Lesson 3.1: Investment Companies

Question 1

Under the Investment Company Act of 1940, a vote of the majority of outstanding shares may:

Answer 1

approve changing from an open-end (mutual fund) to a closed-end company, changing the investment objectives of the fund, and deciding to cease to be an investment company.

Question 2

The Investment Company Act of 1940 allows a majority vote of the outstanding shares of a registered investment company to authorize the fund to:

Answer 2

change the objectives of the fund.

Question 3

The investment adviser:

Answer 3

**is responsible for making investments according to the objectives stipulated by the investment company. **

Question 4

The investment adviser may NOT:

Answer 4

change investment objectives that he believes are in the best interest of the investors.

The fund’s objectives may be changed only by majority vote of the outstanding shares (i.e., by the owners of the company, not the portfolio manager).

Question 5

Under the 1940 Investment Company Act, an investment company may take all forms except:

Answer 5

**a limited partnership with partners as passive investors & Holding companies are not included in the definition of investment company.*

An investment company is not a limited partnership. Investment companies are organized as open-end companies (mutual funds), closed-end companies, unit investment trusts (UITs), or face-amount certificate companies.

Question 6

Jasper is considered an affiliated person of the Tahor Clean Energy Mutual Fund. Under the Investment Company Act of 1940, Jasper is prohibited from all of the following except

A) being elected to the fund’s board of directors.
B) borrowing from the fund (money or property).
C) buying securities from the fund’s portfolio.
D) selling stock to the fund for its portfolio.

Answer 6

A) being elected to the fund’s board of directors.

There is no problem with an affiliated person being elected to the fund’s board of directors. Under the act, as many as 60% of the board members may be affiliated persons (the law states that at least 40% must be noninterested parties). Affiliated persons may not have any dealings with the investment company (outside of contractual obligations and the purchase or redemption of shares of the investment company), such as buying securities, furniture, real estate, or other property from the company or selling such property to the company.

Question 7

In a mutual fund portfolio, you might find all of the following except

A) a short stock position.
B) index options.
C) junk bonds.
D) preferred stock.

Answer 7

A) a short stock position.

A mutual fund is generally prohibited by the Investment Company Act of 1940a from taking short stock positions. There are exceptions to this rule, such as in the case of hedge funds. Index options are permissible if they are consistent with the fund’s stated objectives. Junk bonds or high-yield bonds are permissible in those high-income funds that authorize such an investment. Some funds may use covered calls to generate income. Remember, mutual funds cannot issue preferred stock, but they can certainly use the capital invested by the fund’s common stockholders to buy preferred stock for the portfolio.

Question 8

In accordance with the stated provisions of the Investment Company Act of 1940, renewal of an open-end management investment company’s investment adviser’s contract must be approved by:

Answer 8

majority vote of the fund’s board of directors or of the outstanding voting shares, as well as by majority vote of the noninterested members of the board.

When it comes to management investment companies (open-end or closed-end), renewal of the investment adviser’s contract is approved annually by the fund’s board of directors or a majority vote of the outstanding voting shares. The initial contract must be approved by both the board of directors and a majority vote of the outstanding shares. In both of these cases, initial and renewal, a majority vote of the noninterested (outside) members of the fund’s board of directors is also required.

Question 9

Who safeguards the securities held in a mutual fund’s portfolio?

Answer 9

The custodian

The Investment Company Act of 1940 requires that investment companies employ the services of a commercial bank as custodian to hold and safeguard the physical assets (cash and investment portfolio) of the fund.

Question 10

Open-end investment companies must have a minimum of:

Answer 10

$100,000 in assets to have a public offering.

Question 11

The sale of open-end investment company shares is:

Answer 11

a continuous public offering and must be accompanied by a prospectus.

Question 12

Mutual funds may be used as:

Answer 12

collateral in a margin account if they have been owned for more than 30 days.

Question 13

Mutual fund shares may NOT:

Answer 13

be purchased on margin because their shares are always public offerings of new shares.

