Studies and Reports
Mutual Funds and Derivative Instruments
Sept. 26, 1994
========> INTRODUCTORY LETTER FROM CHAIRMAN LEVITT <==========
September 26, 1994
The Honorable Edward J. Markey
Chairman
Subcommittee on Telecommunications and Finance
Committee on Energy and Commerce
U.S. House of Representatives
2125 Rayburn House Office Building
Washington, D.C. 20515
The Honorable Jack Fields
Ranking Republican Member
Subcommittee on Telecommunications and Finance
Committee on Energy and Commerce
U.S. House of Representatives
2125 Rayburn House Office Building
Washington, D.C. 20515
Dear Chairman Markey and Representative Fields:
Thank you for your letter dated June 15, 1994 concerning
mutual fund use of derivatives. Your letter raises a number of
important questions concerning the framework for the regulation
and oversight of these activities. I share your concern for
these important investor protection issues, and am particularly
committed to finding improved ways for funds to communicate to
shareholders the risks of investment.
Your letter requested that the Commission undertake a
comprehensive study of the use of derivatives by mutual funds. I
am enclosing a memorandum prepared by the Division of Investment
Management that comprises the requested study.
Mutual funds are the investment vehicle of choice for
funding Americans' essential needs -- for educating their
children, for retiring with dignity. The Commission considers
the protection of mutual fund investors absolutely essential. We
have been, and will be, vigilant in addressing the issues raised
by mutual fund use of derivatives, and we look forward to working
with you in this endeavor.
Sincerely,
Arthur Levitt
Chairman
--------------------- BEGINNING OF PAGE #2 -------------------
=============> ATTACHED MEMORANDUM: THE REPORT <==============
MEMORANDUM
September 26, 1994
TO: Chairman Levitt
FROM: Division of Investment Management
RE: Mutual Funds and Derivative Instruments
This memorandum responds to a letter dated June 15, 1994
(the "Letter"), from Edward J. Markey, Chairman, and Jack Fields,
Ranking Republican Member, of the Subcommittee on
Telecommunications and Finance of the House Committee on Energy
and Commerce ("Subcommittee"), requesting that the Commission
undertake a study of the use of derivatives by mutual funds and,
more particularly, the adequacy of laws and regulations governing
their disclosure and use. The Letter raises questions about
(1) Commission knowledge of mutual fund use of derivatives, (2)
disclosure of mutual fund use of derivatives, (3) the effect of
mutual fund competition on derivatives use, (4) mutual fund
pricing of derivatives, (5) liquidity of derivatives held by
mutual funds, (6) leverage available to mutual funds through
derivatives, (7) risks faced by investors in bank-advised mutual
funds, and (8) derivative use by money market funds.
As you are aware, investor protection issues raised by
mutual fund use of derivatives have received heightened attention
by the Commission since you became Chairman. You have urged fund
directors and trustees to exercise meaningful oversight of fund
derivative investments and have encouraged the management of
every fund using derivatives to manage their derivatives risks
effectively. In addition, you have directed the Division to make
mutual fund use of derivatives a priority -- in the disclosure
review process, in fund inspections, and in policy
considerations. In responding to the Letter, this memorandum
also reviews the steps taken to date by the Commission and the
Division to address investor protection issues raised by mutual
fund use of derivatives and describes the further actions that
the Division recommends.
Background
A. The Use of the Term "Derivative"
The term "derivative" is generally defined as an instrument
whose value is based upon, or derived from, some underlying
index, reference rate, (e.g., interest rates or currency exchange
rates), security, commodity, or other asset.-[1]- "Derivative"
may cover a wide variety of instruments,-[2]- and public debate
concerning issues raised by derivatives is often complicated by
imprecision regarding the instruments that raise a particular
issue. Indeed, the public debate about "derivatives" sometimes
suggests that a "derivative" is any complicated instrument that
has caused losses. Mutual fund investments in derivatives raise
significant investor protection concerns, which are addressed in
-------- FOOTNOTES --------
-[1]- See, e.g., GROUP OF THIRTY GLOBAL DERIVATIVES STUDY
GROUP, DERIVATIVES: PRACTICES AND PRINCIPLES 2 (July 1993)
[hereinafter G-30 REPORT].
-[2]- The term "derivative" generally is used to embrace
forward contracts, futures, swaps, and options. See, e.g., id.
at 28-34; U.S. GENERAL ACCOUNTING OFFICE, FINANCIAL DERIVATIVES:
ACTIONS NEEDED TO PROTECT THE FINANCIAL SYSTEM 5 (May 1994). The
term is also commonly used to describe instruments that are
created by separating other financial instruments into
constituent pieces, e.g., mortgage derivatives. See, e.g., James
K. Glassman, Mortgages, and Governments, Can Get Sliced and
Diced, WASH. POST, Sept. 7, 1994, at F1.
--------------------- BEGINNING OF PAGE #3 -------------------
this memorandum, but these concerns typically relate to specific
instruments used by specific funds and not to all derivatives and
all funds. Derivatives may be standard or customized, traded on
an exchange or over-the-counter, liquid or illiquid, novel or
familiar, leveraged or unleveraged. Derivatives may increase or
reduce portfolio risk. As the Subcommittee and the Commission
continue to address the important issues raised by mutual fund
use of derivatives, it will be important in each case to focus on
the specific parameters of the problems to be addressed.
B. Mutual Fund Use of Derivative Instruments
Mutual funds, other than money market funds, use derivative
products for a wide variety of purposes, including hedging
interest rate, currency, and other market risks; substituting for
a direct investment in the underlying instrument; or increasing
returns. Money market funds also invest in debt instruments
sometimes referred to as derivatives that have interest rates
that are adjusted periodically based on changes in market
interest rates. Many non-money market funds have the authority
to use derivative instruments, but the Division's inspections to
date suggest that the use of derivatives by most of these funds
is limited. There are exceptions, however, to this general
observation. Funds primarily investing in mortgage-backed
securities, for example, generally have significant investments
in derivatives. Long-term municipal bond funds use derivatives
to seek increased tax-exempt returns. In addition, funds
investing internationally may use derivative investments to
lessen currency risks.
A recent industry survey of non-money market funds also
suggests that mutual fund use of derivatives is limited.-[3]-
The survey reported that the total market value of all
derivatives held by participating funds was $7.5 billion,
representing 2.13% of the total net assets of all funds reporting
derivatives holdings and 0.78% of the total net assets of all
funds participating in the survey. The total notional amount of
these derivatives was $54.3 billion, representing 15.51% of the
total net assets of all funds reporting derivatives holdings and
5.67% of the total net assets of all funds participating in the
survey.-[4]- The survey also indicated that the level of use of
derivatives varied by fund type, with fixed income funds
accounting for 84% of the total market value of all derivatives
held by reporting funds and 62% of the notional amount.
C. Investor Protection Concerns and Commission Actions
Although the use of derivatives by mutual funds generally
appears to be limited, some funds have recently experienced
problems relating to derivative investments. Several short-term
-------- FOOTNOTES --------
-[3]- Investment Company Institute, Derivative Securities
Survey, Feb. 1994. Survey respondents included 52 fund complexes
with 1,728 non-money market funds holding aggregate net assets of
$958 billion (76% of industry assets in non-money market funds).
The survey was limited to a quantitative investigation of the use
of derivatives by mutual funds and did not attempt to measure
associated risks. Id. at 1.
-[4]- "Notional amount" was defined in the survey as "the
maximum theoretical exposure presented by the instrument, i.e.,
the amount whose changes in value impact the fund's net asset
value." Id. at 2.
--------------------- BEGINNING OF PAGE #4 -------------------
government bond funds have experienced significant losses from
mortgage derivatives.-[5]- In addition, losses in the value of
certain adjustable rate notes held by some money market funds
have resulted in the funds' advisers electing to take actions,
including contributing capital or purchasing instruments held by
the funds, designed to prevent the funds' per share net asset
values from falling below $1.00.-[6]- Although the reported
problems to date have affected a limited number of funds and fund
types, they raise investor protection issues that merit serious
consideration.
As you are aware, months before these reports surfaced, the
Commission expressed concern about investor protection issues
raised by mutual fund investments in derivatives. Since the
summer of 1993, the Commission has taken a multi-faceted approach
to mutual fund use of derivative instruments, focusing on a broad
range of issues, including disclosure, pricing, liquidity,
leverage, and risk management. A Division task force has
examined the derivatives disclosures of 100 investment companies,
representing a broad sample of complexes and fund types, and the
Division's fund disclosure review staff has given heightened
scrutiny to derivatives disclosure in prospectuses. In addition,
the Division's inspection staff is examining and reporting on the
derivatives activities of each fund inspected, and has conducted
special examinations of certain funds holding significant
positions in derivatives.
D. Division Recommendations
This memorandum makes a number of recommendations for
further action by the Commission to address mutual fund use of
derivatives. The principal recommendations are the following:
* The Commission should consider requiring some form of
quantitative risk measure in mutual fund prospectuses
and should seek public comment on this topic no later
than early 1995.
* The Commission should promptly consider reducing the
ceiling on fund illiquid holdings. In addition, the
Commission should continue to evaluate liquidity and
pricing issues raised by derivatives through the mutual
fund inspection process. If it appears appropriate as
a result of these inspections, the Commission should
consider issuing rules to address matters such as
proper procedures for mutual fund pricing and liquidity
determinations.
* The Commission should reexamine the application of the
leverage restrictions of the Investment Company Act of
-------- FOOTNOTES --------
-[5]- See, e.g., Robert McGough, Piper Jaffray Acts to
Boost Battered Fund, WALL ST. J., May 23, 1994, at C1; Andrew
Bary, Derivatives Undo a Popular PaineWebber Fund, Triggering 4%
One-Day Drop in Value, BARRON'S, May 16, 1994, at MW12
[hereinafter PaineWebber Fund].
-[6]- See, e.g., A History of Stepping up to the Plate,
FUND ACTION, Sept. 12, 1994, at 9 [hereinafter Stepping up to the
Plate].
--------------------- BEGINNING OF PAGE #5 -------------------
1940 ("Investment Company Act" or "Act")-[7]- to
derivative instruments and should seek public comment
on whether regulatory and legislative solutions are
necessary to address the leverage created by mutual
fund use of derivatives.
* The Commission should recommend that Congress enact
legislation to enhance the Commission's ability to
obtain information required to monitor fund use of
derivatives.
E. Management and Board Responsibilities
The Commission has a critical role to play in enhancing
investor protection in the area of mutual fund derivative
investments. As you have noted, however, responsibility for
managing a mutual fund's derivative investments falls, in the
first instance, on the fund's management and board of directors
or trustees.-[8]- To that end, you have urged fund boards to
exercise meaningful oversight of fund derivative investments by
becoming more involved in portfolio strategies, risk management,
disclosure and pricing issues, accounting questions, and internal
controls.-[9]- In correspondence with the chief executive
officers of the 80 largest fund complexes, you encouraged the
management of every fund that holds derivative instruments to
take steps that will ensure the proper understanding and
effective management of derivatives risk.-[10]- The Division's
inspection staff examines mutual fund management controls, and is
giving particular emphasis to controls relating to derivatives
risk. On the basis of our findings during inspections and
discussions with fund industry participants, we will determine
whether to recommend that the Commission consider rulemaking to
encourage better mutual fund management controls of derivatives
-------- FOOTNOTES --------
-[7]- 15 U.S.C. 80a.
-[8]- Strong management controls are generally recognized
as essential to monitoring and controlling the derivatives
activities and risks of derivatives dealers and end-users. See,
e.g., Statement of the Securities and Exchange Commission, the
Commodity Futures Trading Commission and the Securities and
Investments Board, OTC Derivatives Oversight 3-4 (Mar. 15, 1994);
The Technical Committee of the International Organization of
Securities Commission, Operational and Financial Risk Management
Control Mechanisms For Over-the-Counter Derivatives Activities of
Regulated Securities Firms (July 1994); G-30 REPORT, supra note
1, at 9-13; Investment Company Institute, Investments in
Derivatives by Registered Investment Companies 4-6 (Aug. 1994).
