Mutual Funds and Regulation
Other Investment Company Products
Todd Cipperman, Esq.
November 1, 2007
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Other Investment Company Products
Other Investment Company Products
 Closed-End Funds
 Unit Investment Trusts (UITs)
 Exchange Traded Funds (ETFs)
 Variable Insurance Products
 Section 529 Plans
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Closed-End Funds
 Features:
 Closed-Ended Funds:
– Generally a fixed number of shares is issued
– Trade on a Stock Exchange
– Shares trade based upon market price rather than net asset value (NAV)
 With only some relationship to Funds actual NAV
 Funds sold at POP (not equal to NAV – at a discount or premium to NAV)
– As of year-end 2005, total assets in Closed-End Funds was $276 billion (vs.
over $8.9 trillion in Open-End Funds)
 62% of all assets in Closed-End Funds are held in Debt Securities and 38%
were in Equity Funds
 Open-Ended Funds
– Mutual funds continuously issue shares
– Mutual funds redeem (buy back) their shares continuously
– Redeemability within 7 days (i.e. liquidity). See Section 22(e) (7 days to
redeem) and Rule 22c-1 (daily pricing for redeemable securities)
 See Rule 23c-3 re Interval Funds and quarterly liquidity
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Why Closed End Funds
 “Illiquid Securities”
 Fund-of-Hedge Funds
 Emerging Market Funds
 CDOs etc.
 Bank loan funds
 BDCs and private equity
 Less Cash Drag
 Lower Costs related to cash management
 Stability of fees especially performance fees
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Disclosure and Regulation
 Form N-2
 Periodic Reporting Obligations of 1934 Act do not apply
 Section 13 and 16 do apply
 Repurchases generally effected through periodic tender offers
 No prospectus updates unless 10b-5 issues
 Importance of Annual and Semi-Annual reports
 Financial Statements
 Registration under 1933 Act, 1940 Act, both, or neither
 Rule 102 of Regulation M (limitations during distribution period)
not applicable
 Restrictions on multi-class structures
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Registration under the Investment Company Act
 Limits on investment activities
 Leverage limited to 33%
 Limits on senior securities
 Limits on fund-of-funds
 Compliance requirements
 Registration Statements
 Board meetings
 Affiliate transactions
 Distribution
 Compliance Program
 Cost of registration
 Liability
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Interval Funds (Rule 23c-3)
 No more often than quarterly
 No more than 25%/repurchase
 Cash at NAV
 Specified time periods for notice and payment
 Fundamental policies in N-2
 Must calculate NAV weekly
 No CDSCs or 12b-1 fees
 Majority of Board must be disinterested
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Closed-End Fund assets: 1995 - 2006
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Unit Investment Trusts
 Features:
 Registered Investment company.
 Buy & Hold Strategy
– Generally buys and holds a fixed portfolio of stocks, bonds, or other securities
for a very specific period of time
– Positions may be liquidated/replaced due to issuer-viability concerns
 Dividend income paid ‘regularly’ (quarterly or semi-annually) and interest usually
paid monthly
– Dividends can be reinvested into “new” Units of UIT’s for Fixed Income UIT’s, or
– Dividends can be reinvested into a similar Open-Ended Mutual Fund with the
same investment strategy
 Maturity dates set at issuance.
– As short as one year for equity UITs
 (broker-sold “Dogs of the Dow” UITs)
– As long as 30 years for bond UITs
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UIT vs. Mutual Fund
 Static Portfolio: no active management
 Sponsor maintains secondary market
 Fixed Term
 Grantor Trust, rather than RIC, for tax
 Single offering
 Sales Charge, low fees
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Why a UIT
 Bond Insurance
 Specific Market Sectors: “Dogs of the Dow”
 Secondary Market allows for more liquidity and derivatives
 Off-Shore investors
 Asset Allocation
 ETFs (e.g. SPDRs)
 No concern about market timing, revenue sharing, etc.
