OVERVIEW OF REGISTERED FUNDS
AND KEY MATTERS TO CONSIDER
WHEN ADVISING REGISTERED
FUNDS
Seward & Kissel LLP
January 9, 2013
Discussion Topics
• Overview of Investment Companies
• Types of SEC-Registered Funds
• Issues for Private Fund Managers Considering
Sponsoring or Advising a Registered Fund
• Fees and Other Economics of Advising/Sponsoring a
Registered Fund
• Roles of Adviser/Sponsor and Sub-Adviser
2
Discussion Topics (continued)
• 1940 Act and Internal Revenue Code Constraints on
Investment Strategies
• Valuation and Other Key Operational Issues
• Tax Treatment of Registered Investment Companies
• Marketing Registered Fund Shares
• Role of Independent Directors
• Service Provider Functions
• Chief Compliance Officer and Compliance Program
• Questions
3
Overview of Investment Companies
•
Section 3(a)(1) of Investment Company Act: “investment company” is any
issuer which
– (A) is or holds itself out as being engaged primarily, or proposes to engage
primarily, in the business of investing, reinvesting, or trading in securities
– (B) is engaged or proposes to engage in the business of issuing face-amount
certificates of the installment type, or has been engaged in such business and
has any such certificate outstanding or
– (C) is engaged or proposes to engage in the business of investing, reinvesting,
owning, holding, or trading in securities, and owns or proposes to acquire
investment securities having a value exceeding 40 per centum of the value of
such issuer’s total assets (exclusive of Government securities and cash items)
on an unsolicited basis
•
•
Unless excepted or exempt, any issuer meeting the definition of investment
company must register with SEC under the Investment Company Act
Common private fund exceptions: Section 3(c)(1) or Section 3(c)(7)
4
Types of SEC-Registered Funds
Open-End Registered Investment Company
• “Mutual Fund” - continuously offers shares and redeems shares daily
• Fund registered under the Investment Company Act of 1940
(“‘40 Act”) and shares registered under Securities Act of 1933
(“‘33 Act”)
• As of 12/31/2011 - $11.6 Trillion (in total net assets)
5
Types of SEC-Registered Funds
Closed-End Registered Investment Company
• Fund registered under the ‘40 Act (and possibly the Securities
Exchange Act of 1934) and shares registered under the ‘33 Act
• Shares may be exchange-listed or fund makes periodic discretionary
tender offers to repurchase shares
• Fund-of-funds have utilized the closed-end fund structure
• As of 12/31/2011 - $239 Billion (in total net assets)
6
Types of SEC-Registered Funds
Interval Fund
• Type of closed-end fund that makes required periodic tender or
repurchase order offers on a specified schedule (e.g., quarterly or
semi-annually)
Unit Investment Trusts
• As of 12/31/2011 - $60 Billion (in total net assets)
Exchange Traded Funds
• As of 12/31/2011 - $1.0 Trillion (in total net assets)
7
Issues for Private Fund Managers
Considering Sponsoring or Advising
a Registered Fund
Transparency & Publicly-Available Information
• Portfolio holdings schedule filed with SEC (and publicly available)
quarterly within 60 days
• Annual and semi-annual reports
• Prospectus and Statement of Additional Information filed with SEC
and publicly available
– detailed portfolio manager/team information
– disclosure regarding number of private funds, RICs and performance
compensation vehicles managed by portfolio manager/team
– description of compensation of portfolio manager/team and related
conflicts of interest policies
8
Issues for Private Fund Managers
Considering Sponsoring or Advising
a Registered Fund
Impact on Overall Business
• Mutual funds are typically lower fee products than private funds
• If strategy substantially replicates private fund strategy may
create MFN issues
• Potential allocation and conflict issues – private funds have
performance-based fees and typically substantial inside
investment
• Significantly less control over RIC business due to Board of
Directors/governance structure
• Administrative “back office” burdens
