The Organization and Operation of a Mutual Fund

The Investment Company Institute is the national association of the American mutual fund industry. The Institute has prepared this document to respond to requests from persons interested in entering the mutual fund business. The brochure summarizes a number of factors that should be considered carefully when deciding whether or not to organize a mutual fund.

This summary is not intended to be, and should not be used as, a guide for the creation of a mutual fund and compliance with federal and state laws and regulations. This summary provides an overview and is not a step-by-step manual. The Institute believes that it is not advisable to attempt to establish or operate a mutual fund without the assistance of experienced attorneys, accountants and other professionals.

Mutual funds are complex, vigorously regulated financial institutions that must comply with a large number of federal laws and regulations. In particular, mutual funds are regulated by the United States Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 (1940 Act). Mutual funds offering their shares to the public must register them pursuant to the Securities Act of 1933 (1933 Act) and provide notice filings to those states in which they intend to offer their shares. Those who sell fund shares to the public are subject to regulation as broker-dealers under the Securities Exchange Act of 1934 (1934 Act), while investment advisers to funds generally must register under the Investment Advisers Act of 1940 (Advisers Act). In addition, the Internal Revenue Code of 1986 grants pass-through tax treatment to mutual funds, but only if they follow certain operational requirements.

Setting up a mutual fund is a complicated and costly process. Preparing the federal registration statement, contracts, state filings and corporate documents typically costs $100,000 or more in legal fees. While state notice filing fees vary from state to state, total state fees for a fund that offers its shares in all jurisdictions may exceed $30,000. Printing and other costs often exceed $25,000. Unusual types of funds or funds with novel features can raise special issues that increase start-up costs. In addition, the 1940 Act requires that each new fund have assets of at least $100,000 before distributing its shares to the public; this is usually contributed by the adviser or sponsor in the form of an initial investment.

The ongoing operation of a mutual fund is also complicated and costly. In addition to management fees, funds regularly incur transfer agent, custodian, accounting and other business expenses, which must be accounted for daily. It is often estimated that in order to be viable economically, a mutual fund must reach assets of $50 to $100 million within a relatively short time.

Contents:

Background
Mutual funds provide an economical way by which an investor of modest means can obtain the same professional advice and diversification of investments as a wealthy individual or institution. A wealthy person can retain an investment adviser to select and manage his or her investments and, by investing in a number of different securities, can achieve diversification of risk. Mutual funds are designed to permit thousands of investors to pool their resources as shareholders in a fund that, in turn, invests in a large number of securities selected by a professional investment adviser. The shareholders of a mutual fund are its owners and are entitled to all of the fund's income and gain from its investments, net of fees and other operating expenses.

There are mutual funds designed for many different investment objectives, ranging from maximizing total return to providing the highest level of income consistent with the preservation of investors' principal. To achieve their objectives, funds invest in a wide variety of securities: some funds invest primarily in common stocks; some invest primarily in bonds issued by corporations or the federal government; some invest mainly in obligations of state and local governments; and some, known as money market funds, invest in short-term money market instruments like certificates of deposit, commercial paper and United States Treasury bills.

Mutual funds are organized under state laws as corporations or business trusts. However, mutual funds differ from other companies in a number of important respects. First, almost all mutual funds are externally managed; they do not have employees of their own, and all their operations are carried out by third parties such as investment managers, broker-dealers, and banks. Second, virtually all mutual funds continuously offer new shares to the public. Third, mutual funds are required by law to redeem (buy back) their outstanding shares at any time upon a shareholder's request, at a price based on the current value of the fund's assets. Fourth, federal laws impose detailed requirements on the structure and operations of mutual funds and impose special responsibilities on their independent directors or trustees. The following portions of this document discuss each of these matters.

Organization and Structure
Virtually all mutual funds are externally managed. They do not have employees of their own; instead, their operations are conducted by various affiliated organizations and by independent contractors. The following diagram depicts a typical mutual fund complex and its principal service providers.

The following discussion summarizes the functions performed by selected people and companies.

Directors/Trustees
The directors or trustees of a mutual fund, as in the case of other types of companies, have oversight responsibility for the management of the fund's business affairs. When established as a corporation, a mutual fund is governed by a board of directors, while a mutual fund established as a business trust is governed by a board of trustees. The duties of directors and trustees are essentially identical. Under state law, directors generally must perform their responsibilities with the care expected of a "prudent person" - i.e., they must exercise the care that a reasonably prudent person would take with his or her own business. They are expected to exercise sound business judgment, establish procedures and perform oversight and review functions, including evaluating the performance of the investment adviser, principal underwriter, and other parties that perform services for the fund. Directors also owe a duty of undivided loyalty to the fund.

