The Securities and Exchange Commission is asking how it should regulate the way investment companies including mutual funds, closed-end funds, exchange-traded funds, and business development companies ("funds") use derivatives. In a concept release published August 31, 2011, the Commission examined the current regulatory scheme and set the stage for future regulation that likely will have far-reaching implications for funds, their investment advisers, independent directors, investors and counterparties.

Funds use derivatives for a variety of purposes, including to leverage and boost returns, gain access to certain markets or reference assets, achieve greater transaction efficiency, and hedge interest rates, credit, and other risks. Over the past 30 years, the Commission has expressed concern about the use of derivatives, especially in areas involving leverage, illiquidity, and counterparty risk.

The Commission's concern is rooted in a perceived gap between how the law and investors look at fund portfolios versus how investment advisers look at them. In a 2009 speech to the American Bar Association's Committee on Federal Regulation of Securities of the ABA's Business Law Section, Andrew J. Donohue, counsel at partner at Morgan Lewis & Bockius in Washington, D.C. and former director of the SEC's Division of Investment Management, emphasized three primary concerns...