On January 13, 2009, the Securities and Exchange Commission (the “Commission”) adopted amendments to Form N-1A, the registration form for open-end investment companies or “mutual funds” (the “N-1A Amendments”), to ensure that investors have better access to key information typically considered when making informed investment decisions. First, Form N-1A was amended to require a mutual fund to provide, at the front of its prospectus, a standardized, concise and plain English summary of key terms contained within the statutory prospectus. Second, Form N-1A was also amended to provide investors purchasing shares of exchange-traded funds (ETFs) with additional relevant information about these products.
In addition to the N-1A Amendments, the Commission also adopted a new rule that permits sending only a summary prospectus (the “Summary Prospectus”) to satisfy the current prospectus delivery requirements imposed by the Securities Act of 1933, as amended (the “Securities Act”), provided that all other disclosure documents that are currently required are available online and that certain other conditions are met.
The N-1A Amendments require that each statutory prospectus include a summary section, in substantially the same form as was initially proposed, at the front of the prospectus consisting of key information presented in plain English and in a standardized order (“Summary Section”). The purpose of the Summary Section is to provide investors with concise and user-friendly information that is “simpler, clearer and more useful” than the information currently contained within the statutory prospectus. This information will be available to all investors, regardless of whether the relevant fund elects to use the Summary Prospectus. While there is no stated page limit for the Summary Section, the Commission stated that funds should remember that the purpose of the amendments is to provide a concise (generally three- to four-page) resource for investors.
Multiple Fund Prospectuses
In the case of prospectuses that contain multiple funds, the N-1A Amendments require that separate Summary Sections be included for each fund covered by the statutory prospectus and, unlike the current risk/return summary, generally do not permit the presentation of integrated fund information.
The purpose of requiring separate Summary Sections for each fund is to reduce confusion and ensure that investors are able to readily find information about the specific fund in which they are interested, without having to weed through information relating to other funds offered within the fund complex. The N-1A Amendments do provide one exception that allows multiple fund prospectuses to integrate the summary information when the information related to purchase and sale of fund shares, tax information and financial intermediary compensation is identical for all funds covered. In those cases, the integrated information is required to immediately follow the separate individual fund summaries containing the other non-integrated information.
Separate Purchase and Redemption Document
The N-1A Amendments also eliminate the option in Form N-1A for a fund to present detailed information regarding purchase and redemption procedures in a separate document that accompanies the prospectus, rather than include such information directly in the prospectus. Under the N-1A Amendments, the only option available to a fund to convey such information is to use a Summary Prospectus that contains the same purchase and redemption information of a fund as is in the Summary Section of the statutory prospectus. The elimination of this option does not alleviate or remove a fund’s obligation to include the information about purchase and redemption procedures currently required in such fund’s prospectus and statement of additional information (SAI).
Exchange Ticker Symbols
Finally, the N-1A Amendments require that a fund include its exchange ticker symbol on the cover pages of the statutory prospectus and SAI.
Information Required in the Summary Section
Order of Information
The N-1A Amendments require that the following information be contained in the Summary Section of a mutual fund statutory prospectus in the following order: (1) investment objectives/goals; (2) fee table (costs); (3) investments, risks and performance; (4) management; (5) purchase and sale of fund shares and tax information; and (6) financial intermediary compensation. While comments were received regarding the order of these items, the Commission ultimately felt that this order best suited the needs of investors.
Elimination of Portfolio Holdings Requirement
Although contained in the initial proposing release, the final version of the N-1A Amendments did not include a portfolio holdings requirement, largely because commentators pointed out that such information may not accurately represent a fund’s overall holdings and may become stale. In electing not to include such information, the Commission also noted that such information is readily available to investors via alternate sources.
Investment Objectives and Goals
As with the current risk/return summary, the first item in the Summary Section is disclosure of the fund’s investment objectives or goals. Funds may utilize this section to identify its type or category (e.g., that it is a money market fund or balanced fund).
Fee Table (Costs)
Next, the Summary Section must include a fee table and example showing the cost of investing in the fund. While the fee table disclosure is similar to the current fee table used in the risk/return summary and as initially proposed, there are several notable differences.
First, the fee table must include a brief narrative describing the types of discounts, if any, on front-end sales charges for volume purchases (“breakpoint discounts”) and the minimum level of investment required for eligibility. While this information is required elsewhere in the statutory prospectus, the Commission is of the opinion that including a brief description in the Summary Section increases investor awareness of this issue. Unlike under the initial proposed amendments, the narrative description must state that further information is available from the investor’s financial professional, as well as identify the section heading and page number of the fund’s prospectus and SAI where more information can be found. The instructions to this item have been altered from the initial proposal to clarify that the dollar level at which investors may qualify for breakpoint discounts that must be disclosed should be the minimum level of investment required to qualify for a discount as disclosed in the table required by current Item 7(a)(1) of Form N-1A.
