United States

Author: | Published: 3 Oct 1999
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This article will provide a brief overview of the wide variety of laws and regulations which affect investment funds in the US, with the primary focus on the Investment Company Act of 1940 (the 1940 Act).

The Investment Company Act of 1940

The 1940 Act is a highly restrictive regulatory statute, as compared to other disclosure-oriented US federal securities laws.

Definition of an investment company

The definition of an investment company in the 1940 Act is broadly worded, sweeping within the scope of the statute a wide variety of organizations and structures not commonly thought of as investment companies. The 1940 Act defines an investment company to include any entity which:

  • is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities (a subjective test).
  • is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the issuer's total assets (an objective test).

The 1940 Act, however, contains specific exemptions for certain types of companies (banks, insurance companies, mortgage banks) and two exemptions for privately offered investment funds, found in Sections 3(c)(1) and 3(c)(7) of the 1940 Act.

The Section 3(c)(1) exemption is available to funds whose securities are not offered to the public and are beneficially owned by no more than 100 holders. There are important qualifications to the 100-holder limitation, including a requirement under certain circumstances to look through registered and private funds, and to count the investor's investors to determine compliance with the limit. The limitation on ownership applies for the life of the fund, not just the offering; this complicates simultaneous US and non-US offerings.

The second private fund exemption is available for funds sold only to qualified purchasers, regardless of their number. Each purchaser must own a significant investment portfolio (generally, at least $25 million for institutions and $5 million for individuals).

In addition, the 1940 Act provides that the SEC, after public notice, may conditionally or unconditionally exempt any person, security or transaction from any provision of the 1940 Act where it finds that the exemption would be in the public interest and consistent with the protection of investors and the purposes of the 1940 Act.

Types of registered investment companies

Most funds required to be registered as investment companies under the 1940 Act are management companies. Securities in the fund are managed but must conform to policies set out in the prospectus, and a board of directors is ultimately responsible for the company. There are two types of management companies: open-ended companies and closed-end companies.

Open-ended fund. An open-ended fund, commonly referred to as a mutual fund, issues redeemable shares (which an investor is entitled to sell back to the company at net asset value upon seven days' notice). An open-ended company generally offers its shares to the public continually at a price based on net asset value.

Closed-end fund. A closed-end fund's shares are not redeemable and therefore trade like other securities, but often at a discount from net asset value. Shares are usually listed on a stock exchange. Closed-end companies can also issue additional shares at not less than net asset value, but generally new shares are not continuously offered. The SEC has somewhat alleviated the inflexibility and drawbacks inherent in the closed-end fund structure by allowing interval management companies. To address the discount problem, the SEC allows qualifying closed-end companies to offer to repurchase shares at fixed intervals at net asset value, but no more frequently than quarterly. Unit investment trust. A less common type of investment company is a unit investment trust, which is an unmanaged portfolio of securities in trust form with no board of directors and which issues only redeemable securities. Each unit represents an undivided interest in specified securities. The portfolio cannot, with limited exceptions, acquire different securities, and if securities are sold the proceeds are generally distributed to unit holders.


Any fund subject to the 1940 Act is required to register with the SEC, filing a detailed form describing, among other matters, the fund's investment objectives, policies and restrictions.

Board of directors

The 1940 Act requires the board of directors of a fund to regulate the activities of the fund and to monitor self-dealing by the sponsor or adviser to the fund. It allows up to 60% of a management company's board of directors to be "interested persons" (which is very broadly defined), but it is usually advisable to have a majority of directors who are not interested persons. In addition, the SEC has recently been reviewing the role of the board of directors, including independence issues and may promulgate additional rules in this area in the near future.

