Commissioner Stein Discusses Future of Mutual Fund Regulation (with Lofchie Comment)

SEC Commissioner Kara Stein delivered remarks at the Brookings Institution. She spoke about the importance of the Investment Company Act ("ICA"), the evolution of the registered fund industry and future areas of concern for the SEC.

Commissioner Stein noted that the 75th anniversary of the ICA coincides with a major rulemaking initiative by the SEC to update and modernize some of its rules for investment companies and advisors. She reported that SEC staff members are also considering potential opportunities to "enhance and improve" SEC rules that govern changes to liquidity management and the use of derivatives by registered funds.

Commissioner Stein emphasized that "the registered fund regime is not meant to mirror the private fund world." She explained that, since private funds and registered funds are two different forms of investment, allowing "substantial leeway" and greater flexibility for private funds' investments is justified.

Commissioner Stein also voiced her concern regarding "cracks in the foundation" of the ICA's framework, particularly in the areas of disclosure, liquidity and leverage. She explained that "registered funds have slowly drifted toward a more flexible and permissive disclosure regime," but sounded a cautionary note by adding that this flexibility in disclosure "places the onus on the retail investor to figure out whether a fund is right for him or her."

Additionally, Commissioner Stein explained that the liquidity of registered funds is one area in which regulation has drifted into "buyer beware" territory, and stated that retail investors often assume that investments in registered funds are more liquid than they really are. According to Commissioner Stein, this assumption can be "misplaced," given the increasing number of more complicated registered funds entering the market.

Commissioner Stein voiced a further concern that the 3:1 coverage ratio has "gradually eroded," and emphasized that derivatives usage by registered funds has "skyrocketed." She asserted that the SEC has taken an "ad hoc" approach to overseeing leverage obtained through derivatives, and noted that this "patchwork" of regulation does not always comport with ICA Section 18. As the SEC considers this issue, she stated, its approach "must reflect the Investment Company Act's foundational principle that leverage be limited in registered funds." Commissioner Stein also reported that the SEC is in the beginning stages of launching a rules initiative focused on asset managers and registered funds, and added that the intention behind the initiative is to take a "holistic look" at the ICA to evaluate the ways in which it might be helping or hurting market participants.

Lofchie Comment: The gist of Commissioner Stein's remarks is that SEC-registered investment companies should be subject to more regulation – particularly as to the ICA leverage restrictions – and to a more limited definition of the types of investments that are deemed to be "liquid" for purposes of the ICA. These ideas are certainly defensible, but it must be acknowledged that such restrictions will come at a price for investors who will be denied the opportunity to gain exposure to higher risks and rewards, e.g. through certain types of assets and through more leveraged vehicles; i.e., investor choice will be limited. Is the denial of investment opportunities better for retail investors? Perhaps, but the outcome should not be assumed. In theory, the end result should be less risk and lower returns for these investors; whether that trade-off is to the good or not is a judgment call and not an absolute certainty.It is also possible that registered investment companies could operate in ways that are less restrictive. For example, if mutual funds that invest in bank loans (a product specifically highlighted by Commissioner Stein) should not be viewed as truly providing daily liquidity – as is required of all mutual funds – then perhaps the ideal solution might not be to prohibit mutual funds from investing in bank loans. Perhaps a better solution would be to allow mutual funds to provide their investors with lesser redemption rights that are weekly or monthly rather than daily.

See: Commissioner Stein's Speech.Related news: SEC Proposes to Amend Reporting and Disclosure Requirements for Investment Companies and Advisers (Fed. Reg.) (June 12, 2015); SEC Proposes Amended Reporting and Disclosure Requirements for Investment Companies and Advisers (with Mehta and Lofchie Comments and Delta Strategy Group Summary) (May 20, 2015); SEC to Hold Open Meeting on Proposals Regarding Registered Investment Companies and Advisers (May 14, 2015).