SEC Proposes Mutual Fund and ETF Disclosure Amendments

Investment Management Update

Date: September 25, 2020

On August 5, the Securities and Exchange Commission (SEC) proposed numerous changes that would require mutual funds and exchange-traded funds (ETFs) to tailor disclosures provided to investors. The disclosures would highlight key information investors need to assess and monitor their fund investments and make informed investment decisions. The proposal would:

  • require streamlined reports to shareholders that would include, among other things, fund expenses, performance, illustrations of holdings and material fund changes;
  • significantly revise the content of these items to better align disclosures with developments in the markets and investor expectations;
  • encourage funds to use graphic or text features – such as tables, bullet lists and question-and-answer formats – to promote effective communication; and
  • promote a layered and comprehensive disclosure framework by continuing to make available online certain information that is currently required in shareholder reports but may be less relevant to retail shareholders generally.
Annual Shareholder Reports

The chart below provides an overview of the proposed changes to annual shareholder reports. In addition, the proposed modifications would require a registrant to prepare a separate annual report for each of its series and limit the content a fund may include in its annual report.

Current Annual Shareholder Report Disclosure

Proposed Amendments

Management’s discussion of fund performance

Add new fund statistics section to the annual report.

Graphical representation of holdings

Add new material fund changes section to the annual report.

Changes in and disagreements with accountants

The entirety of the currently required disclosure would move to Form N-CSR and would need to be available online and delivered (in paper or electronic format) upon request.

Statement regarding the availability of quarterly portfolio schedule, proxy voting policies and procedures, and proxy voting record

Include a more general reference to the availability of additional fund information in the annual report.

Add a provision allowing funds to optionally disclose in their annual reports how shareholders may revoke their consent to householding.

Financial statements, including schedule of investments

Move to Form N-CSR. Would need to be available online and delivered (in paper or electronic format) upon request.

Financial highlights

Retain certain data points, but generally move to Form N-CSR. Would need to be available online and delivered (in paper or electronic format) upon request.

Results of any shareholder votes during the period

Move to Form N-CSR. Would need to be available online and delivered (in paper or electronic format) upon request.

Remuneration paid to directors, officers and others

Move to Form N-CSR. Would need to be available online and delivered (in paper or electronic format) upon request.

Statement regarding the basis for the board’s approval of investment advisory contract

Move to Form N-CSR. Would need to be available online and delivered (in paper or electronic format) upon request.

Management information and statement regarding availability of additional information about fund directors

Remove from shareholder reports, but information would remain available in a fund’s SAI, which is available online or delivered upon request.

Rule 30e-3 disclosure

Remove from shareholder reports.

Funds have discretion to provide other information in their shareholder reports (e.g., president’s letter)

Limit annual report disclosures to those that are permitted or required under proposed Item 27A of Form N-1A.

 

Separate Annual Reports

To reduce the complexity and length of shareholder reports, the proposal would require each registrant to produce a separate shareholder report for each fund. If enacted, shareholders would receive an annual report that only addresses the series or fund in which they are invested. Although the proposal would provide new restrictions, it would not require funds with multiple share classes to produce separate reports for each individual share class. For disclosures that would differ amongst share classes, the amended disclosure would require class-specific information.

Scope of Content

Under the proposal, the SEC would modify the information required to be disclosed in shareholder reports. Funds would only be allowed to include the information listed in the new Item 27A of Form N-1A (see below), unless additional information is required to prevent a disclosure from becoming materially misleading or if the disclosure item is inapplicable. Due to the limited number of disclosure requirements, a fund would not be allowed to incorporate by reference any information from a previous source. However, the proposal would not restrict disclosure materials that a fund may transmit with an annual report, which include summary prospectuses, statutory prospectuses, notices of the online availability of proxy materials and other shareholder reports.

Report Contents

The table below outlines the information the proposal would require funds to include in their annual reports. As part of the proposed changes, the SEC released a hypothetical release annual report. As is the case today, the proposed annual report would not be subject to page or word limits.

