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    IC Chapter 4.doc IC Chapter 4.doc Document Transcript

    • 1 From Readings on the Investment Company Act and the Investment Advisers Act Larry D. Barnett School of Law Widener University Wilmington, Delaware Copyright © 2008 by Larry D. Barnett All rights reserved Additional materials © 2008 by C. Steven Bradford
    • 2 Chapter 4. Marketing Tactics and Practices The Registration Requirement of The Securities Act Of 1933 Unless an exemption is available, the Securities Act requires an investment company offering its securities to the public to file with the SEC a disclosure document known as a registration statement. Open-end investment companies usually file on Form N-1A and closed-end investment companies usually file on Form N-2. These two forms are integrated forms that can be used to fulfill the registration requirements of both the Investment Company Act and the Securities Act. These forms are fairly long and detailed, so I have not reproduced them. An investment company's registration statement consists of three parts: (1) the prospectus; (2) a Statement of Additional Information (SAI); and (3) other information, including exhibits. The prospectus is the primary disclosure document provided to purchasers of investment company securities. A prospectus must be made available to every investor at some point in the process of purchasing investment company shares. The Statement of Additional Information, which contains more expansive and detailed disclosure, is not routinely provided to investors, but must be furnished free of charge upon request. The third part of the registration statement is only required to be filed with the SEC. Open-end investment companies usually offer their shares to the public on a continuous basis. They are allowed to file a single registration statement to offer an unlimited amount of securities for an indefinite time in the future.1 However, they are obligated to update the prospectus provided to investors and sometimes to file amendments to the registration statement to keep the information provided current. 1Investment Company Act Rule 24f-2.
    • 3 The SEC’s Summary Prospectus Proposal The SEC recently adopted amendments to the registration requirements that would allow open-end investment companies to provide to investors a more limited “summary prospectus” that contains only certain key information from the full prospectus. A fund’s prospectus delivery requirements would be met by providing this summary prospectus and a link to a web site containing the full prospectus, unless a particular investor requested a copy of the full prospectus. See Enhanced Disclosure and New Prospectus Delivery Options for Registered Open-End Management Investment Companies, Securities Act Release No. 8998 (Jan. 13, 2009). This proposal was scheduled to become effective on March 31, 2009, but it is currently trapped in the Obama administration freeze on the effectiveness of rules adopted in the last days of the Bush administration. President Obama has ordered agencies not to publish in the Federal Register any rules not yet published when he became President, and rules such as this cannot become effective until they are published. At this point, it is unclear what the SEC with a new Democratic majority led by newly appointed chair Mary Schapiro will do about this proposal.
    • 4 Investment Company Advertising And Sales Literature Introduction Investment company advertising and sales practices are regulated by both the SEC and the National Association of Securities Dealers ("NASD"), a self-regulatory association of securities professionals. NASD enforces policies set by the SEC, but it also has adopted policies of its own which are in some cases more restrictive than the SEC policies. False Or Misleading Sales Material Investment company sales materials are subject to the usual securities law prohibitions on false or misleading statements or omissions. Rule 10b-5 under the Exchange Act, ' 12(a)(2) of the Securities Act, and ' 34(b) of the Investment Company Act all prohibit, in contexts relevant to solicitations by investment companies, untrue statements of material fact or omissions of material facts necessary to make the statements made not misleading. Securities Act Rule 156 is relevant to the question of whether investment company advertisements and sales literature are misleading. Rule 156 neither permits nor prohibits any specific disclosure. It merely provides general guidance as to ways investment company sales literature might be misleading. Rule 156 replaced the SEC's long-standing "Statement of Policy on Investment Company Sales Literature," which was much more detailed and specific. In withdrawing the "Statement of Policy," the SEC indicated that it continued to be a historical expression of the SEC's views, and it is still looked to as a source of guidance. Communications Prior To Filing The Securities Act Registration Statement Section 5(c) of the Securities Act broadly prohibits all solicitations of investment company investors before the Securities Act registration statement is filed (unless the offering is exempt from the registration requirement). This includes written, oral, electronic, and broadcast communications. Thus, an investment company may not attempt to sell its shares to the public until it files a registration statement with the SEC.
    • 5 Communications After Filing the Registration Statement But Prior to Delivery of the Statutory Prospectus 1. Introduction Once the investment company files a Securities Act registration statement, oral sales communications are allowed. However, many written, broadcast, and electronic communications are prohibited until after a copy of the final, statutory prospectus that is part of the registration statement has been made available to investors. Investment companies have available three exceptions to this general prohibition on written, electronic, and broadcast communications--Rules 135A, 134, and 482. You should read each of these rules. Rule 135A, 134, and 482 communications may be transmitted to investors after the investment company has filed a registration statement and before investors have been given the final, statutory prospectus. The communications allowed by these rules may be sent by mail, broadcast, included in a newspaper or magazine advertisement, or transmitted by other means. For convenience, I shall refer to them as "advertisements." The usual sales procedure is to solicit potential purchasers through Rule 134, 135A, or 482 communications. If an investor indicates interest, a prospectus is then sent. Once the statutory prospectus is sent to an investor, supplemental sales material that goes beyond the limits of the three rules may be sent.2 2. Rule 135A Securities Act Rule 135A allows generic advertising that does not specifically refer to a particular investment company or its securities. A Rule 135A advertisement might, for example, extol the benefit of investing in mutual funds generally, with a phone number to call for additional information. A Rule 135A ad must include the sponsor's name and address.3 3. Rule 134 Securities Act Rule 134 allows the use of what is known as a "tombstone ad." The communication may include any of the information specified in section (a) of the rule, but it does not have to include all of the information allowed by subsection (a). A Rule 134 communication may not contain any additional material not specifically allowed by the rule. Except as provided in subsection (c), a Rule 134 communication must include the information specified in subsection (b). 2The supplemental sales literature may be sent simultaneously with the prospectus. 3See Rule 135A(a)(2).
    • 6 4. Rule 482 Securities Act Rule 482 is the primary rule used for investment company advertising. Note that section 482(a) says the advertising “may include information the substance of which is not included in” the statutory, § 10(a) prospectus. Section (b) of Rule 482 tells us that a Rule 482 advertisement must include various legends warning potential investors. The most important limitations on investment company advertising in Rule 482 deal with fund performance data. Section 482(g) requires that any performance data provided be timely, and sections 482(d) and (e) limit the performance data that may be included. Section (e) applies to money market funds. Section (d) applies to open-end management investment companies that are not money market funds. If the fund's yield or return are specified in the Rule 482 ad, they must be calculated in a standardized manner. An open-end management company that is not a money market fund may also include other measures of performance, but only if the standardized measure is included.4 The purpose of requiring standardized performance data like this is to allow investors to compare the performances of different funds. Supplemental Sales Literature Any sales literature not covered by Rules 134, 135A, and 482 may be sent only after a statutory prospectus (the prospectus filed as part of the registration statement) is made available to the investor. Investment Company Act Rule 34b-1 provides that any supplemental sales literature must usually contain the standardized performance data specified in Rule 482. Other performance data may also be provided, but only if the Rule 482 standardized data is included. NASD Requirements The National Association of Securities Dealers ("NASD") has Rules of Fair Practice, including advertising rules, that apply to all of its members. These rules are important because almost all of the underwriters and distributors selling investment company shares are NASD members subject to the rules. Rule 2210, which appears immediately following this material, deals with advertising generally. Note particularly the restrictions in section (d). IM-2210-3, which 4Securities Act Rule 482(d)(5).
    • 7 appears in these materials immediately after Rule 2210, contains guidelines for advertising of fund rankings. You will need these materials to answer the problems. Filing Requirements Section 24(b) of the Investment Company Act requires registered open-end investment companies, unit investment trusts, and face-amount certificate companies to file with the SEC "any advertisement, pamphlet, circular, form letter, or other sales literature addressed to or intended for distribution to prospective investors." The SEC staff has interpreted ' 24(b) to cover virtually all sales material, including advertisements pursuant to Rule 134, but not including Rule 482 advertisements.5 Rule 482 advertisements must be filed pursuant to the Securities Act.6 NASD also requires all advertisements and sales material used by members to be filed with NASD. See NASD Rule 2210. To avoid duplication, materials filed with NASD are generally deemed to satisfy the SEC filing requirement.7 The SEC does not review the content of most of the filed sales material, but it does try to systematically spot-check some of the sales literature. NASD review is more thorough, and the NASD staff sometimes requests that sales material be revised or clarified. Record-Keeping Requirement Investment Company Act Rule 31a-2(a)(3) requires every registered investment company to preserve all sales literature for at least six years. 5It is unclear whether Rule 135A communications must be filed under ' 24(b). See 1 Thomas P. Lemke, et al, REGULATION OF INVESTMENT COMPANIES ' 20.03[1][d] (2006). 6Securities Act Rule 497. 7Investment Company Act Rule 24b-3; Securities Act Rule 497(i).
    • 8 Selected NASD Rules Concerning Advertising and Sales Material Rule 2210. Communications with the Public (a) Definitions For purposes of this Rule and any interpretation thereof, "communications with the public" consist of: (1) "Advertisement." Any material, other than an independently prepared reprint and institutional sales material, that is published, or used in any electronic or other public media, including any Web site, newspaper, magazine or other periodical, radio, television, telephone or tape recording, videotape display, signs or billboards, motion pictures, or telephone directories (other than routine listings). (2) "Sales Literature." Any written or electronic communication, other than an advertisement, independently prepared reprint, institutional sales material and correspondence, that is generally distributed or made generally available to customers or the public, including circulars, research reports, market letters, performance reports or summaries, form letters, telemarketing scripts, seminar texts, reprints (that are not independently prepared reprints) or excerpts of any other advertisement, sales literature or published article, and press releases concerning a member's products or services. (3) "Correspondence" as defined in Rule 2211(a)(1). (4) "Institutional Sales Material" as defined in Rule 2211(a)(2). (5) "Public Appearance." Participation in a seminar, forum (including an interactive electronic forum), radio or television interview, or other public appearance or public speaking activity. (6) "Independently Prepared Reprint." (A) Any reprint or excerpt of any article issued by a publisher, provided that: (i) the publisher is not an affiliate of the member using the reprint or any underwriter or issuer of a security mentioned in the reprint or excerpt and that the member is promoting; (ii) neither the member using the reprint or excerpt nor any underwriter or issuer of a security mentioned in the reprint or excerpt has commissioned the reprinted or excerpted article; and
    • 9 (iii) the member using the reprint or excerpt has not materially altered its contents except as necessary to make the reprint or excerpt consistent with applicable regulatory standards or to correct factual errors; (B) Any report concerning an investment company registered under the Investment Company Act of 1940, provided that: (i) the report is prepared by an entity that is independent of the investment company, its affiliates, and the member using the report (the "research firm"); (ii) the report's contents have not been materially altered by the member using the report except as necessary to make the report consistent with applicable regulatory standards or to correct factual errors; (iii) the research firm prepares and distributes reports based on similar research with respect to a substantial number of investment companies; (iv) the research firm updates and distributes reports based on its research of the investment company with reasonable regularity in the normal course of the research firm's business; (v) neither the investment company, its affiliates nor the member using the research report has commissioned the research used by the research firm in preparing the report; and (vi) if a customized report was prepared at the request of the investment company, its affiliate or a member, then the report includes only information that the research firm has already compiled and published in another report, and does not omit information in that report necessary to make the customized report fair and balanced. (b) Approval and Recordkeeping (1) Registered Principal Approval for Advertisements, Sales Literature and Independently Prepared Reprints (A) A registered principal of the member must approve by signature or initial and date each advertisement, item of sales literature and independently prepared reprint before the earlier of its use or filing with NASD's Advertising Regulation Department ("Department"). (B) With respect to debt and equity securities that are the subject of
    • 10 research reports as that term is defined in Rule 472 of the New York Stock Exchange, the requirements of paragraph (A) may be met by the signature or initial of a supervisory analyst approved pursuant to Rule 344 of the New York Stock Exchange. (C) A registered principal qualified to supervise security futures activities must approve by signature or initial and date each advertisement or item of sales literature concerning security futures. (D) The requirements of paragraph (A) shall not apply with regard to any advertisement, item of sales literature, or independently prepared reprint if, at the time that a member intends to publish or distribute it: (i) another member has filed it with the Department and has received a letter from the Department stating that it appears to be consistent with applicable standards; and (ii) the member using it in reliance upon this paragraph has not materially altered it and will not use it in a manner that is inconsistent with the conditions of the Department's letter. (2) Record-keeping (A) Members must maintain all advertisements, sales literature, and independently prepared reprints in a separate file for a period beginning on the date of first use and ending three years from the date of last use. The file must include: (i) a copy of the advertisement, item of sales literature or independently prepared reprint, and the dates of first and (if applicable) last use of such material; (ii) the name of the registered principal who approved each advertisement, item of sales literature, and independently prepared reprint and the date that approval was given, unless such approval is not required pursuant to paragraph (b)(1)(D); and (iii) for any advertisement, item of sales literature or independently prepared reprint for which principal approval is not required pursuant to paragraph (b)(1)(D), the name of the member that filed the advertisement, sales literature or independently prepared reprint with the Department, and a copy of the corresponding review letter from the Department. (B) Members must maintain in a file information concerning the source of any statistical table, chart, graph or other illustration used by the member in communications with the public.
    • 11 (c) Filing Requirements and Review Procedures (1) Date of First Use and Approval Information The member must provide with each filing under this paragraph the actual or anticipated date of first use, the name and title of the registered principal who approved the advertisement or sales literature, and the date that the approval was given. (2) Requirement to File Certain Material Within 10 business days of first use or publication, a member must file the following communications with the Department: (A) Advertisements and sales literature concerning registered investment companies (including mutual funds, variable contracts, continuously offered closed-end funds, and unit investment trusts) not included within the requirements of paragraph (c)(3). The filing of any advertisement or sales literature that includes or incorporates a performance ranking or performance comparison of the investment company with other investment companies must include a copy of the ranking or comparison used in the advertisement or sales literature. (B) Advertisements and sales literature concerning public direct participation programs (as defined in Rule 2810). (C) Advertisements concerning government securities (as defined in Section 3(a)(42) of the Act). (D) any template for written reports produced by, or advertisements and sales literature concerning, an investment analysis tool, as such term is defined in Rule IM-2210-6. (3) Sales Literature Containing Bond Fund Volatility Ratings Sales literature concerning bond mutual funds that include or incorporate bond mutual fund volatility ratings, as defined in Rule IM-2210-5, shall be filed with the Department for review at least 10 business days prior to use (or such shorter period as the Department may allow in particular circumstances) for approval and, if changed by NASD, shall be withheld from publication or circulation until any changes specified by NASD have been made or, if expressly disapproved, until the sales literature has been refiled for, and has received, NASD approval. Members are not required to file advertising and sales literature which have previously been filed and which are used without change. The member must
    • 12 provide with each filing the actual or anticipated date of first use. Any member filing sales literature pursuant to this paragraph shall provide any supplemental information requested by the Department pertaining to the rating that is possessed by the member. (4) Requirement to File Certain Material Prior to Use At least 10 business days prior to first use or publication (or such shorter period as the Department may allow), a member must file the following communications with the Department and withhold them from publication or circulation until any changes specified by the Department have been made: (A) Advertisements and sales literature concerning registered investment companies (including mutual funds, variable contracts, continuously offered closed-end funds and unit investment trusts) that include or incorporate performance rankings or performance comparisons of the investment company with other investment companies when the ranking or comparison category is not generally published or is the creation, either directly or indirectly, of the investment company, its underwriter or an affiliate. Such filings must include a copy of the data on which the ranking or comparison is based. (B) Advertisements concerning collateralized mortgage obligations. (C) Advertisements concerning security futures. (5) Requirement for Certain Members to File Material Prior to Use (A) Each member that has not previously filed advertisements with the Department (or with a registered securities exchange having standards comparable to those contained in this Rule) must file its initial advertisement with the Department at least 10 business days prior to use and shall continue to file its advertisements at least 10 business days prior to use for a period of one year. (B) Notwithstanding the foregoing provisions, the Department, upon review of a member's advertising and/or sales literature, and after determining that the member has departed from the standards of this Rule, may require that such member file all advertising and/or sales literature, or the portion of such member's material which is related to any specific types or classes of securities or services, with the Department, at least 10 business days prior to use. The Department will notify the member in writing of the types of material to be filed and the length of time such requirement is to be in effect. Any filing requirement imposed under this
    • 13 paragraph will take effect 21 calendar days after service of the written notice, during which time the member may request a hearing under Rules 9551 and 9559. (6) Filing of Television or Video Advertisements If a member has filed a draft version or "story board" of a television or video advertisement pursuant to a filing requirement, then the member also must file the final filmed version within 10 business days of first use or broadcast. (7) Spot-Check Procedures In addition to the foregoing requirements, each member's written and electronic communications with the public may be subject to a spot-check procedure. Upon written request from the Department, each member must submit the material requested in a spot-check procedure within the time frame specified by the Department. (8) Exclusions from Filing Requirements The following types of material are excluded from the filing requirements and (except for the material in paragraphs (G) through (J)) the foregoing spot-check procedures: (A) Advertisements and sales literature that previously have been filed and that are to be used without material change. (B) Advertisements and sales literature solely related to recruitment or changes in a member's name, personnel, electronic or postal address, ownership, offices, business structure, officers or partners, telephone or teletype numbers, or concerning a merger with, or acquisition by, another member. (C) Advertisements and sales literature that do no more than identify a national securities exchange symbol of the member or identify a security for which the member is a registered market maker. (D) Advertisements and sales literature that do no more than identify the member or offer a specific security at a stated price. (E) Prospectuses, preliminary prospectuses, fund profiles, offering circulars and similar documents that have been filed with the Securities and Exchange Commission (the "SEC") or any state, or that is exempt from such registration, except that an investment company prospectus published pursuant to SEC Rule 482 under the Securities Act of 1933 will
    • 14 not be considered a prospectus for purposes of this exclusion. (F) Advertisements prepared in accordance with Section 2(10)(b) of the Securities Act of 1933, as amended, or any rule thereunder, such as SEC Rule 134, and announcements as a matter of record that a member has participated in a private placement, unless the advertisements are related to direct participation programs or securities issued by registered investment companies. (G) Press releases that are made available only to members of the media. (H) Independently prepared reprints. (I) Correspondence. (J) Institutional sales material. Although the material described in paragraphs (c)(8)(G) through (J) is excluded from the foregoing filing requirements, investment company communications described in those paragraphs shall be deemed filed with NASD for purposes of Section 24(b) of the Investment Company Act of 1940 and Rule 24b-3 thereunder. (9) Material that refers to investment company securities, direct participation programs, or exempted securities (as defined in Section 3(a)(12) of the Act) solely as part of a listing of products or services offered by the member, is excluded from the requirements of paragraphs (c)(2) and (c)(4). (10) Pursuant to the Rule 9600 Series, NASD may exempt a member or person associated with a member from the pre-filing requirements of this paragraph (c) for good cause shown. (d) Content Standards (1) Standards Applicable to All Communications with the Public (A) All member communications with the public shall be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service. No member may omit any material fact or qualification if the omission, in the light of the context of the material presented, would cause the communications to be misleading. (B) No member may make any false, exaggerated, unwarranted or misleading statement or claim in any communication with the public. No member may publish, circulate or distribute any public communication
    • 15 that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading. (C) Information may be placed in a legend or footnote only in the event that such placement would not inhibit an investor's understanding of the communication. (D) Communications with the public may not predict or project performance, imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast. A hypothetical illustration of mathematical principles is permitted, provided that it does not predict or project the performance of an investment or investment strategy. (E) If any testimonial in a communication with the public concerns a technical aspect of investing, the person making the testimonial must have the knowledge and experience to form a valid opinion. (2) Standards Applicable to Advertisements and Sales Literature (A) Advertisements or sales literature providing any testimonial concerning the investment advice or investment performance of a member or its products must prominently disclose the following: (i) The fact that the testimonial may not be representative of the experience of other clients. (ii) The fact that the testimonial is no guarantee of future performance or success. (iii) If more than a nominal sum is paid, the fact that it is a paid testimonial. (B) Any comparison in advertisements or sales literature between investments or services must disclose all material differences between them, including (as applicable) investment objectives, costs and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, and tax features. (C) All advertisements and sales literature must: (i) prominently disclose the name of the member and may also include a fictional name by which the member is commonly recognized or which is required by any state or jurisdiction; (ii) reflect any relationship between the member and any non- member or individual who is also named; and (iii) if it includes other names, reflect which products or services are being offered by the member.