Second, the parenthetical following the fee table heading “Annual Fund Operating Expenses” is revised to read, “expenses that you pay each year as a percentage of the value of your investment,” rather than, “expenses that are deducted from Fund assets,” as is the case with the current risk/ return summary. The intent of this change is to clarify to investors that they will be charged expenses on an annual basis. While it was proposed by several industry commentators, this parenthetical will not make reference to the fact that investors do not directly pay fund expenses.
Third, immediately following the fee table example, all funds, except money market funds, must provide their portfolio turnover rate for the most recent fiscal year as a percentage of the average value of its portfolio. Funds are required to supplement this disclosure with a written explanation of the effect of such turnover on transaction costs and fund performance, including an explanation of the adverse tax consequences that may result from a higher portfolio turnover rate when fund shares are held in a taxable account. As with the disclosure of breakpoint discounts, an in-depth discussion of this topic is currently required in the statutory prospectus; however, the Commission is of the view that a brief description at the front of the prospectus could enhance investor understanding of this complex concept. Although included in the initially proposed amendments, the Commission elected not to require funds to disclose: (1) the impact of transaction costs in a fund’s expense ratio as disclosed in the fee table and (2) portfolio turnover rates over a period greater than one year.
Fourth, the N-1A Amendments amend the requirement that a fund disclose in its fee table gross operating expenses that do not reflect the effect of expense reimbursement or fee waiver arrangements. While a fund is currently required to disclose in the risk/return summary only its gross operating expenses, the Commission is aware that such information does not always convey the actual expenses currently associated with an investment in the fund. Under the N-1A Amendments, in instances where a fund has entered into expense reimbursement or fee waiver arrangements, the fund is permitted to include two captions directly below the “Total Annual Fund Operating Expenses” column. The first caption indicates the amount of the expense reimbursement or fee waiver, and the second caption indicates the fund’s net expenses after subtracting the fee reimbursement or expense waiver from the total fund operating expenses. Funds that disclose these arrangements must disclose the period for which the expense reimbursement or fee waiver arrangement is expected to continue, including the expected termination date, and briefly describe who can terminate the arrangement and under what circumstances. In computing the fee table example, a fund may reflect any expense reimbursement or fee waiver arrangements that will reduce any operating expenses for no less than one year from the effective date of the fund’s registration statement.
Investments, Risks and Performance
The next item required in the Summary Section is disclosure of the fund’s principal investment strategies and risks. This disclosure follows the format established for the current risk/return summary whereby funds must provide a bar chart and table illustrating the variability of returns and showing the fund’s past performance. However, the N-1A Amendments additionally require a fund that makes updated performance information available on a Web site or at a toll-free (or collect) telephone number to include a statement explaining this and providing the Web site address and/ or telephone number. In an attempt to control the length of the Summary Section, the Commission elected not to require additional comparative performance information.
The next item in the Summary Section relates to the management of the fund and requires that funds disclose the name of each investment adviser and sub-adviser of the fund, followed by the name, title and length of service of the fund’s portfolio managers. As with the previous Rule 498 profile prospectus (“profile prospectus”), a fund, except one that operates an investment strategy of regularly holding cash instruments, is not required to disclose sub-advisers whose sole responsibility is the day-to-day management of the fund’s cash instruments. The Summary Section also does not require the disclosure of the individual identity of sub-advisers if a fund employs three or more such advisers (unless a sub-adviser is individually responsible for the management of more than 30 percent of the fund’s assets). Disclosure will be required only with respect to the members of a management team who are jointly and primarily responsible for the day-to-day management of the fund’s portfolio.
Purchase and Sale of Fund Shares
The Summary Section next requires that funds disclose their minimum initial and subsequent investment requirements, the fact that fund shares are redeemable and the procedures for redeeming fund shares. This disclosure is similar to what is currently required in the profile prospectus, but does not require a fund to disclose information contained within the fee table portion of the Summary Section, such as redemption charges and sales loads. The N-1A Amendments also include modifications regarding this topic as they relate to ETFs, as described more fully below.
The penultimate portion of the Summary Section mandates disclosure regarding the taxable nature of the distributions that the fund intends to make. This disclosure indicates whether the fund intends to make distributions that may be taxed as ordinary income or capital gains, or that is tax-exempt.
