As discussed in the March 2016 edition of

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1 The Investment Lawyer Covering Legal and Regulatory Issues of Asset Management VOL. 23, NO. 6 JUNE 2016 Industry Response to SEC Derivatives and Senior Securities Rule Proposal By Philip Hinkle, Matthew Kerfoot, and Nathaniel Dreyfuss As discussed in the March 2016 edition of The Investment Lawyer, 1 proposed Rule 18f-4 under the Investment Company Act of 1940 (1940 Act) would substantially limit the ability of registered investment companies and business development companies (BDCs) (collectively, funds) to invest in derivatives and incur other forms of leverage. Under the proposed rule, a fund may enter into derivatives and financial commitment transactions subject to the satisfaction of three conditions: (i) for funds that utilize derivatives, compliance with notional portfolio limitations, (ii) compliance with uniform asset segregation requirements, and (iii) implementation of board-approved procedures and derivatives risk management programs for certain funds that utilize derivatives. In some cases, the proposed rule could cause certain types of funds, such as leveraged ETFs and managed futures mutual funds, to cease operations as currently structured or otherwise operate in a form other than as a registered investment company. The Securities and Exchange Commission (SEC) received more than 175 comment letters in response to the proposal. While many commenters welcomed the SEC s interest in addressing the patchwork of SEC and Staff guidance under Section 18 of the 1940 Act, the vast majority of the letters requested that the SEC change primary aspects of the proposed rule. This article summarizes and reviews the principal arguments made in those letters. Comments on the Proposed Notional Portfolio Limits The proposed rule would permit a fund to enter into derivatives transactions provided that, immediately after entering into each derivative or other senior securities transaction: The aggregate exposure of the fund does not exceed 150 percent of the value of the fund s net assets; or If the fund s derivatives use reduces its market risk (called value-at-risk (VaR)), the aggregate exposure of the fund does not exceed 300 percent of the value of the fund s net assets. In either case, exposure is measured as the sum of (i) aggregate derivatives notional amounts (with a special definition for complex derivatives ); (ii) aggregate financial commitment obligations; and (iii) aggregate indebtedness with respect to any other senior securities transaction. Scope of Affected Funds Wider Than Identified under SEC Data The notional portfolio limits in the proposed rule were based, in part, on a study conducted by

2 2 THE INVESTMENT LAWYER the SEC s Division of Economic and Risk Analysis (DERA). However, the Investment Company Institute (ICI) conducted a study that concluded that the proposed rule would have a larger-thananticipated impact on the industry. The ICI wrote in its letter 2 that the DERA study had evaluated a limited data set in evaluating the impact of the proposed rule, and, as a result, the ICI did not believe the SEC was able to evaluate fully the impact of the notional portfolio limits on funds. The ICI conducted its own study to determine the effect of the proposed portfolio limits on funds and received information on 6,661 funds with a total of $13.6 trillion in assets under management as of year-end According to the ICI, the sample represented 59 percent of the industry-wide number and 80 percent of the industry-wide assets of long-term mutual funds (including variable annuities and funds-offunds), closed-end funds, and 1940 Act registered exchange-traded funds. The DERA study had estimated that about 4 percent of the existing funds would exceed the 150 percent exposure limit and about 1 percent would exceed the 300 percent exposure limit. The ICI argued that these figures, however, failed to focus on the absolute number of funds that would be affected and their total assets. The ICI study determined that 471 funds with $613 billion in assets would exceed the 150 percent exposure limit and 173 funds with $338 billion in assets would exceed the 300 percent exposure limit. Moreover, in contrast to the DERA study, which, as the ICI wrote, failed to note any particular impact on bond funds, the ICI study indicated that the proposed portfolio limits would have unintended consequences on taxable bond funds. The ICI explained that taxable bond funds often use derivatives to mitigate risks (for example, to hedge interest-rate risk or credit risk) or gain exposure to the fixed income markets. The ICI study showed that 42 percent or 198 of the 471 funds with exposures relative to their assets greater than 150 percent were taxable bond funds. These bond funds represented 79 percent or $485 billion of the $613 billion in assets over the 150 percent exposure limit. Overall, these funds represented 10 percent of the industry-wide number