Investment Funds, Advisers and Derivatives Update
At an open meeting held on October 13, 2016, the Securities and Exchange Commission (SEC) adopted, by a vote of 2-1,1 amendments (the Amendments) to rules and forms under the Investment Company Act of 1940 (Investment Company Act), that are designed to improve the frequency, quality and usability of the information reported by registered funds. The Adopting Release reflecting the Amendments was issued the same day.2
The Amendments are part of a broader rulemaking agenda announced by SEC Chair Mary Jo White in December 2014 to address the risk of the "increasingly complex" asset management industry, including improving the data used to draw conclusions about risks posed by the industry and develop appropriate regulatory responses.3 The Amendments are designed to "improve the information that the [SEC] receives from investment companies and assist the [SEC], in its role as primary regulator of investment companies, to better fulfill its mission of protecting investors, maintaining fair, orderly and efficient markets, and facilitating capital formation."4 As described by Chair White at the open meeting, the Amendments are "sweeping" and "fundamentally change how the [SEC] and investors can monitor and assess funds, including their potential risks."5 David Grim, Director of the Division of Investment Management, similarly characterized the Amendments as "transformational" and a “game-changer” for registered investment company regulation.
Among other things, the Amendments require that registered investment companies provide the following enhanced reporting and disclosure to the SEC:
- New Form N-PORT, which requires certain registered investment companies to report information about their monthly portfolio holdings in a structured data format, with information reported every third month available to the public 60 days after the end of the fund’s fiscal quarter;
- Amendments to Regulation S-X, which require a registered investment company to include standardized, enhanced disclosure about its investments in derivatives in its financial statements;
- New Form N-CEN, which requires registered investment companies (other than face amount certificate companies) to annually report certain census-type information; and
- For management investment companies only, disclosure in their registration statements regarding securities lending activities.
The Amendments also rescind current Form N-Q and Form N-SAR and amend certain other rules and forms under the Investment Company Act.
The Amendments were adopted largely as proposed by the SEC in May 2015,6 with the exception of proposed Rule 30e-3, as discussed in more detail below. At the open meeting, the SEC also adopted certain amendments relating to investment company liquidity risk management programs7 and the use of swing pricing by investment companies.8 These final rule amendments are discussed in a separate Sidley Update.
New Form N-PORT
Currently, most registered investment companies are required to report their complete portfolio holdings to the SEC on Form N-Q as of the end of each first and third fiscal quarter, and on Form N-CSR as of the end of each second and fourth fiscal quarter. As described in the Adopting Release, the SEC's concern with this existing reporting regime is that such reports are not filed in a format that allows for efficient searches or analyses both of individual portfolios and across portfolios. The Amendments are designed to improve on this format by requiring funds to provide the SEC with more frequent and timely information about fund portfolios.
Under the Amendments, Form N-Q is rescinded9 and, in its place, all registered investment companies10 and unit investment trusts (UITs) that operate as exchange-traded funds (ETFs), are required to file portfolio holdings reports on Form N-PORT.
Specifically, funds are required to report certain information about the fund and the fund’s portfolio investments11 as of the closing of the preceding month, including:
- General information about the fund;
- Assets and liabilities;
- Certain portfolio-level metrics, including certain risk metrics, that facilitate risk analyses and other SEC oversight. Such additional information includes data relating to derivative investments substantially identical to the disclosure that the Amendments also include in a fund's financial statements12 and risk metric calculations that measure a fund's exposure and sensitivity to changing market conditions, such as changes in asset prices, interest rates or credit spreads;13
- Information regarding securities lending counterparties;14
- Information regarding monthly returns;
- Flow information;15
- Certain information regarding each investment in the portfolio;
- Miscellaneous securities (if any);
- Explanatory notes (if any); and
In response to comments, the SEC staff confirmed that, in reporting information on Form N-PORT, a fund may respond using its own methodology and the convention of its service provider, so long as the methodology and conventions are consistent with the way the fund reports internally and to current and prospective investors.16 This approach, the SEC staff explained, is intended to strike a balance between easing the reporting burden on funds by allowing them to rely on existing practices, while still providing useful information to the SEC and investors.17
Funds that offer multiple series will be required to file a report for each series separately even if some information is the same for two or more series.
