investment company products 11-1-07

8/3/2019 Investment Company Products 11-1-07

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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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

investment company products 11-1-07

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