# Registration Form Used by Open-End Management Investment Companies > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A98-7070 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** March 23, 1998 - **Citation:** 63 FR 13916 ## Text SUMMARY: The Securities and Exchange Commission is adopting amendments to Form N-1A, the form used by mutual funds to register under the Investment Company Act of 1940 and to offer their shares under the Securities Act of 1933. The amendments are intended to improve fund prospectus disclosure and to promote more effective communication of information about funds to investors. The amendments focus the disclosure in a fund's prospectus on essential information about the fund that will assist investors in deciding whether to invest in the fund. The amendments also minimize prospectus disclosure about technical, legal, and operational matters that generally are common to all funds. DATES: Effective Date: June 1, 1998. Compliance Dates: 1. Initial Compliance Date: All new registration statements filed on or after December 1, 1998 must comply with the amendments to Form N- 1A. 2. Final Compliance Date: All funds with effective registration statements must comply with the amendments to Form N-1A for post- effective amendments filed to update their registration statements on or after December 1, 1998, and no later than December 1, 1999. FOR FURTHER INFORMATION CONTACT: Kathleen K. Clarke, Assistant Director, Markian M.W. Melnyk, Deputy Chief, George J. Zornada, Team Leader, Jonathan F. Cayne, Senior Counsel, John M. Ganley, Senior Counsel, Doretha M. VanSlyke, Attorney, (202) 942-0721, Office of Disclosure Regulation, or Anthony A. Vertuno, Senior Special Counsel, (202) 942-0591, Office of the Associate Director (Legal and Disclosure), Division of Investment Management, Securities and Exchange Commission, 450 5th Street, N.W., Mail Stop 5-6, Washington, D.C. 20549-6009. Contact the Office of Chief Counsel, Division of Investment Management, Securities and Exchange Commission, at (202) 942-0659, 450 5th Street, N.W., Mail Stop 5-6, Washington, D.C. 20549-6009 for additional information, including interpretive guidance, about this release or Form N-1A, as amended, and related rules. SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (``Commission'') is adopting 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 adopting technical amendments to rules 483, 485, 495, and 497 under the Securities Act [17 CFR 230.483, 230.485, 230.495, and 230.497]. In a companion release, the Commission is adopting new rule 498 [17 CFR 230.498] under the Securities Act and the Investment Company Act that permits a fund to provide investors with a new short-form document, called a ``profile,'' which summarizes key information about the fund. If a fund makes a profile available, an investor would have the option of purchasing the fund's shares after reviewing the information in the profile or after requesting and reviewing the fund's prospectus (and other information about the fund) before making a decision about investing in the fund. An investor deciding to purchase a fund's shares based on a profile will receive a copy of the fund's prospectus with the purchase confirmation.\1\ --------------------------------------------------------------------------- \1\ Investment Company Act Release No. 23065 (Mar. 13, 1998) (``Profile Adopting Release''). --------------------------------------------------------------------------- Table of Contents I. Introduction and Background II. Discussion A. Part A--Information in the Prospectus 1. Risk/Return Summary:Investments, Risks, and Performance (Item 2) a. Investment Objectives and Principal Strategies b. Risks 2. Risk/Return Summary: Fee Table (Item 3) 3. Investment Strategies and Risk Disclosure (Item 4) a. Principal Investment Strategies, Investment Objectives, and Implementation of Investment Objectives b. Risk Disclosure 4. Management's Discussion of Fund Performance (Item 5) 5. Management, Organization, and Capital Structure (Item 6) a. Management and Organization b. Capital Structure 6. Shareholder Information (Item 7) a. General Purchase and Sale Information b. Valuation of Fund Shares and Net Asset Value c. Restrictions on Portability d. Tax Consequences 7. Distribution Arrangements (Item 8) 8. Financial Highlights Information (Item 9) 9. Front and Back Cover Pages (Item 1) B. Part B--Statement of Additional Information C. Part C--Other Information D. General Instructions 1. Reorganizing and Simplifying the Instructions 2. Plain English Disclosure 3. Disclosure Guidelines 4. Modified Prospectuses for Certain Funds 5. Incorporation By Reference 6. Form N-1A Guidelines and Related Staff Positions E. Technical Rule Amendments F. Administration of Form N-1A G. Coordination with the NASD H. Effective Dates and Transition Period III. Cost/Benefit Analysis and Effects on Competition, Efficiency, and Capital Formation IV. Paperwork Reduction Act V. Summary of Final Regulatory Flexibility Analysis VI. Statutory Authority Text of Rule and Form Amendments I. Introduction and Background Over the last decade, the mutual fund industry has grown enormously both in total assets and in the number of funds.\2\ Today, fund assets exceed the deposits of commercial banks.\3\ Coincident with the explosive growth of fund investments, the business operations of many funds have become increasingly complex as funds offer 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. --------------------------------------------------------------------------- \2\ See Investment Company Institute (``ICI''), Mutual Fund Fact Book 16-23 (37th ed. 1997) (``ICI Fact Book'') and ICI, Trends in Mutual Fund Investing: September 1997, at 3 (Oct. 30, 1997) (ICI News No. 97-93) (``ICI Trends'') (between 1990 and 1997, fund assets increased from $1.1 trillion to $4.4 trillion and the number of funds increased from 3,105 to 6,666). \3\ Compare ICI Trends at 1 (fund net assets exceeded $4.4 trillion as of Sept. 1997) with Federal Reserve Bank Statistical Release H.8: Assets and Liabilities of Commercial Banks in the United States (Nov. 7, 1997) (commercial bank deposits were approximately $3.0 trillion as of Oct. 1997). --------------------------------------------------------------------------- Many have criticized fund prospectuses, finding them unintelligible, tedious, and legalistic.\4\ [[Page 13917]] Although the prospectus remains the most complete source of information about a fund, technical and unnecessarily long prospectus disclosure often obscures important information about a fund investment and does not serve the informational needs of the majority of fund investors.\5\ The millions of investors who turn to funds as their investment vehicle of choice \6\ need clear and comprehensible information to help them evaluate and compare fund investments. --------------------------------------------------------------------------- \4\ See, e.g., The Investment Company Act Amendments of 1995: Hearings Before the Subcomm. on Telecommunications and Finance of the House Comm. on Commerce, 104th Cong., 1st Sess. 56, 58 (1995) (statement of Don Powell, President and CEO of Van Kampen American Capital, Inc.) (noting the frequent complaint that prospectuses are too long, cumbersome, and legalistic); J. Bogle, Bogle on Mutual Funds 147 (1994); Rothchild, The War on Gobbledygook, Time, Oct. 31, 1994, at 51; Savage, SEC Doesn't Want 1987's Painful Lessons Forgotten, Chicago Sun-Times, Oct. 26, 1997, at 53; Sloan, Selling Attitude, Newsweek, June 17, 1996, at 52; Skrzycki, Prospectuses to be in English, Donkeys to Fly Tomorrow, Wash. Post, Oct. 21, 1994, at B1; ``Taking the Mystery Out of Mutual Funds,'' Remarks by Arthur Levitt, Chairman, SEC, before the Boston Citizens Seminar, Boston, MA (Feb. 25, 1997); ``Fulfilling the Promise of Disclosure,'' Remarks by Arthur Levitt, Chairman, SEC, before the American Savings Education Council, New York, NY (July 23, 1997). \5\ Levitt, Plain English in Prospectuses, N.Y. St. B. J., Nov. 1997, at 37 (``Levitt Article'') (``[D]isclosure is not disclosure if it doesn't communicate.''). See also Report on the OCC/SEC Survey of Mutual Fund Investors 12-13 (June 26, 1996) (although fund investors surveyed 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); 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). \6\ U.S. households own 74.2% of the mutual fund industry's assets. ICI Fact Book, supra note 2, at 35. --------------------------------------------------------------------------- New Disclosure Initiatives In seeking to improve the quality and usefulness of fund disclosure, the Commission proposed two major disclosure initiatives on February 27, 1997.\7\ First, the Commission issued for public comment a release (the ``Form N-1A Proposing Release'') that proposed significant amendments to the prospectus disclosure requirements for funds (the ``Proposed Amendments'').\8\ Second, the Commission proposed, in a companion release, new rule 498 under the Securities Act and the Investment Company Act that would allow a fund to offer investors the option to purchase its shares after reviewing the information in the fund's profile or after requesting and reviewing the fund's prospectus (and other information about the fund) before making a decision about investing in the fund.\9\ As proposed, the profile (the ``Proposed Profile'') would summarize key information about a fund, including the fund's investment objectives, strategies, risks, performance, and fees. Under proposed rule 498, a fund would be required to send investors the fund's prospectus and certain other information within 3 business days of a request, and any investor purchasing the fund's shares on the basis of a profile would receive the prospectus with the purchase confirmation. --------------------------------------------------------------------------- \7\ As part of these disclosure initiatives, the Securities and Exchange Commission (the ``Commission'') also proposed a new rule that would address investment company names that are likely to mislead investors about the investments and risks of an investment company. Investment Company Act Release No. 22530 (Feb. 27, 1997) [62 FR 10955], correction [62 FR 24161]. This proposed rule would require, among other things, funds and other registered investment companies with names suggesting a specific investment emphasis to invest at least 80% of their assets in the type of investment suggested by their name. The Commission received a number of substantive comments on the proposed rule, many of which asserted that the proposal had flaws that the Commission should address. The Commission's Division of Investment Management (the ``Division'') is analyzing the comments and expects to recommend a final rule for Commission consideration in the near future. \8\ Investment Company Act Release No. 22528 (Feb. 27, 1997) [62 FR 10898], correction [62 FR 24160] (``Form N-1A Proposing Release''). \9\ See Investment Company Act Release No. 22529 (Feb. 27, 1997) [62 FR 10943], correction [62 FR 24160] (``Profile Proposing Release''). --------------------------------------------------------------------------- The Commission's disclosure initiatives were intended to: improve fund disclosure by requiring prospectuses to focus on information central to investment decisions; provide new disclosure options for investors; and enhance the comparability of information about funds. Taken together, these initiatives are designed to promote more effective communication of information about funds to investors without reducing the amount of information provided to investors. The Proposed Amendments reflected the Commission's strong belief that the primary purpose of the disclosure in a fund's prospectus is to help an investor make a decision about investing in the fund.\10\ Consistent with this belief, the objective of the Proposed Amendments was to provide investors with prospectus disclosure that presents clear, concise, and understandable information about an investment in a fund. --------------------------------------------------------------------------- \10\ The Commission is adopting the amendments to Form N-1A under its authority in section 10(a) of the Securities Act [15 U.S.C. 77j(a)] 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. --------------------------------------------------------------------------- Commenters expressed overwhelming support for the Commission's disclosure initiatives.\11\ Commenters believed that the Commission's disclosure initiatives would enhance the quality of disclosure that funds provide to investors. Some commenters emphasized that improved disclosure about funds was long overdue and would substantially benefit investors. In particular, commenters strongly supported the Proposed Amendments as effective steps toward improving fund prospectuses. Commenters also provided numerous additional suggestions to improve prospectus disclosure. The Commission is adopting the initiatives substantially as proposed. --------------------------------------------------------------------------- \11\ Eighty-seven percent of the commenters supported the Proposed Amendments. The Commission received 78 comment letters on the Proposed Amendments, over half of which were from individual investors (44 letters or 57%). The Commission also received comment letters from 8 professional and trade associations, 13 fund groups, 4 law firms, 2 broker-dealers/investment advisers, and 7 other interested organizations. The comment letters, as well as a comment summary prepared by the Commission's staff, are available for public inspection and copying at the Commission's Public Reference Room in File No. S7-10-97. The Commission received 256 comment letters on the fund profile, a large number of which were from individual investors (226 letters or 88%). See Profile Adopting Release, supra note 1. --------------------------------------------------------------------------- Prior Commission Disclosure Initiatives The amendments to the prospectus disclosure requirements adopted today are another important step in the Commission's ongoing efforts to improve disclosure about funds. In 1983, the Commission introduced an innovative approach to prospectus disclosure by adopting a two-part disclosure format that permitted a fund to provide investors with a simplified prospectus containing essential information about the fund and to place more detailed information in a companion document called the ``Statement of Additional Information'' (``SAI''), which investors could obtain upon request.