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Unit Investment Trusts
 Advertising Issues:
 UITs typically cite “estimated current return” in advertisements and sales literature
– Defined as estimated net annual interest income per unit, divided by the offering
price
 This is a measure of a trust’s current cash flow
 For fixed-income UITs the interest paid is usually predictable
 Fixed-income UITs also may cite estimated long-term return, or estimated yield
– Uses weighted average yield to maturity, and reflects impact of sales charges
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Exchange Traded Funds (ETF’s)
 Listed and traded on Stock Exchanges
 Continuous Trading
 No discount from NAV
 Started as institutional cash “equitization” product
 Hedge funds and short selling
 More tax efficient: manage capital gains
 Very inexpensive: Compare ETF vs. Index Fund
 Available to Non-US investors
 Fewer regulatory limits on distribution (no revenue sharing
issues)
 No market timing issues
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Structures and Mechanics
 UITs (e.g. SPDRs, NASDAQ 100, DIAMONDS) vs. Open-End
Management Company (e.g. Barclay’s I-Shares, Vanguard
VIPERS)
 Portfolio more fixed; “sampling” of index not allowed
 Some tax differences
 Old School vs. New School
 Creation Units: securities + cash = 22c-1 price
 “In-kind” transactions
 Settlement through NSCC guarantees delivery
 Constant arbitrage among Authorized Participants eliminates discount to
NAV
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Regulation
Need exemptive relief
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Purchases by 5% holders
Separate class of shares differing by redeemabilty (e.g. VIPERS)
Secondary market prices rather than NAV
Greater than 7-day settlement for non-US securities
Prospectus delivery requirements (closed vs. open-end funds)
Reimbursement of expenses to UIT sponsor
Fund-of-funds
 1934 Act: BD activities
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Regulation M: activities of affiliates during distribution
Tender Offer rules
Margin Rules
Confirmation Rules
Section 13 and 16 reporting
 Conduct Rule 2830(c): sales at other than NAV
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ETFs: The New Frontier
Actively Managed ETFs
 Need for arbitrage vs. portfolio returns
 See SEC Concept Release “Actively Managed Exchange Traded Funds”
(2001)
Leveraged ETFs
Alternative asset classes (e.g. gold-linked ETFs)
 Search for tax efficiency
401(k) plans
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Variable Insurance Products
 Variable Annuities, Variable Life
 Insurance Features: Death Benefit, Living Benefit
 A shares and B shares (See sales practices)
 Ability to move money among underlying funds
 Small firm 401(k) marketplace
 Tax deferral benefits
 Estate tax planning
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Variable Product Legal Issues
 Fixed grouping of funds under each contract
 Different funds than offered in retail marketplace
 Expenses: Loads, Admin, Mortality, Investment, Death Benefit
 Sold by life insurance agents/registered reps
 FINRA Conduct Rule 2821: Members' Responsibilities Regarding
Deferred Variable Annuities
 Enhanced suitability requirements that require consideration of surrender
charges, fees, and market risks
 Consider exchanges within the prior 36 months
 Principal review and approval
 Procedures and training
 Sales Practices
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Unique Variable Insurance Features
 Subchapter L requirements for Life Insurance Policies or Annuity
Contracts
– Because a Trust is used to fund Insurance Contracts, each portfolio must meet certain
Diversification requirements
> No more than 55% of total value of assets may be represented by one investment
> No more than 70% by any two investments
> No more than 80% by any three investments
> No more than 90% by any four investments
 No Free Lunch
– Variable insurance products generally carry high internal fees
 Fees cover costs of insurance features and investment management
 Suitability issue:
– Is it cheaper to invest and buy insurance separately?
 Should there be a per se rule that customer should always get lowest cost (limiting
customer choice)
 Regulatory Scheme
 Because of dual nature of the products – subject to many levels of regulation
– SEC – regulation of offering documents and periodic reporting
– FINRA – regulation of sales practices/advertising
– State by State – regulation of substantive insurance law and sales practice
Mutual Funds and Regulation  Confidential  Copyright 2007 FINRA
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529 Plans
 States Sponsor/Issue the Plans
 Plans are subject to MSRB regulation on a State-by-State basis
 Plans generally are managed by professional money managers
 Tax Advantaged Investment
 Federal
– No deduction on contributions
– Earnings grow tax-deferred
– Earnings are never taxed when used for education
 Flexibility
 Account “owners” retain control over account, not the beneficiary (no conversion
at defined age)
 If beneficiary does not go to college, account can rollover to family
member (includes children, nephew/nieces and 1st cousins of original
beneficiary)
 Anyone can contribute to an account
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529 Plans
 College savings plans under IRS Section 529
 Contributions federally taxable
 Many states do not tax contributions to state plans
 State Plans operated by a professional investment management firm.
 Earnings in a 529 Plan accumulate tax-free and can be withdrawn taxfree for the purpose of paying for certain qualifying higher education
expenses – tuition, room, board, books, etc.
 Underlying investments generally include mutual funds.
 Regulation
 Municipal Securities Rulemaking Board (municipal securities)
 Reps must have Series 7 or 52 (or Series 6 if the only municipal securities sold are
529 Plans) and must be supervised by a Series 53 or 51, depending on the
circumstances.
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529 Plan Sales Practices
MSRB and FINRA jurisdiction: interest in plan and
interests in funds
 MSRB Rule G-21:no false or misleading advertisements
–Consider state tax benefit
–Performance data must comply with Rule 482
 MSRB Rule G-19: broker-dealer must ensure suitability
–FINRA will enforce G-19 (See Ameriprise action)
FINRA NtM 03-17: comply with 2210 and other FINRA
rules (including pre-filing of marketing materials)
MSRB Notice 2007-18: Amendments to G-21: conform
performance advertising to 2210 and Rule 482
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529 Plans
Account Features
 You can have multiple accounts for one child
 Many plans offer age-based or “life-cycle” investment plans that
readjust over time from aggressive to conservative based on age of
beneficiary
 Usually cannot change investment selection after initial selection
 You can rollover between states once per year (and therefore change investment
strategy)
 You could open 2 accounts in 2 states if you wanted to blend
investment styles, and change weighting going forward
 This is the standard current practice
 Financial Aid
 529 is the parents’ asset, so it has less effect than a traditional gift account when
applying for financial aid at Colleges
 Distributions from a 529 plan to pay a child’s expenses will show up in the child’s
tax return, and will impact financial aid eligibility in years 2-4
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Summary
 Closed-End Funds: portfolio liquidity
 UITs: SPDRs
 ETFs: low-cost indexing
 Variable Insurance Products: tax deferral
 Section 529 Plans: college savings
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Todd Cipperman, Esq.
Todd Cipperman is the principal of Cipperman & Company, which provides legal consulting
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.
150 S. Warner Road
Suite 140
King of Prussia, PA 19406
tcipperman@cipperman.com
www.cipperman.com
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