Series 6: Investment Companies (Investment Company Act of 1940 Rules)

In order for a management company to register with the SEC, it must have minimum net assets of:

$100,000 To register with the SEC, a management company must have minimum net assets of $100,000.

At the time a mutual fund takes a position in an issuer's stock, what is the maximum interest that an associated person of a mutual fund can own in that issuing company?

0.5% of the issuer's stock The Investment Company Act of 1940 prohibits a fund from taking a position in an issuer's stock if any person associated with the fund owns more than ½ of 1% (.5%) of that issuer's stock. This rule limits the potential for the following manipulation: A person associated with the fund takes a large position in one issuer's stock just before the fund itself takes a large position. When the fund makes its purchases, the price of the issuer's stock increases due to the buying pressure, and now that individual can sell at a large profit. This is a violation known as "front running."

For a management company to register with the SEC, it must have at least what percentage of net assets invested in securities?

40% Before a management company can register with the SEC, it must have a net worth of $100,000; a minimum of 100 shareholders; and it must have at least 40% of assets invested in securities. Do not confuse this minimum investment requirement with the 75/5/10 rule for a fund to be "diversified" (which states that a "diversified" fund must have at least 75% of assets invested in securities with no more than 5% of assets invested in any one issuer with that holding representing no more than 10% of the voting control over that issuer). A fund that has less than 75% of assets invested in securities is a "non-diversified" fund by definition. In no event can a non-diversified fund have less than 40% of its assets invested in securities.

Under the Investment Company Act of 1940, the board of directors of an investment company must consist of at least what percentage of "non-interested" persons?

40% The Investment Company Act of 1940 requires that the board of directors of a management company have at least 40% "non-interested" directors. This means individuals who are either "non-interested" or not affiliated with the fund. Thus, up to 60% of the board can be persons who are "interested" or affiliated with the fund. An interested person is someone that receives substantial compensation from the fund; an affiliated person is someone who is in a position to influence board decisions. For example, the legal counsel and accountant for the fund are "interested persons" if they are on the board; while the fund investment adviser or fund underwriter are "affiliated persons" if they are on the board.

Which statement is true about the composition of the boards of mutual funds?

A load fund's board of directors must be composed of at least 40% non-interested persons while a no-load fund board of directors have at least 1 non-interested person The Investment Company Act of 1940 requires that the board of directors of a management company have at least 40% "non-interested" directors - but this rule only applies to "load" funds. No-load funds come under a much simpler requirement that they have at least 1 non-interested director.

Which of the following statements concerning voting by a mutual fund's shareholders is TRUE?

A shareholder can vote by means of a proxy on any issue presented to shareholders Proxies enable shareholders to vote on any issue without the need for the shareholder to be present at the annual meeting. The "proxy" authorizes someone to stand in as the shareholder's "proxy" at the annual meeting and vote the shares. Shareholders get to vote both full and fractional shares. Any shareholder can attend the annual meeting - it makes no difference if the shares are being voted by that shareholder or by proxy.

The Investment Company Act of 1940 specifies that a majority of the outstanding shares must vote to change investment policies of an investment company. All of the following also require a majority vote of the shares EXCEPT:

An increase in the investment company's holdings of equity securities from 85% to 95% of its assets Statement C is an incorrect choice because it does not indicate a change in policy. The company had funds available for investment in equity securities but may have decided to hold cash in anticipation of a turn in the market. This market timing is within management discretion and judgment.

What is the debt coverage requirement for open-end and closed-end companies?

For open-end companies the net assets to debt ratio must be at least 300% while for closed-end companies the net assets to debt ratio must be at least 200% Open-end management companies can borrow up to 1/3 of Total Net Assets from a bank. After doing so, the "asset coverage ratio" must be at least 300% (Total Net Assets/Bank Borrowings). Closed-end management companies can issue bonds as long as the "asset coverage ratio" is at least 300% - the same as for open-end funds. Note that closed-end management companies can also issue preferred stock, in which case the asset coverage ratio must be at least 200%.

Which of the following requirements apply to an open-end management company under the Investment Company Act of 1940? I Minimum of 100 shareholders II Minimum of $100,000 of net worth III Minimum of 40% of assets invested in securities IV Clearly defined investment objective

I, II, III & IV The Investment Company Act of 1940 requires that to register as a "management company," that the issuer must invest at least 40% of its assets in securities and the fund must have a clearly defined investment objective. To register as an open-end management company requires at least 100 shareholders and at least $100,000 of net worth.

The Investment Company Act of 1940 defines which of the following as "interested persons?" I A person holding 10% of the voting securities of the fund II Corporation which is 10% owned by the fund III Secretary of the fund IV Investment adviser to the fund

I, II, III, IV The Investment Company Act of 1940 limits the composition of the Board of Directors of a fund to no more than 60% so-called "interested persons." An interested person is either someone who is affiliated with the fund ("an affiliated person"); or is someone who derives substantial income from the fund, such as an outside attorney or accountant. An affiliated person to a fund is an individual in a control position. Affiliated persons include: Officers, directors, and employees of the fund; Investment adviser to the fund; Underwriter/Distributor for the fund; Any person that holds 5% or the fund's shares; and Any issuer that is at least 5% owned by the fund. Thus, all of the choices offered fall under the "affiliated/interested person" definition.

