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SEC Wants Funds to Re-Work Principal Disclosure Risk in Summary Prospectuses


The SEC’s Division of Investment Management, through its Disclosure Review and Accounting Office, requests that mutual fund sponsors revamp the principal risk disclosure in the summary prospectuses.  The staff “strongly encourage[s]” funds to list principal risks in order of importance (rather than alphabetically) to better highlight risks that investors should consider.  Although the staff recognizes that this requires subjective judgment, the staff will not comment on a fund’s methodology.  The staff also recommends that funds tailor principal risk disclosure rather than utilize generic, standardized disclosure across funds, especially where different funds have differing investment objectives and policies.  The staff also reminds registrants to leave non-principal risks and other details to the Statement of Additional Information.

New registrants should expect the Disclosure staff to provide significant comments if they merely offer kitchen sink disclosure for principal risks.

SEC Faults Adviser Platform for Failing to Promote Funds that Did Not Share Revenue

The SEC has sued a large RIA platform for failing to fully disclose that it had a material conflict of interest because it received revenue sharing from certain funds.  The SEC alleges that the defendant received ongoing revenue sharing through its clearing firm on certain funds and share classes.  Although the firm disclosed that it received revenue sharing and might have a conflict, it did not fully disclose that it actually received millions of dollars in revenue sharing and that lower cost funds and share classes were often available.  The SEC asserts that the firm should have described the incentive it received to select funds and classes that benefited the firm to the detriment of its clients.

The SEC breaks new ground in this complaint by suggesting that the firm should have invested client assets in other funds (including funds sponsored by an affiliate of the clearing broker) that did not offer revenue sharing.  Most prior revenue sharing cases have focused on the use of higher fee share classes of the same fund.  This line of argument raises a concern that the SEC is implicitly advocating for the lowest cost fund regardless of investment mandate or performance.  For example, would an adviser violate its fiduciary duty, absent revenue sharing, if it recommended a higher cost fund for reasons other than total expense ratio? 

SEC Allows Broker-Dealer Fund Research Reports

 The SEC has adopted a new rule allowing third party broker-dealers to publish mutual fund research reports, so long as the reports include standardized performance information.  The new rule (139b) provides that a research report prepared by a broker-dealer unaffiliated with the mutual fund manager or sponsor will not result in an unregistered offering, and the research report will not constitute a prospectus.  The rule requires several conditions including: (i) the subject fund must have met all reporting requirements during the prior 12 months, (ii) the fund must have a net asset value of at least $75 Million, and (iii) any performance information must comply with Rule 482, which requires performance information to be presented in a standardized format.  The SEC initially proposed the rule in May.

The only controversy here is whether performance information should need to comply with Rule 482.  To keep performance information consistent probably makes life simpler for investors, broker-dealers, and the staff at the SEC and FINRA.  Regardless, we still believe that the SEC should take a fresh look at Rule 482 given the proliferation of investment products beyond open end funds investing in publicly-traded securities. 

SEC Allows Fund Boards to Rely on CCO for Exemptive Rule Compliance

 The staff of the SEC’s Division of Investment Management has issued no-action relief allowing fund boards to rely on the representations of the Chief Compliance Officer for Rule 10f-3, 17a-7 and 17e-1 transactions.  Rather than duplicate the due diligence performed by the CCO, the no-action letter allows fund boards to rely on quarterly CCO representations that transactions effected under exemptive Rules 10f-3 (affiliated underwriting), 17a-7 (cross-trades) and 17e-1 (affiliated brokerage) complied with the applicable fund procedures.  The SEC opines that this reliance will allow fund boards to more efficiently exercise its oversight role with respect to conflicts of interest.  The no action letter reverses a 2010 staff position.

OUR TAKE: The no-action position reflects the reality of how most funds operate.  The Board has very little ability to perform due diligence independent of the work performed by the Chief Compliance Officer, so it makes sense to rely on the representations.  The big open question is whether this position increases CCO liability, thereby creating additional due diligence requirements.

SEC Proposes New Fund Research Reports

The SEC has proposed a new rule that would allow third party broker-dealers to publish research reports about registered investment companies without having to comply with current performance presentation requirements.  Proposed Rule 139b would allow a broker-dealer that is not affiliated with the fund’s adviser to publish research reports that meet certain presentation requirements even where the broker-dealer participates in the offering.  A similar safe harbor already exists for other issuers.  The SEC seeks comment about whether performance information should be required to comply with Rule 482’s performance presentation requirements currently applicable to fund advertising.

OUR TAKE: We would go a step further and rewrite Rule 482 to allow more flexibility for all fund materials.  Then, the SEC would not have to wrestle with whether to allow different types of fund reports depending on the preparer, which could result in more confusion.


Large Adviser Penalized $3 Million over Revenue Sharing

A large investment adviser agreed to pay over $3 Million in disgorgement, fines and interest for failing to disclose mutual fund revenue sharing received from its clearing broker.  The SEC alleges that, during the last 10 years, the clearing broker paid the adviser a portion of trailer fees received from mutual funds to which the adviser directed client assets.  The SEC also described an arrangement whereby the clearing broker paid the adviser for certain shareholder services.  The SEC faults the adviser for failing to disclose in either the ADV or its client agreements that it received payments and that such payments created a conflict of interest.  The adviser and clearing broker have since altered their agreement so that the revenue sharing is calculated based on total assets rather than the funds in which the adviser invests client assets.

OUR TAKE: The SEC does not allege that this conflict actually harmed any client, or that the revenue sharing had any empirical effect on the adviser’s investment decisions.  Also, the SEC seems to be ok with revenue sharing that does not present a potential conflict of interest i.e. based on total assets.  It is also less than clear whether disclosure would have actually cured the SEC’s conflict of interest concerns.