[Federal Register Volume 76, Number 173 (Wednesday, September 7, 2011)]
[Rules and Regulations]
[Pages 55237-55255]
[FR Doc No: 2011-22724]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 271

[Release No. IC-29776; File No. S7-33-11]
RIN 3235-AL22

Use of Derivatives by Investment Companies Under the Investment
Company Act of 1940

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; request for comments.

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SUMMARY: The Securities and Exchange Commission (the ``Commission'')
and its staff are reviewing the use of derivatives by management
investment companies registered under the Investment Company Act of
1940 (the ``Investment Company Act'' or ``Act'') and companies that
have elected to be treated as business development companies (``BDCs'')
under the Act (collectively, ``funds''). To assist in this review, the
Commission is issuing this concept release and request for comments on
a wide range of issues relevant to the use of derivatives by funds,
including the potential implications for fund leverage,
diversification, exposure to certain securities-related issuers,
portfolio concentration, valuation, and related matters. In addition to
the specific issues highlighted for comment, the Commission invites
members of the public to address any other matters that they believe
are relevant to the use of derivatives by funds. The Commission intends
to consider the comments to help determine whether regulatory
initiatives or guidance are needed to improve the current regulatory
regime for funds and, if so, the nature of any such initiatives or
guidance.

DATES: Comments should be received on or before November 7, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/concept.shtml);
     Send an e-mail to<EMAIL_ADDRESS>or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.

All submissions should refer to File Number S7-33-11. This file number
should be included on the subject line if comments are submitted by e-
mail. To help us process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (http://www.sec.gov/rules/concept.shtml). Comments are also available for public inspection and
copying in the Commission's Public Reference Room, 100 F Street, NE.,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. All comments received will be posted without change;
the Commission does not edit personal identifying information from
submissions. Therefore, you should only submit information that you
wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Edward J. Rubenstein, Senior Special
Counsel, or Michael S. Didiuk, Senior Counsel, at<PHONE_NUMBER>,
Office of Chief Counsel, Division of Investment Management, Securities
and Exchange Commission, 100 F Street, NE., Washington, DC 20549-5030.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
    A. Purpose and Scope of the Concept Release
    B. Background Concerning the Use of Derivatives by Funds
    C. Request for Comment
II. Derivatives Under the Senior Securities Restrictions of the
Investment Company Act
    A. Purpose, Scope, and Application of the Act's Senior
Securities Limitations
    1. Statutory Restrictions on Senior Securities and Related
Commission Guidance
    2. Staff No-Action Letters Concerning the Segregated Account
Approach
    B. Alternative Approaches to the Regulation of Portfolio
Leverage
    1. The Current Asset Segregation Approach
    2. Other Approaches
    C. Request for Comment
    1. Issues Concerning the Current Asset Segregation Approach
    2. Alternatives to the Current Asset Segregation Approach
    3. Related Matters
III. Derivatives Under the Investment Company Act's Diversification
Requirements
    A. The Diversification Requirements
    B. Application of the Diversification Requirements to a Fund's
Use of Derivatives
    1. Valuation of Derivatives for Purposes of Determining a Fund's
Classification as Diversified or Non-Diversified
    2. Identification of the Issuer of a Derivative for Purposes of
Determining a Fund's Classification as Diversified or Non-
Diversified
    C. Request for Comment
IV. Exposure to Securities-Related Issuers Through Derivatives
    A. Investment Company Act Limitations on Investing in
Securities-Related Issuers
    B. Counterparty to a Derivatives Investment
    C. Exposure to Other Securities-Related Issuers Through
Derivatives
    D. Valuation of Derivatives for Purposes of Rule 12d3-1 Under
the Investment Company Act
    E. Request for Comment
V. Portfolio Concentration
    A. Investment Company Act Provisions Regarding Portfolio
Concentration
    B. Issues Relating to the Application of the Act's Concentration
Provisions to a Fund's Use of Derivatives
    C. Request for Comment
VI. Valuation of Derivatives
    A. Investment Company Act Valuation Requirements
    B. Application of the Valuation Requirements to a Fund's Use of
Derivatives
    C. Request for Comment
VII. General Request for Comment
* * * * *

I. Introduction

    The activities of funds, including their use of derivatives, are
regulated extensively under the Investment Company Act,\1\ Commission
rules, and Commission guidance.\2\ Derivatives may

be broadly described as instruments or contracts whose value is based
upon, or derived from, some other asset or metric (referred to as the
``underlier,'' ``underlying,'' or ``reference asset'').\3\ As detailed
below,\4\ funds employ derivatives for a variety of purposes, including
to increase leverage to boost returns, gain access to certain markets,
achieve greater transaction efficiency, and hedge interest rate,
credit, and other risks.\5\ At the same time, derivatives can raise
risk management issues for a fund relating, for example, to leverage,
illiquidity (particularly with respect to complex OTC derivatives), and
counterparty risk, among others.\6\
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    \1\ 15 U.S.C. 80a. All statutory references to the Investment
Company Act are to 15 U.S.C. 80a, and, unless otherwise stated, all
references to rules under the Investment Company Act are to Title
17, Part 270 of the Code of Federal Regulations [17 CFR 270]. All
references to the Securities Act of 1933 (the ``Securities Act'')
are to 15 U.S.C. 77a, and, unless otherwise stated, all references
to rules under the Securities Act are to Title 17, Part 230 of the
Code of Federal Regulations [17 CFR 230]. All references to the
Securities Exchange Act of 1934 (the ``Exchange Act'') are to 15
U.S.C. 78a, and, unless otherwise stated, all references to rules
under the Exchange Act are to Title 17, Part 240 [17 CFR 240].
    \2\ The staff has also issued no-action and other letters that
relate to fund use of derivatives. In addition to Investment Company
Act provisions, funds using derivatives must comply with all other
applicable statutory and regulatory requirements, such as other
Federal securities law provisions, the Internal Revenue Code (the
``IRC''), Regulation T of the Federal Reserve Board (``Regulation
T''), and the rules and regulations of the Commodity Futures Trading
Commission (the ``CFTC''). See also Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act, Public Law 111-203, 124
Stat. 1376 (2010) (the ``Dodd-Frank Act''), available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.
    \3\ See, e.g., Board Oversight of Derivatives, Independent
Directors Council Task Force Report (July 2008) (``2008 IDC
Report'') at 1, 3, available at http://www.ici.org/pdf/ppr_08_derivatives.pdf. See also Mutual Funds and Derivative Instruments,
Division of Investment Management Memorandum transmitted by Chairman
Levitt to Representatives Markey and Fields (Sept. 26, 1994) (``1994
Report'') at text accompanying n. 1 (``[t]he term `derivative' is
generally defined as an instrument whose value is based upon, or
derived from, some underlying index, reference rate (e.g., interest
rates or currency exchange rates), security, commodity, or other
asset.''), and at n. 2 (the ``term `derivative' generally is used to
embrace forward contracts, futures, swaps, and options''), available
at http://www.sec.gov/news/studies/deriv.txt; John C. Hull, Options,
Futures, and Other Derivatives (7th ed. 2009) (``Hull'') at 1, 779
(``A derivative can be defined as a financial instrument whose value
depends on (or derives from) the values of other, more basic
underlying variables,'' and a derivative is an ``instrument whose
price depends on, or is derived from, the price of another asset'')
(italics in original); rule 3b-13 under the Exchange Act, which
defines ``eligible OTC derivative instrument,'' and rule 16a-1(c)
under the Exchange Act, which defines ``derivative securities;''
section 5200(b) of the Revised Statutes of the United States [12
U.S.C. 84(b)] (as amended by section 610(a)(3) of the Dodd-Frank
Act, supra note 2), which defines a ``derivative transaction'' to
include ``any transaction that is a contract, agreement, swap,
warrant, note, or option that is based, in whole or in part, on the
value of, any interest in, or any quantitative measure or the
occurrence of any event relating to, one or more commodities,
securities, currencies, interest or other rates, indices, or other
assets.''
    \4\ For a definition, and examples of types, of derivatives, see
infra Section I.B.
    \5\ See 2008 IDC Report, supra note 3, at 8-11. See also infra
Section I.B.
    \6\ See 2008 IDC Report, supra note 3, at 12-13. See also Mutual
Fund Derivative Holdings: Fueling the Need for Improved Risk
Management, JPMorgan Thought Magazine (Summer 2008) (``2008 JPMorgan
Article''), available at http://www.jpmorgan.com/cm/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1158494213964&blobheader=application%2Fpdf&blobnocache=true&blobheadername1=Content.
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    The dramatic growth in the volume and complexity of derivatives
investments over the past two decades, and funds' increased use of
derivatives,\7\ have led the Commission and its staff to initiate a
review of funds' use of derivatives under the Investment Company
Act.\8\ The staff generally has been exploring the benefits, risks, and
costs associated with funds' use of derivatives. The staff also has
been exploring issues relating to the use of derivatives by funds such
as: whether current market practices involving derivatives are
consistent with the leverage, concentration, and diversification
provisions of the Investment Company Act; whether 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 their derivatives
investments; whether funds' boards of directors are providing
appropriate oversight of the use of derivatives by the funds; whether
existing rules sufficiently address matters such as the proper
procedures for a fund's pricing and liquidity determinations regarding
its derivatives holdings; whether existing prospectus disclosures
adequately address the particular risks created by derivatives; and
whether funds' derivative activities should be subject to any special
reporting requirements.
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    \7\ While complete data concerning the nature of derivatives
activities of funds is unavailable, for a partial snapshot of
derivatives activity by selected fund complexes see Commodity Pool
Operators and Commodity Trading Advisors: Amendments to Compliance
Obligations, Investment Company Institute (``ICI'') Comment Letter
to the CFTC at 18 (Apr. 12, 2011), available at http://www.ici.org/pdf/25107.pdf. See also, e.g., Tim Adam and Andre Guettler, The Use
of Credit Default Swaps by U.S. Fixed-Income Mutual Funds, FDIC Ctr.
for Fin. Research, Working Paper No. 2011-01, (Nov. 19, 2010)
(``Adam and Guettler Article''), available at http://www.fdic.gov/bank/analytical/cfr/2011/wp2011/CFR_WP_2011_01.pdf (study of the
use of credit default swaps (``CDS'') by the largest 100 U.S.
corporate bond funds between 2004 and 2008 reflects an increase from
about 20% of funds using credit default swaps in 2004 to 60% of
funds using them in 2008; among CDS users, the average size of CDS
positions (measured by their notional values) increased from 2% to
almost 14% of a fund's NAV over the same period, with the CDS
positions representing less than 10% of NAV for most funds, but with
some funds exceeding this level by a wide margin, particularly in
2008; CDS are predominantly used to increase a fund's exposure to
credit risks (net sellers of CDS) rather than to hedge credit risk
(net buyers); the frequency of credit default swap usage by the
largest bond funds is comparable to that of most hedge funds),
available at http://www.fdic.gov/bank/analytical/cfr/2011/wp2011/CFR_WP_2011_01.pdf; Assess the Risks: Key Strategies for
Overseeing Derivatives, Board IQ at 1 (Jan. 15, 2008) (``In recent
years, the use of derivatives by mutual funds has soared.''),
available at http://www.interactivedata.com/uploads/BoardIQ1207.pdf;
2008 JPMorgan Article, supra note 6.
    \8\ In a press release issued in March 2010, the Commission
announced that the staff was conducting a review to evaluate the use
of derivatives by mutual funds, registered exchange-traded funds
(``ETFs''), and other investment companies. The press release
indicated that the review would examine whether and what additional
protections are necessary for those funds under the Investment
Company Act. The press release further indicated that pending
completion of this review, the staff would defer consideration of
exemptive requests under the Act relating to ETFs that would make
significant investments in derivatives. See SEC Press Release 2010-
45, SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25,
2010) (``2010 Derivatives Press Release''), available at http://www.sec.gov/news/press/2010/2010-45.htm. As part of the staff's
review to evaluate fund use of derivatives, and to further enhance
its knowledge of how funds are using, and managing their use of,
derivatives, the staff met with industry groups as well as with some
fund complexes that use OTC derivatives. The staff also reviewed
fund disclosures relating to the use of derivatives and their risks.
In addition, the staff considered The Report of the Task Force on
Investment Company Use of Derivatives and Leverage, Committee on
Federal Regulation of Securities, ABA Section of Business Law (July
6, 2010) (``2010 ABA Derivatives Report''), available at http://meetings.abanet.org/webupload/commupload/CL410061/sitesofinterest_files/DerivativesTF_July_6_2010_final.pdf.
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A. Purpose and Scope of the Concept Release

