An Overview of Investment Funds Law
Investment funds law is a subpart of the broader financial law and it is closely related to investment companies. It regulates companies and other institutions that pool investors’ assets until such time the assets can be deployed and invested in securities or other assets. Investment fund law also covers the ongoing compliance operations of these institutions and may include the permitting of securities by the securities and exchange commission. Since most investors deal with these vehicles these days or allocate assets to them, investment funds law is important and relevant to most people, not just corporate practitioners and financial executives. Investment funds law covers every aspect of the lifecycle of an investment fund. This may include the formation of the fund and organizing the management company and its officers, preparation of required board resolutions, creation of the debt and equity structure, and party to appropriate agreements, including BVI investment fund and others. Insurance and indemnity are often involved, thus insurance, investment or captive insurance companies will often find investment funds law relevant to their area of practice . This area of the law also covers the corporate governance of investment funds, its committees and officers, its investors, and regulations of the members of the board of governors. Regulations of service providers, such as the custodian, investment adviser, principal underwriter, or independent accountants are also covered under this area of the law. All aspects of corporate governance of the investment fund companies, investment company board decision making, and disclosure compliance – whether mandated under federal law or pursuant to a contract are regulated under investment funds law. Securities regulations, such as those enacted by the Securities Act of 1933, and those of the SEC are very relevant to investment funds law and its regulatory oversight. This area of the law may also apply to private equity funds, venture capital funds, hedge funds, mutual funds, and funds that invest in asset securities. Other types of financial products, including hybrid vehicles, bank products, funds of hedge funds and funds of funds, exchange traded funds and funds that utilize derivatives, retirement funds and defined contribution plans, insurance funds and managed futures may also fall under the scope of investment funds law.
Different Categories of Investment Funds
Investment funds can be classified into three broad categories, which correspond to the different regulatory perspectives from which they are governed: investment funds that mainly focus on marketable securities, investment funds that mainly focus on private equity investments and hedge funds. Investment funds holding marketable securities are generally classified as either open-end or closed-end investment funds. Open-end investment funds correspond to what most people consider to be a mutual fund. Investors in such funds acquire investment units which are redeemable on a daily basis at a price based on net asset value components. This type of investment fund is commonly registered as a mutual fund under NI 81-102. In most provinces, it is possible for a mutual fund to be registered at two levels: as a mutual fund at the category level and as a mutual fund at the fund manager level. The former is commonly referred to as a "flow-through fund" as the tax flow-through treatment would depend, among other factors, inflows and outflows of the mutual fund being distributed to the mutual fund’s investor base on an annual basis. The manager level registration, on the other hand, refers to the investment fund as being able to subscribe (by way of prospectus) to other mutual funds without any tax implications. Open-end investment funds are also referred to as public mutual funds. Investments may be made in securities of private issuers by such funds so long as the mutual fund has appropriate disclosure in the prospectus. These funds are also regulated by the applicable securities regulators at the category level (such as the full prospectus disclosure regarding private funds), but are treated as "public mutual funds". Closed-end investment funds are generally referred to as a "flow-through fund" and are subject to the mutual fund regulatory regime under NI 81-102 as well, but subject to certain exemptions. Closed-end funds are not redeemable by its investors, and the general investment strategy of such funds is to trade or re-sell its securities in a private placement without having to make a prospectus offering to its securityholders. Investment funds that mainly focus on private equity investments, such as venture capital funds and real estate funds, are usually structured as a private issuer and are not subject to the NI 81-102 regime. While certain funds of this category may operate in a similar manner as the open-end investment fund discussed above, those funds that operate by way of a closed-end investment strategy are generally considered as a flow-through fund and are therefore not subject to the intention of the NI 81-102 regime. Similarly, the same regulatory requirements apply to hedge funds, which are generally structured as general partnerships or as limited partnerships. Hedge funds may also decide to opt-in to National Instrument 81-104: Commodity Futures and Other Commodity Contracts ("81-104"). 81-104 provides exemptions to certain funds from complying with NI 31-103 if certain requirements are met. Similar to venture capital funds and real estate funds, hedge funds are not subject to the NI 81-102 regime and are regulated by the applicable exemptive relief granted by the applicable securities regulator. Unlike closed-end investment funds where the tax flow-through treatment would only occur if the investment is made in securities of other issuers, investment funds focusing on private equity investments or a hedge fund would need to allocate its unrealized and realized income to the limited partners accordingly. Hedge funds are qualified investors from a regulatory standing, but for income tax purposes, the investor’s eligibility will be based on its ability to meet certain test (described below). Hedge funds are also considered as flow-through funds for tax purposes. In order to qualify as such, they must meet at least one of the following conditions: Other exemptions based on statutory interpretation may be obtained in individual situations where the fund may not be considered a mutual fund subject to the NI 81-102 regime and file the necessary tax forms with Revenue Canada. Generally, an investment fund that qualifies as a flow-through fund would permit the fund to process distributions pertaining to its investor base without first making distributions to the whole investor base.
