SEC Concept Release on Use of Derivatives by Funds

The following post comes to us from David Gilberg, partner at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication.

The Securities and Exchange Commission recently published a concept release and request for comments (the “Release”) on a wide range of issues relating to the use of derivatives by investment companies regulated under the Investment Company Act of 1940, including mutual funds, closed-end funds, exchange-traded funds and business development companies (collectively, “funds”).

The stated purpose of the Release is to assist in the SEC’s evaluation of whether the current regulatory framework, as it applies to funds’ use of derivatives, continues to fulfill the purposes and policies underlying the Act and is consistent with investor protection. The SEC states that it intends to use the comments it receives to help determine whether regulatory initiatives or guidance are necessary to improve the current regulatory regime and the specific nature of any such initiatives.

The Release solicits broad public comment and comprehensive information on any matters that may be relevant to the use of derivatives by funds, and it focuses particular attention, and requests specific comment, on issues relating to:

  • senior securities and leverage restrictions;
  • diversification requirements;
  • exposure to securities-related issuers;
  • concentration limitations; and
  • valuation.

Somewhat surprisingly, in light of the breadth of the SEC’s request for information and comments, comments on the Release are due within a relatively short 60-day period, on November 7, 2011.


According to the Release, [1] “the dramatic growth in the volume and complexity of derivatives investments over the past two decades, and funds’ increased use of derivatives” have led the SEC and its staff to initiate a review of funds’ use of derivatives under the Act. In a March 2010 press release, [2] the SEC announced that its staff was conducting a review to evaluate the use of derivatives by funds that would examine whether and what additional protections are necessary for those funds under the Act. The press release also indicated that, pending completion of the review, the staff would defer consideration of exemptive requests under the Act relating to exchange-traded funds (“ETFs”) that propose to make extensive use of derivatives in implementing their investment objectives. [3] As part of such review, the SEC states that members of the staff met with industry groups and some fund complexes that use OTC derivatives, and that the staff also reviewed fund disclosures relating to the use of derivatives and their risks. The SEC further stated that the staff had considered the 2010 report of a task force of the Committee on Federal Regulation of Securities of the American Bar Association on the use of derivatives and leverage by funds (the “2010 ABA Derivatives Report”), [4] which the SEC cites extensively throughout the Release.

The SEC states that its staff generally has been exploring the benefits, risks and costs associated with funds’ use of derivatives and also has been exploring various specific issues relating to funds’ use of derivatives, including whether: (i) current market practices involving derivatives are consistent with the leverage, concentration and diversification provisions of the Act; (ii) funds that rely substantially upon derivatives, particularly those that seek to provide leveraged returns, maintain and implement adequate risk management and other procedures in light of the nature and volume of their derivatives investments; (iii) funds’ boards of directors are providing appropriate oversight of the use of derivatives by the funds; (iv) existing rules sufficiently address matters such as the proper procedures for a fund’s pricing and liquidity determinations regarding its derivatives holdings; (v) existing prospectus disclosures adequately address the particular risks created by derivatives; and (vi) funds’ derivative activities should be subject to any special reporting requirements. [5]

The Release states that while the SEC or its staff has addressed over the years a number of issues relating to derivatives on a case-by-case basis, the SEC “now seeks to take a more comprehensive and systematic approach to derivatives-related issues under the [Act].”

The Release

General Request for Comments

The SEC requests data and comment on the types of derivatives used by funds, the purposes for which funds use derivatives, whether funds’ use of derivatives has undergone changes, and the nature of any such changes. In addition to these requests for general background and information, comment is specifically requested on, among other things: (i) the costs and benefits to funds from the use of derivatives; (ii) the risks to funds from investing in derivatives; (iii) the role that collateral used in derivatives transactions plays or could play in mitigating concerns relating to the use of derivatives by funds; (iv) how different types of funds use different types of derivatives or use derivatives for different purposes; and (v) whether an ETF’s use of derivatives raises unique investor protection concerns under the Act.

