SEC Adopts Summary Prospectus Rules

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1 Issue 4, Fourth Quarter 2009 A summary of mutual fund regulatory updates for the third quarter of 2009 SEC Adopts Summary Prospectus Rules The stated purpose of the amendments is to provide key fund information to investors in more streamlined, userfriendly format and to enhance the method of delivering more in-depth information to investors. On January 13, 2009, the Securities and Exchange Commission (SEC) adopted amendments to Rule 498 under the Securities Act of 1933 (1933 Act) and Form N-1A, the form used by mutual funds to register under the Investment Company Act of 1940, as amended (1940 Act). As mutual funds prepare for their registration statement annual updates in the coming year, it is important to consider the new rule requirements that affect the format and content of the information presented in mutual fund prospectuses, implement a new summary prospectus delivery option and detail specific technological requirements for electronic versions of registration statement documents. Summary Sections The amendments to Rule 498 and Form N-1A require that each mutual fund include a summary section at the front of its statutory prospectus containing the following key fund information: 1) investment objectives/goals; 2) fee and expense tables; 3) principal investment strategies, principal risks and performance table; 4) management information; 5) purchase and sale information; 6) tax information; and 7) financial intermediary compensation information. This Regulatory Administration Digest Newsletter is provided for informational and educational purposes only and is not accounting, legal or tax advice, opinion or a substitute for the advice of your legal counsel or other professional advisors.. According to the amendments, the summary section must present the aforementioned information in accordance with the SEC s plain English guidelines in the standardized order indicated and cannot omit required information or include additional information other than that specifically prescribed by the rule. The amendments state that a summary section may cover multiple share classes of a single fund; however, a mutual fund must provide a separate summary section for each individual fund covered by a multiple fund statutory prospectus. If purchase and sale, tax and financial intermediary compensation information is identical for multiple funds that appear within the same statutory prospectus, then this information may be presented in an integrated section that immediately follows the presentation of the individual fund summary sections. A statement directing investors to the location of the integrated information must appear in each individual summary section where the integrated information would have appeared. PAGE 1 OF 9

2 Summary Prospectus Delivery Option Additionally, the amendments to Rule 498 permit mutual funds to satisfy the prospectus delivery requirements of Section 5(b)(2) of the 1933 Act by sending shareholders a summary prospectus in hard copy or via in lieu of the more detailed statutory prospectus and by providing the statutory prospectus online. The amendments dictate that the summary prospectus must contain the same information in the same order as the summary section and must also include the following information on its front cover page: 1) the fund s name and the class or classes, if any, to which the summary prospectus relates; 2) the exchange ticker symbol of the fund s shares, or if the summary prospectus relates to more than one class of fund shares, the exchange ticker symbol of each class adjacent to the class to which it relates; 3) a statement identifying the document as a summary prospectus ; 4) the approximate date of first use; and 5) the following legend: Before you invest, you may want to review the Fund s prospectus, which contains more information about the Fund and its risks. You can find the Fund s prospectus and other information about the Fund online at [ ]. You can also get this information at no cost by calling [ ] or by sending an request to [ ]. The amendments require a summary prospectus contain all of the information, and only that information, required in the corresponding summary section of the statutory prospectus in the prescribed order, except that a summary prospectus may omit the required explanation regarding a change in the fund s broad-based securities index. According to the amendments, similar to the statutory prospectus, the summary prospectus may incorporate certain information by reference. A summary prospectus may incorporate by reference information contained in its statutory prospectus, statement of additional information (SAI) and/or shareholder reports. A fund may not incorporate by reference into the summary prospectus information from any other source, any information required to be included in a summary prospectus or any information that is incorporated by reference into the statutory prospectus, SAI and/or shareholder reports. Delivery Requirements Summary prospectuses: may be provided to shareholders electronically if prior consent has been obtained (consent for electronic delivery of a statutory prospectus is considered sufficient consent for electronic delivery of a summary prospectus); must be delivered at least at the same time as securities are purchased or confirmation of purchase is received; may not be bound with any other documents, including, but not limited to, privacy policies, account applications and wrappers (certain exceptions apply to variable annuity products); must be prominently placed on top of all other mailed materials; and PAGE 2 OF 9

