Financial Services Alert - July 8, 2014

The staff of the SEC’s Division of Investment Management issued IM Guidance Update No. 2014-8 (the “Guidance Update”) to provide guidance based on comments the Division has provided on the information required to be presented in standardized order at the beginning of mutual fund statutory prospectuses (the “Summary Section”) in response to Form N-1A Items 2 through 8.  This is also the information required in a summary prospectus provided to investors pursuant to Rule 498 under the Securities Act of 1933.

Principal Investment Strategies and Risks.  The Guidance Update notes that the staff often finds that the principal investment strategies and risks provided in response to Item 4 are not, as required by the Item, a concise summary of the information provided in response to Item 9.  The Guidance Update also expresses concern over instances where the staff has observed that the disclosure in response to Item 4 substantially duplicates Item 9 disclosure, which the staff views as undermining the layered disclosure regime adopted by the SEC by increasing the length of mutual fund prospectuses.

Plain English.  The Guidance Update expresses concern over the failure by certain registrants to comply with the plain English requirements of Rule 421(d) under the Securities Act of 1933 that apply to the Summary Section, in particular, through the use of (a) technical terms that are not explained in plain English, (b) unnecessary defined terms,(c) long, compound sentences, and (d) long, dense paragraphs that the staff believes may be difficult for investors to understand.

Limitations on Information Provided in Summary Section.  The Guidance Update provides a reminder that the Summary Section may not include information other than that required by Items 2 through 8 of Form N-1A.  The Guidance Update provides examples of two areas scrutinized by the staff for compliance with this requirement: (1) footnotes to the Fee Table and (2) purchase and sale information provided in response to Item 6.

Inclusion of Non-Principal Strategies and Risks in the Prospectus.  The Guidance Update notes that while a fund is permitted to include non-principal investment strategies and risks in its prospectus that it could otherwise disclose in its statement of additional information, the staff has observed instances where these additional strategies and risks are presented in a way that does not clearly indicate which of the fund’s strategies and risks are principal and which are not. In such instances, the staff comments that the fund should distinguish between them.

Use of Cross References in the Summary Section.  The Guidance Update provides a reminder that the instructions to Form N-1A direct a fund to avoid cross-references to its statement of additional information or shareholder reports.  The staff frequently observes numerous such cross-references in the Summary Section, and when appropriate, the staff suggests that the cross-references be deleted to streamline the Summary Section.

The Government Accountability Office (the “GAO”) issued a report concerning virtual currencies (the “Report”) to the U.S. Senate’s Committee on Homeland Security and Governmental Affairs.  The Report discusses emerging regulatory, law enforcement and consumer protection challenges related to virtual currencies i.e., digital representations of value (such as bitcoins) that are not government-issued.

The GAO found that virtual currencies are posing emerging and increasing challenges to federal financial regulatory and law enforcement agencies.  As examples of these challenges, the GAO cited:

1. the greater anonymity provided by virtual currencies as opposed to traditional payment systems, which makes it more difficult for agencies to detect money laundering and other criminal activity;
2. the global nature of virtual currencies, which often leads to payments and fund transfers across borders thereby requiring U.S. agencies “to rely upon cooperation from international partners who may operate under different regulatory and legal regimes;” and
3. consumer and investor protection issues raised by volatility in bitcoin prices, loss of consumer funds maintained by bitcoin exchanges and new virtual-currency-based investment products.

In the Report, the GAO found that federal financial regulatory and law enforcement agencies have focused their efforts on fighting money laundering and other criminal activities related to bitcoin and other virtual currencies.  The GAO concluded that increased attention should be given to emerging consumer protection issues related to the use of virtual currencies, and the GAO recommended that the Consumer Financial Protection Bureau (“CFPB”) “take steps to identify and participate in pertinent interagency working groups addressing [issues related to] virtual currencies.”  Included as an exhibit to the Report is a letter from the CFPB in which the CFPB agreed with the GAO’s recommendation that CFPB increase its involvement in interagency working groups addressing regulation of virtual currencies, and in particular, consumer protection concerns.  Among the other appendices and figures provided with the Report are a figure listing ways to obtain and spend bitcoins and a figure illustrating the price volatility of bitcoins.