\12\ The Commission intended that, under this format, a fund's prospectus would include essential information about the fund that would be most useful to typical or average investors in making an investment decision about the fund. The Commission contemplated that more detailed discussions of matters geared to the needs of more sophisticated investors would be available in the SAI, which all fund 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 [[Page 13918]] fundamental characteristics of the particular investment company * * * .'' \13\ --------------------------------------------------------------------------- \12\ Investment Company Act Release No. 13436 (Aug. 12, 1983) [48 FR 37928] (``1983 Form N-1A Adopting Release''). \13\ Investment Company Act Release No. 12927 (Dec. 27, 1982) [48 FR 813, 814] (``1982 Form N-1A Proposing Release''). --------------------------------------------------------------------------- Since 1983, the Commission has implemented a number of other initiatives to improve fund prospectus disclosure, including a uniform fee table \14\ and a requirement that a fund's management discuss the fund's performance over the past year in its prospectus or annual report to shareholders (the management's discussion of fund performance (``MDFP'')).\15\ While these changes have provided investors with clear and helpful information about fund expenses and performance, they were not intended to address the overall effectiveness of Form N-1A's prospectus disclosure requirements. The Proposed Amendments and Form N- 1A, as amended, reflect the Commission's view that current prospectus disclosure must be considered on a comprehensive basis to ensure that the prospectus, as a whole, meets the information needs of investors. --------------------------------------------------------------------------- \14\ See Item 3 of current Form N-1A; Investment Company Act Release No. 16244 (Feb. 1, 1988) [53 FR 3192] (``Fee Table Adopting Release''). \15\ Item 5A of current Form N-1A; Investment Company Act Release No. 19382 (Apr. 6, 1993) [58 FR 19050] (``MDFP Adopting Release''). --------------------------------------------------------------------------- Reassessment of Fund Disclosure The Commission's recent efforts to improve disclosure began with an evaluation of the use of a standardized, summary disclosure document that highlights key information about a fund. The Commission, with the cooperation of the Investment Company Institute (``ICI'') and several large fund groups, conducted a pilot program permitting funds to use profile-like summaries (``Pilot Profiles'') together with their prospectuses.\16\ The program's purpose was to determine whether investors found the Pilot Profiles, which summarize important information about a fund, helpful in making investment decisions. Focus groups conducted on the Commission's behalf, and fund investors participating in a survey sponsored by the ICI, responded very positively to the profile concept.\17\ --------------------------------------------------------------------------- \16\ See Investment Company Institute (pub. avail. July 31, 1995) (``1995 Profile Letter''); Investment Company Institute (pub. avail. July 29, 1996) (``1996 Profile Letter''). The Division permitted the pilot program to continue pending the adoption of proposed rule 498. Investment Company Institute (pub. avail. July 16, 1997) (``1997 Profile Letter''). After the effective date of new rule 498, a fund could continue to use a Pilot Profile as supplemental sales literature. See Profile Adopting Release, supra note 1. \17\ See ICI Profile Survey, supra note 5, at 31-32. --------------------------------------------------------------------------- In considering fund disclosure issues, the Commission also has evaluated over 3,700 letters submitted in response to a release requesting comment on ways to improve risk disclosure in fund prospectuses, as well as the comparability of fund risk levels (``Risk Concept Release'').\18\ The commenters, mostly individual investors, confirmed the importance of risk disclosure in evaluating and comparing funds and emphasized 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\ See Investment Company Act Release No. 20974 (Mar. 29, 1995) [60 FR 17172] (``Risk Concept Release''). --------------------------------------------------------------------------- Plain English Initiatives The fund disclosure initiatives being adopted today are part of the Commission's broad undertaking to bring sweeping revisions to prospectus disclosure for all public companies.\19\ As part of its commitment to make all prospectuses simpler, clearer, and more useful, and to eliminate jargon and boilerplate, the Commission recently adopted rule amendments to require the use of plain English principles in drafting prospectuses and to provide other guidance on improving the readability of prospectuses.\20\ The Commission's plain English principles reflect fundamentals of clear communication and contemplate disclosure documents that: \19\ See Levitt Article, supra note 5, at 36. \20\ Rule 421 under the Securities Act [17 CFR 230.421]. See Securities Act Release No. 7497 (Jan. 28, 1998) [63 FR 6370] (``Plain English Release'') and discussion infra Section II.D.2. As part of the plain English initiatives, the Commission plans to issue A Handbook on Plain English: How to Create Clear SEC Disclosure Documents, prepared by the Commission's Office of Investor Education and Assistance. --------------------------------------------------------------------------- --Present information in an easily readable format; --Use everyday language that investors can easily understand; and --Eliminate repetition of disclosure that lengthens a document and overwhelms the investor. Improved Fund Disclosure As one commenter on the disclosure initiatives pointed out, the Commission's proposals reflect an unprecedented number and variety of public comments and expert views, the results of Commission and other research, and broad investor input. The Commission agrees with the commenter's further observation that the Commission has never had a more detailed, comprehensive, and compelling basis for a rulemaking than that developed for the fund disclosure initiatives. Through focus groups and written comments on the initiatives, investors have confirmed that they concur strongly with the Commission's view that fund disclosure documents will be useful only if they communicate information effectively. The Commission has designed both the fund prospectus and profile initiatives to meet this goal. The amendments to Form N-1A seek to make the prospectus, which will remain a fund's primary disclosure document, a more effective tool by focusing its contents on information that is essential to an investment in the fund. The profile responds to investors' strongly expressed desire for a new, concise disclosure document that summarizes key fund information and helps investors evaluate and compare funds more easily. To encourage the use of disclosure that communicates effectively, the Commission's fund disclosure initiatives include a number of important innovations: --The initiatives provide for a standardized risk/return summary at the beginning of every fund prospectus and in the profile that: \21\ --------------------------------------------------------------------------- \21\ These improvements are based in large part on comments received in response to the Risk Concept Release. See Risk Concept Release, supra note 18. 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''). --------------------------------------------------------------------------- --Concisely summarizes information in a specific sequence about a fund's investment objectives, strategies, risks and performance, and fees; --Discusses the risks of a fund's portfolio taken as a whole and minimizes detailed and technical descriptions of the risks associated with specific portfolio securities potentially held by the fund; and --Provides a graphic presentation of a fund's annual returns over a 10- year period in a bar chart that illustrates the variability of the fund's returns and gives investors some idea of the risks of an investment in the fund. To help investors evaluate a fund's risks and returns relative to ``the market,'' a table accompanying the bar chart compares the fund's average annual returns for 1, 5, and 10 years with that of a broad-based securities market index. --The initiatives require a fund to prepare disclosure documents using plain English disclosure, which is designed to give investors [[Page 13919]] understandable disclosure documents. --The initiatives eliminate prospectus clutter that obscures other information helpful to investors when making a decision about an investment in a fund. Specifically, the amendments to prospectus disclosure requirements: --Move certain disclosure about fund organization and legal requirements from the prospectus to the SAI; --Permit a fund that is offered as an investment alternative in a participant-directed defined contribution plan (or certain other tax- advantaged arrangements) to tailor its prospectus for the plan (or other arrangement); --Update and incorporate certain staff interpretive positions into Form N-1A; \22\ and --------------------------------------------------------------------------- \22\ The amendments contemplate further that the Division will consolidate its interpretive positions under the Investment Company Act relating to, among other things, fund operations in a new ``Investment Company Registration Guide'' (``Registration Guide''). The Registration Guide is discussed infra Section II.D.6. Form N-1A, as amended, incorporates certain staff disclosure requirements to identify those requirements that would apply to all funds regardless of their particular circumstances. Among other things, this approach addresses 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. --------------------------------------------------------------------------- --Simplify current disclosure instructions to provide clearer guidance for preparing and filing fund registration statements. Disclosure Principles The Commission believes that, in revising Form N-1A and in providing for the use of profiles, it has laid the foundation for the development of fund disclosure documents of a significantly higher quality than those often used today, which have drawn the consistent criticism of fund investors and others. If the initiatives are to have their intended effect, however, all those who participate in the preparation and review of those documents--funds, their legal counsels and other advisors, the Commission and its staff, and other regulators and their staffs--should act consistently with the basic disclosure principles that serve as the cornerstones of the initiatives. These principles, which are referred to throughout this release, include the following: --Funds should design disclosure documents, particularly their prospectuses, first and foremost, to communicate information to investors effectively. Funds should present information in prospectuses following the principles of plain English, using language that is concise, straightforward, and easy to understand. --A fund's prospectus principally should include essential information about the fundamental characteristics of, and risks of investing in, the fund. Whenever possible, a fund should present this information in a manner that: --Assists investors in comparing and contrasting the fund with other funds; --Avoids simply restating legal or regulatory requirements to which funds generally are subject; and --Avoids a disproportionate emphasis on possible investments or activities of the fund that are not a significant part of the fund's investment operations. --Funds should limit disclosure in prospectuses generally to information that is necessary for an average or typical investor to make an investment decision. Detailed or highly technical discussions, as well as information that may be helpful to more sophisticated investors, dilute the effect of necessary prospectus disclosure and should be placed in the SAI. --Prospectus disclosure requirements should not lead to lengthy disclosure that discourages investors from reading the prospectus or obscures essential information about an investment in a fund. The Commission has instructed its staff to use these principles consistently in administering the requirements of both amended Form N- 1A and new rule 498 and strongly encourages all other participants in the development of fund disclosure documents to apply these principles in preparing their prospectuses and profiles.\23\ --------------------------------------------------------------------------- \23\ The Commission expects that these disclosure principles also will provide useful guidance in resolving disclosure issues relating to funds under the federal securities laws as these issues arise from time to time. See discussion of administration of Form N- 1A, infra Section II.F. --------------------------------------------------------------------------- II. Discussion A. Part A--Information in the Prospectus Form N-1A, as amended, retains the overall structure of current Form N-1A. The most significant changes to Form N-1A adopted today are the new risk/return summary at the beginning of the prospectus and improved disclosure about the risks of investing in a fund. This release first addresses these changes and then discusses other changes to substantive prospectus disclosure requirements in Part A of Form N- 1A.