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Mutual Funds and Regulation
Other Investment Company ProductsTodd Cipperman, Esq.November 1, 2007
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 2
FINRA Disclaimer on content herein:
FINRA's classroom learning course information is the sole property of FINRAand the content provided is for informational and educational purposes only.The content of the classroom learning courses does not constitute any FINRArule or amendment or interpretation to such rules. Compliance with anyrecommended conduct presented does not mean that a firm or person hascomplied with the full extent of their obligations under FINRA rules, the rules ofany other SRO or securities laws. Use of this classroom learning course doesnot create a safe harbor from regulatory responsibility. This classroom learningcourse is provided "as is." FINRA and its affiliates are not responsible for anyhuman or mechanical errors or omissions. Parties may not reproduce theclassroom learning courses in any form, nor reference them in any publication,without the express written consent of FINRA. It is important to emphasize thatwhile the particular materials that individual speakers have provided from theirfirms have been reviewed by FINRA, these may not reflect the express views ofFINRA. The regulations and rules are the final authority. Opinions that may beexpressed are the opinions of the speakers and participants and not those of
FINRA.
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1OtherInvestment Company Products
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 4
Other Investment Company Products
Closed-End Funds
Unit Investment Trusts (UITs)
Exchange Traded Funds (ETFs)
Variable Insurance Products
Section 529 Plans
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Closed-End Funds
Features: Closed-Ended Funds:
Generally a fixed number of shares is issued
Trade on a Stock Exchange
Shares trade based upon market price rather than net asset value (NAV)
With only some relationship to Funds actual NAV
Funds sold at POP (not equal to NAV at a discount or premium to NAV)As of year-end 2005, total assets in Closed-End Funds was $276 billion (vs.
over $8.9 trillion in Open-End Funds)
62% of all assets in Closed-End Funds are held in Debt Securities and 38%were in Equity Funds
Open-Ended Funds
Mutual funds continuously issue shares Mutual funds redeem (buy back) their shares continuously
Redeemability within 7 days (i.e. liquidity). See Section 22(e) (7 days toredeem) and Rule 22c-1 (daily pricing for redeemable securities)
See Rule 23c-3 re Interval Funds and quarterly liquidity
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Why Closed End Funds
Illiquid Securities
Fund-of-Hedge Funds
Emerging Market Funds
CDOs etc.
Bank loan funds
BDCs and private equity
Less Cash Drag
Lower Costs related to cash management
Stability of fees especially performance fees
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 7
Disclosure and Regulation
Form N-2
Periodic Reporting Obligations of 1934 Act do not apply
Section 13 and 16 do apply
Repurchases generally effected through periodic tender offers
No prospectus updates unless 10b-5 issues
Importance of Annual and Semi-Annual reports
Financial Statements
Registration under 1933 Act, 1940 Act, both, or neither
Rule 102 of Regulation M (limitations during distribution period)not applicable
Restrictions on multi-class structures
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 8
Registration under the Investment Company Act
Limits on investment activities
Leverage limited to 33%
Limits on senior securities
Limits on fund-of-funds
Compliance requirements
Registration Statements Board meetings
Affiliate transactions
Distribution
Compliance Program
Cost of registrationLiability
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Interval Funds (Rule 23c-3)
No more often than quarterly
No more than 25%/repurchase
Cash at NAV
Specified time periods for notice and payment
Fundamental policies in N-2
Must calculate NAV weekly
No CDSCs or 12b-1 fees
Majority of Board must be disinterested
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Closed-End Fund assets: 1995 - 2006
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 11
Unit Investment Trusts
Features: Registered Investment company.
Buy & Hold Strategy
Generally buys and holds a fixed portfolio of stocks, bonds, or other securitiesfor a very specific period of time
Positions may be liquidated/replaced due to issuer-viability concerns
Dividend income paid regularly (quarterly or semi-annually) and interest usuallypaid monthly
Dividends can be reinvested into new Units of UITs for Fixed Income UITs, or
Dividends can be reinvested into a similar Open-Ended Mutual Fund with thesame investment strategy
Maturity dates set at issuance.
