Shareholder report rules pose even bigger challenge than fund CCOs expected

Effort required to rewrite narratives, redesign, print, mail reports adds to expected difficulty of creating data-heav but “visually engaging” layout

Changes designed to make tailored shareholder reports more useful to retail investors are turning out to be a lot more expensive and difficult to implement than most fund compliance officers expected.

By July 24 mutual funds and ETFs must be ready to send out annual and semi-annual shareholder reports that have been redesigned into a more standardized format that is also “concise and visually engaging” format that should make it easier for retail investors to compare the performance of one fund to another.

Under rule changes the SEC approved in October 2022, the reports must also be mailed out on paper to shareholders who have not opted for electronic delivery. Requiring postal delivery as a default is one of several requirements that disappointed industry experts who found the final rule confirmed under SEC chair Gary Gensler reversed many of the changes favored by fund advisers when the amendments were first proposed in 2020 under the administration of previous SEC chair Jay Clayton.

The deadline itself is not as big a problem as the effort required to meet it, especially considering the effort required to implement a growing number of other regulatory changes that, collectively, have put the chief compliance officers of mutual funds and ETFs “under enormous pressure,” says Carolyn McPhillips, president of the Mutual Fund Directors Forum.

Nailing the mailing

Preparing shareholder reports with details on each share class in each fund – rather than consolidating reports as previous versions of the rule allowed – has cost many advisers far more time and effort than they had expected, McPhillips said.

The additional cost of preparing paper versions of the reports and arranging to mail them only adds to the burden. “That changes the calculus a bit,” McPhillips said.

The costs of printing and mailing for the new reports is “staggering,” according to Lisa Hamman, associate managing director at the Independent Directors Council.

Previously, funds could simply offer shareholder reports on their websites under Rule 30e-3, as long as shareholders were notified that the information was there.

By eliminating that exemption, the new rule adds extra steps for fund advisers who have to re-examine shareholder authorizations to verify which have opted for electronic delivery and make an extra effort to ask for permission from shareholders who either didn’t opt in to electronic delivery or didn’t express a preference, according to Amy Lynch, president of consulting firm FrontLine Compliance. 

There seems to be an industry-wide consensus that the mailing requirement is “a step back,” Lynch said.

“Clearly the costs, initially especially, are very high because they have to go back and do that work; revert back to a system that they had in place many, many years ago – over 20 years ago now,” Lynch said.

Mailing reports on paper also makes it impossible for fund companies to track which shareholder receives the report, Lynch said. “They can find ways to ensure delivery electronically, but it’s much more difficult to do so when you’re sending out paper forms,” she said.

Fund advisers’ only hope of making the process simpler lies in the possibility of more shareholders opting for electronic delivery in the future, rather than sticking with postal mail as a default option, she said.

Broad-based outcry

Another unexpected difficulty – or at least one that puzzles some involved in implementation plans – is the requirement that shareholder reports include a line graph showing a fund’s performance versus a broad-based securities market index, according to Paulita Pike, a managing partner at Ropes & Gray in Chicago,

Fund managers have been reporting to their boards on the broad-based indexes they are choosing for individual funds, but whether or not it makes sense to include that information in shareholder reports has become a frequent topic of conversation at board meetings, she said.

“The question that keeps getting asked – and I think is a good one – is: ‘How is this information going to be helpful to shareholders?’” Pike said. Especially when considering specialty funds, “does it really make sense to compare a natural resources fund to the S&P 500?”

The SEC’s published guidance on the shareholder-report rule does not include a list of permissible indexes, but it does list some that wouldn’t be appropriate –  including indexes that track growth, value, ESG, small-cap or mid-cap characteristics.

“The SEC is saying: ‘We think that shareholders will get value by having a fund compared to that broad domestic or international equity or domestic or international debt market, on a very large scale,’” said Mark Parise, a partner in the Hartford, Connecticut office of Morgan Lewis.

However, funds are allowed to include a second or third index for comparison – indexes that they may consider as more appropriate comparisons for their investment strategy – in addition to the broad-based index, Parise said.

With the compliance date in mind, most boards are now reviewing their management recommendations for which broad-based indexes to adopt for the performance comparison, as well as second and third indexes, when applicable, Parise said. They’re also starting to review design and content samples for the new reports, he said.

Hamman predicted that most funds will use a broad-based index benchmark to comply with the tailored shareholder report rule but also find targeted indexes to use in their performance reporting to the board.

Parise doesn’t believe the index-comparison requirement signals any change by the SEC in how fund boards should conduct annual 15(c) reviews of fund managers.

Boards want to understand how a fund is being managed, and if the fund manager isn’t trying to match a broad-based securities index, then the comparison wouldn’t be apt for a 15(c) review, he said. Instead, “boards would be looking at an appropriately tailored set of peers.”

Uncreative writing

Another stumbling block has been the desire by many fund advisers to try to use the new report format to convey narratives that were popular under the old format, according to Alexandra Alberstadt, an attorney in the investment management group of Seward & Kissel in New York. 

It’s been difficult for funds to transform their lengthy reports of old, which for most funds “had a lot of artful writing” about factors that may have impacted performance during a specific period, Alberstadt said. But it can be difficult to adapt those explanations to new requirements designed to focus more on “data points” that make it easier to compare one fund to another, she said.

“Most people are struggling with this, trying to figure out [whether they are] still going to do something like the ‘Dear Shareholder’ letter,” she said.

Those letters, contained in annual reports and semiannual reports prior to the new rule, allowed funds to explain their results at length, and they’re concerned about how they can now deliver that information. Some funds that want to keep the explanatory narrative are moving it from the tailored shareholder report to the online portion, while others are considering dropping the narrative element altogether, Alberstadt said.

All funds seem to be in the same quandary, Parise said. “That’s the art of it that everyone’s going through right now: what level of detail to provide and what not to provide.”

Depending on a given fund’s fiscal year, their first annual or semiannual report may not be distributed until months after the July 24 deadline, so some fund managers are still working out how they will write the tailored shareholder report, Alberstadt said.

Many are planning to reconsider their approach after seeing how their first attempt under the new format goes, she said, and already some funds are circulating test documents and test SEC filings.

Parise said he expects the tailored aspect of the new reports will be adjusted during the first year or two. “I imagine we’ll see everyone will come out with their first stab at it; people will look at what everyone else is doing and then start modifying their approach, after seeing what others are doing in the industry. And then a more standardized approach will evolve over time.”

Don’t overlook oversight

Most fund boards are involved in tailored shareholder report compliance issues only in their oversight role, McPhillips said. “It’s more just making sure that the adviser, the administrator, the printer, your legal, audit teams, everybody is on the same page and these things are on track to being sent on time.”

Any chief compliance officer of a fund should want the topic of compliance with the tailored shareholder reports requirements to be on the board agenda for its meetings just before and after the July deadline, Lynch said, to review how the firm prepared and what problems arose in advance of the deadline, and then a postmortem after the first round of reports are issued.

“There should be a recap of what has happened, how the firm has prepared,” she said. “How did it work or not work? What were the problems? How many reports failed to be delivered, for example, that they can quantify? And what are they going to do about it?”

“This is a pretty significant change to the way in which finding fund reporting occurs for shareholders,” Lynch said. “Because of that, the fund board should have an interest in how this is implemented. It’s a matter of providing them with the information so they can understand how the fund has complied.”