(Article from Registered Funds Alert, May 2016)
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Following recent volatile markets and the SEC’s ongoing concerns about fund liquidity risks, particularly in light of the dissolution of a high-yield open-end fund in December 2015, the staff of the SEC’s Division of Investment Management (“Staff”) issued a guidance update in March 2016 reminding fund complexes of their obligation to monitor market conditions and assess whether a fund’s risk disclosure adequately reflects changing conditions (“Guidance Update”). The Guidance Update supplements prior guidance updates issued in recent years that highlighted the importance of summarizing principal risks in the prospectus and reevaluating fund names that suggest protection from loss.
The Guidance Update emphasizes the important role that full and accurate information about fund risks plays in allowing investors to make informed investment decisions. As a fund reacts to changing market conditions, its risks are dynamic and may increase or decrease overall risk for investors at different points in time. Once-adequate disclosure may become inadequate, or risk disclosure may need to be added or moved to become more or less prominent. Consequently, the Guidance Update states that a fund (i) should review its disclosure risks on an ongoing basis to ensure that they remain adequate in light of current conditions and (ii) if any disclosure is inadequate, communicate any new or modified risks to investors.
The Guidance Update places emphasis on heightened responsibilities for a fund adviser in confirming that disclosures remain, in all material respects, accurate and complete in light of changing market conditions. Noting that many fund boards request that the adviser report on its process for preparing the fund’s disclosure materials, the Guidance Update recommends that the adviser go one step further by providing information to the board on steps taken to evaluate fund risk disclosures and determine whether changes are appropriate.
The Staff states that funds should undertake three steps on an ongoing basis to assess and, if necessary, revise their risk disclosures to remain suitable in changing market conditions:
- Monitor Market Conditions and their Impact on Fund Risks. As part of day-to-day operations, funds should continually monitor market conditions and assess their impact on the fund and the risks associated with its investments.
- Assess the Adequacy of Risk Disclosures. Once a fund determines that changed market conditions have affected risks associated with the fund, it should assess the change’s significance and materiality to investors. If it is significant and material, a fund should assess the adequacy of existing disclosures.
- Communicate with Investors: If the fund determines that changes to a fund’s risks are material to investors and that the current disclosures are inadequate, it should update its communications and provide them to investors “at the time and in the manner required by the federal securities law and as otherwise appropriate.”
The Guidance Update adopts an encouraging tone in discussing two evolving areas in which funds have provided “useful” information to investors regarding current market conditions. The first example relates to disclosures by certain fixed-income funds in response to potential changes in government policy that would raise the current historically low interest rates. In anticipation of such change many fixed-income funds warned investors of: (i) a possible decline in the value of fixed-income investments in response to higher interest rates; (ii) potential periods of volatility and increased redemptions; and (iii) the sensitivity of longer-term securities to interest rate changes. Secondly, in light of recent concerns over whether Puerto Rico would default on its debt, the Staff similarly commended funds with significant exposure to Puerto Rico debt for disclosing in their prospectuses that they invested in Puerto Rico debt, as well as the factors expected to impact the value of the Puerto Rico debt held by
the fund.
While some in the industry have expressed concern that the Guidance Update will encourage funds to add technical risk disclosure about specific securities, an approach that the SEC expressly disavowed in the 1998 amendments to Form N-1A, when read more generally, the Guidance Update seems to be focused on how significant or historic changes in market conditions can impact existing risk disclosure. The Guidance Update provides a framework for funds and advisers to utilize in evaluating risks and risk disclosure in connection with other significant market changes and events that may occur in the future (beyond interest rate and liquidity risks). Namely, a fund should (i) monitor market changes that may cause changes in a fund’s susceptibility to risk and (ii) review and assess risk disclosures in light of these market changes, which requires evaluating whether that impact is both material and significant to investors. After employing the framework, a fund should look to the SEC’s endorsements of the disclosure practices of fixed-income funds and those holding Puerto Rico debt in order to extrapolate how those practices would apply to the risk at hand. For example, the Staff approvingly cited a fund for looking toward the future and accounting for the interest of long-term investors by disclosing that interest rates are at historic lows and are likely to increase in the future, and explaining the potential secondary impacts that would affect a fund’s fixed-income investments. The Guidance Update lays out a framework that may help funds and advisers struggling with whether to communicate a change in fund risk profile to investors.