[Federal Register Volume 62, Number 46 (Monday, March 10, 1997)] [Proposed Rules] [Pages 10898-10942] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 97-5368] [[Page 10897]] _______________________________________________________________________ Part II Securities and Exchange Commission _______________________________________________________________________ 17 CFR Part 230, et al. Registration Form Used by Open-End Management Investment Companies; Proposed Rule Proposed New Disclosure Option for Open-End Management Investment Companies; Proposed Rule Investment Company Names; Proposed Rule Federal Register / Vol. 62, No. 46 / Monday, March 10, 1997 / Proposed Rules [[Page 10898]] SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 230, 239, 270, and 274 [Release Nos. 33-7398; 34-38346; IC-22528; S7-10-97] RIN 3235-AE46 Registration Form Used by Open-End Management Investment Companies AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. ----------------------------------------------------------------------- SUMMARY: The Securities and Exchange Commission is proposing amendments to Form N-1A, the form used by open-end investment companies to register under the Investment Company Act of 1940 and to offer their shares under the Securities Act of 1933. The proposed amendments would revise disclosure requirements for fund prospectuses. Among other things, the proposed amendments seek to minimize prospectus disclosure about technical, legal, and operational matters that generally are common to all funds and, in keeping with the purpose of Form N-1A, to focus prospectus disclosure on essential information about a particular fund that would assist an investor in deciding whether to invest in that fund. The proposed amendments are intended to improve fund prospectuses and to promote more effective communication of information about funds. DATES: Comments must be received on or before June 9, 1997. ADDRESSES: Submit comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 5th Street, NW, Washington, DC 20549-6009. Comments can be submitted electronically at the following E-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-10-97; this file number should be included on the subject line if E-mail is used. All comments received will be available for public inspection and copying in the Commission's Public Reference Room, 450 5th Street, NW, Washington, DC 20549-6009. Electronically submitted comment letters will be posted on the Commission's Internet Web site (http://www.sec.gov). FOR FURTHER INFORMATION CONTACT: Jonathan F. Cayne, Attorney, John M. Ganley, Senior Counsel, Markian M.W. Melnyk, Senior Counsel, David U. Thomas, Senior Counsel, Kathleen K. Clarke, Special Counsel, or Elizabeth R. Krentzman, Assistant Director, (202) 942-0721, Office of Disclosure and Investment Adviser Regulation, Division of Investment Management, Securities and Exchange Commission, 450 5th Street, NW, Mail Stop 10-2, Washington, DC 20549-6009. SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (``Commission'') is proposing for comment amendments to Form N-1A (17 CFR 274.11A), the registration form used by open-end management investment companies (``funds'') to register under the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) (``Investment Company Act'') and to offer their shares under the Securities Act of 1933 (15 U.S.C. 77a et seq.) (``Securities Act''). The Commission also is proposing technical amendments to rules 481 and 497 under the Securities Act (17 CFR 230.481, .497). In a companion release, the Commission is proposing new rule 498 under the Securities Act and the Investment Company Act, which would permit an investor to buy a fund's shares based on a short-form document, or ``profile,'' that contains a summary of key information about the fund; each investor purchasing fund shares based on a profile would receive a copy of the fund's prospectus with the purchase confirmation.\1\ In another companion release, the Commission is proposing new rule 35d-1 under the Investment Company Act, which would require a fund with a name suggesting that it focuses on a particular type of investment (e.g., a fund that calls itself the ABC Stock Fund, the XYZ Bond Fund, or the QRS U.S. Government Fund) to invest at least 80% of its assets in the type of investment suggested by its name.\2\ --------------------------------------------------------------------------- \1\ Investment Company Act Release No. 22529 (Feb. 27, 1997) (``Profile Release''). \2\ Investment Company Act Release No. 22530 (Feb. 27, 1997) (``Fund Names Release''). Proposed rule 35d-1 would apply to all registered investment companies, including funds, closed-end investment companies, and unit investment trusts. --------------------------------------------------------------------------- Table of Contents I. INTRODUCTION AND EXECUTIVE SUMMARY II. DISCUSSION A. Part A--Information in the Prospectus 1. Item 1--Front and Back Cover Pages 2. Item 2--Risk/Return Summary: Investments, Risks, and Performance a. Investment Objectives and Principal Strategies b. Risks 3. Item 3--Risk/Return Summary: Fee Table a. Fee Table Example b. Shareholder Account Fees c. Improving and Simplifying Fee Table Presentation 4. Item 4--Investment Strategies and Risk Disclosure a. Investment Objectives and Implementation of Investment Objectives b. Risk Disclosure 5. Item 5--Management's Discussion of Fund Performance 6. Item 6--Management, Organization, and Capital Structure a. Management and Organization b. Capital Structure 7. Item 7--Shareholder Information a. Purchase and Redemption b. Tax Consequences 8. Item 8--Distribution Arrangements a. Placement of Prospectus Disclosure b. Rule 12b-1 Plans c. Sales Loads d. Multiple Class and Master-Feeder Funds 9. Item 9--Financial Highlights Information B. Part B--Statement of Additional Information C. Part C--Other Information D. General Instructions 1. Reorganizing and Simplifying the Instructions 2. Form N-1A Guidelines and Related Staff Positions E. Technical Rule Amendments F. Transition Period III. General Request for Comments IV. Paperwork Reduction Act V. Summary of Initial Regulatory Flexibility Analysis VI. Statutory Authority VII. Text of Proposed Amendments I. Introduction and Executive Summary Over the last decade, the fund industry has experienced enormous growth both in total assets and in the number of funds.\3\ Today, fund assets exceed the deposits of commercial banks.\4\ Coincident with the explosive growth of fund investments, the business operations of many funds have become increasingly complex as funds seek to offer investors new investment options and a wider variety of shareholder services. These factors, combined with new and more sophisticated fund investments, have resulted in fund prospectuses that often include long and complicated disclosure, as funds explain their operations, investments, and services to investors. --------------------------------------------------------------------------- \3\ Investment Company Institute (``ICI'), Mutual Fund Fact Book 29-37 (36th ed. 1996) (``ICI Fact Book'') (between 1987 and 1996, assets increased from $769.9 billion to $3.5 trillion and the number of funds increased from 2,317 to 6,243). \4\ Compare ICI, Trends in Mutual Fund Investing: November 1996 at 3 (Dec. 1996) (ICI News No. ICI-96-107) (fund net assets exceeded $3.5 trillion as of Nov. 1996) with 82 Fed. Res. Bull. 12, table 1.21, at A13 (1996) (commercial bank deposits were approximately $2.5 trillion as of Sept. 1996). --------------------------------------------------------------------------- Many have criticized fund prospectuses, finding them unintelligible, tedious, and legalistic.\5\ [[Page 10899]] Although the prospectus remains the most complete source of information about a fund, technical and unnecessarily lengthy prospectus disclosure often obscures important information relating to a fund investment and does not serve the information needs of the majority of fund investors.\6\ As millions of Americans have turned to funds as an investment vehicle of choice,\7\ investors need to be provided with clear and comprehensible information that will help them evaluate and compare fund investments. --------------------------------------------------------------------------- \5\ See, e.g., ``The SEC and the Mutual Fund Industry: An Enlightened Partnership,'' Remarks by Arthur Levitt, Chairman, SEC, before the ICI's General Membership Meeting at the Washington Hilton Hotel, Washington, D.C. (May 19, 1995); Simple Concept from SEC: Use Plain English in Fund Prospectuses, L.A. Times, Mar. 2, 1995, at D14; J. Bogle, Bogle on Mutual Funds 147 (1994); Rothchild, The War on Gobbledygook, Time, Oct. 31, 1994, at 51; Skrzycki, Prospectuses to be in English, Donkeys to Fly Tomorrow, Wash. Post, Oct. 21, 1994, at B1. \6\ A 1995 survey conducted on behalf of the Commission and the Office of the Comptroller of the Currency (``OCC'') found that, although fund investors consulted the prospectus more than any other source of information about the fund they bought, they considered the prospectus only the fifth-best source of information, behind employer-provided written materials, financial publications, family or friends, and brokers. Report on the OCC/SEC Survey of Mutual Fund Investors 12-13 (June 26, 1996). See also ICI, The Profile Prospectus: An Assessment by Mutual Fund Shareholders 4 (1996) (``ICI Profile Survey'') (about half of fund shareholders surveyed had not consulted a prospectus before making a fund investment). \7\ Over 30 million U.S. households own funds. ICI Fact Book, supra note 3, at 92. --------------------------------------------------------------------------- The Commission is committed to improving the disclosure provided to fund investors \8\ and is proposing two major initiatives to meet this objective. First, the Commission is proposing changes to fund disclosure requirements in an effort to focus prospectus disclosure on essential information about a particular fund that would assist an investor in deciding whether to invest in that fund.\9\ Second, in a companion release, the Commission is proposing a new rule to permit investors to buy fund shares based on a fund profile (the ``profile'') that would provide a summary of key information about a fund, including the fund's investment objectives, strategies, risks, performance, and fees.\10\ Under this proposal, investors would receive the fund's prospectus upon request or no later than with delivery of the purchase confirmation. --------------------------------------------------------------------------- \8\ See ``Taking the Mystery Out of the Marketplace: The SEC's Consumer Education Campaign,'' Remarks by Arthur Levitt, Chairman, SEC, at the National Press Club, Washington, D.C. (Oct. 13, 1994); ``Investor Protection: Tips from an SEC Insider,'' Remarks by Arthur Levitt, Chairman, SEC, before the Investors' Town Meeting at the Adam's Mark Hotel, Philadelphia, Pa. (June 11, 1996). \9\ As part of the improvements to prospectus disclosure, the Commission is proposing a new rule intended to address certain broad categories of investment company names that are likely to mislead investors about an investment company's investments and risks. The new rule would require funds and other registered investment companies with names suggesting a particular investment emphasis to invest at least 80% of their assets in the type of investment suggested by their name. \10\ Profile Release, supra note 1. --------------------------------------------------------------------------- These two initiatives are intended to improve fund disclosure by requiring prospectuses to focus on information central to investment decisions, to provide new disclosure options for investors, and to enhance the comparability of information about funds. Taken together, the proposals seek to promote more effective communication of information about funds without reducing the amount of information available to investors. As part of its commitment to give investors improved disclosure documents, the Commission recently proposed rule amendments to require the use of plain English principles in drafting prospectuses and to provide other guidance on improving the readability of prospectuses.\11\ The Commission intends that the plain English initiatives serve as the standard for all disclosure documents, and the plain English proposals are an important counterpart of the proposed fund disclosure initiatives. If adopted, the plain English requirements would apply to fund prospectuses and the profile. --------------------------------------------------------------------------- \11\ Securities Act Release No. 7380 (Jan. 14, 1997) (62 FR 3152) (``Plain English Release'). In conjunction with these proposals, the Commission's Office of Investor Assistance has issued a draft of A Plain English Handbook: How to Create Clear SEC Disclosure Documents to explain the plain English principles of the proposed amendments and other techniques for preparing clear disclosure documents. See also ``Plain English: A Work in Progress,'' Remarks by Isaac C. Hunt, Commissioner, SEC, before the First Annual Institute on Mergers and Acquisition: Corporate, Tax, Securities, and Related Aspects, Key Biscayne, Fla. (Feb. 6, 1997). --------------------------------------------------------------------------- The Commission's efforts to improve fund disclosure are long- standing. In 1983, the Commission introduced an innovative approach to prospectus disclosure by adopting a two-part disclosure format.12 Under this format, the Commission intended that a fund would provide investors with a simplified prospectus designed to contain essential information about the fund that assists an investor in making an investment decision. The Commission contemplated that more extensive information and detailed discussions of matters included in the prospectus would be available in a Statement of Additional Information (``SAI'') that investors could obtain upon request. In adopting this new format, the Commission's goal was to provide investors with more useful information in ``a prospectus that is substantially shorter and simpler, so that the prospectus clearly discloses the fundamental characteristics of the particular investment company. . . .'' 13 --------------------------------------------------------------------------- \12\ Investment Company Act Release No. 13436 (Aug. 12, 1983) (48 FR 37928) (``Form N-1A Adopting Release'). \13\ Investment Company Act Release No. 12927 (Dec. 27, 1982) (48 FR 813, 814) (``Form N-1A Proposing Release'). --------------------------------------------------------------------------- Since 1983, the Commission has adopted a number of other initiatives to improve fund disclosure, including a uniform fee table and a requirement for management's discussion of fund performance (``MDFP').14 While these changes have provided investors with clear and helpful information about fund expenses and performance, they were not intended to address overall prospectus disclosure requirements. The Commission has concluded that a comprehensive review and revision of fund disclosure requirements is necessary to improve the information provided in fund prospectuses.15 --------------------------------------------------------------------------- \14\ Investment Company Act Release Nos. 16244 (Feb. 1, 1988) (53 FR 3192) (``Fee Table Adopting Release'') and 19382 (Apr. 6, 1993) (58 FR 19050) (``MDFP Adopting Release''). See also Investment Company Act Release Nos. 21216 (July 19, 1995) (60 FR 38454) (``Money Market Fund Prospectus Release'') (proposing amendments designed to make money market fund prospectuses simpler and more informative) and 16245 (Feb. 2, 1988) (53 FR 3868) (``Performance Release'') (adopting a uniform formula for calculating fund performance). \15\ See, e.g., SEC, Report of the Advisory Committee on the Capital Formation and Regulatory Processes (July 24, 1996); SEC, Report of the Task Force on Disclosure Simplification (1996) (``Disclosure Simplification Task Force Report'') (recommending specific improvements in the disclosure provided by corporate issuers). --------------------------------------------------------------------------- The Commission's consideration of disclosure issues has included evaluating the use of the profile as a standardized, summary disclosure document. The Commission, with the cooperation of the Investment Company Institute (``ICI'') and several large fund groups, conducted a pilot program permitting funds to use profiles (``pilot profiles'') together with their prospectuses.16 The pilot profiles (like the profile proposed today) contain a summary of key information about the fund. The program's purpose was to determine whether investors found the pilot profiles helpful in making investment decisions. Focus groups conducted on the Commission's behalf [[Page 10900]] (``Focus Groups'') responded very positively to the profile concept. Fund investors participating in a survey sponsored by the ICI also strongly favored the pilot profiles.17 --------------------------------------------------------------------------- \16\ See Investment Company Institute (pub. avail. July 31, 1995) (``1995 Profile Letter''). The Division of Investment Management (the ``Division'') has permitted the pilot program, with some modifications, to continue for another year. See Investment Company Institute (pub. avail. July 29, 1996) (``1996 Profile Letter''). The Division also has permitted variable annuity registrants to use ``variable annuity profiles'' together with their prospectuses. National Association for Variable Annuities (pub. avail. June 4, 1996). \17\ See ICI Profile Survey, supra note 6, at 31-32. --------------------------------------------------------------------------- In another recent initiative, the Commission issued a release requesting comment on ways to improve risk disclosure and comparability of fund risk levels (``Risk Concept Release'').18 The Commission received over 3,700 comment letters, mostly from individual investors. Commenters confirmed the importance of risk disclosure to investors when evaluating and comparing funds and highlighted the need to improve prospectus disclosure of fund risks. In particular, commenters indicated that current risk disclosure is difficult to understand and does not fully convey to investors the risks associated with an investment in a fund. --------------------------------------------------------------------------- \18\ Investment Company Act Release No. 20974 (Mar. 29, 1995) (60 FR 17172). --------------------------------------------------------------------------- The Commission remains committed to the same goals articulated in adopting Form N-1A. The initiatives proposed today are intended to further these goals and achieve clear and concise disclosure that would assist fund investors in making investment decisions. Based on the Commission's review of current fund prospectuses and related disclosure requirements, the Commission has identified 5 major objectives that form the basis for today's initiatives:
Improved prospectus disclosure: Although some funds have made significant and commendable efforts to improve their prospectuses,19 prospectus disclosure relating to a fund tends to be overly complex and difficult to follow and should be revised to focus on essential information about the fund to help an investor make an informed investment decision. --------------------------------------------------------------------------- \19\ See, e.g., McTague, Simply Beautiful: Shorn of Legalese, Even Prospectuses Make Sense, Barron's, Oct. 7, 1996, at F10 (about the recent efforts of the John Hancock funds and other fund groups to improve their prospectuses). --------------------------------------------------------------------------- Fund names: Although a fund's name (like any other single piece of information about an investment) cannot tell the whole story about a fund investment, names may communicate a great deal to an investor, and investors should have greater assurance that a fund whose name suggests that the fund focuses on certain investments will make those investments. Investor choice: Different investors prefer different amounts of information before making an investment decision, and regulatory requirements should not foreclose options that respond to prospective investors'' information needs. Standardized fund summaries: Investors have expressed a strong preference for summary information about funds in a standard format; summaries should provide investors with additional tools to help them make better use of the extensive information available about funds. Clearer risk disclosure: The risks of investing in a fund often are not readily apparent to investors and should be communicated more effectively. The proposed disclosure initiatives address these objectives. Improved Prospectus Disclosure The proposed amendments would change the disclosure requirements for fund prospectuses. The Commission regards the prospectus as an investor's primary source of information about a fund. A prospectus, however, is not useful to investors if it is in a form that discourages investors from reading it. The prospectus is intended to provide information about matters of fundamental importance to most investors.20 The Commission's proposals are intended to update and streamline prospectus disclosure requirements to focus on essential information about a particular fund and make the prospectus less technical and easier to read.21 This initiative is designed to eliminate prospectus clutter that tends to obscure information that could help an investor make an investment decision. The proposed amendments would: --------------------------------------------------------------------------- \20\ See Form N-1A Proposing Release, supra note 13, at 814. \21\ Under the authority in section 10(a) of the Securities Act (15 U.S.C. 77j(a)), the Commission is proposing amendments to current prospectus disclosure requirements based on its determination that certain disclosure requirements result in information that, while useful to some investors, is not necessary in the public interest or for the protection of investors to be included in the prospectus. Move certain disclosure about fund organization and legal requirements from the prospectus to the SAI to focus prospectus disclosure on essential information about a fund, while continuing to assure that the information is available to those interested in reviewing it; Permit a fund that is offered as an investment alternative in a participant-directed defined contribution plan to tailor its prospectus for use by plan participants; Update and incorporate certain staff disclosure requirements into the amended registration form and include guidance about legal, interpretive, and operational matters in a new ``Investment Company Registration Package,'' which, together, would provide more effective guidance about disclosure and legal matters; 22 and --------------------------------------------------------------------------- \22\ Incorporating certain staff disclosure requirements into the revised form is intended to formally identify those disclosure requirements that would apply to all funds regardless of their particular circumstances. Among other things, the proposed approach seeks to address disclosure requirements that have been developed in connection with an issue presented by a specific fund, but applied to all funds regardless of their particular circumstances. See Securities Act Release No. 5906 (Feb. 15, 1978) (regarding a 1977 report of the Advisory Committee on Corporate