Have You Disclosed Your Derivatives Positions?


The Securities and Exchange Commission filed charges against a fund manager and its subadviser for their extensive use of derivatives. From April 2007 through October 2008, the Fiduciary/Claymore Dynamic Equity Fund engaged in derivative strategies to supplement the Fund’s primary investment strategy. But the Fund failed to include adequate disclosure about the risks to the Fund arising from the Fund’s use of derivatives, either in its annual report or in an amended Fund registration statement.

The Fund’s primary investment strategy was to invest in equities and write call options on a substantial portion of those equities. This covered call strategy trades upside potential in the equities held in the portfolio for current income from option premiums received.

Things changed in April 2007 when the Fund supplemented its income and returns by writing out-of-money S&P 500 put options. The Fund collected a premium from the purchaser of the option, and in exchange agreed to compensate the purchaser for any declines in the S&P 500 beyond the strike price of the option. Between April 2007 and August 2008, the Fund collected $9.6 million in premiums from written put options. For the six months ending May 31, 2008, written put options  added approximately 2.1% to the Fund’s return.

Then the financial markets collapsed in October 2008. The Fund lost  $45,396,878, or 45% of the Fund’s NAV in its undisclosed derivates strategy.

The Fund was a registered investment company so some of the violations stem from the failure to make proper disclosures under the Investment Company Act. The SEC also found violations under the anti-fraud provisions of the Investment Advisers Act, Section 206(4) and Rule 206(4)-8. Those provisions prohibit the making of any untrue statement of a material fact or the omission of a material fact necessary to make statements made not misleading, or to otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in a pooled investment vehicle.

If derivatives are substantial part of a fund’s portfolio, it sounds like the SEC expects you to disclose that fact to investors.