Most Important Rules Within Investment Funds Law
Investment funds in the United States are primarily governed by the Investment Company Act of 1940, as amended (the "1940 Act") and securities laws. The 1940 Act regulates the organization and operation of mutual funds and other investment companies, such as closed-end funds and exchange traded funds. The SEC is the principal regulator of investment funds and oversees mutual funds and other U.S. issuers. Under the 1940 Act, investment funds must register the fund organization and investment adviser with the SEC unless the investment fund qualifies for an exemption or other registration exclusion.
In adopting the 1940 Act, Congress recognized that the federal regulation of the fund industry was necessary to protect investors from abuse, unfair competition and unequal and unfair trade practices. Today, the SEC’s Division of Investment Management administers most of the rules and regulations under the 1940 Act.
For review, here are some basic definitions under the 1940 Act: ● "Investment company" – An issuer that is engaged primarily in the business of investing in, reinvesting in, owning, holding, trading, or investing in securities for investment and whose interest in securities are offered to the public. ● "Open-end investment company" – An investment company that is "offering for sale to the public, or has outstanding any redeemable security issued by it, redeemable in the issuer’s securities." ● "Closed-end investment company" – An investment company whose "securities are not issued or sold continuously to the public during a period of time or continuously at a fixed price, may not have a warden number of stockholders or partners, and whose shares are offered to the public at a time and price set by a board of directors, trustees, or an equivalent entity."
The 1940 Act requires funds to register as open-end or closed-end investment companies as required by the company’s structure, subject to exclusion or exemption from registration. Of course, once an investment fund registers with the SEC, it must be careful to ensure that it operates in compliance with all applicable provisions of the 1940 Act, which, among other things, governs its capital structure.
In addition to the 1940 Act, mutual funds and other investment funds are subject to various general federal and state securities laws. Although the 1940 Act exempts funds from certain basic securities laws, it does not exempt the funds from general requirements to disclose current information to shareholders and the public.
The Securities Act of 1933, as amended (the "Securities Act") is the primary federal law concerning the registration and sale of securities. The Securities Act requires issuers of securities, including mutual funds and other investment funds, to file a registration statement with the SEC and publish a prospectus containing certain information before a sale of securities can occur.
President Franklin D. Roosevelt signed the Act into law in 1933 in response to the stock market crash of 1929 and following years of far reach of speculative and risky trading activity. The Securities Act gave the SEC broad powers to regulate securities and individual transactions with the goal of encouraging investor trust and confidence in the securities markets.
Another purpose of the Securities Act is to prevent fraud, misrepresentation and other unfair practices in the securities markets. It is unlawful for companies or individuals to use the U.S. mail or other means to employ schemes or fraudulent means in connection with the purchase or sale of any security to make untrue or misleading statements to potential purchasers or to omit material facts from statements issued in connection with the offer or sale of securities.
To encourage our national economy, the Securities Act provides certain exemptions for securities offerings, such as offerings issued by municipalities, securities issued and backed by the U.S. government, employee benefit plans, church groups and offerings by small businesses. Investment funds may also be entitled to certain exemptions.
Mutual funds and other investment fund companies must comply with the securities laws and are subject to liability under those laws for fraud, misrepresentation, omissions of material fact, and insider trading. In addition, shareholders and others often assert private rights of action for violations of the securities laws by investment funds.