Disclosure, which, among other things, recommended that, after identifying a disclosure problem of general significance, the Commission initiate rulemaking and not rely for prolonged periods on ad hoc procedures such as commenting on filings and enforcement actions). --------------------------------------------------------------------------- Simplify current disclosure instructions to provide clearer guidance for preparing and filing fund registration statements. Fund Names and Investments In a companion release, the Commission is proposing a new rule under the Investment Company Act that would address certain broad categories of investment company names that are likely to mislead investors about an investment company's investments and risks. The rule would require a fund or any other registered investment company with a name that suggests a particular investment emphasis (e.g., a fund that calls itself the ABC Stock Fund, the XYZ Bond Fund, or the QRS U.S. Government Fund) to invest at least 80% of its assets in the type of investment suggested by its name.23 Under current positions of the Division of Investment Management (the ``Division''), these funds and investment companies generally are subject to a 65% investment requirement. The rule would address investment companies with names that suggest the company focuses its investments in a particular country or geographic region and investment companies with names that indicate the company's distributions are exempt from income tax. In addition, the rule would prohibit an investment company from using a name that suggests that the company or its shares are guaranteed or approved by the U.S. Government. --------------------------------------------------------------------------- \23\ Fund Names Release, supra note 2. --------------------------------------------------------------------------- Investor Choice The proposed initiatives would give investors new disclosure options so that they could determine the amount of information they want to review before investing in a fund. The proposed profile would contain a summary of key information about a fund and enable investors who are comfortable with that level of information to purchase a fund's shares based on the profile.24 Each investor using the profile to make an investment decision would receive the [[Page 10901]] fund's prospectus with the confirmation of his or her investment. Investors also would have the option to request and review the fund's prospectus and other information about the fund (e.g., the fund's shareholder reports and SAI) before making an investment decision. --------------------------------------------------------------------------- \24\ The profile would be a summary prospectus adopted under sections 10(b) of the Securities Act (15 U.S.C. 77j(b)) and 24(g) of the Investment Company Act (15 U.S.C. 80a-24(g)). --------------------------------------------------------------------------- Standardized Fund Summaries The proposals would require standardized information in the profile and in a new risk/return summary at the beginning of all fund prospectuses. The profile would include disclosure of 9 items in a specific order and in a question-and-answer format designed to help investors evaluate and compare funds.25 The risk/return summary at the beginning of the prospectus (also included as the first 4 items in the proposed profile) would highlight information about a fund's investment objectives, strategies, risks and performance, and fees, and make this information readily available to investors in a consistent presentation. --------------------------------------------------------------------------- \25\ The profile would include disclosure about a fund's investment objectives, strategies, risks and performance, fees, investment adviser and portfolio manager, purchase and redemption procedures, tax implications, and the services available to shareholders. See Profile Release, supra note . --------------------------------------------------------------------------- Clearer Risk Disclosure The proposals seek to improve prospectus disclosure about the risks of investing in a particular fund. Based in large part on comments received in response to the Risk Concept Release,26 the proposals would improve risk disclosure as follows: \26\ The Commission also considered other information about fund risk disclosure, including the results of an investor survey sponsored by the ICI. See ICI, Shareholder Assessment of Risk Disclosure Methods (1996) (``ICI Risk Survey'). --------------------------------------------------------------------------- Overall fund risks--A fund would be required to discuss in the prospectus the overall risks of investing in the fund. The proposed amendments are designed to minimize the detailed and technical descriptions of the risks associated with specific portfolio securities typically included in a fund's prospectus and to elicit risk disclosure that relates to the particular fund and would be more useful to investors. Narrative risk summary--The profile and the prospectus risk/ return summary would include a narrative risk summary. The risk summary would provide a concise description of a fund's overall risks that could be used to evaluate and compare the risks of different funds. Graphic presentation of risk--The profile and prospectus risk/ return summary would include a bar chart reflecting a fund's returns over a ten-year period, which would illustrate fund risks by showing changes in the fund's performance from year to year. To help investors evaluate a fund's risks and returns relative to ``the market,'' a table accompanying the bar chart would compare the fund's performance to that of a broad-based securities market index. * * * * * The proposed initiatives are designed to promote more effective communication of information about funds without reducing the amount of information available to investors and other interested parties (e.g., financial analysts and advisers). The proposals would further Commission actions to improve prospectus disclosure beginning with the two-part disclosure format adopted in 1983. Permitting funds to use profiles would respond to investor support for a concise disclosure document highlighting key fund information. The profile would complement the revised prospectus, which, as the primary disclosure document, would be delivered to all investors that purchase fund shares. Taken together, these initiatives are intended to better realize the Commission's commitment to improving disclosure for fund investors. II. Discussion Release Organization. The revised Form would retain the overall structure of current Form N-1A. To make the proposed requirements of revised Form N-1A easy to follow and to highlight the proposed changes, this release addresses revised Items in the order that they would appear in the Form. While some Items in proposed Part A (the prospectus) would not be changed (except for technical revisions to improve clarity), other Items would be new or extensively revised. Certain disclosure currently required in the prospectus would be moved to Part B (the SAI), where the information would continue to be available to investors and others who are interested in the information.27 The proposed amendments would incorporate certain disclosure requirements from the Guidelines for Form N-1A (the ``Guides'') and the Generic Comment Letters (``GCLs'') that have been issued over time by the Division.28 --------------------------------------------------------------------------- \27\ In addition, Parts B and C of proposed Form N-1A would include a number of technical revisions to clarify and simplify the Form's requirements. \28\ See Letters to Registrants (Jan. 11, 1990) (``1990 GCL''); (Jan. 3, 1991) (``1991 GCL''); (Jan. 17, 1992) (``1992 GCL''); (Feb. 22, 1993) (``1993 GCL''); (Feb. 25, 1994) (``1994 GCL''); (Feb. 3, 1995) (``1995 GCL''); (Feb. 16, 1996) (``1996 GCL''). For a discussion of the Guides and GCLs, see infra notes 255-261 and accompanying text. --------------------------------------------------------------------------- The proposed amendments also would revise the General Instructions to Form N-1A to update the Instructions and make them easier to use. The release discusses in detail the proposed changes to the General Instructions after discussing changes to the Form's disclosure requirements.29 The proposed amendments would add several definitions to the General Instructions to standardize certain terms used in the Form. In particular, a new definition of ``fund'' would accommodate the use of Form N-1A by series funds.30 The General Instructions also would address other matters regarding the use of Form N-1A, including disclosure relating to multiple funds and classes, prospectuses used in the defined contribution plan market, and incorporation by reference. --------------------------------------------------------------------------- \29\ See infra Part II.D. \30\ Funds often organize as series funds and offer investors an opportunity to invest in one or more ``portfolios,'' each of which has a specific investment objective. The revised Form would define a ``fund'' to include both the registrant and a series of the registrant unless otherwise indicated. --------------------------------------------------------------------------- Plain English. Investment company registration statement forms currently include instructions, which govern all prospectus disclosure, directing a fund to provide information in the prospectus in a clear, concise, understandable manner by, among other things, avoiding the use of technical or legal terms, complex language, or excessive detail.31 The Commission's plain English proposals also would apply to prospectus disclosure.32 Initially, the proposed plain English principles would apply to the front and back cover pages of a fund's prospectus and to the summary of the prospectus, if any.33 Because the Commission issued the plain English release before this release proposing amendments to Form N-1A, the proposed requirement for plain English risk factors disclosure does not specifically identify the proposed risk/return summary, which is the parallel type of disclosure for funds and is not a summary of the prospectus. If the proposed plain English requirements and the proposed risk/return summary are adopted, the Commission intends to clarify that plain English disclosure principles apply to the risk/return summary.34 The Commission also requested comment whether the plain English disclosure principles should be modified for fund prospectuses. --------------------------------------------------------------------------- \31\ See, e.g., General Instruction G of Form N-1A. \32\ See Plain English Release, supra note 11. \33\ Id. (proposing amendments to add new paragraph (d) to rule 421 under the Securities Act (17 CFR 230.421)). \34\ To improve the clarity of prospectus disclosure, the Plain English Release also proposed revisions to Regulation S-K (17 CFR 229.10 et seq.), which sets out general disclosure requirements for corporate issuers. Similar requirements are included in specific rules for funds, and conforming changes to these rules would be made in connection with this and other fund disclosure initiatives. See proposed amendments to rule 481(b)(1) (disclaimer about the Commission's approval of securities offered in a prospectus), infra note 31. --------------------------------------------------------------------------- [[Page 10902]] A. Part A--Information in the Prospectus 1. Item 1--Front and Back Cover Pages Form N-1A requires certain information to appear on the outside front cover page of a fund's prospectus. In an effort to ``unclutter'' the prospectus cover page and avoid repeating information contained in the proposed risk/return summary at the beginning of the prospectus, the proposed amendments would simplify the disclosure currently required on the front cover page and require certain information to be included on the outside back cover page. The front cover page would be required to include a fund's name.35 The front cover page also would include the disclaimer about the Commission's approval of the securities being offered and the accuracy and adequacy of the information included in the prospectus. The wording of the disclaimer would be simplified and the disclaimer would no longer be required to be in large capital letters and bold- faced type.36 --------------------------------------------------------------------------- \35\ When a prospectus relates to one or more series, both the name of the registrant and the series would be required to appear on the back cover page. The name of the registrant may assist investors in obtaining additional information about a particular series or the registrant. \36\ Proposed amendments to rule 481(b)(1) under the Securities Act (17 CFR 230.481(b)(1)). Amended rule 481(b)(1) would require disclosure to the effect that: The Securities and Exchange Commission has not approved or disapproved these securities or passed upon the adequacy of this prospectus and any representation to the contrary is a criminal offense. The same revisions to Item 501 of Regulation S-K (17 CFR 229.501) were recently proposed for corporate registrants. See Plain English Release, supra note 11. See also Disclosure Simplification Task Force Report, supra note 15, at 18. --------------------------------------------------------------------------- The proposed amendments would not require cover page disclosure that would repeat information required to be disclosed in the proposed risk/return summary. This information would include the identification of the type of fund offered (or a brief statement of the fund's investment objectives) and certain disclosure required for money market funds.37 The proposed amendments also would no longer require a fund to provide statements that the prospectus sets forth concise information about the fund that a prospective investor ought to know before investing and should be retained for future reference.38 These statements do not appear to be particularly helpful to investors. --------------------------------------------------------------------------- \37\ See infra notes 52-58 and accompanying text. \38\ See Disclosure Simplification Task Force Report, supra note 15, at 19 (recommending elimination of many legal warnings to make the cover page more inviting and present any necessary legal warnings in a more readable style and format). See also Plain English Release, supra note 11, at 3160. --------------------------------------------------------------------------- The proposed amendments would consolidate disclosure regarding the availability of additional information about a fund on the back cover page of the fund's prospectus. The back cover page would include disclosure about the availability and date of the SAI, which would be revised to require a telephone number that investors could use to obtain the SAI without charge. To ensure prompt delivery of the SAI to those investors who request it, a new Instruction would require a fund to send the SAI within 3 days of the receipt of a request.39 The back cover page would include information (if applicable) regarding the incorporation by reference of a fund's SAI or financial information from the annual report into the prospectus and disclosure that other information about the fund has been filed with, and is available from, the Commission.40 The back cover page also would include disclosure about how a shareholder can make inquires about the fund.41 --------------------------------------------------------------------------- \39\ See Letter from Paul Schott Stevens, Senior Vice President and General Counsel, ICI, to Barry P. Barbash, Director, Division of Investment Management, SEC, at 11 (May 20, 1996) (``ICI Survey Letter'') (recommending that funds be required to deliver shareholder reports within 3 days of a request); Form N-2 (17 CFR 274.11a-1) (requiring closed-end investment companies to include a telephone number for investors to request a SAI and to send the SAI within 2 days of a request). \40\ The disclosure would be revised to indicate, among other things, that information about the fund (including the SAI) is available on the Commission's Internet Web site. Currently, only funds that disseminate prospectuses electronically are required to provide disclosure about the Commission's Web site. See Investment Company Act Release No. 21946 (May 9, 1996) (61 FR 24652). \41\ This information currently is required by Item 6(e) to be disclosed in the prospectus. To assist the Division in responding to investor inquiries, the proposed amendments would require a fund to include its Investment Company Act file number on the back cover page. --------------------------------------------------------------------------- 2. Item 2--Risk/Return Summary: Investments, Risks, and Performance The proposed amendments would require at the beginning of every prospectus a risk/return summary that would provide key information about a fund's investment objectives, principal strategies, risks, performance, and fees. This information would be required to appear in a specific sequence and to be presented in a question-and-answer format.42 The proposed question-and-answer format, frequently used by many funds, is intended to help communicate the required information effectively. The Commission requests comment on this format and whether funds instead should be permitted to choose the type of heading for the prescribed disclosure topics. --------------------------------------------------------------------------- \42\ The information in the risk/return summary would be substantially the same as the first 4 items of the proposed profile. See Profile Release, supra note 1. --------------------------------------------------------------------------- The risk/return summary, like the profile, is intended to respond to investors' strong preference for summary information about a fund in a standardized format.43 Since the profile would be optional, the proposed risk/return summary in the prospectus would provide all investors with key information about a fund in a standardized, easily accessible place that could be used to evaluate and compare fund investments. --------------------------------------------------------------------------- \43\ Focus Group participants, for example, expressed strong support for summary information in a standardized format. In addition, in connection with the profile initiative, many individual investors have written to the Commission about the need for concise, summary information relating to a fund. See also Profile Prospectuses: An Idea Whose Time Has Come, Mutual Funds Magazine, Aug. 1996, at 11. In keeping with the goal of providing key information in a standardized summary, proposed General Instruction C.2(b) would not permit a fund to include in the risk/return summary information that is not required or otherwise permitted. --------------------------------------------------------------------------- a. Investment Objectives and Principal Strategies The proposed amendments would require a fund to disclose in the risk/return summary its investment objectives and to summarize, based on the information provided in the prospectus, how the fund intends to achieve those objectives. The summary would be required to identify the fund's principal investment strategies, including the particular types of securities in which the fund invests or will invest principally, and any policy of the fund to concentrate in an industry or group of industries.44 --------------------------------------------------------------------------- \44\ The criteria for determining whether a particular strategy is a principal strategy and disclosure about concentration policies are discussed infra notes--and accompanying text. --------------------------------------------------------------------------- A fund also would be required to inform investors about the availability of additional information about the fund's investments in the fund's shareholder reports. Fund annual reports typically include the MDFP, which discusses a fund's strategies that materially affected the fund's performance during the most recent fiscal year.45 The Division's review of and experience with MDFP disclosure indicates that the annual report may be a valuable resource for investors.46 The [[Page 10903]] proposed amendments would require the risk/return summary to contain --------------------------------------------------------------------------- disclosure to the following effect: \45\ See proposed Item 5 (current Item 5A) (requiring the MDFP to be disclosed in the prospectus unless disclosed in the annual report). \46\ Commenters also have cited the annual report as a source of valuable information. See Voss Sanders, Dear Shareholder, Morningstar Mutual Funds, Apr. 26, 1996, at 1 (commenting on improved annual report disclosure). --------------------------------------------------------------------------- Additional information about the fund's investments is available in the fund's annual and semi-annual reports to shareholders. In particular, the fund's annual report discusses the relevant market conditions and investment strategies used by the fund's investment adviser that materially affected the fund's performance during the last fiscal year. You may obtain these reports at no cost by calling ________________.47 \47\ If applicable, a fund could indicate that its annual and semi-annual reports are available on its Internet site or by E-mail. In addition, a fund that provides its MDFP in the prospectus or a money market fund (which is not required to prepare a MDFP) would omit the second sentence of this disclosure. --------------------------------------------------------------------------- The proposed amendments would require this disclosure to appear in the context of information about a fund's investments. The Commission requests comment on this approach. For example, would disclosure about the availability of additional information about the fund (e.g., the fund's shareholder reports, SAI, or any other information) be more helpful to investors if the disclosure was presented under a separate caption in the risk/return summary or on the back cover page of the prospectus? Should this disclosure include an explanation about the various types of information available to investors? 