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Why You Don’t Want to Be aRegistered Investment Company

Stephen A. Keen September 15, 2011

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A Little Knowledge Can Be Useful as Well As Dangerous

Many contracts include a representation or condition that a party is not required to register as an investment company under the Invest-ment Company Act of 1940 (the “1940 Act”)

Clients sometimes ask if this can be omitted

Clients who need to rely on exemptions from registration will sometimes ask in frustration, “Why don’t we just register?”

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The 1940 Act Is About More Than Disclosure

A securities attorney without experience representing registered investment companies (“RICs”) may not anticipate the implications of registration Other federal securities laws are based on principles

of disclosure Regulation of RICs is more like broker/dealer regulation

In addition to disclosure, substantive requirements and limitations apply to RICs

This presentation will review some of the more onerous requirements

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Why Other People Might Care Whether Your Client Is a RIC [§§47 & 48]

“A contract that is made, or whose performance involves, a violation of [the 1940 Act], or of any rule, regulation, or order thereunder, is unenforceable by either party.”

“It shall be unlawful for any person, directly or indirectly, to cause to be done any act or thing through or by means of any other person which it would be unlawful for such person to do under the provisions of [the 1940 Act] or any rule, regulation, or order thereunder.”

Any adviser to a RIC must register with the SEC

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1940 Definition of Security: Broader Than You Might Think [§2(a)(36)]

Definition of “security” in the 1940 Act is basically the same as the 1933 and 1934 Acts, but . . .

“[W]hile excluding commercial instruments from the disclosure requirements of the Securities Act and the Exchange Act is consistent with the purposes of those Acts, issuers that pool these instruments nevertheless may be functionally equivalent to, and present the same investor protection concerns as, investment companies that invest in securities that are registered under those Acts.” Protecting Investors: A Half Century of Investment Company Regulation n. 339

In other words commercial loans, mortgages, credit card accounts, bank accounts, etc. are all “securities” under the 1940 Act

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Limitations on Advisory Contracts[§§15(a) & (f), 17(i) & 36(b)]

Must be terminable without penalty on 60-days’ notice Must describe all of the adviser’s compensation, which

cannot be increased without shareholder approval Private right of action if compensation is found to be

excessive Contract must terminate automatically upon assignment

(including change of control) Adviser can only profit from assignment if certain

conditions are met No exculpation for misconduct or gross negligence

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Valuation of Shares[§§2(a)(41), 5(a), 14(a), 22(c)&(e), & 23(b)]

RICs must start with at least $100,000 in net assets Two types of “managed” RICs

Open-end funds continuously issue redeemable securities priced at their net asset value

Closed-end funds sell shares in an IPO and trade on an exchange at their market value

Open-end RICs Must use forward-pricing Board must fair value securities without available market prices Cannot suspend redemptions without permission from the SEC

Closed-end RICs cannot sell shares for less than their net asset value after underwriters’ discount

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Capital Limitations [§§18 & 19(a)]

Open-end RICs can have only one class of equity securities Closed-end RICs can also issue one class of

preferred shares subject to a 200% asset coverage requirement

Closed-end RICs can issue one series of debt securities subject to a 300% asset coverage requirement Open-end RICS can only borrow from banks

Shareholders must be notified of any distributions that include a return of capital

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Limitations on Directors & Officers[§§2(a)(19), 10(a), 16(a) & 17(h)]

Some directors must not be “interested persons,” who include: “Affiliated persons” of the RIC, its adviser and principal

underwriter, and their immediate family members Anyone who has had a material business or professional

relationship with the RIC or its officers

To profit from an assignment of the advisory contract, at least 75% of the directors must not be interested persons

At least two-thirds of directors must have been elected by shareholders

No exculpation for misconduct or gross negligence

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Transactions with Affiliated Persons [§§2(a)(3), 10(f), 17(a), (d) & (e), & 21]

Advisers, principal underwriters, directors, officers and employees and “control” relationships are treated as affiliated persons

5% shareholders and 5% owned companies are affiliated persons of each other

Prohibitions extend to affiliated persons of affiliated persons Affiliated persons cannot

Trade as a principal with the RIC or borrow money Participate in a joint enterprise or arrangement with the RIC Receive compensation for acting as the agent in a transaction

involving the RIC The RIC cannot purchase from a syndicate in which an affiliated

person is a principal underwriter

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Other Transactional Limitations[§§12(d) & 20(c)]

RICs cannot invest in securities related businesses

There are limits to how much a RIC can Invest in another RICs

Limits also apply to investments by 3(c)(1) and 3(c)(7) funds

Invest in insurance companies Engage in cross or circular ownership

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Required Investment Policies[§§5(b), 8(b) &13(a)]

RICs must adopt investment policies regarding

Diversification and Concentration

Investing in Real Estate and Commodities

Lending and Borrowing

Issuing Senior Securities

Shareholder approval required to change policies

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Required Arrangements and Procedures [§§17(f)-(g), 17(j), 31, 33 & 38]

RICs must maintain custody of assets at a bank or registered B/D

RICs must maintain fidelity bonds RICs must adopt codes of ethics that regulate personal

trading RICs must maintain required books and records RICs must file copies of civil case proceedings with

SEC RICs must have Chief Compliance Officers who report

to the RIC’s board

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There Are Exceptions to Everything

RICs do not have to comply with these limitations and requirements in all circumstances

Exemptions may be found in The 1940 Act SEC regulations SEC exemptive orders SEC no-action letters

All exemptions are subject to conditions, which changes the nature of the limitation or requirement without removing it entirely

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Why Register as a RIC?

There are reasons that RICs hold over $12 trillion in assets

You can raise unlimited amounts of money for investment from an unlimited number of investors

You can plug into an existing distribution system

Intermediaries and investors understand the product

RICs qualify for Subchapter M of the IRC, another way of avoiding double taxation

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Other Resources

Robert H. Rosenblum, Investment Company Determination under the 1940 Act : Exemptions and Exceptions (ABA 2003)

Victoria E. Schonfeld and Thomas M.J. Kerwin, Organization of a Mutual Fund, 49 Bus. Law. 107 (1993)

Protecting Investors: A Half Century of Investment Company Regulation (1992); http://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf

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Stephen A. Keen, CounselTel: 970-689-3153Email: skeen@reedsmith.com

Steve is a member of the Financial Industry Group, practicing in the area of Investment Management. A nationally known Investment Company Act lawyer, Steve is recognized for his experience with money market funds. Steve represents investment industry groups such as the Investment Company Institute and is a regular speaker at industry conferences.