The Investment Company Act | Objectives of the Act | Regulation Reviewed

To look at Wall Street history, it must be observed that when Wall Street and Washington cooperate it is news indeed. It may be long before another industry so heartily endorses a regulatory measure and before both houses of Congress pass a similar proposal without a single negative vote. The Investment Company Act of 1940 was approved August 22 and became effective on November 1 of that year. Its terms and provisions were worked out in conference between representatives of the industry and the Securities and Exchange Commission after the commission had completed an exhaustive study and investiga­tion of investment companies.

Three statements concerning the act are worth recording: William Cole, Chairman of the House of Representatives Committee on Interstate and Foreign Commerce declared:

"The bill as drafted has the unqualified support and en­dorsement of practically the entire investment company industry and of the Securities and Exchange Commission, the body by whom the provisions of the bill are to be administered. No opposition to the bill was expressed by any witness who appeared before the subcommittee of this committee which held hearings on the bill. Every wit­ness representing the industry who appeared unqualifiedly endorsed the bill.

"The bill is a highly salutary indication that Government and business can come together in a cooperative spirit to do a constructive job."

On completion of his testimony, the late Judge Robert E. Healy stated for the Securities and Exchange Commission:

"I would like to add deliberately a further word of opti­mism as to the possible future of the investment trusts. I think it is rather fortunate perhaps that the investment trust industry encountered its difficulties and a govern­mental study comparatively early in its history, before bad practices and abuses and evils had gotten so completely frozen in that they could not be rooted out or where the leaders of the industry would not be willing to do what they have done here, and that is, sit down with the Govern­ment representatives and recognize those evils and try to get rid of them.

"It leads me to hope, and it leads me to express the belief I have that under this regulation and under the kind of sensible and honest management I believe we are going to have for these trusts, that they will have a very fine future, a very promising future, one rendering useful service to the small investor. I believe they can make a definite and very useful contribution to our economy and national welfare."

Finally, Arthur H. Bunker, executive vice-president of The Lehman Corporation, declared in wall street history:

"We feel that it is a very healthy sign that the Govern­ment and industry can come together and do a constructive job of this character.

"With this legislation the confidence of the public in in­vestment companies will, we believe, be restored, and these companies will be able to serve not only the investor but also the important function of supplying new capital to those industries vital to the national defense.

"In closing, may I just add a word of appreciation of the splendid cooperation which our group has received from the Securities and Exchange Commission? I think it is a real achievement, which both we and the Commission can feel proud of, that we have been able to cooperate so effec­tively and work in such close harmony in the development of these proposals for legislation."

THE INVESTMENT COMPANY ACT

The key to the provisions of the Investment Company Act that played such a large part of wall street history was the experience of the industry. As the Commission put it, the problems of invest­ment companies flow from the very nature of their assets, which consist of cash and securities, i.e. assets which are usually liquid and readily negotiable. Because of these characteristics, control of the funds offers manifold opportunities for exploita­tion by an unscrupulous management. The Commission might have added that the conception of management-stockholder relations also had changed in the interim and that practices which fell short of being scrupulous were now frowned upon, if not universally, at least by many in the industry, who felt the need of legislation to impose the new concepts on the indus­try at large. The provisions of the Investment Company Act may be divided into two broad categories:

1. Informational requirements, in which the act carries for­ward the doctrine of full disclosure contained in the Securities Act of 1933.



2. Positive requirements and prohibitions, in which the act regulates the practices and activities of companies in the man­ner of the Public Utility Holding Company Act.

In reviewing this aspect of wall street history, one might offer this bird's-eye view of the act: investment companies are required to register with the Securities and Ex­change Commission, and they are regulated by the act. Invest­ment companies are defined as companies engaged primarily in the business of investing, reinvesting, and trading in securi­ties. This excludes companies, which may own securities but are mainly engaged in operating businesses other than investment companies. Also excluded are brokers, underwriters, banks, in­surance companies, small loan companies, factors, and the like.