-[9]- Arthur Levitt, Chairman, U.S. Securities and Exchange
Commission, Mutual Fund Directors as Investor Advocates, Remarks
at the Investment Company Institute Investment Company Directors
Conference, Washington, D.C. (Sept. 23, 1994) [hereinafter Levitt
Remarks, Directors as Investor Advocates]; Arthur Levitt,
Chairman, U.S. Securities and Exchange Commission, Mutual Fund
Directors: On the Front Line for Investors, Remarks at the
Mutual Funds and Investment Management Conference, Scottsdale,
Arizona (Mar. 21, 1994).
-[10]- Letters from Arthur Levitt, Chairman, U.S.
Securities and Exchange Commission, to chief executive officers
of 80 largest fund complexes (June 16, 1994) [hereinafter Levitt
Letters].
--------------------- BEGINNING OF PAGE #6 -------------------
risk.
Responses to Questions Raised by the Letter
Set forth below are the questions contained in the Letter,
followed by the Division's responses.
1. Does the SEC Have Adequate Knowledge of Industry Practices
a. Please identify the information needed by the SEC to
fulfill its responsibilities.
The Commission's responsibility with respect to mutual funds
is to administer and enforce the Investment Company Act and other
applicable provisions of the federal securities laws. Through
its inspection and registration processes, the Division can and
does monitor individual mutual fund policies and portfolios,
including derivatives activities. The Investment Company Act
requires funds to maintain and provide to the Commission records
reflecting much of this information.-[11]- In addition, during
the course of examinations, funds generally voluntarily provide
the Division with additional documents and access to fund
personnel and often make records available in electronic media.
Information concerning a fund's investments in derivatives is
also contained in the fund's registration statement and
amendments thereto, which describe investment policies and
practices, and semi-annual reports on Form N-SAR and reports to
shareholders, which contain information about portfolio
activities. The information needed by the Commission, much of
which is generally available to it, includes the following:
* complete information concerning the purchase and sale
of portfolio instruments (e.g., date and time of trade,
counterparty, transaction price, identity of instrument
traded);
* detailed information concerning each portfolio
instrument (e.g., for mortgage-backed securities, cash
flow projections, including prepayment assumptions with
respect to underlying mortgages);
* information regarding portfolio strategies and the
manner in which each portfolio instrument contributes
to portfolio strategies (e.g., identity of portfolio
positions that hedge other positions);
* valuations of fund assets and liabilities; and
* information relating to fund risk monitoring, e.g.,
analyses of fund performance under various market
scenarios.
-------- FOOTNOTES --------
-[11]- Section 31(a) of the Investment Company Act requires
every registered investment company to maintain and preserve
those accounts, books, and other documents that constitute the
basis for its financial statements. 15 U.S.C. 80a-30(a).
Section 31(b) of the Investment Company Act provides that
investment company records required to be maintained under
section 31(a) are subject to examination by the Commission. 15
U.S.C. 80a-30(b).
--------------------- BEGINNING OF PAGE #7 -------------------
b. What obstacles, if any, prevent the Commission from
obtaining and processing this information?
Resource constraints are the principal obstacle to improved
Commission monitoring of mutual funds. Although the Division
generally can obtain the information it requires to monitor
funds, the scope and frequency of our inspections are severely
constrained by available resources.-[12]- Aside from information
contained in a mutual fund's periodic filings, our knowledge of
the fund's investment practices, including its derivatives
holdings, is no more current than our most recent inspection. In
addition, the increasing use of derivatives and other complex
portfolio strategies has heightened the Commission's need to
hire, train, and retain a highly skilled mutual fund inspection
force.
The recordkeeping, reporting, and inspections provisions of
the Investment Company Act also impose some limits on the
Commission's authority to obtain information required to monitor
mutual funds. In practice, these limits often do not hinder the
Commission's fulfillment of its responsibilities, but they may do
so in some circumstances, including, for example, when a fund
does not voluntarily cooperate with the Commission; when, in
times of market stress, rapid access to fund information is
important; when the unavailability of electronic records in a
format usable by the Division interferes with an efficient
inspection; or when a fund does not maintain records that, if
available, would improve Commission understanding of the fund's
operations. These limits are described in detail below.
We emphasize that most investment companies cooperate fully
with the Division's inspection staff and produce not only records
required to be kept under the Commission's investment company
recordkeeping rules, but other requested records. Most funds
also allow Division inspection staff to interview employees
responsible for maintaining these records, as well as portfolio
managers, who are in the best position to explain many fund
investments. And many funds make their records available
electronically.
i. Recordkeeping Authority
Section 31(a) of the Investment Company Act requires every
registered investment company to "maintain and preserve for such
period . . . as the Commission may prescribe . . . such accounts,
books, and other documents as constitute the record forming the
basis for financial statements required to be filed pursuant to
[the Investment Company Act] . . . ."-[13]- This provision
presents two potential limitations for the Commission, one
relating to the scope of required recordkeeping and the other
relating to the form in which the required records are kept.
First, as a general matter, the Commission may require
investment companies to keep records forming the basis for the
preparation of financial statements. These records alone,
however, often do not provide the Commission with enough
-------- FOOTNOTES --------
-[12]- See, e.g., Testimony of Arthur Levitt, Concerning
Appropriations for Fiscal Year 1995, Before the Subcommittee on
Commerce, Justice, and State, the Judiciary, and Related Agencies
of the Senate Committee on Appropriations 4-6 (May 5, 1994).
-[13]- 15 U.S.C. 80a-30(a).
--------------------- BEGINNING OF PAGE #8 -------------------
information to evaluate the portfolio strategies that may
underlie a mutual fund's use of derivatives. For example, these
records may not disclose the relationships among portfolio
instruments, e.g., the identities of positions that hedge other
positions. Nor is it clear that they include records related to
portfolio management strategies, such as computer models that
funds may use to evaluate the expected volatility of a specific
derivative or the portfolio as a whole or the records generated
by these models.-[14]-
Second, the Investment Company Act's recordkeeping
provisions do not specifically address the medium in which
records are required to be kept. In particular, the Commission
would like specific authority to require that fund records be
kept in an electronic medium.-[15]- Given the growth of the
investment company industry, the size of individual funds, and
the volume of transactions in which they engage, paper records
are extremely cumbersome. Using paper records, the staff can
only review a limited sample of the securities transactions in
which a fund has participated over a specified period. Moreover,
paper-based records do not facilitate modern examination
techniques, such as computerized analysis to check for "red
flags" that suggest the need for an inspection. Many funds
voluntarily make their records available electronically, but fund
records are not always maintained in an electronic format that is
usable by the Division.
ii. Inspection Authority
Section 31(b) of the Investment Company Act provides that
investment company records "required to be maintained . . . shall
be subject at any time and from time to time to such . . .
examinations by the Commission . . . as the Commission may
prescribe."-[16]- This provision presents an issue that may
-------- FOOTNOTES --------
-[14]- The Division is currently preparing rulemaking
recommendations that should increase the Commission's access to
information concerning fund portfolios. For example, in light of
the recent proliferation of derivatives and other novel financial
instruments, the Division is reviewing the books and records
rules to ensure that fund records are required to contain all
information necessary to determine an investment's suitability
for the fund and its value for the daily net asset value
calculation. The Division previously recommended, and the
Commission proposed, amendments to the recordkeeping requirements
for money market funds that would require more detailed
description of portfolio instruments. Revisions to Rules
Regulating Money Market Funds, Investment Company Act Release No.
19959, Part II.D.7. (Dec. 17, 1993), 58 FR 68585, 68604 (Dec. 28,
1993) [hereinafter Release 19959]. These amendments, when
adopted, should facilitate the ability of the Division staff to
identify instruments that have interest rate provisions that are
inconsistent with the limitations imposed by the Commission's
money market fund regulations. See the answer to question 8,
below. The Division also intends to recommend revisions to Form
N-SAR that should result in the Commission having more
information concerning the nature of fund portfolios.
-[15]- In 1986, the Commission amended rule 31a-2 to permit
investment companies to maintain their records electronically.
17 C.F.R. 270.31a-2(f)(ii).
-[16]- 15 U.S.C. 80a-30(b).
--------------------- BEGINNING OF PAGE #9 -------------------
affect the scope of the Commission's inspection authority.
Under section 31(b), there is no explicit requirement that
funds provide records that are not required to be maintained
under a specific provision of the Investment Company Act or
Commission rules. The required records often cannot be
understood without referring to other documents that are not
required to be kept by Commission rules. These additional
records, for example, may explain innovative products and
investments. They may also provide important insights into the
portfolio management strategies of a fund. At present, in the
inspection context, the Commission often relies on voluntary fund
production of these records to examine fund transactions in
investments that present novel investor protection issues, such
as derivative instruments.-[17]-
iii. Frequency of Fund Reporting
Section 30(b) of the Investment Company Act authorizes the
Commission to require a fund to file with the Commission "such
information and documents (other than financial statements) as
the Commission may require, on a semi-annual or quarterly basis,
to keep reasonably current the information and documents
contained in the [fund's Investment Company Act] registration
statement . . . ."-[18]- The limitation to periodic reporting
restricts the Commission's ability to monitor funds, particularly
in times of market stress. For example, recent events have
demonstrated that sudden changes in interest rates can have
significant effects on fund portfolios that can be magnified by
substantial derivative exposure.-[19]- The Commission is not now
in a position to require prompt reports from funds on the effects
of these interest rate changes, but must await the next periodic
reports or initiate inspections.
c. What steps should be taken to insure that the
Commission is able to obtain accurate and reliable
information quickly and efficiently?
The Division recommends that the Commission seek legislative
clarification and expansion of its existing authority to address
the issues identified above. In particular, the Division intends
to submit to the Commission recommended legislation that would do
the following.
First, the Investment Company Act would be amended to
authorize the Commission to require investment companies to
"maintain and preserve such records as the Commission may
prescribe as necessary or appropriate in the public interest or
-------- FOOTNOTES --------
-[17]- In the context of an enforcement investigation, the
Commission may require the production of all records that may be
related to the inquiry. See, e.g., Investment Company Act
42(b), 15 U.S.C. 80a-41(b).
-[18]- 15 U.S.C. 80a-29(b). Currently, the Commission
requires funds to file semi-annual reports on Form N-SAR. 17
C.F.R 270.30b1-1.
-[19]- See, e.g., PaineWebber Fund, supra note 5; G. Bruce
Knecht, Piper Manager's Losses May Total $700 Million, WALL ST.
J., Aug. 25, 1994, at C1 [hereinafter Piper Fund].
--------------------- BEGINNING OF PAGE #10 -------------------
for the protection of investors."-[20]- This provision would
authorize the Commission to require any additional records that
are necessary to enable its inspection staff, among other things,
to analyze a fund's derivative investments.
Second, the Investment Company Act would be amended to
expressly authorize the Commission to specify the medium and
format in which records must be kept, including electronic media.
Electronic recordkeeping in a usable format would enable the
Division's inspection staff to review an entire portfolio at
multiple points in time, and transaction flows over time, to
evaluate a fund's portfolio activities. This ability is
particularly important in analyzing derivative investments, which
are often used together with other instruments in the portfolio.
Electronic recordkeeping would also facilitate the use of
developing technologies that would make the Commission's
investment company examination program more efficient. For
example, if fund information were supplied electronically to the
Commission's offices prior to an inspection, the inspection staff
could analyze the data prior to commencing field work and target
their efforts in the field on issues raised by that analysis.
Third, the Investment Company Act would be amended to
require explicitly that a fund provide the Commission with all
records that are kept by the fund, whether or not required by
Commission rule to be kept.-[21]- Documents that are not
required to be kept often provide the best description of the
risks of a particular derivative instrument and may point to
operational deficiencies.
Fourth, the Investment Company Act would be amended to
authorize the Commission to specify the frequency of reporting by
investment companies. This authority would assist the Commission
by providing more timely access to information on fund portfolios
and sales and redemption activity in times of market
stress.-[22]- This authority would also enable the staff to
obtain information that would help to identify particular funds
or patterns of events that require closer scrutiny.
We believe that the legislation described above, if enacted,
-------- FOOTNOTES --------
-[20]- This is the same grant of recordkeeping authority
that Congress has provided the Commission with respect to broker-
dealers in Section 17(a)(1) of the Securities Exchange Act of
1934 and investment advisers in Section 204 of the Investment
Advisers Act of 1940. 15 U.S.C. 78q(a)(1), 80b-4.
