Investment Company Governance

The Investment Company Act (ICA) of 1940 governs how registered investment companies are organized, how their boards operate, how they name themselves, and how they structure their capital. These governance rules are the backbone that keeps fund pricing, fund names, and the sales-charge caps enforceable.

How do investment companies register under the Investment Company Act?

Registration is the front door for any registered investment company.

• Form N-1A is the registration statement filed by open-end funds with the Securities and Exchange Commission (SEC)
• An investment company must register with the SEC before offering its shares to the public
• The registration statement identifies the fund, its objectives, and its structure for regulators and investors

Exam Tip: Gotchas

• Form N-1A is the open-end fund registration form. Closed-end funds use Form N-2; UITs use Form N-8B-2. The exam typically asks about N-1A in the mutual fund context.
• ICA registration is separate from Securities Act registration used for the shares themselves. A mutual fund registers both under the ICA (as a company) and under the Securities Act (for its share offering).

What does the Investment Company Act require for independent directors?

The ICA governs the independence of fund boards of directors.

• At least 40% of directors must be independent (not "interested persons" as defined in the ICA)
• An affiliated person is generally one who controls, is controlled by, or is under common control with the fund, or who owns 5% or more of its voting securities. That 5% line feeds the "interested person" test
• Funds relying on common exemptive rules (including distribution-and-service-fee plans) must have at least a majority of independent directors
• Independent directors provide oversight of:
  • Affiliated transactions
  • Advisory contracts
  • Distribution-and-service-fee plan renewals

Think of it this way: The 40% minimum is the floor. Most modern funds operate with majority-independent boards because virtually every mainstream fund relies on at least one exemptive rule that triggers the majority requirement.

Exam Tip: Gotchas

• The 40% independent directors minimum is the baseline. A fund with a distribution-and-service-fee plan must have a majority of independent directors (more than 40%). The distribution-and-service-fee rule itself imposes the stricter requirement.
• "Interested person" is defined broadly in the ICA to include affiliates of the investment adviser, the distributor, and certain family members. A director who works for an affiliated company is not independent.

When does an investment policy change require shareholder approval?

The ICA requires shareholder approval for certain fundamental changes.

• Fundamental investment policies require shareholder approval to change, including:
  • Investment objectives
  • Principal investment strategies
  • Concentration limits
  • Diversification status
• A change from diversified to non-diversified, from one objective to another, or a material concentration change cannot be made unilaterally by management

Exam Tip: Gotchas

• Fundamental policy changes require shareholder approval. A question that says "the adviser decided to change the fund's objective" is wrong: the adviser can recommend, but shareholders must vote.
• Diversification status change triggers the shareholder-vote requirement. Moving from diversified to non-diversified (or back) is a fundamental change.

How are investment company directors elected?

The ICA governs how directors are elected.

• Directors must be elected by shareholders at an annual or special meeting called for that purpose
• A vacancy arising between meetings may be filled without a shareholder vote only if, immediately after it is filled, at least two-thirds of the directors then holding office were shareholder-elected
• If at any time fewer than a majority of sitting directors were shareholder-elected, the board must call a shareholder meeting within 60 days to fill the vacancies

Exam Tip: Gotchas

• The two-thirds figure is a condition on filling a vacancy, not a standing headcount rule. The board may appoint to a vacancy between meetings only while at least two-thirds of the directors then in office are shareholder-elected. An answer choice phrasing it as "two-thirds must be shareholder-elected at all times" is stating the wrong rule.
• Two-thirds and majority are two different triggers. Dropping below two-thirds only ends the board's power to appoint; dropping below a majority forces a shareholder meeting within 60 days.

What does the Names Rule require?

The misleading-fund-names rule prevents misleading fund names. It is often called the Names Rule.

• If a fund's name suggests a particular focus, the fund must adopt a policy to invest at least 80% of its net assets (plus borrowings for investment) in investments of the type suggested by the name
• The 80% policy must be either:
  • Fundamental (requires shareholder vote to change), OR
  • Subject to 60 days' prior notice to shareholders before change
• The rule also covers names suggesting particular characteristics:
  • "Environmental, Social, Governance (ESG)"
  • "Sustainable"
  • "Growth"

Examples:

Exam Tip: Gotchas

• The Names Rule requires 80% of net assets (plus borrowings) in investments of the type suggested by the name. A fund called "XYZ Technology Fund" must hold at least 80% technology securities.
• The 60-day notice requirement applies only to non-fundamental 80% policies. Fundamental policies require a shareholder vote to change.
• The Names Rule extends to characteristics (ESG, sustainable, growth), not just asset classes. A fund called "XYZ ESG Growth Fund" has an 80% policy tied to both ESG and growth characteristics.

