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SEC Issues Guidance on Fund Derivatives Disclosures

On July 30, 2010, Barry Miller, Associate Director in the SEC's Division of Investment Management, sent a letter to the Investment Company Institute providing guidance on derivatives related disclosures by investment companies.  According to the letter, the guidance is being provided prior to the completion of the Commission's comprehensive review of investment company use of derivatives in order to help funds improve their disclosures: 

We are providing these observations now, prior to completion of our review, because we believe these observations may give investment companies immediate guidance to provide investors with more understandable disclosures related to derivatives, including the risks associated with them.

The letter provides guidance for disclosures about derivatives in funds' registration statements and shareholder reports and financial statements.

Registration Statement Disclosures

The letter notes that most funds provide fairly generic, and either abbreviated or very lengthy and technical, disclosures about the kinds of derivative instruments they might use, as opposed to more specific disclosures about derivative instruments it intends to use, and how and why it intends to use them.  The guidance warns against these kinds of generic disclosure:

The types of generic disclosures discussed above may not enable investors to distinguish which, if any, derivatives are in fact encompassed in the principal investment strategies of the fund or specific risk exposures they will entail. Indeed, while more abbreviated disclosures could lead some investors to believe that a fund's exposure to derivatives is minimal, we have observed that some funds employing this type of disclosure, in fact, appear to invest significantly in derivatives and thereby may have substantial exposure to derivatives-related risks. Conversely, the comprehensive nature oflengthy, often highly technical, derivatives-related disclosures could lead some investors to believe that a fund with such disclosure would have substantial exposure to derivative transactions, yet we have observed that some funds providing this disclosure actually appear to have relatively small exposure to derivatives.

The guidance counsels funds to reexamine their disclosures about derivatives in their registration statements, and recast them focusing on the kinds of derivatives the fund actually does use, or intends to use, the reasons four using them, and providing substantive discussions of the risks involved.

Given these observations, we believe that all funds that use or intend to use derivative instruments should assess the accuracy and completeness oftheir disclosure, including whether the disclosure is presented in an understandable manner using plain English. Further, any principal investment strategies disclosure related to derivatives should be tailored specifically to how a fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its objectives and that it anticipates will have a significant effect on its performance. [footnote omitted] In determining the appropriate disclosure, a fund should consider the degree of economic exposure the derivatives create, in addition to the amount invested in the derivatives strategy.[footnote omitted]  This disclosure also should describe the purpose that the derivatives are intended to serve in the portfolio (e.g., hedging, speculation, or as a substitute for investing in conventional securities),[footnote omitted] and the extent to which derivatives are expected to be used.

Additionally, the disclosure concerning the principal risks ofthe fund should similarly be tailored to the types of derivatives used by the fund, the extent oftheir use, and the purpose for using derivative transactions. [footnote omitted]  The risk disclosure in the prospectus for each fund should provide an investor with a complete risk profile ofthe fund's investments taken as a whole, rather than a list of the risks of various derivative strategies, and should reflect anticipated derivatives usage.

Shareholder Reports and Financial Statement Disclosures

Miller notes in his letter that the Commission has observed some funds that appear to have significant derivatives exposure in their financial statements, yet their Management's Discussion of Fund Performance disclosures in their shareholder reports includes limited or, in some cases, no discussion of the effect ofthose derivatives on the funds' performance. Miller also notes that other funds also include limited or, in some cases, no derivatives-related disclosure in their shareholder reports, yet their registration statements disclose principal investment strategies that include the use of derivatives. Also, the Commission has observed some funds with derivatives-related discussions in their shareholder reports that is solely forward looking, and does not discuss the effect of derivatives on performance for the fiscal year.  The letter cautions funds to ensure that their discussion in shareholder reports of their use of derivatives focuses not just on forward-looking discussions, but on how the derivatives employed affected the past year's performance.  In addition, the letter emphasizes that the discussion in shareholder reports must be consistent with what is disclosed in the fund's registration statement.  

Further, Miller observes that fund financial statements often do not adequately comply with the spirit of GAAP guidance about the use of derivatives.  The letter urges funds to improve their financial statement disclosures about derivatives in the following ways:

[P]rovide qualitative disclosures about their objectives and strategies for using derivative instruments by addressing the effect of using derivatives during the reporting period. While many funds state that they "may" engage in certain types of derivatives transactions, they do not provide qualitative information about how the funds achieved their objectives and strategies by using derivative instruments during the reporting period. The financial statements and accompanying notes should inform shareholders how a fund actually used derivatives during the period to meet its objectives and strategies.

It is clear from the substance and timing of this guidance, as well as recent remarks by Commission staff, that the SEC expects funds to reexamine both their use of derivatives, and their disclosures and communications with shareholders about what instruments they use, how they use them, why they use them, and what effects their use has on fund performance.  

The full text of the Commission's July 30, 2010 letter is available at: