Financial Regulatory Reform Update

Welcome to PwC's Financial Regulatory Reform Update where we update you on the latest developments relating to financial services regulatory reform.

September 7, 2011

"Delay is preferable to error." - Thomas Jefferson

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." - Woody Allen

The Securities & Exchange Commission (SEC) Issues Concept Release on the Use of Derivatives by Investment Companies under the Investment Company Act


The SEC and its staff have been reviewing the use of derivatives by management investment companies registered under the Investment Company Act of 1940 (the 40 Act) and by business development companies under the 40 Act (collectively referred to as "funds"). To obtain input on a wide range of issues relevant to the use of derivatives by funds, the SEC issued on August 31, 2011 a lengthy, detailed and, in many respects, highly technical Concept Release that focuses on the use of derivatives under a number of provisions of the 40 Act, including with respect to senior securities (debt) restrictions, diversification requirements, exposure to securities related issuers, portfolio concentrations, and valuation of derivatives.

The SEC notes in its Release that the activities of funds, including their use of derivatives, are regulated extensively under the 40 Act, and SEC rules and guidance. The Release broadly describes "derivatives" 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"). Funds employ derivatives for a variety of purposes, including increasing leverage to boost returns, gaining access to certain markets, achieving greater transaction efficiency, and hedging interest rate, credit, and other risks. 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 other issues.

Background and Purpose of the Concept Release

A key impetus for the Release appears to be the dramatic growth in the volume and complexity of derivatives investments over the past two decades, and funds' increased use of derivatives. The SEC staff generally has been exploring the benefits, risks, and costs associated with funds' use of derivatives and 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 40 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.

The stated goal of the review by the SEC and its Staff 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 the Concept Release is to assist with this review and solicit public comment on the current regulatory regime under the 40 Act as it applies to funds' use of derivatives.

The SEC intends 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.

Issues Explored by the Release under the Investment Company Act

In its Release, the SEC first describes common uses of derivatives by funds and seeks input on the costs and benefits associated with the use of derivatives, whether different types of funds use derivatives for different purposes and whether ETFs use derivatives, among other questions.

However, the bulk of the Release analyzes the use of derivatives in light of several key statutory provisions of the 40 Act, with most of the discussion focused on Section 18 of the 40 Act which essentially limits the ability of a fund to borrow by issuing "senior securities" (debt securities and preferred stock ). The SEC's longstanding position has been that funds can remain in compliance with Section 18 if they "cover" senior securities by maintaining "segregated accounts" to limit the risk of loss. Under this "segregated account approach," a fund would establish and maintain with the fund's custodian a segregated account containing liquid assets equal to the indebtedness incurred by the fund with the issuance of the senior security.

However, the ways that the SEC Staff have approached the valuation of segregated assets have engendered criticism and the Release discusses several approaches to valuation, including one recommended in the 2010 ABA Derivatives Report as well as approaches in a number of jurisdictions for measuring and limiting risk, including in the EU, Singapore, Hong Kong and Canada. The SEC is seeking specific detailed comments on the segregated account approach and the ways it can be improved.

In briefer discussions, the Release reviews and seeks input on (i) derivatives valuation issues as they arise in determining whether a fund is classified as "diversified" or "non-diversified" based on its total assets, (ii) whether in interpreting Section 12(d)(3) which prohibits a fund from investing in "securities related issuers" (e.g., broker-dealers, underwriters or investment advisers), should apply when a securities related issuer is a counterparty to a fund in a derivatives transaction or the issuer of a reference asset in a derivatives transaction with the fund, (iii) how derivatives transactions with funds should be valued for purposes of determining application of fund concentration provisions in a particular industry or group of industries, and (iv) in determining a fund's net asset value, how do funds determine the value of derivatives for which market quotations are not readily available.

Comments will be due on the Concept Release 60 days after publication in the Federal Register.

The SEC Has Issued an Advance Notice of Proposed Rulemaking on the Treatment of Issuers of Asset Backed Securities under the Investment Company Act

The SEC (or Commission) is considering proposing amendments to Rule 3a-7 under the Investment Company Act of 1940 (40 Act), the rule that provides certain asset backed securities issuers with a conditional exclusion from the definition of Investment Company in the 40 Act. The SEC may consider amendments to Rule 3a-7 that could reflect market developments since 1992, when Rule 3a-7 was adopted, and recent developments affecting asset backed issuers, including passage of the Dodd-Frank Act and the SEC's recent rulemakings regarding the asset backed markets. To assist the SEC in its review it is issuing an Advance Notice of Proposed Rulemaking (ANPR) and soliciting broad public comment. The Commission is withdrawing its 2008 proposal to amend Rule 3a-7, which was published at 73 FR 40124 (July 11, 2008).

