Document ID: SEC-2011-1338-0001
Agency: sec
Document Type: Rule
Title: Use of Derivatives by Investment Companies under Investment Company Act of 1940
Posted Date: 2011-09-07T04:00Z

[Federal Register Volume 76, Number 173 (Wednesday, September 7, 2011)]
[Rules and Regulations]
[Pages 55237-55255]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-22724]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 271

[Release No. IC-29776; File No. S7-33-11]
RIN 3235-AL22

Use of Derivatives by Investment Companies Under the Investment 
Company Act of 1940

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; request for comments.

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SUMMARY: The Securities and Exchange Commission (the ``Commission'') 
and its staff are reviewing the use of derivatives by management 
investment companies registered under the Investment Company Act of 
1940 (the ``Investment Company Act'' or ``Act'') and companies that 
have elected to be treated as business development companies (``BDCs'') 
under the Act (collectively, ``funds''). To assist in this review, the 
Commission is issuing this concept release and request for comments on 
a wide range of issues relevant to the use of derivatives by funds, 
including the potential implications for fund leverage, 
diversification, exposure to certain securities-related issuers, 
portfolio concentration, valuation, and related matters. In addition to 
the specific issues highlighted for comment, the Commission invites 
members of the public to address any other matters that they believe 
are relevant to the use of derivatives by funds. The Commission intends 
to consider the comments to help determine whether regulatory 
initiatives or guidance are needed to improve the current regulatory 
regime for funds and, if so, the nature of any such initiatives or 
guidance.

DATES: Comments should be received on or before November 7, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/concept.shtml);
     Send an e-mail to rule-comments@sec.gov; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-33-11. This file number 
should be included on the subject line if comments are submitted by e-
mail. To help us process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/concept.shtml). Comments are also available for public inspection and 
copying in the Commission's Public Reference Room, 100 F Street, NE., 
Washington, DC 20549, on official business days between the hours of 10 
a.m. and 3 p.m. All comments received will be posted without change; 
the Commission does not edit personal identifying information from 
submissions. Therefore, you should only submit information that you 
wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Edward J. Rubenstein, Senior Special 
Counsel, or Michael S. Didiuk, Senior Counsel, at (202) 551-6825, 
Office of Chief Counsel, Division of Investment Management, Securities 
and Exchange Commission, 100 F Street, NE., Washington, DC 20549-5030.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
    A. Purpose and Scope of the Concept Release
    B. Background Concerning the Use of Derivatives by Funds
    C. Request for Comment
II. Derivatives Under the Senior Securities Restrictions of the 
Investment Company Act
    A. Purpose, Scope, and Application of the Act's Senior 
Securities Limitations
    1. Statutory Restrictions on Senior Securities and Related 
Commission Guidance
    2. Staff No-Action Letters Concerning the Segregated Account 
Approach
    B. Alternative Approaches to the Regulation of Portfolio 
Leverage
    1. The Current Asset Segregation Approach
    2. Other Approaches
    C. Request for Comment
    1. Issues Concerning the Current Asset Segregation Approach
    2. Alternatives to the Current Asset Segregation Approach
    3. Related Matters
III. Derivatives Under the Investment Company Act's Diversification 
Requirements
    A. The Diversification Requirements
    B. Application of the Diversification Requirements to a Fund's 
Use of Derivatives
    1. Valuation of Derivatives for Purposes of Determining a Fund's 
Classification as Diversified or Non-Diversified
    2. Identification of the Issuer of a Derivative for Purposes of 
Determining a Fund's Classification as Diversified or Non-
Diversified
    C. Request for Comment
IV. Exposure to Securities-Related Issuers Through Derivatives
    A. Investment Company Act Limitations on Investing in 
Securities-Related Issuers
    B. Counterparty to a Derivatives Investment
    C. Exposure to Other Securities-Related Issuers Through 
Derivatives
    D. Valuation of Derivatives for Purposes of Rule 12d3-1 Under 
the Investment Company Act
    E. Request for Comment
V. Portfolio Concentration
    A. Investment Company Act Provisions Regarding Portfolio 
Concentration
    B. Issues Relating to the Application of the Act's Concentration 
Provisions to a Fund's Use of Derivatives
    C. Request for Comment
VI. Valuation of Derivatives
    A. Investment Company Act Valuation Requirements
    B. Application of the Valuation Requirements to a Fund's Use of 
Derivatives
    C. Request for Comment
VII. General Request for Comment
* * * * *

I. Introduction

    The activities of funds, including their use of derivatives, are 
regulated extensively under the Investment Company Act,\1\ Commission 
rules, and Commission guidance.\2\ Derivatives may

[[Page 55238]]

be broadly described as instruments or contracts whose value is based 
upon, or derived from, some other asset or metric (referred to as the 
``underlier,'' ``underlying,'' or ``reference asset'').\3\ As detailed 
below,\4\ funds employ derivatives for a variety of purposes, including 
to increase leverage to boost returns, gain access to certain markets, 
achieve greater transaction efficiency, and hedge interest rate, 
credit, and other risks.\5\ At the same time, derivatives can raise 
risk management issues for a fund relating, for example, to leverage, 
illiquidity (particularly with respect to complex OTC derivatives), and 
counterparty risk, among others.\6\
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    \1\ 15 U.S.C. 80a. All statutory references to the Investment 
Company Act are to 15 U.S.C. 80a, and, unless otherwise stated, all 
references to rules under the Investment Company Act are to Title 
17, Part 270 of the Code of Federal Regulations [17 CFR 270]. All 
references to the Securities Act of 1933 (the ``Securities Act'') 
are to 15 U.S.C. 77a, and, unless otherwise stated, all references 
to rules under the Securities Act are to Title 17, Part 230 of the 
Code of Federal Regulations [17 CFR 230]. All references to the 
Securities Exchange Act of 1934 (the ``Exchange Act'') are to 15 
U.S.C. 78a, and, unless otherwise stated, all references to rules 
under the Exchange Act are to Title 17, Part 240 [17 CFR 240].
    \2\ The staff has also issued no-action and other letters that 
relate to fund use of derivatives. In addition to Investment Company 
Act provisions, funds using derivatives must comply with all other 
applicable statutory and regulatory requirements, such as other 
Federal securities law provisions, the Internal Revenue Code (the 
``IRC''), Regulation T of the Federal Reserve Board (``Regulation 
T''), and the rules and regulations of the Commodity Futures Trading 
Commission (the ``CFTC''). See also Title VII of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act, Public Law 111-203, 124 
Stat. 1376 (2010) (the ``Dodd-Frank Act''), available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.
    \3\ See, e.g., Board Oversight of Derivatives, Independent 
Directors Council Task Force Report (July 2008) (``2008 IDC 
Report'') at 1, 3, available at http://www.ici.org/pdf/ppr_08_derivatives.pdf. See also Mutual Funds and Derivative Instruments, 
Division of Investment Management Memorandum transmitted by Chairman 
Levitt to Representatives Markey and Fields (Sept. 26, 1994) (``1994 
Report'') at text accompanying n. 1 (``[t]he term `derivative' is 
generally defined as an instrument whose value is based upon, or 
derived from, some underlying index, reference rate (e.g., interest 
rates or currency exchange rates), security, commodity, or other 
asset.''), and at n. 2 (the ``term `derivative' generally is used to 
embrace forward contracts, futures, swaps, and options''), available 
at http://www.sec.gov/news/studies/deriv.txt; John C. Hull, Options, 
Futures, and Other Derivatives (7th ed. 2009) (``Hull'') at 1, 779 
(``A derivative can be defined as a financial instrument whose value 
depends on (or derives from) the values of other, more basic 
underlying variables,'' and a derivative is an ``instrument whose 
price depends on, or is derived from, the price of another asset'') 
(italics in original); rule 3b-13 under the Exchange Act, which 
defines ``eligible OTC derivative instrument,'' and rule 16a-1(c) 
under the Exchange Act, which defines ``derivative securities;'' 
section 5200(b) of the Revised Statutes of the United States [12 
U.S.C. 84(b)] (as amended by section 610(a)(3) of the Dodd-Frank 
Act, supra note 2), which defines a ``derivative transaction'' to 
include ``any transaction that is a contract, agreement, swap, 
warrant, note, or option that is based, in whole or in part, on the 
value of, any interest in, or any quantitative measure or the 
occurrence of any event relating to, one or more commodities, 
securities, currencies, interest or other rates, indices, or other 
assets.''
    \4\ For a definition, and examples of types, of derivatives, see 
infra Section I.B.
    \5\ See 2008 IDC Report, supra note 3, at 8-11. See also infra 
Section I.B.
    \6\ See 2008 IDC Report, supra note 3, at 12-13. See also Mutual 
Fund Derivative Holdings: Fueling the Need for Improved Risk 
Management, JPMorgan Thought Magazine (Summer 2008) (``2008 JPMorgan 
Article''), available at http://www.jpmorgan.com/cm/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1158494213964&blobheader=application%2Fpdf&blobnocache=true&blobheadername1=Content.
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    The dramatic growth in the volume and complexity of derivatives 
investments over the past two decades, and funds' increased use of 
derivatives,\7\ have led the Commission and its staff to initiate a 
review of funds' use of derivatives under the Investment Company 
Act.\8\ The staff generally has been exploring the benefits, risks, and 
costs associated with funds' use of derivatives. The staff also has 
been exploring issues relating to the use of derivatives by funds such 
as: whether current market practices involving derivatives are 
consistent with the leverage, concentration, and diversification 
provisions of the Investment Company Act; whether 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; whether funds' boards of directors are providing 
appropriate oversight of the use of derivatives by the funds; whether 
existing rules sufficiently address matters such as the proper 
procedures for a fund's pricing and liquidity determinations regarding 
its derivatives holdings; whether existing prospectus disclosures 
adequately address the particular risks created by derivatives; and 
whether funds' derivative activities should be subject to any special 
reporting requirements.
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    \7\ While complete data concerning the nature of derivatives 
activities of funds is unavailable, for a partial snapshot of 
derivatives activity by selected fund complexes see Commodity Pool 
Operators and Commodity Trading Advisors: Amendments to Compliance 
Obligations, Investment Company Institute (``ICI'') Comment Letter 
to the CFTC at 18 (Apr. 12, 2011), available at http://www.ici.org/pdf/25107.pdf. See also, e.g., Tim Adam and Andre Guettler, The Use 
of Credit Default Swaps by U.S. Fixed-Income Mutual Funds, FDIC Ctr. 
for Fin. Research, Working Paper No. 2011-01, (Nov. 19, 2010) 
(``Adam and Guettler Article''), available at http://www.fdic.gov/bank/analytical/cfr/2011/wp2011/CFR_WP_2011_01.pdf (study of the 
use of credit default swaps (``CDS'') by the largest 100 U.S. 
corporate bond funds between 2004 and 2008 reflects an increase from 
about 20% of funds using credit default swaps in 2004 to 60% of 
funds using them in 2008; among CDS users, the average size of CDS 
positions (measured by their notional values) increased from 2% to 
almost 14% of a fund's NAV over the same period, with the CDS 
positions representing less than 10% of NAV for most funds, but with 
some funds exceeding this level by a wide margin, particularly in 
2008; CDS are predominantly used to increase a fund's exposure to 
credit risks (net sellers of CDS) rather than to hedge credit risk 
(net buyers); the frequency of credit default swap usage by the 
largest bond funds is comparable to that of most hedge funds), 
available at http://www.fdic.gov/bank/analytical/cfr/2011/wp2011/CFR_WP_2011_01.pdf; Assess the Risks: Key Strategies for 
Overseeing Derivatives, Board IQ at 1 (Jan. 15, 2008) (``In recent 
years, the use of derivatives by mutual funds has soared.''), 
available at http://www.interactivedata.com/uploads/BoardIQ1207.pdf; 
2008 JPMorgan Article, supra note 6.
    \8\ In a press release issued in March 2010, the Commission 
announced that the staff was conducting a review to evaluate the use 
of derivatives by mutual funds, registered exchange-traded funds 
(``ETFs''), and other investment companies. The press release 
indicated that the review would examine whether and what additional 
protections are necessary for those funds under the Investment 
Company Act. The press release further indicated that pending 
completion of this review, the staff would defer consideration of 
exemptive requests under the Act relating to ETFs that would make 
significant investments in derivatives. See SEC Press Release 2010-
45, SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25, 
2010) (``2010 Derivatives Press Release''), available at http://www.sec.gov/news/press/2010/2010-45.htm. As part of the staff's 
review to evaluate fund use of derivatives, and to further enhance 
its knowledge of how funds are using, and managing their use of, 
derivatives, the staff met with industry groups as well as with some 
fund complexes that use OTC derivatives. The staff also reviewed 
fund disclosures relating to the use of derivatives and their risks. 
In addition, the staff considered 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) (``2010 ABA Derivatives Report''), available at http://meetings.abanet.org/webupload/commupload/CL410061/sitesofinterest_files/DerivativesTF_July_6_2010_final.pdf.
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A. Purpose and Scope of the Concept Release

    The goal of the Commission's and staff's review is to evaluate 
whether the 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 purpose of this 
concept release is to assist with this review and solicit public 
comment on the current regulatory regime under the Act as it applies to 
funds' use of derivatives. We intend to use the comments to help 
determine whether regulatory initiatives or guidance are needed to 
improve the current regulatory regime and the specific nature of any 
such initiatives.\9\
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    \9\ Section 2(c) of the Investment Company Act provides that 
``[w]henever pursuant to this title the Commission is engaged in 
rulemaking and is required to consider or determine whether an 
action is consistent with the public interest, the Commission shall 
also consider, in addition to the protection of investors, whether 
the action will promote efficiency, competition, and capital 
formation.''
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    A fund that invests in derivatives must take into consideration 
various provisions of the Investment Company Act and Commission rules 
under the Act. The fund must consider the leverage limitations of 
section 18 of the Investment Company Act, which governs the extent to 
which a fund may issue ``senior securities.'' \10\ A fund's use of 
derivatives also may raise issues

[[Page 55239]]

