e.g., cash-settled forwards) are based on informal SEC staff positions or other non-published SEC staff guidance. The Task Force believes that the SEC should issue revised general guidance in this area, which would set forth an approach to segregation that would cover all types of derivatives in a comprehensive manner.

The Task Force also recommends that funds investing in derivative instruments that involve leverage within the meaning of Release 10666 adopt policies and procedures that would include, among other things, minimum asset segregation requirements for each type of derivative instrument. These requirements would be based on relevant factors attributable to each derivative instrument (known as "Risk Adjusted Segregated Amounts" or "RAS Amounts") and would take into consideration the risks applicable to each particular instrument, as well as any offsetting transactions. Higher risk instruments would require greater RAS Amounts, while "plain vanilla" instruments with low price volatility and risk may require segregation close to or equal to daily market value. The Task Force recommends that asset segregation policies and procedures be developed by a fund's adviser and approved by the fund's board of directors. The Task Force also recommends that funds disclose their policies (including the principles underlying the RAS Amounts) in the fund's statement of additional information ("SAI").

Types of Assets to be Segregated

The Task Force notes that some observers have expressed concern that the SEC staff's position in the Merrill Lynch No-Action Letter,5 which greatly expanded the types of fund assets that could be segregated to satisfy Section 18, could expose a fund to the possibility that it would not have sufficient assets to meet its obligations under the derivative contract. The ABA Paper explicitly states that the Task Force does not believe the SEC should revert to the pre-Merrill Lynch standard (i.e., only cash, U.S. Government securities and other high grade obligations could be segregated). Rather, it believes that fund policies and procedures should address the types of assets to be segregated, taking into account the risk profile of the individual instruments.

Offsetting Transactions

The Task Force notes that what constitutes an "offsetting transaction" in the context of the asset coverage requirements of Section 18 is an open issue. The Task Force believes that the fund policies and procedures discussed above should define which transactions would be considered offsetting, by addressing matters such as pegged currencies, substantially offsetting positions, different counterparties and the like.

Implicit Leverage

The Task Force also considers whether investments with "implicit leverage"6 should be considered to involve the creation of a senior security and, therefore, require asset segregation. The Task Force does not believe that Section 18 does, or should be interpreted to, cover these investments. Accordingly, the Task Force believes that the SEC's approach in Release 10666 remains correct (i.e., applying Section 18 to derivative investments that could result in a fund owing money but not to other types of derivatives or complex securities).

Section 5(b) and Diversification

The Task Force argues that it is unclear under the wording of the relevant statutory provisions how a fund should treat various derivatives in determining compliance with its diversification policy. Moreover, the Task Force notes that the SEC and its staff have given little or no guidance with respect to this issue. The Task Force recommends a bifurcated approach to regulating diversification, with funds measuring diversification for purposes of Section 5(b) of the 1940 Act by looking at reference assets, where applicable.7

Under this bifurcated approach, a threshold determination would be whether the derivative instrument in question is a security. Derivative instruments that are securities should be included in calculating the amount of a fund's assets that are represented by the securities of one issuer. Derivative instruments that are not securities (e.g., Treasury futures and futures on broad-based indices) should not be included in calculating the amount of a fund's assets that are represented by the securities of one issuer because, in part, the reference assets are excluded from the scope of Section 5(b). After identifying the derivatives to which a fund's diversification policy may apply, the next step would be to identify the issuer of the security.

The Task Force recommends that the SEC consider an alternative approach to measuring diversification and dealing with counterparty exposures. Specifically, the Task Force argues that the SEC should recognize the need to bifurcate the regulatory treatment of counterparties and reference securities to achieve diversification in a manner consistent with the purposes of the statute and the regulatory concerns of the SEC. The Task Force recommends that the SEC acknowledge that diversification should be measured for purposes of Section 5(b) of the 1940 Act by looking only at the reference securities and that the SEC should not enforce Section 5(b) with respect to counterparty exposures.

While neither the SEC nor its staff has provided guidance as to how to make calculations under the diversification tests, the Task Force believes that it is reasonable to use the market values (or fair values) of the relevant derivative positions in calculating issuer positions. In addition, because it is unclear how to apply the diversification tests when there is a negative market value for a derivative instrument, the Task Force recommends that the SEC invite comment on this issue.

