New Hampshire Bar Journal
2005 Spring, 50.
Regulation of Mutual Funds What You Don't Know Can Hurt You
New Hampshire Bar Journal Volume 46, No. 1, Pg. 50 Spring 2005 Regulation of Mutual Funds What You Don't Know Can Hurt You Bar Journal Author - Attorney Jeffrey D. Spill
Many of the issues that a securities regulator may encounter on a day-to-day basis have little relevance to the majority of practicing lawyers in New Hampshire. However, as individuals with personal assets to invest or as professionals who advise on the management of assets, the subject of mutual fund securities and mutual fund investing is an important one that touches many individuals. According to the Investment Company Institute, "an estimated 91 million individuals in 53.3 million U.S. households owned mutual funds in 2003. These individuals held 77 percent of all mutual fund assets."(fn1) Mutual fund assets totaled $7.4 trillion dollars by the end of 2003.
Recent enforcement actions by the Securities and Exchange Commission (SEC) against well-known mutual fund companies highlight the abuses that can occur when regulation does not fully protect shareholders. During the past year the SEC has amended rules regarding boards of directors, trading practices, and codes of ethics in an effort to better protect shareholders. Although a quick fix to the mutual fund industry is perhaps more optimistic than realistic, the rule changes provide a comprehensive road map to greater investor protection and confidence.
State and Federal Regulation of Securities
For those unfamiliar with securities regulation, the New Hampshire Bureau of Securities Regulation (the Bureau) administers the New Hampshire Uniform Securities Act (Uniform Act)(fn2) under the authority of the Secretary of State.(fn3) Mutual fund companies are subject to the jurisdiction of the Bureau for offers and sales of share interests of the fund in this state. These share interests are defined as "securities," under the Uniform Act.(fn4) The chief regulator of mutual funds is the U.S. Securities and Exchange Commission (SEC) as provided by the Investment Company Act of 1940 (Investment Company Act).(fn5 )
Mutual fund companies are required to register their shares under the Securities Act of 1933 (Securities Act),(fn6) and pursuant to Section 18 of the Securities Act,(fn7) they must "notice file" in each state they intend to offer shares for sale. Notice filing is an abbreviated filing meant only to inform the state that shares are offered and sold. Fund shares are sold by broker-dealers, who must be registered with the SEC, pursuant to the Securities Exchange Act of 1934 (Securities Exchange Act),(fn8) and the state of New Hampshire, pursuant to Section 6 of the Uniform Act.(fn9)
The sales practices of broker-dealers selling mutual fund shares in New Hampshire are also regulated by the SEC and the Bureau, and also are policed by self-regulatory organizations such as the National Association of Securities Dealers (NASD). Mutual funds are managed by investment adviser firms, which must be registered with the SEC under the Investment Advisors Act of 1940 (Investment Advisers Act).(fn10)
Despite the multiple levels of regulation over mutual fund companies, their investment advisers, and the broker-dealers, a recent series of regulatory enforcement actions by state and federal regulators, as well as the NASD, against mutual fund companies has caused the SEC to take another look at the body of laws that regulate these companies and their broker-dealers.
Congress passed the Investment Company Act in 1940 to require registration of certain investment companies and the registration of the shares that they issue and to protect investors against the conflict of interest between the investment companies, also known as mutual fund companies, and their investment adviser, who manages the investment company. Despite this very significant body of law intended to protect investors, mutual fund companies and broker-dealers have found ways to enrich their coffers, sometimes at the expense of shareholders. While some of the methods of skirting the law are blatantly illegal, others fall within a gray area where arguably the best interests of the shareholders become secondary to those of the money managers and selling agents.
A Closer Look At Mutual Fund Companies
Section 4 of the Investment Company Act(fn11) divides investment companies into three categories: Face amount certificate companies; unit investment trusts; and management companies. Section 5 of the Investment Company Act(fn12) divides management companies into two categories: open-end investment companies and closed-end investment companies, also known as mutual fund companies. Most investment companies are open-end, meaning they issue and reissue redeemable shares priced at net asset value of the company. (Net asset value , NAV, equals the current market value of fund assets minus liabilities, divided by the total number of outstanding shares.) Closed-end companies have a fixed number of shares available for purchase and are traded on the securities exchanges or over-the-counter at a price established by the market.
Mutual fund companies uniquely allow investors to pool cash with others who want liquid and readily negotiable instruments, such as stocks and bonds, selected by investment professionals called investment advisers. Sections 10, 15, and 16 of the Investment Company Act(fn13) establish the structure of mutual fund companies with investor protection in mind.
Section 10(a)(fn14) requires that the board of directors of the investment company is comprised of both interested and disinterested persons. (To be disinterested means that the director has no affiliation with the investment adviser. The disinterested or independent director structure of the board establishes the means by which the interests of the shareholders can be protected against abuses by the investment adviser.)
Section 15 of the Investment Company Act requires that...