under Investment Company Act provisions governing diversification,\11\ 
concentration,\12\ investing in certain types of securities-related 
issuers,\13\ valuation,\14\ and accounting and financial statement 
reporting,\15\ among others,\16\ as well as under applicable disclosure 
provisions.\17\
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    \10\ See sections 18(a)(1) and 18(f)(1) of the Investment 
Company Act. See also Securities Trading Practices of Registered 
Investment Companies, Investment Company Act Release No. 10666 (Apr. 
18, 1979) (``Release 10666'') [44 FR 25128 (Apr. 27, 1979)], and 
Registered Investment Company Use of Senior Securities-Select 
Bibliography (``Senior Security Bibliography''), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm 
(prepared by the staff). See also discussion infra at Section II. 
(Derivatives under the Senior Securities Restrictions of the 
Investment Company Act).
    \11\ See sections 5(b)(1) and 13(a)(1) of the Investment Company 
Act. See also infra discussion at Section III. (Derivatives under 
the Investment Company Act's Diversification Requirements).
    \12\ See sections 8(b)(1)(E) and 13(a)(3) of the Investment 
Company Act. See also Form N-1A, Item 4(a), instruction 4 to Item 
9(b)(1), and Item 16(c)(1)(iv); Form N-2, Item 8.2.b (2), and Item 
17.2.e. See also infra discussion at Section V. (Portfolio 
Concentration).
    \13\ See section 12(d)(3) of the Investment Company Act and rule 
12d3-1 thereunder. See also infra discussion at Section IV. 
(Exposure to Securities-Related Issuers Through Derivatives).
    \14\ See section 2(a)(41) of the Investment Company Act. See 
also Restricted Securities, Investment Company Act Release No. 5847 
(Oct. 21, 1969) [35 FR 19989 (Dec. 31, 1970)] (``ASR 113''), 
available at http://www.sec.gov/rules/interp/1969/ic-5847.pdf; 
Accounting for Investment Securities by Registered Investment 
Companies, Investment Company Act Release No. 6295 (Dec. 23, 1970) 
[35 FR 19986 (Dec. 31, 1970)] (``ASR 118''), available at http://www.sec.gov/rules/interp/1970/ic-6295.pdf. See also infra discussion 
at Section VI. (Valuation of Derivatives).
    \15\ See generally section 30(e) of the Investment Company Act.
    \16\ See, e.g., Investment Company Act provisions relating to 
custody (section 17(f) and related rules), and fund names (section 
35(d) and rule 35d-1). Also, an open-end fund should consider the 
effect that the use of derivatives may have on the liquidity of the 
fund's portfolio. For general guidance on liquidity and open-end 
funds, see, e.g., Resale of Restricted Securities; Changes to Method 
of Determining Holding Period of Restricted Securities Under Rules 
144 and 145, Investment Company Act Release No. 17452 (Apr. 23, 
1990) [55 FR 17933 (Apr. 30, 1990)], available at http://www.sec.gov/rules/final/1990/33-6862.pdf. See also Revisions of 
Guidelines, Investment Company Act Release No. 18612 (Mar. 12, 1992) 
[57 FR 9828 (Mar. 20, 1992)], available at http://www.sec.gov/rules/other/1992/33-6927.pdf.
    \17\ See, e.g., section 8(b) of the Investment Company Act, and 
Items 4(a), 4(b), 9(b), 9(c), and 16(b) of Form N-1A. Certain 
derivatives-related disclosure issues were discussed in a 2010 staff 
letter to the ICI. 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, ICI (July 30, 2010) (``2010 
Staff Derivatives Disclosure Letter''), available at http://www.sec.gov/divisions/investment/guidance/ici073010.pdf.
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    Derivatives generally entail the potential for leveraged future 
gains and/or losses that may significantly impact the overall risk/
reward profile of a fund. Applying the Act's provisions relating to 
diversification, concentration, and investments in securities-related 
issuers, among others, may require determining what value to assign to 
the derivative and which of the derivative's multiple exposures should 
be measured for purposes of the relevant provision. This determination 
may be complex because there are at least two potential measures of the 
``value'' \18\ of a derivative for purposes of applying various 
provisions of the Act: the current market value or fair value 
reflecting the price at which the derivative could be expected to be 
liquidated; and the notional amount reflecting the contract size 
(number of units per contract) multiplied by the current unit price of 
the reference asset on which payment obligations are calculated.\19\ In 
addition, derivatives often create exposures to multiple variables, 
such as the credit of a counterparty as well as to a reference asset on 
which the derivative is based.
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    \18\ The Bank for International Settlements (the ``BIS'') 
reports gross market values (positive and negative) for open 
derivative contracts, which are defined as ``the sums of the 
absolute values of all open contracts with either positive or 
negative replacement values evaluated at market prices prevailing at 
the reporting date. Thus, the gross positive market value of a 
dealer's outstanding contracts is the sum of the replacement values 
of all contracts that are in a current gain position to the reporter 
at current market prices * * * The gross negative market value is 
the sum of the values of all contracts that have a negative value on 
the reporting date * * *.'' Guide to the International Financial 
Statistics, Bank for International Settlements (July 2009) (``BIS 
Guide'') at 31, available at http://www.bis.org/statistics/intfinstatsguide.pdf. See also Sarah Sharer Curley and Elizabeth 
Fella, Where to Hide? How Valuation of Derivatives Haunts the 
Courts--Even After BAPCPA, 83 Am. Bankr. L.J. 297, 298-99 (Spring 
2009) (``In a simple interest rate swap * * * [t]he value of the 
swap is the net difference between the present value of the payments 
each party expects to receive and the present value of the payments 
each party expects to make. The value is generally zero to each 
party at the inception of the swap, and becomes positive to one 
party and negative to the other depending on what direction the 
interest rates move.''); CFTC Glossary, Mark-to-Market Definition, 
available at http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/index.htm (stating that marking to market is 
accomplished for a futures or option contract by ``calculating the 
gain or loss in each contract position resulting from changes in the 
price of the contracts at the end of each trading session. These 
amounts are added or subtracted to each account balance.'').
    \19\ The BIS describes ``notional amounts outstanding'' as ``a 
reference from which contractual payments are determined in 
derivatives markets.'' BIS Guide, supra note 18, at 30. ``Notional 
value'' can be defined as ``the value of a derivative's underlying 
assets at the spot price.'' In the case of an options or futures 
contract, the notional value is the number of units of an asset 
underlying the contract, multiplied by the spot price of the asset. 
See http://www.investorwords.com/5930/notional-value.htm. The ``spot 
price'' of a derivative's underlying asset is the asset's price for 
immediate delivery, i.e., in the current market, in contrast with 
the asset's future or forward price. See, e.g., Hull, supra note 3, 
at 789. ``Notional value'' is also defined as ``the underlying value 
(face value), normally expressed in U.S. dollars, of the financial 
instrument or commodity specified in a futures or options on futures 
contract.'' See CME Group Glossary, available at http://www.cmegroup.com/education/glossary.html. `` `Notional principal' or 
`notional amount' of a derivative contract is a hypothetical 
underlying quantity upon which interest rate or other payment 
obligations are computed.'' ISDA Online Product Descriptions and 
Frequently Asked Questions at http://www.isda.org/educat/faqs.html#7. See also Hull, supra note 3, at 786 (``Notional 
principal'' is the ``principal used to calculate payments in an 
interest rate swap. The principal is `notional' because it is 
neither paid nor received''); Frank J. Fabbozzi, et al., 
Introduction to Structured Finance, at 27 (2006) (``[In an interest 
rate swap] [t]he dollar amount of the interest payments exchanged is 
based on some predetermined dollar principal, which is called the 
notional amount.'') (italics in original); 2010 ABA Derivatives 
Report, supra note 8, at n.11 (noting that the term ``notional 
amount'' is used differently by different people in different 
contexts, but is used, in the Report, to refer to ``the nominal or 
face amount that is used to calculate payments made on a particular 
instrument, without regard to whether its obligation under the 
instrument could be netted against the obligation of another party 
to pay the fund under the instrument.'').
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    The Commission or its staff, over the years, has addressed a number 
of issues relating to derivatives on a case-by-case basis. The 
Commission now seeks to take a more comprehensive and systematic 
approach to derivatives-related issues under the Investment Company 
Act. In particular, in this release the Commission discusses and seeks 
comment on the following issues, among others, relating to funds' use 
of derivatives: \20\
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    \20\ The Commission recognizes that there are other significant 
derivatives-related issues under the Investment Company Act that 
this release does not address, such as disclosure-related issues, 
which the Commission may consider at a later date.
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     The attendant costs, benefits and risks;
     The application of the Act's prohibitions and restrictions 
on senior securities and leverage;
     The application of the Act's prohibition on investments in 
securities-related issuers;
     The application of the Act's provisions concerning 
portfolio diversification and concentration; and
     The application of the Act's provisions governing 
valuation of funds' assets.
    In addition to the specific issues highlighted for comment, the 
Commission invites members of the public to address any other matters 
that they believe are relevant to the use of derivatives by funds.

B. Background Concerning the Use of Derivatives by Funds

    As noted above, derivatives may be broadly defined to include 
instruments or contracts whose value is based upon, or derived from, 
some reference asset. Reference assets can include, for example, 
stocks, bonds, commodities, currencies, interest rates, market indices, 
currency exchange rates, or other assets or interests, in virtually 
endless variety.\21\
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    \21\ For example, the reference asset of a Standard & Poor's 
(``S&P'') 500 futures contract is the S&P 500 index. 2008 IDC 
Report, supra note 3, at Appendix C at C5.

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[[Page 55240]]

    Derivatives are often characterized as either exchange-traded or 
OTC.\22\ Exchange-traded derivatives--such as futures, certain 
options,\23\ and options on futures \24\--are standardized contracts 
traded on regulated exchanges, such as the Chicago Mercantile Exchange 
and the Chicago Board Options Exchange. OTC derivatives--such as 
swaps,\25\ non-exchange traded options, and combination products such 
as swaptions \26\ and forward swaps \27\--are contracts negotiated and 
entered into outside of an organized exchange. Unlike exchange-traded 
derivatives, OTC derivatives may be significantly customized, and may 
not be guaranteed by a central clearing organization. OTC derivatives 
that are not centrally cleared, therefore, may involve greater 
counterparty credit risk, and may be more difficult to value, transfer, 
or liquidate than exchange-traded derivatives.\28\ The Dodd-Frank Act 
and Commission rules thereunder seek to establish a comprehensive new 
regulatory framework for two broad categories of derivatives--swaps and 
security-based swaps--designed to reduce risk, increase transparency, 
and promote market integrity within the financial system.\29\
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    \22\ See, e.g., Robert W. Kolb & James A. Overdahl, Financial 
Derivatives, at 21 (2010) (``Kolb & Overdahl'').
    \23\ An option is the right to buy or sell an asset. There are 
two basic types of options, a ``call option'' and a ``put option.'' 
A call option gives the holder the right (but does not impose the 
obligation) to buy the underlying asset by a certain date for a 
certain price. The seller, or ``writer,'' of a call option has the 
obligation to sell the underlying asset to the holder if the holder 
exercises the option. A put option gives the holder the right (but 
does not impose the obligation) to sell the underlying asset by a 
certain date for a certain price. The seller, or ``writer'', of a 
put option has the obligation to buy from the holder the underlying 
asset if the holder exercises the option. The price that the option 
holder must pay to exercise the option is known as the ``exercise'' 
or ``strike'' price. The amount that the option holder pays to 
purchase an option is known as the ``option premium,'' ``price,'' 
``cost,'' or ``fair value'' of the option. For a basic explanation 
of options, see, e.g., Hull, supra note 3, at 6-8, 179-236, and Kolb 
& Overdahl, supra note 22, at 13-16.
    \24\ Options on futures generally trade on the same exchange as 
the relevant futures contract. When a call option on a futures 
contract is exercised, the holder acquires from the writer a long 
position in the underlying futures contract plus a cash amount equal 
to the excess of the futures price over the strike price. When a put 
option on a futures contract is exercised, the holder acquires a 
short position in the underlying futures contract plus a cash amount 
equal to the excess of the strike price over the futures price. See, 
e.g., Hull, supra note 3, at 184, 341-54, and 782.
    \25\ A ``swap'' is generally an agreement between two 
counterparties to exchange periodic payments based upon the value or 
level of one or more rates, indices, assets, or interests of any 
kind. For example, counterparties may agree to exchange payments 
based on different currencies or interest rates. See generally, 
e.g., Kolb & Overdahl, supra note 22, at 11-13; Hull, supra note 3, 
at 147-73. See also section 3(a)(69) of the Exchange Act for the 
definition of ``swap'' (using the definition in section 1a of the 
Commodity Exchange Act, 7 U.S.C. 1a (the ``CEA'')); section 3(a)(68) 
of the Exchange Act for the definition of ``security-based swap;'' 
section 721(a)(3) of the Dodd-Frank Act, supra note 2, for the 
definition of ``cleared swap;'' and section 721(a)(12) of the Dodd-
Frank Act for the definition of ``foreign exchange swap.'' See also 
Further Definition of ``Swap,'' ``Security-Based Swap,'' and 
``Security-Based Swap Agreement;'' Mixed Swaps; Security-Based Swap 
Agreement Recordkeeping, Securities Act Release No. 9204 (Apr. 29, 
2011) [76 FR 29818 (May 23, 2011)] (``Swap Definition Release''), 
available at http://www.sec.gov/rules/proposed/2011/33-9204.pdf.
    \26\ A ``swaption'' is an option to enter into an interest rate 
swap where a specified fixed rate is exchanged for a floating rate. 
See, e.g., Hull, supra note 3, at 172, 658-62, 790.
    \27\ A forward swap (or deferred swap) is an agreement to enter 
into a swap at some time in the future. See Swap Definition Release, 
supra note 25, at n. 147. See also, e.g., Hull, supra note 3, at 
171, 779 (``deferred swap'').
    \28\ An OTC derivative may be more difficult to transfer or 
liquidate than an exchange-traded derivative because, for example, 
an OTC derivative may provide contractually for non-transferability 
without the consent of the counterparty, or may be sufficiently 
customized that its value is difficult to establish or its terms too 
narrowly drawn to attract transferees willing to accept assignment 
of the contract, unlike most exchange-traded derivatives.
    \29\ The Dodd-Frank Act, supra note 2, was signed into law on 
July 21, 2010. The Dodd-Frank Act mandates, among other things, 
substantial changes in the OTC derivatives markets, including new 
clearing, reporting, and trade execution mandates for swaps and 
security-based swaps, and both exchange-traded and OTC derivatives 
are contemplated under the new regime. See Dodd-Frank Act sections 
723 (mandating clearing of swaps) and 763 (mandating clearing of 
security-based swaps). Some of these changes will require Commission 
action through rulemaking to become effective. See Temporary 
Exemptions and Other Temporary Relief, Together With Information on 
Compliance Dates for New Provisions of the Securities Exchange Act 
of 1934 Applicable to Security-Based Swaps, Exchange Act Release No. 
64678 (June 15, 2011) [76 FR 36287 (June 22, 2011)], available at 
http://www.sec.gov/rules/exorders/2011/34-64678.pdf. For summaries 
of other recent, pending, and future Commission and staff 
initiatives relating to derivatives, see, e.g., Testimony on 
Enhanced Oversight after the Financial Crisis: The Wall Street 
Reform Act at One-Year, by Chairman Mary L. Schapiro, Chairman, U.S. 
Securities and Exchange Commission, before the United States Senate 
Committee on Banking, Housing and Urban Affairs (July 21, 2011), 
available at http://www.sec.gov/news/testimony/2011/ts072111mls.htm. 
See also, e.g., http://www.sec.gov/spotlight/dodd-frank/accomplishments.shtml#derivatives; http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#07-12-12; http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#08-12-11; http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#01-06-12; 
http://www.sec.gov/news/press/2011/2011-137.htm; http://www.sec.gov/rules/other/2011/34-64926.pdf; and http://www.sec.gov/spotlight/dodd-frank/derivatives.shtml.
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    A common characteristic of most derivatives is that they involve 
leverage.\30\ Certain derivatives investments entered into by a fund, 
such as futures contracts, swaps, and written options, create 
obligations, or potential indebtedness, to someone other than the 
fund's shareholders, and enable the fund to participate in gains and 
losses on an amount that exceeds the fund's initial investment.\31\ 
Other derivatives entered into by a fund, such as purchased call 
options, 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.\32\
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    \30\ The Commission has stated that ``[l]everage exists when an 
investor achieves the right to a return on a capital base that 
exceeds the investment which he has personally contributed to the 
entity or instrument achieving a return.'' Release 10666, supra note 
10, at n. 5.
    \31\ The leverage created by such an arrangement is sometimes 
referred to as ``indebtedness leverage.'' 1994 Report, supra note 3, 
at 22.
    \32\ This type of leverage is sometimes referred to as 
``economic leverage.'' See 1994 Report, supra note 3, at 23 (``Other 
derivatives provide the economic equivalent of leverage because they 
display heightened price sensitivity to market fluctuations * * * 
such as changes in stock prices or interest rates. In essence, these 
derivatives magnify a fund's gain or loss from an investment in much 
the same way that incurring indebtedness does.''). The 1994 Report 
gives a leveraged inverse floating rate bond, with an interest rate 
that moves inversely to a benchmark rate, as another example of an 
instrument that displays economic leverage. See also 2010 ABA 
Derivatives Report, supra note 8, at 20-21 (discussion of 
``implied'' or ``economic'' leverage''). For additional discussion 
of the leveraging effects of derivatives (not limited to ``economic 
leverage''), see 2010 ABA Derivatives Report, supra note 8, at 8-9. 
See also 2008 IDC Report, supra note 3, at 3 (``Market participants 
are able to acquire exposure (either long or short) to a large 
dollar amount of an asset (the notional value) with only a small 
down payment, enabling parties to shift risk more efficiently and 
with lower costs. The leverage inherent in these instruments 
magnifies the effect of changes in the value of the underlying asset 
on the initial amount of capital invested. For example, an initial 
5% collateral deposit on the total value of the commodity would 
result in 20:1 leverage, with a potential 80% loss (or gain) of the 
collateral in response to a 4% movement in the market price of the 
underlying commodity.'').
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    Funds use derivatives to implement their investment strategies, and 
to manage risk.\33\ A fund may use derivatives to gain, maintain, or 
reduce exposure to a market, sector, or security more quickly and/or 
with lower transaction costs and portfolio

