Managing Mutual Funds and Exchange Traded Funds: Advanced Topics in Derivatives

Managing Mutual Funds and Exchange Traded Funds: Advanced Topics in Derivatives Jedd H. Wider, Richard F. Morris, Sean Graber, Thomas V. D Ambrosio and Brian T. London June 3, 2014 Please note that any advice contained in this communication is not intended or written to be used, and should not be used, as legal advice. www.morganlewis.com

Agenda Diversification Requirements Portfolio Concentration Valuation Leverage and Coverage Requirements Proposed Position Limit Aggregation Rules 2

Diversification Requirements 1940 Act Diversification A fund must elect to be either diversified or non-diversified Must specify in the prospectus if non- diversified Under Section 5(b), a diversified fund is a fund that, with respect to 75% of the value of fits total assets, has (among other things) no more than 5% of the value of its total assets in the securities of any one issuer The remaining 25% of the fund can be nondiversified A non-diversified fund does not meet these requirements Generally tested on a daily basis Diversified Bucket Non-Diversified Bucket 3

Diversification Requirements Identifying the Securities A fund must identify the derivatives to which the fund s diversification policy may apply. Section 5(b) focuses on the amount of a fund s assets that are represented by the securities of any one issuer. Only some derivative instruments are specifically identified as securities in Section 2(a)(35) of the 1940 Act (e.g., options on securities and security futures ). Other types of futures contracts (e.g., currency futures) are not securities because they are not security futures. A security future is a contract for future sale or delivery of a single security (but not an exempted security under Section 3(a)(12) of the 1934 Act) or of a narrow-based security index. 15 U.S.C. 78c(a)(55). The status of other instruments (e.g., swaps and forwards) as securities under Section 5(b) is not clear. Many funds treat some swaps and forwards as securities, for purposes of determining the amount of total assets that are attributable to a single issuer, if the instruments use specific securities as 4 reference assets.

Diversification Requirements Identifying i the Securities (continued) Other types of derivatives (e.g., Treasury futures and futures on broad-based based security market indexes) are not securities under the 1940 Act even though they provide exposure to the securities of certain issuers. For example, U.S. Government securities are the reference assets for Treasury futures, and Section 5(b) specifically excludes U.S. Government securities from calculation for diversification ifi purposes. It stands to reason that t Treasury futures therefore should not be included in determining the amount of total assets that are attributable to a single issuer. 5

Diversification Requirements Identifying the Issuer A fund must also identify the issuer of the security to which the fund s diversification policy may apply. Section 2(a)(22) of the 1940 Act defines issuer to mean every er person who issues or proposes to issue a security, or has outstanding any security which it has issued, unless the context otherwise requires. When a fund enters into a derivatives transaction, ti the fund may gain exposure both to the issuer of the derivative (counterparty) and to the issuer of the underlying reference security. For example, in the case of a total return swap on the common stock of a corporate issuer, the potential exposure of the fund created by such derivative is to both the counterparty to the contract and the issuer of the reference security. 6

Diversification Requirements Identifying the Issuer (continued) In the context of a derivative instrument, it is therefore not always clear whether the diversification test should consider the derivative s counterparty or the issuer of the underlying referenced securities. The SEC has not directly addressed this issue, but in Hyperion Capital Management, Inc., SEC No-Action Letter (Aug. 1, 1994) the SEC Staff stated that the Staff generally has deemed the issuer of a security to be the person to whom the holder of the security looks for payment. How are OTC derivatives treated? In the case of OTC derivatives (e.g., swaps, forwards, non-exchange traded options), a fund looks to payment from its counterparties. As a result, funds generally treat their counterparties as the issuers for purposes of determining compliance with diversification requirements. 7

Diversification Requirements Identifying the Issuer (continued) How are exchange-traded derivatives treated? In the case of exchange-traded derivatives (e.g., exchange-traded options on securities and security futures), a fund does not have an identified counterparty. As a result, funds generally look through such instruments to the underlying reference assets for purposes of determining compliance with diversification requirements. The treatment of exchange-traded derivatives in this context is akin to the treatment of fully collateralized repurchase agreements. Rule 5b-3 sets forth the circumstances in which a fund may look through the obligation of a counterparty to the collateral securing a repurchase agreement in identifying the issuer for purposes of Section 5(b). See Treatment of Repurchase Agreements and Refunded Securities as an Acquisition of the Underlying Securities, Investment Company Act Release No. 25058 (July 5, 2001), 66 Fed. Reg. 36156 (July 11, 2001). 8

