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.

What Trading Activities Are Prohibited for the Fund Itself?

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 the same trading restrictions.

Exam Tip: Gotchas

• These trading 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.

What Does the Affiliated-Transaction Prohibition Cover?

• 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

• The affiliated-transaction prohibition stops 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.

What Leverage Rules Apply to Capital Structure?

The senior-securities limitation 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.

When Must a Fund Disclose the Source of a Dividend?

• 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

• The Act 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.

What Governs 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 the SEC's forward-pricing requirement

Can a Closed-End Fund Sell Shares Below NAV?

• 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.

What Rules Govern Fund Names?

• Fund names must not be deceptive or misleading
• A fund using "diversified" in its name must meet the 75-5-10 test
• Fund-naming rules further require a fund to invest at least 80% of assets consistent with the investment focus suggested by its name
• Separately, no one may represent that a fund's securities have been guaranteed, sponsored, or approved by the United States or a federal agency, are insured by the FDIC, or are an obligation of a bank. A fund advised by or sold through a bank must prominently disclose that the investment is not FDIC-insured

Exam Tip: Gotchas

• The FDIC/government-approval ban is a separate rule from the deceptive-name rule. A fund can have a compliant, non-misleading name and still violate this section if a rep implies government backing or FDIC insurance, especially when the fund is sold through a bank.

What Enforcement Provisions Apply to Fund Governance?

• 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

What Criminal Provision Applies to Theft From a Fund?

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

Do Funds Have Ongoing SEC Reporting Duties?

• Registered investment companies must file periodic reports with the SEC, including annual and semiannual shareholder reports and census-type filings, and affiliated persons of the fund have their own reporting obligations
• This is a recordkeeping and disclosure requirement, not a sales-practice rule; the exam mainly expects you to recognize that funds carry ongoing SEC reporting duties

What Should You Check on Exam Day?

• Can you list the three activities barred to the fund itself (margin, joint accounts, short selling) and explain why ETF shareholders can still margin or short the ETF shares?
• Can you state the asset coverage requirements for open-end bank borrowing and for closed-end debt and preferred stock?
• Do you know that non-income dividends are not banned outright, only require written disclosure of their source?
• Can you explain why closed-end funds cannot sell shares below NAV without shareholder approval?
• Can you state what a fund may never claim about government backing or FDIC insurance, and when a bank-sold fund must disclose the absence of FDIC coverage?