Basics of Investment Companies

An investment company is an issuer of securities that:

• Holds itself out as being engaged in the business of investment, reinvesting, or trading securities,
• Is engaged in the business of issuing face-amount certificates of the installment type (FACCs), or
• Owns or proposes to acquire investment securities having a value exceeding 40% of its total assets (exclusive of government securities and cash items), on an unconsolidated basis.

Excluded would be government securities, securities issued by employee’s securities companies, and securities issued by majority owned subsidiaries of the owner which are not investment companies, and are not relying on one of the two private fund exceptions from the definition of investment company (a fund with no more than 100 owners, or one owned only by qualified purchasers, that makes no public offering).

Depending on how we want to break them down, there are either 3 or 4 different types of investment companies. The most basic 3, are FACCs, unit investment trusts (UITs), and management companies. Management companies are split into open-end management companies and closed-end management companies. That would therefore be how we could break them into 4 types of investment companies: FACCs, UITs, open-end management companies, and closed-end management companies.

An open-end company is a management company that offers redeemable securities for sale. Most often called mutual funds, the fund itself is the only party that redeems shares from investors and the only party that issues new shares to investors. As the issuer is involved in every sale, all sales of open-end company stock are primary offerings and require a prospectus. Open-end mutual funds are the most common security sold by series 6 representatives. Open-end companies may not issue senior securities such as preferred stock or bonds under Section 18(f) of the Investment Company Act of 1940; they issue only redeemable common stock, which may be offered in multiple share classes. We will go into more detail into open-end companies in the next section.

A closed-end company is a management company that offers a fixed number of shares that are sold on exchanges or OTC. Once issued in the primary offering the shares will trade on exchanges. A series 6 registration covers the initial public offering of closed-end shares, while secondary-market trading of those shares requires a series 7 or similar registration. Closed-end companies most often issue common stock, but could issue senior securities such as preferred stocks and bonds. We go a bit more into closed-end funds in the next section.

A Unit investment trust (UIT), is a fixed portfolio of redeemable securities for a finite time. These units of the portfolio, represent equal ownership in all securities in the portfolio. UITs do not have a board of directors as other investment companies do, they have managers that are basically responsible for taking in any dividends or income and sending them out to the unit owners. The managers make no investment decisions and no changes to the portfolio. The portfolio is fixed, unchanging for the life of the UIT. All UITs, when created, have a fixed life time, and at the end are liquidated and send to the unit holders.

Example: Why a bond UIT has a fixed life

A UIT raises money from investors and buys a fixed portfolio of 30-year bonds. The trust never trades those bonds: it collects their interest and passes it through to the unit holders. When the bonds mature 30 years later, the trust collects the principal, pays it out to the unit holders, and terminates.

A Face amount certificate company (FACC) is an investment company that doesn’t really exist anymore. They were popular in the 40s as an alternative to banks when people were concerned about the banking system. They issue debt securities that are backed by some security interest. They work similar in nature to mortgage bond financing.

Municipal fund security is based in MSRB Rule D-12 and is defined as a municipal security, that really looks like an investment company, but being a municipal security is specifically excluded from being an investment company. The most common example would be 529 plans. These are not investment companies, by legal definition, but can easily be confused for them.

A real estate investment trust (REIT) is another pooled investment that is generally not an investment company: the Investment Company Act of 1940 excludes a company whose main business is acquiring real estate or mortgages.

Registration of investment companies

All investment companies must register with the SEC under the Investment Company Act of 1940, and the registration statement has to disclose the fund’s policies. Most of them are fundamental policies: once stated, the fund can’t change them without a vote of a majority of its outstanding shares. The registration statement includes:

• The fund’s policy on each of these activities:
  • its classification and subclassification (for example, open-end or closed-end, diversified or non-diversified)
  • borrowing money
  • issuing senior securities
  • underwriting securities issued by others
  • concentrating its investments in a particular industry
  • buying or selling real estate or commodities
  • making loans to other persons
  • portfolio turnover (the one item on this list a fund can change without a shareholder vote)
• Any other investment policies that can be changed only by a vote of the shares, and any other policies the fund treats as fundamental.
• The name and address of each affiliated person, every other company in which each of them is an officer, director, or partner, and a brief statement of each officer’s and director’s business experience for the preceding 5 years.
• The information and documents the fund would have to file to register its securities under the Securities Act of 1933 and the Securities Exchange Act of 1934.

The names of any investment company must either be non-descript of the investment policy, or if it implies a policy that investment company must follow that strategy at least 80% of its investments. If a fund is called the “ABC Growth Fund”, that is implying growth, and therefore at least 80% of its investments must be in growth investments. A name like “DEF Achievable Fund” suggests no particular investment focus, so it triggers no 80% requirement, and only the fund’s stated objectives tell you its strategy.