SEC Concept Release on Use of Derivatives by Investment Companies

On August 31, 2011, the SEC issued (i) a concept release (the “Derivatives Concept Release”) soliciting public comment on the use of derivatives by registered investment companies under the Investment Company Act of 1940 (the “ICA”); (ii) an advance notice of proposed rulemaking on the treatment of asset-backed issuers under the ICA (the “Proposed Rule”); and (iii) a concept release (the “Mortgage Concept Release”) seeking public comment regarding the ICA status of companies engaged in the business of acquiring mortgages and mortgage-related instruments.

A brief summary of key topics in each release is below.

Use of Derivatives by Investment Companies under the ICA

The SEC is seeking public comment to assist its review of the use of derivatives by management investment companies registered under the ICA and companies that have elected to be treated as business development companies under the ICA (collectively, “funds”), with the goal of evaluating whether the regulatory framework, as it applies to funds’ use of derivatives, continues to fulfill the purposes and policies underlying the ICA and is consistent with investor protection.  Specifically, the Derivatives Concept Release seeks public comment on several issues relating to funds’ use of derivatives, including: (i) the attendant costs, benefits and risks of such use; (ii) the application of the ICA’s prohibitions and restrictions on senior securities and leverage, as well as current SEC guidance on the use of segregated accounts to “cover” senior securities; (iii) the application of the ICA’s limits on investments in securities-related issuers; (iv) the application of the ICA’s provisions concerning portfolio diversification and concentration (including valuation of derivatives for purposes of determining a fund’s diversification classification); (v) the application of the ICA’s provisions regarding valuation of funds’ assets and (vi) any other matters relevant to the use of derivatives by funds.

Treatment of Asset-Backed Issuers under the ICA

The SEC is considering amendments to Rule 3a-7 under the ICA, which provides certain asset-backed issuers with a conditional exclusion from the definition of “investment company” under the ICA.  The Proposed Rule solicits public comment on such possible amendments, including: (i) replacing, in light of the Dodd-Frank Act’s mandate to review the use of credit ratings in SEC regulations, existing credit ratings conditions in Rule 3a-7 with new conditions to address the structure and operations of asset-backed issuers (including a requirement for the asset-backed issuer to undergo an independent review to protect investors against self-dealing and overreaching by insiders); and (ii) strengthening the provisions of Rule 3a-7 relating to the preservation and safekeeping of eligible assets and cash flow of the issuer (such as requiring a servicer to keep the cash flow of asset-backed issuers in a segregated account).  The Proposed Rule solicits comment on whether Rule 3a-7 issuers should be considered “investment companies” under the ICA for the limited purpose of determining whether an entity investing in Rule 3a-7 issuers itself meets the definition of “investment company” under the ICA.  The Proposed Rule also requests comment on whether Section 3(c)(5) of the ICA should be amended to limit the ability of asset-backed issuers, including certain issuers of mortgage-backed securities, to rely upon that section for an exclusion from the definition of “investment company” under the ICA.

Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments

The SEC is reviewing interpretive issues relating to the ICA status of companies engaged in the business of acquiring mortgages and mortgage-related instruments (“mortgage-related pools”), including real-estate investment trusts, many of which seek to rely on the exclusion under Section 3(c)(5)(C) of the ICA from the definition of an “investment company.”  Noting the evolution and expansion of mortgage markets since Section 3(c)(5)(C)’s enactment in 1940, and the reliance upon Section 3(c)(5)(C) by a wide variety of mortgage-related pools, many of them unforeseen at the time of the statute’s adoption, the Mortgage Concept Release seeks public comment regarding interpretative issues relating to the status of mortgage-related pools under the ICA and whether sufficient SEC guidance exists to assist mortgage-related pools in making judgments about their status under the ICA.  The Mortgage Concept Release requests information about mortgage-related pools that rely on Section 3(c)(5)(C), including with respect to their management styles, the types of investors that invest in such pools, corporate governance and the similarities and operational or structural differences between certain mortgage-related pools and traditional investment companies.  The SEC expressed concerned that some mortgage-related pools currently relying on Section 3(c)(5)(C) may closely resemble investment companies that are closed-end funds and may not be the types of companies intended to be excluded from regulation under the ICA.

Comments on each of the three releases are due 60 days after its publication in the Federal Register.