Cover page or beginning of report

  • Fund/class name(s)
  • Ticker symbol(s)
  • Principal U.S. market(s) for ETFs
  • Statement identifying document as “Annual Shareholder Report”
  • Legend

Content

  • Fund statistics
  • Management’s discussion of fund performance
  • Graphical representation of holdings
  • Material fund changes
  • Changes in and disagreements with accountants
  • Statement regarding liquidity risk management program
  • Availability of additional information
  • Householding disclosure (optional)

 

Fund Expenses

The proposal would require a fund to provide a simplified expense presentation that would describe the expenses associated with a hypothetical $10,000 investment in the fund during the precedent reporting period. Each annual shareholder report would be required to include a fee table that would show:

  • an assumed $10,000 beginning account value;
  • total return during the period, before deducting expenses;
  • expenses in dollars paid during the period;
  • ending account value in dollars, based on net asset value return and the assumed $10,000 beginning account value; and
  • expenses as a percent of an investor’s investment in the fund (i.e., expense ratio).

An ETF would include the ending value of the account, based on market value return.

In addition, the proposal would replace the two expense examples currently in the shareholder report with one simplified expense table and the current narrative disclosure prior to the example tables with a specified footnote. A fund would be required to include a footnote to the “Total return before costs paid” column that qualitatively describes, in plain English, other costs included in a fund’s total return, if material to the fund. Furthermore, the fund would be required to briefly explain, in plain English, in a footnote to the “Costs paid as a percentage of your investment” column that the expense information does not reflect shareholder transaction costs associated with purchasing or selling fund shares. Also, the instructions for calculating cost paid would require the fund to multiply the figure in the “Cost paid as a percentage of your investment” column by the average account value over the period, based on an investment of $10,000 at the beginning of the period.

ETF-Specific Disclosures

Under the proposal, an ETF would be required to disclose two versions of the ending account value: one based on the ETF’s net asset value return and the other based on its market value return. The ETF would have to present expense information both as a dollar amount and as a percentage of a shareholder’s investment in the fund (which would be an addition to the current presentation).

Management’s Discussion of Fund Performance

The proposal largely maintains the current requirements for management’s discussion of fund performance (MDFP). The SEC did propose amendments to the MDFP requirements to make the disclosure more concise and to consider that shareholders may no longer receive fund prospectuses. The requirements include:

  • Additional performance-related information that is available in fund prospectuses, including certain class-specific performance information and comparative information showing the average annual total returns of one or more relevant benchmarks.
  • An instruction that would direct a fund not to include lengthy, generic or overly broad discussions of factors that generally affected market performance during the fund’s last fiscal year. The proposed instruction would also direct the fund to use graphics or text features – such as bullet lists or tables – to present the key factors, as appropriate.
  • A prohibition on including a president’s letter to shareholders, interviews with portfolio managers, market commentary and other similar information. However, the fund would be able to provide shareholders with materials that include this additional information in the same transmission as the annual report (e.g., in the same email or envelope), provided the annual report is given greater prominence.
Performance Line Graph and Use of Market Indexes in Performance Disclosure

The SEC proposed to retain the requirements for the performance line graph currently included in annual reports, with certain amendments designed to improve the current presentation, including:

  • Add an instruction to clarify the scope of required disclosure in an annual report that covers multiple classes by requiring a fund to present performance information for at least one class in the line graph (in addition to the required information for an appropriate broad-based securities market index).
  • Remove an instruction that allows the line graph to cover periods longer than the past 10 fiscal years.
  • Clarify the definition of an appropriate broad-based securities market index by specifying that a “broad-based index” is one that represents the overall applicable domestic or international equity or debt markets, as appropriate.
Performance Table

The proposal retains the current requirement that an annual report include a table presenting average annual total returns for the past one-, five- and 10-year periods, although with amendments to require three additional pieces of information:

  • the average annual total returns of an appropriate broad-based securities market index;
  • the fund’s average annual total returns without sales charges (in addition to current disclosure that shows returns reflecting applicable sales charges); and
  • average annual total returns for each class that the report covers, in each case for the past one-, five- and 10-year periods.
Other MDFP Amendments

The SEC would simplify the current requirement that a fund discuss the effect of any policy or practice of maintaining a specified level of distribution to shareholders on the fund’s investment strategies and per share net asset value during the last fiscal year, as well as the extent to which the fund’s distribution policy resulted in distributions of capital. The amendment would simply require a fund that has a stable distribution policy and that was unable to maintain the specified level during the past fiscal year to disclose this shortfall.