    The goal of the Commission's and staff's review is to evaluate
whether the regulatory framework, as it applies to funds' use of
derivatives, continues to fulfill the purposes and policies underlying
the Act and is consistent with investor protection. The purpose of this
concept release is to assist with this review and solicit public
comment on the current regulatory regime under the Act as it applies to
funds' use of derivatives. We intend to use the comments to help
determine whether regulatory initiatives or guidance are needed to
improve the current regulatory regime and the specific nature of any
such initiatives.\9\
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    \9\ Section 2(c) of the Investment Company Act provides that
``[w]henever pursuant to this title the Commission is engaged in
rulemaking and is required to consider or determine whether an
action is consistent with the public interest, the Commission shall
also consider, in addition to the protection of investors, whether
the action will promote efficiency, competition, and capital
formation.''
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    A fund that invests in derivatives must take into consideration
various provisions of the Investment Company Act and Commission rules
under the Act. The fund must consider the leverage limitations of
section 18 of the Investment Company Act, which governs the extent to
which a fund may issue ``senior securities.'' \10\ A fund's use of
derivatives also may raise issues

under Investment Company Act provisions governing diversification,\11\
concentration,\12\ investing in certain types of securities-related
issuers,\13\ valuation,\14\ and accounting and financial statement
reporting,\15\ among others,\16\ as well as under applicable disclosure
provisions.\17\
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    \10\ See sections 18(a)(1) and 18(f)(1) of the Investment
Company Act. See also Securities Trading Practices of Registered
Investment Companies, Investment Company Act Release No. 10666 (Apr.
18, 1979) (``Release 10666'') [44 FR 25128 (Apr. 27, 1979)], and
Registered Investment Company Use of Senior Securities-Select
Bibliography (``Senior Security Bibliography''), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm
(prepared by the staff). See also discussion infra at Section II.
(Derivatives under the Senior Securities Restrictions of the
Investment Company Act).
    \11\ See sections 5(b)(1) and 13(a)(1) of the Investment Company
Act. See also infra discussion at Section III. (Derivatives under
the Investment Company Act's Diversification Requirements).
    \12\ See sections 8(b)(1)(E) and 13(a)(3) of the Investment
Company Act. See also Form N-1A, Item 4(a), instruction 4 to Item
9(b)(1), and Item 16(c)(1)(iv); Form N-2, Item 8.2.b (2), and Item
17.2.e. See also infra discussion at Section V. (Portfolio
Concentration).
    \13\ See section 12(d)(3) of the Investment Company Act and rule
12d3-1 thereunder. See also infra discussion at Section IV.
(Exposure to Securities-Related Issuers Through Derivatives).
    \14\ See section 2(a)(41) of the Investment Company Act. See
also Restricted Securities, Investment Company Act Release No. 5847
(Oct. 21, 1969) [35 FR 19989 (Dec. 31, 1970)] (``ASR 113''),
available at http://www.sec.gov/rules/interp/1969/ic-5847.pdf;
Accounting for Investment Securities by Registered Investment
Companies, Investment Company Act Release No. 6295 (Dec. 23, 1970)
[35 FR 19986 (Dec. 31, 1970)] (``ASR 118''), available at http://www.sec.gov/rules/interp/1970/ic-6295.pdf. See also infra discussion
at Section VI. (Valuation of Derivatives).
    \15\ See generally section 30(e) of the Investment Company Act.
    \16\ See, e.g., Investment Company Act provisions relating to
custody (section 17(f) and related rules), and fund names (section
35(d) and rule 35d-1). Also, an open-end fund should consider the
effect that the use of derivatives may have on the liquidity of the
fund's portfolio. For general guidance on liquidity and open-end
funds, see, e.g., Resale of Restricted Securities; Changes to Method
of Determining Holding Period of Restricted Securities Under Rules
144 and 145, Investment Company Act Release No. 17452 (Apr. 23,
1990) [55 FR 17933 (Apr. 30, 1990)], available at http://www.sec.gov/rules/final/1990/33-6862.pdf. See also Revisions of
Guidelines, Investment Company Act Release No. 18612 (Mar. 12, 1992)
[57 FR 9828 (Mar. 20, 1992)], available at http://www.sec.gov/rules/other/1992/33-6927.pdf.
    \17\ See, e.g., section 8(b) of the Investment Company Act, and
Items 4(a), 4(b), 9(b), 9(c), and 16(b) of Form N-1A. Certain
derivatives-related disclosure issues were discussed in a 2010 staff
letter to the ICI. See Derivatives-Related Disclosures by Investment
Companies, Letter from Barry D. Miller, Associate Director, Division
of Investment Management, U.S. Securities and Exchange Commission,
to Karrie McMillan, General Counsel, ICI (July 30, 2010) (``2010
Staff Derivatives Disclosure Letter''), available at http://www.sec.gov/divisions/investment/guidance/ici073010.pdf.
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    Derivatives generally entail the potential for leveraged future
gains and/or losses that may significantly impact the overall risk/
reward profile of a fund. Applying the Act's provisions relating to
diversification, concentration, and investments in securities-related
issuers, among others, may require determining what value to assign to
the derivative and which of the derivative's multiple exposures should
be measured for purposes of the relevant provision. This determination
may be complex because there are at least two potential measures of the
``value'' \18\ of a derivative for purposes of applying various
provisions of the Act: the current market value or fair value
reflecting the price at which the derivative could be expected to be
liquidated; and the notional amount reflecting the contract size
(number of units per contract) multiplied by the current unit price of
the reference asset on which payment obligations are calculated.\19\ In
addition, derivatives often create exposures to multiple variables,
such as the credit of a counterparty as well as to a reference asset on
which the derivative is based.
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    \18\ The Bank for International Settlements (the ``BIS'')
reports gross market values (positive and negative) for open
derivative contracts, which are defined as ``the sums of the
absolute values of all open contracts with either positive or
negative replacement values evaluated at market prices prevailing at
the reporting date. Thus, the gross positive market value of a
dealer's outstanding contracts is the sum of the replacement values
of all contracts that are in a current gain position to the reporter
at current market prices * * * The gross negative market value is
the sum of the values of all contracts that have a negative value on
the reporting date * * *.'' Guide to the International Financial
Statistics, Bank for International Settlements (July 2009) (``BIS
Guide'') at 31, available at http://www.bis.org/statistics/intfinstatsguide.pdf. See also Sarah Sharer Curley and Elizabeth
Fella, Where to Hide? How Valuation of Derivatives Haunts the
Courts--Even After BAPCPA, 83 Am. Bankr. L.J. 297, 298-99 (Spring
2009) (``In a simple interest rate swap * * * [t]he value of the
swap is the net difference between the present value of the payments
each party expects to receive and the present value of the payments
each party expects to make. The value is generally zero to each
party at the inception of the swap, and becomes positive to one
party and negative to the other depending on what direction the
interest rates move.''); CFTC Glossary, Mark-to-Market Definition,
available at http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/index.htm (stating that marking to market is
accomplished for a futures or option contract by ``calculating the
gain or loss in each contract position resulting from changes in the
price of the contracts at the end of each trading session. These
amounts are added or subtracted to each account balance.'').
    \19\ The BIS describes ``notional amounts outstanding'' as ``a
reference from which contractual payments are determined in
derivatives markets.'' BIS Guide, supra note 18, at 30. ``Notional
value'' can be defined as ``the value of a derivative's underlying
assets at the spot price.'' In the case of an options or futures
contract, the notional value is the number of units of an asset
underlying the contract, multiplied by the spot price of the asset.
See http://www.investorwords.com/5930/notional-value.htm. The ``spot
price'' of a derivative's underlying asset is the asset's price for
immediate delivery, i.e., in the current market, in contrast with
the asset's future or forward price. See, e.g., Hull, supra note 3,
at 789. ``Notional value'' is also defined as ``the underlying value
(face value), normally expressed in U.S. dollars, of the financial
instrument or commodity specified in a futures or options on futures
contract.'' See CME Group Glossary, available at http://www.cmegroup.com/education/glossary.html. `` `Notional principal' or
`notional amount' of a derivative contract is a hypothetical
underlying quantity upon which interest rate or other payment
obligations are computed.'' ISDA Online Product Descriptions and
Frequently Asked Questions at http://www.isda.org/educat/faqs.html#7. See also Hull, supra note 3, at 786 (``Notional
principal'' is the ``principal used to calculate payments in an
interest rate swap. The principal is `notional' because it is
neither paid nor received''); Frank J. Fabbozzi, et al.,
Introduction to Structured Finance, at 27 (2006) (``[In an interest
rate swap] [t]he dollar amount of the interest payments exchanged is
based on some predetermined dollar principal, which is called the
notional amount.'') (italics in original); 2010 ABA Derivatives
Report, supra note 8, at n.11 (noting that the term ``notional
amount'' is used differently by different people in different
contexts, but is used, in the Report, to refer to ``the nominal or
face amount that is used to calculate payments made on a particular
instrument, without regard to whether its obligation under the
instrument could be netted against the obligation of another party
to pay the fund under the instrument.'').
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    The Commission or its staff, over the years, has addressed a number
of issues relating to derivatives on a case-by-case basis. The
Commission now seeks to take a more comprehensive and systematic
approach to derivatives-related issues under the Investment Company
Act. In particular, in this release the Commission discusses and seeks
comment on the following issues, among others, relating to funds' use
of derivatives: \20\
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    \20\ The Commission recognizes that there are other significant
derivatives-related issues under the Investment Company Act that
this release does not address, such as disclosure-related issues,
which the Commission may consider at a later date.
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     The attendant costs, benefits and risks;
     The application of the Act's prohibitions and restrictions
on senior securities and leverage;
     The application of the Act's prohibition on investments in
securities-related issuers;
     The application of the Act's provisions concerning
portfolio diversification and concentration; and
     The application of the Act's provisions governing
valuation of funds' assets.
    In addition to the specific issues highlighted for comment, the
Commission invites members of the public to address any other matters
that they believe are relevant to the use of derivatives by funds.

B. Background Concerning the Use of Derivatives by Funds

    As noted above, derivatives may be broadly defined to include
instruments or contracts whose value is based upon, or derived from,
some reference asset. Reference assets can include, for example,
stocks, bonds, commodities, currencies, interest rates, market indices,
currency exchange rates, or other assets or interests, in virtually
endless variety.\21\
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    \21\ For example, the reference asset of a Standard & Poor's
(``S&P'') 500 futures contract is the S&P 500 index. 2008 IDC
Report, supra note 3, at Appendix C at C5.

