Why You Don’t Want to Be a
Registered Investment Company
Presented by
Stephen A. Keen
September 15, 2011
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 Investment 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, Counsel
Tel: 970-689-3153
Email: 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.
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