Steven A. Keen of Perkins Coie has posted an insightful discussion of section 18 of the Investment Company Act of 1940, and of the pending proposed regulation under that mandate, Rule 18f-4, on one of that firm’s blogs, the Derivatives & Repo Report.
Both that proposal and Keen’s observations are worth some examination here, not least because a good engine- parts metaphor is relatively rare in this field.
Last year, the SEC’s Division of Economic and Risk Analysis (DERA) produced a White Paper on the use of derivatives by registered investment companies that is generally regarded as the empirical foundation of the present form of the proposed rule. That paper found that funds that “make a greater use of derivatives have received a disproportionately large share of fund inflows since the end of 2010.”
The proposal if finalized would create an exemption from existing restrictions on the issuance of senior securities by mutual funds, available for funds that elect to be treated as business development companies. But there would be a trade-off. A mutual fund that elected BDC treatment would have to “comply with one of two alternative portfolio limitations designed to impose a limit on the amount of leverage the fund may obtain through derivatives transactions and other senior securities transactions….”
Also, and for some more intriguingly, the proposal would step up the level of responsibility that the SEC assigns to the directors of a mutual fund. The Independent Directors Council, in its comment, wrote to “caution the [SEC] to be mindful about the effect each new initiative has on the totality of fund board responsibilities.”
The Automotive of the 1940
One obvious question raised by the proposal: why did Congress back in 1940 want to limit the issuance of senior securities in the first place? Because, says the Securities and Exchange Commission, the issuance of excessive amounts of senior securities renders the junior securities overly speculative, and because funds might find themselves operating without adequate assets and reserves to meet their commitments. Those concerns have their historical basis in certain scandals of 1920s pre-Crash finance, and they remain present in the generations of regulations and rule making that have followed.
As Keen, a member of Perkins Coie’s Investment Management Group observes, the life of the proposed reg began as a concept release five years ago. Keen himself contributed a comment letter to that 2011 concept release, and he empathized there with the SEC’s to keep up with the changing market realities given an antiquated law, a situation analogous to “regulating 1940’s era carburetors in today’s world of computerized fuel-injected engines.” Although “some basic principles remain the same … the mechanisms are almost entirely different.”
Another obvious question, one that is outside the scope of Keen’s brief blog entry, might be: what does the proposed regulatory change do to the understood nature of a BDC? The BDC form was first created to serve as a source of capital for small and medium sized businesses. To that end, as noted by a committee of the Business Law section of the American Bar Association has observed, Congress intended that BDCs would be able to incur more leverage than is permitted for other regulated funds. By turning BDCs into a special case of mutual funds and adding leverage limits, the SEC arguably undermines that congressional intent.
This ABA committee also, like the IDC commenter quoted above, is concerned about the expanding role of directors. The committee urges that the SEC “confirm that it does not intend any final version of the proposed rule to change the relevant legal standards applicable to Bard oversight of Funds and their investment advisors.”
Speculation Can Continue
But to return to and to conclude with Keen’s blog entry, posted on April 28: it is chiefly concerned with making the point that the SEC is now trying to regulate the means of speculation, not the end or degree. It isn’t regulating how speculative mutual funds can be, only how speculative they can become by means of borrowing or of issuing senior securities. Other means by which they might get to the same speculative end, he says, are: investing in the equity of highly leveraged companies or using put or call options.
Fuel injection systems, then, can stay on the road.