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    Derivatives are often characterized as either exchange-traded or
OTC.\22\ Exchange-traded derivatives--such as futures, certain
options,\23\ and options on futures \24\--are standardized contracts
traded on regulated exchanges, such as the Chicago Mercantile Exchange
and the Chicago Board Options Exchange. OTC derivatives--such as
swaps,\25\ non-exchange traded options, and combination products such
as swaptions \26\ and forward swaps \27\--are contracts negotiated and
entered into outside of an organized exchange. Unlike exchange-traded
derivatives, OTC derivatives may be significantly customized, and may
not be guaranteed by a central clearing organization. OTC derivatives
that are not centrally cleared, therefore, may involve greater
counterparty credit risk, and may be more difficult to value, transfer,
or liquidate than exchange-traded derivatives.\28\ The Dodd-Frank Act
and Commission rules thereunder seek to establish a comprehensive new
regulatory framework for two broad categories of derivatives--swaps and
security-based swaps--designed to reduce risk, increase transparency,
and promote market integrity within the financial system.\29\
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    \22\ See, e.g., Robert W. Kolb & James A. Overdahl, Financial
Derivatives, at 21 (2010) (``Kolb & Overdahl'').
    \23\ An option is the right to buy or sell an asset. There are
two basic types of options, a ``call option'' and a ``put option.''
A call option gives the holder the right (but does not impose the
obligation) to buy the underlying asset by a certain date for a
certain price. The seller, or ``writer,'' of a call option has the
obligation to sell the underlying asset to the holder if the holder
exercises the option. A put option gives the holder the right (but
does not impose the obligation) to sell the underlying asset by a
certain date for a certain price. The seller, or ``writer'', of a
put option has the obligation to buy from the holder the underlying
asset if the holder exercises the option. The price that the option
holder must pay to exercise the option is known as the ``exercise''
or ``strike'' price. The amount that the option holder pays to
purchase an option is known as the ``option premium,'' ``price,''
``cost,'' or ``fair value'' of the option. For a basic explanation
of options, see, e.g., Hull, supra note 3, at 6-8, 179-236, and Kolb
& Overdahl, supra note 22, at 13-16.
    \24\ Options on futures generally trade on the same exchange as
the relevant futures contract. When a call option on a futures
contract is exercised, the holder acquires from the writer a long
position in the underlying futures contract plus a cash amount equal
to the excess of the futures price over the strike price. When a put
option on a futures contract is exercised, the holder acquires a
short position in the underlying futures contract plus a cash amount
equal to the excess of the strike price over the futures price. See,
e.g., Hull, supra note 3, at 184, 341-54, and 782.
    \25\ A ``swap'' is generally an agreement between two
counterparties to exchange periodic payments based upon the value or
level of one or more rates, indices, assets, or interests of any
kind. For example, counterparties may agree to exchange payments
based on different currencies or interest rates. See generally,
e.g., Kolb & Overdahl, supra note 22, at 11-13; Hull, supra note 3,
at 147-73. See also section 3(a)(69) of the Exchange Act for the
definition of ``swap'' (using the definition in section 1a of the
Commodity Exchange Act, 7 U.S.C. 1a (the ``CEA'')); section 3(a)(68)
of the Exchange Act for the definition of ``security-based swap;''
section 721(a)(3) of the Dodd-Frank Act, supra note 2, for the
definition of ``cleared swap;'' and section 721(a)(12) of the Dodd-
Frank Act for the definition of ``foreign exchange swap.'' See also
Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement;'' Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, Securities Act Release No. 9204 (Apr. 29,
2011) [76 FR 29818 (May 23, 2011)] (``Swap Definition Release''),
available at http://www.sec.gov/rules/proposed/2011/33-9204.pdf.
    \26\ A ``swaption'' is an option to enter into an interest rate
swap where a specified fixed rate is exchanged for a floating rate.
See, e.g., Hull, supra note 3, at 172, 658-62, 790.
    \27\ A forward swap (or deferred swap) is an agreement to enter
into a swap at some time in the future. See Swap Definition Release,
supra note 25, at n. 147. See also, e.g., Hull, supra note 3, at
171, 779 (``deferred swap'').
    \28\ An OTC derivative may be more difficult to transfer or
liquidate than an exchange-traded derivative because, for example,
an OTC derivative may provide contractually for non-transferability
without the consent of the counterparty, or may be sufficiently
customized that its value is difficult to establish or its terms too
narrowly drawn to attract transferees willing to accept assignment
of the contract, unlike most exchange-traded derivatives.
    \29\ The Dodd-Frank Act, supra note 2, was signed into law on
July 21, 2010. The Dodd-Frank Act mandates, among other things,
substantial changes in the OTC derivatives markets, including new
clearing, reporting, and trade execution mandates for swaps and
security-based swaps, and both exchange-traded and OTC derivatives
are contemplated under the new regime. See Dodd-Frank Act sections
723 (mandating clearing of swaps) and 763 (mandating clearing of
security-based swaps). Some of these changes will require Commission
action through rulemaking to become effective. See Temporary
Exemptions and Other Temporary Relief, Together With Information on
Compliance Dates for New Provisions of the Securities Exchange Act
of 1934 Applicable to Security-Based Swaps, Exchange Act Release No.
64678 (June 15, 2011) [76 FR 36287 (June 22, 2011)], available at
http://www.sec.gov/rules/exorders/2011/34-64678.pdf. For summaries
of other recent, pending, and future Commission and staff
initiatives relating to derivatives, see, e.g., Testimony on
Enhanced Oversight after the Financial Crisis: The Wall Street
Reform Act at One-Year, by Chairman Mary L. Schapiro, Chairman, U.S.
Securities and Exchange Commission, before the United States Senate
Committee on Banking, Housing and Urban Affairs (July 21, 2011),
available at http://www.sec.gov/news/testimony/2011/ts072111mls.htm.
See also, e.g., http://www.sec.gov/spotlight/dodd-frank/accomplishments.shtml#derivatives; http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#07-12-12; http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#08-12-11; http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#01-06-12;
http://www.sec.gov/news/press/2011/2011-137.htm; http://www.sec.gov/rules/other/2011/34-64926.pdf; and http://www.sec.gov/spotlight/dodd-frank/derivatives.shtml.
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    A common characteristic of most derivatives is that they involve
leverage.\30\ Certain derivatives investments entered into by a fund,
such as futures contracts, swaps, and written options, create
obligations, or potential indebtedness, to someone other than the
fund's shareholders, and enable the fund to participate in gains and
losses on an amount that exceeds the fund's initial investment.\31\
Other derivatives entered into by a fund, such as purchased call
options, provide the economic equivalent of leverage because they
convey the right to a gain or loss on an amount in excess of the fund's
investment but do not impose a payment obligation on the fund above its
initial investment.\32\
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    \30\ The Commission has stated that ``[l]everage exists when an
investor achieves the right to a return on a capital base that
exceeds the investment which he has personally contributed to the
entity or instrument achieving a return.'' Release 10666, supra note
10, at n. 5.
    \31\ The leverage created by such an arrangement is sometimes
referred to as ``indebtedness leverage.'' 1994 Report, supra note 3,
at 22.
    \32\ This type of leverage is sometimes referred to as
``economic leverage.'' See 1994 Report, supra note 3, at 23 (``Other
derivatives provide the economic equivalent of leverage because they
display heightened price sensitivity to market fluctuations * * *
such as changes in stock prices or interest rates. In essence, these
derivatives magnify a fund's gain or loss from an investment in much
the same way that incurring indebtedness does.''). The 1994 Report
gives a leveraged inverse floating rate bond, with an interest rate
that moves inversely to a benchmark rate, as another example of an
instrument that displays economic leverage. See also 2010 ABA
Derivatives Report, supra note 8, at 20-21 (discussion of
``implied'' or ``economic'' leverage''). For additional discussion
of the leveraging effects of derivatives (not limited to ``economic
leverage''), see 2010 ABA Derivatives Report, supra note 8, at 8-9.
See also 2008 IDC Report, supra note 3, at 3 (``Market participants
are able to acquire exposure (either long or short) to a large
dollar amount of an asset (the notional value) with only a small
down payment, enabling parties to shift risk more efficiently and
with lower costs. The leverage inherent in these instruments
magnifies the effect of changes in the value of the underlying asset
on the initial amount of capital invested. For example, an initial
5% collateral deposit on the total value of the commodity would
result in 20:1 leverage, with a potential 80% loss (or gain) of the
collateral in response to a 4% movement in the market price of the
underlying commodity.'').
---------------------------------------------------------------------------

    Funds use derivatives to implement their investment strategies, and
to manage risk.\33\ A fund may use derivatives to gain, maintain, or
reduce exposure to a market, sector, or security more quickly and/or
with lower transaction costs and portfolio

disruption than investing directly through the securities markets. At
the same time, use of derivatives may entail risks relating, for
example, to leverage, illiquidity (particularly with respect to complex
OTC derivatives), and counterparty risk, among others.\34\ A fund's use
of derivatives presents challenges for its investment adviser and board
of directors to ensure that the derivatives are employed in a manner
consistent with the fund's investment objectives, policies, and
restrictions, its risk profile, and relevant regulatory requirements,
including those under Federal securities laws. With respect to some
primary types of reference assets, funds may use derivatives for the
following purposes, among others:
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    \33\ 2008 IDC Report, supra note 3, at 7-11. A fund may also use
derivatives to hedge current portfolio exposures (for example, when
a fund's portfolio is structured to reflect the fund's long-term
investment strategy and its investment adviser's forecasts, interim
events may cause the fund's investment adviser to seek to
temporarily hedge a portion of the portfolio's broad market, sector,
and/or security exposures). Industry participants believe that
derivatives may also provide a more efficient hedging tool than
reducing exposure by selling individual securities, offering greater
liquidity, lower round-trip transaction costs, lower taxes, and
reduced disruption to the portfolio's longer-term positioning. See
id. at 11.
    \34\ See, e.g., 2008 IDC Report, supra note 3, at 12-13. See
also 2008 JPMorgan Article, supra note 6.
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     Currency derivatives. \35\ A fund may use currency
derivatives to increase or decrease exposure to specific currencies, to
hedge against adverse impacts on the fund's portfolio caused by
currency fluctuations, and to seek additional returns. For example,
currency derivatives can provide a hedge against the risk that a fund's
investment in a foreign debt security will decline in value because of
a decline in the value of the foreign currency in which the foreign
debt security is denominated.\36\ Funds also may use currency
derivatives to hedge against a rise in the value of a foreign currency,
or may use ``cross-currency'' hedging or ``proxy'' hedging when, for
instance, it is difficult or expensive to hedge a particular currency
against the U.S. dollar.\37\ Apart from hedging, funds may use currency
derivatives to seek returns on the basis of anticipated changes in the
relative values of two currencies.\38\
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    \35\ See Swap Definition Release, supra note 25, at II.C.1, for
a description of certain currency derivatives (foreign exchange
swaps, foreign exchange forwards, foreign currency options, non-
deliverable forwards, currency swaps, and cross-currency swaps). The
2010 ABA Derivatives Report, supra note 8 at 6-7, gives as examples
of currency derivatives forward currency contracts, currency futures
contracts, currency swaps, and options on currency futures
contracts. As a general matter, futures, forwards, swaps, and
options can all be used to increase or decrease exposures to
reference currencies. A fund's investment adviser selects the
particular instrument based on the level and type of exposure the
adviser seeks to obtain and the costs that are associated with the
particular instrument.
    \36\ For example, if a fund enters into a short currency forward
(which obligates the fund to sell the currency at a future date, at
a predetermined price, and in the currency in which the foreign debt
security is denominated), the fund's exposure to a decline in the
value of the currency is reduced. See 2010 ABA Derivatives Report,
supra note 8, at 6.
    \37\ For example, a fund may use a forward contract on one
foreign currency (or a basket of foreign currencies) to hedge
against adverse changes in the value of another foreign currency (or
basket of currencies). See id.
    \38\ Id. at 7.
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     Interest rate derivatives.\39\ A fund may use interest
rate derivatives to modify its exposure to the gains or losses arising
from changes in interest rates and to seek enhanced returns. For
example, a fund may use an interest rate swap to hedge against the risk
of a decline in the prices of bonds owned by a fund due to rising
interest rates. Similarly, a fund could shorten the duration of its
portfolio by selling futures contracts on U.S. Treasury bonds or notes,
or Eurodollar futures. Apart from hedging, a fund might use interest
rate derivatives to seek to enhance its returns based on its investment
adviser's views concerning future movements in interest rates or
changes in the shape of the yield curve.\40\
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    \39\ Interest rate derivatives include interest rate or bond
futures, Eurodollar futures, caps, floors, overnight indexed swaps,
interest rate swaps, and options on futures and swaps. See, e.g.,
id. See also Swap Definition Release, supra note 25, at III.B.1
(briefly describing interest and other monetary rate swaps, and
discussing that when payments exchanged under a Title VII (of the
Dodd-Frank Act) instrument are based solely on the levels of certain
interest rates or other monetary rates that are not themselves based
on securities, the instrument would be a swap but not a security-
based swap).
    \40\ For example, if a fund's investment adviser believes that
the London Interbank Offered Rate (``LIBOR'') will decrease compared
to a Federal funds rate, the adviser could enter into an interest
rate swap whereby the fund would be obligated to make payments based
upon the application of LIBOR to an agreed notional amount in
exchange for payments from the counterparty based upon the
application of the Federal funds rate to the notional amount. 2010
ABA Derivatives Report, supra note 8, at 7.
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     Credit Derivatives.\41\ Credit derivatives allow a fund to
assume an investment position concerning the likelihood that a
particular bond, or a group of bonds, will be repaid in full upon
maturity. When a fund purchases credit protection, it pays a premium to
a counterparty in return for which the counterparty promises to pay the
fund if a bond or bonds default or experience some other adverse credit
event. When a fund sells (or writes) credit protection, the fund agrees
to pay a counterparty if a bond or bonds default or experience some
other adverse credit event, in exchange for the receipt of a premium
from the protection purchaser. A fund may purchase credit protection
using credit derivatives to hedge against particular risks that are
associated with a bond that it owns, such as the risk that the bond
issuer will default, a rating agency will downgrade the bond or the
credit of the counterparty, or the risk that credit ``spread'' will
increase.\42\ A fund may sell (or write) credit protection to enhance
its income and return by the amount of the payment that it receives for
providing such protection, or to obtain some investment exposure to the
reference asset (that is, the underlying bond), without owning the
bond. The Commission understands that selling protection may be more
cost effective than an outright purchase of a bond.\43\
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    \41\ Credit derivatives include single-name and index-linked (or
basket) credit default swaps. See, e.g., id. at 7-8. For additional
description of CDS, see Swap Definition Release, supra note 25, at
III.G.3.
    \42\ See 2010 ABA Derivatives Report, supra note 8, at 7.
    \43\ See id. at 8. The 2010 ABA Derivatives Report, supra note
8, at 8, also observes that ``a fund could write a CDS, offering
credit protection to its counterparty. In doing so the fund gains
the economic equivalent of owning the security on which it wrote the
CDS, while avoiding the transaction costs that would have been
associated with the purchase of the security.''
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     Equity Derivatives.\44\ Funds may use equity derivatives
to enhance investment opportunities (for example, by using foreign
index futures to obtain exposure to a foreign equity market). Equity
derivatives also can be used by funds as an income-producing strategy
by, for example, selling equity call options on a particular security
owned by the fund.\45\ A fund also may use equity derivatives (usually
stock index futures) to ``equitize'' cash.\46\
---------------------------------------------------------------------------