and 15 percent of the industry-wide assets of taxable bond funds. The ICI study also found that the 300 percent exposure limit has the greatest impact on taxable bond funds, as a group 64 percent or 111 of the 173 funds with exposure greater than 300 percent were taxable bond funds. These funds represented 80 percent or $269 billion of the $338 billion in assets over the 300 percent exposure limit. Overall, these funds represented 6 percent of the industrywide number and 8 percent of the industry-wide assets of taxable bond funds. Consistent with the DERA study, the ICI found that the portfolio limits would have a disproportionate impact on alternative funds 47 percent or 221 of the 471 funds with notional values greater than 150 percent relative to their assets were alternative funds. These alternative funds represented 13 percent or $79 billion of the $613 billion in assets over the 150 percent exposure limit. Overall, these funds represented 34 percent of the industry-wide number and 37 percent of the industry-wide assets of alternative funds. Based on the ICI s analysis, at least 393 funds, with $463 billion in assets under management, either would have to de-register or substantially change their investment strategies to continue their businesses as registered funds. In light of the results of the study, the ICI urged the SEC to more fully and carefully consider the consequences of the proposed portfolio limits. The significance of the ICI study was underscored by the various comment letters that cited to or quoted from the ICI study, including the letter from the Asset Management Group of the Securities Industry and Financial Markets Association (SIFMA letter) and the joint letter from the Managed Funds Association and Alternative Investment Management Association (MFA/AIMA letter). 3

3 VOL. 23, NO. 6 JUNE Legal and Policy Arguments Against Notional Limits As would be expected based on the results of the ICI study, the notional portfolio limitations in particular attracted an extensive amount of commentary from fund companies and trade associations. Many commenters opposed the limitations on both legal and policy grounds. The MFA/AIMA letter noted that the SEC and its Staff interpretations of Section 18 began with the issuance of Investment Company Act Release No in 1979 (Release 10666) and continued in a series of subsequent no-action letters. Over time, through Release and these no-action letters the SEC developed the segregated account approach, which requires a fund to segregate liquid assets sufficient to meet potential obligations arising from, or to enter into offsetting positions against, the fund s investment in certain types of instruments, including reverse repurchase agreements, firm commitment agreements and standby commitment agreements, and other practices with analogous effects on the capital structure of the fund. The MFA/AIMA letter acknowledged that the SEC has taken the position that derivatives may raise senior securities issues under Section 18 and would be subject to this asset segregation approach. However, through a series of no-action letters, the SEC Staff has taken the position that these transactions would not be senior securities if funds were to cover their obligations under the instruments or enter into offsetting positions, consistent with SEC guidance. MFA/AIMA referenced an SEC no-action letter issued to Dreyfus Strategic Investing & Dreyfus Strategic Income fund in In that letter, the SEC stated that, with respect to the derivatives transactions entered into by the funds, [w]e agree that, if a fund meets the segregation requirements, a senior security would not be present and, therefore, the 300-percent asset-coverage requirement of Section 18(f) would not apply. MFA/AIMA noted that, in 1995, the SEC again addressed the issue in the context of short sales when it stated that if the funds segregated an amount that, when combined with the amount deposited with their broker as collateral, is equal to the current market value of the underlying instrument as it varies over time, there would be no senior security concerns related to the transaction. 4 MFA/ AIMA further noted that, in a 1996 letter issued to Merrill Lynch Asset Management, 5 SEC Staff again addressed the matter by issuing relief to a fund engaged in derivatives trading, stating that the Staff would not recommend enforcement under Section 18 provided the [f]und covers its obligations that may otherwise be deemed to be senior securities. In 2011, MFA/AIMA stated that the SEC set forth its asset segregation approach to derivatives under Section 18 of the 1940 Act in its derivatives concept release. Based on this pattern of SEC guidance, the MFA/AIMA letter argued that it is well-settled under both the actions of the SEC itself and of the Staff, that when a fund complies with the segregation requirements, the Section 18 senior securities concept does not apply to derivatives transactions. With respect to general SEC policy, several letters stated that the SEC s long-standing asset coverage regime has successfully addressed undue derivatives speculation in the nearly 40 years since Release was issued. 