In its adoption of amendments to a rule under the Investment Company Act of 1940 ("1940 Act"), the SEC has dramatically changed the compliance framework for the custody of U.S. investment company assets outside the United States, and has recently extended the date for compliance with the new requirements.
On the interpretative front, the SEC issued releases regarding the use of the Internet by investment companies and investment advisers, and has permitted the purchase of investment company shares with credit cards. The SEC has also addressed the implications of the "Year 2000" issue for investment advisers and other fund service providers by proposing new rules and reporting obligations.
A. Plain English Philosophy Underlies Adoption of Disclosure Amendments & Profile Prospectus Rule
The first event impacting funds' investor communications was the culmination of what may be characterized as the SEC's "plain English initiative," evidenced by the adoption of subparagraph (d) of Rule 421 under the Securities Act of 1933 (the "1933 Act").(1) Effective December 1, 1998, the SEC will require all mutual funds to use plain English principles in drafting the cover pages, summary and risk factors sections of fund prospectuses, and in the preparation of a new disclosure documented called a "Profile" (as further discussed below).
In mandating the use of plain English, the SEC has presented six basic drafting principles: (i) use short sentences; (ii) employ definite, concrete, everyday language; (iii) write in the active voice; (iv) utilize tabular presentation or bullet lists for complex material; (v) avoid legal jargon or highly technical business terms; and (vi) avoid multiple negatives. Further, Rule 421(d) permits the use of pictures, logos, charts, graphs or other design elements, provided the information is clear and the presentation is not misleading.
The SEC also amended subparagraph (b) of Rule 421 to provide certain required drafting techniques and to identify other writing conventions that funds should avoid in prospectus preparation. Funds should strive for clear and concise sections, paragraphs and sentences, and should rely on descriptive headings and subheadings. The rule discourages reliance on glossaries for explanatory purposes and the use of legalistic, overly complex and vague boilerplate explanations. The Rule requires the deletion of repetitive disclosure. It should be noted that the SEC has indicated that it will, in the future, issue a final version of A Plain English Handbook, which will contain additional guidelines.
The rationale behind the plain English principles can also be seen in the wide-ranging amendments (the "Amendments")(2) to Form N-1A (the "Form"), the legal road-map that determines the contents of a mutual fund's registration statement (which includes both its prospectus and statement of additional information ("SAI")), which were adopted by the SEC in March. The Amendments are intended to improve prospectus disclosure and to promote more effective communication of pertinent investment information to investors about a particular fund. The Amendments seek to minimize disclosure about technical, legal and operational matters generally common to all funds.
The more notable modifications affected by the Amendments include:
- Risk/Return Summary At the beginning of each prospectus there must appear a risk/return summary (the "Summary") that provides information about a fund's investment objectives, strategies, performance and fees. The Summary must include a discussion of the principal risks of investing in the fund. The Summary must present a bar chart showing the fund's annual return for each of the last ten calendar years, and must report the fund's best and worst quarterly returns during the period covered by the bar chart. A performance table showing the fund's average returns for the last one, five and ten years, compared to those of a broad-based securities market index, is also required. The fund's fee table must reflect operating expenses incurred by the fund, without regard to expense reimbursements and fee waiver arrangements (although these may be disclosed in a footnote). The hypothetical investment example, which depicts projected investor costs of investing in a fund, must be calculated on the basis of a $10,000 (rather than $1,000, as previously required) assumed investment.
- Financial Highlights A fund's financial highlights table has been shortened to five years (from the previously-required period of ten years), and may now appear anywhere in a prospectus.
- Investment Strategies and Risk Disclosure A fund must describe its principal investment strategies and the primary risks of the fund as a whole, as opposed to individual securities or techniques.
- Distribution Arrangements All disclosure pertaining to distribution arrangements (such as sales charges and Rule 12b-1 fees) must be presented in a central location in a prospectus.
- Purchase and Redemption Information A prospectus should contain only essential information relating to purchases and redemptions. Notably, the Amendments now allow a fund, if it prefers, to present to shareholders all purchase and redemption information in another document, a so-called "owner's manual."
- Other Changes Effected by the Amendments Disclosure that merely restates applicable legal requirements or that is common to all mutual funds has been modified or relocated to the SAI.
