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News September 6, 2004 Issue

Final Portfolio Manager Rules Focus on the Fund’s Fab Five

On August 18, the SEC adopted amendments to Forms N-1A, N-2, and N-3 to require enhanced disclosure about registered fundsí portfolio managers (in the case of Form N-3, this will be brand new disclosure).

As expected, the final version of the amendments smoothed many of the rough edges in the SECís March 2004 proposal. The key change: the SEC capped the number of portfolio managers potentially subject to the disclosure requirements at five. Although the SEC stuck with the basic definition of who is a portfolio manager, it helpfully added a sentence to the form instructions stating that if more than five persons are jointly and primarily responsible for the day-to-day management of the fundís portfolio, the fund need only provide information for the five persons with "the most significant responsibility" for the portfolioís day-to-day management.

Funds will have to comply with the new disclosure requirements in registration statement filings made on or after February 28, 2005. In addition to the information in the prospectus, funds will have to add SAI disclosure about their managersí compensation structure, other accounts under management, and securities ownership in the fund. The good news for funds managed by a team or group: each of these SAI discussions can be limited to the five portfolio managers required to be covered in the prospectus. Even if a fund voluntarily discusses more than the five required managers in its prospectus, the SAI disclosure still can be limited to the five required individuals.

At the open meeting, and again in the adopting release, the SEC emphasized that identifying the managers to be disclosed will involve a facts and circumstances determination. The release noted that if a fundís portfolio management team has a "lead member" or "coordinator" responsible for overall coordination of the fundís management, it may be "appropriate" for the fund to identify that individual as the fundís portfolio manager. If thereís no clear leader, a fund could pick the five managers with the largest percentages of the fundís assets under their management, said the SEC.

The SEC also clarified that an analyst who makes securities recommendations for the fund, but who doesnít have decision-making authority, does not have to be identified in the prospectus, unless the analyst is, in fact, jointly and primarily responsible for daily management of the fundís portfolio. That would be the case, said the SEC, if the analystís recommendations are routinely adopted by the individual who has decision-making authority over the fundís portfolio. In that case, the analyst would have be to added to the prospectus (unless, of course, the analyst wasnít among the five most responsible persons).

The SEC also required funds to describe the limitations on the portfolio managerís responsibility, and the relationship between the managerís role and the role of others responsible for the fund (including team members not identified in the prospectus). "What weíre trying to do is to get to disclosure regarding [the] key individuals, explaining their role [ . . .] background, and experience," said Division of Investment Management director Paul Roye. "If there are others who play subsidiary roles, than that can be explained in a narrative disclosure about just what their roles are."

Highlights of other changes:

Compensation. In response to commenters who argued that certain types of compensation are difficult to quantify, the SEC allowed funds to omit disclosure regarding group life, health, hospitalization, medical reimbursement, relocation, and pension and retirement plans and arrangements, provided that they do not discriminate in favor of the portfolio manager and are available generally to all salaried employees.

The other major change in the compensation department: not only did the SEC require that funds describe the criteria on which each type of compensation is based, but it additionally emphasized that the criteria be described with specificity. Funds discuss whether compensation is based on criteria such as fund pre- or after-tax performance and the value of assets held in the fund, as well as how it is based on those criteria.

Ownership of securities. The big change here: the fund must disclose its portfolio managersí ownership in the fund itself, not in other accounts managed by the portfolio managers or the fundís adviser. Because of the way beneficial ownership is defined, portfolio managers also will have to disclose the ownership of their immediate relatives sharing the same household (unless they plan to rebut the presumption that they do not really beneficially own those individualsí securities).

The SEC addressed commentersí concerns that a portfolio managerís own personal investment objectives or horizons may preclude him from holding shares of the fund he manages, but that resulting disclosure could lead investors to reach the wrong conclusions based on the resulting disclosure. The SECís release noted that a fund is free to disclose the reasons why a manager might not own shares of his fund. Similarly, during the SECís open meeting, Roye acknowledged that it "may not make sense for a portfolio manager that lives in New York to own shares of a New Jersey tax-exempt fund," adding that funds with managers in such a situation "can explain that." He also said, however, that the SEC has "heard from investors over and over again" that disclosure about whether a fund portfolio manager eats his own cooking "ought to be required."

Interestingly, Roye emphasized that the SEC is not trying to encourage portfolio managers to eat their own cooking. He acknowledged that there are times when the SEC does require disclosures as a means to influence behavior. Moreover, he noted that one result of the new disclosure requirements might be that some portfolio managers are persuaded to invest in their own funds. He went on, however, to add that "I donít think our motivation was to necessarily encourage [portfolio managers] to make those investments." Instead, the staffís goal was "simply to inform investors as to whether or not [portfolio managers] have those types of investments."

The SEC also backed off from its proposed requirement that funds disclose their portfolio managersí securities ownership in a mandatory tabular format. However, ownership must be disclosed using the same dollar ranges specified in the proposal. The SEC stuck with its top range of $1 million.

Other accounts managed. Funds will have to disclose, in aggregate, other accounts managed by their portfolio managers. For each portfolio manager required to be identified in the prospectus, funds will have to disclose the number and total assets of other accounts they manage in each of three categories: RICs, other pooled vehicles, and other accounts.

The SEC backed off from the proposed requirement that funds describe the policies and procedures designed to address conflicts that may arise by the management of other accounts, saying it was persuaded by comments that this could lead to lengthy disclosure. While the potential conflicts still need to be described, the SEC scaled the requirement back to cover only "material" conflicts. Some examples, suggested by Roye during the open meeting:

  • conflicts in how securities, including IPOs, are allocated;
  • conflicts that arise when orders for different accounts are affected at the same time and in how prices are determined (such as when an average price is used) (of course, conflicts also can arise when orders are effected sequentially, such as when directed orders go last); and
  • conflicts arising from inconsistencies in different accountsí investment strategies (does the manager short the same stocks that it is holding long in the fund?).

Roye said that funds should discuss how they are "managing or monitoring" those conflicts and "assuring fairness among the funds relative to the other accounts that may be managed."

In its release, the SEC noted that it had asked for comment on whether it should prohibit side-by-side management of mutual funds and other accounts, such as hedge funds. The agency said that it has "determined not to do so," citing commentersí concerns about shutting off investors from portfolio management talent and harmful affects on smaller investment advisers.

Odds and ends. Closed-end funds also must comply with the new disclosure requirements, albeit a bit differently. Since closed-end funds donít have an evergreen registration statement, the SEC required them to make the new disclosures in their annual and semi-annual reports on Form N-CSR. Reports filed for fiscal years ending on or after December 31, 2005, and semi-annual reports thereafter, must include the new disclosure.

Index funds are now subject to the new disclosures. Old Form N-1A carved out index funds from the portfolio manager disclosure, but the new amendments eliminated the carve out.

The SEC also adopted disclosure amendments cross referencing the SAI. These amendments are designed to encourage funds to make SAIs available on their websites.

During the open meeting, Commissioner Cynthia Glassman raised concerns about the disclosure overload and the SECís estimate of the burden that the amendments would impose. Commissioner Paul Atkins echoed her concerns, saying that the time has come for the SEC to conduct a "full-scale review" of fund disclosure requirements. He also agreed that the burden estimate seemed low, adding that "at some point we need to review how we go about putting that together."