6 Asset segregation, including segregation based on mark-to-market amounts, has worked effectively to protect investors in funds from losses due to the inability of funds to meet their obligations under derivatives and financial commitment transactions. 7 Several commenters stated that the long-standing regulatory framework permitting funds use of derivatives and other instruments where funds enter into offsetting transactions or segregate assets to cover exposures has served funds and fund investors well. 8 Commenters also noted that the SEC did not appear to present convincing evidence that would justify imposing additional leverage limits beyond the asset coverage requirements already in place. 9 As the Financial Services Roundtable (FSR) argued, for nearly four decades, the fund industry has followed

4 4 THE INVESTMENT LAWYER SEC guidance assuring that the asset coverage requirements set forth in Release 10666, and reaffirmed in subsequent SEC Staff positions, will satisfy the investor protection purposes and concerns underlying Section 18 because such requirements will function as a practical limit on the amount of leverage which [funds] may undertake and on the potential increase in the speculative character of an investment in the fund, and will assure the availability of adequate funds to meet the obligations arising from such activities. 10 However, the FSR letter stated that they are aware of no instances since the publication of Release 10666, including during the global financial crisis of , of a fund being unable to satisfy its derivatives obligations when in compliance with the Commission s asset coverage requirements. 11 The FSR letter addressed, in particular, the isolated instances identified by the SEC in the proposing release of funds incurring substantial losses in connection with certain derivatives or financial commitment transactions. According to the FSR letter, while these instances demonstrate the risks of derivatives investments, they do not, however, demonstrate changes in the nature of the derivatives markets or funds use of derivatives that undermine the rationale behind the asset segregation approach of Release as an appropriate and sufficient means, when combined with adequate disclosures, of satisfying the investor protection purposes and concerns underlying Section Several letters cited Commissioner Piwowar, 13 who stated in his dissent that [T]he proposed asset segregation requirements should function as a leverage limit on funds and ensure that funds have the ability to meet their obligations arising from derivatives. Therefore, absent data indicating that a separate specified leverage limit is warranted there is no justification for imposing any additional requirements or burdens on funds. This is particularly the case given that our current guidance to funds concerning their derivatives transactions rests solely on asset segregation. Comments on the Inability of Notional Limits to Accurately Capture Risk Several letters questioned the SEC s reliance on notional exposure to gauge the relative risk of a fund s portfolio. The Delta Strategy Group letter (DSG letter) 14 argued that using gross notional amounts to measure the leverage and risk resulting from a fund s derivatives holdings is flawed because gross notional amount has little relationship to the leverage and risk that the SEC purports it would measure. A fund with a high gross notional amount of derivatives exposure, according to the letter, may be riskier, less risky, or equally risky as a fund without any derivatives exposure. Delta Strategy Group further argued that gross notional amounts are understood to be poor measures of market exposure, because for most derivative transactions the cash flow obligations are a small percentage of the derivatives notional amounts. Gross notional amounts can also be misleading because they do not account for differences across different types of derivative contracts. The DSG letter explained that the meaning of the gross notional amount can vary depending on the type of derivative being considered. For example, in an interest rate derivative, the notional amount refers to the hypothetical underlying amount used to calculate cash flow obligations. For a credit default swap, the notional amount refers to the par amount of credit protection bought or sold and is used for both coupon payment calculations for each payment period and setting the recovery amounts in the event of a default. For an equity derivative, the notional amount refers to the hypothetical amount that can be used to calculate equity swap cash flows, or the value of the delivery obligation for physically-settled equity forwards. Similar arguments questioning the ability of notional exposure to address risk concerns were expressed in the MFA/AIMA letter and other letters.