To afford investors full and complete information with re­spect to investment company activities, the act requires disclosure of their finances and investment policies. Such com­panies are forbidden to change the nature of their business or their investment policies without the approval of stockholders. Management contracts must be submitted to security holders in advance for their approval. Persons guilty of security frauds are barred from serving as officers and directors of investment com­panies. No more than a minority of the directors of such com­panies may be underwriters, investment bankers, and brokers. Transactions between investment companies and their officers, directors, and other insiders are prohibited except on the ap­proval of the Commission. Except in specific instances and under safeguards, the issuance of senior securities is prohibited. Pyramiding of such companies and cross-ownership of their securities also are prohibited.

The Commission is authorized to prepare advisory reports on plans of reorganization of registered investment companies upon their request or the request of 25 per cent of their stock­holders and to institute proceedings to enjoin such plans if they are grossly unfair. The act also requires that face-amount-certificate companies maintain reserves adequate to meet ma­turity payments upon their certificates.

OBJECTIVES OF THE ACT

The objectives of the act are:

Honest and unbiased management

1. Greater participation in management by security holders
2. Adequate and feasible capital structures
3. Full disclosure and sound principles relating to financial statements and accounting
4. Elimination of abuses in selling practices

The objectives of the act in the main are achieved by affirma­tive requirements or prohibitions. In other words, the industry is told: "This you must do," or "This you may not do."

1. Honest and Unbiased Investment Management

The Investment Company Act, doing something of paramount importance to wall street history, provided for a degree of inde­pendence in management personnel by restricting investment bankers, brokers, commercial bankers, principal underwriters, etc., who may have a possible bias in the management of an investment company, to a minority of the board of directors. It also requires a majority of the board to be independent of the officers of the company. All this is directed toward avoiding the temptations for self-dealing.

The act limits the extent to which persons affiliated with management may become directors. In the event that neither the management organization nor an affiliate thereof serves as prin­cipal underwriter for the fund, six out of ten board members of a fund may be affiliated persons. This drops to four out of ten if the management and the principal underwriter are the same, or are affiliated with management; and in several other cases principally where, among other things, no sales charge is made on sales and the management fee of the fund is not over 1 per cent annually of average net assets, all of the fund direc­tors but one may be affiliates of management.

A recent thoughtful study concludes that "in practice it is not the number of affiliated directors that effectuates the result intended by the statute, but their diligence and astuteness and the sense of responsibility of the management personnel."x

Insider trading in the securities of investment companies is subject to the same regulation as that contained in the Securi­ties and Exchange Act of 1934. This requires reporting of pur­chases and sales of equity securities by large shareholders and company officials, who cannot retain the profits from transac­tions in equity securities, which have been held less than six months.

The Investment Company Act enables the Commission to sue in the courts to prevent gross abuse of trust and gross miscon­duct and grossly unfair plans of reorganization of investment companies. It makes embezzlement of investment company funds a federal offense, and prevents investment bankers and other affiliated persons from using their investment companies to assist them in underwriting activities. The act also provides that an investment company may maintain its portfolio secu­rities and other property in its own custody or in the custody of brokers, subject, however, to compliance with the Commission's regulations. Otherwise, portfolio securities must be maintained in the custody of a bank, which is the usual practice. The act also provides for bonding of employees having access to the company's assets.
1 Nathan D. Lobell, "The Mutual Fund: A Structural Analysis," Virginia Law Review, March 1961, p. 208.

2. Greater Participation in Management by Security Holders

Further adding to its part in wall street history, the act requires investment companies in their registration statements to designate their status as a diversified or a non-diversified company, as defined in the act, and to set forth therein a precise statement of their investment policies. This refers to their rationale or broad policies. With reference to management companies the act imposes at most only limited restrictions as to the nature and types of investments manage­ment may make. In other words, the act does not in any sense make the Commission the manager of investment companies. The status and policies of a company as set forth in its registra­tion cannot be changed without an affirmative vote of a ma­jority of the security holders.

