SECURITIES AND EXCHANGE COMMISSION

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON. D.C. 20549

;E CHAI RMAN

September 26, 1994

The Honorable Edward J. Markey

Chaian

Subcommittee on Telecommunications and Finance

Committee on Energy and Commerce

U.S. House of Representatives

2125 Rayburn House Office Building

ACT p~ - L/

Washington, D.C. 20515

SECTION b!Æ)( t/~)

RULE

The Honorable Jack Fields

PUBLIC 9/;1 ¡; ! -E .

Raking Republican Member

Subcommittee on Telecommunications and Finance

A"'/1!1!¡3/,Íes ?%~- ~~#W~

Committ on Energy and Commerce

U.S. House of Representatives

2125 Rayburn House Office Building

Washington, D.C. 20515

Dea Chairman Markey and 'Representative Fields:

Thank you for your letter dated June 15, 1994 concerning mutual fund use of

derivatives. Your letter rases a number of importt questions concerning the frework

for the regulation and oversight of these activities. I shar your concern for these importt

investor protection issues, and am parcularly committed to finding improved ways for

funds to communicate to shareholders the risks of investment.

.

Your letter requested that the Commission underte a comprehensive study of the

use of derivatives by mutual funds. I am enclosing a memoradum prepared by the Division

of Investment Management that comprises the requested study.

Mutual funds are the investment vehicle of choice for funding Americas' essenti

nees - for educating their children, for retinng 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 denvatives, and we look

forward to working with you in this endeavor.

Sincerely,

./1' /

11'/i";

Arthur Lévitt

Chairman

Enclosure

.'

MEORAUM

September 26, 1994

TO:

Chairman Levitt

FROM:

Division of Investment Managemen~

RE:

Mutual Funds and Derivative Intruents

Ths memorandum responds to a letter dated June 15, 1994 (the "Letter"), from

Edward J. Markey, Chaian, and Jack Fields, Rag Republica Member, of the

Subcommittee on Telecmmunications and Finance of the House Committee on Energy and

Commerce ("Subcommittee"), requesting that the Commission underte a study of the use

of derivatives by mutual funds and, more paricularly, the adequacy of laws and regulations

governg their disclosure and use. The Letter rases 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

avaiable to mutual funds through derivatives, (7) risks face by investors in ban-advised

mutual funds, and (8) derivative use by money market funds.

As you are aware, investor protection issues rased by mutual fund use of derivatives

have received heightened attention by the Commission since you became Chaian. You

have urged fund directors and trstees to exercise meagfl 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 diected 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 memoradum

also reviews the steps taen to date by the Commission and the Division to address investor

protection issues rased 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 concerng issues raised by derivatives is

ISee, e.g., GROUP OF THIRTY GLOBAL DERIVATIVES STUDY GROUP, DERIVATIVES:

PRACTICES AND PRINCIPLES 2 (July 1993) (hereinafter G-30 REPORT).

1'he 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

(continued.. .)

often complicated by imprecision regarding the instruments that rase a paricular issue.

Indee, the public debate about "derivatives" sometimes suggests that a "derivative" is any

complicated instrument that has caused losses. Mutual fund investments in derivatives rase

significant investor protection concerns, which are addressed in this memoradum, but these

concerns typically relate to specifc instruments used by specifc funds and not to al

derivatives and al funds. Derivatives may be stadad or customiz, trded on an

exchange or over-the-counter, liquid or ilquid, novel or familar, leveraged or unleveraged.

Derivatives may increase or reuce portolio risk. As the Subcmmittee and the

Commission continue to address the importt issues rased by mutual fund use of

derivatives, it wil be importnt in each case to focus on the specifc pareters of the

problems to be addressed.

B. Mutual Fund Use of Derivative Inruments

money market funds, use derivative products for a wide

varety of puiposes, including hedgig 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 periodicay 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

Mutual funds, other than

liited. There ar exceptions, however, to thiH genera observation. Funds priary

investing in mortgage-backed securities, for example, generay have signicat investments

in derivatives. Long-term municipal bond funds use derivatives to seek increased ta­

exempt returns. In addition, funds investing internationaly 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 liited.3 The survey reported that the tota market value of al

derivatives held by paricipatig funds was $7.5 bilon, representing 2.13 % of the tota net

assets of al funds reporting derivatives holdings and 0.78 % of the tota net assets of al

funds parcipating in the survey. The tota notional amount of these derivatives was $54.3

bilon, representing 15.51 % of the tota net assets of al funds reportg derivatives holdings

and 5.67% of the tota net assets of al funds paricipating in the survey.4 The survey also

indicated that the level of use of derivatives vared by fund type, with fixed income funds

accounting for 84 % of the tota market value of al derivatives held by reporting funds and

62 % of the notional amount.

ZC.. .continued)

pieces, e.g., mortgage derivatives. See, e.g., James K. Glassman, Mortgages, an Governments,

Can Get Sliced and Diced, WASH. POST, Sept. 7, 1994, at F1.

31nvestment 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 bilion (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. ¡d. 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." /d. at 2.

2

C. Investor Protection Concerns and Commsion Actions

Although the use of derivatives by mutual funds generay appeas to be liited,

some funds have recently experience problems relating to derivative investments. Severa

short-term ~overnent bond funds have experienced signicant losses from mortgage

derivatives. In addition, losses in the value of cert adjustable rate notes held by some

money market funds have resulted in the funds' advisers electing to tae actions, including

contnbuting capita or purchasing instrments held by the funds, designed to prevent the

funds' per share net asset values from faIg below $1.00.6 Although the reported problems

to date have afected a liited number of funds and fund types, they rase investor

protection issues that merit serious consideration.

As you are aware, months before these reports surface, the Commission expressed

concern about investor protection issues rased by mutual fund invest.ments in derivatives.

Since the summer of 1993, the Commission has taen a multi-faceted approach to mutual

fund use of derivative instruments, focusing on a broad rage of issues, includig disclosure,

pricing, liquidity, leverage, and risk management. A Division task force has examed the

derivatives disclosures of 100 investment companes, representing a broad saple of

complexes and fund types, and the Division's fund disclosure review sta has given

heightened scrutiny to derivatives disclosure in prospectuses. In addition, the Division's

inspection staf is examirg and reporting on the derivativt;s activities of each fund

inspected, and has conducted special examinations of cert funds holding signcat

positions in derivatives.

D. Division Recommendations

This memoradum makes a number of recommendations for further action by the

Commission to address mutual fund use of derivatives. The pricipal recommendations are

the following:

· The Commission should consider requirg some form of quantitative risk

measure in mutual fund prospectuses and should seek public comment on this

topic no later than ealy 1995.

· The Commission should promptly consider reducing the ceilg on fund

ilquid holdings. In addition, the Commission should contiue to evaluate

liquidity and pncing issues rased by derivatives through the mutual fund

inspection process. If it appeas 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.

5 See, e. g., Robert McGough, Piper Jajay Acts to Boost Battered Fund, WALL ST. J., May

23, 1994, at C1; Andrew Bar, Derivatives Undo a Popular PaineWebber Fund, Triggering 4%

Webber Fund.

One-Day Drop in Value, BARON'S, May 16, 1994, at MW12 (hereinafter Paine

óSee, e.g., A History of Stepping up to the Plate, FUND AcrION, Sept. 12, 1994, at 9

(hereinafter Stepping up to the Plate).

3

· The Commission should reexamine the application of the leverage restrictions

of the Investment Company Act of 1940 ("Investment Company Act" or

"Act") 7 to derivative instruments and should seek public comment on whether

regulatory and legislative solutions are necessar to address the leverage

created by mutual fund use of derivatives.

· The Commission should recommend that Congress enact legislation to enhance

the Commission's abilty to obta inormation reuir to monitor fund use of

derivatives.

E. Management and Board Responsibilties

The Commission has a critica role to play in enhancing investor protection in the

area of mutual fund derivative investments. As you have noted, however, responsibilty for

managing a mutual fund's derivative investments fal, in the first instace, on the fund's

8 To that end, you have urged fund boards to

management and board of directors or trstes.

exercise meagful oversight of fund derivative investments by becomig more involved in

portolio strategies, risk management, disclosure and pricing issues, accounting questions,

9 In correspondence with the chief executive offcers of the 80 largest

fund complexes, you encouraged the management of every fund that holds derivative

and internal controls.

instrments to tae steps that wil ensure the proper understadig and effective management

of derivatives risk. 10 The Division's inspetion sta exames mutual fund management

controls, and is giving parcular emphasis to controls relating to derivatives risk. On the

basis of our findings durig inspections and discussions with fund industry paricipants, we

wil determine whether to recommend that the Commission consider rulemakg to

encourage better mutual fund management controls of derivatives risk.

715 U.S.c. § 80a.

8Strong management controls are generally recogniz as essential to monitoring and

controllng 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).

9Artur 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); Artur 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, Scottdale, Arizona (Mar. 21, 1994).

IOLetters from Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, to chief

executive offcers of 80 largest fund complexes (June 16, 1994) (hereinafter Levitt Letters).

4

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 inormation needed by the SEe to fulIil its

responsibilties.

The Commission's responsibilty with respect to mutual funds is to adminster and

enforce the Investment Company Act and other applicable provisions of the federa securities

laws. Though its inspection and registration processes, the Division ca and does monitor

individual mutual fund policies and portfolios, including derivatives activities. The

Investment Company Act requirs funds to maita and provide to the Commission reords

reflecting much of this inormation.ll In addition, durig the course of examinations, funds

generally voluntay provide the Division with additional documents and access to fund

personnel and often make records avaiable in electronic media. Inormation concerng a

fund's investments in derivatives is also contaed in the fund's registrtion statement and

amendments thereto, which describe investment policies and practices, and semi-anual

reports on Form N-SAR and reports to shareholders, which conta inormation about

portfolio activities. The inormation neeed by the Commission, much of which is g~neray

avaiable to it, includes the following:

· complete inormation concerng the purchase and sale of portolio

instruments (e.g., date and time of trade, counterparty, trasaction price,

identity of instrument traded);

· detailed inormation concerng each portfolio instrument (e.g., for mortgagebacked securities, cash flow projections, including prepayment assumptions

with respect to underlying mortgages);

· inormation regarding portolio strategies and the maner in which each

portfolio instrument contributes to portolio strategies (e.g., identity of

portolio positions that hedge other positions);

· valuations of fund assets and liabilties; and

· inormation relating to fund risk monitorig, e.g., analyses of fund

performance under varous market scenaros.

