United States: SEC Adopts Revised Disclosure And Delivery Requirements For Mutual Funds

On January 13, 2009, the Securities and Exchange Commission (the "SEC") adopted amendments to the Form N-1A used by open-end management investment companies commonly known as mutual funds. The Form N-1A is used by mutual funds to register under the Investment Company Act of 1940, and to offer and sell their securities under the Securities Act of 1933 (the "Securities Act"). The SEC amended the Form N-1A to require enhanced disclosure and permit a mutual fund to satisfy its prospectus delivery obligations by providing investors with a "Summary Prospectus," which contains key information about the mutual fund. The amendments are intended to make mutual fund disclosure information more accessible to investors while allowing investors to compare key information essential to making informed investment decisions.

The amendments will become effective March 31, 2009, subject to a transition period. A mutual fund may prepare its filings in accordance with the requirements of Form N-1A, as amended, any time after March 31, 2009. Compliance with the amendments are required for initial registration statements on Form N-1A and post-effective amendments that are annual updates to an effective Form N-1A filed on or after January 1, 2010. Post-effective amendments adding a new series filed on or after January 1, 2010 must comply with the amendments with respect to the new series. The final compliance date for filing amendments to an effective registration statement using the new Form N-1A requirements is January 1, 2011.

New Summary Section Of The Prospectus

The amendments to Form N-1A require that every prospectus include a summary of key information about a mutual fund. This new summary must be included at the beginning of the prospectus and may only be preceded by a cover or table of contents. The summary is to be written in plain English (as defined by the SEC) and must include specified information in a standardized format to facilitate the comparison between mutual funds.

The new summary section of the mutual fund prospectus is expected to be three to four pages long and contain, in the order prescribed, the following information:¹

1. Investment objectives/goals
2. Costs
3. Investments, risks, and performance
4. Management
5. Purchase and sale of mutual fund shares
6. Tax information
7. Financial intermediary compensation

Investment Objectives/Goals (Item 2)

The summary section must begin with a mutual fund's investment objectives and goals and include a description of the type or category of the mutual fund, such as a money market or fixed income fund.

Costs-Fee Table (Item 3)

The next required item in the summary is the fee table and example. These are similar to the current fee table and example with several modifications.

First, mutual funds which offer discounts on front-end sales charges for volume purchases are required to disclose the availability of these discounts.²

Second, the heading "Annual Fund Operating Expenses (expenses that are deducted from fund assets)" has been revised to "Annual Fund Operating Expenses (expenses that you pay each year as a percentage of the value of your investment)." This amendment is intended to clarify that investors pay the costs to invest in a mutual fund.

Third, a mutual fund that is not a money market fund must disclose, after the fee table, its portfolio turnover rate for the most recent fiscal year as a percentage of the average value of its portfolio. The turnover rate must be accompanied by an explanation of the effect of the portfolio turnover on transaction costs and the mutual fund's performance, and the adverse tax consequences that may result from a higher portfolio turnover rate when a mutual fund's shares are held in a taxable account.

Finally, the amendments modify the previous Form N-1A requirement that a mutual fund disclose gross operating expenses without reflecting the effect of expense reimbursement or fee waivers. In the fee table example, a mutual fund may now include expense reimbursements or fee waiver arrangements that will reduce operating expenses for no less than one year from the effective date of the registration statement by adding two lines to the fee table: 1) the amount of the expense reimbursement or fee waiver; and 2) the mutual fund's net expenses after subtracting the expense reimbursement or fee waiver. If a mutual fund discloses these arrangements, it must also disclose how long the waiver or reimbursement will continue, an expected termination date, and must describe who can terminate the arrangement and the circumstances under which it may be terminated.

Investments, Risks, And Performance (Item 4)

The next required item is a description of principal investment strategies and risks. The disclosure is the same as that currently required, including the bar chart and table illustrating the variability of returns and the mutual fund's past performance. However, a mutual fund that makes updated performance information available on an Internet website or through a toll-free number will now be required to include a statement to this effect and provide the Internet website address and toll-free number.

Management (Item 5)

The summary section must include the name of each investment adviser and sub-adviser of the mutual fund, and the name, title and length of service of the mutual fund's portfolio managers. A mutual fund does not have to disclose sub-advisers who solely manage cash instruments unless the mutual fund is a money market fund or similar fund. In addition, if a mutual fund has three or more sub-advisers, it only has to disclose sub-advisers who, or are expected to, manage a significant portion of the mutual fund's net assets (generally 30% or more).

