The SEC recently brought an enforcement action against a mutual fund’s investment adviser for a violation of Section 17 of the Investment Company Act of 1940 (the “1940 Act”).  The enforcement order was notable, in that it involved cash collateral posted on total return and portfolio return swaps (“Swaps”).  Here is an overview of the enforcement order: 

  • To carry out the fund’s investment strategies, the investment adviser traded equities and derivatives including the Swaps;
  • Section 17 of the 1940 Act requires all mutual funds to comply with strict custody requirements.  Section 17(f)(5) of the 1940 Act generally provides that if a mutual fund maintians its securities and similar investments in the custody of a qualified bank (the “Fund Custodian”), the cash proceeds from the sale of such securities and similar investments and other cash assets of the fund must also be kept in the custody of the Fund Custodian;
  • According to the order, the investment adviser caused the fund to post contractually required cash collateral relating to the Swaps directly with the broker-dealer counterparties, instead of keeping the cash collateral at the Fund Custodian; and
  • The enforcement order noted that, “The cash collateral could have, for example, been maintained with the [Fund Custodian] subject to a tripartite agreement, that is, a three-way agreement between the [Fund Custodian], the counterparty, and the [fund].  These agreements are standard industry practice.“

As a reminder, not all derivatives require the use of a tri-party control agreement.  For example, Rule 17f-6 affords some relief for margin on qualifying exchange-traded futures contracts.  And, as described in our January 5th posting, SEC Extends No-Action Relief for Cleared Swaps for Another Year, the Rule 17f-6 relief has also been applied to collateral posted in respect of qualifying cleared swaps.

Finally, this particular enforcement action also involved circumstances relating to portfolio transactions, use of fund brokerage, and compliance issues related to Section 12 of the 1940 Act.  The enforcement order, which resulted in a $50,000 penalty, is available here.

Good day.  Good to keep custody in mind always. DR2