On October 26, 2022, the US Securities and Exchange Commission (SEC) voted to adopt rule and form amendments (the "final rules") related to (1) shareholder reports of mutual funds and exchange-traded funds (ETFs) registered on Form N-1A and (2) fee and expense information in advertisements of all registered investment companies and business development companies (BDCs). The rules were proposed in August 2020.
The final rules consist of the following principal elements:
- The final rules change both the structure and the content of shareholder reports for open-end management investment companies and ETFs registered on Form N-1A ("open-end funds" or "funds"). Under the new framework, shareholders will receive "concise and visually engaging" shareholder reports emphasizing the information the SEC considers most valuable to retail investors, including fund expenses, performance, and portfolio holdings.
- More in-depth information will be made available online, delivered free of charge upon request, and filed with the SEC on Form N-CSR.
- The final rules further amend the scope of Rule 30e-3 to exclude open-end funds, requiring the mailing of the new tailored shareholder reports in paper unless the shareholder has affirmatively elected electronic delivery or (if elected by the shareholder) electronically.
- The final rules make significant changes to advertising for all registered investment companies and BDCs, including changes to how fee and expense information is presented.
This client alert provides an overview of the final rules, and describes certain changes from the proposal in August 2020.
Most aspects of the final rules become effective 60 days after publication in the Federal Register and allow for an 18-month transition period beginning from the effective date, meaning that most aspects of the final rules must be implemented mid-2024 (assuming that the final rules are published relatively soon). As discussed further in this client alert, certain aspects of the final rules apply on the effective date.
CHANGES TO SHAREHOLDER REPORTS FOR OPEN-END MUTUAL FUNDS AND ETFS
The SEC adopted substantially as proposed Item 27A to Form N-1A, which specifies the design and content of shareholder reports. This change replaces provisions in Item 27 of current Form N-1A that relate to shareholder reports. Funds are required to send shareholders information only about the funds and share classes they hold. A fund is not permitted to incorporate by reference any information into its shareholder reports.
CONTENTS OF SHAREHOLDER REPORTS
As seen in the chart below, Item 27A to Form N-1A contains a number of requirements for shareholder reports, some of which are specific only to annual reports.
|Description||Item of Amended Form N-1A||Item of Current Form N-1A Containing Similar Requirements||Shareholder Report (Annual Report or Both Annual Report and Semi-Annual Report)|
|Cover Page or Beginning of Report||Fund/Class Name||Item 27A(b)||[None]||Both|
|Ticker Symbol||Item 27A(b)||[None]||Both|
|Principal US Market(s) for ETFs||Item 27A(b)||[None]||Both|
|Statement Identifying as "Annual Shareholder Report"||Item 27A(b)||[None]||Both|
|Statement on Material Fund Changes in the Report||Item 27A(b)||[None]||Both|
|Content||Expense Example||Item 27A(c)||Item 27(d)(1)||Both|
|Management's Discussion of Fund Performance||Item 27A(d)||Item 27(b)(7)||Annual Report|
|Fund Statistics||Item 27A(e)||[None]||Both|
|Graphical Representation of Holdings||Item 27A(f)||Item 27(d)(2)||Both|
|Material Fund Changes||Item 27A(g)||[None]||Annual Report|
|Changes in and Disagreements With Accountants||Item 27A(h)||Item 27(b)(4)||Both|
|Availability of Additional Information||Item 27A(i)||Item 27(d)(3) Through (5)||Both|
|Householding Disclosure (Optional)||Item 27A(j)||[None]||Optional|
The below explanations apply to both annual and semi-annual reports, unless otherwise stated.
COVER PAGE OR BEGINNING OF SHAREHOLDER REPORTS
The final rules require funds to provide certain key information on a cover page or at the beginning of the shareholder report. This includes the fund's name, the class of shares to which the shareholder report relates, the ticker symbol, and whether the shareholder report is an annual report or a semi-annual report. If the fund is an ETF, it must provide the principal US market(s) on which the fund's shares are traded. Further, the cover page must include a specific legend about the shareholder report. In a change from the proposing release, if a shareholder report is disclosing material fund changes, the fund will be required to include a prominent statement, in bold-face type, noting that the shareholder report is disclosing material changes.
The final rules require shareholder reports to include a simplified expense presentation, including a table showing the expenses associated with a hypothetical $10,000 investment in the fund during the most recent reporting period. The expenses must be presented in two formats: (1) as a percentage of a shareholder's investment in the fund and (2) as a dollar amount. In a notable difference from the proposed rules, the table will not be required to include information about the fund's total return during the period. The simplified expense presentation should look as follows:
|What Were the Fund Costs for the Last [Year/Six
(Based on a Hypothetical $10,000 Investment)
|[Fund or Class Name]||Costs of a $10,000 Investment||Costs Paid as a Percentage of a $10,000 Investment|
MANAGEMENT'S DISCUSSION OF FUND PERFORMANCE
Substantially as proposed, the final rules largely maintain the current requirements for the Management's Discussion of Fund Performance (MDFP) section of annual reports, with several targeted changes. The MDFP section is optional for semi-annual reports.