Financial Intermediary Compensation
The Commission believes that investors may not be fully cognizant of the impact of, and conflicts that may be created by, certain costs related to the distribution of a fund. Accordingly, the final portion of the Summary Section must be the following statement (or a similar legend that retains the original meaning):
Payments to Broker-Dealers and Other Financial Intermediaries
If you purchase the Fund through a broker-dealer or other financial intermediary (such as a bank), the Fund and its related companies may pay the intermediary for the sale of Fund shares and related services. These payments may create a conflict of interest by influencing the broker-dealer or other intermediary and your salesperson to recommend the Fund over another investment. Ask your salesperson or visit your financial intermediary’s Web site for more information.
The N-1A Amendments include a provision permitting a fund to omit the financial intermediary disclosure if neither the fund nor any of its related companies pay financial intermediaries for the sale of fund shares or related services.
Exchange Traded Funds
The N-1A Amendments also include amendments that accommodate the use of Form N-1A by ETFs. While most ETFs are organized and registered as open-end funds, unlike traditional mutual funds, ETFs only sell and redeem individual shares (“ETF shares”) to certain financial institutions in large aggregations called “creation units.” The N-1A Amendments for ETF prospectuses are designed for the benefit of investors, including retail investors, that purchase ETF shares on the secondary market, rather than direct purchasers of creation units, and address the purchase and redemption of shares and disclosure of premium/discount information. In adopting the N-1A amendments, however, the Commission elected not to include its earlier proposal that would require ETFs to disclose their market based returns in addition to returns based on NAV. Having received overwhelming criticism from commenters, the Commission agreed that such information would not be as relevant to an investor’s experience in the ETF as would returns based on NAV.
Purchase and Redemption of Shares
The N-1A Amendments eliminate the requirement that ETF prospectuses disclose information on purchasing and redeeming shares directly and implement a requirement that ETFs state the number of shares contained in a creation unit (i.e., the aggregate number of shares required for issuance or redemption by an ETF), that individual shares can only be bought and sold on the secondary market through a broker-dealer and that shareholders may pay more than net asset value (NAV) when they buy ETF shares and receive less than NAV when they sell shares. The N-1A Amendments also amend the fee table disclosure in Form N-1A to exclude fees and expenses for purchases or redemptions of creation units, and instead modify the narrative explanation preceding the example in the fee table to state that investors in ETF shares may pay brokerage commissions that are not reflected in the example. Consistent with the proposed amendments to Form N-1A, the alternative disclosures for the “fee table” and “purchase and sale of fund shares” sections are not available to ETFs with creation units of fewer than 25,000 shares.
The N-1A Amendments require ETFs to disclose in their prospectus information about the extent and frequency with which market prices of fund shares have tracked the fund’s NAV. Each ETF is required to disclose the number of trading days during the most recently completed calendar year and quarters since that year on which the market price1 of the ETF shares was greater than the fund’s NAV and the number of days it was less than the fund’s NAV (i.e., premium/discount information). Such information is intended to inform investors as to the relationship between NAV and the market price of the ETF’s shares, and that investors may purchase or sell ETF shares at prices that do not correspond to NAV. However, the N-1A Amendments do permit an ETF to omit the disclosure of specific premium/discount information in its prospectus or annual report, should they elect to provide the information on their Internet Web site and disclose in the prospectus or annual report an Internet address where investors can locate the information.
New Delivery Option for Mutual Funds
Section 5(b)(2) of the 1933 Act makes it unlawful to deliver a security for purposes of sale or for delivery after sale “unless accompanied or preceded” by a statutory prospectus. Previously, Rule 498 under the 1933 Act provided that an open-end management investment company may provide a profile prospectus to investors in lieu of a full prospectus contingent upon such document containing certain requisite information, including information regarding how investors can obtain the statutory prospectus and other relevant information. However, the profile prospectus was not received favorably by the investment management industry. Reluctance by industry participants to embrace this option rested primarily on the fear that the use of summarized information that did not incorporate by reference the more fulsome disclosure contained within the statutory prospectus could result in a violation of the anti-fraud provisions of the securities laws because of the omission of material information.
New Delivery Option for Mutual Funds
In response to the industry’s rejection of the profile prospectus, the Commission has elected to adopt a new rule that replaces Rule 498 and permits a mutual fund to satisfy its prospectus delivery requirements through the use of the new Summary Prospectus that incorporates by reference key information contained within the full prospectus contingent upon the full prospectus being made available online and in hard copy upon request (“Rule 498 Revisions”). The intent of the Commission in adopting the Rule 498 Revisions was to create a layered approach to disclosure whereby key information is sent or given to the investor and more detailed information is provided online and, upon request, is sent in paper format or by email.