Purchase And Sale Of Mutual Fund Shares And Tax Information (Item 6)

The summary section must next state the mutual fund's minimum initial or subsequent investment requirements, whether the shares are redeemable, and the procedures for redeeming shares. The SEC has also eliminated the provision in the instructions to Form N-1A that permitted a mutual fund to omit detailed purchase and redemption procedures from the prospectus or Statement of Additional Information ("SAI") and incorporate by reference to a separate document delivered with the prospectus. Under the amendments, a mutual fund is required to briefly describe the redemption procedure. For example, a mutual fund could make a statement to the effect that shares are redeemable on any business day by written request, telephone, or wire transfer.

Tax Information (Item 7)

The summary section also requires disclosure, as applicable, that the mutual fund intends to make distributions that may be taxed as ordinary income or capital gains or that it intends to distribute tax exempt income. Mutual funds that distribute tax exempt income are required to state that the distributions may be subject to federal income tax.

Financial Intermediary Compensation (Item 8)

Finally, if a mutual fund or its related companies pay financial intermediaries for the sale of the mutual fund's shares or related services, the summary section must include the following (or similar) statement:

Combining Summary Information

The summary information for each mutual fund must be provided in the numerical order as listed above. In a multiple fund prospectus, the summary must provide the required information for each mutual fund separately, rather than discussing all the mutual funds together under a single Item. However, mutual funds may integrate Items 6, 7, and 8 relating to the purchase and sale of the mutual funds' shares, tax information and financial intermediary compensation respectively, if the disclosure is identical for each mutual fund in a multiple fund prospectus. This information may be presented once at the end of the individual mutual fund summaries, provided the following statement is included in each individual mutual fund summary where the information would have otherwise been listed:

In addition, mutual funds with multiple share classes may integrate the summary information for multiple classes under each Item, or present the information separately for each class, or use another format that provides the information in the standard order at the beginning of the prospectus.

Additional Requirements

Mutual funds will not be required to repeat information contained in the summary section elsewhere in the prospectus, but are not permitted to include additional information in the summary. The cover pages of the statutory prospectus and the SAI must also provide the exchange ticker symbol of the mutual fund's shares, or if the mutual fund has more than one class of shares, the exchange ticker symbol of each class adjacent to each class. If the mutual fund is an exchange traded fund, the cover page must also identify the principal U.S. market or markets on which the mutual fund's shares are traded.

Summary Prospectus Delivery Option

Under the federal securities laws, mutual funds must deliver a prospectus to investors before or at the time of carrying or delivering a mutual fund security. The SEC has now adopted a new prospectus delivery option which permits (but does not require) mutual funds to satisfy their Section 5(b)(2) prospectus delivery obligation by:

1. Providing investors with key information in a Summary Prospectus;
2. Posting the statutory prospectus, as well as other information, on an Internet website;
3. Not binding the Summary Prospectus with any other materials;³
4. Providing the statutory prospectus, SAI and most recent annual and semi-annual shareholder reports via mail or e-mail to investors within three business days of their request;⁴ and
5. Giving the Summary Prospectus greater prominence than other materials that accompany it, except other Summary Prospectuses or statutory prospectuses.

While noncompliance with (1), (2) and (3) will result in violation of Section 5(b)(2),5 noncompliance with (4) and (5) results in violation of Rule 498, not Section 5(b)(2). In addition, if a mutual fund complies with the requirements of amended Rule 498, communications sent or given after the effective date of its registration statement that are preceded or accompanied by a Summary Prospectus are not deemed prospectuses under Section 2(a)(10) of the Securities Act and are not subject to the liability provisions of Section 12(a)(2) of the Securities Act.

Filing Of The Summary Prospectus

The new Summary Prospectus must be filed via EDGAR no later than the date of its first use. Although the Summary Prospectus is not deemed part of a registration statement and not directly subject to Section 11 of the Securities Act, since the Summary Prospectus contains the same information as the summary section of the statutory prospectus, the information is nonetheless subject to Section 11.⁶ The Summary Prospectus is also subject to the administrative provisions of Section 8 of the Securities Act and the SEC may prevent or suspend its use under Section 10(b) of the Securities Act.

Content Of The Summary Prospectus

With limited exceptions, the Summary Prospectus must contain the same information, and present the information in the same order, as required in the summary section of the statutory prospectus (i.e., Items 2 through 8 of Form N-1A).⁷ A Summary Prospectus that provides more or less information than the information required and provided in the statutory prospectus will not fulfill the prospectus delivery obligations. Similar to the summary section of the statutory prospectus, the Summary Prospectus must describe only one mutual fund but may describe multiple classes of a single mutual fund.