[[Page 55241]]

disruption than investing directly through the securities markets. At 
the same time, use of derivatives may entail risks relating, for 
example, to leverage, illiquidity (particularly with respect to complex 
OTC derivatives), and counterparty risk, among others.\34\ A fund's use 
of derivatives presents challenges for its investment adviser and board 
of directors to ensure that the derivatives are employed in a manner 
consistent with the fund's investment objectives, policies, and 
restrictions, its risk profile, and relevant regulatory requirements, 
including those under Federal securities laws. With respect to some 
primary types of reference assets, funds may use derivatives for the 
following purposes, among others:
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    \33\ 2008 IDC Report, supra note 3, at 7-11. A fund may also use 
derivatives to hedge current portfolio exposures (for example, when 
a fund's portfolio is structured to reflect the fund's long-term 
investment strategy and its investment adviser's forecasts, interim 
events may cause the fund's investment adviser to seek to 
temporarily hedge a portion of the portfolio's broad market, sector, 
and/or security exposures). Industry participants believe that 
derivatives may also provide a more efficient hedging tool than 
reducing exposure by selling individual securities, offering greater 
liquidity, lower round-trip transaction costs, lower taxes, and 
reduced disruption to the portfolio's longer-term positioning. See 
id. at 11.
    \34\ See, e.g., 2008 IDC Report, supra note 3, at 12-13. See 
also 2008 JPMorgan Article, supra note 6.
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     Currency derivatives. \35\ A fund may use currency 
derivatives to increase or decrease exposure to specific currencies, to 
hedge against adverse impacts on the fund's portfolio caused by 
currency fluctuations, and to seek additional returns. For example, 
currency derivatives can provide a hedge against the risk that a fund's 
investment in a foreign debt security will decline in value because of 
a decline in the value of the foreign currency in which the foreign 
debt security is denominated.\36\ Funds also may use currency 
derivatives to hedge against a rise in the value of a foreign currency, 
or may use ``cross-currency'' hedging or ``proxy'' hedging when, for 
instance, it is difficult or expensive to hedge a particular currency 
against the U.S. dollar.\37\ Apart from hedging, funds may use currency 
derivatives to seek returns on the basis of anticipated changes in the 
relative values of two currencies.\38\
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    \35\ See Swap Definition Release, supra note 25, at II.C.1, for 
a description of certain currency derivatives (foreign exchange 
swaps, foreign exchange forwards, foreign currency options, non-
deliverable forwards, currency swaps, and cross-currency swaps). The 
2010 ABA Derivatives Report, supra note 8 at 6-7, gives as examples 
of currency derivatives forward currency contracts, currency futures 
contracts, currency swaps, and options on currency futures 
contracts. As a general matter, futures, forwards, swaps, and 
options can all be used to increase or decrease exposures to 
reference currencies. A fund's investment adviser selects the 
particular instrument based on the level and type of exposure the 
adviser seeks to obtain and the costs that are associated with the 
particular instrument.
    \36\ For example, if a fund enters into a short currency forward 
(which obligates the fund to sell the currency at a future date, at 
a predetermined price, and in the currency in which the foreign debt 
security is denominated), the fund's exposure to a decline in the 
value of the currency is reduced. See 2010 ABA Derivatives Report, 
supra note 8, at 6.
    \37\ For example, a fund may use a forward contract on one 
foreign currency (or a basket of foreign currencies) to hedge 
against adverse changes in the value of another foreign currency (or 
basket of currencies). See id.
    \38\ Id. at 7.
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     Interest rate derivatives.\39\ A fund may use interest 
rate derivatives to modify its exposure to the gains or losses arising 
from changes in interest rates and to seek enhanced returns. For 
example, a fund may use an interest rate swap to hedge against the risk 
of a decline in the prices of bonds owned by a fund due to rising 
interest rates. Similarly, a fund could shorten the duration of its 
portfolio by selling futures contracts on U.S. Treasury bonds or notes, 
or Eurodollar futures. Apart from hedging, a fund might use interest 
rate derivatives to seek to enhance its returns based on its investment 
adviser's views concerning future movements in interest rates or 
changes in the shape of the yield curve.\40\
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    \39\ Interest rate derivatives include interest rate or bond 
futures, Eurodollar futures, caps, floors, overnight indexed swaps, 
interest rate swaps, and options on futures and swaps. See, e.g., 
id. See also Swap Definition Release, supra note 25, at III.B.1 
(briefly describing interest and other monetary rate swaps, and 
discussing that when payments exchanged under a Title VII (of the 
Dodd-Frank Act) instrument are based solely on the levels of certain 
interest rates or other monetary rates that are not themselves based 
on securities, the instrument would be a swap but not a security-
based swap).
    \40\ For example, if a fund's investment adviser believes that 
the London Interbank Offered Rate (``LIBOR'') will decrease compared 
to a Federal funds rate, the adviser could enter into an interest 
rate swap whereby the fund would be obligated to make payments based 
upon the application of LIBOR to an agreed notional amount in 
exchange for payments from the counterparty based upon the 
application of the Federal funds rate to the notional amount. 2010 
ABA Derivatives Report, supra note 8, at 7.
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     Credit Derivatives.\41\ Credit derivatives allow a fund to 
assume an investment position concerning the likelihood that a 
particular bond, or a group of bonds, will be repaid in full upon 
maturity. When a fund purchases credit protection, it pays a premium to 
a counterparty in return for which the counterparty promises to pay the 
fund if a bond or bonds default or experience some other adverse credit 
event. When a fund sells (or writes) credit protection, the fund agrees 
to pay a counterparty if a bond or bonds default or experience some 
other adverse credit event, in exchange for the receipt of a premium 
from the protection purchaser. A fund may purchase credit protection 
using credit derivatives to hedge against particular risks that are 
associated with a bond that it owns, such as the risk that the bond 
issuer will default, a rating agency will downgrade the bond or the 
credit of the counterparty, or the risk that credit ``spread'' will 
increase.\42\ A fund may sell (or write) credit protection to enhance 
its income and return by the amount of the payment that it receives for 
providing such protection, or to obtain some investment exposure to the 
reference asset (that is, the underlying bond), without owning the 
bond. The Commission understands that selling protection may be more 
cost effective than an outright purchase of a bond.\43\
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    \41\ Credit derivatives include single-name and index-linked (or 
basket) credit default swaps. See, e.g., id. at 7-8. For additional 
description of CDS, see Swap Definition Release, supra note 25, at 
III.G.3.
    \42\ See 2010 ABA Derivatives Report, supra note 8, at 7.
    \43\ See id. at 8. The 2010 ABA Derivatives Report, supra note 
8, at 8, also observes that ``a fund could write a CDS, offering 
credit protection to its counterparty. In doing so the fund gains 
the economic equivalent of owning the security on which it wrote the 
CDS, while avoiding the transaction costs that would have been 
associated with the purchase of the security.''
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     Equity Derivatives.\44\ Funds may use equity derivatives 
to enhance investment opportunities (for example, by using foreign 
index futures to obtain exposure to a foreign equity market). Equity 
derivatives also can be used by funds as an income-producing strategy 
by, for example, selling equity call options on a particular security 
owned by the fund.\45\ A fund also may use equity derivatives (usually 
stock index futures) to ``equitize'' cash.\46\
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    \44\ Equity derivatives include equity futures contracts, 
options on equity futures contracts, equity options, and various 
kinds of equity-related swaps (such as a total return swap on an 
equity security). See, e.g., id. at 8.
    \45\ By selling the options, a fund can earn income (in the form 
of the premium received for writing the option) while at the same 
time permitting the fund to sell the underlying equity securities at 
a targeted price set by the fund's investment adviser. See, e.g., 
id.
    \46\ As an example of ``equitizing'' cash, the 2010 ABA 
Derivatives Report, supra note 8, at 8, states that:
    [W]hen a fund has a large cash position for a short amount of 
time, the fund can acquire long futures contracts to retain (or 
gain) exposure to the relevant equity market. When the futures 
contracts are liquid (as is typically the case for broad market 
indices), the fund can eliminate the position quickly and frequently 
at lower costs than had the fund actually purchased the reference 
equity securities.
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C. Request for Comment

    The Commission generally requests data and comment on the types of 
derivatives used by funds, the purposes for which funds use 
derivatives, and whether funds' use of derivatives has undergone or may 
be undergoing changes and, if so, the nature of such changes. The 
Commission specifically requests comment on the following:
     What are the costs and benefits to funds from the use of 
derivatives? What are the factors that influence those costs and 
benefits? What are the risks to funds

[[Page 55242]]

from investing in derivatives? What role does or could collateral used 
in derivatives transactions play in mitigating the concerns relating to 
the use of derivatives? Please be specific and provide data or 
statistics, if possible.
     Do different types of funds use different types of 
derivatives or use derivatives for different purposes? If so, what are 
the differences in the types of funds that account for the differences 
in their use of derivatives? For example, do BDCs use derivatives in a 
manner different from other funds and, if so, how and what are the 
differences?
     How do ETFs use derivatives? Do they use derivatives for 
the same purposes that other open-end funds use them? Does an ETF's use 
of derivatives raise unique investor protection concerns under the 
Investment Company Act?

II. Derivatives under the Senior Securities Restrictions of the 
Investment Company Act

    In this section, the Commission discusses the limitations on senior 
securities imposed by section 18 of the Investment Company Act, 
summarizes related Commission and staff guidance, discusses certain 
alternative approaches, and highlights issues for comment.

A. Purpose, Scope, and Application of the Act's Senior Securities 
Limitations

1. Statutory Restrictions on Senior Securities and Related Commission 
Guidance
    The protection of investors against the potentially adverse effects 
of a fund's issuance of ``senior securities'' \47\ is a core purpose of 
the Investment Company Act.\48\ Congress' concerns underlying the 
limitations in section 18 included, among others: (i) Potential abuse 
of the purchasers of senior securities; \49\ (ii) excessive borrowing 
and the issuance of excessive amounts of senior securities by funds 
which increased unduly the speculative character of their junior 
securities; \50\ and (iii) funds operating without adequate assets and 
reserves.\51\ To address these concerns, section 18(f)(1) of the 
Investment Company Act prohibits an open-end fund \52\ from issuing or 
selling any ``senior security'' other than borrowing from a bank, and 
unless it maintains 300% ``asset coverage.'' \53\ Section 18(a)(1) of 
the Investment Company Act prohibits a closed-end fund \54\ from 
issuing or selling any ``senior security that represents an 
indebtedness'' unless it has at least 300% ``asset coverage.'' \55\
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    \47\ Section 18(g) of the Investment Company Act defines 
``senior security,'' in part, as ``any bond, debenture, note, or 
similar obligation or instrument constituting a security and 
evidencing indebtedness,'' and ``any stock of a class having 
priority over any other class as to the distribution of assets or 
payment of dividends.'' The definition excludes certain limited 
temporary borrowings.
    \48\ See, e.g., Investment Company Act sections 1(b)(7), 
1(b)(8), 18(a), and 18(f). See also, e.g., 1994 Report, supra note 
3, at 20-22.
    \49\ See Investment Trusts and Investment Companies: Hearings on 
S. 3580 Before a Subcomm. of the Senate Committee on Banking and 
Currency, 76th Cong., 3d Sess., pt. 1, 265-78 (1940) (``Senate 
Hearings''). See also 1994 Report, supra note 3, at 21 (describing 
the practices in the 1920s and 1930s that gave rise to section 18's 
limitations on leverage, and specifically discussing the potential 
abuse of senior security holders).
    \50\ See section 1(b)(7) of the Investment Company Act. See 
also, e.g., Release 10666, supra note 10, at n. 8.
    \51\ See section 1(b)(8) of the Investment Company Act; Release 
10666, supra note 10, at n. 8.
    \52\ Section 5(a)(1) of the Investment Company Act defines 
``open-end company'' as ``a management company which is offering for 
sale or has outstanding any redeemable security of which it is the 
issuer.''
    \53\ ``Asset coverage'' of a class of securities representing 
indebtedness of an issuer generally is defined in section 18(h) of 
the Investment Company Act as ``the ratio which the value of the 
total assets of such issuer, less all liabilities and indebtedness 
not represented by senior securities, bears to the aggregate amount 
of senior securities representing indebtedness of such issuer.''
    \54\ Section 5(a)(2) of the Investment Company Act defines 
``closed-end company'' as ``any management company other than an 
open-end company.''
    \55\ Section 18(a)(1)(A). A BDC is also subject to the 
limitations of section 18(a)(1)(A) to the same extent as if it were 
a closed-end investment company except that the applicable asset 
coverage amount is 200%. See Investment Company Act section 
61(a)(1).
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    In a 1979 General Statement of Policy (Release 10666), the 
Commission considered the application of section 18's restrictions on 
the issuance of senior securities to reverse repurchase agreements, 
firm commitment agreements, and standby commitment agreements.\56\ The 
Commission concluded that such agreements, while not securities for all 
purposes,\57\ may involve the issuance of senior securities and ``fall 
within the functional meaning of the term `evidence of indebtedness' 
for purposes of section 18 of the Act,'' which generally would include 
``all contractual obligations to pay in the future for consideration 
presently received.'' \58\ Further, the Commission stated that 
``trading practices involving the use by investment companies of such 
agreements for speculative purposes or to accomplish leveraging fall 
within the legislative purposes of Section 18.'' \59\ The Commission 
also explained that:

    \56\ As described in Release 10666, supra note 10, in a typical 
reverse repurchase agreement, the fund transfers possession of a 
debt security, often to a broker-dealer or a bank, in return for a 
percentage of the market value of the security (``proceeds''), but 
retains record ownership of, and the right to receive interest and 
principal payments on, the security. At a stated future date, the 
fund repurchases the security and remits to the counterparty the 
proceeds plus interest. Id. at nn. 2-3 and accompanying text. A firm 
commitment agreement (also known as a ``when-issued security'' or a 
``forward contract'') is a buy order for delayed delivery in which a 
fund agrees to purchase a debt security from a seller (usually a 
broker-dealer) at a stated future date, price, and fixed yield. Id. 
at text accompanying n. 12. A standby commitment agreement is a 
delayed delivery agreement in which a fund contractually binds 
itself to accept delivery of a debt security with a stated price and 
fixed yield upon the exercise of an option held by the counterparty 
to the agreement at a stated future date. Id. at discussion of 
``Standby Commitment Agreements.''
    \57\ Release 10666, supra note 10, at ``The Agreements as 
Securities'' discussion. The Commission notes, however, that the 
Investment Company Act's definition of the term ``security'' is 
broader than the term's definition in other Federal securities laws. 
Compare section 2(a)(36) of the Investment Company Act with sections 
2(a)(1) and 2A of the Securities Act and sections 3(a)(10) and 3A of 
the Exchange Act. For example, the definition of ``security'' in the 
Investment Company Act includes any ``evidence of indebtedness,'' 
which is not included in the definition of ``security'' in section 
3(a)(10) of the Exchange Act. Further, the Commission has 
interpreted the term ``security'' in light of the policies and 
purposes underlying the Act. For example, the brief for the United 
States as Amicus Curiae in Marine Bank v. Weaver, No. 80-1562, 1980 
U.S. Briefs 1562 (Oct. Term, 1980) (July 29, 1981) (``Marine Bank v. 
Weaver Amicus Brief'') stated that the issue of whether a particular 
instrument is a ``security'' depends on the context, including the 
statute being applied, and further stated that the Investment 
Company Act ``presents a significantly different context'' (i.e., 
the regulation of the operation and management of investment 
companies) than the context of the Securities Act and the Exchange 
Act (i.e., the issuance or trading of such securities). Marine Bank 
v. Weaver Amicus Brief at 38, 40.
    \58\ Release 10666, supra note 10, at ``The Agreements as 
Securities'' discussion.
    \59\ Id.
---------------------------------------------------------------------------

    [l]everage exists when an investor achieves the right to a 
return on a capital base that exceeds the investment which he has 
personally contributed to the entity or instrument achieving a 
return* * *. Through a reverse repurchase agreement, an investment 
company can achieve a return on a very large capital base relative 
to its cash contribution. Therefore, the reverse repurchase 
agreement is a highly leveraged transaction.\60\
---------------------------------------------------------------------------

    \60\ Id. at n. 5 (citation omitted).

    Leveraging of a fund's portfolio through the issuance of senior 
securities ``magnifies the potential for gain or loss on monies 
invested and, therefore, results in an increase in the speculative 
character of the investment company's outstanding securities.'' \61\ 
Each of the agreements discussed by the Commission in Release 10666--
the reverse repurchase agreement, the firm commitment agreement, and 
the standby commitment agreement--``may be a substantially higher risk 
investment'' than direct investment in

[[Page 55243]]

the underlying securities ``because of the additional risk of loss 
created by the substantial leveraging in each agreement, and in light 
of the volatility of interest rates in the marketplace.'' \62\
---------------------------------------------------------------------------

    \61\ Id. at text accompanying n. 5.
    \62\ Id. at discussion of ``The Agreements as Securities.'' The 
Commission also stated that, ``[t]he gains and losses from the 
transactions can be extremely large relative to invested capital; 
for this reason, each agreement has speculative aspects. Therefore, 
it would appear that the independent investment decisions involved 
in entering into such agreements, which focus on their distinct 
risk/return characteristics, indicate that, economically as well as 
legally, the agreements should be treated as securities separate 
from the underlying Ginnie Maes for purposes of Section 18 of the 
Act.'' Id.
---------------------------------------------------------------------------

    In Release 10666, the Commission further stated that, although 
reverse repurchase agreements, firm commitment agreements, and standby 
commitment agreements are functionally equivalent to senior securities, 
these and similar arrangements nonetheless could be used by funds in a 
manner that would not warrant application of the section 18 
restrictions. The Commission noted that in circumstances involving 
similar economic effects, such as short sales of securities by funds, 
our staff had determined that the issue of section 18 compliance would 
not be raised if funds ``cover'' senior securities by maintaining 
``segregated accounts.'' \63\ The Commission stated that the use of 
segregated accounts ``if properly created and maintained, would limit 
the investment company's risk of loss.'' \64\ To avail itself of the 
segregated account approach, a fund could establish and maintain with 
the fund's custodian a segregated account containing liquid assets, 
such as cash, U.S. government securities, or other appropriate high-
grade debt obligations, equal to the indebtedness incurred by the fund 
in connection with the senior security (``segregated account 
approach'').\65\ The amount of assets to be segregated with respect to 
reverse repurchase agreements lacking a specified repurchase price 
would be the value of the proceeds received plus accrued interest; for 
reverse repurchase agreements with a specified repurchase price, the 
amount of assets to be segregated would be the repurchase price; and 
for firm and standby commitment agreements, the amount of assets to be 
segregated would be the purchase price.\66\ As the Commission stated in 
Release 10666, the segregated account functions as ``a practical limit 
on the amount of leverage which the investment company may undertake 
and on the potential increase in the speculative character of its 
outstanding common stock,'' and ``will assure the availability of 
adequate funds to meet the obligations arising from such activities.'' 
\67\
---------------------------------------------------------------------------