Portfolio Concentration Concentration Under Section 8(b)(1)(E) of the 1940 Act, registered funds are required to disclose in their registration statements their policy concerning concentrating investments in a particular industry or group of industries. Note the use of the term investments as opposed to securities securities. Funds are prohibited from deviating from their concentration policy without obtaining shareholder approval. If a fund has a policy to concentrate, it must at all times be concentrated. Generally, a fund cannot reserve the freedom of action to deviate from its concentration policy based on the current market environment or at the discretion of the adviser. 9

Portfolio Concentration Concentration ti (continued) The SEC has stated generally that a fund is concentrated in a particular industry or group of industries if the fund invests or proposes to invest more than 25% of the value of its net assets in a particular industry or group of industries. Per SEC no-action letters, an index fund is permitted to concentrate its investments in a particular industry or group of industries to the same extent that its underlying index is concentrated. This gives index funds the flexibility to be concentrated or not concentrated depending on the current makeup of the holdings of the index. 10

Portfolio Concentration Identifying the Industry When a fund enters into a derivatives transaction, the fund may gain exposure to more than simply the reference asset. E.g., g, in a total return swap between a fund and a bank on Toyota stock, the fund may become exposed to both the banking industry (associated with the counterparty) and the automobile industry (associated with the issuer of the reference asset). Concentration standard does not address whether the fund should look to the counterparty or the reference asset when determining compliance with its concentration policy. If funds were to test concentration compliance by looking at the counterparty, funds could be deemed to be concentrated in the financial services industry depending on their use of OTC derivatives. 2010 ABA Derivatives Report states that funds typically comply with their concentration ti policies i by looking to the reference asset and not any counterparty to the derivative instrument. 11

Valuation Valuation When determining compliance with a fund s concentration and diversification policies, the fund must calculate the value of its portfolio securities (including certain derivatives held by the fund). Pursuant to Section 2(a)(41) of the Investment Company Act, a fund must use the market value (or fair value) to value derivatives. 12

Valuation Valuation in Connection with Concentration ti Requirements One issue relevant to determining industry concentration is whether a fund values its derivatives using notional amount or market value. 2010 ABA Derivatives Report states that using the notional value, rather than the market value, of a derivative instrument may inflate an industry position relative to the fund s current economic exposure. 2010 ABA Derivatives Report further states that a fund will typically apply the market value of the derivative to the reference asset when determining compliance with its concentration policy. 13

Valuation Valuation in Connection with Diversification Requirements SEC has also questioned whether a mark-to-market valuation method is adequate to achieve Section 5(b) s purpose of preventing a fund that holds itself out as being diversified from being overly exposed to a single issuer, given that the market or fair value of a derivative instrument may not reflect the true extent of the fund s exposure to the underlying reference asset. For example, a fund that holds itself out as diversified may invest four percent of its assets in securities of an issuer to which it has additional exposure through a total return swap that creates exposure equal to another four percent of its assets on a notional basis, yielding a combined exposure to the issuer of eight percent of the fund s total assets. Although the current mark-to-market value of the total return swap would likely be sufficiently low to enable the fund to calculate its investments in the issuer at less than five percent of its total assets, the fund s total exposure to that issuer is over five percent of its total assets. See Derivatives Concept Release issued by the SEC. 14

Valuation Valuation in Connection with Rule 35d-1 It has been the SEC staff s position that only the market value of a fund s investments in derivatives should be used for purposes of determining compliance with the 80% investment policy requirement of Rule 35d-1 under the 1940 Act (the names rule ) ). This position can be particularly challenging when the majority of a fund s exposure is obtained through derivatives with large government securities acting as collateral l for such derivatives. 15

Leverage and Coverage Requirements Senior Securities Issues (Section 18) A senior security under Section 18 of the 1940 Act is broadly defined to represent any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness of a fund In essence, any indebtedness or borrowing by a fund is generally considered a senior security Rule of thumb: If a third party has a claim on fund assets that is senior to equity claims, then a senior security is likely Rules for open-end and closed-end funds are different 16

Leverage and Coverage Requirements Borrowing Open-End Fund An open-end fund is permitted to borrow from a bank, so long as there is asset coverage on all borrowings equal to at least 300% An open-end fund is permitted to make temporary borrowings (borrowings repaid within 60 days without being renewed or extended ) in an amount not exceeding 5% of the fund s total assets Closed-End d Fund Closed-end funds are permitted to issue senior securities representing indebtedness to any lender if there is an asset coverage of at least 300% for all borrowings. o Treatment of Short Sales Per industry practice, reinvesting short sale proceeds in portfolio securities (e.g., as part of a 130/30 strategy) may be considered a borrowing subject to 300% asset coverage requirements. 17