9
Issues for Private Fund Managers
Considering Sponsoring or Advising a
Registered Fund
Adviser Compensation
• Significantly less control over adviser compensation due
to role of independent directors
• Performance compensation structures not possible
unless all shareholders are “qualified clients” or fund
uses “fulcrum fee”
10
Issues for Private Fund Managers
Considering Sponsoring or Advising
a Registered Fund
Restrictions on Investment Process
• ‘40 Act and Internal Revenue Code (“IRC”) impose restrictions and
limitations (including diversification and distribution requirements)
• Limits on leverage and borrowing, short-selling, derivatives, illiquid
securities
• Restrictions on transactions with “affiliated persons”
• Total investment flexibility not possible (e.g., portfolio concentration,
“names” rule)
• Fundamental investment objectives and strategies may not be
changed without shareholder approval
11
Issues for Private Fund Managers
Considering Sponsoring or Advising
a Registered Fund
Liquidity of Mutual Funds
• Fund must honor daily redemption requests
• NAV determined daily
• 15% limit on illiquid securities
12
Issues for Private Fund Managers
Considering Sponsoring or Advising
a Registered Fund
Benefits
•
•
•
•
•
3(c)(1) and 3(c)(7) limitations do not apply
Advertising permitted (although regulated)
ERISA 25% limitation does not apply
Ability to access retirement plan industry (e.g., 401(k) plans, small and
large benefit plans)
Invest in “new issues” without restrictions
• Provide structure for institutional investors that want governance
(significant oversight by independent directors, numerous service
providers)
13
Fees and Other Economics of
Advising/Sponsoring a Registered Fund
Mutual fund fees fall within 3 general categories:
• Fund-Level Fees: fees paid out of the fund assets to service
providers (e.g., the adviser) and vendors
• Shareholder-Level Fees: fees paid by investors when purchasing,
redeeming or exchanging fund shares (e.g., front-end sales load)
• Indirect Fees: fees that are embedded in the costs of operating a
fund (e.g., brokerage)
14
Fees and Other Economics of
Advising/Sponsoring a Registered Fund
Advisers typically waive fees and/or reimburse fund
expenses until assets grow enough to lower expense ratio:
• $0 to $35 Million: unlikely that fund is profitable
• $35 to $50 Million: fund may be profitable but adviser has not
recouped organizational costs
• $50 to $100 Million: fund has recouped organizational costs but
not reimbursed adviser for waived fees
• $100 Million: fund approaches profitability
15
Fees and Other Economics of
Advising/Sponsoring a Registered Fund
Typical Fund Fee Categories:
Management fee
Independent director compensation
Shareholder servicing fees
CCO compensation
Custodian fees
Printing
Fund accounting fees
State (Blue Sky) fees
Legal fees
Insurance
Audit fees
Transfer agency and administrative fees
16
Roles of
Adviser/Sponsor and Sub-Adviser
• Adviser/Sub-Adviser must be SEC-registered investment
adviser
• Section 15 of ‘40 Act and Board approval of
advisory/sub-advisory contract; Gartenberg factors
• Adviser/Sub-Adviser required to manage fund in
accordance with fund investment objective, strategies
and restrictions and with ‘40 Act and Internal Revenue
Code (Subchapter M) requirements
• Sarbanes-Oxley certifications and sub-certifications
17
Roles of
Adviser/Sponsor and Sub-Adviser
• Adviser/Sponsor is likely responsible for additional fund
operational matters, oversight of sub-adviser(s), overlay
management
• Multi-manager exemptions
18
1940 Act and IRC Constraints on
Investment Strategies
‘40 Act Constraints
• Section 5: Diversification limitations
• Section 12: Restrictions on investing in other registered funds,
registered investment advisers, registered broker-dealers and
insurance companies
• Section 8 and 13: Fundamental investment policies
• Section 17: Restrictions on transactions and arrangements with
“affiliated persons”
19
1940 Act and IRC Constraints on
Investment Strategies
