Mutual Fund Basics
June 2007
Todd Cipperman, Esq.
Cipperman & Company
The Players
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Sponsor: organizes and promotes the Fund; arranges service providers
Investment Advisor/Manager: manage the portfolio and invest the assets
– Investment Managers may retain Sub-Advisors
Directors: > 50% independent
Administrator: accounting, NAV calculation
– May be affiliated with Advisor
Distributor: broker-dealer activities
Custodian: certain banks
Transfer Agent: keep shareholder records
Auditors: annual audit and opinion on financials
Fund Counsel: registration statement, filings, opinions, Board meetings, advice
Chief Compliance Officer: annual report to Board re compliance with
securities laws
The Laws
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Investment Company Act of 1940
Investment Advisers Act of 1940
Internal Revenue Code, Subchapter M
ERISA
NASD Rules
Securities Exchange Act of 1934
SEC Interpretations, Statements, No-Action Letters,
Enforcement Actions
The Paper
• Registration Statement
– Prospectus
– Statement of Additional Information
– Part C
• Shareholder Reports
• SEC Filings
• Agreements
– Investment Advisory
– Distribution
– Administration
– Custody
– Other
• Board Materials
Restrictions on Advisor
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Prospectus and SAI Disclosure
– Disclose investment objective and policies
– Certain policies may only be changed upon shareholder vote
Advisory Contract
– Annual Board approval includes review of investment performance, compensation,
brokerage, fund expenses
Board of Directors
– Valuation of securities
– Approve distribution arrangements
– Approve service providers
Private Rights of Action (Lawsuits)
– Adviser has fiduciary duty with respect to the amount of compensation received
Affiliated Transactions
– Transactions between affiliated funds
– Joint transactions
– Affiliated brokerage
Investment Restrictions
– Disclosure
– Fund-of-funds
– Diversified/Non-Diversified (e.g. no more than 5% in one security)
Advisory Contract
• Approval by shareholders
– Includes material amendments
• Annual approval by Board
– In-Person meeting of independent directors
• Termination in the event of assignment or on 60 days’ notice
• Services
– Invest pursuant to Prospectus & SAI
– Place orders
– Vote proxies
– Report to Board
– Back office work
• Fees based on AUM
– Limits on performance fees
– Breakpoints
Sub-Advisory Contracts
• Approval by shareholders required
• Allocation of responsibilities
– Records retention
• Fees paid by Advisor or Fund
• Manager-of-Managers structures
– Exemptive relief to appoint sub-advisers
Board Role in Reviewing
Advisory Contract (15(c))
• 36(b): fiduciary duty on adviser not to receive excessive compensation
– Includes private rights of action
• Gartenberg standard: “arm’s length”
– Nature and quality of services
– Comparable fees and expenses
– Advisor profitability
– Economies of scale
– Fall-out benefits (e.g. soft-dollars)
• Shareholder reports require discussion of Board review
• 15(c) report prepared by Advisor: description of business and personnel,
compensation and performance, compliance, brokerage
Investment Restrictions: Prospectus/SAI
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Fund Name: 80% test (e.g. country, region)
Investment objective
Concentration policies
Fundamental Investment policies: require shareholder vote to change
Diversified vs. Non-diversified
– 75% of assets: no investment > 5%
– IRC: no more than 25% in any one issuer
– Shareholder vote to become Non-diversified
• 1940 Act
– Other funds: 3/5/10 Rule
– Insurance Companies
– Securities-related businesses
– Illiquid securities
Trading
• No purchases if an affiliate is a member of
an underwriting syndicate (n.b. Rule 10f-3)
• Effecting trades through affiliated brokers
(n.b. Rule 17e-1)
• Restrictions on agency cross trades (Advisers
Act, ERISA
Custody
• Qualified Bank
• Foreign Custody
– Foreign Sub-Custodian
– Qualified Foreign Banks
• Financial strength
• Ability to enforce judgments and protect assets
• No exchange controls
• Access to auditors
– Eligible Securities Depository
– Board approval and reporting
• Custody at Futures Commission Merchant for exchange-traded futures
contracts and commodity options
– Segregation of assets
– Sweeping of gains
Proxy Voting
• Must disclose proxy voting policies and procedures
in Registration Statement
– Conflicts between shareholders and adviser
• Fund must file proxy voting record
• Allocate proxy voting responsibility between adviser
and sub-adviser (and third party)
• Advisers Act requires proxy voting in the best
interest of clients and procedures for resolving
conflicts of interest
• ERISA requirements
Conflicts of Interest
• Affiliate: investment adviser, officers, directors, partners, etc. (n.b.
complex definition)
• An Affiliate may not:
– Sell any security to the Fund
– Purchase any security from the Fund
– Borrow money from the Fund
– Exception for exchange-traded securities at the current market price
(Rule 17a-7)
• E.g. seeding of GOBF fund
• An affiliate may not engage in a joint enterprise with a fund (e.g.