Section 8(b)(1) Concentration Limitations

Due to the disclosure-based nature of the concentration requirements under the 1940 Act, the Task Force believes that it is reasonable to include the market value of reference assets in the calculation for determining compliance with concentration restrictions, and ignore the counterparty. The Task Force recommends that the SEC or its staff issue guidance affirming this approach.

Section 12(d)(3) Securities-Related Business Considerations

Some funds include reference assets in applying Section 12(d)(3) and Rule 12d3-1. Other funds take into consideration reference assets when the derivative instrument entails an obligation to accept delivery of the securities of securities-related issuers. The Task Force believes that guidance from the SEC or its staff would be beneficial in clarifying the appropriate consideration of reference assets.

In addition, the Task Force believes that Section 12(d)(3) provides an appropriate framework for dealing with fund counterparty exposures (as opposed to Section 5(b)). The Task Force recommends that, in applying Section 12(d)(3) to limit counterparty exposure, the SEC acknowledge a fund's derivative positions that are collateralized. The Task Force recommends that the SEC address the issue of lack of full collateralization by adopting a new rule to place limitations on the amount of uncollateralized exposure a fund could have to a single counterparty. Such new rule should distinguish between investments made for the purpose of exposing a fund's assets to securitiesrelated issuers and the credit risks presented by derivatives counterparties. Significant uncollateralized positions could also be addressed through disclosure. To the extent that the risk of a counterparty is mitigated by possession of bankruptcy-remote collateral, the Task Force believes that a fund may decrease its exposure to risk of a single counterparty. In addition, the Task Force recommends that nationally recognized exchanges or clearinghouses be excluded from the definition of counterparties.

Valuation of Derivative Instruments

The Task Force believes that funds should clearly disclose how they are calculating limits with respect to derivative instruments (i.e., whether based on market value or other measures such as notional value).


The Task Force notes that neither the SEC nor its staff has provided guidance concerning: (i) the custody of fund assets in the derivatives context, including collateral and margin posted in connection with forward contracts, swaps or options (other than options on futures); or (ii) whether central clearing companies comply with Section 17(f) of the 1940 Act and the associated rules.


Fund Names

For funds subject to Rule 35d-1 under the 1940 Act (commonly known as the "names rule"), the Task Force believes that the reference asset, rather than the counterparty, should be the relevant focus for determining whether a fund invests in a manner that is consistent with its name. The Task Force recommends that the SEC or its staff clarify that this approach is appropriate.

Disclosures Regarding Investment Objectives, Policies, Strategies and Risks

The Task Force notes that the prospectus and SAI are generally effective in describing types of derivatives used, mechanics of how particular instruments operate, the purpose of derivatives (i.e., hedging, investment, etc.), and key risks. Also, because the disclosures called for under FASB Accounting Standards Codification Topic 815-10 (formerly FAS No. 161) ("Topic 815") have helped to provide shareholders with meaningful information about fund use of derivatives, the Task Force believes that it would be premature to revisit the requirements for shareholder reports at this time.8

Possible Disclosure Enhancements

The Task Force recommends that funds enhance disclosure of how derivative instruments affect actual investment results. The Task Force proposes sample disclosure in the shareholder letter that: (i) discusses if derivatives account for a meaningful portion of a fund's performance results (positive and negative) over a particular period; and (ii) highlights instances when significant performance results are realized from derivative positions representing relatively small segments of a fund's portfolio as an illustration of the volatility of a particular instrument.

SEC Guidance

The Task Force believes that the SEC or its staff should provide guidance that funds, when measuring compliance with their disclosed investment objectives and policies, should look through to a derivative's reference assets (or the nature of the economic exposure, when applicable), rather than to the issuer.

Fund Director Oversight Responsibilities of Fund Directors

Fund directors' responsibilities with respect to a fund's use of derivatives are generally the same as for other portfolio instruments and are based on the directors' duty of care. Fund directors should be satisfied that the fund's policies and procedures are reasonably designed to achieve their objectives, and should monitor the investment manager's adherence to those policies and procedures. In order to meet their responsibilities, the Task Force believes that it would be prudent for directors to:

  • Review each fund's use of derivatives in order to ascertain whether such use is appropriate for the fund, taking into account the fund's investment objectives and policies and the general manner in which the fund is marketed;
  • Discuss with management whether the fund's use of derivatives is achieving its objectives, within the risk tolerances established by the fund manager as disclosed in the fund's registration statement;
  • Be familiar with the public disclosures concerning derivatives that the fund makes pursuant to the federal securities laws;
  • Be confident that the relevant operations of the investment manager, including its risk management systems, are adequate to accommodate the use of derivatives;
  • Discuss relevant information with the fund's chief compliance officer ("CCO") concerning compliance by the fund and its investment manager with the legal requirements that apply to derivatives; and
  • Look out for "red flags" that indicate undue risk or that derivatives are not achieving their intended use.