48 --------------------------------------------------------------------------- \48\ As proposed, the back cover page of the prospectus would include more general disclosure about the availability of additional information. --------------------------------------------------------------------------- b. Risks Narrative Risk Disclosure. The proposed amendments would require a fund to summarize the principal risks of investing in the fund based on the information provided in the prospectus. More than 75% of the individual investors commenting on the Risk Concept Release specifically favored requiring a risk summary in fund prospectuses. This disclosure would be required to focus on the risks to which the fund's particular portfolio as a whole is subject and the circumstances reasonably likely to affect adversely the fund's net asset value, yield, and total return.49 The risk section of the risk/return summary also would include disclosure about the risk of losing money and identify the types of investors for whom the fund may be an appropriate or inappropriate investment (based on, for example, an investor's risk tolerance and time horizon).50 A fund, at its option, could discuss in the risk section the potential rewards of investing in the fund as long as the discussion provides a balanced presentation of the fund's risks and rewards.51 --------------------------------------------------------------------------- \49\ See infra notes 133-138 and accompanying text. The proposed amendments also would require a fund to disclose, if applicable, that it is non-diversified. See section 5(b) of the Investment Company Act (15 U.S.C. 80a-5(b)) (regarding diversified and non- diversified funds). To help investors understand this disclosure, a non-diversified fund would be required to describe the effects and to summarize the risks of non-diversification. \50\ Information about whether a fund is appropriate for particular types of investors is designed to help investors evaluate and compare funds based on their investment goals and individual circumstances. In the pilot profiles, this information is presented under a separate caption relating to the appropriateness of an investment for certain investors. Because this information is closely related to the risks of investing in a fund, the proposed amendments would integrate this disclosure into the risk section of the risk/return summary. \51\ The 1996 Profile Letter, in contrast, permits disclosure about the rewards of investing in a fund only if presented separately from disclosure about the fund's risks. 1996 Profile Letter, supra note 16, at 2. --------------------------------------------------------------------------- Special Risk Disclosure Requirements. Certain types of funds are required to provide special disclosure on the cover page of their prospectuses. Form N-1A requires a money market fund to disclose on the cover page of its prospectus that an investment in the fund is neither insured nor guaranteed by the U.S. Government, and that there can be no assurance that the fund will be able to maintain a stable net asset value of $1.00 per share.52 The Form requires a tax-exempt money market fund that concentrates its investments in a particular state (a ``single state money market fund'') to disclose that the fund may invest a significant percentage of its assets in a single issuer and that investing in the fund may be riskier than investing in other types of money market funds.53 The disclosure required for all money market funds is intended to alert investors that investing in a money market fund is not without risk.54 The disclosure required for single state money market funds seeks to inform investors about the particular risks associated with a single state money market fund and to distinguish these funds from other money market funds.55 In addition, a fund that is advised by or sold through a bank is required to disclose on the cover page of its prospectus that the fund's shares are not deposits or obligations of, nor guaranteed or endorsed by, the bank, and that the shares are not insured by the Federal Deposit Insurance Corporation (``FDIC'') or any other government agency.56 This disclosure is intended to alert investors that funds advised by or sold through banks are not federally insured.57 --------------------------------------------------------------------------- \52\ Item 1(a)(vi). \53\ Item 1(a)(vii). This disclosure is not required if the fund limits its investments in a single issuer to no more than 5% of the fund's assets. \54\ See Investment Company Act Release Nos. 17589 (July 17, 1990) (55 FR 30239, 30247) and 18005 (Feb. 20, 1991) (56 FR 8113, 8123) (proposing and adopting revisions to rules relating to money market funds). \55\ Unlike other money market funds, a single state money market fund is not subject to the issuer diversification requirements of rule 2a-7 (17 CFR 270.2a-7). In March 1996, the Commission adopted amendments to rule 2a-7 that would require a single state money market fund, with respect to 75% of its assets, to invest no more than 5% of its assets in securities of a single issuer. Investment Company Act Release No. 21837 (Mar. 21, 1996) (61 FR 13956). The Commission has suspended the compliance date for these amendments pending the adoption of technical changes to amended rule 2a-7. Investment Company Act Release Nos. 22135 (Aug. 13, 1996) (61 FR 42786) and 22283 (Dec. 10, 1996) (61 FR 66621). \56\ 1994 GCL, supra note 28, at II.B; Letter to Registrants from Barbara J. Green, Deputy Director, Division of Investment Management, SEC (May 13, 1993) (``Division Bank Letter''). \57\ See Division Bank Letter, supra note 56. See also Testimony of Ricki Helfer, Chairman, FDIC, on FDIC Survey of Nondeposit Investment Sales at FDIC-Insured Institutions Before the Subcomm. on Capital Markets, Securities, and Government Sponsored Enterprises of the House Comm. on Banking and Financial Services, 104th Cong., 2d Sess. (June 26, 1996) (citing surveys in October 1995 and April 1996 indicating that approximately one-third of bank customers either thought that, or did not know whether, funds sold through banks were insured). --------------------------------------------------------------------------- The proposed amendments would move the required disclosure for all money market funds, single state money market funds, and funds advised by or sold through banks to the risk section of the risk/return summary. Since this disclosure relates directly to a particular fund's risks, it would appear to be more meaningful to investors when presented in the context of information about the fund's risks. The proposed approach also would help streamline the prospectus cover page and avoid repeating information on the cover page and in the risk section of the risk/return summary. The proposed amendments would revise the wording of the current disclosure required for all money market funds and funds advised by or sold through banks. The proposed amendments would simplify the disclosure that fund shares are not federally insured as follows: An investment in the fund is not insured or guaranteed by the FDIC or any other government agency. The proposed amendments also would simplify the technical disclosure that a money market fund may not be able to maintain a stable net asset value. The revised disclosure would state: Although the fund seeks to preserve the value of your investment at $1.00 per share, [[Page 10904]] it is possible to lose money by investing in the fund.58 \58\ The proposed disclosure, which would be required to be given by a money market fund in place of the proposed general risk disclosure about losing money, seeks to strike a balance between the potential to lose money in a money market fund and the relative risk of losing money in a money market fund as compared to other types of funds. --------------------------------------------------------------------------- The Commission requests comment whether the disclosure required for all money market funds, single state money market funds, and funds advised by or sold through banks should be moved from the prospectus cover page to the risk/return summary. If the disclosure is moved from the cover page, should it be highlighted in a typographically distinctive manner (e.g., boldface or italics)? The Commission also requests comment on the wording of the proposed disclosure. In addition, the Commission requests comment whether the disclosure for single state money market funds should continue to be required. The disclosure, for example, may exaggerate the risks of a single state money market fund since these funds, like all money market funds, may purchase only those portfolio instruments that meet the credit quality and maturity requirements of rule 2a-7.59 --------------------------------------------------------------------------- \59\ Among other things, rule 2a-7 requires a money market fund to invest in securities that are rated in one of the two highest categories by a nationally recognized statistical rating organization (or, if unrated, to be of comparable quality) and have a maturity of 13 months or less. Rules 2a-7 (a)(9) and (c)(3). --------------------------------------------------------------------------- Risk/Return Bar Chart and Table. The proposed amendments would require a bar chart showing a fund's annual returns for each of the last 10 calendar years and a table comparing the fund's average annual returns for the last one, five, and ten fiscal years to those of a broad-based securities market index.60 The bar chart would illustrate graphically a fund's past risks by showing changes in the fund's returns over time. The information in the table would enable investors to evaluate a fund's performance and risks relative to ``the market.'' Over 75% of individual investors responding to the Risk Concept Release favored a bar chart presentation of fund risks.61 Focus Group participants found both a bar chart and tabular presentation of fund performance helpful in evaluating and comparing fund investments, particularly when the table included return information for a broad-based index. --------------------------------------------------------------------------- \60\ Proposed Item 2(c)(2). \61\ Risk Concept Release, supra note 18. See also ICI Risk Survey, supra note 26, at 21, 37 (51% of survey participants indicated they were very confident about using a bar chart to compare the risks of different funds and 49% of survey participants indicated they were very confident in using a bar chart to assess the risks of a single fund). In addition, all commenters responding to the Commission's initiative to simplify money market fund prospectuses supported the proposal to replace the financial highlights information in money market fund prospectuses with a ten- year bar chart reflecting a money market fund's returns. See Summary of Comment Letters on Proposed Amendments to the Rules Regulating Money Market Fund Prospectuses Made in Response to Investment Company Act Release No. 21216, at 2 (File No. S7-21-95) (``Money Market Prospectus Comment Summary''). --------------------------------------------------------------------------- The proposed amendments would require the bar chart and table to be included in the risk section of the risk/return summary under a subheading that refers to both risk and performance.62 To help investors use the information in the bar chart and table, the proposed amendments would require a fund to explain how the information illustrates the fund's risks and performance. --------------------------------------------------------------------------- \62\ The 1996 Profile Letter, in contrast, requires the bar chart and table to appear under a caption relating to a fund's past performance. 1996 Profile Letter, supra note 16, at 2. --------------------------------------------------------------------------- An example of the risk/return bar chart and table is set forth below: BILLING CODE 8010-01-P [[Page 10905]] [GRAPHIC] [TIFF OMITTED] TP10MR97.000 BILLING CODE 8010-01-C [[Page 10906]] Bar Chart Return Information. 63 The proposed amendments would require the bar chart to reflect annual returns for a fund's last 10 calendar years. 64 Requiring calendar year returns is intended to help investors compare the risks of different funds over similar time periods. --------------------------------------------------------------------------- \63\ Funds generally file Form N-1A electronically on the Commission's electronic data gathering analysis and retrieval system (``EDGAR''). Although EDGAR currently does not reproduce graphic images like the bar chart, the EDGAR rules require a fair and accurate narrative description or tabular presentation in the place of any omitted material. Rule 304(a) of Regulation S-T (17 CFR 232.304(a)). The Commission anticipates future modifications that would permit EDGAR to reflect graphic images on electronically-filed documents. \64\ A fund also would be required to present the corresponding numerical return next to each bar. The proposed amendments would require a fund to have at least one calendar year of returns before including the bar chart. A fund that includes a single bar in the bar chart or a fund that does not include the bar chart because the fund does not have annual returns for a full calendar year would be required to modify, as appropriate, the narrative explanation accompanying the bar chart and table (e.g., by stating that the information shows the fund's risks and performance by comparing the fund's performance to a broad measure of market performance). The proposed amendments would require the bar chart of a fund in operation for fewer than 10 years to include annual returns for the life of the fund. --------------------------------------------------------------------------- A fund would calculate the annual returns in the bar chart by using the same method required for calculating annual returns in the financial highlights information included in fund prospectuses. 65 Like the returns in the financial highlights information, the returns in the bar chart would not reflect sales loads. Sales loads can be accurately and fairly reflected in return information of the type contained in the table by deducting sales loads at the beginning (or end) of particular periods from a hypothetical initial fund investment. 66 Reflecting sales loads in the bar chart, however, may be impracticable. In addition, reflecting the payment of sales loads may be less important in the bar chart than in the table, since the bar chart is intended primarily to depict fund risks graphically. The proposed amendments would require a fund that charges sales loads to disclose that sales loads are not reflected in the bar chart and that if the loads were included, returns would be less than those shown. 67 --------------------------------------------------------------------------- \65\ Instruction 1(a) to proposed Item 2(c)(2). See also Instruction 3 to proposed Item 9(a) (regarding the calculation of total returns provided in financial highlights information). \66\ As a consequence, the fund's average annual returns in the table would reflect the payment of sales loads (if any). \67\ Instruction 1(a) to proposed Item 2(c)(2) (requiring similar disclosure if a fund charges account fees). --------------------------------------------------------------------------- The Commission requests comment on the proposed bar chart. In particular, the Commission requests comment whether the bar chart communicates information about fund risks effectively or whether the bar chart has limitations that detract from its usefulness. 68 The Commission requests comment whether the bar chart should include return information for additional or different time periods. For example, should the bar chart reflect return information for shorter time periods (e.g., calendar quarters) or longer time periods (e.g., for the life of the fund when more than 10 years)? The Commission also requests comment whether the return information in the bar chart should include sales loads and, specifically, how sales loads could be accurately and fairly reflected. --------------------------------------------------------------------------- \68\ See, e.g., Remarks by Steven M.H. Wallman, Commissioner, SEC, before the ICI's 1995 Investment Company Directors Conference and New Directors Workshop, Washington, DC. (Sept. 22, 1995) (discussing circumstances when a bar chart's presentation of fund risks may be confusing to investors, such as when bar charts use different scales). --------------------------------------------------------------------------- Bar Chart Presentation for More than One Fund. The proposed amendments would not limit the number of funds for which return information could be included in a single bar chart. While the proposed approach would give funds flexibility in preparing the bar chart, including return information in a single bar chart for a number of funds could make the graphic presentation of the bar chart complex and difficult to follow. 69 Bar charts included in the pilot profiles reflect information for only one fund. 70 In addition, Focus Group participants found prototype bar charts that included information for 6 funds (i.e., 6 bars per year) to be confusing. The Commission requests comment whether the number of funds that could be included in a single bar chart should be limited to one fund or to some other number of funds (e.g., 2, 4, or no more than 6 funds). This approach could enhance the clarity of the bar chart presentation. Limiting the number of funds that could be included in a single bar chart, however, could require a prospectus offering several funds to include more than one chart, which, in turn, could complicate bar chart disclosure and lengthen the prospectus. --------------------------------------------------------------------------- \69\ While the proposed amendments would not impose a specific limit on the number of funds included in a bar chart, the presentation of the bar chart would be subject to the general requirement that information in the prospectus be set forth in a clear and understandable manner. See proposed General Instruction C.1(a). \70\ See 1995 Profile Letter, supra note 16 (permitting the pilot profiles to include disclosure for a single fund or series of a fund). --------------------------------------------------------------------------- Multiple Class Funds. In contrast to the proposed approach with respect to the bar chart presentation for funds, the proposed amendments would require a multiple class fund to include annual return information in the bar chart for only one class. 71 Unlike individual funds, classes represent interests in the same investment portfolio, and the returns of each class differ only to the extent the classes do not have the same expenses. Including return information for all classes appears to be unnecessary to illustrate the risks of investing in the fund. In addition, the proposed amendments would require the table accompanying the bar chart to provide return information for each class so that investors would be able to identify and compare the performance of the classes offered in the prospectus. --------------------------------------------------------------------------- \71\ Instruction 3(a) to proposed Item 2(c)(2). --------------------------------------------------------------------------- The proposed amendments would require the bar chart to reflect annual return information for the class offered in the prospectus that has returns for the longest period over the last 10 years. This approach is intended to provide the greatest amount of information about changes in the fund's returns. When two or more classes have returns for at least 10 years or returns for the same period but fewer than 10 years, the fund would be required to provide annual returns for the class with the greatest net assets as of the end of the most recent calendar year. Focusing on the class with the greatest net assets is intended to provide returns in the bar chart for a ``representative'' class offered in the prospectus. The proposed requirements may result in including returns in the bar chart for a class that has lower annual operating expenses (and better performance) than other classes offered in the prospectus. The Commission considered several other approaches, including requiring a fund to show returns in the bar chart for the class with the highest annual operating expenses. The Commission has not proposed these alternatives because they would make the bar chart requirements too complex and difficult to apply. In addition, the bar chart primarily is designed to show graphically the risks of investing in a fund and not the costs of investing in the fund. The Commission requests comment whether the bar chart presentation for multiple class funds should be limited to one class. If so, should the selection of the class be made on a basis other than that proposed? Tabular Presentation of Fund and Index Returns. The proposed amendments would require the table accompanying the bar chart to present the fund's average annual returns for the [[Page 10907]] last one, five, and ten fiscal years (or for the life of the fund, if shorter) 72 and to compare that information to the returns of a broad-based securities market index. 73 Requiring comparative return information for a broad-based securities market index would provide investors with a basis for evaluating a fund's performance and risks relative to the market. 74 The proposed approach also would be consistent with the line graph presentation of fund performance required in MDFP disclosure. 75 --------------------------------------------------------------------------- \72\ The proposed amendments would require a money market fund to provide its 7-day yield in the table. A non-money market fund would be permitted to disclose its yield, and any fund (including a money market fund) would be permitted to disclose its tax-equivalent yield. When yield information is disclosed, a fund would be required to include a telephone number that investors can use without charge to obtain current yield information. \73\ A fund's average annual returns would be calculated using the same method required to calculate fund performance included in advertisements, which reflects the payment of sales loads and recurring shareholder account fees. Instruction 2(a) to proposed Item 2(c)(2) (incorporating the requirements of proposed Item 21). See also proposed Item 5 (requiring sales loads and recurring shareholder account fees to be reflected in the return information shown in the MDFP line graph). Consistent with the preparation of the MDFP line graph, if a fund has not had the same adviser for the last 10 years, the fund would be permitted to begin the bar chart and performance information in the table on the date the new adviser began to provide advisory services to the fund so long as certain conditions are met. \74\ See MDFP Adopting Release, supra note 14, at 19054. Consistent with the preparation of the MDFP line graph, if a fund changes indexes, the fund would be required to explain the reasons for the change and provide information for both the newly selected and the former index. \75\ See Instruction 5 to proposed Item 5(b) (defining ``appropriate broad-based securities market index'). See also 1996 Profile Letter, supra note 16, at 3 (permitting a fund, at its option, to compare its returns to those of an appropriate broad- based securities market index). --------------------------------------------------------------------------- Consistent with the requirements for preparing the MDFP line graph, the proposed amendments would allow a fund to include return information for other indexes, including a ``peer group'' index of comparable funds. 76 Focus Group participants indicated that comparing fund returns to a broad-based securities market index and a peer group index could be useful in evaluating and comparing fund investments. 77 --------------------------------------------------------------------------- \76\ If an additional index is included, the fund would be required to discuss the additional index in the narrative explanation accompanying the bar chart and table. Instruction 2(b) to proposed Item 2(c)(2). \77\ Other commenters have suggested different ways to provide comparative return information. See Letter from John C. Bogle, Chairman of the Board, The Vanguard Group, to Jonathan G. Katz, Secretary, SEC, at 3 (July 28, 1995) (File No. S7-10-95) (recommending disclosure of fund and market index returns on a quarterly basis over a 10-year period); Letter from Daniel Pierce, Chairman of Board, Scudder, Stevens & Clark, Inc., to Jonathan G. Katz, Secretary, SEC, at 2 (July 28, 1995) (recommending that a fund's returns be compared to both a benchmark index (e.g., the S&P 500) and a risk-free measure (e.g., the yield on 3-month U.S. Treasury bills)); ICI Survey Letter, supra note 39, at 8-9 (recommending that a fund be permitted to show either a broad-based market index or an appropriate index of fund performance). --------------------------------------------------------------------------- The Commission believes that a comparison of a fund's performance to a broad-based securities market index can assist investors in evaluating the risk of a fund investment. The proposed amendments would include this information in the table accompanying the bar chart to minimize the complexity of the graphic presentation of a fund's risks and returns. The Commission recognizes that other presentations could improve fund risk disclosure and requests comment on alternative approaches. 