Overlaying state law duties is the fundamental concept of the 1940 Act that independent fund directors serve as watchdogs for the shareholders' interests and provide a check on the adviser and other persons closely affiliated with the fund. The 1940 Act requires that a specified percentage of the fund's board of directors be persons who are entirely independent of the fund's investment adviser or principal underwriter. The 1940 Act rigorously defines independence through the concepts of "affiliated person" and "interested person" so as to ensure that the fund's affairs are supervised by independent directors who have no other business or family relationships with the fund's investment adviser, principal underwriter, officers or employees.

The 1940 Act and SEC rules give independent directors of a mutual fund special responsibilities with respect to a large number of matters, including initial approval and periodic renewal of investment advisory and distribution contracts. Specifically, the 1940 Act requires that these contracts be renewed annually after the first two years following initial approval. Both initially and when renewed, the contracts must be approved by a majority of a fund's independent directors. During the annual renewal process, directors typically request and review detailed information about the advisory and underwriting organizations and the quality of service they provide to the fund.

Shareholders
Like shareholders of other companies, mutual fund shareholders have certain voting rights. These voting rights are defined by the laws of the state in which the fund was formed, by the fund's own charter and by-laws, and by the 1940 Act. While most mutual funds no longer have annual shareholder meetings, there are situations in which state law or the 1940 Act requires funds to call special meetings. For example, the 1940 Act requires that directors be elected by shareholders at a meeting called for that purpose (with a limited exception for filling vacancies); changes in the terms of a fund's investment advisory contract must be approved by a shareholder vote; and funds that wish to change investment objectives or policies deemed "fundamental" must also obtain shareholder approval.

Under the 1940 Act, all shares issued by a mutual fund must be voting stock and have equal voting rights. The solicitation of proxies, the form and content of proxy statements and the treatment of shareholder proposals are governed by proxy rules adopted under the 1934 Act and the 1940 Act. Proxy materials are subject to prior review by the SEC unless they are limited to certain routine matters. The fund must take steps to insure that banks, brokers, and nominees having shares registered in their names forward copies of the proxy materials to the beneficial owners.

Investment Adviser
The investment adviser is responsible for selecting portfolio investments in accordance with the objectives and policies set forth in the fund's prospectus and statement of additional information. Investment advisers also place portfolio orders with broker-dealers and are responsible for obtaining the best overall execution of those orders.

The investment adviser performs these services pursuant to a written contract with the fund. Most advisory contracts provide for the adviser to receive an annual fee based on a percentage of the fund's average net assets during the year. A few contracts provide for performance-based fees, subject to fairness requirements specified by the Advisers Act.

The adviser is subject to many legal restrictions, especially regarding transactions between itself and the fund it advises and joint transactions with that fund. Under Section 36(a) of the 1940 Act, a legal action may be brought against a mutual fund adviser based on an alleged "breach of fiduciary duty involving personal misconduct." Section 36(b) of the 1940 Act provides that the investment adviser has a specific fiduciary duty with respect to compensation paid by the fund. The adviser also owes the fund a general fiduciary duty under the Advisers Act.

The 1940 Act provides for automatic termination of any advisory contract that is assigned, and deems transfer of control of the adviser to be an assignment of the contract. Reapproval of the contract requires a vote of fund shareholders.

Administrator
Administrative services may be provided to a fund by an affiliate of the fund, typically the investment adviser, or by an unaffiliated third party. Administrative services include overseeing the performance of other companies that provide services to the fund, as well as assuring that the fund's operations comply with applicable federal requirements. Fund administrators typically pay for office space, equipment, personnel, and facilities; provide general accounting services; and help establish and maintain compliance procedures and internal controls. Often, they also assume responsibility for preparing and filing SEC, tax, shareholder and other reports.

Principal Underwriter
Most mutual funds continuously offer new shares to the public at a price based on the current value of fund assets (plus, if applicable, a sales charge). Mutual funds typically distribute their shares through separate organizations, designated as the funds' principal underwriters.

Principal underwriters are regulated as broker-dealers by the SEC under the 1934 Act. Most are also members of the National Association of Securities Dealers, Inc. (NASD), and are subject to NASD rules governing mutual fund sales practices.