Fund Statistics

Under the proposal, a fund would be required to disclose certain statistics in its annual report, including its:

  • net assets;
  • total number of portfolio holdings;
  • portfolio turnover rate; and
  • any additional statistics the fund believes would help shareholders better understand the fund’s activities and operation during the reporting period (e.g., tracking error, maturity, duration, average credit quality or yield).
Graphical Representation of Holdings

The proposal includes two changes to the current requirements relating to the graphical representation of holdings. Currently, a fund has the flexibility to base the tabular or graphic presentation of holdings on its net asset value or total investments. The proposed amendments would:

  • permit a fund to show its holdings based on either its net or total exposure to particular categories of investments; and
  • implement a minor change affecting funds that intend to depict portfolio holdings according to credit quality.
Material Fund Changes

The SEC proposed a new section in the annual report that would describe material changes to a fund. Specifically, a fund would have to describe briefly any material change in an enumerated list of items (as well as any other material change that the fund chooses to disclose) that has occurred since the beginning of the reporting period or that the fund plans to make in connection with its annual prospectus update. The fund would be required to include disclosure in its annual report that briefly describes a material change with respect to any of the following items:

  • A change in the fund’s name (as described in Item 1(a)(1) of Form N-1A).
  • A change in the fund’s investment objectives or goals (as described in Item 2 of Form N-1A).
  • An increase in the fund’s ongoing annual fees, transaction fees or maximum account fee (as described in Item 3 of Form N-1A).
  • A change in the fund’s principal investment strategies (as described in Item 4(a) of Form N-1A).
  • A change in the principal risks of investing in the fund (as described in Item 4(b) of Form N-1A).
  • A change in the fund’s investment adviser(s), including sub-adviser(s) (as described in Item 5(a) of Form N-1A).
  • A change in the fund’s portfolio manager(s) (as described in Item 5(b) of Form N-1A).
  • Any other material change it would like to disclose to its shareholders.
Changes in and Disagreements with Accountants

The SEC proposed to require a fund to include in its annual report a concise discussion of certain disagreements with accountants. A fund currently is required to disclose certain information concerning changes in and disagreements with its accountant if the accountant has resigned or was dismissed. Under the proposal, the current disclosure would be moved to Form N-CSR and replaced in the annual report with a high-level summary of information the fund would report on Form N-CSR. Specifically, when a fund has a material disagreement with an accountant who has resigned or been dismissed, the fund would have to include in its annual report a statement of whether the former accountant resigned, declined to stand for reelection or was dismissed and the date thereof and a brief, plain English description of any disagreement(s) with the former accountant during the fund’s two most recent fiscal years and any subsequent interim period that the fund discloses on Form N-CSR.

Availability of Additional Information

Under the proposal, a fund would be required to include in its annual report a brief, plain English statement informing investors that additional information is available on the fund’s website. The statement would have to include plain English references to, as applicable, the fund’s prospectus, financial information, holdings and proxy voting information. In addition, if the shareholder report appears on the fund’s website or otherwise is provided electronically, the fund must provide a means of immediately accessing this additional information (such as a hyperlink or QR code).

Householding

The SEC proposed to retain the provision that permits funds to explain how to revoke consent to the householding of the annual report.

Format and Presentation

The SEC also proposed changes to the format and presentation of annual reports:

  • Information must appear in the same order as would be required under the proposed amendments to Form N-1A.
  • A fund must use “plain English” principles for the report’s organization, wording and design, taking into consideration fund shareholders’ level of financial experience.
  • A fund must consider using, as appropriate, a question-and-answer format, charts, graphs, tables, bullet lists and other graphics or text features to help provide context for the information presented.
  • The body of every printed annual or semi-annual shareholder report and other tabular data must meet legibility requirements.
Electronic Annual Reports

The SEC proposed instructions designed to clarify requirements for electronic annual reports and promote the use of interactive, user-friendly design features that may be tailored to meet individual investors’ needs and improve investor engagement. In addition to specifying that annual reports may be electronic as well as paper-based, the instructions would:

  • Apply the requirements for the annual report’s “cover page” to the “beginning” of the report, which acknowledges that an electronic report may not have a physical page at its beginning.
  • Provide an ordering requirement for the annual report’s contents that also includes a provision for reports that appear on a website or are otherwise provided electronically.
  • Encourage funds to use online tools designed to enhance investors’ understanding of material in the annual report, including, for example, video or audio messages, mouse-over windows, pop-ups, definitions or explanations of difficult concepts, chat functionality, and expense calculators, as well as other forms of electronic media, communications or tools.
  • Specify that if the shareholder report references other information that is available online, the report should include a link or some other means of immediately accessing that information.
Semi-Annual Reports

Under the proposal, the design and content specifications for semi-annual reports are similar to those proposed for annual reports. The table below summarizes the proposed content that a fund would include in its semi-annual report. The proposal would limit the scope of semi-annual reports in several respects to reduce their overall length and complexity. It would require a fund’s registrant to prepare a separate semi-annual report for each series of the fund and generally limit the content the fund may include to the information in Item 27A of Form N-1A.

