Every decade or so, the Securities and Exchange Commission revisits mutual fund reporting requirements, usually with the objective of simplifying and clarifying disclosure to investors.
And while past rule changes made frustratingly modest improvements, the commission’s recent proposal to revamp shareholder communications may be a game-changer.
Here’s why this “Tailored Shareholder Reporting” proposal is different:
1. Fewer Prospectuses to Recycle
Mutual funds are professionally managed portfolios designed to be held by investors over several years, usually a full market cycle or more. Yet, securities laws have traditionally had the effect of treating every fund share purchase as though it is part of an initial public offering.
This has meant that a current prospectus must be delivered to each investor not only at the time of initial purchase, but each year thereafter even if, as is often the case, there were no material changes in the fund’s risks, objectives or expenses.
The duplication was needed to assure compliance with the prospectus delivery requirements of Securities Act section 5. Without it, shareholders who make subsequent purchases or reinvest dividends would have a right of rescission: a money-back guarantee if the fund shares happened to decline in value. Because shares always fluctuate — which is the point of investing — the rescission risk has been unacceptable to fund sponsors.
The SEC already had allowed for delivery to take place electronically for most investors, which eased the burden on our forests but not on investors’ attention spans. As the agency recognized, attention spans are important, too: When investors receive too much duplicative information in the mail or email, they may learn to ignore all communications.
Under the SEC proposal, section 5 would be satisfied for existing shareholders by summarizing material prospectus changes in a different document, the annual report to shareholders.
The full prospectus will still have to be prepared, filed with the SEC, delivered to new investors and made available online, so there is no reduction in the information available to the public. But the largely unread annual deliveries may soon become a thing of the past.
2. Streamlined Shareholder Reports
Twice-a-year shareholder reports — which include full sets of financial statements and accounting footnotes — also may get a more consumer-friendly update.
Based on surveys suggesting that few investors read the financial statements, the proposal would instead allow expanded, graph-focused summary information, including fund performance and expense information, holdings summaries and (as noted) any changes to key prospectus information.
The SEC is on the right track in separating shareholder communication needs from financial reporting. Sophisticated investors and investment professionals, as well as academics and the public, still will be able to access financial reports online.
The streamlined shareholder reports highlighting the most-read parts of existing reporting (as well as some need-to-know risk disclosure) should be well accepted by investors who do read current reports and may be more inviting to investors who do not.
3. Reforming Expense Disclosures
The SEC also tackled the difficult issue of investment costs, less successfully in our view. In an effort to make fund expenses easier to understand and compare, the proposal would require simplified up-front tables showing annual expenses both in dollars and as a percentage of assets.
Amended advertising rules would require standardized expense disclosure in any fund ad that mentions expenses.
This topic is difficult, however, and the proposal has two main problems.
First, it’s difficult to reduce the two main types of fund expenses — transaction charges at purchase or sale, and ongoing operating expenses — to a single meaningful number.
Hypothetical investments must be assumed, which do not improve clarity. Perhaps it would not be too much to expect investors to understand a presentation showing transaction and ongoing expenses separately.
Second, the SEC continues to want to summarize expenses in two different ways in the prospectus and shareholder reports. The simplified prospectus disclosure is forward-looking (although based on past operating expenses), includes projected transaction costs, and is based on hypothetical investment with a hypothetical fixed rate of return.
The annual report disclosure is backward looking (reflecting actual prior year expenses and performance) and does not include transaction costs.
Neither is wrong, but two “simplified” disclosures are inherently confusing, while the differences are not especially illuminating. Moreover, the two could appear in the same shareholder report, if there is a material prospectus change.
Mark Jensen is of counsel in Nutter McClennen & Fish LLP’s litigation department and a member of the firm’s Securities Enforcement and Litigation practice group. Ian Roffman leads the firm’s Securities Enforcement and Litigation practice.