The final rules specify the narrative discussion must "briefly summarize" the "key" factors that materially affected a fund's performance during the most recent fiscal year, such as market conditions and the fund's investment strategies. Further, the final rules instruct funds to utilize graphics or text features, including bullet lists and tables, to present such factors. The final rules direct funds not to include lengthy, generic, or overly broad disclosure and prohibit funds from including additional information, such as a fund president's letter to shareholders, interviews with portfolio managers, general market commentary, and other similar information.
The final rules maintain the current requirements for a performance line graph, but with certain amendments designed to improve the current presentation and to reflect that annual reports cover a single class. Annual reports must include a performance line graph that depicts the performance of a $10,000 investment in the fund (for the relevant class) and in an appropriate broad-based securities market index over a ten-year period. Additionally, the definition of an appropriate broad-based securities market index was amended to ensure that funds compare their performance to the overall applicable securities market, for purposes of both shareholder reports and prospectuses. A "broad-based" index is defined as one that "represents the overall applicable domestic or international equity or debt markets, as appropriate." Funds may also compare their performance to other indexes, including more narrowly based indexes that reflect the market sectors in which the fund invests.
The final rules require funds to disclose in their shareholder reports certain fund statistics, including, but not limited to, (1) the fund's net assets, (2) the total number of portfolio holdings, (3) for funds other than money market funds, portfolio turnover rate, and (4) the total advisory fees paid by the fund during the reporting period. A fund may disclose any additional statistics that it believes would help shareholders better understand the fund's activities and operations during the reporting period, but the required statistics must precede any additional statistics the fund chooses to include.
GRAPHICAL REPRESENTATIONS OF HOLDINGS
The final rules retain current requirements related to the graphical representation of holdings in shareholder reports. Funds will continue to be required to include one or more tables, charts, or graphs depicting the fund's portfolio holdings by category, as of the end of the holding period. Funds may present such information using one of the currently available methods, including showing holdings based on the percentage of net asset value or total investments attributable to each category. The final rules, however, also permit funds to show its holdings based on total exposure to particular categories of investments in addition to one of the currently available methods. In a change from the proposed rules, the final rules permit funds to include, along with the graphical representation of holdings, a list of its ten largest portfolio holdings and the percentage of the fund's net asset value, total investments, or total exposure attributable to each such holding.
MATERIAL FUND CHANGES
Only applicable to annual reports, the final rules require funds to disclose and describe the following material changes:
|Changes Requiring Description||Corresponding Item in Form N-1A|
|A change to the fund's name||Item 1(a)(1)|
|A change to the investment objectives or goals||Item 2|
|A change to the annual operating expenses, shareholder fees, or maximum account fee, including the termination or introduction of an expense reimbursement or fee waiver arrangements||Item 3|
|A change to the principal investment strategies||Item 4(a)|
|A change to the principal risks of investing in the fund||Item 4(b)|
|A change to the investment adviser(s), including subadvisor(s)||Item 5(a)|
Funds may elect to disclose other material changes or changes that may assist in a shareholder's understanding of the fund's operations or performance. Any descriptions about changes must be concise while still providing enough detail to inform shareholders of how the change may affect them.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
As proposed, the final rules require funds to include a concise disclosure of certain disagreements with accountants in their shareholder reports. If a fund has a material disagreement with an accountant that has resigned or been dismissed, the fund is required to include: (1) a statement of whether the former accountant resigned, declined to stand for re-election, or was dismissed and the date thereof, and (2) a brief, plain English description of any disagreement(s) with a former accountant during the fund's two most recent fiscal years and any subsequent period that the fund disclosed on Form N-CSR. There is no requirement for funds to disclose the absence of disagreements.
AVAILABILITY OF ADDITIONAL INFORMATION
The final rules require funds to include in their shareholder reports a brief, plain English statement notifying shareholders that certain additional information is on the fund's website. Such statement must reference, as applicable, the fund's prospectus, financial information, holdings, and proxy voting information. Funds may also elect to refer to additional information on the website, so long as such information would likely be found important to shareholders. Any such information would be treated the same as other electronic content produced or circulated by a fund for federal securities laws purposes. If shareholder reports are presented electronically, they must include a tool, such as a hyperlink or QR code, to immediately access the additional information.
The final rules maintain current Rule 30e-1, which permits householding of fund shareholder reports if a shareholder has written or implied consent to such householding. Funds relying on written or implied consent must further explain to shareholders, at least once a year, how to revoke their consent. Such a statement may be included in annual reports.
