The Securities and Exchange Commission (SEC) recently adopted substantial amendments to shareholder reports used by investment companies, including mutual funds and exchange-traded funds (ETFs) (collectively, funds) registered on Form N-1A (Amendments).1 The Amendments are designed to ensure annual and semi-annual reports (together, shareholder reports) are concise and visually engaging and will significantly alter how shareholder reports are presented and delivered to investors. The new tailored shareholder report that will be mailed to shareholders will contain much less information than current reports, and be presented in a more standardized format to facilitate comparisons. Information removed to satisfy the new concise format will be available on the fund’s website, and filed on Form N-CSR. The Amendments also exclude open-end funds from the scope of Rule 30e-3 under the Investment Company Act of 1940 (1940 Act) and modify advertising rules that apply to mutual funds, ETFs, registered closed-end funds, and business development companies (BDCs).
The Amendments become effective 60 days after publication in the Federal Register, which has not occurred as of the date of this Client Alert. Funds will have 18 months from the effective date of the Amendments to comply with the Amendments.
Key aspects of the Amendments are summarized below.
I. Amendments to Shareholder Reports
The Amendments add new Item 27A to Form N-1A, which makes changes to the scope, format and presentation, and content of annual reports. Conceptually, the tailored shareholder report delivered to each fund shareholder will be (i) shorter; (ii) limited to the specific fund class; (iii) directed to retail fund shareholders; and (iv) include layered references to where further information can be found.
Scope. Currently, shareholder reports commonly cover multiple funds, and each fund may have multiple classes of shares. The Amendments require a separate annual report for each class of each series of a multi-series fund, so that a shareholder will only receive the report covering their class of shares. In addition, a fund may generally only include in annual reports those items specifically permitted by new Item 27A. However, a fund may omit a disclosure item if it is inapplicable to the fund and may include additional information to make a standard disclosure not misleading.
Format and presentation. The Amendments are designed to improve and simplify the presentation of annual reports.
- Information must appear in annual reports in the same order as it appears in Item 27A of the amended Form N-1A, including basic identifying information and a legend.
- A fund must use plain-English principles for the wording, design, and organization of annual reports.
- A fund is encouraged to use text or graphic features, such as bullet lists and charts, to provide additional context to the information presented.
- The Amendments impose legibility requirements for annual reports that are printed or provided electronically.
Content. The Amendments implement a layered disclosure approach that highlights key information, such as fund expenses, performance, and holdings; with more detailed information available online and delivered upon request, free of charge.
New items. Annual reports must include new sections that:
- disclose fund statistics, which are: net assets, total number of portfolio holdings, portfolio turnover rate (except for money market funds), and total advisory fees paid by the fund over the reporting period;2
- describe material changes to the fund, including a change in the fund’s name, principal investment strategies, principal risks, fees, investment objectives, advisers or sub-advisers;3 and
- provide a short discussion of any material disagreement with an accountant that has resigned or been dismissed.4
Amended Items. Several items will be treated differently:
The Amendments make several changes to the narrative disclosure, performance line graph, and performance table sections within the management discussion of fund performance (MDFP).
a. Narrative Disclosure
MDFP is retained, but the MDFP must be limited to a brief summary of key factors that materially affected the fund’s performance, including relevant market conditions and investment strategies and techniques. A fund may not include extraneous information that is currently included in annual reports, such as a president’s letter to shareholders, general market commentary, or interviews with portfolio managers. This information may be presented in Form N-CSR.
b. Performance Line Graph
The performance line graph that shows the performance of a $10,000 investment in the fund and a broad-based index will be presented with the following modifications:
- the line graph may only show the performance for the specific class of the fund;
- a fund may no longer present performance for a period longer than 10 years; and
- the Amendments define “broad-based” index as an index that represents the overall applicable domestic or international equity or debt markets in which the fund invests. A fund will be permitted to include narrower indices that reflect the market segments in which the fund invests in its performance presentation, along with the required appropriate broad-based securities market index.
c. Performance Table
Annual reports will continue to include a performance table that presents annual total returns for the past 1-, 5-, and 10-year periods; however, only the performance for the specific class may be shown.
