Investment Companies and the Investment Company Act of 1940

The two frameworks work together: the FINRA investment-company-securities requirement binds member firms; the ICA binds the funds themselves.

FINRA Investment-Company-Securities Requirement

The FINRA investment-company-securities requirement governs how member firms sell investment company securities and parallels the cash and non-cash compensation framework covered in Unit 5.

Cash Compensation in the Prospectus

A member shall not accept any cash compensation from an offeror unless the compensation is described in a current prospectus.

• The compensation arrangement must appear in the prospectus that the customer receives at or before sale
• A special arrangement (revenue-sharing-style payments not made available on the same terms to all members) requires disclosure of the member's name and details of the arrangement in the prospectus

Breakpoint Discount Supervision

WSPs must require reps to identify when a customer qualifies for a front-end load breakpoint and apply the discount. FINRA recommends a written breakpoint disclosure statement at or shortly after purchase.

Reps must also inform eligible customers of two breakpoint-qualifying mechanisms:

• Letter of intent (LOI): customer commits in writing to invest a target amount over 13 months (or other agreed period) and receives the breakpoint discount immediately
• Rights of accumulation (ROA): customer's existing fund holdings count toward future-purchase breakpoint thresholds

A rep who recommends a $24,000 Class-A purchase to a customer eligible for a $25,000 breakpoint without disclosing the LOI / ROA option violates the FINRA investment-company-securities requirement even if the customer never asks. The exam tests this fact pattern frequently.

Exam Tip: Gotchas

• Cash compensation must be in a current prospectus. A member firm that accepts cash compensation outside the prospectus disclosure has violated the investment-company-securities requirement even if the customer is fully informed in writing through other channels. The prospectus is the required vehicle.
• Breakpoint sales just below a threshold are quantitative-suitability red flags. A pattern of recommendations at $24,500, $24,800, $24,900 in funds with $25,000 breakpoints is the classic exam scenario: each individual sale is suitable; the pattern is not.

ICA Definition of Investment Company

The general statutory definition is broad. An issuer is an investment company if it meets any of:

• Is or holds itself out as being engaged primarily in the business of investing, reinvesting, or trading in securities
• Is engaged in the business of issuing face-amount certificates of the installment type
• Owns or proposes to acquire investment securities having a value exceeding 40% of the issuer's total assets (the "40% test" for inadvertent investment companies)

Private-Fund Exclusions

The ICA lists exclusions from the investment company definition. The two most-tested are:

• The 100-or-fewer-beneficial-owners exclusion: private funds with 100 or fewer beneficial owners that do not make a public offering
• The qualified-purchaser-only exclusion: private funds owned exclusively by qualified purchasers (high-net-worth individuals and institutions) regardless of count

Both exclusions support the private-fund and hedge-fund industry, which would otherwise be subject to ICA registration.

ICA Classification of Investment Companies

The ICA classifies investment companies into three types:

A UIT does not have a board of directors because the portfolio is fixed and the trustee administers under the trust indenture; a management company has a board because the portfolio is actively managed.

Management Company Sub-Classifications

The ICA sub-classifies management companies along two axes: open-end vs. closed-end and diversified vs. non-diversified.

Diversified vs. Non-Diversified: The 75-5-10 Test

A diversified company meets the 75-5-10 test for at least 75% of its assets:

• 75% in cash, government securities, or other-issuer securities (no concentration)
• 5% maximum in any one issuer
• 10% maximum of any one issuer's voting securities

A non-diversified company does not meet the test. It is permitted to concentrate; it must label itself as non-diversified in its prospectus.

Exam Tip: Gotchas

• A UIT has NO board of directors. The trustee administers a fixed portfolio under the trust indenture. The exam tests this distinction; a UIT is not a management company even though it issues redeemable securities.
• The 75-5-10 test is "75% in compliant holdings, no more than 5% in any one issuer of those holdings, no more than 10% of that issuer's voting securities." It is not "75% diversified, 5% other, 10% other." The test is a single integrated requirement applied to 75% of the fund's assets.

Registration and Operating Provisions

The offers-of-exchange policy prevents sponsors from using exchange offers to disadvantage existing shareholders.

Distribution Fees: 12b-1 Plans

The distribution-fee framework permits a registered open-end management investment company to use fund assets to pay distribution and shareholder-service expenses under a written 12b-1 plan.

FINRA-Imposed Caps Under the investment-company-securities requirement

"No-Load" Definition

A fund may charge a 12b-1 fee up to 0.25% and still describe itself as "no-load." Above 0.25%, the "no-load" label is impermissible.