The provisions of the Investment Company Act of 1940 include: I minimum initial fund capital of $100,000 II interested persons on the board of directors cannot hold over 60% of the seats III changing the fund's investment objective requires a majority vote of the outstanding shares IV setting maximum sales charges on single payment purchases of mutual fund shares

I, II, and III only The Investment Company Act of 1940 requires that the minimum initial capital requirement to start a fund is $100,000. It also requires that no more than 60% of the fund's board of directors be composed of interested persons. Thus, at least 40% of the board must be non-interested persons. An interested person is anyone who is in a position to influence the operations of the investment company, such as a 5% or greater shareholder, officer, director, or employee of the investment company. Thus, at least 40% of the board must be composed of truly independent individuals. The Act also requires that changing a fund's investment objective requires a majority vote of the outstanding shares. Maximum sales charges on mutual fund purchases are not set under the 1940 Act. These are set by the FINRA Conduct Rules at 8 1/2% of P.O.P.

Before a management company can register with the SEC, it must meet which requirement?

Minimum of 100 shareholders Before a management company can register with the SEC, it must have minimum net assets of $100,000 and a minimum of 100 shareholders. There is no stock exchange listing for open-end management companies (mutual funds). To be registered with the SEC, minimum percentage of a management company's portfolio that must be invested in securities is 40%, not 90%.

Which of the following statements is NOT true regarding mutual funds?

Mutual funds may issue common and preferred shares Mutual funds may only issue common stock. They may not issue preferred shares. Shareholders acquire an undivided interest in the fund's portfolio. Each share is entitled to one vote in shareholder elections, such as for the members of the board of directors.

Which of the following statements concerning borrowing by open-end and closed-end companies is TRUE?

Open-end companies can borrow using portfolio securities as collateral but closed-end companies cannot Open-end companies can borrow using portfolio securities as collateral but closed-end companies cannot. To raise additional capital, a closed-end company can only issue senior securities such as preferred stock or bonds.

Which of the following companies could register as a management company under the Investment Company Act of 1940?

Safety Securities with 121 stockholders and assets valued at $150,000 invested equally in ACME Motors common stock and in an office building To register as a management company, the fund must have at least 100 shareholders, eliminating Choices (A) and (C). To register as a management company, the fund must have at least 40% of assets invested in securities, eliminating Choice (B). Only Choice (D) meets the registration minimums of at least 100 shareholders and at least 40% of assets invested in securities. Note that all 4 Choices meet the minimum $100,000 net assets requirement.

Which of the following statements concerning the investment adviser for the fund's portfolio is correct?

The investment adviser cannot invest in companies owned .5% or more by a person associated with the fund The Investment Company Act of 1940 prohibits a fund from taking a position in an issuer's stock if any person associated with the fund owns more than ½ of 1% (.5%) of that issuer's stock. The investment adviser does not set the investment objective of the fund; this is set by the fund sponsor and can only be changed by majority vote of the outstanding shares. The investment adviser cannot change the investment objective on his or her own. The board of directors sets the policy on investments and leaves the execution of the policy to the investment adviser (not vice-versa).

All of the following statements concerning proxies are correct EXCEPT:

a shareholder cannot revoke a proxy after it is signed Proxies enable shareholders to vote on any issue without the need for the shareholder to be present at the annual meeting. The "proxy" authorizes someone to stand in as the shareholder's "proxy" at the annual meeting and vote the shares. After signing a proxy, a shareholder can revoke it at any time, either before or at the shareholders' meeting.

All of the following require a majority vote of the shares of a mutual fund EXCEPT a(n):

increase in the investment company's holdings of equity securities from 85% to 95% of its assets The investment adviser has the discretion to manage the assets of the fund as he or she sees fit, as long as the investment objective of the fund is being followed. The manager can increase or decrease securities holdings at will, consistent with meeting the fund's investment objective. To change the actual investment objective of the fund would require majority vote of the outstanding shares, as would changing the fund's subclassification; changing the fund's borrowing and lending policies; or changing the nature of the company's business (a very unlikely event).

Semi-annual reports sent to a mutual fund's shareholders provide all of the following information EXCEPT a:

listing of current shareholders The semi-annual reports prepared by a mutual fund do not provide a list of current shareholders. The reports do include financial information such as the fund's balance sheet, income statement, portfolio holdings and their value; and a statement of the aggregate dollar amount of purchases and sales of investment securities.

A mutual fund that wishes to change its fundamental investment objective must obtain:

majority vote of the outstanding shares Under the provisions of the Investment Company Act of 1940, if a mutual fund wishes to change its investment objective, it must obtain a majority vote of the outstanding shares.

Responsibilities of an investment company's board of directors include all of the following EXCEPT:

managing the day-to-day operations of the investment company The board of directors appoints the fund officers to manage the day-to-day operations of the fund. Additionally, the board approves 12b-1 fees; sets the policies and objectives of the fund; and ensures that they are followed.

All of the following statements concerning the level of debt permitted for open-end and closed-end companies are correct EXCEPT:

open-end and closed-end companies are not permitted to pledge portfolio investments as collateral for bank loans Open-end companies can borrow using portfolio securities as collateral but the net assets to debt ratio must be at least 300%. Closed-end companies cannot pledge portfolio investments as collateral for bank loans but they can issue bonds as long as their ratio of net assets to debt is at least 300% (the same as for an open-end management company).

A customer reads in an investment company prospectus that the company must maintain a "coverage ratio" of assets to bank borrowing of 300%. This company must be a(n):

open-end management company The Investment Company Act of 1940 allows an open-end management company (a mutual fund) to borrow from banks, up to 1/3 of its total assets (300% coverage ratio, which means than for every $3 of net assets, $1 can be borrowed from a bank).

Mutual fund shareholders must receive financial reports from the fund:

semi-annually The shareholders must receive financial reports from the mutual fund at least semi-annually.

All of the following statements concerning the rights of a mutual fund's shareholders are correct EXCEPT shareholders:

usually vote for officers annually Shareholders must approve changes in fund investment objectives, and they approve the investment advisory contract. They also vote for the fund directors, but they do not vote for officers. The board of directors either appoints or elects officers.