‘40 Act Constraints (continued)
• Section 18: Restrictions on borrowing, leverage and
senior securities
• Rule 35d-1 (Names Rule): 80% of portfolio investments
consistent with certain fund names
• Other limitation and restrictions unique to mutual funds
vs. closed-end funds
IRC Constraints
• IRC – diversification and income tests
20
Valuation and
Other Key Operational Issues
The ‘40 Act requires fund shares to be sold and redeemed
at net asset value per share (NAV)
NAV = Market Value of Assets – Liabilities
Number of Shares Outstanding
21
Valuation and
Other Key Operational Issues
The definition of “value” in the ‘40 Act has two elements:
• Securities for which market quotations are “readily
available” are to be valued at market value
• All other securities and other assets are to be valued at
“fair value”
The “fair value” of a security is the price that the fund might
reasonably expect to receive upon a current sale
22
Valuation and
Other Key Operational Issues
The SEC has stated that a fund must:
• Adopt written policies and procedures that require the
fund to monitor for circumstances that may necessitate
the use of fair value pricing
• Establish criteria for determining when market quotations
are not reliable for a particular security
• Establish a methodology or methodologies to determine
the current fair value of a security
• Regularly review the appropriateness and accuracy of the
methods used in valuing securities
23
Valuation and
Other Key Operational Issues
Fair valuing…
Does the security have a “readily available
market quotation”?
If yes
Use the
market
quotation
If no
Fair value the
security
24
Valuation and Other Operational Issues
Determining whether to use a market quotation…
Is the market quotation
current?
Yes
Use the market
quotation
Use proxy
to fair value
Has a significant
event occurred?
Yes
Is a market-based
proxy available?
Yes
No
No
Market
quote may
be best
price
Fair value the
security
factoring in the
event
No
Use the market
quotation
25
Tax Treatment of
Registered Investment Companies
Taxation of RICs
• If a domestic corporation qualifies as a RIC under the
Internal Revenue Code, then:
– No corporate tax is imposed to the extent the RIC
distributes its income
– Shareholders are taxed on a modified pass-thru basis
on income and capital gains from the RIC
26
Tax Treatment of
Registered Investment Companies
Requirements of RIC Qualification
• Taxed as a domestic corporation
• Registered under the ‘40 Act as a management
company, unit investment trust or business development
company
• Derives a specified portion of its income from
permissible sources (the “Income Test”)
• Satisfies specialized asset diversification requirements
(the “Asset Diversification Test”)
• Annually distributes a specified portion of its income
• Elects to be treated as a RIC
27
Tax Treatment of
Registered Investment Companies
Income Test
• A RIC satisfies the Income Test if it derives at least 90% of
its gross income for the taxable year from:
– Dividends (including from REITs)
– Interest (including OID, market discount, bankers acceptances,
tax exempt interest, repos, CDs)
– Payments with respect to securities loans
– Payments pursuant to options on stock, debt instruments,
foreign currencies, stock indices, futures contracts on securities,
stock index or municipal bond index futures
– Income from futures contracts on securities, stock indices,
GNMA certificates, Eurodollar CDs, commercial paper,
municipal bond indices
28
Tax Treatment of
Registered Investment Companies
Income Test (continued)
– Gain on foreign currency, options on foreign currency or
futures contracts on foreign currency
– Income from notional principal contracts (to the extent related
to RIC’s business of investing in stock, securities or
commodities) (e.g., a hedge)
– Gain from the disposition of stocks or securities
– Income from controlled foreign corporations and from passive
foreign investment companies (e.g., under Subpart F, QEF or
mark-to-market regimes)
