ABA Section of Business Law
ABA Section of Business Law
Business Law Today
March / April 2000
When performance is an issue The SEC vs. ad claims
By CHARLES J. ZANGARA
According to one prominent theory on investing, the price of any publicly traded security reflects all the publicly available information about that security. In this way, prices of stocks are said to be "efficient." But what if some of the information reaching the market has a footnote that says, "what you’re reading does not necessarily mean what you think it does"?
Does the market discount for disclaimers?
SEC Chairman Arthur Levitt has called information the "lifeblood of the markets," and the federal securities laws reflect this axiom by compelling companies that offer shares to the public to comply with a variety of disclosure and reporting duties. But the securities laws also require companies in some cases to remind investors what certain information doesn’t mean. Of course, telling investors what information doesn’t mean is not the same as telling them what it does mean. And when the information is designed in such a way that it suggests a certain meaning, can a qualifier that disclaims such a meaning be truly meaningful?
See what I mean?
Nowhere is this seeming contradiction more apparent, and potentially more troublesome,
than in the way mutual fund companies advertise their performance — particularly
since net inflows of cash from investors have generally accounted for a greater percentage
of mutual fund asset growth than has fund performance during the period 1995-1998.
(Investment Company Institute, "Mutual Fund Developments in 1998," available at
http://www.ici.org/pdf/99fb_ch1.pdf.) Moreover, while "institutional investors"
— banks, pension funds, mutual funds — continue to dominate the market for
public company stocks, (Gompers and Metrick, "Institutional Investors and
Equity Prices," available at http://papers.nber.org/
papers/W6723 (Aug. 1998)), individuals dominate the market for mutual funds. (Investment
Company Institute, "Mutual Fund Ownership and Shareholder Characteristics,"
available at http://www.ici.org/pdf/99fb_ch5.pdf.)
The Securities Act of 1933, the federal law that regulates the issuance of corporate equity to the public, and the Investment Company Act of 1940, the federal law that regulates mutual funds, have a similar objective. Both aim to protect investors from uninformed decision making by ensuring that they get the right kinds of information at the right time.
The ’40 Act, however, differs from the ’33 Act in several important respects. For example, unlike the ’33 Act, which generally leaves to state law questions about the relationship between the board of directors and shareholders, the ’40 Act defines the roles played by each constituency and further defines many of the rights of fund shareholders (See the sidebar on mutual fund structure below).
But the real distinction lies in the ways in which mutual funds may communicate with investors. Although both the ’33 Act and the ’40 Act have been moving toward streamlining and simplifying the kinds of information that reach investors, the latter has done so with more zeal. And there are signs that the SEC and investors have become a bit edgy.
Of course, it would be inaccurate to view the ’33 Act and the ’40 Act as totally distinct regulatory schemes. In reality, much of the disclosure obligations imposed by the ’33 Act also apply to the offering of investment company shares. So it is useful to briefly review the broad disclosure requirements of the ’33 Act as they apply to investment companies.
With very few exceptions, the ’33 Act prohibits reporting companies proposing to sell shares to the public from making "offers to sell" — a phrase that is defined very broadly — securities unless a registration statement has been filed. (§5(c) of the ’33 Act.) A registration statement discloses various information about a company’s operations, management, industry, use of proceeds, etc. (See Form S-1 and Regulation S-K.) Once the registration statement has been filed — but before it has been reviewed or deemed "effective" by the SEC, that is, the "waiting period" — "offers to sell" may generally only be made by means of a statutory prospectus. (§§5(b) and 10 of the ’33 Act.)
A statutory prospectus includes much of the information disclosed in the registration statement (§10(a) of the ’33 Act); as a result, it can be a cumbersome document to wade through. Nevertheless, the regulations are intended give the public time to digest all of the information without first being enticed by selective disclosures. (See Release No. 33-4697.)
Whether this goal is achieved is debatable. The ’33 Act requires only that a statutory prospectus be delivered prior to, or at the time of confirmation of a sale of security, that is, after the investor has made the investment decision. Issuers do have the option of delivering a preliminary prospectus — one that essentially mirrors a final prospectus — prior to sale so long as the statutory prospectus is also delivered at or before confirmation of sale. (See Rule 430.) The SEC has sought to encourage the use of the early dissemination of the preliminary prospectus through Rule 460 and Rule 15c2-8 of the Securities & Exchange Act of 1934.