    \44\ Equity derivatives include equity futures contracts,
options on equity futures contracts, equity options, and various
kinds of equity-related swaps (such as a total return swap on an
equity security). See, e.g., id. at 8.
    \45\ By selling the options, a fund can earn income (in the form
of the premium received for writing the option) while at the same
time permitting the fund to sell the underlying equity securities at
a targeted price set by the fund's investment adviser. See, e.g.,
id.
    \46\ As an example of ``equitizing'' cash, the 2010 ABA
Derivatives Report, supra note 8, at 8, states that:
    [W]hen a fund has a large cash position for a short amount of
time, the fund can acquire long futures contracts to retain (or
gain) exposure to the relevant equity market. When the futures
contracts are liquid (as is typically the case for broad market
indices), the fund can eliminate the position quickly and frequently
at lower costs than had the fund actually purchased the reference
equity securities.
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C. Request for Comment

    The Commission generally requests data and comment on the types of
derivatives used by funds, the purposes for which funds use
derivatives, and whether funds' use of derivatives has undergone or may
be undergoing changes and, if so, the nature of such changes. The
Commission specifically requests comment on the following:
     What are the costs and benefits to funds from the use of
derivatives? What are the factors that influence those costs and
benefits? What are the risks to funds

from investing in derivatives? What role does or could collateral used
in derivatives transactions play in mitigating the concerns relating to
the use of derivatives? Please be specific and provide data or
statistics, if possible.
     Do different types of funds use different types of
derivatives or use derivatives for different purposes? If so, what are
the differences in the types of funds that account for the differences
in their use of derivatives? For example, do BDCs use derivatives in a
manner different from other funds and, if so, how and what are the
differences?
     How do ETFs use derivatives? Do they use derivatives for
the same purposes that other open-end funds use them? Does an ETF's use
of derivatives raise unique investor protection concerns under the
Investment Company Act?

II. Derivatives under the Senior Securities Restrictions of the
Investment Company Act

    In this section, the Commission discusses the limitations on senior
securities imposed by section 18 of the Investment Company Act,
summarizes related Commission and staff guidance, discusses certain
alternative approaches, and highlights issues for comment.

A. Purpose, Scope, and Application of the Act's Senior Securities
Limitations

1. Statutory Restrictions on Senior Securities and Related Commission
Guidance
    The protection of investors against the potentially adverse effects
of a fund's issuance of ``senior securities'' \47\ is a core purpose of
the Investment Company Act.\48\ Congress' concerns underlying the
limitations in section 18 included, among others: (i) Potential abuse
of the purchasers of senior securities; \49\ (ii) excessive borrowing
and the issuance of excessive amounts of senior securities by funds
which increased unduly the speculative character of their junior
securities; \50\ and (iii) funds operating without adequate assets and
reserves.\51\ To address these concerns, section 18(f)(1) of the
Investment Company Act prohibits an open-end fund \52\ from issuing or
selling any ``senior security'' other than borrowing from a bank, and
unless it maintains 300% ``asset coverage.'' \53\ Section 18(a)(1) of
the Investment Company Act prohibits a closed-end fund \54\ from
issuing or selling any ``senior security that represents an
indebtedness'' unless it has at least 300% ``asset coverage.'' \55\
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    \47\ Section 18(g) of the Investment Company Act defines
``senior security,'' in part, as ``any bond, debenture, note, or
similar obligation or instrument constituting a security and
evidencing indebtedness,'' and ``any stock of a class having
priority over any other class as to the distribution of assets or
payment of dividends.'' The definition excludes certain limited
temporary borrowings.
    \48\ See, e.g., Investment Company Act sections 1(b)(7),
1(b)(8), 18(a), and 18(f). See also, e.g., 1994 Report, supra note
3, at 20-22.
    \49\ See Investment Trusts and Investment Companies: Hearings on
S. 3580 Before a Subcomm. of the Senate Committee on Banking and
Currency, 76th Cong., 3d Sess., pt. 1, 265-78 (1940) (``Senate
Hearings''). See also 1994 Report, supra note 3, at 21 (describing
the practices in the 1920s and 1930s that gave rise to section 18's
limitations on leverage, and specifically discussing the potential
abuse of senior security holders).
    \50\ See section 1(b)(7) of the Investment Company Act. See
also, e.g., Release 10666, supra note 10, at n. 8.
    \51\ See section 1(b)(8) of the Investment Company Act; Release
10666, supra note 10, at n. 8.
    \52\ Section 5(a)(1) of the Investment Company Act defines
``open-end company'' as ``a management company which is offering for
sale or has outstanding any redeemable security of which it is the
issuer.''
    \53\ ``Asset coverage'' of a class of securities representing
indebtedness of an issuer generally is defined in section 18(h) of
the Investment Company Act as ``the ratio which the value of the
total assets of such issuer, less all liabilities and indebtedness
not represented by senior securities, bears to the aggregate amount
of senior securities representing indebtedness of such issuer.''
    \54\ Section 5(a)(2) of the Investment Company Act defines
``closed-end company'' as ``any management company other than an
open-end company.''
    \55\ Section 18(a)(1)(A). A BDC is also subject to the
limitations of section 18(a)(1)(A) to the same extent as if it were
a closed-end investment company except that the applicable asset
coverage amount is 200%. See Investment Company Act section
61(a)(1).
---------------------------------------------------------------------------

    In a 1979 General Statement of Policy (Release 10666), the
Commission considered the application of section 18's restrictions on
the issuance of senior securities to reverse repurchase agreements,
firm commitment agreements, and standby commitment agreements.\56\ The
Commission concluded that such agreements, while not securities for all
purposes,\57\ may involve the issuance of senior securities and ``fall
within the functional meaning of the term `evidence of indebtedness'
for purposes of section 18 of the Act,'' which generally would include
``all contractual obligations to pay in the future for consideration
presently received.'' \58\ Further, the Commission stated that
``trading practices involving the use by investment companies of such
agreements for speculative purposes or to accomplish leveraging fall
within the legislative purposes of Section 18.'' \59\ The Commission
also explained that:

    \56\ As described in Release 10666, supra note 10, in a typical
reverse repurchase agreement, the fund transfers possession of a
debt security, often to a broker-dealer or a bank, in return for a
percentage of the market value of the security (``proceeds''), but
retains record ownership of, and the right to receive interest and
principal payments on, the security. At a stated future date, the
fund repurchases the security and remits to the counterparty the
proceeds plus interest. Id. at nn. 2-3 and accompanying text. A firm
commitment agreement (also known as a ``when-issued security'' or a
``forward contract'') is a buy order for delayed delivery in which a
fund agrees to purchase a debt security from a seller (usually a
broker-dealer) at a stated future date, price, and fixed yield. Id.
at text accompanying n. 12. A standby commitment agreement is a
delayed delivery agreement in which a fund contractually binds
itself to accept delivery of a debt security with a stated price and
fixed yield upon the exercise of an option held by the counterparty
to the agreement at a stated future date. Id. at discussion of
``Standby Commitment Agreements.''
    \57\ Release 10666, supra note 10, at ``The Agreements as
Securities'' discussion. The Commission notes, however, that the
Investment Company Act's definition of the term ``security'' is
broader than the term's definition in other Federal securities laws.
Compare section 2(a)(36) of the Investment Company Act with sections
2(a)(1) and 2A of the Securities Act and sections 3(a)(10) and 3A of
the Exchange Act. For example, the definition of ``security'' in the
Investment Company Act includes any ``evidence of indebtedness,''
which is not included in the definition of ``security'' in section
3(a)(10) of the Exchange Act. Further, the Commission has
interpreted the term ``security'' in light of the policies and
purposes underlying the Act. For example, the brief for the United
States as Amicus Curiae in Marine Bank v. Weaver, No. 80-1562, 1980
U.S. Briefs 1562 (Oct. Term, 1980) (July 29, 1981) (``Marine Bank v.
Weaver Amicus Brief'') stated that the issue of whether a particular
instrument is a ``security'' depends on the context, including the
statute being applied, and further stated that the Investment
Company Act ``presents a significantly different context'' (i.e.,
the regulation of the operation and management of investment
companies) than the context of the Securities Act and the Exchange
Act (i.e., the issuance or trading of such securities). Marine Bank
v. Weaver Amicus Brief at 38, 40.
    \58\ Release 10666, supra note 10, at ``The Agreements as
Securities'' discussion.
    \59\ Id.
---------------------------------------------------------------------------

    [l]everage exists when an investor achieves the right to a
return on a capital base that exceeds the investment which he has
personally contributed to the entity or instrument achieving a
return* * *. Through a reverse repurchase agreement, an investment
company can achieve a return on a very large capital base relative
to its cash contribution. Therefore, the reverse repurchase
agreement is a highly leveraged transaction.\60\
---------------------------------------------------------------------------

    \60\ Id. at n. 5 (citation omitted).

    Leveraging of a fund's portfolio through the issuance of senior
securities ``magnifies the potential for gain or loss on monies
invested and, therefore, results in an increase in the speculative
character of the investment company's outstanding securities.'' \61\
Each of the agreements discussed by the Commission in Release 10666--
the reverse repurchase agreement, the firm commitment agreement, and
the standby commitment agreement--``may be a substantially higher risk
investment'' than direct investment in

the underlying securities ``because of the additional risk of loss
created by the substantial leveraging in each agreement, and in light
of the volatility of interest rates in the marketplace.'' \62\
---------------------------------------------------------------------------

    \61\ Id. at text accompanying n. 5.
    \62\ Id. at discussion of ``The Agreements as Securities.'' The
Commission also stated that, ``[t]he gains and losses from the
transactions can be extremely large relative to invested capital;
for this reason, each agreement has speculative aspects. Therefore,
it would appear that the independent investment decisions involved
in entering into such agreements, which focus on their distinct
risk/return characteristics, indicate that, economically as well as
legally, the agreements should be treated as securities separate
from the underlying Ginnie Maes for purposes of Section 18 of the
Act.'' Id.
---------------------------------------------------------------------------

    In Release 10666, the Commission further stated that, although
reverse repurchase agreements, firm commitment agreements, and standby
commitment agreements are functionally equivalent to senior securities,
these and similar arrangements nonetheless could be used by funds in a
manner that would not warrant application of the section 18
restrictions. The Commission noted that in circumstances involving
similar economic effects, such as short sales of securities by funds,
our staff had determined that the issue of section 18 compliance would
not be raised if funds ``cover'' senior securities by maintaining
``segregated accounts.'' \63\ The Commission stated that the use of
segregated accounts ``if properly created and maintained, would limit
the investment company's risk of loss.'' \64\ To avail itself of the
segregated account approach, a fund could establish and maintain with
the fund's custodian a segregated account containing liquid assets,
such as cash, U.S. government securities, or other appropriate high-
grade debt obligations, equal to the indebtedness incurred by the fund
in connection with the senior security (``segregated account
approach'').\65\ The amount of assets to be segregated with respect to
reverse repurchase agreements lacking a specified repurchase price
would be the value of the proceeds received plus accrued interest; for
reverse repurchase agreements with a specified repurchase price, the
amount of assets to be segregated would be the repurchase price; and
for firm and standby commitment agreements, the amount of assets to be
segregated would be the purchase price.\66\ As the Commission stated in
Release 10666, the segregated account functions as ``a practical limit
on the amount of leverage which the investment company may undertake
and on the potential increase in the speculative character of its
outstanding common stock,'' and ``will assure the availability of
adequate funds to meet the obligations arising from such activities.''
\67\
---------------------------------------------------------------------------

