Registered Investment Companies Research Articles

Economic demand for auditing services in the “registered” investment management industry

AbstractWe hypothesize that the demand for auditing in the registered investment management industry arises from the auditor's ability to act as a solvent indemnifier when outside parties incur losses because of financial misrepresentations. Consistent with this insurance demand, we find that, relative to financial companies, registered investment companies are more likely to retain Big 4 auditors. Restricting the sample to the registered investment management industry, we construct three direct tests of the insurance demand hypothesis. We find that (a) the market share of a Big 4 firm is positively associated with the firm's wealth, (b) changes in audit fees are positively associated with changes in the audit firms’ wealth, and (c) net fund flows increase when clients switch from non‐Big 4 to Big 4 auditors. Our results highlight an unusually high demand for Big 4 auditors in the registered investment industry, which we attribute to the insurance demand for auditing services.

FINRA relaxes restrictions on pre-inception performance data

Purpose To explain the significance of a recently issued interpretive letter in which FINRA staff agreed to permit the use of pre-inception index performance data by passively managed, registered open-end investment companies. Design/methodology/approach FINRA recently issued an interpretive letter extending previously issued guidance by permitting passively managed open-end registered investment companies including separately-managed series of a business trust to use pre-inception index performance data in Institutional Communications. Findings The 2019 Letter is an important shift in how FINRA staff views PIP data in Institutional Communications by acknowledging that passively managed open-end funds should be treated in a similar manner as passively managed exchange-traded funds. This shift will be a welcome development for FINRA member firms wishing to include PIP data in marketing materials for the passively managed open-end funds they distribute. Originality/value Practical guidance from experienced investment management and broker-dealer lawyers.

Insights from an Analysis of Audit Committee Governance Practices at U.S. Registered Investment Companies and Public Operating Companies

Guided by agency theory and institutional theory, we investigate the influence of the unique aspects of investment companies (ICs) on audit committee (AC) governance and compare AC IC and operating company (OC) governance practices. We use a dual-method, three-stage research approach: (1) surveys of 107 IC AC members, (2) interviews of ten AC and ten management members at ICs, and (3) interviews of ten OC AC members and follow-up interviews of the ten IC AC members. Consistent with agency theory, we find IC ACs are substantively engaged in overseeing AC operations quality (AC composition and diligence) and other critical governance areas (auditor hiring/retention, audit process, agenda setting, and critical risks), whereas management is not. In contrast, our findings for OC ACs reveal evidence of both ceremonial oversight (auditor retention/hiring and agenda setting) and substantive oversight (audit process and critical risks). Our study’s findings have important implications for regulators and practitioners.

SEC’s Division of Investment Management voices concerns over registered funds investing in cryptocurrencies and cryptocurrency-related products

Purpose This paper aims to provide an overview of recent US Securities and Exchange Commission (SEC) Division of Investment Management staff (“Staff”) guidance related to investment funds registered under the Investment Company Act of 1940 that seeks to provide exposure to cryptocurrencies or cryptocurrency-related products. Design/methodology/approach This paper provides analysis regarding the Staff’s view on registered investment companies that intend to invest in cryptocurrencies or cryptocurrency-related products, including an overview of the questions posed by the Staff with respect to registered investment companies that seek to hold cryptocurrencies or cryptocurrency-related products, which are divided into five categories: valuation, liquidity, custody, arbitrage (for exchange-traded funds) and potential manipulation and other risks. Findings The Staff is asking for additional information from industry participants to fully analyze and evaluate registered investment companies that seek to invest in cryptocurrencies. Practical implications The industry should continue to provide information to the Staff with the short-term goal of fostering an open dialogue and with the long-term goal of launching a registered investment company that invests in cryptocurrencies or cryptocurrency-related products. Originality/value This paper provides practical guidance from experienced lawyers of the Investment Company Act and Securities Act.

