Subject: Profile Prospectus Comment Date: 4/18/97 10:11 AM U.S. Securities and Exchange Commission Dear Sirs: The following commentary appears in the April 25, 1997 issue of Morningstar Mutual Funds. We also wish to file it as public comment on proposed amendments to form N-1A and proposed rules 498 and 35d-1 regarding the creation of a stand-alone profile prospectus. Briefly stated, we believe the creation of a separate, shorter prospectus is not in the best interest of investors. Our opposition is summed up in a quote from the attached commentary that states: "Investing in a mutual fund is not the same as buying a car. Good regulation should stress the differences, not the similarities." We hope that you will give our comments serious consideration in ruling on the proposed changes. Thank you. Owner or Consumer? Commentary Don Phillips, President Are mutual fund shareholders owners of investment companies or are they consumers of investment advisory services? While aspects of both may apply, one view or the other must ultimately define the relationship. Which way the industry tilts has profound implications. An owner thinks of himself or herself as having rights; a customer thinks "buyer beware." If the fund industry views its shareholders as owners, it ensures its integrity and safeguards investors. To the extent that industry leaders view shareholders as mere customers, both investors and the industry's reputation lose some protection. As such, there is no more vital responsibility for fund regulators than to insist that shareholders be accorded the privileges of ownership, rather than the risks of being a consumer. This principle should govern the Securities and Exchange Commission's every action, including-but certainly not limited to-its current exploration of the suitability of the profile prospectus. Wisdom for the Ages The Investment Company Act of 1940 is clear on the definition of fund shareholders as owners. Its writers recognized that there's a reason mutual funds are called investment companies, not managed investment products. They saw the significance of independent directors who act as the voice of shareholder/owners. They had little choice. Legislation enacted in 1940 had its roots in the depths of the Depression, on the heels of the closed-end fund scandals of the late 1920s. In short, this legislation was crafted at a time when no one wanted to buy a mutual fund. The industry's leaders had to go out of their way to ensure the public that if it put its trust in funds, its interests would be paramount. Those were dark days for the fund industry, but they provided exactly the right context in which to draft lasting legislation. Few fund-industry observers dispute the significance of the Investment Company Act of 1940 in keeping the fund arena free of major scandals like those that have plagued other financial services. Because of the trust this relationship has created, mutual funds have become the cornerstone of many Americans' financial planning. It's tempting for the industry and its regulators to think of the current condition as the norm and to lose sight of the core principles that built the industry. They had better not. Just as the desperation of the 1930s led to policies that forged the way for the industry's ascent, so too may the current embarrassment of riches lead to subtle changes that ultimately trigger the industry's downfall. Losing the Vision It's clear that treating shareholders as owners benefits all parties in the long run. Unfortunately, there are short-term advantages to fund companies who view their shareholders merely as customers, and in roaring good times like these for the fund industry, such voices dominate. Rising expenses and management fees regardless of good performance; 12b-1 fees that promise economies of scale, but which serve only to fatten fund-management companies' profit margins; "independent" directors who blindly vote with management instead of representing owners' (shareholders') interests. These are all symptoms of the consumer-rather-than-owner mentality fostered by fund companies and permitted by regulators in recent years. The current debate over the profile prospectus is the latest in a long run of examples that showcase how far the industry has drifted from the shareholders-are-owners principle that helped make funds great in the first place. The creation of a compact document that highlights some key data an investor should know before buying a fund seems an innocuous change if one views shareholders merely as customers. Supporters of the profile liken it to the sticker on a new car's window showing mileage estimates and costs. While highlighting certain information is not a concern in any case, the industry also seeks to detach these tables from the main prospectus and to be able to close a sale prior to the delivery of the full prospectus. Is this really in the best interest of owners? The full prospectus is unmistakably a legal document. It tells investors that they are entering into a contract with the fund company. There's no disagreement that the contract should be better written, but making the profile a separate document does little to address that issue. Instead, the profile prospectus sends an entirely