-[21]- Cf. Section 17(b) of the Securities Exchange Act of
1934 ("Exchange Act"), 15 U.S.C. 78q (making all records of
broker-dealers subject to Commission examination); 12 U.S.C.
248 (authorizing the Board of Governors of the Federal Reserve
System to "examine at its discretion the accounts, books, and
affairs of each Federal reserve bank and of each member bank and
to require such statements and reports as it may deem
necessary"); 12 U.S.C. 481 (authorizing Comptroller of Currency
to appoint bank examiners who "have power to make a thorough
examination of all the affairs of" national banks).
-[22]- Cf. Section 17(h)(2) of the Exchange Act, 15 U.S.C.
78q(h)(2) (authorizing the Commission, in times of adverse
market conditions, to require registered broker-dealers to make
reports concerning the financial and securities activities of
their associated persons).
--------------------- BEGINNING OF PAGE #11 -------------------
would increase the availability to the Commission of the data
required to monitor adequately mutual fund investments, including
investments in derivatives. We would emphasize, however, that,
absent significant additional resources for the highly-qualified
staff necessary to perform fund inspections and analyze available
data, the Commission will remain constrained in its ability to
monitor mutual funds even if the recommended legislation is
adopted.
2. Better Disclosure May be Critical to Help the SEC, but Will
it be Accomplished in a Manner that Makes a Significant
Difference to Average Investors?
a. First, we suspect that investors often develop general
expectations about risk based on how their fund is
categorized, and would like to know if the Commission
agrees.
Neither the Commission nor the Division establishes,
regulates, or gives guidance with respect to fund categories.
Fund categories develop, over time, through use by the fund
industry and rating services such as Lipper Analytical Services,
Inc., and Morningstar, Inc. As a general matter, certain
categories of funds tend to be more or less risky than other
categories. For example, among fixed income funds, a portfolio
comprised of short-term bonds is normally less volatile than one
comprised of long-term bonds. Acknowledging these general
characteristics, investors presumably do develop general
expectations about risk based on how their fund is categorized.
The Commission does regulate fund names, which often convey
information about a fund's category. The Investment Company Act
makes it unlawful for a registered investment company to use as
part of its name any word that the Commission finds to be
deceptive or misleading.-[23]- A Division guideline states that
if a registrant's name suggests a certain type of investment
policy, its name should be consistent with its statement of
investment policy. The guideline also provides generally that if
a fund's name implies that it invests primarily in a particular
type of security, its investment policy should require that,
under normal circumstances, at least 65 percent of the value of
the fund's total assets will be invested in that type of
security.-[24]- The Division also takes the position that where
a fund has a name or investment objective that characterizes the
maturity of its portfolio, the dollar-weighted average portfolio
maturity of the fund must reflect that characterization.-[25]-
-------- FOOTNOTES --------
-[23]- Investment Company Act 35(d), 15 U.S.C. 80a-
34(d). Under section 35(d), the Commission may bring an action
to enjoin a registered investment company from using a materially
deceptive or misleading name.
-[24]- Guidelines for Form N-1A, Guide 1. Commission rules
restrict the use of the term "money market" in fund names. See
section 8.a., below.
-[25]- Form N-7 for Registration of Unit Investment Trusts
Under the Securities Act of 1933 and the Investment Company Act
of 1940, Investment Company Act Release No. 15612 (Mar. 9, 1987),
52 FR 8268, 8301. The Division takes the position that fund
portfolios must have the following dollar-weighted average
maturities: short-term fund - not more than three years;
short/intermediate-term fund - more than two years but less than
(continued ...)
--------------------- BEGINNING OF PAGE #12 -------------------
We would emphasize that a name, or any single piece of
information about a mutual fund, cannot tell the whole story of
mutual fund risk. The prospectus is a mutual fund's basic
disclosure document. Fund prospectuses convey a range of
information to investors, including the fund's name, investment
objectives and policies, permitted investments, and risk
descriptions.-[26]- This information, taken together, should
communicate to investors a comprehensible and accurate picture of
fund risk.
The Division is taking several steps to help ensure that a
fund's name is consistent with the fund's use of derivatives and
educate investors regarding the danger of relying too heavily on
fund names. First, on an ongoing basis, in the review of fund
registration statements, the staff looks for, and requests
changes to, disclosure that is inconsistent with a fund's name.
Second, because there are inherent limitations on the usefulness
of fund names, the Division is undertaking consumer education
efforts to alert investors to the need to read prospectuses and
periodic reports and the danger of relying too heavily on fund
names as the sole source of information regarding the fund's
investments. Third, the Division is reevaluating the current
requirements regarding fund names to determine whether they
should be revised. In particular, the Division contemplates
reevaluating the requirements applicable to a fund whose name
suggests that its portfolio is limited to instruments of a
particular maturity. The Division also expects to review the use
by funds of the word "government" in their names.
b. Second, even if the fund's disclosures are presented
clearly, concisely, and in a manner designed to
maximize comprehensibility, it is still questionable
whether investors would be able to understand and
assimilate information that is useful to their
investment decision. A discussion of how inverse
floaters work, or definitions of principal-only
strips of CMOs, will involve unavoidable elements of
abstraction. Are there alternative ways of creatively
presenting the critical information needed by
investors, such as the effect on risk and volatility
created by the fund's holdings of derivatives, that
avoid the dilemma of attempting to define these
instruments and strategies?
Since the summer of 1993, the Division's fund disclosure
review staff has given heightened scrutiny to derivatives
disclosure in prospectuses; and a Division task force has
examined the derivatives disclosures of 100 investment companies,
representing a broad sample of complexes and fund types. We have
found that funds generally provide investors with a list and
technical description of instruments, including derivatives, that
are permissible fund investments. Funds often describe the
purposes for using particular derivative instruments (e.g., to
hedge currency risks), but typically provide only the most
general information on the risk level of the fund taken as a
-------- FOOTNOTES --------
(-[25]- continued ...)
five years; intermediate-term fund - more than three years but
not more than ten years; intermediate/long-term fund - more than
ten years but less than fifteen years; long-term fund - more than
ten years. Id.
-[26]- Investment Company Act Form N-1A, Items 1 and 4.
--------------------- BEGINNING OF PAGE #13 -------------------
whole or on how derivative instruments, taken as a group, modify
that risk level.
The Division has advised mutual fund registrants that, in
many cases, it has found fund disclosures regarding derivative
instruments to be highly technical and has encouraged registrants
to modify their existing disclosure to enhance investor
understanding of pertinent risks.-[27]- The Division is also
considering possible modifications of the Commission's disclosure
requirements. In the Division's view, a potentially better form
of disclosure may be some means of describing the risk profile of
a fund's portfolio as a whole with greater specificity. This
information would assist an investor in determining whether a
fund's risk characteristics are consistent with his or her own
investment objectives. Consumer focus groups conducted on the
Division's behalf early this year indicated that investors may in
fact find this information helpful.
In order to address investors' need for information about
portfolio risk characteristics, the Division recommends that the
Commission issue a release seeking public comment on whether
mutual fund disclosure of some quantitative risk measure should
be required and what that measure should be. This action would
enable the Commission to obtain investor and industry input
regarding the utility of various risk measures and the
feasibility of their computation. A quantitative risk measure
could have significant benefits for investors by providing a
means of comparing risks across and within fund categories,
particularly for fixed income funds whose market risks may be
less well understood by investors than those associated with
equity funds.
There are a number of quantitative risk measures that
deserve consideration, and the comment process should help the
Commission determine which, if any, of the available measures
would be most helpful to investors and feasible for funds to
calculate. The following are among the possibilities.
Duration: a measure of the price sensitivity of a
fixed income fund to changes in interest rates.
Standard deviation: a measure of the volatility of a
mutual fund's total return over specified time periods.
Beta: a measure of a mutual fund's risk relative to
the market.
We acknowledge that the selection of an appropriate risk
measure is a difficult task because all measures have
limitations. Most measures rely on historical data and can only
estimate the level of risk that was incurred in the past, not
what will happen in the future. In addition, measurements will
change depending on the time period over which risk is measured
and the benchmark against which a fund is compared. Some
measures (e.g., duration) are not applicable to all funds. And
each measure would require investor education regarding the
proper interpretation of the measure and its limited predictive
-------- FOOTNOTES --------
-[27]- Letter to Registrants from Carolyn B. Lewis,
Assistant Director, Division of Investment Management (Feb. 25,
1994).
--------------------- BEGINNING OF PAGE #14 -------------------
value.-[28]-
c. Finally, formal disclosure to investors takes place
annually in the prospectus. But various derivatives
positions, each with distinctly different possible
risks, can change by the hour, or even by the minute.
So it's not clear how much value there is in knowing
what the fund held at a particular past moment in time.
Does the Commission agree that this quality should be
considered when evaluating the utility of requiring
enhanced disclosure of derivatives holdings?
The Division agrees that the fluid nature of the investment
management process limits the utility of reviewing specific
portfolio positions previously taken by a fund. Nonetheless, the
Division believes that historical data does provide fund
shareholders with important information.
A mutual fund is required to provide a schedule of portfolio
holdings to its shareholders semi-annually.-[29]- This
requirement ensures that shareholders receive a twice-yearly
snapshot of a fund's investments. The snapshot is important in
that it provides shareholders with a concrete, historical picture
of how the fund has been managed.
The portfolio schedule is not, however, a complete guide to
the portfolio manager's strategy. Other forms of disclosure help
to enhance the picture. For example, non-money market mutual
funds are required to include "Management's Discussion of Fund
Performance" in their prospectus or annual report, discussing the
investment strategies and techniques that materially affected
fund performance during the preceding year.-[30]- Thus, a fund
whose performance was materially affected by derivatives would be
required to discuss that fact -- whether or not derivatives were
reflected in the portfolio schedule at the close of the year. As
another example, the use of quantitative risk measures, as
described in the preceding section, could enhance investor
understanding of a portfolio manager's strategy.
3. Is Intense Competition in the Fund Industry (or Any Other
Reason) Leading Some Portfolio Managers to Move Risky
Derivatives Into Otherwise Risk Averse Funds?
a. Is the competition for assets within the industry so
intense that otherwise conservative funds take on
disproportionate risks in order to outperform rivals?
In recent years, there has been tremendous growth in the
-------- FOOTNOTES --------
-[28]- The standardized measures of fund yield and total
return that are currently required to be disclosed in the
prospectus are subject to similar limitations. Form N-1A, Item
22.
-[29]- Investment Company Act 30(d)(2), 15 U.S.C. 80a-
29(d)(2); 17 C.F.R. 270.30d-1; Form N-1A, Item 23; 17 C.F.R.
210.6-05.1, .6-10(c)(1), .12-12.
-[30]- Form N-1A, Item 5A(a). Non-money market funds also
are required to provide a graph comparing the fund's performance
over the past 10 years with an appropriate broad-based market
index. Form N-1A, Item 5A(b).
--------------------- BEGINNING OF PAGE #15 -------------------
number of mutual funds competing for investor dollars.-[31]-
There have also been recent reports of significant losses by
several short-term government bond funds, which generally are
considered to be relatively conservative investments, and reports
of losses on some adjustable rate instruments held by money
market funds.-[32]- These facts, taken together, suggest that
competition may, at present, play some role in encouraging mutual
fund use of derivatives to enhance yield.
With more than 4,700 mutual funds competing vigorously for
investor dollars, superior investment performance is one key way
in which a fund can distinguish itself from rivals. Studies
generally show, however, that it is much more difficult to
maintain a high level of performance over a long period of time
than over a short period of time.-[33]- Studies also show that
investor money tends to flow toward funds with superior near-
term performance.-[34]- Thus, it would not be surprising if some
mutual fund managers perceive pressure to take on additional risk
in order to attain at least a short-term performance
"boost."-[35]-
b. Is the Commission concerned that the cause of the
-[31]- In June 1994, there were 4,901 separate mutual fund
portfolios, an increase of 769% from the 564 that existed at the
beginning of 1981. Investment Company Institute Press Release,
June Mutual Fund Sales Total $36.8 Billion, July 28, 1994;
INVESTMENT COMPANY INSTITUTE, MUTUAL FUND FACT BOOK 101 (1993).
