Abuses and Substantive Remedies

* Transactions with sponsors and managers: Section 17 prohibition of most afffiliated

transactions
* Complex capital structures, often involving excessive leverage: Section 18, limiting to one or
two classes of stock; limitation on leverage
* Pyramiding of investment companies: Section 12 limitation on investment in other investment
companies
* Lack of independence; favoritism of insiders: Section 10, requiring 40% independent directors
* No stability in investment policies or shareholder voice in policy changes: Section 8
(registration and policies) and Section 13 (changes in policies)
* Insufficient capital required from sponsors of investment companies: Section 14 (minimum
capitalization)

Substantive Regulation: Sarbanes-Oxley and Dodd-Frank

* Board independence and committee requirements
* Ban on loans to officers and directors
* Say on pay
* Proxy access

(Why funds? Diversification, no idiosyncratic risk of loss. At purest level, individual risk may be
as low as market risk generally. Also, lets someone else do the picking for you. Someone else
decides what the good investments are, because you’re not going to do a very good job of
picking them on your own. Very smart, well-paid people spend all of their time doing just this.)

Indexed funds are better, because they’re just tied to a market segment. Mechanical, and
therefore lower fees.

Investment Company Act, the 40 act,

* Funds subject to the ICA, sponsored by a number of different companies. One main
investment advisor for that fund, and that company basically makes all the decisions regarding
what they are invested in and how they are advertised to get people to invest in the fund. Fund
is structured as a corporation with the investors as shareholders. Board of the corporation
enters into a contractual relationship with the investment advisor to provide the services in
running the fund. Formal relationship is the BoD is in control and is hiring the investment advisor
to run the fund. The ACTUAL relationship is that the investment advisor is the one who started
the fund and chooses who is on the board. Vote on the list presented to them, and it’s really just
the adviser running the business.

Threshold question, are you regulated by the ICA?

If so, then what? Must register with SEC (registration statement needed, extensive disclosure --
want clear disclosure of what investments the company is going to make, and clear notice
required if you are changing your practices).

Giant limitations on capital structure you can have. One or two classes of stock, big limit on the
amount of debt you can take. (Section 18 of the 40 act)

Investment Advisers Act of 1940

* Must register if manage portfolio > $25 million of advise investment company
* Must safeguard against misuse of privat einformation
* Client consent before selling securities
* Anti-fraud rules
* Limits on affiliate transactions and fees

“Investment Company”
* “is or holds itself out as being … engaged primarily in the business of investing, reinvesting, or
trading in securities.”
* “engaged in the business of investing, reinvesting, owning, holding, or trading in securities and
owns … 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 unconsolidated
basis”

CASE
**reasonable amount of time to become an operating company again so that it can be
reinvested**
**period of time**

Exception
* Some types of institutions: depository, insurnace, financial holding companies, retirement
plans, underwriters, broker-dealers
* Not more than 100 securities holders
* Only “qualified purchasers” (>$5 mil. in investments
* 3(b)(1): primarily engaged directly or through a wholly-owned sub in business other than
investing, reinvesting, owning, holding or trading in securities
* 3(b)(2): primarily engaged in business other than etc either directly or through majority-owned
subs or controlled companies, if apply to SEC and it says OK

Mutual Fund Regulation --Types

* Heavily Regulated
Money market mutual funds
Open end funds
Closed end funds
Exchange traded funds
* Lightly regulated
Hedge funds
Private equity funds

#1: Money Market Mutual Funds

* Short-term, high-quality, liquid securities as assets (much as commercial paper)
* Net asset value (NAV) $1
* Can write checks on account
* Competes with bank accounts

MMMFs -- Crisis Response

* In 2010, SEC revised Rule 2a-7: reduced maturities, tighter credit standards, liquidity
requirements
* Proposed: floating NAV
* Proposed: capital buffer

Hedge Funds
* Exceptions from Investment Company Act:
3(c)(1) fewer than 100 investors
3(c)(7) only “qualified purchasers”
* Former exemption from Investment Advisers Act: fewer than 15 ‘clients’
SEC changed by rule in 2004, overturned by DC Circuit
Congress changed in Dodd-Frank; now must register if over $15 mil. in assets