On August 5, 2020, the Securities and Exchange Commission (SEC) announced proposed modifications (the Proposed Rule)1 to the disclosure framework for mutual funds and exchange-traded funds (ETFs) registered on Form N-1A (open-end funds) intended to better serve the needs of retail investors by highlighting key information. This Legal Alert focuses on the two proposed modifications that will impact business development companies (BDCs). First, the proposal would revise current requirements for open-end funds to disclose the “acquired fund fees and expenses” (AFFE) associated with investments in other funds (e.g., BDCs). Open-end funds that invest 10% or less of their total assets in other funds (acquired funds) would be permitted to omit the AFFE line item from the prospectus fees and expenses table that is a part of the fund’s bottom line ongoing annual fees. Instead, such funds could provide AFFE information in a footnote to the prospectus fees and expenses table. Second, the proposal would amend investment company advertising rules to promote more transparent and balanced statements about investment costs. The proposed advertising rule amendment would affect all registered funds and BDCs.
A copy of the Proposed Rule is available
here. The SEC will accept comments from all interested parties on the Proposed Rule for 60 days following the Proposed Rule’s publication in the Federal Register.
Background
In 2006, the SEC approved the acquired fund fees and expenses rule (the AFFE Rule) which requires registered funds, such as open-end funds, that invest in other funds to include a separate AFFE line item in the fees and expenses table contained in their prospectus. The separate AFFE line item must include the registered fund’s pro rata share of the “acquired fund’s” expenses (including interest expense), which is then added to the registered fund’s overall expense ratio. Such disclosure requirements have no impact on the financial statements of registered funds, including their net asset value per share calculations (i.e., it only impacts the disclosure in the fees and expenses table). In early 2014, Standard & Poor’s (S&P) and FTSE Russell removed BDCs from their indexes due to concerns cited by the indexes, including expense ratios of BDCs.
Enhancements to prospectus disclosure of fund fees and risks
The proposal would amend open-end fund prospectus disclosure requirements to help investors more readily understand fund fees and risks, which investors have identified as two areas that are critically important in assessing a prospective fund investment, and yet often can be complex and confusing. Using layered disclosure principles, the proposal would tailor disclosures of these topics to different types of investors’ informational needs. The proposal would, in part, (1) replace the existing fee table in the summary section of the statutory prospectus with a simplified fee summary, (2) move the existing fee table to the statutory prospectus, for use by investors seeking additional details about fund fees, and (3) replace certain terms in the current fee table with terms that may be clearer to investors.
As discussed above, the proposed modifications would revise the AFFE Rule to disclose AFFE in a footnote rather than as a line item in the prospectus fees and expenses table so long as no more than 10% of the open-end fund’s total assets are invested in other funds. Open-end funds that invest more than 10% of their total assets in acquired funds would continue to present AFFE as a line item in the prospectus fees and expenses table and include AFFE in the bottom-line expense figure. A fund that was eligible to include AFFE presentation in a footnote would have to include: (1) the amount of the fund’s AFFE, and (2) a statement that the fund’s total ongoing annual fees in the table and fee summary would be higher if these fees and expenses were included.
As of now, the proposal is limited to AFFE disclosure requirements in Form N-1A but the SEC has requested comment as to whether the SEC should similarly amend the AFFE disclosure requirements in Form N-2 for closed-end funds. The proposal cites comments previously received by the SEC on the AFFE Rule. The proposal includes the following requests for comment as to whether the proposed amendments address such concerns, or if funds should be allowed to exclude fees and expenses from BDC investments in AFFE disclosure:
- Commenters have expressed particular concern about AFFE disclosure’s impact on BDC investments. Would our proposed amendments address these concerns? Why or why not? If not, how could we address these concerns? Should we, as some commenters suggested, allow funds to exclude fees and expenses from BDC investments in AFFE disclosure? If so, why should BDC fees and expenses be excluded when other types of acquired funds that may have similar strategies, nature of expenses, and portfolio holdings are included?
- Should we amend AFFE disclosure requirements in Forms N-2, N-3, N-4, and N-6 for other types of investment companies? If so, should we modify these requirements in the same manner as the proposed amendments to Form N-1A, or are there changes we should make to recognize differences between registrant types?
In addition, SEC Commissioner Allison Herren Lee has requested comment to see how to best address a situation where an open-end fund invests slightly below 10% in funds with high expense ratios as compared to an open-end fund that invests slightly above 10% in funds with low expense ratios.