-------- FOOTNOTES --------
-[32]- See, e.g., PaineWebber Fund, supra note 5; Piper
Fund, supra note 19; Stepping up to the Plate, supra note 6.
-[33]- Michael C. Jensen, The Performance of Mutual Funds
in the Period 1945-1964, 23 J. FIN. 23, 389 (1968); Edwin J.
Elton, Martin J. Gruber, Sanjiv Das, & Matthew Hlavka, Efficiency
With Costly Information: A Reinterpretation of Evidence From
Managed Portfolios, 6 REV. FIN. STUD. 1 (1993).
-[34]- Erik R. Sirri & Peter Tufano, Competition in the
Mutual Fund Industry, Paper Presented at Harvard Business School
Colloquium, Managing the Financial Service Firm in a Global
Environment (Aug. 26, 1992).
-[35]- A recent news article suggested that many fund
portfolio managers have compensation arrangements with their
employers that encourage them to take inappropriate risks.
Robert McGough, Taking Chances: Risk in Mutual Funds is Rising
as Managers Chase After Bonuses, WALL ST. J., Aug. 11, 1994, at
A1. The Investment Advisers Act of 1940 prohibits most types of
performance fees for registered investment advisers, but this
prohibition does not apply to the compensation arrangements that
investment advisers have with their employees, including mutual
fund portfolio managers. Investment Advisers Act 205(a)(1), 15
U.S.C. 80b-5(a)(1). The Division is not persuaded that there
is sufficient evidence of abuse to support extending the
performance fee prohibition to mutual fund portfolio managers at
the present time. At the same time, however, we believe that
fund managers and boards of directors or trustees should review
portfolio manager compensation arrangements to ensure that they
are designed with sufficient controls and other oversight
mechanisms to protect the interests of fund shareholders. See
Levitt Remarks, Directors as Investor Advocates, supra note 9, at
8-9.
--------------------- BEGINNING OF PAGE #16 -------------------
losses reported at two short-term government bond funds
may represent a growing trend?
It is unclear whether the recent losses by short-term
government bond funds represent a growing trend. The losses
reported to date, however, do not appear to be evidence of a
systemic problem in the mutual fund industry. It is also worth
noting that losses by mutual funds from strategies undertaken to
boost current yield are not a new phenomenon, but, unfortunately,
recur from time to time in various forms. In the 1980s, for
example, similar problems were associated with so-called
"government-plus funds."-[36]- In addition, the recent losses
have been a forceful reminder to the fund industry that the
upside rewards of assuming increased risk also carry downside
penalties. This market lesson may significantly dampen industry
enthusiasm for competition through assuming increased risk.
c. Does the Commission believe that a legislative or
regulatory response is needed to address any issues
related to the derivatives losses reported at these
funds?
In general, competition within the mutual fund industry
should be a positive force, encouraging funds to improve
performance, lower costs, and reduce risks; and the Division
believes that each individual mutual fund must determine how to
respond to competitive market forces. We also believe that the
regulatory structure established by the Investment Company Act,
through the disclosure and fiduciary obligations it imposes,
generally provides an adequate framework for ensuring that
investors are adequately protected. A mutual fund, for
example, is currently required to disclose to investors material
information regarding the fund, including the risks of investing
in the fund.-[37]- Accordingly, it is a violation of existing
laws and rules for a fund to mislead investors materially as to
its risk profile, including the effect that derivatives have on
that risk profile.
The Division believes, however, that the risks assumed by
some funds that use derivatives to enhance performance could be
better disclosed to shareholders. Funds are presently required
to disclose significant quantitative information in the areas of
performance-[38]- and costs-[39]-, and the Division is
recommending that the Commission consider requiring disclosure of
some form of quantitative risk measure in mutual fund
prospectuses. This is discussed in greater detail in response to
question 2.
4. Are Mutual Funds Experiencing Problems Pricing Exotic
Derivatives?
-------- FOOTNOTES --------
-[36]- See, e.g., Jane Bryant Quinn, No Place to Hide,
NEWSWEEK, May 11, 1987, at 62 (use of options to boost income on
portfolio of government bonds at potential cost of diminished
capital).
-[37]- See, e.g., Securities Act 17(a), 15 U.S.C.
77q(a); Exchange Act 10(b), 15 U.S.C. 78j(b); Exchange Act
rule 10b-5, 17 C.F.R. 240.10b-5; Form N-1A, Item 4(c).
-[38]- Form N-1A, Item 2.
-[39]- Form N-1A, Item 3.
--------------------- BEGINNING OF PAGE #17 -------------------
a. Pricing requirements
Mutual fund share pricing policies and practices are
governed generally by sections 2(a)(41) and 22(c) of the
Investment Company Act and rules 2a-4 and 22c-1 thereunder.-[40]-
Section 22(c) provides the Commission with the authority to make
rules governing the methods for computing the prices for mutual
fund shares. Rule 22c-1 provides in part that a mutual fund may
not sell or redeem its securities "except at a price based on the
current net asset value of such security which is next computed
after receipt of a tender of such security for redemption or of
an order to purchase or sell such security."-[41]-
Rule 22c-1 generally provides that the current net asset
value of a mutual fund's securities must be calculated every
business day during which an order is received either to purchase
or redeem a share of the fund.-[42]- Section 2(a)(41) and rule
2a-4 require a fund to mark its assets to market in computing net
asset value. In the marking to market process, market quotations
are required to be used for those securities for which the
quotations are readily available. For all other securities and
assets, a fund is required to use fair values as determined in
good faith in accordance with procedures approved by its board of
directors or trustees.-[43]-
b. Pricing v. price reporting
Before addressing the issue of mutual fund pricing of
derivative investments, we believe it would be useful to
distinguish between pricing and price reporting.-[44]- Although
the Investment Company Act, and thus the Commission, regulate the
pricing of fund shares in the manner described above, neither the
Investment Company Act nor the Commission regulates -- or even
requires -- the reporting of share prices to the news media. The
incident referred to in the Letter, the absence of a reported
price in the morning paper for a fund with derivative
investments, is not the subject of either federal law or
Commission regulation and is a separate issue from the question
of whether purchasing and redeeming shareholders receive the
correct price for their shares. Although share prices may be
unreported because they are not calculated in time to meet
newspaper deadlines, and the presence of certain derivatives in a
fund's portfolio may make it more difficult to meet publication
deadlines, this does not mean that investors receive an incorrect
-------- FOOTNOTES --------
-[40]- 15 U.S.C. 80a-2(a)(41), -22(c); 17 C.F.R.
270.2a-4, .22c-1.
-[41]- 17 C.F.R. 270.22c-1(a).
-[42]- 17 C.F.R. 270.22c-1(b)(1).
-[43]- 15 U.S.C. 80a-2(a)(41)(B); 17 C.F.R. 270.2a-
4(a)(1); Restricted Securities, Investment Company Act Release
No. 5847 (Oct. 21, 1969) [hereinafter Release 5847].
-[44]- A fuller discussion of this issue appears in our
August 22, 1994 Memorandum on Mutual Fund Share Price Reporting,
responding to a letter dated June 30, 1994, from Edward J.
Markey, Chairman, and Jack Fields, Ranking Republican Member, of
the Subcommittee on Telecommunications and Finance of the House
Committee on Energy and Commerce.
--------------------- BEGINNING OF PAGE #18 -------------------
price upon redemption, or pay an incorrect price at
purchase.-[45]-
c. Pricing and derivatives
The obligation of a mutual fund to calculate daily net asset
value accurately for purposes of share sales and redemptions is
critical to investor confidence. If net asset value is
incorrectly computed, purchasing or redeeming shareholders may
pay or receive too little or too much, and the interests of other
shareholders may be overvalued or diluted. The accurate
valuation of each portfolio asset, including derivative
instruments, is the foundation for computing fund net asset
value.
Funds normally obtain market quotations from one or more
sources, such as last sale prices reported by service vendors or
bid and asked quotations supplied by market makers. Many
derivatives may be priced in this manner. Exchange-traded
derivatives, such as futures and exchange-traded options, for
example, generally can be priced based on last sale prices or
market quotations.
Prior to purchasing an instrument, derivative or otherwise,
a mutual fund typically evaluates the availability of market
prices for the instrument. If market quotations are not readily
available for the instrument, the fund must be prepared to use
fair value as determined in good faith in accordance with
procedures approved by its board of directors or trustees. When
a fund decides to purchase an instrument, it typically will have
determined either that market quotations are readily available or
that it can implement fair value procedures. This decision-
making process acts as a brake on a fund's acquisition of an
instrument when it is evident, from the outset, that pricing will
be problematic.
Market conditions change over time, and a fund may find that
an instrument that had readily available market prices when it
was acquired ceases to have such price availability. This
appears to have been the situation during recent months in the
mortgage-backed securities market, where decreased liquidity has
resulted in the deterioration of accurate market pricing
information for some derivative securities -- such as certain
collateralized mortgage obligations. In these circumstances, it
-------- FOOTNOTES --------
-[45]- Chairman Levitt recently requested that the National
Association of Securities Dealers, Inc. ("NASD"), and the
Investment Company Institute ("ICI") address issues relating to
fund price reporting. Letter from Arthur Levitt, Chairman, U.S.
Securities and Exchange Commission, to Joseph R. Hardiman,
President and Chief Executive Officer, NASD, and Matthew P. Fink,
President, ICI (June 28, 1994). The NASD and the mutual fund
industry have taken some steps to alleviate the time pressures
and technological problems that may result in reporting problems,
including an extension of the NASD's price reporting deadline,
and are considering others. See Letters from Joseph R. Hardiman,
President and Chief Executive Officer, NASD, and Matthew P. Fink,
President, ICI, to Arthur Levitt, Chairman, U.S. Securities and
Exchange Commission (July 13, 1994). We are monitoring further
developments in this area and working with the NASD and the
mutual fund industry to ensure that the reporting system serves
the interest of investors in obtaining accurate price
information.
--------------------- BEGINNING OF PAGE #19 -------------------
may be more difficult to establish reliable prices.-[46]-
The changing nature of markets makes it difficult, if not
impossible, to ensure that mutual funds will never purchase
instruments that become illiquid and, consequently, difficult to
price. Nevertheless, the statutory and regulatory pricing
requirements discussed above, together with the liquidity
requirements discussed in response to question 5, act as
significant checks on mutual fund investments in instruments that
are difficult to price. Indeed, fund sponsors face substantial
liabilities for pricing errors. In those instances when fund
transactions occur at incorrect prices, it is the Division's
policy that errors should be corrected when discovered, and fund
sponsors should reimburse shareholders who have experienced a
material economic loss due to the errors. Fund sponsors' own
economic interests therefore militate against significant use of
instruments that will cause pricing problems.
In order to provide assurances of price accuracy, funds
typically employ extensive control procedures. For many funds,
the control process begins with the use of independent pricing
services to value fund holdings. Because pricing services
compete for business, it is in their best interests to provide
accurate prices. At the fund level, validation procedures,
tolerance checks, and other reviews are often employed to test
and control the validity of pricing.-[47]-
The Division does not believe that legislative changes are
needed at this time to address pricing issues raised by
derivatives. The Division intends, however, to continue to
evaluate pricing issues in our inspections and will perform
targeted examinations to obtain more information on these issues.
If appropriate, we will consider issuing rules to address proper
procedures for pricing determinations.
-------- FOOTNOTES --------
-[46]- See, e.g., PaineWebber Fund, supra note 5; Robert
McGough, Baird Fund Spurs Worries About Pricing, WALL ST. J.,
Aug. 15, 1994, at C1 [hereinafter Baird Fund].
-[47]- For example, many funds employ automated exception
reports that compare the current day's price for each portfolio
instrument to the previous day's closing price and note any
instrument that has changed by more than a preset limit. A
second typical procedure identifies any portfolio instrument
price changes that cause the fund's share price to move more than
a preset amount. A third common procedure compares portfolio
transaction prices to price quotations obtained from pricing
services and/or dealers. A fourth procedure involves portfolio
manager review of the "price make-up sheet," the detailed listing
of each instrument held by the fund and the associated price.
At the share price level, changes in share price are
compared to changes in comparable indices to assure
reasonableness. Price changes that exceed preset levels must be
reverified and explained before they are entered into the
accounting system for share price computation. Fund pricing
staff may also look for corporate actions, news stories, or other
developments to explain price changes.
