SEC Proposes to Improve the Retail Investor Experience Through Modernized Fund Shareholder Reports and Disclosures

August 27, 2020

The Securities and Exchange Commission (SEC) recently proposed amendments to the rules and forms applicable to mutual funds and exchange-traded funds (ETFs) (collectively, funds) to modernize and tailor information provided by these funds to their investors (Proposed Amendments).1 The Proposed Amendments would update the information required to be provided in prospectuses and shareholder reports, differentiating information required to be delivered to initial investors from that required to be delivered to existing shareholders (Existing Shareholders).2 The Proposed Amendments would also modify advertising rules that apply to funds, registered closed-end investment companies (CEFs) and business development companies (BDCs). Generally, the Proposed Amendments are designed to provide retail investors with tailored, material and timely information that will help them assess and monitor their investments and make informed investment decisions.

Among the significant changes included in the Proposed Amendments are changes that would:

  • revise the current disclosure requirements for annual and semi-annual shareholder reports to require a fund to deliver concise, visually appealing streamlined documents that better highlight fund expenses, performance, holdings and material fund changes;
  • bifurcate a fund’s periodic financial reporting obligations by moving certain information currently required to be disclosed in shareholder reports to the fund’s Form N-CSR filing;
  • provide an alternative method for a fund to satisfy its obligations to inform Existing Shareholders of material changes as part of the prospectus “annual update” process;
  • amend existing prospectus disclosure requirements relating to fund fees and risk factors; and
  • amend advertising rules that apply to funds, CEFs and BDCs to improve fee- and expense-related disclosure.

Notable aspects of the Proposed Amendments are summarized below.

Revisions to Shareholder Report Requirements

Under the Proposed Amendments, shareholder reports would serve as the central source of disclosure for Existing Shareholders and their scope would be limited to one fund (e.g., a series fund would be required to prepare a separate report for each of its series). The content of shareholder reports would also be limited so as to achieve the SEC’s expectation of annual reports of only 3 or 4 pages.3

New Items. Annual reports would be required to include new sections:

  • highlighting certain fund statistics such as its net assets, number of holdings and portfolio turnover, and other statistics that are reasonably related to its investment strategy; and
  • disclosing certain material changes to the fund (i.e., a change in name, investment objective(s), principal investment strategies, fees, principal risks, investment adviser or portfolio manager) that occurred during the reporting period or that the fund plans to make in its annual update.

Amended Items. Under the Proposed Amendments, the existing required disclosure items for the expense example and management discussion of fund performance (MDFP) would be retained, but would be revised so that the disclosure is presented in a more concise format. The expense example would be simplified to remove the legend that is currently required as a lead-in paragraph and to reflect a single table based on actual fund returns and expenses. The example also would include a column specific to ETFs that would disclose market value returns. The requirement to include MDFP information would be revised to only permit a brief summary of key information, and is meant to exclude the fund president’s letter, general market commentary, and other supplemental information from the report. The Proposed Amendments would clarify the definition of “appropriate broad-based securities market index” to indicate that funds should compare their performance to the overall applicable securities market (for purposes of both fund annual reports and prospectuses).

Items Moving from Shareholder Reports to Form N-CSR. Information that is currently included in shareholder reports, such as the schedule of investments and other financial statement items, would be required to be included in a fund’s Form N-CSR filed on a semi-annual basis with the SEC, made available on the fund’s website and delivered free of charge in paper or electronically upon request. To satisfy the online posting obligations, funds could post the entire Form N-CSR or only the relevant sections of the filing.

The Proposed Amendments would make similar revisions to the requirements that currently apply to a fund’s semi-annual reports. However, funds would be permitted but not required to include MDFP and material changes sections in their semi-annual reports.4

Alternative Procedure for Delivering Annual Updates

Section 10(a)(3) of the Securities Act of 1933 (1933 Act) and Rule 8b-16 under the Investment Company Act of 1940 (1940 Act) require a fund to update its prospectus each year to reflect current financial information, and Section 5(b)(2) of the 1933 Act requires a fund to deliver a current prospectus to Existing Shareholders if they make subsequent investments. New proposed Rule 498B would exempt a fund from the requirement to provide an updated prospectus on an annual basis to Existing Shareholders if certain conditions are met.5 These conditions include requirements that concern the maintenance of online availability of the fund’s current disclosure documents. They also include additional requirements for a fund to produce and post a summary prospectus online and to provide a notice of certain material changes that is included in a post-effective amendment or prospectus supplement filing, unless the material change is disclosed in the relevant summary included in the fund’s most recent annual report. The form of notice, which is not specified in the Proposed Amendments, would have to be included in the post-effective amendment or prospectus supplement that discloses the material change if the notice provided to shareholders will not take the form of the fund’s amended prospectus or statement of additional information (SAI) or supplement thereto.6