Leverage and Coverage Requirements Securities Lending Pursuant to SEC policies and interpretations, a fund is required to maintain asset coverage of at least 300% for all loaned securities. For purposes of determining compliance with the 300% asset coverage requirement, a fund may treat both the securities on loan and the collateral received in return for the loaned securities as assets of the fund. The SEC staff has stated that collateral may be treated as an asset for purposes of coverage requirements regardless of the form of collateral (e.g., cash or liquid securities) and regardless of whether the collateral should be treated as an asset of the fund for accounting purposes. See The Brinson Funds, et al., SEC No-Action Letter (pub. avail. Nov. 25, 1997); Salomon Brothers, SEC No-Action Letter (pub. avail. May 4, 1975); DataConcepts Fund, Inc., SEC No-Action Letter (pub. avail. Aug. 25, 1980). 18

Leverage and Coverage Requirements Senior Securities Futures, forwards, written options, swaps, and short sales are generally considered senior securities because they have a leveraging g effect on a portfolio. These securities are leveraged because you can create an exposure that far exceeds the amount of money used to buy the exposure. For example, you can generally buy a futures contract with a notional exposure of $100 by committing just $5. SEC will not treat these as senior securities if the exposure on the transaction is covered, which can be done by: Earmarking or segregating liquid assets equal to the fund s obligation under the derivative; or Entering into an offsetting transaction that hedges away the fund s exposure. 19

Leverage and Coverage Requirements Cost-to-Close t Cl the Transaction The SEC has provided some guidance with respect to the amount of coverage required in the context of various no-action letters and other guidance, but this is somewhat of a gray area for many instruments and is very fact dependent. As a general rule, many fund companies use the cost-to-close to close a transaction when determining the level of appropriate coverage. Cost-to-close, as the term suggests, is the dollar amount to be delivered upon settlement to close the transaction. In some cases, this may be a net marked-to-market amount. In other cases it is the full notional amount. 20

Sample Transactions Options Option Purchase Transactions. Assume that the Fund buys a call option on a bond. (a) Is the Fund deemed to be using leverage or issuing a senior security that needs to be covered for purposes of the 1940 Act? No, because the option gives the Fund the option to purchase, but no obligation to purchase, the underlying bond. Option Writing Transactions. Assume that the Fund sells (writes) a call option on a bond and does not own the underlying bond. (a) Is the Fund deemed to be using leverage or issuing a senior security that needs to be covered for purposes of the 1940 Act? Yes, when the Fund writes a call option it creates an obligation to sell a security to the purchaser at the stated price and time. (b) What is the amount that needs to be covered? The Fund needs to cover its obligation with cash or liquid securities in an amount equal to the greater of the strike price of the option or the current market value of the underlying bond. Alternatively, the Fund may cover its obligation by holding the underlying bond. 21

Sample Transactions Futures Assume that the Fund buys $100 of five-year interest rate futures and sells $100 of ten-year interest rate futures. The futures have the same term. (a) Is the Fund deemed to be using leverage or issuing a senior security that needs to be covered for purposes of the 1940 Act? Yes, the Fund has two positions that create a senior security and must be covered on each side of the transaction. The futures create senior securities under the 1940 Act because, unlike the options, both the long and short futures impose the obligation on the Fund to settle. (b) What is the amount that needs to be covered? The amount that needs to be covered depends on whether the futures in question provide for net cash settlement or delivery of the underlying. However, in general, the Fund is required to cover its obligations with cash or liquid securities in an amount equal to the value of whatever the Fund is obligated to deliver at settlement. (c) Can the long and short positions be used to cover each other? The futures in the above example cannot be used to cover each other, because the obligations created by the transactions are not economically offsetting. Accordingly, each future would have to be covered in the manner described above. 22

Sample Transactions Short Sales Assume that the Fund borrows $100 of XYZ stock from a broker-dealer and sells XYZ stock in a short-sale transaction. (a) Is the Fund deemed to be using leverage or issuing a senior security that needs to be covered for purposes of the 1940 Act? Yes, the borrowing XYZ stock to sell short results in an obligation to return the XYZ stock to the brokerdealer, which results in a senior security for purposes of the 1940 Act. (b) What is the amount that needs to be covered? The amount that needs to be covered is the value of the XYZ stock borrowed from the broker-dealer. This amount needs to be marked to market daily as the value of the XYZ stock fluctuates. 23

