Enhanced Disclosure and New Prospectus Delivery Option Proposed for Mutual Funds

On November 16, 2007, the Securities and Exchange Commission ("SEC") unanimously approved a series of proposed amendments to rules under the Securities Act of 1933, as amended (the "Securities Act"), and Investment Company Act of 1940, as amended (the "1940 Act"), that would dramatically alter the manner and form in which disclosure about open-end management investment companies ("mutual funds") is provided to investors. The SEC published these proposed rule amendments in a release on November 21, 2007.¹ Among other things, the amendments would require mutual fund prospectuses to include a summary of certain required prospectus disclosures in a prescribed format that could also be used on a "stand-alone" basis as a summary prospectus if the full prospectus and other information is made available to investors via the Internet. As the release noted, the proposed rule amendments "have the potential to revolutionize the provision of information to millions of mutual fund investors who rely on mutual funds for their most basic financial needs."²

HIGHLIGHTS OF THE PROPOSED RULE CHANGES

If the rule amendments are adopted as proposed, they would implement the following major changes to the mutual fund disclosure regime:

• Authorize a new short-form prospectus called a "Summary Prospectus." Unlike the current "Profile Prospectus" (a rarely used summary prospectus), it could be used to satisfy the prospectus delivery requirements of Section 5(b)(2) of the Securities Act as long as a full statutory prospectus and certain other documents are made available (in the prescribed manner) on an Internet website and other conditions are met.
• Certain information in a Summary Prospectus would need to be updated quarterly.

• Form N-1A would be amended to require certain pertinent information to be presented in a prescribed order and standardized format in the front of the prospectus. This would be called the "Summary Section" of the prospectus.

• The information required in the Summary Section of a prospectus would include a number of items currently required in a full prospectus, such as those in the "risk-return" section, and two new items not currently required in a full prospectus:
• A mutual fund’s 10 largest portfolio holdings; and

• Prescribed disclosure about compensation paid to broker-dealers or other financial intermediaries.

• With only a few exceptions, the Summary Section of the prospectus could not contain any information other than the required information.

• Prospectuses offering more than one mutual fund would be required to include a separate Summary Section describing each fund.

• With special cover page disclosure and quarterly updating of certain information, the Summary Section of a prospectus could serve as a Summary Prospectus.

• Authority for Profile Prospectuses would be repealed.

The SEC’s proposed amendments to Form N-1A would require the prospectus of a mutual fund to include a Summary Section at the front of the document. The items that would be required in the Summary Section, in the order in which they would be required, are set forth below:

• Investment Objectives and Goals. Here, a mutual fund would disclose its investment objectives or goals. A fund also would be permitted to identify its type or category (e.g., that it is a money market fund or balanced fund).

• Fee Table and Example. This section would be similar to the current fee table and example. However, the SEC is proposing the following modifications:

• The fee table would be moved forward from its current location.
• Mutual funds that offer discounts on front-end sales charges for volume purchases (so-called "breakpoint discounts") would be required to include brief narrative disclosure alerting investors to the availability of those discounts.
• The fee table heading would be revised to include the following parenthetical: "ongoing expenses that you pay each year as a percentage of the value of your investment."
• Mutual funds other than money market funds would be required to provide brief disclosure regarding portfolio turnover.
• Additional information would be permitted in the fee table to show the net expenses of funds that are subject to contractual expense reimbursement or fee waiver arrangements that will continue for no less than one year. This additional information will come in the form of two new captions. One caption would show the amount of the expense reimbursement or fee waiver, and a second caption would show the fund’s net expenses after subtracting the expense reimbursement or fee waiver from the total fund operating expenses. Funds that disclose these arrangements would also be required to disclose the period for which the expense reimbursement or fee waiver arrangement is expected to continue, and briefly describe who can terminate the arrangement and under what circumstances.

• Investments, Risks and Performance. This section would be the same as in the current risk/return summary section of the prospectus.

• Portfolio Holdings. This section would require the disclosure of the 10 largest issues held in the fund’s portfolio, in descending order, together with the percentage of net assets represented by each.

• Investment Advisers and Portfolio Managers. This section would require the disclosure of each investment adviser and sub-adviser of the fund, followed by the name, title, and length of service of the fund’s portfolio managers.
• Purchase and Sale of Fund Shares. This section would disclose the fund’s minimum initial or subsequent investment requirements and the fact that the fund’s shares are redeemable, and would identify the procedures for redeeming shares.

