On October 26, 2022, the Securities and Exchange Commission (SEC) adopted final rule and form amendments (Final Rule) that significantly alter the form and content of annual and semi-annual shareholder reports provided by mutual funds and exchange traded funds (ETFs) that file on Form N-1A. Additionally, under the Final Rule, mutual funds and ETFs that file on Form N-1A will no longer be able to satisfy shareholder report delivery requirements by relying on Rule 30e-3 under the Investment Company Act of 1940, as amended (1940 Act), which allows funds to post shareholder reports online and deliver only a notice of availability of those reports. The Final Rule also contains amendments to various rules related to investment company advertising, applicable to all investment companies and business development companies (BDCs).
The proposed rule that preceded the Final Rule contained several additional proposals that were not adopted as part of the Final Rule, including: (i) proposed Rule 498B, which would have allowed investment companies to opt out of the annual prospectus delivery requirement; (ii) amendments to prospectus fee disclosures, which would have included a new approach to disclosing acquired fund fees and expenses; and (iii) amendments to prospectus risk disclosures. The SEC determined that, based on comments received, each of these proposals raised issues that merited further consideration.
Annual and Semi-Annual Shareholder Reports
The amendments related to annual and semi-annual shareholder reports apply only to open-end investment companies that file their registration statements on Form N-1A, which includes mutual funds and ETFs (hereinafter referred to as Funds, or each a Fund), but does not include closed-end funds (including BDCs), unit investments trusts, or open-end managed investment companies not registered on Form N-1A.
Many Funds are organized as single registrants with several series (each a mutual fund or ETF), and under the current shareholder reporting regime, registrants are able to prepare a single shareholder report and group multiple Funds and classes into such reports. Under the Final Rule, in a significant departure from current practice, shareholder reports may only contain information for one Fund and one class of that Fund. For example, where currently, a registrant can prepare one shareholder report for five Funds, each having three classes, and send that report to all shareholders across the different classes of the five Funds, that registrant must now prepare fifteen separate reports and ensure that each shareholder only receives the reports for the Funds and classes in which such shareholder invests.
In addition to changing the series and class scope of shareholder reports, the SEC has also limited the content scope of shareholder reports, allowing only information that new Item 27A of Form N-1A (Item 27A) specifically permits or requires.1 Further, the information included in the shareholder report is required to be presented in “plain English” in the order that it is listed in Item 27A. Item 27A also encourages Funds to use, 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 Final Rule takes a layered approach to disclosure, meaning that shareholder reports2 will only contain what the SEC believes to be the most important information, but include instructions on how to access additional information about the Fund if desired. Much of the information that is currently included in a shareholder report will now only be available in Form N-CSR and on the Fund’s website.
Form N-CSR is the form used by Funds to file their annual and semi-annual shareholder reports and other information, such as information about the registrant’s code of ethics, and certain certifications. Currently, Form N-CSR must be filed on EDGAR within 10 days after the distribution of shareholder reports (which must begin no later than 60 days after the end of the Fund’s fiscal year or semi-annual period). Under the Final Rule, Form N-CSR must be filed on EDGAR and posted on the Fund’s website within 60 days after the Fund’s fiscal year end or semi-annual period. Under the Final Rule, consistent with current practice, registrants may continue to group shareholder reports for several Funds and classes of those Funds into one Form N-CSR filing; however, registrants must follow certain presentation guidelines when posting the information from Form N-CSR online. The presentation guidelines are meant to facilitate clear and effective communication of information. For example, if a registrant has multiple Funds with multiple classes, when posting the information from Form N-CSR online, that registrant may include a master table of contents that contains hyperlinks to specific materials for each Fund and each class.
The table below, adapted from the Final Rule, describes certain shareholder report requirements, and whether, under the Final Rule, those items will remain in the shareholder report, or be moved to Form N-CSR.
Certain items that are currently included in shareholder reports will be removed from shareholder reports and the Form N-CSR in their entirety, including the following: Management information and statement regarding availability of additional information about fund directors (Currently required by Form N-1A Item 27(b)(5) and (6)); Statement regarding liquidity risk management program (Currently required by Form N-1A Item 27(d)(6)(ii)); and 1940 Act Rule 30e-3 Disclosure, if applicable (currently required by Form N-1A Item 27(d)(7)).