The Investment Company Act of 1940 generally prohibits mutual funds (open-ended) from making purchases on margin. There are exceptions to this rule, such as in the case of hedge funds. A fund is not prohibited from buying options or low-quality bonds. A mutual fund may invest in other mutual funds so long as it does not acquire more than 3% of the outstanding shares of the other fund.

Question 14

The Investment Company Act of 1940 states that:

Answer 14

Open-end (mutual) companies may issue only common stock. The prospectus must state the management fee, and an investment company needs only $100,000 to offer itself to the public. In addition, no more than 60% of the board of directors can be made up of officers or employees of the company.

Question 15

Among the restrictions placed on open-end investment companies by the Investment Company Act of 1940 are:

Answer 15

no public offering may commence unless the fund has at least $100,000 in net assets & no registered investment company may own more than 3% of the voting shares of another registered investment company

The minimum capitalization requirement for a new fund is $100,000 in net assets. A further restriction placed by the act is limiting one fund’s holdings to a maximum of 3% of the voting shares of another fund. Because the shares of an open-end company are always considered a new issue, the shares may not be purchased on margin, but, as with other new issues, do have a loan value once owned at least 30 days. However, this restriction is part of the Securities Exchange Act of 1934, not the Investment Company Act of 1940.

Question 16

Under the Investment Company Act of 1940, what statements about advisory contracts between an investment company and an outside adviser is true?

Answer 16

The contract may not be unilaterally assigned to another adviser.

All contracts between an investment company and an outside adviser must be in writing and must contain certain provisions; these include that the contract may not be unilaterally assigned to another adviser. The initial contract must be for two years and it is subject to annual renewal by a majority vote of the outstanding shares or the board of directors, as well as a majority of the directors who are considered to be noninterested parties.

Question 17

Under the Investment Company Act of 1940, regarding the renewal provisions of an investment adviser’s contract:

Answer 17

A) The contract must be terminable upon no more than 60 days’ notice.
B) The renewal must be approved by either majority vote of the board or majority vote of the outstanding shares, as well as majority vote of the noninterested members of the board.
C) The renewal must state the adviser’s compensation.

When an investment company employs an outside investment advisory firm to manage its portfolio, the act requires a written contract setting forth the adviser’s compensation. The contract is for two years initially and must be renewed annually thereafter. The contract must be initially approved by a majority vote of the outstanding shares and the noninterested members of the board of directors and annually renewed by either a majority vote of the board of directors or of the outstanding shares, as well as a majority vote of the noninterested members of the board. The contract must be terminable at any time, with a maximum of 60 days’ notice and with no penalty, upon a majority vote of the board of directors or of the outstanding shares, and it must terminate automatically if assigned.

Question 18

Regarding an investment company’s board of directors:

Answer 18

A) No convicted felon or person convicted of a misdemeanor involving the securities industry ​within the past 10 years ​may serve on the board of directors of an investment company.

B) An investment company’s board of directors concerns itself with policy and administrative matters.

C) The board of directors contracts with an outside investment adviser or portfolio manager to invest the cash and securities held in the fund’s portfolio.

The board of directors sets policy and manages the administrative affairs of the investment company, but it does not manage the portfolio. The board contracts with an outside investment manager to invest the funds.​ It is unlawful for any person to serve or act in the capacity of employee, officer, director, or investment adviser of any registered investment company, or principal underwriter for any registered open-end company, registered unit investment trust, or registered face-amount certificate company if that person, within the past 10 years, has been convicted of any felony or a misdemeanor involving the purchase or sale of any security.

Question 19

Under the Investment Company Act of 1940, an investment company may initially retain the services of an investment adviser only with approval of the majority vote of:

Answer 19

the outstanding shares and a majority of that portion of the board of directors that is considered noninterested members.

The contract between the investment company and the investment adviser must be in writing.