--------------------- BEGINNING OF PAGE #20 -------------------
5. Are Mutual Funds Experiencing Liquidity Problems Because of
Exotic Derivatives?
a. Does the Commission believe that some of the more
exotic and volatile derivatives should be considered
"illiquid?" Has the Commission considered whether the
15% rule should be applied to any types of derivative
products?
Section 22(e) of the Investment Company Act generally
requires that a mutual fund make payment for redeemed shares
within seven days after the tender of the shares.-[48]- Because
mutual funds hold themselves out to investors as being prepared
at all times to meet redemptions within seven days, it is
essential that funds maintain investment portfolios that will
enable them to fulfill this obligation. For this reason, and
because the extent of redemption demands are not predictable,
mutual funds must maintain highly liquid portfolios.-[49]-
The Commission has published a guideline requiring that
mutual funds generally limit their investments in illiquid assets
to 15% of net assets. The guideline limit is 10% in the case of
money market funds.-[50]- An asset is considered "illiquid" if a
fund cannot dispose of the asset in the ordinary course of
business within seven days at approximately the value at which
the fund has valued the instrument.-[51]-
On occasion, the Commission and the Division have taken the
position that certain classes of instruments are generally
illiquid.-[52]- Generally, however, the determination of whether
a particular mutual fund asset, including a derivative
instrument, is illiquid should be made under guidelines and
-------- FOOTNOTES --------
-[48]- 15 U.S.C. 80a-22(e). This requirement does not
apply during any period that (1) the New York Stock Exchange
("NYSE") is closed other than customary weekend and holiday
closings or trading on the NYSE is restricted; (2) an emergency
exists as a result of which disposal by the fund of securities
owned by it is not reasonably practicable or it is not reasonably
practicable for the fund fairly to determine the value of its net
assets; or (3) the Commission permits for the protection of
shareholders of the fund. Id.
-[49]- See Release 5847, supra note 43.
-[50]- See Revisions of Guidelines to Form N-1A, Investment
Company Act Release No. 18612 (Mar. 12, 1992), 57 FR 9828
(raising guideline for non-money market funds from 10% to 15% to
facilitate capital raising by small businesses) [hereinafter
Release 18612]; Letter from Marianne K. Smythe, Director,
Division of Investment Management, to Matthew P. Fink, President,
Investment Company Institute (Dec. 9, 1992) (clarifying that
change in limit from 10% to 15% does not apply to money market
funds); Release 5847, supra note 43, at 7.
-[51]- Acquisition and Valuation of Certain Portfolio
Instruments by Registered Investment Companies, Investment
Company Act Release No. 14983 (Mar. 12, 1986), 51 FR 9773, 9777;
Guidelines for Form N-1A, Guide 4.
-[52]- Release 5847, supra note 43 (restricted securities
generally illiquid).
--------------------- BEGINNING OF PAGE #21 -------------------
standards established by the fund's board of directors or
trustees.-[53]- Examples of factors that may be taken into
account in determining liquidity include (1) the frequency of
trades and quotes for the instrument, (2) the number of dealers
willing to purchase or sell the instrument and the number of
other potential purchasers, (3) dealer undertakings to make a
market in the instrument, and (4) the nature of the instrument
and the nature of the marketplace in which the instrument trades,
including the time needed to dispose of the security, the method
of soliciting offers, and the mechanics of transfer.-[54]-
Ultimate responsibility for liquidity determinations rests with
the fund's board, but the board may delegate the day-to-day
function of determining liquidity to the fund's investment
adviser, provided the board retains sufficient oversight.-[55]-
The Division believes that particular derivative instruments
may be illiquid under all or most market conditions. This will
more likely be the case if a derivative is designed to meet the
needs of a particular investor. Such a derivative, almost by
design, would not have the broad market required to support a
finding that the instrument is liquid. The liquidity of other
derivative instruments, however, may vary depending on market
conditions. An instrument that is liquid in one market
environment may become illiquid in another market environment.
This has recently been the case, for example, for certain
collateralized mortgage obligations. Recent interest rate
increases and full dealer inventories apparently caused markets
for these instruments virtually to disappear, leaving previously
liquid instruments illiquid.-[56]-
Fund management's obligation to make liquidity
determinations is a continuing one in the case of instruments,
including derivatives, whose liquidity may vary under different
market conditions. If changed market conditions result in
previously liquid portfolio holdings becoming illiquid, fund
management should determine whether any steps are required to
-------- FOOTNOTES --------
-[53]- See Merrill Lynch Money Markets Inc. (pub. avail.
Jan. 14, 1994) (commercial paper issued in reliance on
registration exemption in section 4(2) of Securities Act of
1933); Letter from Carolyn B. Lewis, Assistant Director, Division
of Investment Management, to Investment Company Registrants (Jan.
17, 1992) (government-issued interest-only and principal-only
securities backed by fixed-rate mortgages, municipal lease
obligations); Letter from Carolyn B. Lewis, Assistant Director,
Division of Investment Management, to Catherine L. Heron,
Investment Company Institute (June 21, 1991) (municipal lease
obligations) [hereinafter ICI letter]; Resale of Restricted
Securities; Changes to Method of Determining Holding Period of
Restricted Securities under Rules 144 and 145, Investment Company
Act Release No. 17452 (Apr. 23, 1990), 55 FR 17933, 17940-41
(Rule 144A securities, foreign securities) [hereinafter Release
17452].
-[54]- See Release 17452, supra note 53, at 55 FR 17940-
41; ICI Letter, supra note 53, at 1.
-[55]- Release 17452, supra note 53, at 55 FR 17940 n.61.
-[56]- See, e.g., Saul Hansell, Markets in Turmoil:
Investors Undone: How $600 Million Evaporated -- A special
report; Fund Manager Caught Short By Crude and Brutal Market,
N.Y. TIMES, Apr. 5, 1994, at A1 [hereinafter Markets in Turmoil].
--------------------- BEGINNING OF PAGE #22 -------------------
assure that the fund continues to meet the 15% guideline.-[57]-
We note that, in general, there is a close relationship
between the liquidity of an instrument, derivative or otherwise,
and the ease with which the instrument may be priced, the subject
of question 4. If a security trades in a liquid market, there is
a strong likelihood that reliable market prices will be readily
available. Conversely, reliable prices for securities traded in
an illiquid market are often difficult to obtain.
b. Has the Commission considered whether the 15% figure
itself should be revisited?
In 1992, the Commission raised the limit on illiquid assets
from 10% to 15% for non-money market funds to facilitate capital
raising by small businesses.-[58]- The limit for money market
funds remains 10%. Recent illiquidity in the market for certain
mortgage derivatives raises once again the question of what limit
is appropriate.-[59]-
The Division has been focusing on the illiquid assets limit
in its inspections of mutual funds to determine whether funds are
complying with the limit on an ongoing basis, whether funds are
holding illiquid investments to the maximum amount permitted, and
whether there is a need to reduce the limit. We recommend that
the Commission act promptly to consider reducing the ceiling.
6. Does the Use of Derivatives Permit Mutual Funds to Avoid
Limitations on the Use of Leverage Mandated by the
Investment Company Act of 1940?
a. Please describe for the Subcommittee the original
purpose of the restrictions on leverage contained in
the Investment Company Act.
Investment company abuse of leverage was a primary concern
that led to enactment of the Investment Company Act.-[60]- In
the Act's preamble, Congress cited excessive leverage as a major
abuse that it meant to correct, declaring that the public
interest and the interest of investors are adversely affected
"when investment companies by excessive borrowing and the
-------- FOOTNOTES --------
-[57]- Release 17452, supra note 53, at 55 FR 17940 n.61.
-[58]- Release 18612, supra note 50.
-[59]- See, e.g., Baird Fund, supra note 46; Robert McGough
& Anita Raghavan, PaineWebber Again Props Up Bond Fund, WALL ST.
J., July 25, 1994, at C1 [hereinafter PaineWebber Again Props Up
Bond Fund].
-[60]- In 1939, the Commission released an exhaustive study
of the investment company industry that laid the foundation for
the Investment Company Act. SEC, INVESTMENT TRUSTS AND
INVESTMENT COMPANIES, H.R. Doc. No. 707, 75th Cong., 3d Sess. pt.
1 (1939) [hereinafter INVESTMENT TRUST STUDY PT. 1]; SEC,
INVESTMENT TRUSTS AND INVESTMENT COMPANIES, H.R. Doc. No. 70,
76th Cong., 1st Sess. pt. 2 (1939); SEC, INVESTMENT TRUSTS AND
INVESTMENT COMPANIES, H.R. Doc. No. 279, 76th Cong., 1st Sess.
pt. 3 (1939) [hereinafter INVESTMENT TRUST STUDY PT. 3]. For a
discussion of leveraged capital structures of investment
companies, see INVESTMENT TRUST STUDY PT. 3, Ch. V, "Problems in
Connection with Capital Structure," 1563-1940.
--------------------- BEGINNING OF PAGE #23 -------------------
issuance of excessive amounts of senior securities increase
unduly the speculative character of their junior
securities."-[61]-
Section 18(f) of the Investment Company Act restricts
leveraged capital structures, generally prohibiting mutual funds
from issuing any class of "senior security."-[62]- Funds may,
however, borrow from banks if they maintain 300% asset coverage
for all such borrowings.-[63]- Section 12(a) authorizes the
Commission to regulate two trading practices that may result in
leverage, margin purchases and short sales.-[64]-
One reason for limiting investment company leverage was to
prevent abuse of the purchasers of senior securities, which were
sold to the public as low risk investments.-[65]- Investment
company assets during the 1920s and 1930s consisted mostly of
common stocks that did not provide the stable asset values or
steady income stream necessary to support senior charges.-[66]-
Because the sponsors often kept all or most of the junior, voting
securities for themselves, they could operate the company in
their own interests.-[67]- Senior securities tended to lead to
speculative investment policies to the detriment of senior
securityholders because the common stockholder/sponsors, who
often had a relatively small investment at risk in the fund,
-------- FOOTNOTES --------
-[61]- Investment Company Act 1(b)(7), 15 U.S.C. 80a-
1(b)(7). The preamble also refers to "investment companies
operat[ing] without adequate assets or reserves." Investment
Company Act 1(b)(8), 15 U.S.C. 80a-1(b)(8).
-[62]- 15 U.S.C. 80(a)-18(f). "Senior security" is
defined to include preferred stock, bonds, debentures, notes, and
other securities evidencing indebtedness. Investment Company Act
18(g), 15 U.S.C. 80a-18(g).
-[63]- Investment Company Act 18(f)(1), 15 U.S.C. 80a-
18(f)(1).
-[64]- 15 U.S.C. 80a-12(a)(1), (3). The Commission has
not adopted any rules under section 12(a); instead it has
regulated margin purchases and short sales under section 18.
E.g., Guidelines for the Preparation of Form N-8B-1, Investment
Company Act Release No. 7221 (June 9, 1972), 37 FR 12790
[hereinafter 1972 Guidelines].
-[65]- Id. at 1583; Investment Trusts and Investment
Companies: Hearings on S. 3580 Before a Subcomm. of the Senate
Committee on Banking and Currency, 76th Cong., 3d Sess. 265, 272
(1940) (statements of David Schenker, Chief Counsel, and L. M. C.
Smith, Associate Counsel, SEC Investment Trust Study)
[hereinafter Senate Hearings].
-[66]- Senate Hearings, supra note 65, at 265; INVESTMENT
TRUST STUDY PT. 3, supra note 60, at 1587-89.
-[67]- Senate Hearings, supra note 65, at 239-40, 268-71,
273; INVESTMENT TRUST STUDY PT. 3, supra note 60, at 1594-98.
See Investment Company Act 1(b)(3), 15 U.S.C. 80a-1(b)(3)
(public interest and interest of investors adversely affected
"when investment companies issue securities containing
inequitable or discriminatory provisions, or fail to protect the
preferences and privileges of the holders of their outstanding
securities").
