LESTER R. WOODWARD
DAVIS GRAHAM & STUBBS LLP
TELEPHONE 303-892-9400 TELEX 413726 DGS DVR UD
BOULDER, CO OFFICE
VIEW POINT ON THE PARKWAY
June 30, 2000
VIA FEDERAL EXPRESS
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Re: Disclosure of Mutual Fund After-Tax Returns, File No. S7-09-00
Dear Mr. Katz:
As an individual investor in mutual funds and as an attorney who has represented various mutual funds, investment advisers to mutual funds and independent directors/trustees of mutual funds, I offer my personal views on the Securities and Exchange Commission's (the "SEC" or "Commission") proposed rule and form amendments to improve disclosure regarding the effect of taxes on the performance of mutual funds, as set forth in Release No. IC-24339 (Mar. 15, 2000) (the "Release").
Section I of this letter summarizes several potential investor confusion concerns that arise out of the particular assumptions contained in the proposed rule. Section II outlines an alternative approach that relies exclusively on historical data and may alleviate some of these adverse consequences without sacrificing the SEC's stated objective of "providing information about the tax efficiency of portfolio management decisions"1 and allowing investors to make better investment decisions.
Section I: Potentially Adverse Consequences of Hypothetical Return
A. Assumptions Contained in Hypothetical Return
The Commission has proposed to require mutual funds to disclose after-tax returns. The proposal would require these after-tax returns to be computed according to a standardized formula. The proposal includes a number of critical assumptions that funds would be required to follow in computing after-tax returns:
Based on these assumptions, funds would be required to disclose after-tax returns for 1-, 5-, and 10-year periods on both a "pre-liquidation" and "post-liquidation" basis, accompanied by explanatory narrative disclosure. Pre-liquidation after-tax returns assume that shareholders continue to hold fund shares at the end of the measurement period and, as a result, reflect the effect of taxable distributions by a fund to its shareholders but not any taxable gain or loss that would be realized by shareholders upon the sale of fund shares. Post-liquidation after-tax returns assume that shareholders sell fund shares at the end of the measurement period, and, as a result, reflect the effect of both taxable distributions by a fund to its shareholders and any taxable gain or loss realized by shareholders upon the sale of fund shares.
B. Potential for Investor Confusion
Although the use of these assumptions implicitly causes the Commission to create a hypothetical after-tax return for a hypothetical investor, the Commission acknowledges that "[t]he computation of after-tax return depends on several assumptions, such as tax bracket, that vary from investor to investor."2 The Commission, however, believes that the hypothetical return still has some utility because even though "the proposed standardized after-tax return measures are not intended as precise computations of any individual investor's after-tax returns from a fund, [they are intended] as guides to understanding the effect of taxes on the fund's performance" (italics added).3
The critical issue not addressed in the Release is whose "understanding" would be enhanced by this disclosure. On the one hand, financially sophisticated investors will recognize the inherent limitations of the hypothetical after-tax return calculation and, to the extent such investors need assistance to calculate actual after-tax returns, they will use more precise tools, such as web site calculators or the assistance of a certified financial planner or accountant. On the other hand, unsophisticated investors, who presumably are the primary intended beneficiaries of the new disclosure, are most likely not to fully understand the consequences of the assumptions and could, depending on the degree of deviation of their particular tax circumstances from the circumstances of the hypothetical investor, make worse, rather than better, investment decisions based on the hypothetical after-tax return.
Furthermore, referring to the hypothetical after-tax return as the "worst-case" scenario" may itself be misleading to unsophisticated investors because although the proposed scenario represents that "worst-case" highest federal income tax bracket, other critical assumptions are not "worst-case" and are likely to minimize, rather than maximize, the potential tax burden on the investor (e.g., ignoring state and local taxes and assuming full deductibility of capital losses).
The problem with requiring presentation of the hypothetical afer-tax returns is not simply that the wrong assumptions have been chosen; the difficulty is inherent in the use of hypothetical calculations. The very listing of the required assumptions makes it clear that it is extremely unlikely that the information provided in the prospectus will be appropriate for any particulars investor. Given that fact the very presentation of the information would be inherently misleading but for the required disclosure that all of these assumptions may not apply to the individual investor reading the calculations. I submit that this is not an appropriate disclosure to be required and that the improbability of the information being truly helpful would rather call for its prohibition.
Section II: Proposed Alternative :
Disclosure of Historical Capital Gains and Ordinary Income
In Part H of the Release, the Commission requested comment on other, alternative measures that "could provide investors with enhanced information about the tax consequences of mutual fund investments."
One alternative measure to providing information that purports to tell a hypothetical individual investor what the result of his investment, after tax, might be, would be to provide factual information concerning the fund's historical distributions of capital gains and ordinary income. Subject to the inherent limitation that past performance is not predictive of future results, it could be useful to an investor to compare the historical pattern of distributions from a fund with those of other funds in which he is considering making an investment. The specific information as to the amount of the distributions made by the fund annually for the last ten years or the life of the fund could be required to be presented in each prospectus . The information presented should include a breakdown between distributions that would qualify for preferential tax rates, such as long-term capital gains or return of capital, and those which would be taxed as ordinary income. The table setting forth this information could also include simple calculations of the percentage of the per share net asset value represented by each such distribution at the date of the distribution or the end of the fiscal period. Additionally, the table should include the per share amount and percentage of net asset value represented by unrealized gains in the portfolio at the most recent date presented.
From this information it would be possible for an investor to obtain a picture as to whether particular funds have a consistent pattern of trading and realizing gains in the portfolio that will ultimately be taxed at ordinary income or capital gains rates to the shareholder. All prospective investors who are interested in this information presumably pay taxes and are therefore aware of the fact that, had they owned shares of the fund during the historical periods presented, they would have incurred taxes as a result of those distributions. They would have comparative information from the other funds that could be taken into consideration in making their investment decisions. Investors who hold their shares in non-taxable accounts would, of course, ignore the information that is irrelevant to their investments.
This suggestion, of course, rests on the assumption that mutual fund investors are generally aware that income taxes are paid, and payable at different rates on long-term capital gains, an assumption which we believe is realistic and appropriate. As this disclosure would present factual information rather than hypothetical calculations, we believe it also has the merit of resting on the fundamental premise of the securities laws that fully informed investors will be able to make rational and appropriate decisions with respect to their investments.
Thank you for the opportunity to comment on the proposed rule. You may call me at (303) 892-7392 if you have any questions or would like to discuss my comments.
Lester R. Woodward
1 Release, II.A.
2 Release, II.F.