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Chapter 3
Regulation and
Disclosure for
Mutual Funds
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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
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3–1
Taxation (cont.)
• Transfer agent sends out annual tax
statements to fund shareholders for income
tax reporting
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3–2
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
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3–3
Disclosure and Advertising (cont.)
• Procedures
– Prospectuses must be “cleared” through
the SEC
– Sales literature must be filed with the
NASD
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3–4
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
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3–5
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 nonaffiliates
– Updates must be sent annually or
whenever a policy changes materially
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3–6
Limits on Sales Charges
• Front-end loads
– Paid by shareholders to the fund’s underwriter;
most are usually passed on to the selling brokerdealer or sales representative
– Maximum of 8.5% set by NASD
• Back-end loads
– Paid by shareholders
– Contingent deferred sales charge (CDSC)
declines over time
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3–7
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
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3–8
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
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3–9
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
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3–10
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
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3–11
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
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3–12
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
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3–13
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
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3–14
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
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3–15
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
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3–16
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
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3–17
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?
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3–18
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?
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3–19
Ch. 3 Class Exercise: Designing a
Short-Form Prospectus (cont.)
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?
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3–20
Ch. 3 Class Exercise: Designing a
Short-Form Prospectus (cont.)
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?
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3–21
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?
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3–22
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?
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3–23
Ch. 3 Class Exercise: Evaluating
a Profile Prospectus (cont.)
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?
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3–24
Ch. 3 Class Exercise: Evaluating
a Profile Prospectus (cont.)
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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3–25