overview of registered funds and key matters to consider when advising registered funds seward &...

OVERVIEW OF REGISTERED FUNDS AND KEY MATTERS TO CONSIDER

WHEN ADVISING REGISTERED FUNDS

Seward & Kissel LLP

January 9, 2013

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Discussion Topics

• Overview of Investment Companies• Types of SEC-Registered Funds• Issues for Private Fund Managers Considering

Sponsoring or Advising a Registered Fund• Fees and Other Economics of Advising/Sponsoring a

Registered Fund• Roles of Adviser/Sponsor and Sub-Adviser

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Discussion Topics (continued)

• 1940 Act and Internal Revenue Code Constraints on Investment Strategies

• Valuation and Other Key Operational Issues

• Tax Treatment of Registered Investment Companies

• Marketing Registered Fund Shares

• Role of Independent Directors

• Service Provider Functions

• Chief Compliance Officer and Compliance Program

• Questions

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Overview of Investment Companies

• Section 3(a)(1) of Investment Company Act: “investment company” is any issuer which

– (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities

– (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding or

– (C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unsolicited basis

• Unless excepted or exempt, any issuer meeting the definition of investment company must register with SEC under the Investment Company Act

• Common private fund exceptions: Section 3(c)(1) or Section 3(c)(7)

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Types of SEC-Registered Funds

Open-End Registered Investment Company

• “Mutual Fund” - continuously offers shares and redeems shares daily• Fund registered under the Investment Company Act of 1940

(“‘40 Act”) and shares registered under Securities Act of 1933 (“‘33 Act”)

• As of 12/31/2011 - $11.6 Trillion (in total net assets)

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Closed-End Registered Investment Company

• Fund registered under the ‘40 Act (and possibly the Securities Exchange Act of 1934) and shares registered under the ‘33 Act

• Shares may be exchange-listed or fund makes periodic discretionary tender offers to repurchase shares

• Fund-of-funds have utilized the closed-end fund structure• As of 12/31/2011 - $239 Billion (in total net assets)

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Interval Fund• Type of closed-end fund that makes required periodic tender or

repurchase order offers on a specified schedule (e.g., quarterly or semi-annually)

Unit Investment Trusts• As of 12/31/2011 - $60 Billion (in total net assets)

Exchange Traded Funds• As of 12/31/2011 - $1.0 Trillion (in total net assets)

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Issues for Private Fund Managers Considering Sponsoring or Advising

a Registered Fund

Transparency & Publicly-Available Information• Portfolio holdings schedule filed with SEC (and publicly available)

quarterly within 60 days• Annual and semi-annual reports• Prospectus and Statement of Additional Information filed with SEC

and publicly available– detailed portfolio manager/team information

– disclosure regarding number of private funds, RICs and performance compensation vehicles managed by portfolio manager/team

– description of compensation of portfolio manager/team and related conflicts of interest policies

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a Registered Fund

Impact on Overall Business • Mutual funds are typically lower fee products than private funds• If strategy substantially replicates private fund strategy may

create MFN issues• Potential allocation and conflict issues – private funds have

performance-based fees and typically substantial inside investment

• Significantly less control over RIC business due to Board of Directors/governance structure

• Administrative “back office” burdens

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Issues for Private Fund Managers Considering Sponsoring or Advising a

Registered Fund

Adviser Compensation• Significantly less control over adviser compensation due

to role of independent directors• Performance compensation structures not possible

unless all shareholders are “qualified clients” or fund uses “fulcrum fee”

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a Registered Fund

Restrictions on Investment Process

• ‘40 Act and Internal Revenue Code (“IRC”) impose restrictions and limitations (including diversification and distribution requirements)

• Limits on leverage and borrowing, short-selling, derivatives, illiquid securities

• Restrictions on transactions with “affiliated persons”• Total investment flexibility not possible (e.g., portfolio concentration,

“names” rule)• Fundamental investment objectives and strategies may not be

changed without shareholder approval

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a Registered Fund

Liquidity of Mutual Funds• Fund must honor daily redemption requests• NAV determined daily• 15% limit on illiquid securities

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a Registered Fund

Benefits• 3(c)(1) and 3(c)(7) limitations do not apply• Advertising permitted (although regulated)• ERISA 25% limitation does not apply• Ability to access retirement plan industry (e.g., 401(k) plans, small and

large benefit plans) • Invest in “new issues” without restrictions• Provide structure for institutional investors that want governance

