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News September 26, 2011 Issue

Rominger Outlines Derivatives Duties of Mutual Fund Directors

The SEC has been telling mutual fund directors about their responsibilities with respect to derivatives since 1979. Fund directors may be in the best position to see the "forest for the trees" when it comes to derivatives, and SEC Division of Investment Management director Eileen Rominger wanted to remind them to brush up.

Speaking at a joint Mutual Fund Directors Forum/University of Maryland conference earlier this month on the oversight of derivatives, Rominger traced through the SEC’s guidance.

Just last week the SEC issued a concept release seeking broad public comment on the wide range of issues that mutual funds face under the Investment Company Act when investing in derivatives, she said. The release is "legal, technical and detailed," but figuring out the legal framework and complying with it is only a starting point. The fundamental issue for directors, in her view, is that the funds they supervise use derivatives responsibly, consistent with investor expectations, and against a backdrop of good risk management systems. "Derivatives are not ‘bad,’ but they are potent and at times full of surprises," said Rominger.

In 1979, the SEC’s concern focused on mutual fund practices with respect to reverse repurchase agreements, firm commitment agreements, and standby commitment agreements. At the time, the SEC issued a policy statement "a good part of which" addressed fund directors’ responsibilities, she said.

The SEC was concerned about the leveraging of fund portfolios, about funds’ ability to meet redemptions, valuation and accounting issues, and about investor understanding of what the funds were doing with derivatives.

Since 1979, this basic framework for looking at funds' leveraged trading practices and the use of derivatives has not changed much, she observed.

Fifteen years later in 1994, some mutual funds experienced some significant derivatives-related losses. Then-SEC Chairman Arthur Levitt urged fund boards to exercise meaningful oversight of fund derivative investments by becoming more involved in portfolio strategies, risk management, disclosure and pricing issues, accounting questions, and internal controls. In a 1995 symposium held by the SEC for mutual fund directors, Levitt said, "When I called upon directors more than a year ago to review derivatives policies, some people were skeptical. 'That's of concern to money managers, not directors,' they said. Some asserted that I was expecting too much of directors, asking them to get involved with something as technical as derivatives."

Levitt then cut to the chase.

"If directors don't take the time to understand how derivatives work, how a fund is using them, how clearly they are described to shareholders, and what the exposure of shareholders is — well, if the investment portfolio begins to explode, those directors are likely to get burned along with the fund and its shareholders."

Fastforwarding to the present, Rominger observed that the issues surrounding mutual funds' use of derivatives, and fund directors' role in dealing with them, are both old and new. The issues are old because they have been around for decades. The issues are new because "derivatives are evolving, funds are evolving, and effective risk oversight cannot stand still," she said. The SEC is looking to keep up through comprehensive review of the use of derivatives by mutual funds, including ETFs.

Rominger urged directors to use the concept release’s comment process to express their views on their funds' experiences with derivatives and about their responsibilities in this area.