Crisis on Wall Street – What Now?

Recent developments in the financial markets have led to tremendous turmoil in the financial industry. In recent days, we have seen the merger of two large broker-dealers, the federal government’s takeover of Freddie Mac and Fannie Mae, the acquisition of one of the world’s largest brokerage houses by a consumer bank and yet another Fed bailout of one of the largest insurance companies. In addition, at least one money market fund has fallen below $1 per share in net asset value due to significant losses on debt issued by a troubled financial institution. The implications of these events on the fund industry are still evolving. Funds and their investment advisers will face difficult decisions as they seek to respond to the financial crisis and protect shareholder assets. This Fund Alert identifies some of the common issues that funds and their investment advisers will face in the wake of the recent market turmoil.

Money Market Funds. In order to maintain a constant share value, most money market funds use the “amortized cost” method of valuation. Under this method securities are valued at acquisition cost rather than market value, and interest earned on each security (plus any discount received or less any premium paid upon purchase) is accrued uniformly over the remaining maturity of the purchase. By declaring these accruals as a daily dividend to its shareholders, the fund is able to maintain a stable price of $1 per share. Money market funds should evaluate their holdings to determine if they can continue to utilize the “amortized cost” method of valuation if their holdings include securities of troubled financial institutions. Money market funds that hold troubled securities have, more often than not, received assistance from their affiliates in order to maintain their $1 per share price. The SEC Staff has been very willing and available to assist such funds with the necessary regulatory relief.

Valuation. Aside from the immediate impact of recent declines in securities prices to the value of fund holdings, funds must determine the appropriateness of their valuations of troubled financial institutions as market valuations of such institutions become more questionable in the face of rapidly changing circumstances.

Risk Assessment. Investments in derivative instruments involve counterparty risk. In light of recent market events, financial institutions that act as counterparties may face insolvency or otherwise risk defaulting on their obligations. Investment advisers are identifying the exposure of their funds to troubled issuers and counterparties and reporting the extent of such exposure to fund boards.

Shareholder Communications. As the value and risks of portfolio holdings change over time, funds should continue to evaluate whether prospectus and other shareholder communications accurately reflect evolving investment positions. Funds and their advisers will need to ensure that shareholder communications remain accurate in a rapidly changing marketplace.

Disclosure of Portfolio Holdings. Institutional and other investors seeking to manage their investments, as well as various financial intermediaries, may inquire about fund holdings of troubled financial institutions. In responding to such inquiries, funds must comply with their portfolio holdings disclosure policies.

Investments in Securities Related Businesses. Section 12(d)(3) of the Investment Company Act makes it unlawful for funds to acquire any security issued by, or any interest in the business of, any broker-dealer, any person engaged in the business of underwriting, or an investment adviser of an investment company, or a registered investment adviser. However, Rule 12d3-1 under the Investment Company Act provides an exemption from the prohibition of Section 12(d)(3) for acquisitions of certain securities. In light of increasing mergers and buyouts of troubled financial firms, funds investing in securities-related businesses should evaluate whether their investments in securities-related businesses continue to be exempt pursuant to Rule 12d3-1.

Securities Lending. Funds that have lent portfolio securities to troubled broker-dealers and other financial firms should consider whether to recall such securities. Funds may also reassess the value of collateral involving securities of such broker-dealers and financial firms to ensure sufficient coverage for loaned securities.

ISDA Issues. Funds and investment advisers should consider whether the bankruptcy of a counterparty or a Credit Support Provider to an ISDA Master Agreement has resulted in an Event of Default or other Termination Event. Even if the agreement is not in default, ratings downgrades may occur and further monitoring may be necessary to determine whether a right to early termination has been triggered. Failure of a counterparty to make a payment or transfer collateral in accordance with the terms of their Credit Support Agreement would also give rise to an Event of Default. If Automatic Early Termination for Bankruptcy has been designated, the agreement terminates as of the date of the bankruptcy filing.

We have received inquiries regarding the implication of these recent market events for funds and their investment advisers. Accordingly, we have established teams of Stradley attorneys to respond to such inquiries. The teams and their contact information are provided on page 3 of the Fund Alert.