    • 16 This paragraph (C) does not apply to so-called "blind" advertisements used to recruit personnel. (3) Disclosure of Fees, Expenses and Standardized Performance (A) Communications with the public, other than institutional sales material and public appearances, that present non-money market fund open-end management investment company performance data as permitted by Rule 482 under the Securities Act of 1933 and Rule 34b-1 under the Investment Company Act of 1940 must disclose: (i) the standardized performance information mandated by Rule 482 and Rule 34b-1; and (ii) to the extent applicable: a. the maximum sales charge imposed on purchases or the maximum deferred sales charge, as stated in the investment company's prospectus current as of the date of submission of an advertisement for publication, or as of the date of distribution of other communications with the public; and b. the total annual fund operating expense ratio, gross of any fee waivers or expense reimbursements, as stated in the fee table of the investment company's prospectus described in paragraph (a). (B) All of the information required by paragraph (A) must be set forth prominently, and in any print advertisement, in a prominent text box that contains only the required information and, at the member's option, comparative performance and fee data and disclosures required by Rule 482 and Rule 34b-1. (e) Violation of Other Rules Any violation by a member of any rule of the SEC, the Securities Investor Protection Corporation or the Municipal Securities Rulemaking Board applicable to member communications with the public will be deemed a violation of this Rule 2210.
    • 17 NASD IM-2210-3. Use of Rankings in Investment Companies Advertisements and Sales Literature (a) Definition of "Ranking Entity" For purposes of the following guidelines, the term "Ranking Entity" refers to any entity that provides general information about investment companies to the public, that is independent of the investment company and its affiliates, and whose services are not procured by the investment company or any of its affiliates to assign the investment company a ranking. (b) General Prohibition Members may not use investment company rankings in any advertisement or item of sales literature other than (1) rankings created and published by Ranking Entities or (2) rankings created by an investment company or an investment company affiliate but based on the performance measurements of a Ranking Entity. Rankings in advertisements and sales literature also must conform to the following requirements. (c) Required Disclosures (1) Headlines/Prominent Statements A headline or other prominent statement must not state or imply that an investment company or investment company family is the best performer in a category unless it is actually ranked first in the category. (2) Required Prominent Disclosure All advertisements and sales literature containing an investment company ranking must disclose prominently: (A) the name of the category (e.g., growth); (B) the number of investment companies or, if applicable, investment company families, in the category; (C) the name of the Ranking Entity and, if applicable, the fact that the investment company or an affiliate created the category or subcategory; (D) the length of the period (or the first day of the period) and its ending date; and (E) criteria on which the ranking is based (e.g., total return, risk-adjusted performance). (3) Other Required Disclosure
    • 18 All advertisements and sales literature containing an investment company ranking also must disclose: (A) the fact that past performance is no guarantee of future results; (B) for investment companies that assess front-end sales loads, whether the ranking takes those loads into account; (C) if the ranking is based on total return or the current SEC standardized yield, and fees have been waived or expenses advanced during the period on which the ranking is based, and the waiver or advancement had a material effect on the total return or yield for that period, a statement to that effect; (D) the publisher of the ranking data (e.g., "ABC Magazine, June 2003"); and (E) if the ranking consists of a symbol (e.g., a star system) rather than a number, the meaning of the symbol (e.g., a four-star ranking indicates that the fund is in the top 30% of all investment companies). (d) Time Periods (1) Current Rankings Any investment company ranking included in an item of sales literature must be, at a minimum, current to the most recent calendar quarter ended prior to use. Any investment company ranking included in an advertisement must be, at minimum, current to the most recent calendar quarter ended prior to the submission for publication. If no ranking that meets this requirement is available from the Ranking Entity, then a member may only use the most current ranking available from the Ranking Entity unless use of the most current ranking would be misleading, in which case no ranking from the Ranking Entity may be used. (2) Rankings Time Periods; Use of Yield Rankings Except for money market mutual funds: (A) advertisements and sales literature may not present any ranking that covers a period of less than one year, unless the ranking is based on yield; (B) an investment company ranking based on total return must be accompanied by rankings based on total return for a one year period for investment companies in existence for at least one year; one and five year periods for investment companies in existence for at least five years; and one, five and ten year periods for investment companies in existence for at least ten years supplied by the same Ranking Entity, relating to the same
    • 19 investment category, and based on the same time period; provided that, if rankings for such one, five and ten year time periods are not published by the Ranking Entity, then rankings representing short, medium and long term performance must be provided in place of rankings for the required time periods; and (C) an investment company ranking based on yield may be based only on the current SEC standardized yield and must be accompanied by total return rankings for the time periods specified in paragraph (d)(2)(B). (e) Categories (1) The choice of category (including a subcategory of a broader category) on which the investment company ranking is based must be one that provides a sound basis for evaluating the performance of the investment company. (2) An investment company ranking must be based only on (A) a published category or subcategory created by a Ranking Entity or (B) a category or subcategory created by an investment company or an investment company affiliate, but based on the performance measurements of a Ranking Entity. (3) An advertisement or sales literature must not use any category or subcategory that is based upon the asset size of an investment company or investment company family, whether or not it has been created by a Ranking Entity. (f) Multiple Class/Two-Tier Funds Investment company rankings for more than one class of investment company with the same portfolio must be accompanied by prominent disclosure of the fact that the investment companies or classes have a common portfolio. (g) Investment Company Families Advertisements and sales literature may contain rankings of investment company families, provided that these rankings comply with the guidelines above, and further provided that no advertisement or sales literature for an individual investment company may provide a ranking of an investment company family unless it also prominently discloses the various rankings for the individual investment company supplied by the same Ranking Entity, as described in paragraph (d)(2)(B). For purposes of this IM-2210-3, the term "investment company family" means any two or more registered investment companies or series thereof that hold themselves out to investors as related companies for purposes of investment and investor services. In the Matter of Competitive Capital Corporation Securities Exchange Act Release No. 9184
    • 20 Securities and Exchange Commission May 25, 1971 1971 SEC LEXIS 927 This was a private proceeding . . . with respect to Competitive Capital Corporation ('registrant'), a registered broker-dealer and a member of the National Association of Securities Dealers, Inc., and Richard E. Boesel, Jr. and Robert L. Sprinkel, III, who at the times relevant here were registrant's principal executive officers and together owned over 90 percent of its outstanding voting stock. ... On February 20, 1969, Fund [Competitive Associates, Inc.], a management, open-end diversified investment company, filed with us a registration statement under the Securities Act with respect to its initial public offering of 5,000,000 shares of common stock at $20 per share. Registrant was Fund's investment adviser and principal underwriter, and also at that time was acting as investment adviser and principal underwriter for another registered open-end management investment company, Competitive Capital Fund ('CCF'). Registrant, Fund and CCF were then managed by a common group of officers headed by Boesel and Sprinkel. Upon the filing of the registration statement, including Fund's preliminary prospectus, registrant and a public relations firm which it had previously retained in January 1968 to provide continuing financial public relations services for registrant and the investment companies it was managing and advising, sent copies of that prospectus, together with an accompanying press release announcing the proposed initial public offering, to approximately 120 business and financial editors throughout the country. That mailing was the start of a publicity campaign designed to attract attention to the Fund, through emphasizing, among other matters, the Fund's investment policies and the fact that separate portions of the Fund's assets would be managed by independent portfolio managers who would compete with each other. The public relations firm also mailed biographical sketches of Boesel and Sprinkel and during the period February 20 through March 4, 1969, arranged a schedule of approximately 19 interviews with members of the business and financial press for Boesel, Sprinkel and two other officers of registrant while such officers were in various cities to discuss the proposed public offering with prospective members of the selling group. At least 11 of the financial reporters participating in those interviews wrote articles concerning the prospective Fund offering which appeared in various newspapers and magazines throughout the country. Some of the articles were written under the by- line of nationally syndicated columnists and were printed in more than one publication. After each interview the public relations consultant communicated with the reporter to determine if he could supply the reporter with additional information. All of these activities took place prior to the effective date of the public offering. On or about March 4, 1969, the publication of articles concerning the proposed public offering came to the attention of counsel involved in the filing of the registration statement and of members of our staff. As a result, further interviews which had been
    • 21 scheduled were cancelled, and steps were taken to terminate any further publicity or public relations activities by the Fund and respondents, and efforts were made to have articles prepared for publication in various cities withdrawn. Despite such efforts, however, a number of such stories did appear thereafter. The registration statement was not declared effective until April 10, 1969. A basic purpose of the Securities Act [of 1933] is to require the dissemination of adequate and accurate information concerning issuers and their securities in connection with the offer and sale of securities to the public. To this end, Section 5 of the Act contains various restrictions on offers and sales prior to the filing or the effective date of a registration statement covering a public offering of securities. Thus Section 5(c) prohibits offers to sell securities prior to the filing of a registration statement. Section 5(b), insofar as here pertinent, prohibits any such written offers during the period between the filing of a registration statement and the date it becomes effective, the so- called waiting period, except an offer which is made by means of a prospectus which meets the informational requirements specified in Section 10 and the rules adopted thereunder. Accordingly, during such waiting period written communications concerning the securities must be restricted to the preliminary or 'red herring' prospectus filed as a part of the registration statement, a summary prospectus as authorized by Section 10(b), or the so-called 'tombstone' announcements permitted under Section 2(10) or Rule 134 thereunder. In order to implement the statutory objective, the term 'offer to sell' is broadly defined in Section 2(3) to include 'every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value,' and it has been liberally construed both by us and the courts. We have repeatedly pointed out that publicity or public relations activities under certain circumstances may constitute offers to sell securities within the statutory definition and thus involve violations of the Act. We have specifically noted that the publication of information and statements and publicity efforts generally about an issuer, its securities or a proposed offering, made prior to the filing of a registration statement, may constitute an illegal offer to sell even though not couched in terms of an express offer, where such activities are in effect a sales campaign which conditions the public mind or arouses the public interest in the particular securities. And we have stated that the release of publicity and the publication of information between the filing date and the effective date of a registration statement may similarly raise a question whether the publicity is not in fact a selling effort by an illegal means; i.e., other than by means of a statutory prospectus. Courts have also ruled that press releases announcing that securities would be sold at some time in the future and containing an attractive description of the securities or of the issuer constituted illegal offers to sell. It is necessary that the managers, investment advisers and underwriters of investment companies, as well as retained public relations firms, recognize that the Securities Act imposes certain responsibilities and limitations upon them as well as upon other persons engaged in the public sale of securities, and that failure to exercise proper control at any time over public relations activities respecting the distribution of securities may result in violations of law and adverse consequences to the investment companies
    • 22 and their underwriters in connection with the distribution of the securities.8 Insofar as this case is concerned, Congress has specified an exclusive procedure by which information concerning a proposed offering may be disseminated during the waiting period. Persons undertaking to employ public media of communication to give publicity to a forthcoming issue in ways not specified in the Act must carefully consider the possi- bility that such publicity oversteps the statutory limitations and constitutes a type of sales activity prohibited during the waiting period by Section 5(b). Even if we recognize that the limited advertising that an issuer which has a registration statement pending can employ may pose special problems for an investment company engaged in a continuous offering of its shares to the public, here the issuer was not at the time engaged in a continuous public offering. As has been seen, respondents, solely in connection with a pending registration statement for an essentially new investment vehicle, participated in an organized campaign utilizing a wide distribution of publicity material which was designed to and had the effect of conditioning the public for the forthcoming offering of Fund shares. Such activities constituted an offer to sell, and the publicity material constituted a prospectus which did not meet the requirements of Section 10 of the Securities Act. Its transmittal through various means of interstate commerce and the mails therefore constituted a willful violation of Section 5(b) of the Act by the respondents. In addition, Boesel and Sprinkel, as principal owners and executive officers of registrant, failed reasonably to supervise other officers of registrant who were engaged in similar publicity activities in order to prevent violations of Section 5(b). . . . [R]espondents stated in mitigation that the press release was used only after consultation with counsel; that the granting of interviews by the individual respondents was considered by them to be in accordance with practice in the industry; that the appropriate sanction of delay in the effectiveness of the Fund's registration statement has already imposed substantial adverse economic consequences to the Fund and registrant; and that respondents otherwise have an unblemished record in the securities business. We have considered these and other factors . . . . With respect to registrant, which is only being censured, we note that Boesel and Sprinkel are no longer officers, that subsequent to the events involved herein another unrelated corporation purchased a controlling interest, and that thereafter registrant filed a notice of withdrawal of its registration as a broker and dealer. In imposing a suspension for ten business days upon Boesel and Sprinkel, we note that each of them is experienced in the securities business and should have been familiar with the requirements of the Securities Act respecting the use of publicity in connection with a public offering. By the Commission . . . . 8 Violations of the Securities Act subject the persons involved not only to the risk of penal sanctions under the law but also to the possibility of civil liabilities to purchasers of securities, to the denial of acceleration of the effective date of a registration statement, or to elimination of a broker-dealer from participation as an underwriter or as a member of the selling group in a distribution.
