June 2007
Volume 4, Number 4
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Securities Lending:
A Q&A with Robert A. Wittie of K&L Gates
Securities lending has been a topic of great interest in
the mutual fund industry lately. The SEC staff recently
conducted a securities lending sweep examination. In
addition, some boards have been reevaluating their
securities lending programs. In light of this attention,
Board Update asked Robert A. Wittie of K&L Gates, a
legal expert on securities lending, to provide his insights
about board oversight of securities lending
arrangements.
BU: What types of securities lending programs do you
see in your law practice?
RW: Funds generally engage in securities lending through a lending agent,
which may be the fund’s custodian or a third party. However, some funds enter
into direct lending arrangements with borrowers, often on an exclusive basis.
Another route to market is an auction process that combines elements of both
agency and direct lending.
BU: What questions should directors ask when a fund is considering whether
to engage in a securities lending program?
RW: Directors should assess the type of program the fund’s investment
adviser is recommending, and ask what alternatives were considered and how
the proposed program compares with those alternatives. Similarly, if an agent
would be used, directors will want to know the agent’s qualifications, including
its experience and its operational and systems capacity. If no agent is used,
directors should ask how lending will be implemented and monitored. Directors
also may want to ask about the style of the program—will the focus be on
lending a large volume of the available securities, on primarily making highreturn “special” loans, or a mix of the two—and how that style fits the nature of
the fund portfolios and lending objectives.
BU: How does a board weigh the potential benefits and risks of a securities
lending program?
RW: Directors typically will want to look at the projected net benefits to the
fund, including the expected return and anticipated fees and costs. In doing so,
they may want to inquire as to the reasonableness of the assumptions used in
order to make those projections, such as the percentage of the fund’s assets
expected to be on loan. They also may want to inquire about any potential
downsides. For example, because the payments that lenders receive in lieu of
dividends on loaned securities will not constitute qualified dividend income,
directors of funds investing in dividend-paying stocks may want to consider the
tax effects of lending these securities during dividend dates.
BU: Once the decision has been made for a fund to engage in securities
lending activities, what should directors do on an ongoing basis?
RW: Initially, the board should approve
securities lending policies that establish the
parameters for the fund’s lending program—
approved borrowers, restrictions on the portion
of a fund’s portfolio that may be loaned,
required collateral levels, and similar matters.
After the securities lending program is in
place, the board, in conjunction with fund
management, should periodically review the
appropriateness of those policies. The board
should ensure that it receives periodic
performance reports and that loan transactions
and operations are being appropriately
monitored for compliance with the fund’s policies.
The board, in conjunction with fund management, also should periodically
evaluate the program performance and costs. Performance can be compared
with projections and, using available data sources, usually can be compared
with the performance of other, comparable portfolios. Special monitoring would
be necessary if loans are made to affiliated borrowers or through an affiliated
lending agent. Exemptive relief is usually necessary in order to have these
affiliated arrangements.
BU: What risks might arise with regard to securities lending?
RW: One risk is that loaned securities may not be returned in a timely fashion.
This is more likely to occur with thinly traded securities that, of course, are the
very securities for which there is likely to be high loan demand and that,
therefore, may generate higher returns. Directors also may want to ask fund
management whether non-returns could cause other disruptions that would be
of concern.
BU: What can be done to protect against that risk?
RW: Funds can mitigate the risk of financial losses from non-returns in several
ways, such as by verifying the creditworthiness of borrowers, obtaining
sufficient collateral, and obtaining guarantees against collateral shortfalls from
their lending agents. Lending agents can further mitigate this risk by finding
alternative sources to replace the unreturned securities.
BU: What other risks need to be considered?
RW: Historically, the more significant securities lending losses have resulted
from aggressive cash collateral investment strategies. Funds normally protect
against such losses by investing cash collateral in conservative, short-term
investments having average maturities or durations that are appropriately
matched to those of the loans. Conversely, however, funds need to be
confident that their cash collateral investment programs, taken together with
any fee income and after deducting any agency fees and other costs, will yield
returns that are sufficient to generate the anticipated profits.
Beyond that, there are operational and administrative risks that can be
addressed through sound and well-conceived systems and procedures.
BU: What else should directors consider when establishing a securities lending
program?
RW: Directors should inquire as to the procedures and other protections that
will be in place to ensure that lending securities will not be disruptive to
management of the fund. They should also determine what procedures will be
in place to enable the fund to learn about and, where appropriate, act upon
corporate actions and proxy votes affecting loaned securities. For example, a
fund should have procedures that will enable it to either block lending or recall
loans of particular securities in order to be able to cast those proxies that the
fund decides are sufficiently important to warrant that action.
*****
This article is for informational purposes and does not contain or convey legal advice.
Each investment company board should seek the advice of counsel for issues relating
to its individual circumstances.
For more information about the Independent Directors Council, contact Amy Lancellotta,
Managing Director, at 202/326-5824 or amy@ici.org.
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Copyright © 2007 by the Investment Company Institute. All rights reserved. Reprinted with
permission.