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 the conduit-theory tax treatment, the forward-pricing requirement, and the sales-charge caps enforceable.

How do investment companies register under ICA Section 8?

Section 8 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)
• Section 8(a) defines the registration obligation
• Section 8(b) establishes registration procedures
• A registered investment company must complete Section 8 registration before offering shares

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.
• Registration under ICA Section 8 is separate from the 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 ICA Section 10 require for independent directors?

Section 10 governs the independence of fund boards of directors.

• At least 40% of directors must be independent (not "interested persons" as defined in Section 2(a)(19))
• Funds relying on common exemptive rules (including Rule 12b-1 plans) must have at least a majority of independent directors
• Independent directors provide oversight of:
  • Affiliated transactions
  • Advisory contracts
  • 12b-1 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 under Section 10. A fund with a 12b-1 plan must have a majority of independent directors (more than 40%). The 12b-1 rule itself imposes the stricter requirement.
• "Interested person" is defined broadly in Section 2(a)(19) 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?

Section 13(a) 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 Section 13(a). Moving from diversified to non-diversified (or back) is a fundamental change.

How are investment company directors elected under Section 16(a)?

Section 16(a) governs how directors are elected.

• Directors must be elected by shareholders at a meeting
• At any time, at least two-thirds of directors must have been elected by shareholders
• Directors fill interim vacancies, but no more than one-third of the board can be filled by interim appointment without a shareholder election

Exam Tip: Gotchas

• Two-thirds of directors must be shareholder-elected at all times. The board can fill up to one-third through interim appointments, but once that threshold is crossed, a shareholder meeting is required.

ICA Rule 35d-1: Investment Company Names (the "Names Rule")

Rule 35d-1 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
• 2023 amendments broadened the rule to cover 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.
• 2023 amendments extended the Names Rule 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 ICA Section 18 limit fund leverage?

Section 18 limits 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 under Section 18. 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 under Rule 22c-1?

Section 22(c) authorizes the SEC to regulate how fund shares are priced. Rule 22c-1 implements that authority.

• 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

• Rule 22c-1 is the forward-pricing rule. Section 22(c) is the statutory authority; Rule 22c-1 is the operative rule.
• 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?

Section 30 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
• Shareholders receive annual and semi-annual reports
• Audited financial statements required in annual reports only

Exam Tip: Gotchas

• Section 30 reports are separate from prospectus delivery. The prospectus is the front-end disclosure (before or at purchase); Section 30 reports are the ongoing shareholder disclosure.

What antifraud duties apply under ICA Sections 35, 36, and 37?

Three anti-abuse sections round out the governance framework.

Exam Tip: Gotchas

• Section 36 fiduciary duty applies specifically to compensation. Excessive advisory fees can give rise to a Section 36 claim by shareholders.
• Section 37 makes theft from an investment company a federal crime. This is why a rep who commingles customer funds (or worse) faces federal, not just state, liability.
• Section 35 supports the Names Rule (35d-1). The statutory hook for misleading-name enforcement is Section 35.

How do the ICA governance rules fit together?

The governance rules form a complete lifecycle.

Exam Tip: Gotchas

• Section 22(c) forward pricing and Section 22(e) seven-day redemption are the two big Section 22 numbers to memorize. Forward pricing prevents late trading; seven-day redemption ensures liquidity for shareholders.
• Section 2(a) defines the vocabulary used throughout the ICA, including "investment company," "interested person," and "affiliated person." Many exam questions turn on these definitions.