--------------------- BEGINNING OF PAGE #24 -------------------
looked to capital gains for profit.-[68]- Multiple classes of
senior securities and pyramiding frustrated senior
securityholders' attempts to determine whether secure returns
were likely.-[69]-
Another reason for limiting investment company leverage was
to protect public common stockholders by limiting the volatility
of their investments. This purpose was a motivating factor for
restricting the issuance of senior securities to the public
because the leverage of the senior-junior capital structure
magnified losses suffered by common stockholders.-[70]- This
purpose also motivated the Investment Company Act restrictions on
mutual fund bank borrowings.-[71]- The provisions authorizing
the Commission to regulate margin purchases and short sales
implicate similar concerns.
b. Is the leverage that is made available to funds through
the use of derivatives inconsistent with the intent
underlying the Investment Company Act?
i. Derivatives and leverage
Certain derivatives involve leverage for a fund because they
create an obligation, or indebtedness, to someone other than the
fund's shareholders and enable the fund to participate in gains
-------- FOOTNOTES --------
-[68]- Senate Hearings, supra note 65, at 239-40;
INVESTMENT TRUST STUDY PT. 3, supra note 60, at 1615, 1668-74.
The relatively small investment of the common stockholders
meant that the equity "cushion" protecting senior securityholders
was small. INVESTMENT TRUST STUDY PT. 3, supra note 60, at 1665-
68. Senior securityholders of a mutual fund could be further
compromised because the right of redemption held by the fund's
common stockholders could erode the "cushion" of equity
protecting the senior securityholders. Investment Trusts and
Investment Companies: Hearings on H. R. 10065 Before a Subcomm.
of the House Committee on Interstate and Foreign Commerce, 76th
Cong., 3d Sess 121 (1940) (statement of David Schenker, Chief
Counsel, SEC Investment Trust Study); INVESTMENT TRUST STUDY PT.
3, supra note 60, at 1870-71. At the time of the study, however,
mutual funds almost invariably had only one class of securities
outstanding. INVESTMENT TRUST STUDY PT. 1, supra note 60, at 29;
INVESTMENT TRUST STUDY PT. 3, supra note 60, at 1563.
-[69]- INVESTMENT TRUST STUDY PT. 3, supra note 60, at
1665, 1674-75. Section 12(d)(1) of the Investment Company Act
controls pyramiding by restricting an investment company's
acquisition of securities issued by other investment companies.
15 U.S.C. 80a-12(d)(1).
-[70]- Investment Company Act 1(b)(7), 15 U.S.C. 80a-
1(b)(7); Senate Hearings, supra note 65, at 1027-31 (Commission
memorandum to the effect that dangers to common stock at least as
important as senior securities with respect to ends sought by
section 18).
-[71]- See Senate Hearings, supra note 65, at 288
(statement of John H. Hollands, Attorney, SEC staff) ("[B]ank
borrowings will be a fixed charge against the company; and,
because of the fixed charge, the value of the common stock will
shoot up and down in the same way that it would if they had
debentures outstanding.").
--------------------- BEGINNING OF PAGE #25 -------------------
and losses on an amount that exceeds its initial investment
(referred to herein as "indebtedness leverage"). Examples are
futures, forward contracts, and written options. The writer of a
stock put option, for example, makes no initial investment, but
instead receives a premium in an amount equal to a fraction of
the price of the underlying stock. In return, the writer is
obligated to purchase the underlying stock at a fixed price,
thereby participating in losses on the full stock price.-[72]-
As another example, a fund purchasing a futures contract makes an
initial margin payment that is typically a small percentage of
the contract price.-[73]- As a result of this margin payment,
the fund participates in gains and losses on the full contract
price.-[74]-
Other derivatives provide the economic equivalent of
leverage because they display heightened price sensitivity to
market fluctuations (referred to herein as "economic leverage"),
such as changes in stock prices or interest rates. In essence,
these derivatives magnify a fund's gain or loss from an
investment in much the same way that incurring indebtedness
does.-[75]- One example is a purchased stock call option. In
return for the payment of a premium in an amount equal to a
fraction of the stock price, the holder of a stock call option
participates in gains on the full stock price. If there are no
gains, the holder generally loses the entire initial
premium.-[76]- Another example is a leveraged inverse floating
rate bond, with an interest rate that moves inversely to a
benchmark rate. A leveraged inverse floating rate bond displays
heightened price sensitivity to interest rate changes, resulting
in the holder experiencing market value fluctuations equivalent
to those that he or she would experience on a conventional bond
of larger principal amount.-[77]-
ii. Derivatives and Investment Company Act leverage
restrictions
The leverage of derivatives raises concerns related to the
volatility of fund common stock, but does not raise concerns
related to the protection of public senior securityholders. In
the case of derivatives that create indebtedness leverage, the
fund assumes a future obligation or indebtedness. While this
obligation or indebtedness does not run to public senior
securityholders, it does expose the fund to gains and losses on
an amount that exceeds its initial investment. In the case of
derivatives that create economic leverage, the fund does not
assume a future obligation or indebtedness. Investing in these
-------- FOOTNOTES --------
-[72]- THE OPTIONS CLEARING CORPORATION, CHARACTERISTICS
AND RISKS OF STANDARDIZED OPTIONS 17-18 (1985) [hereinafter OCC
GUIDE].
-[73]- ROBERT E. FINK AND ROBERT B. FEDUNIAK, FUTURES
TRADING: CONCEPTS AND STRATEGIES 137 (1988).
-[74]- Id. at 39.
-[75]- See, e.g., Lee Berton, Understanding the Complex
World of Derivatives, WALL ST. J., June 14, 1994, at C1.
-[76]- OCC GUIDE, supra note 72, at 15-17.
-[77]- James E. Lebherz, Inverse Floaters Offer Potential
Benefits, and Dangers, WASH. POST, Aug. 29, 1993, at H7.
--------------------- BEGINNING OF PAGE #26 -------------------
derivatives, however, magnifies the fund's gains or losses in
much the same way that incurring indebtedness does.
The Commission and the Division have applied section 18 of
the Investment Company Act to derivatives that create
indebtedness leverage, such as futures, forward contracts, and
written options.-[78]- In applying section 18 to these
instruments, the Commission and the Division have required funds
to "cover" the obligations these derivatives create by
establishing and maintaining segregated accounts consisting of
cash, U.S. government securities, or high-grade debt securities
in an amount at least equal in value to the obligations.-[79]-
The Division also has permitted funds to cover certain
derivatives by holding the underlying instruments or other
offsetting instruments.-[80]- The Commission and the Division
have not applied section 18 of the Investment Company Act to
derivatives that create economic leverage, such as purchased
stock call options and leveraged inverse floating rate bonds.
c. Apart from its relation to existing provisions in the
statute, is the Commission concerned about the leverage
available to funds that hold derivatives? If so, how
does the Commission propose to address those concerns?
The Division is concerned about both indebtedness and
economic leverage that are potentially made available to funds
through the use of certain derivatives. The potential for
increased volatility from such leverage may result in significant
losses to investors.
One approach to the issue of leverage would be to prohibit
directly, or restrict, the use of derivatives by mutual funds.
The Commission has imposed requirements on derivative investments
by money market funds,-[81]- but we do not recommend this
approach for non-money market funds for three reasons. First, a
prohibition or restriction on derivatives use could chill the use
of instruments in a manner that is beneficial for mutual funds,
such as hedging. Second, a prohibition or restriction on
-------- FOOTNOTES --------
-[78]- E.g., Sanford C. Bernstein Fund, Inc. (pub. avail.
June 25, 1990); Dreyfus Strategic Investing (pub. avail. June 22,
1987) [hereinafter Dreyfus]; Putnam Option Income Trust II (pub.
avail. Sept. 23, 1985); Securities Trading Practices of
Registered Investment Companies: General Statement of Policy,
Investment Company Act Release No. 10666 (Apr. 18, 1979), 44 FR
25128 [hereinafter Release 10666]; 1972 Guidelines, supra note
64.
-[79]- Release 10666, supra note 78, at 44 FR 25131-32.
The rationale is that covered transactions do not raise concerns
about undue leverage and speculation that section 18 was intended
to address. Id.
-[80]- For example, instead of maintaining a segregated
account, a fund that sells a call option may cover the position
by owning the securities against which the call is written (or
securities convertible into the underlying securities without
additional consideration) or by purchasing a call on the same
securities at the same price. 1972 Guidelines, supra note 64.
For additional examples of cover, see Dreyfus, supra note 78.
-[81]- These requirements are discussed in response to
question 8, below.
--------------------- BEGINNING OF PAGE #27 -------------------
derivatives use would be inconsistent with the general approach
of the Investment Company Act, which imposes few substantive
limits on mutual fund investments.-[82]- Funds generally are
permitted to make investments without regard to their volatility,
e.g., emerging market securities and small company stocks, and we
are not persuaded that derivatives should be treated
differently.-[83]- Third, it would be extremely difficult, if
not impossible, to devise appropriate prohibitions or
restrictions on the use of derivatives by mutual funds because of
the wide variety of instruments that may be considered
"derivatives." The available "derivatives" are likely to change
as innovation occurs in the marketplace, possibly rendering
substantive prohibitions or restrictions ineffective within a
short time.
The Division believes that one of the most effective means
for addressing leverage concerns associated with mutual fund use
of derivatives is improved risk disclosure. It is crucial that
investors understand the risks of investing in a mutual fund,
including the risks of the fund's intended use of various
derivatives. The risk/return profile of a mutual fund may be
affected significantly by derivatives that are potentially
volatile, and we believe that it is critical that fund investors
understand this profile. For this reason, we have given
heightened scrutiny to derivatives disclosure in prospectuses,
and a Division task force has examined the derivatives
disclosures of 100 investment companies. The Division has
encouraged registrants to modify their existing disclosure to
enhance investor understanding of pertinent risks. We are
engaged in fundamental reconsideration of mutual fund disclosure,
assessing whether the use of quantitative risk measures would
improve investor understanding of fund risk. Because fund use of
derivatives is relatively new and evolving, the Division is
continuing to develop approaches to improving disclosure about
derivatives. If these approaches do not prove to be sufficiently
protective of the interests of fund shareholders, the Division
may reconsider whether to recommend that the Investment Company
Act be amended to place substantive limits on derivatives use.
The Division also recommends that the Commission reexamine
the application of section 18 to derivative instruments. In
practice, section 18 has proven to be a somewhat crude tool for
-------- FOOTNOTES --------
-[82]- The provisions of the Investment Company Act that
prohibit or restrict certain types of investment are quite
narrow. See, e.g., 12(d), 15 U.S.C. 80a-12(d) (investments
in other investment companies, insurance companies, or
securities-related businesses). See also Investment Company Act
rule 2a-7, 17 C.F.R. 270.2a-7 (limiting portfolio investments
of money market funds). The framers of the Investment Company
Act specifically disavowed any attempt to prohibit speculative
mutual fund investments. See, e.g., Senate Hearings, supra note
65, at 44, 247.
-[83]- The legislative history of the Investment Company
Act indicates that the Act was not intended to eliminate all
leverage from fund investments. See, e.g., INVESTMENT TRUST
STUDY PT. 3, supra note 60, at 1580-81 (common stocks held by
investment companies are leveraged in that issuing companies have
senior securities in their capitalization); Id. at 1592-93
(leverage easier to increase or decrease in investment company
with only one class of securities outstanding, where leverage
attributable to portfolio securities).
--------------------- BEGINNING OF PAGE #28 -------------------
addressing the leverage issues raised by derivatives, largely
because it was originally designed to address a different
problem, namely, the leverage created by the issuance of public
senior securities.-[84]- Given the recent proliferation of
derivatives, we believe that it is appropriate to reexamine both
the way in which section 18 has been applied to derivatives that
create indebtedness leverage and the differential treatment under
section 18 of derivatives that create indebtedness and economic
leverage. These are complicated issues that are not susceptible
to a simple solution. For this reason, we recommend that the
Commission issue a release seeking public comment on appropriate
regulatory and legislative solutions to address the issues raised
by leverage resulting from fund use of derivatives.
7. Do the Recent Capital Infusions by Two Fund Complexes
Indicate that Bank Mutual Fund Investors may be Facing
Special Undisclosed Risks?
The questions raised by the Letter in the area of bank-
advised mutual funds relate primarily to the interpretation and
application of federal banking laws. The Division's responses
are based on our understanding of the banking laws and informal
discussions with the staffs of the federal banking agencies. It
also may be advisable for Congressmen Markey and Fields to
contact the federal banking agencies directly, however, as they
have the greatest expertise in interpreting the federal banking
laws and are in the best position to predict how they might
exercise their authority in specific circumstances.