As short as one year for equity UITs
(broker-sold Dogs of the Dow UITs)As long as 30 years for bond UITs
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 12
UIT vs. Mutual Fund
Static Portfolio: no active management
Sponsor maintains secondary market
Fixed Term
Grantor Trust, rather than RIC, for tax
Single offering
Sales Charge, low fees
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 13
Why a UIT
Bond Insurance
Specific Market Sectors: Dogs of the Dow
Secondary Market allows for more liquidity and derivatives
Off-Shore investors
Asset Allocation
ETFs (e.g. SPDRs)
No concern about market timing, revenue sharing, etc.
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 14
Unit Investment Trusts
Advertising Issues:
UITs typically cite estimated current return in advertisements and sales literature
Defined as estimated net annual interest income per unit, divided by the offeringprice
This is a measure of a trusts current cash flow
For fixed-income UITs the interest paid is usually predictable
Fixed-income UITs also may cite estimated long-term return, or estimated yield
Uses weighted average yield to maturity, and reflects impact of sales charges
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 15
Exchange Traded Funds (ETFs)
Listed and traded on Stock Exchanges
Continuous Trading
No discount from NAV
Started as institutional cash equitization product
Hedge funds and short selling
More tax efficient: manage capital gains
Very inexpensive: Compare ETF vs. Index Fund
Available to Non-US investors
Fewer regulatory limits on distribution (no revenue sharingissues)
No market timing issues
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 17
Structures and Mechanics
UITs (e.g. SPDRs, NASDAQ 100, DIAMONDS) vs. Open-End
Management Company (e.g. Barclays I-Shares, Vanguard
VIPERS)
Portfolio more fixed; sampling of index not allowed
Some tax differences
Old School vs. New School
Creation Units: securities + cash = 22c-1 price
In-kind transactions
Settlement through NSCC guarantees delivery
Constant arbitrage among Authorized Participants eliminates discount to
NAV
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Regulation
Need exemptive relief Purchases by 5% holders
Separate class of shares differing by redeemabilty (e.g. VIPERS)
Secondary market prices rather than NAV
Greater than 7-day settlement for non-US securities
Prospectus delivery requirements (closed vs. open-end funds)
Reimbursement of expenses to UIT sponsor Fund-of-funds
1934 Act: BD activities
Regulation M: activities of affiliates during distribution
Tender Offer rules
Margin Rules
Confirmation Rules
Section 13 and 16 reporting
Conduct Rule 2830(c): sales at other than NAV
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ETFs: The New Frontier
Actively Managed ETFs Need for arbitrage vs. portfolio returns
See SECConcept Release Actively Managed Exchange Traded Funds(2001)
Leveraged ETFs
Alternative asset classes (e.g. gold-linked ETFs) Search for tax efficiency
401(k) plans
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 20
Variable Insurance Products
Variable Annuities, Variable Life
Insurance Features: Death Benefit, Living Benefit
A shares and B shares (See sales practices)
Ability to move money among underlying funds
Small firm 401(k) marketplace
Tax deferral benefits
Estate tax planning
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 21
Variable Product Legal Issues
Fixed grouping of funds under each contract
Different funds than offered in retail marketplace
Expenses: Loads, Admin, Mortality, Investment, Death Benefit
Sold by life insurance agents/registered reps
FINRA Conduct Rule 2821: Members' Responsibilities RegardingDeferred Variable Annuities
Enhanced suitability requirements that require consideration of surrendercharges, fees, and market risks
Consider exchanges within the prior 36 months
Principal review and approval
Procedures and training
Sales Practices
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 22
Unique Variable Insurance Features
Subchapter L requirements for Life Insurance Policies or Annuity
Contracts Because a Trust is used to fund Insurance Contracts, each portfolio must meet certain
Diversification requirements
> No more than 55% of total value of assets may be represented by one investment
> No more than 70% by any two investments
> No more than 80% by any three investments
> No more than 90% by any four investments
No Free Lunch Variable insurance products generally carry high internal fees
Fees cover costs of insurance features and investment management
Suitability issue:
Is it cheaper to invest and buy insurance separately?
