SEC examining mutual funds' use of derivatives

by Sarah N. Lynch, in.reuters.com
August 31st 2011 2:49 PM

WASHINGTON (Reuters) - U.S. securities regulators voted to seek public comment on whether to write new rules to better address the risks posed by mutual funds, exchange-traded funds and other investment companies that use derivatives.

The unanimous decision on Wednesday to solicit input marks an initial step by the Securities and Exchange Commission as it examines the effectiveness of current disclosure and leverage rules as they relate to derivatives.

The fear is that funds can use derivatives to potentially exceed borrowing rules and risk limits, while technically complying with the letter of the law.

The SEC's interest in derivatives use by investment companies predates the 2007-2009 financial crisis, which laid bare the potential risks of over-the-counter derivatives.

Credit default swaps played a central role in crises at Bear Stearns, Lehman Brothers and American International Group Inc.

SEC Chairman Mary Schapiro said that taking a closer look at derivatives use by funds is important because a lot has changed since the 1940 Investment Company Act was written.

"The Act imposes important leverage, valuation, diversification, and industry concentration requirements to help protect fund investors. However, those limitations were written with stocks and bonds in mind, not complex financial derivatives," she said.

"As a result, fund investments in derivatives are not always wholly captured by the statutory limitations and requirements."

The initial reform push began with former SEC Investment Management Director Andrew "Buddy" Donohue, who several years ago began questioning whether federal laws governing mutual funds and exchange-traded funds needed to be modernized. He asked the American Bar Association to study the issue.

In March 2010, the SEC announced it was conducting its own broad review of derivatives use by investment companies. The agency at that time also suspended exemptive requests from exchange-traded funds seeking to let them invest heavily in derivatives. That suspension is still in effect as the agency continues to study the issue.

The 1940 act places various restrictions on mutual funds, including the amount of money a fund can borrow.

But derivatives can be used as another means to achieve leverage, allowing funds potentially to exceed borrowing rules while still complying with the law.

Derivatives also allow funds to seek exposure to various things like bonds or stocks, without purchasing them directly.

Existing law primarily addresses direct investments by funds, raising questions about how swaps and other derivatives should be accounted for and valued on their books.

Jay Baris, a partner at Morrison and Foerster who helped lead the ABA task force that studied the derivatives issue, said the SEC has a difficult task ahead to come up with a uniform approach for derivatives use by investment companies.

"We want to make sure any potential fix doesn't change the fundamental character of these funds and their ability to be innovative," he said in an interview after Wednesday's meeting.

ASSET-BACKED SECURITIES, REAL ESTATE INVESTMENT TRUSTS

Also on Wednesday, the SEC voted unanimously to seek comment on two companion documents that will help the agency determine how it should modernize regulations for asset-backed securities issuers and real estate investment trusts, or REITS, which are in the business of acquiring mortgages and mortgage-related instruments.

Both issuers of ABS and REITs generally rely on exemptions from most investment company regulations to be able to operate.

Recent changes in financial law and investment practice, however, are forcing the SEC to take another look at how it should apply these exemptions.

In the past, asset-backed issuers making public offerings could be exempt from investment company regulations if the securities were rated by a credit-rating agency registered with the SEC. But last year's Dodd-Frank financial oversight law requires the SEC to remove the reliance on credit ratings from its rules, forcing the SEC to take another look at how to replace them.

The SEC plans to ask questions about how it should go about removing the rating reference and how it should be replaced.

REITS and other mortgage-backed securities issuers, meanwhile, have also typically relied on various conditions to qualify for an exemption as well.

As the mortgage market has evolved, however, the SEC said it is concerned that certain pooled investment vehicles have relied on the exemption without sufficient SEC guidance, even as their activities have shifted in some cases away from a direct interest in the real estate business to more indirect interests through mortgage-related securities investments.

(Reporting by Sarah N. Lynch; Editing by Lisa Von Ahn, Matthew Lewis and Tim Dobbyn)