Cover page or beginning of report

  • Fund/class name(s)
  • Ticker symbol(s)
  • Principal U.S. market(s) for ETFs
  • Statement identifying as “semi-annual shareholder report”
  • Legend

Content

  • Expense example
  • Management’s discussion of fund performance (optional)
  • Fund statistics
  • Graphical representation of holdings
  • Material fund changes (optional)
  • Changes in and disagreements with accountants
  • Statement regarding liquidity risk management program
  • Availability of additional information

 

Format and Presentation

The proposal specifies that a semi-annual report would be generally subject to the same format and presentation requirements as an annual report.

Electronic Reports

Under the proposal, instructions for electronic annual reports, including those that promote the use of interactive, user-friendly electronic design features, would also apply to semi-annual reports. The proposed instructions would provide ordering and presentation requirements for semi-annual reports that appear on a website or are otherwise provided electronically, provide additional flexibility for funds to add additional tools and features to semi-annual reports that appear on a website or are otherwise provided electronically, and require a semi-annual report to include a link or some other means of immediately accessing information referenced in the report that is available online.

Fund Prospectus Disclosure Requirements

The SEC proposed several amendments to the disclosures that relate to fees and risks.

Improved Prospectus Fee Disclosures

The proposal includes revisions to simplify the presentation of fees and expenses in the prospectus and help increase investor comprehension. Under the proposal, the SEC is proposing to:

  • Replace the current fee table in the summary section of the statutory prospectus with a “fee summary.”
  • Permit funds that make limited investments in other funds to disclose acquired fund fees and expenses (AFFE), the fees and expenses associated with those investments, in a footnote to the fee table and fee summary instead of reflecting AFFE as a line item in the fee table and fee summary (as all funds do today).
Fee Summary

A fund would be required to adopt a simplified fee summary that would streamline the presentation of fees and focus on the total costs or “bottom line” of an investment in the fund. It would:

  • Be included in the summary section of the statutory prospectus (or, for funds that rely on Rule 498, the summary prospectus), which funds provide investors at their initial purchase.
  • Begin with a narrative statement that the fee summary shows amounts the investor could pay to buy, hold and sell shares of the fund and that these costs reduce the value of the investment.
  • Modify the body of the fee summary to consist of two sections: a summary fee table showing the fund’s transaction fees, maximum account fee (if applicable), and ongoing annual fees, and a simplified version of the example.
Simplified Example

In addition, the SEC proposed to simplify the example in the fee summary by modifying the current narrative that precedes the example slightly to enhance clarity and brevity. The proposal also decreases the number of time periods the expense example must show from one, three, five and 10 years to just one and 10 years (or one and three years in the case of a new fund).

Simplified Fee Terminology

The SEC is also proposing changes in some terminology funds would use to describe fees in the prospectus to enhance the presentation of fees and investors’ understanding of them. The changes in terminology used in the fee table would flow through to the fee summary, as applicable. The chart below shows captions and terms that the current fee table references, along with their replacements.

Current Caption or Term and Form N-1A Location Proposed Caption

Proposed Caption or Term and Form N-1A Location Proposed Caption

Shareholder fees (Item 3)

Transaction fees (Items 3 and 8A)

Annual fund operating expenses (Item 3)

Ongoing annual fees (Items 3 and 8A)

Maximum sales charge (load) imposed on purchases (Item 3)

Purchase charge (Items 3 and 8A)

Maximum deferred sales charge (load) (Item 3)

Exit charge (Items 3 and 8A)

Redemption fee (Item 3)

Early exit fee (Items 3 and 8A)

Total annual fund operating expenses (Item 3)

Ongoing annual fees (Items 3 and 8A)

Distribution [and/or service] (12b-1) fees (Item 3)

Selling fees (Item 8A)

Fee waiver [and/or expense reimbursement] (Item 3)

Temporary discount (Items 3 and 8A)

Total annual fund operating expenses after fee waiver [and/or expense reimbursement] (Item 3)

[Total] ongoing annual fees with temporary discount (Items 3 and 8A)

 