    \63\ Release 10666, supra note 10, at text accompanying n. 15.
    \64\ Id. at discussion of ``Segregated Account.''
    \65\ The Commission stated that, under the segregated account 
approach, the value of the assets in the segregated account should 
be marked to the market daily, additional assets should be placed in 
the segregated account whenever the total value of the account falls 
below the amount of the fund's obligation, and assets in the 
segregated account should be deemed frozen and unavailable for sale 
or other disposition. See id. The Commission also cautioned that as 
the percentage of a fund's portfolio assets that are segregated 
increases, the fund's ability to meet current obligations, to honor 
requests for redemption, and to manage properly the investment 
portfolio in a manner consistent with stated its investment 
objective may become impaired. Id.
    \66\ Id.
    \67\ Id.
---------------------------------------------------------------------------

2. Staff No-Action Letters Concerning the Segregated Account Approach 
\68\
---------------------------------------------------------------------------

    \68\ This release includes extensive discussion of staff no-
action letters; accordingly the Commission notes that its discussion 
of staff statements is provided solely for background and to 
facilitate comment on issues that the Commission might address. The 
discussion is in no way intended to suggest that the Commission has 
adopted the analysis, conclusions or any other portion of the staff 
statements discussed here. Staff no-action letters are issued by the 
Commission staff in response to written requests regarding the 
application of the Federal securities laws to proposed transactions. 
Many of the staff no-action letters are ``enforcement-only'' 
letters, in which the staff states whether it will recommend 
enforcement action to the Commission if the proposed transaction 
proceeds in accordance with the facts, circumstances and 
representations set forth in the requester's letter. Other staff no-
action letters provide the staff's interpretation of a specific 
statute, rule or regulation in the context of a specific situation. 
See Informal Guidance Program for Small Entities, Investment Company 
Act Release No. 22587 (Mar. 27, 1997).
---------------------------------------------------------------------------

    Following the Commission's issuance of Release 10666, the 
Commission staff issued more than twenty no-action letters to funds 
concerning the maintenance of segregated accounts or otherwise 
``covering'' their obligations in connection with certain senior 
securities, primarily interest rate futures, stock index futures, and 
related options.\69\
---------------------------------------------------------------------------

    \69\ See ``No-Action Letters and Releases from 1982-1985 
Regarding Covering Futures and Options'' at Senior Security 
Bibliography, supra note 10. (Certain of these letters also 
addressed the use of when-issued bonds, currency forwards, and other 
senior securities).
---------------------------------------------------------------------------

    In a 1987 no-action letter issued to two Dreyfus funds, the staff 
summarized and expanded upon the methods by which, in its view, 
obligations could be covered by funds transacting in futures, forwards, 
written options, and short sales.\70\ The staff provided no-action 
assurance that the Dreyfus funds could:
---------------------------------------------------------------------------

    \70\ Dreyfus Strategic Investing and Dreyfus Strategic Income, 
SEC Staff No-Action Letter (June 22, 1987) (``Dreyfus no-action 
letter'' or ``Dreyfus Letter''), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
---------------------------------------------------------------------------

     Cover a long position in a futures or forward contract, or 
a written put option, by establishing a segregated account (not with a 
futures commission merchant or broker) containing cash or certain 
liquid assets equal to the purchase price of the contract or the strike 
price of the put option (less any margin on deposit); and
     Cover short positions in futures or forward contracts, 
sales of call options, and short sales of securities by establishing a 
segregated account (not with a futures commission merchant or broker) 
with cash or certain liquid assets that, when added to the amounts 
deposited with a futures commission merchant or a broker as margin, 
equal the market value of the instruments or currency underlying the 
futures or forward contracts, call options, and short sales (but are 
not less than the strike price of the call option or the market price 
at which the short positions or short sales were established).\71\
---------------------------------------------------------------------------

    \71\ But see Robertson Stephens Investment Trust, SEC Staff No-
Action Letter (Aug. 24, 1995), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm (the staff 
agreed not to recommend enforcement action where the value of the 
segregated account, to cover a short position in a security, was 
equal to the daily (fluctuating) market price of the security sold 
short (less certain amounts pledged with the broker as collateral), 
even if the value of the segregated account was less than the price 
at which the short position was established).
---------------------------------------------------------------------------

    The staff also provided no-action assurance that the Dreyfus funds 
could cover these transactions by owning, or holding the right to 
obtain, the instrument or cash that the fund has obligated itself to 
deliver. For example:
     A fund could cover a long position in a futures or forward 
contract by purchasing a put option on the same futures or forward 
contract with a strike price as high or higher than the price of the 
contract held by the fund; and
     A fund could cover a written put option by selling short 
the instruments or currency underlying the put option at the same or 
higher price than the strike price of the put option or, alternatively, 
by purchasing a put option with the strike price the same or higher 
than the strike price of the put option written by the fund.
    The Commission staff has also discussed the types of assets that 
may be segregated and the manner in which, in the staff's view, 
segregation may be effected. In Release 10666, the Commission stated 
that the assets eligible to be included in segregated accounts should 
be ``liquid assets,'' such as cash, U.S. government securities, or

[[Page 55244]]

other appropriate high grade debt obligations. In a 1996 staff no-
action letter issued to Merrill Lynch Asset Management, the staff took 
the position that a fund could cover its derivatives-related 
obligations by depositing any liquid asset, including equity securities 
and non-investment grade debt securities, in a segregated account.\72\ 
In the Merrill Lynch no-action letter, the staff explained that, in the 
staff's view, segregating any type of liquid asset would be consistent 
with the purposes underlying the asset segregation approach because it 
would place a practical limit on the amount of leverage that a fund may 
undertake and on the potential increase in the speculative character of 
its outstanding shares.\73\ With respect to the manner in which 
segregation may be effected, the Commission staff took the position 
that a fund could segregate assets by designating such assets on its 
books, rather than establishing a segregated account at its 
custodian.\74\
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    \72\ Merrill Lynch Asset Management, L.P., SEC Staff No-Action 
Letter (July 2, 1996) (``Merrill Lynch no-action letter'' or 
``Merrill Lynch Letter''), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
    \73\ Id. The staff noted that ``the type of asset placed in the 
segregated account would have no effect on the maximum amount of 
leverage that a fund can assume.''
    \74\ See Dear Chief Financial Officer Letter from Lawrence A. 
Friend, Chief Accountant, Division of Investment Management (Nov. 7, 
1997), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
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    Asset segregation practices with respect to other derivatives 
investments have not been addressed by the Commission, or by the staff 
in no-action letters.\75\ Certain swaps, for example, 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.\76\ Similarly, some funds have disclosed that 
they segregate only their daily, mark-to-market liability, if any, with 
respect to futures and forward contracts that are contractually 
required to cash-settle.\77\
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    \75\ Our discussion of current and past industry practices is 
not intended to indicate any Commission approval or disapproval of 
those practices.
    \76\ See, e.g., 2010 ABA Derivatives Report, supra note 8, at 
13-14.
    \77\ For a discussion of asset segregation practices involving 
futures and forwards that are contractually required to cash-settle, 
see, e.g., id. at 14-15.
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B. Alternative Approaches to the Regulation of Portfolio Leverage

1. The Current Asset Segregation Approach
    As noted above, the segregated account approach serves both to 
limit a fund's potential leverage and to provide a source of payment of 
future obligations arising from the leveraged transaction. In 
determining the amount of assets required to be segregated to cover a 
particular instrument, the Commission and its staff have generally 
looked to the purchase or exercise price of the contract (less margin 
on deposit) for long positions and the market value of the security or 
other asset underlying the agreement for short positions, measured by 
the full amount of the reference asset, i.e., the notional amount of 
the transaction rather than the unrealized gain or loss on the 
transaction, i.e., its current mark-to-market value.\78\
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    \78\ See Release 10666, supra note 10, at discussion of 
``Segregated Account'' (with regard to each reverse repurchase 
agreement that lacks a specified repurchase price, the fund should 
maintain in a segregated account ``liquid assets equal in value to 
the proceeds received on any sale subject to repurchase plus accrued 
interest. If the reverse repurchase agreement has a specified 
repurchase price, the investment company should maintain in the 
segregated account an amount equal to the repurchase price, which 
price will already include interest charges.'' With regard to each 
firm commitment agreement, the fund should maintain in a segregated 
account ``liquid assets equal in value to the purchase price due on 
the settlement date under the * * * agreement.'' With regard to each 
standby commitment agreement, the fund should maintain in a 
segregated account ``liquid assets equal in value to the purchase 
price under the * * * agreement.'').
---------------------------------------------------------------------------

    The segregated account approach has drawn criticism on several 
grounds. For example, we understand that some industry participants 
argue that the segregated account approach calls for an instrument-by-
instrument assessment of the amount of cover required, further arguing 
that this may create uncertainty about the treatment of new products, 
and that new product development will inevitably lead to circumstances 
in which available guidance does not specifically address each new 
instrument subject to section 18 constraints. Other industry 
participants have argued that the staff's application of the segregated 
account approach results in differing treatment of arguably equivalent 
products.\79\
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    \79\ They argue, for example, that a physically-settled and a 
cash-settled future or forward are equivalent products, and that 
segregation of the delivery obligation amount for a physically-
settled future or forward, and segregation of the generally smaller 
mark-to-market liability amount for a cash-settled future or 
forward, constitutes different treatment of equivalent products. See 
the 2010 ABA Derivatives Report, supra note 8, at 14-15 for a 
discussion of cash-settled futures and forwards and the asset 
segregation treatment of those products.
---------------------------------------------------------------------------

    Others have argued that, with respect to the amount to be 
segregated, both notional amount and a mark-to-market amount have their 
limitations.\80\ For example, for many futures contracts, the notional 
amount may, as a practical matter, exceed the maximum loss or total 
risk on the contract.\81\ Consequently, it is argued with respect to 
such derivatives that segregation of assets equal to the notional 
amount may limit the use of such derivative products and strategies 
that could potentially benefit funds and their investors. Conversely, 
it is argued that segregation of an amount equal to only the daily, 
mark-to-market liability, if any, with respect to cash-settled 
derivatives,\82\ may fail to take into account potential future losses 
on such instruments. Consequently, it is argued that segregation of 
this amount may understate the risk of loss to the fund, permit the 
fund to engage in excessive leveraging, fail to adequately set aside 
sufficient assets to cover the fund's ultimate exposure, and, 
therefore, perhaps not adequately fulfill the purposes underlying the 
segregated account approach and section 18.\83\
---------------------------------------------------------------------------

    \80\ Id. at 16-17.
    \81\ See BIS Guide, supra note 18, at 30, commenting in the 
context of OTC derivatives that ``[n]ominal or notional amounts 
outstanding provide a measure of market size and a reference from 
which contractual payments are determined in derivatives markets. 
However, with the partial exception of credit default swaps, such 
amounts are generally not those truly at risk. The amounts at risk 
in derivatives contracts are a function of the price level and/or 
volatility of the financial reference index used in the 
determination of contract payments, the duration and liquidity of 
contracts and the creditworthiness of counterparties.''
    \82\ This is also a concern with respect to the coverage of 
short sales.
    \83\ See 2010 ABA Derivatives Report, supra note 8, at 15 
(``reducing the amount of assets subject to segregation increased 
the practical ability of funds to engage in derivatives on an 
increasing scale''), and at 16 (where only the mark-to-market 
liability, if any, is segregated, ``a fund's exposure under a 
derivative contract could increase significantly on an intraday 
basis, resulting in the segregated assets being worth less than the 
fund's obligations (until the fund is able to place additional 
assets in the segregated account * * *.). To the extent that a fund 
relying on the Merrill Lynch Letter segregates assets whose prices 
are somewhat volatile, this `shortfall' could be magnified.'').
---------------------------------------------------------------------------

    The significant disparity between these two widely recognized 
measures--notional amount and mark-to-market amount--is illustrated by 
data relevant to actual swap positions held by funds. A recent study of 
the use of credit default swaps (``CDS'') by a group of the 100 largest 
U.S. corporate bond funds analyzed data relevant to the notional amount 
and ``book value,'' i.e., unrealized gains and losses, of the funds' 
CDS positions during the period 2004 through 2008.\84\ Among the 65 
funds in the sample group that used CDS sometime between 2004 and 2008, 
the total notional amount of CDS positions increased from an average of 
$103 million per fund in 2004 to an

[[Page 55245]]

average of $632 million in 2008. The mean total notional amount of a 
fund's CDS positions relative to its net asset value (``NAV'') 
increased from 2% to almost 14%.\85\ At three funds, the notional 
amounts of CDS positions held in 2008 exceeded those funds' NAVs. 
During the same period, reported CDS book losses (i.e., unrealized 
losses) remained, on average, less than 1% of a fund's NAV.\86\
---------------------------------------------------------------------------

    \84\ Adam and Guettler Article, supra note 7.
    \85\ Id. at 12.
    \86\ Id. at 13.
---------------------------------------------------------------------------

    Critics of the notional and mark-to-market standards often advocate 
use of a more complex analysis of the risk of a fund's investments, 
including its derivatives positions, such as Value at Risk (``VaR'') or 
another methodology for assessing the probability of portfolio 
losses.\87\ VaR and other alternative approaches are discussed in the 
following section.
---------------------------------------------------------------------------

    \87\ See, e.g., 2010 ABA Derivatives Report, supra note 8, at 
18. As discussed infra, some non-U.S. regulatory schemes have 
incorporated VaR or comparable methodologies in their approach to 
derivatives. See, e.g., CESR's Guidelines on Risk Measurement and 
the Calculation of Global Exposure and Counterparty Risk for UCITS, 
Committee of European Securities Regulators (July 28, 2010) 
(``CESR's Global Exposure Guidelines''), available at http://www.esma.europa.eu/popup2.php?id=7000. See also Henry T.C. Hu, The 
New Portfolio Society, SEC Mutual Fund Disclosure, and the Public 
Corporation Model, 60 BUS. LAW. 1303 (2005) (advocating disclosure 
by funds of VaR data). We note that the Commission has permitted VaR 
to be used by certain registrants in other circumstances. For 
example, the Commission permits certain registered broker-dealers to 
use VaR models to compute net capital charges. See, e.g., Exchange 
Act rule 15c3-1f.
---------------------------------------------------------------------------

2. Other Approaches
    The 2010 ABA Derivatives Report observed that the ``the basic 
framework as articulated in Release 10666 has worked very well'' as 
applied to funds' derivatives investments,\88\ but ``there are open 
issues and inconsistencies in the current [Commission] and staff 
guidance regarding the application of Section 18 of the 1940 Act to 
transactions in derivatives.'' \89\ Accordingly, the 2010 ABA 
Derivatives Report states that the Commission ``should issue revised 
guidance in this area, which would set forth an approach to segregation 
that would cover all types of derivative instruments in a comprehensive 
manner.'' \90\ The 2010 ABA Derivatives Report, however, considers 
comprehensive guidance unlikely to be achievable, given that any 
generalized approach will likely fail to take into account significant 
variations in individual transactions. Consequently, in lieu of 
comprehensive guidance concerning the asset segregation approach, the 
2010 ABA Derivatives Report proposes an alternative approach pursuant 
to which individual funds would establish their own asset segregation 
standards for derivative instruments that involve leverage within the 
meaning of Release 10666. Under this approach, each fund would be 
required to adopt policies and procedures that would include, among 
other things, minimum asset segregation requirements for each type of 
derivative instrument, taking into account relevant factors such as the 
specific context of the transaction. In developing these standards, 
fund investment advisers could 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 
standards. These minimum ``Risk Adjusted Segregated Amounts'' 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 Risk Adjusted Segregated Amounts for 
different types of derivatives) in the fund's statement of additional 
information.\91\
---------------------------------------------------------------------------

    \88\ 2010 ABA Derivatives Report, supra note 8, at 16.
    \89\ Id. at 15.
    \90\ Id. at 17.
    \91\ Id. at 18.
---------------------------------------------------------------------------

    The challenge of designing a regulatory standard by which leverage 
can be measured and limited effectively also has drawn the attention of 
regulators in jurisdictions around the globe. Internationally, 
limitations on leveraged exposure 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 and some provide for specialized funds that may assume 
derivatives exposure exceeding otherwise applicable limits.
    The Committee of European Securities Regulators (``CESR'') (which, 
as of January 1, 2011, became the European Securities and Markets 
Authority, or ``ESMA''), conducted an extensive review and consultation 
concerning exposure measures for derivatives used by Undertakings for 
Collective Investment in Transferable Securities (``UCITS''), 
investment vehicles authorized for sale to retail investors. In 2010, 
CESR's Global Exposure Guidelines for UCITS were issued,\92\ addressing 
implementation of the European Commission's 2009 revised UCITS 
Directive.\93\ Under the revised UCITS Directive, UCITS are permitted 
to engage in derivatives investments subject to a ``global exposure'' 
limitation, under which the derivatives exposure of a UCITS may not 
exceed the total net value of the UCITS' portfolio.\94\ CESR's Global 
Exposure Guidelines extensively address the calculation of derivatives 
exposure under the ``global exposure'' limit and define two 
permissible, alternative methods for this purpose: (i) The 
``commitment'' approach; and (ii) the advanced risk measurement method 
to measure maximum potential loss, such as the VaR approach.\95\
---------------------------------------------------------------------------

    \92\ See supra note 87. In order for CESR's Global Exposure 
Guidelines to be binding and operational in a particular EU Member 
State, the Member State must adopt them. To date, it appears that a 
few EU Member States, e.g., Ireland and Luxembourg, have adopted 
them.
    \93\ See Directive 2009/65/EC of the European Parliament and of 
the Council of 13 July 2009 on the coordination of laws, 
regulations, and administrative provisions relating to undertakings 
for collective investment in transferable securities (``2009 
Directive''), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0032:0096:en:PDF.
    \94\ Id. at Article 51(3) at 62 (``The exposure is calculated 
taking into account the current value of the underlying assets, the 
counterparty risk, future market movements and the time available to 
liquidate the positions'').
    \95\ See CESR's Global Exposure Guidelines, supra note 87. The 
CESR's Global Exposure Guidelines note that the ``use of a 
commitment approach or VaR approach or any other methodology to 
calculate global exposure does not exempt UCITS from the requirement 
to establish appropriate internal risk management measures and 
limits.'' Id. at 5. In addition, with respect to the selection of 
the methodology used to measure global exposure, CESR's Global 
Exposure Guidelines note that the ``commitment approach should not 
be applied to UCITS using, to a large extent and in a systematic 
way, financial derivative instruments as part of complex investment 
strategies.'' Id. at 6.
---------------------------------------------------------------------------

    The commitment approach is a method for standard derivatives that 
uses the market value of the equivalent position in the underlying 
asset but may be ``replaced by the notional value or the price of the 
futures contract where this is more conservative.'' \96\ CESR's Global 
Exposure Guidelines incorporates a schedule of derivative investments 
and their corresponding conversion methods to be used in calculating 
global exposure.\97\ The conversion method to be used depends on the 
derivative.\98\
---------------------------------------------------------------------------

    \96\ See id. at 7.
    \97\ See id. at 7-12.
    \98\ Id. at 8. For example, for bond futures, the applicable 
conversion method is the number of contracts multiplied by the 
notional contract size multiplied by the market price of the 
cheapest-to-deliver reference bond. For plain vanilla fixed/floating 
interest rate and inflation swaps, the applicable conversion method 
is the market value of the underlier (though the notional value of 
the fixed leg may also be applied). Id. For foreign exchange 
forwards, the prescribed conversion method is the notional value of 
the currency leg(s). Id. at 9. With respect to non-standard 
derivatives, where it is not possible to convert the derivative into 
the market value or notional value of the equivalent underlying 
asset, CESR's Global Exposure Guidelines note that ``an alternative 
approach may be used provided that the total amount of the 
derivatives represent a negligible portion of the UCITS portfolio.'' 
Id. at 7.

