Derivatives and You: Trustee Oversight of Derivatives and Leverage

Transcription

1 Derivatives and You: Trustee Oversight of Derivatives and Leverage September 23, 2010 Prepared for the Mutual Fund Directors Forum Presented by Jay G. Baris Attorney Advertising

2 Contents Caveats Background Origin of Trustee Oversight Responsibilities Trustees Oversight of Derivatives Current Developments and Outlook 1

3 Caveats This outline is for informational purposes only and does not by itself constitute legal advice or create an attorney-client relationship IRS Circular 230 Disclosure To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein This outline may constitute attorney advertising 2

4 Background What is a derivative? A derivative is simply a financial instrument whose value is derived from another asset or metric Primary categories of derivatives Futures and forward contracts Options Swaps Other complex instruments Structured notes Asset-backed and mortgage-backed securities 3

5 Background Derivatives used for Hedging Reducing risks or costs with no incremental increase in risk Generating return Asset substitution Gain access to markets or securities when direct investment is difficult or impossible Gain exposure to market pending investment in securities Target exposure to specific sectors 4

6 Background Growth of fund use of derivatives Congress noted that steady rise in interest rates beginning in 1994 hurt CMO market and resulted in large amount of CMO derivatives In response, Congress asked SEC to study how funds use derivatives SEC Division of Investment Management cited limited use of derivatives, but noted potential for increased volatility from leverage Study emphasized increased disclosure Renewed interest by SEC in increased derivatives usage 5

7 Background Risks and controls Leverage (actual and embedded) Liquidity of fund assets Counterparty risks 6

8 Background Operational and regulatory considerations Fund operations Custody and collateral Senior security and asset segregation Issuer exposure Valuation Accounting and financial reporting Tax Disclosure Enterprise risk 7

9 Trustee Oversight of Derivatives Origin of responsibilities Section 18(f) generally prohibits funds from issuing senior securities except under limited circumstances Senior security is any security or obligation that creates a priority over any other class to a distribution of assets or payment of a dividend Congress sought to limit speculative character of junior securities SEC concerned that leverage increased speculative investing 8

10 Origin of Trustee Oversight Responsibilities SEC Release ( Ten-Triple-Six ) Starting point of SEC s derivatives policies Focus on reverse repos, firm commitments, standby commitments, because they involve leverage Does not refer to derivatives Intended to address all comparable trading practices affecting a fund s capital structure SEC said that if fund covers a senior security by maintaining a segregated account, the staff will not raise the issue of compliance with Section 18 Asset coverage serves to limit leverage and assure liquidity to meet fund s obligations 9

11 Origin of Trustee Oversight Responsibilities SEC cautioned fund directors to consider potential loss of flexibility when evaluating use of leverage. SEC said trustees of funds entering into transactions involving such securities trading practices should review documents to ensure complete disclosure of leverage, including Potential risk of loss Identifying transactions as separate and distinct from underlying securities Differing investment goals when using transactions Any other material relating information relating to entering into those transactions (Read transactions to include derivatives ) 10

12 Trustee Oversight of Derivatives Summary of fund trustee responsibilities Investments generally Trustees are responsible generally for oversight of fund investments Trustees must ensure that risks assumed are consistent with disclosures Oversight of derivatives is generally the same as oversight of other investments Fair valuation Trustees are responsible for establishing fair value procedures used to price derivatives in the absence of readily available market quotations 11

13 Trustee Oversight of Derivatives Compliance Trustees are responsible generally for adopting compliance procedures reasonably designed to prevent violations of securities laws Code of Ethics Trustees are responsible for approving code of ethics Risk Management Rules do not impose day-to day risk management responsibilities on fund trustees Funds must disclose role of trustees in risk oversight General fiduciary responsibilities 12

14 Trustee Oversight of Derivatives Level of expertise Fund trustees are not expected to be technical experts in derivatives Trustees not expected to micromanage details of individual derivatives Business judgment rule Board actions generally are protected from judicial inquiry if the trustees acted on an informed basis, in good faith and that actions are in the best interests of shareholders 13

15 Trustee Oversight of Derivatives Gohlke speech OCIE Associate Director Gene Gohlke identifies risks that fund trustees should monitor, including Intellectual and financial resources of adviser Trustee due diligence on new products and strategies Adequacy of Adviser s investment risk management function Adequacy of public disclosure of investment and operational risks Prevention of misuse of non-public information 14

16 Trustee Oversight of Derivatives Gohlke speech OCIE Associate Director Gene Gohlke identifies risks that fund trustees should monitor, including Assurance that funds have adequate liquidity Measurement and monitoring of embedded economic leverage Valuation Back office capacity to handle crises Service provider compliance procedures Role of fund s CCO in monitoring risks Board reporting 15

17 Current Developments and Outlook Regulatory dichotomy Director Donohue identifies gap between technical compliance by funds with 1940 Act and actual performance Reaffirms relevance of Ten Triple Six to fund trustees Asks whether SEC should impose new limits on leverage Patchwork of SEC regulation is sufficient Trustees are exercising meaningful oversight 16

18 Current Developments and Outlook Regulatory dichotomy Challenges ABA group to address concerns that Funds should have a means to deal effectively with derivatives outside of disclosure; A fund's approach to leverage should address both implicit and explicit leverage; and A fund should address diversification from investment exposures taken on versus the amount of money invested 17

19 Current Developments and Outlook 2010 Task Force response Task force of Committee on Federal Regulation of Securities offers suggestions to SEC Calls for principles-based approach to regulation of derivatives and leverage Seeks clarification that trustee role is one of oversight 18

20 Current Developments and Outlook 2010 SEC announces study of fund derivatives practices (March 25) Defers consideration of requests for exemptive orders by ETFs that make extensive use of derivatives Study will look at whether Current market practices involving derivatives are consistent with leverage, concentration and diversification requirements of 1940 Act Leveraged funds maintain adequate risk management Fund boards are providing appropriate oversight of use derivatives Existing rules are sufficient to address procedures for pricing and liquidity determinations concerning derivatives holdings Existing prospectus disclosures adequately address the derivatives risks Funds derivatives activities should be subject to special reporting requirements 19

21 Current Developments and Outlook 2010 SEC staff reminds funds of disclosure obligations Staff: some derivatives-related disclosures may not be consistent with requirements Generic disclosures are of limited use to investors Lengthy, highly technical disclosure could mislead Urges review for accurate, complete and understandable disclosure tailored to a fund s actual use of derivatives SEC likely to publish guidance or notice of rule making by end of 2010 (July 30) 20

22 Current Developments and Outlook 2010 Dodd Frank Act Imposes federal regulation of derivatives markets and their significant players Requires central clearing and exchange trading of many derivatives Imposes asset segregation requirements on non-cleared transactions Prohibits certain swap market participants from receiving federal assistance Effectively pushes these activities out of banks Effect on funds? 21

23 Current Developments and Outlook Outlook for fund trustees Trustees can expect increased scrutiny of their oversight of derivatives use by funds Focus on risk oversight and disclosure SEC or staff action by year-end Combination of principles-based guidance possibly accompanied by substantive limits on funds Disclosure, disclosure, disclosure 22

24 Derivatives and You: Trustee Oversight of Derivatives and Leverage September 23, 2010 Prepared for the Mutual Fund Directors Form Presented by Jay G. Baris Attorney Advertising