Schrödinger’s Currency: How Virtual Currencies Complicate the RIC and REIT Qualification Requirements

Internal Revenue Code (hereinafter “I.R.C.” or “the Code”) provisions governing Regulated Investment Companies (RICs) or “mutual funds” predate the internet by nearly half a century. The Investment Company Act of 1940 (hereinafter “the ‘40 Act”) followed four years thereafter. Twenty years later, I.R.C. § 856 was added; it contains very similar qualification requirements to Section 851 but is only applicable to investments in Real Estate Investment Trusts (REITs). Computers were in their infancy when RICs and REITs changed the way individuals invested. At that time, no one could have predicted the impact the internet would have on the world. Even more recently, virtual currency has emerged as a lucrative new way for individuals to invest their real-world cash, but tax policy has not caught up. In 2014, the Internal Revenue Service (hereinafter “the Service” or “the IRS”) declared that virtual currency will be treated as property—not currency—for federal income tax purposes. Other administrative agencies have taken a markedly different stance, classifying virtual currency as a commodity, or a security, although the Securities and Exchange Commission (SEC) has not yet taken a public position on the regulation of virtual currency. None of these characterizations adequately define virtual currency for the RIC or REIT context. The Code does not yet allow a security which is not regulated by the ‘40 Act to constitute a security for the purposes of the RIC or REIT qualification requirements. To qualify as a tax-favored RIC or REIT, (1) the entity must derive a high percentage of its income from certain enumerated sources (hereinafter “good” income), and (2) a certain percentage of its assets must be represented by cash, securities, and, in the case of REITs, real estate (hereinafter “good” assets). This paper explores the origin and justification of the “good” income and “good” asset qualification requirements or “tests.” The tests’ complete dependence on the ‘40 Act to classify qualifying securities can hinder the Service’s ability to adjust the tax rules to technological advancements. The paradigm should be driven by the Service’s classification of securities and other income and assets, wherein the ‘40 Act supplements the Code’s RIC and REIT qualification requirements but does not dictate them. As new technologies manifest, the Service will be able to address them quickly, thereby fostering investment in new technologies without the confusion or abuse attendant when technological advancements and the Tax Code collide.

New Special Study of the Securities Markets: Institutional Intermediaries

This essay, written for the Conference on the New Special Study of Securities Markets at Columbia Law School, identifies the key regulatory challenges posed by institutional intermediaries in America’s capital markets. We survey existing legal and economic research and suggest new areas for regulatory reform and scholarly inquiry. We cover registered investment companies (such as mutual funds), private investment funds (such as hedge funds and private equity funds), credit-rating agencies, and broker-dealers.

Mutual Fund Capital Structure

The Investment Company Act of 1940 regulates the capital structure of mutual funds in order to restrain their leverage and speculative character. It is often (mistakenly) assumed that the law prohibits open-end mutual funds from borrowing money. This Article (i) analyzes the law governing mutual fund capital structure to reveal when (and to what extent) borrowing is allowed and (ii) examines a novel dataset on mutual fund capital structure that shows borrowing is an unexpectedly common practice. Using data on all registered investment companies in the U.S. from 1998 to 2013, I find that nearly 8% of open-end mutual funds, and 10% of all mutual funds, borrow money for leverage purposes each year. This figure increases to over 12% of funds when I include non-conventional forms of borrowing. In fact, mutual funds borrow about as often as they employ the most commonly used derivatives. Closed-end funds are more aggressive than open-end funds in their borrowing, often pushing leverage to the regulatory limits. I find that, in addition to borrowing for leverage purposes, mutual funds also borrow on a short-term basis to manage liquidity, via a host of practices: bank lines of credit, overdrafts on custodial accounts, and joint borrowing and lending facilities that allow funds to borrow from other funds. Recent regulatory initiatives (which focus on risks arising from illiquidity and derivatives) overlook the substantial borrowing practices of mutual funds.