    • 23 Advertising Problems 1. The Royal Equity Fund (the "Fund") is a registered investment company. Almost all of the mutual fund ranking services rank the Fund in the middle of its category. However, StarSearch Rankings, Inc. ranks the Fund second out of a total of 40 funds in its category. StarSearch considers, in addition to total returns in the past, its evaluation of the quality of the people managing the fund, future market trends and their effect on the fund's portfolio, and the likely success of the fund in attracting new capital. May the Fund include the StarSearch ranking in its advertisements? May it do so even if it doesn't disclose the other rankings? Should it be able to? 2. Global Advisers, Inc. is the investment adviser of the Enterprise Fund, a registered investment adviser. Global Advisers is a wholly-owned subsidiary of Global Parent, Inc. Global Rankings, Inc., another wholly-owned subsidiary of Global Parent, Inc., is a leading, nationally recognized ranking entity for mutual funds. May the Enterprise Fund include its ranking by Global Rankings in its advertisements? Should it be able to? 3. Eveningstar, Inc. is a company that publishes mutual fund rankings. Its "Blue Chip Stock Fund" category includes funds that invest primarily in stable, well- established "blue chip" companies. However, funds in the category may have up to 20 percent of their assets invested in riskier, non-blue chip stocks. Eveningstar ranks the Quality Blue Chip Fund (the "Fund") sixth out of 50 Blue Chip Stock Funds. The Fund invests only in what Eveningstar would consider blue chip companies; it does not own any non-blue chip stocks. The managers of the Fund believe that Eveningstar's inclusion of companies with non-blue chip investments is unfair. Non-blue chip stocks, although they sometimes produce higher returns, are riskier and not what the Fund's managers think people are looking for when they seek a "blue chip" fund. If funds that invest part of their assets in non-blue chip stocks are excluded from the Eveningstar rankings, the Fund ranks first out of 30 funds. May the Fund include this revised ranking in its advertising? Should it be able to? 4. The Green International Fund (the "Fund) invests in the securities of foreign companies. It limits its investments to companies that are "socially responsible" as defined by a lengthy list of criteria it has developed. For example, it won't invest in companies that are involved with tobacco products, companies that do business with Yugoslavia, or companies that are heavy polluters. Most ranking services categorize funds as International or Socially Responsible, but do not have a separate category for socially responsible international funds. The Fund is ranked either with the international funds or with the social responsibility funds. The managers of the Fund believe this is unfair because the international fund
    • 24 rankings include funds that don't restrict their investments to socially responsible companies and the rankings of social responsibility funds include funds that invest in less risky domestic companies. The Fund's managers are aware of seven funds with investment restrictions similar to their own. The Fund's total return is better than any of the other socially responsible international funds. May they include this information in their advertisements? Should they be able to?
    • 25 Investment Company Act Release No. 25575 Securities and Exchange Commission May 24, 2002 67 Fed. Reg. 36712 Like most issuers of securities, when an investment company ("fund") offers its shares to the public, its promotional efforts become subject to the advertising restrictions of the Securities Act. Congress imposed these restrictions so that investors would base their investment decisions on the full disclosures contained in the "statutory prospectus," which Congress intended to be the primary selling document. 2 The advertising restrictions of the Securities Act cause special problems for many investment companies, particularly for open-end management investment companies ("mutual funds") and other investment companies that continuously offer and sell their shares.I For these funds, the advertising restrictions apply continuously because the offering process, in effect, is continuous. In recognition of these problems, the Commission has adopted special advertising rules for investment companies. The most important of these is rule 482 under the Securities Act, which permits investment companies to advertise investment performance data, as well as other information. Rule 482 advertisements are "prospectuses" under section 10(b) of the Securities Act (so-called "omitting prospectuses"), which means that, historically, they could only contain information the "substance of which" is included in the statutory prospectus. In the National Securities Markets Improvement Act of 1996, Congress amended the Investment Company Act to permit, subject to rules adopted by the Commission, the use of prospectuses under section 10(b) of the Securities Act that 2 2"Statutory prospectus" refers to the full prospectus required by Section 10(a) of the Securities Act. I I Editor=s note: Elsewhere in the Release, the Commission explained that Amutual funds typically offer and sell their shares continuously to provide an ongoing flow of capital into their portfolios and to enable them to meet redemption requests from outgoing shareholders. Unit investment trusts typically have active secondary markets in which the trusts' sponsors are continuously purchasing and selling the trusts' units.@
    • 26 include information the substance of which is not included in the statutory prospectus. II . .. ... Section 5 of the Securities Act contains prohibitions regarding the dissemination of written selling material to investors during the offering period. Section 5(b)(1) makes it unlawful to use interstate commerce to transmit any prospectus relating to a security with respect to which a registration statement has been filed unless the prospectus meets the requirements of section 10 of the Securities Act. "Prospectus" is broadly defined in section 2(a)(10) to include any advertisement or other communication, "written or by radio or television, which offers any security for sale or confirms the sale of any security." Thus, advertisements are considered prospectuses under the Securities Act if they offer a security for sale. Because the term "offer" is defined and interpreted broadly to encompass any attempt to procure orders for a security, written and radio or television advertisements relating to a security, or aiding in the selling effort with respect to a security, generally must be in the form of a section 10 prospectus. There is a limited exception to the general requirement that written and radio or television offers after the filing of a registration statement must be in the form of a section 10 prospectus. So-called "supplemental sales literature" may be used after the effective date of a registration statement if accompanied or preceded by the statutory prospectus.16 . . . ... Rule 482 The Commission adopted rule 482 under the authority of section 10(b) of the Securities Act, which permits the Commission to adopt rules that provide for a prospectus that "omits in part" or "summarizes" information contained in the statutory prospectus. . . . Significantly, rule 482 provides a means for mutual funds to advertise performance information according to standardized formulas.21 I IIEditor=s note: The National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290, ' 204, 110 Stat. 3416, 3428, added paragraph (g) to section 24 of the Investment Company Act. Paragraph (g) authorizes the Commission to allow, Aby rules or regulations deemed necessary or appropriate in the public interest or for the protection of investors, the use of a prospectus for purposes of section 5(b)(1) of [the Securities Act] with respect to securities issued by a registered investment company. Such a prospectus, which may include information the substance of which is not included in the [statutory] prospectus . . . , shall be deemed to be permitted by section 10(b)@ of the Securities Act. 6 16Under section 2(a)(10)(a) of the Securities Act, supplemental sales literature is not considered to be a prospectus and, as a result, is not subject to section 5(b)(1) of the Securities Act.
    • 27 Because a rule 482 advertisement is a prospectus under section 10(b) of the Securities Act, a rule 482 advertisement is subject to section 12(a)(2) of the Securities Act, which imposes liability for materially false or misleading statements in a prospectus or oral communication, subject to a reasonable care defense. 22 Rule 482 advertisements are also subject to the antifraud provisions of the federal securities laws. Mere compliance with the terms of rule 482 is not a safe harbor against antifraud liability. ... Rule 34b-1 Rule 34b-1 under the Investment Company Act applies to supplemental sales literature, i.e., sales literature that is preceded or accompanied by the statutory prospectus.30 Under rule 34b-1, any performance data included in supplemental sales literature must be accompanied by performance data computed using the standardized formulas for advertising performance under rule 482. The Commission adopted rule 34b-1 to ensure that performance claims in supplemental sales literature would not be misleading and to promote comparability and uniformity among supplemental sales literature and rule 482 advertisements. Supplemental sales literature is subject to the antifraud provisions of the federal securities laws. Mere compliance with the terms of rule 34b-1 is not a safe harbor against antifraud liability. Rule 156 Rule 156 under the Securities Act provides guidance on the types of information that could be misleading in fund sales literature. It applies to all advertisements and supplemental sales literature. Under rule 156, whether a statement involving a material fact is misleading depends on an evaluation of the context in which it is made. Rule 156 indicates that representations about past performance could be misleading in situations where portrayals of past performance convey an impression of net investment results that would not be justified under the circumstances. 21 1 . . . The Commission adopted the use of standardized formulas in order to permit prospective investors to compare the performance claims of competing funds and to prevent misleading performance claims by funds. 22 2 An action under section 12(a)(2) does not require proof of scienter (i.e., an intent to defraud investors). . . . [H]owever, the plaintiff must establish that the misrepresentation or omission is material. 30 0 Under section 2(a)(10)(a) of the Securities Act, a communication sent or given after the effective date of the registration statement is not deemed a "prospectus" if it is proved that prior to or at the same time with such communication a written statutory prospectus was sent or given to the person to whom the communication was made.
    • 28 Note Rules 482 and 34b-1 resulted from a concern of the Securities and Exchange Commission Athat investors could not compare performance claims [of different funds] because no prescribed methods of calculating fund performance existed (except for money market funds), and because funds were being advertised on the basis of different types of performance data. In addition, the Commission [was concerned] that some of the methods being used distorted performance. The [Rules] were designed to prevent misleading performance claims by funds and to permit investors to make meaningful comparisons among fund performance claims in advertisements.@ Advertising by Investment Companies, Investment Company Act Release No. 16245, 53 Fed. Reg. 3868 (1988). The provisions of Rules 482 and 34b-1 that govern after-tax returns were added in 2001. Disclosure of Mutual Fund After-Tax Returns, Investment Company Act Release No. 24832, 66 Fed. Reg. 9002 (2001). In the Release, the Commission explained the need for the provisions as follows: ATaxes are one of the most significant costs of investing in mutual funds through taxable accounts. . . . Recent estimates suggest that more than two and one-half percentage points of the average stock fund's total return is lost each year to taxes. Moreover, it is estimated that, between 1994 and 1999, investors in diversified U.S. stock funds surrendered an average of 15 percent of their annual gains to taxes. Despite the tax dollars at stake, many investors lack a clear understanding of the impact of taxes on their mutual fund investments. Generally, a mutual fund shareholder is taxed when he or she receives income or capital gains distributions from the fund and when the shareholder redeems fund shares at a gain. The tax consequences of distributions are a particular source of surprise to many investors when they discover that they can owe substantial taxes on their mutual fund investments that appear to be unrelated to the performance of the fund. Even if the value of a fund has declined during the year, a shareholder can owe taxes on capital gains distributions if the portfolio manager sold some of the fund's underlying portfolio securities at a gain.8 The tax impact of mutual funds on investors can vary significantly from fund to fund. For example, the amount and character of a fund's 8 8 This is attributable, in part, to the fact that a mutual fund generally must distribute substantially all of its net investment income and realized capital gains to its shareholders in order to qualify for favorable tax treatment as a >regulated investment company= (>RIC=) [under the Internal Revenue Code]. As a RIC, a mutual fund is generally entitled to deduct dividends paid to shareholders, resulting in its shareholders being subject to only one level of taxation on the income and gains distributed to them. . . .
    • 29 taxable distributions are affected by its investment strategies, including the extent of a fund's investments in securities that generate dividend and other current income, the rate of portfolio turnover and the extent to which portfolio trading results in realized gains, and the degree to which portfolio losses are used to offset realized gains. . . . While the tax- efficiency of a mutual fund is of little consequence to investors in 401(k) plans or other tax-deferred vehicles, it can be very important to an investor in a taxable account, particularly a long-term investor whose tax position may be significantly enhanced by minimizing current distributions of income and capital gains. ... Today we adopt rule . . . amendments that require a fund to disclose its standardized after-tax returns for 1-, 5-, and 10-year periods. After-tax returns, which will accompany before-tax returns in fund prospectuses, will be presented in two ways: (i) After taxes on fund distributions only; and (ii) after taxes on fund distributions and a redemption of fund shares. Although after-tax returns will not generally be required in fund advertisements and sales literature, any fund that either includes after-tax returns in these materials or includes other performance information together with representations that the fund is managed to limit taxes will be required to include after-tax returns computed according to our standardized formulas. . . .@ The Commission has taken the position that an advertisement satisfying Rule 482 may nonetheless be materially misleading and violate Rule 156. Proposed Amendments to Investment Company Advertising Rules, Investment Company Act Release No. 25575, 67 Fed. Reg. 36712, 36717 (2002). In the Release, the Commission wrote: A[F]und advertisements are subject to the antifraud provisions of the federal securities laws. We understand that questions have been raised regarding whether compliance with the terms of rule 482 satisfies all of the obligations of a fund with respect to its advertisements. . . . [C]ompli- ance with the >four corners= of rule 482 does not alter the fact that funds, underwriters, and dealers are subject to the antifraud provisions of the federal securities laws with respect to fund advertisements.@
    • 30 Zweig Series Trust Securities and Exchange Commission No-Action Letter Publicly Available January 10, 1990 1990 SEC NOACT LEXIS 48 LETTER TO SEC We are counsel for Zweig Series Trust (the "Trust"), formerly Drexel Series Trust. Since September 1, 1989, the Trust has been advised by Zweig/Glaser Advisers ("ZGA") and its principal distributor has been Zweig Securities Corp. (the "Distributor"). Prior thereto, the Trust was managed by Drexel Management Corporation ("DMC") and its principal distributor was Drexel Burnham Lambert Incorporated ("DBLI"), both wholly-owned subsidiaries of The Drexel Burnham Lambert Group Inc. ("Group"). The Trust currently consists of nine series: Money Market Series; Government Securities Series; Bond-Debenture Series; Blue Chip Series ("Blue Chip"); Emerging Growth Series ("Emerging Growth"); Option Income Series ("Option Income"); Convertible Securities Series ("Convertible Securities"); Limited Term Government Series; and Priority Selection List Series ("Priority Selection"). A tenth series is presently in registration. Since the change in management, the investment management and portfolio supervisory service for Blue Chip, Emerging Growth, Option Income, Convertible Securities and Priority Selection Series have been provided by individuals and entities with no prior or present affiliation with Group or its subsidiaries, including DMC. On behalf of the Trust, ZGA and the Distributor, we respectfully request that the staff of the Securities and Exchange Commission (the "Staff") advise us that it will not recommend enforcement action if investment results for Blue Chip, Emerging Growth, Option Income, Convertible Securities, and Priority Selection Series prior to September 1, 1989 are not included in calculations of average annual total return in advertisements, sales literature or omitting prospectuses pertaining to the Trust or these series. I. Background The Trust is an open-end management investment company organized as a Massachusetts business trust. The Trust commenced operations on March 25, 1985 and was managed by DMC until September 1, 1989, at which time ZGA assumed management responsibilities. ZGA, registered with the Commission as an investment adviser since August 26, 1989, is a partnership comprised of two corporations, themselves controlled by Mr. Eugene J. Glaser and Dr. Martin E. Zweig. Glaser Corp. purchased the business and substantially all of the assets of the Trust's management company from Group, and contributed them to ZGA; Dr. Zweig acquired exclusivity rights and contributed them to ZGA. At meetings held in May, June and July 1989, the Board of Trustees of the Trust voted to approve a new management agreement with ZGA. At meetings held in June and
    • 31 July, the Board of Trustees approved a subadvisory agreement between ZGA and Davis, Weaver & Mendel, Inc. (the "Subadviser") with respect to Option Income and Priority Selection Series. On August 31, 1989, the shareholders of each Series of the Trust voted to approve the new management agreements between ZGA and the Trust and ZGA and the Subadviser. Within ZGA, Dr. Zweig's primary role is investment advisory while Mr. Glaser's is primarily administrative and marketing. Dr. Zweig is an investment adviser, president of two closed-end funds and publisher of five investment advisory newsletters. In keeping with Dr. Zweig's and his staff's securities selection processes, changes in the fundamental investment policies of six of the nine series of the Trust were approved by the shareholders in connection with the change of management so as to enable the series to utilize the investment techniques of Dr. Zweig and his staff. The new distributor is a corporation controlled by Dr. Zweig. Dr. Zweig is Chairman of ZGA and Mr. Glaser is President. Mr. Glaser is Chairman and Chief Executive Officer of the Trust and Dr. Zweig is President. Certain individuals who were employees of DMC have severed that relationship and are currently employed by ZGA. Portfolio supervisory responsibilities for Blue Chip and Emerging Growth and Convertible Securities reside with individuals at ZGA who have been associated with Dr. Zweig and have no prior or present affiliation with DMC, DBLI or Group. The Subadviser has responsibility for Option Income and Priority Selection and it, too, has no prior or present affiliations with DMC, DBLI or Group. Until September 1, 1989, Mr. Glaser was President and a director of DMC, President, Chief Executive Officer and a trustee of the Trust and Senior Vice President and a director of DBLI. As president of DMC, Mr. Glaser's responsibilities were primarily administrative and marketing. Although as President, the portfolio managers technically reported to him, Mr. Glaser had no day-to-day responsibilities for portfolio selection. Mr. Glaser would periodically meet with the portfolio managers to review the existing portfolio for informational purposes only. Since the new management company, ZGA, became adviser to the Trust, Dr. Zweig supervises and directs the portfolio managers and their selections. Mr. Glaser continues to be responsible for overall administrative and marketing activities. Currently, there are no affiliations, as defined in Section 2(a)(3) of the Investment Company Act of 1940, between DMC, DBLI and Group, and any of their officers, directors or employees, and the Trust, ZGA, the Distributor, the Subadviser, or any of their officers, directors, trustees or employees. Nor is there any continuity of portfolio management or supervision for Blue Chip, Emerging Growth, Option Income, Convertible Securities, or Priority Selection Series. II. Discussion In the Philadelphia Fund, Inc. no-action letter (pub. avail. October 17, 1989) ("Philadelphia Fund") and in the Investment Trust of Boston Funds' no-action letter (pub. avail. April 13, 1989) ("Boston Funds"), the Staff took no- action positions concerning mutual fund advertising of performance figures in situations where there was a change of
    • 32 investment advisers. In both cases, the Staff advised that it would not recommend enforcement action if the performance data presented in advertisements, sales literature or omitting prospectuses covered only the period commencing with the new investment adviser because the new adviser had no prior affiliation with prior management. The Staff required that the advertisements or sales literature for those funds would clearly state: (1) the date of inception of the particular fund, and the fact that the fund was under different management; (2) that per share income and capital charges for the last 10 years were disclosed in the fund's statutory prospectus; and (3) that average annual total return figures for one, five and ten year periods were available on request. We believe that the facts set forth above, with respect to Blue Chip, Emerging Growth, Option Income, Convertible Securities and Priority Selection Series, and their total change in the management, are similar to those in the Philadelphia Fund and Boston Funds letters. We submit that here, as there, it is in the best interests of prospective shareholders that advertisements and sales literature reflect performance data commencing with September 1, 1989, the date of new management. We recognize that the Trust's situation is not totally on all fours with the situation in Boston Funds where there were no prior advisory personnel in common with new management. In Philadelphia Fund, however, the individual responsible for portfolio management, who is now sole shareholder of the new adviser, had joined the prior adviser approximately 18 months before. No-action assurance was requested for the advertised performance to commence with the date of this individual's assumption of management of the fund's portfolio, and not the date that the new adviser commenced management. We believe that this approach, which looks to the substance of the change, i.e., who had portfolio responsibility and when, is more important than the form, i.e., the mere fact of change in the corporate identity of the adviser. Therefore, in recognizing the continuity of certain of the portfolio managers themselves, even though they are now under Dr. Zweig's supervision, we are not seeking no-action relief for four of the series. We respectfully submit, however, that no-action relief for the other five series would be in the best interests of prospective shareholders. We believe that this request is consistent with the purposes underlying the amendments to Rule 482 of the Securities Act of 1933 and the adoption of new Rule 34b-1 under the Investment Company Act of 1940 . . . . As the Commission stated in proposing these changes, their primary purpose is to "enhance investors' ability to compare and evaluate investment company performance claims." In order for prospective shareholders to obtain a fair view of the series' performance, they must be able to evaluate the series' performance under current management. Otherwise, they will be making a comparison that has no validity. As required in Philadelphia Fund and Boston Funds, advertisements containing performance data from September 1, 1989 to the present will clearly indicate the date of inception of the series and the fact that the series previously operated under different management, state that the per share income and capital charges for the last ten years are disclosed in the Trust's statutory prospectus and indicate that average annual total return figures for one, five and ten year periods are available upon request.