Revisiting Rule 3a-7 -- the Ratings Requirement

Asset backed issuers typically meet the definition of Investment Company under the 40 Act but generally cannot operate under the Act's requirements and restrictions. In 1992, the SEC adopted Rule 3a-7 specifically to exclude from the Investment Company definition certain asset backed securities that meet the Rule's conditions. In particular, to rely on Rule 3a-7, an asset backed issuer must issue fixed income securities that entitle holders to receive payments that depend primarily on the cash flow from eligible assets. The rule provides that the issuer's fixed income securities generally must be rated in one of the four highest ratings categories by a Nationally Recognized Statistical Rating Agency (NRSRO). The SEC indicated that it is considering the elimination of this rating requirement because it is concerned that such ratings have not served as a "proxy" to address Investment Company Act related issues. In this regard, when Rule 3a-7 was adopted, the SEC understood the rating to be based not only on creditworthiness but also on certain structural requirements and safeguards -- a situation which may not always be the case. The SEC seeks particular comment on whether ratings criteria should be replaced by other conditions.

Possible New Conditions for Rule 3a-7

Prescriptive or Principles Based Approach. To address the potential for conflicts of interest or abusive practices emanating from the asset backed structure, the SEC questions whether Rule 3a-7 should be more prescriptive -- imposing specific requirements or limitations on operations and structure -- or whether the SEC should follow a principles based approach relying more on disclosure of how the issuer is organized to address structural issues?

Ratings vs. an Independent Review. The Commission is considering whether to replace the rating condition in the Rule with a condition that would provide for an independent review of an asset backed issuer and its intended operations prior to the sale of its securities. Should the issuer provide a similar "certification" in its operating documents? The required independence of the potential "independent evaluator," whether a NRSRO could be an evaluator and the disclosure and scope of such evaluation are some of many issues the Commission is seeking input on.

Should Servicer Requirements Be Addressed More Directly under the Rule? The Commission is seeking comment on whether Rule 3a-7 should be amended to strengthen the preservation and safekeeping of the issuer's assets and cash flow. The current Rule does not limit the practice of servicers commingling the cash flow of asset backed securities with their own assets for periods of time. Should that be prohibited? The Commission after noting the irregularities that recently surfaced surrounding the ownership of certain securitized mortgages, asks how the requirement that an independent trustee have a perfected security interest in the eligible assets be strengthened?. Should the ways in which the cash flow from asset backed securities is invested include a condition on how it may be invested under the Rule and who receives the returns?

Determining Eligibility to Use Rule 3a-7

The Commission requests comment on whether the requirements of Regulation AB or the shelf eligibility requirements for asset backed securities may serve as a means to address some of the Commission's concerns with Rule 3a-7? What would be the effect of any such Rule changes, including on some asset backed issuers that privately offer their securities based on Rule 3a-7?

The Exclusion Provided by 3a-7 in Light of Changes in the Asset Backed Markets

The SEC is I also interested in better understanding how the manner in which the exclusion provided by the Rule affects the status of holders of securities issued by Rule 3a-7 issuers. The SEC notes that many asset backed issuers under Rule 3a-7 were established by companies that sought to capture -- by holding the equity or residual interest in these issuers - the spread between the yield of the assets being securitized and the financing cost of the securities being issued. In this regard, the SEC notes that approximately 11.5% of the CDOs issued globally were issued to remove assets from the balance sheet of the originator. The rest consisted of arbitrage CDOs. Should such companies be considered as being engaged in the business of investing in securities and regulated as investment companies under the Act? The SEC expands on this market change in footnote 100, where it makes the point that at the time the Rule was adopted most private-sector sponsors of asset backed securities typically securitized financial assets that they themselves had originated to facilitate the operation of their non-investment company businesses. At the time the rule was adopted, the purpose and operations of asset backed issuers were thus fundamentally different from investment companies.

The SEC is requesting that comments be provided within 60 days of publication in the Federal Register.

