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Statutory and Regulatory Responsibilities of Fund Boards Under the Investment Company Act of 1940

This section provides a brief overview of the legal responsibilities commonly encountered by fund directors under the 1940 Act and its rules. Because this overview is expansive, it may highlight rules or requirements that are not applicable to every board.

Fund Governance

To comply with Rule 0-1(a)(7), a fund’s board or its independent directors must:

  • Determine the independence of any counsel for the independent directors;
  • Conduct an annual self-assessment of board performance;
  • Be authorized to hire employees and to retain advisers and experts necessary to carry out their duties;
  • Meet at least once quarterly in executive session; and
  • Select and nominate other independent directors.

Fair Valuation of Portfolio Securities

Section 2(a)(41) and Rule 2a-4 assign to boards the responsibility for valuing portfolio securities.

  • Securities with an ascertainable market value are priced using the market value.
  • Other securities must be valued “as determined in good faith by the board of directors.”
  • Directors may delegate the pricing of portfolio securities to a fund’s investment adviser so long as that delegation is overseen by the board in a prudent and conscientious manner.

Money Market Funds

In 2013, the SEC proposed amendments which would impose additional responsibilities on money market fund boards. To date, the SEC has not taken action on these proposals.

To comply with Rule 2a-7, the board of a money market fund must do the following things.

  • Find that it is in the best interests of the fund and its shareholders to maintain a stable NAV per share or stable price per share.
  • If the fund uses the amortized cost method of valuation:
    • Determine that the Amortized Cost Method fairly reflects the funds’ market-based net asset value per share (“shadow price”);
    • Establish and periodically review procedures designed to stabilize the fund’s NAV at $1.00;
    • Establish and periodically review procedures for calculating the fund’s shadow price at appropriate intervals (in light of market conditions) and reviewing the deviation between the shadow price and the fund’s amortized cost NAV;
    • If the deviation exceeds ½ of 1 percent, promptly consider what action, if any, should be initiated by the board; and
    • If the board believes the extent of the deviation could result in material dilution or other unfair results to investors, determine what action is appropriate to eliminate or reduce the deviation (this could include suspending redemptions and liquidating the fund).
  • If the fund uses the penny-rounding method of valuation, assure that the fund’s price per share will not deviate from the single price established by the board.
  • Adopt procedures that provide for periodic stress testing of the fund’s ability to maintain a stable NAV based on hypothetical events. The board must review reports on the results of the stress testing.
  • Determine whether it is in the interest of the fund not to dispose of a security that no longer presents minimal credit risk or that is no longer an eligible security.
  • Adopt procedures requiring periodic review of whether certain floating and variable rate securities can be expected to have a market value that approximates their amortized cost.
  • Delegate to the fund’s adviser or officers, subject to written guidelines and procedures and continued oversight by the board, responsibility for:
    • Determining that securities acquired and held by the fund present minimal credit risks and, if the security is subject to a conditional demand feature, the risk that the demand feature will terminate is minimal;
    • Determining whether unrated securities are of comparable quality to first- or second-tier securities;
    • Reassessing a security’s credit quality or disposing of the security after it is downgraded;
    • Determining whether any other money market fund in which the fund invests meets diversification requirements;
    • Evaluating the creditworthiness of the seller of a repurchase agreement;
    • Determining that the fund should not rely on a demand feature or guarantee;
    • Determining that it would not be in the fund’s interest to exercise demand features that have been downgraded to second tier; and
    • Determining whether asset-backed securities have any 10 percent obligors.
  • Adopt and periodically review Rule 38a-1 procedures for compliance with Rule 2a-7’s conditions:
    • Limiting investments to U.S. dollar-denominated securities;
    • Limiting the fund’s dollar-weighted average maturity (determine with and without regard for interest rate adjustments);
    • Limiting investment to eligible securities;
    • Requiring diversification of issuers and the providers of demand features and guarantees; and
    • Requiring the fund to maintain sufficient liquid assets to meet anticipated redemptions (including procedures to assess anticipated redemptions of certain shareholders) and satisfy other liquid asset standards.

Subclassification of Funds

Rule 5b-3 allows an investment company to “look through” repurchase agreements and pre-refunded bonds to the underlying collateral to determine the issuer in connection with the diversification criteria of Section5(b)(1). Under the rule, the board (or its delegate) must evaluate the creditworthiness of the repurchase agreement counterparty.

Exemptions

Under Rule 6c-6, for purposes of maintaining an exemption under Section 6 for certain separate accounts, the board must determine that a transfer of securities from an existing portfolio to a new portfolio is fair and reasonable to all shareholders.

Under Rule 6e-3T, directors of an insurance-dedicated fund that sells its shares to both variable life separate accounts and variable annuity separate accounts must monitor for material irreconcilable conflicts between the interests in the two types of contract owners and determine what action, if any, should be taken in the event of a conflict.

Directors, particularly independent directors, also often have significant responsibilities under any exemptive orders a fund may have received from the SEC.

Affiliate Transactions

Rule 10f-1 requires that in the case of a purchase by a fund acting as an underwriter of an issuer that is not an investment company, the board must approve the underwriting agreement.

Rule 10f-3 requires that the board: (i) approve procedures reasonably designed to provide that purchases of securities otherwise prohibited by Section 10(f) comply with the rule’s conditions; (ii) approve changes to the procedures as necessary; and (iii) determine at least quarterly that the purchases complied with the procedures.