The cover page of the Summary Prospectus must contain the following information:

• The mutual fund's name and the share classes to which the Summary Prospectus relates; 
• The exchange ticker symbol of the mutual fund's securities or, if applicable, the exchange ticker symbol for each class of security; 
• A statement that the document is the Summary Prospectus; 
• The approximate date of the Summary Prospectus' first use; and 
• The following legend on the cover page or the beginning of the Summary Prospectus:
  Before you invest, you may want to review the Fund's prospectus, which contains 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 [_____________].⁸

Under the amended rule, mutual funds are permitted to incorporate by reference in the Summary Prospectus information contained in the statutory prospectus, SAI and shareholder reports, with some restrictions.⁹ First, a mutual fund may not incorporate by reference information that is required to be included in the Summary Prospectus. Second, information can only be incorporated by reference to the specific document that contains the information, not by referencing a document which itself references the source of the information. Third, the legend of the Summary Prospectus must indicate which documents or sections of the documents have been incorporated by reference and that the SAI or shareholder reports, if incorporated, can be obtained free of charge. For Sections 12(a)(2) and 17(a)(2) liability purposes, information that is incorporated by reference according to Rule 498 is deemed conveyed to a person not later than when the Summary Prospectus is received by such person.

Updating Requirements

The Summary Prospectus must be updated with the same frequency as the mutual fund's statutory prospectus. The SEC did not adopt the requirement contained in the proposed rule that certain information contained in the Summary Prospectus be provided as of the end of the most recent calendar quarter.

Information Available Online

Every mutual fund is required to post its current Summary Prospectus, statutory prospectus, SAI and most recent annual and semi-annual reports to shareholders on an Internet website, free of charge. The documents must remain online from the date the Summary Prospectus is sent or given to investors until at least 90 days after (i) the date of delivery of a security (if the rule is being used to meet the prospectus delivery obligation) or (ii) a communication in reliance on Rule 498 is sent or given (if the rule is relied upon for purposes of Section 2(a)(10)).¹⁰

The information posted online must be in a format that is human-readable and can be printed in a human-readable format. While only a condition for Rule 498 and not for compliance with Sections 5(b)(2) and 2(a)(10) of the Security Act, the information must be in a format that is convenient for both reading online and printing on paper. The SEC intended that "convenient" mean user-friendly.

The SEC has also imposed technological requirements for linking in and between the documents that are available online. A person accessing the statutory prospectus or SAI online must be able to move directly from a section listed in the table of contents to the relevant section of the respective document. The table of contents used in the statutory prospectus must be either the table of contents required by Rule 481(c) or one that contains the same section headings but is not contained in the document itself. ¹¹ The SEC has also adopted requirements for linking between documents. When accessing a Summary Prospectus, a user must be able to either: 1) move directly between a section of the Summary Prospectus and the section of the SAI and statutory prospectus that provides additional relevant information; or 2) move between links located at both the beginning and end of the Summary Prospectus, or links that are continuously visible on the computer screen, and the tables of contents of both the statutory prospectus and the SAI.¹²

Finally, mutual funds must permit users to download an electronic version of the statutory prospectus, Summary Prospectus, SAI and shareholder reports. The downloadable documents must be in a format that is human readable, can be printed in a human-readable format, and contains links between the table of contents of the statutory prospectus or SAI and the relevant section in the respective document.

Exchange Traded Funds ("EFTs")

The SEC has amended Form N-1A to facilitate the use of the form by ETFs.¹³ On the cover page of the Summary Prospectus, ETFs will be required to disclose the exchange ticker symbol and the principal U.S. market on which the shares are traded. The SEC also requires greater disclosure for ETFs which sell or redeem shares in creation units of 25,000 shares or less, as these ETFs are more likely to be purchased by individual investors. With regard to purchases and redemptions, an ETF with creation units of 25,000 shares or less is required to include in its prospectus information on how to purchase and redeem creation units and the costs associated with those transactions.¹⁴ Item 6 of Form N-1A also requires disclosure that the ETF shares may trade at a price greater than or less than net asset value (i.e., at a premium or discount). In addition, Item 11(g)(2) of Form N-1A requires each ETF to disclose the number of trading days during the most recently completed calendar year and quarters since that year on which the shares traded at a premium or discount.