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 V.S.C. § 801-30(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 V.S.c. § 80a-30(b).

5

b. What obstacles, if any, prevent the Commsion from obtaing and

procesing this inormation?

Resource constrts are the pricipal obstacle to improved Commission monitorig

of mutual funds. Although the Division generay can obta the inormation it requirs to

monitor funds, the scope and frequency of our inspections are severely constraed by

available resources.12 Aside from inormation contaed in a mutual fund's periodic filgs,

our knowledge of the fund's investment practices, including its derivatives holdigs, is no

more current than our most rent inspection. In addition, the increasing use of derivatives

and other complex portolio strategies has heightened the Commission's nee to hi, tra,

and reta a highly skied mutual fund inspetion force.

The recordkeeping, reprting, and insptions provisions of the Investment Company

Act also impose some liits on the Commission's authority to obta inormation reuir to

monitor mutual funds. In practice, thesr. liits often do not hider the Commission's

fulfilent of its responsibilties, but they may do so in some circumstaces, includig, for

example, when a fund does not voluntay cooperate with the Commission; when, in ties

of market stress, rapid access to fund inormation is importt; when the unavaiabilty of

electronic records in a format usable by the Division interferes with an effcient inspection;

or when a fund does not maita recrds that, if avaiable, would improve Commission

understanding of the fund's operations. These liits are described in deta below.

We emphasize that most investment companes cooperate fully with the Division's

inspection staf and produce not only records required to be kept under the Commssion's

investment company recordkeeping rules, but other requested recrds. Most funds also

alow Division inspection sta to interview employees responsible for maitag these

records, as well as portolio managers, who are in the best position to explai many fund

investments. And many funds make their records avaiable electronicay.

i. Recordkeeping Authority

Section 31(a) of the Investment Company Act requires every registered investment

company to "maita 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

liitations for the Commission, one

relating to the scope of required recordkeeping and the other relating to the form in which

Act) . . . . ,,13 Ths provision presents two potential

the required records are kept.

First, as a genera matter, the Commission may require investment companes to

keep records forming the basis for the prepartion of financial statements. These recrds

alone, however, often do not provide the Commission with enough inormation 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 portolio instruments, e.g., the

identities of positions that hedge other positions. Nor is it clea that they include rerds

12See, e.g., Testimony of Artur Levitt, Concerning Appropriations for Fiscal Year 1995,

Before the Subcommittee on Commerce, Justice, and State, the Judiciar, and Related Agencies of

the Senate Committee on Appropriations 4-6 (May 5, 1994).

1315 V.S.C. § 80a-30(a).

6

related to portfolio management strategies, such as computer models that funds may use to

evaluate the expected volatilty of a specifc derivative or the portolio as a whole or the

records generated by these models.

14

Second, the Investment Company Act's recordkeeping provisions do not specifcay

address the medium in which records are required to be kept. In paricular, the Commission

would lie specifc authority to requir that fund recrds be kept in an electronic medium.

15

Given the growth of the investment company industr, the siz of individual funds, and the

volume of trasactions in which they engage, paper reords are extremely cumbersome.

Using paper records, the sta can only review a liited saple of the seurities trsactions

in which a fund has paricipated over a specifed period. Morever, paper-based records do

not faciltate modem examination technques, such as computeried analysis to check for

"red flags II that suggest the nee for an inspection. Many funds voluntay make their

records avaiable electrnicaly, but fund records are not always maitaed in an electronic

format that is usable by the Division.

ii. Inpection Authority

Section 31 (b) of the Investment Company Act provides that investment company

records "required to be maitaed. . . shal be subject at any tie and from time to time

to such . . . examinations by the Commission . . . as the Commission may prescribe. ,,16

Ths provision presents an issue that may afect 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 maitaed under a specifc provision of the Investment Company Act

or Commission rules. The required reords often caot be understood without referrg to

other documents that are not requir to be kept by Commission rules. These additional

records, for example, may explai inovative products and investments. They may also

provide importt insights into the portolio management strtegies of a fund. At present, in

the inspection context, the Commission often relies on volunta fund production of these

l'Te Division is currently preparing rulemaking recommendations that should increae the

Commission's access to information concerning fund portolios. 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 necessar to

determine an investment's suitability for the fund and its value for the daily net asset value

calculation. The Division previously recmmended, 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, Par II.D.7. (Dec. 17, 1993), 58 FR 68585, 68604 (Dec. 28, 1993)

(hereinafter Release 19959). These amendments, when adopted, should facilitate the abilty 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.

1sln 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).

1615 U.S.c. § 80a-30(b).

7

records to examine fund transactions in investments that present novel investor protection

issues, such as derivative instruments.

17

IÜ. Frequency of Fund Reporting

Section 30(b) of the Investment Company Act authonzes the Commission to require a

fund to fie with the Commission "such inormation and documents (other than fInancial

statements) as the Commission may requir, on a semi-anual or quarerly basis, to kee

resonably current the inormation and documents contaed in the (fund's Investment

Company Act) registrtion statement. . . . ,,18 The liitation to periodic reporting restrcts

the Commission's abilty to monitor funds, paricularly in times of market strss. For

example, recent events have demonstrted that sudden changes in interest rates ca have

signicant effects on fund portolios that ca be magned by substatial derivative

19 The Commission is not now in a position to reuire prompt reports from funds

on the effects of these interest rate changes, but must await the next periodic reports or

exposure.

intiate inspections.

c. What steps should be taken to inure that the Commsion is able to

obtain accurate and reliable inormation quickly and efficiently?

The Division recommends that the Commission seek legislative clarcation and

expansion of its existing authority to address the issues identifed above. In parcular, the

Division intends to submit to the Commission recommended legislation that would do the

following.

First, the Investment Company Act would be amended to authonze the Commission

to require investment companes to "maita and preserve such records as the Commission

may prescribe as necessar or appropriate in the public interest or for the protection of

investors. ,,20 Ths provision would authonze the Commission to require any additional

records that are necessar to enable its inspetion sta, among other thigs, to analyze a

fund's derivative investments.

Second, the Investment Company Act would be amended to expressly authori 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 staf to review an entire portfolio at multiple points in time, and trasaction flows

171n 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

D.S.C. § 80a-41

(b).

1815 D.S.C. § 80a-29(b). Currently, the Commission requires funds to file semi-anual

reports on Form N-SAR. 17 C.F.R § 270.30bl-1.

19See, e.g., PaineWebber Fund, supra note 5; G. Bruce Knecht, Piper Manager's Losses May

Total $700 Milion, WALL ST. J., Aug. 25, 1994, at CL (hereinafter Piper Fund.

2lis 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 Securiti€", Exchange Act of

1934 and investment advisers in Section 204 of th(~ Investment Advisers Act of 1940. 15 D.S.C.

§§ 78q(a)(I), 80b-4.

8

over time, to evaluate a fund's portfolio activities. Ths abilty is parcularly importt in

analyzing derivative investments, which are often use together with other instrments in the

portfolio. Electronic recrdkeeping would also faciltate the use of developing technologies

that would make the Commission's investment company examation progra more

effcient. For example, if fund information were supplied electronicay to the

Commission's office prior to an inspetion, the inspetion staf could analyze the data prior

to commencing field work and taget their effort in the field on issues rase by that

analysis.

Thd, the Investment Company Act would be amended to require explicitly that a

fund provide the Commission with al recrds 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 parcular derivative instrment and may point

to operational deficiencies.

Fourt, the Investment Company Act would be amended to authorize the Commission

to speify the frequency of reportng by investment companies. This authority would assist

the Commission by providing more timely accss to information on fund portfolios and saes

and redemption activity in times of market stress.22 Ths authority would also enable the

staf to obta information that would help to identify parcular funds or patterns of events

that require closer scrutiny.

We believe diai ihe legislation described above, if enacted, would increase the

availabilty to the Commission of the data required to monitor adequately mutual fund

investments, including investments in derivatives. We would emphasize, however, that,

absent significat additional resources for the highly-quaified staf necssa to perform

fund inspetions and analyze available data, the Commission wil remain constrained in its

abilty to monitor mutu funds even if the recmmended legislation is adopted.

2. Better Disclosure May be Critical to Help the SEC, but Wil it be Accomplihed

in a Manner that Makes a Signifcant Difference to Average Invesors?

a. Fi, we supect that invesors often develop general expectations about

rik based on how their fund is categorid, and would lie to know if the

Commion 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 industr and rating services such as Lipper Analytica Services, Inc., and Morningsta,

21Cf, Section l7(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C.

§ 78q (making all records of broker-deaers subjec to Commission examnation); 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 ban and of each member ban and to require

such statements and report as it may deem necessar"); 12 U.S.C. § 481 (authorizing Comptroller

of Currency to appoint ban examiners who "have power to make a thorough examination of all the

affairs of' national ban).

nCf, Section l7(l)(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

report concerning the financial and securities activities of their associated persons).

9

Inc. As a genera matter, cert categories of funds tend to be more or less risky than

other categories. For example, among fixed income funds, a portolio comprised of short-

term bonds is normaly less volatile than one comprised of long-term bonds.

Acknowledging these genera charcteristics, investors presumably do develop genera

expectations about risk based on how their fund is categori.

The Commission does regulate fund names, which often convey inormation about a

fund's category. The Investment Company Act makes it unlawful for a registere

investment company to use as par of its name any word that the Commission fmds to be

deceptive or misleading.23 A Division guidelie states that if a registrt's name suggests a

cert tye of investment policy, its name should be consistent with its statement of

investment policy. The guidelie also provides generay that if a fund's name implies that

it invests priary in a paricular ty of security, its investment policy should reuire that,

under normal circumstaces, at least 65 percent of the value of the fund's tota assets wil be

invested in that type of security. 24 The Division also taes the position that where a fund

has a name or investment objective.that charcteris the maturity of its portolio~the dollweighted average portfolio maturity of the fund must reflect that charcterition.

We would emphasize that a name, or any single piece of inormation about a mutual

fund, caot tell the whole story of mutual fund risk. The prospectus is a mutual fund's

basic disclosure document. Fund prospectuses convey a rage of inormation to investors,

including the fund's name, investment objectives and policies, permitted investments, and

risk descriptions.26 Ths inormation, taen together, should communicate to investors a

comprehensible and accurate picture of fund risk.