– Net income from “Qualified Publicly Traded Partnerships”
29
Tax Treatment of
Registered Investment Companies
Bad Income
• The following items of income do not count towards
satisfying the Income Test:
– Gains and other income from commodities, options on
commodities, or commodity futures
– Income from futures contracts on the consumer price index
– Gains from the sale of real property
– Rental income from real property
– Fees for services (unless characterized as interest)
– Income from notional principal contracts unrelated to RIC’s
business of investing in stocks, securities or currencies (this
area is uncertain)
30
Tax Treatment of
Registered Investment Companies
Asset Diversification Test
• There are two prongs to the Asset Diversification Test,
each of which must be satisfied at the end of a quarter:
– First, at least 50% of the value of the RIC’s assets must be
represented by:
• cash, cash items, U.S. government securities, securities of
other RICs
• other securities with respect to which the RIC’s
investment is limited, in respect of any one issuer, to an
amount not greater than 5% of the value of the RIC’s
assets and to not more than 10% of the outstanding voting
securities of such issuer
31
Tax Treatment of
Registered Investment Companies
Asset Diversification Test (continued)
– Second, not more than 25% of the value of the RIC’s assets
may be invested in:
• Securities of any one issuer (other than U.S. government
securities or securities of other RICs
• Securities of two or more issuers under common control and in
the same or related trades or business
• Securities of one or more “Qualified Publicly Traded
Partnerships”
32
Tax Treatment of
Registered Investment Companies
Cure Provisions
• Even if a RIC fails the diversification test at the end of a quarter, it
may avail itself of one or more cure provisions:
– A diversification failure can be eliminated within 30 days after
the close of a quarter
– In measuring the diversification test, a RIC will not be treated
as failing such test solely as a result of increases in the fair
market values of its securities
– A failure due to reasonable cause (and not willful neglect) can
be eliminated within 6 months after the close of the quarter by
disposing of the assets and paying a tax on the income
generated by the assets
33
Tax Treatment of
Registered Investment Companies
Distribution Requirement
• If a RIC makes timely distributions to its shareholders of 90% or
more of its investment company taxable income for a taxable year
(calculated without regard to its net capital gain, e.g., the excess
of its net long-term capital gain over its net short-term capital
loss), it will not be subject to federal income tax on the portion of
its taxable income for the year (including any net capital gain) that
it distributes to shareholders
• Special rules apply to dividends paid after the close of a RIC’s
taxable year
34
Tax Treatment of
Registered Investment Companies
Excise Tax
• A RIC is subject to a four percent federal excise tax on its
undistributed income for a given calendar year unless it makes
timely distributions to shareholders equal to the sum of:
– 98% of its ordinary income for such year
– 98.2% of its capital gain net income and foreign currency
gains for the twelve-month period ending on October 31 of
such year
– any ordinary income or capital gain net income from the
preceding calendar year that was not distributed during
such year
35
Tax Treatment of
Registered Investment Companies
Taxation of a RIC’s U.S. Shareholders
• A RIC’s U.S. shareholders are subject to taxation on the
dividends they receive from a RIC, which are reported to
them on Form 1099
• A RIC is a modified pass-through entity and may pay
different types of dividends:
–
–
–
–
Ordinary dividends
Capital gains dividends
Qualified dividends
Exempt interest dividends
36
Tax Treatment of
Registered Investment Companies
Taxation of a RIC’s Non-U.S. Shareholders
• Because a RIC is a corporation, its dividends, other than
capital gains dividends, are subject to a 30% U.S.