2 SEC Commissioner Hester M. Peirce has requested comment as to whether all AFFE should be footnoted and whether other fees should also be footnoted in order to simplify the shareholder reports.
3
Fee and expense information in investment company advertisements
The Proposed Rule would require that presentations of investment company fees and expenses in advertisements and sales literature are consistent with relevant prospectus fee table presentations and are reasonably current. As a result of investment companies competing amongst themselves on the basis of cost, the SEC is concerned that investment company advertisements may mislead investors by creating an inaccurate impression of the costs associated with that investment. These amendments would affect all registered fund and BDC advertisements. Under the proposed amendments, investment company fee and expense presentations in advertisements would have to include timely and prominent information about a fund’s maximum sales load (or other nonrecurring fee) and gross total annual expenses, based on the methods of computation that the company’s registration statement form prescribes for a prospectus. In addition, the SEC is also proposing to amend rule 156 under the Securities Act of 1933, as amended, to add factors that an investment company should consider to determine whether representations in its advertisements about the fees or expenses associated with an investment in the fund could be materially “misleading, 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.”
4 Such factors will be used to evaluate a particular description, representation, illustration or other statement based on the context in which it was made. Similar to the current rule 156, the proposed amendments will apply to all investment company sales literature.
What these modifications could mean for BDCs
As a result of these changes, index providers may consider permitting BDCs to return to their various indexes. The SEC acknowledged the detrimental effect of the AFFE Rule on BDCs by citing various comment letters received from BDC industry participants, and stated that the proposed modifications to the AFFE Rule could lead to an increase in capital formation by BDCs.
5 The SEC further acknowledged that “changes in the prospectus fee disclosure could affect the willingness of index providers to include funds in their indexes or of funds to invest in other funds, as some commenters have indicated.” If the proposed amendments encourage open-end funds to increase their investments in acquired funds, that could, in turn, stimulate capital formation for the types of companies in which the acquired funds invest. For example, to the extent the proposal would result in open-end funds investing more in BDCs, the proposal could potentially enable BDCs, a significant funding source for U.S. middle-market companies, to make greater investments in such middle-market companies. How the index providers may react to the proposed modifications to the AFFE Rule remains to be seen, but the Proposed Rule is a welcome first step in addressing the reasons previously cited by S&P and FTSE Russell upon the removal of BDCs from their indexes.
Conclusion
In conclusion, the Proposed Rule could have a significant impact on the market for BDCs. The modifications to the AFFE Rule provide BDCs with a potential path back into various indexes, which could result in greater institutional ownership, increased market depth and liquidity for investors and greater third-party research coverage. With respect to the Proposed Rule’s revisions to investment company fees and expenses in advertisements, BDCs and their advisers should be prepared to review and update their policies and procedures, as well as the related sections of their compliance manuals, to comply with the requirements of the Proposed Rule.
We will discuss the impact of the Proposed Rule on open-end funds in a separate forthcoming Legal Alert.
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1 Tailored Shareholder Reports, Treatment of Annual Prospectus Updates for Existing Investors, and Improved Fee and Risk Disclosure for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Rel. Nos. 33-10814; 34-89478 (August 5, 2020).
2 Public Statement, Commissioner Allison Herren Lee, Statement on Proposed Summary Shareholder Report (Aug.
5, 2020) (“Lee Statement). A copy of the Lee Statement is available here.
3 Public Statement, Commissioner Hester M. Peirce, Statement on Tailored Shareholder Reports (Aug. 5, 2020)
(“Peirce Statement). A copy of the Peirce Statement is available here.
4 Proposed Rule at 481.
5 See, e.g., Comment Letter of Small Business Investor Alliance (Apr. 30, 2019) on File No. S7-27-18 (stating that AFFE disclosure distorts an acquiring fund’s expense ratio and has disproportionately harmed BDCs because this disclosure requirement has led to funds no longer investing in BDCs and several index providers dropping BDCs from their indexes); Comment Letter of TPG Specialty Lending, Inc. (May 2, 2019) on File No. S7-27-18; Comment Letter of Coalition for Business Development (May 2, 2019) on File No. S7-27-18; Comment Letter of Alternative Credit Council (May 2, 2019) on File No. S7-27-18 (stating that AFFE disclosure overstates the costs of a fund investing in a BDC because it essentially requires double-counting of a BDC’s operating expenses and that because AFFE disclosure has effectively resulted in funds no longer investing in BDCs, it has restricted the market for BDCs, limited institutional ownership of BDCs, and reduced investor choice); ICI Comment Letter I.
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