78 Specifically, the Commission requests comment on requiring the annual returns of a broad-based securities market index (and any optional peer group or other index) to appear in the bar chart instead of the table. By providing investors with a graphic illustration of the relationship between the returns of the fund and the index(es), this approach could help investors evaluate the comparative risk of the fund and the index(es). Including additional bars or lines for index comparisons in the bar chart, however, could complicate the chart (especially if the chart included return information for more than one fund) and make it difficult for investors to follow. --------------------------------------------------------------------------- \78\ Focus Group participants did not express a preference as to the placement of this information in the bar chart or accompanying table. --------------------------------------------------------------------------- As an alternative to, or in addition to the bar chart, the Commission requests comment on requiring a fund to show its highest and lowest annual returns (or ``range'' of returns) over a ten-year or other period compared with the same information for a broad-based market index (and any optional peer group or other index). This information, which could be presented as a separate table or included in the proposed table showing a fund's average annual returns, could help investors assess fund risks. 3. Item 3--Risk/Return Summary: Fee Table Form N-1A would continue to require a fee table in the prospectus, which summarizes the sales loads and expenses associated with an investment in a fund. The fee table seeks to provide uniformity, simplicity, and comparability in fee disclosure. 79 Consistent with this objective, the Commission is proposing several amendments designed to improve fee table disclosure. --------------------------------------------------------------------------- \79\ See Fee Table Adopting Release, supra note 14, at 3194. --------------------------------------------------------------------------- a. Fee Table Example Form N-1A requires an ``Example'' to accompany the fee table that discloses the cumulative amount of fund expenses over one, three, five, and ten year periods based on a hypothetical investment of $1,000 and an annual 5% return. The Example primarily is intended to provide information about the cost of investing in one fund that can be compared with similar information about another fund. 80 Focus Group participants, however, had difficulty understanding and using the information in the Example. --------------------------------------------------------------------------- \80\ Id. (also noting that the Example provides information about the cost of a fund investment). --------------------------------------------------------------------------- The proposed amendments seek to improve the Example by requiring a fund to provide a specific narrative description that explains the purpose of the information presented. The revised Form would require a narrative explanation to the following effect: This Example is intended to help you compare the cost of investing in the fund to the cost of investing in other mutual funds. 81 \81\ Like the current Form, the proposed amendments would require a fund that charges sales loads on reinvested dividends to disclose that these loads are not reflected in the Example and that, if the loads were included, the expenses reflected in the Example would be higher. Instruction 4(d) to proposed Item 3 would require this disclosure to follow the Example to avoid informing investors about what is not included in the Example before they have an opportunity to review what is included. --------------------------------------------------------------------------- To further assist investors in understanding the Example, the proposed amendments would revise the description of how the Example is calculated. 82 --------------------------------------------------------------------------- \82\ See proposed Item 3. Instruction 4(a) to proposed Item 3 also would permit a fund to adjust the expenses included in the Example to reflect the completion of the amortization period for expenses associated with the initial organization of the fund. See Money Market Fund Prospectus Release, supra note 14, at 38458 (proposing this change). --------------------------------------------------------------------------- The proposed amendments also would increase the initial hypothetical investment in the Example from $1,000 to $10,000. The increase is intended to reflect a typical fund investment (many funds have minimum investments exceeding $1,000) and more closely approximate the amount of expenses that may be paid over time. 83 Using the $10,000 figure in the Example also would be consistent with the $10,000 [[Page 10908]] hypothetical initial account value used in the MDFP line graph. 84 --------------------------------------------------------------------------- \83\ See Letter from John C. Bogle, Chairman of the Board, The Vanguard Group, to Barry P. Barbash, Director, Division of Investment Management, SEC (Sept. 16, 1996) (suggesting that few investors have as little as $1,000 invested in a given fund, and that the average fund investment typically amounts to $10,000- 25,000, with the median investment probably in the range of $6,000- 7,000). \84\ See proposed Item 5(b). --------------------------------------------------------------------------- The Commission requests comment on the proposed amendments. The Commission also requests comment whether the Example communicates useful information to investors and, specifically, whether the Example should continue to be required. The Commission requests comment about other ways to provide information that investors can use to compare the costs of fund investments. b. Shareholder Account Fees Instructions to the fee table require a fund to include, under the caption ``Other Expenses,'' fees that are charged to all shareholder accounts. 85 Funds that have account fees (e.g., account maintenance fees) typically charge these fees as a fixed dollar amount and disclose the fees in a separate line item to the fee table. 86 Because account fees are paid directly by shareholders and are not fund operating expenses, the proposed amendments would create a new line item in the shareholder transaction section of the fee table that would describe the type of account fees charged by a fund. 87 Like the fee table requirements applicable to sales loads, the proposed amendments would require a fund to show the maximum account fee imposed. 88 --------------------------------------------------------------------------- \85\ Instruction 10 to Item 2(a). \86\ Certain funds charge shareholder account fees as a percentage of assets invested. A small number of funds charge account fees based on the fund's average net assets. \87\ Instruction 2(d) to proposed Item 3. This Instruction would address when account fees must be included in the fee table. For example, account fees would be required in the fee table even if a fund waived the fees for certain shareholders, such as employees of the fund's investment adviser and investors with large account balances. In certain circumstances, case-by-case determinations would continue to be made regarding the inclusion (or exclusion) of account fees from the fee table based on the number and type of shareholders subject to the fee and the services provided. \88\ If an account fee is charged only to accounts that do not meet a certain threshold (e.g., accounts under $2,500) or if an account fee is non-recurring (e.g., it is paid to open or close an account), a fund would be permitted to disclose the threshold or the type of fee imposed in a parenthetical to the caption or in a footnote to the fee table. In computing the expenses shown in the Example, Instruction 4(d) to proposed Item 3 would allow the allocation of account fees when they are charged to invest in more than one fund. See Money Market Fund Prospectus Release, supra note 14, at 38461 (proposing this change). In addition, a fund that charges account fees based on a minimum investment requirement would be permitted to prorate its account fees for purposes of the Example if the fund's minimum account requirement exceeds $10,000 (the proposed hypothetical investment). For instance, adjusting an account fee of $100 to $50 would be appropriate to avoid overstating the fee in the Example when the fund's minimum investment requirement is $20,000. --------------------------------------------------------------------------- c. Improving and Simplifying Fee Table Presentation Fee Table Narrative. Form N-1A requires a fund to provide a narrative description following the fee table explaining the purpose of the table. 89 To help investors use the information presented, the proposed amendments would require the narrative explanation to appear before (rather than after) the fee table and to include disclosure to the following effect: \89\ Instruction 1 to Item 2(a). --------------------------------------------------------------------------- This table describes the fees and expenses you may pay in connection with an investment in the fund. New Fee Table Headings and Captions. The fee table is divided into two sections: ``Shareholder Transaction Expenses'' and ``Annual Fund Operating Expenses.'' Captions beneath the two general headings list the fees that make up transaction and operating expenses. The general heading for the shareholder transaction section of the fee table refers to shareholder transaction ``expenses'' and captions underneath this heading refer to sales ``loads'' and redemption and exchange ``fees.'' The proposed amendments would revise the shareholder transaction section so that the general heading and captions consistently refer to ``fees.'' As a result of this change, captions relating to sales loads would refer to ``sales fees.'' Since some investors are familiar with the term ``load'' and many funds use the term ``no load'' in marketing materials, however, these captions would include the term ``load'' in parentheses (e.g., ``Maximum Sales Fee (Load) Imposed on Purchases').90 --------------------------------------------------------------------------- \90\ See ICI Survey Letter, supra note 39 (changing the caption from ``sales load'' to ``sales charge,'' without using the term ``load'). --------------------------------------------------------------------------- The proposed amendments also would revise the caption ``12b-1 Fees,'' which includes any distribution and other expenses a fund pays under a rule 12b-1 plan.91 The proposed amendments would change the caption to ``Marketing (12b-1) Fees.'' 92 Retaining the designation ``12b-1'' would enable investors familiar with rule 12b-1 plans to identify those fees in the fee table. The Commission requests comment whether another caption (e.g., ``Distribution (12b-1) Fees'') would be more appropriate. --------------------------------------------------------------------------- \91\ 17 CFR 270.12b-1. \92\ Focus Group participants indicated that the term ``marketing fees'' would help them understand the expenses included in the line item. --------------------------------------------------------------------------- To help explain the difference between the fees paid by shareholders and expenses paid by the fund, the proposed amendments would require the following parentheticals after each heading: ``Shareholder Fees (fees paid directly from your account)'' and ``Annual Fund Operating Expenses (expenses that are deducted from the fund's assets).'' 93 --------------------------------------------------------------------------- \93\ See ICI Survey Letter, supra note 39 (enclosing a prototype profile that includes similar explanatory information). --------------------------------------------------------------------------- Fee Schedules. Instructions to the fee table permit a fund to include a tabular presentation within the fee table that shows a range of deferred sales loads over time and a range of exchange fees.94 Since the presentation of a table within the larger fee table tends to complicate the fee disclosure and may discourage investors from reviewing the information presented, the proposed amendments would no longer permit this disclosure in the fee table. Like the current Form, the proposed amendments would continue to permit a fund to explain the range of deferred sales loads or exchange fees in a footnote.95 --------------------------------------------------------------------------- \94\ Instructions 5 and 7 to Item 2(a). \95\ Instructions 2(a)(i) and 2(c) to proposed Item 3. The GCLs require a fund to disclose wire redemption charges in a footnote to the fee table. 1991 GCL, supra note 28, at II.G. Given the small amount of these fees (typically $5 to $10 per redemption) and since these fees are charged only when shareholders elect to receive redemption proceeds by wire, the proposed amendments would not require disclosure of wire redemption charges in the fee table. A fund may include this disclosure in a footnote to the table or together with other prospectus disclosure regarding redemption procedures. --------------------------------------------------------------------------- Expense Reimbursement and Fee Waiver Arrangements. Instructions to the fee table require a fund that has an expense reimbursement or fee waiver arrangement to reflect the arrangement in the fee table if the reimbursement or waiver will continue.96 The proposed amendments would clarify that a fund is required to reflect expense reimbursement and fee waiver arrangements without regard to whether the arrangement has been guaranteed for a full fiscal year.97 This approach is intended to assure that investors are informed about decreases in expense reimbursement and fee waiver arrangements that could affect the fund's performance. --------------------------------------------------------------------------- \96\ Instruction 13 to Item 2(a). \97\ Instruction 3(e) to proposed Item 3. See Money Market Fund Prospectus Release, supra note 14, at 38458 (proposing this clarification). --------------------------------------------------------------------------- Other Expenses. Instructions to the fee table permit a fund to subdivide the line item for ``Other Expenses'' into 3 subcategories of its own choosing.98 Since some funds identify the fees that make up this line item by adding a parenthetical following the ``Other Expenses'' caption, the proposed amendments would permit a fund to [[Page 10909]] identify the expenses that comprise this line item either under separate subcaptions or in a parenthetical following the ``Other Expenses'' caption.99 When subcaptions are provided, the proposed amendments would clarify that the subcaptions must identify the 3 largest expenses that comprise ``Other Expenses.'' --------------------------------------------------------------------------- \98\ Instruction 10(b) to Item 2(a). \99\ Instruction 3(c)(iii) to proposed Item 3. --------------------------------------------------------------------------- 4. Item 4--Investment Strategies and Risk Disclosure Prospectus disclosure about fund investments and risks typically consists of descriptions of each type of security in which a fund may invest and the risks associated with those securities. The investments described often include instruments, such as illiquid securities, repurchase agreements, and options and futures contracts, that do not have a significant role in achieving a fund's investment objectives. Disclosing information about each type of security in which a fund might invest does not appear to help investors evaluate how the fund's portfolio will be managed or the risks of investing in the fund. This disclosure also adds substantial length and complexity to fund prospectuses, contributing to investor perceptions that prospectuses are too complicated and discouraging investors from reading a fund's prospectus.100 --------------------------------------------------------------------------- \100\ See Money Market Fund Prospectus Release, supra note 14, at 38456 (giving examples of lengthy and technical disclosure about portfolio holdings frequently found in money market fund prospectuses). --------------------------------------------------------------------------- The Commission believes that prospectus disclosure would be more useful to investors if it emphasized the principal investment strategies of a fund and the principal risks of investing in the fund, rather than the characteristics and risks of each type of instrument in which the fund may invest.101 Since funds are intended to offer investors professional investment management,102 the focus of investment disclosure should be on the fund's investment objectives and the principal means used by the fund's adviser to achieve those objectives. Consistent with this view, the proposed amendments seek to encourage prospectus disclosure that would help investors understand how a fund's portfolio will be managed. The proposed amendments are designed to be consistent with, and to implement more effectively, the Commission's intention in adopting Form N-1A that the prospectus should describe a fund's ``fundamental characteristics.'' 103 --------------------------------------------------------------------------- \101\ The ICI has recommended that prospectus disclosure focus primarily on a fund's broad investment objectives, practices, and associated risks, and not on particular types of securities in which the fund invests. See, e.g., Letter from Paul Schott Stevens, General Counsel, ICI, to Jonathan G. Katz, Secretary, SEC, at 4-6 (July 28, 1995) (``1995 ICI Risk Comment Letter'); Letter from Amy B.R. Lancellotta, Associate Counsel, ICI, to C. Gladwyn Goins, Associate Director, Division of Investment Management, SEC, at 7 (Mar. 7, 1995) (``1995 ICI Disclosure Letter'). \102\ See, e.g., 1 T. Lemke, G. Lins & A.T. Smith III, Regulation of Investment Companies Sec. 1.01, at 1-1 (1996). \103\ See Form N-1A Proposing Release, supra note 13, at 815; Form N-1A Adopting Release, supra note 12, at 39729. See also Money Market Fund Prospectus Release, supra note 14 (proposing amendments that would permit money market funds to include in their prospectuses ``basic, general statements about their investment objectives and portfolio composition''). --------------------------------------------------------------------------- a. Investment Objectives and Implementation of Investment Objectives To assist investors in identifying funds that meet their investment needs, the proposed amendments, like the current Form, would require prospectus disclosure of a fund's investment objectives.104 The proposed amendments, however, would change the disclosure requirements regarding how a fund intends to achieve its investment objectives. Form N-1A currently requires a fund to disclose the types of securities in which it invests or will invest principally as well as any ``special investment practices and techniques'' that will be used in connection with investing in those securities.105 Form N-1A also requires disclosure about ``significant investment policies or techniques'' that a fund intends to use, subject to certain limitations.106 --------------------------------------------------------------------------- \104\ Proposed Item 4(a). A fund may refer to its investment objectives as investment goals. If a fund's investment objectives can be changed without a shareholder vote, the proposed amendments would continue to require disclosure of this fact in the prospectus. Although not required by Form N-1A, some funds disclose in the prospectus that their investment objectives may not be changed without a shareholder vote. Since investors generally do not expect fund investment objectives to change, this disclosure does not appear to help investors evaluate and compare funds. This disclosure would be moved to the SAI and proposed Item 12(c)(1)(vii) would require a fund to disclose when its investment objectives may not be changed without a shareholder vote. \105\ Item 4(a)(ii)(B)(1). \106\ Item 4(a)(ii)(D). --------------------------------------------------------------------------- One of those limitations directs a fund to limit prospectus disclosure about practices that place no more than 5% of a fund's assets at risk.107 Many funds disclose in their prospectuses information about securities and investment practices that do not and may not ever place more than 5% of a fund's assets at risk, often to retain the flexibility to exceed the 5% threshold in the future.108 --------------------------------------------------------------------------- \107\ Item 4(b)(ii). Item 4(b)(i) directs a fund not to disclose so-called ``negative'' practices (i.e., practices in which a fund may not or does not intend to engage). Instruction 3 to proposed Item 4(b)(1) would retain this limitation by providing that a negative strategy is not a principal strategy. Avoiding disclosure about negative strategies should help keep prospectus disclosure focused on what the fund will do to achieve its investment objectives, rather than on what the fund will not do. \108\ A fund, within a short period of time, may increase its holdings of a particular type of security from less than 5% of its assets to more than 5%, which, under the current Form, requires a different level of disclosure about the security. To avoid having to amend their prospectuses in response to changes in portfolio holdings, many funds include information in their prospectuses about any security or strategy that might at some point place more than 5% of the fund's assets at risk. --------------------------------------------------------------------------- The proposed amendments would eliminate the 5% standard. Instead, the revised Form would require a fund to disclose in the prospectus the principal strategies to be used to achieve its investment objectives, including the particular type or types of securities in which the fund will invest principally.109 This approach is designed to shift prospectus disclosure away from an inventory of the various investments a fund may make and to focus disclosure on a fund's overall portfolio management. Whether a particular strategy (including a strategy to invest in a particular type of security) would constitute a principal strategy that must be disclosed in the fund's prospectus would depend upon the strategy's anticipated importance in achieving the fund's investment objectives and how the strategy affects the fund's potential risks and returns.110 In determining what is a principal strategy, a fund would consider, among other things, the amount of assets expected to be committed to the strategy, the amount of assets expected to be placed at risk by the