Mutual Fund Basics

1
Mutual Fund Basics

• June 2007
• Todd Cipperman, Esq.
• Cipperman Company

2
The Players

• Sponsor organizes and promotes the Fund
  arranges service providers Investment
  Advisor/Manager manage the portfolio and invest
  the assets
• Investment Managers may retain Sub-Advisors
• Directors gt 50 independent
• Administrator accounting, NAV calculation
• May be affiliated with Advisor
• Distributor broker-dealer activities
• Custodian certain banks
• Transfer Agent keep shareholder records
• Auditors annual audit and opinion on financials
• Fund Counsel registration statement, filings,
  opinions, Board meetings, advice Chief Compliance
  Officer annual report to Board re compliance
  with securities laws

3
The Laws

• Investment Company Act of 1940
• Investment Advisers Act of 1940
• Internal Revenue Code, Subchapter M
• ERISA
• NASD Rules
• Securities Exchange Act of 1934
• SEC Interpretations, Statements, No-Action
  Letters, Enforcement Actions

4
The Paper

• Registration Statement
• Prospectus
• Statement of Additional Information
• Part C
• Shareholder Reports
• SEC Filings
• Agreements
• Investment Advisory
• Distribution
• Administration
• Custody
• Other
• Board Materials

5
Restrictions on Advisor

• Prospectus and SAI Disclosure
• Disclose investment objective and policies
• Certain policies may only be changed upon
  shareholder vote
• Advisory Contract
• Annual Board approval includes review of
  investment performance, compensation, brokerage,
  fund expenses
• Board of Directors
• Valuation of securities
• Approve distribution arrangements
• Approve service providers
• Private Rights of Action (Lawsuits)
• Adviser has fiduciary duty with respect to the
  amount of compensation received
• Affiliated Transactions
• Transactions between affiliated funds
• Joint transactions
• Affiliated brokerage
• Investment Restrictions
• Disclosure
• Fund-of-funds
• Diversified/Non-Diversified (e.g. no more than 5
  in one security)

6
Advisory Contract

• Approval by shareholders
• Includes material amendments
• Annual approval by Board
• In-Person meeting of independent directors
• Termination in the event of assignment or on 60
  days notice
• Services
• Invest pursuant to Prospectus SAI
• Place orders
• Vote proxies
• Report to Board
• Back office work
• Fees based on AUM
• Limits on performance fees
• Breakpoints

7
Sub-Advisory Contracts

• Approval by shareholders required
• Allocation of responsibilities
• Records retention
• Fees paid by Advisor or Fund
• Manager-of-Managers structures
• Exemptive relief to appoint sub-advisers

8
Board Role in Reviewing Advisory Contract (15(c))

• 36(b) fiduciary duty on adviser not to receive
  excessive compensation
• Includes private rights of action
• Gartenberg standard arms length
• Nature and quality of services
• Comparable fees and expenses
• Advisor profitability
• Economies of scale
• Fall-out benefits (e.g. soft-dollars)
• Shareholder reports require discussion of Board
  review
• 15(c) report prepared by Advisor description of
  business and personnel, compensation and
  performance, compliance, brokerage

9
Investment Restrictions Prospectus/SAI

• Fund Name 80 test (e.g. country, region)
• Investment objective
• Concentration policies
• Fundamental Investment policies require
  shareholder vote to change
• Diversified vs. Non-diversified
• 75 of assets no investment gt 5
• IRC no more than 25 in any one issuer
• Shareholder vote to become Non-diversified
• 1940 Act
• Other funds 3/5/10 Rule
• Insurance Companies
• Securities-related businesses
• Illiquid securities

10
Trading

• No purchases if an affiliate is a member of an
  underwriting syndicate (n.b. Rule 10f-3)
• Effecting trades through affiliated brokers (n.b.
  Rule 17e-1)
• Restrictions on agency cross trades (Advisers
  Act, ERISA

11
Custody

• Qualified Bank
• Foreign Custody
• Foreign Sub-Custodian
• Qualified Foreign Banks
• Financial strength
• Ability to enforce judgments and protect assets
• No exchange controls
• Access to auditors
• Eligible Securities Depository
• Board approval and reporting
• Custody at Futures Commission Merchant for
  exchange-traded futures contracts and commodity
  options
• Segregation of assets
• Sweeping of gains

12
Proxy Voting

• Must disclose proxy voting policies and
  procedures in Registration Statement
• Conflicts between shareholders and adviser
• Fund must file proxy voting record
• Allocate proxy voting responsibility between
  adviser and sub-adviser (and third party)
• Advisers Act requires proxy voting in the best
  interest of clients and procedures for resolving
  conflicts of interest
• ERISA requirements

13
Conflicts of Interest

• Affiliate investment adviser, officers,
  directors, partners, etc. (n.b. complex
  definition)
• An Affiliate may not
• Sell any security to the Fund
• Purchase any security from the Fund
• Borrow money from the Fund
• Exception for exchange-traded securities at the
  current market price (Rule 17a-7)
• E.g. seeding of GOBF fund
• An affiliate may not engage in a joint enterprise
  with a fund (e.g. securities purchases, kickbacks
  from service providers, trade allocation)
• An affiliate may not act as agent for
  compensation in a transaction with the Fund (e.g.
  broker)
• Rule 17e-1 permissible affiliated brokerage

