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News February 27, 2012 Issue

Rominger Describes Reorganization and Change in IM

Word has already spread of initial changes in the Division of Investment Management (IM). The rulemaking groups have been migrated under a central command. Subject matter experts are being hired into the division, or promoted from within to key roles in a reorganizing structure. Earlier this month in remarks before the Practicing Law Instituteís Investment Management Institute, IM director Eileen Rominger confirmed those moves and more as she described the many changes that have been implemented, that are in process, and that are on the radar for action in IM.

Fine tuning efficiency and effectiveness.

The goal is to support the Commissionís mission of protecting investors and facilitating capital formation without imposing unnecessary costs and burdens on regulated entities, she said. This task has become more and more challenging over the last decade as the size, but more significantly, the complexity of the investment management industry increased exponentially.

The goal is also to positively affect a registrantsí ability to work with the staff in solving day-to-day legal and business problems and comply with the regulations.

Rominger said IM is sensitive to the fact that advisers and investment companies rely on information and guidance from the SEC to run their business, serve client interests, and in the development of new products that may offer investors attractive benefits. She pledged improved responsiveness in those regards. "Although our response may not always be the one you were hoping for, we will work harder to respond in a timely manner at every step of the process," she said.

Internal efficiencies.

IM is seeking closer alignment to the way adviser and investment company registrants function, and to developments in the securities markets, including new products and instruments, said Rominger.

This initiative has resulted in the creation of new offices, policy-making modifications, acquisition of specific expertise where needed, and continuing development of existing expertise.

Rominger highlighted the following recent actions to promote internal efficiencies within IM:

  • Creation of a new private funds branch, led by seasoned hedge fund attorney Tram Nguyen. This branch will oversee the regulation of private fund advisers and the implementation of Form PF, addressing legal issues that may be relatively unique to these new SEC registrants. IM will develop and institutionalize this expertise as a resource for the SECís regulatory program, said Rominger.
    Rominger encouraged advisers with private funds to use the new branch as a resource. "Some of you in the audience may be working on private fund advisersí Form ADV and Form PF filings at this time and I want to let you know that this new branch is available should you need assistance," she said.
  • Implementing project teams in which subject matter experts in other offices within the Division are paired with experienced rule-writers to develop and draft rulemakings. This is a practice that has been successfully utilized by other divisions within the Commission and has, among other things, added significant value to the Commissionís policy-making function, said Rominger. It has also enhanced the professional experience of the staff.
  • Merging IMís two existing rulemaking offices to further enhance efficiencies in the rulemaking process.
  • Hiring additional subject matter experts to augment IMís current expertise. Recently, IM added exchange-traded funds expert Barry Pershkow, and derivatives expert Paul Schlichting. IM also anticipates hiring one or more financial analysts to advise the Division and the Commission on novel and complex investment products and other projects.
  • Hiring exam staff into IM that will work closely with OCIE to support IMís policy role and help the IM staff better understand the impact of regulations in the marketplace.

IM is also taking significant steps to provide its talented and dedicated staff with the resources and tools it needs to work more efficiently, said Rominger. One important step is IMís newly created Task Force on Knowledge Management.

This Task Force exists to assist senior management in identifying and implementing technology, processes, and procedures that will enable the Division to better manage its knowledge assets and workflow. Its goal is to create a knowledge management system that will increase productivity by improving the Divisionís ability to share information internally, track workflow, and access information relevant to specific projects.

Using focus groups to assist in assessing the effectiveness of current regulations.

IM is evaluating how effective its existing rules are in meeting their intended goals. Assessing empirical evidence, appropriate data, knowledge of investment and business practices, and obtaining feedback from investors and market participants all support that evaluation. The various costs and benefits associated with policy options warrant thoughtful consideration, too, she said.

Most companies providing products or services to the public routinely conduct focus groups or consumer testing, and realize the importance of this feedback, said Rominger.

IM has launched an investor testing initiative to evaluate the effectiveness of various types of disclosure. "I think it is extraordinarily valuable to have this kind of information as we work on our disclosure policy and I hope we will be able to do much more of it in the future," she said. Assuring that information is provided in a clear and useful manner to investors is central to the SECís mission, she observed.

The Division also has a responsibility to ensure that its rules continue to be effective years after adoption. Put simply, we need to make sure that our existing rules actually work the way we originally intended for them to work. We will work closely with OCIE in this endeavor.

Review of fund use of derivatives.

The SECís August concept release regarding fund use of derivatives was both a culmination and a beginning of efforts for IM, said Rominger. The concept release culminated a process of gathering several decades of regulatory and policy developments regarding derivatives for public comment. The concept release was also a starting point for the next generation of derivatives regulation.