(significant oversight by independent directors, numerous service providers)

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Fees and Other Economics of Advising/Sponsoring a Registered Fund

Mutual fund fees fall within 3 general categories:• Fund-Level Fees: fees paid out of the fund assets to service

providers (e.g., the adviser) and vendors • Shareholder-Level Fees: fees paid by investors when purchasing,

redeeming or exchanging fund shares (e.g., front-end sales load)• Indirect Fees: fees that are embedded in the costs of operating a

fund (e.g., brokerage)

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• $0 to $35 Million: unlikely that fund is profitable• $35 to $50 Million: fund may be profitable but adviser has not

recouped organizational costs• $50 to $100 Million: fund has recouped organizational costs but

not reimbursed adviser for waived fees• $100 Million: fund approaches profitability

Advisers typically waive fees and/or reimburse fund expenses until assets grow enough to lower expense ratio:

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Management fee Independent director compensation

Shareholder servicing fees CCO compensation

Custodian fees Printing

Fund accounting fees State (Blue Sky) fees

Legal fees Insurance

Audit fees Transfer agency and administrative fees

Typical Fund Fee Categories:

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• Adviser/Sub-Adviser must be SEC-registered investment adviser

• Section 15 of ‘40 Act and Board approval of advisory/sub-advisory contract; Gartenberg factors

• Adviser/Sub-Adviser required to manage fund in accordance with fund investment objective, strategies and restrictions and with ‘40 Act and Internal Revenue Code (Subchapter M) requirements

• Sarbanes-Oxley certifications and sub-certifications

Roles of Adviser/Sponsor and Sub-Adviser

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Roles of Adviser/Sponsor and Sub-Adviser

• Adviser/Sponsor is likely responsible for additional fund operational matters, oversight of sub-adviser(s), overlay management

• Multi-manager exemptions

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1940 Act and IRC Constraints on Investment Strategies

‘40 Act Constraints• Section 5: Diversification limitations• Section 12: Restrictions on investing in other registered funds,

registered investment advisers, registered broker-dealers and insurance companies

• Section 8 and 13: Fundamental investment policies• Section 17: Restrictions on transactions and arrangements with

“affiliated persons”

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1940 Act and IRC Constraints on Investment Strategies

‘40 Act Constraints (continued)

• Section 18: Restrictions on borrowing, leverage and senior securities

• Rule 35d-1 (Names Rule): 80% of portfolio investments consistent with certain fund names

• Other limitation and restrictions unique to mutual funds vs. closed-end funds

IRC Constraints • IRC – diversification and income tests

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Valuation and Other Key Operational Issues

The ‘40 Act requires fund shares to be sold and redeemed at net asset value per share (NAV)

NAV = Market Value of Assets – Liabilities

Number of Shares Outstanding

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• Securities for which market quotations are “readily available” are to be valued at market value

• All other securities and other assets are to be valued at “fair value”

The “fair value” of a security is the price that the fund might reasonably expect to receive upon a current sale

The definition of “value” in the ‘40 Act has two elements:

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The SEC has stated that a fund must:• Adopt written policies and procedures that require the

fund to monitor for circumstances that may necessitate the use of fair value pricing

• Establish criteria for determining when market quotations are not reliable for a particular security

• Establish a methodology or methodologies to determine the current fair value of a security

• Regularly review the appropriateness and accuracy of the methods used in valuing securities

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Valuation andOther Key Operational Issues

Does the security have a “readily available market quotation”?Does the security have a “readily available market quotation”?

Use the market quotation Use the market quotation

Fair value the securityFair value the security

If yes If no

Fair valuing…

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Valuation and Other Operational Issues

Determining whether to use a market quotation…

Is the market quotation current?Is the market quotation current?

Use the market quotationUse the market quotation

Has a significant event occurred?Has a significant event occurred?

Yes No

Use the market quotationUse the market quotation

Fair value the security factoring in the event

Fair value the security factoring in the event

Is a market-based proxy available?Is a market-based proxy available?