Elements of Knowledgeable and Meaningful Oversight

  • Investment management – The Task Force believes that a fund's policies concerning the use of derivative instruments should be set forth in its registration statement and that such policies should include a mechanism for reviewing and approving new instruments or new uses for previously approved instruments.
  • The investment manager's operations and risk management – The Task Force believes that directors should be satisfied that the relevant operations of the investment manager are adequate to accommodate the actual and proposed uses of derivatives, including risk management systems, fund accounting systems and compliance systems.
  • Compliance monitoring – The Task Force recommends that the fund's CCO report to the directors any material issues and violations arising under the compliance procedures, including with respect to derivative instruments.
  • Board communications – The Task Force believes that periodic reports to boards that disclose the degree to which a fund has employed derivatives at given points in time can be a useful tool. The ABA Paper states that "[t]he need for specific risk reporting depends on the inherent risk that is associated with the kinds of derivative instruments being used and if the derivatives are being used to hedge or for investment."
  • Role of the board – The Task Force argues that the role of fund directors is that of oversight, rather than micro-management.
  • SEC guidance – The Task Force recommends that the SEC or its staff publish guidance for fund directors in this area, including guidance that clarifies that the role of fund directors is one of oversight.

Special Context: Funds that Use Derivatives Extensively

The ABA Paper notes that certain investment companies use derivatives extensively as part of their investment strategies. The ABA Paper states that "[t]he recommendations contained in this ABA Paper concerning asset segregation requirements and proposed counterparty limits, combined with clear disclosure, should be effective to address the staff's concerns relating to these types of funds."

The Task Force notes that many fund managers that use derivatives extensively have established formal committees to approve the use of a new derivative and the use of a derivative in a new way. These committees are generally made up of personnel from the legal, compliance, tax, operations, portfolio management, risk and accounting departments of the firm. The ABA Paper states that "[s]uch committees serve as valuable resources to fund boards."

The SEC Letter

Disclosure in Registration Statements

The "primary observation" of the SEC Letter is that some registration statements include generic disclosures about derivatives that, in the SEC staff's view, may be of limited usefulness for investors in evaluating the fund's investment operations, including how the fund's investment manager actually intends to manage the portfolio and the consequent risks.9 The SEC Letter notes that at one end of the spectrum these generic disclosures include highly abbreviated disclosures that briefly identify a variety of derivative products or strategies. These highly abbreviated disclosures often provide generic risk disclosures that cite various potential risks but provide limited explanation of those risks. The SEC Letter continues that, at the opposite end of the spectrum, certain funds include lengthy, often technical, disclosures that detail a wide variety of potential derivatives transactions without explaining the relevance to the fund's investment operations. These lengthy disclosures generally provide risk disclosure that is more tailored to each specific type of derivative but the complex and lengthy nature of the disclosure may reduce its usefulness to investors.

According to the SEC Letter, the SEC staff has observed that certain funds employing highly abbreviated disclosures appear to be significantly invested in derivatives and may have substantial exposure to derivatives-related risks. Conversely, certain funds with small exposure to derivatives and the related risks include complex and lengthy disclosures in their registration statements. In the view of the SEC staff, the lack of correlation between a fund's investments and exposure to derivatives-related risk and its registration statement disclosures may prevent investors from distinguishing which, if any, derivatives are encompassed in the principal investment strategies of the fund and the corresponding principal risks.

The SEC staff suggests that a fund that uses or intends to use derivative instruments should:

  • Assess the accuracy and completeness of its disclosure in light of actual operations;
  • Specifically tailor any disclosure of principal investment strategies related to derivatives to how a fund expects to be managed and to address those strategies the fund expects to be the most important means of achieving its objectives and expects to have a significant impact on its performance;
  • Address the principal investment strategies disclosure related to derivatives that the fund expects to be the most important means of achieving its objectives and that the fund anticipates will have a significant impact on its performance; 10
  • Consider the degree of economic exposure created by the derivatives and the amount invested in the derivatives strategy in determining the appropriate disclosure.
  • Describe the purpose that the derivatives are intended to serve (e.g., hedging, speculation or as a substitute for investing in conventional securities) and the extent to which derivatives are expected to be used; and
  • Tailor its disclosure of principal risks to the types of derivatives used by the fund, the extent of their use and the purpose for using derivative transactions.

Disclosure in Shareholder Reports and Financial Statements

According to the SEC Letter, the SEC staff has observed that some funds that appear to have significant derivatives exposure include only limited discussion regarding the effect of those derivatives on fund performance in the Management's Discussion of Fund Performance ("MDFP") section of their annual reports to shareholders. In addition, the SEC staff has observed that some funds with derivatives-related disclosure in the MDFP include solely forward-looking statements and do not discuss the impact of derivatives on performance for the most recently completed fiscal year.

The SEC Letter reminds funds that the MDFP is intended to discuss the factors that affected performance during the most recently completed fiscal year and should not be limited to forward-looking statements. In addition, because the MDFP should be consistent with operations reflected in the financial statements, a fund whose performance was materially affected by derivatives should discuss that fact regardless of whether derivatives are reflected in the schedule of portfolio holdings.

Moreover, the SEC Letter notes that some funds can improve certain disclosures required by Topic 815, which requires that funds provide qualitative disclosures about their objectives and strategies for using derivative instruments. The SEC staff believes that funds may improve their disclosures when meeting the requirements of Topic 815 by: (i) addressing the effect of using derivatives during the reporting period, (i.e., by informing shareholders how a fund actually used derivatives during the period to meet its objectives and strategies); and (ii) explaining the relevance of credit spreads when selling protection through credit default swaps (e.g., explaining the significance of the size of the credit spread in relation to the likelihood of a credit event or the possible requirement for a fund to make payments to counterparties).

The SEC Letter also notes that some funds do not disclose the counterparties to forward currency and swap contracts reported in the "Schedule of Investments – Other Than Securities" portion of their financial statements. The SEC staff believes that, because over-the-counter derivatives are subject to the risk of nonperformance by the counterparty, the identification of the counterparty is a material component of the description of the risks associated with a derivative instrument and, therefore, should be disclosed.

The Division of Investment Management had previously announced that it was evaluating the use of derivatives by funds, exchange-traded funds and other investment companies. It is likely that recommendations set forth in the ABA Paper and observations noted in the SEC Letter will inform this evaluation. We will continue to monitor developments in this area.


1 Specifically, Mr. Donohue asked whether: (i) investment companies should have a means to deal effectively with derivatives outside of disclosure; (ii) a fund's approach to leverage should address both implicit and explicit leverage; and (iii) a fund should address diversification from investment exposures taken on rather than the amount of money invested. See Andrew J. Donohue, Director, SEC Division of Investment Management, Investment Company Act of 1940: Regulatory Gap between Paradigm and Reality?, Address before American Bar Association Spring Meeting (April 2009), available at speech/2009/spch041709ajd.htm.

2 Letter from Barry D. Miller, Associate Director, Office of Legal and Disclosure, Division of Investment Management, to Karrie McMillan, Esq., General Counsel, Investment Company Institute (July 30, 2010) available at ci073010.pdf (the "SEC Letter").

3 Id. at 1.

4 As articulated in Securities Trading Practices of Registered Investment Companies, Investment Company Release No. 10666 (April 18, 1979) ("Release 10666") and subsequent no-action letters.

5 Merrill Lynch Asset Management, L.P., SEC No-Action Letter (July 2, 1996).

6 Securities with implicit leverage permit a fund to gain exposure that is greater than would be the case by investing in a corresponding long or conventional security but do not result in the possibility of a fund incurring obligations beyond its initial investment. An example would be certain types of structured notes.

7 Although a reference asset may be any asset, index, or basket of assets, the Task Force believes that broadbased indices or certain reference assets such as commodities or currencies should be excluded when measuring diversification.

8 Topic 815 requires that funds provide qualitative disclosures about their objectives and strategies for using derivative instruments.

9 SEC Letter at 2.

10 SEC Letter at 4. The SEC staff states that, in its view, referencing all types of derivatives, if not expected to be used in connection with principal strategies, is not consistent with the intent of Form N-1A requirements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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