Alert January 29, 2013

SEC Settles Administrative Proceedings Against Registered Closed-End Fund Adviser and Subadviser Over Inadequate Disclosure of Fund Derivatives Activities

On December 19, 2012, the SEC issued orders (the “Orders”) settling administrative proceedings against the adviser (the “Adviser,” whose order can be found here) and subadviser (the “Subadviser,” whose order can be found here) to a registered closed-end investment company (the “Fund”) regarding various failures to properly disclose certain derivative strategies implemented by the Subadviser in the registration statement (the “Registration Statement”) for the Fund under the Investment Company Act of 1940 (the “1940 Act”) and the Fund’s annual and semi-annual shareholder reports filed with the SEC (the “Shareholder Reports”).  This article summarizes the SEC’s findings, which the Adviser and Subadviser have neither admitted nor denied.


The Adviser is an SEC-registered investment adviser that served as investment adviser and administrator to the Fund.  The Adviser delegated day-to-day management of the Fund’s portfolio to the Subadviser; however, under the Adviser’s fund policies and procedures manual (the “Fund Manual”) and its advisory agreement with the Fund, the Adviser continued to be responsible for supervising the Subadviser.  In its capacity as administrator, the Adviser was responsible for monitoring on a post-trade basis the Fund’s compliance with the investment objective, policies and restrictions set out in the Registration Statement.  Under the Fund Manual, the Adviser was responsible, in conjunction with Fund counsel, for preparing the Fund’s Registration Statement and for updating the Registration Statement as necessary to reflect any material changes in the Fund’s investment policies and principal risks.  As administrator, the Adviser was also charged with managing the preparation, filing and distribution of the Shareholder Reports including commentary provided by the Fund’s portfolio managers at the Subadviser.

The Subadviser is an SEC-registered investment adviser that served as subadviser to the Fund and, subject to the Adviser’s oversight and supervision, was responsible for managing the Fund’s portfolio in accordance with the investment objective, policies and restrictions in the Registration Statement.  The Subadviser was also responsible for reviewing and confirming certain information included in the Shareholder Reports. 

As stated in the Registration Statement, the Fund’s primary investment strategy was to invest in equities and write call options on a substantial portion of those equities to generate current income.  The Fund was marketed on the basis of its income potential and had a goal of paying an annual dividend equal to an 8.5% yield on the Fund’s initial public offering price. 

The Derivative Transactions

In April 2007, the Fund started writing out-of-the-money S&P 500 put options and entering into short variance swaps (together, the “Derivative Transactions”).  The Derivative Transactions went on to be part of the Fund’s portfolio from July 2007 to October 2008 except for a 2 month period during this timespan. In writing (selling) an out-of-the-money S&P 500 put option, the Fund received a premium from the purchaser of the option in exchange for agreeing to compensate the purchaser if the S&P 500 declined during a specified period below a specified price, which typically was set between 6%-10% below the S&P 500’s current level at the time the option was written.  Throughout 2008, the Fund’s notional exposure on out-of-the-money S&P 500 put options ranged from 60% to 140% of the Fund’s net asset value. By entering into a variance swap, the Fund would seek to profit based on whether market volatility ended up being higher or lower than expected.  With short variance swaps, the Fund would profit if the market was less volatile than expected.       

The SEC found that from April 2007 through August 2008, the Fund’s Derivative Transactions contributed materially to the Fund’s performance.  For the twelve month period ending November 30, 2007, written put options added approximately 2.0% to the Fund’s net asset value, contributing to the Fund’s 12.87% total return for this period.  For the six month period ending May 31, 2008, written put options and variance swaps added approximately 2.1% and 0.8%, respectively, to the net asset value of the Fund, contributing to the Fund’s 0.37% total return for this period.  By comparison, the S&P 500 returned 7.72% and -4.50%, respectively, during these periods.

The SEC also found that the use of the Derivative Transactions materially altered the Fund’s risk profile by increasing its sensitivity to market declines and volatility, and that in September and October 2008, the Derivative Transactions lead to significant losses for the Fund.  During that two-month period, the Fund realized losses of approximately $45.4 million on its five Derivative Transactions.  This represented a decline of 45% of the Fund’s net assets, contributing significantly to an overall decline in its net asset value of 72.4%.  By comparison, during this same period, the S&P 500 declined 24.5%.

Disclosure Regarding the Derivative Transactions 

The Registration Statement

Form N-2, the SEC registration form used by the Fund, requires a fund to describe its investment policies, the types of investments it makes or intends to make, and the principal risks associated with the fund’s investment policies and investments.  Furthermore, Rule 8b-16 under the 1940 Act requires a closed-end fund to update its 1940 Act registration statement on an annual basis or disclose certain matters, including any material changes to its principal investment policies and practices and the principal risks associated with such investment policies and practices, in its annual report to shareholders.    

The Registration Statement did not include a description of the Derivative Transactions in the list of principal strategies to be employed by the Fund or in the description of the types of investments the Fund would make under normal conditions.  Specifically, the Registration Statement stated that the Fund could use a variety of derivative strategies, including “purchas[ing] and sell[ing] exchange listed and over-the-counter put and call options on securities, equity and fixed income indices and other instruments, purchas[ing] and sell[ing] futures contracts and options thereon and enter[ing] into various transactions such as swaps, caps, floors or collars.”  The statement of additional information also noted that the Fund could use index options, but did not include any detail on the extent to which these options would be used.  Although the Registration Statement did reference the potential use of swaps, there was no specific disclosure in the Registration Statement regarding the use of variance swaps. 

