4.17.2009 SEC Division of Investment Management Director Andrew J. (Buddy) Donohue spoke at the American Bar Association Spring Meeting Vancouver, Canada. He spoke about the investment companies' use of derivatives and what he perceives as the increasing gap between how the 1940 Act and investors look at fund portfolios versus how investment advisers look at them.
He began by noting that the 1940 Act limits the amount of leverage that funds may bear, including the accompanying leverage that derivatives give to mutual funds. Specifically, Section 18(f) of the 1940 Act generally prohibits an investment company from issuing a "senior security" except under certain circumstances. A "senior security" is any security or obligation that creates a priority over any other class to a distribution of assets or payment of a dividend. Permissible "senior securities" include, among other things, a borrowing from a bank where the fund maintains an asset coverage ratio of at least 300% while the borrowing is outstanding.
He reviewed Release 10666, which was issued on April 27, 1979. In that release, the SEC stated that leverage exists "when an investor achieves the right to a return on a capital base that exceeds the investment which he has personally contributed to the entity or instrument achieving a return." The SEC noted in Release 106666 that the leveraging of an investment company portfolio by issuing senior securities and borrowing magnified the potential for gains or losses, thus increasing speculative investing.
In continuing with the history of derivatives regulation, Director Donohue stated that after interpreting Section 18 as limiting funds' ability to leverage, the SEC analyzed certain securities trading practices to determine whether and how far funds could go without violating Section 18. The SEC noted in Release 10666 that the staff in analogous circumstances had determined that it would not raise with the full Commission the issue of compliance with Section 18 if the investment company "'covers' the senior security by establishing and maintaining certain 'segregated accounts'." The SEC thus took the position that properly created and maintained segregated accounts would limit the investment company's risk of loss. The SEC explained that allocating assets into a segregated account would:
- Function as a practical limit on both the amount of leverage undertaken by a fund and the potential increase in the speculative character of the fund's outstanding shares; and
- Assure the availability of adequate funds to meet the obligations arising from such activities.
He then reviewed the board of directors’ role with respect to derivatives. He stated that that directors should consider the potential loss of flexibility when determining the extent to which funds engage in leveraged transactions. He next suggested that directors should review a fund's disclosure documents to "ensure complete disclosure," including:
- The potential risk of loss;
- The identification of the securities trading practices as separate and distinct from the underlying securities;
- The differing investment goals inherent in participating in the securities trading practices versus investing in the underlying securities;
- Whether the fund's name accurately reflects its portfolio investment policies and securities trading practices; and
- Any other material information relating to such trading practices.
He then briefly reviewed the 1994 Division of Investment Management study, which noted that a couple of mutual funds failed because of their use of mortgage-backed derivative securities. Nevertheless, the 1994 study did not support a prohibition or restriction on the use of derivatives by mutual funds. He noted that the mutual fund industry has dramatically increased its use of derivatives since 1994. Thus, Director Donohue announced that he Division of Investment Management would examine publicly available information to see whether funds have engaged in improved risk disclosures to address leverage concerns. He identified certain requirements contained in the 1940 Act and rules thereunder related to the use of derivatives:
- A mutual fund investing in derivatives must comply with the fund's name as required by Section 35(d);
- A fund's derivative transactions must be consistent with its investment objectives and policies set forth in the fund's registration statement;
- Consistent with Release 10666 and its progeny, for purposes of Section 18 of the 1940 Act, a fund engaging in trading practices involving derivatives and leverage should cover its position with segregated assets or an offsetting hedge; and
- A fund's portfolio must meet stringent diversification and liquidity standards. He next noted that in his review of prospectuses and statements of additional information, there is a wealth of disclosure about the characteristics of derivatives. However, he is concerned that disclosure about the impact of the derivatives on the portfolio of the mutual fund may be missing or insufficient.
This dichotomy, i.e., the gap between technical compliance with the 1940 Act versus actual performance, is precisely the issue that he believes the Division should be concerned about today. He highlighted the recent performance of fixed income funds in 2008 when a number of funds suffered one-year losses in excess of 30%. Unquestionably, some of this performance is due to adverse results from investment decisions concerning security selection, industry or sector concentration, or to the negative impact in a down market of old fashioned bank borrowing-type leverage. He noted, however, that some funds may use of derivatives to magnify the economic exposure of the portfolio. He stated that he is not suggesting that the fund disclosures were legally deficient. Rather, he stated that many investors in these funds, particularly at the retail level, neither appreciated the potential magnitude of nor anticipated the actual diminution in value of these funds.
He advised any mutual funds using derivatives to consider the following:
- Funds should have a means to deal effectively with derivatives outside of disclosure;
- A fund's approach to leverage should address both implicit and explicit leverage; and
- A fund should address diversification from investment exposures taken on versus the amount of money invested.
Click http://www.sec.gov/news/speech/2009/spch041709ajd.htm#P30_5040 to access the speech.