    \63\ Release 10666, supra note 10, at text accompanying n. 15.
    \64\ Id. at discussion of ``Segregated Account.''
    \65\ The Commission stated that, under the segregated account
approach, the value of the assets in the segregated account should
be marked to the market daily, additional assets should be placed in
the segregated account whenever the total value of the account falls
below the amount of the fund's obligation, and assets in the
segregated account should be deemed frozen and unavailable for sale
or other disposition. See id. The Commission also cautioned that as
the percentage of a fund's portfolio assets that are segregated
increases, the fund's ability to meet current obligations, to honor
requests for redemption, and to manage properly the investment
portfolio in a manner consistent with stated its investment
objective may become impaired. Id.
    \66\ Id.
    \67\ Id.
---------------------------------------------------------------------------

2. Staff No-Action Letters Concerning the Segregated Account Approach
\68\
---------------------------------------------------------------------------

    \68\ This release includes extensive discussion of staff no-
action letters; accordingly the Commission notes that its discussion
of staff statements is provided solely for background and to
facilitate comment on issues that the Commission might address. The
discussion is in no way intended to suggest that the Commission has
adopted the analysis, conclusions or any other portion of the staff
statements discussed here. Staff no-action letters are issued by the
Commission staff in response to written requests regarding the
application of the Federal securities laws to proposed transactions.
Many of the staff no-action letters are ``enforcement-only''
letters, in which the staff states whether it will recommend
enforcement action to the Commission if the proposed transaction
proceeds in accordance with the facts, circumstances and
representations set forth in the requester's letter. Other staff no-
action letters provide the staff's interpretation of a specific
statute, rule or regulation in the context of a specific situation.
See Informal Guidance Program for Small Entities, Investment Company
Act Release No. 22587 (Mar. 27, 1997).
---------------------------------------------------------------------------

    Following the Commission's issuance of Release 10666, the
Commission staff issued more than twenty no-action letters to funds
concerning the maintenance of segregated accounts or otherwise
``covering'' their obligations in connection with certain senior
securities, primarily interest rate futures, stock index futures, and
related options.\69\
---------------------------------------------------------------------------

    \69\ See ``No-Action Letters and Releases from 1982-1985
Regarding Covering Futures and Options'' at Senior Security
Bibliography, supra note 10. (Certain of these letters also
addressed the use of when-issued bonds, currency forwards, and other
senior securities).
---------------------------------------------------------------------------

    In a 1987 no-action letter issued to two Dreyfus funds, the staff
summarized and expanded upon the methods by which, in its view,
obligations could be covered by funds transacting in futures, forwards,
written options, and short sales.\70\ The staff provided no-action
assurance that the Dreyfus funds could:
---------------------------------------------------------------------------

    \70\ Dreyfus Strategic Investing and Dreyfus Strategic Income,
SEC Staff No-Action Letter (June 22, 1987) (``Dreyfus no-action
letter'' or ``Dreyfus Letter''), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
---------------------------------------------------------------------------

     Cover a long position in a futures or forward contract, or
a written put option, by establishing a segregated account (not with a
futures commission merchant or broker) containing cash or certain
liquid assets equal to the purchase price of the contract or the strike
price of the put option (less any margin on deposit); and
     Cover short positions in futures or forward contracts,
sales of call options, and short sales of securities by establishing a
segregated account (not with a futures commission merchant or broker)
with cash or certain liquid assets that, when added to the amounts
deposited with a futures commission merchant or a broker as margin,
equal the market value of the instruments or currency underlying the
futures or forward contracts, call options, and short sales (but are
not less than the strike price of the call option or the market price
at which the short positions or short sales were established).\71\
---------------------------------------------------------------------------

    \71\ But see Robertson Stephens Investment Trust, SEC Staff No-
Action Letter (Aug. 24, 1995), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm (the staff
agreed not to recommend enforcement action where the value of the
segregated account, to cover a short position in a security, was
equal to the daily (fluctuating) market price of the security sold
short (less certain amounts pledged with the broker as collateral),
even if the value of the segregated account was less than the price
at which the short position was established).
---------------------------------------------------------------------------

    The staff also provided no-action assurance that the Dreyfus funds
could cover these transactions by owning, or holding the right to
obtain, the instrument or cash that the fund has obligated itself to
deliver. For example:
     A fund could cover a long position in a futures or forward
contract by purchasing a put option on the same futures or forward
contract with a strike price as high or higher than the price of the
contract held by the fund; and
     A fund could cover a written put option by selling short
the instruments or currency underlying the put option at the same or
higher price than the strike price of the put option or, alternatively,
by purchasing a put option with the strike price the same or higher
than the strike price of the put option written by the fund.
    The Commission staff has also discussed the types of assets that
may be segregated and the manner in which, in the staff's view,
segregation may be effected. In Release 10666, the Commission stated
that the assets eligible to be included in segregated accounts should
be ``liquid assets,'' such as cash, U.S. government securities, or

other appropriate high grade debt obligations. In a 1996 staff no-
action letter issued to Merrill Lynch Asset Management, the staff took
the position that a fund could cover its derivatives-related
obligations by depositing any liquid asset, including equity securities
and non-investment grade debt securities, in a segregated account.\72\
In the Merrill Lynch no-action letter, the staff explained that, in the
staff's view, segregating any type of liquid asset would be consistent
with the purposes underlying the asset segregation approach because it
would place a practical limit on the amount of leverage that a fund may
undertake and on the potential increase in the speculative character of
its outstanding shares.\73\ With respect to the manner in which
segregation may be effected, the Commission staff took the position
that a fund could segregate assets by designating such assets on its
books, rather than establishing a segregated account at its
custodian.\74\
---------------------------------------------------------------------------

    \72\ Merrill Lynch Asset Management, L.P., SEC Staff No-Action
Letter (July 2, 1996) (``Merrill Lynch no-action letter'' or
``Merrill Lynch Letter''), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
    \73\ Id. The staff noted that ``the type of asset placed in the
segregated account would have no effect on the maximum amount of
leverage that a fund can assume.''
    \74\ See Dear Chief Financial Officer Letter from Lawrence A.
Friend, Chief Accountant, Division of Investment Management (Nov. 7,
1997), available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
---------------------------------------------------------------------------

    Asset segregation practices with respect to other derivatives
investments have not been addressed by the Commission, or by the staff
in no-action letters.\75\ Certain swaps, for example, that settle in
cash on a net basis, appear to be treated by many funds as requiring
segregation of an amount of assets equal to the fund's daily mark-to-
market liability, if any.\76\ Similarly, some funds have disclosed that
they segregate only their daily, mark-to-market liability, if any, with
respect to futures and forward contracts that are contractually
required to cash-settle.\77\
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    \75\ Our discussion of current and past industry practices is
not intended to indicate any Commission approval or disapproval of
those practices.
    \76\ See, e.g., 2010 ABA Derivatives Report, supra note 8, at
13-14.
    \77\ For a discussion of asset segregation practices involving
futures and forwards that are contractually required to cash-settle,
see, e.g., id. at 14-15.
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B. Alternative Approaches to the Regulation of Portfolio Leverage

1. The Current Asset Segregation Approach
    As noted above, the segregated account approach serves both to
limit a fund's potential leverage and to provide a source of payment of
future obligations arising from the leveraged transaction. In
determining the amount of assets required to be segregated to cover a
particular instrument, the Commission and its staff have generally
looked to the purchase or exercise price of the contract (less margin
on deposit) for long positions and the market value of the security or
other asset underlying the agreement for short positions, measured by
the full amount of the reference asset, i.e., the notional amount of
the transaction rather than the unrealized gain or loss on the
transaction, i.e., its current mark-to-market value.\78\
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    \78\ See Release 10666, supra note 10, at discussion of
``Segregated Account'' (with regard to each reverse repurchase
agreement that lacks a specified repurchase price, the fund should
maintain in a segregated account ``liquid assets equal in value to
the proceeds received on any sale subject to repurchase plus accrued
interest. If the reverse repurchase agreement has a specified
repurchase price, the investment company should maintain in the
segregated account an amount equal to the repurchase price, which
price will already include interest charges.'' With regard to each
firm commitment agreement, the fund should maintain in a segregated
account ``liquid assets equal in value to the purchase price due on
the settlement date under the * * * agreement.'' With regard to each
standby commitment agreement, the fund should maintain in a
segregated account ``liquid assets equal in value to the purchase
price under the * * * agreement.'').
---------------------------------------------------------------------------

    The segregated account approach has drawn criticism on several
grounds. For example, we understand that some industry participants
argue that the segregated account approach calls for an instrument-by-
instrument assessment of the amount of cover required, further arguing
that this may create uncertainty about the treatment of new products,
and that new product development will inevitably lead to circumstances
in which available guidance does not specifically address each new
instrument subject to section 18 constraints. Other industry
participants have argued that the staff's application of the segregated
account approach results in differing treatment of arguably equivalent
products.\79\
---------------------------------------------------------------------------

    \79\ They argue, for example, that a physically-settled and a
cash-settled future or forward are equivalent products, and that
segregation of the delivery obligation amount for a physically-
settled future or forward, and segregation of the generally smaller
mark-to-market liability amount for a cash-settled future or
forward, constitutes different treatment of equivalent products. See
the 2010 ABA Derivatives Report, supra note 8, at 14-15 for a
discussion of cash-settled futures and forwards and the asset
segregation treatment of those products.
---------------------------------------------------------------------------

    Others have argued that, with respect to the amount to be
segregated, both notional amount and a mark-to-market amount have their
limitations.\80\ For example, for many futures contracts, the notional
amount may, as a practical matter, exceed the maximum loss or total
risk on the contract.\81\ Consequently, it is argued with respect to
such derivatives that segregation of assets equal to the notional
amount may limit the use of such derivative products and strategies
that could potentially benefit funds and their investors. Conversely,
it is argued that segregation of an amount equal to only the daily,
mark-to-market liability, if any, with respect to cash-settled
derivatives,\82\ may fail to take into account potential future losses
on such instruments. Consequently, it is argued that segregation of
this amount may understate the risk of loss to the fund, permit the
fund to engage in excessive leveraging, fail to adequately set aside
sufficient assets to cover the fund's ultimate exposure, and,
therefore, perhaps not adequately fulfill the purposes underlying the
segregated account approach and section 18.\83\
---------------------------------------------------------------------------

    \80\ Id. at 16-17.
    \81\ See BIS Guide, supra note 18, at 30, commenting in the
context of OTC derivatives that ``[n]ominal or notional amounts
outstanding provide a measure of market size and a reference from
which contractual payments are determined in derivatives markets.
However, with the partial exception of credit default swaps, such
amounts are generally not those truly at risk. The amounts at risk
in derivatives contracts are a function of the price level and/or
volatility of the financial reference index used in the
determination of contract payments, the duration and liquidity of
contracts and the creditworthiness of counterparties.''
    \82\ This is also a concern with respect to the coverage of
short sales.
    \83\ See 2010 ABA Derivatives Report, supra note 8, at 15
(``reducing the amount of assets subject to segregation increased
the practical ability of funds to engage in derivatives on an
increasing scale''), and at 16 (where only the mark-to-market
liability, if any, is segregated, ``a fund's exposure under a
derivative contract could increase significantly on an intraday
basis, resulting in the segregated assets being worth less than the
fund's obligations (until the fund is able to place additional
assets in the segregated account * * *.). To the extent that a fund
relying on the Merrill Lynch Letter segregates assets whose prices
are somewhat volatile, this `shortfall' could be magnified.'').
---------------------------------------------------------------------------

    The significant disparity between these two widely recognized
measures--notional amount and mark-to-market amount--is illustrated by
data relevant to actual swap positions held by funds. A recent study of
the use of credit default swaps (``CDS'') by a group of the 100 largest
U.S. corporate bond funds analyzed data relevant to the notional amount
and ``book value,'' i.e., unrealized gains and losses, of the funds'
CDS positions during the period 2004 through 2008.\84\ Among the 65
funds in the sample group that used CDS sometime between 2004 and 2008,
the total notional amount of CDS positions increased from an average of
$103 million per fund in 2004 to an

average of $632 million in 2008. The mean total notional amount of a
fund's CDS positions relative to its net asset value (``NAV'')
increased from 2% to almost 14%.\85\ At three funds, the notional
amounts of CDS positions held in 2008 exceeded those funds' NAVs.
During the same period, reported CDS book losses (i.e., unrealized
losses) remained, on average, less than 1% of a fund's NAV.\86\
---------------------------------------------------------------------------

