SEC Division of Investment Management staff letter: Chief Financial Officer of Investment Company Registrants

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INVESTMENT MANAGÈMENT
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d °,':1 H.eh1l1 ty l'lbY'ifd V'l/ J 1''7"', s' """"'-' "h"~_-t",::." ',: -"~",- r /, I 'i,' , Dear Chief l"nè1I,,:iil gff1f'~1"' ~".-""-""i,e~i'~t&¡;;itúi,.j

The accounting staff of the Division of Investment Management has prepared this

supplementa letter to our November 1, 1994 letter to assist investment company registrants and their independent public accountats in addressing certn timely accounting-related matters.

These comments represent the views of the staf of the Division of Investment Management and are not necssaly those of the Securities and Exchange Commission (the "Commission"). The comments addressed in this letter apply to fiings made by registered investment companies, including reports to shareholders. While we do not anticipate issuing a regular supplement to our annua accounting letter, this letter is precipitated by the occurrence of certain accounting￾related events that we believe merit timely communication. A. Applying SF AS 1/ 119 to Invesment Companies

In October 1994, the Financial Accouòting Stadads Bod issued Statement of Financial Accounting Stadards # i 19, Disclosure About Derivatve Financial Instruments and Fair Value of Financial Instruents ("SFAS # 119" or lIthe Stadad") which requires financial statement disclosures about certn derivative financial instrments. Paragraph 9 of the Stadard makes a distinction between financial instruments held or issued for trading purpses and financial instruments held or issued for purpses other than trading. The Staff recognizes that funds

could have instruments in their portfolios from both categories, depending on the purpose for which the derivative is held or issued. Investment companies should designate each derivative covered by the Standard as either held or issued for trading purpses or held or issued for purpses other than trading, and should make the designation at the time the derivative financial instrument is acquired. Funds have a continuing obligation to regularly evaluate the appropriateness of the original designations which could lead to changes in a designation, and, accordingly, differences in disclosure requirements during the holding period of the instrument. B. Presntation and Accounting for Enhanced Seurities

The staff has recently addressed several issues related to the accounting for and financial statement presentation of enhance seurities!. These issues have included 1) the separate

valuation of the components of such investments; 2) the appropriate financial statement presentation of these components; and 3) the contrbution. to capita to be recognize for the

enhancement.
Enhanced securities include separate and distinct credit mechanisms provided to maintain the carrying value of an investment.

(1) Valuation
The credit enhancements have ben segregate into the two commonly used types,

typicaly issued through the adviser: non-trasferable put options (which ~xpire at or prior to maturity of the enhanced seurity) and non-trsferable letters of credit ("LOCs") (which expire at maturity of the enhanced seurity)2. For these enhancements, the staff believes that valuing each component separtely is appropriate. For example, a seurity with a market value of 70, linked with a 90-day put option (or LOC) allowing the fund to put the security to the adviser (or draw against the LOC) for 95, would be valúed at 70; the value attributable to the enhancement would be 253. 'I (2) Presntation '4 Separte and distinct disclosure of the components of a credit -enhance security provides a more complete and meaingful presentation to fund shareholders, and is required by Items 6-04.1 and 6-04.3 of Regulation S-X which require the disclosure of investments in securities of unaffiliated issuers separte from the disclosure of investments other than seurities. The staff would not object to presentation of separte, contiguous disclosure on the face of the portfolio of investments schedule of the seurity (at market value without the enhancement) and the enhancement (valued at the difference between caing value of the seurity with the enhancement and market value of the seurity without the enhancement). For put options, the presentation on the portfolio of investments schedule should describe the option as being from an affiiate pary (if applicable) with the name and relationship of the affiliate, and any terms and conditions of the put discusse in a note to the financial statements. If the enhancement is a LOC, the name of the financial institution providing the LOC should be separately disclosed in the notes to the financial statements along with the terms, conditions and other arangements related to the LOC. 4 Disclosure should also comply with the requirements of Statement of Financial Accunting Stadads number 57 - Related Part Disclosures ("SFAS 57"), issued by the Financial Accounting Stadads Board. The staff views the relationship between an adviser and a financial institution issuing a LOC (as an enhancement) as being encompasse by SF AS 57. (3) Transferrble Enhancements The separate valuation and presentation of the components of investments with transferable enhancements (regardless of when the enhancement attaches) would not be required. The presentation of securities with trsferrble enhancements on the portfolio of investments

schedule should identify the name and relationship of the issuer of the enhancement. The terms,
conditions and other arangements relate to the enhancement should be disclosed in the notes to the financial statements.

2 Although not specifically addressed here, "portolio insurance", not tied to an individual security

but guaranteeing the timely payment of interest and principal for investments in the portfolio,

is also considered a form of enhancement requiring the disclosure, valuation and capital

recognition discussed herein.

The views expressed herein do not address and are not meat to resolve the issues presented by Sections 17(a) and (d) of the Investment Company Act of 1940 which prohibit certain tranactions between an investment company and affliated persons. 4 Separate disclosure is not required for the components of a security which at the time of the

funds purchase included a LOC. .

2

(4) Contribution to Capital
In keeping with related guidance,:i the staf believes a contrbution to capita is made at the time the enhancement (whether transferrable or non-trasferrable) becomes available to the fund. The amount of the contrbution is measured by the cost of obtaning a similar enhancement in an arm's-length transaction. Any change in the value of the enhancement would be recorded as unreaized

appreciation or depreciation. There would be nò adjustment to contributed capita as a result of a change in value of the enhancement or the disposition of that enhancement.

This letter contans information of importce to the company's indepndent public açcountat; therefore, we encourage these items to be discusse with them. Any questions on the contents of this letter or related matters can be addressed to me, Anthony S. Evangelista or Janies F. Volk, Assistat Chief Accountats, at (202) 942-0590. Very truly yours, ~M-"U- d, ~--

Lawrence A. Fnend
Chief Accountat
See letter to Chief Financial Offcers from Lawrence A. Friend dated November 1, 1994. 3