different message to investors than does the full contract. The profile suggests that one is simply comparing nutrition labels on cans of soup; the full prospectus says one is entering a contractual relationship. The difference in mindset is extreme. It may be easier to close a sale with a soup buyer, but it is almost certainly in the industry's-and investors'-best long-term interests to have both parties recognizing the contractual bonds between them. In that regard, the profile prospectus is clearly ill-advised-so much so that an American Bar Association group already hints that use of the profile may open fund companies to lawsuits because the contractual terms of the prospectus are so buried. The Solution Is the Problem In defense of the profile, advocates note that focus groups suggest investors prefer the profile to the full prospectus. That's a rigged argument. Most investors have more experience acting as consumers than as owners. They naturally prefer the role to which they are more accustomed. It's imperative, however, to both them and the industry that they not fall simply into the more comfortable role, but instead adopt the more appropriate one. Buying a mutual fund is not the same as buying a car. Good regulation should stress the differences, not the similarities. Profile supporters also claim that while the profile prospectus may not have all the information an investor needs, at least by highlighting a few facts some information will be communicated. There are two holes in this argument. First, it only makes a case for having standard tables at the front of the current prospectus, not for creating an entirely separate document, as profile supporters want to do. Second, the argument assumes current prospectuses go unread without considering why. In effect, the industry is treating the symptoms, not the cause. Current prospectuses go unread for the simple reason that they have been rendered unreadable. The blame lies with the fund companies who write them and the regulators who supervise the process. (Amusingly, both parties fault the other for what they concede are wretched results.) Given the unprecedented popularity of funds today, it's easy for these groups to hide problems, rather than to fix them, but doing so may ultimately undermine the hard-won victories funds have enjoyed. Fund leaders are already pledging their support of continued efforts to improve prospectus language, and the industry's trade group, the Investment Company Institute, will undoubtably sponsor numerous meetings in posh locations to address the issue with regulators, but it's hard to believe that much will come of these discussions if the profile has already been adopted. The SEC in effect will have already played its trump card. Fund leaders will have what they want-a sales document that conveys an image of funds as plain-talking, Main Street kinds of enterprises. At the same time, of course, the full prospectus spells out exceptions and caveats to the simple prose of the profile that create intricate legal protections for the fund-management company. Fund companies get to have their cake and eat it too. With the profile promoting an image of candor, the main prospectus will become even more so a document by lawyers for lawyers. For precedent, look no further than the Statement of Additional Information, Part B of the current prospectus. Next to this document, the current prospectus reads like The Sun Also Rises. What's disturbing about the rush to adopt the profile prospectus is that several fund companies, including John Hancock and Vanguard, have recently taken steps to make their prospectuses more accessible while still conveying a tone and level of sophistication that suggests shareholders are owners. Several more like Scudder have improved their prospectuses, but are waiting for the sec's ruling on the profile prospectus before issuing them. If the profile passes, it is questionable whether these improvements will ever see the light of day. Moreover, the incentive for future prospectus improvements will certainly diminish. By mandating the size, content, sequence, and layout of the profile-and by defining it as an approved document, which in many cases will be all an investor sees before purchase-the sec may improve the reporting of the weakest fund groups, but it stifles the competitive and creative instincts of the best. Conclusion The tenet that fund shareholders should be treated like owners, not customers, has served the fund industry long and well. Why abandon it now? It has helped safeguard the industry from the scandals that have plagued other financial services. It's one of the core principles that have made mutual funds the investment vehicle of choice of so many Americans. It's easy to lose sight of such things in good times, but the industry should recall the words of Abraham Lincoln that Vanguard's Jack Bogle recently invoked, "Important principles must be inflexible." Insisting that shareholders are owners may force the industry to address some difficult issues, such as fixing the mess it's made of prospectuses, but it's clearly the right thing to do. Investors can only hope that today's fund regulators have the vision and the courage to stand up for these important principles.