withholding tax when paid to non-U.S. shareholders
(subject to reduction by a tax treaty)
• The result is that even dividends paid by a RIC
attributable to items not subject to U.S. withholding tax if
received directly by a non-U.S. person may be subject to
such tax when received through a RIC
– Through 2013, dividends attributable to short-term capital
gains and portfolio interest income of a RIC are exempt from
the 30% withholding tax
37
Marketing Registered Fund Shares
Registered funds enjoy a big advantage over hedge funds
in terms of marketing:
• General advertising of mutual funds is permissible (no
need to navigate the JOBS Act), but highly regulated
• An unlimited number of shareholders can own a mutual
fund (no 3(c)(1), 3(c)(7) or ‘34 Act limits)
• Investors at any income or net worth level can purchase
mutual fund shares (unless the fund charges a
performance fee)
38
Marketing Registered Fund Shares
Major marketing channels of registered funds include:
• Direct retail market
• Broker-dealers, banks and other financial intermediaries
• Retirement plan platforms
• Fund supermarkets
• Wrap fee arrangements
39
Marketing Registered Fund Shares
A single fund can have multiple classes of shares to tailor
marketing to different types of investors:
• Class A: front-end load
• Class B: CDSC and higher 12b-1 fee
• Class C: CDSC and lower 12b-1 fee
• Class I or Z: institutional investors
• Class R: retirement plans
40
Marketing Registered Fund Shares
Registered fund marketing regulated by several regulatory
schemes:
• Advertising subject to Section 5 of the ‘33 Act and
detailed rules thereunder
• Ads must be filed with FINRA
• Persons involved in the sale of registered funds must be
licensed as registered representatives of a broker-dealer
• The fund’s distributor must be a registered broker-dealer
(issuer exemption not practical)
41
Role of Independent Directors
At least 40% of directors must be independent (50% to take
advantage of certain rules):
• Not affiliated with the fund, its adviser or its distributor
• During the past 2 years, no independent director
candidate may have engaged in a material business or
professional relationship with the fund, its adviser or its
distributor
42
Role of Independent Directors
Duties include:
• Monitor performance of the fund
• Annually tasked with approving advisory fee paid by the
fund and investment management arrangement
• Oversee distribution of fund shares and approve 12b-1
plan (if any)
• Select and retain auditor (through an audit committee)
• Approve fair value of certain portfolio securities
43
Role of Independent Directors
Fund directors are subject to following duties:
• Owe a fiduciary duty to fund and its shareholders
• Subject to a duty of care (must be informed and diligent)
• Subject to a duty of loyalty (must avoid or address
conflicts of interest)
44
Service Provider Functions
• Investment Adviser/Sub-Adviser – Section 15(a) & (c) and Section
36(b)
– Makes investment and brokerage decisions
– Oversees operational matters
– Provides fund officers
– Compensation/fees
• Distributor/Principal Underwriter – Section 15(b) & (c)
– Sale of fund shares through intermediaries
– Marketing and advertising
• Custodian – Section 17(f)
– Holds fund assets/securities
45
Service Provider Functions
• Transfer Agent, Fund Accountant and Administrator
– Maintains master fund shareholder list; AML/CIP
– Receives portfolio holdings pricing information and determines
fund net asset value per share
– Administers fund books/expense accruals
– Determines fund distributions
– Coordinates regulatory filings and board meetings
• Independent Auditors – Section 32(a)
– Annual audit of fund financial statements
• Fund Counsel/Independent Director Counsel – Rule 0-1(a)(7)
46
CCO and Fund Compliance Program
• Rule 38a-1: Requires designation of fund Chief
Compliance Officer and related compensation and fund
board approval of compliance policies and procedures
• CCO must report to fund board annually – material
changes and material compliance matters
• Compliance policies and procedures – use of exemptive
rules
47
QUESTIONS?
48
Speakers
Jim Cofer
cofer@sewkis.com
(212) 574-1688
Paul Miller
millerp@sewkis.com
(202) 737-8833
Pat Poglinco
poglinco@sewkis.com
(212) 574-1247
Bibb Strench
strench@sewkis.com
(202) 661-7141
www.sewkis.com
49
DISCLAIMERS
This presentation is not intended as legal or tax advice. You are
encouraged to consult your own legal and tax advisers regarding
the matters discussed herein.
To ensure compliance with Treasury regulations regarding
practice before the IRS, we inform you that any federal tax
advice contained in this communication was not intended or
written to be used, and cannot be used, by any taxpayer for the
purpose of (i) avoiding penalties that may be imposed on the
taxpayer under United States federal tax law, or (ii) promoting,
marketing or recommending to another party any tax-related
matters addressed herein.
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