3 must be posted on the fund website along with other fund documents. Mutual funds that opt to use the summary prospectus to satisfy the Section 5(b)(2) prospectus delivery requirement are required by the amendments to send the statutory prospectus in hard copy or via to shareholders upon request. Delivery of a summary prospectus is not currently mandated under the amended rules, however, the SEC has indicated that it may consider mandating summary prospectuses in the future. Technology Requirements For those funds that avail themselves of the summary prospectus delivery option outlined above, the SEC amendments also require that certain technology requirements are met when posting the required documents on the fund website. The electronic versions of the summary prospectus, statutory prospectus, SAI and shareholder reports must be in human-readable format that is capable of being printed on paper and downloaded, and permanently retained, in an electronic version. The electronic versions of the statutory prospectus and SAI must each contain a linked table of contents that permits users to move between each section heading in the table of contents and the corresponding section in each document. The electronic version of the summary prospectus must contain links (section-bysection, at the beginning and end of document, or continuously visible) that permit users to move back and forth between the summary prospectus, statutory prospectus and SAI. Filing Requirements A fund that decides to deliver a summary prospectus in lieu of the statutory prospectus must file the summary prospectus with the SEC no later than the date it is first used. Obama Administration Releases Financial Regulatory Reform Proposal The stated purpose of the proposal is to build a new foundation for financial regulation and supervision that is simpler and more effectively enforced, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial market. On June 17, 2009, the U.S. Treasury Department released the white paper titled A New Foundation: Rebuilding Financial Supervision and Regulation, outlining the Obama administration s financial regulatory reform proposal. The proposal outlines five key objectives: 1) to promote robust supervision and regulation of financial firms; 2) to establish comprehensive supervision of financial markets; 3) to protect consumers and investors from financial abuse; 4) to provide the government with the tools it needs to manage the financial crises; and 5) to raise international regulatory standards and improve international cooperation. A product of consultations among members of the President s Working Group on Financial Markets, members of Congress, academics, consumer and investor advocates, community-based organizations, business community, and industry and market participants, the proposal advocates a restructuring of the regulatory system. It proposes the creation of a Financial Services Oversight Council, chaired by Treasury and including the heads of the principal federal regulators as members, and a Consumer Financial PAGE 3 OF 9

4 Protection Agency, an independent entity dedicated to consumer protection in credit, savings, and payments markets. The Office of Thrift Supervision would be abolished and subsumed under the Office of the Comptroller of the Currency, which would be renamed the National Bank Supervisor, a single agency with separate status in Treasury to oversee federally chartered depository institutions. Additionally, the proposal advocates the creation of an Office of National Insurance within Treasury to promote national coordination in the insurance sector. Under the proposal, the Federal Reserve, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Securities Exchange Commission and the Commodity Futures Trading Commission would all maintain their current roles and responsibilities, with better synchronization of the statutory and regulatory frameworks for futures and securities. Treasury Temporary Guarantee Program for Money Market Funds Expires The U.S. Treasury Department s Temporary Guarantee Program for Money Market Funds, which provided uncapped coverage to shareholders for shares held in participating funds as of September 19, 2008, expired on September 18, All money market mutual funds regulated under Rule 2a-7 of the Investment Company Act of 1940, as amended, that had a market-based net asset value (NAV) of at least $0.995 on September 19, 2008 were eligible to participate in the program. The program could not extend beyond September 18, 2009, due to a provision in the Emergency Economic Stabilization Act of 2008 (the Act) that prohibits further use of the Act s funds for additional guarantee programs for the money market mutual fund industry. Newly Adopted SEC Rule Requires Disclosure of Money Market Fund Portfolio Holdings The intent of the Final Temporary Rule is to continue the SEC s ability to monitor certain money market funds under the expiring Guarantee Program while the June 2009 proposed regulatory changes to money market funds (as discussed on the next page) are under consideration. On the heels of the expiration of the U.S. Treasury Department s Temporary Guarantee Program for Money Market Funds (Guarantee Program) (see description above), and in an effort to maintain greater transparency for shareholders about the risks inherent to investing in money market funds, the Securities and Exchange Commission (SEC) has adopted an interim final temporary rule under the Investment Company Act of 1940, as amended (Final Temporary Rule or the Rule). The Final Temporary Rule, which became immediately effective on September 18, 2009, requires money market funds whose per share market-based net asset value (marketbased NAV) falls below $ to provide detailed weekly portfolio schedules and valuation information to the SEC. The Rule states that when a money market fund s market-based NAV first dips below $0.9975, the fund is required to provide its portfolio schedule in Microsoft Excel format to the SEC by no later than the next business day. Every week thereafter that the money market fund s market-based NAV remains below $0.9975, the fund must continue to report its portfolio schedule as of the last business day of each week to the SEC by no later than the second business day of the following week. The Final Temporary Rule is scheduled to expire on September 17, 2010 and the SEC has asked for comments by October 26, PAGE 4 OF 9

