On July 30, 2010, SEC staff issued a letter to the ICI containing staff observations made in connection with its review of derivatives disclosure included in fund registration statements and shareholder reports. The letter provides that derivatives disclosure for certain funds may not be consistent with prospectus disclosure requirements regarding principal investment strategies and risks. The letter focused on the generic nature of funds’ derivatives disclosure, noting that the disclosure ranged from briefly identifying derivative products or strategies to lengthy, technical disclosure that did not explain the relevance of the derivatives to the funds’ investment operations. In particular, the letter noted that these generic disclosures generally: (1) state as a principal investment strategy that the funds will or may use derivatives and then often list all or a substantial majority of all types of derivatives as potential investments, (2) provide generic purposes for using derivatives (such as “hedging or non-hedging purposes”) and (3) broadly characterize the extent to which the funds may use derivatives (such as “the fund may invest ‘all’ of its assets in derivatives”). The letter highlighted other issues with derivatives disclosure in fund prospectuses, including: (a) generic derivatives risk disclosure that fails to sufficiently explain the risks of the particular derivatives used by a fund, (b) the extent to which derivatives are used by a fund is not consistent with the amount of derivatives disclosure included in the fund’s documents, and (c) the same derivatives disclosure is used for multiple funds in a fund complex despite the funds having significantly different exposures to derivatives.
The letter suggest that funds that use or intend to use derivatives review and assess the accuracy and completeness of their disclosure. Specifically, a fund should ensure: (1) its principal investment strategies accurately reflect the extent to which it will use derivatives, (2) its prospectus specifically describes the derivatives the fund will use, the extent to and purpose for which the fund will use derivatives and the risks of such derivatives and (3) its prospectus disclosure complies with the plain English requirement. The letter suggests that, in drafting prospectus disclosure, a fund should take into account the degree of economic exposure created by the fund’s use of derivatives, as well as the amount of the fund’s assets allocated to the derivatives strategy. The letter further states that a fund’s prospectus risk disclosure should provide “a complete risk profile of the fund’s investments taken as a whole, rather than a list of the risks of various derivative strategies, and should reflect anticipated derivatives usage.”
The letter also identifies issues with derivatives disclosure in fund shareholder reports. In particular, the letter provides that Management’s Discussion of Fund Performance should include derivatives disclosure commensurate with the fund’s usage and should discuss any material effect a fund’s use of derivatives had on the fund’s performance during its most recently completed fiscal year, regardless of whether the fund is currently using derivatives. The letter also provides that a fund should disclose in its financial statements and accompanying notes how the fund used derivatives during the reporting period to meet its investment objective and strategies and the effect using derivatives had on the fund during the reporting period. The letter provides examples of how funds could improve their financial statement disclosure, including: (1) for a fund that sells credit derivatives, describing the nature of the credit derivatives, (2) for a fund that sells protection through credit default swaps, explaining the significance of the size of the credit spreads in relation to the likelihood of a credit event or the possible requirement for the fund to make payments to counterparties and (3) disclosing counterparties to forward currency and swap contracts reported in the schedule of investments. (The letter states that over-the-counter derivatives are subject to the risk of counterparty nonperformance, and therefore, the identification of the counterparty should be disclosed.)