Plan Approval and Review

• Board and shareholder approval required at adoption
• Annual review by independent directors
• Plan and fees must be described in the prospectus

Exam Tip: Gotchas

• A 12b-1 fee above 0.25% disqualifies the "no-load" label even if the fund has no front-end or back-end sales charge. A "no-load fund" with a 0.50% 12b-1 fee is misleadingly named under the ICA's misleading-names prohibition and FINRA communications rules.
• The 12b-1 plan must be approved by both the board AND the shareholders at adoption. Annual review thereafter is by independent directors. The bilateral approval reflects the conflict of interest in using fund assets to fund distribution.

Pricing and Redemption

The ICA governs distribution, redemption, and repurchase of redeemable securities.

Forward Pricing

Funds, principal underwriters, and dealers must sell and redeem fund shares at the NAV next computed after receipt of the order. NAV must be computed at least once daily Monday through Friday at a time set by the board (industry standard: 4 PM ET market close).

• An order placed at 3:30 PM is filled at the same-day 4 PM NAV
• An order placed at 4:01 PM is filled at the next day's 4 PM NAV
• Late trading (filling post-4 PM orders at the same-day NAV) violates the forward-pricing rule

Think of it this way: Forward pricing prevents arbitrage: a customer cannot wait to see the closing price, then place an order at the previous NAV. Whoever places the order sees only the future price.

Retail Price Maintenance

Dealers must sell redeemable securities to the public at the current public offering price described in the prospectus (the uniform load schedule). The rule applies to dealers, not to brokers acting purely as agents on a commission basis.

Sales Load Schedule Exemptions

• Scheduled variations: permits scheduled variations in or elimination of the sales load (breakpoints, NAV transfers, conversion privileges) provided variations are applied uniformly within the specified class and disclosed
• Separate-account exemption: exempts certain registered separate accounts

Suspension of Redemption Rights

Funds may NOT suspend redemption or postpone payment more than 7 days after tender, except:

• (a) periods when the NYSE is closed (other than weekend or holiday)
• (b) periods when NYSE trading is restricted
• (c) emergencies making disposal of portfolio securities not reasonably practicable
• (d) SEC order for the protection of investors

A separate exemption applies during the annuity payment period of variable annuity contracts in certain registered separate accounts.

Exam Tip: Gotchas

• Forward pricing fills the order at the NAV next computed after the order is received, not the NAV at the time of the customer's decision. Late trading (filling post-4 PM orders at the same-day NAV) is a forward-pricing violation that has been the subject of major enforcement actions.
• The retail-price-maintenance rule applies to dealers selling at a markup, not to brokers acting as customer agents on a commission basis. The distinction matters for clean-share programs and some no-transaction-fee platforms where the intermediary is structured as a broker not bound to the prospectus load schedule.
• The 7-day suspension limit is a hard cap with four narrow exceptions. A fund cannot extend redemption postponement beyond 7 days based on its own discretion; it needs an NYSE-closure trigger, a trading-restriction trigger, a documented emergency, or an SEC order.

Distributions and Closed-End Funds

Payments and Distributions

• Return-of-capital disclosure: requires a written statement to accompany any dividend payment that is partly from sources other than current or accumulated net income (e.g., return of capital component); investors must know what portion of the dividend is income versus return of their own principal
• Frequency of capital gains distributions: limits the frequency of capital gains distributions to generally one per year (with limited exceptions)

Closed-End Distribution and Repurchase

The ICA governs closed-end companies separately (closed-end funds do not offer redeemable securities and therefore are not subject to the open-end pricing mechanics). Closed-end funds do not have continuous primary offerings; new shares enter the market through follow-on offerings and rights offerings.

Names and Misuse

Unlawful Representations and Names

The ICA prohibits any representation that an investment company or its securities have been guaranteed, sponsored, or recommended by the U.S. Government or any agency. It also prohibits names that are materially deceptive or misleading.

Larceny and Embezzlement

Federal criminal offense for any officer, director, employee, or agent of a registered investment company to steal, unlawfully abstract, or willfully misapply the company's funds or securities. The provision overlays state criminal law and supports federal enforcement against fund insiders.

Exam Tip: Gotchas

• The ICA prohibits any representation suggesting U.S. Government guarantee, sponsorship, or recommendation. A government securities fund may invest exclusively in U.S. Treasury securities and still violate the misleading-names prohibition if its name or marketing implies the fund itself carries a government guarantee. Only the underlying Treasuries do; the fund does not.
• The ICA's embezzlement provision makes theft from a fund a federal crime. This is a separate offense from any state-law charge and can be brought even where the state declines to prosecute. The fund's own financial-controls and internal-audit framework supports detection.