As a primary federal regulator of investment funds, the SEC enforces federal securities laws, including the 1940 Act. The SEC also oversees the regulation of mutual funds, ensures compliance by fund organizations and its advisers, and reviews disclosure and sales materials used by investment funds and advisers. The SEC not only regulates investment fund formation and investment adviser registration, but also is tasked with supervising and monitoring investment funds and providing for the appropriate on-site inspections of fund organizations, advisers and affiliates. Voluntary compliance with investment company regulation is urged by the SEC, and failure to comply can result in enforcement action.
Compliance Obligations Under Investment Funds
Like many other regulated industries, investment funds are bound by statutes and rules governing their operations. Investment funds must comply with various laws and regulations requiring periodic reporting, investment restrictions and fiduciary obligations to protect the interests of their investors. Financial services firms that do business in the area of investment funds must also satisfy regulations to avoid fines, licenses suspensions and other liabilities. Investment funds and financial services firms that fail to satisfy regulatory compliance obligations face significant civil penalties, criminal sanctions, reputational harm and in some cases, imprisonment. In the past, many financial giants and local firms have faced stiff criminal sanctions for failing to comply with securities regulations. Board members, managers and other individuals involved in the operations of investment funds must navigate the complex world of investment funds law and stay current with changes in federal and state statutes and regulations governing the field.
Recent Changes & Developments in Investment Funds Law
There have been several significant developments in investment funds law over the past few years that have implications for fund management companies and their sponsors. These include the increasing regulation of fund marketing, non-resident investment funds, investment fund taxation and the Brexit negotiations.
Investment Funds Marketing
An increasing number of countries have put more regulatory focus on how funds and their sponsors market the investment opportunities offered by the funds. Canada, Australia, China, the US and the EU are all examples of jurisdictions that have introduced or increased regulations relating to fund marketing. The EU is perhaps the most advanced in rolling out regulation S-I, although Canada’s variation appears to be similar. Both capital raising or distribution and internal promotion (to existing shareholders) are actively being monitored by regulators.
Non-Resident Investment Funds
As countries become more transparent in their regulatory approach to non-resident investment funds, as in the above examples of the EU and Canada, an increasing number will want to regulate how non-resident investment funds solicit investment from domestic markets. Therefore, to the extent that a non-resident investment fund is looking to solicit investors through electronic, promotional or regulatory documentation in any jurisdiction , it would be wise to consult local investment fund advisers with respect to the technicalities of doing so.
Investment Fund Taxation
Recent tax negotiations between governments have made headline news, particularly the introduction of the OECD’s BEPS initiatives. With the increased emphasis on greater transparency with respect to taxation, we expect that it will be imperative for investment fund managers to be aware of how different investments are taxable in the jurisdictions in which they are made. This would involve determining the residency of the investment fund and how the resulting investments will impact the tax positions of the fund and its investors.
Brexit Negotiations
The physical movement of people, capital and goods across surrounding borders has always been a feature of human existence. The Brexit negotiations have sparked concern regarding a potential reduction in the movement of capital and labour between the UK and the EU. The duality of the UK and the EU’s future relationship could mean that we see more differences in the regulatory approaches and structures between the two territories. The precise impact on investment funds, however, has yet to be determined and will depend on the conclusion to the negotiations. This gives rise to uncertainty; however, the Brexit outcomes once agreed could potentially impact investment funds and their transactions.
Investment Funds Law Around the World
Investment Funds Law is not meant to apply in the same way all over the world. It is instead a patchwork of rules that only speaks to investors in some regions, if at all. In this section we examine some of the main jurisdictions.
United States
The SEC, the self-regulatory organizations (SROs), and the states all have some jurisdiction over the investment funds industry, although the extent of each varies. Usually, state laws only apply to advisers and broker-dealers that operate only regionally. They do not have any influence over investment companies. The SEC’s jurisdiction is dependent on the level of assets managed and the number and type of clients. The SROs enforce federal securities regulation.
European Union
Fund administrators must provide detailed information and report on changes that occur throughout the course of their business. There are a set of EU regulations that have been implemented to protect investors.