The Division is tag severa steps to help ensure that a fund's name is consistent

with the fund's use of derivatives and educate investors regarding the dager of relying too

heavily on fund names. First, on an ongoing basis, in the review of fund registrtion

statements, the sta looks for, and requests changes to, disclosure that is inconsistent with a

fund's name. Second, becuse there are inerent liitations on the usefulness of fund

names, the Division is undertg consumer education efforts to alert investors to the nee

to read prospectuses and periodic reports and the dager of relying too heavily on fund

names as the sole source of inormation regarding the fund's investments. Thd, the

Division is reevaluating the current requirements regarding fund names to determine whether

they should be revised. In paricular, the Division contemplates reevaluatig the

23Investment 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.

24Guidelines for Form N-IA, Guide 1. Commission rules restrict the use of the term "money

market" in fund names. See section 8.a., below.

25Form 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; shortintermediate­

term fund - more than two years but less than five years; intermediate-term fund - more than three

years but not more than ten years; intermediatellong-term fund - more than ten years but less than

fifteen years; long-term fund - more tha.ri ten years. ¡d.

261nvestment Company Act Form N- i A, Items 1 and 4.

10

requirements applicable to a fund whose name suggests that its portolio is liited to

instruments of a paricular 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 comprehensibilty, it is stil

questionable whether invesors would be able to understand and assimate

inormation that is useful to their invesment decision. A dicussion of

how 'inverse floaters' work, or deiintions of 'pricipal-only strips of

CMOs,' wil involve unavoidable elements of abstraction. Are there

alternative ways of creatively presenting the critical inormation needed

by investors, such as the effect on risk and volatilty created by the fund's

holdigs of derivatives, that avoid the dilemma of attempting to deime

these intruents and strategies?

Since the summer of 1993, the Division's fund disclosure review sta has given

heightened scrutiny to derivatives disclosure in prospectuses; and a Division task force has

examined the derivatives disclosures of 100 investment companes, reresentig a broad

sample of complexes and fund types. We have found that funds generay provide investors

with a list and techncal description of instruments, including derivatives, that ar

permissible fund investments. Funds often describe the puiposes for using paricula

derivative instruments (e.g., to hedge currncy risks), but typicay provide only the most

genera inormation on the risk level of the fund taen as a whole or on how derivative

instruments, taen as a group, modiy that risk leveL.

The Division has advised mutual fund registrats that, in many cases, it has found

fund disclosures regarding derivative instrments to be highly techncal and has encouraged

registrants to modify their existing disclosure to enhance investor understading of pertinent

risks.

27 The Division is also considerig possible modifcations of the Commission's

disclosure requirements. In the Division's view, a potentialy better form of disclosure may

be some meas of describing the risk profie of a fund's portolio as a whole with grter

specifcity. Ths inormation would assist an investor in determing whether a fund's risk

charcteristics are consistent with his or her own investment objectives. Consumer focus

groups conducted on the Division's behal ealy this yea indicated that investors may in fact

find ths inormation helpfuL.

In order to address investors' nee for inormation about portolio risk

characteristics, the Division recommends that the Commission issue a release seekig public

comment on whether mutual fund disclosure of some quantitative risk measure should be

required and what that measure should be. Ths action would enable the Commission to

obta investor and industry input regarding the utilty of varous risk measures and the

feasibilty of their computation. A quantitative risk measure could have signicat benefits

for investors by providing a meas of comparg risks across and withi fund categories,

paricularly 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 avaiable

27Letter to Registrants from Carolyn B. Lewis, Assistant Director, Division of Investment

Management (Feb. 25, 1994).

11

measures would be most helpful to investors and feasible for funds to calculate. The

following are among the possibilties.

· Duration: a measure of the price sensitivity of a fixed income fund to

changes in interest rates.

· Stadad deviation: a measure of the volatilty of a mutual fund's tota return

over specifed tie 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 dicult task

becuse al measures have liitations. Most measures rely on historica data and ca only

estimate the level of risk that was incurr in the past, not what wil happen in the future.

In addition, measurements wil change depnding on the tie period over which risk is

measured and the benchmark agaist which a fund is compar. Some measures (e.g.,

duration) are not applicable to al funds. And each measure would reuir investor

education regardig the proper interpretation of the measure and its liited predctive

28

value.

c. Fially, formal diclosure to investors takes place annually in the

prosp'~us. But various derivatives positions, each with diinctly

diferent possible riks, can change by the hour, or even by the miute.

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 Commsion agree that

this quality should be considered when evaluating the utilty of requirg

enhanced disclosure of derivatives holdigs?

The Division agrees that the fluid nature of the investment management process liits

the utilty of reviewing specifc portolio positions previously taen by a fund. Nonetheless,

the Division believes that historical data does provide fund shareholders with importt

inormation.

A mutual fund is rtxuired to provide a schedule of portolio holdings to its

shareholders semi-anualy. 9 Ths requirment ensures that shareholders recive a twice­

yealy snapshot of a fund's investments. The snapshot is importnt 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 portolio 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 anual report, discussing the investment strategies and

28The 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-IA, Item 22.

29lnvestment Company Act § 30(d)(2), 15 U.S.c. § 80a-29(d)(2); 17 C.F.R. § 270.30d-l;

Form N-1A, Item 23; 17 C.F.R. §§ 210.6-05.1, .6-1O(c)(1), .12-12.

12

techniques that materialy affected fund performance durig the precing yea.3O Thus, a

fund whose performance was materialy afected by derivatives would be required to discuss

that fact -- whether or not derivatives were reflected in the portolio schedule at the close of

the yea. As another example, the use of quantitative risk measures, as described in the

preceding section, could enhance investor understading of a portfolio manager's strategy.

3. Is Intense Competition in the Fund Indusry (or Any Other Reason) Ledig

Some Portfolio Managers to Move Riky Derivatives Into Otherwise Rik Averse

Funds?

a. Is the competition for assets within the industry so intense that otherwise

conservative funds take on diproportionate risks in order to outperform

rivals?

In recent yeas, there has been tremendous growth in the number of mutual funds

31 There have also been recnt reports of signicant losses by

competing for investor dollars.

severa short-term governent bond funds, which generay are considered to be relatively

conservative investments, and reports of losses on some adjustable rate instruments held by

money market funds.32 These facts, taen 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 distiguish itself from rivals.

Studies generay show, however, that it is much more difcult to maita a high level of

33 Studies also

performance over a long period of time than over a short period of time.

show that investor money tends to flow toward funds with superior nea-term performance.

34

JOorm N-IA, 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-IA, Item 5A(b).

31In June 1994, there were 4,901 separate mutual fund portolios, 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 Billon, July 28, 1994; INVESTMENT COMPANY INSTITUTE, MUTUAL

FUND FACl BOOK 101 (1993).

32See, e.g., PaineWebber Fun, supra note 5; Piper Fund, supra note 19; Stepping up to the

Plate, supra note 6.

33Michael C. Jensen, The Performce of Mutual Funds in the Period 1945-1964, 23 J. FIN.

23, 389 (1968); Edwin J. Elton, Marin J. Gruber, Sanjiv Das, & Mattew Hlavka, Effciency 'Wth

Costly Information: A Reinterpretation of Evidence From Managed Ponjolios, 6 REv. FIN. STUD. 1

(1993).

34Erik R. Sirri & Peter Tufano, Competition in the Mutual Fund Industry, Paper Presented at

Harvard Business School Colloquium, Managing the Financial Servce Firm in a Global Environment

(Aug. 26, 1992).

13

Thus, it would not be suiprising if some mutual fund managers perceive pressure to tae on

additional risk in order to att at least a short-term pedormance "boost. ,,35

b. Is the Commsion concerned that the cause of the losses reported at two

short-term government bond funds may represent a growing trend?

It is unclea whether the recnt losses by short-term governent bond funds reresent

a growing trend. The losses reported to date, however, do not appea to be evidence of a

systemic problem in the mutual fund industry. It is also worth noting that losses by mutual

funds from strategies underten to boost current yield are not a new phenomenon, but,

unfortnately, recur from time to time in varous forms. In the 1980s, for example, similar

problems were associated with so-caed "governent-plus funds.li36 In addition, the recnt

losses have been a forceful reminder to the fund industry that the upside rewards of

assuming increased risk also car dowIlside penalties. Ths market lesson may signcatly

dampen industr enthusiasm for competition through assuming increased risk.

c. Does the Commsion 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 withi the mutual fund industry should be a positive force,

encouraging funds to improve pedormance, L.ower 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 fiduciar obligations it imposes, generay

provides an adequate fraework for ensurig that investors ar adequately protected. A

mutu fund, for example, is currently required to disclose to investors material inormation

37 Accordingly, it is a

regarding the fund, including the risks of investing in the fund.

violation of existing laws and rules for a fund to mislead investors materialy as to its risk

profie, includig the effect that derivatives have on that risk profile.

35 A recent news aricle suggested that many fund portolio managers have compensation

arrangements with their employers that encourage them to take inappropriate risks. Robert

McGough, Talång Chances: Risk in Mutual Funs is Rising as Mangers Chse After Bonuses,

WALL ST. J., Aug. 11, 1994, at AI. The Investment Advisers Act of 1940 prohibits most tyes 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 suffcient 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 trustee should review

portfolio manager compensation arrangements to ensure that they are designed with suffcient

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.

36See, 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).

37See, e.g., Securities Act § 17(a), 15 V.S.C. § 77q(a); Exchange Act § 10(b), 15 V.S.C.

§ 78j(b); Exchange Act rule lOb-5, 17 C.F.R. § 240.10b-5; Form N-IA, Item 4(c).

14

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 r~uired to disclose signicat quantitative inormation in the areas of

performance 8 and costs39, and the Division is recmmending that the Commission consider

requirg disclosure of some form of quantitative risk measure in mutual fund prospectuses.

This is discussed in greater deta in response to question 2.