5 VOL. 23, NO. 6 JUNE The SIFMA letter, along with the DSG letter, made the argument that the adoption of a notionalbased leverage limit for funds does not reduce risk and, instead, actually leads to incentives to invest based on notional size rather than economic effect. SIFMA expressed concerns that that the notional portfolio limits could create perverse incentives for portfolio managers of funds to invest in riskier, less liquid instruments. SIFMA provided an example. The risk to a fund of a listed futures contract on a 30-year US Treasury bond is substantially greater than the risk to the fund of a listed futures contract on a two-year Treasury bond. Under the proposed rule, though, each of these derivatives would contribute equally to a fund s exposure without accurately capturing the risks associated with each instrument. According to the SIFMA letter, a portfolio manager could be disincentivized from investing in the lower-risk bond futures contracts since these lower-risk contracts would use up the same amount of space in the notional limit exposure calculation as the higher-risk bond futures contracts while the higher-risk contracts would have greater possibility of appreciation. Similarly, the letter from the Center for Capital Markets Competitiveness (CCMC) 15 stated that using the notional value as the reference for the exposure-based limit is an exceedingly blunt method of measuring potential risk posed by a fund s derivatives holdings. While it is administratively easy to use a notional test, as the CCMC letter argued, the use of this type of test does not accurately measure potential risk profiles, particularly among different types of derivatives. Echoing the DSG letter, CCMC stated that the risk profile of an interest rate swap can differ dramatically from the risk profile of a credit default swap, even if they both have the same notional value. Further, the CCMC letter also critiqued the accuracy of the proposed rule s risk measurements, adding that certain derivatives may offset risk to one another, but if those derivatives do not satisfy the netting provisions of the proposed rule, the risk measurement using notional value alone will treat those derivatives as having a greater total risk than were the derivatives risk accurately offset. Comments on Calculating Notional Exposure Among the comment letters, one of the most frequent points was that if the SEC does proceed with implementing notional portfolio limits, it should adjust these limits based on the specific type of the derivatives transactions. These letters generally argued that the calculation of notional exposure for various derivatives transactions, and particularly for fixed-income derivatives, should be subject to certain haircuts to more appropriately address the specific risks arising from each underlying asset class. The SIFMA letter, for example, stated that revisions to the calculation of exposure for both of the proposed notional portfolio limits are appropriate to accurately value derivatives exposure and measure relative risk among all portfolio assets, including non-derivatives. As SIFMA wrote, use of a risk-adjusted exposure would also allow funds more freedom to select the most liquid and least costly instruments to mitigate risk. For example, using a listed futures overlay to hedge duration and interest rate risk of a long-term bond portfolio, according to the SIFMA letter, is often more cost-effective than selling the long-dated bonds and replacing them with newly issued instruments when rates change or are anticipated to change. The SIFMA letter stated that it is both counterintuitive and counterproductive for SEC rules to penalize [funds] for selecting more liquid and more cost-effective investments. 16 In order to standardize valuations and provide regulators with a uniform but intelligent point of comparison, SIFMA recommended differentiating derivatives by risk in reliance on uniform risk adjustments. SIFMA explained that uniform risk schedules are currently used by regulators for different purposes and could be effectively adapted for purposes of the proposed rule. As regulators have recognized, risk adjustments through application of different valuation haircuts reflect differing credit, liquidity, and market

6 6 THE INVESTMENT LAWYER risk inherent in the instruments. SIFMA suggested the standard initial margin schedule published by the Bank for International Settlements (BIS). SIFMA noted that prudential regulators globally rely on this schedule as a framework to risk-weight different assets and SIFMA suggested that it could effectively be used by funds to determine the relative riskiness of the referenced assets. According to SIFMA, the proposed BIS table would provide a conservative risk adjustment and be an appropriate measure of risk. Similarly, the MFA/AIMA letter suggested risk adjustments to notional exposure in response to the SEC s request for comment on whether there are other appropriate adjustments for determining a fund s exposure to certain derivatives, such as Euribor and Eurodollar futures, that the SEC should consider to avoid overstating a Fund s derivatives investment exposure. MFA/AIMA recommended that the calculation of a risk-adjusted exposure be based on the initial margin requirements of the final rules of the Federal Reserve and other prudential regulators. The MFA/AIMA letter stated that using these final margin rules would be subject to less discretion for interpretation, reducing possible market manipulation or abuse. Comments on the Asset Segregation Requirements The proposed rule would also require a fund to segregate on its books qualifying coverage assets daily. For derivatives, such