The 1940 Act imposes several specific responsibilities upon the directors (and in some cases, separately on disinterested directors), including:

  • approving the investment advisory agreement;
  • electing independent accountants;
  • determining the method of valuing assets;
  • approving any distribution plan (under which an investment company could pay distribution expenses);
  • monitoring certain affiliated transactions;
  • using securities depositories;
  • trading among affiliated funds; and
  • using affiliated brokers and purchases during underwritings in which affiliates participate.
Shareholders and voting

Each share issued by a registered management investment company must be voting stock and have equal voting rights with all other voting stock. Besides being required for changes in fundamental policies, approval by vote of the majority of the outstanding voting securities of management companies is required for its advisory agreement and any distribution plan, and shareholder approval may be needed to elect directors and ratify the directors' selection of independent accountants.

Capital structure

Open-ended funds may not issue any senior class of securities. The 1940 Act allows for multiple equity series, each preferred over all others with respect to specific portfolio assets. Funds also may offer multiple interests in the same portfolio with different sales loads or services. Temporary borrowing and limited borrowing from banks not used for leverage is permitted, under certain conditions. Unit investment trusts are also generally limited to one class of stock.

Closed-end funds are allowed a single class each of common stock, preferred stock and debt, subject to prescribed maximum asset coverage for debt and preferred stock.

Private funds have considerably more flexibility in devising capital structures since they are not subject to 1940 Act limitations and are generally restricted only by federal tax laws.

Sales, repurchases and redemptions

The 1940 Act requires that sales, repurchases and redemptions of redeemable shares of open-ended companies and unit trusts be at a price based on net asset value. Net asset value must be determined each business day when there is any purchase or redemption of shares, utilizing specified valuation procedures. Shares can only be sold at the current net asset value plus a sales load specified in the prospectus.

Most mutual funds have distribution fees, often coupled with contingent deferred sales charges collected on redemptions in the first few years.

Limits on investments

The 1940 Act restricts the investments that can be made by registered investment companies. An investment company is limited in its ability to purchase the securities of, or sell its own securities to, other investment companies. The 1940 Act also restricts investments by any registered investment company in the securities issued by broker/dealers, underwriters or investment advisers (or companies 15% or more of whose gross revenues are derived from one or more of those businesses) and insurance companies.

Open-ended management companies may not invest more than 15% of net assets in illiquid assets (that is, those not saleable without a substantial discount within seven days).

Limits on transactions with affiliates

The 1940 Act imposes strict limits on investment company transactions with affiliates. These restrictions generally require prior SEC approval for affiliates to buy from or sell to a fund as principal, to borrow from a fund or to engage in joint transactions in which a fund participates. However, the SEC does not require prior approval for the aggregation of orders for advisory clients, including a registered investment company, provided that the investment company participates on terms no less advantageous than those of any other participant. Other 1940 Act limits include restrictions on an affiliate acting as a fund's agent in securities transactions and on a fund purchasing securities during an underwriting if an affiliate is a principal underwriter.

Public offerings by non-US funds

Section 7(d) of the 1940 Act prohibits a foreign investment company from making a public offering of its shares in the US unless the SEC issues an order permitting it to register under the 1940 Act. Because the standards for granting a Section 7(d) order have been interpreted by the SEC as requiring a foreign investment company to structure itself and operate as a US investment company, it has proved to be virtually impossible for foreign investment companies to offer publicly their shares in the US.

The SEC has eased the restrictions of Section 7(d) to some extent by allowing offshore funds (or companies relying on a private fund exemption) to sell securities privately to up to 100 US investors or to an unlimited number of US qualified purchasers — generally individuals or entities with significant investments in securities — without having to restrict the transfer of securities distributed in a simultaneous offshore offering.

The Securities Act of 1933

Any offering of securities in the US must either be registered with the SEC under the 1933 Securities Act or be subject to a specific exemption from that act. Registration is costly and time consuming, but generally unavoidable for retail investment funds.

Registration under the Securities Act

To register under the Securities Act, a registration statement must be filed with the SEC containing a prospectus in preliminary form. A registration fee is payable in advance on non-redeemable securities, and shortly after each selling year on redeemable shares. For an investment company, the prospectus must contain disclosure of expense information, the fund's financial history, its investment objectives and policies, the organization and management of the fund, distributions, calculation of share price, how to buy the shares, and financial statements. Once the registration statement is filed, the preliminary prospectus may be distributed and indications of interest solicited.