\24\ Following this discussion, the release describes revisions to requirements for information on the front and back cover pages of the prospectus, the General Instructions to Form N-1A, which have been updated and revised to make them easier to use, and other technical revisions to Form N-1A's requirements.\25\ --------------------------------------------------------------------------- \24\ A chart in Appendix A to this release compares the revised Items in Form N-1A, as amended, to the current Items in Form N-1A. \25\ Form N-1A, as amended, incorporates certain disclosure requirements from the Guidelines to current Form N-1A (the ``Guides'') and the Generic Comment Letters (``GCLs'') that have been issued over time by the Division. 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 the GCLs, see infra notes 209-215 and accompanying text. --------------------------------------------------------------------------- 1. Risk/Return Summary: Investments, Risks, and Performance (Item 2) The Commission proposed to require a risk/return summary at the beginning of every prospectus that would provide key information about a fund's investment objectives, principal strategies, risks, performance, and fees. The risk/return summary, also included in the Proposed Profile, was intended to respond to investors' strong preference for summary information about the fund in a standardized format.\26\ The proposed risk/return summary in a fund's prospectus would provide investors with a type of ``executive summary'' of key information about the fund in a standardized, easily accessible place that investors could use to evaluate and compare the fund to others, regardless of whether the fund uses a profile. --------------------------------------------------------------------------- \26\ Participants in focus groups conducted on the Commission's behalf (``Focus Groups''), for example, expressed strong support for summary information in a standardized format. Many individuals in commenting on the profile initiative have confirmed the need for concise, summary information relating to a fund. See also Joe Six- Pack: Public Favors Profile Plan, Fund Action, Oct. 1997, at 9; Profile Prospectuses: An Idea Whose Time Has Come, Mutual Funds Magazine, Aug. 1996, at 11. --------------------------------------------------------------------------- While most commenters supported the proposed risk/return summary, several questioned whether it was necessary in a prospectus. These commenters argued that the summary could repeat other information in the prospectus and that it would undermine the Commission's goal of making prospectus disclosure clear and concise. The Commission is of the view that the prospectus risk/return summary will not undermine, but further, the goal of making prospectuses more useful for investors. The Commission believes that [[Page 13920]] the disclosure in the risk/return summary need not generally repeat other information in the prospectus; much of the summary consists of information that Form N-1A would not require to be disclosed elsewhere in the prospectus, such as the bar chart, performance table, and fee table. The Commission has concluded that the possibility that the risk/ return summary could repeat some information appearing elsewhere in the prospectus is outweighed by the benefits of providing investors with standardized and comparable fund information at the beginning of every prospectus and in the profile. Thus, the Commission is adopting the requirement that every prospectus and profile contain a risk/return summary.\27\ --------------------------------------------------------------------------- \27\ Items 2 and 3. Consistent with the goal of providing key information in a standardized summary, General Instruction C.3(b) to Form N-1A, as amended, precludes a fund from including information in the prospectus risk/return summary that is not required or otherwise permitted by Items 2 and 3. Form N-1A, as amended, does not require a fund to include any risk disclosure elsewhere in the prospectus if the requirements of Item 4 of Form N-1A are met by the disclosure in the fund's risk/return summary (i.e., if a fund is able to describe its risks, as required by Item 4, in its risk/ return summary, the fund would not need to describe those risks elsewhere in its prospectus). --------------------------------------------------------------------------- The Commission proposed to require that the risk/return information in the prospectus, like that in the Proposed Profile, appear in a specific sequence and in a question-and-answer format. Many commenters objected to the question-and-answer format, stating, among other things, that rigid adherence to the format would not necessarily result in effective communication of information to investors.\28\ To allow funds to design effective disclosure documents, the Commission has determined not to require this format in the prospectus or the profile. Any fund that chose to do so could use a question-and-answer format in its prospectus, profile, or in both documents. --------------------------------------------------------------------------- \28\ See Profile Adopting Release, supra note 1 (discussing commenters' critiques of the question-and-answer format). --------------------------------------------------------------------------- a. Investment Objectives and Principal Strategies. The Proposed Amendments would require a fund to disclose its investment objectives in the risk/return summary and to summarize, based on the information provided in its prospectus, how the fund intends to achieve those objectives. The purpose of the proposed disclosure was to provide a summary of the fund's principal investment strategies, including the specific types of securities in which the fund principally invests or will invest, and any policy of the fund to concentrate its investments in an industry or group of industries.\29\ The Commission is adopting this requirement as proposed.\30\ --------------------------------------------------------------------------- \29\ See infra notes 91-101 and accompanying text (discussing the criteria for determining whether a particular strategy is a principal strategy and disclosure about concentration policies). \30\ Items 2 (a) and (b). --------------------------------------------------------------------------- The information contained in the risk/return summary about a fund's investment objectives and principal strategies is intended to meet the needs of an average or typical fund investor. Recognizing that disclosure about a fund's specific portfolio holdings may be important to some investors, the Proposed Amendments would require a fund to inform investors in its prospectus risk/return summary that additional information about the fund's investments is available in the fund's shareholder reports.\31\ While supporting the proposed disclosure, most commenters suggested placing statements about how investors can obtain a fund's SAI, shareholder reports, and other information about the fund on the back cover page of the prospectus. According to these commenters, this disclosure would be easier for investors to find if it were located in one place rather than in different places in the prospectus. The Commission agrees with the commenters that typical fund investors may find a single reference to the availability of additional information helpful. Therefore, Form N-1A, as amended, requires all disclosure about the availability of additional information to appear on the back cover page of the prospectus.\32\ The Commission is adopting the disclosure as proposed, with minor adjustments to the language to ensure that the disclosure clearly explains the availability of additional information about a fund to a typical investor.\33\ --------------------------------------------------------------------------- \31\ The Commission proposed that the prospectus risk summary refer to fund shareholder reports. A fund's reports to its shareholders typically contain a discussion by the fund's management of the fund's performance (``MDFP''). The Commission believes that the information in a fund's MDFP, including the discussion of the fund's performance during its most recent fiscal year, could be useful to some investors considering an investment in the fund. The Proposed Amendments would require the risk/return summary to provide disclosure to the following effect: 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 ____________________. \32\ Item 1(b). Rule 498, as adopted, requires this disclosure to appear in the profile risk/return summary. See Profile Adopting Release, supra note 1. \33\ The Commission has made a few revisions to the disclosure about the availability of additional information to make it clearer and more understandable for investors. Item 1(b)(1) of Form N-1A, as amended, requires a fund (other than a new fund) to include disclosure to the following effect on the back cover page of its prospectus: Additional information about the fund's investments is available in the fund's annual and semi-annual reports to shareholders. In the fund's annual report, you will find a discussion of the market conditions and investment strategies that significantly affected the fund's performance during its last fiscal year. --------------------------------------------------------------------------- b. Risks. Summary Risk Disclosure. The Proposed Amendments would require the risk/return summary to include a discussion of the principal risks of investing in a fund that summarizes information about those risks set out in the fund's prospectus. Reflecting the Commission's proposed new approach to risk disclosure, this discussion was intended to summarize the risks of a fund's anticipated portfolio holdings as a whole, and the circumstances reasonably likely to affect adversely the fund's net asset value, yield, and total return. Commenters generally supported the summary risk disclosure contemplated by the Proposed Amendments, agreeing that it would be specific and brief and would assist investors in identifying the principal risks of investing in a particular fund. The Commission is adopting this disclosure requirement with modifications to reflect certain commenters' suggestions.\34\ --------------------------------------------------------------------------- \34\ Item 2(c). --------------------------------------------------------------------------- Several commenters asked the Commission to clarify the scope of the proposed summary risk disclosure, arguing that the requirement would not serve its purpose if the risk disclosure simply repeated information from other sections of the prospectus. In the Commission's view, the purpose of the summary risk disclosure in a fund's prospectus is to identify briefly the principal risks of investing in the particular fund and to emphasize those risks reasonably likely to affect the fund's performance. In light of this purpose, the Commission expects a fund, in meeting this requirement, to present only a succinct summary of the principal risks of investing in the fund and not to repeat the fuller discussion of these risks required elsewhere in the prospectus.\35\ On the other hand, the Commission believes that it generally would be inconsistent with the summary risk requirement for a fund to include a ``laundry list'' of generic risk factors that may apply to any fund and [[Page 13921]] that does not identify the risks of investing in the fund. --------------------------------------------------------------------------- \35\ See discussion of risk disclosure, infra Section II.A.3.b. --------------------------------------------------------------------------- The Commission proposed to require that the prospectus risk summary identify the types of investors for whom the fund may be an appropriate or inappropriate investment.\36\ Commenters either opposed or raised significant concerns about this provision, arguing that it could be viewed as requiring a fund to determine whether its shares, among other things, are a suitable investment for a particular investor.\37\ Commenters also stated that the disclosure would tend to be generic and not meaningful or useful for investors. --------------------------------------------------------------------------- \36\ As discussed in the Form N-1A Proposing Release, supra note 8, at 10902, the purpose of this disclosure was to help investors evaluate and compare funds based on their investment goals and individual circumstances. \37\ As several commenters pointed out, applicable regulatory rules for brokers and other investment professionals require that these determinations be made on the basis of a review of information about the unique circumstances of an individual investor. See, e.g., rule 2310(a) of the National Association of Securities Dealers, Inc. (``NASD'') Conduct Rules, NASD Manual (CCH) 4261 (suitability of recommendations to customers) and rule 405 of the New York Stock Exchange, 2 N.Y.S.E. Guide (CCH) para.2403 (the ``know your customer'' rule). --------------------------------------------------------------------------- The Commission is persuaded by commenters that disclosure about the appropriateness of funds for particular investors should not be required in all fund prospectuses and has deleted this requirement from the prospectus risk summary. The Commission believes, however, that disclosure indicating whether a fund is appropriate for specific types of investors or is consistent with certain investment goals, even if generic in nature, may be useful for some investors and may provide a means for the fund to distinguish itself from other investment alternatives.