SEC adopts rules and forms to modernize reporting requirements for registered investment companies

PurposeTo explain the new rules, forms, and amendments to current rules and forms (Final Rule) that the Securities and Exchange Commission (SEC) has adopted to modernize the reporting of information provided by registered investment companies (funds) and to improve the quality and type of information that funds provide to the SEC and investors.Design/methodology/approachDiscusses the background leading up to the Final Rule, provides an overview and summary of the Final Rule’s key components, and highlights issues that may be raised by the new reporting regime.FindingsThe Final Rule will have a significant effect on many funds. Funds will experience a substantially increased reporting burden with respect to both the frequency of reporting and the granularity of information required.Practical implicationsFund managers and fund service providers should begin to evaluate the impact of the Final Rule, the processes that will need to be implemented to prepare filings on new forms, and the changes in fund disclosure practices that will be required in response to the amendments to certain forms.Originality/valuePractical guidance from financial services lawyers specializing in the investment management industry.

The Choice of Business Entity: Corporate, Pass-Through, and Disregarded Entities

This technical note focuses on common business entities: sole proprietorships, general partnerships (GPs), limited partnerships (LPs), limited liability partnerships (LLPs), limited liability companies (LLCs), S corporations, and C corporations and offers insights into the basic factors to consider when choosing one of these entities. The Appendix provides an overview of other important entities in the federal tax code: real-estate investment trusts (REITs), regulated investment companies (e.g., mutual funds), and publicly traded partnerships (PTPs). Excerpt UVA-C-2293 Rev. Sept. 1, 2016 The Choice of Business Entity: Corporate, Pass-Through, and Disregarded Entities When starting a business, there are many important choices that must be made, from the hiring of key personnel to the choice of a business model. One choice that can have far-reaching effects on the success of any business is the legal form through which it will operate and interact with the rest of the business community. Not only does the choice of a legal form have important federal income tax implications, but it can also affect a business owner's administrative workload, the manner in which he runs his day-to-day operations, his ability to transfer his ownership interest, and how he can compensate his employees. This technical note focuses on common business entities: sole proprietorships, general partnerships (GPs), limited partnerships (LPs), limited liability partnerships (LLPs), limited liability companies (LLCs), S corporations, and Ccorporations and offers insights into the basic factors to consider when choosing one of these entities. Appendix 1 provides an overview of other important entities in the federal tax code: real-estate investment trusts (REITs), regulated investment companies (e.g., mutual funds), and publicly traded partnerships (PTPs). State Law Entities . . .

SEC issues guidance on business continuity planning for registered investment companies

Purpose To explain guidance from the US Securities and Exchange Commission (SEC) Division of Investment Management concerning registered investment companies’ business continuity and transition plans (BCPs). Design/methodology/approach Discusses the SEC’s concerns with fund complexes’ operational complexity and reliance on technology and third-party service providers, lists notable practices in the BCPs of some registered fund complexes, and addresses practical considerations. Findings While the SEC staff recognizes that it is not possible for a fund complex to anticipate or prevent every business continuity event, the staff also believes that fund complexes’ preparedness would be enhanced if in addition to complying with the federal securities laws, fund complexes and their advisers consider additional factors related to BCPs discussed in the Guidance. Practical implications It would be prudent for the fund boards to consider discussing the Guidance with fund investment advisers and fund CCOs to determine the status of fund complex BCPs and any gaps related to the Guidance. Boards may also want to review with their counsel the current BCP reporting framework and any enhancements needed in light of the Guidance. Originality/value Practical guidance from experienced securities, fund management, regulatory and compliance lawyers.

SEC proposes sweeping changes to the use of derivatives and financial commitment transactions by registered funds and BDCs

Purpose To describe and analyze a proposed rule recently issued by the US Securities and Exchange Commission (“SEC”) that would overhaul the use of derivatives and financial commitment transactions by registered investment companies and business development companies. Design/methodology/approach This article summarizes the various aspects of the proposed rule, discusses the elements of the proposed rule in greater detail, explains the effect of the proposed rule on existing guidance from the SEC and its staff, and notes the potential transition period for any final rule. Findings While the proposed rule is subject to public comment and subsequent consideration by the SEC and its staff, if the proposed rule is adopted in its current form it would result in sweeping changes for registered investments companies and business development companies. Originality/value This article contains a detailed overview of a recent SEC rule proposal regarding the use of derivatives by registered investment companies and business development companies and practical guidance from experienced asset management lawyers.