Custodian
The 1940 Act requires mutual funds to keep their portfolio securities in the custody of a qualified bank or otherwise protect them pursuant to SEC rules. Nearly all funds use bank custodians. The standard mutual fund bank custody agreement is far more elaborate and specific than the typical bank custody agreement for other clients. The SEC requires mutual fund custodians to protect the funds by segregating their portfolio securities from the rest of the bank's assets. Fund custodians must refuse to deliver cash or securities except for specified types of transactions or upon receipt of proper instructions from officers of the fund. The selection of custodians for foreign securities involves consideration of foreign laws governing access by accountants to the custodian's records, treatment of lost securities, and insolvency by the custodian, among other factors.

Transfer Agent
Fund transfer agents maintain records of shareholder accounts, which reflect daily investor purchases, redemptions, and account balances. Transfer agents typically serve as dividend disbursing agents, and their duties as such involve calculating dividends, authorizing payment by the custodian, and maintaining dividend payment records. They prepare and mail to shareholders periodic account statements, federal income tax information, and other shareholder notices. In many cases, transfer agents also prepare and mail on behalf of the fund and its principal underwriter statements confirming transactions and reflecting share balances. In addition, transfer agents maintain customer service departments that respond to telephone and mail inquiries concerning the status of shareholder accounts.

Distribution
Investors may purchase mutual fund shares from a variety of sources, including full-service brokers, discount brokers, banks, insurance companies, or the mutual fund companies themselves.

Fund shares are distributed to investors primarily in two ways. In some cases, funds distribute shares through a sales force, which may be employed by the fund's principal underwriter or by independent broker-dealers. The registered representatives of these broker-dealers actively solicit customer interest and typically provide investors with ongoing advice and information regarding their fund investments. In other cases, investors purchase shares directly from the fund or its underwriter, typically in response to newspaper or magazine advertising. These investors generally receive no advice regarding their investments.

Fund distributors incur costs related to advertising, distribution of prospectuses, compensation of sales personnel, and general overhead. Some distributors bear these costs out of their own assets. Others offset the costs by collecting a distribution fee from the fund or a sales load from the fund's investors. A sales load can take several different forms. A front-end load is one that investors pay when they purchase fund shares. A back-end load is charged when shares are redeemed and may be reduced progressively the longer the investor has held the shares. A fund may also expend a small portion of its assets to pay distribution expenses (commonly called a 12b-1 fee). Funds may employ these methods in combination, e.g., a small front-end sales load and an ongoing 12b-1 fee. NASD regulations govern the maximum amount of sales loads and 12b-1 fees.

Different groups of investors (e.g., individuals and various types of institutions) have different service needs and, accordingly, may require different fee structures. To accommodate these differences, mutual funds may offer different classes of shares or offer differently structured funds through a master/feeder structure.

Funds that offer multiple classes typically offer several retail classes, with different combinations of front- and back-end sales charges and 12b-1 fees. Other classes may be available to institutional investors, such as banks and trust companies, designed specifically to accommodate the needs of their individual beneficiaries. The different classes of shares represent ownership in the same portfolio of securities. IRS positions limit the size of the differences between the expenses paid by the different classes.

Under a master/feeder structure, several different funds are offered, each of which has a fee structure and other attributes appropriate to its particular market. Each of these "feeder" funds invests its assets in another mutual fund, termed the "master" fund. The master fund, in turn, invests those assets in the securities markets.

Mutual funds are subject to special advertising rules adopted by the SEC. Funds can run only two types of advertisements - "tombstone advertisements," which are permitted to contain limited information about the fund, and "omitting prospectuses," which may contain more information, including fund performance information. An advertisement cannot include an investment application or invite prospective investors to send money; it can only attract investor interest in requesting the full statutory prospectus, which may be accompanied by the application. Funds also are permitted to distribute more extensive sales literature, so long as it is accompanied or preceded by the full prospectus.

NASD rules require mutual fund distributors and dealers to file all advertising and sales literature for staff review. Through this process, a principal underwriter can get NASD assistance in assuring that sales literature complies with federal requirements and NASD guidelines. Moreover, the SEC does not require the filing of sales literature that has been cleared by the NASD.

