T (SEC) adopted new rules recently that changes take effect on - - PDF document

December 2003

New Disclosure Rules Impose Additional Requirements

• n Mutual Fund Advertisements

By William M. Uptegrove, Esq.

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he Securities and Exchange Commission (“SEC”) adopted new rules recently that will change the way mutual funds disclose

• information. In the wake of Canary Capital

Partners’ $40 million settlement with the Attorney General of New York, Elliot Spitzer, the SEC has been under increasing pressure to halt the perceived abuses in the mutual fund industry. The SEC’s new requirements likely represent only the first salvo in the battle to reform the industry, and constitute important changes that will impact mutual fund managers and investors alike. The amendments primarily modify two rules promulgated under the Securities Act of 1933 (the “Act”). First, the SEC amended Rule 482, which permits funds to advertise more freely than other issuers by allowing them to omit certain information contained in their statutory prospectuses. Rule 482 has been amended to encourage more complete and timely disclosures and to make it easier for investors to access and understand the information provided by funds. Second, the SEC rescinded Rule 134 as it applies to mutual funds. Prior to its rescission, Rule 134 allowed funds to advertise a broad range of information in “tombstone” ads. Both of these changes take effect on March 31, 2004, so it is important for funds to prepare to implement changes now.

Mutual Fund Advertisement Rules Prior to the Amendments

The federal securities laws mandate what any company must disclose during the registration

• process. To protect the investing public, Congress

passed the Act, which has two basic objectives: (1) to provide investors with accurate information regarding securities that are offered for sale and (2) to prohibit fraudulent practices during the offer or sale of securities. With these goals in mind, section 5 of the Act places certain constraints on individuals engaged in the offer or sale of

• securities. Section 5 requires the filing of a

registration statement with the SEC prior to any public offering. Once the registration statement is filed, a statutory waiting period commences. During the waiting period, section 5 of the Act prohibits the distribution of any written material unless it complies w ith the prospectus requirements of section 10 of the Act. To comply w ith section 10(a), an issuer must comply with a lengthy list of disclosures. These disclosure requirements make it difficult for issuers to advertise at all during the “w aiting period,”

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. . . the SEC is stepping up its scrutiny

• f mutual funds.

because the Act defines “prospectus” broadly (to include radio and television). While the Act defines “prospectus” broadly, section 2(a)(10)(b) provides some relief by excluding certain communications from that

• definition. Rule 134 implements this exception,

providing a safe harbor for ads that conform to its

• requirements. Rule 134 lists twelve categories of

information that may be provided in a “tombstone” ad without contravening the mandates of the Act. These categories include, among other things, the issuer’s name, the issuer’s type of business, and the price of the securities to be offered. Over the years, Rule 134 has been broadened and, prior to the SEC’s recent amendment, mutual funds were permitted to advertise a broad range of information under the Rule. Notwithstanding the broadening interpretation, significant restrictions remained. Rule 482, promulgated under the Act, attempted to alleviate these restrictions by permitting specific investment companies to advertise more freely, while still complying with the Act’s prospectus requirements. Originally, Rule 482 restricted advertisement content to information the “substance of which” was included in the statutory prospectus. Congress later expanded the scope of permissible advertising to include information not encompassed by the statutory prospectus requirements, so long as that information would not be materially false or misleading.

Requirements Under the Amended Rules

The SEC’s recent rule changes implement Congress’s more flexible advertising standard, while imposing new disclosure requirements on mutual

• funds. These changes are in recognition that, in

many ways, investment companies -- mutual funds in particular -- differ from other entities regulated under the Act. Unlike other issuers, the offering process of a mutual fund is continuous. The continuous nature

• f the offering process effectively prohibits any

dissemination of written material to investors.

“Substance of Which” Requirement

New Rule 482 eliminates the “substance of which” requirement, permitting funds to include a wider range of information in their advertisements. That is, the new rule provides greater flexibility by permitting funds to use a section 10(b) summary prospectus in lieu of providing information the substance of which is included in the section 10(a) statutory prospectus. Although this change provides flexibility, funds must remain cautious when advertising. The elimination

• f the “substance of which” requirement does not

alter a fund’s liability for making false or misleading

• statements. Funds remain subject to liability for fraud

under section 12(a)(2) of the Act and to the general anti-fraud provisions of the federal securities laws. In addition, funds still must file their advertisements with NASD Regulation, Inc. (NASDR) or the SEC, and the NASDR rules regulating fund advertisements will continue to apply. Given the current environment, and the SEC’s stress on using the anti-fraud provisions to protect investors, funds must prepare their advertisements with great caution

• r risk costly litigation.