The Rule 498 Revisions provide that any obligation under Section 5(b)(2) of the Securities Act to have a statutory prospectus precede or accompany the carrying or delivery of a mutual fund security in an offering registered on Form N-1A is satisfied if (1) a Summary Prospectus is sent or given no later than the time of the carrying or delivery of the fund security; (2) the Summary Prospectus is not bound together with any materials, except in the case of funds that are available as an investment option in a variable annuity or variable life insurance contract; (3) the Summary Prospectus that is sent or given satisfies the rule’s requirements at the time of the carrying or delivery of the fund security; and (4) the conditions set forth in the rule, which require a fund to provide the Summary Prospectus, statutory prospectus and other information on the Internet in the manner specified in the rule, are satisfied. These requirements are intended to ensure that investors do not receive the statutory prospectus after the purchase transaction, as was previously the norm, when the investment decision is complete.
Contents of the Summary Prospectus
The Summary Prospectus contains the same information, in the same order, as the Summary Section of the statutory prospectus discussed above. As with the Summary Section, the Summary Prospectus must be specific to an individual fund and may not be used for multiple funds of the same fund family. Furthermore, unless specifically authorized by rule, the Summary Prospectus may not include any additional information or omit any information required to be included in the Summary Section of the statutory prospectus. If the Summary Prospectus deviates from this requirement, it is not permitted for use for any purpose. In the event that a fund elects to sticker its statutory prospectus that alters information also contained within the Summary Prospectus, the Summary Prospectus and the Summary Section should be either stickered or amended accordingly.
The Summary Prospectus must begin with a cover page or introductory section listing the fund’s name and the share classes to which it relates, the exchange ticker symbol of the fund’s securities (or, if the Summary Prospectus relates to one or more classes of the fund’s securities, adjacent to each such class, the exchange ticker symbol of such class of the fund’s securities), a statement indicating that the document is a “Summary Prospectus,” the date of the document’s first use and a legend indicating that additional information is contained in the statutory prospectus and the means of obtaining such document.
The aforementioned legend must provide the Internet address, toll-free (or collect) telephone number and email address that investors can use to obtain the statutory prospectus and other information. The rule does not allow a fund to use the address of the Commission’s Electronic Data Gathering, Analysis, and Retrieval System (“Edgar”), and the link must to be specific enough to lead investors directly to the statutory prospectus, rather than to a home page or other section of a Web site on which the materials are posted. However, the legend is permitted to indicate that the statutory prospectus and other information are available from a financial intermediary (such as a broker-dealer or bank), through which shares of the fund may be purchased or sold.
Summary prospectuses must be filed on Edgar no later than the date that they are first used and need only be updated with the same frequency as the statutory prospectus.
Provision of Other Required Information (Statutory Prospectus, SAI and Shareholder Reports)
If a fund wishes to use the Summary Prospectus to satisfy its prospectus delivery requirements, it must also provide a copy of the statutory prospectus along with other required information, such as the statement of additional information (SAI) and the most recent annual and semi-annual shareholder reports (“Other Information”), to investors by (1) posting a copy on an Internet Web site and (2) by sending the document by email or in hard copy to any investor that requests a copy.
Internet Access to Statutory Prospectus and Other Information
Under the Rule 498 Revisions, the statutory prospectus and Other Information must be made accessible, free of charge, at the Web address listed on the cover of the Summary Prospectus.2 These documents must be made available at the time the Summary Prospectus is sent and must remain on the Web site for 90 days following such time. As noted above, these documents must be provided in a manner that permits (1) persons accessing the statutory prospectus or SAI to move directly back and forth between a table of contents and each section within that document, and (2) persons accessing the Summary Prospectus to move directly back and forth between each section of the Summary Prospectus and a table of contents of the statutory prospectus and SAI that prominently display the sections within those documents that provide additional detail concerning information contained in the Summary Prospectus. In connection with the latter requirement, investors must be able to navigate between the sections of a document with one mouse click and between related sections of a document with two clicks. The information contained within the Summary Prospectus must be “human-readable” and capable of being printed on paper in a “human-readable” format. The information must also be in a format that is convenient for both reading online and printing on paper. The format in which this information is presented (e.g. HTML, PDF, etc.) is at the discretion of the fund.