Use proxy to fair valueUse proxy to fair value

Market quote may be best price

Market quote may be best price

NoYes

NoYes

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Tax Treatment of Registered Investment Companies

Taxation of RICs• If a domestic corporation qualifies as a RIC under the

Internal Revenue Code, then:– No corporate tax is imposed to the extent the RIC

distributes its income– Shareholders are taxed on a modified pass-thru basis

on income and capital gains from the RIC

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Requirements of RIC Qualification• Taxed as a domestic corporation• Registered under the ‘40 Act as a management

company, unit investment trust or business development company

• Derives a specified portion of its income from permissible sources (the “Income Test”)

• Satisfies specialized asset diversification requirements (the “Asset Diversification Test”)

• Annually distributes a specified portion of its income • Elects to be treated as a RIC

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Income Test• A RIC satisfies the Income Test if it derives at least 90% of

its gross income for the taxable year from:– Dividends (including from REITs)– Interest (including OID, market discount, bankers acceptances,

tax exempt interest, repos, CDs)– Payments with respect to securities loans– Payments pursuant to options on stock, debt instruments,

foreign currencies, stock indices, futures contracts on securities, stock index or municipal bond index futures

– Income from futures contracts on securities, stock indices, GNMA certificates, Eurodollar CDs, commercial paper, municipal bond indices

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Income Test (continued)– Gain on foreign currency, options on foreign currency or

futures contracts on foreign currency– Income from notional principal contracts (to the extent related

to RIC’s business of investing in stock, securities or commodities) (e.g., a hedge)

– Gain from the disposition of stocks or securities – Income from controlled foreign corporations and from passive

foreign investment companies (e.g., under Subpart F, QEF or mark-to-market regimes)

– Net income from “Qualified Publicly Traded Partnerships”

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Bad Income• The following items of income do not count towards

satisfying the Income Test:– Gains and other income from commodities, options on

commodities, or commodity futures– Income from futures contracts on the consumer price index– Gains from the sale of real property– Rental income from real property– Fees for services (unless characterized as interest)– Income from notional principal contracts unrelated to RIC’s

business of investing in stocks, securities or currencies (this area is uncertain)

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Asset Diversification Test• There are two prongs to the Asset Diversification Test,

each of which must be satisfied at the end of a quarter:

– First, at least 50% of the value of the RIC’s assets must be represented by:

• cash, cash items, U.S. government securities, securities of other RICs

• other securities with respect to which the RIC’s investment is limited, in respect of any one issuer, to an amount not greater than 5% of the value of the RIC’s assets and to not more than 10% of the outstanding voting securities of such issuer

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Asset Diversification Test (continued)

– Second, not more than 25% of the value of the RIC’s assets may be invested in:• Securities of any one issuer (other than U.S. government

securities or securities of other RICs • Securities of two or more issuers under common control and in

the same or related trades or business • Securities of one or more “Qualified Publicly Traded

Partnerships”


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Cure Provisions• Even if a RIC fails the diversification test at the end of a quarter, it

may avail itself of one or more cure provisions:– A diversification failure can be eliminated within 30 days after

the close of a quarter– In measuring the diversification test, a RIC will not be treated

as failing such test solely as a result of increases in the fair market values of its securities

– A failure due to reasonable cause (and not willful neglect) can be eliminated within 6 months after the close of the quarter by disposing of the assets and paying a tax on the income generated by the assets

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Distribution Requirement• If a RIC makes timely distributions to its shareholders of 90% or

more of its investment company taxable income for a taxable year (calculated without regard to its net capital gain, e.g., the excess of its net long-term capital gain over its net short-term capital loss), it will not be subject to federal income tax on the portion of its taxable income for the year (including any net capital gain) that it distributes to shareholders

• Special rules apply to dividends paid after the close of a RIC’s taxable year

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Excise Tax• A RIC is subject to a four percent federal excise tax on its

undistributed income for a given calendar year unless it makes timely distributions to shareholders equal to the sum of:

– 98% of its ordinary income for such year – 98.2% of its capital gain net income and foreign currency

gains for the twelve-month period ending on October 31 of such year

– any ordinary income or capital gain net income from the preceding calendar year that was not distributed during such year

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Taxation of a RIC’s U.S. Shareholders• A RIC’s U.S. shareholders are subject to taxation on the

dividends they receive from a RIC, which are reported to them on Form 1099

• A RIC is a modified pass-through entity and may pay different types of dividends:

– Ordinary dividends– Capital gains dividends– Qualified dividends– Exempt interest dividends

