Over the past year, the SEC has placed greater focus on the use of derivatives by investment companies and their disclosures regarding such use. Products of that scrutiny have recently emerged in the form of a Report of the Task Force on Investment Company Use of Derivatives and Leverage (ABA Report) and an SEC letter to the ICI regarding derivatives- related disclosure by investment companies (SEC Letter).
The ABA Report identifies common practices and approaches of investment companies regarding derivatives and leverage, and suggests certain changes to the current regulatory framework including, but not limited to:
- Diversification. The ABA Report recommends that funds measure diversification for purposes of Section 5(b) of the 1940 Act by looking at reference assets, when applicable.
- Counterparties. The ABA Report recommends that the SEC regulate counterparty risk through Section 12(d)(3) of the 1940 Act, including risk related to counterparties that are not in a traditional securities-related business.
- Limits on leverage. The ABA Report recommends that the SEC issue guidance to set forth a principles-based approach to segregation that would encompass all types of derivatives. It further recommends that funds establish minimum amounts of required segregated assets based on the risk profiles of the derivative instruments, and establish policies and procedures that address both the value of assets and the types of assets that are appropriate for risk-adjusted segregated amounts.
- Concentration. The ABA Report notes that many funds measure concentration based on reference assets and believes that this measurement is appropriate.
- Fund names. The ABA Report recommends that the SEC clarify that, under Rule 35d-1 of the 1940 Act, whether a fund invests in a manner that is consistent with its name should be determined by looking to its reference assets.
- Disclosure. The ABA Report recommends that funds enhance disclosure regarding how derivative instruments affect actual investment results.
- Director oversight. The ABA Report recommends that the SEC emphasize that the role of a fund board with respect to the fund’s use of derivatives and leverage is one of oversight, rather than micro-management.
The SEC is currently conducting a review to evaluate the use of derivatives by investment companies and has observed that derivatives-related disclosure in fund registration statements is often either highly abbreviated (briefly identifying a variety of derivative products or strategies) or highly technical (covering a variety of potential derivative transactions at great length without explaining their relevance to the fund’s investments). The SEC Letter expresses the Staff’s concern that highly abbreviated disclosure may not be appropriately tailored to address the specific derivative instruments in which a fund invests, and highly technical disclosure may not be understandable by, or useful to, investors. The Staff was also troubled by some fund complexes’ use of the same “standardized” derivatives-related disclosure for funds with significantly different exposure to derivatives. The SEC Letter recommends that all funds that use or intend to use derivative instruments review their disclosure to assess its accuracy and completeness in light of actual fund operations, taking care to also assure that the disclosure is understandable by investors. Principal investment strategies disclosure regarding derivatives should be tailored to each fund and should address strategies that the fund expects to be the most important means of achieving its objectives and that it anticipates will have a significant effect on its performance. Additionally, principal strategies and risks disclosure should identify the types of derivatives used by the fund, and the purpose and extent of their use.
Additionally, the SEC Letter reminds investment companies that Management’s Discussion of Fund Performance in annual shareholder reports should be consistent with operations reflected in the financial statements, and funds whose performance was materially affected by derivatives should include discussions to that effect. The SEC Letter also discusses FASB Accounting Standards Codification Topic 815: Derivatives and Hedging, noting that funds could improve their disclosure by providing qualitative information about how the funds achieved their objectives and strategies through their use of derivatives and explaining the relevance of any credit spreads disclosed.
A copy of the SEC letter is available at http://www.sec.gov/divisions/investment/guidance/ici073010.pdf.