    \84\ Adam and Guettler Article, supra note 7.
    \85\ Id. at 12.
    \86\ Id. at 13.
---------------------------------------------------------------------------

    Critics of the notional and mark-to-market standards often advocate
use of a more complex analysis of the risk of a fund's investments,
including its derivatives positions, such as Value at Risk (``VaR'') or
another methodology for assessing the probability of portfolio
losses.\87\ VaR and other alternative approaches are discussed in the
following section.
---------------------------------------------------------------------------

    \87\ See, e.g., 2010 ABA Derivatives Report, supra note 8, at
18. As discussed infra, some non-U.S. regulatory schemes have
incorporated VaR or comparable methodologies in their approach to
derivatives. See, e.g., CESR's Guidelines on Risk Measurement and
the Calculation of Global Exposure and Counterparty Risk for UCITS,
Committee of European Securities Regulators (July 28, 2010)
(``CESR's Global Exposure Guidelines''), available at http://www.esma.europa.eu/popup2.php?id=7000. See also Henry T.C. Hu, The
New Portfolio Society, SEC Mutual Fund Disclosure, and the Public
Corporation Model, 60 BUS. LAW. 1303 (2005) (advocating disclosure
by funds of VaR data). We note that the Commission has permitted VaR
to be used by certain registrants in other circumstances. For
example, the Commission permits certain registered broker-dealers to
use VaR models to compute net capital charges. See, e.g., Exchange
Act rule 15c3-1f.
---------------------------------------------------------------------------

2. Other Approaches
    The 2010 ABA Derivatives Report observed that the ``the basic
framework as articulated in Release 10666 has worked very well'' as
applied to funds' derivatives investments,\88\ but ``there are open
issues and inconsistencies in the current [Commission] and staff
guidance regarding the application of Section 18 of the 1940 Act to
transactions in derivatives.'' \89\ Accordingly, the 2010 ABA
Derivatives Report states that the Commission ``should issue revised
guidance in this area, which would set forth an approach to segregation
that would cover all types of derivative instruments in a comprehensive
manner.'' \90\ The 2010 ABA Derivatives Report, however, considers
comprehensive guidance unlikely to be achievable, given that any
generalized approach will likely fail to take into account significant
variations in individual transactions. Consequently, in lieu of
comprehensive guidance concerning the asset segregation approach, the
2010 ABA Derivatives Report proposes an alternative approach pursuant
to which individual funds would establish their own asset segregation
standards for derivative instruments that involve leverage within the
meaning of Release 10666. Under this approach, each fund would be
required to adopt policies and procedures that would include, among
other things, minimum asset segregation requirements for each type of
derivative instrument, taking into account relevant factors such as the
specific context of the transaction. In developing these standards,
fund investment advisers could take into account a variety of risk
measures, including VaR and other quantitative measures of portfolio
risk, and would not be limited to the notional amount or mark-to-market
standards. These minimum ``Risk Adjusted Segregated Amounts'' would be
reflected in policies and procedures that would be subject to approval
by the fund's board of directors and disclosed (including the
principles underlying the Risk Adjusted Segregated Amounts for
different types of derivatives) in the fund's statement of additional
information.\91\
---------------------------------------------------------------------------

    \88\ 2010 ABA Derivatives Report, supra note 8, at 16.
    \89\ Id. at 15.
    \90\ Id. at 17.
    \91\ Id. at 18.
---------------------------------------------------------------------------

    The challenge of designing a regulatory standard by which leverage
can be measured and limited effectively also has drawn the attention of
regulators in jurisdictions around the globe. Internationally,
limitations on leveraged exposure take a variety of forms, including
maximum exposure limitations, asset segregation requirements, and other
measures. In the context of maximum exposure or leverage limitations,
the notional or principal amount of the reference asset underlying the
derivative has commonly been used as a conservative measure of the
exposure created by derivatives. In addition to limitations on
aggregate positions or leveraged exposure, some regulatory frameworks
include restrictions on concentrated exposures to individual
counterparties and some provide for specialized funds that may assume
derivatives exposure exceeding otherwise applicable limits.
    The Committee of European Securities Regulators (``CESR'') (which,
as of January 1, 2011, became the European Securities and Markets
Authority, or ``ESMA''), conducted an extensive review and consultation
concerning exposure measures for derivatives used by Undertakings for
Collective Investment in Transferable Securities (``UCITS''),
investment vehicles authorized for sale to retail investors. In 2010,
CESR's Global Exposure Guidelines for UCITS were issued,\92\ addressing
implementation of the European Commission's 2009 revised UCITS
Directive.\93\ Under the revised UCITS Directive, UCITS are permitted
to engage in derivatives investments subject to a ``global exposure''
limitation, under which the derivatives exposure of a UCITS may not
exceed the total net value of the UCITS' portfolio.\94\ CESR's Global
Exposure Guidelines extensively address the calculation of derivatives
exposure under the ``global exposure'' limit and define two
permissible, alternative methods for this purpose: (i) The
``commitment'' approach; and (ii) the advanced risk measurement method
to measure maximum potential loss, such as the VaR approach.\95\
---------------------------------------------------------------------------

    \92\ See supra note 87. In order for CESR's Global Exposure
Guidelines to be binding and operational in a particular EU Member
State, the Member State must adopt them. To date, it appears that a
few EU Member States, e.g., Ireland and Luxembourg, have adopted
them.
    \93\ See Directive 2009/65/EC of the European Parliament and of
the Council of 13 July 2009 on the coordination of laws,
regulations, and administrative provisions relating to undertakings
for collective investment in transferable securities (``2009
Directive''), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0032:0096:en:PDF.
    \94\ Id. at Article 51(3) at 62 (``The exposure is calculated
taking into account the current value of the underlying assets, the
counterparty risk, future market movements and the time available to
liquidate the positions'').
    \95\ See CESR's Global Exposure Guidelines, supra note 87. The
CESR's Global Exposure Guidelines note that the ``use of a
commitment approach or VaR approach or any other methodology to
calculate global exposure does not exempt UCITS from the requirement
to establish appropriate internal risk management measures and
limits.'' Id. at 5. In addition, with respect to the selection of
the methodology used to measure global exposure, CESR's Global
Exposure Guidelines note that the ``commitment approach should not
be applied to UCITS using, to a large extent and in a systematic
way, financial derivative instruments as part of complex investment
strategies.'' Id. at 6.
---------------------------------------------------------------------------

    The commitment approach is a method for standard derivatives that
uses the market value of the equivalent position in the underlying
asset but may be ``replaced by the notional value or the price of the
futures contract where this is more conservative.'' \96\ CESR's Global
Exposure Guidelines incorporates a schedule of derivative investments
and their corresponding conversion methods to be used in calculating
global exposure.\97\ The conversion method to be used depends on the
derivative.\98\
---------------------------------------------------------------------------

    \96\ See id. at 7.
    \97\ See id. at 7-12.
    \98\ Id. at 8. For example, for bond futures, the applicable
conversion method is the number of contracts multiplied by the
notional contract size multiplied by the market price of the
cheapest-to-deliver reference bond. For plain vanilla fixed/floating
interest rate and inflation swaps, the applicable conversion method
is the market value of the underlier (though the notional value of
the fixed leg may also be applied). Id. For foreign exchange
forwards, the prescribed conversion method is the notional value of
the currency leg(s). Id. at 9. With respect to non-standard
derivatives, where it is not possible to convert the derivative into
the market value or notional value of the equivalent underlying
asset, CESR's Global Exposure Guidelines note that ``an alternative
approach may be used provided that the total amount of the
derivatives represent a negligible portion of the UCITS portfolio.''
Id. at 7.

---------------------------------------------------------------------------

    The second method is VaR or a comparably sophisticated risk
measurement method, designed to measure the maximum potential loss due
to market risk rather than leverage.\99\ When using the VaR approach to
calculate global exposure, either the relative VaR approach or the
absolute VaR approach may be used.\100\ Under the relative VaR
approach, the VaR of the portfolio cannot be greater than twice the VaR
of an unleveraged reference portfolio.\101\ The absolute VaR approach
limits the maximum VaR that a UCITS can have relative to its NAV, and
as a general matter, the absolute VaR is limited to 20 percent of the
UCITS NAV.\102\
---------------------------------------------------------------------------

    \99\ Id. at 22 (``More particularly, the VaR approach measures
the maximum potential loss at a given confidence level (probability)
over a specific time period under normal market conditions.'').
    \100\ Id. at 23. A global exposure calculation using the VaR
approach should consider all the positions in the UCITS' portfolio.
Id. at 22. The VaR approach measures the probability of risk of loss
rather than the amount of leverage in portfolio. Id. at 22. The
absolute VaR of a UCITS cannot be greater than 20% of its NAV. Id.
at 26. For both VaR approaches, the calculation must have a ``one-
tailed confidence interval of 99%,'' a holding period of one month
(20 business days), an observation period of risk factors of at
least one year (unless a shorter observation period is justified by
a significant increase in price volatility), at least quarterly
updates, and at least daily calculation. Id. at 26. UCITS employing
the VaR approach are required to conduct a ``rigorous, comprehensive
and risk-adequate stress testing program.'' Id. at 30-34.
    \101\ CESR's Global Exposure Guidelines note that the relative
VaR approach does not measure leverage of the UCITS' strategies but
instead allows the UCITS to double the risk of loss under a given
VaR model. Id. at 24.
    \102\ Id. at 25-26.
---------------------------------------------------------------------------

    In addition to the global exposure limitation, CESR's Global
Exposure Guidelines subject UCITS to ``cover rules'' for investments in
financial derivatives.\103\ Under these cover rules, UCITS should, at
any given time, be capable of meeting all its payment and delivery
obligations incurred by financial derivatives' investments, and cover
should form part of the UCITS' risk management process.\104\ More
specifically, in the case of a derivative that provides, automatically
or at the counterparty's choice, for physical delivery of the
underlier, the UCITS should hold: (i) the underlier in its portfolio,
or, if the underlier is deemed to be sufficiently liquid, (ii) cash or
other liquid assets on the condition that these other assets (after
applying appropriate haircuts), held in sufficient quantities, may be
used at any time to acquire the underlier that is to be delivered.\105\
In the case of a derivative that provides, automatically or at the
UCITSs choice, for cash settlement, the UCITS should hold enough liquid
assets after appropriate haircuts to allow the UCITS to make the
contractually required payments.\106\
---------------------------------------------------------------------------

    \103\ Id. at 40.
    \104\ Id.
    \105\ Id.
    \106\ Id. On April 14, 2011, ESMA published a final report on
the guidelines on risk measurement and the calculation of the global
exposure for certain types of structured UCITS. See Guidelines to
Competent Authorities and UCITS Management Companies on Risk
Measurement and the Calculation of Global Exposure for Certain Types
of Structured UCITS (final report) (Apr. 14, 2011) (ref.: ESMA/2011/
112), available at http://www.esma.europa.eu/popup2.php?id=7542
(these guidelines, which will need to be adopted and implemented by
Member States, propose for certain types of structured UCITS, an
optional regime for the calculation of the global exposure).
---------------------------------------------------------------------------

    Singapore has adopted a bifurcated approach similar to that
applicable under CESR's Global Exposure Guidelines for UCITS. The
Monetary Authority of Singapore (the ``MAS'') requires that the risks
of derivatives used by investment companies are ``duly measured,
monitored and managed on an ongoing basis.'' \107\ An investment
company's exposure to derivatives is limited to 100% of its NAV, and
global exposure is calculated using the commitment approach as the
default method. Under the commitment approach, which is similar to the
commitment approach in CESR's Global Exposure Guidelines, global
exposure is calculated by converting the investment company's
derivatives positions into equivalent positions in the underlying
assets and then is quantified as the sum of the absolute values of the
individual positions.\108\ The investment company's exposure to the
counterparty of an OTC derivative is limited to 10% of its NAV and is
measured on a maximum potential loss basis that may be incurred by the
investment company if the counterparty defaults.\109\ Cash or money
market instruments and bonds issued by a government with a rating of
AAA may be tendered as collateral to reduce counterparty exposure.\110\
---------------------------------------------------------------------------