The “Risks” section in the Registration Statement did not describe the principal risks associated with the Derivative Transactions.  In describing the risk disclosures in the Registration Statement, the SEC noted that “there was no mention of the downside risks the Fund could face by trading index put options and variance swaps, including the Fund’s leveraged exposure to market declines and to spikes in market volatility.  While the Registration Statement included a generic warning that the use of derivatives could leave the Fund worse off, depending on the adviser’s ability to correctly predict movements in the securities and interest rate markets, it did not include anything specific regarding the type of market movements that could harm the Fund or the particular risks associated with writing index put options and trading variance swaps.”  The SEC found that the risk disclosures regarding index options focused on the risk that they might be imperfect hedges for the portfolio rather than on the specific risks associated with these types of transactions. 

The Shareholder Reports

The Shareholder Reports typically included commentary from the Fund’s portfolio managers at the Subadviser (the “Portfolio Manager Commentary”) which discussed the Fund’s performance during the relevant period, including which investments contributed to or detracted from the Fund’s performance.  The SEC found that, despite the fact that the Derivative Transactions had contributed significantly to the Fund’s performance in 2007 and during the first half of 2008, neither the 2007 annual shareholder report (the “2007 Annual Report”) nor the 2008 semi-annual shareholder report (the “2008 Semi-Annual Report”) mentioned these strategies or their contribution to the Fund’s performance.  For example, in the 2008 Semi-Annual Report, in response to the question about which investments had contributed most to the Fund’s performance, the Portfolio Manager Commentary stated “industry stock selection, the covered call strategy, and the hedge program” and that “during most of this period, the portfolio was strategically hedged for additional downside protection, and that proved to be a good decision as equity markets trended downward.”   There was no mention of the fact that the Fund had actually generated significant income from the Derivative Transactions during this period.  Moreover, the S&P 500 actually increased during most of this period so the Fund actually lost money as a result of its long put options and long variance swaps (i.e., its hedging strategy).

Defects in Disclosures Regarding the Derivative Transactions

The SEC found that the Subadviser used the Derivative Transactions during 2007-2008 to such an extent that “those strategies became an integral part of how the Fund sought to achieve its investment objective and, those strategies exposed the Fund to new and material risks”; however, neither the Adviser nor the Subadviser took steps to include disclosures on these strategies or the principal risks associated with these strategies in either an amendment to the Registration Statement or in the Fund’s 2007 Annual Report, as required by Rule 8b-16.   

The SEC also found that the Portfolio Manager Commentary in the 2007 Annual Report and 2008 Semi-Annual Report failed to disclose the impact of the Derivative Transactions on Fund performance and also misrepresented the Fund’s exposure to downside market risk by claiming that the Fund was strategically hedged against downside market risk when the Derivative Transactions had in fact increased sensitivity to market declines and volatility.

The Portfolio Manager Commentary was prepared by the Adviser based on interviews with the Fund’s portfolio managers and was reviewed and approved by the Subadviser.  By virtue of being, among other things, apprised of the Fund’s portfolio on a daily basis, the Adviser was aware that the Subadviser was using the Derivative Transactions and that these transactions had contributed to the Fund’s performance.  Additionally, the Subadviser regularly prepared attribution reports regarding the Fund’s performance and was also aware of the extent to which the Derivative Transactions had contributed to Fund performance.  The SEC found, however, that neither the Adviser nor the Subadviser corrected the Portfolio Manager Commentary in the 2007 Annual Report or 2008 Semi-Annual Report and as a result these Reports contained misleading statements and omissions regarding the contributors to the Fund’s performance and the risks associated with the Derivative Transactions.

Violations – The Adviser

  • Rule 8b-16 under the 1940 Act – The SEC found that by not providing appropriate disclosures regarding the Derivative Transactions in an amendment to the Registration Statement or in the 2007 Annual Report, the Adviser caused the Fund’s violations of Rule 8b-16.  
  • The SEC also found that Adviser failed to reasonably supervise the Subadviser.

Violations – The Subadviser

  • Section 34(b) of the 1940 Act – The SEC found that Subadviser willfully violated Section 34(b) of the 1940 Act, which prohibits any person from omitting material facts in any reports or documents filed with the SEC.
  • Section 206(4) and Rule 206(4)-8 under the Advisers Act –  The SEC found that Subadviser willfully violated Section 206(4) and Rule 206(4)-8 under the Investment Advisers Act of 1940 (the “Advisers Act”), which prohibits fraudulent, deceptive or manipulative practices with respect to investors in a pooled vehicle.


Adviser.  In addition to agreeing to censure and a cease and desist order, the Adviser established a plan to distribute up to $45 million to former shareholders of the Fund as reimbursement for 100% of the losses attributable to the Derivative Transactions between September and October 2008.  In determining to accept the Adviser’s offer, the SEC took into considerations certain remedial measures the Adviser has taken to strengthen its compliance program.     

Subadviser.  In addition to agreeing to censure and a cease and desist order, the Subadviser also agreed to pay disgorgement of $644,951, prejudgment interest of $134,978 and a civil penalty of $1.3 million.    

Proceedings Instituted Against the Fund’s Portfolio Managers

The SEC has instituted administrative proceedings against the two individuals employed by the Subadviser who served as portfolio managers of the Fund, related to the matters that are the subject of the Orders.  Consistent with its findings with respect to the Adviser and Subadviser, the SEC alleges violations of Section 206(4) and Rule 206(4)-8 under the Advisers Act, and Section 34(b) and Rule 8b-16 under the 1940 Act.  In addition, the SEC has alleged violations of Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder, which prohibit the use of manipulative and deceptive practices in connection with the purchase and sale of securities.