A recent settlement order serves as a reminder of how investment strategies using derivatives can produce unanticipated results. In this case, the results led to undisclosed returns of capital and a $6.5 million civil penalty. The case illustrates the importance of instituting regular communications among portfolio managers, risk and compliance officers, attorneys and accountants, so that the results of an investment strategy are fully anticipated.

Swaps and Taxes

I am not a tax attorney, so the following is not tax advice. Any inaccuracies only emphasize the need for the measures discussed at the end of this post.

The fund involved in the settlement “disclosed that income would be generated by, among other means, the Fund ‘active[ly] manag[ing] duration and yield curve exposure’ of its debt portfolio, which … consists of income-producing debt securities, including interest rate swaps.” For several years, the fund engaged in a strategy of pairing current and forward interest rate swaps. The current swap paid a fixed rate of interest to the fund in exchange for the fund’s payment of a floating rate of interest. The fixed rate was higher than the initial floating rate, so the fund received net payments at the outset of the swap.

The fund also entered into an offsetting forward swap—a swap that sets the fixed and floating rates but delays when payments begin. The forward swap was the inverse of the current swap because it required the fund to pay a fixed rate and receive a floating rate. The forward swap may have been intended to hedge the risk that the floating rate might rise above the fixed rate during the term of the current swap. In this circumstance, the fund would use the net payments received from the forward swap to make the net payments that would be due on the current swap.

The Fed kept short-term rates low during the period in question, so the current swaps provided income to the fund throughout their terms. This led the fund to close out the forward swaps before they started requiring net payments from the fund. The forward swaps were “out of the money” (i.e., because the fixed rate was greater than the floating rate on those swaps), so the fund had to pay a close-out amount to the other party.

One consequence of this strategy was that the current swaps produced ordinary income for income tax purposes while the close-out payments for the forward swaps produced capital losses. Tax laws require mutual funds to distribute nearly all of their net income to shareholders, but the laws generally do not allow capital losses to be deducted from ordinary income. To comply with this requirement, the fund included all the income produced by the current swaps in taxable dividends paid to its shareholders, even though the fund had already used some of the income to make the close-out payments. “Under those circumstances, portions of [the] dividend distributions … were economically equivalent to a return of capital.”


Given this conclusion, it is surprising that the SEC did not find a violation of Section 19(a) of the Investment Company Act, which requires a fund to disclose when dividends are paid from capital rather than income or gains. Instead, the SEC cited the failure to disclose that a significant portion of the dividends came from paired swaps “and that the forward leg of the paired swaps had a substantial risk of capital loss and a downward effect on the NAV” as violating disclosure requirements of the Investment Company Act and the Investment Advisers Act.

Compliance Countermeasures

When funds that I represented in the 1990s started to use derivatives, they encountered tax and other issues similar to those outlined above. This led their adviser to institute the following measures.

  • The adviser established a multidisciplinary (investment, risk, compliance, legal and accounting) committee to review and regulate complex instruments and strategies. The committee sought to consider all aspects of a proposed investment: risks, effects on performance, pricing, disclosure, legal terms, tax, accounting, and board oversight.
  • Disclosure attorneys and portfolio managers met in advance of each annual update to the registration statement to review the investment strategy and risks. This provided an opportunity for the portfolio manager to discuss any changes in the investment strategy and consider whether further disclosures were advisable.

The adviser in this case may well have taken both of these measures: no system is infallible. But many funds will find such measures helpful, even though the use of derivatives has become commonplace.