4. Are Mutual Funds Experiencing Problems Pricing Exotic Derivatives?

a. Pricing requirements

Mutual fund share pricing policies and practices are governed generay by sections

2(a)(41) and 22(c) of the Investment Company Act and rules 2a-4 and 22c-l thereunder.40

Section 22( c) provides the Commission with the authority to make rules governg the

methods for computing the prices for mutual fund shares. Rule 22c-l provides in par 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 afer receipt of a tender of such security

for redemption or of an order to purchase or sell such security. ,,41

Rule 22c-l generay provides that the current net asset value of a mutual fund's

securities must be caculated every business day durig which an order is reeived either to

purchase or redeem a share of the fund.42 Section 2(a)(41) and rule 2a-4 requir a fund to

mark its assets to market in computig net asset value. In the markig to market process,

market quotations are required to be used for those securities for which the quotations are

readily avaiable. For al other securities and assets, a fund is required to use fai values as

determined in good faith in accordace with procedures approved by its board of directors

43

or trustees.

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

38Form N-1A, Item 2.

39Form N-1A, Item 3.

4015 D.S.C. § 80a-2(a)(41), -22(c); 17 C.F.R. § 270.2a-4, .22c-1.

4117 C.F.R. § 270.22c-1(a).

4217 C.F.R. § 270.22c-1(b)(1).

4315 D.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).

44A fuller discussion of this issue appears in our August 22, 1994 Memorandum on Mutual

Fund Si-,are 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.

15

the manner described above, neither the Investment Company Act nor the Commission

regulates -- or even requires -- the reportng of share prices to the news media. The

incident referred to in the Letter, the absence of a reported price in the morng paper for a

fund with derivative investments, is not the subject of either federa law or Commission

regulation and is a separte issue from the question of whether purchasing and reeeming

shareholders receive the correct price for their shares. Although shar prices may be

unreported because they are not caculated in tie to meet newspaper deadlies, and the

presence of cert derivatives in a fund's portolio may make it more difcult to meet

publication deadlies, this does not mean tha investors receive an incorrect price upon

redemption, or pay an incorrect price at purchae.45

c. Pricing and derivatives

The obligation of a mutual fund to calculate day net asset value accurately for

purposes of share sales and redemptions is critica to investor confdence. If net asset value

is incorrectly computed, purchasing or redeeming shareholders may payor recive too little

or too much, and the interests of other shareholders may be overvalued or diluted. The

accurate valuation of each portolio asset, including derivative instruments, is the foundation

for computing fund net asset value.

Funds normaly obta market quotations from one or more sources, such as last sae

prices reported by service vendors or bid and asked quotations supplied by market makers.

Many derivatives may be priced in this maner. Exchange-traded derivatives, such as

futures and exchange-trded options, for example, generay can be priced based on last sale

prices or market quotations.

Prior to purchasing an instrument, derivative or otherwise, a mutual fund tyicaly

evaluates the avaiabilty of market prices for the instrument. If market quotations are not

readily avaiable for the instrument, the fund must be prepared to use fai value as

determined in good faith in accordace with procedures approved by its board of directors

or trustees. When a fund decides to purchase an instrument, it typicay wil have

,implement fai

determined either that market quotations are redily avaiable or that it can

value procedures. Ths decision-makg process acts as a brae on a fund's acquisition of

an instrument when it is evident, from the outset, that pricing wil be problematic.

Market conditions change over time, and a fund may find that an instrument that had

readily avaiable market prices when it was acquired ceases to have such price avaiabilty.

Ths appeas to have been the situation durig recent months in the mortgage-backed

45Chairman 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 Artur Levitt, Chairman, U. S. Securities and Exchange Commission, to

Joseph R. Hardiman, President and Chief Executive Offcer, NASD, and Mattew 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 Offcer, NASD, and Mattew P.

Fink, President, ICI, to Artur Levitt, Chairman, U.S. Securities and Exchange Commission (July

13, 1994). We are n'.vnitoring furter 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.

16

secunties market, where decreased liquidity has resulted in the detenoration of accurate

market pncing inormation for some derivative securities -- such as cert collatera

m?rtgtle obligations. In these circumstaces, it may be more difficult to establish reliable

pnces.

The changing nature of markets makes it dicult, if not impossible, to ensure that

mutual funds wil never purchase instruments that becme ilquid and, consequently,

difficult to price. Nevertheless, the statutory and regulatory pricing reuirments discussed

above, together with the liquidity requirements discussed in response to question 5, act as

signcat checks on mutual fund investments in instruments that are difcult to price.

Indee, fund sponsors face substatial liabilties for pricing errrs. In those instaces when

fund trasactions 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 spnsors' own economic

interests therefore miltate agaist signicant use of instruments that wil cause pricing

problems.

In order to provide assuraces of price accuracy, funds tyicay employ extensive

control procedures. For many funds, the control process begins with the use of independent

pricing services to value fund holdings. Becuse pricing services compete for business, it is

in their best interests to provide accurate prices. At the fund level, valdation proceures,

tolerace checks, and other reviews are often employed to test and control the valdity of

47

pricing.

The Division does not believe that legislative changes ar neeed at this time to

address pricing issues rased by derivatives. The Division intends, however, to continue to

evaluate pricing issues in our inspections and wil perform tageted examinations to obta

more inormation on these issues. If appropriate, we wil consider issuing rules to address

proper procedures for pricing determinations.

46See, e.g., PaineWebber Fund, supra note 5; Robert McGough, Baird Fund Spurs Worries

About Pricing, WALL ST. 1., Aug. 15, 1994, at CL (hereinafter Baird Fund.

47For example, many funds employ automated exception report 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 tyical procedure identifies any portolio

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 fourt 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 excee preset levels must be reverified and

explained before they are entered i~.to 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.

17

5. Are Mutual Funds Experiencing Liquidity Problems Becuse of Exotic

Derivatives?

a. Does the Commion believe that some of the more exotic and volatile

derivatives should be considered II

ilquid?

II Has the Commsion

considered whether the 15% rule should be applied to any types of

derivative product?

Section 22(e) of the Investment Company Act generay requires that a mutual fund

make payment for reeemed shars withi seven days afer the tender of the shars.

48

Because mutual funds hold themselves out to investors as being prepared at al times to meet

redemptions withi seven days, it is essential that funds maita investment portolios that

wil enable them to fulfill this obligation. For this reason, and becuse the extent of

redemption demands are not predictable, mutual funds must maita highly liquid

49

portfolios.

The Commission has published a guidelie requirg that mutual funds generay liit

their investments in ilquid assets to 15 % of net assets. The guidelie liit is 10% in the

50 An asset is considered "ilquid" if a fund caot dispose of

the asset in the ordinar course of business withi seven days at approxiately the value at

case of money market funds.

which the fund has valued the instrment.Sl

On occasion, the Commission and the Division have taen the position that cert

classes of instruments are generay ilquid. S2 Generay, however, the determination of

whether a paricular mutual fund asset, including a derivative instrument, is ilquid should

be made under guidelies and stadads established by the fund's board of directors or

4815 D.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 customar 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. ¡d.

49See Release 5847, supra note 43.

SlSee Revisions of Guidelines to Form N-IA, Investment Company Act Release No. 18612

(Mar. 12, 1992), 57 FR 9828 (raising guideline for non-money market funds from 10% to 15% to

faciltate capita raising by small businesses) (hereinafter Release 18612); Letter from Mariane K.

Smyte, Director, Division of Investment Management, to Mattew 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.

S'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-IA, Guide 4.

s2Release 5847, supra note 43 (restricted securities generally iliquid).

18

53 Examples of factors that may be taen into account in determing liquidity

include (1) the frequency of trades and quotes for the instrument, (2) the number of deaers

wiling to purchase or sell the instrument and the number of other potential purchasers, (3)

trustees.

dealer undertgs 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 neeed

to dispose of the security, the method of soliciting offers, and the mechancs of trsfer.54

Ultimate responsibilty for liquidity determinations rests with the fund's board, but the board

may delegate the day-to-day function of determing li,\uidity to the fund's investment

adviser, provided the board retas suffcient oversight. 5

The Division believes that paricular derivative instruments may be ilquid under al

or most market conditions. Ths wil more liely be the case if a derivative is designed to

meet the nees of a paricular investor. Such a derivative, alost by design, would not

have the broad market required to support a fmding that the instrument is liquid. The

liquidity of other derivative instruments, however, may var dependig on market

conditions. An instrument that is liquid in one market environment may become ilquid in

another market environment. Ths has recently been the case, for example, for cert

collateraed mortgage obligations. Recent interest rate increases and full deaer inventories

apparently caused markets for these instruments viraly to disappea, leaving previously

56

liquid instruments ilquid.

Fund management's obligation to make liquidity determinations is a contiuing one in

the case of instruments, including derivatives, whose liquidity may var under dierent

market conditions. If changed market conditions result in previously liquid portolio

holdings becoming ilquid, fund management should determine whether any steps are

57

required to assure that the fund continues to meet the 15 % guidelie.

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 price,

the subject of question 4. If a security trades in a liquid market, there is a strong lieliood

53See Merril 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, Assistat Director, Division of Investment Management, to Investment Company

Registrants (Jan. 17, 1992) (government-issued interest-onlyand principal-only securities backed by

lease obligations); Letter from Carolyn B. Lewis, Assistat 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,

fixed-rate mortgages, municipal

Investment Company Act Release No. 17452 (Api. 23, 1990), 55 FR 17933, 17940-41 (Rule 144A

securities, foreign securities) (hereinafter Release 17452).

54See Release 17452, supra note 53, at 55 FR 17940-41; ICI Letter, supra note 53, at 1.

55Release 17452, supra note 53, at 55 FR 17940 n.61.

56See, e.g., Saul Hansell, Markets in Turmoil: Investors Undone: How $600 Milion

Evaporated -- A special report; Fund Manager Caught Short By Crude and Brutal Market, N.Y.

TIMES, Api. 5, 1994, at Al (hereinafter Markets in Turmoill

57Release 17452, supra note 53, at 55 FR 17940 n.61.

19

that reliable market prices wil be readily avaiable. Conversely, reliable prices for

securities traded in an ilquid market ar often difficult to obta.

b. Has the Commion considered whether the 15% figure itself should be

revisited?

In 1992, the Commission rased the lit on ilquid assets from 10% to 15% for

58 The lit for

non-money market funds to faciltate capita rasing by smal businesses.

money market funds remais 10%. Recnt ilquidity in the market for cert mortgage

59

derivatives rases once agai the question of what liit is appropriate.

The Division has ben focusing on the ilquid assets liit in its inspetions of mutual

funds to determine whether funds ar complying with the liit on an ongoing basis, whether

funds are holding ilquid investments to the maxum amount permitted, and whether there

is a nee to reduce the liit. We reommend that the Commission act promptly to consider

reducing the ceilg.

