November 2011
Inside this issue:
SEC Issues Concept Release
Relating to the Use of
Derivatives by Investment
Companies ................................ 1
Changes in Composition of
Commissioners at the SEC........ 2
SEC’s OCIE Issues First Ever
National Exam Risk Alert ........... 3
SEC Launches New
Whistleblower Website .............. 4
FSOC Issues Second Proposed
Rule for SIFI Designation........... 4
SEC Issues Concept Release Relating to the
Use of Derivatives by Investment Companies
The Securities and Exchange Commission (“SEC”) recently issued a concept release
(“Concept Release”) requesting information on funds’ use of derivatives, including
whether funds have changed their approach to the use of derivatives – and, if so, in
what respects — as well as what benefits, risks and costs funds experience in their
use of derivatives. The SEC is eliciting this information in order to assess
whether its approach should be modernized to acknowledge how funds are
using derivatives today.
The Concept Release does not specifically address the role of mutual fund
boards in derivative oversight. Eileen Rominger, Director of the SEC Division of
Investment Management, remarked in a speech before the Mutual Fund Directors
Forum on September 9, 2011, at the University of Maryland “Oversight of
Derivatives” Conference:
In my view, the fundamental issue and what you care about as
fund directors is that mutual funds use derivatives responsibly,
consistent with their investors’ expectations, and with the
backdrop of good risk management systems.
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Ms. Rominger invited board members to comment on the Concept Release and
stressed the need for board members to express to the SEC their views as to whether
the rules could be clearer and whether the SEC can provide assistance in helping
fund boards be more effective in their role.
The Concept Release also focuses on several specific issues under the 1940 Act
implicated by funds’ use of derivatives, including the following:

regulatory restrictions associated with the 1940 Act concept of senior securities
as it applies to derivatives

approach to identifying the issuer of a derivative for purposes of measuring fund
portfolio diversification

approach to determining fund exposure to certain securities-related issuers

limitations on fund portfolio concentration

valuation of fund assets
Senior Securities Restrictions. The 1940 Act restricts the manner in which, and the
extent to which, funds may incur indebtedness and may leverage their portfolios. It
also requires funds to maintain certain asset coverage requirements. The Concept
Release requests industry guidance on how to measure the amount of leverage
that a fund incurs when it invests in a derivative.
The Concept Release acknowledges, as part of its review, that the SEC considered
the American Bar Association’s Section of Business Law’s Report of the Task Force
on Investment Company Use of Derivatives and Leverage (the “ABA Derivatives
Report”). The ABA Derivatives Report had observed that the “basic framework as
articulated in [the SEC’s interpretations of
derivatives as senior securities in] Release 10666 has
worked very well” as applied to funds’ derivative
investments, but “there are open issues and
inconsistencies in the current [Commission] and
staff guidance regarding the application of . . . the
1940 Act to transactions in derivatives.” The
Concept Release is requesting comment on funds’
current approach to segregation and industry views
on alternative approaches which may recognize the
significant differences in individual transactions.
The Concept Release is also requesting comment on
whether current asset segregation practices are
adequate and whether fund boards have sufficient
expertise to oversee alternate approaches to
procedures.
By way of example, the Concept Release noted:
“if a fund and bank enter into a total return
swap on stock issued by a corporation in the
pharmaceuticals industry, the fund will have
gained exposure to the banking industry (i.e.,
the industry associated with the fund’s
counterparty) as well as exposure to the
pharmaceutical industry (the industry associated
with the issuer of the reference asset).”
The SEC is requesting comment on whether
funds, when measuring concentration, should
look to counterparties or reference assets.

Valuation of Fund Assets. The Concept
Release also considers whether the SEC should
issue guidance on how funds should value
derivatives in their portfolios, including OTC
derivatives. Market quotations may not be
available for certain derivatives and, when
market quotations are not readily available, the
fund must calculate NAV by using the fair
value of those securities or assets as
determined in good faith by the board of
directors. The SEC is seeking comment on
whether it should issue guidance on the fair
valuation of derivatives.