14
Personal Trading

• No fraudulent, manipulative, deceptive practices
  in connection with purchase/sale of securities by
  related persons
• Includes securities held by the fund during the
  last 15 days or had been considered for purchase
  during the last 15 days
• Excludes Treasuries, Short-term instruments,
  Mutual Funds
• Fund and Adviser must adopt a Code of Ethics
• Approved by Board
• Periodic reporting of violations
• Advisers Act (More restrictive Code of Ethics)
• Form ADV disclosure
• Broader holdings reports

15
Code of Ethics

• Reports by Access Persons
• Holdings and Transaction reports
• Must be reviewed by management or compliance
• Access Person any director, officer, general
  partner of adviser who, with respect to any Fund,
  makes any recommendation, participates in the
  determination of which recommendation will be
  made, or whose principal function or duties
  relate to the determination of which
  recommendation will be made, or who, in
  connection with his or her duties, obtains any
  information concerning recommendations made by
  the investment adviser to any Fund
• Pre-approval of participation by investment
  personnel in IPOs and private placements
• Recordkeeping Code, violations, certifications,
  access persons, holdings reports
• Disclosure about personal trading policies in
  prospectus
• Filing of Code of Ethics w/ SEC

16
Marketing Mutual Funds

• Does the material reference the Fund?
• Anti-fraud (Rule 156 and 10b-5)
• Is the material accompanied or preceded by the
  Prospectus?
• Exceptions
• Generic advertisement no reference to a specific
  fund (e.g. magazine ads)
• Rule 482
• Rules apply equally to internet advertising
• Effect on marketing to non-US jurisdictions
• UK directed communications, reasonable
  precautions

17
Rule 482 Materials

• Specific disclosures (e.g. obtaining and reading
  prospectus)
• Standardized presentation and calculation of
  performance information
• Formulas for average annual total return
• Must present 1, 5 and 10 year performance
• Current to the most recent calendar quarter
• Disclosures about past performance, risk, loads

18
Other Marketing Rules

• Add disclosure about qualifications and
  limitations on past performance presentation
• Conveying an unjustified impression
• Caution with respect to future investment
  performance without adequate qualification
• Balance benefits of fund structure/attributes
  with risks (e.g. high yield bonds, emerging
  markets, IPOs)
• Exaggerated claims about manager skill or process
• Misleading comparisons to other funds or indexes
• Testimonials

19
Related Account Performance

• Permissible in marketing material if
• Disclosure that it is not funds performance
• Cannot omit funds performance
• Explanation of purpose of related performance
• Disclosure of material differences
• NASD members cannot use sales literature that
  includes related account information
• Note Portfolio Holdings Policy and disclosure

20
NASD Regulation of Marketing

• Observe principles of fair dealing and good
  faith communications must be balanced
• No false or exaggerated claims
• No predicting future results
• Limits on testimonials
• Fair presentation of comparisons
• Specific ranking guidelines
• Principal must approve sales material
• Must file marketing materials within 10 days of
  first use
• Often file before use to avoid re-printing
• Pre-filing and approval if certain rankings or
  bond fund volatility ratings included

21
Recordkeeping

• Financial records, shareholder account ledgers,
  agreements, board meeting minutes, brokerage
  reports
• All records must be maintained in easily
  accessible place (aka on-site) for 2 years
• Certain records must be maintained indefinitely
  journal entries and ledgers, portfolio histories,
  corporate documents, minute books
• Other records must be maintained for 6 years
• Electronic storage permissible
• SEC access upon request
• Third party service providers may hold records
• Advisers Act requirements (generally 5 years)

22
Compliance

• Fund must adopt and implement policies and
  procedures reasonably designed to prevent
  violations of the securities laws
• Portfolio management, trading, disclosures,
  recordkeeping, valuation, privacy, market timing
• Oversight of Fund service providers
• Board approval of written policies and procedures
• Consider recent compliance experience
• Best practices
• Annual review of adequacy and effectiveness
• Includes testing
• Consider changes in business, regulations,
  compliance
• Presentation to Board
• Designate responsible Chief Compliance Officer
  (competent, senior, independent)
• Record-keeping

23
Summary

• Mutual Funds are highly regulated
• Consult your Legal or Compliance Professional

24
Todd Cipperman, esquire
Todd Cipperman is the principal of Cipperman
Company, which provides legal services to
investment managers, investment advisers,
broker-dealers, mutual funds, hedge funds, and
technology providers. Cipperman Company
provides a wide range of services for the
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
and financial services industries. As a
principal of Cipperman Company, he has
represented a wide range of investment management
clients with a focus on distribution issues
facing advisers and broker-dealers. He
previously served as general counsel of a public
mutual fund and financial technology firm,
including its 65 Billion proprietary mutual
fund family. He has also served as general
counsel of one of the largest international
equity managers. He spent several years in
private practice on Wall Street representing both
buy and sell side clients in investment
management and capital markets transactions. He
is a graduate of the University of Pennsylvania
Law School and Cornell University.
1905 General Alexander Drive Malvern, PA
19355 610.648.9449 tcipperman_at_cipperman.com www.c
ipperman.com