FORMAT AND PRESENTATION OF SHAREHOLDER REPORTS
The final rules were designed to simplify the presentation of shareholder reports and encourage the use of plain English; graphics, lists, and tables; and investor-friendly principles. The information must be presented in the order the requirements appear in Item 27A. Additionally, the final rules provide legibility requirements for hard copy shareholder reports.
The final rules, in a change from the proposed rules, require funds to tag the information in shareholder reports in a structured, machine-readable data language (i.e., using Inline XBRL structured data language) in accordance with rule 405 of Regulation S-T and the EDGAR Filer Manual.
ELECTRONIC ANNUAL REPORTS
FORM N-CSR AND WEBSITE AVAILABILITY REQUIREMENT
As part of the transition to a layered disclosure framework for shareholder reports, the SEC also adopted amendments to Form N-CSR and Rule 30e-1. Funds will continue to be required to file certain information, which is currently included in fund shareholder reports, on Form N-CSR. The amendments to Rule 30e-1 will require funds to make available on a website the information that they file on Form N-CSR, and to deliver such information upon request to shareholders, free of charge.
Certain information currently required in shareholder reports will now no longer be required in shareholder reports or by Form N-CSR. This change applies to (1) certain information about management and the statement about the availability of additional information about a fund's directors and (2) the brief discussion/statement regarding the operation and effectiveness of a fund's liquidity risk management program over the past year. This disclosure will remain available in other fund disclosure documents such as a fund's statement of additional information or its prospectus.
NEW FORM N-CSR FILING REQUIREMENTS
The SEC adopted as proposed the requirement for funds to file their most recent complete annual or semi-annual financial statements on Form N-CSR, and provide certain data points from the financial statements in their shareholder reports, in lieu of including the fund's complete financial statements in their shareholder reports. Unlike the changes to shareholder reports, the amendments to Form N-CSR do not prohibit funds from preparing and submitting multicolumn financial statements that include multiple series or portfolios, or that address multiple share classes of a fund, provided such financial statement presentation is consistent with Regulation S-X. The annual financial statements will continue to be required to be audited and accompanied by any associated accountant's reports. The semi-annual financial statements need not be audited.
In connection with these changes, the SEC also adopted amendments to Form N-1A that will eliminate funds' ability to provide a summary schedule in lieu of providing a complete schedule of portfolio investments as part of the financial statements.
The final rules will require funds to file their financial highlights information on Form N-CSR. The final rules also require that funds must file on Form N-CSR the disclosures that Item 304 of Regulation S-K currently requires concerning changes in and disagreements with accountants. The requirements in Form N-CSR provide additional, more nuanced and technical disclosure than the similar requirement in shareholder reports. The final rules require that funds must include information about (1) matters submitted for a shareholder vote and (2) the aggregate remuneration the fund paid to its directors, officers, and certain affiliated persons on Form N-CSR, rather than in their shareholder reports. This information requirement is identical to the information requirement currently included in shareholder reports. Lastly, instead of requiring funds provide a statement regarding the basis for the board's approval of the fund's investment advisory contract in shareholder reports, the final rules instead require funds to provide this information on Form N-CSR.
WEBSITE AVAILABILITY REQUIREMENTS
As proposed, the final rules will require funds to make available on a website all of the information that will be newly required on Form N-CSR (Items 7-11 of amended Form N-CSR). This information is required to be publicly accessible and free of charge. Funds will also be required to make this information available from 60 days after the end of the relevant fiscal period until 60 days following the end of the next respective fiscal period, mirroring the required period of transmission of shareholder reports. This represents a change from the proposal, which would have required funds to make that same information available from 70 days after the end of the fiscal period until 70 days following the next fiscal period. Funds will continue to have 70 days to file the complete Form N-CSR with the SEC, as they do today.
In addition, as proposed, the SEC will also require funds (other than money market funds) to make their complete portfolio holdings, as of the close of the fund's most recent first and third fiscal quarters, available on a website. The final rules also ensure that investors can easily reach and navigate the information that appears online:
- First, the website address where the required information appears must be specified on the cover page or in the beginning of the shareholder reports and cannot be the SEC's EDGAR address. The website address must be specific enough to provide the requisite information, but can be a general website with clear links to the relevant information. It may not be the fund's home page.
- Second, the required online materials must be presented in a format convenient for both reading online and printing on paper, and persons accessing the materials must be able to retain permanently (free of charge) an electronic copy of the materials in this format. Funds may elect to post their most recent Form N-CSR report in its entirety, thereby satisfying the website availability requirement. The SEC noted in the adopting release that funds will have flexibility in how online information is presented so long as the information is consistent with the requirements described above.
The final rules also will include a safe harbor providing that funds shall have satisfied their obligations to transmit shareholder reports even if they did not meet the posting requirements of the rule for a temporary period of time. To rely on this safe harbor, funds must have reasonable procedures in place to help ensure that the required materials appear online in the manner required by the rule, and also must take prompt action to correct noncompliance with the final rules' website availability requirements.