Asia
In Asia, the various regulations that exist for investment funds depend on the country and region. The varying factors that affect the industry include tax burden, access to capital markets, preventative tax treaties, as well as other regulatory frameworks. With such a high amount of liquidity available, Asia offers large amounts of growth for sponsors.
Pitfalls, Future Challenges of Investment Funds Law
Challenges and Trends in Investment Funds Law
The rapidly evolving financial markets and the globalization of the economy have posed significant challenges for regulators and other parties operating in the investment funds industry. The last two decades have witnessed unprecedented growth in the industry, now with trillions of dollars in net assets under management in the United States, according to the Investment Company Institute. Yet with this growth has come extraordinary pressure for regulators to ensure that sufficient safeguards are in place to protect investors – especially retail investors – from potential abuses. Regulators have had to make tough choices about whether and how to regulate in order to prevent systemic risk and protect investors, while at the same time promoting a vibrant, fair and efficient market in which to conduct capital formation activities. This balancing act is never easy, but over the next 5 to 10 years, we should expect to see several pertinent developments.
First, regulators are presently conducting an in-depth review of numerous rules and regulations governing investment advisers. In July 2015, the Securities and Exchange Commission approved the investment adviser general reporting and recordkeeping requirements, which were proposed in 2013 to create a single universal form for registered investment advisers. In November 2015, the Division of Investment Management of the SEC published a request for public comment on the use of derivatives by registered investment companies and business development companies. And in recent months, the SEC’s Office of Compliance Inspections and Examinations has hosted three national Risk Alerts highlighting compliance issues at investment advisory firms.
Second, market participants should expect to see increased regulatory initiatives tied to the Prohibitions Against Conflicted Transactions rule (Rule 206(4)-3 under the Investment Advisers Act). This rule prohibits advisers from receiving sales charges, redemption fees, 12b-1 fees or other fees from mutual funds (as opposed to the funds’ investors) or participating in sales of securities on behalf of issuers, if the firm has a conflict of interest in such transaction that is not addressed by a statutory exemption (namely , the standalone statutory exceptions for purchase orders routed directly to a fund’s distributor (and not the fund) or purchase orders that allow the fund to fulfill its obligations under any co-investment exemptive rule). Industry observers and legal pundits have long criticized the narrow scope of the exemptions as being ill-suited to the reality of how financial transactions are carried out in today’s markets. A Democratic majority in the House of Representatives, in artful language, recently urged the SEC to address these concerns by more robustly applying the "best interest" conduct standard applicable to broker-dealers under the so-called "fiduciary rule" to interaction between investment advisers and 12b-1 fees. This relatively flat rule, popularly known as the "Brokerage Rule," could have significant implications for investment funds. We also expect to see renewed efforts to align the fiduciary standards applicable to ERISA plans for qualified retirement funds with the Investment Advisers Act fiduciary duty rules as well as the fiduciary rules of state common law.
Third, regulators are expected to continue exploring changes to existing regulations that govern money market funds. Money market funds are typically considered low-risk vehicles because they seek to maintain a stable net asset value, rather than track an index or other benchmark. Nevertheless, the "breaking-a-dollar" fiasco in 2014 led to new amendments to money market fund rules. The amendments aimed at mitigating risk and stresses on money markets are being implemented in the hope of restoring investor confidence in money market PE funds and the continued growth in their use.
Lastly, we expect to see increased investment in FinTech innovations in the coming years. The UK and the EU in general have taken a lead in this area by establishing a multi-million Euro fund aimed at improving competition and innovation in the financial services sector. The GC and FCA in the UK are actively working with and advancing the use of new FinTech. It is widely believed that increased investment in FinTech will inure benefits to retail clients in the form of lower prices and lower minimum investment thresholds. Although the US agencies have not made similar strides in terms of co-operating with FinTech companies, we expect that to change. We believe that the US SEC’s newly-created analyst rating desk has the potential to provide some insight into what is happening in this space, as will the increasing involvement of investment banks in FinTech and big data operations that cater to retail clients. We expect these efforts have the potential to bridge both the supply and demand divide in the retirement fund industry.