\38\ Therefore, Form N-1A, as amended, permits, but does not require, a fund to include disclosure in the narrative risk summary about the types of investors for whom the fund is intended or the types of investment goals that may be consistent with an investment in the fund.\39\ --------------------------------------------------------------------------- \38\ In a recent review of fund prospectuses, the Division found many examples of this type of disclosure, which was usually included in a fund's discussion of the risks associated with an investment in the fund. For example, one fund disclosed that it was not an appropriate investment for investors seeking either preservation of capital or high current income or for those investors unable to assume the increased risks of higher price volatility and currency fluctuations associated with investments in international equities traded in non-U.S. currencies. Another fund urged investors to remember that the fund was an aggressive capital appreciation fund designed for long-term investors for a portion of their investments and was not designed for investors seeking income or conservation of capital. Tax-exempt funds frequently stated that an investment in the fund is not appropriate for Individual Retirement Accounts or other tax-advantaged accounts. \39\ Instruction to Item 2(c)(1)(i). --------------------------------------------------------------------------- Under the Proposed Amendments, a fund could choose to discuss the potential rewards of investing in the fund in the risk summary as long as the discussion provided a balanced presentation of the fund's risks and rewards. One commenter strongly questioned this provision of the proposal, asserting that it would detract from a clear presentation of risks in the risk summary. The Commission has reconsidered this disclosure in light of the intended standardized and summary nature of the risk summary and has concluded that the disclosure should focus solely on the risks of investing in a fund. Thus, the Commission has determined to eliminate the option to describe the rewards of investing in a fund in the risk summary. A fund desiring to add this disclosure elsewhere in its prospectus can do so subject to Form N-1A's general rule with respect to information that is not required to be in a prospectus. Under this general rule, a fund can disclose this information, so long as it is not incomplete or misleading and would not obscure or impede understanding of the information that is required to be in the prospectus.\40\ --------------------------------------------------------------------------- \40\ See General Instruction C.3(b). --------------------------------------------------------------------------- Special Risk Disclosure Requirements. The Proposed Amendments were intended to simplify the prospectus cover page and to avoid repeating information on the cover page and in the risk summary discussion. In seeking to meet this goal, the Commission proposed to move certain cover page disclosure requirements relating to the risks associated with specific types of funds to the risk summary where, the Commission believed, it would be more meaningful to investors. Form N-1A currently requires that each money market fund \41\ 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. This required disclosure is intended to alert investors that investing in a money market fund is not without risk.\42\ In addition to moving this disclosure to the risk summary, the Proposed Amendments would simplify the technical disclosure that a money market fund may not be able to maintain a stable net asset value.\43\ Commenters supported the proposed disclosure for money market funds, and the Commission is adopting it as proposed.\44\ --------------------------------------------------------------------------- \41\ For these purposes, a money market fund is defined as a fund that holds itself out to investors as a money market fund and meets the conditions of paragraphs (c)(2), (c)(3), and (c)(4) of rule 2a-7 under the Investment Company Act [17 CFR 270.2a-7]. General Instruction A. \42\ 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 rule 2a-7 for money market funds). \43\ The Proposed Amendments would require the following disclosure: An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund. \44\ Item 2(c)(1)(ii). --------------------------------------------------------------------------- Form N-1A currently requires specific prospectus cover page disclosure for a tax-exempt money market fund that concentrates its investments in a particular state (a ``single state money market fund''). Each such fund is required to disclose that it 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. This disclosure was intended to make investors aware of special risks that could be associated with an investment in a single state money market fund.\45\ In the Form N-1A Proposing Release, the Commission asked whether it should continue to require this disclosure in prospectuses. The Commission noted that this disclosure may exaggerate the risk of investing in a single state money market fund. As the Form N-1A Proposing Release pointed out, although these funds are subject to less stringent issuer diversification provisions under Commission rules than other money market funds, they are subject to credit quality and maturity investment restrictions that are comparable to other money market funds.\46\ --------------------------------------------------------------------------- \45\ Form N-1A currently does not require this disclosure if, with respect to 100% of its assets, a fund limits its investments in a single issuer to no more than 5% of its assets. \46\ See Form N-1A Proposing Release, supra note 8, at 10904. Under rule 2a-7, a ``national'' tax-exempt money market fund generally is limited to investing no more than 5% of its assets in the securities of a single issuer. For a single state money market fund, the 5% single issuer limitation applies with respect to 75% of the fund's assets. This limitation recognizes that single state money market funds concentrate their investments in debt securities issued by a single state (or issuers located within that state), making diversification more difficult to achieve. See Investment Company Act Release Nos. 21837 (Mar. 21, 1996) [61 FR 13956] and 22921 (Dec. 2, 1997) [62 FR 64968]. --------------------------------------------------------------------------- In response to the Commission's question regarding single state money market funds, commenters indicated that the special disclosure now required [[Page 13922]] on the cover page of fund prospectuses overstates the risks of investing in single state money market funds, particularly in view of the minimal risk that commenters asserted is associated with these funds. The Commission is persuaded by these comments and has determined not to require the disclosure in Form N-1A. Form N-1A currently requires a fund that is advised by or sold through a bank 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.\47\ This disclosure is intended to alert investors that funds advised by or sold through banks are not federally insured.\48\ The Commission proposed to move this disclosure to the prospectus risk summary and to simplify the wording of the current disclosure required for funds advised by or sold through banks.\49\ Commenters supported the revised disclosure requirements for bank-sold funds, and the Commission is adopting them substantially as proposed.\50\ --------------------------------------------------------------------------- \47\ 1994 GCL, supra note 25; Letter to Registrants from Barbara J. Green, Deputy Director, Division of Investment Management, SEC (May 13, 1993) (``Division Bank Letter''). \48\ See Division Bank Letter, supra note 47. See also Testimony of Ricki Helfer, Chairman, Federal Deposit Insurance Corporation (``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). \49\ The Proposed Amendments would require a fund that is not a money market fund but is advised by or sold through a bank to disclose that its shares are not federally insured as follows: An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. \50\ Item 2(c)(1)(iii). Some commenters asserted that the proposed disclosure was inconsistent with that required by bank regulators in the Interagency Statement on Retail Sales of Nondeposit Investment Products. 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) (``Interagency Statement'') (requiring disclosure that the fund is not a deposit or other obligation of the bank). The Commission has confirmed with these bank regulators that no such inconsistency exists, because the disclosure required by the Interagency Statement applies to sales material and not to fund prospectuses. In response to suggestions from the bank regulators, the Commission has revised the legend required for funds that are advised by or sold through banks, to read as follows: An investment in the Fund is not a deposit of the bank and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The requirement, as amended in this way, is consistent with the requirement now in effect. --------------------------------------------------------------------------- Risk/Return Bar Chart and Table. The Proposed Amendments would require a fund's risk/return summary to include a bar chart showing the 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 1-, 5-, and 10-fiscal years to those of a broad-based securities market index. Commenters generally supported the proposed bar chart and performance table, but had a number of suggestions about the content and presentation of the information in both. The Commission is adopting the proposed bar chart and table requirements with modifications to reflect suggestions of commenters.\51\ --------------------------------------------------------------------------- \51\ Item 2(c)(2). An example of the bar chart and performance table is attached as Appendix B to this release. --------------------------------------------------------------------------- The bar chart reflects the Commission's determination that investors need improved disclosure about the risks of investing in a fund. The bar chart is intended to illustrate graphically the variability of a fund's returns (e.g., whether a fund's returns for a 10-year period have changed significantly from year to year or were relatively even over the period) and thus provide investors with some idea of the risk of an investment in the fund.\52\ The average annual return information in the table should enable investors to evaluate a fund's performance and risks relative to ``the market.'' --------------------------------------------------------------------------- \52\ In adopting the bar chart requirement, the Commission does not mean to suggest that all, or even a significant portion of all, fund investors equate variability in a fund's returns with the risks of investing in the fund. As discussed below, the Commission acknowledges that investors have a wide range of ideas of what ``risk'' means. See infra Section II.A.3. Nonetheless, the Commission's bar chart proposal was supported by many investors who expressed strong interest in seeing prospectuses include a version of the bar chart. Focus group participants, for instance, found the bar chart helpful in evaluating and comparing fund investments. Over 75% of individual investors responding to the Risk Concept Release favored a bar chart presentation of fund volatility. Risk Concept Release, supra note 18. See also ICI, Understanding Shareholders' Use of Information and Advisers (1997) (``ICI Shareholder Use Study'') at 20 and 30 (discussing investors' interest in receiving and understanding fund risk information) and ICI Risk Survey, supra note 21. 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 10-year bar chart reflecting a money market fund's yield. 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). --------------------------------------------------------------------------- In the Form N-1A Proposing Release, the Commission requested comment about alternative presentations that could improve fund risk disclosure.\53\ In particular, the Commission expressed interest in disclosure that would show a fund's highest and lowest returns (or ``range'' of returns) for annual or other periods as an alternative, or in addition, to the bar chart. The Commission suggested that a fund could present the information in a separate table or could include it in the performance table. --------------------------------------------------------------------------- \53\ See Form N-1A Proposing Release, supra note 8, at 10907. --------------------------------------------------------------------------- In response to the Commission's request, some commenters suggested including in a fund's bar chart one or more indexes or other benchmarks (such as 3-month Treasury returns or the rate of inflation) to help investors evaluate the fund's returns by comparisons to other measures of market performance or economic factors.