strategy, and the likelihood of losing some or all of those assets.111 The proposed amendments would require disclosure about non-principal strategies to appear in the SAI.112 --------------------------------------------------------------------------- \109\ Proposed Item 4(b)(1). A bond fund, for example, typically would discuss the maturities, durations, ratings, and issuers of the bonds in which the fund principally invests. \110\ Instruction 1 to proposed Item 4(b)(1) would define a strategy to include any policy, practice, or technique used to achieve a fund's investment objectives. \111\ Instruction 2 to proposed Item 4(b)(1). \112\ Proposed Item 12(b). --------------------------------------------------------------------------- Focusing disclosure requirements on a fund's principal strategies is intended to improve prospectus disclosure by eliminating the need for disclosure about securities and strategies that do not have an important role in achieving the fund's investment objectives. Under the revised Form, for example, it generally would be unnecessary to include in the prospectus disclosure about a fund's cash management [[Page 10910]] practices (e.g., entering into overnight repurchase agreements) since these practices are not typically among a fund's principal strategies.113 --------------------------------------------------------------------------- \113\ Similarly, in most cases, a fund would be able to move to the SAI disclosure about hedging strategies that limit downside risk, securities lending, purchasing securities on a ``when-issued'' basis, short selling ``against the box'' to defer recognition of gains or losses, and investing in illiquid or restricted securities, since these strategies typically are not principal strategies. --------------------------------------------------------------------------- To further focus prospectus disclosure on a fund's principal strategies, the proposed amendments would require the prospectus to explain in general terms how the fund's adviser decides what securities to buy and sell.114 This disclosure is intended to provide investors with general information about the fund's investment approach and how the fund's portfolio will be managed. The information might describe, for example, whether an equity fund emphasizes value or growth, or blends the two approaches, or whether the fund invests in stocks based on a ``top-down'' analysis of economic trends or a ``bottom-up'' analysis that focuses on the financial condition and competitiveness of individual companies.115 --------------------------------------------------------------------------- \114\ Proposed Item 4(b)(2). The prospectus of a value-oriented fund might state, for example, that the fund's adviser selects stocks it considers to be undervalued by recognized measures of economic value such as earnings, cash flow, and book value. A growth and income fund might state that it invests in the stock of issuers whose earnings have increased from year to year and issuers that have paid dividends continuously for a certain period of time. \115\ Because proposed Item 4(b)(2) would require the prospectus to explain in general terms how the fund's adviser decides what securities to buy and sell, a fund (or its adviser) would not be required to provide proprietary information about its investment strategies. --------------------------------------------------------------------------- Concentration. Form N-1A requires a fund to disclose in its prospectus any policy to concentrate (i.e., invest 25% or more of its total assets) in a particular industry or group of industries. The proposed amendments would retain this requirement since concentrating in an industry or group of industries is likely to be a principal strategy in achieving a fund's investment objectives.116 The proposed amendments also would continue to require a single state money market fund to discuss its concentration in securities issued by a particular state or by issuers located within a state. --------------------------------------------------------------------------- \116\ Proposed Item 4(b)(3). --------------------------------------------------------------------------- Temporary Defensive Positions. Many funds adopt policies permitting them to take ``temporary defensive positions'' to avoid losses in response to adverse market, economic, political, or other conditions. When a fund assumes a temporary defensive position, the fund may depart from its usual investment strategies without a shareholder vote or specific notice to shareholders. The GCLs require a fund to disclose, if applicable, certain information about the possibility of taking temporary defensive positions.117 --------------------------------------------------------------------------- \117\ 1994 GCL, supra note 28, at II.E. --------------------------------------------------------------------------- The proposed amendments would continue to require disclosure about temporary defensive positions to alert investors of potential changes in a fund's investments.118 In particular, the proposed amendments would require a fund to disclose the percentage of its assets that may be committed to temporary defensive positions (e.g., up to 100% of the fund's assets), the risks, if any, associated with the positions, and the likely effect of these positions on the fund's performance. The Commission requests comment on requiring this information given the temporary nature of defensive positions and the proposed approach of focusing prospectus disclosure on a fund's principal strategies.119 --------------------------------------------------------------------------- \118\ Proposed Item 4(e). See also Fund Names Release, supra note 2 (permitting a fund with a name suggesting that the fund focuses on a particular type of investment to make other investments while assuming a temporary defensive position). \119\ In light of these considerations, the revised Form, unlike the 1994 GCL, supra note 28, would not require a fund to disclose the types of securities in which it may invest while taking a temporary defensive position. --------------------------------------------------------------------------- Portfolio Turnover. The Guides require a fund that has had in the past year, or anticipates having, a portfolio turnover rate of approximately 100% or more to disclose in the prospectus any tax and brokerage consequences that will result from the fund's ``high'' portfolio turnover rate.120 The proposed amendments would require prospectus disclosure only when a fund anticipates having a portfolio turnover rate of 100% or more in the coming year.121 This approach is designed to focus prospectus disclosure on a fund's expected portfolio practices, not past practices.122 --------------------------------------------------------------------------- \120\ Guide 5. \121\ Proposed Item 4(b)(4). A fund that expects its portfolio turnover rate to be less than 100% would continue to be required to disclose the anticipated rate of its portfolio turnover in the SAI. As under the current requirements, a money market fund would not be required to discuss portfolio turnover in either the prospectus or the SAI. See MDFP Adopting Release, supra note 14, at 19051 n.3. \122\ Information about a fund's portfolio turnover rate in previous fiscal years is disclosed in the financial highlights table. See proposed Item 9. --------------------------------------------------------------------------- The proposed amendments would require disclosure of the fund's anticipated portfolio turnover rate and what that rate means (e.g., that a portfolio turnover rate of 200% is equivalent to the fund buying and selling all of the securities in its portfolio twice in the course of a year).123 Disclosing the anticipated turnover rate and explaining its meaning are intended to enable investors to evaluate how actively a fund buys and sells portfolio securities and to compare the anticipated portfolio turnover rates of different funds. --------------------------------------------------------------------------- \123\ Like any other fund, a ``balanced'' fund would discuss its anticipated turnover rate with respect to its entire portfolio. Guide 5, in contrast, requires a balanced fund to discuss portfolio turnover separately for the stock and bond portions of the fund's portfolio. --------------------------------------------------------------------------- The proposed amendments also would require a fund to explain the tax consequences to shareholders of the fund's high portfolio turnover rate. In addition, the proposed amendments would require a fund to explain how trading costs associated with the fund's high portfolio turnover may affect the fund's performance. The Commission requests comment on the proposed requirements. In particular, the Commission requests comment whether a fund with a portfolio turnover rate of 100% should be viewed as having a high portfolio turnover rate. An informal review by the Division of fund portfolio turnover rates suggests that nearly half of all funds have portfolio turnover rates exceeding 100%. The Commission also requests comment whether specific information about portfolio turnover should be required in connection with prospectus disclosure about a fund's investment strategies. In response to current disclosure requirements, for example, funds often make generic statements that do not appear to help investors evaluate and compare fund investments.124 --------------------------------------------------------------------------- \124\ Prospectuses, for example, state that high portfolio turnover rates will likely result in higher transaction costs and may increase taxable gains. --------------------------------------------------------------------------- Classification and Subclassification. All funds that register on Form N-1A are classified as management companies and subclassified as open-end companies under sections 4 and 5 of the Investment Company Act.125 Funds may be further subclassified as diversified or non- diversified under section 5. Form N-1A requires a fund to disclose its classification and subclassifications in the prospectus.126 --------------------------------------------------------------------------- \125\ See 15 U.S.C. 80a-4, -5. \126\ Item 4(a)(i)(B). --------------------------------------------------------------------------- The proposed amendments would move to the SAI disclosure about a fund's legal status as an open-end management company.127 This information is technical and repetitive of information required to be disclosed in the prospectus. A fund's classification as a management company is communicated to investors through [[Page 10911]] disclosure about the fund's investment adviser and portfolio management. A fund's open-end status is communicated through disclosure about the redeemability of the fund's shares. --------------------------------------------------------------------------- \127\ Proposed Item 12(a). --------------------------------------------------------------------------- The proposed amendments also would move to the SAI disclosure that a fund is diversified under section 5. Since most funds are diversified, this information (which often includes a technical description of the diversification requirements under the Investment Company Act) does not appear to provide investors with useful information about a particular fund. A non-diversified fund would continue to be required to disclose its non-diversified status in the prospectus.128 To avoid technical disclosure, the proposed amendments would require a non-diversified fund to describe the effects of non-diversification (e.g., by indicating that, compared to diversified funds, the fund may invest a greater percentage of its assets in a particular issuer) and to disclose the risks of investing in the fund. --------------------------------------------------------------------------- \128\ Proposed Item 4(d). --------------------------------------------------------------------------- Section 8 Policies. Section 8 requires a fund to disclose in its registration statement the fund's policies with respect to borrowing money, issuing senior securities, underwriting securities issued by other persons, investing in real estate or commodities, and making loans.129 Most funds do not engage in these practices to a significant extent, because the Investment Company Act limits their use by funds.130 Although they are not required to do so, some funds disclose in the prospectus their policies with respect to the practices identified under section 8.131 To provide a clearer directive to disclose this information in the SAI, the proposed amendments specifically would require disclosure about these policies in the SAI.132 --------------------------------------------------------------------------- \129\ 15 U.S.C. 80a-8. Section 8 also requires a fund to disclose in the registration statement its policies on concentration and portfolio turnover, see supra note 121 and accompanying text, and any other policies that the fund deems fundamental or that may not be changed without shareholder approval. \130\ See, e.g., section 18(f) (15 U.S.C. 80a-18(f)) (limiting a fund's ability to issue senior securities and borrow money); section 12(c) (15 U.S.C. 80a-12(c)) (limiting the underwriting practices of a diversified fund). \131\ See Items 4(a)(ii)(C), 4(b); Guides 3, 14. \132\ Proposed Item 12(c). If a policy specified in section 8 is a principal strategy, Instruction 4 to proposed Item 4(b)(1) would require the fund to disclose the policy in the prospectus. --------------------------------------------------------------------------- b. Risk Disclosure Risk disclosure in fund prospectuses typically consists of detailed, and often technical, descriptions of the risks associated with particular securities in which a fund may invest. Just as disclosure about each type of security in which a fund may invest does not appear to effectively communicate how the fund's portfolio will be managed, disclosure about the risks associated with each type of security in which the fund may invest does not appear to effectively communicate the overall risks of investing in the fund. Disclosing the risks of each portfolio investment, rather than the overall risks of investing in a fund, does not appear to help investors evaluate a particular fund or compare the risks of different funds. Consistent with the proposal to shift prospectus disclosure away from an inventory of the various securities that may be held by a fund, the proposed amendments would revise Form N-1A to shift prospectus disclosure away from the risks associated with specific securities. The revised Form would require a fund to disclose the risks to which the fund's particular portfolio as a whole is expected to be subject.133 As part of this disclosure, a fund would be required to discuss the circumstances that are reasonably likely to affect adversely the fund's net asset value, yield, or total return. --------------------------------------------------------------------------- \133\ Proposed Item 4(c). See supra note 101. The requirement that a fund disclose the risks to which its particular portfolio as a whole is subject is intended to elicit risk disclosure specific to that fund. In meeting this requirement, a growth fund, for example, would have to disclose the risks of the growth stocks in which the fund invests as opposed to describing the general risks of equity securities. --------------------------------------------------------------------------- The proposed approach is intended to improve fund risk disclosure. Comments from both individual investors and members of the fund industry responding to the Risk Concept Release strongly supported improving narrative discussions of fund risks. In a survey of fund investors sponsored by the ICI (``ICI Risk Survey''), respondents were asked to consider various methods that could be used to describe risk and expressed the greatest overall confidence about using narrative information.134 --------------------------------------------------------------------------- \134\ ICI Risk Survey, supra note 26, at 21, 37. --------------------------------------------------------------------------- The Risk Concept Release requested comment whether quantitative risk measures, such as standard deviation, beta, and duration, would help investors evaluate and compare fund risks.135 While more than half of the individual commenters and some industry members expressed a desire for some form of quantitative risk information, commenters did not broadly support any one risk measure. In addition, a number of commenters strongly opposed requiring disclosure of quantitative risk information.136 These commenters, among other things, questioned the value of quantitative risk measures, suggesting that investors have too wide a range of investment goals and ideas of what ``risk'' means to be well-served by a single quantitative risk measure.137 The ICI Risk Survey suggests that investors who use quantitative measures may not understand the measures well enough to use them for the special purposes for which they were designed.138 --------------------------------------------------------------------------- \135\ Risk Concept Release, supra note 18, at 17176. Standard deviation measures the volatility of a fund's total return; beta measures the sensitivity of a fund's total return to the market's performance; and duration measures the sensitivity of a bond fund's return to changes in interest rates. Id. at 17174-76. \136\ See, e.g., 1995 ICI Risk Comment Letter, supra note 101, at 10-16 (questioning, among other things, the feasibility of developing a single, all-encompassing measure of fund risks and whether quantitative information would be understood and accurately used by fund investors). \137\ See also P. Bernstein, Against the Gods: The Remarkable Story of Risk 269-303 (1996) (suggesting it is inaccurate to assume that investors evaluate investments based on risk and return and that investors' attitudes towards risk may overrule a decision that may be appropriate based on quantitative measures). \138\ ICI Risk Survey, supra note 26, at 14-18 (e.g., 45% of respondents who had used duration, 44% of those who used standard deviation, and 23% of those who used beta reported using these measures to estimate future performance). --------------------------------------------------------------------------- Based on these and other considerations, the Commission is not proposing at this time to require funds to use quantitative risk measures. The proposed prospectus risk/return summary and the proposed amendments to the narrative discussion of risk within the prospectus are designed to improve fund risk disclosure, without raising the issues associated with Commission-mandated quantitative information. The Commission's determination not to require quantitative risk information is not intended to suggest, however, that this information is not useful to some investors. Funds that wish to include quantitative risk disclosure in their prospectuses may continue to do so. Item 5--Management's Discussion of Fund Performance The proposed amendments would continue to require a fund to provide its MDFP and the related line graph comparing the fund's returns to a broad-based securities market index in either the prospectus or the annual report. The Division's review of and experience with MDFP disclosure indicates that the discussion of fund performance and the line graph have been successful in providing fund shareholders with useful, comparative information about a fund's performance. Other than technical and conforming changes, the proposed amendments would not modify these disclosure requirements. [[Page 10912]] Funds typically include the MDFP in their annual reports, rather than in their prospectuses, which may be, in part, due to the relevance of the MDFP to other current financial information appearing in annual reports. As a result of recent legislation, the Commission has more flexibility to specify the content of annual reports and to require additional disclosure in annual and semi-annual reports as necessary or appropriate in the public interest or for the protection of investors.139 The Commission is not proposing to modify fund shareholder report disclosure requirements in this release, but recognizes that revisions to shareholder report requirements could further enhance the disclosure provided to fund investors. The Division currently is evaluating whether funds should be required to include the MDFP in the annual report. The Division also is considering whether certain disclosure required by Form N-1A would be more useful to investors in shareholder reports. An ``integrated'' approach to registration and reporting requirements could improve the overall information about a fund available to investors.140 Shareholder reports, for example, could disclose information about a fund's investments and operations for a current period (such as information about the fund's portfolio turnover or the tax consequences of investing in the fund). Fund prospectuses could disclose more general information about the fund's intended investments and operations (such as its investment objectives, anticipated risks, and fees). The Commission requests comment on specific prospectus disclosure that could be more appropriately disclosed in a fund's shareholder reports. --------------------------------------------------------------------------- \139\ National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290 (1996) (the ``1996 Securities Act''), section 206(f) (amending section 30 of the Investment Company Act (15 U.S.C. 80a- 29)] to add new paragraph (f)). \140\ In the past, the concept of ``integrated'' disclosure for funds has addressed eliminating duplicative registration requirements under the Investment Company Act and the Securities Act. See Investment Company Act Release No. 10378 (Aug. 28, 1978) (43 FR 39548) (``Integrated Registration Statement Release'') (adopting integrated registration statements for funds and closed- end investment companies by replacing separate registration statement forms under the Investment Company Act and Securities Act). New ``integrated'' disclosure initiatives for funds could expand the concept of integrated disclosure to include an approach similar to that adopted for corporate issuers, which integrates registration statement disclosure requirements with periodic reports. See Securities Act Release Nos. 6235 (Sept. 2, 1980) (45 FR 63693) and 6383 (Mar. 3, 1982) (47 FR 11386) (proposing and adopting new forms for the offering of securities under the Securities Act). --------------------------------------------------------------------------- Item 6--Management, Organization, and Capital Structure a. Management and Organization The proposed amendments would streamline the current disclosure requirements concerning a fund's management and organization. Consistent with the intent of Form N-1A to provide investors with essential information about a fund, the revised Form would require prospectus disclosure about the fund's investment adviser, the advisory fee paid by the fund, and the person or persons primarily responsible for the day-to-day management of the fund's portfolio.141 As in the current Form, the revised Form would require prospectus disclosure of fees paid to any sub-adviser.142 The Commission requests comment whether information about individual sub-advisory fees helps investors evaluate and compare fund investments or whether this disclosure obscures the aggregate investment advisory fee associated with