The SEC created a transition period to give funds adequate time to update their prospectuses or to prepare new registration statements on the revised Form. All new registration statements and post-effective amendments to existing registration statements filed on or after December 1, 1998 must comply with the requirements contained in the amended Form. The final date for filing post-effective amendments to conform with the Amendments is December 1, 1999.
Simultaneous with the Amendments, the SEC adopted Rule 498 (the "Profile Rule")(3) under the 1933 Act, which permits a fund to use a "Fund Profile" to provide a summary of its key information to potential investors. Under the Profile Rule, a fund may distribute a Profile without any accompanying prospectus, and investors may either purchase fund shares based on the Profile (using an investment application included with the Profile) or request additional information. Investors who purchase fund shares relying on the Profile alone will receive the fund's prospectus with their confirmations. The SEC's objective in adopting the Profile Rule was to provide a new disclosure option for investors, as well as to promote more effective communication of information about funds to investors, without reducing the amount of information provided to investors.
Fund Profiles must contain nine specific items of information, presented in a fixed sequence and in plain English. The first four Profile items are identical to those required in the Summary under the Amendments. In addition to certain introductory information, the items of disclosure that must appear in a Profile include: (i) a description of the fund's goals; (ii) a description of the fund's primary investment strategies; (iii) a description of the principal risks of investing in the fund (including narrative risk disclosure, a risk/return bar chart and a risk/return table); (iv) a list of the fund's fees and expenses; (v) an identification of the fund's investment adviser and portfolio managers; (vi) an explanation of how to buy shares of the fund; (vii) an explanation of how to sell shares of the fund; (viii) an explanation of how the fund's distributions are made and taxed; and (ix) a listing of the other services available from the fund. Similar to a prospectus, a Profile may describe more than one fund.
Profiles must initially be filed with the SEC (both electronically and in a paper format) at least 30 days prior to their initial use. A Profile that incorporates substantial changes to a previously-filed and reviewed version of Profile must be re-filed (electronically, but not in paper) with the SEC within five business days after use. A fund is required to send a prospectus to an investor within three business days of the investor's request. Profiles may be deliverable by conventional methods, such as mail, or electronic media, such as e-mail or the Internet.
B. Amendments to 1940 Act Rule
Rule 17f-5 under the 1940 Act regulates the custody of U.S. funds' assets outside the United States. Formerly, Rule 17f-5 had permitted a fund to hold its assets with foreign custodians, but the Rule placed responsibility for approving and monitoring foreign custodians with a fund's board of directors ("board"). On at least an annual basis, the board was required to approve all foreign custody arrangements and to determine that holding the fund's securities in a particular country with a specific custodian was in the shareholders' best interests, in light of certain factors, including political, liquidity and market risks. As the number of funds investing abroad grew dramatically in recent years, so did the compliance burdens placed on boards under Rule 17f-5.
In an effort to more logically allocate oversight responsibility, the SEC, in May, 1997, adopted amendments to Rule 17f-5 (the "17f-5 Amendments")(4) that permit the board or its delegate (the "Foreign Custody Manager") to supervise the foreign custody of a fund's assets. Permissible delegates are the fund's investment adviser, the fund's officers or a U.S. or foreign bank. Further, different delegates may be used for different foreign custodial responsibilities. A delegate must exercise "reasonable care" in performing its delegated duties, although a fund's board and its delegates may agree that the delegate must adhere to a higher standard. Under the 17f-5 Amendments, the board is no longer required to approve the fund's foreign custody arrangements or other foreign custody matters on an initial or annual basis. Instead, the Foreign Custody Manager must notify the board through written reports about the placement of the fund's assets in a particular country and with a specific custodian, and any material changes in the fund's foreign custody arrangements. Originally, the 17f-5 Amendments were to become effective on June 16, 1997, with funds bringing their foreign custody arrangements into compliance with the amended rule by June 16, 1998.
Following the announcement of the 17f-5 Amendments, the SEC clarified that the amended Rule permits the board to delegate authority to the Foreign Custody Manager to select a securities depository that a fund is required to use if it holds assets in a particular country (a "compulsory depository"). The SEC's position provoked industry controversy and uncertainty among global custodians, since most compulsory depositories are governmental or quasi-governmental organizations, causing a Foreign Custody Manager, in certain cases, to be unable to obtain the necessary contractual provisions or information to make the findings contemplated by the Rule 17f-5 Amendments.