---------------------------------------------------------------------------

[[Page 55246]]

    The second method is VaR or a comparably sophisticated risk 
measurement method, designed to measure the maximum potential loss due 
to market risk rather than leverage.\99\ When using the VaR approach to 
calculate global exposure, either the relative VaR approach or the 
absolute VaR approach may be used.\100\ Under the relative VaR 
approach, the VaR of the portfolio cannot be greater than twice the VaR 
of an unleveraged reference portfolio.\101\ The absolute VaR approach 
limits the maximum VaR that a UCITS can have relative to its NAV, and 
as a general matter, the absolute VaR is limited to 20 percent of the 
UCITS NAV.\102\
---------------------------------------------------------------------------

    \99\ Id. at 22 (``More particularly, the VaR approach measures 
the maximum potential loss at a given confidence level (probability) 
over a specific time period under normal market conditions.'').
    \100\ Id. at 23. A global exposure calculation using the VaR 
approach should consider all the positions in the UCITS' portfolio. 
Id. at 22. The VaR approach measures the probability of risk of loss 
rather than the amount of leverage in portfolio. Id. at 22. The 
absolute VaR of a UCITS cannot be greater than 20% of its NAV. Id. 
at 26. For both VaR approaches, the calculation must have a ``one-
tailed confidence interval of 99%,'' a holding period of one month 
(20 business days), an observation period of risk factors of at 
least one year (unless a shorter observation period is justified by 
a significant increase in price volatility), at least quarterly 
updates, and at least daily calculation. Id. at 26. UCITS employing 
the VaR approach are required to conduct a ``rigorous, comprehensive 
and risk-adequate stress testing program.'' Id. at 30-34.
    \101\ CESR's Global Exposure Guidelines note that the relative 
VaR approach does not measure leverage of the UCITS' strategies but 
instead allows the UCITS to double the risk of loss under a given 
VaR model. Id. at 24.
    \102\ Id. at 25-26.
---------------------------------------------------------------------------

    In addition to the global exposure limitation, CESR's Global 
Exposure Guidelines subject UCITS to ``cover rules'' for investments in 
financial derivatives.\103\ Under these cover rules, UCITS should, at 
any given time, be capable of meeting all its payment and delivery 
obligations incurred by financial derivatives' investments, and cover 
should form part of the UCITS' risk management process.\104\ More 
specifically, in the case of a derivative that provides, automatically 
or at the counterparty's choice, for physical delivery of the 
underlier, the UCITS should hold: (i) the underlier in its portfolio, 
or, if the underlier is deemed to be sufficiently liquid, (ii) cash or 
other liquid assets on the condition that these other assets (after 
applying appropriate haircuts), held in sufficient quantities, may be 
used at any time to acquire the underlier that is to be delivered.\105\ 
In the case of a derivative that provides, automatically or at the 
UCITSs choice, for cash settlement, the UCITS should hold enough liquid 
assets after appropriate haircuts to allow the UCITS to make the 
contractually required payments.\106\
---------------------------------------------------------------------------

    \103\ Id. at 40.
    \104\ Id.
    \105\ Id.
    \106\ Id. On April 14, 2011, ESMA published a final report on 
the guidelines on risk measurement and the calculation of the global 
exposure for certain types of structured UCITS. See Guidelines to 
Competent Authorities and UCITS Management Companies on Risk 
Measurement and the Calculation of Global Exposure for Certain Types 
of Structured UCITS (final report) (Apr. 14, 2011) (ref.: ESMA/2011/
112), available at http://www.esma.europa.eu/popup2.php?id=7542 
(these guidelines, which will need to be adopted and implemented by 
Member States, propose for certain types of structured UCITS, an 
optional regime for the calculation of the global exposure).
---------------------------------------------------------------------------

    Singapore has adopted a bifurcated approach similar to that 
applicable under CESR's Global Exposure Guidelines for UCITS. The 
Monetary Authority of Singapore (the ``MAS'') requires that the risks 
of derivatives used by investment companies are ``duly measured, 
monitored and managed on an ongoing basis.'' \107\ An investment 
company's exposure to derivatives is limited to 100% of its NAV, and 
global exposure is calculated using the commitment approach as the 
default method. Under the commitment approach, which is similar to the 
commitment approach in CESR's Global Exposure Guidelines, global 
exposure is calculated by converting the investment company's 
derivatives positions into equivalent positions in the underlying 
assets and then is quantified as the sum of the absolute values of the 
individual positions.\108\ The investment company's exposure to the 
counterparty of an OTC derivative is limited to 10% of its NAV and is 
measured on a maximum potential loss basis that may be incurred by the 
investment company if the counterparty defaults.\109\ Cash or money 
market instruments and bonds issued by a government with a rating of 
AAA may be tendered as collateral to reduce counterparty exposure.\110\
---------------------------------------------------------------------------

    \107\ The Monetary Authority of Singapore, Code on Collective 
Investment Schemes, Chapter 3, section 3.1(f) (April 2011) at 7, 
available at http://www.mas.gov.sg/resource/legislation_guidelines/securities_futures/sub_legislation/110408%20Revised%20Code_8%20April_final.pdf.
    \108\ MAS allows for the use of a VaR approach, with prior 
approval and submission of specific information on the investment 
company manager's risk management process. Id. at Appendix 1, 
section 3.2(b).
    \109\ Id. at Appendix 1, sections 5.2 and 5.4.
    \110\ Id. at Appendix 1, sections 5.7 and 5.8.
---------------------------------------------------------------------------

    Other jurisdictions have adopted approaches to investment 
companies' use of derivatives that limit aggregate exposure and/or 
require maintaining liquid assets equal to the notional or ``exercise'' 
value of derivatives contracts. For example, the Central Bank of 
Ireland, in addressing non-UCITS investment companies offered to the 
public generally, has issued guidelines that provide standards 
analogous to a `notional amount' or commitment approach and generally 
limits the maximum potential exposure to 25% of the investment 
company's NAV.\111\ Separately, the Central Bank of Ireland permits the 
use of techniques and instruments by investment companies for the 
purposes of ``efficient portfolio management,'' subject to certain 
conditions. These include a requirement that an investment company 
selling a futures contract must own the security that is the subject of 
the contract. Alternatively, the investment company's assets, or a 
proportion of its assets at least equal to the exercise value of the 
futures contracts sold, must reasonably be expected to behave in terms 
of price movement in the same manner as the futures contract.\112\
---------------------------------------------------------------------------

    \111\ Central Bank of Ireland, NU SERIES OF NOTICES: Conditions 
Imposed in Relation to Collective Investment Schemes Other than 
UCITS (July 2011) at 13.12, available at http://www.centralbank.ie/regulation/industry-sectors/funds/non-ucits/Documents/Non%20UCITS%20Notices.pdf
    \112\ Id. at 16.10. In addition, certain requirements are 
imposed on the use of OTC derivatives. Id. at 16.10.
---------------------------------------------------------------------------

    A similar approach is followed by the Canadian Securities 
Administrators, which permits investment companies sold to the general 
public to use derivatives for hedging and non-hedging purposes but 
limits the derivatives exposure and requires certain ``cash cover'' 
intended to limit leverage.\113\ For

[[Page 55247]]

example, an investment company may enter into a swap if, among other 
things, the investment company holds cash cover in an amount that, 
together with margin on account for the swap and the market value of 
the swap, is not less than the underlying market exposure of the 
swap.\114\
---------------------------------------------------------------------------

    \113\ National Instrument 81-102 Mutual Funds (Jan. 2011) at 
sections 2.7 and 2.8, available at http://www.bcsc.bc.ca/uploadedFiles/securitieslaw/policy8/81-102%20Mutual%20Funds%20%5BNI%5D%20Jan-1-11.pdf. In addition, for 
periods when the investment company would be required to make 
payments under the swap, the investment company is required to hold 
an equivalent quantity of the reference asset of the swap, a right 
or obligation to acquire an equivalent quantity of the reference 
asset of the swap and cash cover that, together with the margin on 
account for the swap, have a value at least equal to the aggregate 
amount of the obligations of the investment company under the swap, 
or a combination of the positions, without recourse to other assets 
of the investment company, to enable it to satisfy its obligations 
under the swap. Id. at sections 2.7 and 2.8.
    \114\ Id. at section 2.8.
---------------------------------------------------------------------------

    The Hong Kong Securities and Futures Commission (the ``SFC'') 
applies a differentiated approach, limiting investment companies 
generally to the use of derivatives for non-hedging positions that are 
capped at 15% of NAV for options and warrants and 20% for futures.\115\ 
For investment companies that may acquire financial derivative 
instruments extensively for investment purposes, the investment 
companies' global exposure relating to the financial derivative 
instruments should not exceed 100% of the total net asset value of the 
investment companies. For purposes of calculating global exposure, 
investment companies must use the commitment approach. This approach 
requires that derivative positions be converted into the equivalent 
position in the underlying assets of the derivative, taking into 
account the prevailing value of the underlying assets, counterparty 
risk, futures market movements, and the time available to liquidate the 
positions. There are also requirements for: (a) the over-the-counter 
derivative counterparties (or their guarantors, if applicable) of these 
investment companies to be substantial financial institutions (as 
defined in the Code on Unit Trusts and Mutual Funds); (b) the net 
exposure for these investment companies to a single over-the-counter 
derivative counterparty to be no greater than 10% of NAV; and (c) the 
acceptability criteria of collateral as provided by the over-the-
counter derivative counterparties.\116\
---------------------------------------------------------------------------

    \115\ Hong Kong Securities and Futures Commission, Code on Unit 
Trusts and Mutual Funds (June 2010), Chapter 7, available at http://www.sfc.hk/sfc/doc/EN/intermediaries/products/handBooks/Eng_UT.pdf. 
See also Hong Kong Securities and Futures Commission Handbook for 
Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes 
and Unlisted Structured Investment Products.
    \116\ Hong Kong Securities and Futures Commission, Code on Unit 
Trusts and Mutual Funds (June 2010), Chapter 8, available at http://www.sfc.hk/sfc/doc/EN/intermediaries/products/handBooks/Eng_UT.pdf.
    Other requirements include a restriction on premium paid to 
acquire identical options exceeding 5% of the NAV of the investment 
company, open positions in any futures contract month or option 
series may not be held if the combined margin requirement represents 
5% or more of the NAV of the investment company, and the investment 
company may not hold open positions in futures or options contracts 
concerning a single commodity or a single underlying financial 
instrument for which the combined margin requirement represents 20% 
or more of the NAV of the investment company. Id.
    Futures and options investments companies are subject to still 
different requirements, including that at least 30% of the 
investment company's NAV be held on deposit in short-term debt 
instruments and may not be used for margin requirements and no more 
than 70% of the NAV of the investment company may be committed as 
margin for futures or option contracts and/or premium paid for 
options purchased. Other requirements applicable to futures and 
options investment companies include a restriction on premium paid 
to acquire options outstanding with identical characteristics 
exceeding 5% of the NAV of the investment company, open positions in 
any futures contract month or option series may not be held if the 
combined margin requirement represents 5% or more of the net asset 
value of the investment company, and the investment company may not 
hold open positions in futures or options contracts concerning a 
single commodity or a single underlying financial instrument for 
which the combined margin requirement represents 20% or more of the 
net asset value of the investment company. Id.
---------------------------------------------------------------------------

C. Request for Comment

    The Commission 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. The Commission seeks views 
concerning the appropriateness and effectiveness of the asset 
segregation approach as a basis for section 18 compliance, and ways in 
which the approach might be improved to better serve the statutory 
purposes and protect investors. The Commission also seeks views 
concerning potential alternative approaches under which funds could 
capture the benefits of using derivatives that would meet these same 
important goals. Commenters are requested to consider these broad 
questions as well as the specific questions that follow:
1. Issues Concerning the Current Asset Segregation Approach
     Is the definition of leverage articulated by the 
Commission in Release 10666--that is, the right to a return on a 
capital base that exceeds a fund's investment in the instrument 
producing the return--sufficiently precise, and appropriate to limit 
the risks addressed by the senior security prohibition of section 18? 
Are other measures of leverage equally pertinent to, and sufficiently 
objective, precise, and transparent to achieve the investor protection 
purposes of section 18? Do funds make use of any leverage measurements 
as part of their own portfolio oversight procedures? Are leveraged 
transactions involving derivatives subject to any special approval or 
review procedures?
     Does the segregated account approach adequately address 
the investor protection purposes and concerns underlying section 18 of 
the Act? What are the benefits and the shortcomings of the segregated 
account approach? What benefits may be lost under an approach that is 
more restrictive than the current segregated account approach?
     Derivatives can raise risk management issues for funds, 
such as leverage, illiquidity (particularly with respect to complex OTC 
derivatives), and counterparty risk, among others.\117\ The segregated 
account approach addresses leverage, but may not address liquidity and 
counterparty concerns. Should funds that use derivatives be required to 
consider and address these concerns? For example, should funds be 
required to undertake an ongoing credit analysis of their derivatives 
counterparties, and an ongoing analysis of the liquidity of the 
derivatives, and to take action should the creditworthiness of the 
derivatives counterparties and the liquidity of the derivatives 
themselves decline below a certain point? Should diversification among 
counterparties be a requirement? Are there other risk considerations 
that funds engaged in derivatives investments should be required to 
take into account?
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    \117\ See 2008 IDC Report, supra note 3, at 12-13. See also 2008 
JPMorgan Article, supra note 6, at page 25.
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     What is the optimal amount of assets that should be 
segregated for purposes of complying with the leverage limitations of 
section 18? In general, should a fund segregate assets in an amount 
equal to the notional amount of a derivative contract? In what 
situations, if any, would a lesser amount satisfy the purposes and 
concerns underlying section 18's leverage limitations and why? Since 
futures, swaps, and similar derivatives generally have zero market 
value at inception and subsequent mark-to-market amounts may fluctuate 
widely, how effectively does segregating an amount equal to the daily, 
mark-to-market amount serve the Act's objective of limiting leverage 
and assuring the availability of adequate assets to cover a fund's 
ultimate obligations? To what extent do funds rely upon the mark-to-
market standard to determine the amount of assets to be segregated? Are 
CDS, or some subset thereof, generally covered based on their notional 
amount, their mark-to-market value, or some other measure? Does it 
depend on whether the CDS cash-settles or involves physical delivery of 
the underlier?