Derivatives under the “Senior Securities” Restrictions

Section 18 of the Act imposes significant restrictions on a fund’s ability to issue and sell “senior securities.” The SEC and its staff have broadly interpreted the term “senior security” to include any transaction or arrangement – including fund investments in derivatives – that involve leverage and may expose a fund to potential payment obligations of amounts that exceed the fund’s initial investment. [6]

The Release reviews SEC guidance [7] issued in 1979 with respect to the application of section 18 to fund transactions involving derivatives in the form of reverse repurchase agreements, firm commitment agreements and standby commitment agreements. In Release 10666, the SEC stated that such agreements may create the functional equivalent of “senior securities” by means of their substantial inherent leveraging. The SEC indicated, however, that these agreements and similar derivatives arrangements could nevertheless be entered into by a fund provided it utilized the “segregated asset approach” – i.e., the fund established and maintained with its custodian a segregated account containing liquid assets sufficient to meet all payment obligations incurred by it in connection with the derivatives arrangement. Subsequent to Release 10666, the staff issued various no-action letters that supplemented the original segregated asset approach and, in part, extended it to certain other derivatives. [8]

The SEC states that the segregated account approach serves both to limit a fund’s potential leverage and provide a source of payment of future obligations arising from leveraging transactions. In determining the amount of assets required to be segregated to cover a particular transaction, the SEC and its staff generally have looked to the notional amount of the transaction rather than the unrealized gain or loss (i.e., mark-to-market value) of the transaction. The SEC observes that in the case of derivatives for which no SEC or staff guidance has been provided, segregation may not be done based on the notional amount of the contract. For example, the Release states that “[c]ertain swaps . . . that settle in cash on a net basis, appear to be treated by many funds as requiring segregation of an amount of assets equal to the fund’s daily mark-to-market liability, if any.”

The SEC observes that the segregated account approach has drawn criticism on several grounds. Some industry participants argue that the segregated account approach calls for an instrument-by-instrument assessment of the amount of asset cover required, thereby creating potential uncertainty about the treatment of new products. Others assert that the approach can result in different treatment of similar products. Other industry participants argue that, with respect to the amount to be segregated, the uses of both notional amount and mark-to-market amount have limitations: on the one hand, segregating assets equal to the full notional amount may limit the use of derivatives products that could potentially benefit funds and investors; on the other, limiting asset segregation to an amount equal to the daily mark-to-market amount may understate the risk of loss to the fund and permit it to engage in excessive leveraging without sufficient asset coverage.

The Release observes that critics of the notional and mark-to-market approaches often advocate use of a more complex analysis of the risk of a fund’s investments, such as Value at Risk (“VaR”) or other methodologies for assessing the probability of portfolio losses. The Release describes one such alternative approach, proposed in the 2010 ABA Derivatives Report, whereby individual funds would establish their own asset segregation standards for derivatives that involve leverage within the meaning of Release 10666. Under this approach, each fund would be required to adopt policies and procedures that would set minimum asset segregation requirements for each type of derivative instrument, which would take into account a variety of risk measures, including VaR and other quantitative measures of portfolio risk, and would not be limited to the notional amount or mark-to-market measures. These minimum “risk adjusted segregated amounts,” or RASAs, would be reflected in policies and procedures that would be subject to approval by the fund’s board of directors and disclosed (including the principles underlying the RASAs for different types of derivatives) in the fund’s statement of additional information.