Federal Reserve Issues Proposal Outlining Procedures for Securities Holding Companies to Elect to be Supervised by the Federal Reserve

The Federal Reserve Board (FRB) issued a proposed rule on August 31 to implement Section 618 of the Dodd-Frank Act which allows nonbank companies that own at least one registered broker or dealer and that are required by a foreign regulator or provision of foreign law to be subject to comprehensive consolidated supervision, to register with the FRB as a Securities Holding Company (SHC) and be subject to supervision by the FRB.


U.S.-based investment banking firms may need banking licenses in many countries to conduct their full scope of capital markets activities. Consistent with Basel principles, bank regulators overseas typically require that the parent institution be subject to comprehensive consolidated supervision in its home country. Within the last several years, most major U.S. investment banking firms have become bank holding companies and thus meet such CCS requirements. Other firms have met such local CCS requirements through use of Savings and Loan Holding Company status or use of Article XII banking companies in New York to hold their foreign operations. The SHC provides a specific option for firms who don't otherwise qualify or want BHC or SLHC status.

The proposed regulation outlines the requirements that a SHC must satisfy to make an effective election, including submitting initially required information, providing all additional required information and satisfying the statutory waiting period of 45 days.

Scope of SHC Supervision

An SHC that registers with the FRB is subject to the full regulatory reporting, examination, supervision and enforcement regime applicable to a registered Bank Holding Company (BHC), including capital requirements set by the FRB (which the FRB can modify to take into account differences in activities and structure.) The main difference between a BHC and an SHC is that the latter need not comply with the BHC Act restrictions on nonbanking activities. Under the proposed rules, a company is not eligible to become a SHC if it is already a BHC, a savings and loan holding company, a foreign bank with US operations or an insured bank or savings association.

The proposal specifies the information that an SHC will need to provide to the FRB as part of registration, including information related to its organizational structure, ownership, capital, and financial condition, as well as information on the bank regulatory system that exists in the home country of any of its foreign bank subsidiaries. The proposed form is similar to the Board's current form Y-3F which is used by a company registering to become a bank holding company.

Comments on the proposal are due by October 11, 2011.

The Financial Stability Board's Work on Shadow Banking Continues

The Financial Stability Board (FSB) announced that it has approved the initial recommendations for strengthening the oversight and regulation of the shadow banking system prepared by its Shadow Banking Task Force (Task Force). The FSB has been established to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability. It brings together national authorities responsible for financial stability in 24 countries and jurisdictions.

Progress on Monitoring

The initial recommendations are for developing a stronger monitoring framework of the shadow banking system, and include high-level principles for the relevant authorities and a stylized monitoring process that would require authorities to first assess the broad scale and trends of non-bank credit intermediation in the financial system, drawing on information sources such as Flow of Funds and Sector Balance Sheet data, and complemented with other relevant information such as supervisory data. Based on this assessment, authorities will narrow down their focus to non-bank credit intermediation that has the potential to pose systemic risks, by focusing in particular on those involving four key risk factor: (i) maturity transformation; (ii) liquidity transformation; (iii) imperfect credit risk transfer; and/or (iv) leverage.

Work Plan on Regulation

With regard to the initial recommendations for strengthening regulation of the shadow banking system, the Task Force has developed general principles for designing and implementing regulatory measures. It has also conducted a regulatory mapping exercise to take stock of existing national and international initiatives on the four broad categories of possible regulatory measures set out in an April Background Note.

As a result of this, the Task Force has identified five areas where more detailed work is warranted to help gauge the case for further regulatory action. The five areas are:

  1. the regulation of banks' interactions with shadow banking entities (indirect regulation), in particular, examining: consolidation rules for prudential purposes; limits on the size and nature of a bank's exposures to shadow banking entities; risk-based capital requirements for banks' exposures to shadow banking entities; and treatment of implicit support;
  2. the regulatory reform of money market funds (MMFs);
  3. the regulation of other shadow banking entities;
  4. the regulation of securitizations, in particular with regard to retention requirements and transparency; and
  5. the regulation of activities related to securities lending/repos, including possible measures on margins and haircuts.

In order to make progress, the FSB has decided to set up dedicated work streams to focus on each area. The work streams will develop preliminary work plans shortly, and report their progress as well as the proposed policy recommendations to the FSB by July 2012 (or end-2012 for securities lending/repos). The FSB will elaborate on the recommendations for strengthening the oversight and regulation of shadow banking in a report for the G20 in October.