Flexible approach needed in regulating funds use of derivatives: ABA

Assessing risks from mutual funds' use of synthetics requires principals-based approach, group tells SEC

Jul 9, 2010 @ 1:48 pm

By Jessica Toonkel Marquez

The Securities and Exchange Commission needs to redefine investment diversification requirements for mutual funds when drafting new rules on how funds use derivatives, according to a task force assigned by a committee of the American Bar Association.

That's one of several recommendations made by the task force in a July 6 letter to Andrew J. Donahue, director of the Division of Investment Management at the SEC. Last year, the SEC said that it was planning to pass rules restricting how mutual funds use derivatives.

“At the time this law was written, no one had heard of derivatives,” Jay G. Baris, a partner at Kramer Levin Naftalis & Frankel LLP and chairman of the task force.

For example, bond funds that invest in a single bond are subject to the diversification requirements. However, a fund could have increased exposure to the credit of a single company by engaging in credit default swaps in which the counterparties all issue swaps on the credit of that sole company, Mr. Baris said.

“At the end of the day, all you own are credit default swaps issued by 20 different counterparties, and you also have 100% of your assets in the credit of that single company,” he said. “The SEC has to look not just at diversification but at economic diversification.”

The task force, which is made up of investment management lawyers, issued the report in response to a request Mr. Donahue made at an ABA meeting last year to provide feedback on how investment companies should use derivatives and leverage, Mr. Baris said.

The task force recommended that the SEC take a principals-based approach to the derivatives rules.

“Right now, it's a combination of the rules-based and principals-based approach, and we suggest that the SEC acknowledge that there is no one-size-fits-all solution,” Mr. Baris said. “Every time you come out with a new derivative, it won't fit into the definition.”

The task force also recommended that the SEC require funds to develop and maintain “risk-adjusted segregated amounts,” which would be based on the risk profiles of the derivative instruments they use to cover their obligations.

“We have come up with a suggestion that would require funds to do a risk-based analysis of their exposure,” Mr. Baris said. “It goes beyond what the current rules are.”

The SEC has received the letter and is giving “careful consideration to the report as its review of derivatives activities of registered investment companies progresses,” said John Heine, an SEC spokesman.

“We commend the task force, the Subcommittee on Investment Companies and Investment Advisers, and the ABA Committee on Federal Regulation of Securities for initiating this project,” he said.

The SEC hasn't provided a timeline for when it will issue rules on funds' use of derivatives, Mr. Heine said.

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