Government Regulation
As noted, the mutual fund industry is highly regulated. It is primarily regulated by the SEC, which administers the federal securities laws. In addition to the 1940 Act, there are three other principal federal securities statutes that govern the organization and operation of a mutual fund complex: the Securities Act of 1933; the Securities Exchange Act of 1934; and the Investment Advisers Act of 1940. Funds are also subject to detailed regulation under the Internal Revenue Code of 1986. In addition, funds must comply with notice filing requirements and anti-fraud statutes in those states where they intend to offer their shares. Where a mutual fund is managed by or sold through a bank or other depository institution, its operations also may be affected by the statutes that govern those institutions. The following discussion outlines certain key provisions of these statutes that pertain to mutual funds; it is by no means a comprehensive review of applicable restrictions and requirements.

The Investment Company Act of 1940
The 1940 Act often is called the most complex SEC statute. Mutual fund activities are subject to a pervasive pattern of substantive regulation that goes far beyond the disclosure and anti-fraud provisions characteristic of most federal securities laws. This regulation imposes restrictions not only on mutual funds themselves, but also on their investment advisers, principal underwriters, directors, officers and employees.

Mutual funds belong to a class of investment companies defined in the 1940 Act as "management companies," which are further subclassified as either "diversified" or "nondiversified." A diversified company is one in which at least 75 percent of the value of its total assets is represented by cash and cash items (including receivables), government securities, securities of other investment companies, and other securities limited in respect of any one issuer to an amount not greater in value than 5 percent of the fund's total assets and not more than 10 percent of the outstanding voting securities of such issuer. (In order to qualify for favorable tax treatment, a mutual fund - whether or not classified as "diversified" under the 1940 Act - must meet additional diversification requirements under the Internal Revenue Code of 1986.)

Mutual funds are subclassified as "open-end" investment companies under the 1940 Act. The Act requires that open-end companies redeem their shares at any time upon shareholder request, and requires them to pay redeeming shareholders a price based on the net asset value of the fund's investment portfolio within seven days of receiving a request for redemption. ("Closed-end" investment companies, by contrast, do not redeem their shares. Shareholders who wish to dispose of their shares generally must sell them in the open market (shares of many closed-end funds are listed on the stock exchanges), at a price agreed on by the buyer and the seller.)

The 1940 Act restricts a mutual fund's investment in the securities of broker-dealers, insurance companies, and other investment companies. It also requires mutual funds to establish investment policies in certain areas, including lending, borrowing, industry concentration, investing in real estate, and investing in commodities. Through interpretations of the statutory restrictions on issuing senior securities and investing in broker-dealers, the SEC regulates the ability of mutual funds to use certain investment techniques, such as repurchase and reverse repurchase agreements, futures, options, and swaps.

Under the 1940 Act, certain fund policies may not be changed without a shareholder vote. Shareholder approval also is required to change the fund's subclassification as an open-end company, its subclassification as a diversified company or the nature of its business so as to cease to be an investment company.

The 1940 Act contains specific prohibitions against certain transactions between a fund and its principal underwriter, investment adviser or other affiliated persons. These provisions are designed to regulate strictly the potential for affiliates to profit unfairly from the operations of mutual funds. Thus, a mutual fund's principal underwriter, an affiliated person of a fund, or any affiliated persons of such person may not knowingly sell to or purchase from that fund any security or other property, nor may they borrow any money or other property from the fund.

The 1940 Act requires all funds to safeguard their assets by placing them in the hands of a custodian and by providing fidelity bonding of officers and employees of the fund; to be effective, such bonds also must cover employees of the adviser. The Act also requires daily valuation of the securities held in a mutual fund's portfolio.

Money market funds are subject to additional requirements regarding the maturity, diversification, and credit quality of their portfolio instruments. These requirements are designed to assure the stability of their net asset values.

The 1940 Act requires all mutual funds to maintain detailed books and records regarding both the securities owned by the fund and the fund's outstanding shares, and to file semiannual reports with the SEC and send semiannual reports to shareholders. The financial statements in a fund's annual report must be certified by independent accountants. In addition, independent accountants annually must furnish a report on the mutual fund's system of internal accounting controls.

The Securities Act of 1933
The 1933 Act requires the registration of all public offerings of securities, including shares sold by mutual funds. A registration statement is a comprehensive disclosure document that typically takes several months to prepare and be declared effective by the SEC. The 1933 Act requires that all prospective investors receive a current prospectus describing the fund, and that the fund provide upon request a document containing further details (known as a "Statement of Additional Information"). As discussed above, the 1933 Act also regulates the types of advertisements that mutual funds may use.

