Funds Use of Derivatives November 8, Derivatives: A Regulatory Overview

Transcription

1 MUTUAL FUND DIRECTORS FORUM AND COLUMBIA UNIVERSITY Funds Use of Derivatives November 8, 2007 Derivatives: A Regulatory Overview Susan C. Ervin Dechert LLP Washington, DC susan.ervin@dechert.com 2006 Dechert LLP

2 Board Responsibility: Informed Oversight Knowledgeable, meaningful oversight of adviser and other service providers Not responsible for management of specific investment decisions or mastery of specific instruments Seek to ensure that fund management has expertise, resources, capabilities and risk management controls sufficient to manage the fund s derivative transactions Board responsibility for approving valuation procedures 2

3 Board Responsibility: Informed Oversight (continued) The SEC has stated that fund boards have a particular responsibility to ask questions concerning: Why and how the fund uses futures and other derivative instruments Risks of using such instruments The effectiveness of internal controls designed to monitor risk and assure compliance with investment guidelines regarding the use of such instruments 3

4 Topics for Discussion How are derivatives regulated? Investment Company Act of 1940 (1940 Act) Subchapter M of the Internal Revenue Code (IRC) Commodity Exchange Act (CEA) Swaps and other unregulated derivatives 4

5 Mutual Funds and Derivatives In General Investment activity subject to 1940 Act, Subchapter M, and CEA 1940 Act and Subchapter M geared toward conventional securities investments; CEA governs futures trading Derivatives tend to reflect design innovations that repackage conventional instruments Many derivative investments test the scope of existing standards large regulatory gray areas Current SEC stance: senior staff stresses need for enhanced attention to derivatives; most SEC guidance antedates current generation of derivative products 5

6 Derivatives Regulation, Aerial View UNREGULATED REGULATED SWAPS, OTHER EXCLUDED AND EXEMPTED TRANSACTIONS FUTURES/ COMMODITY OPTIONS UNREGULATED - FORWARDS/SPOT SECURITIES OPTIONS/HYBRID PRODUCTS 6

7 Dual-Status Products Security Futures DB Commodity Tracking Fund PIMCO TRAKRS Hybrid Securities Futures Futures Contracts Commodity Options Securities Securities Options on Securities Options on Futures Unregulated Transactions Spot Forward Swaps 7

8 Derivatives Regulators Futures Options on Futures Options on Commodities COMMODITY FUTURES TRADING COMMISSION SECURITIES AND EXCHANGE COMMISSION Securities Options on Securities CFTC/SEC Single Stock Futures 8

9 Exchange vs. OTC Transactions Futures Contracts Swaps and Other OTC Derivatives Contract Terms Standardized Customized Margin Settlement; Margin Amount Daily; Exchange Minimum Determined by Contract Trading Mechanism Exchange Bilateral Agreement Netting/Clearing Regulated Clearinghouse Netting To Extent Provided by Contract 9

10 Selected 1940 Act Issues for Mutual Funds Compliance with fund investment policies Adequacy of prospectus disclosure Senior security prohibition Liquidity constraints Section 12(d)(3) limitations on investments in securities of certain financial intermediaries 10

11 Selected Legal and Regulatory Issues for Mutual Funds (continued) Valuation Diversification requirements Subchapter M of IRC: income and diversification tests 11

12 Senior Security Issues Many derivatives considered senior securities, which are largely prohibited for mutual funds, absent asset reserve ICA senior security bar applies to investments that create leverage Leverage means risk exposure of instrument exceeds initial capital outlay Functional definition of senior security based on leverage reaches, e.g., forwards, futures, written options Swaps generally considered senior securities Structured notes generally not senior securities 12

13 Senior Security Issues (continued) To avoid senior security status: asset segregation ( cover ) Liquid assets or offsetting position equal to market exposure/notional amount Amount of required cover may vary by product category 13

14 Liquidity No more than 15% of net assets may be invested in illiquid assets: 7-day liquidity test Fact-based assessment of product and market Exchange-traded products generally liquid Elective termination provisions may be used to ensure liquidity of OTC derivatives 14

15 Valuation Issues Daily valuation requirement for mutual funds Market quotations, if readily available; otherwise, fair value per board-approved procedures 15

16 ICA Section 12(d)(3) Section 12(d)(3) bars investments in securities issued by, or any other interest in, a broker, dealer, underwriter or investment adviser if: the investment would exceed 5% of investment company s total assets or the investment company would own more than 5% of the issuer s outstanding equity securities or more than 10% of outstanding principal amount of issuer s debt securities, Unless issuer derived <15% of gross revenues from securities-related activities during last fiscal year. Question: Is a swap or other derivative a security issued by the counterparty? 16

17 IRC Subchapter M For pass-through tax treatment: income and diversification tests. Income Test: 90% of regulated investment company (RIC) income to be derived from dividends, interest and gains from business of investing in securities. Diversification Tests: (a) (b) at close of each quarter, RIC must have at least 50% of total asset value invested in: cash; cash items; government securities; securities of other RICs; and other securities (with securities of any one issuer not exceeding 5% of RIC assets or 10% of issuer s voting securities); no more than 25% of total assets in securities of any 1 issuer or of 2 or more issuers controlled by RIC and engaged in similar business. 17

18 Income Test: Commodity-Linked Swaps Ruling December 2005: IRS rules that income from commodity-linked swaps is not qualifying income for purposes of 90% test Subsequent private letter rulings confirm that qualifying income would arise from certain commodity-linked notes, which (among other things) gave RIC redemption right on 1-day notice and automatic redemption based on specified index decline 18

19 Commodity Exchange Act: Special Issues for Exchange Traded Futures Contracts CFTC Commodity Pool Operator Registration/Exemption Issues for Collective Investment Vehicles and Advisers Speculative Position Limits Large Trader Reports (Form 40) 19

20 Swap Transactions Swap documentation defines the key rights, duties and terms of dealing for the parties ISDA (International Swaps and Derivatives Association) standard documents are the foundation for negotiated, customized terms Credit, liquidity, pricing and bankruptcy protections depend upon negotiated contract terms 20

21 ISDA Swap Documentation ISDA Master Agreement Schedule to the Master Agreement Credit Support Annex Trade Confirmations Events of Default Eligible Collateral Legal Terms Termination Events Threshold & Calculations Economic Terms 21

22 OTC Derivatives Markets: Negotiated Protections Replace Regulatory Safeguards In OTC context, dealers and their counterparties define terms of dealing and must address credit risk, liquidity drops, market disruptions and other contingencies Given unregulated state of market, no firewalls protect against contagion effects of market disruptions ISDA documentation under constant review and refinement; possible under-representation of asset managers and end-user interests 22

23 OTC Derivatives Markets: Negotiated Protections Replace Regulatory Safeguards (continued) Market trends and regulatory concerns affect contract terms and process e.g., ISDA Novation Protocol, response to documentation backlog at dealer firms Contract terms should reflect current risk issues, e.g., enhanced force majeure provisions post-9/11; credit, liquidity and valuation sensitivity impacted by subprime events 23

24 Conclusion Use of derivatives entails product choices that: impact multiple regulatory variables/uncertainties under the 1940 Act and Internal Revenue Code call for design of tailored contract provisions to address, e.g., liquidity, credit exposure and pricing issues pose risk management and supervisory challenges that call for specialized expertise and procedures 24