Reshaping the American financial system - Mutual Funds, part 1

New England Economic Review, July-August, 1997 by Peter Fortune

While many statutory and regulatory rules are "technical" in nature, dealing with accounting, auditing, reporting, and other aspects of the fund's activities, some are particularly noteworthy because they shape the fund's portfolio and liquidity decisions. Section 17(a) of the 1940 Act restricts transactions between an "affiliated person of a registered investment company" and that investment company. Section 17(a)(1) prohibits sales of securities by the affiliated person to the investment company, Section 17(a)(2) prohibits an affiliated person from buying securities from the investment company, and Section 17(a)(3) prohibits lending by an affiliated person to the investment company. Because each mutual fund within a family is an affiliated person of the registered investment company, this prohibits intrafamily lending of cash or securities as well as intrafamily security trades. However, under Section 17(b) the SEC can grant an exemptive order if certain conditions of fairness are met, and it has done so for both intrafamily lending and intrafamily security transactions, making each subject to limitations ensuring the protection of mutual fund shareholders. As noted above, few families have requested the exemption from the intrafamily lending prohibition; the exemption from security transactions is more widespread.

Section 18 of the 1940 Act addresses a mutual fund's capital structure. Its primary intent is to limit the ability of a mutual fund to take on leverage. Section 18(f)(1) of the 1940 Act prohibits open-end funds from issuing senior securities, allowing funds to borrow only from banks and limiting bank loans to no more than 33 1/3 percent of the fund's total assets. There is no requirement that bank loans be collateralized, and loan agreements with banks are typically unsecured. If collateral is required it is typically less than the 3:1 asset coverage ratio specified in the 1940 Act.(12) If the fund's assets fall below three times the outstanding loans, the loans are immediately payable because they violate the 1940 Act's debt limit.

Section 18(g) defines a senior security as "any bond, debenture, note, or similar obligation constituting a security and evidencing indebtedness, and any stock of a class having priority over any other class in the distribution of assets or payment of dividends." Several common transactions are considered senior securities: Repurchase agreements, option writing, short futures positions, lending securities for short-selling by broker-dealer clients, and short sales are examples. In spite of the 1940 Act's Section 18(f)(1) restriction, the SEC has released interpretations allowing these transactions under certain circumstances: They must be explicitly allowed in the prospectus, they must be subject to the 300 percent asset coverage required for bank loans, and the fund must hold in a segregated account securities no less than equal in value to the liability created, marked to market daily.

As noted above, Section 22 of the 1940 Act covers redemption and repurchase of shares. Redemptions can be either in cash or in kind, with in-kind redemptions treated as a sale of securities under Section 22(d). Section 22(e) requires that redemption payments be made within seven days of the request. In-kind redemptions are subject to two important limitations. First, a fund must make cash redemptions to any shareholder redeeming 5 percent or more of outstanding shares.(13) Second, many funds have used SEC Rule 18f-1 to waive the right to make in-kind redemptions if the shareholder redeems less than $250,000 or 1 percent of net assets in any 90-day period. Thus, in-kind redemptions are not a significant alternative for shareholders with small to moderate or with very large holdings.