    • 33 III. Conclusion In light of the reasons stated herein, and consistent with the Staff's positions in Philadelphia Fund and Boston Funds, and Commission intent in amending Rule 482 so as to enhance investors' ability to compare and evaluate fund performance, we respectfully request the Staff to advise us that it will not recommend enforcement action to the Commission if the Trust, ZGA and the Distributor do not include any period prior to September 1, 1989 for calculations of annual total return for Blue Chip, Emerging Growth, Option Income, Convertible Securities and Priority Selection Series of the Trust in omitting prospectuses, advertisements and sales literature of the Trust or any of the enumerated series. ... SEC REPLY Your letter . . . requests our assurance that we would not recommend that the Commission take any enforcement action against the Zweig Series Trust ("Trust"), or Zweig Securities Corp. (the "Distributor")[,] if investment results prior to September 1, 1989, for five series of the Trust are excluded from calculation of average annual total returns presented in advertisements under Rule 482[(d)](3) of the Securities Act of 1933 ("1933 Act") and sales literature under Rule 34b-1[b] of the Investment Company Act of 1940I ("1940 Act"). The Trust commenced operations on March 25, 1985, and was managed by Drexel Management Corporation ("DMC") until September 1, 1989. Since that time, Zweig/Glaser Advisers ("ZGA") has assumed management responsibilities for the Trust. ZGA is a partnership comprised of two corporations; one corporation is controlled by Mr. Eugene J. Glaser and the other is controlled by Dr. Martin E. Zweig. Mr. Glaser is President of ZGA, and Chairman and Chief Executive Officer of the Trust. Prior to September 1, 1989, Mr. Glaser was President and a director of DMC, and President, Chief Executive Officer and a Trustee of the Trust. You believe that the Trust's no-action request is similar to requests to which the staff has granted no-action relief. Your letter acknowledges that the [Investment Trust of Boston Funds] letter is generally not applicable to the Trust's situation[;] however[,] you believe that the Trust's request is similar to the Philadelphia Fund letter. We believe that the Philadelphia Fund letter is distinguishable from the circumstances outlined in your letter. In the [Boston Funds] letter, the staff granted no-action relief permitting a fund to present performance information under Rule 482[(d)](3) of the 1933 Act that reflected only the performance results of a new adviser, thus eliminating the performance results attained under a previous adviser. The staff response explicitly stated that it was based I I Editor's note: Rule 34b-1 was amended after the staff responded to the Zweig Series Trust request. The relevant portion of the Rule presently appears in subsection (b) (1)(iii).
    • 34 on the fact that all investment advisory and portfolio management services were provided and supervised exclusively by officers and employees of the new adviser who had no prior affiliation with the previous adviser or any of its affiliates. Similarly, in the Philadelphia Fund letter the staff permitted the funds to eliminate performance results achieved prior to the time that a new adviser provided investment advice to the funds. Because the new adviser was neither affiliated with, nor at any time under the control of, the adviser whose performance results the funds sought to omit, the staff permitted the Philadelphia Fund to present performance results that only reflected the results of the new adviser (and the prior adviser with which it was affiliated) rather than the one, five, and ten year periods required by Rule 482[(d)](3).4 We believe it important to emphasize that the Rule, by its terms, requires fund performance to be calculated for the one, five, and ten year time periods; the staff has carved a narrow exception to that requirement only when the performance results of the fund would include the performance results of an unrelated previous adviser. We believe that Mr. Glaser's positions (President and a director) with DMC, the Trust's previous adviser, as well as with affiliates of DMC, preclude the Series from eliminating their prior performance.5 Accordingly, we are unable to assure you that we would not recommend that the Commission take any enforcement action under Rule 482[(d)](3) of the 1933 Act or Rule 34b-1[b] under the 1940 Act, against the Trust or the Distributor if investment results prior to September 1, 1989, for the five series are excluded from calculations of average annual total return.6 4 4 In the Philadelphia Fund letter, three advisers had provided investment advice to the funds. The current adviser was affiliated with the prior adviser because a portfolio manager, Mr. Baxter, who had been solely responsible for providing investment advice to the investment companies when they were managed by the prior adviser, organized a corporate investment adviser, which is the current adviser to the funds, and became the President, Treasurer, sole director, and sole shareholder of that advisory firm. The funds sought to eliminate those performance results attained prior to Mr. Baxter's management of the funds. Because Mr. Baxter was affiliated with the prior adviser[,] only the perfor- mance results of the original adviser -- and not those of the prior adviser -- to the investment companies could be omitted from calculations of performance results. . . . 5 5You state that Mr. Glaser was also a Senior Vice President and a director of Drexel Burnham Lambert Incorporated, which wholly owned DMC. 6 6 Of course, Rule 482[(d)(5)] permits a fund to demonstrate its total return over different periods of time by means of aggregate, average, year-by-year, or other types of total return figures provided that, among other things, any nonstandardized return is accompanied by quotations of total return as required by Rule 482[(d)](3). Therefore, while the Trust may not omit the past performance results of the Series, under subparagraph [(d)(5)] of Rule 482 it may include average annual total return figures for the Series from September 1, 1989, in an advertisement that otherwise complies with the Rule. See The Fairmont Fund Trust (pub. avail. Dec. 9, 1988).
    • 35 North American Security Trust Securities and Exchange Commission No-Action Letter Publicly Available August 5, 1994 1994 SEC NOACT LEXIS 876 LETTER TO SEC We are writing on behalf of North American Security Trust ("NAST"), a registered management investment company, to request your assurance that you will not recommend to the Commission any action against NAST if, in advertising the performance of its Asset Allocation Trust ("New Trust") as permitted by Rule 482 under the Securities Act of 1933 ("1933 Act") and Rule 34b-1 under the Investment Company Act of 1940 ("1940 Act"), NAST uses, for periods prior to the establishment of the New Trust, the historical performance of a predecessor portfolio, the Moderate Asset Allocation Trust, the largest of three portfolios combined to form the New Trust. NAST is an open-end, management investment company . . . . It has a number of separate investment portfolios, each of which is represented by a separate series of shares of beneficial interest . . . . Prior to July 10, 1992, NAST had nine separate portfolios, three of which were designated the "Conservative Asset Allocation Trust," the "Moderate Asset Allocation Trust" and the "Aggressive Asset Allocation Trust." NASL Financial Services, Inc., a wholly-owned subsidiary of North American Security Life Insurance Company, . . . is NAST's investment adviser. Pursuant to its advisory agreement with NAST, it selects, contracts with and compensates subadvisers for each of NAST's portfolios. Prior to December 13, 1991, the subadviser for the Conservative, Moderate and Aggressive Asset Allocation Trusts and for three other NAST portfolios was M.D. Sass Investors Services, Inc. On that date, NAST's trustees accepted the resignation of that subadviser and retained as subadviser for certain of the portfolios, including the three Asset Allocation Trusts, Goldman Sachs Asset Management . . . . On January 31, 1992, the trustees of NAST approved a plan of reorganization providing for the combination of the Conservative, Moderate and Aggressive Asset Allocation Trusts into a newly-established portfolio, the New Trust. Following the approval of the plan of reorganization by shareholders of each of the affected portfolios, the combination of the three portfolios was implemented on July 10, 1992 by the transfer of all assets of each such portfolio to the New Trust, and the assumption of all liabilities of each such portfolio by the New Trust, in exchange for shares of the New Trust and the immediate distribution by each such portfolio, to its shareholders pro rata, of the New Trust shares it received from the New Trust. The three Asset Allocation Trusts were then abolished. Although effected by means of a newly-established portfolio, the reorganization was in substance a combination of the Conservative and Aggressive Asset Allocation Trusts with and into the Moderate Asset Allocation Trust, with the Moderate Asset Allocation Trust being the surviving entity. The investment objective, policies and
    • 36 restrictions of the Moderate Asset Allocation Trust were carried over without change to the New Trust. At the time of the reorganization, the net assets of the Moderate Asset Allocation Trust constituted 70% of the net assets of the New Trust, while the net assets of the Conservative and Aggressive Asset Allocation Trusts constituted 21% and 9%, respectively, of the net assets of the New Trust. In effect, shareholders of the Conservative and Aggressive Asset Allocation Trusts became shareholders of the Moderate Asset Allocation Trust. The reorganization had a limited effect on the individual securities held by the Moderate Asset Allocation Trust. At the time of the reorganization, all of the individual securities held by the Conservative and Aggressive Asset Allocation Trusts were also held by the Moderate Asset Allocation Trust. Moreover, sixty-two of the sixty-four securities then held by the Moderate Asset Allocation Trust were also held by each of the Conservative and Aggressive Asset Allocation Trusts. The principal difference in the three portfolios was the relative portion of assets held in three categories of securities -- equity, fixed income and money market. As here pertinent, Rule 482[(d)] under the 1933 Act requires, among other things, that any quotations of investment performance of NAST's non-money market portfolios used in advertisements permitted by the rule . . . include quotations of average annual total return for the one year period, and the period since inception, preceding the most recently completed calendar quarter. Rule 34b-1 under the 1940 Act would declare misleading any sales literature containing performance quotations for NAST's non- money market portfolios unless it contained, among other things, the total return information required by Rule 482[(d)]. For the one year period ending June 30, 1992, the total return . . . for the Conservative, Moderate and Aggressive Asset Allocation Trusts was 8.46%, 11.20% and 9.78%, respectively. For the period from inception (August 28, 1989) through June 30, 1992, the average annual total return so computed for such portfolios was 5.23%, 2.74%, and 2.51%, respectively. We believe that the requirements of the Commission's rules governing the advertising of investment company performance, in the context of the combination of the three Asset Allocation Trusts, are satisfied if the [N]ew Trust uses, for periods prior to the reorganization, the historical performance of the Moderate Asset Allocation Trust, provided the advertising material discloses that for the period prior to July 10, 1992 the performance used is that of the former Moderate Asset Allocation Trust. ... If the reorganization had been implemented by a combination of the Conservative and Aggressive Asset Allocation Trusts into the Moderate Asset Allocation Trust, there would be no basis for precluding the quotation of the Moderate Asset Allocation Trust's performance history prior to the date of the combination. In substance, such was the result of the reorganization. The two smaller portfolios were combined into a third, the investment adviser and investment objectives and policies of which were unchanged by the transaction. To preclude the quotation of the Moderate Asset Allocation Trust's historical performance because the combined assets were allocated to a new portfolio would seem to be nothing more than an elevation of form over substance.
    • 37 . . . A purpose of the Commission's performance quotation rules is to show investment experience for intermediate-term and long-term investors. Such purpose should be ignored only where a significant change, such as a change in manager or in investment objectives or policies, has occurred which makes use of performance data prior to the change potentially misleading. Where, as here, the only change in substance is a substantial increase in net assets, there is, in our view, no legitimate basis for depriving shareholders of the surviving portfolio, many of whom will have been shareholders of the predecessor portfolio, of information relating to the historical performance of the latter. In view of the foregoing, we request your concurrence in our view that historical performance quotations of the New Trust may, consistent with Rules 482 and 34b-1, reflect the performance of the Moderate Asset Allocation Trust for periods prior to the reorganization of the three Asset Allocation Trusts into the New Trust or, alternatively, your assurance that you will not recommend to the Commission any action against NAST if its advertisements of the historical performance of the New Trust include, for periods prior to the reorganization, the performance of the Moderate Asset Allocation Trust. NAST agrees that any performance of the Moderate Asset Allocation Trust will prominently disclose that fact. SEC REPLY Your letter . . . requests our assurance that we would not recommend that the Commission take any enforcement action if North American Security Trust ("NAST") advertises the performance of one of its portfolios, the Asset Allocation Trust ("New Trust"), as described in your letter. NAST . . . is an open-end management investment company. On January 31, 1992, NAST's trustees approved a plan to reorganize three of its portfolios -- the Conservative Asset Allocation Trust ("Conservative Trust"), the Moderate Asset Allocation Trust ("Moderate Trust"), and the Aggressive Asset Allocation Trust ("Aggressive Trust") (collectively, the "Asset Allocation Trusts") -- into a newly established portfolio, the New Trust. NAST implemented the reorganization on July 10, 1992.1 Rather than treating the New Trust as a new portfolio with no historical performance data prior to its establishment on July 10, 1992, you propose to advertise the historical performance of the New Trust using, for periods prior to July 10, 1992, the performance data for the Moderate Trust. You represent that any advertising material containing historical performance would prominently disclose that for the period prior to July 10, 1992, the performance used is that of the Moderate Trust. 1 1Each of the Asset Allocation Trusts transferred all of its assets and liabilities to the New Trust in exchange for shares of the New Trust, and immediately distributed New Trust shares pro rata to its shareholders. The three Asset Allocation Trusts were then dissolved.
    • 38 In 1988, the Commission amended rule 482 under the [S]ecurities Act of 1933 and adopted rule 34b-1 under the Investment Company Act of 1940 to standardize the computation of mutual fund performance for presentation in advertisements and sales literature.2 Rule 482[(d)] provides, in relevant part, that any advertisement by an open- end investment company that contains performance information must include the fund's average annual total return for one, five, and ten year periods. Rule 34b-1 provides that sales literature containing performance information is misleading unless it contains, among other things, the total return information required by rule 482[(d)]. In determining whether a surviving fund, or a new fund resulting from a reorganization, may use the historical performance of one of several predecessor funds, funds should compare the attributes of the surviving or new fund and the predecessor funds to determine which predecessor fund, if any, the surviving or new fund most closely resembles. Among other factors, funds should compare the various funds' investment advisers; investment objectives, policies, and restrictions; expense structures and expense ratios; asset size; and portfolio composition. These factors are substantially similar to the factors the staff considers in determining the accounting survivor of a business combination involving investment companies. We believe that, generally, the survivor of a business combination for accounting purposes, i.e., the fund whose financial statements are carried forward, will be the fund whose historical performance may be used by a new or surviving fund. With respect to the factors set forth in the preceding paragraph, you make the following representations. Although effected by means of a newly established portfolio, the reorganization was in substance a combination of the Conservative and Aggressive Trusts with and into the Moderate Trust. The New Trust has the same adviser and subadviser, and the same investment objectives, policies, and restrictions, as the Moderate Trust. Of the three Asset Allocation Trusts, the expense ratio of the Moderate Trust most closely resembles the expense ratio of the New Trust.3 At the time of the reorganization, the net assets of the Moderate Trust constituted 70% of the net assets of the New Trust, while the net assets of the Conservative and Aggressive Trusts constituted 21% and 9%, respectively. All of the securities held by the Conservative and Aggressive Trusts at the time of the reorganization also were held by the Moderate Trust. Finally, the financial statements of the New Trust reflect the fact that the Moderate Trust was the "accounting survivor" of the reorganization involving the three Asset Allocation Trusts.4 2 2See Investment Company Act Release No. 16245 (Feb. 2, 1988). The Commission stated in this release that the amendments to rule 482 "preclude performance information about any related entity to the fund such as its adviser, i.e., other funds or private accounts controlled by the adviser, where the use of such performance is intended as a substitute for the performance of the fund." Id. Because we view the New Trust as a continuation of the Moderate Trust, we do not believe that the Moderate Trust's performance is a "substitute" for the performance of the New Trust. 3 3 Telephone conversation [with] . . . counsel to NAST . . . . 4 4 Id. . . .
