By Clifford E. Kirsch, Wendell M. Faria and W. Thomas Conner*
The Business Lawyer
American Bar Association | May 1995
* Mr. Kirsch is Chief Counsel, Variable Products, The Prudential Insurance Company of America. Mr. Kirsch was formerly Assistant Director in the Securities and Exchange Commission’s Division of Investment Management, in charge of the Office of Insurance Products. Mr. Faria is an associate with the firm of Paul, Hastings, Janofsky & Walker. Mr. Faria was formerly Deputy Chief of the Office of Insurance Products. Mr. Conner is an associate with the firm of Sutherland, Asbill & Brennan. Mr. Conner was formerly a staff attorney in the Office of Insurance Products and the Division of Investment Management’s Office of Disclosure and Investment Adviser Regulation.
Parts of this Article were prepared while the authors were attorneys with the Securities and Exchange Commission. As a matter of policy, the Commission disclaims responsibility for any private publications by any of its employees, past or present. Thus, the views expressed in this Article are those of the authors and do not necessarily reflect the views of the Commission or of the authors’ former colleagues on the staff.
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The investment company industry has grown dramatically in recent years. Since 1980, investment company assets have grown at an annual rate of 23.1%–doubling every four years–and now stand at $ 2.4 trillion. n1 Mutual funds, n2 the most popular form of investment company, account for 86% of this $ 2.4 trillion. n3 Mutual funds are now an investment choice for 27% of U.S. households. n4 In June 1994, there were 4901 separate mutual fund portfolios, an increase of 769% from the 564 that existed at the beginning of the 1980s. n5 During that time, mutual fund assets soared from $ 135 billion to over $ 2 trillion, an increase of more than 1445%. n6
Variable annuities and variable life insurance policies, which are other types of investment company securities, have also become very popular. n7 These products offer insurance protection but also permit policyholders to accumulate policy values by investing in underlying mutual funds rather than receiving the fixed income returns generally earned under more traditional insurance policies. The products have the added advantage of tax deferral. From March 1993 to March 1995, total net assets of variable annuities increased from $ 122 billion to $ 193 billion, with 1750 subaccounts. n8 During the same period, total net assets for variable life policies increased from $ 8 billion to almost $ 14 billion, with 834 subaccounts. n9
Advertising by mutual funds and variable insurance product issuers and their sponsors and underwriters has played a crucial role in the growth of these products. Advertising serves to educate prospective investors about the types of products available and the services offered in connection with those products.
Many fund groups, banks, and insurance companies, however, face a common problem: they offer similar types of products and services. Differentiation is key. Even a quick survey of advertisements and articles in the financial press shows that performance advertising is an essential tool to differentiate an issuer’s product. n10 Performance advertising answers what, for many investors, remains the most fundamental question–how has the investment performed?
The Securities and Exchange Commission (SEC or Commission) has permitted investment companies to advertise performance data since 1979. n11 Specifically, Rule 482 under the Securities Act of 1933 (the 1933 Act) permits any registered investment company to advertise any information the substance of which is contained in its statutory prospectus. n12 The Commission has twice amended the rule to require standardized computations of performance data for money market funds, mutual funds, and variable annuity separate accounts. n13
Rule 482 permits investment companies to present yield and total return–the current income and overall appreciation (including income), respectively–that an investor would have received by investing in the fund for specified periods. n14 Overall, the rule appears to have been effective in regulating historical performance data. The rule arguably has been less effective, however, in situations when competitive pressures have caused funds to engage in structural changes. When a structural change has occurred, it may be difficult to determine whether the use of historical performance data is appropriate, and, if so, how to recalculate that data. In response, the staff of the Commission has had to develop a significant body of interpretive positions to augment the black letter of Rule 482. n15 In addition, the long-term nature and structural and product complexity of variable insurance products require specialized, and often forward-looking, quantitative information to be presented to investors. The staff also has had to develop positions to cover these presentations.
This Article presents a detailed analysis of the regulation of mutual fund and variable insurance products advertising, with an emphasis on the regulation of performance advertising. The Article is divided into four sections.
The first section describes generally the three types of sales literature that mutual funds and variable insurance product issuers use to market their products. Mutual funds and insurance products are marketed through prospectuses that must be provided to investors, through advertisements, and through supplemental sales literature given to investors at the same time, or after, they are given prospectuses. n16
The second section gives an overall view of the regulatory framework governing investment company sales literature. Investment company advertising is regulated primarily under the 1933 Act, n17 but the Investment Company Act of 1940 (the 1940 Act) regulates some aspects as well. n18 This section provides a “black letter” analysis of the provisions of these statutes governing investment company communications with the public, discusses how the three types of sales literature are regulated under the Commission’s rules, and concludes with a discussion of several provisions of the NASD’s Rules of Fair Practice that have been developed recently. n19
The third section discusses the development by the Commission of the rules that govern mutual fund and variable insurance products advertising and pays particular attention to Rule 482, which governs performance advertising. The final section examines the interpretive positions developed by the staff of the Commission as mutual funds and variable product issuers have developed new products and services and as structural changes have occurred in the industry. This section analyzes the use by variable insurance product issuers of different types of hypothetical illustrations, which, although not generally permitted for mutual funds, have been permitted in the insurance products area because of the structural and product complexity and long-term nature of these products. This section also discusses various problematic issues relating to variable life insurance performance advertising.
n99 Evaluations come in various forms. For example, Morningstar, Inc. assigns funds one, two, three or four stars, Value Line Investment Survey assigns numbers, and Lipper Analytical Services ranks funds by performance. See Charles A. Jaffe, Mutual Fund Ratings Can Be Misleading, BOSTON GLOBE, July 7, 1994, at 37. The term “rankings” is used hereinafter to refer to any type of ranking or rating system, since in many cases the terms seem to be used interchangeably. See Alyssa A. Lappen, “Who rates among the fund raters?,” INSTITUTIONAL INVESTOR, Feb. 1994, at 63 (rankers can’t all be No. 1). A distinction may be drawn, however, in certain contexts. For example, the term “rating” could be used to refer to the assessment of the credit quality of debt instruments issued by various companies. Such ratings are performed generally by companies such as Standard & Poors, Moody’s, and Duff & Phelps.
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