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
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.
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.
Investment Company Advertising And Sales Literature
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
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.
Communications After Filing the Registration Statement But Prior to Delivery of
the Statutory Prospectus
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
3See Rule 135A(a)(2).
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
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).
appears in these materials immediately after Rule 2210, contains guidelines for
advertising of fund rankings. You will need these materials to answer the problems.
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
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 '
6Securities Act Rule 497.
7Investment Company Act Rule 24b-3; Securities Act Rule 497(i).
Selected NASD Rules Concerning Advertising and Sales
Rule 2210. Communications with the Public
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
(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
(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
(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
(iii) the research firm prepares and distributes reports based on
similar research with respect to a substantial number of investment
(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
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.
(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.
(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
(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
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
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
(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
(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
(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
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
(G) Press releases that are made available only to members of the media.
(H) Independently prepared reprints.
(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
(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
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
(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
(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
(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.
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.
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
(E) criteria on which the ranking is based (e.g., total return, risk-adjusted
(3) Other Required Disclosure
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
(D) the publisher of the ranking data (e.g., "ABC Magazine, June 2003");
(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
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).
(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
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
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
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
. . . [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.
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
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?
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
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
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.@
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 . . .
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
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
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 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 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.
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.
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.
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.
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
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 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. . . .
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.@
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
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.
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
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
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
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.
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
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.
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
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
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 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)
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 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 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).
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
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
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.
. . . 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.
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,
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
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 Telephone conversation [with] . . . counsel to NAST . . . .
4 Id. . . .
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.
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:
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").
Fund Factors specified
by the Division of Investment Management
The Equity Income Fund and the Total Return Fund had the
same investment adviser, which will be the investment adviser
to the combined Fund.
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
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
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
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-
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
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
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
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
Total investments 103.9%
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%
EQUITY INCOME FUND PROSPECTUS (April 30, 1997).
[TOTAL RETURN FUND] PROSPECTUS (April 30, 1997).
SUPPLEMENT TO [TOTAL RETURN FUND] PROSPECTUS DATED APRIL 30, 1997 (Sept. 25, 1997).
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.
SCHEDULES OF INVESTMENTS DECEMBER 31, 1996; 1996 ANNUAL REPORT.
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
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
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 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 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
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 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
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
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
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"
* 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.
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 . . . .
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
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
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.
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.
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
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
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
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. . . .
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
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").
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.
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
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
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.
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
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
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
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. . . .
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 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,
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
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 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.
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
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"
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
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
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.
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
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
. . . 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 It is interesting to note that this same clause of the Hyperion 1997 Term Trust
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.
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." . . .
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
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 . . .
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
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
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
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
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
Rule 15(a) of the Federal Rules of Civil Procedure provides that the court should
grant leave to amend "freely . . . when justice so requires." . . .
[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.
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.
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
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
$ 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 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.
$ 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.
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. . . .
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 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
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 . . ."
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
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.
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.
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 For example, if AFD distributes sales literature in a language other than English
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
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.
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.
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
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