SRZ Reviews SEC’s Derivatives Proposal | Pocketmags.com

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SRZ Reviews SEC’s Derivatives Proposal

The unintended consequences of leverage restrictions

Proposal threatens returns, hedging, investor diversification and choice

Schulte Roth & Zabel (SRZ) investment management partner John J. Mahon is based in the firm’s Washington D.C. office and regularly assists clients in connection with the establishment and operation of business development companies (BDCs) and both open-ended and closed-ended registered funds. He explains that the SEC’s recent release proposing the adoption of new Rule 18f-4 under the Investment Company Act of 1940 is “the culmination of years of focus on the concept of hidden leverage.” Indeed, the SEC’s Concept Releases date back to 2011. The SEC is particularly concerned about funds where the risks of leverage may not be apparent, and is of the opinion that derivatives-related exposures should be viewed as leverage. The SEC’s initial proposal might not be ideally suited to meeting the agency’s stated aims, and could have a number of unintended consequences.

1. Fund-level leverage only one form of leverage

Investor protection is one of the SEC’s guiding stars. The SEC gives examples of three registered funds using derivative-related leverage around 2008-2009 that incurred substantial losses in the region of 70-80%. The SEC omits to mention that some wholly unleveraged funds lost as much or more during the financial crisis – in some cases because they invested in companies, such as banks, that were themselves very heavily leveraged, or bought technology, biotechnology, energy or mining stocks at the top of their respective cycles.

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