# SECURITIES AND EXCHANGE COMMISSION > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Asec%3Ac11faa1cf819a92d ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text 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 [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Asec%3Ac11faa1cf819a92d. Public record. Not legal advice.