Fund Portfolio Diversification. The 1940 Act
requires disclosure on whether funds are
diversified or non-diversified. The Concept
Release raises for consideration the question of
how a fund should value a derivative to
determine the percentage of the fund’s assets
that is invested in a particular company for
diversification purposes. In addition, the SEC is
seeking guidance on how to treat counterparty
issues under the diversification requirements.

Fund Investments in Certain SecuritiesRelated Issuers. The 1940 Act generally
prohibits funds from acquiring any security
issued by, or any other interest in, the business
of a broker, dealer, underwriter or investment
adviser. Funds that meet certain conditions,
however, may acquire some securities issued by
companies engaged in such businesses. Issues
arise for funds when using derivatives, when a
counterparty is a securities-related issuer or
when the reference asset underlying the
derivative creates economic exposure to a
securities-related issuer. The SEC is seeking
comment on the application of those restrictions
to derivatives.
The deadline for commenting on the Concept
Release is November 7, 2011. The SEC recognized
in the Concept Release that “[a] fund’s use of
derivatives presents challenges for its investment
adviser and board of directors to ensure that the
derivatives are employed in a manner consistent
with the fund’s investment objectives, policies,
and restrictions, its risk profile, and relevant
regulatory requirements.” The SEC may well
rely on the comments received to change the
regulatory framework.
Fund Portfolio Concentration. Funds are
required to disclose whether they are
concentrating investments in a particular
industry or group of industries. The Concept
Release is seeking comment on how funds
determine the industry or industries to which
they may be exposed through a derivative
investment. Derivatives present unique issues
for funds. When a fund enters into a derivative
transaction, it can gain exposure to the industry
associated with the issuer of the reference asset.
SEC Chairman Mary Schapiro has indicated that
she plans to continue in her current position for
at least another year. On the one hand, her
statement ends speculation that she may be rapidly
tiring of the political battering surrounding SEC
activities and might have been planning to leave
soon. On the other hand, it focuses a potential end
date to her tenure and, given the outlook in the
coming year for the SEC to remain a political target,
weakens any suggestion, when she does step down,
that she might be leaving for political reasons.