6. Does the Use of Derivatives Permt Mutual Funds to Avoid Limtations on the

Use of Leverage Mandated by the Invesment Company Act of 1940?

a. Pleae describe for the Subcommttee the original purpose of the

restrictions on leverage contained in the Investment Company Act.

Investment company abuse of leverage was a priar concern that led to enactment

of the Investment Company Act.60 In the Act's preable, Congress cited excessive leverage

as a major abuse that it meat to correct, declarg that the public interest and the interest of

investors are adversely affected "when investment companes by excessive borrowing and the

issuance of excessive amounts of senior securities increase unduly the speculative charcter

of their junior securities. ,,61

58Release 18612, supra note 50.

S9See, e.g., Baird Fund, supra note 46; Robert McGough & Anita Raghavan, Paine

Webber

Again Props Up Bond Fwi, WALL ST. J., July 25, 1994, at CL (hereinafter PaineWebber Again

Props Up Bond Fun.

60In 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, INVEMENT TRUSTS AND INVEMENT COMPANIES, H.R.

Doc. No. 70, 76th Cong., 1st Sess. pt. 2 (1939); SEC, INVESTMENT TRUSTS AND INVEMENT

COMPANIES, H.R. Doc. No. 279, 76th Cong., 1st Sess. pt. 3 (1939) (hereinafter INVEMENT 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.

611nvestment Company Act § 1

(b)(7), 15 D.S.C. § 80a-l(b)(7). The preamble also refers to

"investment companies operat(ing) without adequate assets or reserves." Investment Company Act

§ i (b)(8), 15 D.S.C. § 80a-l(b)(8).

20

Section 18(t) of the Investment Company Act restricts leveraged capita structures,

generally prohibiting mutual funds from issuing any class of "senior security. ,,62 Funds may,

however, borrow from bank if they maintain 300 % asset coverage for all such

63 Section 12(a) authories the Commission to regulate two trading practices that

borrowings.

may result in leverage, margin purchases and short sales.64

One reason for liiting investment company leverage was to prevent abuse of the

purchasers of senior securities, which were sold to the public as low risk investments.6S

Investment company assets durig the 1920s and 1930s consisted mostly of common stocks

that did not provide the stable asset values or steady income stre necessa to support

senior charges.66 Because the sponsors often kept al or most of the junior, votig securities

for themselves, they could operate the company in their own interests.67 Senior securities

tended to lead to speculative investment policies to the detrient of senior securityholders

because the common stockholder/sponsors, who often had a relatively smal investment at

risk in the fund, looked to capital gais for profit.68 Multiple classes of senior securities and

6215 U.S.C. § 80(a)-18(t). "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).

631nvestment Compahy Act § 18(t)(1), 15 U.S.C. § 80a-18(t)(I).

6415 U.S.c. § 80a-12(a)(I), (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-l, Investment Company Act Release No. 7221 (June 9, 1972), 37

FR 12790 (hereinafter 1972 Guidelines).

65Id. at 1583; Investment Trusts an Investment Companies: Hearings on S. 3580 Before a

Subcomm. of

the Senate Committee on Banng

an 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).

66Senate Hearings, supra note 65, at 265; INVEMENT TRUST STUDY PT. 3, supra note 60,

at 1587-89.

6lSenate Hearings, supra note 65, at 239-40, 268-71, 273; INVEMENT TRUST STUDY PT. 3,

supra note 60, at 1594-98. See Investment Company Act § 1(b)(3), 15 U.S.C. § 80a-l(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").

68Senate 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 furter 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. IOO65

the House Committee on Interstate and Foreign Commerce, 76th Cong., 3d

Sess 121 (1940) (statement of David Schenker, Chief Counsel, SEC Investment Trust Stu,ly);

Before a Subcomm. of

INVESTMENT TRUST STUDY PT. 3, supra note 60, at 1870-71. At the time of the study, however,

(continued.. .)

21

pyramiding frustrated senior securityholders' attempts to determine whether secure returns

were likely. 69

Another reason for liiting investment company leverage was to protect public

common stockholders by liiting the volatity of their investments. Ths purpose was a

motivating factor for restrcting the issuance of senior securities to the public becuse the

leverage of the senior-junior capita structure magnied losses suffere by common

stockholders.70 Ths purpose also motivated the Investment Company Act restrctions on

71 The provisions authoriing the Commission to regulate

margin purchases and short sales implicate similar concerns.

mutual fund ban borrowings.

b. Is the leverage that is made available to funds through the use of

derivatives inconsisent with the intent underlying the Investment

Company Act?

i. Derivatives and leverage

Cert derivatives involve leverage for a fund becuse they create an obligation, or

indebtedness, to someone other than the fund's shareholders and enable the fund to

paricipate in gais and losses on an amount that excees its intial investment (referred to

herein as "indebtedness leverage"). Examples ar futures, forward contracts, and written

options. The writer of a stock put option, for example, makes no intial 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 paricipating in losses on the full stock price.72 As another example, a fund

purchasing a futures contract makes an intial margin payment that is tyicaly a smal

68(.. .

continued)

mutual funds almost invariably had only one class of securities outstading. INVEMENT TRUST

STUDY PT. 1, supra note 60, at 29; INVEMENT TRUST STUDY PT. 3, supra note 60, at 1563.

691NVESTMENT TRUST STUDY PT. 3, supra note 60, at 1665, 1674-75. Section 12(d)(I) 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).

?Onvestment Company Act § 1(b)(7), 15 U.S.C. § 80a-l(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).

71See Senate Hearings, supra note 65, at 288 (statement of John H. Hollands, Attorney, SEC

staff (" (Blank borrowings wil be a fixed charge against the company; and, because of the fixed

charge, the value of the common stock wil shoot up and down in the same way that it would if they

had debentures outstanding. ").

72THE OPTIONS CLEARING CORPORATION, CHARAClERISTICS AND RISKS OF STANDARDIZED

OPTIONS 17- i 8 (1985) (hereinafter OCC GUIDE).

22

percentage of the contract price.73 As a result of this margin payment, the fund paricipates

in gains and losses on the fun contract price.

74

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

magniy a fund's ~ai or loss from an investment in much the sae way that incurrg

indebtedness does. S One example is a purchased stock cal option. In return for the

payment of a premium in an amount equal to a fraction of the stock price, the holder of a

Other derivatives provide the economic

stock ca option paricipates in gais on the full stock price. If there are no gais, the

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

holder generay loses the entire intial premium.

changes, resulting in the holder experiencing market value fluctuations equivalent to those

that he or she would experience on a conventional bond of larger pricipal amount.77

ü. Derivatives and Invesment Company Act leverage resrictions

The leverage of derivatives rases concerns related to the volatity of fund common

stock, but does not rase 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. Whie this obligation or indebtedness does not run to public

senior securityholders, it does expose the fund to gais and losses on an amount that exces

its intial investment. In the case of derivatives that create economic leverage, the fund does

not assume a future obligation or indebtedness. Investing in these derivatives, however,

magnies the fund's gais or losses in much the sae way that incurrg 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 establishig and maitag segregated accounts consisting of cash,

U.S. governent securities, or high-grade debt securities in an amount at least equal in

73ROBERT E. FINK AND ROBERT B. FEDUNIAK, FUTURE TRAING: CONCEPTS AND

STRATEGIES 137 (1988).

74Id. at 39.

7SSee, e.g., Lee Berton, Understanding the Complex World of Derivatives, WALL ST. J., June

14, 1994, at Cl.

760CC GUIDE, supra note 72, at 15-17.

77James E. Lebherz, 'Inverse Floaters' Offer Potential Benefits, an Dangers, WASH. POST,

Aug. 29, 1993, at H7.

78E.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); i 972 Guidelines, supra note 64.

23

value to the obligations.

79 The Division also has permitted funds to cover cert derivatives

by holding the underlying instrments 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 cal options and leveraged inverse

floating rate bonds.

c. Apart from its relation to exising provisions in the statute, is the

Commsion concerned about the leverage available to funds that hold

derivatives? If so, how does the Commion propose to address those

concerns?

The Division is concerned about both indebtedness and ecnomic leverage that are

potentialy made avaiable to funds through the use of cert derivatives. The potential for

increased volatilty from such leverage may result in signcat losses to investors.

One approach to the issue of leverage would be to prohibit diectly, or restrct, the

use of derivatives by mutual funds. The Commission has imposed requirments on

derivative investments by money market funds,81 but we do not recommend this approach for

non-money market funds for thr resons. First, a prohibition or restrction on derivatives

use could chi the use of instruments in a maner that is beneficia for mutual funds, such

as hedging. Second, a prohibition or restriction on derivatives use would be inconsistent

with the genera approach of the Investment Company Act, which imposes few substative

liits on mutual fund investments.

82 Funds generay are permtted to make investments

without regard to their volatilty, e.g., emergig market securities and smal company

stocks, and we are not persuaded that derivatives should be trted dierently. 83 Thd, it

would be extremely difficult, if not impossible, to devise appropriate prohibitions or

7~elease 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. ¡d.

8Oor 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 calIon

the same securities at the same price. 1972 Guidelines, supra note 64. For additional examples of

cover, see Dreyfus, supra note 78.

81These requirements are discussed in response to question 8, below.

~e provisions of the Investment Company Act that prohibit or restrict certin tyes of

investment are quite narrow. See, e.g., § 12(d), 15 D.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.

~e 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 capitaization); ¡d. 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).

24

restrictions on the use of derivatives by mutual funds becuse of the wide varety of

instruments that may be considered "derivatives. II The avaiable "derivatives" ar liely to

change as innovation occurs in the marketplace, possibly renderig substantive prohibitions

or restrictions ineffective withi a short time.

The Division believes that one of the most effective meas for addressing leverage

concerns associated with mutual fund use of derivatives is improved risk disclosure. It is

crucial that investors understad the risks of investing in a mutual fund, includig the risks

of the fund's intended use of varous derivatives. The risk/return profile of a mutual fund

may be affected signicatly by derivatives that are potentialy volatile, and we believe that

it is critical that fund investors understad this profi1e. For this reason, we have given

heightened scrutiny to derivatives disclosure in prospectuses, and a Division task force has

examined the derivatives disclosures of i 00 investment companes. The Division has

encouraged registrts to modi their existig disclosure to enhance investor understadig

of pertinent risks. Weare engaged in fundaenta reonsideration of mutual fund

disclosure, assessing whether the use of quantitative risk measures would improve investor

understading of fund risk. Becuse 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 suffciently protective of the interests of fund

shareholders, the Division may reconsider whether to reommend that the Investment

Company Act be amended to place substantive liits 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 addressing the leverage issues rased by derivatives, largely becuse it was

originaly designed to address a diferent problem, namely, the leverage created by the

issuance of public senior securities.84 Given the recent prolieration of derivatives, we

believe that it is appropriate to reexamine both the way in which section 18 has ben applied

to derivatives that create indebtedness leverage and the diferential 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 seekig public comment on appropriate regulatory and legislative

solutions to address the issues rased by leverage resulting from fund use of derivatives.

