Thomas C. Bogle
Washington, D.C. +1 202 261 3360
Mutual funds may soon be permitted to provide key information directly to investors in a “sum- mary prospectus” and make the statutory prospectus and certain other information available on an Internet web site in satisfaction of their prospectus delivery obligations under the Secu- rities Act of 1933, as amended (the “Securities Act”). On November 21, 2007, the U.S. Securities and Exchange Commission (the “SEC”) issued a release1 (the “Proposing Release”) proposing rule and form amendments (“Proposed Rules”) that would permit these changes. The Proposed Rules would also require each fund to provide key investment information in plain English in a standardized order at the front of the statutory prospectus, using the same format as the summary prospectus.
Since 1978, the statutory prospectus for mutual funds has undergone numerous modifications designed principally to make the prospectus less complex and easier for the average investor to understand, and to assure that the prospectus contains information that the SEC believes is necessary for an investor to make an informed investment decision. In 1978, the SEC adopted a unified form for mutual funds, Form N-1, which included two parts: (i) the prospectus; and (ii) a list of exhibits, financial statements, and other information required in the registration statement but not in the prospectus.
Soon after Form N-1’s adoption, the SEC staff began considering a more simplified prospectus for mutual funds. These efforts culminated with the adoption of Form N-1A, which was designed to provide investors with a prospectus that is substantially shorter and simpler, so that the prospectus clearly disclosed the fundamental characteristics of the particular investment company. One reason for Form N-1A’s success was that more detailed information could be provided in a Statement of Additional Information (“SAI”) that did not need to be delivered to investors with the prospectus, but that could be incorporated into the prospectus to assuage liability concerns.
Many mutual funds subsequently took steps to substantially revise and simplify prospectus disclosures in response to the SEC’s “Plain English” initiative, launched in the late 1990s. In 1998, the SEC again tried to simplify and improve fund prospectuses by adopting rule amendments to permit funds to provide investors with a “profile prospectus” that includes key summary information about the mutual fund, including:
A significant drawback with the profile, however, was that SEC rules did not allow a fund to incorporate by reference the full statutory prospectus or SAI into the profile—in part because the SEC recognized that limitations existed on the ability of investors to easily access additional information not provided in the profile. In the end, this inability to incorporate the full statu- tory prospectus and SAI into the profile meant that very few fund groups have used the profile, principally due to significant concerns regarding potential liability for material omissions.
In recent years, the SEC has taken steps to consider how the Internet could be used to facilitate investor access to information about issuers, while simplifying the written disclosure documents delivered to investors. As investors have gained increased access to the Internet, the SEC began to consider the possibility of allowing a fund to deliver a short, summary prospec- tus to investors—similar to the profile—that directed investors to the fund’s statutory prospectus or SAI on an accessible web site, and allow the fund to incorporate by reference the prospectus or SAI into the summary prospectus. These efforts have culminated with the Commission’s action on the Proposed Rules.
Proposed Summary Section to Statutory Prospectus
The Proposed Rules would require every mutual fund to include a summary section, in plain English, at the front of the fund’s statutory prospectus under the Securities Act. This summary section would be required to include only the following information, presented in the following order:
Payments to Broker-Dealers and Other Financial Intermediaries
If you purchase the Fund through a broker- dealer or other financial intermediary (such as a bank), the Fund and its related companies may pay the intermediary for the sale of Fund shares and related services. These payments may influence the broker-dealer or other intermediary and your salesperson to recommend the Fund over another investment. Ask your salesperson or visit your financial intermediary’s web site for more information.
For a statutory prospectus relating to multiple funds, the Proposed Rules would require that the summary information be presented separately for each fund. The Proposed Rules, however, would permit a fund with multiple share classes to integrate the information about those classes into one summary section.
The New Summary Prospectus
The Proposed Rules would replace Rule 498 under the Securities Act—the current voluntary profile rule— with a new rule that would allow a fund to satisfy its prospectus delivery obligations under the Securities Act by sending a summary prospectus, and providing the statutory prospectus online. Under the Proposed Rules, any materials provided along with the summary prospectus cannot be given greater prominence than, or be bound together with, the summary prospectus.2
The summary section appearing in a fund’s statutory prospectus would form the body of the fund’s summary prospectus, except that a fund’s top ten hold- ings and investment performance information would be updated in the summary prospectus each quarter, as described below. The summary prospectus also would include a cover page and certain introductory information, and could incorporate by reference information included in the fund’s statutory prospectus, statement of additional information and most recent shareholder report.
Before you invest, you may want to re- view the Fund’s prospectus, which con- tains more information about the Fund and its risks. You can find the Fund’s prospectus and other information about the Fund online at __________. You can also get this information at no cost by calling __________ or by sending an e- mail request to __________.
The legend could also indicate that the summary pro- spectus is intended for use in connection with a 401(k), 403(b), or 457 plan, or a variable life insur- ance or annuity contract, and is not intended for use by other investors. In addition, the legend could indicate that the statutory prospectus and other information are available from a broker-dealer or other financial intermediary.