2
November 2011
Changes in Composition of
Commissioners at the SEC
Investment Management Update
Commissioner Kathleen L. Casey, who was
appointed to the SEC by President George W. Bush
in 2006, stepped down in August when her term
expired. The Senate recently confirmed as her
replacement Daniel M. Gallagher Jr., a DC
lawyer who had been deeply involved as a leader in
the SEC’s Division of Trading and Markets in 2008
and has been in private practice since leaving the
SEC in 2010. Remaining Commissioners are, in
addition to Chairman Schapiro, Elisse Walter, Luis
Aguilar (whom the Senate also confirmed for an
additional term) and Troy Paredes.
SEC’s OCIE Issues First
Ever National Exam Risk
Alert
The staff of the SEC’s Office of Compliance
Inspections and Examinations (“OCIE”) in
September issued a National Exam Risk Alert. The
Risk Alert is labeled “Vol. I, Issue 1,” and the SEC
noted that it “is the first in a continuing series of
Risk Alerts that the SEC’s examination staff expects
to issue.” The Risk Alert focuses on an increasingly
popular broker-dealer trading model used by
investment managers, called a “master/sub-account
trading model,” and warns of concerns raised by
trading through these sub-accounts and offers
“suggestions” to help address the risks raised.
In general, under the master/sub-account model, a
customer (typically an LLC or similar entity or
another broker-dealer with various other traders
trading through the account) opens a master account
with an SEC-registered broker-dealer that allows the
customer to divide the master account into subaccounts for use by the individual traders or groups
of traders. The sub-accounts may also be further
divided, and the original customer and broker-dealer
may not know the identity of the underlying traders.
Although the Risk Alert acknowledges that
master/sub-account arrangements may be used for
legitimate business purposes, it raises concerns that
in some cases a customer may set up this structure
“to avoid or minimize regulatory obligations and
oversight” and identifies specific types of abuses.
Furthermore, the Risk Alert warns of significant
regulatory risk in the event that a broker-dealer may
not know the identities of the underlying traders in a
master/sub-account and, thus, may not know who is
utilizing its Market Participant Symbol (“MPID”).
The Risk Alert prominently identifies in the left
margin certain “Key Takeaways,” including a
concise list of the risks that OCIE believes
master/sub-account trading arrangements can
pose, including “Money laundering; Insider trading;
Market manipulation; Account intrusions and
information security; Unregistered broker-dealer
activity and excessive leverage.” It then identifies
the operative legal requirement: “New Rule
15c3-5 [the Market Access Rule] requires brokerdealers to have controls and procedures reasonably
designed to manage the financial, regulatory and
other risks associated with providing a customer or
other person with market access” and concludes
with the statement: “This alert highlights
examination points of inquiry and compliance
suggestions to address these risks.”
The text of the Risk Alert includes an informative
discussion of the risks, advises the industry that
OCIE intends to use the SEC’s recently adopted
Market Access Rule as a tool to address the
associated regulatory risks, and provides
guidance for addressing and mitigating those
risks. It also provides a road map of the kinds of
compliance activities OCIE expects to see when
conducting a compliance audit.
In sum, the Market Access Rule requires brokerdealers to establish, document and maintain a
system of risk management controls and supervisory
procedures that are reasonably designed, among
other things, to manage the financial, regulatory and
other risks in connection with providing market
access. In examining for compliance with the
Market Access Rule, the Risk Alert states that the
OCIE staff intends to scrutinize:
(1) a broker-dealer’s system of risk management
controls and supervisory procedures that
addresses master account customers who are
offered market access, and
(2) whether, in accordance with its controls and
procedures, a broker-dealer is appropriately
vetting the master/sub-account customers and
individual traders with access to the brokerdealer’s MPID, trading system and/or
technology providing market access.
It will be interesting to follow the development of
OCIE’s Risk Alerts for information about new SEC
staff interpretations and when preparing for an SEC
staff examination.
3
SEC Launches New
Whistleblower Website
In connection with the effective date of the SEC’s
new whistleblower rules, on August 12, 2011, the
SEC launched a new website for its Office of the
Whistleblower, designed to carry out the DoddFrank Act whistleblower provisions. The Tips,
Complaints and Referrals webpage provides
user-friendly access and a new Form TCR for
reporting to the SEC information regarding
potential securities law violations. The page
prominently notes the opportunity to receive a
monetary award, if the information submitted leads
to an SEC action that results in monetary sanctions
exceeding $1 million, and provides a link to a
Whistleblower Declarations for Online TCR
Questionnaire, which must be completed to
establish eligibility for an award.
The new website also provides information about a
whistleblower’s usage of a company’s internal
compliance program, retaining anonymity while
being a whistleblower, applying for an award with
the SEC, factors used by the SEC in determining the
amount of an award and protections available to
whistleblowers in case of retaliation. The website
address is http://www.sec.gov/whistleblower.
FSOC Issues Second
Proposed Rule for SIFI
Designation
The Financial Stability Oversight Council
(“FSOC”), created by the Dodd-Frank Act, issued a
second proposed rule identifying parameters for
designating non-bank financial companies, so-called
SIFIs, that require heightened regulation because
4
November 2011
FSOC has concluded that they pose systemic risks
to the financial stability of the economy. Mutual
funds have been lobbying for an industry
carve-out from SIFI designation – which
otherwise would expand existing regulation of
mutual funds – and, barring that, for greater
certainty as to how FSOC will apply the criteria
and go about designating a SIFI.
The new guidance does not answer how mutual
funds will be treated by FSOC during its SIFI
deliberations. It avoids making any definitive
statement on the issue by acknowledging that
mutual funds are different from other types of
companies without providing meaningful insight
into how mutual funds will be treated.
The proposed rule provides a detailed description of
the process the FSOC will use to designate nonbank
financial companies as systemically significant,
including a three-stage designation process, with
each stage requiring the company to provide
additional information to FSOC and being subjected
to a more rigorous analysis. Although the
quantitative thresholds detailed for a Stage 1
analysis appear to make it unlikely that a mutual
fund would be considered during Stage 1, there are
also opportunities for FSOC to apply “other firmspecific qualitative or quantitative factors, such as
substitutability and existing regulatory scrutiny” and
take into account other, non-specific factors.
Moreover, the proposal states that FSOC “may
issue additional guidance for public comment
regarding potential additional metrics and
thresholds relevant to asset manager
determinations.” No timeline was given for this
future guidance.