    • 39 In light of the foregoing, we would not recommend that the Commission take any enforcement action against NAST if it advertises the historical performance of the New Trust using, for periods prior to the reorganization, the performance data of the Moderate Trust. Our position is based on the facts and representations contained in your letter, and specifically your representation that any advertising material containing historical performance data will disclose prominently that for the period prior to July 10, 1992, the performance used is that of the Moderate Trust.
    • 40 Discussion Problem 4.1 In June 1997, the Equity Income Fund in a fund family was acquired by the Total Return Fund in the same family. Both were open-end funds. The Equity Income Fund had been established in January 1990, but the Total Return Fund did not start until December 1993. During the pre-acquisition years that both funds were in existence -- i.e., 1994, 1995, and 1996 -- investment performance (from changes in share price and distributions of capital gains and investment income) was as follows: Year Fund ended Dec. 31 Equity Income Fund Total Return Fund 1996 16.5% 25.5% 1995 16.4 26.9 1994 -3.3 5.2 Should the combined fund, in advertisements referring to performance prior to the acquisition, be allowed to use the record of the Total Return Fund? Or should the combined fund be required to use the pre-acquisition performance of the Equity Income Fund? The table below compares the Equity Income Fund and the Total Return Fund on the factors specified by the Division of Investment Management for choosing between the two funds, i.e., for selecting the fund whose performance record is advertised. After the two funds were combined, just one relevant aspect of the Total Return Fund prospectus was changed (in the section on "Investment policies").
    • 41 Fund Factors specified by the Division of Investment Management Investment adviser The Equity Income Fund and the Total Return Fund had the same investment adviser, which will be the investment adviser to the combined Fund. Investment objective Equity The objective of the Fund is "reasonable income," an objective Income pursued by "investing primarily in dividend-paying common Fund and preferred stocks and debt securities convertible into com- mon stocks. . . . The potential for capital appreciation will also Total be considered when selecting the Fund's securities."1 Return Fund The Fund has "an equal focus on both long-term growth of capital and current income," an objective pursued by investing in "a broadly diversified portfolio of dividend-paying common stocks."2
    • 42 Investment policies Equity Income The Fund "will normally invest at least 80% of its assets in Fund common stocks, convertible preferred stocks and convertible bonds." Of these securities, a minimum of 90% will be Total "income-producing," and a minimum of 65% will have been Return issued by companies whose stock market capitalization was less Fund than $1 billion when the Fund acquired their securities. The Fund follows a "value" approach to investing.1 The Fund "will normally invest at least 80% of its assets in common stocks." Of these securities, a minimum of 90% will be "dividend-paying," and a minimum of 65% will have been issued by companies whose market capitalization was less than $1 billion when the Fund acquired their securities. The Fund follows a "value" approach to investing.2 In September 1997, a change was made in the allocation of assets. Henceforth, the Fund "will normally invest at least 65% of its assets in common stocks and convertible securities." Of these securities, a minimum of 90% will be "income- producing." A minimum of 65% will continue to be from companies whose stock market capitalization was less than $1 billion when the Fund acquired their securities.3
    • 43 Investment limitations Equity A maximum of 10% of the Fund's assets can be invested in the Income securities of issuers located outside the United States, and a Fund maximum of 5% of the Fund's net assets can be in nonconvertible debt securities that have been rated below in- vestment grade.1 A maximum of 10% of the Fund's assets can be invested in the securities of issuers that are outside the United States. A Total maximum of 20% of the Fund's assets can be in investment- Return grade debt securities carrying the lowest investment-grade Fund rating. A maximum of 5% of the Fund's net assets can be in nonconvertible debt securities that have been rated below nvestment grade.2 Net assets Equity Year (end of year) Expense ratio4 Income 1996 $36,000,000 1.37% Fund1 1995 56,000,000 1.24 Total 1994 77,000,000 1.27 Return Fund2 1996 $ 6,000,000 1.25% 1995 3,000,000 1.67 1994 2,000,000 1.96
    • Portfolio composition on December 31, 19965 Equity Corporate bonds 12.7% Income Repurchase Agreements 6.1 Fund Common stocks 80.6 Consumer Products 15.3% 44 Financial Intermediaries 7.4 Financial Services 9.5 Industrial Products 22.9 Industrial Services 11.5 Natural Resources 4.7 Retail 5.8 Technology 3.5 Total investments 99.4% Total Other assets Return less liabilities 0.6 Fund Net assets 100.0% Median market capitalization: $383 million Weighted average price/earnings ratio: 15.0 Weighted average price/book ratio: 1.7 Weighted average yield: 4.0% Corporate bonds 4.9% Repurchase Agreements 17.6 Common stocks 81.4 Consumer Products 11.1% Financial Intermediaries 12.6 Financial Services 12.5 Industrial Products 18.1 Industrial Services 15.2 Natural Resources 1.8 Retail 4.2 Technology 5.9 Total investments 103.9% Liabilities less other assets -3.9 Net assets 100.0% Median market capitalization: $314 million Weighted average price/earnings ratio: 15.4 Weighted average price/book ratio: 1.9 Weighted average yield: 3.7%
    • 45 1 EQUITY INCOME FUND PROSPECTUS (April 30, 1997). 2 [TOTAL RETURN FUND] PROSPECTUS (April 30, 1997). 3 SUPPLEMENT TO [TOTAL RETURN FUND] PROSPECTUS DATED APRIL 30, 1997 (Sept. 25, 1997). 4 Actual expense ratios are shown. Expenses would have been higher had the investment adviser and distributor not waived fees for, and reimbursed expenses of, each Fund. 5 SCHEDULES OF INVESTMENTS DECEMBER 31, 1996; 1996 ANNUAL REPORT.
    • 46 Lucia v. Prospect Street High Income Portfolio, Inc. 36 F.3d 170 (1st Cir. 1994) OPINION OF THE COURT In the late 1980's, plaintiffs-appellants purchased shares of two separate "junk bond" funds. After the value of the purchased shares plummeted, plaintiffs alleged various federal securities law violations. In a series of related rulings, the district court dismissed some of plaintiffs' allegations for failure to state a claim, and granted summary judgment in favor of defendants on all remaining claims. We affirm in part and reverse in part. I. FACTUAL BACKGROUND AND PRIOR PROCEEDINGS Prior to this appeal, the proceedings in these two cases were not formally consolidated. As the district court noted, the two cases raise many identical issues. Thus, our discussion, unless we specifically state otherwise, applies equally to both cases. In 1988, both New America High Income Fund, Inc. and Prospect Street High Income Portfolio, Inc. ("the New America Fund," and "the Prospect Street Fund," or collectively "the funds") were first publicly offered on the New York Stock Exchange. Each fund's purpose, as stated in their nearly identical prospectuses, was to invest in a diversified portfolio of high yield fixed-income securities, commonly known as "junk bonds." In April 1989, well after the initial public offerings, a study headed by Professor Paul Asquith ("the Asquith study") disclosed that the default rate of junk bonds was much higher than had been previously believed.1 This conclusion was reached by calculating the adverse effects of "aging" on junk bonds.2 1 1 The results of the Asquith study were first made public through various financial and general periodicals in April of 1989. See, e.g., Kenneth N. Gilpin, Further Rise in Rates is Expected, N.Y. Times, Apr. 10, 1989, at D9; Linda Sandler & Michael Siconolfi, Junk Bonds are Taking Their Lumps, Wall St. J., Apr. 14, 1989, at C1. The study itself was not published until September 1989. See Paul Asquith, et al., Original Issue High Yield Bonds: Aging Analyses of Defaults, Exchanges and Calls, 44 J. FIN., No. 4 (September 1989). 2 2 The record reveals that, prior to the Asquith study, the traditionally accepted method of determining annual bond default rates was to divide the total number of defaults per year by the total size of the relevant market sector for that year. As the affidavit of Professor Asquith points out, however, this method loses its accuracy in a rapidly expanding market, such as the junk bond market of the 1970's and '80's, where new issues greatly enlarged the existing market. In other words, the traditional method does not reveal whether a preponderance of older or newer issues are defaulting in a given year.
    • 47 Within months of the study, though not necessarily as a direct result of the study, the market for junk bonds began to collapse. By November 1989, both funds had reduced their dividends, and the share value of each fund had declined considerably. Plaintiffs, who consist of putative classes of purchasers of each fund, commenced parallel actions against the two funds. . . . The gist of the original complaints was that the funds' directors, advisors and underwriters ("defendants") knew of, but failed to disclose, adverse information about the junk bond market. . . . The district court dismissed many of plaintiffs' claims on the pleadings, [citations omitted to the district court opinions in "Miller" and "Lucia"], but nonetheless allowed both sets of plaintiffs to replead. Plaintiffs' Second Amended Complaints (hereinafter "the revised complaints") alleged causes of action only under sections 11 and 12(2) [of the Securities Act of 1933]. . . . Among other things, the revised complaints focused on a ten-year comparison between junk bonds and United States Treasury securities ("Treasury securities") that was included in the prospectuses.5 Though the ten-year figure showed that junk bonds Breaking from the traditional method of calculation, Asquith's study tracked the default rate of bonds based on their dates of issuance. The study revealed that junk bonds become more likely to default as they grow older, hence the term "aging." 5 5 The relevant portion of the New America Fund's prospectus states: The Fund's portfolio will consist primarily of "high yield" corporate bonds. . . . "High yield" bonds offer a higher yield to maturity than bonds with higher ratings as compensation for holding an obligation of an issuer perceived to be less credit worthy. The DBL composite measures the performance of the most representative bonds in the "high yield" market and is compiled monthly by Drexel Burnham Lambert Incorporated. As of December 31, 1987, the DBL Composite offered a yield spread of 484 basis points (i.e., 4.84%; 1% equals 100 basis points) over the comparable Treasury security, 7% U.S. Treasury due 1994. U.S. Treasury securities are considered to have minimal risk. The average spread between the DBL Composite and the comparable U.S. Treasury issue was 358 basis points for 1980, 397 basis points for 1981, 503 basis points for 1982, 337 basis points for 1983, 311 basis points for 1984, 362 basis points for 1985, 496 basis points for 1986 and 451 basis points for 1987. For the years 1977 through 1986, the spread in yields between "high yield" securities and representative U.S. Treasury securities has averaged approximately 393 basis points. For this period, the loss in principal and interest due to defaults on "high yield" securities has averaged approximately 97 basis points. Thus, for the period 1977 to 1986, the net average spread between "high yield" securities and representative U.S. Treasury securities (i.e., the average spread between "high yield" securities and U.S. Treasury securities, minus the average default loss on "high yield" securities) was 296 basis points. For 1987, the loss of principal and interest due to defaults is estimated to have been 125 basis points.* However, past performance is not necessarily indicative of future
    • 48 had outperformed Treasury securities, the revised complaints alleged that during the six years leading up to each fund's public offering, Treasury securities had actually outperformed junk bonds.6 ... II. DISCUSSION ... B. Section 11 and 12(2) Claims As noted above, plaintiffs were allowed to replead. Defendants' motions for summary judgment soon followed, and summary judgment was granted in favor of defendants. 1. Standard of Review "A district court's grant of summary judgment is subject to plenary review." We read the record indulging all inferences in favor of the non-moving party. Summary judgment is appropriate only "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Fed.R. Civ.P. 56(c). In seeking to forestall the entry of summary judgment, a nonmovant may not rely upon allegations in its pleadings. Rather, the nonmovant must "set forth specific facts showing that there is a genuine issue for trial." Fed. R.Civ.P. 56(e). 2. Parallel Paths Diverge [T]he Miller plaintiffs, unlike the Lucia plaintiffs, in their response to defendants' motion for summary judgment, set forth facts showing that the six-year figure, as well as performance. . . . The capital structure of the Fund has been designed to take advantage of the historical spread in yields between "high yield" securities and representative U.S. Treasury securities, compared with the average default loss on "high yield" securities. * Statistical data appearing above are based on information provided by Drexel Burnham Lambert Incorporated. The Prospect Street prospectus is similarly structured and worded. We note in passing that the Prospect Street prospectus reports significantly different annual spreads for the years 1980 through 1987. Because neither the Miller nor the Lucia plaintiffs have argued, either below or on appeal, that these inconsistencies are actionable, we deem the issue waived. 6 6 Both revised complaints at & 29 state: 29. The [Asquith] Study also disclosed that high yield debt had not in fact produced higher realized returns and lower standard deviations of returns than either investment grade or treasury bonds for the period 1982 through 1987 . . . . ...
    • 49 a shorter three-year figure, actually favored Treasury securities. . . . Accordingly, we see no merit to defendants' argument that the Miller plaintiffs waived this issue. ... 3. Materiality under Sections 11 and 12(2) and the Omission of the Six-Year Comparison Sections 11 and 12(2) both prohibit, inter alia, the use of any "untrue statement of a material fact," as well the use of any information which "omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they are made, not misleading." The boundaries of materiality in the securities context are clearly enunciated in our case law. The mere fact that an investor might find information interesting or desirable is not sufficient to satisfy the materiality requirement. Rather, information is "material" only if its disclosure would alter the "total mix" of facts available to the investor and "if there is a substantial likelihood that a reasonable shareholder would consider it important" to the investment decision. It is equally well established that "[w]hen a corporation does make a disclosure -- whether it be voluntary or required -- there is a duty to make it complete and accurate." Moreover, disclosed facts may "not be 'so incomplete as to mislead.'" In addition, the fact that a statement is literally accurate does not preclude liability under federal securities laws. "Some statements, although literally accurate, can become, through their context and manner of presentation, devices which mislead investors. For that reason, the disclosure required by the securities laws is measured not by literal truth, but by the ability of the material to accurately inform rather than mislead prospective buyers." Under the foregoing standards, "emphasis and gloss can, in the right circumstances, create liability." ... As we have said, plaintiffs argue that the ten-year comparison between Treasury securities and junk bonds, though accurate, was misleading because a shorter, six-year comparison favored Treasury securities. We begin by noting that the six years at issue are the six years leading up to the fund's public offering. Moreover, while any one or two years might favor Treasury securities without amounting to an unfavorable trend, we think that a six-year comparison favoring Treasury securities is substantial enough to cast some doubt on the reliability of the reported ten-year figure. In other words, we cannot say as a matter of law that the undisclosed information about the six-year period would not alter the total mix of facts available to the investor. Rather, a jury could find that there is a substantial likelihood that a reasonable shareholder would consider the six-year comparison important to the investment decision. We expressly decline to make hard and fast rules about the time length of reported investment results, i.e., we do not hold that ten-year comparisons must always be accompanied by shorter-term comparisons. Nor do we hold that a plaintiff always creates a triable issue of fact by merely unearthing unfavorable news regarding shorter time intervals than those reported.
    • 50 Moreover, the unfavorable six-year figure in this case does not necessarily render the ten-year comparison misleading. Rather, a jury, knowing the individual annual returns over the ten-year period at issue (which are not now ascertainable on the record before us) and perhaps having other guideposts for determining the relative reliability of shorter- and longer-term bond comparisons, may conclude that the ten-year comparison standing alone is not misleading at all. Because the district court felt it irrelevant that defendants had not reported the claimed six-year negative trend, it gave no attention to whether the Miller plaintiffs had adequately established a factual base -- viz., that defendants knew, or reasonably should have known, of that change of circumstances. . . . We reverse and remand to permit further discovery in this area. . . . Thus, on the current state of the record in the Miller case, summary judgment on this issue was improper. We agree with the district court that the ten-year comparison "paints a much rosier picture" than the six-year comparison. Having established this fact, the district court erred in concluding in the Miller case that the comparison nonetheless was not misleading as a matter of law. 4. Other Summary Judgment Issues While fact issues remain with regard to the Treasury security comparison in the Miller case, the district court properly granted summary judgment on all other issues in both cases. For example, plaintiffs alleged that (1) defendants knew or should have known of the effect that "aging" calculations have on determining junk bond returns . . . . It is doubtless true, as plaintiffs allege, that several significant studies with regard to "aging" discovered statistical infirmities in the traditional methods of calculating junk bond returns. However, these studies were completed only after the prospectuses [involved in these cases] were issued. Moreover, according to affidavits in the record, the Asquith study was the first study of its kind to display the infirmities of previous calculation methods. Plaintiffs failed to adduce any facts which, contrary to defendants' affidavits, would tend to show that defendants were aware of these infirmities, or that they could or should have been aware of the effects of "aging" analysis at the time the funds were initially offered to the public. Given plaintiffs' failure to raise a triable issue of fact, we affirm the district court's grant of summary judgment on this issue. ...