qualifying coverage assets would be equal to the sum of a mark-to-market coverage amount plus a risk-based coverage amount and for a newly defined category of instruments, financial commitment transactions, equal to the fund s financial commitment obligations. The proposed rule would define the mark-tomarket coverage amount as the amount payable by the fund if the fund were to exit the derivatives transaction at the time of measurement. The markto-market coverage amount would be reduced by the value of any variation margin but not by any initial margin. The proposed rule would define the risk-based coverage amount as a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions. This amount must be determined using board-approved policies and procedures that take into account the structure, terms, and characteristics of the derivatives transaction and the underlying reference asset. The SEC states in the proposing release that a fund could use one or more financial models that take these factors into account to determine the risk-based coverage amount. The risk-based coverage amount would be reduced by the value of initial margin or other collateral but not variation margin. The proposed rule would also impose an obligation on a fund engaged in financial commitment transactions, defined as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement, whether conditional or unconditional. Under the proposed rule, a fund must segregate an amount equal to the fund s financial commitment obligations, defined as the amount of cash or other assets the fund is required to pay or deliver under a financial commitment transaction. Qualifying Coverage Assets Comments Under the proposed rule, the qualifying coverage assets that a fund may segregate to cover its obligations under derivatives positions are limited to cash, cash equivalents, and the particular asset with which a Fund may satisfy its delivery obligation under a derivatives transaction or financial commitment transaction. 17 Many letters urged the SEC to expand the categories of assets eligible to satisfy the asset segregation requirements. As the ABA letter argued, 18 the proposed rule would prevent funds from segregating many of the types of assets that they have segregated in connection with their derivatives since 1996, when the SEC Staff issued the Merrill Lynch letter. The Merrill Lynch letter permitted funds to segregate any asset,

7 VOL. 23, NO. 6 JUNE including equity securities and non-investmentgrade debt, so long as the asset is liquid and markedto-market daily. 19 The ABA letter explained that the Merrill Lynch letter significantly increased the degree to which funds could use derivatives because all or substantially all of their portfolio securities could be used to cover their derivatives positions. By contrast, the proposed rule would significantly decrease the extent to which funds would be able to use derivatives. The ABA previously noted its concern regarding restrictions on the types of assets that may be segregated to cover a Fund s performance of its obligations under its derivatives. In its 2011 Task Force Report, 20 the ABA expressed the view that the SEC should not limit the types of assets that may be segregated to only cash, US Government securities, and other high grade obligations because, for many funds, holding more than a minimal amount of such securities would be inconsistent with their investment objectives and policies. For that reason, the ABA argued in its letter, the limitations on qualifying coverage assets contained in the proposed rule would prevent some funds from entering into derivative instruments that otherwise would be appropriate for them. The ABA letter asserted that Section 18 does not require this result, which is not in the interests of funds or their shareholders. Rather, as the ABA stated in the Task Force Report, the nature of the assets that a fund may segregate to cover its obligations should be addressed in policies and procedures developed by a fund s adviser, approved by the fund s board, and disclosed to potential fund investors. The FSR letter also noted that limiting qualifying coverage assets essentially to cash and cash equivalents also would be inconsistent with the SEC s proposed rules regulating assets for collateralizing non-cleared security-based swaps and similar collateral requirements of other regulators, including the CFTC. The FSR letter cited the CFTC s recently adopted margin rules, in which the CFTC broadened the scope of collateral eligible to post as margin. The FSR letter further argued that, under the proposed rule, it would be an odd result if, on the one hand, both the mark-to-market coverage amounts and risk-based coverage amounts could be reduced by the value of assets representing variation margin or collateral (in the case of mark-to-market coverage amounts) or initial margin or collateral (in the case of risk-based coverage amounts), but on the other hand, if the assets that could be used for margin could not count as qualifying coverage assets if they were not used as margin. Concerns Specific to Currency- Hedged Exchange-Traded Funds One commenter noted that the SEC s proposed definition of qualifying coverage assets would particularly affect currency-hedged index ETFs, which have attracted significant assets in recent years. 21 As the Dechert letter explained, currency movements can significantly affect the total returns of international investments across asset classes. The higher the currency volatility, the larger the potential impact on portfolio returns when measured in the base currency. For investors seeking to reduce volatility, currency-hedged ETFs provide a solution by allowing them to hedge the currency of their investment returns into that of their target base currency. The impact of currency movements is thus reduced by implementing a currency hedge. Currency-hedged indices typically assume 100 percent investment in non-us securities and currency hedging instruments (typically one month forward currency contracts). In turn, currency-hedged ETFs invest as close as possible to 100 percent of their assets in non-us securities and currency-hedging instruments in order to track their respective benchmark indices. Typically, such ETFs only maintain minimal amounts of cash or cash equivalents; the ETFs use the securities in their portfolios for asset coverage purposes. The Dechert letter argued that the requirement to maintain cash or cash equivalents as qualifying coverage assets would restrict currency-hedged