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Taxation of a RIC’s Non-U.S. Shareholders• Because a RIC is a corporation, its dividends, other than

capital gains dividends, are subject to a 30% U.S. withholding tax when paid to non-U.S. shareholders (subject to reduction by a tax treaty)

• The result is that even dividends paid by a RIC attributable to items not subject to U.S. withholding tax if received directly by a non-U.S. person may be subject to such tax when received through a RIC

– Through 2013, dividends attributable to short-term capital gains and portfolio interest income of a RIC are exempt from the 30% withholding tax

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Marketing Registered Fund Shares

• General advertising of mutual funds is permissible (no need to navigate the JOBS Act), but highly regulated

• An unlimited number of shareholders can own a mutual fund (no 3(c)(1), 3(c)(7) or ‘34 Act limits)

• Investors at any income or net worth level can purchase mutual fund shares (unless the fund charges a performance fee)

Registered funds enjoy a big advantage over hedge funds in terms of marketing:

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Major marketing channels of registered funds include:• Direct retail market• Broker-dealers, banks and other financial intermediaries• Retirement plan platforms• Fund supermarkets• Wrap fee arrangements

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A single fund can have multiple classes of shares to tailor marketing to different types of investors:• Class A: front-end load• Class B: CDSC and higher 12b-1 fee• Class C: CDSC and lower 12b-1 fee• Class I or Z: institutional investors• Class R: retirement plans

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• Advertising subject to Section 5 of the ‘33 Act and detailed rules thereunder

• Ads must be filed with FINRA• Persons involved in the sale of registered funds must be

licensed as registered representatives of a broker-dealer• The fund’s distributor must be a registered broker-dealer

(issuer exemption not practical)

Registered fund marketing regulated by several regulatory schemes:

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Role of Independent Directors

• Not affiliated with the fund, its adviser or its distributor• During the past 2 years, no independent director

candidate may have engaged in a material business or professional relationship with the fund, its adviser or its distributor

At least 40% of directors must be independent (50% to take advantage of certain rules):

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Duties include:• Monitor performance of the fund• Annually tasked with approving advisory fee paid by the

fund and investment management arrangement• Oversee distribution of fund shares and approve 12b-1

plan (if any)• Select and retain auditor (through an audit committee)• Approve fair value of certain portfolio securities

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Fund directors are subject to following duties:• Owe a fiduciary duty to fund and its shareholders• Subject to a duty of care (must be informed and diligent)• Subject to a duty of loyalty (must avoid or address

conflicts of interest)

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Service Provider Functions

• Investment Adviser/Sub-Adviser – Section 15(a) & (c) and Section 36(b)– Makes investment and brokerage decisions– Oversees operational matters– Provides fund officers– Compensation/fees

• Distributor/Principal Underwriter – Section 15(b) & (c) – Sale of fund shares through intermediaries– Marketing and advertising

• Custodian – Section 17(f)– Holds fund assets/securities

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Service Provider Functions

• Transfer Agent, Fund Accountant and Administrator– Maintains master fund shareholder list; AML/CIP– Receives portfolio holdings pricing information and determines

fund net asset value per share– Administers fund books/expense accruals– Determines fund distributions – Coordinates regulatory filings and board meetings

• Independent Auditors – Section 32(a) – Annual audit of fund financial statements

• Fund Counsel/Independent Director Counsel – Rule 0-1(a)(7)

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CCO and Fund Compliance Program

• Rule 38a-1: Requires designation of fund Chief Compliance Officer and related compensation and fund board approval of compliance policies and procedures

• CCO must report to fund board annually – material changes and material compliance matters

• Compliance policies and procedures – use of exemptive rules

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QUESTIONS?

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Speakers

Jim [email protected]

(212) 574-1688

Paul [email protected]

(202) 737-8833

Pat [email protected]

(212) 574-1247

Bibb [email protected]

(202) 661-7141

www.sewkis.com

mailto:[email protected]




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DISCLAIMERS

This presentation is not intended as legal or tax advice. You are encouraged to consult your own legal and tax advisers regarding the matters discussed herein.

To ensure compliance with Treasury regulations regarding practice before the IRS, we inform you that any federal tax advice contained in this communication was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (i) avoiding penalties that may be imposed on the taxpayer under United States federal tax law, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

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