How does the Investment Company Act limit fund leverage?

The senior-securities limitation caps leverage by requiring asset coverage for senior securities.

What "asset coverage" means:

• 300% asset coverage = total assets are at least 3× the senior security amount (2:1 equity cushion over debt)
• 200% asset coverage = total assets are at least 2× the senior security amount (1:1 equity cushion over preferred)

Purpose:

• Prevents excessive leverage that would magnify losses to common shareholders
• Protects the common shareholders who do not have the priority position of the senior securities

Exam Tip: Gotchas

• Open-end funds may only borrow from a bank. No issuing of debt or preferred stock.
• 300% coverage for debt, 200% for preferred. Debt is senior to preferred, so it requires the larger cushion.
• If asset coverage falls below 300% for open-end bank borrowings, the fund must reduce borrowings within three days to restore coverage.

What is forward pricing?

Forward pricing governs the price at which fund-share orders are executed.

• Redeemable-security transactions (purchases and redemptions) must be executed at the next-computed Net Asset Value (NAV) after receipt of the order: forward pricing
• Prevents late trading: executing today's order at a known stale NAV
• Orders received before the fund's pricing time (typically 4:00 p.m. Eastern Time (ET)) receive that day's NAV; orders after receive the next day's NAV

Exam Tip: Gotchas

• Forward pricing means the next-computed NAV, never a stale one. The price of a purchase or redemption is not known at the moment the order is placed: it is the next NAV the fund calculates after receiving the order.
• Forward pricing is what makes late trading illegal. If orders could be priced at a known stale NAV, late traders could profit from after-market news at the expense of long-term shareholders.

What periodic reports must investment companies file?

The ICA requires registered investment companies to file periodic reports with the SEC and to send reports to shareholders.

• Annual and semi-annual reports filed with the SEC
• Copies of the periodic or interim reports the fund sends to shareholders are due to the SEC no later than 10 days after transmission to those shareholders
• Shareholders receive annual and semi-annual reports
• Audited financial statements required in annual reports only

Exam Tip: Gotchas

• Periodic shareholder reports are separate from prospectus delivery. The prospectus is the front-end disclosure (before or at purchase); periodic reports are the ongoing shareholder disclosure.

What antifraud duties apply to investment companies?

Three anti-abuse provisions round out the governance framework.

Exam Tip: Gotchas

• The breach-of-fiduciary-duty-for-fees provision applies specifically to compensation. Excessive advisory fees can give rise to a shareholder claim.
• Theft from an investment company is a federal crime. This is why a rep who commingles customer funds (or worse) faces federal, not just state, liability.
• A misleading fund name is an antifraud violation, not just a Names Rule technicality. A name that misrepresents the portfolio can be challenged as a deceptive practice, separate from the 80% policy requirement.

How do the ICA governance rules fit together?

The governance rules form a complete lifecycle.

Exam Tip: Gotchas

• Forward pricing and the seven-calendar-day redemption deadline are the two big pricing numbers to memorize. Forward pricing prevents late trading; the seven-calendar-day deadline (not business days) ensures liquidity for shareholders.
• "Interested person" is the ICA definition that matters most. It captures affiliates of the adviser and distributor (and certain family members), which is exactly why an interested person cannot count toward the independent-director minimum.

What Should You Check on Exam Day?

• Do you know Form N-1A is the registration form open-end funds file with the SEC, separate from Securities Act registration for the shares themselves?
• Can you state that independent directors must be at least 40% of the board, rising to a majority if the fund has a distribution-and-service-fee plan?
• Do you know a fund's fundamental investment policies, such as its objective or diversification status, require a shareholder vote to change?
• Can you explain the Names Rule: a fund must invest at least 80% of net assets in the type of investment its name suggests?
• Do you know forward pricing requires trades to execute at the next-computed NAV, which is what makes late trading illegal?