The concept release posed over one hundred fifty questions for comment. The questions were both specific and spanned a number of broad areas, such as: the costs, benefits, and risks of fund use of derivatives, including any special considerations for ETFs; the application to derivatives of the Act's restrictions on leverage and portfolio diversification and concentration requirements; considerations relating to investment in securities-related issuers and to counterparty exposure; and valuation issues.

"Experience suggests that the controls in place to address fund investments in traditional securities can lose their effectiveness when applied to derivatives," said Rominger. This is particularly the case because a relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss ó or to an outsized exposure to an individual counterparty.

Historically, regulation of fund use of derivatives has developed on an ad hoc basis as new derivative instruments were introduced and new derivative hedging strategies gained popularity.

IM is now taking an opportunity in the wake of the financial crisis and concurrently with certain reforms related to the Dodd-Frank Act to re-think the SECís approach to the regulation of fundsí use of derivatives.

Rominger noted IMís deferred consideration of exemptive requests under the Investment Company Act (ICA) relating to ETFs intending to make significant investments in derivatives, pending this review. "We are cognizant of the need to act in a timely and expeditious manner, and in particular of the inconvenience that our deferred review of ETF exemptive requests may be causing some industry participants," she said.

The central issue identified in the concept release and echoed in the comments in response to the release is one of the leverage that funds incur when using derivatives, said Rominger.

The ICA draws a bright line limiting leverage, generally out of concern for the holders of both the senior and the junior securities of a fund. The current approach of segregating assets to cover a fund's obligation in a derivative transaction draws another bright line, with a similar goal of preventing excessive leverage, she said.

The concept release essentially asked whether the overall picture makes sense from a policy standpoint, and how it could be improved.

Could a level of autonomy be on the horizon for fund use of derivatives?

In the almost 50 comment letters received from across the industry and from individual investors, comments ranged from the impassioned Ė the derivatives market is "a giant casino" Ė to deep dives into detailed legal analyses, to requests for deferral of any action until the regulatory framework for swaps and security-based swaps under the Dodd-Frank Act is developed.

Rominger noted that the staff is mindful of the parallel regulatory developments on derivatives taking place under the Dodd-Frank Act as it reviews the comments received and considers next steps.

A significant number of commenters felt that funds should have greater flexibility in using derivatives, and in determining the amounts of assets that they need to segregate to cover their derivatives obligations, said Rominger. Many of these commenters also suggested that funds be given the ability to determine for themselves how and where to set their leverage limits in the context of derivatives.

This last suggestion is one of several that IM is examining more closely as it begins to analyze the comments on the concept release, she said.

"We are trying to imagine a regulatory world in which funds essentially set their own asset coverage and leverage limits in using derivatives," said Rominger.

IM is mulling over questions like:

"Would this approach lead to excessive leverage and raise the concerns that led Congress to limit fundsí leverage in the first place?

How would a fund go about deciding on its derivatives leverage limits?

Would there be a Ďrace to the bottomí if leverage drives performance and performance drives sales of fund shares?

Are fund directors or chief compliance officers in a position to guard against abuses in this area?

If they are, what tools do they have at their disposal and how would they use them?"

These types of questions are at the base of any future efforts to help ensure that the regulatory framework, as it applies to funds' use of derivatives, continues to fulfill the purposes and policies underlying the ICA, she said.

Next steps - more work to be done.

Even though the concept release covered a broad scope of issues related to fund use of derivatives, Rominger noted the many issues that were not discussed. Custody-related issues, broader risk management concerns, and IMís ongoing efforts to monitor and improve funds' disclosure about leverage generally and about the implications of using derivatives in particular are a few examples.

"We are continuously on the look-out, for example, for funds that appear to have significant derivatives exposure in their financial statements, but have limited or no discussion in their annual reports of the effect of those derivatives on the fundsí performance," she said.

The list of relevant issues to fund use of derivatives is long Ė leverage, valuation, diversification and concentration, counterparty exposure, custody, oversight, internal controls and risk management, as well as disclosure and investor understanding. Additionally, Rominger noted that assessing the costs and benefits of the various potential measures that could be considered to address these issues is an essential part of the process.

In a fund group that uses derivatives and worries about these issues, there is likely to be coordination and input from many sources Ė portfolio managers, fund directors, the chief compliance officer, risk management committee, auditors, custodians, legal counsel, to name a few, said Rominger.

As IM moves forward in reviewing these issues, it also coordinates with and draws input from sources within the SEC.

This means that the staff who contribute to the funds' use of derivatives initiative are not just the legal and policy experts in IM, but also disclosure reviewers, accountants, financial analysts, examiners, and members of the SEC's Division of Risk, Strategy, and Financial Innovation, to name a few, she said.