The performance table must include the following enhancements:
- the average annual total returns of the fund’s chosen broad-based index and the fund’s average total returns without sales charges (in addition to the current disclosure showing returns reflecting applicable sales charges).
- a “noticeable and prominent”5 statement indicating that a fund’s past performance is not a good indicator of future performance.
- a statement that updated performance information is available through “widely accessible mechanisms,” such as fund websites, and must direct shareholders to this information.6
Graphical Representation of Fund Holdings and Expense Example Amendments
In addition to the changes to the MDFP, the Amendments also alter the graphical representation of fund holdings and expense example disclosures.
a. Graphical Representation of Fund Holdings
A fund must continue to provide a graphical representation of the fund’s holdings. The representation must use categories reasonably designed to clearly depict the types of investments made by the fund in accordance with its investment objectives. The Amendments permit funds to:
- show holdings based on total exposure to certain categories of investments,7 and
- include a list of its ten largest portfolio holdings with the percentage of the fund’s net asset value, total investments, or total exposure attributable to each holding.
b. Expense Example
A fund must continue to provide an expense example, but the format is “simplified” through use of a single table instead of two tables as is currently required, and by presenting just costs in dollars and the expense ratio of the fund. The expense example must now show the expenses associated with a hypothetical $10,000 investment in the fund (a hypothetical $1,000 investment is currently required) shown as both a dollar amount and a percent of shareholder investment in the fund. In addition, the current narrative preamble is no longer required.
Revisions to semi-annual reports. The Amendments make similar revisions to semi-annual report requirements. However, funds are not required to include the MDFP and material changes sections in their semi-annual reports but may voluntarily do so.
II. Amendments to Rule 30e-3 (Delivery of Printed Reports)
Rule 30e-3. In 2021, funds began relying on Rule 30e-3, which generally permits investment companies to satisfy shareholder report transmission requirements by making the reports available online and mailing a notice of availability to shareholders, rather than mailing the reports. The Amendments remove this option. By excluding open-end funds from Rule 30e-3, a fund will be required to mail a printed copy of the new tailored form of shareholder report directly to each shareholder, unless the shareholder has consented to electronic delivery.8
III. Presentation of Electronic Shareholder Reports
Amended Form N-1A provides instructions for electronic shareholder reports that are intended to promote the use of interactive, user-friendly electronic design features. The instructions:
- clarify certain ordering and presentation requirements for electronic reports.
- encourage funds to use web-based tools to help an investor understand material in the shareholder reports, for example, by using interactive graphics.
- provide that if the shareholder report references information that is available elsewhere online, the fund must include a link or other means of immediately accessing that information.
IV. Items Moving from Shareholder Reports to Form N-CSR
The Amendments require funds to file on Form N-CSR certain information currently included in shareholder reports and require that funds make this information available on a website and delivered free of charge in paper or electronically upon request. Among the items that are moving to Form N-CSR are:
- complete annual and semi-annual financial statements9
- fund financial highlights
- changes in and disagreements with accountants
- information regarding matters submitted for a shareholder vote
- aggregate renumeration paid by the fund to its directors, officers, and certain affiliated persons
- information regarding the basis for the board’s approval of the fund’s investment advisory contracts
The Amendments require a fund to make the information moving to Form N-CSR available on a free, public website from 60 days after the end of the relevant fiscal period until 60 days following the end of the next respective fiscal period; however, a fund may satisfy this requirement by posting its most recent Form N-CSR on the website. A fund must also make its complete portfolio holdings, as of the close of the fund’s most recent first and third fiscal quarters, available on a website within 60 days of the close of the quarter. The Amendments also contain website accessibility and presentation requirements.
V. Investment Company Advertising Rules Amendments
The Amendments also modify Rules 482, 156, and 433 under the Securities Act of 1933 and Rule 34b-1 under the 1940 Act to promote transparent and balanced presentations of fees and expenses in investment company advertisements by funds, registered closed-end funds, and BDCs.
