On March 25, 2010, the SEC announced its staff was conducting a review of the use of derivatives by investment companies, including mutual funds and exchange-traded funds (ETFs), to determine if additional protections are necessary for these funds. Pending completion of this review, the SEC staff is deferring consideration of certain requests for exemptive relief under the Investment Company Act of 1940 (the Investment Company Act) to form ETFs that particularly rely on swaps and other derivative instruments to achieve their investment objectives. The SEC has stated that the deferral does not affect any existing ETFs or other types of fund applications for exemptive relief.

Evaluation of the Use of Derivatives

The press release relating to this announcement indicated that in its review of the use of derivatives by investment companies, the SEC staff intends to explore, among other issues, whether:

  • current market practices involving derivatives are consistent with the leverage, concentration and diversification provisions of the Investment Company Act.
  • 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 the fund’s derivatives transactions.
  • fund boards of directors are providing appropriate oversight of the use of derivatives by funds.
  • existing rules sufficiently address matters such as the proper procedure for a fund’s pricing and liquidity determinations regarding its derivatives holdings.
  • existing prospectus disclosures adequately address the particular risks created by derivatives.
  • funds’ derivative activities should be subject to special reporting requirements.

The release further stated that the SEC staff will also seek to determine what, if any, changes in SEC rules or guidance may be warranted.

Andrew Donohue, Director of the SEC’s Division of Investment Management, had previously asked the American Bar Association to look at investment companies’ use of derivatives. Mr. Donohue indicated at the SEC Speaks 2010 conference that the SEC will consider the ABA’s report, among other resources, in its review of the use of derivatives. The SEC has not provided any projected completion date for the SEC staff’s review.

Deferral of Certain ETF Exemptive Applications

The announced deferral of the consideration of certain ETF exemptive applications will affect new and pending exemptive requests to operate actively managed and leveraged ETFs that rely heavily on swaps and other derivative instruments to achieve their investment objectives. The SEC staff has indicated that if a fully transparent, actively managed ETF applicant agrees that it will not invest in futures, swaps and options, its application will be considered. The SEC staff also clarified that ETFs operating under existing exemptive orders are not affected and can continue to issue new ETFs. Leveraged and inverse ETF applicants will be more adversely affected as nearly all such ETFs rely extensively on the use of derivatives in order to achieve their performance objectives. Elizabeth Osterman, an Associate Director in the Division of Investment Management, has stated that two or three exemptive applications for leveraged ETFs currently under review by her office will be affected by the deferral.

The Investment Company Institute has issued a statement to the effect that, while it supports the SEC’s review of the use of derivatives, it is concerned that the deferral will disadvantage new and pending ETF applicants relative to other ETFs that may currently use similar strategies.

A copy of the press release is available at: http://www.sec.gov/news/ press/2010/2010-45.htm.