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From Securities Regulation Daily, December 11, 2015

Derivative and resource extraction proposals get green light

By Amy Leisinger, J.D.

By a 3-1 vote, the SEC has proposed new rules to require a fund entering into derivatives transactions to comply with certain portfolio limitations and asset requirements and to establish a derivatives risk management program if the fund’s exposure reaches a certain threshold. By the same margin, the Commission also reproposed rules to require disclosure of certain payments made to governments by resource extraction issuers to replace those vacated by the D.C. federal court in 2013. Commissioner Michael Piwowar objected to both proposals, citing insufficient information as to the application of currently pending initiatives and the need for the changes in furtherance of investor protection.

Funds’ derivative use. The SEC voted to propose a new rule designed to enhance the regulation of the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds (ETFs), closed-end funds, and business development companies. Specifically, the proposed rule would require each fund to comply with limitations on the amount of its leverage derivatives and other transactions and to manage risks associated with derivatives transactions by segregating assets in an amount sufficient to enable the fund to meet its obligations under stressed conditions. A fund that engages in more than a limited amount of derivatives transactions would also be required to establish a formalized derivatives risk management program under the rule. The proposed reforms would also address funds’ use of financial commitment transactions by requiring funds to segregate certain assets to cover their obligations. The comment period on the proposal will remain open for 90 days after publication in the Federal Register.

Chair Mary Jo White noted that inadequate controls on the use of derivatives can create significant risks and that the proposal is designed to modernize the regulation of funds’ use of derivatives in harmonization with staff positions regarding the application of laws and regulations to derivatives transactions. The proposal would require funds to meet certain risk monitoring and management conditions in order to rely on an exemption from restrictions on derivatives use, safeguarding both investors and the overall financial system.

Echoing these sentiments, Commissioners Luis Aguilar and Kara Stein supported the proposal and continuing efforts to enhance investor protection. Investor protection requires “a sharper focus on funds’ use of derivatives” and “prudent safeguards to ensure funds properly manage the associated risks,” Aguilar explained, and fund boards should to be proactive in anticipating and responding to risks, particularly in light on the new obligations imposed by the proposed rule. Stein noted that these investment vehicles were not intended to be highly leveraged and noted that the proposed changes will go long way in allowing funds to continue to serve the needs of retail investors. The proposal promotes flexibility while mitigating concerns regarding investment risks and undue speculation, she said.

While supporting the proposed asset segregation requirement to address “the inadequacies of the current market practices” and “serve as a functional leverage limit on funds,” Commissioner Piwowar objected to the other proposed changes. According to the commissioner, there is no evidence that a separate leverage limit is warranted, and, in any case, the Commission should hold off on additional changes until data from and full application of other fund initiatives, including the investment company reporting modernization proposal, can be considered. The Commission is obliged to ensure that proposed changes are based on clearly identified justifications for action, he concluded.

Payment disclosure by resource extraction issuers. The SEC also voted to propose rules mandated by Dodd-Frank Act Section 1504 to require resource extraction issuers to disclose payments made to the U.S. government or foreign governments for the commercial development of oil, natural gas, or minerals. The rules would require these issuers to file annually a Form SD disclosing information about such payments if they are required to file annual reports with the Commission under the Exchange Act. Initial public comments on the proposed rules are due by January 25, 2016. Reply comments responding only to issues raised in initial comments are due on February 16, 2016.

The Commission adopted rules to implement this Dodd-Frank mandate in 2012, but these rules were subsequently vacated, White noted. More recently, other jurisdictions have adopted related disclosure initiatives, and the proposal furthers U.S. policy interests in reducing corruption in resource-rich countries and promoting transparency in connection with payments to further commercial development related to resource extraction, White stated. Aguilar and Stein also supported the proposal and its potential to increase accountability while using a tailored approach with appropriate flexibility in the form of potential exemptions.

Piwowar criticized the insertion of the resource extraction provision into Dodd-Frank at the last minute in an effort to appease special interest groups. Further, disclosure of resource extraction payments provides no enhanced protection for consumers, is no way connected with the actual causes of the financial crisis, and “is wholly unrelated, and largely contrary, to the Commission’s core mission,” he stressed. “[T]he law is what the law is,” he explained, but circumstances still matter. The Commission has not completed its required Dodd-Frank-related rulemakings, and priorities must be set—priorities that “first focus on areas that, unlike resource extraction, actually contributed to the 2008 financial crisis,” he explained. Additionally questioning the standards proposed to govern the disclosures and potential unfair advantages to private companies, Piwowar declined to support the proposal.

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