    • 51 Olkey v. Hyperion 1999 Term Trust, Inc. 98 F.3d 2 (2d Cir. 1996), cert. denied, 520 U.S. 1264 (1997) OPINION OF THE COURT ... I. BACKGROUND The plaintiffs are a group of more than twenty investors who purchased common stock in three investment companies -- Hyperion 1997 Term Trust, Inc., Hyperion 1999 Term Trust, Inc., and Hyperion 2002 Term Trust, Inc. (collectively, "the Trusts"). . . . The defendants include the Trusts, Hyperion Capital Management, which served as the investment advisor and administrator of the Trusts, individuals who served as officers or directors of the Trusts or Hyperion Capital, and nine underwriters who participated in the Hyperion offerings. The Trusts are closed-end investment companies, so they are not obligated to redeem shares bought by investors; investors must resell their shares on the secondary market. The Trusts were formed to invest primarily in mortgage-backed securities. The securities comprising the Trusts included interest-only strips (IOs) of mortgages, which tend to go up with interest rates, and mortgage-backed securities, which tend to go down when interest rates go up. IOs and mortgage-backed securities were intended to balance each other, to serve as a hedge against interest rate changes. Interest rates subsequently declined to historic lows, and the value of the trusts declined. The plaintiffs alleged that the prospectuses misled investors by indicating that securities would be selected to achieve a balance such that, as interest rates rose and fell, the value and earnings of the Trusts would remain stable. The plaintiffs contended that this was a misrepresentation because the defendants actually invested in a combination of securities which required rising interest rates to succeed. The plaintiffs further alleged that the defendants failed to disclose the limitations of their hedging strategy, namely, its vulnerability to decreasing interest rates, and that therefore the prospectuses and registration statements misrepresented both the investment strategy of the trust and the risks involved. . . . The plaintiffs claimed that these alleged misrepresentations violate the following securities laws: (1) Section 11(a) of the 1933 Act, which makes any signer, officer of the issuer or underwriter liable for a registration statement that "contains an untrue statement of a material fact or omits to state a material fact"; (2) section 12(2) of the 1933 Act, providing for liability for making a securities offering "by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements . . . not misleading"; (3) section 15 of the 1933 Act and section 20(a) of the 1934 Act, providing for liability of controlling persons; (4) section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibiting
    • 52 fraudulent, material misstatements or omissions in connection with the sale or purchase of a security . . . . The defendants moved to dismiss the claim pursuant to the Federal Rules of Civil Procedure. . . [for] failure to state a claim upon which relief can be granted under Rule 12(b)(6) . . . . The district court granted the motion to dismiss the suit pursuant to Rule 12(b)(6), on the ground that the investment strategy and risks were fully revealed on the face of the prospectuses. . . . The plaintiffs offer the following argument: The Trusts were based upon a failed bet that interest rates would rise. The riskiness of this bet was disproportionate to the level of return promised to investors; promised profits were small in comparison to the risk and potential size of losses. This bet was not disclosed to investors. If it had been disclosed, the investors would not have bought shares in the trust because no reasonable investor would accept low return for high risk. The cautionary language in the prospectuses is too general and generic to have alerted investors of the actual risks they faced and should therefore be ignored as boilerplate. These warnings do not mention risk to capital, to the total value of the portfolio rather than merely components of it. Read as a whole, each prospectus gave the false impression of an attempt to pursue a balanced strategy to minimize risk. In fact, the Trusts speculated on high interest rates. . . . II. DISCUSSION We review de novo the district court's dismissal of the complaint under Rule 12(b)(6) and draw all reasonable inferences in the plaintiff's favor. The complaint may be dismissed under Rule 12(b)(6) "only if it is clear that no relief could be granted under any set of facts that could be proved consistent with the allegations." . . . It is undisputed that the prospectuses must be read "as a whole" . . . . It is further undisputed that the "central issue . . . is not whether the particular statements, taken separately, were literally true, but whether defendants' representations, taken together and in context, would have misled a reasonable investor about the nature of the [securities]". A prospectus will violate federal securities laws if it does not disclose "material objective factual matters," or buries those matters beneath other information, or treats them cavalierly. The prospectuses included the following assurances of balancing: [T]he Adviser believes that it will be able to manage the composition of the Trust's portfolio in such a manner that any decreases in the value of securities as a result of changes in interest rates will be offset by increases in the value of other securities whose value moves in the opposite direc- tion in response to changes in interest rates, thereby avoiding the realization of capital losses which are not offset by capital gains over the life of the Trust . . . . Prospectus for Hyperion 1997 Term Trust, Inc. ("1997"); Prospectus for Hyperion 1999 Term Trust, Inc. ("1999"); Prospectus for Hyperion 2002 Term Trust, Inc., ("2002").
    • 53 The Trust's investment in IOs, when combined with other instruments in the Trust's portfolio, is expected to aid the Trust in its attempt to preserve capital. The values of IOs tend to increase in response to changes in interest rates when the values of these other Mortgage-Backed Securities and of Zero Coupon Securities are decreasing, and to decrease when the values of such other instruments are increasing. While the Adviser has no control over changes in levels of interest rates, it has designed the initial composition of the Trust's portfolio and will manage the portfolio on an ongoing basis in an attempt to minimize the impact of changes in interest rates on the net asset value of the portfolio. 1997; 1999; 2002. Despite these assurances of hedging, we agree with the district court that the prospectuses when read in their entirety are not overly sanguine but instead "bespeak caution". The assurances were balanced by extensive cautionary language. The plaintiffs seek to have all of the cautionary language disregarded as boilerplate, but it is too prominent and specific to be disregarded. The prospectuses warn investors of exactly the risk the plaintiffs claim was not disclosed. A reasonable investor could not have read the prospectuses without realizing that, despite the use of balancing1 in an attempt to minimize the impact of fluctuating interest rates, a significant downturn in interest rates could decrease the value of the Trusts and decrease earnings. The prospectuses included the following warnings about mortgage-backed securities: The investment characteristics of Mortgage-Backed Securities differ from traditional debt securities. . . . These differences can result in significantly greater price and yield volatility than is the case with traditional debt securities. As a result, if the Trust purchases Mortgage-Backed Securities at a premium, a prepayment rate that is faster than expected will reduce both the market value and yield to maturity from that which was anticipated. . . . 1997; 1999; 2002. Because of the effect that changes in interest rates may have on prepayment rates, changes in interest rates may have a greater effect on the value of Mortgage-Backed Securities than is the case with more traditional fixed income securities. 1997; 1999; 2002. Amounts available for reinvestment by the Trust are likely to be greater during a period of declining interest rates due to increased prepayments 1 1To the extent that the complaint may be read to suggest that the defendants made no attempt whatsoever to balance, such an allegation is put to rest by the prospectuses them- selves. They fully disclosed the actual initial investments with a percentage breakdown and a description of different likely responses to interest rate changes. The plaintiffs do not dispute these percentages but contend that the percentages chosen did not permit a balanced portfolio when interest rates fell. The balancing may have been imperfect, but this is a matter of opinion and judgment -- not the basis for a securities fraud claim, which requires a material misrepresentation or omission and is not sustained merely by a claim of poorly implemented investment strategy.
    • 54 and, as a result, likely to be reinvested at lower interest rates than during a period of rising interest rates. Most Mortgage-Backed Securities in which the Trust may invest, like other fixed income securities, tend to decrease in value as a result of increases in interest rates but may benefit less than other fixed income securities from declining interest rates because of the risk of prepayment. 1997; 1999; 2002. In a section set apart under the heading "Risk Factors," the prospectuses even suggested the possibility of precisely the scenario that occurred -- namely, interest rates fell, and, because prepayments increased significantly and because of the Trusts' use of leverage, the Mortgage-Backed Securities were an insufficient hedge against the decline in value of the IO strips: A significant decline in interest rates could lead to a significant decrease in the Trust's net income and dividends . . . . . . . [T]he Trust may be unable to distribute at least $10.00 per share . . . on [its termination date]. . . . The market prices of [most mortgage-backed securities] may be more sensitive to changes in interest rates than traditional fixed income securities. While the Trust will seek to minimize the impact of such volatility on the net asset value of the Trust's assets, there can be no assurance it will achieve this result. In addition, in the case of an IO, prepayment of the underlying mortgages may result in the Trust's not recouping a portion of its initial purchase price in addition to the loss of interest income. . . . To the extent that the Trust utilizes leverage, the impact . . . of volatility on the Trust's income and net asset value will be magnified. 1997; 1999; 2002. The prospectuses stated the intent to use leverage and noted that leverage would "exaggerate the decline in the net asset value or market price of the Shares." 1997; 1999; 2002. The prospectuses repeatedly warned of risk to the entire portfolio: [T]he market value of the Trust's portfolio . . . [is] dependant [sic] on market forces not in the control of the Adviser. 1997; 1999; 2002. [T]he Trust may be unable to distribute to its shareholders at the end of the Trust's term an amount equal to at least $10.00 for each Share then outstanding. 1997; 1999; 2002. No assurance can be given that the Trust will achieve its investment objectives, and the Trust may return less than $10.00 per Share. A signifi- cant decline in interest rates could lead to a significant decrease in the Trust's net income and dividends while a significant rise in interest rates could lead to only a moderate increase in the Trust's net income and dividends. Changes in interest rates will also lead to changes in the Trust's net asset value.
    • 55 1997; 1999; 2002. The second sentence of this passage -- positioned on the second page of each prospectus such that no reasonable reader could miss it -- unequivocally states that a drop in interest rates could significantly reduce net income and dividends. The next sentence by itself is vague -- it does not state whether changes in interest rates could reduce net asset value, only that they will change net asset value. But the juxtaposition of the two sentences creates an unmistakable inference that a drop in interest rates could decrease net asset value. The two sentences combined elaborate the first sentence by spelling out the condition under which the Trusts could fail to return the investor's money -- a significant drop in interest rates. As stated above, the complaint alleges that investors were misled into believing that their investment would be balanced to remain stable as interest rates rose and fell, when in fact there was an undisclosed bias toward rising interest rates. . . . The complaint also alleges failure to disclose the risk that falling interest rates could diminish asset value and dividends. The passages quoted above dispose of both of these allegations. While we agree that the prospectuses contain no specific statement that there was a bias in favor of rising interest rates, we find that the prospectuses implicitly and clearly communicated such a bias. Reasonable investors in the Trusts would hope to preserve capital and earn income. They were informed that the nature of the investment was such that fluctuating interest rates could affect the investment's value. They were told that different types of securities would be affected differently by rising or falling rates and that hedging would be used to minimize those effects. And they were told that a significant decline in interest rates could lead to significant decreases in income and asset values while significant rate increases could lead to only moderate increases in income and asset value. Thus, they were told that the value of losses if rates dropped could exceed the value of profits if rates rose. The only way reasonable investors would then invest in the Trusts would be if they believed that the probability of rates rising exceeded the probability of interest rates dropping. This is the very bias which plaintiffs claim was not disclosed. Reasonable investors would have to be aware that they were risking low returns and erosion of capital if there was a significant drop in interest rates, which is precisely what occurred. Any reasonable investor would have to conclude that the investment objectives could only be achieved here if interest rates rose more than they fell. No reasonable investor could have relied on perfect balancing because that was not promised. The dissent believes that this claim should proceed because the fund managers failed to disclose the fact that they were betting on rising interest rates and, therefore, "invested disproportionately in instruments that would benefit from rising rates." But, the dissent also acknowledges, as it must, that if all that the plaintiffs are claiming is that the fund managers turned out to be "less skillful at balancing their portfolios than the investors hoped[,] . . . their suit would be properly dismissed." In fact, that is exactly what is being claimed here. As the dissent indicates, the appellants "do not claim that no balancing occurred; clearly there was some diversification in the portfolios." The prospectuses reveal that a combination of mortgage-backed investments and IO strips were used in an attempt to
    • 56 minimize the impact of interest rate fluctuations. However, the appellants say too much emphasis was placed on IOs because the investment managers believed that interest rates would likely rise. Every attempt at balancing, of course, must necessarily involve the selection of a mix of investments based in part upon an assessment of what might happen with interest rates; attempting to balance investments in interest-rate sensitive securities without taking prospective rates into account would surely be foolhardy. The plaintiffs are displeased that the fund managers made what turned out to be the wrong assumptions about interest rates while attempting to balance the portfolio. This is not something upon which a fraud claim can be based. Disclosure of the specific reasons for making the investment choices that were made is not required by the Securities laws. The risks involved, in the event that incorrect choices were made or interest rates fell, were appropriately and fully disclosed. Despite that, plaintiffs now claim that balancing was not as skillfully done as it should have been. They claim that another set of investment choices should have been made, based upon a different conception of what interest rates would likely do. It is hardly a sound argument, as the dissent suggests, to say that some other unspecified income funds performed better. That is only to say in hindsight that the managers of those funds turned out to be more skillful in their predictions. It should also be noted that the alleged undisclosed bias had no direct relationship to the losses claimed to have been incurred. The losses resulted from an extraordinary drop in interest rates. The plaintiffs claim that the failure to disclose the bias toward rising rates masked the fact that this was a high risk/low return investment that they would not have purchased if they had known. The risk, however, was that interest rates would fall or not rise more than they fell. That risk was fully and explicitly disclosed. Therefore, there is no causal relationship between losses claimed to have been suffered and any risk factor not clearly disclosed in the prospectuses. The plaintiffs repeatedly argue that all of the warnings in the prospectuses should be ignored as boilerplate. Yet, they offer no serious rationale as to why a reasonable investor who was reading the prospectuses would consider the warnings too generic to be taken seriously and, at the same time, would find the sections discussing the opportunities and protections enticingly specific. The plaintiffs conveniently dismiss as boilerplate anything in the prospectuses that undermines their argument. The plaintiffs' sole rationale for doing this is that if the warnings are not dismissed as boilerplate, the prospectuses would be read as offering a low return, high risk investment, an impossibly unattractive investment. Hence, the fact, they argue, that the offerings did attract investors must mean that those (presumably reasonable) investors dismissed the cautionary language as boilerplate. But any investment that turns out badly can appear to be -- in hindsight -- a low return, high risk investment. Not every bad investment is the product of misrepresentation. . . . To show misrepresentation, the complaint must offer more than allegations that the portfolios failed to perform as predicted. . . . The plaintiffs deny that they are bringing suit merely because they allege the investments turned out badly. They argue that no reasonable investor would seek only
    • 57 modest returns in the face of the risk of substantial losses, as such an offering would constitute a low return, high risk investment. The plaintiffs conclude that, since there could be no market for such an unattractive investment, prospective investors, reading each prospectus as a whole, necessarily dismissed the cautionary language as boilerplate. This argument is meritless. Reasonable investors may find the promise of merely modest returns sufficient if they perceive the risk of substantial losses as sufficiently small. Low returns and a low or moderate risk of substantial loss do not equal a low return, high risk investment. The plaintiffs do not even attempt to give any rationale for why a belief at the time of the offerings in a low probability of interest rates dropping significantly would have been unreasonable. Nor do they assert that the defendants should have expected interest rates to drop, let alone to historic lows. See Lucia v. Prospect St. High Income Portfolio, Inc., 36 F.3d 170, 177 (1st Cir. 1994) (affirming summary judgment where plaintiffs "failed to adduce any facts" showing that defendants "could or should have been aware of" plaintiff's analysis at the time of offering). Since a reasonable investor could have found the promise of moderate returns attractive despite the risk of substantial losses, there is no reason to dismiss the extensive and detailed cautionary language of the prospectuses as boilerplate. That language fully disclosed the risk of investment and was specific enough to warrant a reasonable investor's attention. . . . Made cognizant by the Hyperion prospectuses of the risk posed by declining interest rates, reasonable investors purchased shares of the Trusts in the failed expectation that interest rates would rise. Their expectations were not deceptively manipulated but were simply unmet. The prospectuses contained no material misstatements or omissions of fact, and the plaintiffs fail to state a claim under either the 1933 or 1934 Acts . . . . Dismissal under Rule 12(b)(6) is appropriate because "it is clear that no relief could be granted under any set of facts that could be proved consistent with the allegations". Since the plaintiffs' claims are contradicted by the disclosure of risk made on the face of each prospectus, no set of additional facts could prove the plaintiffs' claims. . . . DISSENTING OPINION I respectfully dissent. This stock fraud claim alleges that the issuers of closed- end funds, formed to invest primarily in mortgage-backed securities, represented that the portfolios would be "balanced," i.e., invested in debt instruments that respond in opposite directions to fluctuations in interest rates, and failed to disclose that the fund managers were in fact betting heavily on rising interest rates and invested disproportionately in instruments that would benefit from rising rates.1 During the [time period at issue in this 1 1 Normally, the value of mortgage-backed securities decrease when interest rates increase, and rise when interest rates decline. These effects are enhanced by the change in the rate at which mortgagors elect to pay off their mortgages. When interest rates rise, the pay-off rate declines, and holders of mortgage-backed securities have, in effect, lengthened maturities on average and thereby reduced value. When interest rates decline,
    • 58 litigation], interest rates declined 1.3 percentage points, contrary to the managers' expectation of a rise, and the three funds lost 8.5 percent, 10.5 percent, and nearly 25 percent, respectively, of their net asset values -- an outcome that Barron's described as "far and away the worst showing of any closed-end bond fund." It is undisputed that several months after the prospectuses were issued and the appellants' investments were made, the chairman and chief executive officer of the issuer of the funds disclosed in a report to shareholders that the initial portfolio of one of the funds was designed "with a bias toward a rising interest rate environment." The Court affirms the dismissal of the complaint for failure to state a claim on the ground that the allegedly undisclosed bias in favor of rising interest rates was in fact disclosed. Though the Court acknowledges that "the prospectuses contain no specific statement that there was a bias in favor of rising interest rates," the Court nevertheless concludes that the prospectuses "implicitly and clearly communicated such a bias." As evidence, the Court points to a passage in the prospectuses that disclosed that the decrease in net income and dividends that could result from a significant decline in interest rates could be greater than the increase in net income and dividends that could result from a significant rise in interest rates.2 The disclosure of these unequal consequences, the majority states, revealed the fund managers' bias toward rising interest rates because "the only way reasonable investors would then invest in the Trusts would be if they believed that the probability of rates rising exceeded the probability of interest rates dropping." (emphasis in original). To reach this conclusion before any evidence has been presented is contrary to Rule 12(b)(6) standards, which, as the Court recognizes, prohibit dismissal of a complaint unless "it is clear that no relief could be granted under any set of facts that could be proved consistent with the allegations." the mortgage pay-off rate rises, and holders of mortgage-backed securities have, in effect, shortened maturities on average, received back principal sooner than anticipated, and thereby enhanced value. One way of balancing a portfolio of mortgage-backed securities in order to lessen the effect of interest rate fluctuations is to purchase interest- only securities ("IO strips") -- securities that entitle the holder to the interest payments of a mortgage, but no principal payments. IO strips respond to interest rate fluctuations in opposite directions from mortgage-backed securities (both those that entitle the holder to receive principal and interest and those that entitle the holder to receive only principal). Thus, the value of IO strips increases when interest rates rise and decreases when interest rates decline. The funds in this case included significant amounts of IO strips in anticipation of rising interest rates. Some IO strips were purchased with borrowed funds, and this leveraging accentuated the adverse impact of the decline in interest rates that occurred. 2 2 The key sentence states, "A significant decline in interest rates could lead to a significant decrease in the Trust's net income and dividends while a significant rise in interest rates could lead to only a moderate increase in the Trust's net income and dividends." Prospectus for Hyperion 1997 Term Trust, Inc. at 2. Identical statements were contained in the prospectuses for the 1999 and 2002 funds.