\54\ Most commenters, however, opposed requiring additional information in the bar chart, asserting that it could complicate and reduce the effectiveness of the bar chart. --------------------------------------------------------------------------- \54\ Form N-1A, as amended, permits a fund to use other indexes in the presentation of the average annual return information in the table accompanying the bar chart. Instruction 2(b) to Item 2(c)(2). --------------------------------------------------------------------------- Several commenters supported the inclusion of return information in the bar chart on a quarterly or semi-annual rather than an annual basis. They argued that this change to the bar chart would respond to concerns that investors may not sufficiently appreciate that an investment in a fund may be subject to the risk of a short-term decline in value. This risk, commenters asserted, may not be apparent from the annual returns proposed to be shown in the bar chart. One commenter recommended that the Commission require quarterly returns in the bar chart so that investors would have more information about returns over shorter periods to use in assessing the variability reflected in a fund's past returns. The commenter argued that including returns on an annual basis in the bar chart may not show a significant amount of shorter-term price fluctuation. The Commission acknowledges that a fund's returns may vary significantly and could decrease in value over short periods and that the annual returns in the bar chart will not necessarily reflect this pattern. On the other hand, the Commission is concerned that requiring quarterly returns over a 10-year period would make the bar chart more complex and less useful in communicating information to investors. In balancing the desire to make typical fund investors aware that fund shares may [[Page 13923]] experience fluctuations over shorter periods with its underlying goal that fund documents communicate information in as straightforward and uncomplicated a manner as possible, the Commission has determined to require a fund to disclose, in addition to the bar chart, its best and worst returns for a quarter during the 10-year (or other) period reflected in the bar chart.\55\ The Commission believes that this information will assist investors in understanding the variability of a fund's returns and the risks of investing in the fund by illustrating, without adding unwarranted complexity to the bar chart, that the fund's shares may be subject to short-term price fluctuations. --------------------------------------------------------------------------- \55\ Item 2(c)(2)(ii). --------------------------------------------------------------------------- Presentation of Return Information. The Proposed Amendments would require a fund to include the bar chart and table in the risk section of the prospectus risk/return summary under a separate sub-heading that referred to both risk and performance. Several commenters argued that the separate sub-heading requirement was unnecessary and suggested that a fund should be able to choose whether to include any sub-heading. Consistent with the objective of encouraging funds to develop disclosure formats that are most helpful to investors, Form N-1A, as amended, does not require the sub-heading included in the Proposed Amendments.\56\ To help investors use the information in the bar chart and table, Form N-1A, as amended, however, does require a fund to provide a brief narrative explanation of how the information illustrates the variability of the fund's returns.\57\ --------------------------------------------------------------------------- \56\ General Instruction C.1(a) to Form N-1A, as amended, encourages funds to use document design techniques that promote effective communication. \57\ Item 2(c)(2)(i). --------------------------------------------------------------------------- Bar Chart Return Information. The Proposed Amendments would require that a fund's prospectus bar chart show the fund's annual returns for the last 10 calendar years of the fund's existence. The purpose of the calendar year requirement was to facilitate the comparison of annual returns among funds, which typically have fiscal periods that do not correspond to the calendar year.\58\ Unlike the proposed bar chart, the proposed performance table required disclosure of a fund's returns for fiscal year periods. In requiring this disclosure to be made for fiscal year periods, the proposal was consistent with existing disclosure requirements for the presentation of other financial information included in a fund's prospectus. --------------------------------------------------------------------------- \58\ The Commission understands that funds increasingly organize themselves as series companies and tend to stagger the financial periods of their series so that audits and financial reporting periods are spread over an entire calendar year. --------------------------------------------------------------------------- Several commenters argued that using different time periods for the proposed bar chart and performance table would confuse investors and urged the Commission to minimize potential investor confusion by adopting consistent time periods for this information. The Commission is persuaded by these comments and believes that requiring both the bar chart and the performance table to be based on calendar year periods will promote understandable information in fund prospectuses. Therefore, Form N-1A, as amended, requires calendar year periods for both the bar chart and table.\59\ Rule 498, as adopted, also requires the bar chart and table in the profile to show calendar year data so that both the profile and the prospectus of a fund will have virtually the same risk/return information.\60\ --------------------------------------------------------------------------- \59\ Item 2(c)(2). Form N-1A, as amended, requires a fund to have at least one calendar year of returns before including the bar chart and requires a fund to modify the narrative explanation accompanying the bar chart and table if the fund does not include the bar chart (e.g., by stating that the information gives some indication of the risks of an investment in the fund by comparing the fund's performance with a broad measure of market performance). Form N-1A, as amended, also requires the bar chart of a fund in operation for fewer than 10 years to include calendar year returns for the life of the fund. \60\ Rule 498(c)(2)(iii). Unlike Form N-1A, as amended, rule 498, as adopted, requires average annual return information in the performance table in the profile to be as of the most recent calendar quarter and updated as soon as practicable after each quarter of a calendar year. See Profile Adopting Release, supra note 1. A fund would update the average annual return information included in its prospectus when filing the annual update of its registration statement required by section 10(a)(3) of the Securities Act. --------------------------------------------------------------------------- The Commission is adopting, as proposed, the requirement that a fund calculate the annual returns in the bar chart using the same method required for calculating annual returns in the financial highlights information included in fund prospectuses.\61\ The bar chart does not reflect sales loads assessed upon the sale of a fund's shares, although the average annual return information for the fund in the table would reflect the payment of any sales loads.\62\ Commenters generally supported this presentation of annual return information. The Commission believes that, in light of the different types of sales loads that may be charged on funds shares, it would be difficult for funds to compute annual returns for the purposes of the bar chart and to communicate the information effectively to investors.\63\ In addition, the Commission has concluded that more precise return information is not necessary for the bar chart to serve the purpose of graphically showing fund annual returns and illustrating the variability of an investment in a fund over a 10-year period. --------------------------------------------------------------------------- \61\ Instruction 1(a) to Item 2(c)(2). Form N-1A, as amended, requires a fund to present the corresponding numerical return adjacent to each bar. Item 2(c)(2)(ii). \62\ Instruction 2(a) to Item 2(c)(2). Form N-1A, as amended, requires a fund whose shares are sold subject to a sales load to disclose that the load is not reflected in the bar chart and that, if it were included, returns would be less than those shown. Instruction 1(a) to Item 2(c)(2). \63\ In contrast, sales loads can be accurately and fairly reflected in annual 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. --------------------------------------------------------------------------- Bar Chart Presentation. The Proposed Amendments would allow a single bar chart to include return information for more than one fund. Most commenters supported the proposal, agreeing that it would give funds the appropriate amount of flexibility to present the information in the bar chart in a manner designed to assist investors in making investment decisions. Under Form N-1A, as amended, the bar chart may include returns for more than one fund, subject to the general requirement that the information presented in the bar chart appear in a clear and understandable manner.\64\ --------------------------------------------------------------------------- \64\ See General Instruction C.3(c). --------------------------------------------------------------------------- Multiple Class Funds. Although the Commission proposed to permit return information for more than one fund to be included in a single bar chart, the Proposed Amendments would require a fund offering more than one class of its shares in a prospectus to limit the information in the fund's bar chart to one class. Commenters uniformly supported this approach, and the Commission is adopting it as proposed.\65\ Unlike individual funds, classes of a fund represent interests in the same portfolio of securities, and the returns of each class differ only to the extent the classes do not have the same expenses. The Commission believes that including return information for all classes offered through a fund's prospectus is not necessary to provide some indication of the risks of investing in the fund. In addition, the table accompanying such a fund's bar chart would provide return information for each class offered in the prospectus so that investors would be able to identify and compare the performance of each class.\66\ --------------------------------------------------------------------------- \65\ Instruction 3(a) to Item 2(c)(2). \66\ Instruction 3(c) to Item 2(c)(2). --------------------------------------------------------------------------- The Proposed Amendments would require the bar chart of a fund offering more than one class of shares through a prospectus to reflect annual return [[Page 13924]] information for the class offered in the prospectus that had the longest performance history over the last 10 years. When two or more classes have returns for at least 10 years, or returns for the same period but fewer than 10 years, the Proposed Amendments would require annual returns for the class with the greatest net assets as of the end of the most recent calendar year. Most commenters addressing the issue opposed this approach. They argued that, if all classes had existed for the same amount of time, the largest class could change from year to year, thus requiring a fund to change the class reflected in the bar chart. According to the commenters, changes in the information each year could be confusing for investors and result in unwarranted administrative burdens for funds. Commenters suggested that the Commission permit a fund having classes with performance histories extending over the same period of time to include the performance of any existing class in the bar chart, maintaining that the effect of expenses on the returns for different classes of shares is not significant.\67\ The Commission is persuaded that allowing a multiple class fund in such a case to choose the class reflected in the fund's bar chart will simplify compliance with Form N-1A's requirements and provide investors with sufficient information to evaluate the variability of returns for any class of the fund. Therefore, Form N-1A, as amended, permits a fund to choose the class to be reflected in the bar chart, subject to certain limitations.\68\ Under Form N-1A, as amended, the bar chart must reflect the performance of any class that has returns for at least 10 years (e.g., a fund could not present a class in the bar chart with 2 years of returns when another class has returns for at least 10 years). In addition, if two or more classes offered in the prospectus have returns for different periods shorter than 10 years, the bar chart must reflect returns for the class that has returns for the longest period. --------------------------------------------------------------------------- \67\ In making this argument, commenters cited rule 18f-3 under the Investment Company Act [17 CFR 270.18f-3], which provides that a class of shares may have different expenses for shareholder service fees, distribution fees, or other expenses actually incurred in a different amount by the class. The rule does not permit expenses for advisory or custodial fees, or other management fees, to vary among classes. \68\ Instruction 3(a) to Item 2(c)(2). --------------------------------------------------------------------------- Tabular Presentation of Fund and Index Returns. The Proposed Amendments would require a table accompanying a fund's bar chart to present the fund's average annual returns for the last 1-, 5-, and 10- fiscal years (or for the life of the fund, if shorter) and to compare that information to the returns of a broad-based securities market index for the same periods. The purpose of including return information for a broad-based securities market index was to provide investors with a basis for evaluating a fund's performance and risks relative to the market. The proposed approach also was consistent with the line graph presentation of fund performance required in MDFP disclosure.\69\ --------------------------------------------------------------------------- \69\ See MDFP Adopting Release, supra note 15, at 19054. --------------------------------------------------------------------------- Commenters generally supported the proposed performance table, but had several technical suggestions. The Commission is adopting the performance table with revisions to clarify the disclosure requirements for the table.