Dec. 11, 2015
Before thanking the staff, I want to take a moment to thank Commissioner Aguilar at what is likely to be his last open meeting. For your nearly seven and a half years of service as a Commissioner, you have been a champion and advocate for the investor. I have greatly benefitted from your perspectives and friendship since I have been here. You will be greatly missed, and thank you again for your years of distinguished service.
Now I would like to thank the Commission staff for all of their work on this rule. This particular proposal was a long and massive undertaking. I think the proposal is something to be very proud of. In particular, I want to thank David Grim, Diane Blizzard, Dan Townley, Brian Johnson, Aaron Schlaphoff, Thoreau Bartmann, Jamie Walter, Erin Loomis, Adam Bolter, Sara Cortes, and Jacob Krawitz from the Division of Investment Management. I also want to thank Mark Flannery and his team in the Division of Economic and Risk Analysis for their work on the proposal and the accompanying white paper, in particular Christof Stahel, Daniel Deli, Yue Tang, William Yost, and John Cook.
As I have mentioned several times this year,[1] it is important to keep in mind the vital role that registered funds have played, and will continue to play, in the lives of everyday Americans. For many, these funds are how they save for retirement, or to send a child to college, or various other savings goals. Thoughtful revisions and modernizations of the Investment Company Act of 1940 ("40 Act" or "Act"), such as today´s proposal, will go a long way toward ensuring that these funds can continue to serve such an important mission for decades to come.
This proposal answers a pressing question that the Commission has been grappling with for many years – how should our rules be modernized to address the increasing use of financial innovations such as derivatives by mutual funds, exchange-traded funds ("ETFs"), and other funds? When the 40 Act was passed, the use of derivatives by funds was nonexistent and obviously not on the radar of regulators. But it is now, as we have seen significant growth in the use of derivatives by funds. Derivatives can be used for a variety of purposes, including hedging. However, today´s proposal deals in particular with how to address funds´ increasing use of derivatives to obtain leverage, in excess of amounts ever contemplated under the 40 Act.
For example, traditionally, a fund would simply purchase a debt security for whatever price that security cost. However, today a fund may enter into a derivatives contract called a total return swap. This swap may only require that the fund put down a very small amount of cash collateral upfront, but would provide the fund with the same economic exposure as if it had purchased the debt security in the traditional way. One of the questions in the proposal before us today, in effect is, what limits need to be put on such transactions?
Congress was clearly concerned about excessive leverage and borrowing when it wrote the 40 Act 75 years ago. This concern is reflected in the language of the Investment Company Act. Section 1(b)(7) of the Act notes that it is adverse to the national public interest when investment companies excessively borrow in a way that leads to undue speculation. And Section 18 of the Act has a core, fundamental investor protection purpose that is focused on the risks of excessive leverage and inadequate asset coverage. Clearly, investment managers that cater to sophisticated or accredited investors are free to pursue a highly leveraged strategy through a private hedge fund. But, today´s proposal appropriately recognizes that a highly leveraged strategy is at odds with 40 Act funds, and the retail investors that own such funds.
Today´s proposal breathes new life into these (and other) foundational provisions of the 40 Act. It modernizes our approach to addressing leverage and undue speculation, all while staying true to the investor protection intent underlying the Act. Registered investment companies were never intended to be highly levered vehicles. Since the inception of the Act, both regulators and legislators have recognized the risks that leverage can pose in both accelerating and exacerbating losses in investment companies.
Unfortunately, over the years we have seen a gradual erosion of the protections afforded under the 40 Act, especially when it comes to limiting leverage. Staff guidance and no action letters incrementally led us to a place unintended by the 40 Act. We drifted from the core principles meant to protect American families and individuals invested in these funds. Today´s proposal tackles this problem head on. It allows the Commission to make an active choice about how the 40 Act´s restriction on leverage should function in a modern world.
As staff has just discussed, the proposal´s three main components are: (1) a fixed limit on the amount of notional exposure; (2) asset segregation requirements; and (3) a derivatives risk management program. I am particularly pleased that the proposal imposes limits on a fund´s notional exposure, whether 150% for the exposure-based test, or 300% for the risk-based test. Although notional exposure is not an exact way to ascertain leverage, it does serve as a general measure of the fund´s economic exposure to the underlying reference asset for a derivative. The proposed limits should allow flexibility in a fund´s use of derivatives, while at the same time helping mitigate concerns about excessive leverage.
I am pleased to support this proposal. It forms a thoughtful framework for addressing a complicated issue. Thank you again to the staff for all of your hard work. I look forward to receiving comments.
[1] See, e.g., Commissioner Kara M. Stein, "Mutual Funds – The Next 75 Years," June 15, 2015, available at https://www.sec.gov/news/speech/mutual-funds-the-next-75-years-stein.html.