CHICAGO - The Securities and Exchange Commission plans to make all footnotes and related commentary for Form N-Q filings public, which is causing consternation in the industry.
One of several issues that industry executives confronted at the recent Investment Company Institute Tax & Accounting Conference here, Form N-Q is a particularly contentious topic among fund firms because it risks revealing proprietary strategy to competitors and, to shareholders, sensitive information regarding fund expenses.
Adopted by the SEC last year as an amendment to the broader Form N-CSR annual financial statement filing, and to be filed every three months, Form N-Q additionally details fund holdings, which could reveal to shareholders and competitors instances of style drift or other deviations from the stated investment objective. It is also designed to offer shareholders a more accurate picture of a fund's performance, as well as discourage window dressing and portfolio pumping among managers desperate to make up for losses.
The SEC has previously estimated that making Form N-Q available to shareholders either at fund Web sites, through a link to the form in the SEC's EDGAR database, or through the mail at a shareholder's request, could shave at least one page from fund annual reports and save nearly $6.5 million annually.
In a 2003 comment letter to the SEC, the ICI strongly endorsed the spirit of Form N-Q but questioned the benefits of requiring funds to disclose portfolio holdings more frequently than semi-annually. Specifically, the ICI expressed concern that it would "facilitate abusive trading practices," such as front running and free riding on funds' research and investment strategies, which in turn would harm shareholders.
Today, according to Bernie Grzelak, treasurer of Lord Abbett of Jersey City, N.J., there remains a great deal of speculation among industry accountants as to how much disclosure, or footnoting, would be enough in the eyes of the SEC.
"There has been quite a bit of discussion in the industry around this," Grzelak noted during a panel discussion on current industry trends in financial reporting.
When compiling its Form N-Q earlier this year, for example, Grzelak said Lord Abbett wrestled with options from including no footnotes at all, to notes on securities valuation, to securities/portfolio-related matters to "the full slate of footnotes you put in an annual financial statement."
"When we finally cracked it, it came to somewhere between securities/portfolio notes to no notes at all. So it's primarily a judgment call based on the fund family," he said.
Generally, said Richard F. Sennett, assistant chief accountant in the SEC's division of investment management, all filings after Aug. 1, 2004, are made public, although "registrants have the option of requesting confidential treatment" for comments that address concerns the regulator may have uncovered during its review of a filing.
And while Sennett did not specifically address Form N-Q footnotes, he did say during a broader overview of omissions and errors in fund financial reporting that footnotes on performance fees, or the compensation paid to advisors that's based on fund performance relative to a particular benchmark, require "over-and-above" disclosure. Among the items funds should consider including are a description of the benchmark, a description of the measurement period, fund performance relative to the benchmark during the reporting period and how often the payments are made to the advisor.
In terms of making Form N-Q readily available to shareholders - as part of the cost-savings end of the initiative, the SEC does not demand that funds distribute the forms unless a shareholder makes a specific request - some fund complexes are posting the filing at their Web sites, although most shops, including Lord Abbett, have simply chosen to provide a link to the SEC's Form N-Q database.
"We have not received any [shareholder] requests for Form N-Q, and, according to my informal survey, by and large, I don't think other funds are seeing a large influx of requests for Form N-Q. That could be, in part, due to shareholders choosing to get the information themselves through the Internet," Grzelak said.
"Or," he added to the delight of the tax and accounting professionals assembled, "there just isn't a lot of interest. But you will see a spike in hits on some Web sites because of the research I did for this panel."
The ostensible shareholder disinterest in Form N-Q could also be due to the fact that many funds have chosen to provide a generic list of portfolio holdings at their Web site, Grzelak observed, which also fulfills the disclosure requirement.
Form N-Q hasn't impacted staffing at Lord Abbett, Grzelak added, although he said his staff now encounters additional "peak times," or those periods of heavy workloads that an accounting staff would previously experience only while compiling semi-annual and annual financial reports.
Chris Roetzer, vice president of fund administration at State Street in Boston, a financial statement outsourcer that is arguably much closer to the staffing demand precipitated by Form N-Q and a vendor to Lord Abbett, said there has been an increase in the workload because of the new disclosure form. He speculated that it would likely be a cost that's absorbed by the funds.
"Indeed, I would say that, in a fair amount of our relationships, it did mean that an increase in resources was passed on. So maybe it didn't mean an increase in employees at [Lord Abbett], but it did in ours," he said, adding that it appears that Form N-Q also fails to provide firms with the "jump-start" on the annual financial reporting process that the industry had hoped it would.
From the perspective of a medium-size fund shop, Joe Kauten, assistant treasurer at Overland Park, Kan.-based Waddell & Reed, added that "while we haven't increased staffing in our [accounting] area, we are looking to automate more of the process due to the sheer volume of filings and reporting that we have today," whereas in the past "it was a highly manual business function."
But if the extent of disclosure that traditional mutual funds should include on their Form N-Q is puzzling, Steve Bowen, a partner at auditor KPMG, headquartered in the Netherlands, said determining the appropriate level of transparency in financial reporting for the rapidly growing fund-of-funds sector is an outright enigma.
"If you're confused," Bowen told his peers, "you're not alone. There's a lot of confusion in the industry right now around fund-of-funds financial reporting, and the number one issue is transparency."
Items like investment risk, investment holdings, investment objectives and expenses, Bowen observed, are principle areas of concern. For example, when trying to determine whether a fund-of-funds should include the financial statements of particular underlying holdings, Bowen said that a holding constituting 75% of a fund-of-funds' assets is widely considered the "investment threshold." However, when the investment is less than 75% but still significant, he said, it is unclear whether to include the underlying holding's financials.
"There isn't a bright light, or fine line standard," Bowen said, adding that, historically, funds have been uncomfortable disclosing such high investment concentrations for competitive reasons.
The SEC's Sennett replied that the regulator most likely would not argue for the inclusion of underlying fund financials if the investment concentration exceeds 75%, but during the course of its financial statement reviews, it has asked registrants whether they have included underlying fund financial statements when the threshold is much lower.
"We agree, there is no bright light," said Sennett, whose office is in the third year of the first three-year cycle of fund financial statement reviews required under Sarbanes-Oxley.
That ambiguity, Bowen offered, might be reason enough for fund-of-funds reporting to command its own panel next year.
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