Expected Effects of Financial Industry Reform on Derivatives Activities of Funds

June 1, 2010

On May 20, 2010, the United States Senate passed the “Restoring American Financial Stability Act of 2010”. The Senate bill will go to a conference committee of the House and Senate in order to reconcile the differences in the Senate bill as compared to the financial regulatory reform bill adopted by the House of Representatives in December of 2009. The stated intention of the Obama administration is to have a final bill for the President to sign by the July 4 weekend.

The bills adopted by the House and Senate are subject to change by the conference committee. Moreover, many provisions in the bills require the adoption of regulations by the Securities and Exchange Commission and/or the Commodities Futures Trading Commission in order for the meaning of key provisions to be clarified. Such regulations are expected to require a period of at least six months after the signing of the legislation before they are promulgated. Accordingly, it is not possible at this point in time to definitively describe the law as it will ultimately come into effect. We can, however, identify certain provisions of the bills which may be relevant to investment funds in the context of their derivatives activities. This memorandum does not address provisions in the bills that are directly applicable to banks.

1. Centralized Clearing and Exchange Trading.

The bills require swaps generally to be cleared by a central clearinghouse counterparty, and traded on a regulated exchange or a swap execution facility. The intent of these provisions is to provide a creditworthy counterparty for settlements, and greater price transparency. Whether this ultimately will improve pricing for swap end-users, given that the effects of other provisions of the bills may be to reduce the overall liquidity of the swap markets, is open to question. Certain end-users will be exempted from these centralized clearing and exchange traded requirements. Specifically, a “commercial end user” as defined in the Senate bill will not be subject to these requirements. It is expected that funds will not typically qualify as commercial end users, since the Senate bill excludes persons predominantly engaged in activities that are financial in nature.

2. Regulation of Swap Dealers.

The Senate bill would impose new registration requirements on swap dealers, which registration is separate from and additional to other registration and licensing requirements imposed on brokers and banks. The definition of swap dealer includes a person who holds itself out as a dealer in swaps, makes a market in swaps, regularly engages in swaps in the ordinary course of business, or is commonly known as a dealer in swaps. Some parts of that definition could be argued to apply to certain investment funds. However, the bill excludes a person that buys or sells swaps for its own account, but not as part of a regular business. Although the definitions are not perfectly clear, we anticipate that investment funds will typically determine that they are not required to register as swap dealers.

3. Regulation of Major Swap Participants.

Another area of concern for fund managers is that there is expected to be substantial new regulation of “major swap participants”. These are defined in the Senate bill to include a non-dealer (i) that maintains a substantial position in swaps as determined by the applicable Commission, excluding positions for hedging or mitigating commercial risks, (ii) who has substantial counterparty exposure that could have serious adverse effects on the U.S. banking system or financial markets, or (iii) that is highly leveraged relative to its capital and maintains a substantial position in swaps as determined by the applicable Commission. The definition of “substantial portion” will be determined in the future regulations. If an investment fund or its manager is determined to constitute a major swap participant, they will be subject under the Senate bill to a range of regulation, including registration, record-keeping, reporting, examination, capital and margin requirements, and will be required to appoint a compliance officer to assure compliance with such regulation. It is expected that certain investment funds may be included in this category, but the exact parameters, including the capital and margin levels required, are yet to be defined by the future regulations of the applicable Commission.

4. Collateral Treatment.

Under the Senate bill, any collateral delivered by a fund to a swap dealer would, at the fund’s request, be segregated from the swap dealer’s proprietary assets and held in an account at an independent third party custodian. This should help the fund to assert its ownership interest in the collateral in the event of the insolvency of the swap dealer, rather than being treated as a general creditor of the swap dealer. This collateral treatment has frequently been requested by funds in the past, but has rarely been agreed to by swap dealers.

5. Amendments and Supplements to Documentation.

It is likely that swap dealers will eventually send out to their fund customers amendments or supplements to their existing derivatives documentation in order to reflect the changes imposed by the final financial industry reform legislation. The fact that such amendments or supplements are required by a change of law should not be interpreted to mean that the amendments or supplements are therefore non-negotiable. We suggest that funds review such documentation carefully, and they may wish to consult counsel.

If you have any questions regarding this, please contact the undersigned.

Craig T. Hickernell

Lauri Goodwyn