• Tax Information. This proposed disclosure is a streamlined version of the tax disclosure required in the current Profile Prospectus.

• Financial Intermediary Compensation. This section would conclude the Summary Section with the following (or a similar) statement: "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."

The proposed rule amendments would authorize the use of a new disclosure document – the Summary Prospectus. In a number of ways, it resembles the current, but little-used Profile Prospectus, a document that it would replace.

• Information in a Summary Prospectus. A Summary Prospectus would include the same information as the Summary Section of the statutory prospectus in the same order as would be required in the statutory prospectus. A Summary Prospectus generally could not omit any of the required information or include any additional information. Each Summary Prospectus could describe only one mutual fund, but could describe multiple share classes of that fund.

• Updating Requirements. Both the performance information and the top ten holdings information would be required to be updated each calendar quarter.

The proposed Rule amendments include extensive revisions to Securities Act Rule 498. The amendments would redefine the circumstances under which, and the conditions pursuant to which: (1) a Summary Prospectus could be used to satisfy the prospectus delivery requirements of Section 5(b)(1) of the Securities Act; and (2) a Summary Prospectus combined with Internet access to a statutory prospectus and other documents could be used to satisfy the prospectus delivery requirements of Section 5(b)(2) of the Securities Act and/or to qualify certain other communications as having been accompanied or preceded by a statutory prospectus pursuant to Section 2(a)(10) of the Securities Act.³

Securities Act Rule 498 currently defines and provides authority for Profile Prospectuses. The proposed amendments to Rule 498 would replace the Profile Prospectus provisions with provisions authorizing Summary Prospectuses.⁴ Revised Rule 498 also would prescribe conditions pursuant to which a Summary Prospectus could be used to satisfy various prospectus delivery requirements and would specify the legal effect of compliance (and non-compliance) with such conditions under several sections of the Securities Act and rules thereunder that address prospectus disclosure and related liability.

As is currently the case for Profile Prospectuses, revised Rule 498 would classify a Summary Prospectus as an "omitting" prospectus permitted by Section 10(b) of the Securities Act. This would permit a Summary Prospectus to be used to satisfy the prospectus delivery requirements of Section 5(b)(1) of that Act. More significantly, as proposed to be revised, Rule 498 would entail provisions that "have the potential to revolutionize" the delivery of prospectus and other disclosure about mutual funds. Revised Rule 498 would provide that where an investor or prospective investor in a mutual fund receives a Summary Prospectus, a full or "statutory" prospectus, as defined by Section 10(a) of the Securities Act, could be delivered to the investor or prospective investor merely by providing Internet access to the statutory prospectus and to other fund disclosure documents. Therefore, although a Summary Prospectus would not be a statutory prospectus, its delivery in combination with prescribed Internet availability of a statutory prospectus and other documents could be used to satisfy the statutory prospectus delivery requirements of Section 5(b)(2) of the Securities Act. If the proposed revisions to Rule 498 are adopted, then "access equals delivery" will become law.

Internet access to a statutory mutual fund prospectus would equal delivery of the prospectus for Section 5(b)(2) purposes only if a number of specific conditions in revised Rule 498 are met. Two conditions relate to the delivery of the Summary Prospectus. First, the Summary Prospectus would have to be sent or given no later than the time Section 5(b)(2) would require delivery of a statutory prospectus. Second, if any other materials accompany the Summary Prospectus, the Summary Prospectus would have to be given greater prominence than those materials and not be bound together with any of those materials. The other requirements relate to the manner in which Internet access would be provided and are discussed below.

Under Section 2(a)(10) of the Securities Act, certain sales materials that otherwise would come within the definition of the term "prospectus" are not prospectuses if they are accompanied or preceded by a statutory prospectus. The proposed amendments to Rule 498 would provide that Internet access to a statutory mutual fund prospectus would equal delivery of the prospectus for Section 2(a)(10) purposes, just as it would for Section 5(b)(2) purposes. Likewise, such delivery of a statutory prospectus for Section 2(a)(10) purposes would be subject to substantially the same conditions as delivery for Section 5(b)(2) purposes.