    • 59 Not only is the Court's assumption about purchasers of fixed-income securities unsupported by any evidence, it is also highly likely to be incorrect. Many investors, alerted to the possibility that falling interest rates "could" decrease their return in a particular fixed-income fund to a greater extent than rising interest rates "could" raise their return, will nevertheless buy such a fund, if described as "balanced," in the expectation that the fund managers will try to balance their portfolio without a pronounced bias in favor of interest rate movements in either direction. They buy for stable return, slightly above government securities, and for preservation of capital. To assert, especially in the absence of evidence, that the purchasers of the Hyperion funds bought in the expectation of rising rates is a proposition at least unsupported and in all likelihood unsupportable. It is possible that a few of the purchasers expected a slight increase in interest rates. Others who bought might have expected a slight decrease in interest rates. Regardless of their expectations as to rates, the repeated assurances that the funds would be "balanced" entitled all of them to believe that the funds would be so structured as to be relatively insulated from any significant rate movements. The fixed-income securities market uses the term "convexity" to describe the degree to which the values of securities are subject to interest rate fluctuations. The term applies primarily to mortgage-backed securities with components of principal and interest. A security that decreases in value in a rising interest rate environment to a greater extent than it increases in value in a declining interest rate environment is said to have "negative convexity." Conversely, a security that increases in value in a declining interest rate environment to a greater extent than it decreases in value in a rising interest rate environment is said to have "positive convexity." A fund sold as "balanced" can reasonably be expected to try to select securities so that the fund's net convexity approaches zero. If a fund elects not to aim for as much balance as it can achieve and instead bets on a pronounced change in interest rates, it can be so structured (using significant amounts of IO strips) that its overall value will increase with a rise in interest rates or decrease with declining interest rates. That is what happened with the Hyperion funds. But a "balanced" fund, even one that acknowledges the possibility that significant rate decreases could harm more than significant rate increases could benefit, is still expected to structure the portfolio so that the net convexity is very slight. If the fund managers are secretly betting so heavily on rising interest rates by such a significant inclusion of leveraged IO strips that an interest rate decline will cause substantial decreases, they must say so. Their acknowledgement of the possible differing consequences of significantly decreasing and increasing rates does not reveal that their investment strategy is contrary to what would reasonably be expected of a "balanced" fund. Of course, the investors in such funds have no valid stock fraud claim if fund managers turn out to be less skillful at balancing their portfolios than the investors hoped; if that is all that the appellants in this case were claiming, their suit would be properly dismissed. But they are not alleging unsuccessful balancing. Their claim is that the fund managers misrepresented when they announced their intention to try to balance the funds to an extent that would insulate against significant rate fluctuations, yet
    • 60 planned, from the outset and thereafter, to structure the portfolios in a way that would yield benefits only if their undisclosed bet on rising interest rates was successful. The Court asserts that the prospectuses warn investors of exactly the risk the plaintiffs claim was not disclosed. A reasonable investor could not have read the prospectuses without realizing that, despite the use of balancing in an attempt to minimize the impact of fluctuating interest rates, a significant downturn in interest rates could decrease the value of the Trusts and decrease earnings. This assertion misconceives the risk on which this suit is based. The appellants are not suing because of the disclosed risk that if interest rates declined, asset values would decline. They are suing because of the undisclosed risk that the fund managers would structure the initial portfolios and make investment decisions thereafter by selecting securities that would respond significantly to rate fluctuations that the managers believed, but did not disclose, would be rate rises. The investors accepted the risk that interest rates might decline and that imperfect balancing might cost them some money. They did not accept the risk that a fund, sold as being balanced in order to minimize the effects of interest rate fluctuations, would in fact be deliberately tilted so heavily in the expectation of rising interest rates that a decline in interest rates would incur devastating losses. It is no answer to suggest that the funds were "balanced" in that they contained some securities whose values would move in opposite directions in response to interest rate fluctuations. Appellants do not claim that no balancing occurred; clearly, there was some diversification in the portfolios. The claim is that whatever balancing occurred was undertaken, initially and thereafter, on the undisclosed prediction by the fund managers that interest rates would rise. The fact that some mortgage-backed securities and some IO strips were included in the portfolios indicates only that some diversification occurred. The significant losses occurred because of the undisclosed fact that the fund managers, betting heavily on rising interest rates, purchased on a highly leveraged basis a quantity of IO strips of particular rates and maturities to such an extent that interest rate declines proved devastating. It may well be, as the majority suggests, that portfolio managers of funds claimed to be balanced must inevitably make some predictions about future interest rates. Since it is unlikely that interest rates will remain completely static for any significant period of time, a manager of a balanced portfolio probably makes some prediction of the likely near-term direction of rates. But the whole point of balancing is to structure a portfolio so as to minimize the effects of any interest fluctuations, whether interest rate declines or rises are expected. Even a manager who believes that rates will rise will try to live up to the promise of a balanced fund by selecting a group of securities of low net convexity to guard against the risk of significant loss from rate fluctuations in either direction. It cannot be maintained that what happened here is simply the inevitable inability of fund managers to balance as skillfully as might have been hoped. The other fixed- income funds that claimed to be balanced survived the modest interest decline that devastated the Hyperion funds. The Hyperion funds ended disastrously not because the managers lacked skill in balancing, but because they bet their investors' money so heavily on rising rates. They were free to market a fund on that basis and invite investments
    • 61 from those who were also willing to bet heavily on rising interest rates. But they were not free to bet heavily on rising rates and conceal this critical fact from their investors. In a further effort to bolster the argument that the bias toward rising interest rates was disclosed, the Court points out in a footnote that the prospectuses disclosed percentage breakdowns of the initial portfolio investments. [Citation to footnote 1 in the majority opinion.] The implied point is that these percentage breakdowns enabled investors to make their own determination of the degree to which the portfolio managers were balancing and thereby infer the bias toward rising interest rates inherent in their selection of securities. The appellants respond that disclosure of only the percentages of the portfolio in various forms of securities (i.e., mortgage-backed securities and IO strips) cannot inform an investor of a bias toward rising interest rates in the absence of detail as to the precise nature of the various securities, their interest rates, and their maturities. The appellants are probably correct in their response, but, at a minimum, they are entitled to present evidence to support their basic contention that a reasonable investor, reading the prospectuses, would not have learned that the portfolios were initially invested with a heavy bet on rising interest rates. Even if such an understanding was available as to the initial investments, no reasonable investor could possibly learn that, contrary to the promises to try to balance the funds in the future in an effort to preserve capital and minimize the consequences of interest rate fluctuations, the portfolio managers always intended to reinvest with a distinct bias toward rising interest rates. The Court also suggests that the undisclosed bias toward rising interest rates did not cause the appellants' losses, which the Court attributes to declining interest rates. I agree that the appellants cannot claim as damages the entire decline in their investment, some part of which is attributable to falling interest rates, but they are entitled to recover the difference between (a) the modest decline that would have occurred if a good faith effort to balance the funds with portfolios of low net convexity had been attempted and (b) the precipitous decline that occurred in the absence of such attempted balancing. Investors in fixed-income securities or funds of such securities seek rates of return above Treasury issues and accept the risk that unforeseen developments might cause their asset values to drop. But they are entitled to their day in court when they allege, in a detailed complaint, that issuers have promised an attempt to balance a fund to minimize the effects of interest rate fluctuations and have in fact bet heavily on rising interest rates and used the investors' money to make that bet. For these reasons, I respectfully dissent.
    • 62 Karpus v. Hyperion Capital Management, Inc. 1996 Fed. Sec. L. Rep. (CCH) & 99,366 (S.D. N.Y. 1996) 1996 U.S. Dist. LEXIS 17104 OPINION OF THE COURT Plaintiff filed this action for alleged violations of Section 13(a)(3) of the Investment Company Act of 1940 . . . . Defendants moved under Fed. R. Civ. P. 12(b) (6) to dismiss for failure to state a claim upon which relief can be granted . . . . For the reasons set forth below, defendants' motion is granted with leave to amend. Legal Standard for Motion to Dismiss In deciding a Rule 12(b)(6) motion to dismiss, the Court must accept as true material facts alleged in the complaint and draw all reasonable inferences in the nonmovant's favor. . . . Such a motion cannot be granted simply because recovery appears remote or unlikely on the face of a complaint, because "the issue is not whether a plaintiff will ultimately prevail but whether the claimant is entitled to offer evidence to support the claims." Rather, dismissal can only be granted if "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." ... Factual Background Applying the above principles, the facts of this case are as follows. In an October 1992 offering, defendants raised over a half a billion dollars from the public to fund the Hyperion 1997 Term Trust, Inc., a closed-end investment company (the "Trust"). The Trust is due to terminate in November of 1997, at which time it is supposed to pay at least $10 per share to its shareholders. In connection with the offering, defendants filed a registration statement with the Securities and Exchange Commission (SEC). This registration statement, also known as a "Prospectus", provides a description of the Trust's objectives and policies in a section appropriately entitled "INVESTMENT OBJECTIVES AND POLICIES". Set forth in this section was the following statement: The Adviser will manage the Trust's assets so as to reduce sensitivity to changes in interest rates over time as the remaining term of the Trust shortens. . . . Prospectus at 19 (hereafter, the "Statement"). Plaintiff claims this Statement was important to investors because it assured them that the fluctuation in the value of the Trust's assets in response to changing interest rates would decrease as the Trust approached its termination date.2 2 2 It is interesting to note that this same clause of the Hyperion 1997 Term Trust
    • 63 Plaintiff's claim is based on the argument that under the terms of the Prospectus, the Statement was an "investment objective" that could not be changed without shareholder approval. Plaintiff argues that defendants have substantially deviated from the investment requirements described in the Statement by investing the Trust's assets in a manner that increased rather then decreased sensitivity to interest rate changes. Plaintiff maintains that defendants' deviation from the alleged "investment objective" violated the Investment Company Act and caused plaintiff and similarly situated Trust investors to suffer significant losses. Discussion I. The Investment Company Act Section 8 of the Investment Company Act directs an investment company to recite in its registration statement "all investment policies of the registrant . . . which are changeable only if authorized by shareholder vote," as well as all policies that "the registrant deems matters of fundamental policy." Section 13 prohibits a registered investment company from altering any policies defined as "fundamental" by the registration statement "unless authorized by the vote of a majority of its outstanding voting securities." . . . II. Analysis The question presented here is whether a reasonable investor3 could determine, after reading the Hyperion Prospectus in its entirety, that the Statement was a fundamental investment objective from which the Trust could not deviate without shareholder approval (an "investment objective"). Plaintiff puts forth three arguments to support his position. First, plaintiff argues that the Statement's plain meaning "sounds like" an investment objective. Second, plaintiff maintains that the placement of the Statement after the centered bold-faced heading entitled "INVESTMENT OBJECTIVES AND POLICIES", Prospectus at 17, demonstrates that it reasonably may be deemed an investment objective. Third, plaintiff contends that nothing in the Prospectus would prevent the Statement from being placed within the category of investment objectives. A. Plaintiff's Plain Meaning Argument Plaintiff's "plain meaning" argument is unpersuasive. The Prospectus reads, in pertinent part: Prospectus has been the subject of prior litigation. See Olkey et al. v. Hyperion 1999 Term Trust, Inc. et al., 98 F.3d 2 (2nd Cir. 1996) . . . . 3 3. . . [C]ourts have generally used the "reasonable investor" standard to interpret and apply federal securities laws designed to protect the investing public such as the Investment Company Act. See Olkey . . .
    • 64 INVESTMENT OBJECTIVES AND POLICIES The Trust's investment objectives are to provide a high level of current income consistent with investing only in securities of the highest credit quality and to return at least $10.00 per Share (the initial public offering price per Share) to investors on or shortly before November 30, 1997. No assurance can be given that the Trust's investment objectives will be achieved. The Trust's investment objectives are fundamental policies. Fundamental policies may not be changed without the affirmative vote of the holders of a majority of the outstanding Share[s]. See "Investment Limitations". Investment Strategy The Trust will seek to achieve its investment objectives by investing in a portfolio consisting of a variety of different types of Mortgage-Backed Securities and Zero Coupon Securities. . . . The Adviser will manage the Trust's assets so as to reduce sensitivity to changes in interest rates over time as the remaining term of the Trust shortens. Prospectus at 17-19 (italicized portion indicates "Statement"). Later the prospectus states: INVESTMENT LIMITATIONS The Trust's investment objectives and the following restrictions are fundamental and cannot be changed without the approval of the holders of a majority of the outstanding voting securities . . . . All other investment policies or practices are considered by the Trust not to be fundamental and, accordingly, may be changed without shareholder approval. Prospectus at 30 (italics added) (followed by a list of restrictions which are not relevant to the instant motion). A plain meaning interpretation of the text set forth above does not support plaintiff's argument. The first heading is entitled "INVESTMENT OBJECTIVES AND POLICIES", indicating that the following material will delineate "investment objectives" and "policies". A careful reader would reasonably presume the former are distinct from the latter, and expect to find both in the following text. The plain meaning of the first sentence after the heading is that the Trust has two investment objectives: (1) to provide a high level of current income consistent with investing only in securities of the highest credit quality and (2) to return at least $10 per share on November 30, 1997. B. Plaintiff's Argument Regarding Location of Statement Within Prospectus It is true, as plaintiff states, that the Statement follows the heading "INVESTMENT OBJECTIVES AND POLICIES". Yet the location of the Statement alone does not lead inexorably to plaintiff's conclusion that the Statement is an "investment objective" and not merely a "policy". The Prospectus sets the investment
    • 65 objectives apart from the Statement with the bold-faced sub-heading "Investment Strategy". The next sentence explains that the Trust "will seek to achieve its investment objectives" through a series of policies, policies described under the sub-heading "Investment Strategy". That the Statement follows the header "INVESTMENT OBJECTIVES AND POLICIES" should present no confusion to the careful reader. The only reasonable interpretation of the Prospectus, including the Statement itself, is that the text following the sub-heading "Investment Strategy" describes policies and not investment objectives. C. Plaintiff's Argument that Nothing in Prospectus Indicates that the Statement is Not an Investment Objective Plaintiff's argument that nothing in the Prospectus would prevent a reasonable investor from interpreting the Statement to be an "investment" objective ignores the section of the Prospectus entitled "INVESTMENT LIMITATIONS". The italicized portion of this section set forth above clearly indicates that, under the terms of the Prospectus, policies are different from investment objectives in that they may be changed without shareholder approval. As explained above, rigorous scrutiny of the Prospectus reveals that the Statement is set apart from the description of the Trust's investment objectives, and rather forms part of the "Policies" referred to in the heading "INVESTMENT OBJECTIVES AND POLICIES". A quick skim of the Prospectus by a reader unfamiliar with financial terminology and the structure of registration statements might lead that reader to conclude that the Statement is an investment objective. Yet the federal securities laws were not drafted with an improvident investor in mind. The protection of the Investment Company Act does not extend to those who invest money without carefully reading the registration statement of the investment company. Indeed a contrary holding would require registration statements to be drafted so as to make the least diligent investor aware of a company's investment objectives and policies, and the distinction between the two. The deluge of information presented in registration statements under such circumstances would certainly not lead to more careful decision-making by the investment public. . . . D. A Reasonable Interpretation of the Statement Cannot Support Plaintiff's Investment Company Act Claim For the foregoing reasons, I find the only reasonable interpretation of the Statement and the Prospectus as a whole is that the Statement was not a fundamental "investment objective" but rather an "investment strategy" or "policy". Defendants were therefore not bound to seek shareholder approval before altering that strategy or policy. Plaintiff's Investment Company Act claim must therefore be dismissed pursuant to Rule 12(b)6). Rule 15(a) of the Federal Rules of Civil Procedure provides that the court should grant leave to amend "freely . . . when justice so requires." . . .