AFFE

The proposal would modify the current prospectus fee table requirements by refining the scope of funds that must disclose AFFE as a component of bottom-line annual fund operating expenses. Specifically, if adopted, the amendments would permit a fund that invests 10% or less of its total assets in acquired funds to omit the AFFE line item in the fee table and instead disclose the amount of the fund’s AFFE in a footnote to the fee table and fee summary. However, a fund that invests more than 10% of its total assets in acquired funds would still be required to disclose AFFE as a line item in its prospectus fee table and would continue to reflect this amount in its bottom-line ongoing annual fees. Under the proposal, the 10% threshold is based on an average of month-end holdings, rather than holdings as of the end of the fiscal year or another single date, to smooth fluctuations, such as those related to market events and investor flows. Additionally, the proposal would make two minor adjustments to the AFFE disclosure. First, the SEC proposed to correct how a fund that has been in operation for less than a full year calculates AFFE. Rather than calculating it using the number of days in the fund’s fiscal year, the SEC would require the fund to use the number of days since the date the fund made its first investment. Second, the SEC proposed to amend an optional footnote instruction that permits a fund to explain that the total ongoing annual fees in the fee table do not correlate to the ratio of expenses to average net assets provided in the fund’s financial highlights.

Portfolio Turnover

Under the proposal, the SEC would include portfolio turnover disclosure in both the fee summary and the full fee table and modify the narrative that accompanies the portfolio turnover rate to enhance clarity and provide more concise disclosure. The following chart shows the current disclosure along with its replacement.

Current Disclosure and Form N-1A Location

Proposed Disclosure and Form N-1A Location

Portfolio Turnover

The Fund pays transaction costs, such as commissions, when it buys and sells securities (or “turns over” its portfolio). A higher portfolio turnover rate may indicate higher transaction costs and may result in higher taxes when Fund shares are held in a taxable account. These costs, which are not reflected in annual fund operating expenses or in the example, affect the Fund’s performance. During the most recent fiscal year, the Fund’s portfolio turnover rate was ___% of the average value of its portfolio. (Item 3)

Portfolio Turnover

Portfolio turnover measures how often a fund buys and sells its investments. A higher portfolio turnover rate may indicate higher transaction costs and may result in higher taxes. The Fund’s annual portfolio turnover rate is ___%. (Items 3 and 8A)

 

Improved Prospectus Risk Disclosures

The SEC proposed to revise the current provisions and instructions in Form N-1A requiring that a fund disclose in its prospectus the principal risks of investing in the fund. Specifically, the proposed changes would:

  • Insert the term “briefly” before the current requirement that the fund summarize the principal risks.
  • Add an instruction to the summary prospectus principal risk disclosure requirement stating that funds should describe principal risks in order of importance, with the most significant risks appearing first. However, the proposed instruction would specify that a fund may use any reasonable means of determining the significance of risks.
  • Add an instruction to the summary prospectus principal risk disclosure requirement that instructs a fund to, where appropriate, tailor its risk disclosures to how the fund operates rather than rely on generic, standard risk disclosures.
  • Add three new instructions relating to Form N-1A Item 9(c), which requires a fund to disclose the principal risks of investing in the fund in its statutory prospectus. The proposed instructions would require the fund to:
    • state that in determining whether a risk is a principal risk, a fund should consider both whether the risk would place more than 10% of the fund’s assets at risk (“10% standard”) and whether it is reasonably likely that a risk will meet this 10% standard in the future;
    • in the case of acquiring funds, disclose risks only if they are principal risks of the acquiring fund (a principal risk of an acquired fund should not be included unless it is a principal risk of the acquiring fund); and
    • for funds whose strategy provides the freedom to invest in different types of assets at the manager’s discretion, disclose that an investor may not know – and has no way to know – how the fund will invest in the future and the associated risks.
Prospectuses and SAIs Transmitted Under Rule 30e-1(d)

Under the proposal, the SEC would rescind Rule 30e-1(d), which permits a fund to transmit a prospectus and statement of additional information in lieu of an annual report if it requires all information that would otherwise be required to be contained in the shareholder report.

FOR MORE INFORMATION

For more information, please contact:

Andrew J. Davalla
614.469.3353
Andrew.Davalla@ThompsonHine.com

Brian Doyle-Wenger
614.469.3294
Brian.Doyle-Wenger@ThompsonHine.com

This advisory bulletin may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgment of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel.

This document may be considered attorney advertising in some jurisdictions.

© 2020 THOMPSON HINE LLP. ALL RIGHTS RESERVED.