Under the proposed revisions to Rule 498, Internet access to a statutory mutual fund prospectus would equal delivery of the prospectus for Section 2(a)(10) or Section 5(b)(2) purposes only if a number of conditions relating to web site access and presentation are met. The principal condition would be that a mutual fund’s current Summary Prospectus, statutory prospectus, statement of additional information ("SAI"), and most recent annual and semi-annual reports to shareholders be made available, free of charge, at a web site address shown on the cover page or at the beginning of the Summary Prospectus. Other conditions relate to the currentness and format of these documents on the web site.

Web site access to a mutual fund’s Summary Prospectus, statutory prospectus, SAI, and most recent annual and semi-annual reports to shareholders would be required on or before the time that the Summary Prospectus is sent or given. Current versions of these documents would be required to remain on the Web site through a date that is at least 90 days after:

• in the case where Section 5(b)(2) of the Securities Act is being satisfied, the date that Section 5(b)(2) would require delivery of the statutory prospectus; and
• in the case where a communication with respect to a mutual fund security is being deemed not to be a prospectus under Section 2(a)(10) of the Securities Act, the date that the communication is sent or given.

The information required to be posted on the web site would have to be presented in a format that:

• is convenient for both reading online and printing on paper;
• permits persons accessing the statutory prospectus or SAI to move directly back and forth between the table of contents in that document and each section of that document referenced in the table of contents; and
• permits persons accessing the Summary Prospectus to move directly back and forth between each section of the Summary Prospectus and (1) any section of the statutory prospectus and SAI that provides additional detail concerning that section of the Summary Prospectus, or (2) tables of contents in the statutory prospectus and SAI that prominently display the sections within those documents that provide additional detail concerning information contained in the Summary Prospectus.

As a Section 10(b) omitting prospectus, a Summary Prospectus would not necessarily relieve persons who offer or sell mutual fund shares using the Prospectus (usually including, for this purpose, the mutual fund) from liability for material misstatements or omissions in the Prospectus.⁵ Because the information disclosed in a statutory prospectus is generally considered to represent the information that is material to a prospective investor, there has historically been concern in the mutual fund industry that omitting any of the information in a statutory prospectus could, depending on the circumstances, give rise to a material omission in an omitting prospectors, even though the omission is sanctioned by a Securities Act rule.⁶

Recognizing that concern about potential liability could chill any enthusiasm for using Summary Prospectuses, the proposed revisions to Rule 498 would address liability issues in three ways:

• By permitting delivery of a statutory prospectus via Internet access.
• By including a specific mechanism by which information in a statutory prospectus, SAI, and the most recent report to shareholders may be incorporated by reference into the Summary Prospectus.
• By specifically mandating that for purposes of Rule 159 (i.e., for purposes of determining whether or not a document contains a material misstatement or omission), information incorporated into a Summary Prospectus is conveyed to a person when the person receives the Summary Prospectus.

In addition, the Release points out that although the proposed rule amendments would require filing of Summary Prospectuses with the SEC as part of a mutual fund’s registration statement, such Prospectuses would not be considered part of the registration statement for purposes of liability under Section 11 of the Securities Act.⁷

In the Release, the SEC stated that it would provide for a transition period after the effective date of the proposed rule amendments. The SEC further stated that it expects to require all initial registration statements on Form N-1A, and all post-effective amendments that are annual updates to effective registration statements on Form N-1A, filed six months or more after the effective date, to comply with the proposed amendments to Form N-1A.

Section 2(10) of the Securities Act broadly defines the term "prospectus" to include any prospectus, notice, circular, advertisement, letter or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security. Thus, virtually any communication other than an oral communication relating to a security is a prospectus. Fortunately, Section 2(10) contains two important exclusions from its definition of a prospectus. First, a communication about a security given after the effective date of a registration statement for that security which is preceded or accompanied by a statutory prospectus is not a prospectus (hereinafter, "supplemental sales literature"). Second, a communication that does no more than identify the security, state its price and state by whom orders for the security will be executed is not a prospectus.⁸

Section 10 of the Securities Act outlines the requirements as to what information must be included in various types of prospectuses. Section 10(a) defines a traditional or full prospectus (a "statutory prospectus"). A prospectus meets the requirements of Section 10(a) if it contains all of the information required by the form for the registration statement of which it is a part. Section 10(b) refers to a "summary" or "omitting" prospectus which only contains limited information. Rules 482 and 498 under the Securities Act each define a type of omitting prospectus and the types of information that each must or may contain.