investing in a particular fund. The Commission requests specific comment whether a fund should be required to disclose only the fund's aggregate investment advisory fee. --------------------------------------------------------------------------- \141\ Proposed Items 6(a)(1), (2). \142\ See section 2(a)(20) (15 U.S.C. 80a-2(a)(20)) (defining ``investment adviser'' to include a sub-adviser). --------------------------------------------------------------------------- The revised Form would continue to require prospectus disclosure of any material pending legal proceedings involving the fund, investment adviser, or principal underwriter, which would be incorporated in the management and organization Item because the disclosure is related to the other management information required to be disclosed.143 The proposed amendments would modify or move to the SAI other disclosure requirements relating to the management and organization of a fund because this information generally is common to all funds and does not appear to assist an investor in evaluating a particular fund or comparing different funds. --------------------------------------------------------------------------- \143\ Item 9. The legal proceedings disclosure is intended to be substantially the same as Item 103 of Regulation S-K under the Securities Act (17 CFR 229.103) and would be modified to conform to Item 103. See Investment Company Act Release No. 19155 (Nov. 30, 1992) (57 FR 56862) (modifying Form N-2 to conform to Item 103). --------------------------------------------------------------------------- Board of Directors. Form N-1A requires a fund's prospectus to include a brief description of the responsibilities of the fund's board of directors under the applicable laws of the jurisdiction where the fund is organized.144 The proposed amendments would move this disclosure to the SAI.145 The responsibilities of fund directors are governed by the Investment Company Act and state law.146 The summary, generic disclosure typically provided in fund prospectuses about the responsibilities of directors does not appear to assist an investor in deciding whether to invest in a particular fund. --------------------------------------------------------------------------- \144\ Item 5(a). \145\ Proposed Item 13(a). \146\ These responsibilities include, among other things: (i) Evaluating and approving the fund's investment advisory and principal underwriting contracts (sections 15 (a), (c) (15 U.S.C. 80a-15 (a), (c))) and the use of fund assets to pay for the distribution of fund shares (rule 12b-1); (ii) selecting the fund's independent public accountants (section 32(a)(1) (15 U.S.C. 80a- 31(a)(1))); and (iii) reviewing and approving transactions with affiliates under various rules (e.g., rule 10f-3 (17 CFR 270.10f-3); rule 17a-7 (17 CFR 270.17a-7); rule 17e-1 (17 CFR 270.17e-1)). Directors have fiduciary duties to the fund and its shareholders under section 36(a) of the Investment Company Act (15 U.S.C. 80a- 35(a)) and under state law. See 3 W. Fletcher, Cyclopedia of the Law of Private Corporations Sec. 838 (rev. perm. ed. 1994); Hanson Trust PLC v. ML SCM Acquisition, Inc., 781 F.2d 264, 275 (2d Cir. 1986). See also Burks v. Lasker, 441 U.S. 471 (1979) (upholding the authority of independent directors to take actions under state law to the extent not inconsistent with the policies of the Investment Company Act and the Investment Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.) (the ``Advisers Act')). --------------------------------------------------------------------------- The Commission requests comment whether disclosure in the prospectus of the names, experience, and compensation of a fund's directors, along with an address, telephone number, or other means to contact the directors would be more useful to investors. The Commission also requests comment whether this information should be given only for a fund's independent directors, accompanied by disclosure of the number of independent directors in relation to the number of directors on the fund's board.147 The Commission requests specific comment whether information about a fund's directors is essential information that should be required to be disclosed in the prospectus to assist investors in deciding whether to invest in a fund. The Commission also requests specific comment whether information about the compensation paid to directors warrants prospectus disclosure in light of the relatively small portion of a fund's total expenses represented by director compensation. --------------------------------------------------------------------------- \147\ Section 10(a) of the Investment Company Act (15 U.S.C. 80a-10(a)) requires that at least 40% of a fund's board of directors consist of individuals who are not ``interested persons,'' as defined in section 2(a)(19) (15 U.S.C. 80a-2(a)(19)). --------------------------------------------------------------------------- Controlling Persons. Form N-1A requires disclosure of the name of any person that controls the fund's investment adviser and the name of any person that controls the fund.148 The proposed amendments would no longer [[Page 10913]] require this information in the prospectus. Transactions between controlling persons and a fund are subject to restrictions under the Investment Company Act.149 When transactions with controlling persons are permitted, a fund's board of directors is responsible for reviewing and approving the arrangements.150 Disclosure about controlling persons of the investment adviser and the fund would continue to be available in the SAI.151 --------------------------------------------------------------------------- \148\ Items 5(b)(i) and 6(b). \149\ See, e.g., section 17 (15 U.S.C. 80a-17) and rules 17a-6, 17d-1 (17 CFR 270.17a-6, .17d-1). \150\ See supra note 146. \151\ Items 14(a), 15(a)(1). In addition, information about any person who owns 10% or more of a fund's voting stock is required to be disclosed in a proxy statement seeking shareholder approval of the fund's investment adviser, which provides more timely information about the possibility that a person could influence the approval of the advisory contract. Item 22(c)(4) of Schedule 14A (17 CFR 240.14a-101) under the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) (the ``Securities Exchange Act'). --------------------------------------------------------------------------- Affiliated Brokers. Form N-1A requires a fund to state, if applicable, that the fund engages in brokerage transactions with affiliated persons and allocates brokerage transactions based on the sale of fund shares.152 The proposed amendments would no longer require this disclosure in the prospectus. The information called for by the Form typically results in disclosure that restates applicable legal requirements.153 This type of generic disclosure does not appear to assist investors in deciding whether to invest in a particular fund. Payment of commissions to affiliated brokers is governed by section 17(e) of the Investment Company Act and rule 17e-1. In addition, the SAI requires disclosure about affiliated brokers and how brokers are selected to effect the fund's portfolio transactions.154 --------------------------------------------------------------------------- \152\ Item 5(g). \153\ Some funds, for example, state that an affiliated broker may effect portfolio transactions for the fund on an exchange or board of trade, if the commissions, fees, or other remuneration received by the affiliated broker are reasonable and fair compared to the commissions, fees, or other remuneration paid to other brokers or futures commission merchants in connection with comparable transactions involving similar securities being purchased or sold on an exchange or board of trade during a comparable period of time. With respect to allocation of brokerage transactions, funds typically disclose that they may consider sales of fund shares as a factor in selecting brokers to execute portfolio transactions. \154\ Item 16. The Commission has undertaken initiatives designed to improve disclosure about fund brokerage transactions by requiring certain expenses paid by directed brokerage to be treated as an expense in a fund's financial statements and fee table and by requiring average commission rates to be disclosed in the financial highlights information. Investment Company Act Release No. 21221 (July 21, 1995) (60 FR 38918). --------------------------------------------------------------------------- Form of Organization. Form N-1A requires disclosure about a fund's form of organization (along with the date) and state of incorporation.155 Since most funds are organized in one of a few states as corporations or business trusts that seek to provide limited liability to their shareholders,156 disclosure about a fund's organization does not appear to help investors evaluate a particular fund or compare different funds. The proposed amendments would move this disclosure to the SAI,157 unless a fund is organized outside the United States and registered under the Investment Company Act pursuant to section 7(d).158 --------------------------------------------------------------------------- \155\ Item 4(a). \156\ See SEC, Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation, Investment Company Governance 275 (May 1992) (reporting that in 1991 over 84% of funds were organized as Maryland corporations or Massachusetts business trusts) (citing Lipper Analytical Services, The ``Form'' Used by Mutual Funds to Organize State by State (Mar. 1991) (survey prepared for the ICI)). \157\ Proposed Item 11(a). Information about a fund's operating history (including information about the lack of an operating history for a newly organized fund) would continue to be provided in the bar chart, performance table, and the fee table in the risk/ return summary, and in the financial highlights information. \158\ 15 U.S.C. 80a-7(d). See proposed Item 6(b). --------------------------------------------------------------------------- Expenses. Form N-1A requires a fund to provide a statement about its expenses.159 The proposed amendments would no longer require this disclosure since it duplicates information about the fund's expenses required in the fee table. Expense information also would continue to be available in the fund's financial statements and SAI.160 --------------------------------------------------------------------------- \159\ Item 5(f). \160\ Item 15. --------------------------------------------------------------------------- b. Capital Structure Form N-1A requires certain information to be disclosed in the prospectus about a fund's shares and capital structure. The proposed amendments would reorganize and revise these disclosure requirements consistent with the intent of Form N-1A to focus prospectus disclosure on essential information about a particular fund that would assist an investor in deciding whether to invest in that fund. Transferability, Material Obligations, and Potential Liabilities. Form N-1A requires disclosure about any limits on the transferability of, and material obligations or potential liabilities associated with, a fund's shares. Funds rarely restrict share transferability and generally are organized as corporations or business trusts to provide limited liability to their shareholders. If, however, any restrictions or special liabilities applied to the purchase of a fund's shares, information about the restrictions or liabilities would appear to help an investor decide whether to invest in the fund. As a consequence, the proposed amendments would continue to require this information in the prospectus.161 The Commission requests comment on the types and likelihood of restrictions and liabilities imposed on fund shares and on what disclosure, if any, should be required. --------------------------------------------------------------------------- \161\ For funds organized as business trusts under Massachusetts law, prospectuses sometimes include disclosure that, under Massachusetts law, fund shareholders may, under certain limited circumstances, be held personally liable as partners for the fund's obligations. In adopting Form N-1A, the Commission stated that disclosure of possible contingent shareholder liability under this form of organization should not be required if a fund believes that, because of arrangements to protect shareholders, the likelihood of loss or expense to shareholders is remote. Form N-1A Adopting Release, supra note 12, at 37933-34. See 3 T. Frankel, The Regulation of Money Managers 79 (1980) (for funds organized as Massachusetts business trusts, personal liability generally is considered remote). The Division's review of fund prospectuses indicates that certain funds include disclosure about Massachusetts business trusts and state that shareholder liability is remote. Funds should continue to evaluate whether this disclosure is necessary. --------------------------------------------------------------------------- Shareholder Voting Rights. Form N-1A requires a fund to discuss shareholder voting rights and disclose if the rights of shareholders can be modified by other than a majority vote.162 Because the Investment Company Act requires all fund shares to have equal voting rights 163 and prescribes the vote required for significant matters,164 voting rights disclosure typically is generic and does not appear to assist investors in evaluating and comparing funds. The proposed amendments would move this disclosure to the SAI.165 --------------------------------------------------------------------------- \162\ Item 6 (a), (c). \163\ Section 18(i) (15 U.S.C. 80a-18(i))]. \164\ See, e.g., section 15(a) (approval of investment advisory contract); section 16(a) (15 U.S.C. 80a-16(a)) (election of directors); section 13(a) (15 U.S.C. 80a-13(a)) (changes in fundamental investment policies). See also section 2(a)(42) (15 U.S.C. 80a-2(a)(42)) (defining ``voting security'' and a ``vote of a majority of the outstanding voting securities'' for purposes of the Investment Company Act); rules 18f-2, 18f-3 (17 CFR 270.18f-2, -3) (specifying certain voting rights with respect to series funds and multiple class funds, respectively). \165\ Proposed Item 17(a). --------------------------------------------------------------------------- Senior Securities. Form N-1A requires disclosure about any class of senior securities issued by a fund.166 The proposed amendments would delete this requirement. Senior securities issued by funds are limited to borrowings, which are subject to significant legal restrictions under the Investment Company Act 167 and [[Page 10914]] required to be disclosed in a fund's financial statements.168 --------------------------------------------------------------------------- \166\ Item 3(b). \167\ Section 18(f)(1) (requiring, for example, asset coverage of at least 300% for bank borrowings). \168\ The financial statement requirements in Regulation S-X specify that a fund disclose in its balance sheet any amounts payable to banks and others for borrowings. Rule 6-04 of Regulation S-X (17 CFR 210.6-04). --------------------------------------------------------------------------- Fund Classes. Form N-1A requires disclosure about ``other classes'' of fund shares (excluding borrowings that are not senior securities).169 The proposed amendments would delete this requirement. Funds are not permitted to issue other classes of shares except for series funds under section 18f-2 and related rule 18f-2, and multiple class funds under rule 18f-3. When a series or class is offered in the prospectus, disclosure about the series or class would be required to be given. --------------------------------------------------------------------------- \169\ Item 6(d). --------------------------------------------------------------------------- 7. Item 7--Shareholder Information Form N-1A requires prospectus disclosure about a fund's purchase and redemption procedures, dividends and distributions, and the tax consequences of investing in the fund. While most of these disclosure requirements would remain substantially the same, the proposed amendments would make certain revisions, particularly with respect to tax disclosure, to focus this disclosure on essential information about a fund.170 --------------------------------------------------------------------------- \170\ Information about purchase and redemption procedures typically takes up a number of pages in fund prospectuses and may contribute to the perception that prospectuses are too long and complicated. At the same time, this disclosure (e.g., information on dividend reinvestment plans, automatic investment programs, and checkwriting privileges) appears to be included in prospectuses in response to investor interest in the information. --------------------------------------------------------------------------- a. Purchase and Redemption Pricing of Fund Shares. Form N-1A requires a fund to explain that the price of fund shares is based on the fund's net asset value and to identify the methods used to value the fund's assets.171 The proposed amendments would no longer require this information in the prospectus because it does not appear to assist investors in deciding whether to invest in a particular fund. The pricing of fund shares and the valuation of portfolio securities are technical, subject to legal requirements, and disclosed in the SAI.172 --------------------------------------------------------------------------- \171\ Item 7(b)(i). \172\ Item 19(b). A fund's securities are required to be valued based on market quotations or, in the absence of market quotations, at fair value as determined by the board of directors. See section 2(a)(41) (15 U.S.C. 80a-2(a)(41)) (defining ``value''). See also rule 2a-7 (regarding the amortized cost method of valuation for money market funds). --------------------------------------------------------------------------- The proposed amendments would continue to require a fund to state when calculations of net asset value are made and that the price at which a purchase is effected is based on the next calculation of net asset value after the order is placed. A fund also would continue to be required to identify in a general manner any national holidays when shares will not be priced and to identify specifically any additional local or regional holidays when the fund will be closed.173 --------------------------------------------------------------------------- \173\ See Guide 28; proposed Item 7(a)(2). The Instruction to proposed Item 7(a)(2) would incorporate the disclosure required by Guide 28 concerning funds with portfolio securities listed on foreign exchanges that trade on weekends and U.S. holidays. If a fund does not price on days when foreign securities are traded, the Instruction would require the fund to disclose in the prospectus that the net asset value of the fund's shares may change on days when shareholders cannot purchase or redeem fund shares. --------------------------------------------------------------------------- Although not specifically required, many funds disclose in their prospectuses how net asset value is determined. Funds, for example, often disclose that net asset value equals assets minus liabilities divided by the number of outstanding shares.174 Although this disclosure tends to be generic because the calculation of net asset value is the same for all funds, the Commission requests comment whether disclosure about what constitutes net asset value would be helpful to investors. --------------------------------------------------------------------------- \174\ See section 2(a)(41) (15 U.S.C. 80a-2(a)(41)) and rule 2a- 4 (17 CFR 270.2a-4). --------------------------------------------------------------------------- Principal Underwriter. Form N-1A requires a fund to disclose the name and address of the fund's principal underwriter, and whether any affiliated person of the principal underwriter is an affiliated person of the fund.175 This information would be moved to the SAI because it does not appear to provide investors with essential information that would assist them in deciding whether to invest in a particular fund.176 The name and address of the underwriter typically are not necessary for investors to purchase and redeem a fund's shares.177 The fund's board of directors is responsible for approving the fund's contract with the principal underwriter. Conflicts of interest that could influence transactions between a principal underwriter and a fund are governed by legal protections in the Investment Company Act.178 --------------------------------------------------------------------------- \175\ Item 7(a). \176\ Proposed Item 15(b). \177\ Fund investors often effect purchases and redemptions through financial intermediaries (such as broker-dealers and banks) without the involvement of the fund's underwriter. When information about the underwriter is necessary to effect purchase and redemption requests, a fund would disclose this information in the prospectus in connection with the description of how to purchase and redeem the fund's shares. \178\ See supra note . --------------------------------------------------------------------------- Service Providers. Form N-1A requires a fund to disclose the identity of any person (other than the investment adviser) who provides significant administrative or business management services for the fund (e.g., an administrator), including a description of, and the fees paid for, the services.179 The Form also requires the name and address of the fund's transfer agent and dividend paying agent.180 The proposed amendments would move this disclosure to the SAI.181 While a fund could include in the prospectus information about its service providers in describing the fund's purchase and redemption procedures, disclosure about persons that perform administrative or ``back-office'' functions unrelated to the purchase and sale of fund shares does not appear to assist investors in evaluating and comparing fund investments. The fund's investment adviser or board of directors is responsible for overseeing the fund's contractual arrangements with service providers and their costs to the fund. In addition, the costs incurred for services provided to the fund are included in the prospectus fee table and in the fund's financial statements.182 --------------------------------------------------------------------------- \179\ Item 5(d). \180\ Item 5(e). \181\ Proposed Item 15(h). In addition, Item 5(b)(ii) requires a statement, if applicable, that the investment adviser is responsible for overall management of the fund's business. This disclosure would be provided in the SAI in response to proposed Item 15(c)(1). \182\ Rule 6-07 of Regulation S-X (17 CFR 210.6-07); Instruction 3(c) to proposed Item 3. --------------------------------------------------------------------------- Account Transfers. The GCLs require certain information about transfers of shares held in street name accounts.183 This disclosure would be retained in a simplified form in the prospectus. In particular, the proposed amendments would require a fund to disclose any restrictions on, or costs associated with, transferring shares held in street name to inform investors holding shares in street name about these restrictions and costs.184 --------------------------------------------------------------------------- \183\ 1990 GCL, supra note 28, at II.D. \184\ Proposed Item 7(b)(7). --------------------------------------------------------------------------- b. Tax Consequences General Tax Disclosure. Form N-1A requires a fund to describe in its prospectus