The Release observes that limitations on leveraged exposure imposed by regulators in other jurisdictions take a variety of forms, including maximum exposure limitations, asset segregation requirements and other measures. In the context of maximum exposure or leverage limitations, the notional or principal amount of the reference asset underlying the derivative has commonly been used as a conservative measure of the exposure created by derivatives. In addition to limitations on aggregate positions or leveraged exposure, some regulatory frameworks include restrictions on concentrated exposures to individual counterparties or provide for specialized funds that may assume derivatives exposure exceeding otherwise applicable limits. The Release devotes considerable attention to surveying regulatory frameworks in respect of funds’ use of derivatives that have been developed by certain other regulators outside the United States, including the European Securities and Markets Authority, the Monetary Authority of Singapore, the Central Bank of Ireland, the Canadian Securities Administrators and the Hong Kong Securities and Futures Commission.

The SEC requests comment concerning the current approach to the application of the senior securities limitations of section 18 of the Act to funds’ use of derivatives, including comments on the appropriateness and effectiveness of the segregated asset approach, ways in which that approach might be improved and potential alternative approaches. The SEC also requests comment on numerous specific issues relating to the current approach and alternative approaches, including whether:

  • in addition to leverage, funds should also be required to consider and address, e.g., the credit of their derivatives counterparties, the liquidity of their derivatives and diversification among counterparties;
  • a fund should segregate assets in an amount equal to the notional amount of a derivative contract, or whether (and in what situations) a lesser amount, such as the mark-to-market amount or another measure, would be adequate;
  • in the case of derivatives (such as swaps) that generally have a zero market value at inception and whose subsequent mark-to-market amounts may fluctuate widely, segregation on a daily mark-to-market amount serves the Act’s objective of limiting leverage and assuring the availability of adequate assets to cover a fund’s ultimate obligations;
  • a fund should be permitted to segregate any liquid asset, or whether restrictions should be placed on the types of liquid assets that may be utilized;
  • owning, or having the right to obtain, cash or other assets that a fund obligates itself to deliver in connection with senior securities is an adequate substitute for segregation of liquid assets;
  • it is appropriate to treat differently (i) conventional bank borrowings under section 18, which generally require 300% asset coverage, and (ii) other transactions, such as reverse repurchase agreements, that may be functionally equivalent to borrowings but which, under Release 10666, may be covered by segregation of assets equal to 100% of the fund’s obligations;
  • the approach described by the 2010 ABA Derivatives Report, under which funds would specify a RASA for each derivative investment used by the fund, would be an appropriate alternative to the current segregated asset approach, and whether fund boards of directors have sufficient expertise to oversee an alternative approach to leverage and derivatives management, such as RASA and/or VaR;
  • as under certain foreign regulatory schemes, funds should be permitted to choose from among approved alternative quantitative risk assessment methodologies, and whether (and under what circumstances) a fund should be permitted to switch to a different assessment after disclosing a choice;
  • as in the case of bank capital standards, a methodology that combines the current mark-to-market value of a fund’s derivative investments with a measure of potential future exposure based upon a percentage of the notional amount of its derivative contracts would provide a better measure of risk than the notional amount or mark-to-market value of the derivative;
  • incorporating a VaR approach or other comparable risk measurement methodology in the segregated account approach would be desirable, and whether, under a VaR or similar approach, funds should be required to disclose their expected and/or actual leverage levels;
  • a stress testing requirement should be imposed upon funds that use derivatives, where a risk-based methodology is used to determine the required asset segregation value; and
  • derivatives that create economic leverage but that do not impose future payment obligations on funds (e.g., purchased options or commodity-linked notes) raise the same or similar concerns as derivatives that create indebtedness leverage.

Derivatives under the Diversification Requirements

Funds are required to disclose in their registration statements whether they are classified as diversified or non-diversified. A diversified fund is defined in section 5(b) of the Act as a fund that, with respect to 75% of the value of its total assets, has (among other things) no more than 5% of the value of its total assets invested in the securities of any one issuer. For purposes of calculating the 75% bucket based upon total assets and whether the fund has invested 5% of the value of its total assets in the securities of any one issuer, a diversified fund must consider how to value its investments in derivatives, and it must determine the identity of the issuer of each derivative. [9]