Annual shareholder reports under the Final Rule will have a shorter and more simplified format that includes certain new items, such as a cover page with identifying information, fund statistics and material changes. The table below outlines the new annual report format:
Certain New and Updated Disclosure Requirements
Under the Final Rule, Funds will be required to present a simplified expense example that presents expenses associated with a hypothetical $10,000 investment in the Fund during the prior reporting period as a percentage and as a dollar amount. Item 27A(c) notes various clarifying footnotes that a Fund may use (such as if the report covers a period of time less than a full reporting period). The new expense example replaces the current version, which requires a narrative preamble and two separate tables that show expenses based on actual and hypothetical performance.
The requirements for the narrative Management’s Discussion of Fund Performance (MDFP) have not changed greatly under the Final Rule; however, the Final Rule specifies that the disclosure must “briefly summarize” the “key” factors impacting the Fund’s performance, and must not include lengthy, generic or overly broad discussions. Further, under the Final Rule, Funds will no longer be able to include certain additional information in the MDFP that has become standard practice for some, including a management letter to shareholders, interviews with portfolio managers, general market commentary or other similar information.
The Final Rule will generally retain the requirement to show Fund performance in the form of a line graph and a table compared to an “appropriate broad-based securities market index.” Under Item 27A, the definition of an “appropriate broad-based securities market index” has been revised as follows: “an appropriate broad-based securities market index is one that is administered by an organization that is not an affiliated person of the Fund, its investment adviser, or principal underwriter, unless the index is widely recognized and used. A “broad-based” index is an index that represents the overall applicable domestic or international equity or debt markets, as appropriate.” The current instruction to Form N-1A does not actually define a “broad-based” index, beyond stating that if the index is affiliated, it must be widely recognized and used. This new definition, and the SEC’s commentary in the Final Rule’s adopting release, will hopefully bring clarity to what constitutes an “appropriate broad-based securities market index,” a topic which has consistently been the subject of SEC Staff comments on shareholder report filings.
The Final Rule will require that Funds disclose certain statistics in their shareholder reports, including (i) the Fund’s net assets; (ii) the total number of portfolio holdings; (iii) the portfolio turnover rate (except for money market funds); and (iv) the total advisory fees paid by the Fund during the reporting period. The Fund may provide other statistics that it believes would help shareholders better understand the Fund’s activities and operations during the reporting period, such as tracking error, maturity, duration, average credit quality, yield, or other such statistics, provided that these additional statistics are disclosed after the required statistics.
Under the Final Rule, Funds will be required to disclose material fund changes that occurred during the period. If the Fund has a material change to report for the period, the shareholder report must contain a statement on the cover page indicating that “this report describes changes to the Fund that occurred during the reporting period.” Within the shareholder report, material changes to the following must be disclosed:
(1) The Fund’s name;
(2) The Fund’s investment objectives or goals;
(3) The Fund’s annual operating expenses, shareholder fees, or maximum account fee, including the termination or introduction of an expense reimbursement or fee waiver arrangement;
(4) The Fund’s principal investment strategies;
(5) The principal risks of investing in the Fund; and
(6) The Fund’s investment adviser(s).
As stated in the adopting release, the purpose of the material fund change disclosure requirement is to consolidate disclosure of material changes. Currently, any material fund changes are disclosed via annual prospectus updates or other prospectus updates delivered throughout the year, including updated prospectuses and supplements filed pursuant to Rule 497 under the Securities Act of 1933, as amended (Securities Act).
Several commenters addressed the issue of the definition of “material” and how the requirement to disclose material fund changes interacted with other rules, including Rule 485(a)(1)4 or Rule 497 under the Securities Act with respect to amendments to a Fund’s registration statement. The SEC confirmed that, with the adoption of the material change requirement for shareholder reports, it was not also defining material change for purposes of registration statement filings under Rule 485(a)(1) or Rule 497, and did not find it necessary to link the shareholder report disclosure requirement to filings under Rules 485(a)(1) and 497. As such, disclosing an item as a material fund change in a shareholder report would not, on its own, trigger a requirement to file a prospectus supplement under Rule 497 or an amended registration statement under Rule 485(a)(1).
Financial Statements and Changes in and Disagreements with Accountants
In a departure from current practice, the Final Rule will not require that Funds include financial statements and financial highlights in their shareholder reports, or the full “Changes in and Disagreements with Accountants” disclosure (if applicable). Financial statements and Changes and Disagreements with Accountants disclosures will instead be included in Form N-CSR. Under the Final Rule, if a Fund is required to disclose information regarding Changes in and Disagreements with Accountants, it must also provide a brief summary in the shareholder report.