Inusions by Two Fund Complexes Indicate that Bank

Mutual Fund Investors may be Facing Special Undiclosed Riks?

7. Do the Recent Capital

The questions rased by the Letter in the area of ban-advised mutual funds relate

priary to the interpretation and application of federal bankg laws. The Division's

responses are based on our understading of the bang laws and inormal discussions with

the staffs of the federa bang agencies. It also may be advisable for Congressmen

Markey and Fields to contact the federal bankg agencies directly, however, as they have

the greatest expertise in interpreting the federal bankg laws and are in the best position to

predict how they might exercise their authority in specifc circumstaces.

We emphasize, as a preliinar matter, that a mutual fund's adviser, regardless of

whether it is a ban (or a subsidiary or affilate of a ban), is not legaly obligated to inse

84Bank 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.

25

capital into or purchase depreciated instruments from a fund, absent a violation of law.

Mutual funds invest in securities that ca market risk, and fund advisers are not required

to guarntee 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 capitalied subsidiary or afiilate, is there

a risk that bank regulatory concern might prevent the adviser from

makig a capital inusion into the fund, even if such an inusion was in

the interest of the fund's shareholders?

If a ban was the adviser for a fund that suffered a shar unexpected loss, ban

regulatory concerns could prevent the adviser from makg a capita insion into the fund,

even if such an insion was in the interest of the fund's shareholders. Ths risk is present

whether the adviser is par of the ban itself or is a separtely capita subsidiar or

affilate.8s

We understad from our discussions with federa ban regulators that they view the

decision86toIf,inse

capita into a fund as intialy being a business decision of the ban

howevtr, in the ban regulators' view, an adviser's capita insion into a fund

adviser.

threatened the safety and soundness of the ban,87 it is possible that the ban regulators

would tae steps to prevent the insion, regardless of whether it was in the interest of fund

88

shareholders.

8Sel. Proposed Mellon-Dreyfus Merger: Hearings Before the Subcomm. on Oversight, an

the House Comm. on Energy an Commerce, 103d Cong., 2d Sess. 292 (1994)

(hereinafter Mellon-Dreyfus Hearings) (statement of Eugene A. Ludwig, Comptroller of the

Currency) (risk of loss to ban exists whether activities conducted in subsidiar or division of ban).

Investigations of

87he 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 affliate) may assist the fund.

Regardless of which entity makes the infsion or purchase, federal ban regulators could object to

the infusion or the purchase by any ban affliate if they believed that it constituted an unsafe or

unsound baning practice.

&7Federal baning laws focus on the safety and soundness of individual bans and the baning

system as a whole. See, e.g., Federal Deposit Insurance Act § 8, 12 D.S.C. § 1818 (authorizing

federal ban regulators to bring enforcement actions against insured banks that engage in unsafe and

unsound baning practices). See also MICHIE ON BANKS AND BANKING ch. 15, § 6 (1989 & Supp.

1994).

88Recently, however, the Federal Reserve Board did not object when a banking institution

assisted a proprietar mutual fund that had sustained losses from derivatives. See Snigdha Prakash,

B of A's Bailout of Fun 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 Artcle). Other baning institutions recently have taken similar actions,

apparently without intervention by the bank regulators. See, e.g., Stepping up to the Plate, supra

note 6.

26

Even if an adviser was organized as a subsidiar of the bank, bank regulators stil

could cite bank safety and soundness as grounds for objecting to a capita insion. The

Offce of the Comptroller of the Currency, for example, has traditionally viewed national

89 Thus, operating subsidiares

bank operating subsidiaries as deparments of the parent bank.

of national bans are subject to the same bang laws and regulations as the parent ban

and to examination and supeivision by the Office of the Comptroller of the Currency. 90

Consistent with this priciple, the Comptroller of the Currency has indicated that, even if a

fund adviser is a separtely capita ban subsidiary, he stil would have concerns about

the adviser's activities and potential risks to bank capitaL. 91

If advisory activities were conducted in a separately capitalized afilate of a ban

other than a bank subsidiary (e.g., a holding company subsidiary or the holding company

itself), there would be a clearer financial separtion between the bank and the adviser than if

the adviser was a bank subsidiar. 92 Becuse it is less liely that an afilate adviser's

activities would threaten the safety and soundness of the bank, it also may be less liely that

bank regulators would object to the affiliate adviser infusing capita into a fund.93

89See former OCC Interpretive Ruling 7.7376, 12 C.F.R. § 7.7376 (1983), rescindd 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).

9012 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).

9lMellon-Dreyfus Hearings, supra note 85, at 292. (statement of Eugene A. Ludwig,

Comptroller of the Currency) ("(t)rom the perspective of bank safety and soundness, the most serious

concern raised by a proposal such as Mellon's is the possibilty of (bank) exposure to operational or

fiduciar losses in its mutual fund subsidiar.") Specifically, Comptroller Ludwig expressed concern

that "bank managers might feel strong pressure to reimburse an affliated mutual fund or its

customers for market losses, paricularly 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." ¡d.

91'his would be the case because an affliate's capital is not tied to the bank's capital as

as a subsidiary's. Cf. Restructuring of the Bankng 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.

directly

Breeen, Chairman, U.S. Securities and Exchange Commission, regarding bank conduct of brokerdealer activities).

931t 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).

27

b. Would the adviser be able to repurchase intruments 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 ban

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 bankg law.94 For example,

the Glass-Steagal Act generai prohibits a national ban from purchasing and sellg

securities for its own accunt. The Act, however, excepts from this prohibition cert

governent obligations and "investment securities. ,,96

Whether a derivative wil be viewed as a security for purposes of the Glass-Steagall

Act wil depend on the paricular type of instrument and its use. Federa bank regulators

generally do not view futures contracts and related options, foreign currency contracts,

swaRs, and other commodities-related investments as securities under the Glass-Steagal

97 Options (other than ~tions on futures contracts), on the other hand, may be treated

as securities under that Act.

Act.

Even if a derivative is not viewed as a security subject to the restrictions of the

Glass-Steagall Act, a ban sti may not be fre to purchase the derivative from a fund. The

purchase also must conform with recently adopted ban regulatory guidelies on derivatives

activities, which generay set forth managerial, operational, and internal control

requirements for ban 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 Federa

Reserve Act. These provisions restrct trnsactions (including the purchase and sale of

securities or other assets) between banks and their affiiates by imposing aggregate

94Section 17(a) of the Investment Company Act also restricts an investment adviser's abilty 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 in section 8.b., below.

95Glass-Steagall Act, § 16, 12 U.S.c. § 24 (Seventh).

96Glass-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.

97MELANIE L. FEIN, SECURITES AcrivlTIES OF BANKS § 13.01 (1991).

98/d.

9'See, e.g., Banking Circular No. 277 (Oct. 27, 1993) (risk management guidelines issued by

the Comptroller of the Currency). The Offce 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.

28

transaction limits, collateralition requirements, and arm's length dealing requirements.1oo

Section 23A generally j?rohibits a bank and its subsidianes from purchasing a low-qualty

asset from an affùiate. 1 For purposes of Sections 23A and 23B, the term "afliate"

includes any investment company advised by the bank or any affiiate 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 invesors? ,

If an adviser elects not to inse capita 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 portolio

secunties 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 spir. If Moreover,

if the depreciated instrument is ilquid, the fund liely 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 instrment and exposing investors to greater losses if

the pnce of the instrument contiues to declie. These losses could occur in any fund,

whether or not advised by a ban, 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

permtted be disclosed to bank mutual fund investors?

The Commission has broad authority under the Secunties Act of 1933 and the

Investment Company Act to require a fund prospectus to include any matenal information

necssa to make the statements contaed in the prospectus not misleading.104 When the

Commission or the Division has determined that there is a unique material risk associated

with a parcular type of fund, it has reuired paricular disclosure in the prospectus of those

funds. For example, the Division requires every ban-sold mutual fund and every mutual

fund whose name is similar to a bank's name to disclose prominently on the cover page of

10012 U.S.C. §§ 371c and 371c-1.

10112 U.S,c. § 371c(a)(3).

10212 U .S,c. § 371c(b)(1)(D)(ii).

lO1'he 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.

J04See, 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.P.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.P.R.

§ 270.8b-20.

29

105 Similarly, the

its prospectus that the shares in the fund are not federally insured.

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 guarantee by the

U. S. government and that there is no assurance that the fund wil be able to maitain a

stable net asset value of $1.00.106

Ban regulators have not yet objected generay or, to our knowledge, specifcay to

ban advisers insing capita into or purchasing depreciated instrments from their funds.

In fact, one regulator reportedly has stated speifcay that a capita insion by one bang

institution did not rase concerns.107 In addition, a mutual fund's adviser, regardless of

whether it is a ban, is not legaly obligated to inse capita or purchase depreiated

instruments from the fund, absent a violation of law. Accordingly, it does not seem

warted at this time for the Commission or the Division to mandate disclosure for al

ban -advised funds concerng the potential liits on a ban adviser's abilty to assist its

fund. Rather, we believe that each ban-advised fund individualy should assess its own

circumstaces to determine whether this is a material risk that should be disclosed.

e. Better stil, is there a way to avoid the confct between the bank and the

fund?

Under the current regulatory scheme, there is. the potenti for confct between a

ban's obligations under the bang laws and the interests of the fund and its sharholders

with respect to capita insions and purchases of securities. Whie it is unlely, for the

reasons discussed above, that requirg a ban to conduct its fund advisory activities in a

separtely capitaiz subsidiar or afilate would eliinate the conflct completely, it would

appea to reduce the potential for confct between the bank and the fund, paricularly if

such activities are conducted in a separtely capitaiz affilate.

..

