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SIFMA, IAA Balk at SEC Plan to Limit Derivatives in Mutual Funds

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Industry trade groups are coming out against the Securities and Exchange Commission’s proposed portfolio limits in the agency’s plan governing mutual funds’ use of derivatives.

SEC Chairwoman Mary Jo White noted the Commission’s approval in December of the proposed rule regarding the use of derivatives by funds during her Tuesday remarks at the Mutual Fund Directors Forum’s annual policy conference in Washington.

The proposal, which the Investment Adviser Association and the Securities Industry and Financial Markets Association have said needs work, also includes an oversight role for fund directors.

White said Tuesday that the plan would require the board of a fund to approve one of two alternative portfolio limitations on the fund’s use of derivatives and to approve policies and procedures for managing risks associated with the fund’s derivatives transactions. 

Comments on the derivatives proposal were due Monday. The proposal is the third in a series of rulemakings designed to enhance the SEC’s risk monitoring and regulatory safeguards for funds and the asset management industry.

Both IAA and SIFMA told the SEC in their comment letters they opposed the plan’s proposed portfolio limits.

IAA said in its comment letter that the SEC’s derivatives proposal would, for the first time, “condition compliance with Section 18 of the Investment Company Act on the cumulative exposure of all of a fund’s derivatives transactions, financial commitments and indebtedness.”

The SEC proposed a basic cap of 150%, with an exception that would allow up to 300% exposure if the fund met an additional test, the IAA explains. “This represents a significant change in the SEC’s approach to regulating funds’ use of derivatives and would supersede decades of guidance,” IAA said. “The use of caps would also, by the SEC’s own admission, cause some currently operating funds to cease operating as registered investment companies.”

Karen Barr, IAA’s president and CEO, said that “it is not appropriate for the SEC to retroactively determine that a particular investment should no longer be available — especially after the funds were created based on an adviser’s good faith understanding of decades-old Commission and staff positions.”

Investors, Barr added, “may have invested in these funds to diversify their portfolios, pursue returns uncorrelated with the broader securities markets, or in the case of market volatility, to protect their retirement or other savings and investments.”

Timothy Cameron, managing director and head of SIFMA’s Asset Management Group, told the SEC in his comment letter that the proposed portfolio limits “are not the best means to achieve the SEC’s policy objectives, as they could create perverse incentives for portfolio managers to invest in riskier, less liquid instruments and would restrict regulated funds from engaging in risk management and portfolio management activity that otherwise may be beneficial for investors.”

The SEC’s policy objectives, Cameron said, “would be better addressed through the proposed rule’s asset segregation requirements, as well as prospectus disclosure and effective risk management.” 

“If the SEC is disinclined to eliminate portfolio limits,” he continued, SIFMA “urges revisions to the portfolio limits.”

Risk Management

White also noted during her Tuesday remarks that mutual fund directors should be zeroing in on oversight of operational and liquidity risks in funds as well as upping funds’ cybersecurity measures.

White said that just as the agency is recalibrating its regulatory program for funds and advisors to “better match the current marketplace,” independent fund directors must also be “vigilant in considering whether each fund is fully addressing current and potential future risks.”

She pointed to two recent events that highlight potential risk areas for funds. The first event occurred late in August when BNY Mellon was unable to provide timely, system-generated NAVs for several fund families and alternative means of calculating NAVs had to be created.

The second event occurred in December when Third Avenue Focused Credit Fund, an investment in high-yield and distressed debt, suspended redemptions.

“As a director, it is incumbent upon you to consider what these and other risk areas could mean for your fund in the future,” White said. 12b-1 Plans

White also reminded mutual fund boards and directors of their obligations to ensure that fund payments to financial intermediaries that are being used to finance distributions are paid pursuant to a rule 12b-1 plan, pointing to recent SEC staff guidance on funds boards’ obligations.

The staff’s view, White said, “is that the board should focus on understanding the overall distribution process as a whole to inform its judgment about whether certain fees represent payments for distribution and should be able to rely on the advisor and other relevant service providers to provide information about these arrangements.”


As to cybersecurity, White noted that funds “rely heavily on their computer networks,” so fund boards need to carefully consider the “range of risks posed to those cyber systems.”

While cyberattacks “cannot be entirely eliminated, it is incumbent upon funds and their advisors to employ robust, state-of-the-art prevention, detection and response plans,” White said. “It is incumbent on independent directors to consider whether the funds, advisors and other key service providers are taking the appropriate steps to do so.”

She noted the “problems asset managers can face” in cybersecurity as exhibited in the enforcement case the settled in September against St. Louis-based R.T. Jones Capital Equities Management for violating Regulation S-P after a hacker stole sensitive information about more than 100,000 individuals from the web server used by the advisor. 

— Check out Will SEC Crash the Liquid Alts Party? on ThinkAdvisor.


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