Effective January 1, 2021, Funds were able to comply with Rule 30e-3 under the 1940 Act, which allows Funds to satisfy shareholder report transmission requirements by making shareholder reports and other materials available online and providing a notice of that availability instead of directly mailing the report to shareholders. Under the Final Rule, the scope of Rule 30e-3 will be amended to exclude investment companies registered on Form N-1A. As such, Funds will once again be required to deliver shareholder reports directly to shareholders by mail, or electronically if the shareholder has consented to electronic delivery. Further, under the Final Rule, Rule 30e-1(d) will be rescinded, which allows a Fund to transmit a copy of its prospectus or SAI in lieu of a shareholder report, if the prospectus or SAI contains the information required to be disclosed in a shareholder report. The SEC acknowledged the frustration expressed by many commenters that certain registrants had expended considerable resources to update their operations in order to comply with Rule 30e-3, and now the rule would be narrowed before these registrants were able to realize any of the rule’s benefits. Nevertheless, the SEC adopted the amendments substantially as proposed.
All shareholder reports transmitted 18 months or more after the effective date of the Final Rule (which is 60 days after the Final Rule is published in the Federal Register) must be in compliance with the Final Rule.
Investment Company Advertising
As part of the Final Rule, the SEC adopted amendments to Rules 482, 156, and 433 under the Securities Act and Rule 34b-1 under the 1940 Act, which address investment company fee and expense presentations in advertisements. These amendments apply to all investment companies, including mutual funds, ETFs, closed-end funds, and BDCs (hereinafter referred to as investment companies).
The amendments to Rule 482 under the Securities Act will require any investment company advertisements that provide fee and expense figures5 to include: (i) the maximum amount of any sales load or any non-recurring fee; and (ii) the investment company’s total annual expenses without any fee waivers or expense reimbursements, calculated as required by the investment company’s registration statement. The amendments to Rule 433 under the Securities Act (related to post-filing free writing prospectuses) and 34b-1 under the 1940 Act (related to sales literature) incorporate the amendments to Rule 482 so that the same fee and expense requirements are applied consistently across investment company advertisements and sales literature. Investment company advertisements will be permitted to include other figures related to an investment company’s fees and expenses; however, the required fee and expense figures will have to be presented at least as prominently as any other figure. If an investment company includes its total fees and expenses net of fee waivers or expense reimbursement, under the Final Rule, the advertisement must also include the expected termination date of the fee waiver or expense reimbursement arrangement. Any fee and expense information presented will need to be current at least as of the date of the investment company’s most recent prospectus, or if the investment company no longer has a current registration statement under the Securities Act, as of the date of its most recent annual report.
The amendments to Rule 156 under the Securities Act address statements about an investment company’s fees and expenses that could be materially misleading. Rule 156 will be amended to state that “representations about the fees or expenses associated with an investment in an investment company could be misleading because of statements or omissions made involving a material fact, including situations where portrayals of the fees and expenses associated with an investment in the fund omit explanations, qualifications, limitations, or other statements necessary or appropriate to make the portrayals not misleading.” For example, representing that a particular investment company is a “zero expense” or “no expense” fund, without mentioning other costs an investor may incur when investing in that fund, may be misleading under Rule 156, as amended. The SEC acknowledged that, consistent with the current framework of Rule 156, whether a representation is materially misleading, depends on an evaluation of the context in which it was made.
Investment companies have 18 months from the Final Rule’s effective date (which is 60 days after the Final Rule is published in the Federal Register) to comply with the new advertising rules.
1 Other materials not specifically listed in Item 27A may accompany a shareholder report, but must meet certain prominence requirements, including that the shareholder report must be given greater prominence than other materials that accompany the report, with the exception of other shareholder reports, summary prospectuses or statutory prospectuses.
2 This section entitled “Contents” addresses the contents of annual shareholder reports. Semi-Annual shareholder reports generally contain the same content as annual reports, except certain items are not required to be presented in a semi-annual report. These items are noted in Item 27A.
3 Rule 30e-1(f)(3) under the 1940 Act currently requires a Fund to explain, at least once a year, how shareholders may revoke their consent to householding. This explanation is not currently required in Funds’ shareholder reports, and it is not required under the Final Rule, but may be disclosed in a shareholder report if the Fund chooses to do so.
4 Rule 485(a)(1) under the Securities Act is used by Funds to file registration statements that are not eligible to be filed under Rule 485(b), i.e., the registration statement contains a material change. Registration statements filed under Rule 485(a)(1) are subject to SEC review and are automatically effective after 60 days.
5 These requirements would not apply to advertisements that do not present “figures” – i.e., advertisements that only include general narrative information about fee and expense considerations.