When it comes to retaining the services (hiring) of a person (or persons) to manage the portfolio of a mutual fund, there are three parties involved in the approval process. Those three parties are
- the shareholders,
- the fund’s board of directors, and
- that portion of the fund’s board consisting of noninterested members. (Remember, the board must be at least 40% noninterested, which is sometimes stated as a maximum of 60% interested.)

This question asks about the initial contract. That contract is always for two years and requires the approval of a majority vote of the outstanding shares (the shareholders) and a majority vote of that group of board members who are noninterested. You should also know that, when it comes to renewal (done annually after the initial two-year contract), once again, a majority vote of that group of board members who are noninterested is required, along with either a majority of the total board or a majority of the outstanding shares. The one constant is the approval of the noninterested board members.

Question 20

Under the Investment Company Act of 1940, who would be considered affiliated persons?

Answer 20

I. Persons who control, are controlled by, or share common control with the company
II. Any officer, director, or employee of the company
III. Persons who own or control 5% or more of the voting shares of the company

Affiliated persons are any investment company directors, officers, employees, or owners of 5% or more of the voting shares of stock, and/or any persons controlling or controlled by such persons.

Question 21

The Investment Company Act of 1940 requires certain types of investment companies to compute their net asset value on a regular basis. Excluded from this requirement are

Answer 21

face-amount certificate companies.

The two investment companies offering redeemable securities, open-end funds and UITs, must compute their NAV on a daily basis. Closed-end funds can do it daily; many compute every Friday. The concept of NAV makes no sense with a FACC.

Question 22

A mutual fund must redeem its tendered shares within how many days after receiving a request for their redemption?

Answer 22

The seven-day redemption rule is required by the Investment Company Act of 1940.

Question 23

The Investment Company Act of 1940:

Answer 23

Prescribes procedures for the establishment of investment companies

The Investment Company Act of 1940 requires all investment companies to register with the SEC as such and be regulated under the act. The companies are still subject to all the other applicable securities acts. However, the Investment Company Act of 1940 provides additional regulations to ensure that investors are fully informed and fairly treated by the management of investment companies. It is the Investment Advisers Act of 1940 that regulates investment advisers.

Question 24

Who would be considered a noninterested person in a mutual fund?

Answer 24

A member of the board of directors who does not hold another position within the investment company

The Investment Company Act of 1940 defines an interested person as someone employed by or who has a material business relationship with the fund, its adviser, or the underwriter. Someone who owns 5% or more of the outstanding shares (an affiliated person) is also considered interested. Merely sitting on the board does not make someone an interested person. Thus, a director with no other relationship with the fund qualifies as a noninterested person.

Question 25

Mutual funds furnish financial reports to shareholders:

Answer 25

Section 30(d) of the act requires semiannual reports from the fund to its shareholders and an annual filing with the SEC.

Question 26

Holding companies:

Answer 26

are not included in the definition of an investment company, under the Investment Company Act of 1940.

The act lists three different types of investment companies: face-amount certificate companies, unit investment trusts, and management companies. Holding companies—business entities that invest in other companies for the purpose of management control—are not included in the definition.

Question 27

No investment advisory contract may be entered into that does not provide for termination:

Answer 27

with no more than 60 days’ notice in writing.

One of the provisions of the Investment Company Act of 1940 is that the maximum permitted termination notice is 60 days in writing. The custodial bank does not need FDIC coverage (this is not your local bank account) and the 3% limit is the maximum, not a minimum. In order to renew the advisory contract, it is either a majority vote of the fund’s directors or by a vote of a majority of the outstanding voting securities of the fund.

Question 28

Under the Investment Company Act of 1940, what are considered management companies?

Answer 28

Open-end companies & Closed-end companies

Management companies are subclassified into open-end companies (mutual funds) and closed-end companies. Unit investment trusts are a type of investment company that is not managed, as are face-amount certificate companies.

Question 29

How often must an investment company file reports with the SEC as required by the Investment Company Act of 1940?

Answer 29

Annually

Registered investment companies are similar to other publicly registered entities in that an annual audited report must be filed with the SEC. Unrelated to this question is the requirement that semiannual reports must be sent to shareholders.