Amendments to Prospectus Disclosure of Fund Fees

In addition to proposing amendments to the presentation of fund fees in shareholder reports, the SEC also proposed amendments to the required prospectus disclosure of fund fees. The proposed revisions to required prospectus fee disclosure, among other things, would:

  • replace the current fee table in the summary section of the statutory prospectus with a simplified fee summary using different terminology (e.g., under the Proposed Amendments, a “Redemption Fee” in the summary fee table would be called an “Early Exit Fee”);7 and
  • permit a fund with limited investments in underlying funds (defined as less than 10% of the fund’s assets) to disclose “acquired fund fees and expenses” (AFFE) in a footnote to the fee table and fee summary instead of including AFFE as a line item in the fee table.

Amendments to Prospectus Disclosure of Fund Risks

The Proposed Amendments would revise certain instructions of Form N-1A to:

  • require funds to disclose principal risks in order of importance, with the most significant risks appearing first (and would prohibit funds from ordering risks in alphabetical order);
  • establish a 10% guideline (whether the investment would place more than 10% of the fund’s assets at risk and whether it is reasonably likely that a risk will meet this 10% standard in the future) for determining whether a risk is a principal risk; and
  • require non-principal risks to be disclosed in the SAI.

Investment Company Advertising Rule Amendments

The Proposed Amendments would amend Rules 482, 156 and 433 under the 1933 Act and Rule 34b-1 under the 1940 Act (collectively, the Advertising Rules) to promote transparent and balanced presentations of fees and expenses in advertisements by funds, CEFs and BDCs. Under the Proposed Amendments, investment company fee and expense presentations in advertisements would be required to include timely and prominent information about a fund’s maximum sales load (or any other nonrecurring fee) and gross total annual expenses, based on the methods of computation that the fund’s registration statement form prescribes for a prospectus.

Compliance Date and Comment Period

The Proposed Amendments include a compliance period of 18 months after the Proposed Amendments’ effective date for funds to comply with the proposed rule and form changes. Funds may rely on proposed Rule 498B on its effective date, provided they comply with the corresponding changes for shareholder reports.

The comment period for the Proposed Amendments will end 60 days after publication in the Federal Register (which has not occurred as of the date of this Client Alert).

S&K Observations and Insights

The use of the amended shareholder reports will be a significant change for funds that is comparable to the rule and form changes in 2009 that permitted funds to use summary prospectuses. Fund sponsors will certainly welcome the cost savings that will result from not delivering annual prospectus updates to Existing Shareholders nor having to prepare and deliver voluminous shareholder reports to investors. However, the requirement that a separate shareholder report be prepared for each fund in a series trust may impose increased burdens on many fund complexes that combine shareholder reports for related funds that are series of the same legal entity. This increased burden could mitigate much of the potential cost savings for these complexes and will undoubtedly be a major subject of industry comments. With respect to the contemplated changes to prospectus disclosure requirements, the proposed changes relating to disclosure of AFFE fees should enhance the relevancy of prospectus disclosure for shareholders of funds that do not have a principal strategy of investing in underlying funds, as these funds will no longer have to prominently disclose fees in a way that overemphasizes their importance. The additional risk disclosure guidance in the form of instructions will likely require some funds to streamline existing risk disclosure by moving all non-principal risk disclosure to their SAIs, which would result in shorter and more succinct prospectuses.

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1   Proposed Rule: Tailored Shareholder Reports, Treatment of Annual Prospectus Updates for Existing Investors, and Improved Fee and Risk Disclosure for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, SEC Rel. No. IC-33963 (Aug. 5, 2020) (Proposing Release).

2   An “existing shareholder” would generally be defined in the Proposed Amendments as a shareholder to whom a summary or statutory fund prospectus was sent or given to satisfy any obligation under section 5(b)(2) of the Securities Act of 1933 and who has held fund shares continuously since that time. Proposing Release at 230.

3   Proposing Release at n. 134.  The SEC provided a hypothetical example of what the revised annual report might look like, which is available here:

4   The Proposed Amendments would also amend the scope of Rule 30e-3 to exclude open-end funds.  Beginning as early as January 1, 2021, Rule 30e-3 will generally permit investment companies to satisfy shareholder report transmission requirements by making shareholder reports available online and providing notice of that availability instead of directly mailing the report to shareholders.

5   The Proposed Amendments would not change the requirement with respect to new investors that a fund precede or accompany the sale of its shares with a prospectus.

6   Proposing Release at n. 520.

7   Under the Proposed Amendments, the current fee table would be moved to the statutory prospectus.