Mutual funds are subject to special SEC registration rules due to their unique practice of continuously offering new shares to the public. In order to facilitate the continuous offering of shares, the 1940 Act permits a mutual fund to maintain an "evergreen" prospectus (i.e., updated at regular intervals and whenever material changes occur) and register an indefinite number of shares. After the end of each fiscal year, mutual funds pay a registration fee to the SEC based on the shares actually sold. Mutual funds are permitted to net redemptions against sales when calculating their SEC registration fees.

The Securities Exchange Act of 1934
The 1934 Act regulates broker-dealers, including principal underwriters and others who sell mutual funds shares, and requires their registration with the SEC. All broker-dealers are required to join either a national securities exchange or the NASD, under a system of industry self-regulation unique to the brokerage industry.

The 1934 Act requires broker-dealers to meet financial responsibility requirements; to maintain extensive books and records reflecting their own financial position and customer transactions; to segregate customer securities in adequate custodial accounts; and to file detailed, annual financial reports with the SEC and their industry self-regulatory organization. In addition, all sales and research personnel must demonstrate their qualifications by passing an examination administered by the NASD. A mutual fund's principal underwriter is required to have a Registered Principal. This officer must take special qualification examinations administered by the NASD. (Various states have their own qualification and financial responsibility requirements for broker-dealers.)

As discussed above, the 1934 Act also regulates the solicitation of proxies in connection with meetings of fund shareholders.

The Investment Advisers Act of 1940
The Advisers Act requires the registration of all investment advisers to mutual funds (except banks). The Advisers Act imposes a general fiduciary duty on investment advisers and contains several broad antifraud provisions. It also requires advisers to meet recordkeeping, reporting, disclosure and other requirements.

The Internal Revenue Code of 1986
The Internal Revenue Code of 1986 generally provides mutual fund shareholders with favorable tax treatment comparable to that received by an investor holding securities directly. A mutual fund, which otherwise would be taxed as a corporation, can provide this comparable treatment if it (1) satisfies various tests, such as those relating to asset diversification and sources of income, for qualification as a "regulated investment company" or "RIC" and (2) meets certain income distribution requirements.

One important consequence of RIC status is that a mutual fund receives an income tax deduction, and is thereby relieved of entity-level tax, to the extent that it distributes substantially all of its income to its shareholders. The mutual fund shareholder reports on his or her tax return the dividends received from the fund.

Another important consequence of RIC status is that the "character" of the mutual fund's income often flows through to its shareholders. The types of income that retain their character when flowed through a mutual fund include long-term capital gains, which are paid out as a "capital gain dividend," and municipal bond income exempt from federal tax, which flows through a fund investing primarily in municipal obligations as an "exempt-interest dividend." In addition, all states have recognized that the character of federal obligation interest, which is exempt from state tax, can flow through a mutual fund to its shareholders.

State "Blue Sky" Laws
State registration of mutual fund shares is not required. A state in which a fund intends to sell its shares, however, may require a notice filing that typically involves filing a short notice form, a copy of certain documents filed with the SEC and a consent to service of process. In addition, mutual funds must pay a fee to each state in which they intend to offer their shares. Mutual funds must also comply with any state anti-fraud provisions. Once the notice filing requirements are satisfied, a mutual fund may sell its shares in a state.

Most states have adopted securities laws that require the registration of broker-dealers that offer securities in those states. In addition, investment advisers to mutual funds may be required to make a notice filing and pay a fee in states in which it does business.

Copyright © Investment Company Institute, June 1997

We hope that the foregoing information is useful to you. If you decide to establish and operate a mutual fund, the fund may join the Investment Company Institute after it has completed the full registration process under the 1940 Act. The Institute provides a broad range of services to mutual fund organizations in such areas as legislation, regulation, operations, public information, marketing, training and research.

The Institute sponsors a general meeting for the industry in Washington each May at which current marketing, administrative, regulatory, and investment issues affecting the mutual fund industry are discussed. The Institute also offers conferences on specific topics such as current regulatory developments, mutual fund tax and accounting issues, fund operations, pension issues, and international developments. Many of these conferences are open to prospective entrants into the mutual fund industry. Tapes and program books from the conferences may be purchased from the Institute. The Institute also provides a variety of training materials and programs relating to mutual funds for financial professionals.

Membership in the Institute is available to any mutual fund registered under the Investment Company Act of 1940. For information regarding membership, please contact: