Some mutual fund industry insiders say they would not be surprised if the Securities and Exchange Commission chooses to adopt the derivatives rule proposal the agency published last December without making substantive changes to it, Fund Operation’s sister publication Fund Directions reported.
“The SEC put a lot of thought into this proposed rule, which addresses concerns raised by banking regulators,” Jay Baris, partner and chair of Morrison & Foerster‘s investment management practice, told Fund Directions. “It would not surprise me if the final rule follows the basic structure of the proposal,” Baris said. However, there is some room for changes, and it is still unclear whether the public comments will lead to any modifications, he added.
The commentary process for the rule proposal has overlapped with the regulator’s controversial liquidity risk management rule proposal, emphasizing the contrast in the industry’s reaction to the two. The liquidity risk management proposal, whose comment period expired January 13, received some scathing reviews, some going so far as to question the SEC’s jurisdiction to regulate the issue. Comments for the derivatives rule are due March 28.
“Unlike the liquidity proposal, which has received a pretty strong negative reaction from the industry — particularly in terms of the need for such a rule — the derivatives rule has been a long time in the making, the industry knew it was coming, and it is fairly rational,” according to Nora Jordan, partner and head of Davis Polk’s Investment Management Group. Addressing funds’ use of derivatives has long been on the SEC’s rulemaking agenda, having cropped up on the regulator’s published list of priorities for years.
The SEC’s plan to regulate derivatives may have sat better with the fund industry because some say it merely codifies a set of best practices that many fund advisers in the derivatives space already follow to some extent.
“It’s prudent risk management,” Kent Knudson, director at PwC, said on a panel at Voltaire Advisors’ Valuation, Liquidity & Derivatives conference in New York.
The SEC’s derivatives rule addresses derivatives exposure limits, asset segregation, risk management programs, responsibilities for directors and disclosures.
“The 40 Act doesn’t on its face address derivatives,” Jordan said. Previously, derivatives use by mutual funds was regulated by Section 18 of the Investment Company Act — which governs senior securities, in addition to a general policy statement the SEC issued in 1979 and 30-plus no-action letters.
Industry concerns include what the Section 18 implications will be, the costs of implementing new policies and procedures, and circumstantial complications for some highly leveraged funds. The SEC staff has said the proposal is not going to effect the portfolio composition of 95% of registered funds, Jordan said.
Still, the proposal leaves some unanswered questions, according to Jordan. For example, the new rule makes it clear asset managers will have to segregate assets when entering into derivatives and financial commitments. Less clear is whether it would be necessary to have 3x coverage for financial commitments or derivatives in a situation where a fund has bank loans. One possible reading of Section 18 indicates that if a fund has a bank loan it must have asset coverage for all of its senior securities, which could include derivatives under the proposal.