    • 66 [In Olkey,] Chief Judge Newman accurately summarized the gravamen of plaintiffs' complaint: "The [Hyperion] investors accepted the risk that interest rates might decline and that imperfect balancing might cost them some money. They did not accept the risk that a fund, sold as being balanced in order to minimize the effects of interest rates fluctuations, would in fact be deliberately tilted so heavily in the expectation of rising interest rates that a decline in the interest rates would incur devastating [losses]." Olkey (Newman, C.J., dissenting). The Second Circuit has ruled that these alleged facts do not provide plaintiffs with an actionable claim under the Securities Act of 1933, the Securities Exchange Act of 1934, or an actionable common law claim of fraud. Id. Nevertheless, given the underlying facts of this case, it is possible that plaintiffs may yet be able to plead facts sufficient to state a cause of action. Accordingly, plaintiff's Investment Company Act is dismissed with leave to amend. ...
    • 67 Note The Securities and Exchange Commission has adopted rules requiring issuers of publicly offered securities, including mutual funds, to write their prospectuses in "plain English." The passage below is from the Commission Release announcing the rules. Plain English Disclosure, Investment Company Act Release No. 23011, 63 Fed. Reg. 6370 (1998). Full and fair disclosure is one of the cornerstones of investor protection under the federal securities laws. If a prospectus fails to communicate information clearly, investors do not receive that basic protection. Yet, prospectuses today often use complex, legalistic language that is foreign to all but financial or legal experts. The proliferation of complex transactions and securities magnifies this problem. A major challenge facing the securities industry and its regulators is assuring that financial and business information reaches investors in a form they can read and understand. In response to this challenge, we undertake today a sweeping revision of how issuers must disclose information to investors. This new package of rules will change the face of every prospectus used in registered public offerings of securities. Prospectuses will be simpler, clearer, more useful, and we hope, more widely read. First, the new rules require issuers to write and design the cover page, summary, and risk factors section of their prospectuses in plain Eng- lish. Specifically, in these sections, issuers will have to use: short sen- tences; definite, concrete, everyday language; active voice; tabular presentation of complex information; no legal or business jargon; and no multiple negatives. Issuers will also have to design these sections to make them inviting to the reader. . . . [T]he new rules will not require issuers to limit the length of the summary, limit the number of risk factors, or prioritize risk factors. Second, . . . issuers . . . [need] to comply with the current rule that requires the entire prospectus to be clear, concise, and understandable. Our goal is to purge the entire document of legalese and repetition that blur important information investors need to know. The Commission has also adopted "amendments to Form N-1A, the form used by mutual funds to register under the Investment Company Act of 1940 and to offer their shares under the Securities Act of 1933. The amendments are intended to improve fund prospectus disclosure and to promote more effective communication of information about funds to investors. The amendments focus the disclosure in a fund's prospectus on essential information about the fund that will assist investors in deciding whether to invest in the fund. The amendments also minimize prospectus disclosure about technical, legal, and operational matters that generally are common to all funds." Thus, "[f]unds should limit disclosure in prospectuses generally to information that is necessary for an average or typical investor to make an investment decision. Detailed or highly technical
    • 68 discussions, as well as information that may be helpful to more sophisticated investors, dilute the effect of necessary prospectus disclosure and should be placed in the [Statement of Additional Information]. Prospectus disclosure requirements should not lead to lengthy disclosure that discourages investors from reading the prospectus or obscures essential information about an investment in a fund." Registration Form Used by Open-End Management Investment Companies, Investment Company Act Release No. 23064, 63 Fed. Reg. 13916, 13919 (1998). Finally, the Commission has adopted a rule allowing an open-end fund Ato provide to investors a disclosure document called a >profile,= which summarizes key information about the fund and gives investors the option of purchasing the fund's shares based on the information in the profile. . . . A fund that makes a profile available will be able to offer an investor the option of purchasing the fund's shares after reviewing the information in the profile or of requesting and reviewing the fund's prospectus (and other information) before making an investment decision. An investor deciding to purchase fund shares based on the profile will receive the fund=s prospectus with the purchase confirmation.@ The rule, which is at 17 C.F.R. ' 230.498, was adopted because "the growth of the fund industry and the diversity of fund investors warrant a new approach to fund disclosure that will offer more choices in the format and amount of information available about fund investments." Under the rule, Athe profile will include: $ Standardized Fund Summaries. The profile includes concise disclosure of 9 items of key information about a fund in a specific sequence.I $ Improved Risk Disclosure. A risk/return summary . . . provides information about a fund's investment objectives, principal strategies, risks, performance, and fees. $ Graphic Disclosure of Variability of Returns. The risk/return summary provides a bar chart of a fund's annual returns over a 10-year period that illustrates the variability of those returns and gives investors some idea of the risks of an investment in the fund. To help investors evaluate a fund's risks and returns relative to >the market,= a table accompanying the bar chart compares the fund's average annual returns for 1-, 5-, and 10-year periods to that of a broad-based securities market index. I I Editor=s note: The nine items that must be included in the profile for a fund, and the sequence in which they must appear in the profile, are as follows: (1) the objectives of the fund; (2) its principal investment strategies; (3) its principal risks; (4) its fees and expenses; (5) its investment adviser, subadviser(s), and portfolio manager(s); (6) the minimum amounts required for initial and subsequent purchases of fund shares and the sales load, if any, that will be paid for purchases; (7) an explanation that the shares of the fund are redeemable, an outline of the procedures by which shares can be redeemed, and a disclosure of any charges and sales loads applicable to redemptions; (8) an explanation of the frequency and tax character of, and reinvestment options for, distributions made by the fund; and (9) other services offered by the fund, e.g., exchange privileges.
    • 69 $ Other Fund Information. The profile includes information on the fund's investment adviser and portfolio manager, purchase and redemption procedures, tax considerations, and shareholder services. $ Plain English Disclosure. The Commission's recently adopted plain English disclosure requirements, which are designed to give investors understandable disclosure documents, will apply to the profile. . . .@ New Disclosure Option for Open-End Management Investment Companies, Investment Company Act Release No. 23065, 63 Fed. Reg. 13968, 13969 (1998). However, the prospectus will remain the chief disclosure document for a fund, and the profile will serve merely to summarize key facts about the fund. Id., at 13968, 13971, 13974.
    • 70 American Funds Distributors, Inc. Securities and Exchange Commission No-Action Letter Publicly Available October 16, 1989 1989 SEC NOACT LEXIS 1075 LETTER TO SEC American Funds Distributors, Inc. ("AFD"), principal underwriter for 22 investment companies collectively known as The American Funds Group (the "Funds"), is writing to confirm that the staff of the Division of Investment Management (the "staff") will not recommend to the Securities and Exchange Commission (the "Commission") that the Commission take any enforcement action if AFD uses certain sales literature and advertisements written in languages other than English ("non-English sales materials") as described below. . . . 1. Facts Persons who use English as a second language or do not use English at all represent a significant percentage of the U.S. population.1 Accordingly, it is often diffi- cult to communicate effectively with such individuals regarding the Funds with English- language advertisements or sales literature. Of course, non-English speaking individuals living in the U.S. are accustomed to conducting business dealings in English, but are naturally more comfortable with their native language and are more likely to respond to material written in their native language. Therefore, AFD is considering developing non- English sales materials for use in the U.S. Non-English sales materials distributed to the public would either be preceded or accompanied by current prospectuses for the Funds being offered . . . . Only English- language prospectuses would be available in connection with non-English sales materials. Each piece of non-English sales material would bear a prominent legend to the effect that the prospectuses for the Funds being offered are available only in the English language and potential investors should not invest or send money without understanding the content of the prospectuses. . . . Potential investors receiving non-English sales materials who might not understand an English-language prospectus would be further protected by the fact that 1 1 According to the 1980 census, 23 million U.S. residents, or roughly 10% of the nation's population, spoke a language other than English in their homes. In Los Angeles, where AFD has its principal office, according to a report published in The Wall Street Journal, by 1992 two of every three students enrolled in the public school system will come from a family where a language other than English is spoken. The Los Angeles public school student population embraces more than 80 languages and comes from such diverse places as Madagascar, Macao, and Mexico. It would not be economically feasible to reach such disparate groups if it were necessary to translate Fund prospectuses.
    • 71 shares of the Funds are sold through securities dealers who are subject to numerous requirements related to investor protection including Article III, Section 2 of the National Association of Securities Dealers' Rules of Fair Practice which states in pertinent part that "[i]n recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for the customer . . ." 2. Discussion a. Non-English Sales Materials Accompanied or Preceded by a Prospectus AFD requests confirmation that the staff would not recommend that the Commission take action if an English-language prospectus of a Fund were delivered to potential investors pursuant to Sections 5(b) and 10(a) of the 1933 Act along with non- English sales materials for that Fund. The staff has confirmed to the Franklin Group of Funds that it would take a no- action position (under Section 24(b) of the 1940 Act, see below) with respect to audio- taped sales material intended for distribution (along with a written prospectus) to blind and visually impaired persons provided "(1) the Materials, given the audience to whom the Materials are presented[,] provide an accurate representation of the products being offered by Franklin, i.e., the materials are not misleading. . . ." See, Franklin Group of Funds, SEC No-Action Letter (available February 26, 1987) (the "Franklin letter"). AFD believes that delivering, for example, Chinese-language sales literature along with an English-language prospectus to native Chinese-language speakers is analogous to delivering audio-taped sales literature along with a written prospectus to blind and visually impaired individuals. Further, the foreign population has daily exposure to written English and must conduct its business in that language (even if they do not read it fluently). Of course, as discussed above, AFD intends to adhere to the conditions contained in the Franklin letter. ... c. Non-English Sales Materials Filed Pursuant to Section 24(b) and Rule 24b-3 AFD requests confirmation that the staff would not recommend that the Commission take action if non-English sales materials used with English-language prospectuses are filed pursuant to Section 24(b) of the 1940 Act and Rule 24b-3 thereunder.I I I Editor's note: Rule 24b-3 permits advertisements and sales literature to be filed with "a national securities association registered under . . . the Securities Exchange Act of 1934 that has adopted rules providing standards for the investment company advertis- ing practices of its members and has established and implemented procedures to review that advertising." Advertisements and sales literature filed with such an association are deemed to have been filed with the Commission. 17 C.F.R. ' 270.24b-3.
    • 72 The staff in the Franklin letter took a no-action position with respect to the filing of audio-taped material to be used with blind and visually impaired individuals pursuant to Section 24(b) of the 1940 Act. As discussed above, we believe the issue presented in this letter is analogous to the issue presented in the Franklin letter. ... SEC REPLY Your letter . . . requests our assurance that we would not recommend that the Commission take any enforcement action against American Fund Distributors, Inc. ("AFD"), the principal underwriter for The American Funds Group ("Funds"), if AFD distributes non-English language sales materials in the U.S . . . that are accompanied or preceded by an English language prospectus in accordance with Sections 5(b) and 10(a) of the Securities Act of 1933 . . . . You also seek our confirmation that we would not recommend enforcement action if non-English language sales materials used with English language prospectuses are filed under Section 24(b) of the Investment Company Act of 1940 ("1940 Act") and Rule 24b-3 thereunder. You state that persons who use English as a second language or do not use English at all represent a significant percentage of the U.S. population and it is therefore difficult to communicate effectively with such individuals regarding the Funds when distributing English language advertisements or sales literature. Further, you state that non-English speaking individuals living in the U.S. are more likely to respond to material written in their native language. In order to effectively communicate with these individuals, you propose to include a legend on each piece of non-English language sales material indicating that prospectuses for the Funds are available only in English and potential investors should not invest or send money without understanding the content of the prospectus. You believe that your request is analogous to the no-action request made by the Franklin Group of Funds (pub. avail. Feb. 26, 1987) (the "Franklin letter") in which the staff granted no-action relief.1 However, we are unwilling to extend the position taken in the Franklin letter to AFD's distribution of non-English sales literature and advertisements. We believe that if AFD distributes sales literature, or adver- tisements, in a language other than English, a prospectus in the same language should be readily available.2 For the reasons stated above, we are unable to assure you that we 1 1In the Franklin letter the staff stated that it would not recommend any enforcement action to the Commission under Section 24(b) of the 1940 Act if the Franklin Group of Funds filed . . . audio taped advertising materials to be used by the funds in connection with the sale of fund shares to blind and visually-impaired persons. Franklin stated that it would supply a prospectus that would either precede or accompany the sales materials. The sales materials were to include a statement disclosing the availability of a prospectus and a statement advising prospective investors to review the prospectus carefully before investing. The staff is currently reconsidering its position in the Franklin letter. 2 2 For example, if AFD distributes sales literature in a language other than English
    • 73 would not recommend that the Commission take any enforcement action if AFD proceeds as described in your letter. ... and an English language prospectus either precedes or accompanies such sales literature, the sales literature should state that (1) a prospectus in the same language is available upon request, and (2) prospective investors should review a prospectus carefully before investing.
    • 74 Franklin Group of Funds Securities and Exchange Commission No-Action Letter Publicly Available December 5, 1989 1989 SEC NOACT LEXIS 1186 LETTER TO SEC We are writing in response to your request that the Franklin Group of Funds ("Franklin") advise the Division of Investment Management whether and how the Division should continue to distinguish Franklin's situation, in a setting where audio- taped sales literature is provided to visually impaired persons without an accompanying prospectus which is either audio-taped or in braille, from the position taken by the Division in the no-action letter issued to American Funds Distributors, Inc. ("ADF") (pub. avail. Oct. 16, 1989). We believe that the position taken by the Division in its [original] no-action letter to Franklin can be distinguished from the position taken in American Funds for the reasons stated below. First, although we can not offer statistical confirmation at this time, the number of potential investors who are visually impaired must certainly be a fraction of those who speak a language other than English in their homes (noting that ADF's no-action request said that according to the 1980 census, the number of non-English speaking persons was about 10% of the nation's population). Thus, the number of persons who could be adversely affected by the continuation of the policy stated by the Division in its [original] letter [to Franklin] would be substantially fewer. Another distinguishing factor is the probability that, based upon the census statistics cited above, the vast majority of the blind or visually impaired population could understand a prospectus printed in English. Accordingly, if someone were to read the prospectus to such persons they would likely understand it. By contrast, the number of non-English speaking individuals able to understand a prospectus printed in English would be significantly fewer. As a result, the potential for miscommunication and misunderstanding would be greatly increased in a situation where a bilingual person assisted a non-English speaking individual in reading the prospectus. Finally, from a feasibility standpoint the two situations are distinguishable. It would cost many times more to produce and update a prospectus in braille than it would to simply translate a prospectus into another language. In addition, a braille prospectus would be a cumbersome document, difficult to handle and costly to distribute. Moreover, due to the relatively low demand for such a document compared [to] the demand for prospectuses printed in foreign languages, the cost of producing a braille prospectus is not justifiable. In summary, we believe that the potential for harm in the situation where a non- English speaking audience is not provided with a prospectus they can understand far exceeds that which exists in Franklin's situation, and it is upon that basis that we distinguish these two no-action requests. We, therefore, respectfully ask that the Division continue the no-action protection afforded by its [original] letter.
    • 75 Should the Division disagree with Franklin's position, Franklin agrees to provide audio-taped versions of all prospectuses for which audio-taped sales literature now exists, and will do so for any future taped sales literature. SEC REPLY By letter . . . , we asked that the Franklin Group of Funds ("Franklin") advise us whether and, if so, how this Division should continue to distinguish the position taken by the staff in Franklin Group of Funds (pub. avail. Feb. 26, 1987) ("Franklin letter") from the subsequent position stated in American Funds Distributors, Inc. (pub. avail. Oct. 16, 1989) ("AFD letter").1 In response, your letter . . . requests that the Division continue to adhere to the position taken in the Franklin letter. Upon further consideration, we do not believe that the factual differences between the Franklin letter and the AFD letter are legally distinguishable, and believe that the position taken in AFD should apply to Franklin. Accordingly, we hereby withdraw the Franklin letter. Franklin should proceed as stated in the final paragraph of your letter . . . by providing audio taped prospectuses for all audio taped sales literature that is now in existence and for any future audio taped sales literature. 1 1 As you know, in the Franklin letter the staff stated that it would not recommend enforcement action to the Commission under Section 24(b) of the Investment Company Act of 1940, if Franklin filed . . . audio taped advertising materials to be used by the funds in connection with the sale of fund shares to blind and visually-impaired persons. Franklin stated that it would supply a printed prospectus that would either precede or accompany the taped sales materials, and that the sales materials would include a statement advising prospective investors to review the prospectus carefully before investing.