chapter 3 regulation and disclosure for mutual funds viewing recommendations for windows: use the...

Chapter 3

Regulation and Disclosure for Mutual Funds

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Copyright © Houghton Mifflin Company. All rights reserved. 3–2

Taxation

• Internal revenue code– Specifies income distribution requirements for tax

pass-through status (of mutual funds)

• Tax pass-through entities must distribute to shareholders almost all dividends, interest, and net capital gains realized– Fund shareholders have little control over timing of

realization or taxation of capital gains

– SEC requires mutual funds (excluding money market funds) to disclose after-tax returns in fund prospectuses


Taxation (cont.)

• Transfer agent sends out annual tax statements to fund shareholders for income tax reporting


Disclosure and Advertising

• Required disclosure documents– Prospectus disclosing all material facts

– Statement of additional information (SAI)

– Annual and semi-annual fund reports

• Advertising rules include specifics regarding– Generic advertisements

– Tombstone ads

– Omitting prospectuses


Disclosure and Advertising (cont.)

• Procedures

– Prospectuses must be “cleared” through the SEC

– Sales literature must be filed with the NASD


Internet and Privacy

• Internet: improved communication and reduced paperwork costs

– SEC permits disclosure documents to be delivered electronically

– Fund complexes often also provide on-line • Account statements and transaction confirmations

• Newsletters

• Information about the fund complex

• Educational information and investment planning tools


Internet and Privacy (cont.)

• Privacy rules for individual customers of mutual funds– Privacy notice must be sent to customers

that explains policies and allows them to opt out of certain disclosures to others

– Different treatment of affiliates versus non-affiliates

– Updates must be sent annually or whenever a policy changes materially


Limits on Sales Charges

• Front-end loads – Paid by shareholders to the fund’s underwriter;

most are usually passed on to the selling broker-dealer or sales representative

– Maximum of 8.5% set by NASD

• Back-end loads – Paid by shareholders

– Contingent deferred sales charge (CDSC) declines over time


Limits on Sales Charges (cont.)

• 12b-1 fee

– Paid annually by the fund to a distributor of its shares

– Generally limited to 1% (100bp) per year

• Load waivers permitted if

– Disclosed in the prospectus

– Based on objective criteria


Limits on Portfolio Investments and Transactions with Affiliates

• Limits on investments– Mutual funds must focus investments on those

described in the prospectus

– Liquidity requirements force mutual funds to buy mainly securities of public companies traded on established markets

• Generally cannot hold >15% in illiquid securities• Money market funds generally have a limit of 10%

– Mutual funds must determine NAV each business day

– There are tight restrictions on the ability of mutual funds to issue debt securities or borrow money


Limits on Portfolio Investments and Transactions with Affiliates (cont.)

• Extensive prohibitions on transactions with affiliates

– Affiliates broadly defined to include • Anyone holding >5% of voting stock of a fund

or its manager

• Any entity if >5% of its voting stock is held by a fund or its manager

– SEC may issue exemptions


Independent Directors

• Selection of independent (“disinterested”) directors

– Definition of disinterested director recently relaxed by SEC

– Must make up at least 40% of a mutual fund board

– Nominated by incumbent independent directors and elected by fund shareholders


Independent Directors (cont.)

• Service of independent directors– May serve on boards of all funds in a complex (debate on

merits)

– Compensation and other data must be disclosed in fund proxy statements

• Best practices and new SEC rules– In 1999, Advisory Group recommended “best practices” for

directors

– In 2001, SEC adopted three sets of rules relating to independence of directors, incorporating certain of the best practices


Roles of Independent Directors

• Serve as “watchdogs” for fund shareholders

• Key role: negotiate and approve annual management contact with fund’s investment adviser

– Rarely fire a fund’s adviser

– May negotiate for lower fees and better services

• Approve all contracts with external service providers

• Approve all contracts with affiliated service providers


Legal Liabilities: Independent Directors and Management Companies

• Fund complexes are subject to a broad range of public and private actions– Most fund complexes have inside and outside counsel– Independent directors usually retain independent legal

counsel and auditors

• SEC may bring enforcement actions against funds, their advisers and their directors for material violations of securities laws

• NASD may bring disciplinary proceedings against any member firm or employee thereof for material violations of fund advertising or sales rules


Legal Liabilities: Independent Directors and Management Companies (cont.)