[[Page 55248]]

     To what extent does the asset segregation approach cause 
funds to refrain from derivatives investments or strategies that could 
benefit investors? Please describe specific scenarios in which a fund 
might be deterred from engaging in derivatives activities for this 
reason. Does the asset segregation approach create particular 
impediments for certain types of funds or strategies? Please also 
provide any information relevant to assessing the impact upon the funds 
of asset segregation as contemplated by Release 10666.
     In Release 10666, the Commission stated that it believed 
that only liquid assets should be placed in the segregated accounts. 
The Commission listed cash, U.S. Government securities, or other 
appropriate high-grade debt obligations as examples of liquid assets 
that could be placed in a segregated account.\118\ Subsequently, in the 
Merrill Lynch no-action letter, the staff took the position that ``cash 
or liquid securities (regardless of type)'' may be segregated for 
section 18 purposes. Should the Commission permit funds to segregate 
any liquid asset? Or should the Commission further limit the types of 
assets that may be placed in a segregated account? The 2010 ABA 
Derivatives Report has observed that the practical effect of 
segregating ``any liquid asset'' rather than segregating only the 
assets specifically noted as examples in Release 10666 ``greatly 
increase[s] the degree to which funds [may] * * * use derivatives.'' 
\119\ Is segregation of ``any liquid asset'' for purposes of section 18 
consistent with the purposes and concerns underlying section 18's 
limitations on leverage? Should any restrictions be placed on the types 
of liquid assets that may be used for asset cover, e.g., excluding 
assets that replicate the fund's exposure under the covered obligation?
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    \118\ See Release 10666, supra note 10, at discussion of 
``Segregated Account.''
    \119\ 2010 ABA Derivatives Report, supra note 8, at 14.
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     What types of liquid assets are currently used by funds 
for asset segregation purposes? Do funds commonly include equities 
among the liquid assets that they segregate? If so, what types of 
equities?
     Is owning, or having the right to obtain, the cash or 
other assets that a fund obligates itself to deliver in connection with 
senior securities an adequate substitute for segregation of liquid 
assets? To what extent do funds rely on this cover approach rather than 
asset segregation? Are cover methods that do not involve asset 
segregation as effective as asset segregation in terms of limiting a 
fund's ability to engage in leverage, limiting a fund's risk of loss, 
and making sure that a fund has set aside sufficient assets to cover 
its obligations under derivatives and other senior securities?
     Should the Commission revise its position in Release 10666 
to provide expressly for cover methods in addition to asset 
segregation? If so, should the Commission take the position that a fund 
may only enter into such non-asset segregation cover methods with the 
same counterparty to the senior security being covered? If so, what 
conditions, if any, should be imposed on such cover methods?
     The Commission also requests comment on the different 
treatment afforded conventional bank borrowings under section 18, which 
generally require 300% asset coverage, and other transactions, such as 
reverse repurchase agreements, that may be functionally equivalent to 
borrowings but, under Release 10666, may be covered by segregation of 
assets equal to 100% of the fund's obligations. Why, if at all, should 
other senior securities be treated differently from bank borrowings for 
purposes of the amount of cover required? Should the Commission revise 
its position in Release 10666 so that all borrowings and their 
functional equivalents are subject to the same asset segregation 
requirements?
2. Alternatives to the Current Asset Segregation Approach
     What alternatives to the segregated account approach, if 
any, should the Commission consider to fulfill the investor protection 
purposes of section 18 of the Act? Please identify any alternative 
measures that would assure adequate coverage of the fund's ongoing 
exposures under a derivative investment, and provide a cushion to cover 
future exposure.
     What benefits would be lost, and/or what costs would 
increase, if an alternative approach to the segregated account were to 
limit funds' use of derivatives?
     As discussed above, the 2010 ABA Derivatives Report 
recommends a more flexible approach to section 18 compliance, under 
which funds would specify a Risk Adjusted Segregated Amount (``RASA'') 
for each derivative investment used by the fund.\120\ Under this 
recommended approach, the amount of assets to be segregated would be 
determined by each fund, based on the risk profiles of the derivative 
instruments (including issuer- and transaction-specific risk) and its 
assessment of risk based upon consideration of relevant risk measures, 
such as VaR, potentially subject to Commission guidance of a general 
nature.\121\ What benefits would accrue to funds and investors from the 
ABA's RASA approach? What would be the costs of this approach? In what 
respects would fund-determined asset segregation policies be expected 
to deviate from the current segregated account approach? Would such 
policies be likely to incorporate VaR or other risk methodologies? Do 
boards, as currently constituted, have sufficient expertise to oversee 
an alternative approach to leverage and derivatives management such as 
RASA and/or VaR? If funds were permitted to determine the cover amount 
for their derivatives investments, should the Commission give guidance 
concerning minimum requirements for cover amounts or methodologies for 
determining cover amounts? If funds were permitted to determine the 
cover amount for their derivatives investments, would the result be 
that different funds would likely reach different determinations, 
resulting in different cover amounts, for the same derivatives?
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    \120\ 2010 ABA Derivatives Report, supra note 8, at 1, 17-18.
    \121\ Id. at 17.
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     Should the Commission consider a bifurcated approach to 
funds' use of derivatives, similar to that set out in CESR's Global 
Exposure Guidelines (which provides two methodologies, the commitment 
approach or an advanced risk measurement method such as VaR)? If the 
Commission were to pursue a bifurcated approach, should funds be 
permitted to elect to use notional amount (or similar reference) or a 
quantitative risk assessment such as VaR, or should funds with 
different levels of derivatives activities be required to choose one or 
the other measure based upon their level of derivatives activities or 
other factors?
     If funds are permitted to choose which quantitative risk 
assessment approach to use, under what circumstances, if any, should 
they be allowed to switch to a different assessment? Should a fund's 
proposed change in assessment require consideration and approval of its 
board of directors? Should shareholder approval of a fund's proposed 
change in assessment be required? For what reason(s) should a fund be 
permitted to change assessments, if any?
     We note that bank capital standards incorporate 
methodologies by which the current exposure and potential future 
exposure created by derivative investments are calculated. The

[[Page 55249]]

potential future exposure calculation is based upon application of a 
specified multiplier, varying with the type and maturity of the 
derivative, to the notional amount of the investment.\122\ Would a 
formula combining 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 provide a more robust measure of risk than the notional 
amount or mark-to-market value of the derivative? If so, are bank 
capital standards a relevant reference point for our consideration of 
the potential future exposure and asset segregation amount? If not, are 
there other preferable standards for measuring the potential future 
exposure of a derivative investment? How, if at all, would such an 
approach address the leverage concerns underlying section 18 of the 
Act? What would be the costs and benefits of employing an asset 
segregation calculation that reflects both current mark-to-market 
values and a potential future exposure approximation calculated by 
reference to notional amount? Given the purposes of section 18, should 
an additional cushion amount be considered in addition to current mark-
to-market value and potential future exposure?
---------------------------------------------------------------------------

    \122\ See 12 CFR 3 at Appendix C to Part 3 (2011) (Capital 
Adequacy Guidelines for Banks: Internal-Ratings-Based and Advanced 
Measurement Approaches).
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     The Commission also requests comment concerning the 
desirability of incorporating a VaR approach or other comparable risk 
measurement methodology in the segregated account approach to section 
18. To what extent do funds currently employ VaR or a comparable risk 
measure as part of their routine portfolio oversight procedures? Would 
a VaR measure, potentially supplemented by stress testing and a 
leverage measure, provide an adequate methodology for addressing 
leverage risks in fund portfolios? What procedures would be required so 
that any VaR methodology chosen by a fund would be implemented in a way 
that adequately captures any additional risks associated with the use 
of leverage and derivatives by a fund? What other quantitative criteria 
might be employed in lieu of, or as a supplement to, VaR? Would 
adoption of VaR or a comparable risk standard require review by the 
Commission or Commission staff of particular risk measurement 
methodologies in order to establish an appropriate level of investor 
protection? What would be the costs and benefits of adopting a VaR 
standard in lieu of an asset segregation approach in addressing the 
treatment of derivatives under section 18?
     UCITS using VaR approaches to measure global exposure 
limits are required to disclose in their prospectus their expected 
level of leverage and the possibility of higher leverage.\123\ In the 
event that the Commission were to accept a VaR approach in connection 
with funds' use of derivatives, should funds be required to disclose 
their expected and/or actual leverage levels?
---------------------------------------------------------------------------

    \123\ See CESR's Global Exposure Guidelines, supra note 87, at 
35.
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     UCITS using VaR approaches to comply with global exposure 
limits are also required to maintain ``a rigorous, comprehensive and 
risk-adequate stress testing program.'' \124\ Should a stress testing 
requirement be imposed upon funds that use derivatives, at least where 
a risk-based methodology is used to determine the required asset 
segregation value? What standards, if any, should the Commission 
establish for stress testing if such a requirement were to be imposed?
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    \124\ Id. at 31.
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     Are there any alternative measures that would provide 
adequate coverage of a fund's future obligations throughout the life of 
a derivative instrument as well as the availability of resources to 
cover unanticipated price movements?
     During the recent credit crisis, did funds that used 
derivatives and leverage demonstrate the ability to foresee and manage 
the risks that manifested themselves in connection with derivatives and 
leverage? Are there examples during the credit crisis where funds 
incurred losses or experienced gains specifically attributable to their 
derivatives usage?
     Is it the case that most futures contracts are highly 
liquid, and that this facilitates rapid liquidation of a losing 
position, enabling funds to minimize losses? Are there futures 
contracts that are not highly liquid? Have there been instances where 
futures contracts, that may typically be considered liquid, have become 
less liquid, or illiquid? If so, please describe. Could there be 
instances in the future where derivatives that have historically been 
considered to be liquid become less liquid, or illiquid? If so, please 
describe.
3. Related Matters
     Do derivatives that create economic leverage, but that do 
not impose future payment obligations on funds, such as purchased 
options or commodity-linked notes, raise the same or similar concerns 
as derivatives that create indebtedness leverage? Do such derivatives 
present any other material concerns to funds or their investors, or 
raise other concerns under the Investment Company Act? If so, how 
should the Commission address them?
     Please comment on these, or any other, alternative 
approaches to the regulation of leverage under the Act. The Commission 
requests comment on whether any other regulatory frameworks provide 
relevant and useful approaches that the Commission should consider.
     Are there special considerations that need to be taken 
into account for smaller funds? How might taking such considerations 
into account impact investor protection?

III. Derivatives Under the Investment Company Act's Diversification 
Requirements

    In this section of the release, the Commission discusses the 
diversification requirements of the Investment Company Act. The 
Commission also explores, and requests comment on, issues that arise in 
the course of applying those requirements to funds' use of derivatives.

A. The Diversification Requirements

    Funds are required to disclose in their registration statements 
whether they are classified as diversified or non-diversified.\125\ A 
fund that discloses in its registration statement that it is classified 
as diversified is prohibited from changing its classification to non-
diversified without first obtaining shareholder approval.\126\ A 
diversified fund is a fund that, with respect to 75% of the value of 
its total assets (the ``75% bucket''),\127\ has (among other things) no 
more than 5% of the value of its total assets invested in the 
securities of any one issuer.\128\ A non-diversified fund is

[[Page 55250]]

any fund that does not meet these requirements.\129\
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    \125\ Section 8(b)(1)(A) of the Act; Form N-1A, Items 16, 4(a) 
and 4(b)(1); Form N-2, Item 17.
    \126\ Section 13(a)(1) of the Act.
    \127\ Rule 5b-1 under the Investment Company Act generally 
defines ``total assets,'' when used in computing values for purposes 
of sections 5 and 12 of the Act, as ``the gross assets of the 
company with respect to which the computation is made, taken as of 
the end of the fiscal quarter of the company last preceding the date 
of computation.''
    \128\ Section 5(b)(1) of the Act. The term ``issuer'' is defined 
in sections 2(a) and 2(a)(22) of the Act as ``unless the context 
otherwise requires, * * * every person who issues or proposes to 
issue any security, or has outstanding any security which it has 
issued.'' In addition, a diversified fund, with respect to the 75% 
bucket, may not own more than 10% of the outstanding voting 
securities of any one issuer. See Section 5(b)(1) of the Act. A fund 
seeking to qualify as a ``regulated investment company'' must comply 
with the diversification requirements of section 851 of the IRC, 
even if the fund is not diversified under the Investment Company 
Act. The diversification requirements under the IRC are similar, but 
not identical, to the diversification requirements of the Investment 
Company Act. See 26 U.S.C. 851(b)(3)(2010).
    \129\ Section 5(b)(2) of the Act.
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    The purpose of the diversification requirements is to prevent a 
fund that holds itself out as diversified from being too closely tied 
to the success of one or a few issuers or controlling portfolio 
companies.\130\ As one commentator has noted, the requirements are 
designed to ensure that investors receive a clear statement of the 
character of the portfolio of the fund in which they have 
invested,\131\ and are intended to prevent any diversified fund from 
becoming non-diversified without the prior approval of its 
shareholders.\132\
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    \130\ Senate Hearings, supra note 49, at 188 (Statement of David 
Schenker, Chief Counsel, Investment Trust Study, SEC, commenting on 
a version of section 5(b)(1) that was similar, but not identical, to 
the current version) (``a diversified company must have at least 
several different securities in its portfolio, and cannot make 
investments which will put them in a controlling position * * *.'').
    \131\ See, e.g., Alfred Jaretzki, Jr., The Investment Company 
Act of 1940, 26 Wash. U. L. Q. 303, 314 n. 34 (Apr. 1941) 
(``Jaretzki'') (the ``distinction between diversified and non-
diversified companies is due in large part, it is believed, to a 
desire to inform stockholders of the character of the portfolio of 
the company in which they have invested.'')
    \132\ Id. at 316-17.
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    For purposes of determining whether a fund is diversified or non-
diversified, the value of the fund's ``total assets'' is generally 
determined as of the end of the fund's last preceding fiscal quarter 
and includes the value of derivatives held by the fund. Under the 
Investment Company Act's definition of ``value,'' \133\ the appropriate 
valuation methodology to be used by a fund generally depends upon: (a) 
Whether market quotations for the fund's portfolio securities \134\ are 
readily available; and (b) whether the fund owned the particular 
portfolio securities or other assets at the end of its last preceding 
fiscal quarter. Specifically, the Act states that, ``unless the context 
otherwise requires,'' the value of a fund's assets for purposes of the 
diversification requirements is as follows:
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    \133\ ``Value'' is defined in section 2(a)(41) of the Act.
    \134\ Sections 2(a) and 2(a)(36) of the Act provide that, 
``unless the context otherwise requires,'' the term ``security'' 
includes, among other things, any ``note'' or ``evidence of 
indebtedness.'' As discussed supra note 57, the definition of the 
term ``security'' in the Act is broader than the definitions of that 
term in the other Federal securities laws and the Commission has 
interpreted the term ``security'' in light of the policies and 
purposes underlying the Act. As a general matter, most derivatives 
appear to be notes or evidences of indebtedness and thus securities 
for purposes of the diversification requirements. Treating 
derivatives as securities for diversification classification 
purposes appears to be consistent with the policies and purposes 
underlying the diversification requirements, including the concern 
that funds that classify themselves as diversified indeed have 
diverse portfolios of investments, the performance of which is not 
tied too closely to the success of one or a few issuers.
---------------------------------------------------------------------------

     For each portfolio security owned at the end of the fund's 
last preceding fiscal quarter for which market quotations are readily 
available, the value of the security is the market value of the 
security at the end of such quarter;
     For any other portfolio security or asset owned at the end 
of the fund's last preceding fiscal quarter, the value of the security 
or asset is the fair value of the security or asset at the end of such 
quarter, as determined in good faith by the fund's board of directors; 
and
     For any security or asset acquired by the fund after the 
last preceding fiscal quarter, the cost thereof.\135\
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    \135\ Sections 2(a)(41)(A)(i), (ii), and (iii) of the Act. 
Market value and fair value are discussed infra at Section VI. 
(Valuation of Derivatives). See also Adoption of Rules Relating to 
the Classification of Management Investment Companies as either 
Diversified or Non-Diversified, Investment Company Act Release No. 
178 (Aug. 6, 1941) [6 FR 3966 (Aug. 8, 1941)].
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B. Application of the Diversification Requirements to a Fund's Use of 
Derivatives

    A diversified fund that contemplates investing in derivatives must 
consider how to value these instruments for purposes of calculating the 
75% bucket based upon its ``total assets'' and for purposes of 
calculating whether the fund has invested 5% of the value of its total 
assets in the securities of any one ``issuer.'' In addition, the fund 
must determine the identity of the issuer of each such derivative.
1. Valuation of Derivatives for Purposes of Determining a Fund's 
Classification as Diversified or Non-Diversified
    When determining the value of a fund's total assets for purposes of 
determining the fund's classification as diversified or non-
diversified, the fund must calculate the value of any derivative held 
by the fund. Under the Act, ``unless the context otherwise requires,'' 
derivatives (and all other assets) held by a fund must be valued for 
diversification purposes using market values and fair values, at the 
end of the fund's last preceding fiscal quarter, or, if subsequently 
acquired, their cost.\136\
---------------------------------------------------------------------------

    \136\ See section 2(a)(41)(A) of the Act.
---------------------------------------------------------------------------

    For purposes of calculating NAV under the Act's valuation 
provisions, derivatives are generally valued using a ``market value'' 
measure for exchange-traded derivatives and a ``fair value'' measure 
for OTC derivatives; under either measure, the value of a derivative 
would appear to be the value at which the derivative could be sold or 
otherwise transferred at the relevant time.\137\ Compliance with the 
valuation provisions of the Act helps to ensure, among other things, 
that the prices at which fund shares are purchased and redeemed are 
fair and do not result in dilution of shareholder interests or other 
harm to shareholders.\138\
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    \137\ For additional discussion of valuation requirements and 
guidance, see infra Section VI. (Valuation of Derivatives).
    \138\ Compliance Programs of Investment Companies and Investment 
Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003) 
[68 FR 74714 (Dec. 24, 2003)] available at http://www.sec.gov/rules/final/ia-2204.pdf.
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    The diversification requirements are designed to prevent a fund 
that holds itself out as diversified from having heightened exposure to 
one or a few issuers and help to accurately inform investors about the 
nature of the fund. Given that derivatives generally are designed to 
convey a leveraged return based on a reference asset over a period of 
time, their mark-to-market values at a given 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 fund under the 
derivatives investment. Use of a mark-to-market value for derivatives 
held by a fund could thus permit a 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, while continuing to classify itself as 
diversified.\139\
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    \139\ For example, a fund that holds itself out as diversified 
may have invested four percent of its assets in securities of an 
issuer to which it has additional exposure through a total return 
swap that creates exposure equal to another four percent of its 
assets on a notional basis, yielding a combined exposure to the 
issuer of eight percent of the fund's total assets. The current 
mark-to-market value of the total return swap would likely be 
sufficiently low to enable the fund to calculate its investments in 
the issuer at less than five percent of its total assets, but, its 
total exposure to that issuer is over five percent of its total 
assets.
---------------------------------------------------------------------------

    Should the Commission consider whether application of the 
diversification requirements to derivatives is a ``context [that] 
otherwise requires'' a different measure of value than the statutory 
definition of ``value?'' The value at which the derivative can be sold 
or otherwise transferred will reflect the gains or losses on that 
investment at a point in time. Would the use of the notional amount of 
the derivative, rather than its liquidation value, better achieve the 
purposes of the diversification provisions of the Act? The Commission 
requests comment on these issues and related questions set forth below.