The act also requires that at least two-thirds of the directors of an investment company be elected by the stockholders; it restricts the period of effectiveness of management contracts to two years and requires the approval of such contracts and therefore, in effect, of the investment adviser, by the stock­holder-owners. The act also requires ratification of the manage­ment's choice of the accountants of the company. Investment company proxy solicitation is subject to Commission regulation. It is further provided that all shares issued by management companies after the effective date of the act must be voting shares, and preferred shares are required to contain provisions transferring majority-voting power to the holders of such stock in the event of default in the payment of dividends.

3. Adequate and Feasible Capital Structures

The act restricts the amount of bonds and preferred stock, which a closed-end management investment company may issue. Generally speaking, a closed-end investment company may not issue senior securities in an amount equivalent to more than 50 per cent of its assets. Only one class of bonds and one class of preferred stock may be issued. The asset coverage after issuance must be at least 300 per cent for debt securities and 200 per cent for preferred stocks, so that leverage at the time the senior securities are sold cannot be greater than indicated in the following table, assuming a capitalization of $1,000:

Bonds	$ 333	$ 250
Preferred stock	167	250
Common stock and surplus (equity)	500	500
	$1,000	$1,000

In either instance the necessary coverage exists for the senior securities.
There are also limitations on the payment of dividends or purchases of the company's own outstanding stock so long as senior securities are also outstanding. The purpose is to permit a reasonable use of low-cost money in the interest of the com­mon stock but to limit the use of leverage because of its abuse in the past.

Open-end companies are not permitted to issue any senior securities, although the same objective may be obtained because they are permitted to contract bank loans, provided a 300 per cent coverage of assets for such loans is maintained at all times. New face-amount certificate companies are required to have a minimum capital of $250,000 and to maintain statutory reserves presumably adequate to redeem certificates at maturity. Restric­tions are placed on the authority of face-amount certificate companies to declare dividends where the effect of such dec­larations would be to impair the financial stability of such companies. Without an order of the Commission, face-amount certificate companies are not permitted to issue preferred stocks.

4.Full Disclosure

Further adding to wall street history still, the Investment Company Act required investment companies to file registration statements and transmit reports containing prescribed information to their security holders.

The act authorized the Commission to require registered in­vestment companies to file periodic reports on a semiannual or quarterly basis so as to keep reasonably current the information included in the registration statement. The registration state­ment, which is the first step in the general scheme of regulation, contains information of the kind required in statements filed under the Securities Act of 1933 and the Securities and Ex­change Act of 1934. A recital of the policy of the registrant with respect to such matters as issuing senior securities, borrowing money, engaging in underwriting, making loans, or investing in real estate or commodities must be made; the policies outlined may not be altered without the consent of a majority of the company's holders of outstanding voting securities. Companies filing detailed registration statements must file annual reports within 120 days after the close of the fiscal year.

Dividend payments from other than certain types of income must be accompanied by a written statement indicating their source. Closed-end companies may not discriminate improperly in the repurchase of their outstanding securities. There are also other requirements to keep security holders informed.

5. Selling Practices

The Commission's investigation disclosed numerous abuses in selling practices, particularly by open-end companies, pe­riodic-payment plans, and face-amount certificate companies. To provide more adequate information, sales literature issued by face-amount certificate companies, open-end companies, and unit investment trusts (which would include most periodic-payment plans) must be filed with the Commission within ten days after use. In the case of Securities Act prospectuses of face-amount certificate companies and periodic-payment plans, the Commission is empowered by the act to rearrange the form and items of such documents and to require summaries of in­formation which can be prominently displayed in the prospec­tus.