• Fund shareholders may bring individual or class actions for

– Material misrepresentations or omissions in their fund’s prospectus

– Fraud or manipulation in connection with the trading of securities

• Fund shareholders may also bring suits for

– Alleged breaches of fiduciary duty

– Excessive management fees


Ethical Codes

• Mutual fund regulation requires that every mutual fund complex adopt and enforce a Code of Ethics

– Represent a form of self-regulation

– Often go beyond the restrictions in federal securities laws

– Complexes are given considerable leeway in fashioning and implementing an appropriate Code


Ethical Codes (cont.)

• Required criteria for a Code of Ethics– Must be designed reasonably to prevent fraudulent and

manipulative practices– Must require “access persons” to file reports on personal

trading– Must include reasonable procedures for a complex to

maintain records of personal trading and enforce provisions of the Code

– The Code and material changes must be approved by the directors

– Statement of Additional Information for a fund must disclose the adoption of a Code of Ethics and whether the Code permits access persons to engage in personal trading


Ch. 3 Class Exercise: Designing a Short-Form Prospectus

1. What are the key pieces of information an investor needs to decide whether to invest in a fund?

2. How would you report fund performance? Which time periods would you choose, and why? Do you think funds should be required to compare past performance with a benchmark? How do you recommend that performance numbers be updated?


Ch. 3 Class Exercise: Designing a Short-Form Prospectus (cont.)

3. How do you recommend that the Profile disclose the risks associated with investing in the fund, so that prospective investors could compare the relative risks of different funds?

4. What fees should the fund company be required to disclose? Would you require that all fees that appear in the full prospectus also appear in the Profile?



5. What information does the investor need to know about the process of purchasing or selling shares of the fund? And what other information does the investor need regarding the logistics of doing business with the fund company?

6. In your opinion, should the Profile be distributed to prospective investors in lieu of the Section 10(a) prospectus? Or should the Profile always be accompanied by the more detailed prospectus?



7. Do you think all fund companies should be required to distribute Profiles in the same format (with the same questions)? Or should there be different rules for different types of funds, such as money market versus bond versus stock funds?

8. Should there be special types of Profiles for investors in mutual funds used in 401(k) plans, as compared to retail investors? Should fund Profiles be allowed to be displayed on the Internet?


Ch. 3 Class Exercise: Evaluating a Profile Prospectus

1. Is the description of investment objectives and strategies adequate for investors? Should a fund be required to disclose every category of investment that could constitute more than 5% of the assets of the fund?

2. Would you add anything to the disclosure on risks of particular fund investments? Should the bar graph be expanded to include quarterly or semi-annual performance?


Ch. 3 Class Exercise: Evaluating a Profile Prospectus (cont.)

3. Should the SEC require the inclusion of the S&P 500 index in Profiles for all stock funds? Should the Profile include other benchmarks for performance (e.g., a Treasury bond rate)?

4. Does the Profile contain sufficient information on fees, expenses and taxes for investors? In the Profile, should the example of a $10,000 fund investment and the bar chart of total returns as well as the table of average annual returns reflect the investor’s payment of sales loads?



5. What should be disclosed if a fund is managed by 2, 3, or 4 portfolio managers? What happens if a new portfolio manager for the same company takes over a fund?

6. Could a Profile include all stock funds in the same complex? Could the Profile provide the same information to address subjects 6, 7, 8, and 9 for all funds?



7. Should a fund sponsor be permitted to publish a Profile as a newspaper advertisement together with an application to purchase the fund? Should a fund sponsor be allowed to send the Profile along with advertising material to a prospective investor?

8. What if an investor sues the fund sponsor because he or she was misled on the theory that an item of information appeared in the full prospectus, but not in the Profile? Should the fund sponsor be protected if it sends all investors a full fund prospectus along with the confirmation of purchase?

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