Sample Transactions Short Sales (continued) Custody issues Section 17(f) of the 1940 Act generally requires registered investment companies to custody their assets only with certain financial institutions following certain restrictions. As a result, funds typically post collateral to derivative counterparties via a special custody account administered under a tri-party control agreement among the fund, the fund s custodian and the counterparty. 24

Sample Transactions Custody issues (continued) The Staff analyzed custody arrangements in connection with short sales in a no-action letter to Robertson Stephens Investment Trust (pub. avail. Aug. 24, 1995) In analyzing the amount required to be designated to cover the short sale, the Staff acknowledged that broker-dealers typically require (and are required to obtain as initial margin under Regulation T) from a fund selling equities short cash or marginable securities as collateral having a market value at least equal to the proceeds of the short sale, plus an additional amount equal to 50% or more of the value of the securities sold short. Further, the Staff s conclusion expressly agreed that the collateral deposited with the broker in connection with the short sale, could be combined with amounts in the segregated account when calculating the required coverage amount (i.e., the current market value of the securities sold short). 25

Proposed Position Limit Aggregation Rules Position limits it re-proposed 28 physical commodity futures and option contracts as well as economically equivalent swaps Ex: NYMEX light sweet crude oil, NYMEX NY Harbor ULSD (ultra low sulfur diesel), NYMEX RBOB Gasoline, NYMEX Henry Hub Natural Gas Economically equivalent if linked to the price of the future or the price of the commodity at the delivery location Spot month, single month, all month limits Hedging g exclusions 26

Position Aggregation Generally required to aggregate all positions for which: h Person directly or indirectly controls trading; or Holds a 10% or greater ownership or equity interest; or An express or implied agreement exists for trading; or Person controls trading strategies in accounts or pools with substantially identical trading strategies. 27

Position Aggregation (continued) Some exemptions available Use of independent account controller (IAC) to manage positions Entity cannot exercise control over trading or IAC IAC must trade independently IAC must be registered as FCM, IB, CTA, or AP or be the GP of a pool where the CPO is exempt under 4.13 Does not apply to spot month limits in physical Pooled accounts Participants do not have to aggregate pool positions in which there is a 10% or greater interest, unless it is a CPO, a principal/affiliate p of a CPO or 25% ownership of a pool where the CPO is exempt under 4.13 Ownership of an entity greater than 10% but not more than 50% Cannot have knowledge of trading decisions, need independent trading systems, written procedures for information barriers, no sharing employees, risk management systems cannot share information 28

DF Documentation Amendment of ISDAs August 2012 DF Protocol Addresses external business conduct, large trader reporting, position limits, recordkeeping, and reporting rules March ac 2013 DF Protocol ooco Addresses confirmation, portfolio reconciliation, swap trading relationship documentation requirements, and end-user exception to clearing 29

DF Documentation (continued) Clearing requires a futures commission i merchant (FCM) Futures account agreement Addendum for cleared derivatives transactions Addresses liquidation and termination amount calculations for events of default and tax items Cleared derivatives execution agreement Addresses mechanics of clearing the swap and failures to clear Clearing requires clearinghouse and FCM imposed margin 30

EMIR Treatment t under EMIR? Financial counterparty/non-financial counterparty as if it were organized in the EU In either case a party has obligations if it transacts with a dealer that is subject to EMIR (i.e., an EU dealer) 31

EMIR Documentation 2013 EMIR NFC Representation ti Protocol Enables parties to determine which EMIR requirements might apply 2013 EMIR Portfolio Reconciliation, Dispute Resolution, and Disclosure Protocol 2013 Reporting Protocol 32

Key SEC Guidance The Derivatives Concept Release issued by the SEC is available at https://www.sec.gov/rules/concept/2011/ic-29776.pdf. The ABA s Task Force Report on Investment Company Use of Derivatives and Leverage is available at https://apps.americanbar.org/buslaw/blt/content/ibl/2010/08/0002.pdf. In addition to the referenced sources, key SEC guidance on the use of derivatives is contained in: Registered Investment Company Use of Senior Securities Select Bibliography, U.S. Sec. & Exch. Comm n, http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm Securities Trading Practices of Registered Investment Companies, Inv. Co. Act Rel. No. 10666 (April 18, 1979) Merrill Lynch Asset Management, L.P., SEC No-Action Letter (pub. avail. July 2, 1996) Dreyfus Strategic Investing and Dreyfus Strategic Income, SEC No-Action Letter (pub. avail. June 22, 1987) Robertson Stephens Investment Trust, SEC No-Action Letter (pub. avail. Aug. 24, 1995) http://www.sec.gov/divisions/investment/imseniorsecurities/huttonoption101888.pdf /di i i /i /i i i i /h i df 33

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