\70\ --------------------------------------------------------------------------- \70\ Item 2(c)(2)(ii). Consistent with the Proposed Amendments, Form N-1A, as amended, requires a fund to calculate average annual returns 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 Item 2(c)(2) (incorporating the requirements of Item 21). --------------------------------------------------------------------------- One commenter suggested that the Commission allow funds that have existed for more than 10 years to include average annual returns for the life of the fund in the performance table. The Commission agrees that this information could be helpful for typical investors in such a fund. Form N-1A, as amended, permits, but does not require, a fund to include performance information in the table for the life of the fund if it exceeds 10 years.\71\ --------------------------------------------------------------------------- \71\ Item 2(c)(2)(iii). Form N-1A, as amended, permits a fund that has not had the same adviser for the last 10 years 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. Instruction 4 to Item 2(c)(2). Form N-1A, as amended, also requires a fund that changes the index shown in the table to explain the reasons for the change and provide information for both the newly selected and the former index. Instruction 2(c) to Item 2(c)(2). Each of these provisions is consistent with the requirement applicable to the MDFP line graph. Instructions 7 and 11 to Item 5(b). --------------------------------------------------------------------------- The Proposed Amendments would require a money market fund, in meeting the proposed performance table requirement, to provide its 7- day yield as of the end of its most recent fiscal year. One commenter questioned this requirement, arguing that it would result in money market funds giving outdated information to investors and suggested that disclosure describing how an investor can obtain the fund's current 7-day yield would be preferable. As amended, Form N-1A gives a money market fund the option of providing in its performance table its 7-day yield ending on the date of its most recent calendar year or disclosing a toll-free (or collect) telephone number that an investor can use to contact the fund to obtain its current 7-day yield.\72\ --------------------------------------------------------------------------- \72\ Item 2(c)(2)(iii). --------------------------------------------------------------------------- 2. Risk/Return Summary: Fee Table (Item 3) The Proposed Amendments would continue to require a fee table in the prospectus that summarizes the sales charges and fund operating expenses associated with an investment in a fund. Proposed rule 498 also incorporates the fee table requirement in the risk/return summary included in the profile. Including the fee table in both the prospectus and the profile reflects the Commission's strongly held belief in the importance of fees and expenses in a typical investor's decision to invest in a fund. The fee table is designed to help investors understand the costs of investing in a fund and to compare those costs with the costs of other funds. Commenters generally supported the fee table disclosure, and the Commission is adopting it substantially as proposed. The Commission proposed certain amendments designed to improve communication of the information in the fee table. The Commission proposed to require a narrative explanation of the purpose of the ``Example'' that accompanies the fee table.\73\ Recognizing the trend that the typical fund investment is increasing in size,\74\ the Proposed Amendments would increase the initial hypothetical investment included in the Example from $1,000 to $10,000. --------------------------------------------------------------------------- \73\ The Example currently discloses the cumulative amount of fund expenses over 1, 3, 5, and 10 years based on a hypothetical investment of $1,000 and an annual 5% return. The Commission proposed to require funds to include 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. \74\ 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 to 25,000, with the median investment probably in the range of $6,000 to 7,000). --------------------------------------------------------------------------- Several commenters criticized the Example, arguing that, because it is an arbitrary approximation of a fund's actual expenses, the Example is not helpful to investors. These commenters recommended that the Commission eliminate the Example from the fee table disclosure. The Commission recognizes that any example necessarily has limitations. On balance, however, the Commission believes that the Example provides [[Page 13925]] useful information that helps a typical investor understand and compare the expenses of different funds.\75\ The Example is a relatively straightforward means of illustrating the effect of costs in investing in a fund over time. Expressing expense amounts solely as a percentage amount, as is done in the fee table, may not give the average investor enough information to assess the likely effect of a fund's expenses on a dollar amount of an investment in the fund. The addition of a clear narrative explanation of the purpose of the Example should increase its effectiveness in assisting investors' understanding of the Example, and the Commission is adopting this disclosure requirement as proposed.\76\ --------------------------------------------------------------------------- \75\ See Fee Table Adopting Release, supra note 14, at 3194. \76\ Item 3. --------------------------------------------------------------------------- To ensure that all account fees (e.g., administrative fees charged to maintain an account) paid directly by shareholders are disclosed, the Proposed Amendments would require a new line item in the shareholder transaction section of the fee table describing account fees charged by a fund. The Commission is adopting this requirement as proposed.\77\ In response to comments on the Proposed Amendments, Form N-1A, as amended, clarifies that the table should include account fees that affect a typical investor in a fund and not miscellaneous fees that apply to only a limited number of shareholders based on their particular circumstances.\78\ --------------------------------------------------------------------------- \77\ Form N-1A, as amended, clarifies that a fund should disclose only fees charged by or on behalf of the fund, not fees charged by unrelated third parties. Instruction 1(c) to Item 3. \78\ Instruction 2(d) to Item 3. For example, Form N-1A would not require a fund to include in the fee table a fee charged to accounts with small balances (e.g., $10 annual fee on accounts less than $2,500). --------------------------------------------------------------------------- The Commission proposed to modify some of the captions in the fee table relating to fees and expenses. The revisions were intended to result in fee tables referring consistently to different types of expenses as ``fees.'' In particular, the Proposed Amendments would change the captions for ``sales loads'' to ``sales fees (loads).'' The Proposed Amendments also would revise the caption ``12b-1 Fees'' to read ``Marketing (12b-1) Fees.'' Commenters generally criticized these changes. They maintained that the caption sales fees (loads) was not typically used by the industry or industry commentators and could be confusing to investors. The commenters recommended that the caption in the fee table refer to ``sales charges.'' Commenters also recommended that the caption ``Distribution [and/or Service] (12b-1) Fees'' would better describe these fees than the term ``Marketing (12b-1) Fees.'' Commenters said that the types of fees that can be paid in accordance with rule 12b-1 under the Investment Company Act extend beyond marketing fees so that referring to rule 12b-1 fees as marketing fees would be inaccurate. The Commission believes that the terms suggested by commenters are commonly used by the industry and by the press in covering the industry and may be more easily understood by investors than those proposed. Form N-1A, as amended, modifies the caption for sales fees (loads) to refer to sales charges (loads).\79\ The Commission is retaining the reference to loads because many investors are familiar with this term. Form N-1A, as amended, also requires funds to use the captions suggested by the commenters in referring to distribution fees in the fee table. --------------------------------------------------------------------------- \79\ Item 3. --------------------------------------------------------------------------- The Commission proposed to continue to require a fund to reflect in the fee table its operating expenses for the most recent fiscal year, taking into account expense reimbursements and fee waiver arrangements.\80\ As required by current Form N-1A, a footnote to the fee table would disclose the amount of expenses that would have been incurred had there been no waiver or reimbursement. One commenter expressed strong opposition to showing expenses in the fee table that are reduced by reimbursements or fee waivers. The commenter asserted that investors would interpret the disclosure to mean that the net fee disclosed in the table is what they can expect for the life of their investment in the fund, which may not be the case. --------------------------------------------------------------------------- \80\ In an expense reimbursement arrangement, the adviser reimburses the fund for any expenses that exceed a predetermined amount. Under a fee waiver arrangement, the adviser agrees to waive a portion of its fees in order to limit fund expenses to a predetermined amount. --------------------------------------------------------------------------- The Commission believes that typical investors need clear disclosure of information about fees charged by funds.\81\ Reflecting its continuing concern about the quality of disclosure about fees, the Commission has reconsidered the disclosure of expense reimbursement and fee waiver arrangements. The Commission believes that typical investors may tend to overlook or disregard information about a fund's fee structure if it is included in a footnote. Moreover, requiring the fee table to show fees that a fund will charge under its contractual arrangement with its investment adviser, without regard to temporary arrangements that may decrease these fees, is consistent with other Form N-1A requirements.\82\ --------------------------------------------------------------------------- \81\ See, e.g., Testimony of Arthur Levitt, Chairman, SEC, before the Subcomm. on Finance and Hazardous Materials of the House Comm. on Commerce (Mar. 6, 1997) (explaining the Commission's concern about investor confusion with fund fees); Remarks by Steven M.H. Wallman, Commissioner, SEC, before the ICI's 1995 Investment Company Directors Conference and New Directors Workshop, Washington, D.C. (Sept. 22, 1995) (noting investors' confusion about the assessment of advisory fees). \82\ See, e.g., Instruction 2(a)(i) to Item 3 (requiring funds to disclose deferred sales charges even though they apply only to investors leaving the fund). See also ``From Security to Self- Reliance: American Investors in the 1990s,'' Remarks by Arthur Levitt, Chairman, SEC, before the ICI's General Membership Meeting at the Washington Hilton Hotel, Washington, D.C. (May 22, 1996) (citing a survey by the Investor Protection Trust that found that 2 out of 3 investors believed that no-load mutual funds involve no sales charges or fees, as an example of why the Commission should be concerned about the quality of disclosure of fees charged by funds); Testimony of Barry P. Barbash, Director, Division of Investment Management, SEC, 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 a 1994 survey by the American Association of Retired Persons, the Consumer Federation of America, and the North American Securities Administrators, Inc. that found that the vast majority of American bank customers who hold shares of mutual funds are unaware of the risks and fees involved in the sale of mutual funds). --------------------------------------------------------------------------- In view of its desire to improve the quality of fee disclosure, the Commission has revised Form N-1A to require a fund to disclose in the fee table its operating expenses, not taking into account expense reimbursements and fee waiver arrangements.\83\ To ensure that investors have current information about a fund's expenses, however, Form N-1A, as amended, permits a fund to disclose its operating expenses net of reimbursements and waivers in a footnote to the fee table.\84\ The Commission believes that the fee table disclosure of fund expenses, as amended, will give an investor clearer information about the long-term costs of an investment in a fund, while at the same time allowing the fund to provide current information about its operating expenses. --------------------------------------------------------------------------- \83\ Instructions 3(d)(i) and 5(a) to Item 3. \84\ Instructions 3(e) and 5(b) to Item 3. A fund also must disclose the period for which the expense reimbursement or fee waiver is expected to continue, or whether it can be terminated at any time at the option of the fund. The Commission expects that, in the latter case, a fund would provide adequate notice to investors and fund shareholders in advance of the termination of the arrangement. --------------------------------------------------------------------------- 3. Investment Strategies and Risk Disclosure (Item 4) In the Form N-1A Proposing Release, the Commission discussed its concerns about disclosure of fund investments [[Page 13926]] and risks typically found in many fund prospectuses.