We emphasize, as a preliminary matter, that a mutual fund's
adviser, regardless of whether it is a bank (or a subsidiary or
affiliate of a bank), is not legally obligated to infuse capital
into or purchase depreciated instruments from a fund, absent a
violation of law. Mutual funds invest in securities that carry
market risk, and fund advisers are not required to guarantee or
insure fund performance.
a. Assume a bank was the adviser for a short-term
government bond fund or money market fund that had
suffered sharp unexpected losses. If the fund is not
part of a separately capitalized subsidiary or
affiliate, is there a risk that bank regulatory
concerns might prevent the adviser from making a
capital infusion into the fund, even if such an
infusion was in the interest of the fund's
shareholders?
If a bank was the adviser for a fund that suffered a sharp
unexpected loss, bank regulatory concerns could prevent the
adviser from making a capital infusion into the fund, even if
such an infusion was in the interest of the fund's shareholders.
This risk is present whether the adviser is part of the bank
itself or is a separately capitalized subsidiary or
-------- FOOTNOTES --------
-[84]- Bank debt was generally the only significant form of
short-term or current indebtedness incurred by the investment
companies that the Commission studied prior to passage of the
Investment Company Act. INVESTMENT TRUST STUDY PT. 1, supra note
60, at 28 n.23.
--------------------- BEGINNING OF PAGE #29 -------------------
affiliate.-[85]-
We understand from our discussions with federal bank
regulators that they view the decision to infuse capital into a
fund as initially being a business decision of the bank
adviser.-[86]- If, however, in the bank regulators' view, an
adviser's capital infusion into a fund threatened the safety and
soundness of the bank,-[87]- it is possible that the bank
regulators would take steps to prevent the infusion, regardless
of whether it was in the interest of fund shareholders.-[88]-
Even if an adviser was organized as a subsidiary of the
bank, bank regulators still could cite bank safety and soundness
as grounds for objecting to a capital infusion. The Office of
the Comptroller of the Currency, for example, has traditionally
viewed national bank operating subsidiaries as departments of the
parent bank.-[89]- Thus, operating subsidiaries of national
banks are subject to the same banking laws and regulations as the
parent bank and to examination and supervision by the Office of
-------- FOOTNOTES --------
-[85]- Cf. Proposed Mellon-Dreyfus Merger: Hearings Before
the Subcomm. on Oversight, and Investigations of the House Comm.
on Energy and Commerce, 103d Cong., 2d Sess. 292 (1994)
[hereinafter Mellon-Dreyfus Hearings] (statement of Eugene A.
Ludwig, Comptroller of the Currency) (risk of loss to bank exists
whether activities conducted in subsidiary or division of bank).
-[86]- The questions in the Letter, and our discussion,
specifically address the situation where the adviser infuses
capital into or purchases instruments from a fund. It is
possible, however, that an entity other than the adviser (e.g.,
the adviser's parent or an affiliate) may assist the fund.
Regardless of which entity makes the infusion or purchase,
federal bank regulators could object to the infusion or the
purchase by any bank affiliate if they believed that it
constituted an unsafe or unsound banking practice.
-[87]- Federal banking laws focus on the safety and
soundness of individual banks and the banking system as a whole.
See, e.g., Federal Deposit Insurance Act 8, 12 U.S.C. 1818
(authorizing federal bank regulators to bring enforcement actions
against insured banks that engage in unsafe and unsound banking
practices). See also MICHIE ON BANKS AND BANKING ch. 15, 6
(1989 & Supp. 1994).
-[88]- Recently, however, the Federal Reserve Board did not
object when a banking institution assisted a proprietary mutual
fund that had sustained losses from derivatives. See Snigdha
Prakash, B of A's Bailout of Fund Raises No Red Flags at Fed, AM.
BANKER, July 7, 1994, at 12 (public statement by Federal Reserve
Board Governor that bank's capital infusion was an "unusual
circumstance" and did not raise concerns about the safety and
soundness of the banking system)[hereinafter B of A Article].
Other banking institutions recently have taken similar actions,
apparently without intervention by the bank regulators. See,
e.g., Stepping up to the Plate, supra note 6.
-[89]- See former OCC Interpretive Ruling 7.7376, 12 C.F.R.
7.7376 (1983), rescinded 48 FR 48452 (1983); 12 C.F.R. 5.34.
Operating subsidiaries only can perform activities that the
parent bank can perform. 12 C.F.R. 5.34(c).
--------------------- BEGINNING OF PAGE #30 -------------------
the Comptroller of the Currency.-[90]- Consistent with this
principle, the Comptroller of the Currency has indicated that,
even if a fund adviser is a separately capitalized bank
subsidiary, he still would have concerns about the adviser's
activities and potential risks to bank capital.-[91]-
If advisory activities were conducted in a separately
capitalized affiliate of a bank other than a bank subsidiary
(e.g., a holding company subsidiary or the holding company
itself), there would be a clearer financial separation between
the bank and the adviser than if the adviser was a bank
subsidiary.-[92]- Because it is less likely that an affiliate
adviser's activities would threaten the safety and soundness of
the bank, it also may be less likely that bank regulators would
object to the affiliate adviser infusing capital into a
fund.-[93]-
b. Would the adviser be able to repurchase instruments
from the fund that were believed to be the source of
the losses?
In addition to the safety and soundness concerns discussed
above, whether a bank adviser would be able to purchase
instruments from a fund would depend on the types of instruments
to be purchased and how they are treated under banking law.-[94]-
-------- FOOTNOTES --------
-[90]- 12 C.F.R. 5.34(d)(2)(i), 5.34(d)(3). See also
Mellon-Dreyfus Hearings, supra note 85, at 284 (statement of
Eugene A. Ludwig, Comptroller of the Currency).
-[91]- Mellon-Dreyfus Hearings, supra note 85, at 292.
(statement of Eugene A. Ludwig, Comptroller of the Currency)
("[f]rom the perspective of bank safety and soundness, the most
serious concern raised by a proposal such as Mellon's is the
possibility of [bank] exposure to operational or fiduciary losses
in its mutual fund subsidiary.") Specifically, Comptroller
Ludwig expressed concern that "bank managers might feel strong
pressure to reimburse an affiliated mutual fund or its customers
for market losses, particularly if a money-market mutual fund
managed by the bank would otherwise fail to maintain a constant
net asset value" or "to provide emergency credit to or
investments in a mutual fund subsidiary to cover an unexpected
surge in redemptions." Id.
-[92]- This would be the case because an affiliate's
capital is not tied to the bank's capital as directly as a
subsidiary's. Cf. Restructuring of the Banking Industry:
Hearings Before the Subcomm. on Financial Institutions
Supervision, Regulation and Insurance of the House Comm. on
Banking, Finance and Urban Affairs, 102d Cong., 1st Sess. Part
II, 240 (1991) (statement of Richard C. Breeden, Chairman, U.S.
Securities and Exchange Commission, regarding bank conduct of
broker-dealer activities).
-[93]- It should be noted, however, that banking law
requires the Federal Reserve to assure the safety and soundness
of bank holding companies and nonbank bank holding company
subsidiaries. See 12 U.S.C. 1818(b)(3).
-[94]- Section 17(a) of the Investment Company Act also
restricts an investment adviser's ability to purchase instruments
from a fund. 15 U.S.C. 80a-17(a). See PaineWebber Managed
Investments Trust (pub. avail. Aug. 4, 1994). See the discussion
(continued ...)
--------------------- BEGINNING OF PAGE #31 -------------------
For example, the Glass-Steagall Act generally prohibits a
national bank from purchasing and selling securities for its own
account.-[95]- The Act, however, excepts from this prohibition
certain government obligations and "investment securities."-[96]-
Whether a derivative will be viewed as a security for
purposes of the Glass-Steagall Act will depend on the particular
type of instrument and its use. Federal bank regulators
generally do not view futures contracts and related options,
foreign currency contracts, swaps, and other commodities-related
investments as securities under the Glass-Steagall Act.-[97]-
Options (other than options on futures contracts), on the other
hand, may be treated as securities under that Act.-[98]-
Even if a derivative is not viewed as a security subject to
the restrictions of the Glass-Steagall Act, a bank still may not
be free to purchase the derivative from a fund. The purchase
also must conform with recently adopted bank regulatory
guidelines on derivatives activities, which generally set forth
managerial, operational, and internal control requirements for
bank derivatives activities.-[99]-
In addition, whether a bank adviser would be able to
purchase instruments from a fund depends on whether the purchase
is restricted by Sections 23A and 23B of the Federal Reserve Act.
These provisions restrict transactions (including the purchase
and sale of securities or other assets) between banks and their
affiliates by imposing aggregate transaction limits,
collateralization requirements, and arm's length dealing
requirements.-[100]- Section 23A generally prohibits a bank and
its subsidiaries from purchasing a low-quality asset from an
-------- FOOTNOTES --------
(-[94]- continued ...) in section 8.b., below.
-[95]- Glass-Steagall Act, 16, 12 U.S.C. 24 (Seventh).
-[96]- Glass-Steagall Act, 16, 12 U.S.C. 24 (Seventh).
The Glass-Steagall Act authorizes the Comptroller of the Currency
to interpret the definition of investment securities. Id. The
Comptroller of the Currency has used this authority to adopt
regulations defining the term "investment securities" and
limiting the purchase of such securities by national banks. See
12 C.F.R. Part 1.
-[97]- MELANIE L. FEIN, SECURITIES ACTIVITIES OF BANKS
13.01 (1991).
-[98]- Id.
-[99]- See, e.g., Banking Circular No. 277 (Oct. 27, 1993)
(risk management guidelines issued by the Comptroller of the
Currency). The Office of the Comptroller of the Currency also
recently proposed amending its risk-based capital guidelines to
increase capital requirements for national banks that deal in
certain derivatives. Capital Adequacy: Calculation of Credit
Equivalent Amounts of Off-Balance Sheet Contracts, Docket No. 94-
13 (Aug. 24, 1994), 59 FR 45243. See also Jay Matthews, Rules
for Banks' Use of Derivatives Issued, WASH. POST, Sept. 2, 1994,
at B2.
-[100]- 12 U.S.C. 371c and 371c-1.
--------------------- BEGINNING OF PAGE #32 -------------------
affiliate.-[101]- For purposes of Sections 23A and 23B, the term
"affiliate" includes any investment company advised by the bank
or any affiliate of the bank.-[102]-
c. Would you agree that the failure to permit such an
injection or repurchase could result in a further
downward spiral for the fund, leading to even greater
losses for investors?
If an adviser elects not to infuse capital into, or purchase
a depreciated instrument from, a fund to compensate investors for
their losses (or is prohibited from doing so), it is possible
that dissatisfied investors may redeem their shares, causing the
fund to sell portfolio securities to meet redemption
requests.-[103]- These sales could (depending on the market), in
turn, lead to greater losses for the fund, in effect causing a
"downward spiral." Moreover, if the depreciated instrument is
illiquid, the fund likely would choose to sell other, more liquid
portfolio instruments to meet the redemption requests. Such
sales would increase the percentage of fund assets held in the
depreciated instrument, thereby increasing the fund's sensitivity
to price fluctuations in that instrument and exposing investors
to greater losses if the price of the instrument continues to
decline. These losses could occur in any fund, whether or not
advised by a bank, and no adviser is required to compensate fund
shareholders for losses absent a violation of law.
d. Should the prospect that such infusions or repurchases
might not be permitted be disclosed to bank mutual fund
investors?
The Commission has broad authority under the Securities Act
of 1933 and the Investment Company Act to require a fund
prospectus to include any material information necessary to make
the statements contained in the prospectus not misleading.-[104]-
When the Commission or the Division has determined that there is
a unique material risk associated with a particular type of fund,
it has required particular disclosure in the prospectus of those
funds. For example, the Division requires every bank-sold mutual
fund and every mutual fund whose name is similar to a bank's name
to disclose prominently on the cover page of its prospectus that
the shares in the fund are not federally insured.-[105]-
-------- FOOTNOTES --------
-[101]- 12 U.S.C. 371c(a)(3).
-[102]- 12 U.S.C. 371c(b)(1)(D)(ii).