the tax consequences of an investment in the fund.185 Prospectus tax disclosure often includes lengthy information about the tax treatment of the fund and, in some cases, the tax treatment of specific securities held by [[Page 10915]] a fund.186 This disclosure tends to obscure information about the tax treatment of a fund's distributions and the direct tax consequences to investors of investing in the fund. --------------------------------------------------------------------------- \185\ Item 6(g). Form N-1A provides guidance about the tax disclosure to be provided in the prospectus, indicating, among other things, that if a fund intends to qualify under Subchapter M of the Internal Revenue Code (I.R.C. 851 et seq.), the fund should state that it will distribute all of its net income and gains to shareholders and that these distributions are taxable. \186\ Many prospectuses, for example, include information about the conditions a fund must meet to qualify for pass-through tax treatment under Subchapter M and, when applicable, the tax treatment of private activity bonds, foreign currency contracts, and other fund investments. In addition, tax disclosure frequently includes technical jargon by referring, for example, to a fund's status as a ``regulated investment company'' and the fund's payment of ``spillback distributions'' and ``net investment income.'' See proposed General Instruction C.1(a), which would continue to instruct a fund not to use technical or legal terminology in the prospectus. --------------------------------------------------------------------------- The proposed amendments would revise the tax disclosure required in fund prospectuses. In particular, the proposed amendments would require information about a fund's qualification under Subchapter M of the Internal Revenue Code to appear in the SAI.187 Subchapter M confers pass-through tax treatment for funds that meet certain conditions.188 Disclosure about Subchapter M, which relates to the tax treatment of the fund, does not appear to help investors evaluate the tax consequences of investing in the fund. In addition, because virtually all funds qualify for pass-through tax treatment, disclosure about the conditions of, or a fund's qualification under, Subchapter M does not appear to help investors evaluate or compare fund investments.189 --------------------------------------------------------------------------- \187\ Proposed Item 19(a). The proposed amendments would eliminate the requirement that a fund disclose in the SAI any special tax consequences resulting from offering more than one class of capital stock or being a series fund, since the tax consequences of investing in a multiple class or series fund are no different from those of investing in a single class or single series. While in the past a series fund could offset the gains of one portfolio against the losses of another, a series fund no longer may offset the gains and losses of its various portfolios. See I.R.C. 851(h)(1) (treating each portfolio of a series fund as a separate entity for tax purposes). \188\ To qualify for pass-through tax treatment under Subchapter M, a fund must, among other things: derive at least 90% of its gross income from certain specified sources; derive less than 30% of its gross income from the sale of securities and certain other specified investments held for less than 3 months; meet certain diversification requirements; and distribute at least 90% of its taxable income (which does not include capital gains) and net tax- exempt income for the year. See I.R.C. 512(a)(5), 851. \189\ In the rare case of a fund that does not expect to qualify for pass-through tax treatment under Subchapter M, proposed Item 7(d)(3) would require the fund to explain in the prospectus the tax consequences of not qualifying (e.g., by disclosing that income and gains realized by the fund would be subject to double taxation--that is, both the fund and shareholders could be subject to tax liability). This disclosure would distinguish the fund from other funds and help investors appreciate the tax consequences of investing in the fund. Similarly, a fund that expects to pay an excise tax under the Internal Revenue Code with respect to its distributions would be required to disclose in the prospectus the consequences of paying the tax. See I.R.C. 4982. --------------------------------------------------------------------------- To focus prospectus disclosure on the tax consequences of investing in a particular fund, the proposed amendments would require a description of the tax consequences to shareholders of buying, holding, exchanging, and selling the fund's shares.190 The proposed amendments would require a fund to state, as applicable, that the fund intends to make distributions that may be taxed as ordinary income and capital gains. If a fund, as a result of its investment objectives or strategies, expects its distributions primarily to consist of ordinary income (or short-term capital gains that are taxed as ordinary income) or long-term capital gains, the fund would be required to provide disclosure to that effect. Providing specific disclosure about the anticipated tax consequences of a fund's distributions could help investors decide whether to invest in a particular fund and to compare fund investments.191 The proposed amendments also would require a fund to state that it will provide each shareholder by a specified date (typically, January 31 of each year) with specific information about the amount of ordinary income and capital gains, if any, distributed during the prior calendar year.192 --------------------------------------------------------------------------- \190\ Proposed Item 7(d). \191\ The proposed disclosure requirement would apply to funds that have investment objectives or strategies that make it possible to anticipate the tax consequences of the fund's distributions (e.g., funds described as ``tax-managed,'' ``tax-sensitive,'' or ``tax-advantaged'' often have investment strategies to maximize long-term capital gains and minimize ordinary income; conversely, money-market funds have investment objectives and strategies to maximize ordinary income). \192\ See Item 6(g)(iii) (consistent with this requirement). --------------------------------------------------------------------------- The proposed amendments would require a fund to disclose that its distributions will be taxable whether received in cash or reinvested in additional shares. The proposed amendments also would require a fund offering exchange privileges to disclose that exchanging shares of one fund for shares of another fund will be treated as a sale and that any gain from the transaction may be subject to federal income tax. Disclosure about the tax treatment of reinvested dividends and share exchanges would alert investors that reinvested distributions and exchange transactions are subject to tax. Special Tax Disclosure for Tax-Exempt Funds. The proposed amendments would require a tax-exempt fund to inform investors of the special tax consequences associated with investing in the fund.193 Because investors may be unaware that a portion of the distributions received from a tax-exempt fund may be subject to federal, state, or local income taxes, the proposed amendments would require a tax-exempt fund to disclose, as applicable, that: \193\ The proposed amendments also would require a tax-exempt fund to amend the general tax disclosures discussed above to reflect that the fund intends to distribute tax-exempt income. --------------------------------------------------------------------------- (1) The fund may invest a portion of its assets in securities that generate income that is not exempt from federal or state income tax; 194 --------------------------------------------------------------------------- \194\ A fund that holds itself out as a tax-exempt fund can invest up to 20% of its assets in securities that generate taxable income. See Investment Company Act Release No. 9785 (May 31, 1977) (42 FR 29130); Guide 1. See also Fund Names Release, supra note . --------------------------------------------------------------------------- (2) Income exempt from federal income tax may be subject to state and local income tax; (3) Any capital gains distributed by the fund may be taxable; and (4) A portion of the tax-exempt income distributed by the fund may be treated as a tax preference item for purposes of determining whether the shareholder is subject to the federal alternative minimum tax.195 \195\ See Guide 30 (requiring substantially the same disclosure); Letter from Mary Joan Hoene, Associate Director, SEC, to Matthew P. Fink, Senior Vice President and General Counsel, ICI (Nov. 3, 1987) (if a fund uses a name that implies its distributions will be exempt from federal income tax, it may not consider any investments in municipal obligations that pay interest subject to the alternative minimum tax as part of the 80% of the fund's assets that must be invested in tax-exempt securities). --------------------------------------------------------------------------- Item 8--Distribution Arrangements a. Placement of Prospectus Disclosure Rule 12b-1 fees and sales loads directly affect an investor's return on a fund investment, and information about these charges is important to many investors. Currently, narrative explanations about a fund's distribution arrangements may appear in different places in the prospectus, making it difficult for investors to review and compare additional information about rule 12b-1 fees and sales loads.196 The proposed amendments would require information about distribution arrangements to appear together in the prospectus.197 This approach would help investors locate information designed to assist them in evaluating a [[Page 10916]] particular fund and comparing fund investments. --------------------------------------------------------------------------- \196\ A summary of a fund's fees and expenses, which includes information about rule 12b-1 fees and sales loads, is contained in the fee table. \197\ Proposed General Instruction C.2(a). Proposed Item 8 would consolidate prospectus disclosure requirements for rule 12b-1 fees, sales loads, and multiple class and master-feeder funds. Consistent with the proposed amendments to the fee table requirements, rule 12b-1 fees and sales loads would be referred to as ``marketing (12b- 1) fees'' and ``sales fees (loads)'' in the narrative discussion of a fund's distribution arrangements in the prospectus. --------------------------------------------------------------------------- b. Rule 12b-1 Plans Prospectus Disclosure. Form N-1A requires detailed prospectus disclosure about rule 12b-1 plans.198 The technical nature of this disclosure tends to obscure information about the amount of fees paid under a fund's rule 12b-1 plan. Although distribution fees are charged on an on-going basis in lieu of, or in addition to, sales loads, investors may not appreciate the continuing nature of distribution fees or that distribution fees cumulatively could exceed other types of sales charges.199 --------------------------------------------------------------------------- \198\ Item 7(e), (f). \199\ See Updegrave, Fund Investors Need to Go Back to School, Money, Feb. 1996, at 98, 100 (of approximately 1,400 investors surveyed by Money magazine and The Vanguard Funds Group, only 22% knew that rule 12b-1 fees are charged against fund assets to pay for distribution of fund shares). Based on information compiled by the Division from Form N-SAR (17 CFR 274.101) filings, approximately 50% of funds charge rule 12b-1 fees. --------------------------------------------------------------------------- The proposed amendments would revise disclosure requirements for rule 12b-1 plans to focus prospectus disclosure on the fees paid under these plans. Focusing disclosure on fee information, rather than on technical, legal matters relating to a fund's rule 12b-1 plan, would appear to provide greater assistance to an investor in deciding whether to invest in the fund. In particular, the prospectus of a fund with a rule 12b-1 plan would be required to state the amount of the fee and provide disclosure to the following effect: The fund has a rule 12b-1 plan that allows the fund to pay fees for the sale and distribution of its shares; and Since these fees are paid out of the fund's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales loads. The proposed requirement to disclose that, over time rule 12b-1 fees will increase investment costs and may exceed other types of sales loads is intended to help an investor appreciate the continuing effect of rule 12b-1 fees on an investment in a fund. Similar, but more complex, disclosure is required by rules of the National Association of Securities Dealers, Inc. (``NASD').200 The proposed amendments seek to simplify the disclosure so that it may be more readily understood by investors. The Commission requests comment on the proposed disclosure and whether the disclosure should appear with the narrative explanation about rule 12b-1 fees or in connection with the fee table disclosure of these fees.201 --------------------------------------------------------------------------- \200\ Rule 2830(d)(4) of the NASD Conduct Rules (NASD Manual (CCH) 4624) (requiring a fund with a rule 12b-1 plan to disclose adjacent to the fee table that ``long-term shareholders may pay more than the economic equivalent of the maximum front-end sales charges permitted by (NASD rules)''). Rule 2830(d)(2) of the NASD Conduct Rules (NASD Manual (CCH) 4623) limits aggregate front-end, deferred, and asset-based sales charges to 6.25% of total new gross sales for funds that pay service fees and to 7.25% of total new gross sales for funds that do not pay service fees. Because these aggregate caps apply on a fund-wide basis, over time an individual investor may pay fees exceeding the applicable cap. The NASD disclosure is intended to address this issue. See Securities Exchange Act Release No. 30897 (July 7, 1992) [57 FR 30985, 30987]. \201\ If the proposed disclosure requirement is adopted, the Commission intends to discuss with the NASD its disclosure requirement so that similar disclosure is not required to be repeated in the prospectus. More generally, the Commission intends to discuss with the NASD other prospectus disclosure requirements imposed by NASD rules with the goal of incorporating these requirements, when appropriate, in applicable Commission rules or forms. In addition to streamlining disclosure requirements, this approach would give the Commission an opportunity to reassess NASD disclosure requirements in light of the Commission's broad initiatives to improve fund disclosure. --------------------------------------------------------------------------- A fund may pay ``service fees'' alone or combined with fees for the sale and distribution of its shares.202 If a fund pays service fees under a rule 12b-1 plan, the fund would reflect the payment of service fees in its rule 12b-1 disclosure. When service fees are paid outside of a rule 12b-1 plan, the fund would be required to disclose the amount and purpose of the fee in connection with information in the prospectus about any sales loads and rule 12b-1 fees charged by the fund. --------------------------------------------------------------------------- \202\ See Rule 2830(b)(9) of the NASD Conduct Rules (NASD Manual (CCH) 4622) (defining ``service fees'' as payments for personal service and/or the maintenance of shareholder accounts). Rule 2830(d)(5) of the NASD Conduct Rules (NASD Manual (CCH) 4624) limits service fees to .25% of a fund's average annual net assets. See also Item 7(e) (requiring prospectus disclosure about the amount or rate of any trail fees paid out of fund assets to dealers or other persons that provide investors with advice concerning the purchase, sale, or holding of fund shares). --------------------------------------------------------------------------- Additional Information. Form N-1A requires a fund with a rule 12b-1 plan to describe the plan briefly and list the principal activities for which payments under the plan will be made. A fund also must disclose the relationship between amounts paid to and expenses incurred by the distributor (i.e., whether the plan reimburses the distributor only for expenses incurred or compensates the distributor regardless of its expenses).203 The Form requires additional disclosure if the fund engages in joint distribution activities with another fund 204 or if the fund's underwriter has incurred unreimbursed expenses under the fund's 12b-1 plan.205 --------------------------------------------------------------------------- \203\ Guide 29. \204\ A fund that engages in joint distribution activities must disclose that its rule 12b-1 fees may be used to finance another fund's distribution activities and how it allocates costs between funds. \205\ A fund must disclose both the amount of unreimbursed expenses and the amount as a percentage of the fund's net assets, and indicate whether it is obligated to pay the expenses. In addition, under Generally Accepted Accounting Principles, the amount of any unreimbursed expenses under a rule 12b-1 plan is provided in the fund's financial statements. For a fund that has agreed to pay unreimbursed expenses if its rule 12b-1 plan is terminated, any unreimbursed expenses appear as a liability on the fund's financial statements. See Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 5 -- Accounting for Contingencies (Mar. 1975); American Institute of Certified Public Accountants, Statement of Position 95-3, at 5-8 (July 28, 1995). --------------------------------------------------------------------------- The proposed amendments would move this disclosure to the SAI. The information adds unnecessary complexity to rule 12b-1 disclosure and, as a consequence, tends to obscure the amount and purpose of rule 12b-1 fees, which does not appear to help investors evaluate and compare fund investments.206 Rule 12b-1 establishes requirements for a rule 12b-1 plan. In particular, a fund's board of directors must approve the rule 12b-1 plan and related fees.207 NASD rules provide additional protection by limiting rule 12b-1 fees (including the payment of unreimbursed expenses) to a percentage of the fund's new gross sales.208 --------------------------------------------------------------------------- \206\ Fund prospectuses typically include lengthy and generic descriptions of rule 12b-1 plans and related distribution activities. Prospectus disclosure, for example, consists of statements that distribution fees will be used to compensate broker- dealers and other financial intermediaries for providing distribution assistance and administrative, accounting, and other services to fund shareholders and to promote sales of fund shares through the printing and distribution of prospectuses, sales literature, and advertising materials. Some prospectuses include detailed descriptions of the requirements of rule 12b-1. \207\ See rule 12b-1(e) (permitting a fund's directors to implement or continue a rule 12b-1 plan only if they conclude that there is a reasonable likelihood that the plan will benefit the fund and its shareholders). See also rule 12b-1(d) (requiring directors to request and evaluate information reasonably necessary to make an informed decision about whether to adopt or continue a rule 12b-1 plan); rule 12b-1(a)(3)(ii) (requiring a rule 12b-1 plan to provide that directors review, at least quarterly, the amount and purposes of expenditures under the plan). \208\ See supra note 200. The Commission previously expressed concerns about the carryover of a large amount of unreimbursed expenses under a rule 12b-1 plan. Investment Company Act Release No. 16431 (June 13, 1988) (53 FR 23258, 23267) (proposing amendments to rule 12b-1). These concerns generally have been addressed by the NASD sales charge rule. --------------------------------------------------------------------------- c. Sales Loads Form N-1A requires disclosure in the prospectus about the amount of any sales load charged on an investment in a fund and when a sales load may be reduced or eliminated (e.g., for larger [[Page 10917]] investments).209 The proposed amendments would continue to require most of this disclosure to appear in the prospectus.210 The proposed amendments, however, would modify certain requirements that call for detailed and technical information about sales loads because the disclosure tends to obscure information about the amount of the sales load charged by a fund and does not appear to help investors evaluate and compare fund investments. --------------------------------------------------------------------------- \209\ Item 7(b), (c). See section 22(d) [15 U.S.C. 80a-22(d)] (prohibiting the sale of fund shares other than at the current public offering price described in the prospectus) and rule 22d-1 (17 CFR 270.22d-1) (requiring disclosure about sales load breakpoints and waivers). \210\ The proposed amendments would clarify that a fund is required to disclose any sales loads imposed on shares purchased with reinvested dividends or other distributions. The proposed amendments also would codify the requirement in Guide 28 to explain in the prospectus that the term ``offering price'' includes a front- end load. --------------------------------------------------------------------------- Dealer Reallowances. A fund is required to include a table in the prospectus showing any front-end load as a percentage of both the offering price and the net amount invested for each breakpoint, and any amounts reallowed to dealers as a percentage of the offering price. The proposed amendments would move disclosure about dealer reallowances to the SAI 211 because it adds unnecessary complexity to sales load disclosure and does not appear to provide helpful information to investors. NASD rules address concerns about financial incentives brokers may have in recommending that customers buy or hold fund shares. These rules require a broker who recommends investments to a customer to have reasonable grounds for believing that the recommendation is suitable for that customer.212 --------------------------------------------------------------------------- \211\ Proposed Item 15(f). \212\ Rule 2310 of the NASD Conduct Rules (NASD Manual (CCH) 4261). When the Commission proposed amendments to rule 6c-10 (17 CFR 270.6c-10) in 1995, it requested comment whether reallowances to dealers in connection with deferred sales loads should be disclosed in fund prospectuses. Investment Company Act Release No. 20917 (Mar. 2, 1995) (60 FR 11890, 11894). In adopting amended rule 6c-10, the Commission deferred consideration of reallowances because the NASD is studying dealer compensation practices. Investment Company Act Release No. 22202 (Sept. 9, 1996) (61 FR 49011, 49016). Consistent with this approach, the proposed amendments would not revise the SAI disclosure of dealer reallowances to include deferred sales loads. --------------------------------------------------------------------------- Waivers and Sales Load Breakpoints. Sales loads often are waived when fund directors and other affiliated persons of the fund (e.g., employees of the fund's adviser) purchase the fund's shares. 213 Form N-1A requires a fund to provide information about these arrangements in the prospectus. The proposed amendments would move this disclosure to the SAI because the disclosure concerns arrangements that are not available to the majority of investors and, as a consequence, adds unnecessary length to fund prospectuses. 