\85\ This disclosure generally consists of descriptions of the types of securities in which a fund may invest and the risks associated with each of those securities.\86\ In the Commission's view, disclosing information about all of the securities in which a fund might invest does not help a typical fund investor evaluate how the fund's portfolio will be managed or the overall risks of investing in the fund. The disclosure also adds substantial length and complexity to fund prospectuses, which discourages investors from reading them. --------------------------------------------------------------------------- \85\ See Form N-1A Proposing Release, supra note 8, at 10909. \86\ 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. --------------------------------------------------------------------------- The Commission has concluded that prospectus disclosure would be more useful to a typical fund investor 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.\87\ The Commission believes that funds are appropriately viewed as a means through which a professional money manager provides its services to investors \88\ and that, for that reason, the focus of disclosure about a fund's prospective investments should center 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 would require prospectus disclosure that is designed to help investors understand how a particular fund's portfolio will be managed. The purpose of the Proposed Amendments was to implement more effectively the Commission's original goal in adopting Form N-1A that the prospectus should describe a fund's ``fundamental characteristics.'' \89\ Commenters generally supported the proposed approach to disclosure of the fund's investment operations and attendant risks, and the Commission is adopting it substantially as proposed. --------------------------------------------------------------------------- \87\ The ICI has supported prospectus disclosure that focuses primarily on a fund's broad investment objectives, practices, and associated risks, and not on particular types of securities in which the fund may invest. See, e.g., Letter from Paul Schott Stevens, General Counsel, ICI, to Jonathan G. Katz, Secretary, SEC, at 5 (Apr. 8, 1996); 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). \88\ See ``Can We Make Donkeys Fly?,'' Remarks by Barry P. Barbash, Director, Division of Investment Management, SEC, before the Business Law Section of the ABA, Washington, D.C., at 13 (Nov. 11, 1994); see also 1 T. Lemke, G. Lins & A.T. Smith III, Regulation of Investment Companies Sec. 1.01, at 1-1 (1997). \89\ See 1982 Form N-1A Proposing Release, supra note 13, at 815; 1983 Form N-1A Adopting Release, supra note 12, at 39729. --------------------------------------------------------------------------- a. Principal Investment Strategies, Investment Objectives, and Implementation of Investment Objectives. To assist investors in determining whether a fund meets their investment needs, Form N-1A, as amended, continues to require prospectus disclosure of a fund's investment objectives.\90\ The Commission proposed to shift the focus of disclosure about how a fund intends to achieve its investment objectives away from the current practice of listing all types of securities in which a fund may invest to a discussion of the fund's overall portfolio management.\91\ The Commission proposed to require a fund to disclose in its prospectus the principal strategies that it used to achieve its investment objectives, which would include the particular type or types of securities in which the fund will invest principally. This approach was designed to focus disclosure on a fund's anticipated investment operations rather than on investments that the fund might make. --------------------------------------------------------------------------- \90\ Item 4(a). A fund may refer to its investment objectives as investment goals or any other term that clearly communicates the principal investment design of the fund. Form N-1A, as amended, continues to require a fund to disclose in its prospectus when it may change its investment objectives without a shareholder vote. Id. Under current practice, some funds disclose in their prospectuses when a shareholder vote is required to change its investment objectives. The Commission believes that disclosure of this sort is of limited significance to the typical fund investor. In the Commission's view, most investors typically would not expect the investment objectives of their funds to change without their approval. Consistent with this view, Form N-1A, as amended, requires a fund to disclose in its SAI, and not in its prospectus, when a shareholder vote is required to change its investment objectives. Item 12(c)(1)(vii). \91\ 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 the fund will use in connection with investing in those securities. Form N-1A also requires disclosure, subject to certain limitations, about ``significant investment policies or techniques'' that a fund intends to use. One of those limitations directs a fund to limit prospectus disclosure about practices that place no more than 5% of the fund's assets at risk. Many funds disclose in their prospectuses information about securities and investment practices that do not, and may not ever, place more than 5% of the fund's assets at risk, often to retain the flexibility to exceed the 5% threshold in the future. The Commission proposed to eliminate the 5% standard. Form N-1A Proposing Release, supra note 8, at 10909. The standard has been deleted in Form N-1A, as amended. --------------------------------------------------------------------------- The Commission continues to believe that a clear, concise, and straightforward discussion of investment objectives and strategies is central to effective prospectus disclosure. Therefore, the Commission is adopting the requirement for a fund to disclose how it intends to achieve its investment goals as proposed.\92\ --------------------------------------------------------------------------- \92\ Item 4(b). Instruction 1 to Item 4(b)(1) defines a strategy to include any policy, practice, or technique used to achieve a fund's investment objectives. --------------------------------------------------------------------------- Under Form N-1A, as amended, whether a particular investment strategy (including a strategy to invest in a particular type of security) is a principal investment strategy depends 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.\93\ The Commission believes that a fund should disclose those strategies that are expected to be the most important means of achieving the fund's objectives and that the fund anticipates will have a significant effect on its performance. Form N-1A, as amended, requires a fund, when determining whether a strategy is a principal investment strategy, to consider, among other things, the portion of assets that it expects to commit to the strategy, the portion of assets that it expects to place at risk by the strategy, and the likelihood that it will lose some or all of those assets in implementing the strategy.\94\ --------------------------------------------------------------------------- \93\ Instruction 2 to Item 4(b)(1). Form N-1A currently 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 Item 4(b)(1) retains this limitation by providing that a negative strategy is not a principal investment strategy. Avoiding disclosure about negative strategies is intended to ensure that prospectus disclosure states what the fund will do to achieve its investment objectives, rather than what the fund will not do. \94\ Instruction 2 to Item 4(b)(1). As amended, Form N-1A requires a fund to disclose strategies that are not principal strategies in the SAI. Item 12(b). --------------------------------------------------------------------------- The Commission intends that focusing disclosure on a fund's principal investment strategies \95\ will improve the fund's prospectus by eliminating discussions of securities and strategies that do not have a significant role in achieving the fund's investment objectives. Under Form N-1A, as amended, for example, it generally will be unnecessary for a fund (other than, for example, a money market fund) to disclose in its prospectus its cash management practices (e.g., entering into overnight repurchase agreements), because these [[Page 13927]] practices are not typically among the principal investment strategies that a fund uses to achieve its investment objectives.\96\ --------------------------------------------------------------------------- \95\ A bond fund, for example, typically would discuss generally the maturities, durations, ratings, and types of issuers of the bonds in which the fund invests principally. \96\ Under the disclosure principles incorporated into Item 4 of Form N-1A, as amended, a fund that has a principal investment strategy of allocating its assets among stocks, bonds, and money market instruments also would need to disclose its use of cash equivalents. Whether a fund needs to include disclosure in its prospectus about matters such as holding or trading stock futures and option contracts, engaging in securities lending, purchasing securities on a ``when-issued'' basis, or investing in illiquid or restricted securities will depend on the extent to which these instruments or practices have a significant role in achieving the fund's investment objectives. A fund generally would not need to include disclosure about restricted securities in its prospectus because investments in this type of security usually would not be so significant as to constitute a principal investment strategy of the fund. Whether a fund's use of stock futures, option contracts, or other derivatives would need to be disclosed in the fund's prospectus would depend in large part on whether the strategy poses the risk of substantial gains or losses for the fund. --------------------------------------------------------------------------- The Proposed Amendments would require a fund, in discussing its principal investment strategies in its prospectus, to explain in general terms how the fund's adviser decides what securities to buy and sell. This requirement sought to provide investors with essential information about the fund's investment approach and how the fund's portfolio would be managed. One commenter questioned this requirement, arguing that it could place undue emphasis on a fund's decisions to invest in or sell particular securities and result in boilerplate disclosure. The Commission continues to believe that a general discussion of the methods of analysis and investment strategies that a fund's adviser will use in managing the fund will provide typical investors with information that will help them in deciding whether to invest in a fund. Therefore, the Commission is adopting the proposed disclosure requirement regarding the manner in which the investment adviser determines to buy and sell securities.\97\ --------------------------------------------------------------------------- \97\ Item 4(b)(2). In meeting this requirement, an equity fund could describe, for example, whether it emphasizes value or growth, or blends the two approaches. A value-oriented fund might state that the fund's adviser selects stocks that it considers to be undervalued by recognized measures of economic value such as earnings, cash flow, and book value. Other types of disclosure about a fund's investment philosophy might include whether the fund invests in stocks based on a ``top-down'' analysis of economic trends or a ``bottom-up'' analysis based on the financial condition and competitiveness of individual companies. --------------------------------------------------------------------------- Concentration. The Commission proposed to continue to require a fund to disclose in its prospectus any policy to concentrate its investments in any industry or group of industries. This requirement reflects the view that such a policy is likely to be central to a fund's ability to achieve its investment objectives,\98\ and that a fund that concentrates its investments will be subject to greater risks than funds that do not follow the policy. The Commission's staff has taken the position for purposes of the concentration disclosure requirement that a fund investing more than 25% of its assets in an industry is concentrating in that industry.\99\ The Proposed Amendments incorporated this percentage test into Form N-1A. --------------------------------------------------------------------------- \98\ That such a policy can be central to a fund's meeting its investment objective is suggested by section 8(b)(1) of the Investment Company Act [15 U.S.C. 80a-8(b)(1)], which requires a fund to disclose in its registration statement any policy to concentrate its investments in a particular industry or group of industries. Under section 13(a)(3) [15 U.S.C. 80a-13(a)(3)], a fund must obtain shareholder approval to change a policy to concentrate its investments. \99\ Guide 19 to Form N-1A. --------------------------------------------------------------------------- Commenters supported requiring a fund to disclose in its prospectus its policies on industry concentration,\100\ and the Commission continues to believe that 25% is an appropriate benchmark to gauge the level of investment concentration that could expose investors to additional risk. Therefore, the Commission is adopting this disclosure requirement as proposed.