-[103]- The immediate effect of a capital infusion into, or
a purchase of a depreciated instrument from, a fund is to
increase the cash position of the fund, thereby increasing
liquidity and enabling the fund to meet redemptions without
having to sell portfolio securities.
-[104]- See, e.g., Securities Act of 1933 6, 7, 8, 10,
19(a), 15 U.S.C. 77f, 77g, 77h, 77j and 77s(a); Securities Act
rule 408, 17 C.F.R. 230.408; Investment Company Act 8,
30(a), 38(a), 15 U.S.C. 80a-8, -30(a), -38(a); Investment
Company Act rule 8b-20, 17 C.F.R. 270.8b-20.
-[105]- Letter from Barbara J. Green, Deputy Director,
Division of Investment Management, to Investment Company
Registrants (May 13, 1993). The Division was concerned that
investors may mistakenly believe that these mutual funds are
(continued ...)
--------------------- BEGINNING OF PAGE #33 -------------------
Similarly, the Commission also requires every money market fund
to disclose, on the cover page of its prospectus and in its
advertising, both that its shares are not insured or guaranteed
by the U.S. government and that there is no assurance that the
fund will be able to maintain a stable net asset value of
$1.00.-[106]-
Bank regulators have not yet objected generally or, to our
knowledge, specifically to bank advisers infusing capital into or
purchasing depreciated instruments from their funds. In fact,
one regulator reportedly has stated specifically that a capital
infusion by one banking institution did not raise
concerns.-[107]- In addition, a mutual fund's adviser,
regardless of whether it is a bank, is not legally obligated to
infuse capital or purchase depreciated instruments from the fund,
absent a violation of law. Accordingly, it does not seem
warranted at this time for the Commission or the Division to
mandate disclosure for all bank-advised funds concerning the
potential limits on a bank adviser's ability to assist its fund.
Rather, we believe that each bank-advised fund individually
should assess its own circumstances to determine whether this is
a material risk that should be disclosed.
e. Better still, is there a way to avoid the conflict
between the bank and the fund?
Under the current regulatory scheme, there is the potential
for conflict between a bank's obligations under the banking laws
and the interests of the fund and its shareholders with respect
to capital infusions and purchases of securities. While it is
unlikely, for the reasons discussed above, that requiring a bank
to conduct its fund advisory activities in a separately
capitalized subsidiary or affiliate would eliminate the conflict
completely, it would appear to reduce the potential for conflict
between the bank and the fund, particularly if such activities
are conducted in a separately capitalized affiliate.
-------- FOOTNOTES --------
(-[105]- continued ...)federally insured or similarly protected by
the Federal Deposit Insurance Corporation, the Federal Reserve
Board, or some other agency. Id.
-[106]- Form N-1A, Item 1(a)(vi), 17 C.F.R. 239.15A and
274.11A (registration statement of open-end management investment
companies); Securities Act Rule 482(a)(7), 17 C.F.R. 230.482(7)
(advertising by an investment company). In the release proposing
this money market fund disclosure, the Commission stated that
"[w]hile money market funds have been one of the safest available
investment options, the Commission believes it is important for
investors to understand that money market funds are not risk-
free." Investment Company Act Release No. 17589, at text
accompanying n.68 (July 17, 1990) 55 FR 30239, 30247.
-[107]- See B of A Article, supra note 88, at 12 (public
statement by Federal Reserve Board Governor that bank's capital
infusion was an "unusual circumstance" and did not raise concerns
about the safety and soundness of the banking system).
--------------------- BEGINNING OF PAGE #34 -------------------
8. Recent Instability of Money Market Mutual Funds. Please
bring us up-to-date on the Commission's latest views about
the appropriateness of derivatives for money market
portfolios.
a. Background
Money market funds generally seek to maintain a stable net
asset value per share, typically $1.00. Many money market funds
allow investors to use checks to redeem shares, and, because the
value of an account generally does not change due to share value
fluctuations, many investors use money market funds as
alternatives to checking accounts since they can readily
ascertain their account balances. While these features of money
market funds may be responsible for their success, they may also
be responsible for the erroneous perceptions of some investors
that money market funds are "guaranteed" or for some other reason
cannot lose value. To help reduce these misconceptions, the
Commission in 1991 amended its rules governing money market fund
disclosure to require money market fund prospectuses and sales
material to disclose prominently (1) that the shares of the money
market fund are neither insured nor guaranteed by the U.S.
Government and (2) there is no assurance that the fund will be
able to maintain a stable net asset value of $1.00 per
share.-[108]-
Prior to the adoption of 1991 amendments to rule 2a-7 under
the Investment Company Act, the Commission's rule governing money
market funds, a money market fund was required to comply with the
rule only if the fund wished to take advantage of the rule's
exemptive provisions that permit many money market funds to use
the "amortized cost" method of valuing their portfolio.-[109]-
As a result, some funds that held themselves out as money market
funds routinely invested in risky securities that were
inconsistent with developing investor expectations of money
market funds, such as securities whose principal values or
returns were based on non-dollar denominated indexes. To assist
investors to better understand money market funds, the Commission
in 1991 prohibited mutual funds from calling themselves money
market funds unless they comply with the risk-limiting provisions
of rule 2a-7.-[110]-
b. Money Market Funds and Derivatives
-------- FOOTNOTES --------
-[108]- Revisions to Rules Regulating Money Market Funds,
Investment Company Act Release No. 18005 (Feb. 20, 1991), 56 FR
8113 (amendments to Form N-1A, Item 1(a)(ix)).
-[109]- Money market funds that seek to maintain a stable
share price generally use either the amortized cost method of
valuation or the penny-rounding method of share pricing. Under
the amortized cost method, portfolio securities are valued by
reference to their acquisition cost as adjusted for amortization
of premium or accretion of discount. 17 C.F.R. 270.2a-7(a)(1).
Share price is determined under the penny-rounding method by
valuing securities at market value, fair value, or amortized cost
and rounding the per share net asset value to the nearest cent.
17 C.F.R. 270.2a-7(a)(11).
-[110]- 17 C.F.R. 270.2a-7(b). These provisions are
designed to limit a fund's exposure to credit, interest rate, and
currency risks. 17 C.F.R. 270.2a-7(c)(2)-(4).
--------------------- BEGINNING OF PAGE #35 -------------------
Money market funds invest in a variety of instruments that
could be characterized as derivatives. Many of these securities
are created especially for money market fund portfolios, have a
very low level of risk, and have performed as expected during the
recent series of short-term interest rate increases. There have,
however, been an unfortunate number of recent instances in which
money market funds have invested in adjustable rate notes that
have experienced significant volatility and losses. Losses in
value attributable to these securities have resulted in a number
of money market fund advisers electing to take actions, including
contributing capital or purchasing instruments held by the funds,
to prevent the funds' net asset values from falling below
$1.00.-[111]-
Rule 2a-7 limits a money market fund's exposure to interest
rate risk by generally prohibiting it from acquiring securities
with remaining maturities that exceed 397 days.-[112]- The rule
permits a money market fund to measure the maturity of a long-
term adjustable rate security by reference to its interest rate
readjustment date if the fund and its adviser "reasonably expect
the value of the security to approximate par upon adjustment of
the interest rate."-[113]-
Last year, the Division became aware that some funds were
investing in adjustable rate securities that had interest rate
adjustment formulae that would be unlikely to follow short-term
interest rates if those interest rates increased.-[114]- A
December 1993 Commission release proposing amendments to rule 2a-
7 discussed the risks of money market fund investment in these
types of adjustable rate securities.-[115]- In the release, the
Commission noted that these types of securities "share the common
characteristic that, at the time of issuance, changes in interest
rates or other conditions that can reasonably be foreseen to
occur during their term will result in their market values not
returning to par at the time of an interest rate
readjustment."-[116]- The Commission concluded that such
securities are not appropriate investments for a money market
fund.
Several months ago it became apparent that some funds
continued to hold these types of securities. Because of an
-------- FOOTNOTES --------
-[111]- See, e.g., Stepping up to the Plate, supra note 6.
-[112]- 17 C.F.R. 270.2a-7(c)(2).
-[113]- 17 C.F.R. 270.2a-7(a)(7), (21).
-[114]- These securities include capped floaters (whose
floating rates will not adjust above a stated level), CMT
floaters (whose floating rates are tied to long-term rates and
which will not return to par if the relationship between short-
and long-term rates changes), leveraged floaters (whose floating
rates move at multiples of market interest rate changes), and
COFI floaters (whose floating rates are tied to the Cost of Funds
Index, representing the cost of funds to thrift institutions in
the Eleventh Federal Home Loan Bank District, which substantially
lags market rates).
-[115]- Release 19959, supra note 14, at Part II.D.2.d., 58
FR 68601-02.
-[116]- Id. at 58 FR 68601.
--------------------- BEGINNING OF PAGE #36 -------------------
increase in interest rates, the volatility of these instruments
increased. In June, you raised this issue in correspondence with
the chief executive officers of the 80 largest fund
complexes.-[117]- Later that month, the Division provided money
market funds and their advisers with additional guidance
concerning investments in adjustable rate securities.-[118]- The
Division reminded fund managers of their general obligations
under rule 2a-7 to ensure that money market funds invest only in
those securities that are consistent with maintaining stable net
asset values. The Division also urged money market fund advisers
to reexamine all portfolio holdings to determine whether the
funds hold adjustable rate securities that exhibit the
characteristics described above. Funds that hold these
securities were directed to work with their advisers in
developing plans for their orderly disposition.
To maintain their funds' net asset values at $1.00, a number
of fund advisers have purchased certain adjustable rate
securities from their money market funds at their amortized cost
value (plus accrued interest).-[119]- Such a transaction is
prohibited by section 17(a) of the Investment Company Act unless
the Commission issues an order approving the transaction as
"reasonable and fair and . . . not involv[ing] overreaching on
the part of any person concerned."-[120]- In each case, the
adviser represented that the purchase price of the security
exceeded the security's market value and the transaction assisted
in maintaining a stable net asset value. Accordingly, the
Commission could have been expected to make the finding necessary
to issue an order permitting the transaction. Because of the
need to consummate the transactions quickly, however, the
Division, as it has done in the past in similar instances,
granted oral "no-action" relief in which we assured fund advisers
and related parties that we would not recommend enforcement
action if the transaction was effected.-[121]-
Adoption of the Commission's proposed rule 2a-7 amendments
and the June guidance given by you and the Division should
provide additional protection for money market fund investors.
No rule text, however, can anticipate events that may result in a
fund's net asset value falling below $1.00. To date, a number of
-------- FOOTNOTES --------
-[117]- Levitt Letters, supra note 10.
-[118]- Letter from Barry P. Barbash, Director, Division of
Investment Management, to Paul Schott Stevens, General Counsel,
Investment Company Institute (June 30, 1994).
-[119]- See, e.g., Stepping up to the Plate, supra note 6.
-[120]- Investment Company Act 17(a)(2), (b), 15 U.S.C.
80a-17(a)(2), (b).
-[121]- In each case, the relief was limited to section
17(a). This procedure, and the criteria used by the Division for
granting "no-action" relief, are discussed in Release 19959,
supra note 14, at Part IV. In that Release, the Commission
proposed a new rule 17a-9, which would exempt from section 17(a)
certain purchases from a money market fund of securities that are
no longer eligible money market fund investments. The proposed
rule was originally designed to address situations where the
security to be purchased was in default. In light of recent
events, we are considering whether to recommend that the proposed
rule also apply to securities that no longer satisfy the criteria
for money market fund investment in adjustable rate instruments.
--------------------- BEGINNING OF PAGE #37 -------------------
sponsors or advisers of money market funds with positions in the
types of adjustable rate securities identified in the
Commission's December 1993 proposal have taken actions to cause
the net asset values of those funds not to fall below $1.00. The
Division believes that the potential continues to exist that a
sponsor or adviser of a fund holding these or other types of
adjustable rate instruments that pose similar risks will be
unable or unwilling to take similar actions, and that the net
asset value of such a fund will fall below $1.00.
The Division will continue to be vigilant in enforcing
compliance with all provisions of rule 2a-7. In addition, we
will persist in our efforts to impress upon investors that money
market funds are not insured or guaranteed.Last Reviewed or Updated: March 18, 2026