IOSLetter from Barbara J. Green, Deputy Director, Division of Investment Management, to

Investment Company Registrants (May 13, 1993). The Division was concerned that investors may

mistaenly believe that these mutual funds are federally insured or similarly protected by the Federal

Deposit Insurance Corporation, the Federal Reserve Board, or some other agency. ¡d.

I06Form 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 releae proposing this money market fund

disclosure, the Commission stated that "(w)hi1e money market funds have been one of the safest

available investment options, the Commission believes it is importnt for investors to understand that

money market funds are not risk-free." Investment Company Act Releae No. 17589, at text

accompanying n.68 (July 17, 1990) 55 FR 30239, 30247.

I07See B oj 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).

30

8. _ Recent Instabilty 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,

typicaly $1.00. Many money market funds alow investors to use checks to redeem shares,

and, becuse the value of an account generay does not change due to share value

fluctuations, many investors use money market funds as alternatives to checkig accounts

since they can readily ascertin 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 "guarntee" 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 (i) that the shares of the money

market fund are neither insured nor guarantee by the U.S. Governent and (2) there is no

108

assurance that the fund wil be able to mainta a stable net asset value of $1.00 per share.

Prior to the adoption of 1991 amendments to rule 2a-7 under the Investment

Company Act, the Commission's rule governg money market funds, a money market fund

was required to comply with the rule only if the fund wished to ta1ce 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 pricipal

values or returns were based on non-dollar denominated indexes. To assist investors to

better understad money market funds, the Commission in 1991 prohibited mutual funds

from callg themselves money market funds unless they comply with the risk-limiting

provisions of rule 2a_7.110

b. Money Market Funds and Derivatives

Money market funds invest in a variety of instruments that could be characteried as

derivatives. Many of these securities are created especialy 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 unfortnate

I08Revisions to Rules Regulating Money Market Funds, Investment Company Act

Release No.

18005 (Feb. 20, 1991), 56 FR 8113 (amendments to Form N-IA, Item 1

(a)(ix)).

I09Money 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)(I). 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)(lI),

llOl7 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).

31

number of recent instances in which money market funds have invested in adjustable rate

notes that have experienced signifcant volatilty and losses. Losses in value attributable to

these securities have resulted in a number of money market fund advisers electing to tae

actions, including contributing capital or purchasing instruments held by the funds, to

prevent the funds' net asset values from fallg below $1.00.11

Rule 2a-7 limits a money market fund's exposure to interest rate risk by generallr

prohibiting it from acquirg securities with remaining maturities that exce 397 days.

11

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." 11

Last year, the Division bece aware that some funds were investing in adjustable

rate securities that had interest rate adjustment formuJae that would be unlely 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

115 In the release, the Commission

investment in these types of adjustable rate securities.

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 wil result in their market values not returng 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 becme apparent that some funds continued to hold these types

of securities. Because of an increase in interest rates, the volatility of these instruments

increased. In June, you rased this issue in correspondence with the chief executive offcers

of the 80 largest fund complexes. 11 Later that month, the Division provided money market

funds and their advisers with additional guidance concernng investments in adjustable rate

securities. liS The Division reminded fund managers of their general obligations under rule

IIISee, e.g., Stepping up to the Plate, supra note 6.

11217 C.F.R. § 270.2a-7(c)(2).

11317 C.F.R. § 270.2a-7(a)(7), (21).

lI'These securities include capped floaters (whose floating rates wil not adjust above a stated

level), CMT floaters (whose floating rates are tied to long-term rates and which wil 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).

IISRelease 19959, supra note 14, at Part II.D.2,d" 58 FR 68601-02.

116ld. at 58 FR 68601.

"7Levitt Letters, supra note 10,

118Letter from Barry P. Barbash, Director, Division of Investment Management, to Paul

Schott Stevens, General Counsel, Investment Company Institute (June 30, i 994).

32

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 mainta their funds' net asset values at $1.00, a number of fund advisers have

purchased certin adjustable rate securities from their money market funds at their amortized

cost value (plus accrued interest).119 Such a transaction is prohibited by section i 7(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

exceeed the security's market value and the trasaction 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. Becuse of the nee 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 falg below $1.00. To date, a number of 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 taen 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 typs of adjustable rate instruments that

pose similar risks will be unable or unwillng to tae similar actions, and that the net asset

value of such a fund wil fall below $1.00.

The Division wil continue to be vigilant in enforcing compliance with al provisions

of rule 2a-7. In addition, we wil persist in our efforts to impress upon investors that

money market funds are not insured or guarantee.

119See, e.g., Stepping up to the Plate, supra note 6.

I20Investment Company Act § 17(a)(2), (b), 15 U.S.c. § 80a-17(a)(2), (b).

121In each case, the reI ief 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,

33

JUN is . 94 16: Ø3 FROM TF SUBCOMMITTEE

PAGE. ØØ2

TO 9SØ4231B

0". WU1llC nillO tOoCòII..

ll wi.a,.

I'~D I'II O'fl IUli-cu.a

""0'11 aoii uo-i.¡'

lOWAIC ~, .....cO'. i...~..v.CT. t.....

\, "ILL\" ToWzi.. lOUlSlo

I LOU"~ ...QIIIA

JACI PlrUl.. Triv

WICt Q. OXLl. 001O

0..,,10 ", llOUlTON

'lOW.I .l 'UL.. Jl ""1I1NlA

.OI J. NAN. NtwyO.1

lICIl4l1l. Uti... CAUio"'''

L'llC .CHIlIl( CAfONIA

m.iI. ~OUSSt ot l\epreSStntatíbes

ll~ 'CW4lll COIl

Jor U.JlOI. Tll

Coininfttn on tnir;: aidi (øminmi

_IUOIlI_IlUMU\INUY. AUlX NcWILu, -i CA

PlIIIT\VAN

~, O(NIIII KAT(ll.lLOI'

PAUL .. ~ 01l

"IKl i,. O'U.U'lOW.

Mil \I1l. OIlQOIl

~ lilCi. TU

CALOI J. IiHIA.

~OllllØ OFfI

'''Ii' 'Ol.lEl .. IT"~' DI.leTOR

SUBCOMMITT!£ ON TELECOMMUNICATIONS AND FINANCe

.1l II...O.ON. flIW ...LUCO

JIM li.mll. lWI'"

.IIlIIIlAH. TVI

IN

~ TPiillll'

JO D. OIIU MI

limington, J¡( 203 13-e 119

P orio ,

June is, 1994

The Honorable Anur Levitt, Jr.

Chainan

Securties and Exchange Commssion

450 Fift Street, N. W.

Waslungton, D,.C.

Dear Chairan Levitt:

Pursuant to-Rules X an XI of th United States House of Representtives, an ths

Subcomntt's contiuin responsibilty to oversee th nation's muwal fu inustr, we

wrte to request tht the Commssion unerte a comprehensive study of the grwing use of

derivatives by munil fuds, and more pariculy, the adequay of laws an 'reguations

govenug thir disl.osu an use. We believe tht such a stuy is warr in light of a

small but growing number of report of substlossc apparntly attbutable to

dervatives holdings at certin mutu fu. Some of thse losses were apparnty inur

rapidly, and, more importtly ~ occurred at funds. such as short-term governent bond funds

. and money market funds, which may inviduals believe to be cautious an coIÌrvative

(though obviously not entirly nsk-fr) investments.

As you may reall, we have disse the general subject of derivatives an mutual

fund sever~ities durg your tenue at the Commission. Th first time was dur the

Subcommitte's oversight hear on the fund industr in August 1993, when Cha

Markey asked whether some riks assoiated with derivatives were so substatia as to justif

th consideration of limits on a fu's abilty to include them as pan of its ponfolio. We

addressed related issues at the SUbcmmtte's hearing several weeks ago, when we reviewed

the conclusions and recommndtions of a two-year General Accountin Office study (the

GAD study) of how best to manage an oversee the risks associated with derivatives.

In you writtn testimony submitted in connction with

the Subcomminee's hearing on

the GAO study, you observe4 that the Commssion's inpections of investment companes (as

well as a recently conducted surey) appeared to indicate tht derivatives have a limite

though ,apparently growin role in the operation of some mutUal fuds, pancularly fixed

income funds. This conclusion is neithr swprising nor, in general term, unwelcome. As

you knw, we share your belief tht may derivative rincial products play an essential role

in hedging against risks created by tlucniating interest and currency exchnge rates. Othr

derivatives often are useful 'in reducin exposure to potential price ches in various equities

or commodities.

JUN 15 . 94 16: Ø3 FROM TF SUBCOMM I TTEE

TO 9SØ423 i 8

PAGE. ØØ3

The Honorable Artur Levitt, Jr.

, Page 2

June 15, 1994

It is now abundantly clear, however, tht derivatives can create risk as well as hedge

againt it. And for a varety of reasons, derivatives can sometimes create an extrordin

amount of risk virtally overnght. A recent story in ~ magazine quoted a derivatives

dealer and effectively ilustrte the dichotomy between hedgin and speculation. The dealer

said tht "(wle are alost equàly divided between two groups of customers -- one tht wants

to protec everying it.ha an th ~ther tht wants to make a 200% kilin overnght. "J1

Obviously, to tbe extnt tht munil fuds engage in speculative derivatives activity involving

volatile derivatives instrents, they pass th rik on to their sharholders around th

countr .

To respond to the concrn tht have reently beén'rased, the Subcommttee reest

that th Commssion undert a comprehensíve study of the use of derivatives by open-end

"investment companes. The study should, of course, address every issue relate to the use of

derivatives by mntual fuds that the SEC detlI to be importt to its mission of

protectin

invèstors an promotin the integrty, an heath of th inustr. The study should also

respond to the followin speifc Subco~tt concern:

1. Does the SEe Have Adequate Knowledgi of Industr Prtices?

We are pleased tht you have foced the Commission's attenùon on ths issue, as

_~yidenced by your remarks to the Subcommttee and recent speeches. But it is nonetheless

(""..­

; extre~ely unsettlin to hear the SEe in effect conclude tht they oftn don't know th

" identity of the funds that actually hold and trade derivatives, or' the quantity or quality of the

Ld..erivatives themselves. At most fixed inme an equity funds, all th SEC apparently

knows right now is whether th fud retain the option, usully under a broad range of

circumtances, to invest in derivatives. It is goin to be had for the Conussion to achieve

its mandate of protecti investors if it doesn't know what to protect them from. Please

identiy tle informtion needed by th SEC to fufil its responsibilties. What obstales, if

any. prevent the Commission from obtain and processing ths infonntion? What steps

should be taen to lnure tht the Commssion is able to obtain accurate and reliable

information quickly and efficiently?

