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Stein: ‘Cracks’ in Registered Fund Legal Framework

Commissioner Kara Stein focused her remarks on the effect of the Investment Company Act on retail investors in a recent speech. Stein suggested that the 75th anniversary of the Act is a good time to “reassess our regulatory framework under the Investment Company Act, address new and emerging risks, have a dialogue with the asset management industry, and fortify our commitment to investor protection going forward.” While she acknowledged that the framework has fostered strong fund growth, she stated, “I am concerned that we are starting to see some cracks in the foundation of this framework that we should all be thinking about.”

Stein discussed the investor protections intended by the Investment Company Act.  She argued that private funds operate primarily on a disclosure basis, targeting only investors that meet certain thresholds and are thus deemed “sophisticated.” She distinguished funds meant for retail investors by noting that in addition to disclosure, registered funds also are subject to “strong and clear rules.” She worried that the “clear, dependable disclosure and basic bright line protections for investors” that shepherded in 75 years of success has “slowly drifted toward a more flexible and permissive disclosure regime” which “increasingly places the onus on the retail investor to figure out whether a fund is right for him or her.”

One such “buyer beware” area is the liquidity of some registered funds, according to Stein. She points to registered bank loan funds where assets have grown almost 400% since late 2009. Stein argues that there is a mismatch between both the investor expectation and Investment Company Act requirement that funds honor redemption requests within seven days and the fact that many of the loans in which the funds invest may take one month to settle. Stein questioned the current interpretation that permits the liquidity standard to be calculated when a contract price is struck to sell the underlying bank loan and not on when actual settlement of the loan occurs. She wondered whether the interpretation is consistent with the Investment Company Act’s liquidity limitations, investor expectations and disclosures, stating that the limitation “has arguably become more of a compliance exercise than a true restriction.”

Stein also took aim at the increasing use of derivatives by funds that she feels creates leverage in excess of limits set by the Investment Company Act. She asserts that SEC guidance issued in 1979 and almost 30 subsequent no-action letters created “a mixed bag, a patchwork of regulation that does not always comport with Section 18 [of the Investment Company Act]” and has “chipped away at a true leverage restriction.” Stein mentioned reports of funds using instruments such as swaps and futures to obtain notional exposure of up to 10 times the fund’s NAV, a result that she thinks most would find contrary to the leverage limitations. No-action letters represent a statement from SEC staff it would not recommend that the Commission take enforcement action on a particular issue and can be revoked by the Commission at any time. To date, the Commission has yet to take any further action on its 2011 concept release on fund use of derivatives.  Stein’s remarks may reveal her discontent that the Commission has not provided clear rules in this area.

Alternative funds are an additional area that Stein feels may have “gradually drifted away from the intent and foundational principles of the Investment Company Act.” She argues that while traditionally it was understood that restrictions on registered funds prevented them from mimicking the return of a hedge fund, alternative funds today that promise to do just that are “all the rage.” Stein posits that alternative funds “operate on the margins” of several Investment Company Act rules and suggests that perhaps they should be regulated differently than “plain vanilla, traditional mutual funds.” Due to the liquidity and leverage issues coupled with the complex underlying investments, Stein worries whether the funds are appropriate for retail investors.

As retirement savings continue to move away from pensions and defined benefit plans to an era in which investors are asked to be more and more responsible for their own retirement savings, Stein suggests that “regulators and the industry have a responsibility to make certain that the legal framework is stable and remains focused on protecting the retail investor.”