The SEC adopted, as proposed, the requirement that funds file on Form N-PORT on a monthly basis, with every third month available to the public 60 days after the end of the fund’s fiscal quarter. The SEC staff received a significant number of comments on the public disclosure of Form N-PORT information, with some commenters objecting to the public disclosure of any information on Form N-PORT, and others requesting that only certain information be kept nonpublic. A common concern among such commenters was that such information could potentially be proprietary and that disclosure could lead to front-running or free-riding, ultimately harming investors. Notwithstanding these concerns, the Amendments maintain this public disclosure element of Form N-PORT, with the SEC staff noting that it "believes that the public reporting requirements of Form N-PORT generally are appropriate given the filer's status as a registered investment company with the [SEC], which is based on the tenets of disclosure and transparency to fund investors, and not as a private fund."18 The SEC notes that public disclosure once each quarter, as opposed to monthly, on a delayed basis should minimize competitive harms from front-running and free-riding.
Amendments to Regulation S-X
As discussed above, reports on Form N-PORT are required to contain derivatives disclosures to facilitate analysis of derivatives investments across funds. Such disclosure is primarily designed to assist the SEC and the SEC staff, and its format and presentation is not designed for individual investors. Accordingly, as a supplement to the new data reporting required by Form N-PORT, the final rule includes amendments to Regulation S-X that, among other things, require similar disclosures in a fund’s financial statements in a format designed for individual investors.
As amended, Regulation S-X:
- Requires new, standardized enhanced disclosures regarding fund holdings in open futures contracts, open forward foreign currency contracts and open swap contracts, and additional disclosures regarding fund holdings of written and purchased option contracts. To mitigate burdens on the fund industry, the disclosure regarding derivative instruments required by amended Regulation S-X conforms to the disclosure required under Form N-PORT;
- Includes updates to the disclosures for other investments and investments in, and advances to, affiliates, as well as reorganizes the order in which some investments are presented; and
- Amends the rules regarding the general form and content of fund financial statements.
The Amendments also require prominent placement of disclosures regarding investments in derivatives in a fund's financial statements, rather than allowing such disclosures to be placed in the notes to the financial statements.
New Form N-CEN
Currently, funds are required to report a wide variety of census information to the SEC — such as information relating to a fund's organization, service providers, fees and expenses, portfolio strategies and investments, portfolio transactions and share transactions — on Form N-SAR. Funds generally must file reports on Form N-SAR semi-annually.