2. Better Disclosure May Be Critical to Help the SEC, But Will It Be Accomplished in a

Manner That Makes a Signifcant Difference to Average Investors?

Several commentators have alrady suggested tht enhnced disclosure about

derivatives and associated, risks wil fully resolve whatever problems may be experienced by

~

lJ Sinularly. a reent Institutional Investor survey of pension fund offcers revealed that 27 % use derivatives

primarly to tnhaice the fud's returns. An additional 37% viewed enhanin¡ retus as equal in importce to

hedging against risk.

JUN 15 . 94 16: Ø4 FROM TF SUBCOMM I TTEE

TO 95Ø42318

PAGE. ØØ4

The Honorable Anhur Levitt, Jr.

Page 3

June 15, 1994

investors. Whie we are

reluctat to questioll the redempuve power ,of improved dislosure,

we believe there are resons why we may ne to reth how we communcate with mutul

fund inve$tors about an issue as inerently complex as derivatives.

Firt, we suspet that investors oftn develop general expectations about risk based on

how their fund is categoried, and would like to know if th Conuission agrees. In

practica terms, investors tn short-term governent bond funds appea to believe tht they

have taen on relatively modest risk, whie investors in emerg~ markets funds hopefully

understand tht thir investments are subject to a variety of relatively extreme risks.

Disclosues bured in a prospetu tht diverge from these expectations may never get read,

or, if read, fully understoo. A report in'Baron's about one of the fund's tht ha

experiencd, draatic losses tven indicate tht the fund's own brokers, let alone thir

investors, "felt they had ben misled about the fud's tre risk," even though the prospectus

indicated the fu retained the rit to trde in mongage-backed securities.

Second, even if the fud's diS,los\ls are presente clearly, concisely and in a

marier designe to maim comprehensibilty, it is still questionable whether investors

would be'able to understa an assimate inormation tht is usefu to thir invesanent

decision, A discussion of how 'invers floaters' work, or defiiùtions of 'pnncipaI-only strips

of CMOs', wil involve unavoidable eleme~ts of abstraction. Are there alterntive ways of

creatively presentin the critical inormtion needed by invqstors, such as th effect on .risk

and volatility create by the fund's holdins of derivatives, that avoids the dilenua of

attmpting to define these intrents 'and strtegies?

Finally, fonnal disclosure to investors taes place amiually in the prospectus. But

various derivatives positions. each with distictly different possible risks, can chane 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 paricular past moment in tie. Does the Commission agree tht this quaity

should öe considered when evaluating the utility of requiring enhced disclosure of

derivatives holdings?

3. Is Intense Competition in the Fund Industr (or Any Other 'Reason) Leading Some

Pori/olio Managers to Move Riky

Derlvatves Into Otherwise Risk Averse Funds?

In recent' weeks, several mutul funds have reportd substantial and dramtic losses in

fus tht occurred virally overnght. There would be less cause for concern if these funds

had told investors (clearly an concisely, of course) tht th fu took big nsks in th effort

to achieve big return, as is typically the ca with aggressive equity and fixed income fund.

But these were short term governent bond funds. It is, or at least we thought it was,

axiomatic that short term governent bond funds are not terrbly risky. In exchae for

relatively low risk, investors wilingly accept relatively modest retu. Of course, investors

JUN 15 '94 16: 05 FROM TF SUBCOMM I TTEE

TO 95042318

PAGE.

005

The Honorable Artur Levitt, Jr.

Page 4

June 15, 1994

in these funds (as in all mutu funds) should have understood tht they might incur a losst

and that their investments were neithr insured nor guarante. But confion about the

possibilty of some loss, or about the existenc of a federal guntee, is not ui issue.

Instead, the issue here is whethr a 25 % loss in just thee months, or a 4 % loss in a single

day, is consbtent with a typical investor', unerstanding of the risks presented by investing

in a short term governent bond fu. We don't think losses of tht magnitude ar

consistent with a resonable investor's exptations, and we believe the actions of th

respective fu companes suggest tht they reched the same conclusion.

Some might respond tht categories by themselves have virtlly no meat an tht

investors should always review the contents of the fund', portfolio as report in its

disclosue documents. Th is, however, a problematic suggestion at best. Michael Lipper,

one of the coun's most respcted expert on th fund inustr, recenty was reportd to

have said that "many derivatives disppe (from the portfolio) by the stateent date."

Eqly importt, in an era when thre ar signicant public policy concern about whether

inv.estòrs understa the import ,of properly allocatig their assets, it would be extmely

un!Jrtnate to lose the genera guida that is presently provided by the existenc of varous

fu categories.

Is the competition for assets with the inustr so intense tht othrwise conservative

funds take on disproportionate risks in order to outperform rivals? Is the Commssion .

concerned tht the cause of the losses report at the two fus may represent a growing

trend? Does ile Commssion believe tht a legislative or regulatory respons is needed to

address any issues relate to th derivatives losses reportd at these funds?

4. Are Mutual Funds Experiencing Prblems Prcing Exotic Derivatves?

As you know. the establishmnt of a day net asset value is one of the core

requirements of the Investmnt Company Act of 1940, a bedrock par of the fund inustr,

and no doubt one of the key reasons for its grat success. But the esoteric derivatives held

by one fund tht recntly report dratic losses were apparently so complex tht on some

days, the firm couldn't establish their value. If we understand that particular issue properly,

when tht fund' s investors nimed to: thir mornng paper to see the value of their mutual fund

shares, they saw a blan line. Th Subcmmitte believes serious analysis should be given

to finacial products tht ar so exotic, riky and iliquid tht they might interfere with the

absolutely essential function of establishin a daily price for fund shaes.

5. Art Mutual Funds Experiencing Liquidity Problems Because Of Exotic Derivatvøs?

Liquidity is obviously of enormous importnce to mutual funds, because investors are

entitled to redeem their shas at any tie. Tht is one reason why the SEC ~xpressly

JUN 1~ . 94 16: 05 FROM TF SUBCOMM I TTEE

TO 95042318

PAGE. øØS

The Honorable Artur Levitt, Jr.

Page 5

June 1S, 1994

requirs tht a fund hold no more thn 15 % of its assets in iliquid intruments. Some have

argued that the reason one fund complex agreed to inject ten millon dollars of its own

capita into their fund was to eae th liquidity problems ~y had been encounterin as thy

sought to unwin the fu's CMO's. Whe we don't know the details about tlese particular

CMO's, we do know tht some derivatives, are custom dcsigned for use by a sinle

intitution, which would seem to greatly reuc their liquidity. Does the Commission believe

tht some of the more exotic and volatile derivatives should be considered II iliquid?" Has

the Commsion considered whether the 15 % rue should be applied to any tyes of

derivative products, or whether the 15% figu itself should be revisited?

6. Does The Use Of Derivatves Perm Mutu Funds To Avoid Limitatons On The Use

Of Leerage Mandaed lJy The Investent Company Act Of 1940?

We have read tht fund managers ,can mae use of certin derivatives, such as

stnc~ed notes. to build enormous leverage into their portolios. Practices like this

apparenty led' to substatil return for investors as interest rates dramtically declin

though'1992 and 1993, but have posed problems for some fuds with the sha reversal in

rates exprienced so far th year. Whe fu ar permtt to borrow money and use soe

leverage. it is limite and must be collateraiz. But stctud notes enjoy no such

limitations, and the amount of leverage ca be substatial. Pleae describe for the

Subcommtte the original purpose of the restrictions on leverage contained in the Investment

Company Act of 1940. Is the leverage tht is made available to funds though the use of

derivativès innsisttnt with the intent unrlyin the 1940 Act? Apart from its relation to

existig provisions in the statute, is the Commssion concernd about the leverage available

to fus that hold derivatives? If so, how does the Commission propose to addrss those '

concern?

7. Do Tlie Recent Capital

Infusions By 7Wo Fund Complexes Indicate That Bank Mutual

Fund Investors May Be Facing Specia Undisclosed Risks?

Assume a bank was th advisor for a shon tenn governent fund or money market

fu that had suffered sharp unexpecte losses. If the fund is not part of a separately

capitalized subsidial) or affliate. is thre a risk tht ban regulatol) concern might prevent

the fund, even if such an insion was in me

the advisor from mag a capital inion into

interest of the fund's shareholders? Would the advisor be able to repurchase intrents

from th fund tht were' believed to be the souce of th losses? Would you agree tht the

failure to permt such an injection qr repurchase could result in a furter downward spiral-for

the fund, leading to even greater losses for investors? Should th prospect tht such

might not be permttd be disclosed to ban mutul fud investors?

Better stil, is there a way to avoid the confict between th bank and the fund?

infsions or repurchases

TO 95Ø42318

JUN 15 '94 16:Ø6 FROM TF SUBCOMMITTEE

PAGE. ØØ7

The Honorable Artur Levitt. Jr.

Page 6

June 15. 1994

8. Recent Instabil Of Money Market Mutual Funds.

We understa tht the Commsion has spent a considerable amount of time an

resoures reviewin an studying questions related to money market funds. as evidenced by

the proposed amendent to Rule 2a.7 under the Investment Company Act. We also know

that you share our genera concern tht may money market fund investors appea to believe

that thse fund ar the futiona equivalent of inured ban accounts, despite signicant

effort by the ICI and the funds thlves to demonstrate otherwise. Notwithtain the

perception problem, hÇ)wever. we Delieve tht reasonable questions arse when it is

discovered tht money maket fus have investe in sophiticated synttic denvatives, tJt

expose investors to sigcat rik of loss if'interest rates move in unexpecte diections.

Please bnng us up-to-dte on th Commssion's latest views about the appropriteness of

derivatives for money market portolios.

Given the importce of these issues, it is our hope tht the Commssion could

complete its study an report back to the Subcmmittee by July 18, 1994. If you have any

qustions concerng the Subcommitt's reuest or the speifc issues rais by th lettr,

please COntct Timothy Forde, Counel to the Subcommitte, at (202) 226-2424, or Stephen

A. Blumenthl, Republica Counel to the Committee. at (202) 226-3400.

Sincerely.

~

'

. EDwla

CHAIRM