    \107\ The Monetary Authority of Singapore, Code on Collective
Investment Schemes, Chapter 3, section 3.1(f) (April 2011) at 7,
available at http://www.mas.gov.sg/resource/legislation_guidelines/securities_futures/sub_legislation/110408%20Revised%20Code_8%20April_final.pdf.
    \108\ MAS allows for the use of a VaR approach, with prior
approval and submission of specific information on the investment
company manager's risk management process. Id. at Appendix 1,
section 3.2(b).
    \109\ Id. at Appendix 1, sections 5.2 and 5.4.
    \110\ Id. at Appendix 1, sections 5.7 and 5.8.
---------------------------------------------------------------------------

    Other jurisdictions have adopted approaches to investment
companies' use of derivatives that limit aggregate exposure and/or
require maintaining liquid assets equal to the notional or ``exercise''
value of derivatives contracts. For example, the Central Bank of
Ireland, in addressing non-UCITS investment companies offered to the
public generally, has issued guidelines that provide standards
analogous to a `notional amount' or commitment approach and generally
limits the maximum potential exposure to 25% of the investment
company's NAV.\111\ Separately, the Central Bank of Ireland permits the
use of techniques and instruments by investment companies for the
purposes of ``efficient portfolio management,'' subject to certain
conditions. These include a requirement that an investment company
selling a futures contract must own the security that is the subject of
the contract. Alternatively, the investment company's assets, or a
proportion of its assets at least equal to the exercise value of the
futures contracts sold, must reasonably be expected to behave in terms
of price movement in the same manner as the futures contract.\112\
---------------------------------------------------------------------------

    \111\ Central Bank of Ireland, NU SERIES OF NOTICES: Conditions
Imposed in Relation to Collective Investment Schemes Other than
UCITS (July 2011) at 13.12, available at http://www.centralbank.ie/regulation/industry-sectors/funds/non-ucits/Documents/Non%20UCITS%20Notices.pdf
    \112\ Id. at 16.10. In addition, certain requirements are
imposed on the use of OTC derivatives. Id. at 16.10.
---------------------------------------------------------------------------

    A similar approach is followed by the Canadian Securities
Administrators, which permits investment companies sold to the general
public to use derivatives for hedging and non-hedging purposes but
limits the derivatives exposure and requires certain ``cash cover''
intended to limit leverage.\113\ For

example, an investment company may enter into a swap if, among other
things, the investment company holds cash cover in an amount that,
together with margin on account for the swap and the market value of
the swap, is not less than the underlying market exposure of the
swap.\114\
---------------------------------------------------------------------------

    \113\ National Instrument 81-102 Mutual Funds (Jan. 2011) at
sections 2.7 and 2.8, available at http://www.bcsc.bc.ca/uploadedFiles/securitieslaw/policy8/81-102%20Mutual%20Funds%20%5BNI%5D%20Jan-1-11.pdf. In addition, for
periods when the investment company would be required to make
payments under the swap, the investment company is required to hold
an equivalent quantity of the reference asset of the swap, a right
or obligation to acquire an equivalent quantity of the reference
asset of the swap and cash cover that, together with the margin on
account for the swap, have a value at least equal to the aggregate
amount of the obligations of the investment company under the swap,
or a combination of the positions, without recourse to other assets
of the investment company, to enable it to satisfy its obligations
under the swap. Id. at sections 2.7 and 2.8.
    \114\ Id. at section 2.8.
---------------------------------------------------------------------------

    The Hong Kong Securities and Futures Commission (the ``SFC'')
applies a differentiated approach, limiting investment companies
generally to the use of derivatives for non-hedging positions that are
capped at 15% of NAV for options and warrants and 20% for futures.\115\
For investment companies that may acquire financial derivative
instruments extensively for investment purposes, the investment
companies' global exposure relating to the financial derivative
instruments should not exceed 100% of the total net asset value of the
investment companies. For purposes of calculating global exposure,
investment companies must use the commitment approach. This approach
requires that derivative positions be converted into the equivalent
position in the underlying assets of the derivative, taking into
account the prevailing value of the underlying assets, counterparty
risk, futures market movements, and the time available to liquidate the
positions. There are also requirements for: (a) the over-the-counter
derivative counterparties (or their guarantors, if applicable) of these
investment companies to be substantial financial institutions (as
defined in the Code on Unit Trusts and Mutual Funds); (b) the net
exposure for these investment companies to a single over-the-counter
derivative counterparty to be no greater than 10% of NAV; and (c) the
acceptability criteria of collateral as provided by the over-the-
counter derivative counterparties.\116\
---------------------------------------------------------------------------

    \115\ Hong Kong Securities and Futures Commission, Code on Unit
Trusts and Mutual Funds (June 2010), Chapter 7, available at http://www.sfc.hk/sfc/doc/EN/intermediaries/products/handBooks/Eng_UT.pdf.
See also Hong Kong Securities and Futures Commission Handbook for
Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes
and Unlisted Structured Investment Products.
    \116\ Hong Kong Securities and Futures Commission, Code on Unit
Trusts and Mutual Funds (June 2010), Chapter 8, available at http://www.sfc.hk/sfc/doc/EN/intermediaries/products/handBooks/Eng_UT.pdf.
    Other requirements include a restriction on premium paid to
acquire identical options exceeding 5% of the NAV of the investment
company, open positions in any futures contract month or option
series may not be held if the combined margin requirement represents
5% or more of the NAV of the investment company, and the investment
company may not hold open positions in futures or options contracts
concerning a single commodity or a single underlying financial
instrument for which the combined margin requirement represents 20%
or more of the NAV of the investment company. Id.
    Futures and options investments companies are subject to still
different requirements, including that at least 30% of the
investment company's NAV be held on deposit in short-term debt
instruments and may not be used for margin requirements and no more
than 70% of the NAV of the investment company may be committed as
margin for futures or option contracts and/or premium paid for
options purchased. Other requirements applicable to futures and
options investment companies include a restriction on premium paid
to acquire options outstanding with identical characteristics
exceeding 5% of the NAV of the investment company, open positions in
any futures contract month or option series may not be held if the
combined margin requirement represents 5% or more of the net asset
value of the investment company, and the investment company may not
hold open positions in futures or options contracts concerning a
single commodity or a single underlying financial instrument for
which the combined margin requirement represents 20% or more of the
net asset value of the investment company. Id.
---------------------------------------------------------------------------

C. Request for Comment

    The Commission requests comment concerning the current approach to
the application of the senior securities limitations of section 18 of
the Act to funds' use of derivatives. The Commission seeks views
concerning the appropriateness and effectiveness of the asset
segregation approach as a basis for section 18 compliance, and ways in
which the approach might be improved to better serve the statutory
purposes and protect investors. The Commission also seeks views
concerning potential alternative approaches under which funds could
capture the benefits of using derivatives that would meet these same
important goals. Commenters are requested to consider these broad
questions as well as the specific questions that follow:
1. Issues Concerning the Current Asset Segregation Approach
     Is the definition of leverage articulated by the
Commission in Release 10666--that is, the right to a return on a
capital base that exceeds a fund's investment in the instrument
producing the return--sufficiently precise, and appropriate to limit
the risks addressed by the senior security prohibition of section 18?
Are other measures of leverage equally pertinent to, and sufficiently
objective, precise, and transparent to achieve the investor protection
purposes of section 18? Do funds make use of any leverage measurements
as part of their own portfolio oversight procedures? Are leveraged
transactions involving derivatives subject to any special approval or
review procedures?
     Does the segregated account approach adequately address
the investor protection purposes and concerns underlying section 18 of
the Act? What are the benefits and the shortcomings of the segregated
account approach? What benefits may be lost under an approach that is
more restrictive than the current segregated account approach?
     Derivatives can raise risk management issues for funds,
such as leverage, illiquidity (particularly with respect to complex OTC
derivatives), and counterparty risk, among others.\117\ The segregated
account approach addresses leverage, but may not address liquidity and
counterparty concerns. Should funds that use derivatives be required to
consider and address these concerns? For example, should funds be
required to undertake an ongoing credit analysis of their derivatives
counterparties, and an ongoing analysis of the liquidity of the
derivatives, and to take action should the creditworthiness of the
derivatives counterparties and the liquidity of the derivatives
themselves decline below a certain point? Should diversification among
counterparties be a requirement? Are there other risk considerations
that funds engaged in derivatives investments should be required to
take into account?
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    \117\ See 2008 IDC Report, supra note 3, at 12-13. See also 2008
JPMorgan Article, supra note 6, at page 25.
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     What is the optimal amount of assets that should be
segregated for purposes of complying with the leverage limitations of
section 18? In general, should a fund segregate assets in an amount
equal to the notional amount of a derivative contract? In what
situations, if any, would a lesser amount satisfy the purposes and
concerns underlying section 18's leverage limitations and why? Since
futures, swaps, and similar derivatives generally have zero market
value at inception and subsequent mark-to-market amounts may fluctuate
widely, how effectively does segregating an amount equal to the daily,
mark-to-market amount serve the Act's objective of limiting leverage
and assuring the availability of adequate assets to cover a fund's
ultimate obligations? To what extent do funds rely upon the mark-to-
market standard to determine the amount of assets to be segregated? Are
CDS, or some subset thereof, generally covered based on their notional
amount, their mark-to-market value, or some other measure? Does it
depend on whether the CDS cash-settles or involves physical delivery of
the underlier?

     To what extent does the asset segregation approach cause
funds to refrain from derivatives investments or strategies that could
benefit investors? Please describe specific scenarios in which a fund
might be deterred from engaging in derivatives activities for this
reason. Does the asset segregation approach create particular
impediments for certain types of funds or strategies? Please also
provide any information relevant to assessing the impact upon the funds
of asset segregation as contemplated by Release 10666.
     In Release 10666, the Commission stated that it believed
that only liquid assets should be placed in the segregated accounts.
The Commission listed cash, U.S. Government securities, or other
appropriate high-grade debt obligations as examples of liquid assets
that could be placed in a segregated account.\118\ Subsequently, in the
Merrill Lynch no-action letter, the staff took the position that ``cash
or liquid securities (regardless of type)'' may be segregated for
section 18 purposes. Should the Commission permit funds to segregate
any liquid asset? Or should the Commission further limit the types of
assets that may be placed in a segregated account? The 2010 ABA
Derivatives Report has observed that the practical effect of
segregating ``any liquid asset'' rather than segregating only the
assets specifically noted as examples in Release 10666 ``greatly
increase[s] the degree to which funds [may] * * * use derivatives.''
\119\ Is segregation of ``any liquid asset'' for purposes of section 18
consistent with the purposes and concerns underlying section 18's
limitations on leverage? Should any restrictions be placed on the types
of liquid assets that may be used for asset cover, e.g., excluding
assets that replicate the fund's exposure under the covered obligation?
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    \118\ See Release 10666, supra note 10, at discussion of
``Segregated Account.''
    \119\ 2010 ABA Derivatives Report, supra note 8, at 14.
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     What types of liquid assets are currently used by funds
for asset segregation purposes? Do funds commonly include equities
among the liquid assets that they segregate? If so, what types of
equities?
     Is owning, or having the right to obtain, the cash or
other assets that a fund obligates itself to deliver in connection with
senior securities an adequate substitute for segregation of liquid
assets? To what extent do funds rely on this cover approach rather than
asset segregation? Are cover methods that do not involve asset
segregation as effective as asset segregation in terms of limiting a
fund's ability to engage in leverage, limiting a fund's risk of loss,
and making sure that a fund has set aside sufficient assets to cover
its obligations under derivatives and other senior securities?
     Should the Commission revise its position in Release 10666
to provide expressly for cover methods in addition to asset
segregation? If so, should the Commission take the position that a fund
may only enter into such non-asset segregation cover methods with the
same counterparty to the senior security being covered? If so, what
conditions, if any, should be imposed on such cover methods?
     The Commission also requests comment on the different
treatment afforded conventional bank borrowings under section 18, which
generally require 300% asset coverage, and other transactions, such as
reverse repurchase agreements, that may be functionally equivalent to
borrowings but, under Release 10666, may be covered by segregation of
assets equal to 100% of the fund's obligations. Why, if at all, should
other senior securities be treated differently from bank borrowings for
purposes of the amount of cover required? Should the Commission revise
its position in Release 10666 so that all borrowings and their
functional equivalents are subject to the same asset segregation
requirements?
2. Alternatives to the Current Asset Segregation Approach
     What alternatives to the segregated account approach, if
any, should the Commission consider to fulfill the investor protection
purposes of section 18 of the Act? Please identify any alternative
measures that would assure adequate coverage of the fund's ongoing
exposures under a derivative investment, and provide a cushion to cover
future exposure.
     What benefits would be lost, and/or what costs would
increase, if an alternative approach to the segregated account were to
limit funds' use of derivatives?
     As discussed above, the 2010 ABA Derivatives Report
recommends a more flexible approach to section 18 compliance, under
which funds would specify a Risk Adjusted Segregated Amount (``RASA'')
for each derivative investment used by the fund.\120\ Under this
recommended approach, the amount of assets to be segregated would be
determined by each fund, based on the risk profiles of the derivative
instruments (including issuer- and transaction-specific risk) and its
assessment of risk based upon consideration of relevant risk measures,
such as VaR, potentially subject to Commission guidance of a general
nature.\121\ What benefits would accrue to funds and investors from the
ABA's RASA approach? What would be the costs of this approach? In what
respects would fund-determined asset segregation policies be expected
to deviate from the current segregated account approach? Would such
policies be likely to incorporate VaR or other risk methodologies? Do
boards, as currently constituted, have sufficient expertise to oversee
an alternative approach to leverage and derivatives management such as
RASA and/or VaR? If funds were permitted to determine the cover amount
for their derivatives investments, should the Commission give guidance
concerning minimum requirements for cover amounts or methodologies for
determining cover amounts? If funds were permitted to determine the
cover amount for their derivatives investments, would the result be
that different funds would likely reach different determinations,
resulting in different cover amounts, for the same derivatives?
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    \120\ 2010 ABA Derivatives Report, supra note 8, at 1, 17-18.
    \121\ Id. at 17.
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     Should the Commission consider a bifurcated approach to
funds' use of derivatives, similar to that set out in CESR's Global
Exposure Guidelines (which provides two methodologies, the commitment
approach or an advanced risk measurement method such as VaR)? If the
Commission were to pursue a bifurcated approach, should funds be
permitted to elect to use notional amount (or similar reference) or a
quantitative risk assessment such as VaR, or should funds with
different levels of derivatives activities be required to choose one or
the other measure based upon their level of derivatives activities or
other factors?
     If funds are permitted to choose which quantitative risk
assessment approach to use, under what circumstances, if any, should
they be allowed to switch to a different assessment? Should a fund's
proposed change in assessment require consideration and approval of its
board of directors? Should shareholder approval of a fund's proposed
change in assessment be required? For what reason(s) should a fund be
permitted to change assessments, if any?
     We note that bank capital standards incorporate
methodologies by which the current exposure and potential future
exposure created by derivative investments are calculated. The