As discussed in the Adopting Release, the SEC staff "has found that the utility of the information reported on Form N-SAR has become increasingly limited" due to the outdated subject matter of the information required to be reported on the Form and the technology by which funds file reports on Form N-SAR. Accordingly, under the Amendments, Form N-SAR is rescinded and replaced with new Form N-CEN, a "new framework" which would "streamline and update information reported to the [SEC] to reflect current [SEC] staff information needs and developments in the industry."19
Under the Amendments, all funds (except for face amount certificate companies)20 are required to file reports on Form N-CEN within 75 days21 of the end of the fiscal year (for management investment companies) or calendar year (for UITs)22 and structured in an Extensible Markup Language (XML) format. The categories of information to be included in each report depend on the structure and form of organization of a fund, but generally include, among other things: general organizational and identifying information; information about management, including details about the board and the fund's officers;23 information about matters submitted to a shareholder vote; information regarding instances of an affiliated entity's financial support of a fund;24 information as to whether a fund relied on exemptive orders granted by the SEC; information about service providers (including sub-service providers); certain accounting and valuation information, including monthly average net assets (for funds other than money market funds) or daily average net assets (for money market funds); information about payments made to shareholders as a result of errors in the calculation of net asset value; portfolio information; and investments in controlled foreign corporations for purposes of investing in certain types of instruments, such as commodities. New Form N-CEN also includes certain reporting requirements for closed-end funds ETFs and UITs, among others. The Form eliminates a number of Form N-SAR items where the information is reported elsewhere (e.g., items relating to fees and expenses). The Adopting Release includes a chart detailing the full list of items from Form N-SAR that will be included in Form N-CEN or eliminated.25
Like Form N-SAR, Form N-CEN requires that certain attachments be filed, although these attachments are not required to be reported in structured data format. Such attachments include narratives regarding legal proceedings, provision of financial support, independent public accountants' report on internal control and changes to accounting principles and practices, where applicable. The rule proposals required that a fund include a detailed narrative attachment to Form N-CEN reporting a change in independent registered public accountants. In a modification from the proposals, the Amendments require that this narrative instead be attached to Form N-CSR filings.26
Securities Lending Activities
The proposed amendments to Regulation S-X would have required management investment companies to include certain disclosures relating to securities lending activities, including income and expenses, in their financial statements. In the Proposing Release, the SEC staff sought comment whether such disclosures should instead be provided as part of other disclosure documents, such as a fund's Statement of Additional Information. Commenters expressed concerns that such lengthy and detailed disclosure concerning securities lending could detract from other financial statement disclosures. The SEC staff was persuaded by such concerns, and the Amendments require that disclosure regarding securities lending activities be included in the Statement of Additional Information (or, for closed-end funds, in reports on Form N-CSR) rather than in fund financial statements.
Rule 30e-3: Website Reporting
In an effort to "modernize the manner in which periodic information is transmitted to shareholders," the rule proposals included new Rule 30e-3 under the Investment Company Act which would permit, but not require, a fund to satisfy shareholder reporting requirements by making such reports and certain other materials available on its website.
Under new Rule 30e-3, a fund's annual or semi-annual report to shareholders would be considered transmitted to a shareholder if certain conditions set forth in the Rule are satisfied as to (i) availability of the report and other materials, (ii) obtaining shareholder consent, (iii) providing notice to shareholders of the availability of shareholder reports and (iv) shareholder ability to request paper copies of such reports.
As described in the Adopting Release, comments to proposed Rule 30e-3 raised issues that, in the view of the SEC staff, merited further consideration and the SEC staff therefore determined not to include the proposed Rule in the Amendments. This decision, and proposed Rule 30e-3 in general, elicited forceful comments from both Commissioner Stein and Commissioner Piwowar at the open meeting. Commissioner Stein expressed concerns with the proposed Rule, noting her belief that "the potential for harm is lower with the current default to paper than with the proposed alternative."27 By contrast, Commissioner Piwowar expressed his support for proposed Rule 30e-3 which he noted "reflected evolving trends and preferences in Internet usage…[and] offered the hope that more investors would read and make greater use of fund disclosures."28 The decision by the SEC staff to not include proposed Rule 30e-3 in the Amendments, Commissioner Piwowar noted, was a factor in his decision not to vote to adopt the reporting modernization rules in general.
Form N-PORT, Rescission of Form N-Q and Amendments to the Certification Requirements of Form N-CSR. For larger entities (funds that, together with other investment companies in the same "group of related investment companies" have net assets of US$1 billion or more as of the end of the most recent fiscal year of the fund), the compliance date is June 1, 2018. For smaller entities, the compliance date is June 1, 2019.
Additionally, all reports filed in Form N-PORT for the first six months following June 1, 2018 will be maintained as nonpublic.
Form N-CEN, Rescission of Form N-SAR and Amendments to the Exhibit Requirements of Form N-CSR. June 1, 2018 for all funds (i.e., no tiered compliance date based on asset size).
Regulation S-X, Statement of Additional Information and Related Amendments. August 1, 2017 for all funds.