There are some exceptions to the "waiting period" rule, however. Because §5(b) of the ’33 Act does not prohibit oral offers to sell, companies are allowed to conduct "road shows" during the "waiting period" to generate interest. A "road show" is generally a live event during which the company and its underwriters discuss the proposed offering with institutional investors, broker-dealers and analysts.
In addition, companies may use "tombstone ads" during the "waiting period" to disseminate certain basic information. (Rule 134) A "tombstone ad" may only include:
• the name of the issuer,
• a general description of the issuer’s type of business,
• the amount of securities being offered, and
• where a prospectus may be obtained, among other specified information.
(See also §2(b)(10) of the ’33 Act.) But it may not include performance information or recommendations to purchase or sell.
Outside these limited exceptions, though, "free-writing" is prohibited during the "waiting period." And additional materials may not accompany statutory or preliminary prospectuses sent to investors.
Acknowledging that the current regulatory scheme is burdensome and often fails to put concise, timely information into the hands of investors, the SEC has undertaken a broad review and has proposed sweeping changes to the ’33 and ’34 Acts. These proposals, together called the "Aircraft Carrier" — probably because it takes about as much hardware memory to download the proposals as it does fuel to operate a battleship — include efforts to streamline and liberalize the information disclosed in prospectuses and make delivery of these documents more timely. (See Release No. 33-7606A.)
But, in some sense, these efforts have already materialized in the regulation of the
offering of investment company shares to the public. In a 1997 speech that anticipated new
investment company rulemaking, SEC Chairman Levitt acknowledged the reason why the agency
was liberalizing disclosure rules for investment companies: fear of being ignored.
"Signs of the prospectus’ disuse are everywhere
. . . like the cartoon that appeared in the Washington Post the other day. A man
and a woman are researching mutual funds, at a table covered with papers. The man cracks
open a prospectus and says, ‘You know, I met a guy once who actually read one of
these.’" ("Taking the mystery out of mutual funds," 1997 WL
213033 (Feb. 27, 1997))
These efforts to arm mutual fund investors with timely information began as far back as 1988, when the SEC adopted rules standardizing advertising of "performance" information by mutual funds during the "waiting period." (Rule 482; See Release IC-16245.) (Rule 34b-1 of the ’40 Act provides that all fund advertising that uses performance information must comply with Rule 482.) Acknowledging that it may be "unrealistic to expect than an investor would request the prospectuses of the hundreds of funds that may be available in an attempt to compare them," the SEC determined that investors had begun to rely on fund performance advertising to winnow fund investment choices. And if fund performance was going to be the vehicle that investors chose to "narrow their search" for funds, why not make all the vehicles come off the same assembly line?
Of course, the SEC recognized the inherent dangers in presenting performance information. Using the car analogy (hey: if Bruce Springsteen can do it, so can I), telling someone that the Ford Mustang achieved customer-satisfaction rates of 87 percent (hypothetical) during the past year is pretty misleading if you fail to mention that those rates fell to 62 percent in the prior year. To remedy this, the SEC requires fund ads (See the sidebar on advertising.) to disclose historical performance so that investors get an idea of the volatility involved in a fund’s performance. (Rule 482)
The sales literature must also prominently display a legend that alerts investors that performance data represents past performance and is no guarantee of future performance. (Consistent with the ’33 Act, Rule 482 ads, as summary prospectuses, must be limited to information found in the statutory prospectus and must also disclose a source from whom an investor can request the statutory prospectus.)
But is that enough? If an investor sees that a fund has had fairly stable average annual returns at the 10-, five- and one-year periods, isn’t it reasonable for that investor to conclude that those stable returns are likely to continue into the future? What’s missing from the information is the measure of risk involved in achieving such performance.
Reviving the car analogy one more time (it worked for the Beach Boys, but see Brian Wilson), telling someone that Ford Mustangs had customer-satisfaction rates of 78 percent (10 year), 72 percent (five year) and 87 percent (one year), isn’t the same as telling them that, in year eight, for example, customer satisfaction reached 99 percent, dipped to 77 percent in year seven before reaching its nadir in year five. Armed with such information, the car buyer could see that there is some risk involved in buying a new car based on the deviation in customer satisfaction from year to year.