Elimination of the Tombstone Safe Harbor

The elimination of the “substance of which”

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requirement has, in the view of the SEC, made the “tombstone advertisement” safe harbor superfluous, as applied to mutual funds. Therefore, the SEC rescinded provisions of Rule 134 that had permitted investment companies to include a broad range of information in tombstone advertisements. While Rule 134 will remain effective for other issuers, investment companies may no longer rely on it.

Elimination of “Boilerplate” Disclosures

The SEC intends to make fund disclosures more intelligible by eliminating the requirement that funds provide certain information in their

• advertisements. The SEC expects the elimination
• f certain prospectus information, such as

boilerplate disclosures about how performance is calculated, to improve investors’ understanding of the information they do receive.

Availability of Up-to-Date Information

The SEC plans to eliminate the “selective use” of information by making more current information available to investors. Previously, mutual fund advertisements could indicate a fund’s performance for a certain period, and therefore, according to the SEC, suggest to potential investors that such past performance was reasonable prediction of future

• performance. Rule 482 allowed a mutual fund to

advertise its performance for any period as long as it provided the fund’s performance for 1-, 5-, and 10- year periods (or, if shorter, for the life of the fund) current to the most recent quarter. That quarterly data, however, could be as much as three months old. This three month gap concerned the SEC. During that gap, a fund’s advertisements could tout its strong past performance, without disclosing more recent poor performance. The amended Rule 482 addresses this concern by requiring funds that advertise performance information to make available total return quotations current to the most recent month-end. These additional disclosures must be accessible to investors, via a toll-free (or collect) telephone number or website, within three calendar days of the applicable month-

• end. The SEC hopes that by giving investors more

current information, it will enhance investor protection and prevent unrealistic expectations about future performance.

Specific Required Disclosures

In addition to making funds’ advertisements more understandable and timely, the SEC amended Rule 482 to require specific disclosures when funds advertise performance figures. Presently, Rule 482 requires funds that advertise to disclose:

·

a source from which an investor may obtain a prospectus containing more complete information about the fund;

·

that the performance data quoted represents

• nly past performance; and

·

for a non-money market fund, that the investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Amended Rule 482 requires that funds provide additional, and more conspicuous, information when using advertisements containing performance

• figures. The new rule requires:

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·

a statement that past performance does not guarantee future results;

·

a statement that current performance may be lower or higher than the performance quoted;

·

additional disclosures that direct investors’ attention to the fund’s investment objectives, risks, and charges and expenses; and

·

more prominent disclosures of important information in fund advertisements, such as the dates in which the quoted performance

• ccurred.

The SEC believes that these changes will help investors better understand historical performance.

What New Rule 482 Means For Mutual Funds

Mutual funds should not take the view that the SEC, by permitting more flexibility in advertising, is taking a more hands-off approach toward them. To the contrary, the SEC is stepping up its scrutiny of mutual funds. Indeed, the SEC has made it a point to state explicitly that the Act’s antifraud provisions continue to apply to all disclosures, despite the increased latitude permitted by the rule

• amendments. In light of the current inquiry into

alleged misconduct by the mutual fund industry, the SEC will likely increase its use of these anti-fraud

• provisions. In many respects, Rule 482’s new, more

flexible standard permits mutual funds to include additional information at their peril. Although a fund can now provide more information than it did in the past, it must do so cautiously. Funds should always seek legal advice prior to disseminating any information to the investing public.

Further Rulemaking Expected

In response to growing public pressure for the SEC to strengthen its role as the investors’ “watch dog,” the SEC will likely increase its regulation of the mutual fund industry. In the near future, fund managers should expect to see new rules designed to give investors more information about fees, portfolio turnover rates, portfolio managers’ compensation, and revenue-sharing payments to brokerage firms. For additional information on this or any other securities litigation matter, please contact Lawrence M. Rolnick, Chair of Lowenstein Sandler’s Securities Litigation and Enforcement Practice Group, at 973- 597-2468 or lrolnick@ lowenstein.com. You can also contact William M. Uptegrove, a member of the firm’s Securities Litigation and Enforcement Practice Group, at 973-422-6424 or wuptegrove@ lowenstein.com.

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