On August 5, 2020, the Securities and Exchange Commission (SEC) proposed significant changes (the Proposed Changes), including new Rule 498B,¹ to the disclosure framework for mutual funds and exchange-traded funds (ETFs) registered on Form N-1A (open-end funds).² The Proposed Changes are intended to establish a disclosure framework that highlights information the SEC believes to be particularly important for retail investors to assess and monitor their fund investments. The central components of the Proposed Changes are:

1. The abbreviation and overhaul of the shareholder report that is delivered to open-end fund investors (Shareholders) to make such reports more concise and visually engaging.³
2. The elimination of the requirement to provide Shareholders with annual prospectus updates, leaving the shareholder report to serve as the central source of fund disclosure for existing Shareholders.
3. The elimination of the ability of open-end funds to rely on recently adopted Rule 30e-3, which would have allowed open-end funds to transmit shareholder reports electronically. Consequently, under the Proposed Changes, unless shareholders affirmatively elect electronic delivery, the revamped shareholder reports would have to be mailed.⁴

Background

Under the established disclosure framework for open-end funds, Shareholders receive multiple disclosure documents over the course of their investment in a fund, including:

• a registration statement and prospectus (either a summary prospectus or full, statutory prospectus)⁵ upon the initial purchase of fund securities;
• an updated summary prospectus or statutory prospectus each year;⁶
• an annual shareholder report that includes detailed information about the fund’s operations over a full-year period, such as fund performance, fund holdings, and financial statements;
• a semi-annual shareholder report that includes similar but less comprehensive information than the annual report over the intermittent half-year period; and
• prospectus supplements during the course of the year notifying Shareholders of material new information about the fund.

In 2018, the SEC launched an “investor experience initiative” that, in part, solicited comments on retail investors’ experience with this disclosure framework.⁷ As a result of the initiative, the SEC concluded that many fund Shareholders would prefer to receive a smaller volume of fund disclosures each year, that the vast majority of individual investors would prefer summary disclosure (over comprehensive disclosure) with additional information available online or upon request and that most investors view fund shareholder reports as difficult to understand.⁸ The Proposed Changes are the result of the SEC’s findings.

Shareholder report contents

Following is a summary of certain key features of the new shareholder report, considered as part of the disclosure framework envisioned by the Proposed Changes.⁹

• Shorter, more graphical shareholder report. Under the Proposed Changes, the shareholder report would be shortened and made “visually appealing.”¹⁰ Information such as fund expenses, performance, a graphical list of portfolio holdings and, for the annual report, the discussion of the matters that materially affected fund performance would remain, but funds would be encouraged to display this information through graphics, tables and bullets in order to highlight the information that the SEC considers critical for retail investors to focus on in a more concise and understandable form. Other elements of a traditional shareholder report would be made available online, and upon request, on Form N-CSR and N-CSRS.¹¹
• Restrictions on content. Under the Proposed Changes, shareholder reports would not be permitted to incorporate by reference information contained in other filings. Further, open-end funds would only be allowed to include information explicitly permitted or required by new N-1A Item 27A in the shareholder report. This restriction represents a detour from current practice in that funds have historically included additional information such as letters from the president and interviews with portfolio managers. However, if additional disclosure is necessary to avoid making other disclosure misleading in light of changes to the fund during the year, such as a change in investment policies, additional information is permitted. For example, expense, performance or holdings information may be misleading without such additional disclosure. Under the new Item 27A, inapplicable disclosure can be omitted and required legends or narratives can be modified to avoid being misleading.
• New section on fund statistics. A new section describing fund statistics (e.g., net assets, total number of portfolio holdings and portfolio turnover rate) would be included in the shareholder report.
• New section on material fund changes. The annual¹² report would include a new section regarding material fund changes that have occurred since the beginning of the reporting period and that the fund expects to make in its upcoming annual prospectus update. The SEC believes that this would help to ensure that material changes are readily apparent to Shareholders and achieve its goal of making the shareholder report the primary source of information and updates to existing mutual fund and ETF shareholders. Under the proposal, the fund would be required to briefly describe a material change with respect to any of the following items: the fund’s name; investment objective or goals; increase in fund ongoing annual fees; transaction fees or maximum account fee; principal investment strategies; principal risks; investment adviser or sub-adviser; portfolio manager; and any other material changes. Material changes would be disclosed to Shareholders in each annual report and also in timely notifications to Shareholders as they occur through a prospectus sticker, a notice required by the Proposed Changes, or the annual prospectus update (which would no longer be mailed to existing Shareholders annually).
• Management discussion of fund performance. Management discussion of fund performance would be retained in the annual report, but this information would only summarize factors that materially affected fund performance.¹³ Since the delivery of shareholder reports would replace the annual delivery of prospectuses, the Proposed Changes would add to the disclosure of management’s discussion of fund performance certain information that currently appears in a fund’s prospectus, including average annual total returns (with and without sales charges), class-specific performance and average annual total returns of relevant benchmarks. For these purposes, the Proposed Changes would also amend the definition of an “appropriate broad-based securities market index” to clarify that the term refers to an index that tracks the overall applicable domestic or international equity or debt securities market, rather than a more narrowly based index. If a fund provides updated performance information on its website, the SEC proposed that funds provide instructions on locating and accessing that information (e.g., in the form of a hyperlink).
• Shareholder expense presentation. The two $1,000 expense examples based on actual returns and hypothetical returns, currently required in shareholder reports, would be replaced with a single simplified $10,000 expense example based on actual returns that disaggregates the fund’s total return and costs paid during the period, with expenses presented as a dollar amount and as a percentage of the Shareholder’s investment in the fund. ETFs would also disclose returns based on net asset value and on market value.
• Liquidity risk management disclosure. The discussion of the operation and effectiveness of a fund’s liquidity risk management program currently required in fund shareholder reports would be replaced with a brief summary of (1) key factors or market events affecting the fund’s program during the reporting period, (2) key features of the program and (3) effectiveness of the program over the past year.¹⁴
• Removal of management information table. The table wherein a fund has in the past disclosed information about its management (including, name, address, age, position held with the fund and term of office and length of time, among other information) is proposed to be removed from the shareholder report requirement, and would also not be included on Form N-CSR.¹⁵

