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SEC Settles with UBS over CDS Investment Strategy Change

The SEC announced a settlement with two UBS advisory firms for failing to disclose a change in the investment strategy of a closed-end fund that they advised. A joint venture between UBS Fund Advisor as the managing member and a small adviser was responsible for the day-to-day management of the portfolio. The fund’s offering memorandum stated that it would invest “primarily in debt securities . . . of U.S. companies that are experiencing significant financial or business difficulties,” and its Form N-CSR noted that it would seek to do so “with low volatility.” However, according to the SEC, the fund increasingly relied on credit default swaps (CDS), which changed the fund’s strategy from one that relied on debt securities increasing in value to one that relied on the securities decreasing in value. 

From 2000 to 2008, the fund invested in distressed debt and only had a “modest” exposure to credit default swaps. In 2008, the fund began investing more heavily in CDS such that its holdings grew from 2.6 percent to 25 percent by the beginning of 2009. The SEC’s order notes that this shift “dramatically changed the Fund’s risk profile” and made the fund more volatile. Despite the fact that the CDS holdings comprised less than a quarter of the fund’s NAV, they became the “primary driver” of performance. The SEC noted that the fund’s disclosed objective was a long-credit strategy, while investing in CDS is a short-credit strategy. The fund performed poorly over subsequent years, and the board voted to liquidate it in 2012.

The order did not charge the fund’s board with wrongdoing. It states that “from fall 2008 to May 2009 [the adviser] failed to ensure adequate disclosure to the Board of the Fund’s change in investment strategy.” According to the SEC, the adviser did not disclose “known risks” such as the results of stress tests that indicated large potential losses or the “substantial cost” of maintain the fund’s large CDS position. Further, it noted that materials including marketing brochures and shareholder reports misrepresented the investment strategy and that investor letters “contained false or misleading information about the fund’s exposure to credit default swaps.”

Julie Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, said that the adviser “completely reversed the fund’s strategy – from investing in distressed debt to betting against it – without adequately disclosing the change.” To settle the charges, the advisers agreed to pay $17.5 million, $13 million of which will be distributed to affected investors. The distribution amount includes $8.2 million of advisory fees and $4.9 million in investor losses calculated based on “a hypothetical portfolio in which the market value of the CDS positions was limited to no more than ten percent of the Fund’s net assets (an approximation of the point at which the Fund deviated from its stated 10 investment strategy).”