An Empirical Analysis of Non-Traded REITs

Non-traded real estate investment trusts (REITs) are registered investment companies formed for the purpose of investing in real estate and marketed to retail investors. Unlike traded REITs, non-traded REITs do not trade on an exchange. We find average annual returns of 4.0% to 89 non-traded REITs, compared to 11.3% average returns over the same period to traded REITs. The economic magnitude of the underperformance exceeds $44 billion. A significant portion of non-traded REITs’ underperformance results from high upfront fees and expenses, which average 13.2% and largely serve to compensate brokers. The remainder of the underperformance is due to conflicts of interest that permeate the issuance and management of non-traded REITs. These conflicts include transactions with affiliated parties, such as the high fees paid to external advisors and property managers affiliated with the sponsor. We find significant reductions in expenses after non-traded REITs list their shares. Non-traded REIT investors suffer from the lack of monitoring and effective mechanisms for shareholder protection, such as the formation of block holdings.

Proposed Rule 18f-4 on the Use of Derivative Instruments by Registered Investment Companies: Data and Economic Analysis

I present data and analysis suggesting that the SEC’s proposed rule 18f-4, in its current form, is an inefficient and ineffective way for the Commission to achieve its regulatory goals of protecting investors and limiting the extent to which registered investment companies can take leveraged exposure to market risks. The rule as proposed uses a limit on risk exposure based on gross notional amounts which places an equal restriction on the use of derivatives whether they are used to take highly speculative positions or whether they are used as part of conservative, low-risk strategies. The proposed rule is likely to have unintended consequences, such as inducing certain types of funds to take on risk exposures using less liquid instruments. Alternative approaches that take risk into account can achieve the Commission’s regulatory goals without depriving investors of the benefits of efficient access to low-volatility, low-correlation strategies achievable through the responsible use of derivative instruments.

SEC issues proposed investment company reporting rules

Purpose – To explain proposed rules recently issued by the US Securities and Exchange Commission (SEC) that would dramatically expand both public and non-public reporting of portfolios and other data by US registered investment companies. A companion article covers new reports proposed at the same time for investment advisers that file Form ADV with the SEC. Design/methodology/approach – Explains how the proposed rules intend to rescind Form N-Q and adopt a new portfolio holding form, Form N-PORT, which would require expansive monthly portfolio and risk reporting; describes amendments to Regulation S-X which would both enhance and standardize derivatives disclosures in fund financial statements; and details the reporting requirements for a new annual ‘census-style’ reporting form, Form N-CEN, which would replace an obsolete existing SEC form, Form N-SAR. Findings – While it still remains to be seen how the final rules will be written, it is clear that US registered investment companies will be subject to broader reporting requirements. Investment companies are likely to incur increased costs due to the detailed nature of the information being requested and the frequency with which they will be required to file. Access to additional and enhanced information will have consequences for investment companies with respect to SEC examinations and enforcement activity. Practical implications – Senior management and boards of investment companies should understand the basic framework of the proposed requirements. An operations and finance working group may need to be established by companies in order to coordinate the planning and preparation process for the requirements. Firms also should determine whether their service providers have the necessary resources to assist in complying with the proposed filing requirements. Originality/value – Practical guidance from experienced investment funds lawyer.

