April 27, 2011

Mutual Fund Managers Cry Foul Over Potential Commodities Regulation

‘Offshore subsidiaries used for tax reasons, not to evade regulators,’ companies say

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The Commodity Futures Trading Commission is moving to increase oversight of the growing number of mutual funds that make speculative bets on gold, oil and other commodities and currencies through offshore subsidiaries.

The Wall Street Journalreports that officials at the federal agency are concerned that a proliferation of non-U.S. subsidiaries set up by mutual funds beyond the reach of current regulations could expose investors to volatile swings in commodities prices and potentially huge losses. A proposed rule by the CFTC would essentially preclude mutual funds from using subsidiaries to invest in commodities, but the mutual-fund industry is fighting the move.

According to the paper, at the center of the battle are mutual funds offering exposure to commodities, mainly through futures contracts and derivatives tied to their prices. Similar funds allow investors to bet on the direction of currencies. Many of the mutual funds have set up foreign subsidiaries, typically in the Cayman Islands, that invest as much as 25% of a mutual fund's assets in commodities.

While the mutual funds are regulated by the Securities and Exchange Commission, they aren't subject to oversight by the CFTC, which scrutinizes other trading vehicles that invest in commodities. U.S. regulators have no power over the foreign units.

"Right now, the funds that we see on the marketplace don't fully disclose what they're doing inside the foreign corporation and don't have much detail on trading strategies or fees," Ken Steben, president and chief executive of Steben & Co., which runs managed futures funds that are subject to CFTC oversight and compete against mutual funds for investor money, told The Journal.

CFTC Commissioner Scott O'Malia has said the agency needs to "close the regulatory gap that allows some registered companies to offer futures-only products outside of the commission's jurisdiction, especially its antifraud authorities."

In the February rule proposal, the CFTC expressed concern that mutual-fund companies are engaging in "regulatory arbitrage" by trying to "avoid registration and compliance obligations under the [CFTC's] regulations."

In addition to closing the loophole used by offshore mutual-fund units, the paper says the proposed rule would require investment firms trading in commodities to register with the CFTC even if they already are regulated by the SEC. Mutual funds would face a host of rules, including greater disclosure about fees and operations, as well as restrictions on marketing and trading. The marketing and trading curbs also would cover fund companies that do swaps transactions.

An SEC spokesman said the agency hasn't taken a position on the proposal.

The Journal notes the potential crackdown has sparked an outcry by the mutual-fund industry, which holds about $12.1 trillion in assets. Earlier this month, the Investment Company Institute trade group said in a letter that the proposed rule is "deeply flawed" and would drag many more mutual funds under the CFTC's jurisdiction than warranted. The U.S. Chamber of Commerce told the CFTC the proposal is "too broad" and "could substantially affect the use of derivatives" by funds.

Some mutual funds note that they already are subject to strict SEC oversight, adding that their subsidiaries are used for tax reasons, not to evade regulators. Rydex Investments told the CFTC in a letter that "no evidence has been presented or any allegations made that the registered investment companies that obtain commodities exposure through their wholly owned [subsidiaries] have harmed investors in any way or that the SEC's oversight of such investment companies has in some way proved deficient."

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