2.2 The Investment Company Act of 1940: Classifications, Registration, and Fund Governance

The outline's Task 1.2 cites the 1940 Act sections a principal must know: Sections 2, 4, 5, 8, 11, 12, 13, 22 and 35, plus Rules 22c-1, 22d-1, 22d-2 and 22e-1. This section covers the structural rules. Section 2.3 covers pricing, sales charges and exchanges, and Section 2.4 covers variable contracts.

Types of Investment Companies (Sections 4 and 5)

Section 4 classifies every investment company as one of three types:

1. Face-amount certificate companies issue debt-like certificates promising a fixed amount at maturity in exchange for installment or lump-sum payments. They are rare today.
2. Unit investment trusts (UITs) are organized under a trust indenture, have no board of directors, and issue redeemable units in a largely fixed, unmanaged portfolio. Most variable annuity separate accounts are registered as UITs that invest in underlying mutual fund portfolios.
3. Management companies are every other investment company, with an investment adviser managing the portfolio.

Section 5 subclassifies management companies two ways:

Worked example. A $400 million diversified fund may hold at most $20 million (5%) of any single issuer within its 75% tested portion. It could still place a larger position in the untested 25% bucket. A fund that met the test at purchase does not lose diversified status merely because market appreciation pushes a holding above 5%. An acquisition that causes it to fail the test is a different matter.

A Series 26 principal supervises mutual funds and closed-end funds only during their original distribution. After the offering, closed-end shares trade on the secondary market, which is outside the Series 6/26 scope.

Registration and Disclosure Documents (Section 8)

Section 8 requires an investment company to register with the SEC, first by notification on Form N-8A and then by filing a full registration statement. Open-end funds use Form N-1A, whose Part A is the prospectus and Part B is the Statement of Additional Information (SAI). Closed-end funds use Form N-2, and variable annuity and variable life separate accounts use Forms N-4 and N-6. Section 2 supplies the definitions used throughout the Act, including "redeemable security," "affiliated person" and "interested person." Interested persons cannot count as independent directors.

Governance: Directors and Shareholders

The 1940 Act relies heavily on fund boards and on shareholder votes:

• Board independence. Section 10(a) requires that at least 40% of a fund's directors not be interested persons. In practice, most fund boards have a majority of independent directors.
• Advisory contracts (Section 15). The investment advisory contract needs initial approval by a majority of the outstanding voting securities. To continue beyond two years, it must be approved at least annually by the board, including a majority of the independent directors.
• 12b-1 plans (Section 12(b) and Rule 12b-1). A fund may pay distribution costs from fund assets only under a written plan. The plan must be approved by the board, including a majority of directors with no financial interest in it; continued at least annually; and supported by quarterly written reports to the board of amounts spent. Independent directors or a shareholder vote may terminate it at any time. A plan adopted after the public offering also needs approval by a majority of the outstanding voting securities.
• Fundamental changes (Section 13(a)). Without approval of a majority of the outstanding voting securities, a fund may not change its subclassification (for example, diversified to non-diversified or open-end to closed-end), borrow money, issue senior securities, underwrite, deal in real estate or commodities, or make loans except as its registration statement permits. It also may not deviate from a stated concentration policy or other fundamental policy, or change its business so it stops being an investment company. "Majority of the outstanding voting securities" means the lesser of 67% of the shares present at a meeting where more than 50% are present, or more than 50% of all outstanding shares.

Capital Structure and Liquidity

• Senior securities (Section 18(f)). An open-end fund may not issue senior securities other than bank borrowings with 300% asset coverage. Rule 18f-3 permits multiple share classes of one portfolio with different sales charges and 12b-1 fees, which is the legal basis for A, C and I shares.
• Liquidity risk management (Rule 22e-4). Open-end funds must maintain a liquidity program and may not acquire an illiquid investment if more than 15% of net assets would then be illiquid.

Names and Government-Backing Claims (Section 35)

• Section 35(a) makes it unlawful to represent or imply that a fund's securities are guaranteed, sponsored, recommended or approved by the United States or any federal agency.
• Section 35(d) prohibits materially deceptive or misleading fund names. Rule 35d-1, as amended in 2023, requires a fund whose name suggests a particular investment focus to adopt a policy of investing at least 80% of its assets accordingly.

These provisions matter for supervising sales literature. A representative who tells a client that a government money market fund is "backed by the U.S. government" makes the misrepresentation Section 35(a) forbids, whatever the fund's holdings.