8 8 THE INVESTMENT LAWYER ETFs ability to achieve their investment objectives and strategies. According to the Dechert letter, requiring such ETFs to hold cash or cash equivalents would not just add a cash drag on the absolute performance of a fund that otherwise would be fully invested but would also prevent a currencyhedged index ETF from accurately tracking its index. The indices tracked by currency-hedged ETFs would not include the cash or cash equivalents required to be held by the ETF as qualifying coverage assets and an ETF that is required to hold such assets, therefore, would experience structural tracking error (the difference between the performance of the ETF and that of its underlying benchmark) that could be substantial. The proposal to limit the scope of assets that may be used as qualifying coverage assets for derivative transactions thus would have disproportionate impact on currency-hedged ETFs. Comments on the Derivatives Risk Management Program Under the proposed rule, a fund that engages in any derivatives transaction must adopt a written derivatives risk management program, unless the fund complies with a portfolio limit under which (i) the aggregate exposure associated with the fund s derivatives transactions (based on the notional value of the derivatives) does not exceed 50 percent of the value of the fund s net assets immediately after entering into any derivatives transaction; and (ii) the fund does not enter into any complex derivatives transactions. The proposed rule would require the derivatives risk management program to include various elements, including written policies and procedures reasonably designed to segregate the fund s derivatives risk management functions from the fund s portfolio management and assess and manage the risks associated with the fund s derivatives transactions, including leverage risk, market risk, counterparty risk, liquidity risk, and operational risk, as applicable, and any other risks considered relevant. In addition, the fund would be required to review and update the program periodically (at least annually), including any models (including any VaR calculation models used by the fund during the period covered by the review), measurement tools, or policies and procedures that are part of, or used in, the program to evaluate their effectiveness and reflect changes in risks over time. A great number of comment letters generally supported the establishment of a derivatives risk management program. 22 Suggested improvement to the derivatives risk management program included the establishment of a de minimis level of activity to address the complex derivatives transactions condition. For example, the FSR letter agreed that a 50 percent notional threshold represents an appropriate threshold for determining which funds must adopt and implement a derivatives risk management program. However, the FSR letter argued that a de minimis threshold for a fund s use of complex derivatives transactions should be implemented. The FSR letter argued that a fund should not be required to adopt and implement a derivatives risk management program if the fund does not exceed the 50 percent notional threshold and the fund s aggregate exposure associated with the fund s complex derivatives transactions does not exceed 5 percent of the value of the fund s net assets. According to the FSR letter, such a de minimis threshold would be helpful in avoiding the application of more rigorous and costly derivatives risk management compliance requirements to funds where the use of derivatives and complex derivatives transactions represents a demonstrably insignificant portion of the fund s overall investment program and risk profile. Commenters also focused on the board s involvement with the derivatives risk management program. The ABA letter urged the SEC to carefully consider the role of a fund s board in connection with the proposed rule and whether it is appropriate to involve the board so deeply in areas where, despite their general oversight responsibility, they must as a practical matter rely on the expertise of