DELIVERY UPON REQUEST REQUIREMENTS
As proposed, the final rules will require funds to send, at no cost by US first class mail or other reasonably prompt means, a paper copy of any of the materials that will have to appear online within three business days after receiving a request for a paper copy. Funds must also send, at no cost by email or other reasonably prompt means, an electronic copy of any materials discussed above within three business days after receiving a request for an electronic copy. These requirements will also apply to any applicable financial intermediary.
TRANSMISSION OF SHAREHOLDER REPORTS
Current Rule 30e-3 generally permits certain registered investment companies to satisfy shareholder report transmission requirements by making shareholder reports available online and providing a notice of the shareholders reports' online availability, instead of mailing the shareholder reports to shareholders. The final rules amend Rule 30e-3 to exclude open-end funds from the scope of Rule 30e-3. Now, unless a shareholder affirmatively opts into e-delivery, open-end funds will be required to mail a paper copy of the new tailored shareholder reports to shareholders. The final rules also clarify that variable contract unit investment trusts may no longer rely on Rule 30e-3 to satisfy their shareholder report transmission requirements with respect to underlying funds registered on Form N-1A.
In a change from the proposing release, the SEC decided against adopting proposed Rule 498B, which would have provided an alternative approach to delivering annual prospectus updates. This proposed layered disclosure framework would have used shareholder reports and other notifications to inform shareholders about their investments.
CHANGES TO INVESTMENT COMPANY ADVERTISING RULE AMENDMENTS
In addition to the changes to shareholder reports discussed above, the SEC adopted amendments to certain advertising rules to require that fee and expense presentations in advertisements and sales literature be consistent with relevant prospectus fee table presentations and be reasonably current. The amendments also address representations of fees and expenses that could be materially misleading. These amendments apply to all investment companies that are subject to the SEC's advertising rules, including mutual funds, ETFs, registered closed-end funds, and BDCs (each, an "investment company").
REQUIREMENTS FOR STANDARDIZED FEE AND EXPENSE FIGURES
The SEC amended Rules 482 and 433 under the Securities Act of 1933 (the "Securities Act") and Rule 34b-1 under the Investment Company Act of 1940 to require that investment company advertisements providing fee or expense figures for the investment company include certain standardized fee and expense figures, and that these figures must adhere to certain prominence and timeliness requirements.
The amendments to Rule 482 will require that investment company advertisements providing fee and expense figures include (1) the maximum amount of any sales load or any other nonrecurring fee, and (2) total annual expenses without any fee waiver or expense reimbursement arrangement. An advertisement need not include required fee and expense figures if it only included general, narrative info about fee/expense considerations and did not include any numerical fee or expense amounts. Similarly, if an investment company does not present total annual expense figures in its prospectus, the amendments addressing the required fee and expense figures would be inapplicable. This is relevant to variable insurance contract separate accounts, which do not present the total annual expense figures, and therefore, those annual expense figures are not presented in variable insurance contract prospectuses.
The amendments to Rules 34b-1 and 433 incorporate Rule 482's requirements for required fee and expense figures. As a result, advertisements and supplemental sales literature covered by those rules will be subject to the same requirements regarding fee and expense information.
The SEC proposed several rules related to prospectus disclosure, which they ultimately did not adopt, including amendments to prospectus fee disclosure and amendments to prospectus risk disclosure. The SEC chose not to adopt proposed rules that would have removed the current fee table out of the summary prospectus and replaced it with a fee summary that would have disclosed "bottom line" costs of an investment using new terminology. The SEC also did not adopt a proposed rule establishing a 10% of assets standard for principal risk disclosure.
MATERIALLY MISLEADING STATEMENTS ABOUT FEES AND EXPENSES IN INVESTMENT COMPANY SALES LITERATURE
As noted above, the amendments also address representation of fees and expenses that could be materially misleading. The SEC amended Rule 156 under the Securities Act to specify the following practice as one that could lead to materially misleading representations: representations about the fees or expenses associated with an investment in an investment company could be misleading because of statements or omissions made involving a material fact, including situations where portrayals of the fees and expenses associated with an investment in the investment company omit explanations, qualifications, limitations, or other statements necessary or appropriate to make the portrayals not misleading.
The SEC referenced investment companies that market themselves as "zero expense" or "no expense funds" without mentioning other costs investors would incur when investing in the investment company. Consistent with the current framework in Rule 156, whether a particular description, representation, illustration, or other statement involving an investment company's fees and expenses is materially misleading depends on evaluation of the context in which it is made. Although the SEC provided an 18-month transition period for other aspects of the adopting release, these amendments to Rule 156 apply on the effective date noted above.
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.