[[Page 55251]]

2. Identification of the Issuer of a Derivative for Purposes of 
Determining a Fund's Classification as Diversified or Non-Diversified
    The diversification requirements restrict a fund that is classified 
as diversified from investing, with respect to its 75% bucket, more 
than 5% of the value of its total assets in the securities of any one 
issuer. The Act defines the term ``issuer'' as ``every person who 
issues or proposes to issue any security, or has outstanding any 
security which it has issued,'' \140\ unless the context otherwise 
requires.\141\ In general, the ``issuer'' of an OTC derivative entered 
into by a fund would appear to be the fund's counterparty, and the 
``issuer'' of an exchange-traded derivative would appear to be the 
clearinghouse due to the novation.\142\ However, a derivative may have 
a reference asset that also has an issuer, e.g., a total return swap on 
the common stock of a corporate issuer. In such a case, the potential 
exposure of the fund created by the derivative is to both the 
counterparty to the contract and the issuer of the reference security.
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    \140\ Section 2(a)(22) of the Act.
    \141\ Section 2(a) of the Act.
    \142\ See Exemptions for Security-Based Swaps Issued by Certain 
Clearing Agencies, Securities Act Release No. 9222 (June 9, 2011) 
[76 FR 34920 (June 15, 2011)] at n. 18 and accompanying text, 
available at http://www.sec.gov/rules/proposed/2011/33-9222.pdf 
(also describing ``novation'' as a process through which the 
original obligation between a buyer and seller is discharged through 
the substitution of the central counterparty as seller to buyer and 
buyer to seller, creating two new contracts).
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C. Request for Comment

    The Commission requests comment concerning the application of the 
Act's diversification requirements to derivatives held in fund 
portfolios, including the following specific issues:
     Valuation of Derivatives for Purposes of the 
Diversification Requirements. As discussed above, the diversification 
requirements are designed to preclude a fund that has classified itself 
as ``diversified'' from concentrating its portfolio investments in the 
securities of any single issuer. In light of this purpose, how should a 
derivative be valued for purposes of applying the diversification 
tests? Could investors be misled by a fund's disclosure that it is 
diversified when it has ongoing exposure to a single issuer or group of 
issuers in excess of 5% of the fund's assets on a notional basis? In 
what circumstances, if any, would mark-to-market value provide an 
adequate measure of a fund's exposure to an issuer such that the 
purposes of the diversification requirements would be fulfilled? If a 
current market value measure is appropriate for this purpose, should 
any additional safeguards be adopted to address circumstances in which 
a derivative's potential future exposure may materially exceed its 
current market value? For example, should the ``diversification'' 
classification be qualified or supplemented to reflect the impact on 
the fund's diversification of the notional exposures created by 
derivatives? The Commission also requests comment concerning the 
potential for derivatives exposures to be understated. Further, if 
derivatives exposures are potentially understated, how should the issue 
be addressed? For example, should funds be required to provide 
additional information to investors? Also, if mark-to-market values are 
ascribed to derivatives for purposes of the diversification 
requirements, how should negative values for derivatives be treated?
     Alternative Diversification Standards. Should different or 
additional diversification standards be developed that would better 
address the types of exposures attainable through derivatives?
     Treatment of Counterparty Issues under the Diversification 
Requirements. In light of the statutory purpose of preventing a fund 
from holding itself out as diversified even though it is dependent upon 
the performance of a small number of issuers, should counterparties to 
derivatives investments with funds be considered issuers of securities 
for purposes of the diversification requirements? If counterparty 
obligations under a derivative investment are considered securities of 
an issuer for purposes of the diversification requirements, how should 
such obligations be measured for this purpose? The 2010 ABA Derivatives 
Report recommends that, for purposes of determining a fund's 
classification as diversified or non-diversified, a fund should be able 
to disregard its exposures to its derivative investment counterparties 
and that counterparty exposures should be addressed separately under 
section 12(d)(3) of the Act, in part to assure that counterparty 
exposures would be addressed for non-diversified as well as diversified 
funds.\143\ Would it be preferable to address counterparty exposures 
under section 12(d)(3)? \144\ If so, should diversification issues 
relating to counterparties that are not securities-related issuers 
continue to be addressed under the Act's diversification provisions?
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    \143\ 2010 ABA Derivatives Report, supra note 8, at 27-28.
    \144\ Under section 12(d)(3) of the Investment Company Act, 
funds generally may not purchase or otherwise acquire any security 
issued by, or any other interest in, the business of a broker, 
dealer, underwriter, or investment adviser (``securities-related 
issuer''). See infra discussion in Section IV. (Exposure to 
Securities-Related Issuers Through Derivatives).
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     Relevance of Reference Assets Under Derivatives to 
Diversification Requirements. Under the 2010 ABA Derivatives Report's 
suggested approach, a derivative's reference asset would be considered 
a security issued by an issuer for purposes of the diversification 
requirements, an approach that the 2010 ABA Derivatives Report 
indicates is already followed by many funds when calculating ``long 
exposures'' to the fund.\145\ Should the issuer of reference assets 
underlying a derivative entered into by a fund be considered to be the 
issuer of a security for purposes of the diversification requirements 
in lieu of, or in addition to, the counterparty? If not, how, if at 
all, should exposure to the issuer of a reference asset be disclosed to 
investors and the potential inconsistency of such exposure with 
diversification categorization be addressed?
---------------------------------------------------------------------------

    \145\ 2010 ABA Derivatives Report, supra note 8, at 26.
---------------------------------------------------------------------------

     Are there special considerations that need to be taken 
into account for smaller funds? How might taking such considerations 
into account impact investor protection?

IV. Exposure to Securities-Related Issuers Through Derivatives

    Funds engaging in derivatives investments may also confront issues 
under the Act's restrictions upon acquisition of interests in 
securities-related issuers. In this section of the release, the 
Commission discusses the application of section 12(d)(3) and rule 12d3-
1, which address a fund's exposure to securities-related issuers, to 
funds' use of derivatives. The Commission seeks comment on the manner 
in which the Act's prohibition on such acquisitions and the 
Commission's exemptive rule granting limited relief from that 
prohibition should apply in the context of derivatives.

A. Investment Company Act Limitations on Investing in Securities-
Related Issuers

    Under section 12(d)(3) of the Investment Company Act, funds 
generally may not purchase or otherwise acquire any security issued by, 
or any other interest in, the business of a broker, dealer, 
underwriter, or investment adviser (``securities-related

[[Page 55252]]

issuer'').\146\ There are two reasons for this prohibition. First, it 
limits a fund's exposure to the entrepreneurial risks of securities-
related issuers, including the fund's potential inability to extricate 
itself from an illiquid investment in a securities-related issuer.\147\ 
Second, it is one of several Investment Company Act provisions which, 
taken together, prohibit fund sponsors, which include broker-dealers, 
underwriters, and investment advisers, from taking advantage of the 
funds that they sponsor.\148\ Specifically, the prohibition has the 
effect of limiting the possibility of abusive reciprocal practices 
\149\ between funds and securities-related issuers.
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    \146\ Section 12(d)(3) of the Act. See also Statement of the 
Commission Advising All Registered Investment Companies to Divest 
Themselves of Interest and Securities Acquired in Contravention of 
the Provisions of Section 12(d)(3) of the Investment Company Act of 
1940 within a Reasonable Period of Time, Investment Company Act 
Release No. 3542 (Sept. 21, 1962) [27 FR 9652 (Sept. 29, 1962)] 
(``1962 Statement'') (stating that ``prohibited purchases or 
acquisitions occur not only when a security or interest is 
originally purchased or acquired, but also when investment companies 
* * * hold an interest in a portfolio company which thereafter by 
merger, consolidation, reorganization * * * or otherwise, acquires 
an interest in a dealer, broker, underwriter or investment 
adviser''); Exemption for Acquisition by Registered Investment 
Companies of Securities Issued by Persons Engaged Directly or 
Indirectly in Securities Related Businesses, Investment Company Act 
Release No. 13725 (Jan. 17, 1984) [49 FR 2912 (Jan. 24, 1984)] 
(``1984 Proposing Release'') at n.2 and accompanying text 
(discussing the 1962 Statement).
    \147\ See 1984 Proposing Release, supra note 146, at n. 7 and 
accompanying text (discussing that ``[i]n 1940, securities related 
businesses, for the most part, were organized as private 
partnerships. By investing in such businesses, investment companies 
would expose their shareholders to potential losses which were not 
present in other types of investments; if the business failed, the 
investment company as a general partner would be held accountable 
for the partnership's liabilities; if the business floundered, the 
investment company would be locked into its investment.''). Rule 
12d3-1 under the Act has, since 1984, provided a limited exemption 
from section 12(d)(3) for acquisitions of certain securities and, 
until 1993, addressed the liquidity concern underlying section 
12(d)(3) by limiting the equity securities of a securities-related 
issuer that a fund may acquire to ``margin securities,'' as defined 
in Regulation T of the Board of Governors of the Federal Reserve 
System, and generally limiting the permissible debt securities to 
``investment grade securities,'' as determined by at least one 
nationally recognized statistical rating organization. See, e.g., 
1984 Proposing Release, supra note 146, at nn. 24-25 and 
accompanying text. The rule has never permitted a fund to acquire a 
general partnership interest in a securities-related business.
    \148\ See id. at n. 8 and accompanying text.
    \149\  See, e.g., id. at n. 9 and accompanying text (``Such 
reciprocal practices include the possibility that an investment 
company might purchase securities or other interests in a broker-
dealer to reward that broker-dealer for selling fund shares, rather 
than solely on investment merit. Similarly, the staff has expressed 
concern that an investment company might direct brokerage to a 
broker-dealer in which the company has invested to enhance the 
broker-dealer's profitability or to assist it during financial 
difficulty, even though that broker-dealer may not offer the best 
price and execution.'')
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    Rule 12d3-1 under the Act provides funds with a limited exception 
from this prohibition. Under the rule, a fund may acquire securities of 
any person that (a) derives 15 percent or less of its gross revenues 
from ``securities related activities,'' \150\ as long as the fund does 
not control such person after the acquisition, or (b) derives more than 
15 percent of its gross revenues from ``securities related 
activities,'' subject to limits on the percentage of the issuer's 
securities that may be acquired by a fund.\151\ The rule does not 
permit a fund to acquire a general partnership interest in a 
securities-related issuer.\152\
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    \150\ The rule defines ``securities related activities'' as 
``activities as a broker, a dealer, an underwriter, an investment 
adviser registered under the Investment Advisers Act of 1940, as 
amended, or as an investment adviser to a registered investment 
company.''
    \151\ Under these limits, a fund may not acquire more than 5% of 
that class of the issuer's outstanding equity securities or more 
than 10% of the outstanding principal amount of the issuer's debt 
securities, and may not have more than 5% of the value of the fund's 
total assets invested in the securities of the issuer. Rule 12d3-1 
defines ``equity security'' in accordance with rule 3a11-1 under the 
Exchange Act, which in turn includes ``any stock or similar 
security, certificate of interest or participation in any profit 
sharing agreement, preorganization certificate or subscription, 
transferable share, voting trust certificate or certificate of 
deposit for an equity security, limited partnership interest, 
interest in a joint venture, or certificate of interest in a 
business trust; any security future on any such security; or any 
security convertible, with or without consideration into such a 
security, or carrying any warrant or right to subscribe to or 
purchase such a security; or any such warrant or right; or any put, 
call, straddle, or other option or privilege of buying such a 
security from or selling such a security to another without being 
bound to do so.'' Rule 12d3-1 under the Act defines ``debt 
security'' as ``all securities other than equity securities.''
    \152\ Rule 12d3-1 also does not permit the acquisition of a 
security issued by the fund's promoter, principal underwriter, or 
investment adviser, or an affiliated person of the promoter, 
principal underwriter, or investment adviser, subject to an 
exception for certain subadvisory relationships.
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B. Counterparty to a Derivatives Investment

    When a fund invests in an OTC derivative, the fund receives the 
obligation of its counterparty to perform under the contract. If the 
counterparty is a securities-related issuer, a fund's acquisition of 
that obligation may constitute an acquisition of a security or another 
interest in a securities-related issuer within the scope of section 
12(d)(3) of the Investment Company Act.\153\ As noted above, in the 
case of exchange-traded derivatives that are cleared, the issuer of the 
derivative typically is the clearinghouse. In a no-action letter, the 
staff did not object to the assertion that, in acquiring an exchange-
traded option, a fund generally would not appear to be acquiring 
securities issued by, or an interest in, a securities-related 
issuer.\154\ In the case of OTC derivatives, if a fund's counterparty 
is a securities-related issuer, the fund's transaction with the 
counterparty may represent the acquisition of a security issued by, or 
an interest in, that issuer.\155\
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    \153\ If the counterparty is not a securities-related issuer, 
the fund may enter into the transaction without being limited by 
section 12(d)(3). The fund will need to monitor the status of its 
counterparty during the term of the transaction to ensure that the 
counterparty remains a non-securities-related issuer. See 1962 
Statement, supra note 146.
    \154\ See, e.g., Institutional Equity Fund, SEC Staff No-Action 
Letter (Feb. 27, 1984).
    \155\ The Commission has stated, for example, that in entering 
into a repurchase agreement, a fund may be acquiring an interest in 
the counterparty that is prohibited by section 12(d)(3). See, e.g., 
Treatment of Repurchase Agreements and Refunded Securities as an 
Acquisition of the Underlying Securities, Investment Company Act 
Release No. 25058 (July 5, 2001) at n. 5 and accompanying text [66 
FR 36156 at note 5 (July 11, 2001)].
---------------------------------------------------------------------------

    If an OTC derivative with a securities-related issuer as the 
counterparty is a security issued by that counterparty, then the fund 
may be able to rely on rule 12d3-1 to engage in the transaction.\156\ 
If such a derivative is not a security issued by the counterparty, but 
the transaction may be deemed to be the fund's acquisition of ``an 
interest in'' a securities-related issuer (the counterparty), then rule 
12d3-1 would not be available because it exempts only acquisitions of 
securities, and the transaction would be prohibited under the 
Investment Company Act. There is no bright-line test distinguishing 
transactions that may or may not

[[Page 55253]]

constitute a fund's acquisition of an ``interest in'' a securities-
related issuer. However, a fund's acquisition of a general partnership 
interest in a securities-related issuer, whether or not the interest is 
a security, is not permitted by rule 12d3-1.\157\
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    \156\ A derivative is likely to be categorized as a debt 
security subject to the 10% limitation of rule 12d3-1. Rule 12d3-1 
defines ``debt security'' as ``all securities other than equity 
securities.'' The Commission also by order has exempted certain 
transactions from section 12(d)(3) that may have involved a fund's 
acquisition of a security from a securities-related issuer. See, 
e.g., the following orders issued by the Commission involving 
principal-protected funds: AIG SunAmerica Asset Management Corp., et 
al., Investment Company Act Release Nos. 26725 (notice) (Jan. 21, 
2005) [70 FR 3946 (Jan. 27, 2005)] and 26760 (Feb. 16, 2005) (order) 
(by virtue of entering into a protection arrangement with an AIG 
affiliate that is a broker, dealer, underwriter, investment adviser 
to a registered investment company, or an investment adviser 
registered under the Investment Advisers Act, a fund may be deemed 
to have acquired a security from the AGI affiliate); Merrill Lynch 
Principal Protected Trust, et al., Investment Company Act Release 
Nos. 26164 (Aug. 20, 2003) (notice) [68 FR 51602 (Aug. 27, 2003)] 
and 26180 (Sept. 16, 2003) (order) (by virtue of entering into a 
protection arrangement with a Merrill Lynch affiliate that is a 
broker, dealer, underwriter, investment adviser to a registered 
investment company, or an investment adviser registered under the 
Investment Advisers Act of 1940, a fund may be deemed to have 
acquired a security from the Merrill Lynch affiliate).
    \157\ In addition, section 12(d)(3) of the Act prohibits a 
fund's acquisition of any security issued by ``or any other interest 
in'' a securities-related issuer. The Commission has noted that, in 
enacting section 12(d)(3), Congress was particularly concerned with 
funds investing as general partners in securities-related issuers. 
See Exemption of Acquisitions of Securities Issued by Persons 
Engaged in Securities-Related Business, Investment Company Act 
Release No. 19204 (Jan. 4, 1993) [58 FR 3243 (Jan. 8, 1993)] at n. 
10 and accompanying text. Rule 12d3-1(c) provides that ``this 
section does not exempt the acquisition of: (1) a general 
partnership interest[.]''
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C. Exposure to Other Securities-Related Issuers Through Derivatives