To remedy this, the SEC requires the fund’s statutory prospectus (Form N1-A for open-ended investment companies) to present investors with easily digestible risk/return summaries that not only show a fund’s performance deviations, but also compare them to a relevant market index. (Items 2 and 4, Form N1-A) These additional disclosure rules followed investor comments that overwhelmingly favored understandable presentation of fund risks by mutual funds. (Release 33-7153)
Requiring that risk/return disclosure be made in the prospectus, however, assumes that investors haven’t already made the investment decision before reading the prospectus. It also brings us back to the earlier finding that cartoon characters would just as soon use the prospectus to catch birdcage droppings as read one. The SEC has addressed this, giving funds the option of breaking out relevant prospectus information (including the risk/return summary) in a "Fund Profile" summary prospectus that can be used by investors as the sole basis for choosing to purchase a fund’s shares. (Rule 498) Only problem is, the fund industry hasn’t warmed to the idea of using the Fund Profile for a variety of reasons, including fear of liability for saying too little. (See Julie Allecta, "Registering investment companies under new Form N1-A," ALI-ABA Course of Study (June 10, 1999).)
What’s the answer? Why not amend Rule 482 to require that fund-performance ads also include risk/return summary information? Of course, there is the danger of information creep: At some point, Rule 482 ads or Fund Profiles might become just as cumbersome as the statutory prospectus — whose verbosity they were designed to avoid — if more disclosure were imported into them. But the natural link between fund performance, volatility and risk seems to favor such inclusion, and serves as a principled limit on additional disclosures.
Another roadblock may be industry reluctance. Despite assurances by the SEC, as mentioned above, the industry fears using the Fund Profile because of concerns that its use could make funds subject to liability under the ’33 Act (that is, because a profile omits information found in the statutory prospectus, it could technically give rise to a cause of action under §12(a)(2), which makes it unlawful to offer to sell a security by means of a prospectus or oral communication that omits material facts). (See Release 33-7513.) Would the industry’s response be any different if the SEC expanded the disclosure for Rule 482 ads?
Perhaps the market — or the lawsuit — will be the deciding factor. In a complaint filed in late 1999, investors in a fledgling fund called the ESC Strategic Value Fund sued the fund and its investment adviser under state and federal securities laws alleging inadequate disclosure of certain fund risks. Hines v. ESC Strategic Funds, File No. 3-99-0530 (MDTenn) (June 23, 1999).
The plaintiffs — investors who suffered losses when the fund liquidated — alleged that the fund and its adviser marketed the fund in the prospectus and in oral statements as a long-term investment vehicle unsuitable for "investors seeking to capitalize on short-term market fluctuations." What the fund and its adviser failed to also disclose, according to the complaint, was the material risk that the fund managers would unilaterally "decide to sell out the fund prematurely because [the fund’s managers] do not like current market conditions or do not believe that they themselves are making enough money from the fund."
More recently, the SEC fined and censured an investment adviser to one of the Van Kampen Fund family’s mutual funds for, among other things, misleading investors about the fund’s performance during its "incubation" period (that is, the period before a fund goes public during which it attempts to establish a solid performance record). In Re Van Kampen Investment Advisory Corp. and Alan Sachtleben, IA-Release No. 1819 (Sept. 8, 1999). According to the SEC, Sachtleben, the vice president of the fund and the chief investment officer for the adviser, caused the fund to cite in marketing materials and the fund prospectus the fund’s incubation-period performance — a remarkable 62 percent one-year total return — without disclosing that the fund had invested in several high-flying IPOs during that time. The SEC found that this fact would have been material to investors because it cast doubt on the fund’s ability to achieve similar returns going forward.
In both cases, existing disclosure and antifraud principles under the securities laws, such as §12(a)(2) of the ’33 Act, §10(b) and Rule 10b-5 of the ’34 Act, §206 of the Advisers Act and §34(b) of the ’40 Act offer protection to investors. But perhaps both cases also suggest that investors want — and need — more information about risks.
Earlier, Bruce Springsteen was cited for his ability to make romantic metaphors out of cars. The Boss has also long been popular for his closeness with fans; giving ‘em what they want.
Maybe federal regulators will follow suit.
Zangara is a lawyer with the Argus Reseach Corp., an investment-research company in New York City.
