(Article from Registered Funds Alert, February 2015)
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Although many in the U.S. registered fund industry might quibble over the definition of what constitutes an “alternative” fund, there is Subhead_24-26universal agreement that the alternative asset class, however defined, has been a source of significant growth in the industry over the past several years.[1] And not surprisingly, the Securities and Exchange Commission (SEC) has noticed. Recent comments by the SEC Chair and Division of Investment Management senior staff and Office of Compliance, Inspections and Examinations (OCIE) activity suggest that not only is the SEC squarely focused on the growth of alternative funds, but that it is planning on using that growth as a basis for a more risk-based (as opposed to rules-based) approach to mutual fund regulation.
In a recent pair of high profile speeches, Norm Champ, the outgoing Director of the Division of Investment Management, acknowledged the attractiveness of the traditional registered fund wrapper for alternative strategies—both for sponsors and investors—and highlighted certain key risks, most notably liquidity management and derivatives use. Later in this Alert, we discuss in greater detail Mr. Champ’s comments regarding alternative funds.
Following Mr. Champ’s speeches, the SEC announced its regulatory agenda for 2015, which included its intention to propose rules related to fund liquidity management and use of derivatives. In December, SEC Chair Mary Jo White gave a speech in which she highlighted liquidity management and derivatives use as areas of concern, and framed each issue in the context of systemic risks to the financial system as a whole.
Mr. Champ’s remarks are notable because he was the first senior official at the SEC to hint broadly that the SEC may be considering risk-based oversight approaches to regulation of registered funds, including with respect to liquidity management and derivatives use. There had been some indication of a general concern regarding liquidity at the Staff level in an IM Guidance Update relating to fixed-income markets published in January 2014, in which the Staff suggested that fund managers may wish to “assess and stress test liquidity” in light of changing fixed income market conditions. In addition to the update and Mr. Champ’s remarks, OCIE announced a national sweep of alternative funds in early January 2014. This sweep examination is under way, and has focused heavily on liquidity management, in addition to other issues (also identified in Mr. Champ’s speeches). With respect to derivatives, in August 2011, the SEC issued a “concept release” relating to the use of derivatives by registered investment companies. There have been strong indications that derivatives guidance has remained a priority of the Staff since that time, with the delay stemming from a requirement to focus attention on Dodd-Frank related rulemaking, rather than any implication that the concept release and subsequent industry comment obviated the need for further guidance.
Chair White’s speech is notable in this context primarily because of the connection she drew between liquidity management and derivatives use, on the one hand, and systemic risk on the other. The Staff has indicated for some time that a new mutual fund data-gathering rule has been a priority of its rule-making group. Chair White reiterated that initiative as well, placing it in the context of alternative funds by saying that current reporting has not “adequately kept pace with emerging products and strategies.” Together, the three rule-making initiatives she discussed are reflective of the political realities facing the SEC’s continued regulation of the asset management industry. As evidenced by the protracted battle regarding regulation of money market funds, there is significant pressure on the SEC from the Financial Stability Oversight Council (FSOC) to demonstrate that the SEC should remain the primary regulator of the asset management industry and that its historical rules-based approach is adequate to oversee the perceived risks mutual funds may pose to the financial system. Viewed in that light, the SEC’s initiatives may be seen as focusing on the types of systemic risk issues that are the primary focus of FSOC and moving towards a prudential regulatory framework more familiar to the other members of FSOC.
The form that these new rules will take is unclear. For example, we would not expect that the SEC will propose the creation of a “chief risk officer” in the same manner in which it required a chief compliance officer in adopting Rule 38a-1. This belief is based on the fact that no uniform definition exists for what a risk officer would do, and partially on the lack of clear statutory authority for the SEC to create such a role, even under the Dodd-Frank Act.
We also do not know the extent to which the new rules will require mutual fund boards to be involved in risk management oversight. Currently, disclosure rules require disclosure of the extent of the board’s role in the risk oversight of a fund. Several comments by the Staff and Chair White suggest that a heavier emphasis on the board’s substantive role may be forthcoming, although there are many reasons why that would not seem to be an appropriate expectation for fund boards, which are, by design, oversight boards and substantially independent of the day-to-day management of the funds they oversee.
Finally, it would seem to be difficult to propose rules that provide for prudential oversight, as opposed to disclosure or rules-based oversight. Liquidity rules would be based on the statutory requirement for open-end funds to pay redemption proceeds in seven days found in Section 22(e) of the Investment Company Act of 1940 (1940 Act). Derivatives rules would be based on the prohibitions against issuance of senior securities found in Section 18 of the 1940 Act. Such statutory provisions provide the SEC with the ability to proscribe behaviors, but only to the extent the underlying principles of the 1940 Act are at issue. The SEC has broad power to require disclosure on topics, but that is different from requiring actions beyond the requirements of the 1940 Act. It also is worth mentioning that the SEC would not appear to have the requisite amount of examination staff that would be required to implement a prudential regulatory scheme similar to that used by the Federal Reserve with respect to national banks, for example.
If and when the SEC proposes rules on these topics, we would expect substantial industry comment. Regardless of the form these rules take, fund advisers and boards should continue to think carefully about these issues in the context of their own fund complexes. They should also be prepared for multi-pronged regulatory activity on this front in the meantime, including from FINRA and OCIE.
FINRA’s recent release of its Examination Priorities Letter for 2015 also highlighted alternative mutual funds. The release discusses the importance of accurate disclosures regarding how alternative mutual funds work, as well as the importance of maintaining consistency between their prospectuses and communications regarding such funds. FINRA indicated in the release that its review of current practices suggested that investors in such funds might not be able to fully appreciate alternative fund strategies or how such funds will respond in various market situations.
Finally, OCIE recently released its Examination Priorities for 2015. Specifically, the examination priorities release includes “Alternative” investment companies as one of its priorities under its goal of protecting retail investors and those investors saving for retirement. The release indicated a focus on leverage, liquidity and valuation policies and practices and the adequacy of the funds’ internal controls, including staffing, funding and empowerment of boards, compliance personnel and back-offices. Similar to FINRA’s recent Examination Priorities Letter, OCIE also indicated a focus on the adequacy of current disclosure practices during the marketing period.
[1] For example, under the Wall Street Journal’s definition, assets under management in alternative funds have grown 347% since 2008.