Shareholder report logistics

• Primacy of shareholder report as source of fund disclosure for existing shareholders. Instead of receiving both an annual prospectus update and shareholder reports, Shareholders would receive only the annual and semi-annual shareholder report. Initial purchasers of fund securities would continue to receive a statutory prospectus or summary prospectus.
• Electronic presentation. The SEC’s proposed instructions to the form requirement governing the contents of shareholders reports to allow shareholder reports to be further modified for electronic presentation when reviewed on mobile devices or computers.
• Open-end funds excluded from recent electronic delivery rules. Under the Proposed Changes, open-end funds would be excluded from recently adopted Rule 30e-3,¹⁶ so that, absent a shareholder election of electronic delivery, paper copies of shareholder reports would still need to be delivered pursuant to 1940 Act Rule 30e-1.¹⁷ Under Rule 30e-3’s extended transition period, a fund may at the earliest begin transmitting notices (rather than full shareholder reports) pursuant to the rule beginning January 1, 2021. The SEC reasoned in the Proposing Release that if open-end funds were not excluded from Rule 30e-3, Shareholders in an open-end fund would no longer directly receive shareholder reports or annual prospectus updates, and thus would not be sent paper copies of any periodic regulatory disclosure documents, following effectiveness of the Proposed Changes.
• Separate shareholder report for each series. Under the Proposed Changes, open-end funds would issue a shareholder report for each fund in the series, rather than collectively. A fund would be required to prepare a separate shareholder report for each of its series. As a result, Shareholders would receive reports that address only the series in which they are invested. This is similar to the current general requirement that fund families present summary information separately for each fund in a multiple fund prospectus, but it also a deviation from common practice for fund families, which often file a single shareholder report for numerous funds in a family.¹⁸
• Changes to N-CSR. Almost all of the information being excluded from shareholder reports pursuant to the Proposed Changes would instead be filed on Form N-CSR. This information must be available upon request and free of charge, and must also appear on the fund’s website. Importantly, audited annual and unaudited semiannual financial statements would be filed with Form N-CSR rather than shareholder report. As a result, the Proposed Changes would eliminate the ability of open-end funds to provide a summary schedule of investments rather than full schedule of investments. For ETFs, the Proposed Changes amend Item 13(a) of Form N-1A to require an ETF to disclose its total return based on the ETF’s per share market value return as of the end of the period (and provide instructions for how to calculate).

Timing

The SEC will accept comments from all interested parties on the Proposed Changes for 60 days following the Proposing Release’s publication in the Federal Register. We expect a significant number of comments to be submitted on the Proposed Changes, which represent a seismic shift in disclosure reporting obligations for fund complexes.

Commentary

Eversheds Sutherland will be closely monitoring developments with the Proposed Changes and their potential impacts on registered funds. We expect that most fund complexes will be supportive of the proposed elimination of the annual prospectus update requirement and of the abbreviation of the shareholder report, both of which figure to create significant costs savings for fund complexes in the long term. However, we expect that the elimination of the ability of open-end funds to rely on Rule 30e-3 is likely to encounter opposition.

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