potential future exposure calculation is based upon application of a
specified multiplier, varying with the type and maturity of the
derivative, to the notional amount of the investment.\122\ Would a
formula combining the current mark-to-market value of a fund's
derivative investments with a measure of potential future exposure
based upon a percentage of the notional amount of its derivative
contracts provide a more robust measure of risk than the notional
amount or mark-to-market value of the derivative? If so, are bank
capital standards a relevant reference point for our consideration of
the potential future exposure and asset segregation amount? If not, are
there other preferable standards for measuring the potential future
exposure of a derivative investment? How, if at all, would such an
approach address the leverage concerns underlying section 18 of the
Act? What would be the costs and benefits of employing an asset
segregation calculation that reflects both current mark-to-market
values and a potential future exposure approximation calculated by
reference to notional amount? Given the purposes of section 18, should
an additional cushion amount be considered in addition to current mark-
to-market value and potential future exposure?
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    \122\ See 12 CFR 3 at Appendix C to Part 3 (2011) (Capital
Adequacy Guidelines for Banks: Internal-Ratings-Based and Advanced
Measurement Approaches).
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     The Commission also requests comment concerning the
desirability of incorporating a VaR approach or other comparable risk
measurement methodology in the segregated account approach to section
18. To what extent do funds currently employ VaR or a comparable risk
measure as part of their routine portfolio oversight procedures? Would
a VaR measure, potentially supplemented by stress testing and a
leverage measure, provide an adequate methodology for addressing
leverage risks in fund portfolios? What procedures would be required so
that any VaR methodology chosen by a fund would be implemented in a way
that adequately captures any additional risks associated with the use
of leverage and derivatives by a fund? What other quantitative criteria
might be employed in lieu of, or as a supplement to, VaR? Would
adoption of VaR or a comparable risk standard require review by the
Commission or Commission staff of particular risk measurement
methodologies in order to establish an appropriate level of investor
protection? What would be the costs and benefits of adopting a VaR
standard in lieu of an asset segregation approach in addressing the
treatment of derivatives under section 18?
     UCITS using VaR approaches to measure global exposure
limits are required to disclose in their prospectus their expected
level of leverage and the possibility of higher leverage.\123\ In the
event that the Commission were to accept a VaR approach in connection
with funds' use of derivatives, should funds be required to disclose
their expected and/or actual leverage levels?
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    \123\ See CESR's Global Exposure Guidelines, supra note 87, at
35.
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     UCITS using VaR approaches to comply with global exposure
limits are also required to maintain ``a rigorous, comprehensive and
risk-adequate stress testing program.'' \124\ Should a stress testing
requirement be imposed upon funds that use derivatives, at least where
a risk-based methodology is used to determine the required asset
segregation value? What standards, if any, should the Commission
establish for stress testing if such a requirement were to be imposed?
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    \124\ Id. at 31.
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     Are there any alternative measures that would provide
adequate coverage of a fund's future obligations throughout the life of
a derivative instrument as well as the availability of resources to
cover unanticipated price movements?
     During the recent credit crisis, did funds that used
derivatives and leverage demonstrate the ability to foresee and manage
the risks that manifested themselves in connection with derivatives and
leverage? Are there examples during the credit crisis where funds
incurred losses or experienced gains specifically attributable to their
derivatives usage?
     Is it the case that most futures contracts are highly
liquid, and that this facilitates rapid liquidation of a losing
position, enabling funds to minimize losses? Are there futures
contracts that are not highly liquid? Have there been instances where
futures contracts, that may typically be considered liquid, have become
less liquid, or illiquid? If so, please describe. Could there be
instances in the future where derivatives that have historically been
considered to be liquid become less liquid, or illiquid? If so, please
describe.
3. Related Matters
     Do derivatives that create economic leverage, but that do
not impose future payment obligations on funds, such as purchased
options or commodity-linked notes, raise the same or similar concerns
as derivatives that create indebtedness leverage? Do such derivatives
present any other material concerns to funds or their investors, or
raise other concerns under the Investment Company Act? If so, how
should the Commission address them?
     Please comment on these, or any other, alternative
approaches to the regulation of leverage under the Act. The Commission
requests comment on whether any other regulatory frameworks provide
relevant and useful approaches that the Commission should consider.
     Are there special considerations that need to be taken
into account for smaller funds? How might taking such considerations
into account impact investor protection?

III. Derivatives Under the Investment Company Act's Diversification
Requirements

    In this section of the release, the Commission discusses the
diversification requirements of the Investment Company Act. The
Commission also explores, and requests comment on, issues that arise in
the course of applying those requirements to funds' use of derivatives.

A. The Diversification Requirements

    Funds are required to disclose in their registration statements
whether they are classified as diversified or non-diversified.\125\ A
fund that discloses in its registration statement that it is classified
as diversified is prohibited from changing its classification to non-
diversified without first obtaining shareholder approval.\126\ A
diversified fund is a fund that, with respect to 75% of the value of
its total assets (the ``75% bucket''),\127\ has (among other things) no
more than 5% of the value of its total assets invested in the
securities of any one issuer.\128\ A non-diversified fund is

any fund that does not meet these requirements.\129\
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    \125\ Section 8(b)(1)(A) of the Act; Form N-1A, Items 16, 4(a)
and 4(b)(1); Form N-2, Item 17.
    \126\ Section 13(a)(1) of the Act.
    \127\ Rule 5b-1 under the Investment Company Act generally
defines ``total assets,'' when used in computing values for purposes
of sections 5 and 12 of the Act, as ``the gross assets of the
company with respect to which the computation is made, taken as of
the end of the fiscal quarter of the company last preceding the date
of computation.''
    \128\ Section 5(b)(1) of the Act. The term ``issuer'' is defined
in sections 2(a) and 2(a)(22) of the Act as ``unless the context
otherwise requires, * * * every person who issues or proposes to
issue any security, or has outstanding any security which it has
issued.'' In addition, a diversified fund, with respect to the 75%
bucket, may not own more than 10% of the outstanding voting
securities of any one issuer. See Section 5(b)(1) of the Act. A fund
seeking to qualify as a ``regulated investment company'' must comply
with the diversification requirements of section 851 of the IRC,
even if the fund is not diversified under the Investment Company
Act. The diversification requirements under the IRC are similar, but
not identical, to the diversification requirements of the Investment
Company Act. See 26 U.S.C. 851(b)(3)(2010).
    \129\ Section 5(b)(2) of the Act.
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    The purpose of the diversification requirements is to prevent a
fund that holds itself out as diversified from being too closely tied
to the success of one or a few issuers or controlling portfolio
companies.\130\ As one commentator has noted, the requirements are
designed to ensure that investors receive a clear statement of the
character of the portfolio of the fund in which they have
invested,\131\ and are intended to prevent any diversified fund from
becoming non-diversified without the prior approval of its
shareholders.\132\
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    \130\ Senate Hearings, supra note 49, at 188 (Statement of David
Schenker, Chief Counsel, Investment Trust Study, SEC, commenting on
a version of section 5(b)(1) that was similar, but not identical, to
the current version) (``a diversified company must have at least
several different securities in its portfolio, and cannot make
investments which will put them in a controlling position * * *.'').
    \131\ See, e.g., Alfred Jaretzki, Jr., The Investment Company
Act of 1940, 26 Wash. U. L. Q. 303, 314 n. 34 (Apr. 1941)
(``Jaretzki'') (the ``distinction between diversified and non-
diversified companies is due in large part, it is believed, to a
desire to inform stockholders of the character of the portfolio of
the company in which they have invested.'')
    \132\ Id. at 316-17.
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    For purposes of determining whether a fund is diversified or non-
diversified, the value of the fund's ``total assets'' is generally
determined as of the end of the fund's last preceding fiscal quarter
and includes the value of derivatives held by the fund. Under the
Investment Company Act's definition of ``value,'' \133\ the appropriate
valuation methodology to be used by a fund generally depends upon: (a)
Whether market quotations for the fund's portfolio securities \134\ are
readily available; and (b) whether the fund owned the particular
portfolio securities or other assets at the end of its last preceding
fiscal quarter. Specifically, the Act states that, ``unless the context
otherwise requires,'' the value of a fund's assets for purposes of the
diversification requirements is as follows:
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    \133\ ``Value'' is defined in section 2(a)(41) of the Act.
    \134\ Sections 2(a) and 2(a)(36) of the Act provide that,
``unless the context otherwise requires,'' the term ``security''
includes, among other things, any ``note'' or ``evidence of
indebtedness.'' As discussed supra note 57, the definition of the
term ``security'' in the Act is broader than the definitions of that
term in the other Federal securities laws and the Commission has
interpreted the term ``security'' in light of the policies and
purposes underlying the Act. As a general matter, most derivatives
appear to be notes or evidences of indebtedness and thus securities
for purposes of the diversification requirements. Treating
derivatives as securities for diversification classification
purposes appears to be consistent with the policies and purposes
underlying the diversification requirements, including the concern
that funds that classify themselves as diversified indeed have
diverse portfolios of investments, the performance of which is not
tied too closely to the success of one or a few issuers.
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     For each portfolio security owned at the end of the fund's
last preceding fiscal quarter for which market quotations are readily
available, the value of the security is the market value of the
security at the end of such quarter;
     For any other portfolio security or asset owned at the end
of the fund's last preceding fiscal quarter, the value of the security
or asset is the fair value of the security or asset at the end of such
quarter, as determined in good faith by the fund's board of directors;
and
     For any security or asset acquired by the fund after the
last preceding fiscal quarter, the cost thereof.\135\
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    \135\ Sections 2(a)(41)(A)(i), (ii), and (iii) of the Act.
Market value and fair value are discussed infra at Section VI.
(Valuation of Derivatives). See also Adoption of Rules Relating to
the Classification of Management Investment Companies as either
Diversified or Non-Diversified, Investment Company Act Release No.
178 (Aug. 6, 1941) [6 FR 3966 (Aug. 8, 1941)].
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B. Application of the Diversification Requirements to a Fund's Use of
Derivatives