Pending resolution of these issues, the SEC has extended(5) the compliance date for the 17f-5 Amendments to February 1, 1999, except for the amended definition of an "eligible foreign custodian" (which remained June 16, 1998). As a consequence, a fund may either comply (i) with Rule 17f-5 as it existed prior to the 17f-5 Amendments, or (ii) entirely with the 17f-5 Amendments. A fund may apply either of these alternatives separately to each foreign custodian it uses. However, the arrangement with a particular foreign custodian or subcustodian must comply entirely with either the former Rule 17f-5 (subject to the amended definition of "eligible foreign custodian") or the amended Rule 17f-5.
C. Interpretative Issues
(i) Offers and Advertisements on the Internet
The SEC earlier this year(6) stated its views regarding the application of the registration obligations under the U.S. securities laws to the use of Internet web sites to disseminate offering and solicitation materials for non-United States sales of securities and investment advice. Specifically, the SEC sought to clarify when the posting of offering or solicitation materials on a web site would not be construed to be an activity taking place in the United States that would trigger registration requirements under the 1933 Act, the 1940 Act and other U.S. securities laws.
As a general matter, the SEC stated its belief that the application of the registration provisions of the U.S. securities laws depends on whether the Internet offers, solicitations or other communications are targeted to the United States. The SEC stated that it would not consider issuers, broker-dealers, exchanges and investment advisers that implement measures that are reasonably designed to guard against sales or the provision of services to U.S. persons to have targeted persons in the United States with their Internet offers. In other words, an Internet posting, by itself, would not result in a registration obligation.
The SEC emphasized that the specific facts and circumstances of each case will determine whether sufficient measures have been taken to obviate the need to comply with U.S. registration requirements. As a general matter, the SEC will not consider an offshore Internet offer made by a non-U.S. offeror as directed at the United States if (i) the web site contains a prominent, clear and meaningful disclaimer that states that the offer is directed only to countries other than the United States, and (ii) the web site offeror implements procedures that are reasonably designed to guard against sales to U.S. persons in the offshore offering. The SEC stressed that these procedures were not exclusive, and that others may suffice. The SEC also stated that if an offeror utilizes a third party web site to post its offering materials, the third party web site should employ at least the same level of precautions as those described above. In certain instances, more rigorous measures may be justified (for example, if the Internet offeror posts materials on a web site that has a significant number of U.S. clients, or where it is likely that U.S. investors would search for information about investments).
The SEC indicated that it would not consider an Internet offer by a foreign fund as rendering the fund subject to U.S. regulation or registration under the 1940 Act if the foreign fund pursues measures reasonably designed to guard against sales to U.S. persons. However, if the foreign fund is engaged in activities designed to attract U.S. investors, in addition to its Internet offer (for example, advertising the web site in a U.S. publication), the site may be considered as targeting U.S. persons. Where a foreign fund is concurrently conducting both a private U.S. offer and an offshore Internet offer, the SEC would not treat the fund as making a U.S. public offer of its securities provided that the foreign fund pursues steps reasonably designed to prevent public sales of the securities to U.S. persons, and the Internet offer is not directly used as a general solicitation by participants in the private U.S. offer.
Beyond implementing these general precautionary measures, the SEC expects foreign funds to implement certain other procedures to prevent their offshore Internet offers from soliciting participants for the private U.S. offers. An adviser to a foreign fund conducting an offshore Internet offer that also sponsors a U.S. registered investment company with the same objectives and policies as the foreign fund may provide information about, or direct the viewer to, the registered U.S. offer without the Internet offer being considered to be a public offer of the foreign fund's securities in the United States.
With reference to investment advisers, while a foreign adviser that provides information concerning its advisory services on the Internet is generally considered as holding itself out as an investment adviser subject to registration under the U.S. Investment Advisers Act of 1940 (the "Advisers Act"), the SEC will not view an adviser as holding itself out in the United States as an investment adviser if the adviser implements measures reasonably designed to guard against directing information provided on the Internet about its advisory services to U.S. persons. As above, the determination turns on the facts and circumstances of the particular case.