Amendments to Rules 482, 433, and 34b-1 require that investment company advertisements providing fee or expense figures for the investment company include standardized fee and expense figures, and that these figures must adhere to certain prominence and timeliness requirements. Significantly, advertisements that provide numerical fee and expense figures must include the maximum sales load or other non-recurring fee and must present total annual expenses gross of fee waivers or expense reimbursements. Funds could include net fees and expenses, but cannot present net figures more prominently than gross figures, and the advertisement must disclose the expected termination of waiver or cap arrangements. These fee and expense requirements are broader than similar requirements imposed by FINRA that apply to broker-dealer communications with the public (including investment company advertising). In this regard, the SEC requirements apply to all investment company advertisements, including communications with institutional investors and advertisements for closed-end funds and business development companies, whereas FINRA requirements apply only to retail communications and correspondence that present performance for non-money market fund open-end management investment companies. In addition, the Amendments require that fee and expense figures in fund advertisements and sales literature be consistent with relevant prospectus fee table presentations and be reasonably current.
Amendments to Rule 156 address statements and representations about a fund’s fees and expenses that could be materially misleading. The Amendments provide that representations regarding fees or expenses associated with a fund investment could be misleading because of statements or omissions involving a material fact, including situations where portrayals of the fees and expenses omit explanations, qualifications, limitations, or other statements necessary or appropriate to make the portrayals not misleading. The Amendments specifically note concerns over funds that are marketed as “zero expense” or “no expense funds,” but do not mention other costs investors would incur.
S&K Observations and Insights
The Amendments significantly change the form and content of shareholder reports provided to shareholders of mutual funds and ETFs. The Amendments implement a layered approach to disclosure, requiring shareholder reports to include only what the SEC believes is the most important information, with instructions on how to obtain more-detailed information online or by request, free of charge. This disclosure approach is similar to that used for fund summary prospectuses. While the SEC adopted a number of proposals largely as proposed, certain proposals were not adopted, including proposed Rule 498B, which would have allowed investment companies to adopt an alternative approach to satisfy prospectus delivery requirements for existing fund investors, through delivery of shareholder reports. Significantly, Rule 30e-3 under the 1940 Act, which allows a notice and website access approach for delivering shareholder reports, will no longer be available for mutual funds and ETFs.
Seward & Kissel LLP will continue to provide insight on any related developments.
1 Final Rule: Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, SEC Rel. Nos. 33-11125; 34-96158; IC-34731 (Oct. 26, 2022) available at: https://www.sec.gov/rules/final/2022/33-11125.pdf (Release). Although most changes apply to mutual funds and ETFs, some changes will also apply to other types of investment companies.
2 In addition to the required statistics, a fund may disclose any statistics the fund believes would help shareholders better understand the fund’s activities and operations. The total advisory fee disclosure must be fees paid on a net basis, but presented for the whole fund, and not on a share class basis. See Release at n. 265.
3 In addition to the required material change disclosures, a fund may describe other changes that may be helpful to understand the fund’s operations or performance and any planned material changes in connection with updating its prospectus for the current fiscal year.
4 This required information is a high-level summary of more detailed information that currently appears in shareholder reports. A lengthier discussion must be included in Form N-CSR.
5 A fund will be required to use text features, such as graphics, larger font size, or different font colors and styles to make the statement noticeable and prominent. See Release at 80.
6 Additionally, the Release notes that funds may choose to provide additional information that contextualizes the line graph and performance table.
7 However, a fund may not only show net exposure. A fund must show total exposure and may show net exposure if it wishes. See Release at 93-94.
8 The SEC also adopted amendments rescinding Rule 30e-1(d), which currently permits a fund to deliver a copy of its prospectus or SAI in place of its shareholder report, if either or both the prospectus and SAI includes all the information that would otherwise be required to be included in the shareholder reports.
9 In addition, a fund may no longer provide a summary schedule in lieu of providing a complete schedule of portfolio investments as part of the financial statements. See Release at 134.