5 Comment Period Ends for SEC s Proposed Changes to Money Market Funds The proposed amendments are designed to strengthen significantly the regulatory framework for money market funds, increase their resilience to economic stresses and reduce the risk of runs on the funds. The comment period for proposed changes to money market mutual fund regulation ended on September 8, In the proposal, released on June 30, 2009, the Securities and Exchange Commission (SEC) outlined amendments to the rules that govern money market funds under the Investment Company Act of 1940, as amended (1940 Act). These amendments are generally consistent with the recommendations proposed by the Money Market Working Group of the Investment Company Institute (ICI) in March. The SEC s proposed amendments would tighten the risk-limiting conditions of Rule 2a-7 of the 1940 Act; require money market funds to report their portfolio holdings monthly to the SEC; and permit a money market fund that has broken the buck to suspend redemptions to allow for the orderly liquidation of fund assets. In tightening the risk-limiting conditions of Rule 2a-7, the proposed amendments would require increased portfolio quality and liquidity and limited portfolio maturity. The amendments would further limit the amount of credit risk exposure to which money market funds are subject by prohibiting the funds from investing in Second Tier securities, as defined in Rule 2a-7. The SEC proposal also seeks to limit portfolio maturity by, among other means, shortening the weighted average maturity limits for money market funds from 90 days to 60 days. Further, the amendments would require that funds provide in-kind redemptions to satisfy redemption requests in excess of a certain size. Comments from the industry have generally opposed moving money market funds to a floating net asset value rather than stabilized net asset values like other types of mutual funds. However, opinions vary regarding other issues, such as whether to ban acquisitions of illiquid and Tier 2 securities; shorten weighted average maturity limits; or require funds provide in-kind redemptions. The SEC is seeking comments on its proposed changes to money market fund regulation on or before September 8, The Federal Trade Commission s Red Flags Rule Deadline Extended to November 1, 2009 In July 2009, the Federal Trade Commission (FTC) extended the deadline for compliance with its Red Flags Rule to November 1, It did so after learning that a number of industries and entities within the FTC s jurisdiction expressed confusion and uncertainty about their coverage by and/or obligations under the rule. On November 7, 2007, the FTC, along with several other regulatory agencies, issued final rules and guidelines implementing Section 114 of the Fair and Accurate Credit Transactions Act of The rules implementing Section 114 require each financial institution or creditor to develop and implement a written Identity Theft Prevention Program to detect, prevent, and mitigate identity theft in connection with the opening of certain accounts or certain existing accounts (red flags rules). The program must include reasonable policies and procedures to identify, detect and respond to red flags, or to those patterns, practices, or specific activities that indicate the possible existence of identity theft. Implementation of a program, which requires action by a board or committee, was initially required by November 1, By definition, the entities subject to the red flags rules are creditors and financial institutions. A financial institution is defined as any of certain depository institutions, or any other person that, directly or indirectly, holds a transaction account (as defined in PAGE 5 OF 9