The Commission is empowered to correct selling practices of open-end companies which may result in dilution of their shares or in unfair trading profit to insiders and dealers. "Switching” of open-end investment company securities and those of unit investment trusts and of face-amount certificate companies on a basis permitting reloading is prohibited in the absence of an order or ruling by the Commission. The Investment Company Act also regulates the sales load that may be charged on pe­riodic-payment-plan certificates and prescribes the form of trust indentures to be used and the charges which may be made by trustees and sponsors of unit investment trusts, includ­ing those issuing periodic-payment-plan certificates.

A number of other important provisions are designed to elimi­nate temptations. Limitations and prohibitions are imposed on the eligibility and activity of persons affiliated with investment companies and on the transactions of such affiliated persons with those companies. Persons convicted of certain crimes in­volving security transactions or enjoined from specific activities because of similar misconduct may not serve as officers or di­rectors of, or perform certain other functions for, registered investment companies. With certain exceptions, the Investment Company Act prohibits an affiliated person, promoter, or prin­cipal underwriter to sell to, or buy or borrow property from, the investment company or any other company it controls. The Commission is empowered to seek an injunction against any person for gross misconduct or gross abuse of trust in respect to an investment company served by such person in any of certain designated capacities.

The act also attempts to provide protection for investment companies from theft and embezzlement by affiliated persons. First, there is a requirement that the securities of registered management companies shall be placed in the custody of a bank or brokers who are members of a national securities exchange subject to the rules and regulations of the Commission. Second, there is a provision covering the bonding of persons connected with such companies who have access to securities and funds.

Under state statutes, generally known as "blue sky laws” investors also receive protection. Except in a few states, invest­ment companies have had no special difficulties in meeting either registration requirements or regulations concerned with the sale of securities.

REGULATION REVIEWED

After twenty years of this wall street history in motion, what can be said of the administration of the Investment Company Act and the cooperation between Washington and Wall Street? The investment company has reached maturity; it occupies a more important position in American finance than ever before. To state dogmatically that the investment company has taken hold and grown because of the act would be an oversimplification and not in accord with the facts. The act, or an equivalent, nevertheless was essential to the restoration of confidence. As a result of confidence in the country's future, fear of inflation, and institutional buying of common stocks, plus the creditable performance of invest­ment companies, the industry has flourished, especially open-end companies.

1. Regulation pursuant to a statute, which the Commission itself has described as a "complex and elaborate piece of legislation" has presented problems of varied sorts. In its tenth annual re­port, for the fiscal year ended June 30, 1944, the Commission grouped these problems into seven categories:



2. Determining which companies are investment companies entitled to exemption



3. The classification of companies subject to the act



4. Prescribing the information to be filed with the Commis­sion and that to be transmitted to security holders and the integration of the required information with that furnished under other acts administered by the Commission so as to avoid duplication



5. The administration and enforcement of those provisions of the act which regulate the relationships and transactions of persons who are affiliated with investment companies



6. Matters relating to the distribution, redemption, and re­purchase of securities issued by management companies



7. Reorganizations of investment companies



8. The treatment accorded certain special types of com­panies, such as investment trusts, periodic-payment plans, and face-amount certificate companies.

On the whole, the framers of the Investment Company Act did a good job. The regulators and the industry have not always seen eye to eye, but they have worked together to set standards and precedents which have made for democracy in finance. The second chapter in the evolution of American investment com­panies, from 1941 to 1961, stands out in sharp contrast to the period between 1925 and 1940 and shows great advance in fair dealing and integrity.

When President Franklin D. Roosevelt signed the Investment Company Act on August 23, 1940, he mentioned two goals: "I have great hopes that the Act which I have signed today will enable the investment trust industry to fulfill its basic purpose as a vehicle to diversify the small investor's risk and to provide a valuable source of equity capital for deserving small and new business enterprises which the investment bankers have been unable to finance." 2

The first goal has been achieved and is the subject of this book.

2 The Public Papers and Addresses of Franklin D. Roosevelt (New York: Random House, 1938), IX, p. 334.