Too Big to Tax? Vanguard and the Armms Length Standard

Vanguard is the world’s largest complex of mutual funds, with over $3 trillion in assets under management, including $215 billion added in 2014. Vanguard’s main attraction to investors is its low costs. Profs. Freeman and Brown (2000) report that the advisory fees charged by the Vanguard Group “tend to present lower expense ratios than the rest of the mutual fund industry” because “Vanguard funds are run on the same basis as most companies in the economy: boards are unswervingly devoted to making as much money as possible…for shareholders [of the funds]. Stated differently, Vanguard funds are uncontaminated by the conflict of interest that affects most of the rest of the fund industry.” Michael Rawson, a Morningstar analyst, told the Financial Times in May 2015 that “[i]t is phenomenal that a single company could represent almost 20 percent of the US mutual fund industry. But they have done it through offering products that are consistently lower cost than other funds”. The main reason for Vanguard’s lower fees than, for example, the fees charged by Fidelity (its closest rival) is that Vanguard has a unique structure, approved by the SEC in 1975: The investment manager (Vanguard Group Inc., or VGI) is owned by the Vanguard domestic mutual funds (the Funds) in proportion to Net Asset Value. This structure, Profs. Freeman and Brown argue, means that there is no conflict of interest between VGI and the Funds, while every other mutual fund complex has the advisor charging too much because it puts the interest of shareholders of the advisor ahead of investors that are shareholders of the funds.Coates and Hubbard (2007) have argued that this situation should result in investors moving from other funds to Vanguard, and the recent phenomenal growth of Vanguard suggests that they were right. But there is a problem: As David Danon, a former Vanguard in-house tax lawyer, has argued in a lawsuit filed in 2013, the Vanguard structure directly contravenes the arm’s length standard of Treags. Reg. 1.482-1(b)(1) because VGI provides services to the Funds “at cost”, i.e., without charging an arm’s length profit. VGI is a C corporation and the Funds are Regulated Investment Companies (RICs) not taxable at the corporate level, so this situation results in avoidance of billions of corporate taxes. The IRS has not taken action on Danon’s whistleblower complaint, nor has the NY Attorney General intervened in his qui tam lawsuit against Vanguard. Given the millions of Americans that have invested in Vanguard funds and the billions in tax at stake (which would presumably be borne by the investors in the Funds if Vanguard raises its fees to include the tax), this case raises the question: Is Vanguard too big to tax?This article will argue (a) that the Vanguard “at cost” pricing is unsustainable under the arm’s length standard, and that the IRS will win in court if it challenges Vanguard’s transfer pricing; (b) that the Vanguard case illustrates some of the problems with the arm’s length standard and would have been avoided had unitary taxation principles been applied to Vanguard and its Funds.

Funding Translational Medicine via Public Markets: The Business Development Company

A business development company (BDC) is a type of closed-end investment fund with certain relaxed requirements that allow it to raise money in the public equity and debt markets, and can be used to fund multiple early-stage biomedical ventures, using financial diversification to de-risk translational medicine. By electing to be a "Regulated Investment Company" for tax purposes, a BDC can avoid double taxation on income and net capital gains distributed to its shareholders. BDCs are ideally suited for long-term investors in biomedical innovation, including: (i) investors with biomedical expertise who understand the risks of the FDA approval process, (ii) "banking entities," now prohibited from investing in hedge funds and private equity funds by the Volcker Rule, but who are permitted to invest in BDCs, subject to certain restrictions, and (iii) retail investors, who traditionally have had to invest in large pharmaceutical companies to gain exposure to similar assets. We describe the history of BDCs, summarize the requirements for creating and managing them, and conclude with a discussion of the advantages and disadvantages of the BDC structure for funding biomedical innovation.

SEC asset management unit’s enforcement priorities for 2015 – conflicts of interest

Purpose – To address “Conflicts, Conflicts Everywhere,” a speech at the recent IA Watch 17th Annual Compliance Conference by Julie M. Riewe, co-chief of the Securities and Exchange Commission’s Enforcement Division’s Asset Management Unit (AMU). Design/methodology/approach – Provide information on the AMU’s creation, the AMU’s 2015 priorities for each of the primary investment vehicles it polices –registered investment companies; private funds (both hedge funds and private equity funds); and other client accounts, such as separately managed accounts/retail accounts – and the AMU’s central concern across all of the investment vehicles it polices: conflicts of interest. Findings – Conflicts of interest will be receiving much attention from the Commission in the coming months. In order to help avoid an SEC inquiry or, worse yet, an enforcement action, corporations and individuals should seek counsel. Originality/value – Practical explanation and guidance from experienced securities and financial services lawyers.