    The issue of whether an OTC derivative transaction is prohibited 
under the Investment Company Act as an impermissible acquisition of a 
security issued by, or an interest in, a securities-related issuer, 
also may require analysis of a fund's exposure to a reference asset 
underlying the derivative. If the derivative transaction is based upon 
the price or value of securities issued by, or interests in, a 
securities-related issuer, the fund's relationship to the issuer of the 
reference asset may raise both of the concerns underlying section 
12(d)(3)--the fund's exposure to the risks of that securities-related 
issuer and the potential for reciprocal practices. For example, if the 
issuer of the reference asset is a broker-dealer, and the fund's 
position in the derivative transaction benefits from increases in the 
market price of the reference asset, the fund might direct brokerage or 
other business to that broker-dealer to enhance the broker-dealer's 
profitability. Consequently, the fund could be considered to have 
assumed an exposure to a securities-related issuer that is in violation 
of section 12(d)(3). In that event, the fund would need to consider the 
availability and conditions of rule 12d3-1 with respect to that entity 
before determining whether the fund may, and if so, to what extent, 
enter into the derivative transaction.
    Certain OTC derivative transactions involve credit support 
providers or entities performing similar roles. These entities also may 
be securities-related issuers. In that case, the fund would need to 
determine whether the provision of credit support or similar protection 
for the fund's benefit in the derivative 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.\158\ If it 
does, then the fund would need to analyze the derivative transaction 
under section 12(d)(3) with respect to the credit support provider as 
well.
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    \158\ See rule 12d3-1(d)(7)(v) under the Act, deeming an 
acquisition of demand features or guarantees as not being the 
acquisition of securities of a securities-related issuer provided 
certain conditions are met.
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D. Valuation of Derivatives for Purposes of Rule 12d3-1 Under the 
Investment Company Act

    As noted above, if a derivative transaction involves an acquisition 
by the fund of a security issued by a securities-related issuer, the 
fund may be able to rely on rule 12d3-1 under the Investment Company 
Act, which provides a conditional exemption to the prohibition in 
section 12(d)(3). For purposes of the conditions of rule 12d3-1, if the 
securities-related issuer, in its most recent fiscal year, derived more 
than 15% of its gross revenues from securities-related activities, as 
defined in the rule, the fund would need to determine whether such 
derivative is an equity or debt security and apply the percentage 
limitations in the rule accordingly.\159\ Among other things, the fund 
would need to determine whether, immediately after the acquisition of 
such derivative, the fund has invested not more than five percent of 
the value of its total assets in the securities of the issuer. For 
purposes of this calculation, the exposure of the fund to its 
counterparty or its exposure to the issuer of a reference security may 
be understated were the current market or fair value of the derivative 
the appropriate measure. The potential future exposure of the fund to 
the securities-related issuer is, in each case, likely to be 
unaccounted for by a current mark-to-market standard. Neither the 
Commission nor the staff has addressed this point. The Commission 
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.
---------------------------------------------------------------------------

    \159\ See supra discussion at note 151.
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E. Request for Comment

    The Commission asks for comment on all aspects of the application 
of section 12(d)(3) and rule 12d3-1 to funds' derivative transactions.
     Do commenters believe that OTC derivative transactions 
between funds and securities-related issuers implicate the purposes of 
section 12(d)(3), i.e., protection against the entrepreneurial risks of 
securities-related issuers and the potential for reciprocal practices 
that disadvantage fund investors? If so, in what respects? If not, on 
what basis should a fund's exposure to a securities-related issuer in a 
derivatives transaction be distinguished from other types of 
investments to which section 12(d)(3) applies?
     Do commenters believe that 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)? 
If not, on what basis would such exposure be distinguished from other 
types of investments subject to section 12(d)(3)?
     Should the extent to which the securities-related issuer's 
obligations are secured by collateral provided by the issuer affect 
this analysis? If so, what specific effect should collateral 
arrangements be accorded and by what criteria should qualifying 
collateral arrangements be defined?
     The 2010 ABA Derivatives Report suggests that section 
12(d)(3) ``provides an appropriate framework for dealing with fund 
counterparty exposures.'' \160\ The 2010 ABA Derivatives Report states 
that the counterparties to fund derivative transactions generally fall 
within the categories of securities-related issuers addressed by 
section 12(d)(3) and that, unlike the diversification requirements 
discussed above, section 12(d)(3) applies to all registered investment 
companies, regardless of diversification status. The 2010 ABA 
Derivatives Report also suggests that the Commission or the staff issue 
guidance concerning the manner in which the various provisions of rule 
12d3-1 under the Act should apply to derivatives.\161\ Is rule 12d3-1 
the appropriate framework for exempting certain derivatives 
transactions from section 12(d)(3)? Are the existing percentage 
limitations in rule 12d3-1 appropriate in the context of derivatives? 
Should there be additional limitations or conditions to an exemption 
from section 12(d)(3) for derivative transactions? If so, what types of 
conditions or limitations? The Commission also asks commenters to 
identify and discuss the interpretive issues that may arise when rule 
12d3-1 is applied to funds' use of derivatives.
---------------------------------------------------------------------------

    \160\ 2010 ABA Derivatives Report, supra note 8, at 33. The 
Report states that ``counterparty exposure'' presents ``the concern 
that a counterparty cannot pay a fund the amount that the fund is 
due under the derivative instrument * * *.'' Id.
    \161\ Id. at 34-35.

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[[Page 55254]]

V. Portfolio Concentration

    In this section, the Commission discusses the Investment Company 
Act's provisions regarding portfolio ``concentration'' and the 
application of these provisions to a fund's use of derivatives.

A. Investment Company Act Provisions Regarding Portfolio Concentration

    Funds are required to disclose in their registration statements 
their policy concerning ``concentrating investments in a particular 
industry or group of industries.'' \162\ This requirement reflects the 
view that such a policy is likely to be central to a fund's ability to 
achieve its investment objectives, and that a fund that concentrates 
its investments will be subject to greater risks than funds that do not 
follow the policy.\163\ The concentration requirements also are 
intended to prevent funds from substantially changing the nature and 
character of their businesses without shareholder approval.\164\ Funds 
are prohibited from deviating from their policy concerning 
``concentration of investments in any particular industry or groups of 
industries'' as recited in their registration statements without 
obtaining shareholder approval.\165\ The Investment Company Act does 
not include definitions of the terms ``concentration'' and ``industry 
or groups of industries.'' The Commission has stated generally that a 
fund is concentrated in a particular industry or group of industries if 
the fund invests or proposes to invest more than 25% of the value of 
its net assets in a particular industry or group of industries.\166\ 
The Commission also has stated that, in determining industry 
classifications, a fund may select its own industry classifications, 
but such classifications must be reasonable and should not be so broad 
that the primary economic characteristics of the companies in a single 
class are materially different.\167\
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    \162\ See Section 8(b)(1)(E) of the Act; Form N-1A, Items 4, 9 
(instruction 4) and 16(c)(1)(iv); and Form N-2, Items 8.2.b(2) and 
17.2.e.
    \163\ Registration Form Used by Open-End Management Investment 
Companies, Investment Company Act Release No. 23064 (Mar. 13, 1998) 
(``Release 23064'') [63 FR 13916 (Mar. 23, 1998)] at nn. 98-99 and 
accompanying text.
    \164\ See Jaretzki, supra note 131, at 317. The concentration 
requirements focus on all of the funds' investments, and not solely 
on their investments in securities.
    \165\ Section 13(a)(3) of the Act. See also Securities and 
Exchange Commission's Brief Amicus Curiae dated March 25, 2010, In 
re: Charles Schwab Corp. Securities Litigation, Master File No. C-
08-01510-WHA (N.D. Cal.) (``SEC Schwab Amicus Brief'') at 2-3; In 
re: Charles Schwab Corp. Securities Litigation, No. C 08-01510 WHA, 
2010 U.S. Dist. LEXIS 32113 (N.D. Cal. Mar. 30, 2010) (``Schwab 
Opinion'') at *3-*4.
    \166\ See also Form N-1A, Item 9, instruction 4 (defining 
industry concentration for Form N-1A disclosure purposes as 
``investing more than 25% of a Fund's net assets in a particular 
industry or group of industries''); but compare Form N-2, Item 8.2.b 
(instruction) (defining industry concentration for Form N-2 purposes 
as ``25 percent or more of the value of Registrant's total assets 
invested or proposed to be invested in a particular industry or 
group of industries''). See also, e.g., Release No. 23064, supra 
note 163, (``The Commission's staff has taken the position for 
purposes of the concentration disclosure requirement that a fund 
investing more than 25% of its assets in an industry is 
concentrating in that industry.'').
    \167\ See SEC Schwab Amicus Brief, supra note 165, at 8 and 9. 
See also Schwab Opinion, supra note 165, at *20 (``This order agrees 
* * * that a promoter is free to define an industry in any 
reasonable way when it establishes a fund and assumes for sake of 
argument that the promoter may unilaterally, even after the fund is 
up and running, clarify in a reasonable way a definitional line that 
may otherwise be vague. But once the promoter has drawn a clear line 
and thereafter gathers in the savings of investors, the promoter 
must adhere to the stated limitation unless and until changed by a 
stockholder vote.'')
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B. Issues Relating to the Application of the Act's Concentration 
Provisions to a Fund's Use of Derivatives

    When a fund enters into a derivatives transaction, the fund may 
gain exposure to more than one industry or group of industries. For 
example, if a fund and a bank enter into a total return swap on stock 
issued by a corporation in the pharmaceuticals industry, the fund will 
have gained exposure to the banking industry (i.e., the industry 
associated with the fund's counterparty) as well as exposure to the 
pharmaceuticals industry (i.e., the industry associated with the issuer 
of the reference asset). As noted above, the Commission has stated that 
generally a fund is concentrated in a particular industry or group of 
industries if the fund invests or proposes to invest more than 25% of 
the value of its net assets in a particular industry or group of 
industries. This standard does not, by its terms, address derivative 
transactions by which a fund obtains exposure to a particular industry 
or group of industries, whether through exposure to the counterparty to 
the transaction or through its contractual exposure to a reference 
asset.
    Another issue relevant to determining industry concentration is 
whether a fund values its derivatives using notional amount or market 
value. The 2010 ABA Derivatives Report states that ``using the notional 
value, rather than the market value, of a derivative instrument may 
inflate an industry position relative to the fund's current economic 
exposure.'' \168\ The 2010 ABA Derivatives Report further states that 
``funds typically comply with their concentration policies by looking 
to the reference asset and not any counterparty to the derivative 
instrument. Funds typically use market values for these calculations * 
* *.'' \169\
---------------------------------------------------------------------------

    \168\ 2010 ABA Derivatives Report, supra note 8, at n. 57.
    \169\ Id. at 29.
---------------------------------------------------------------------------

C. Request for Comment

    The Commission requests comment on the application of concentration 
requirements to funds' investments in derivatives, including the 
following questions.
     How do funds apply the concentration requirements to their 
investments in derivatives? Do they consider current market value or 
the notional amount of a derivative (or some other measure) for 
purposes of determining whether they have invested 25% or more of the 
value of their net assets in a particular industry or group of 
industries? Do funds focus solely upon the exposures to the industries 
with which their derivatives counterparties are associated, or do they 
also take into account their exposures to the industry or industries 
(if any) of the reference assets underlying those derivatives?
     Is it consistent with the policies and purposes underlying 
the concentration requirements for funds to focus on the industry of 
the issuer of the reference asset and disregard the exposure to the 
industry or industries with which the derivatives counterparty is 
associated? Should this depend on the level of collateral (if any) 
posted by the counterparty?
     Should the Commission provide guidance to funds on how 
they should comply with the concentration requirements when they use 
derivatives? If so, what should that guidance entail?
     Are there special considerations that need to be taken 
into consideration for smaller funds? How might taking such 
considerations into account impact investor protection?

VI. Valuation of Derivatives

    In this section, the Commission discusses, and requests comment on, 
the valuation of derivatives used by funds for purposes of applying the 
various provisions of the Investment Company Act.

A. Investment Company Act Valuation Requirements

    When calculating their NAVs, funds must determine the value of 
their assets, including the value of the derivatives that they hold. 
The Investment Company Act specifies how funds must determine the value 
of their assets.

[[Page 55255]]

Under the Act, all funds (other than money market funds),\170\ whether 
open-end or closed-end, must calculate their NAVs by using the market 
values of their portfolio securities when market quotations for those 
securities are ``readily available.'' \171\ When market quotations for 
a fund's portfolio securities or other assets are not readily 
available, the fund must calculate its NAV by using the fair value of 
those securities or assets, as determined in good faith by the fund's 
board of directors.\172\
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    \170\ Money market funds that comply with the provisions of rule 
2a-7 under the Act [17 CFR 270.2a-7], however, may value their 
portfolio securities on the basis of amortized cost. In addition, 
under certain circumstances, open-end funds may value certain of 
their portfolio securities on the basis of amortized cost. See 
Valuation of Debt Instruments by Money Market Funds and Certain 
Other Open-End Investment Companies, Investment Company Act Release 
No. 9786 (May 31, 1977) [42 FR 28999 (June 7, 1977)], available at 
http://www.sec.gov/rules/interp/1977/ic-9786.pdf.
    \171\ Section 2(a)(41)(B) of the Act. See also ASR 118 and ASR 
113, supra note 14. ``Readily available'' refers to public market 
quotations that are current, i.e., ``[r]eadily available market 
quotations refers to reports of current public quotations for 
securities similar in all respects to the securities in question.'' 
ASR 113, supra note 14, at 2.
    \172\ ASR 113, supra note 14.
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    There is no single methodology for determining the fair value of a 
security or other asset because fair value depends upon the facts and 
circumstances of each situation.\173\ As a general principle, however, 
the fair value of a security or other asset held by a fund would be the 
amount that the fund might reasonably expect to receive for the 
security or other asset upon its current sale.\174\ When determining 
the fair value of a security or other asset held by a fund, all 
indications of value that are available must be taken into 
account.\175\
---------------------------------------------------------------------------

    \173\ ASR 118, supra note 14.
    \174\ ASR 113 and ASR 118, supra note 14.
    \175\ ASR 118, supra note 14.
---------------------------------------------------------------------------

B. Application of the Valuation Requirements to a Fund's Use of 
Derivatives

    For many derivatives that are securities, such as exchange-traded 
options, market quotations typically are readily available. As a 
result, a fund generally must use market values to value such 
derivatives. For many other derivatives, however, market quotations are 
not readily available, and a fund that holds such derivatives is 
required to value those derivatives at their fair values as determined 
by the fund's board of directors.
    Valuation of some derivatives may present special challenges for 
funds. Some derivatives may have customized terms, including 
contractual restrictions on their transferability. Some derivatives 
also may restrict a fund's ability to close out the contract or to 
enter into an offsetting transaction. For some derivatives, there may 
be no quotations available from independent sources, and for some 
derivatives the fund's counterparty may be the only available source of 
pricing information.

C. Request for Comment

    The Commission requests comment on funds' valuation of derivatives, 
including the following questions:
     How do funds determine the fair values of derivatives that 
they hold? To what extent do valuation determinations depend upon the 
type of derivative, reference asset, trading venue, and other factors?
     How do funds, when fair valuing derivatives, assess the 
accuracy and reliability of pricing information that is obtained from 
their counterparties or from other sources?
     How do funds take into account, when valuing derivatives, 
contractual restrictions on transferability, and restrictions on their 
ability to close out the transactions or to enter into offsetting 
transactions?
     Some derivatives held by funds may have negative values 
due to, among other things, changes in the value of the reference 
assets underlying the derivatives. Do funds calculate the values of 
such derivatives in the same manner as they value derivatives that have 
positive values? If not, why not?
     Should the Commission issue guidance on the fair valuation 
of derivatives under the Investment Company Act? If so, what issues 
should be addressed by that guidance?
     Are there special considerations that need to be taken 
into consideration for smaller funds? How might taking such 
considerations into account impact investor protection?

VII. General Request for Comment

    In addition to the specific issues highlighted for comment, the 
Commission invites members of the public to address any other matters 
that they believe are relevant to the use of derivatives by funds.

    Dated: August 31, 2011.

    By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-22724 Filed 9-6-11; 8:45 am]
BILLING CODE 8011-01-P