6 Section 19(b) of the Federal Reserve Act) belonging to a consumer. Initially, the industry believed that the red flags rules would not apply to mutual funds, as the only financial institutions that the FTC had jurisdiction over were state-chartered credit unions. In an attempt to clarify, the FTC issued a Business Alert in June 2008 saying its jurisdiction also included certain other entities that hold consumer transaction accounts, but the FTC did not specifically state whether or not mutual funds whether mutual funds would be subject to the red flags rules. On July 17, 2008, however, the Investment Company Institute (ICI) issued an Urgent Memorandum to investment companies indicating that investment companies with transaction accounts would be required to implement an identity theft prevention program in compliance with the FTC s red flags rules. Finally, in a How-To Guide issued in March 2009, the FTC indicated that mutual funds may be subject to the red flags rules, noting that [e]xamples of financial institutions under the FTC s jurisdiction are state-chartered credit unions, mutual funds that offer accounts with check-writing privileges, or other institutions that offer accounts where the consumer can make payments or transfers to third parties. On October 22, 2008, the FTC decided to delay enforcement of the red flags rules until May 1, 2009, stating that many entities had learned of the rule s requirements too late to be able to comply by the November 1, 2008 deadline. On April 30, 2009, the FTC announced a further delay in enforcement until August 1, 2009 to give creditors and financial institutions more time to develop and implement written identity theft prevention programs. Proposed Rules Enhancing Municipal Securities Disclosure On July 15, 2009, the Securities and Exchange Commission (SEC) unanimously voted to propose rule amendments to Rule 15c-12 of the Securities Exchange Act of 1934 designed to improve the quality and timeliness of municipal securities disclosure. According to SEC Chairman Mary Shapiro, [c]urrently there is a disparity between the level of information available to investors in municipal securities versus information available to investors in corporate securities. These proposals would help investors make more knowledgeable investment decisions about municipal securities, while at the same time enabling broker-dealers to satisfy their obligations with respect to municipal securities. Rule 15c2-12 was initially adopted to improve transparency and the availability of information in the municipal securities market. It prohibits brokers, dealers and municipal securities dealers from purchasing or selling municipal securities unless they reasonably believe that the state or local government issuing the securities has agreed to disclose such things as annual financial statements and notices of certain events. In particular, the following events, if material, require notice: 1) principal and interest payment delinquencies; 2) non-payment related defaults; 3) unscheduled draws on debt service reserves reflecting financial difficulties; 4) unscheduled draws on credit enhancements reflecting financial difficulties; 5) substitution of credit or liquidity providers, or their failure to perform; 6) adverse tax opinions or events affecting the tax-exempt status of the security; 7) modifications to rights of security holders; 8) bond calls; 9) defeasances; 10) release, substitution, or sale of property securing repayment of the securities; and 11) rating changes. While Rule 15c2-12 currently requires notice of the above referenced events if material, the proposed rule amendments would eliminate the need for a materiality PAGE 6 OF 9

7 determination, instead requiring notice of the following events regardless of materiality: 1) failure to pay principal and interest; 2) unscheduled payments from debt service reserves reflecting financial difficulties; 3) unscheduled payments by parties backing the bonds, a change in the identity of parties backing the bonds or their failure to perform, reflecting financial difficulties; 4) defeasances; and 5) rating changes. Some events, like bond calls, for example, would still be subject to a materiality determination. The SEC proposed amendments to Rule 15c2-12 would also increase the number of events for which notice would be required to include: 1) tender offers; 2) bankruptcy, insolvency, receivership or similar proceeding; 3) mergers, consolidations, acquisitions, the sale of all or substantially all of the assets of the obligated person or their termination and 4) appointment of a successor or additional trustee or the change of the name of a trustee, if material. Additionally, the proposed amendments would clarify the rule s provision for disclosure in a timely manner by requiring notice of events listed in the Rule 15c2-12 to be disclosed no more than 10 business days after the event. Comments on these proposed amendments to Rule 15c2-12 are due to the SEC on or before September 8, In the Matter of Evergreen Investment Management Company, LLC and Evergreen Investment Services, Inc. SEC Release No , June 8, 2009 On June 8, 2009, the Securities and Exchange Commission instituted enforcement proceedings against Evergreen Investment Management Company, LLC and its affiliated broker-dealer, Evergreen Investment Services, Inc. (collectively, Evergreen), finding they had violated federal securities laws as a result of incorrectly valuing certain mortgagebacked securities held by the Evergreen Ultra Short Opportunities Fund (the Fund). The incorrect valuation of these securities resulted in overstatement of the fund s net asset value (NAV) from February 2007 to June Consequently, during this period certain shareholders redeemed their shares at a price higher than they should have received, and others purchased shares at a higher price then they should have paid. The overstatement made the Fund appear to rank among the top funds in its category, whereas an accurately reported NAV would have placed it near the bottom. Subsequently, Evergreen s valuation committee reviewed and re-priced the securities, resulting in a lower NAV for the Fund. A number of factors led to overstatement of the Fund s NAV, including: (i) the portfolio management team did not consider readily-available information when recommending valuations to the Fund s valuation committee; (ii) the valuation committee valued certain securities of the Fund in accordance with prices from an individual brokerdealer whose pricing methodology the committee had not reviewed; (iii) despite the valuation committee s expectation that a broker-dealer would be used for pricing on an exception basis, the Fund s portfolio managers used the individual broker-dealer to price a significant portion of the Fund s holdings; and (iv) the portfolio manager withheld relevant negative information about securities from the Fund s valuation committee. Evergreen also violated federal securities laws by selectively sharing material non-public information with Evergreen s distributor regarding the re-pricings and the possibility that Evergreen could further lower the Fund s NAV. The violations in Evergreen highlight the need for mutual fund boards of trustees to ensure adequate oversight of fair-value pricing processes, especially when the portfolio PAGE 7 OF 9

