On August 31, 2011, the Securities and Exchange Commission (the “SEC”) published a Concept Release and requested comments on issues concerning the use of derivatives by investment companies, including mutual funds, closed-end funds, exchange-traded funds and business development companies. Although the Concept Release makes few specific proposals, it lays the groundwork for future action that could change the regulatory landscape affecting funds that use derivatives. At this stage, it is unclear whether the SEC will focus solely on derivatives, or whether the SEC will consider the use of structured products by funds.

The Concept Release appears to be motivated by a belief that the time is ripe for a comprehensive SEC review of how funds use derivatives. The Concept Release states that the SEC seeks to evaluate whether the existing regulatory framework, as it applies to funds’ use of derivatives, continues to fulfill the purposes and policies underlying the Investment Company Act of 1940 (the “1940 Act”) and is consistent with investor protection.

The Concept Release states that funds using derivatives must consider, among other things:

  • Leverage limitations in Section 18 of the 1940 Act that apply to funds;
  • Portfolio diversification;
  • Industry concentration;
  • Investment in securities-related issuers;
  • Valuation;
  • Accounting and financial reporting; and
  • Disclosures.

The Concept Release recognizes that compliance with these statutory and regulatory restrictions may be difficult because derivatives may involve multiple risk exposures and values must be assigned to each exposure. The Concept Release discusses OTC and exchange-traded derivatives. For a complete discussion of the Concept Release, see our alert at http://www.mofo.com/files/Uploads/Images/110906-SEC-Tackles-Fund-Use-of-Derivatives.pdf. It seems likely that the SEC will take some action to address these concerns, but it is equally likely that the issues discussed in the Concept Release will generate a significant number of substantive comments. It will take the SEC and its staff a considerable amount of time and effort to sort through and evaluate these comments. We will monitor the developments related to this Concept Release and the potential impact on structured products.