On August 31, 2011, the SEC issued a concept release seeking public comment on a wide range of issues relevant to the use of derivatives by investment companies, including the different types of derivatives used by different types of funds as well as the risks and costs of the use of derivatives. The concept release is a continuance of the SEC‟s review of the use of derivatives by investment companies in order to determine whether additional investor protections might be necessary under the 1940 Act.

The concept release requests comment on the following specific topics:

  • Restrictions on senior securities: Section 18 of the 1940 Act and related SEC guidance place limitations on a fund‟s issuance of senior securities in order to limit the risks of excessive borrowing and leverage of a fund‟s portfolio. The SEC requests views relating to asset segregation and how funds measure leverage, among other things.
  • Compliance with diversification requirements: In determining whether a fund is “diversified” or “non-diversified” under the 1940 Act, the value of a fund‟s total assets is reviewed. The SEC requests views relating to how a fund should value a derivative in order to determine the percentage of a fund‟s total assets invested in a particular company.
  • Exposure to securities-related issuers: Section 12(d)(3) of the 1940 Act and the rules thereunder place limitations on funds‟ investments in broker-dealers, underwriters and investment advisers. The SEC requests comments relating to how funds treat derivatives issued by securitiesrelated issuers, specifically whether they are treated differently from other securities issued by securities-related issuers.
  • Portfolio concentration: Similar to the SEC‟s request relating to diversification, the SEC asks for views regarding how funds apply their concentration requirements to their investments in derivatives.
  • Valuation of derivatives: The 1940 Act specifies how funds must determine the value of their assets when calculating net asset value. When market quotations are not available for a security, the fund must calculate its net asset value using the fair value of the security. The SEC requests comments on how funds value derivatives and whether the SEC should issue guidance on the fair valuation of derivatives.

In addition to the specific issues noted above, the SEC invites public comment relating to any other matters that are relevant to the use of derivatives by funds. Comments are due by November 7, 2011.