securities purchases, kickbacks from service providers, trade allocation)
• An affiliate may not act as agent for compensation in a transaction with
the Fund (e.g. broker)
– Rule 17e-1: permissible affiliated brokerage
Personal Trading
• No fraudulent, manipulative, deceptive practices in
connection with purchase/sale of securities by related
persons
• Includes securities held by the fund during the last 15 days or
had been considered for purchase during the last 15 days
– Excludes Treasuries, Short-term instruments, Mutual
Funds
• Fund and Adviser must adopt a Code of Ethics
– Approved by Board
– Periodic reporting of violations
• Advisers Act (More restrictive Code of Ethics)
– Form ADV disclosure
– Broader holdings reports
Code of Ethics
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Reports by Access Persons
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Holdings and Transaction reports
Must be reviewed by management or compliance
Access Person: any director, officer, general partner of adviser who, with respect to
any Fund, makes any recommendation, participates in the determination of which
recommendation will be made, or whose principal function or duties relate to the
determination of which recommendation will be made, or who, in connection with
his or her duties, obtains any information concerning recommendations made by
the investment adviser to any Fund
Pre-approval of participation by investment personnel in
IPOs and private placements
Recordkeeping: Code, violations, certifications, access
persons, holdings reports
Disclosure about personal trading policies in prospectus
Filing of Code of Ethics w/ SEC
Marketing Mutual Funds
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Does the material reference the Fund?
Anti-fraud (Rule 156 and 10b-5)
Is the material accompanied or preceded by the Prospectus?
Exceptions:
– Generic advertisement: no reference to a specific fund (e.g. magazine
ads)
– Rule 482
• Rules apply equally to internet advertising
– Effect on marketing to non-US jurisdictions
• UK: directed communications, reasonable precautions
Rule 482 Materials
• Specific disclosures (e.g. obtaining and
reading prospectus)
• Standardized presentation and calculation of
performance information
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Formulas for average annual total return
Must present 1, 5 and 10 year performance
Current to the most recent calendar quarter
Disclosures about past performance, risk, loads
Other Marketing Rules
• Add disclosure about qualifications and limitations
on past performance presentation
– Conveying an unjustified impression
– Caution with respect to future investment performance
without adequate qualification
• Balance benefits of fund structure/attributes with
risks (e.g. high yield bonds, emerging markets, IPOs)
• Exaggerated claims about manager skill or process
• Misleading comparisons to other funds or indexes
• Testimonials
Related Account Performance
• Permissible in marketing material if
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Disclosure that it is not fund’s performance
Cannot omit fund’s performance
Explanation of purpose of related performance
Disclosure of material differences
• NASD members cannot use sales literature that
includes related account information
• Note: Portfolio Holdings Policy and disclosure
NASD Regulation of Marketing
• Observe principles of fair dealing and good faith; communications
must be balanced
• No false or exaggerated claims
• No predicting future results
• Limits on testimonials
• Fair presentation of comparisons
• Specific ranking guidelines
• Principal must approve sales material
• Must file marketing materials within 10 days of first use
– Often file before use to avoid re-printing
– Pre-filing and approval if certain rankings or bond fund volatility
ratings included
Recordkeeping
• Financial records, shareholder account ledgers, agreements,
board meeting minutes, brokerage reports
• All records must be maintained in easily accessible place (aka
on-site) for 2 years
• Certain records must be maintained indefinitely: journal
entries and ledgers, portfolio histories, corporate documents,
minute books
• Other records must be maintained for 6 years
• Electronic storage permissible
• SEC access upon request
• Third party service providers may hold records
• Advisers Act requirements (generally 5 years)
Compliance
• Fund must adopt and implement policies and procedures
reasonably designed to prevent violations of the securities
laws
– Portfolio management, trading, disclosures, recordkeeping, valuation,
privacy, market timing
– Oversight of Fund service providers
• Board approval of written policies and procedures
– Consider recent compliance experience
– Best practices
• Annual review of adequacy and effectiveness
– Includes testing
– Consider changes in business, regulations, compliance
– Presentation to Board
• Designate responsible Chief Compliance Officer
(competent, senior, independent)
• Record-keeping
Summary
• Mutual Funds are highly regulated
• Consult your Legal or Compliance
Professional
Todd Cipperman, esquire
Todd Cipperman is the principal of Cipperman & Company, which provides legal
services to investment managers, investment advisers, broker-dealers, mutual funds,
hedge funds, and technology providers. Cipperman & Company provides a wide range
of services for the industry including regulatory advice, product development,
distribution arrangements, compliance programs, and client and vendor agreements.
Mr. Cipperman has more than 15 years of experience in the investment management and
financial services industries. As a principal of Cipperman & Company, he has
represented a wide range of investment management clients with a focus on distribution
issues facing advisers and broker-dealers. He previously served as general counsel of a
public mutual fund and financial technology firm, including its $65 Billion proprietary
mutual fund family. He has also served as general counsel of one of the largest
international equity managers. He spent several years in private practice on Wall Street
representing both buy and sell side clients in investment management and capital
markets transactions. He is a graduate of the University of Pennsylvania Law School
and Cornell University.
1905 General Alexander Drive
Malvern, PA 19355
610.648.9449
tcipperman@cipperman.com
www.cipperman.com