Director of SEC’s Division of Investment Management Provides Insights into Agency’s View of Alternative Mutual Funds and Focus of Upcoming Sweep Exam

Posted on July 11, 2014, by Mary P. Hansen and William L. Carr in Alternative Mutual Funds, OCIE, Office of Compliance Inspections and Examinations, SEC Guidance. Comments Off on Director of SEC’s Division of Investment Management Provides Insights into Agency’s View of Alternative Mutual Funds and Focus of Upcoming Sweep Exam

On June 30, 2014, in remarks to the Practising Law Institute’s Private Equity Forum, Norm Champ, Director of the SEC’s Division of Investment Management, addressed the increase in the number of mutual funds that use alternative investment strategies and the potential risks that the Division of Investment Management has identified with those strategies. See SEC Press Release. Champ’s observations are particularly relevant in light of the Office of Compliance Inspections and Examination’s (“OCIE’s”) announcement that it will conduct a national sweep exam involving between fifteen and twenty alternative mutual funds beginning this summer and continuing into the fall. According to Champ, the exams are intended to produce valuable insight into how alternative mutual funds attempt to generate yield and how much risk they undertake, in addition to monitoring how boards are overseeing the funds’ operations. To that end, Champ said that the exams will focus on liquidity, leverage, and board oversight.

Champ discussed the following areas of concern to the Division of Investment Management in detail:


For the last several years, the SEC has focused on valuation issues in connection with hedge funds and mutual funds. Section 2(a)(41) of the Investment Company Act requires mutual funds to calculate their net asset values by using the market values of their portfolio securities when market quotations are “readily available.” When market quotations are not “readily available,” a fund must use the “fair value of those securities or assets” as determined in good faith by the fund’s board of directors. The lack of “readily available” market quotations will be a fairly common occurrence in the context of alternative mutual funds. Accordingly, it is imperative that funds have robust valuation policies and procedures.

Champ recommended that those policies and procedures include the following: (1) a requirement that the fund monitor for circumstances that may necessitate the use of fair value prices; (2) an established methodology by which a fund determines fair value; (3) a process for price overrides; (4) assurances that controls are in place to review, monitor, and approve all overrides in a timely manner; and (5) prompt notification to, and review and approval by, persons not directly involved in portfolio management to mitigate conflicts of interests.


Liquidity is a particular concern when alternative mutual funds pursue strategies focusing on illiquid securities such as distress debt. Accordingly, alternative mutual funds that hold significant illiquid or “fair-valued” assets should have policies and procedures for testing and monitoring liquidity for the purpose of complying with ’40 Act liquidity limitations. Champ noted that the ultimate responsibility for determining the liquidity of a fund’s portfolio securities and other assets rests with the fund’s board of directors. He further noted, however, that the board may delegate the day-to-day function of determining liquidity to the fund’s investment adviser, provided that the board retains sufficient oversight.


According to Champ, one of the primary goals of the ’40 Act is to protect mutual fund investors from excessive borrowing. Similar to liquidity requirements, statutory restrictions on borrowing provide some assurance that investment companies operate with adequate reserves. As noted in SEC releases, state no-action letters, and other guidance, mutual funds are permitted to enter into derivative instruments as long as the fund places liquid assets in a segregated account to cover the potential obligation imposed by the derivatives. Champ suggested that alternative mutual funds consider using a risk management framework linked to their use of derivatives that includes assessing the impact of varying market conditions on the funds. Such assessments should be based on the fund’s derivative positions.


Disclosure is the foundation of the federal securities laws, so it comes as no surprise that the SEC is focused on ensuring that those who invest in alternative mutual funds receive clear, concise information about the funds. With respect to alternative mutual funds, the SEC is looking at disclosures, especially with respect to the use of derivatives, to ensure that the risks of using alternative investment strategies are described accurately. Alternative mutual funds should be sure to disclose material risks relating to volatility, leverage, liquidity, and counterparty creditworthiness associated with alternative investment strategies. Alternative mutual funds should also take care to ensure that their marketing materials are accurate, complete, and consistent with the funds’ investment objectives and performance.

Directors’ Obligations/Board Oversight

Since the SEC announced charges against the independent directors of Morgan Keegan, the SEC has increased its focus on board oversight and the involvement of directors—particularly that of independent directors—with compliance programs. Certainly, the OCIE sweep will consider boards’ oversight of funds. In addition to reviewing and approving a fund’s compliance program, Champ suggests that boards of alternative mutual funds pay particular attention to monitoring potential conflicts of interest, such as allocations of trades between side alternative mutual funds and private fund counterparts.

Finally, Champ cautioned against using misleading names that may suggest safety or protection from loss.

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