Should there be a per se rule that customer should always get lowest cost (limitingcustomer choice)
Regulatory Scheme Because of dual nature of the products subject to many levels of regulation
SEC regulation of offering documents and periodic reporting
FINRA regulation of sales practices/advertising
State by State regulation of substantive insurance law and sales practice
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 23
529 Plans
States Sponsor/Issue the Plans Plans are subject to MSRB regulation on a State-by-State basis
Plans generally are managed by professional money managers
Tax Advantaged Investment
Federal
No deduction on contributions Earnings grow tax-deferred
Earnings are never taxed when used for education
Flexibility
Account owners retain control over account, not the beneficiary (no conversionat defined age)
If beneficiary does not go to college, account can rollover to family
member (includes children, nephew/nieces and 1st cousins of original
beneficiary)
Anyone can contribute to an account
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 24
529 Plans
College savings plans under IRS Section 529 Contributions federally taxable Many states do not tax contributions to state plans
State Plans operated by a professional investment management firm.
Earnings in a 529 Plan accumulate tax-free and can be withdrawn tax-free for the purpose of paying for certain qualifying higher education
expenses tuition, room, board, books, etc. Underlying investments generally include mutual funds.
Regulation Municipal Securities Rulemaking Board (municipal securities) Reps must have Series 7 or 52 (or Series 6 if the only municipal securities sold are
529 Plans) and must be supervised by a Series 53 or 51, depending on the
circumstances.
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Mutual Funds and Regulation Confidential Copyright 2007 FINRA 25
529 Plan Sales Practices
MSRB and FINRA jurisdiction: interest in plan andinterests in fundsMSRB Rule G-21:no false or misleading advertisements
Consider state tax benefitPerformance data must comply with Rule 482
MSRB Rule G-19: broker-dealer must ensure suitabilityFINRA will enforce G-19 (See Ameriprise action)
FINRA NtM 03-17: comply with 2210 and other FINRArules (including pre-filing of marketing materials)
MSRB Notice 2007-18: Amendments to G-21: conformperformance advertising to 2210 and Rule 482
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529 Plans
Account Features
You can have multiple accounts for one child
Many plans offer age-based or life-cycle investment plans thatreadjust over time from aggressive to conservative based on age ofbeneficiary Usually cannot change investment selection after initial selection You can rollover between states once per year (and therefore change investment
strategy)
You could open 2 accounts in 2 states if you wanted to blendinvestment styles, and change weighting going forward This is the standard current practice
Financial Aid 529 is the parents asset, so it has less effect than a traditional gift account when
applying for financial aid at Colleges Distributions from a 529 plan to pay a childs expenses will show up in the childs
tax return, and will impact financial aid eligibility in years 2-4
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Mutual Funds and RegulationConfidential
Copyright 2007 FINRA 27
Summary
Closed-End Funds: portfolio liquidity
UITs: SPDRs
ETFs: low-cost indexing
Variable Insurance Products: tax deferral
Section 529 Plans: college savings
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Mutual Funds and RegulationConfidential
Copyright 2007 FINRA 28
Todd Cipperman is the principal ofCipperman & Company, which provides legal consultingservices to investment managers, investment advisers, broker-dealers, mutual funds, hedgefunds, and technology providers. Cipperman & Company provides a wide range of services forthe industry including regulatory advice, product development, distribution arrangements,compliance programs, and client and vendor agreements.
Mr. Cipperman has more than 15 years of experience in the investment management andfinancial services industries. As a principal ofCipperman & Company, he has represented a
wide range of investment management clients with a focus on distribution issues facing advisersand broker-dealers. He previously served as general counsel of a public mutual fund andfinancial technology firm, including its $65 Billion proprietary mutual fund family. He has alsoserved as general counsel of one of the largest international equity managers. He spent severalyears in private practice on Wall Street representing both buy and sell side clients in investmentmanagement and capital markets transactions. He is a graduate of the University of Pennsylvania Law School and Cornell University.
Todd Cipperman, Esq.
150 S. Warner RoadSuite 140
King of Prussia, PA [email protected]
www.cipperman.com