Key Regulatory Provisions (Investment Company Act of 1940)

To conclude this unit, let's consolidate the key sections of the 1940 Act that govern investment company behavior. You've already encountered several of these throughout the unit; this section brings them together as a regulatory reference.

Section 12(a) - Prohibited Activities

Registered investment companies (mutual funds) cannot:

• Purchase securities on margin
• Participate in a joint trading account
• Sell securities short

Important distinction: These restrictions apply to the fund itself, not to ETF shareholders. ETF shares trade on exchanges, so ETF shareholders can margin and short ETF shares. But the ETF fund itself is still bound by Section 12(a).

Exam Tip: Gotchas

• Section 12(a) restrictions apply to the fund, not to ETF shareholders trading on exchanges. An ETF shareholder can short ETF shares; the ETF itself cannot short anything.

Section 17(a) - Affiliated Transactions

• Prohibits affiliated persons (officers, directors, 5%+ shareholders) from selling to or purchasing from the fund
• Designed to prevent self-dealing and conflicts of interest
• An officer cannot sell personal holdings to the fund or buy from the fund's portfolio for personal benefit

Exam Tip: Gotchas

• Section 17(a) prevents insiders from trading with the fund in either direction. They cannot sell to it or buy from it. This is self-dealing, even if the price is fair.

Section 18 - Capital Structure / Senior Securities

This section controls leverage:

Think of it this way: 300% asset coverage for debt means for every $1 borrowed, the fund must have $3 in total assets. 200% for preferred stock means $2 in total assets for every $1 of preferred issued.

Exam Tip: Gotchas

• Open-end funds generally cannot leverage; closed-end funds can. Closed-end funds may issue debt (300% coverage) or preferred stock (200% coverage). Open-end funds may only borrow from banks with 300% coverage.

Section 19 - Dividends

• A fund cannot pay dividends from any source other than net investment income without written notice to shareholders disclosing the source
• Prevents funds from disguising return of capital as income
• If a dividend includes return of capital or capital gains, the fund must clearly disclose this

Exam Tip: Gotchas

• Section 19 does not ban non-income dividends outright. It requires written disclosure when dividends include return of capital or capital gains. The fund must tell shareholders where the money came from.

Section 22 - Distribution, Redemption, and Repurchase

• Governs the pricing and sale of redeemable securities (mutual fund shares)
• Prohibits selling fund shares at a price other than the current offering price described in the prospectus
• Establishes the basis for Rule 22c-1 (forward pricing)

Section 23 - Closed-End Company Shares

• Closed-end companies may not sell shares below net asset value (NAV) without shareholder approval
• This protects existing shareholders from dilution (new shares sold cheaply would reduce existing shareholders' value)

Exam Tip: Gotchas

• Closed-end funds cannot sell shares below NAV without shareholder approval. This protects existing shareholders from dilution. Open-end funds always sell at NAV (plus any sales charge), so this rule only applies to closed-end funds.

Section 35 - Unlawful Representations and Names

• Fund names must not be deceptive or misleading
• A fund using "diversified" in its name must meet the 75-5-10 test
• The SEC's Names Rule further requires a fund to invest at least 80% of assets consistent with the investment focus suggested by its name

Section 36 - Breach of Fiduciary Duty

• The SEC may bring action against officers, directors, advisers, or affiliated persons for breach of fiduciary duty involving personal misconduct
• This provides a legal enforcement mechanism for fund governance

Section 37 - Larceny and Embezzlement

• Criminalizes theft from a registered investment company
• This is a criminal provision (not just civil), carrying potential imprisonment