Alert August 17, 2010

SEC Staff Provides Derivatives Disclosure Guidance for Registered Funds

Although the staff of the SEC (the “Staff”) has not completed its review of derivatives use by registered funds, which, among other issues, is exploring the adequacy of derivatives-related disclosures (see the March 30, 2010 Alert for a more detailed discussion of the Staff’s review), the Staff provided initial observations on registration statement and shareholder report disclosures regarding derivatives use in a letter sent to the Investment Company Institute for communication to its members.

Prospectus Disclosure

The Staff observed that some funds provide generic disclosures about derivatives that are either too abbreviated or too detailed and technical, to be useful to investors.  The Staff indicated that all funds that use or intend to use derivative instruments should assess the accuracy and completeness of their disclosures and should (i) only reference derivatives in a fund’s principal investment strategies if they are expected to be used in connection with such strategies; (ii) describe the purpose that the derivatives are intended to serve in a fund’s portfolio, e.g. hedging, speculation, or as a substitute for investing in conventional securities; and (iii) disclose the extent to which a fund expects to use derivatives.  In addition, the Staff noted that disclosure about a fund’s principal risks that addresses derivatives should similarly be tailored to the types of derivatives used by the fund, the extent of their use, and why they are used.  The Staff suggested that a fund review its use of derivatives annually when it updates its registration statement and assess whether it needs to revise its principal strategy and principal risk disclosures that address derivatives.

Shareholder Reports

The Staff also provided observations regarding derivatives disclosure in shareholder reports.  The Staff observed that some funds whose financial statements appear to reflect significant derivatives exposure do not discuss the effect of those derivatives on fund performance.  The staff noted that Management’s Discussion of Fund Performance (MDFP) included in annual shareholder reports should be consistent with operations reflected in a fund’s financial statements, and a fund whose performance was materially affected by derivatives should discuss that fact, whether or not derivatives are reflected in the portfolio schedule at the close of the fiscal year.  With regard to financial statements themselves, the Staff noted specific improvements that funds should make in certain disclosures required by FASB Accounting Standards Codification Topic 815: Derivatives and Hedging.  In addition, the Staff stated that because an over-the-counter derivative is subject to the risk of nonperformance by the counterparty, the staff views identification of the counterparty to an over-the-counter derivative as a material component of the description of that position provided in a fund’s schedule of investments.