A fund would be able reflect the updated per- formance and portfolio holdings information in the summary prospectus by affixing a label or sticker (or by other reasonable means) in lieu of reprinting the entire summary prospectus each quarter. Moreover, as long as the only changes to the summary prospectus during the year are the required quarterly updates to the fund’s top ten portfolio holdings and investment perform- ance information, a fund would not be required to send an updated summary prospectus to its shareholders more than once annually. Al- though the holdings and investment performance sections of the summary section would need to be updated on a quarterly basis, this requirement would not apply to the same information in the fund’s statutory prospectus. The Proposed Rules specifically provide that the omission of the quarterly updated holdings andinvestment performance information from a fund’s statutory prospectus would not consti- tute, solely by virtue of its use in the summary section, an omission of material information required to be included in the statutory prospectus.
Significantly, the ability to incorporate by reference a fund’s statutory prospectus and SAI represents an attempt by the SEC to address the liability concerns raised by providing only a summary document to fund shareholders. Rule 159 of the Securities Act provides that, in determining a fund’s liability under Sections 12(a)(2) and 17(a)(2)3 of the Securities Act, any in- formation conveyed to the fund purchaser after the purchase is not considered. Rule 159 thus raises the concern that information delivered after the summary prospectus, such as the statutory prospectus and SAI, would not be considered in determining whether a fund is liable under Sections 12(a)(2) and 17(a)(2) of the Securities Act. However, under the Proposed Rules, if a fund’s summary prospectus incorporates information from the fund’s statutory prospectus and SAI by reference, that information therein will be treated as having been conveyed to a person who re- ceived the summary prospectus not later than the time the summary prospectus is received. Thus, an investor will be deemed to have received materials incorporated by reference into the summary prospec- tus at the time the investor receives the summary prospectus.
The Proposing Release further notes the SEC’s belief that a person who provides a summary prospectus in good faith in reliance on the Proposed Rules should be able to rely on Section 19(a) of the Securities Act. This section protects a defendant from liability for actions taken in good faith in conformity with SEC rules, against any claim that the summary prospectus did not include information disclosed in the fund’s statutory prospectus—regardless of whether the fund incorporates the statutory prospectus by reference into the summary prospectus.
Internet Access to Information
A fund that decides to rely on the Proposed Rules to meet its statutory prospectus delivery obligations by delivering a summary prospectus must also make certain information available over the Internet. As described below, the fund’s current summary prospectus, statutory prospectus, SAI, and most recent annual and semiannual reports to shareholders would need to be accessible, free of charge, at the web site address specified on the cover page or at the beginning of the summary prospectus.
The Proposed Rules appear to serve the intended purpose of both enhancing disclosure and giving investors a choice in the format and quantity of information they would like to receive before making an investment decision. By permitting delivery of the summary prospectus on the Internet, and only requiring the delivery of a paper prospectus upon request, the Proposed Rules have the potential to save funds and their shareholders substantial printing and postage expenses. Nonetheless, one SEC Commissioner has observed that the SEC’s proposal “may still need some modifications.”4 Commissioner Paul Atkins has observed that the proposed “quarterly updating requirement” may be unnecessary, and has questioned the usefulness of including information about a fund’s top ten holdings in the summary prospectus.5 Indeed, the SEC’s focus on quarterly performance seems somewhat inconsistent with its past statements that investors should not base investment decisions on short-term investment performance, but instead focus on investment performance over the long term.6
The Proposed Rules’ requirements relating to Internet availability of the summary and statutory prospectus, SAI, and shareholder reports may also pose certain operational challenges for fund firms—particularly insofar as they require “hyperlinking” between the summary prospectus and more detailed disclosure in the statutory prospectus or SAI.
Regardless of whether funds choose to use the sum- mary prospectus, all funds will have to amend their statutory prospectuses under the Proposed Rules. The costs of such action to many fund groups may be sig- nificant. The Proposed Rules also may raise particular concerns for funds that currently use a large multi- fund prospectus. The requirement that each summary section of a statutory prospectus address only one fund could lead to significantly larger statutory pro- spectuses.
The SEC has proposed a compliance date that would require post-effective amendments that are filed within six-months after the effective date of the Pro- posed Rules to comply with these new requirements. Funds may wish to consider whether this is sufficient time to deal with the many operational issues presented, and if not, provide comment to the SEC on this point. Comments must be received by February 28, 2008.
This update was authored by Brendan C. Fox (+1 202 261 3381; firstname.lastname@example.org), John V. O’Hanlon (+1 617 728 7111; email@example.com), Alan Rosenblat (+1 202 261 3332; firstname.lastname@example.org), Thomas C. Bogle (+1 202 261 3360; email@example.com), and Christopher Ha (+1 202 261 3376; firstname.lastname@example.org).
1) Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, SEC Release No. 33- 8861 (Nov. 21, 2007).
2) The SEC did not elaborate on what “greater prominence” means. We anticipate comments on the Proposed Rules seeking clarification on this subject in the adopting release.
3) Sections 12(a)(2) and 17(a)(2) of the Securities Act impose liability on a fund if the fund offering was carried out by means of a prospectus or oral communication that is materially false or misleading.
4) Paul S. Atkins, Remarks Before the Independent Directors Council (Nov. 28, 2007).
5) Paul S. Atkinds, Open Meeting Statement on Mutual Fund Prospectus Disclosure and Delivery (Nov. 15, 2007) available at http://www.sec.gov/news/speech/2007/spch111507psa.htm
6) See, e.g., New SEC Mutual Funds Tips Remind Investors To Look at More Than Short-Term Past Performance (Jan. 24, 2000).