Lawyers may seek more disclosure of mutual funds' derivative risks

ABA task force will release preliminary recommendations to the SEC in November

Aug 16, 2009 @ 12:01 am

By Sara Hansard

An American Bar Association task force studying mutual funds' use of derivatives will likely recommend measures to ensure that investors and fund directors are better-informed about the risks associated with the use of the complex financial instruments.

The Task Force on Investment Company Use of Derivatives and Leverage is also weighing whether the Securities and Exchange Commission should impose specific limits on the ability of funds to invest in derivatives that raise leverage. It may also recommend that funds be required to quantify and disclose the amount of risk posed by their use of derivatives, according to people on the committee.

“We are looking broadly at topics of disclosure, risk controls and leverage limits,” said Daniel Hirsch, a member of the 14-person task force and a partner in the Washington office of Boston-based Ropes & Gray LLP. Although the Investment Company Act of 1940 limits the amount of leverage a fund may carry, the SEC hasn't imposed specific limits on a fund's use of derivatives, in part because derivatives are often used by funds to hedge against risk. “These limits were structured when derivatives didn't exist,” said Jay Baris, chairman of the task force and a partner in Kramer Levin Naftalis & Frankel LLP of New York. “A whole world of derivatives has evolved,” he said. “The SEC is struggling to keep laws and regulations in sync with these developments.” The task force expects to release its preliminary findings in November. It was formed last spring after Andrew “Buddy” Donohue, director of the SEC's Division of Investment Management, challenged the Chicago-based ABA to look into the matter. In recent years, the SEC has issued no-action letters and other forms of guidance addressing how mutual funds may use derivatives. “We constantly get hit with questions,” Mr. Donohue said. “We want to step back and see if there's an approach we could take that better reflected the marketplace,” Although the SEC is un-likely to issue any rule proposals on the matter this year, “it's one of the things I really would like to address,” Mr. Donohue said. In the wake of the financial crisis, derivatives have come under fire in Washington. Many experts contend that the use of derivatives by financial services firms exacerbated the financial crisis.


Last week, the Obama administration unveiled a sweeping plan to monitor more closely the market for derivatives by forcing many of the products to trade on regulated exchanges or electronic venues.

The ABA's task force is unlikely to recommend banning the use of derivatives by mutual funds altogether, because derivatives can improve the efficiency of certain investments since it may be cheaper to buy a derivative based on an underlying investment than it is to buy the investment itself.

The task force is compiling drafts on different aspects of the use of derivatives by funds, and it hasn't come to a consensus on what recommendations it will make to the SEC, Mr. Hirsch said. Simpler disclosures aimed at retail investors could be in-cluded in fund prospectuses, while more detailed, technical disclosures could go into the statement of additional information, he said. “Disclosure is critical,” said Eric Jacobson, a mutual fund analyst at fund research firm Morningstar Inc. in Chicago. “Even though there's always been skeletal data in the reports that the fund companies make to the SEC, there hasn't been enough detail for the average investor or even the average intermediary like a financial planner or broker. [Regulators] need to come up with standards for what information has to be disclosed.” The use of derivatives by mutual funds caught the eye of regulators last year after some fixed-income funds posted steep declines as a result of investments in derivatives. Such investments, for ex-ample, caused the Oppenheimer Core Bond A Fund (OPIGX) to lose 35.83% in 2008, compared with a 5.3% gain for its benchmark, the Barclays U.S. Aggregate Bond Total Return Index, according to Morningstar. “Oppenheimer is the cautionary example of what can go wrong,” Mr. Jacobson said. No one at OppenheimerFunds Inc. of New York would be made available to comment last week, Katherine Herring, a spokeswoman for the firm, wrote in an e-mail. In addition to improved disclosure of funds' use of derivatives, fund board oversight is an issue on which the task force is focusing, Mr. Hirsch said. “It's a very important control,” he said. “The people overseeing the fund adviser must understand the trading technique.” Mutual fund consultant Burton Greenwald agrees. “There has to be some oversight in respect to consistency with the funds' investment charter and disclosure,” said Mr. Greenwald, the managing director of B.J. Greenwald Associates, a Philadelphia-based fund consulting firm.


The task force is also looking at how funds measure risk resulting from the use of derivatives, Mr. Baris said.

The SEC may not have the authority to regulate risks taken by funds, he said. However, “it does regulate risk indirectly through disclosure,” Mr. Baris said.

Extra disclosures regarding fund risks associated with derivatives could be required.

Some fund experts think more attention needs to be paid by funds to risk management pertaining to derivatives.

“The money management firms need to have strong risk management processes to assure that the organization doesn't be-come unreasonably exposed to the vagaries of the derivatives market,” said Geoffrey Bobroff, president of Bobroff Consulting Inc. of East Greenwich, R.I., a fund consulting firm.

E-mail Sara Hansard at


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