In a July 14, 2014 speech (http://www.sec.gov/News/Speech/Detail/Speech/1370542253660), Norm Champ, the Director of the SEC’s Division of Investment Management, addressed issues of concern to issuers of structured products. Among other things, he emphasized that the SEC staff is concerned about misleading fund names and the adequacy of disclosures about use of derivatives and leverage. While his remarks did not necessarily break new ground, they served as a useful reminder that structured products are not immune from the Division’s concerns and potential compliance issues.
Mr. Champ summarized the Division’s November 2013 guidance concerning misleading fund names. Mr. Champ said that the staff’s examination process found that several funds had names that suggested safety or protection from loss, and requested that those funds change their names so that they were not misleading. He summarized past guidance in which the staff has encouraged funds to reevaluate their names and, if appropriate, change the name to eliminate the potential for investor misunderstanding; this might especially be the case when the funds expose investors to market, credit, or other risks but the fund’s name suggests safety or protection from loss.
Use of Derivatives and Leverage
Mr. Champ summarized staff guidance on use of derivatives and leverage by funds. To date, the staff has taken a somewhat piecemeal approach to the regulation of derivatives and leverage; in August 2011, it published a concept release that identified a number of issues of concern to the SEC, including the adequacy of disclosure and misuse of leverage.
Most recently, the staff published guidance that reminded funds of their responsibility to clearly disclose the risks of derivatives, including funds that underlie variable annuity contracts:
- Funds that intend to use derivative instruments should assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner using plain English.
- Any investment strategy disclosure related to derivatives should be tailored specifically to how a fund expects to be managed, and should address those 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.
- The disclosures also should describe the purpose that the derivatives are intended to serve in the portfolio—hedging, speculation, or as a substitute for investing in conventional securities.
Because investment strategies that employ derivatives may introduce additional risks, the staff expects funds that use derivatives strategies to address those risks in their disclosures. These risks could include, for example, risks relating to volatility, leverage, liquidity, and counterparty creditworthiness that are associated with trading and investments in derivatives that are engaged in by the fund.