Section 5(b)(1) of the Securities Act, in effect, prohibits the distribution of a prospectus relating to a security unless the prospectus meets the requirements of Sections 10(a) or 10(b) of the Act. Because virtually any communication other than an oral communication (or supplemental sales literature) relating to a security is a prospectus, it must meet the requirements of Section 10 of the Securities Act. In contrast, oral communications, such as offers by an issuer or dealer over the telephone to sell a security, are not prospectuses and do not have to meet the requirements of Section 10. Therefore, a dealer may offer a security for sale, or even sell a security, over the telephone without delivering a statutory or omitting prospectus, but as soon as any written communication is delivered in connection with the sale (such as a confirmation statement or an application),⁹ Section 5(b)(1) of the Securities Act triggers the requirements of Section 10 unless the communication is preceded or accompanied by a statutory prospectus.¹⁰

Section 5(b)(2) of the Securities Act, in effect, prohibits the distribution of securities for sale or delivery after sale unless accompanied or preceded by a statutory prospectus. Therefore, the delivery of mutual fund shares must be preceded or accompanied by the delivery of a statutory prospectus for the funds.

Taken together, Sections 5(b)(1) and 5(b)(2) of the Securities Act require delivery of a statutory prospectus no later than the delivery of the security or the confirmation of the sale, whichever occurs first.

Rule 482 under the Securities Act defines parameters for mutual fund advertisements that qualify as Section 10(b) omitting prospectuses. Such prospectuses are particularly useful for advertising mutual fund performance and introducing new types of funds to the investing public. Unfortunately, because an application to purchase mutual fund shares cannot be used with a Rule 482 omitting prospectus, qualifying advertisements must be supplemented with Profile Prospectuses or statutory prospectuses in most circumstances in order to complete the sales process.¹¹ Another handicap of Rule 482 omitting prospectuses is that they do not "qualify" other communications as supplemental sales literature (i.e., sales literature preceded or accompanied by a statutory prospectus).

Rule 498 under the Securities Act authorizes Profile Prospectuses; another type of Section 10(b) omitting prospectus. Profile Prospectuses may be used in lieu of a statutory prospectus for the sale of mutual fund shares. Rule 498 does, however, require the delivery of a mutual fund’s statutory prospectus to the purchaser of the fund’s shares on or before the time that the purchaser receives the confirmation of the sale. Most significantly, Rule 498 requires that a prospective purchaser be permitted to request a statutory prospectus before making an investment decision and that such a prospectus be mailed to the prospective purchaser within three days of his or her request. As with Rule 482 omitting prospectuses, Profile Prospectuses do not "qualify" other written communications as supplemental sales literature.

Potential for Material Omissions in the Omitting Prospectus. Section 12(a)(2) of the Securities Act creates a liability for any person who offers or sells a security using a prospectus that omits material information about the security.12 The liability is to the purchaser who has a private right of action against the offender. This liability exists regardless of whether or not the person offering or selling the security has complied with Sections 5 and 10 of the Securities Act.13 In this regard, Rule 159 under the Securities Act makes clear that liability to the purchaser turns on whether or not whether or not there was a material misstatement or omission at the time the offer or sale occurred and that information, including information in prospectuses delivered in compliance with Sections 5 and 10 of the Securities Act, conveyed after the time of the offer or sale is not to be taken into account.

Similarly, Section 17(a)(2) of the Securities Act is a general antifraud provision which makes it unlawful for any person to obtain money or property by means of any material

misstatement or omission in the offer and sale of a security. Though no private right of action exists under Section 17(a)(2), Rule 159 applies to determinations of liability under the Section.¹⁴

Whether or not a prospectus, particularly an omitting prospectus, contains a material misstatement or omission would be judged based on all of the surrounding facts and circumstances. Therefore, the possibility exists that a purchaser of mutual fund shares could claim that he or she was misled as a result of an omitting prospectus for the fund because the prospectus failed to disclose material information

Less Protection Against Material Misstatements or Omissions by Sales Representatives. As a practical matter, mutual fund organizations often rely on the truth and veracity of statutory prospectuses as a way to mitigate the potentially adverse effect of statements (or the failure to make statements) by overzealous or inattentive sales representatives. The delay in delivering a statutory prospectus for a mutual fund could significantly diminish the prophylactic effect of such a prospectus.

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© 2007 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.