Fund Sponsor to Pay Over $35 Million Resulting from Derivatives Exposure

A large fund sponsor agreed to pay over $35 Million in penalties, disgorgement, and interest to settle SEC charges that it misled investors about derivatives exposure in two bond funds. The funds at issue had a significant exposure to the CMBS market through investments in total return swaps. The SEC alleges that the firm and its wholesalers painted a too rosy picture of the CMBS market outlook during 2008 as the market declined and the funds engaged in a strategy to trim their exposures. The SEC also charges that the fund prospectus, although disclosing that the fund would invest in derivatives, did not adequately disclose the extent of the investments or the risk in the event of a market downturn. The SEC cites violations of the anti-fraud rules.

OUR TAKE: The SEC makes clear that advisers and fund sponsors have responsibility for prospectus disclosure, even if the Supreme Court disagrees (See Janus v. First Derivative Traders). With respect to the facts of this case (known only from the SEC action), we are concerned that the respondents have been judged through the lens of 20/20 hindsight. For example, did the wholesalers really mislead investors, or were they just expressing the firm’s opinion on the future of the CMBS market? Is it really inconsistent to make bullish market remarks while paring the fund’s risk position? Is it really fair to criticize prospectus disclosure written before the onslaught of an unprecedented credit crisis?

http://www.sec.gov/litigation/admin/2012/33-9329.pdf