9 VOL. 23, NO. 6 JUNE the fund s investment adviser or third-party consultants. The ABA letter added that, while a board is responsible for overseeing the identification and mitigation of risks, the ABA is concerned that imposing specific, new responsibilities on boards of the type required by the proposed rule may go a step beyond the traditional [b]oard role into areas that are properly the province of the investment adviser. 23 Comments on the Necessity or Appropriateness of the Proposed Rule Some commenters, particularly the Dechert letter, argued that the proposed rule may be vulnerable to legal challenges under the 1940 Act. While many of the comment letters addressed perceived overstated benefits and understated costs of the proposed rule generally, several comment letters noted that these disproportionate costs relative to the benefits may fatally undermine the SEC s authority to regulate derivatives as proposed. As stated in the Dechert letter, we do not believe the [cost-benefit analysis] supports the purposed benefits on which the Derivatives Restrictions rely. Accordingly, the imposition of a new comprehensive and restrictive regime, as is contemplated under the proposed rule, would be viewed as being neither necessary nor appropriate. 24 The Dechert letter grounds this claim in the provisions of the 1940 Act restricting the issuance of regulations under, and exemptions to, the provisions of the 1940 Act. The 1940 Act requires any regulation issued by the SEC to be necessary or appropriate to the exercise of the Commission s powers 25 and any exemption must be necessary or appropriate in the public interest. 26 Further, the Supreme Court has ruled that the costs and benefits of any regulation must be considered in any analysis of whether a regulation issued is necessary or appropriate. 27 Thus, the Dechert letter argued, because the costbenefit analysis of the proposed rule does not support the benefits alleged and imposes substantial costs on an industry that has already been subject to effective regulation, it is neither necessary nor appropriate. As the proposed rule is neither necessary nor appropriate, the SEC lacks statutory authority to issue the regulation under the 1940 Act and the proposed rule would be vulnerable to legal challenge on those grounds. Messrs. Hinkle and Kerfoot are partners, and Mr. Dreyfuss is an associate, in the Financial Services Group of Dechert LLP. The authors, along with other attorneys at Dechert LLP, submitted a comment letter on the proposed rule and consulted with numerous industry participants in connection with their comment letters. NOTES 1 Philip Hinkle and Matthew Kerfoot, An Overview of the SEC s Derivatives and Senior Securities Transactions Rule Proposal, The Investment Lawyer, Vol. 23, No. 3 (March 2016), available at IL_0316_Hinkle_Kerfoot.pdf. 2 Letter from David W. Blass, General Counsel, Investment Company Institute, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 28, 2016 (the ICI letter). 3 See Letter from Stuart J. Kaswell, Executive Vice President & Managing Director, General Counsel, Managed Funds Association, and Jiří Król, Deputy CEO, Alternative Investment Management Association, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 28, 2016 (the MFA/AIMA letter); Letter from Timothy W. Cameron, Esq., Asset Management Group Head, Securities Industry and Financial Markets Association, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 28, 2016 (the SIFMA letter). 4 MFA/AIMA letter, citing Robertson Stevens Investment Trust, SEC No-Action Letter (Aug. 24, 1995).

10 10 THE INVESTMENT LAWYER 5 MFA/AIMA letter, citing Merrill Lynch Asset Management, L.P., SEC No-Action Letter, 1996 WL (July 2, 1996) (Merrill Lynch letter). 6 See, e.g., the MFA/AIMA letter, and Letter from David M. Lynn, Chair, Federal Regulation of Securities Committee, ABA Business Law Section, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated April 8, 2016 (the ABA letter). 7 SIFMA letter. 8 See, e.g., Letter from Richard Foster, Senior Vice President and Senior Counsel for Regulatory and Legal Affairs, Financial Services Roundtable, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 28, 2016 (the FSR letter). 9 MFA/AIMA letter. 10 FSR letter, citing Release FSR letter. 12 Id. 13 See, e.g., FSR letter, quoting Michael S. Piwowar, Commissioner, US Securities and Exchange Commission, Dissenting Statement at Open Meeting on Use of Derivatives by Registered Investment Companies and Business Development Companies (Dec. 11, 2015). See also, MFA/AIMA letter and ICI letter. 14 Letter from James A. Overdahl, Delta Strategy Group, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 24, 2016 (the DSG letter). 15 Letter from Tom Quaadman, Senior Vice President, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 28, 2016 (the CCMC letter). 16 SIFMA letter. 17 For financial commitment transactions, the definition of qualifying coverage assets is broadened to include assets that are convertible to or will generate cash prior to the payment date of, or that are pledged with respect to, a financial commitment transaction. 18 ABA letter. 19 Merrill Lynch letter. 20 Report of the Task Force on Investment Company Use of Derivatives, American Bar Association, Dechert LLP, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 24, 2016 (the Dechert letter). See also, Ben Eisen and Sarah Krouse, Currency-Hedged Funds Safer or Riskier Thanks to Derivatives?, Wall Street Journal, April 11, See, e.g., the ICI letter, the MFA/AIMA letter, SIFMA letter, the CCMC letter, the FSR letter, and the Letter from Robert C. Grohowski, General Counsel Investment Advisers Association, to Brent J. Fields, Secretary, Securities and Exchange Commission, dated March 28, 2016 (the IAA letter). 23 ABA letter. 24 See also, FSR letter ( the Commission must demonstrate that the real and substantial costs associated with the Proposed Rule, which would ultimately be borne by fund investors, are justified by demonstrable gains in risk reduction ), MFA/AIMA letter ( In our view, the discussion of the Proposed Rule s quantifiable benefits and costs in the Proposing Release falls short in demonstrating meaningful benefit to investors. ) U.S.C. 80a-37(a) U.S.C. 80a-6(c). 27 Michigan v. E.P.A., 135 S.Ct (2015). Copyright 2016 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer, June 2016, Volume 23, Number 6, pages 12 21, with permission from Wolters Kluwer, New York, NY, ,