In addition to accessing this information online, a fund must also make these documents available to investors in a format whereby they would have the ability to permanently retain, without charge, an electronic copy of the statutory prospectus and Other Information that meets the hyperlink requirements noted above.3 A fund must comply with each of these requirements in order to satisfy the prospectus delivery requirements of the 1933 Act.4
Technical Requirements for Online Information
The Rule 498 Revisions impose requirements for linking within the statutory prospectus and SAI, and for linking between the Summary Prospectus, on the one hand, and the statutory prospectus and SAI, on the other. First, funds must provide the ability for persons accessing the statutory prospectus or SAI online to be able to move directly back and forth between each section heading in the table of contents of the document and the section of the document referenced in that section heading by a single mouse click and without the need to flip through multiple pages of a paper document. The linked table of contents, however, may be outside the document and does not necessarily have to be contained within the document itself. In addition, links must permit movement directly back and forth between each section heading in the table of contents and the particular section of the document referenced in that section heading.
The Rule 498 Revisions also require that an investor must be able to move back and forth between related sections of the Summary Prospectus, on the one hand, and the statutory prospectus and SAI, on the other, either directly through a single mouse click or indirectly by means of the table of contents of the prospectus or SAI, in which case two mouse clicks would be required.
In addition to the current formatting requirements, the Commission has also already proposed to require a significant portion of the information that is contained in the Summary Section of the statutory prospectus and the Summary Prospectus to be filed in interactive data format.
Safe Harbor for Temporary Noncompliance
While failure to comply with the prospectus delivery obligations under Section 5(b)(2) of the Securities Act would ordinarily result in a securities violation, the Commission adopted a safe harbor for those instances where these requirements may not be met due to events beyond the control of the fund. However, in order to avail itself of this safe harbor, a fund must take prompt action to ensure that those materials become available in the manner required, as soon as practicable following the earlier of the time at which the fund knows or reasonably should have known that the documents are not available in the manner required.
Hardcopy of Statutory Prospectus and Other Information
In addition to making the statutory prospectus and Other Information available online, a fund must also make such information available free of charge (either directly or through a financial intermediary) via first class U.S. mail, within three days of receiving a request from an investor.
Upon the request of the investor, the fund is also required to send an electronic copy by email or a direct link to an electronic copy available on the Internet, within the same time period. Failure to send this information within the prescribed time limits does not render a fund unable to rely upon the Summary Prospectus to satisfy its prospectus delivery requirements, but would cause the fund to be in violation of this rule.
Incorporation by Reference
As noted above, one of the primary reasons why funds were reluctant to use the profile prospectus was its prohibition against incorporating by reference information contained within the statutory prospectus, SAI or shareholder reports. Under the previous Rule 498, incorporation by reference was not permitted because the profile prospectus was intended to serve as a self-contained disclosure document. The Rule 498 Revisions now permit the incorporation of information by reference in the Summary Prospectus because it is intended to serve as “one element in a layered disclosure regime that results in the simultaneous provision of information to investors through multiple means.” Thus, while a fund may only send investors the Summary Prospectus, additional disclosure will be available, both online and via the mail, in the form of the statutory prospectus, SAI and most recent shareholder reports (provided that the information from the shareholder report has itself been incorporated by reference into the statutory prospectus). To direct investors to the additional available disclosure regarding a fund, the Rule 498 Revisions permit the incorporation of information by reference to the aforementioned additional documents and mandate that hyperlinks are provided for the online versions of these documents, to ease the manner in which investors are able to navigate between these various forms of disclosure. The Rule 498 Revisions also ensure that all information that is incorporated by reference is deemed to have been “effectively” conveyed to the investor at the time they receive the Summary Prospectus to avoid violations of the anti-fraud provisions under Sections 12(a)(2) and 17(a)(2) of the 1933 Act.
A fund may incorporate by reference any information not required to be in the Summary Prospectus from any of the sources listed above; however, they may not reference any alternate sources. Furthermore, information cannot be incorporated by reference to a document that only contains the reference by way of another document. To incorporate information by reference, the summary must contain a legend identifying the document from which the information is incorporated and the page, paragraph or caption of any part of a document referenced, the date of the document and a statement that the SAI or shareholder report may be obtained, free of charge, in the same manner as the statutory prospectus.
The effective date of the N-1A Amendments and Rule 498 Revisions is March 31, 2009. All initial registration statements on Form N-1A, and all post-effective amendments that are annual updates to effective registration statements on this form, filed on or after January 1, 2010, must comply with the N-1A Amendments and Rule 498 Revisions. All post-effective amendments that add a new series, filed on or after January 1, 2010, must comply with the N-1A Amendments and Rule 498 Revisions with respect to the new series. The final compliance date for filing amendments to effective registration statements to comply with the new Form N-1A requirements is January 1, 2011.