Once declared effective by the SEC, the final prospectus may be printed and used to confirm sales. Post-effective amendments to the registration statement are required annually for funds that continue to sell shares so that audited financial statements are not more than 16 months old at any time.

Private placements under the Securities Act

To avoid the Securities Act registration process, funds may be exempt as private placements under the Securities Act, which is separate and distinct from the 1940 Act private fund exemptions. The basic requirements of Securities Act exemption are to avoid any public solicitation (that is, no advertising or publicity and strict limits on solicitation) and to sell only to sophisticated investors.

Shares that have been privately placed are generally restricted and may only be resold by the purchaser by means of an offering registered with the SEC or through the private placement exemption. An exemption for resales of restricted securities to qualified institutional buyers — generally institutions with $100 million or more invested in securities — can make privately-placed securities somewhat liquid.

Funds that use a private placement exemption under the Securities Act may still be subject to registration under the 1940 Act. To qualify for an exemption from registration under the 1940 Act, there must be fewer than 100 beneficial owners or all investors must be qualified purchasers.

Marketing of Funds

Communications to stimulate investor interest in investment companies are regulated by the SEC under the Securities Act and the 1940 Act and by the National Association of Securities Dealers (NASD) — a self-regulatory organization authorized by the SEC to regulate brokers and dealers — under its Rules of Fair Practice. These regulations specify when advertisements may be used, what may be said and the filing requirements. The NASD also generally requires that investments be suitable to the sophistication of the investor (known as the "know your customer" rule).

The NASD has also prescribed maximum sales loads. SEC rules specify conditions on the ability of affiliates to recover distribution expenses from the assets of the fund.

Recent SEC rules permit mutual funds to sell their shares off-the-page (similar to sales advertisements used in the UK) to put direct-marketed funds on par with broker-sold funds. Off-the-page advertisements must include prescribed core disclosure and the full prospectus must accompany or precede the confirmation of sale.

Investment Advisers Act or 1940

Generally, any US investment adviser who advises 15 or more clients (or any non-US adviser who advises 15 or more US clients), solicits advisory business or advises any registered investment company, must register under the Investment Advisers Act with the SEC. The term investment adviser is defined to mean any person or company who receives compensation for giving advice in connection with purchasing or selling securities.

Registration as an investment adviser is not difficult but may be time consuming. An investment adviser must complete and submit to the SEC a registration statement on a Form ADV. The form contains two parts. Part I calls for information about an adviser's organizational structure, owners and certain legal actions involving the adviser or its employees. Part II requires disclosure about the adviser's products and services, as well as any potential conflicts of interest between the adviser and its clients. The SEC does not require any registration fee.

The Investment Advisers Act restricts performance fees, requires segregation of client assets and detailed record-keeping, limits advertising, restricts transactions with affiliates and imposes fiduciary obligations with respect to the adviser's clients.

In recent years the SEC has sought to alleviate the regulatory burdens on non-US advisers who register with the SEC. The SEC now permits non-US advisers to register without subjecting their relationship with non-US clients to the substantive provisions of the Advisers Act, so long as non-US advisers submit to jurisdiction, agree with the SEC to maintain certain records (including worldwide trading records) and provide access to their personnel in case of investigations.

The SEC has also provided relief for unregistered, non-US advisers (participating affiliates) who provide advice through SEC-registered, affiliated advisers. The SEC does not require a participating affiliate to also register, provided both the registered adviser and the participating affiliate abide by certain conditions. These conditions include that the registered adviser make additional disclosures on its Form ADV and supervise employees of the participating affiliate who provide advice to US clients. In addition, the participating affiliate must ensure that its employees who provide advice to US clients do so only through the registered adviser.

Contact Details:

Davis Polk & Wardwell

450 Lexington Avenue

New York NY10017

United States

Tel: +1 212 450 4000

Fax: +1 212 450 5536