The Act provides that, “unless the context otherwise requires,” all assets held by a fund (including derivatives) must be valued using market values (if available) and fair values at the end of the fund’s last preceding fiscal quarter, or, if subsequently acquired, their cost. For purposes of calculating a fund’s net asset value, the SEC observes that derivatives are generally valued using a market value measure for exchange-traded derivatives and a fair value measure for OTC derivatives and that, in either case, the value of a derivative would appear to be the value at which it could be sold or transferred at the relevant time. According to the SEC, because derivatives generally are intended to convey a leveraged return based on a reference asset over a period of time, their mark-to-market values at any one point do not reflect the asset base on which future gains and losses will be based or otherwise represent the potential future exposure of the derivatives investor. The SEC expresses concern that the use of a mark-to-market value for derivatives held by a purportedly diversified fund could permit the fund to maintain an ongoing exposure to a single issuer or group of issuers in excess of 5% of the fund’s assets on a notional basis. The SEC requests comment on whether the application of the diversification requirements to derivatives is a “context [that] otherwise requires” a different measure of value than that specified in the statute and whether the use of the notional amount of the derivative, rather than its current market or liquidation value, would be better suited to the Act’s diversification provisions.

The Act defines an “issuer” as “every person who issues or proposes to issue any security, or has outstanding any security which it has issued,” unless the context otherwise requires. The SEC observes that although, in general, the “issuer” of an OTC derivative entered into by a fund would appear to be the fund’s counterparty, a derivative that has a reference asset that has an issuer (such as a total return swap on a corporate issuer’s stock) may create potential exposure of the fund to both the counterparty to the contract and the issuer of the reference security. The SEC requests comment on, among other things, whether a fund should be able to disregard its exposures to its derivative counterparty for purposes of the diversification requirements, and whether the issuer of reference assets underlying a derivative entered into by a fund should be considered the issuer of a security for purposes of the diversification requirements in lieu of, or in addition to, the counterparty.

Exposure to Securities-Related Issuers through Derivatives

The SEC requests comment on how the restrictions under the Act on acquisitions of securities and other interests in securities-related issuers, and the limited rule-based relief with respect to such acquisitions, should apply in the context of funds’ use of derivatives.

Under section 12(d)(3) of the Act, funds generally may not purchase or otherwise acquire any security issued by, or any other interest in, the business of a securities-related issuer – i.e., a broker, dealer, underwriter or investment adviser. Rule 12d3-1 under the Act provides a limited exception from this prohibition, permitting funds to acquire (i) securities of any issuer that derives 15% or less of its gross revenues from securities-related activities (provided the fund does not control the issuer after the acquisition) or (ii) up to a specified percentage of the outstanding securities (5% of equity securities; 10% of debt securities) of an issuer that derives more than 15% of its gross revenues from securities-related activities. Rule 12d3-1 exempts only acquisitions of securities, and consequently provides no exemption for the acquisitions of other interests in a securities-related issuer (e.g., general partnership interests).

The SEC states that if a fund’s counterparty in an OTC derivative transaction is a securities-related issuer, the fund’s transaction with the counterparty may constitute an acquisition of a security issued by, or another interest in, a securities-related issuer within the scope of section 12(d)(3). According to the SEC, if such derivative is a security issued by the counterparty, the fund may be able to rely on rule 12d3-1 to engage in the transaction. However, if the derivative were deemed an acquisition of an interest in a securities-related issuer, no relief under rule 12d3-1 would be available, and the general prohibition of section 12(d)(3) would apply. [10]

The SEC observes that whether a fund’s OTC derivative transaction is prohibited (or limited) as an acquisition of a security issued by, or an interest in, a securities-related issuer may require analysis of the fund’s exposure to a reference asset underlying the derivative. If such exposure is based upon the value of securities of or interests in a securities-related issuer, according to the SEC, the fund could be considered to have assumed an exposure to a securities-related issuer that implicates the limitations of section 12(d)(3) and rule 12d3-1.

