Risk Management By U.S. Mutual Funds Facing European Sovereign Debt Risk

Introduction

In the face of a potential sovereign debt crisis in one or more European countries, management and boards of registered investment companies (hereinafter "mutual funds" or "funds")1 should consider a variety of potential hazards as part of an effective risk management program. The most obvious risks arise from direct investment exposure to the sovereign debt of Greece and the other potentially risky sovereign issuers in the European Monetary Union ("eurozone"). How-ever, other material risks exist that may be harder to detect and quantify. These risks include indirect investment exposure (e.g., banks that have exposure to sovereign debt) as well as liquidity and valuation risks, operational risks and risks from derivatives and other contracts in the aftermath of a default, redenomination or other deleterious event. In addition, it is critically important that the fund's disclosure documents adequately identify and explain any applicable material risks. This DechertOnPoint will highlight certain key considerations for mutual funds, particularly non-money market funds, as they navigate these events.2

Risk Management

Overview of the Risk Management Process

The 2007-08 financial crisis highlighted the importance of enterprise risk management for all types of financial institutions,3 including mutual funds. In the aftermath of these events, most funds have taken steps to address risk management in a more systematic and comprehensive manner.4 Some funds (and many fund advisers and other service providers) have appointed chief risk officers and/or established risk committees or other formalized processes to ensure that all aspects of potential risk (e.g., investment, compliance, operational, credit/counterparty, financial reporting and reputational risk)5 are adequately considered, addressed and disclosed by funds.6 The Securities and Exchange Commission ("SEC or "Commission") has also added specific disclosure requirements relating to the fund board's role with respect to risk management.7 Consequently, risk management issues have become a regular topic for discussion at many fund board meetings.8

As with other aspects of fund operations, the primary responsibility for risk management lies with the fund's management and service providers, while the board's responsibility is one of oversight, e.g., verifying that fund management is considering these issues and that reasonably designed processes are being put in place and followed.9

No risk management program can eliminate all risk. In fact, some managers may take on additional eurozone risk voluntarily, in return for enhanced opportunities to profit from market uncertainty. The key issue is that funds should take reasonable efforts to identify, manage and disclose potentially applicable risks.

Risks Relating to a Potential Eurozone Crisis

There are a number of direct and indirect risks arising from a potential eurozone crisis. Because of the changing parameters of this situation (including the continuing European and international efforts to avoid a full-blown crisis, the nations identified as potentially troubled issuers10 and uncertainties about the potential exposure of various financial institutions),11 the list below is not intended to be exhaustive. Moreover, as events unfold, a fund's risk management efforts need to be ongoing and responsive to changing develop-ments.12 Following is a discussion of some of the most significant risks at the current time.

Defaults or Downgrades, Falling Values and Increased Volatility

Eurozone Sovereign Issuers

The most direct investment risk that a fund can face is where a fund holds a debt security from sovereign issuers that suffer downgrades or defaults. This direct exposure should be easy to quantify, although there are differing, and changing, views of the risks of certain European sovereign issuers, such as Spain and Italy. A fund's holding of a derivative instrument directly exposed to a sovereign issuer, such as a credit default swap under which the fund is selling protection, should also be considered when evaluating direct investment exposure.

As noted above, some funds may choose to invest in distressed sovereign debt or related derivatives that they believe present attractive investment opportuni-ties. In such cases, these investment exposures should be reviewed to ensure that the investments are consis-tent with the fund's investment program and that all material risks have been disclosed to fund investors. Such exposures should generally be reported to, and discussed with, the fund's board.

Indirect Exposure to the Eurozone

A fund's potential investment exposure is obviously not limited to direct holdings of sovereign debt. A number of large financial institutions, particularly in Europe, are known to have considerable exposure to the sovereign debt of Greece and other financially troubled countries. A financial institution's exposure can be both direct (holding sovereign debt) and indirect (writing credit protection). Other types of issuers may also have substantial exposure to the eurozone. For example, a company domiciled outside of the eurozone may be negatively impacted if it derives a substantial portion of its revenue from sales to European governments or European consumers. Because the austerity measures brought about by this crisis have also impacted the healthier European economies, including Germany, France, the UK and the Netherlands, these indirect investment impacts are likely to be wide-ranging.13

In contrast to direct exposure to sovereign issuers, these types of indirect exposures are more difficult to quantify. Nevertheless, fund advisers should be actively considering the ways that their funds may be indirectly exposed to the eurozone crisis and discussing these potential exposures with the fund's board as part of the board's ongoing assessment of investment risk.

Liquidity and Valuation Risks

Liquidity and Valuation Risks Relating to Currency Redenomination

There are a number of possible ways that liquidity could be impacted by developments in the eurozone. One example is if a country were to leave the Euro. While there is no formal mechanism currently in place to enable a country to leave the Euro and return to its local currency, there has been increased speculation that one or more eurozone countries may revert to their legacy currencies either voluntarily or by action of the EU.14

Depending upon how the currency denomination occurs (i.e., negotiated exit versus unilateral withdrawal from the eurozone), there are numerous events that could impact liquidity, including market closures, mandatory bank holidays, restrictions on currency convertibility, rapid devaluation and other events. Moreover, it is conceivable that the economic contagion could result in more than one country leaving the eurozone and returning to its legacy currency, or the eurozone splitting into two groups: a "strong Euro" group and "weak Euro" group.15 If any of these events occur, a fund would be forced to quickly assess both the valuation and liquidity of its impacted holdings. The SEC Staff has specifically cited to market closures as a type of situation where market prices would not be considered "readily available," and consequently assets that are located in an affected country would likely have be fair valued.16 At the same time, securities impacted by any of these events (which may include the sovereign debt of other eurozone members facing financial difficulties) may not meet the test for being deemed a liquid security (i.e., an asset which may not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment).17

In light of these risks, funds should review their current valuation and liquidity policies and procedures to determine whether they are adequate to address these types of events. In particular, fund management...