214 --------------------------------------------------------------------------- \213\ For example, sales loads may be waived for investment advisory employees who are already knowledgeable about the fund, which may render marketing and other services unnecessary. \214\ Proposed Item 13(e). --------------------------------------------------------------------------- The proposed amendments also would move to the SAI disclosure about sales load breakpoints and waivers in connection with a merger or other reorganization. 215 This information does not appear to be important to investors unless and until a reorganization is announced. Because fund reorganizations generally require shareholder approval, this information would be provided to investors in proxy materials at a time when it would be more meaningful to them. 216 --------------------------------------------------------------------------- \215\ Proposed Item 18(b). \216\ Form N-14 under the Securities Act (17 CFR 239.23), which is used by funds to register securities issued in a merger or other reorganization and as the proxy statement for the transaction, requires disclosure about material information concerning the transaction. See Item 4(a) of Form N-14. See also Item 14(a)(3) of Schedule 14A under the Securities Exchange Act (requiring the same information in proxy statements). --------------------------------------------------------------------------- Third-Party Fees. Form N-1A requires a fund to disclose in the prospectus any fees charged by a bank, broker-dealer or other person in connection with the purchase of the fund's shares, if the fees are charged with the fund's knowledge. 217 The proposed amendments would no longer require this disclosure, since these fees are not charged by the fund. 218 Investors are informed of (and pay) the fees as part of their relationship with, and the services provided by, the third party. 219 --------------------------------------------------------------------------- \217\ Item 7(b). Prospectus disclosure is not required if the fees are ``adequately disclosed'' in a wrapper to the prospectus. \218\ In some cases, fees charged by a third party, in effect, represent fees of the fund (e.g., when the fees are charged to all shareholders to invest in the fund) and would be required to be disclosed in the prospectus. \219\ For fee disclosure requirements applicable to banks, broker-dealers and investment advisers, see Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision, Interagency Statement on Retail Sales of Nondeposit Products, 6 Fed. Banking L. Rep. (CCH) para. 70-113, at 82,598 (Feb. 15, 1994); rule 2230 of the NASD Conduct Rules (NASD Manual (CCH) 4211); rule 204-3(a) under the Advisers Act (17 CFR 275.204-3(a)) and Item 1 of Form ADV, Part II (17 CFR 279.1). --------------------------------------------------------------------------- d. Multiple Class and Master-Feeder Funds Form N-1A requires certain information to be included in the prospectus about the different distribution and service arrangements of multiple class and master-feeder funds. 220 Consistent with the proposed approach for sales loads and rule 12b-1 fees, the proposed amendments would require this information to appear in one place in the prospectus. The proposed amendments also would simplify prospectus disclosure requirements for master-feeder funds by eliminating the requirement that a feeder fund discuss the possibility and consequences of no longer investing in the master fund (e.g., if the master fund changes its investment objectives to be inconsistent with those of the feeder fund). Since master-feeder arrangements typically are designed to accommodate feeder funds, the possibility of a feeder fund not investing in the master fund is likely to be remote. 221 --------------------------------------------------------------------------- \220\ General Instruction I; Item 6(h); Guide 34. \221\ Potential changes in fund operations and investments also are not unique to a feeder fund. With any fund investment, changes may occur that significantly affect the nature of the fund. The interests of all fund shareholders, including those of feeder funds, are represented by a board of directors. In addition, as with all shareholders, a feeder fund's shareholders would receive notice of and have an opportunity to vote on fundamental changes relating to the master fund's operations and investments. --------------------------------------------------------------------------- Item 9.--Financial Highlights Information Condensed Financial Information. The financial highlights information currently required at the beginning of the prospectus provides summary financial information about a fund, including the fund's total return for each of the last 10 fiscal years. 222 The proposed amendments would retain the table, but no longer require this information to appear at the front of the prospectus. 223 Requiring detailed financial information at the beginning of a fund's prospectus may unnecessarily impede a fund's ability to present prospectus disclosure in an effective format. --------------------------------------------------------------------------- \222\ Item 3(a); General Instruction G to Form N-1A. \223\ Proposed Item 9; proposed General Instruction C.2(a). --------------------------------------------------------------------------- Form N-1A requires a brief explanation of the nature and source of the information included in the financial highlights table as well as a statement that the auditor's report is available upon request. To meet this requirement, funds generally disclose that the table presents financial information and how shareholders can obtain the auditor's report. The proposed amendments seek to assist investors in using the financial highlights information by requiring a narrative explanation to the following effect: [[Page 10918]] The financial highlights table is intended to help you understand the fund's financial performance for the past 10 years (or, if shorter, for the period of the fund's operations). Certain information reflects financial results for a single fund share. The total returns in the table represent the rate an investor would have earned [or lost] on an investment in the fund for the period indicated (assuming reinvestment of all dividends and distributions). This information has been audited by ________, whose report, along with the fund's financial statements, is included in (the SAI or annual report), which is available upon request. 224 --------------------------------------------------------------------------- \224\ Since the financial highlights information is required to be audited for the latest 5 years, the standardized narrative would continue to refer to the auditor's report and its location. --------------------------------------------------------------------------- The financial highlights disclosure requires performance information for a partial year to be annualized. The proposed amendments would require performance information for a period of less than a year to be stated without annualization. As previously indicated, the Commission is concerned that annualization of performance information may result in a performance figure that could mislead investors. 225 --------------------------------------------------------------------------- \225\ See, e.g., Money Market Fund Prospectus Release, supra note 14, at 38458. --------------------------------------------------------------------------- Apart from certain other technical and conforming changes, the proposed amendments would not revise the requirements for financial highlights disclosure. The Commission recognizes, however, that additional changes may further improve the financial highlights information, which often takes up a full page or more in the prospectus. The Commission intends to revisit this disclosure in a separate rulemaking initiative that would revise fund financial statement requirements generally and requests specific comment on simplifying and updating the financial highlights information. In particular, the Commission requests comment on reducing the number of captions to simplify the table and decreasing the period for which information is required from 10 years to 5 years. Because the proposed amendments would require a bar chart illustrating a fund's returns for a 10-year period, the Commission requests comment whether the financial highlights information should be moved to the SAI, eliminated for certain or all funds, 226 or provided in other disclosure, such as in a fund's Form N-SAR filings. --------------------------------------------------------------------------- \226\ In connection with the proposal to simplify money market fund prospectuses, the Commission proposed to replace the financial highlights table with a 10-year bar graph of fund returns. See Money Market Fund Prospectus Release, supra note 14, at 38455. The summary financial information does not appear to be useful for money market funds because these funds typically do not have changes in net assets or realized capital gains. --------------------------------------------------------------------------- Calculation of Performance Data. Form N-1A requires a brief explanation in the prospectus of how the fund calculates performance data if it includes performance information in advertisements permitted under rule 482 of the Securities Act. 227 This disclosure was required because an advertisement under rule 482 is an omitting prospectus under section 10(b) of the Securities Act and, as an omitting prospectus, was required to contain information ``the substance of which'' is contained in the prospectus. The proposed amendments would eliminate this disclosure requirement. Recent legislation added section 24(g) to the Investment Company Act, which authorizes the Commission to adopt rules permitting a fund to use a summary or omitting prospectus that includes information the substance of which is not included in the prospectus. 228 In the near future, the Commission intends to propose to amend rule 482 to eliminate the ``substance of which'' requirement, which would make the disclosure of performance data unnecessary. Disclosure about how performance is calculated does not appear to assist investors in deciding whether to invest in a particular fund and would continue to be available in the SAI. 229 --------------------------------------------------------------------------- \227\ Item 3(c); 17 CFR 230.482(a). \228\ See 1996 Securities Act supra note 139, at section 204. \229\ Proposed Item 21. For a money market fund, SAI disclosure would include, when applicable, the calculation of the fund's 7-day tax-equivalent yield and tax-effective yield. See Money Market Prospectus Release, supra note 14, at 38458. --------------------------------------------------------------------------- Part B--Statement of Additional Information The SAI provides a more detailed discussion of matters described in the prospectus as well as additional information about a fund. 230 The proposed amendments would make a number of technical and conforming revisions to the SAI disclosure requirements to reflect the proposed changes in the prospectus disclosure requirements. After completion of the prospectus initiative, the Commission intends to review the SAI requirements and propose amendments to simplify and update SAI disclosure. --------------------------------------------------------------------------- \230\ See proposed General Instruction C.1(b) (current General Instruction G). See also supra notes 39 and 47 accompanying text. --------------------------------------------------------------------------- Part C--Other Information Part C of Form N-1A contains information in support of a fund's registration statement that is not included in the prospectus or the SAI. 231 The proposed amendments would revise Part C to eliminate unnecessary filing requirements. 232 As amended, Part C would no longer require a fund to file model retirement plans that are used to offer the fund's shares 233 because funds routinely offer their shares in connection with retirement plans and the terms and other aspects of these plans are governed by the Employee Retirement Income Security Act of 1974 (``ERISA'') and by the Internal Revenue Code. 234 Amended Part C also would no longer require a fund to file a schedule showing how it calculates performance data, 235 since these calculations have become routine and the Commission staff can verify a fund's performance calculations during a fund examination.236 --------------------------------------------------------------------------- \231\ Items 24 to 32. \232\ The proposed amendments also would eliminate the ``Instructions as to Summary Prospectuses'' that follow Part C. To the Commission's knowledge, no fund has used a summary prospectus under these instructions and the proposed profile would give funds the flexibility, at their option, to provide a summary disclosure document to investors. See Profile Release, supra note 1. \233\ Item 24(b)(14) (also requiring information about the costs and fees charged under the plans). \234\ See 29 U.S.C. 1104(c); I.R.C. 401-409. The Commission adopted this requirement in 1978, when the use of funds as vehicles for retirement planning was relatively new. Integrated Registration Statement Release, supra note 140, at 39553, 39557. \235\ Item 24(b)(16). \236\ See Money Market Fund Prospectus Release, supra note 14, at 38458 (proposing to eliminate this requirement). The Commission required funds to file these calculations in connection with the standardization of performance information used in fund advertisements to assure that funds would follow the formula correctly. Performance Release, supra note 14, at 3876. The proposed amendments also would eliminate the requirement in Item 23(b)(3) to file voting trust agreements, because funds are not permitted to use these agreements under section 20(b) (15 U.S.C. 80a-20(b)). The undertaking required by Item 32(c) relating to the delivery of a fund's annual reports would be deleted because the requirement would be incorporated in proposed Item 5. --------------------------------------------------------------------------- Part C requires a newly organized fund to provide an undertaking to file a post-effective amendment to its registration statement containing updated financial statements within 4 to 6 months of the effective date of the registration statement. 237 The purpose of this requirement is to assure the availability of financial information reflecting the fund's operations and investment of the fund's assets in accordance with its investment objectives and strategies. The Division has provided limited relief with respect to the timing of filing the updated financial information in two circumstances: (i) When a fund defers commencement of operations after the [[Page 10919]] effective date of its registration statement; and (ii) when the 4 to 6 month period following the effective date of the registration statement ends near the date of the financial statements to be used in the fund's next annual or semi-annual report. 238 The proposed amendments would codify the requirement to file updated financial information. 239 The proposed amendments would permit a fund to file a post- effective amendment within 4 to 6 months from the date the fund commences operations. The amendments also would give a fund up to 8 months to file updated financial statements that are included in the fund's semi-annual or annual report, if the post-effective amendment is filed within 30 days of the date of the latest balance sheet included in the annual or semi-annual report. The Commission requests comment whether the requirement to provide updated financial information should be retained. In particular, because the financial information may reflect a fund's operations for a very short period of time, is this information useful to investors? --------------------------------------------------------------------------- \237\ Item 32(b). \238\ 1994 GCL, supra note 28, at V. \239\ Proposed Item 22(a)(2). A conforming change would be made to rule 485(b)(1)(iv) under the Securities Act (17 CFR 230.485(b)(1)(iv)), which currently includes a reference to the undertaking required by Item 32(b) of Part C. --------------------------------------------------------------------------- D. General Instructions 1. Reorganizing and Simplifying the Instructions The General Instructions to Form N-1A provide guidance on the use and content of the Form. The proposed amendments would update and reorganize the General Instructions to make the Instructions easier to use. 240 The revised General Instructions would consist of: (1) Definitions; (2) Filing and Use of Form N-1A; (3) Preparation of the Registration Statement; and (4) Incorporation by Reference. --------------------------------------------------------------------------- \240\ Certain information would be deleted as unnecessary (e.g., current Instruction H (Electronic Filers) would be deleted since this Instruction includes only a cross-reference to Item 24(b)(17), which requires a financial data schedule to accompany an electronic filing as an exhibit). --------------------------------------------------------------------------- Definitions. Proposed General Instruction A would define certain terms generally used in Form N-1A. The definitions would provide greater clarity and avoid repeated references throughout the Form (for example, to the Investment Company Act). The proposed amendments would specify that all sections and rules used in Form N-1A refer to sections and rules under the Investment Company Act, unless otherwise indicated, and that all terms defined in the Investment Company Act and related rules have the same meaning in Form N-1A, unless otherwise defined. The proposed amendments would add several definitions to standardize certain terms, which would be capitalized throughout the Form. The term ``Fund'' would be defined as a registrant or a series of the registrant. 241 General Instruction A also would define ``Registrant'' and ``Series'' and these terms would be used when information is specifically required for a registrant or a series. 242 --------------------------------------------------------------------------- \241\ Form N-1A generally calls for disclosure about the ``Registrant'' (meaning the investment company registered under the Investment Company Act), although the Form sometimes refers to a series. Because the Form may be filed for one or more series of a registered investment company, the current references may cause confusion about the entity for which disclosure is required. \242\ General Instruction A would define a ``Master-Feeder Fund'' and a ``Multiple Class Fund,'' which currently are defined in Instruction I. The proposed amendments also would define a ``Money Market Fund'' as a fund that holds itself out as a money market fund and meets the maturity, quality, and diversification requirements of rule 2a-7. --------------------------------------------------------------------------- Filing and Use of Form N-1A; Preparation of the Registration Statement. Proposed General Instruction B would incorporate a more user-friendly, question-and-answer format regarding the filing and use of Form N-1A and would replace current Instructions A through D and F. Proposed General Instruction C would provide streamlined requirements for preparing the registration statement and would replace Instruction G. The new Instruction would continue to emphasize the need to provide clear and concise prospectus disclosure and permit a fund to include in its prospectus or SAI additional information that is not misleading and that does not, because of its nature, quantity, or manner of presentation, obscure the information required to be included. Instructions to the Form permitting information to be added to the prospectus and SAI would be deleted, with Instruction C providing this guidance for purposes of all fund disclosure. 243 --------------------------------------------------------------------------- \243\ See, e.g., Item 1(b) (permitting other information to be included on the cover page of the prospectus). Similarly, specific Instructions in Part A that call for brief and concise prospectus disclosure would be deleted, since Instruction C would include this requirement for purposes of all prospectus disclosure. --------------------------------------------------------------------------- Instruction C also would instruct a fund to avoid referring to the SAI or shareholder reports in the prospectus, unless specifically required by the Form. 244 Repeated cross-references to the SAI and shareholder reports appear to add unnecessary length and complexity to fund prospectuses and detract from the purpose of prospectus disclosure, which is to provide essential information that enables fund investors to make informed investment decisions. Instruction C would allow cross-references to be used within the prospectus when the cross- reference would assist investors in understanding the information presented and would not add complexity to prospectus disclosure. The Commission requests comment on the proposed approach to cross- references. --------------------------------------------------------------------------- \244\ See supra notes 39-40, 45, and 224 and accompanying text. --------------------------------------------------------------------------- Instruction C would provide guidance on the use of Form N-1A by more than one fund and a multiple class fund. Fund prospectuses frequently contain information for multiple series and classes that offer investors different investment alternatives and distribution arrangements. Because this practice was not common in 1983 when Form N- 1A was adopted, certain Form requirements may have the unintended effect of making prospectus disclosure for multiple funds and classes more complex than necessary. 245 When information is presented clearly, prospectuses offering more than one fund may make it easier for investors to compare funds and may be more efficient for funds and investors by eliminating the need to provide investors with multiple prospectuses containing repetitive information. Instruction C generally would give funds the flexibility to organize information about multiple funds and classes in an effective manner based on their particular circumstances as long as the presentation is consistent with the goal of providing clear and concise information about a fund. 246 --------------------------------------------------------------------------- \245\ See John Hancock Funds, Inc. (pub. avail. June 28, 1996). \246\ A fund, for example, may decide that using a horizontal rather than vertical presentation for the fee table would provide the most effective presentation of the required fee information. In responding to the proposed risk/return summary requirements, a fund may find that different formats communicate the required information effectively. Depending on the number and type of funds offered in the prospectus, for example, a fund may find it useful to group the required information for all funds together under each caption or to present the information sequentially for each fund. See id. (using a two-page disclosure format for each of 7 funds offered in a single prospectus). --------------------------------------------------------------------------- Instruction C would permit a fund that is offered as an investment alternative in a participant-directed defined contribution plan qualified under the Internal Revenue Code (``plan'') to modify its prospectus for use [[Page 10920]] by plan participants.