(ii) Purchases of Investment Company Shares with Credit Cards
The SEC this spring granted an exemptive order permitting a broker-dealer to accept credit cards as a form of payment for shares of an investment company regulated as a business development company under the 1940 Act.(7) The SEC staff, in granting an exemption from the prohibitions on arranging for an extension of credit for certain broker-dealers, indicated that the exemption was based on a number of representations by the applicant broker-dealer, including (1) credit card purchases of the fund's shares will only be permitted on or through the Internet; (2) a prominent "warning" will be displayed on the fund's Internet web site to discourage investors from carrying a balance on their credit cards as a result of the purchase of the fund's shares; (3) the broker-dealer will not compensate its employees on the basis of the fund's shares sold, and will not assess a commission or other transaction-related charge in connection with the purchase of the fund's shares; and (4) neither the fund nor the broker-dealer will be affiliated with any entity that issues credit cards.
(iii) Year 2000 Issues
In January, the SEC urged investment companies and investment advisers to consider their disclosure obligations relating to anticipated costs, problems and uncertainties associated with the Year 2000 issue.(8) The SEC stated at that time that if a company determines that it has material Year 2000 issues, based on the scope and severity of such issues with respect to its business, operations, or financial condition, without regard to related mitigating circumstances, then the impact of such issues, as well as the mitigating circumstances, should be disclosed.
The SEC recently superseded its guidance regarding these disclosure obligations,(9) and stated that whether Year 2000 issues are material depends upon the particular facts and circumstances for each investment company. Consideration should be given, for example, to whether Year 2000 issues effect an investment company's own operations, and its ability to obtain and use services provided by third parties, or its portfolio investments. Because many investment company operations are performed by external service providers, the SEC expects that investment companies would, as a matter of course, discuss Year 2000 issues with their various service providers and seek reasonable assurances from those service providers that they will address Year 2000 issues so as to allow the continuation of the services to the investment companies without interruption. As an example of potential disclosure, the SEC recommended that certain investment companies may find it appropriate to include disclosure about the costs of remedying their Year 2000 issues, any liabilities associated with these problems, or contingency plans to deal with disruptions that may occur when Year 2000 issues are encountered. Finally, the SEC emphasized that investment companies should avoid boilerplate disclosure that may not be meaningful to shareholders.
The SEC has taken several steps to gauge the preparedness of fund service providers for the Year 2000. The SEC recently proposed(10) a new rule and form under the Advisers Act that would require most registered investment advisers to file with the SEC status reports of their Year 2000 readiness. Proposed new Rule 204-5 under the Advisers Act would require the filing of two reports, each on proposed new Form ADV-Y2K. The first report would be filed no later than 30 days after the rule becomes effective, and the second report would be submitted not later than eight months from the date of the first filing.
The SEC also recently adopted a temporary rule and temporary rule amendments that would require non-bank transfer agents and certain broker-dealers, respectively, to file progress reports regarding their Year 2000 readiness. New temporary Rule 17Ad-18 under the Securities Exchange Act of 1934 requires non-bank transfer agents, and temporary amendments to Rule 17a-5 under the 1940 Act requires broker-dealers with a requisite net capital, to file two progress reports (by August 31, 1998 and April 30, 1999) containing a summary of the efforts of Year 2000 individuals.
Footnotes
* The author gratefully acknowledges the assistance of his colleague, Mark A. Sheehan, Esq., an associate with Stradley, Ronon, Stevens & Young, LLP, in the preparation of this article.
1. SEC Release Nos. IC-23011 (adopting release) (1/28/98) and 33-7380 (proposing release) (1/21/97).
2. SEC Release Nos. IC-23064 (adopting release)(3/13/98) and IC-22528 (proposing release)(2/27/97).
3. SEC Release No. IC-23065 (3/13/98).
4. SEC Release No. IC-22658 (5/12/97).
5. SEC Release No. IC-23201 (5/21/98).
6. SEC Release No. IC 33-7516 (3/23/98).
7. Technology Funding Securities Corp. (5/20/98).
8. Staff Legal Bulletin No. 5 (Revised January 12, 1998).
9. SEC Release No. IC-23366 (8/4/98).
10. SEC Release No. IA-1728 (6/28/98).
This article is reprinted with permission of the International Financial Law Review. The article first appeared in their Fund Management Guide 1998.
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