An Overview of the U.S. Regulated Fund Industry

The largest segment of the asset management business in the United States is registered investment companies (regulated funds). This article focuses on U.S. regulated investment companies—mutual funds, exchange-traded funds, closed-end funds, and unit investment trusts. These funds manage more than $17 trillion of assets, largely on behalf of U.S. investors. The industry has experienced strong growth over the past quarter century from asset appreciation and strong demand from households due to rising household wealth, the aging of the U.S. population, and the evolution of employer-based retirement systems. Price competition and supply-side product innovations and efficiencies have reduced the average price that investors pay for fund services.

The Taxation of RICs: Replicating Portfolio Investment or Eliminating Double Taxation?

Mutual funds and other regulated investment companies currently occupy a central space in American households’ financial lives. Is spite of their near-ubiquity, though, regulated investment companies occupy a strange tax limbo as quasi-pass-through entities, neither fully taxable nor fully tax-transparent. To qualify for this quasi-pass-through status, regulated investment companies must, among other things, distribute the bulk of their income to shareholders annually. The distribution requirement imposes costs on both regulated investment companies and on their shareholders. It is commonly framed as an attempt to make the economics of investing in regulated investment companies similar to the economics of making direct portfolio investments. History shows, though, that the distribution requirement finds its basis in marketing, and not in any tax policy consideration. If the distribution requirement benefited the shareholders or the government, it would be worth the costs it imposes. But this article concludes that the complexity and expense are not. When tax policymakers discard their flawed premise of attempting to replicate the tax treatment of direct portfolio investment, they can stop clumsily and partially attempting to recreate true pass-through taxation for regulated investment companies. Instead, they can reframe regulated investment company taxation in a way that imposes a single level of taxation while, at the same time, protects regulated investment companies from being transformed into vehicles for tax deferral.In this Article, I evaluate several ways the tax law could tax regulated investment companies and their shareholders while imposing only a single level of taxation and ensuring that shareholders have the liquidity with which to pay taxes. Ultimately, I find that the best model would exempt regulated investment companies from taxation. At the same time, it would defer taxing shareholders until they realized income or gain. It would make up for that deferral by imposing an interest charge on the gain. For shareholders who wanted to avoid this interest regime, it would also allow for a mark-to-market election.

CFTC harmonization rules: CPOs of RICs benefit from “substituted compliance”

Purpose – To explain regulatory developments and changes to compliance obligations for asset managers registered with the Commodity Futures Trading Commission (CFTC) as commodity pool operators of registered investment companies. Design/methodology/approach – Provides a general overview of new CFTC rules (Harmonization Rules) that afford relief to commodity pool operators of commodity pools that are registered as investment companies under the Investment Company Act of 1940; describes the specific CFTC disclosure, reporting and recordkeeping requirements that remain applicable to commodity pool operators that are also subject to Securities and Exchange Commission (SEC) regulation by virtue of operating commodity pools that are registered investment companies; discusses reliance on substituted compliance with applicable SEC requirements; outlines the method for claiming relief under the Harmonization Rules; provides guidance for CPOs of RICs that use controlled foreign corporations (CFCs). Findings – CPOs of RICs benefit from “substituted compliance” under the CFTC Harmonization Rules. Practical implications – Explains to investment advisers that have registered as CPOs of RICs the disclosure, reporting and recordkeeping obligations that apply to them, how to take advantage of compliance with SEC requirements in lieu of CFTC requirements, and how to claim relief with respect to certain CFTC compliance obligations. Originality/value – Practical explanation by experienced derivatives and securities lawyers.