\101\ --------------------------------------------------------------------------- \100\ Some commenters questioned an existing position of the Commission's staff regarding the ability of a fund to adopt a policy of shifting between concentrated and non-concentrated status. One commenter requested reconsideration of the staff's long-standing position that a fund cannot, consistent with the provisions of sections 8(b)(1) and 13(a)(3), have an investment policy permitting the fund to concentrate or not concentrate its investments as determined by the fund's board in its discretion. The commenter argued that this position was too rigid and that a fund's board of directors should have the flexibility to shift the fund's concentration policy, subject to making appropriate disclosure to fund shareholders. The Commission recognizes that fund investment practices have changed as a result of the growth of securities markets and assets invested in funds. The Commission believes that it may be appropriate to reconsider the issue raised by the commenter, but has concluded that the issue should not be reconsidered in the context of the revisions of Form N-1A being adopted today. The Commission has requested that the Division review its positions on concentration, consulting with industry representatives as appropriate, with a view toward allowing funds a greater degree of flexibility in establishing concentration policies. \101\ Instruction 4 to Item 4(b)(1). --------------------------------------------------------------------------- Temporary Defensive Positions. The Proposed Amendments would require disclosure about a fund's policy that permits the fund to take ``temporary defensive positions'' to respond to adverse market, economic, political, or other conditions. The purpose of the requirement was to make investors aware of potential changes in a fund's investments that are not generally contemplated by, or are otherwise inconsistent with, a fund's principal investment objectives and policies. 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. Although commenters generally supported disclosure that a fund may take temporary defensive positions, they found problematic disclosure of the percentage of assets that may be committed to temporary defensive positions and the likely effect of these positions on the fund's performance. Commenters argued that, to maintain flexibility, a fund typically would disclose that all of its assets could be committed to temporary positions. The commenters maintained that such disclosure was boilerplate and would not be meaningful to investors. In addition, commenters asserted that funds would find it difficult to predict the likely effect of temporary defensive positions on their performance. The Commission believes that a typical fund investor would want to know about investment positions that a fund can take from time to time that are inconsistent with the fund's central investment focus. On the other hand, the Commission is aware that, in practice, the disclosure about temporary investment positions currently appearing in some fund prospectuses is so lengthy and detailed as to suggest incorrectly that a fund's temporary investment policies are more important than the fund's investment objectives and the principal investment strategies used to achieve them. The Commission believes that disclosure of this sort, which discusses possible but not probable investments of funds, is inconsistent with the fundamental disclosure principles underlying Form N-1A. In the Commission's view, however, disclosure that a fund may take temporary defensive positions to respond to market conditions will alert investors to the possibility that a fund may vary its investments on a temporary basis. Therefore, Form N-1A, as amended, requires a fund to disclose, if applicable, that in response to unfavorable market conditions it may make temporary investments that are not consistent with its principal investment objectives and policies.\102\ --------------------------------------------------------------------------- \102\ Instruction 6 to Item 4(b)(1). --------------------------------------------------------------------------- Portfolio Turnover. Form N-1A currently requires all funds to state their portfolio turnover rates in their financial highlights tables included in their [[Page 13928]] prospectuses.\103\ Under the Proposed Amendments, a fund would be required to supplement the information in its financial highlights table by disclosing certain information about its portfolio turnover rate if it anticipated having a turnover rate of 100% or more in the coming year.\104\ The disclosure would be required to include an explanation of the tax consequences and effect of increased trading costs on the fund's performance.\105\ Most commenters questioned or opposed the proposed disclosure about portfolio turnover rate. Some commenters suggested that the Commission move this disclosure to the SAI or require it in the MDFP in fund shareholder reports. Other commenters argued that a fund's portfolio turnover rate may reflect the fund's response to particular market events, or special circumstances affecting the fund's investments, that are difficult to predict. These commenters argued further that the unpredictable nature of fund portfolio turnover rates would lead to generic or boilerplate disclosure that would not be meaningful to investors in assessing various funds. The commenters suggested that Form N-1A should instead require disclosure about portfolio turnover rates as part of a discussion of a fund's principal investment strategies when a fund's investment approach is expected to include active and frequent trading (as opposed to, e.g., a ``buy and hold'' strategy). --------------------------------------------------------------------------- \103\ Item 3 of Form N-1A. Form N-1A, as amended, retains this requirement. Item 9. \104\ See Form N-1A Proposing Release, supra note 8, at 10910. \105\ The Proposed Amendments would require a fund to disclose its 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). 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 continues to believe that a discussion about a fund's portfolio turnover in some cases is relevant to typical fund investors. The Commission notes, for instance, that increased portfolio turnover can on some occasions result in tax consequences that can be significant to investors and that can be viewed as a cost to an investor of holding fund shares. Moreover, investors may find information about portfolio turnover particularly relevant in light of recent changes to the tax laws that reduce the tax rate on capital gains.\106\ The Commission agrees with commenters, however, that disclosure about portfolio turnover and its consequences should be made only if an increased portfolio turnover rate is likely to result from the fund's investment objectives and principal investment strategies and would have a significant effect on a fund's returns. Therefore, Form N-1A, as amended, requires a fund to discuss the consequences of its portfolio turnover rate if the fund anticipates that active and frequent trading of portfolio securities will be a likely result of implementing its principal investment strategies.\107\ --------------------------------------------------------------------------- \106\ See infra note 164. \107\ Instruction 7 to Item 4(b)(1). --------------------------------------------------------------------------- Classification and Policies. The Commission proposed to move to the SAI disclosure about a fund's legal status as an open-end management company,\108\ as well as disclosure relating to certain policies identified under the Investment Company Act, such as borrowing money, issuing senior securities, underwriting securities issued by other persons, investing in real estate or commodities, and making loans.\109\ Commenters supported moving this disclosure, agreeing that it is not likely to be significant to a typical fund investor. Form N- 1A, as amended, requires the disclosure to appear in the SAI.\110\ --------------------------------------------------------------------------- \108\ As explained in the Form N-1A Proposing Release, this information is technical in nature and repetitive of other information required to be disclosed elsewhere in a fund's prospectus. All funds that register on Form N-1A must be classified as management companies under section 4 of the Investment Company Act and subclassified as open-end companies under section 5. 15 U.S.C. 80a-4, -5. Funds may be further subclassified as diversified or non-diversified under section 5. \109\ Section 8 of the Investment Company Act requires a fund to disclose these policies in its registration statement. Section 8 also requires a fund to disclose in its registration statement its policies on concentration and portfolio turnover, see supra notes 100 and 105 and accompanying text, and any other policies that the fund deems fundamental or that may not be changed without shareholder approval. Although they are not required to do so, some funds disclose in their prospectuses their policies with respect to the practices identified in section 8. As noted in the Form N-1A Proposing Release, supra note 8, at 10911, the Proposed Amendments sought to provide a clearer directive to disclose these policies in the SAI. To the extent it is a principal investment strategy of a fund within the meaning of Item 4(b)(1) of Form N-1A, as amended, however, a practice identified in section 8 would be required to be disclosed in the fund's prospectus. \110\ Items 12(a) and (c). Form N-1A, as amended, continues to require a non-diversified fund to disclose its non-diversified status in the prospectus. See Item 2(c)(iv). In particular, the Form requires 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. --------------------------------------------------------------------------- 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 communicate effectively to investors 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 effectively communicate to them the overall risks of investing in the fund. In the Commission's view, disclosing the risks of each possible portfolio investment, rather than the overall risks of investing in a fund, does not help investors evaluate a particular fund or compare the risks of the fund with those of other funds. The Commission proposed, consistent with its conclusion that mere inventories of potential portfolio securities do not assist typical investors in selecting among funds, to modify prospectus disclosure requirements in Form N-1A about the risks associated with specific securities. The Proposed Amendments would require a fund to disclose the risks to which the fund's particular portfolio as a whole is expected to be subject and to discuss the circumstances that are reasonably likely to affect adversely the fund's net asset value, yield, or total return. Commenters generally supported the proposed approach to the disclosure of risk, and the Commission is adopting it as proposed.\111\ --------------------------------------------------------------------------- \111\ Item 4(c). 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 be required to disclose the risks of the types of growth stocks in which the fund invests or expects to invest, as opposed to describing the general risks of equity securities. --------------------------------------------------------------------------- The Commission notes that a fund could meet the risk disclosure requirements of Form N-1A, as amended, by including in its prospectus a discussion of the risks of the asset class or classes that the fund expects to hold principally, together with a discussion of the risks to the fund of holding specific types of securities within the asset class or classes. Under such an approach, a fund investing in the equity securities of companies with small market capitalizations, for example, would discuss market risk as a general risk of holding equity securities, as well as the specific risks associated with investing in small capitalization companies (e.g., that these stocks may be more volatile and have returns that vary, sometimes [[Page 13929]] significantly, from the overall stock market).\112\ --------------------------------------------------------------------------- \112\ The Commission emphasizes that this approach is one way, but not the only way, that a fund can seek to use in meeting the risk disclosure requirements of Form N-1A, as amended. --------------------------------------------------------------------------- The Commission did not propose to require a fund to disclose information designed to quantify its expected risk levels, citing, among other things, the lack of a broad consensus as to what measure of risk would best serve fund investors.\113\ Comments submitted in response to the Commission's Risk Concept Release asserted 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. In addition, commenters argued that, if the Commission mandated a risk measure, investors might rely on it as a definitive standard despite the lack of general agreement on how to measure risk. --------------------------------------------------------------------------- \113\ See Form N-1A Proposing Release, supra note 8, at 10911. 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. Risk Concept Release, supra note 18, at 17176. 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 criticized requiring disclosure of quantitative risk information. See, e.g., 1995 ICI Risk Comment Letter, supra note 87, at 10-16 (questioning, among other things, the feasibility of developing a single, all-encompassing measure of fund risk and whether quantitative information would be understood and accurately used by fund investors). --------------------------------------------------------------------------- As adopted, the prospectus risk/return summary and amendments to the general risk disclosure requirements of Form N-1A are designed to improve fund risk disclosure without raising the concerns associated with Commission-mandated quantitative information. While it is not adopting specific q [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A98-7070. Public record. Not legal advice.