The SEC also observes that the credit support providers involved in certain OTC derivative transactions may be securities-related issuers. In such cases, the SEC states that a fund would need to determine whether the provision of credit support or similar protection for the fund’s benefit in such a transaction constitutes the fund’s acquisition of a security issued by, or an interest in, the credit support provider that is a securities-related issuer, and, if it does, whether the fund should also analyze the transaction under section 12(d)(3) with respect to the credit support provider.

The SEC states that, for the purposes of a fund’s calculation of the applicable percentage limitations of rule 12d3-1, the exposure of the fund to its counterparty or to the issuer of a reference security may be understated if the current market or fair value of the derivative were utilized, because the potential future exposure of the fund to such counterparty or issuer is not likely to be accounted for by a current mark-to-market standard. The SEC states that it “understands that many funds perform the calculation under rule 12d3-1 based upon the notional amounts of derivatives transactions, although this practice is not uniform.”

The SEC requests comment on the application of section 12(d)(3) and rule 12d3-1 to funds’ derivatives transactions, including: whether a fund’s exposure to price movements or performance of a reference security issued by a securities-related issuer implicates the purposes of section 12(d)(3); whether the extent to which the securities-related issuer’s obligations are secured by collateral provided by the issuer should affect the analysis; and identification and discussion of interpretive issues that may arise when rule 12d3-1 is applied to funds’ use of derivatives.

Derivatives and Portfolio Concentration

The Act requires that funds disclose in their registration statements their policies concerning concentrating investments in a particular industry or group of industries. Funds are prohibited from deviating from their disclosed concentration policy without obtaining shareholder approval. In the instructions to the applicable registration statement forms, the SEC has stated that a fund generally is concentrated in an industry or group of industries if the fund invests or proposes to invest more than 25% of the value of its net assets in such industry or group of industries.

The SEC observes that, when a fund enters into a derivatives transaction, it may gain exposure to more than one industry or group of industries. Specifically, the fund may be exposed both to the industry or group of industries associated with the derivative counterparty, and to the industry or group of industries associated with the issuer of the reference asset of the derivative. The SEC also observes that whether the fund values its derivatives using their notional amount or their market amount can impact the fund’s conclusion on the extent to which it concentrates its investments.

The SEC requests comment on how funds apply the concentration requirements to their investments in derivatives, including whether they consider current market value or the notional amount of the derivative in their calculations and on whether they focus on the industry(ies) with which the counterparty is associated or the industry(ies) with which the issuer of the reference asset is associated. The SEC asks if it is consistent with the policies and purposes of the concentration requirements for funds to focus solely on the industry(ies) of the issuer of the reference asset, and whether to disregard completely the industry(ies) of the derivatives counterparty should depend on the level of collateral posted by the counterparty. The SEC also asks whether it should issue guidance on compliance with the concentration provisions when funds use derivatives.

Valuation of Derivatives

The SEC observes that the valuation of some derivatives for which market quotations are not readily available may present special challenges for funds.

The SEC requests comment on, among other things, how funds determine the fair values of derivatives that they hold, and the extent to which valuation determinations depend on the type of derivative, reference asset, trading venue and other factors. Comment is also requested on how funds, when valuing derivatives, assess the accuracy and reliability of the pricing information they utilize, and on how they take into account contractual restrictions on transferability and restrictions on the ability to close out the transactions or to enter into offsetting transactions. The SEC also asks whether it should issue guidance on the fair valuation of derivatives under the Act.

Certain Implications

The SEC requests a substantial amount of data and input from the public on a range of issues, but has provided a relatively short comment period of 60 days. The Release outlines a large number of important issues, the resolution of many of which may have a material practical effect on the operation of numerous funds. The Release does not identify any cases of serious material losses or other adverse consequences that have arisen from the use of derivatives by funds. In addition, the Release does not address a number of issues relating to derivatives that the SEC has indicated an interest in, including risk management, board oversight, liquidity, disclosure and reporting. We anticipate that changes, if any, to the SEC’s regulatory approach with respect to funds’ use of derivatives will take a great deal of time to develop, propose for comment and implement.