Distribution Plans

Rule 12b-1 requires the board to approve and monitor distribution-related fee payments under a 12b-1 plan, including revenue-sharing arrangements. This includes a quarterly review of the amounts expended under the plan and the purposes for which such expenditures were made. The board also must reevaluate and reapprove distribution agreements annually.

The board must approve policies and procedures to prevent: (i) persons selecting executing broker-dealers from taking into account the broker-dealers’ distribution efforts on behalf of the fund; and (ii) any directed brokerage agreement.

Investment Advisory Arrangements

Sections 15(a), 15(c), and Section 36(b) require that a majority of the board’s independent directors approve a fund’s advisory contracts (including subadvisory contracts), and that the board (or shareholders) annually approve any advisory contract that continues more than two years. Directors also must request and evaluate information reasonably necessary for them to evaluate the terms of an advisory contract and advisers must furnish this information.

The board must review and approve disclosure describing the factors that it considered in evaluating the advisory contracts.

Section 15(c) requires the board to review principal underwriting contracts, including fees. The board must review and approve multiyear contracts annually (also can be done with a majority shareholder vote).

Rule 15a-4 requires board approval for an interim advisory contract after termination of the previous contract through assignment or nonrenewal.

Independent Director Vacancies

Section 16(b) requires independent directors to select and nominate individuals to fill independent director vacancies that occur in connection with compliance with Section 15(f)(1)(A).

Affiliated Transactions

Section 17 requires independent directors to oversee certain securities transactions involving affiliates to the extent they are permitted by the rules.

Rule 17a-6 allows a fund to engage in certain transactions with portfolio affiliates, including those in which the board, including a majority of the independent directors, has determined that the interests of certain persons are not material. The board must record the basis for its findings in the minutes of its meeting.

Rule 17a-7 allows certain affiliated transactions if the board: (i) adopts procedures by which transactions may be effected in compliance with this rule; (ii) makes and approves changes to the procedures as necessary; and (iii) determines at least quarterly that the purchases or sales made during the preceding quarter were effected in compliance with the procedures.

Rule 17a-8 requires that directors evaluate and approve potential mergers.

Rule 17d-1 requires that directors make annual determinations concerning joint liability insurance.

Rule 17e-1 requires that directors adopt procedures concerning the commissions paid to affiliated brokers and determine at least quarterly that all transactions effected with affiliated brokers were done so in compliance with the procedures.

Rules 17f-1, 17f-4, 17f-5, and 17f-7 require that directors annually review custody contracts and oversee custody arrangements with specific obligations with respect to self-custody, affiliated custody, or foreign custody.

Rule 17g-1 requires that directors review and approve fidelity bonds and the allocation of the premium for a joint bond.

Rule 17j-1 requires that directors approve the fund’s code of ethics and receive and review annual reports of any significant violations of the code.

Multiclass Arrangements

Rule 18f-3 requires directors to evaluate any plan proposed under this rule to ensure fairness to all shareholders and the fund as a whole.

Distribution, Redemption, and Repurchase of Securities

Rule 22c-1 requires the board to determine when NAV is calculated.

Rule 22c-2 requires the board to decide whether to impose a redemption fee.

Rule 23c-3 requires the board to make various determinations with respect to the repurchase of interval fund shares.

Selection of Accountants

Section 32(a)(1) requires a majority of the independent directors select the fund’s independent public accountants.

Rule 32a-1 allows an exemption from the requirement that a majority of the independent directors select the fund’s independent public accountants, so long as the fund meets certain conditions and the accountants are selected by a majority of all of the members of the board.

Rule 32a-4 allows an exemption from the requirement that the fund’s selection of an independent accountant be subject to a shareholder vote, if the board establishes a committee of independent directors to oversee the fund’s accounting and auditing processes and has adopted a charter setting forth the audit committee’s structure, duties, powers, and methods of operation.

The board must also review the accountant’s annual written report to the audit committee.

Compliance

Rule 38a-1 requires the board to:

  • Approve the policies and procedures of the fund and each of its principal service providers. The approval must be based on a board finding that the policies and procedures are reasonably designed to prevent securities law violations by the fund and its service providers—boards typically receive this certification from the fund’s CCO before approving the policies and procedures;
  • Approve the designation and compensation of a CCO and the removal of the CCO;
  • Review the Annual Report provided by the CCO addressing compliance policies and procedures and material compliance matters; and
  • Have an executive session of only the independent directors to meet with the CCO at least once per year.

Directors either must adopt policies and procedures with respect to frequent purchases and redemptions by shareholders, or the fund must include a statement of the specific basis for the view of the board as to why it is not appropriate to have such policies and procedures.

Disclosure

Directors have a statutory responsibility for the accuracy of registration statements and should engage in reasonable investigation to ensure that fund management followed procedures to ensure registration statement accuracy.

Directors must provide necessary information to fund management to allow accurate registration statements, proxy statements, and other disclosures concerning directors and to determine on a continuous basis a director’s status as an independent director or interested person.

Directors must determine whether any member of the audit committee qualifies as an audit committee financial expert.

Special Types of Investment Practices

The board must make certain determinations when the fund engages in repurchase agreements and reverse repurchase agreements, forward commitments and similar arrangements, and options, futures, and other derivative transactions.

The board must make determinations of credit quality with respect to investments in debt securities of issuers deriving more than 15 percent of their revenues from securities-related activities.

The fund must adopt certain policies and procedures with respect to investments in money market funds permitted by Rule 12d1-1.

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