Recommendations

Although the amended rules contain a transition period, mutual funds should begin to review their disclosure documents and assess their technological capabilities in preparation for the transition to the new requirements. Beginning January 1, 2010, annual updates by mutual funds will be required to comply with the amended Form N-1A and mutual funds will need to revise their current prospectuses to include the required new summary section. In addition, mutual funds should begin considering whether they will take advantage of the new Summary Prospectus delivery option that is provided for under the new rules. Given that the information required to be included in the Summary Prospectus is the same as that required to be provided in the new summary section of the statutory prospectus, minimal additional resources would be required to create a Summary Prospectus. In addition, the Summary Prospectus is shorter and eliminates the need to send a more lengthy, costly, and possibly confusing, statutory prospectus to each shareholder, unless an investor requests it. In order to use a Summary Prospectus in 2010, mutual funds should use the upcoming months to ensure they are able to create electronic documents that contain the required links, and that they have the infrastructure, including call center support and website capabilities, to maintain the online documents and respond to customers' requests for additional information. In light of the SEC's increasing use of technology in SEC filings, it may be beneficial to make the technological investment sooner rather than later.¹⁵

Questions

Any person who has a question regarding the issues raised in this Corporate and Securities Update may obtain additional guidance from a member of our Public Companies Group.

Footnotes

1. The information disclosed in the summary section is the same information disclosed in the Summary Prospectus, which is discussed under "Summary Prospectus Delivery Option – Content of Summary Prospectus" below.

2. Item 3 of Form N-1A; Instruction 1(b) to Item 3 of Form N-1A.

3. The amended rule contains an exception to permit the binding of the statutory prospectus of a variable insurance contract with the Summary Prospectuses and statutory prospectuses of its underlying funds. To comply with this exception, all the funds to which the prospectuses relate must be available to the client for investing and a table of contents must be included at the beginning or after the cover page of the bound materials which identifies each Summary Prospectus and statutory prospectus by page number.

4. If a shareholder requests an electronic copy of the documents, a direct link to the document may be sent provided a current version of the document is available for six months after the e-mail is sent, and the e-mail explains how long the link will remain usable and that the document may be saved if the recipient wishes to retain a copy of the document.

5. Rule 498(e)(4) contains a safe harbor which states that the internet availability requirements are met, even though the documents may not be available for a certain time due to events beyond the mutual fund's control (e.g., system outage, natural disasters, etc.), provided the mutual fund has procedures to ensure that the documents are available and it takes prompt action to make them available.

6. Section 11 addresses civil liability due to false or misleading registration statements.

7. A Summary Prospectus may omit an explanation of the reasons for a change in the securities market index used for comparison purposes in the performance presentation.

8. Rule 498(b)(1). The Internet website address used in the legend may not be the SEC's Edgar website. Although not required, the legend may also state that the Summary Prospectus is intended for use in connection with a defined contribution plan meeting the requirements of Section 401(k) of the Internal Revenue Code ("IRC"), a tax-deferred arrangement under Section 403(b) or 457 of the IRC, or a variable contract as defined in Section 817(d) of the IRC and is not intended for use by other investors. Rule 498(b)(1)(v)(B). The legend may also state that the statutory prospectus and other information is available through a financial intermediary, such as a broker-dealer. If the Summary Prospectus includes information that is incorporated by reference, the legend must state the documents (e.g., Statement of Additional Information, statutory prospectus, etc.) or sections of the documents that have been incorporated.

9. Rule 498(b)(3).

10. If a mutual fund complies with Rule 498, a communication will not be deemed a prospectus under Section 2(a)(10) of the Securities Act.

11. Rule 498(e)(2)(ii). The table of contents can be in a separate frame or panel of the computer screen and can utilize technologies such as bookmarks to access the relevant sections of the documents.

12. The ability to move between the relevant sections can be accomplished through the use of multiple windows that remain open simultaneously.

13. ETFs are registered open-end mutual funds that sell and redeem individual shares in large groups, known as creation units, to certain financial institutions.

14. ETFs with creation units greater than 25,000 shares are not required to provide this information.

15. For example, in 2008 the SEC proposed the use of an interactive data format for the financial statements and risk/return sections of the mutual fund prospectus. Interactive Data For Mutual Fund Risk/Return Summary, Investment Company Act Release No. 28298 (June 10, 2008). A final rule has not been released, however the SEC has already implemented a similar requirement for public companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.