8 manager is involved, as well as the need for sound policies and procedures regarding the disclosure of material non-public information. Independent Directors Council and Investment Company Institute File Amicus Briefs in Jones v. Harris Associates Two additional amicus (friend of the court) briefs have been filed as the U.S. Supreme Court is preparing to hear oral arguments in the case of Jones v. Harris Associates (7 th Circuit May 19, 2008) on November 11, As previously noted in the Regulatory Administration Digest, the issue in Jones is the interpretation of the standard for judicial review of excessive fee claims by investors against investment advisers under Section 36(b) of the Investment Company Act of Previously, most courts relied upon the ruling in Gartenberg v. Merrill Lynch Asset Management, (2 nd Cir. 1982), which determined that the test for deciding whether a fund adviser s fees were excessive to the point of breaching its fiduciary duty was whether the fees were disproportionately large for the services provided and could not have been negotiated at arm s-length. In Jones, the respondent, Harris Associates, argues Section 36(b) is limited to assessing the advisory fees and not examining the information used to determine the fee, which would lead to increased litigation and additional costs to shareholders. In contrast, the petitioners argue that the Gartenberg interpretation misconstrued Section 36(b) by ignoring the requirement that an investment adviser must fully disclose material facts regarding compensation to avoid misleading the board of directors of a fund. In an amicus brief in Jones filed on September 3 by the Independent Directors Council (IDC), the IDC argues, Congress entrusted independent directors, not courts or litigants, with the primary responsibility for protecting investor interests. Because most fund boards are composed of at least 75 percent independent directors, the IDC asserts courts should defer to the business judgment of fund directors in approving advisory fees, unless there is a fundamental flaw in the process. The same day, the Investment Company Institute (ICI) also filed an amicus brief in support of the Gartenberg standard arguing it is sensitive to context and allows a court to decide which facts are most relevant in Section 36(b) claims. The ICI also claims that the petitioners in Jones incorrectly assert that advisory fees for mutual funds and those for non-mutual fund institutional accounts are comparable. The ICI states that higher retail mutual fund fees reflect the fact that retail investors are offered more services, have a smaller account size, have different cash flow and liquidity, and have retail advisers who assume entrepreneurial risk in launching a fund. Consequently, the ICI argues, the comparison is rarely useful to fund boards or the courts, whereas the Gartenberg standard allows such comparisons when appropriate. PAGE 8 OF 9

9 Regulatory Administration Group For further information, contact: Owen Meacham, Esq. Shanna Palmersheim, Esq Gwen Cooney Robert P. Mitchell Regulatory Administration Digest is compiled by our Regulatory Administration Group. Northern Trust Corporation. All rights reserved. This Regulatory Administration Digest Newsletter is provided for informational and educational purposes only and is not accounting, legal or tax advice, opinion or a substitute for the advice of your legal counsel or other professional advisors. IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see PAGE 9 OF 9