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19 November 2020

Investment Management Legal And Regulatory Update - October 2020

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The SEC has proposed modifications to the disclosure framework for mutual funds and exchange-traded funds (ETFs).
United States Corporate/Commercial Law

LATEST DEVELOPMENTS: FUNDS

SEC Proposes to Modernize Fund Shareholder Reports and Disclosures

The SEC has proposed modifications to the disclosure framework for mutual funds and exchange-traded funds (ETFs). The proposal sets forth a layered disclosure approach to highlight key information for retail investors.

If adopted, the proposed modifications would:

  • require streamlined shareholder reports that would include fund expenses, performance, illustrations of holdings and material fund changes;
  • encourage the use of graphics or text features to promote effective communications; and
  • promote a layered and comprehensive disclosure framework by continuing to make available online certain information that is currently required in shareholder reports but may be less relevant to retail shareholders.

Highlights from the proposal include the following:

Tailored Shareholder Reports. Under proposed Rule 498B, new investors would receive a fund prospectus in connection with their initial investment, as they currently do, but funds would not deliver annual prospectus updates to shareholders thereafter. Instead, funds would keep existing shareholders informed through streamlined annual and semi-annual reports, as well as timely notifications of material fund changes as they occur.

Certain changes to a registration statement, such as updates to existing risk disclosures, may be deemed not to be material and therefore not subject to the timely notification requirements under proposed Rule 498B. Proposed Rule 498B would not prohibit a fund from continuing to satisfy its prospectus delivery obligations by delivering a copy of the summary prospectus and any supplements to the summary prospectus to existing shareholders.

Current versions of the prospectus, which must include any material fund changes, would remain available online and would be delivered upon request in paper or electronically, consistent with the shareholder's delivery preference. Funds would continue to be subject to the same prospectus and registration statement liability and anti-fraud provisions for fund documents required to be made available online but not required to be delivered to existing shareholders (the summary and statutory prospectus and information required to be incorporated into those documents).

The proposal would require a fund company to prepare separate reports for each of its series but not for each class of a multi-class fund. The proposal also would provide additional flexibility for funds to add tools and features to annual reports that appear on their websites or are otherwise provided electronically. This could include video or audio messages, mouse-over windows, pop-up definitions, chat functionality and expense calculators.

A link to a hypothetical streamlined shareholder report issued by the SEC in connection with the proposal is available here.

Availability of Information on Form N-CSR and Online. Information currently required in shareholder reports that is not included in the streamlined shareholder report would be available online, delivered free of charge upon request, and filed on a semi-annual basis with the SEC on Form N-CSR. Such information includes the schedule of investments and other financial statements, while a graphical representation of a fund's holdings would be retained in the streamlined shareholder reports.

Exclusion of Open-End Funds from Scope of Rule 30e-3. The proposal would also amend the scope of Rule 30e- 3, the optional internet availability of shareholder reports, to exclude open-end funds. The proposal would not affect the availability of Rule 30e-3 for closed-end funds. The SEC's rationale for narrowing the scope of this rule is based on its preliminary belief that the direct transmission of tailored reports represents a more effective means of improving investors' access to and use of fund information, and reducing funds' printing and mailing expenses, than allowing open-end funds to rely on Rule 30e-3.

Amended Prospectus Disclosure of Fund Fees and Risks. The proposal would amend prospectus disclosure requirements and related instructions to provide greater clarity and more consistent information regarding fees, expenses, and principal risks. The proposed amendments would: (1) replace the existing fee table in the summary section of the statutory prospectus with a simplified fee summary, (2) move the existing fee table to the statutory prospectus, and (3) replace certain terms in the current fee table with terms intended to be clearer to investors. The proposed amendments would also permit funds that make limited investments (up to 10% of net assets) in other funds to disclose acquired fund fees and expenses (AFFE) in a footnote to the fee table and summary instead of requiring AFFE to be presented as a line item in the table.

The amendments would preclude a fund from disclosing non-principal risks in the prospectus. An additional new instruction would require that funds describe principal risks in order of importance, with the most significant risks appearing first, and tailor risk disclosure to how the fund operates rather than rely on generic, standard risk disclosures. Proposed instructions would also prohibit the presentation of principal risks in alphabetical order.

Fee and Expense Information in Investment Company Advertisements. The proposed amendments would require that presentations of investment company fees and expenses in advertisements and sales literature be consistent with relevant prospectus fee table presentations and reasonably current. The proposed amendments to the advertising rules would affect all registered investment companies and business development companies.

The amendments would require fees and expenses in advertisements to include timely and prominent information about a fund's maximum sales load (or any other non-recurring fee) and gross total annual expenses.

Next Steps. The SEC has proposed an 18-month transition period. Accordingly, if adopted, the compliance date would be 18 months after the amendments' effective date. Comments on the SEC's proposal are due within 60 days after publication in the Federal Register.

Sources: SEC Proposes to Improve the Retail Investor Experience through Modernized Fund Shareholder Reports and Disclosures, SEC Press Release 2020-172 (Aug. 5, 2020), available here. 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 Release No. IC-33963 (Aug. 5, 2020), available here.

Great-West Prevails Against 401(k) Investors in Excessive Fee Litigation

On August 7, 2020, the U.S. District Court for the District of Colorado entered judgment in favor of defendants Great- West Capital Management, LLC and Great-Western Life & Annuity Insurance Co. in the latest round of excessive fee litigation. The plaintiffs, a group of investors who acquired shares of Great-West Funds as participants in retirement plans offered by their employers, brought suit in a consolidated shareholder derivative action in early 2016, alleging that the advisory and administrative service fees charged by Great-West were excessive.

Following a bench trial, the court ruled that plaintiffs failed to prove that Great-West's fees were so disproportionately large that they bore no reasonable relationship to Great-West's services and could not have been the product of arm's length bargaining. Additionally, the court found that plaintiffs failed to demonstrate they had suffered any actual damages.

The court adopted Great-West's proposed findings of fact and conclusions of law with respect to the Gartenberg factors. In doing so, the court found that: (1) the Great-West Funds Board of Directors' decision to approve Great- West's fees was entitled to substantial deference because the Board was independent, qualified and it engaged in a robust process in approving the fees; (2) the advisory fees and administrative fee were within the range of comparable funds; (3) plaintiffs failed to quantify any alleged economies of scale or show that those economies were not adequately shared with shareholders; (4) Great-West's profits were within the range of their competitors; (5) Great-West provided extensive, high-quality services in exchange for its fees; and (6) plaintiffs failed to identify any significant fall-out benefits to Great-West. Accordingly, the court found Great-West had not breached its fiduciary duties.

In addition, the court found plaintiffs had failed to prove their actual damages at trial. Accordingly, the court entered judgment in favor of defendants and ordered payment of defendants' costs after four years of litigation. The plaintiffs have appealed the decision.

Source: Obeslo, et al. v. Great-West Capital Mgmt., LLC et al., C.A. No. 16-cv-00230-CMA-SKC, 2020 WL 4558982 (D. Colo. Aug. 7, 2020).

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