Given the potentially extensive regulatory process suggested by the Release, and the relatively small portion of the Release pertaining to consideration of ETFs utilizing derivatives and/or leverage in significant ways, it appears that the current moratorium on the approvals of any new such products may continue for a considerable period, continuing the competitive disparity between those sponsors that obtained exemptive relief prior to the imposition of the moratorium and those that did not.


[1] Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Release No. IC-29776 (Aug. 31, 2011) [76 FR 55237 (Sept. 7, 2011)], available at The SEC approved the issuance of two additional releases on the same day it voted to issue the Release: (i) an advance notice of proposed rulemaking regarding the treatment of asset-backed issuers that rely on the exclusion from the definition of investment company in rule 3a-7 under the Act (Treatment of Asset-Backed Issuers under the Investment Company Act, Release No. IC-29779 (August 31, 2011) [76 FR 55308 (Sept. 7, 2011)]); and (ii) a concept release regarding issuers that engage in the business of acquiring mortgages and mortgage-related instruments and rely on the exclusion from the definition of investment company in section 3(c)(5)(C) of the Act (Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments, Release No. IC-29778 (August 31, 2011) [76 FR 55300 (Sept. 7, 2011)]). Sullivan & Cromwell LLP will be publishing a memorandum on these two releases in the near future.
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[2] SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25, 2010), available at The Financial Stability Oversight Council (FSOC), in its recent Annual Report, made reference to the use of leverage by mutual funds and the SEC’s pending review of significantly leveraged ETFs. See FSOC 2011 Annual Report, available at
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[3] The moratorium on exemptions for ETFs that propose to use derivatives in this manner has caused considerable consternation in the industry, as those ETFs that rely extensively on derivatives that had received SEC approval prior to the moratorium continue to operate and are being afforded a significant market advantage so long as the moratorium on new market participants remains in effect.
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[4] The Report of the Task Force on Investment Company Use of Derivatives and Leverage, Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6, 2010), available at
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[5] The Release does not address in detail, or request comment on, issues relating to any of the items in (ii) through (vi) except for valuation. However, the Release notes that certain derivatives-related disclosure issues were discussed in a 2010 staff letter to the Investment Company Institute. See Derivatives-Related Disclosures by Investment Companies, Letter from Barry D. Miller, Associate Director, Division of Investment Management, U.S. Securities and Exchange Commission, to Karrie McMillan, General Counsel, Investment Company Institute (July 30, 2010), available at As noted in the 2010 ABA Derivatives Report, the disclosure regarding derivatives in the financial statements of funds has improved significantly in recent years following the adoption by the FASB of Accounting Standards Codification 815-10.
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[6] The Release distinguishes between “indebtedness leverage” – which creates obligations or potential indebtedness to someone other than the fund’s shareholders and enables the fund to participate in gains and losses on an amount that exceeds the fund’s initial investment – and “economic leverage” – in which certain derivatives provide the economic equivalent of leverage because they convey the right to a gain or loss on an amount in excess of the fund’s investment, but do not impose a payment obligation on the fund above its initial investment.
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[7] Securities Trading Practices of Registered Investment Companies, Release No. IC-10666 (Apr. 18, 1979) (“Release 10666”) [44 FR 25128 (Apr. 27, 1979)].
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[8] The Release notes, however, that asset segregation practices with respect to many derivatives have not been addressed by the SEC or its staff.
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[9] In the Release, the SEC notes that, “as a general matter, most derivatives appear to be notes or evidences of indebtedness and thus securities for purposes of the diversification requirements.”
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[10] In the Release, the SEC notes that a derivative “is likely to be categorized as a debt security subject to the 10% limitation of the rule.”
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