Introduction to US 1940 Act

The Investment Company Act of 1940 (the 1940 Act) regulates mutual funds (as well as other companies).

The 1940 Act has undergone many changes.

Recent key changes include:

  • Dodd-Frank Act of 2010 (introducing stricter regulation on hedge funds, derivatives, and credit ratings)

  • Rule 2a-7 into the act (governing the structure and operation of money market funds).

In addition, there is significant cross referencing to the IRC (Internal Revenue Code) section 851, which provides the legal definition of a regulated investment company under subchapter M, and details any limitations that could lead to a determination of status.

  • The Securities Act of 1933

  • The Securities Exchange Act of 1934

Types of Funds

There are two main types of funds within the mutual fund landscape;

  • Money Market Funds which provide a highly liquid investment strategy primarily focusing on short term debt instruments, and

  • Non-Money Market Funds. Money Market funds

These fund types can be further sub-categorised per the table below, with different regulatory rulesets and guidelines apply to each; this is summarised in the following section.


MONEY MARKET FUND NON-MONEY MARKET FUND
Government Money Market FundDiversified Fund
Tax Exempt Money Market FundNon-Diversified Fund
Single State Tax Exempt Money Market Fund
Other Money Market Fund

There is also distinction in the rules between mandated funds and non-mandated funds.

Defined Terms

A challenge with 1940 Act legislation is the arcane terminology used throughout the Act and the other related provisions.

Their terms include “Core” and “non-Core assets”, “controlled securities”, “First Tier Securities”, guarantee and controlled securities, publicly traded securities, “Qualifying Assets“

Upcoming Developments

On January 17, 2017 the SEC’s Investment Company Reporting Modernization rule became effective.

The regulations are looking to protect investors with more robust reporting requirements and stronger liquidity risk management requirements.

The Final Rule has four key components:

  1. Adoption of Form N-PORT, for reporting portfolio-wide and position-level information, and the rescission of Form N-Q;

  2. Adoption of Form N-CEN, for reporting census-type information, and the rescission of Form N-SAR;

  3. Amendments to Regulation S-X, effective from August 1, 2017 to require (among other changes) standardized reporting of derivatives holdings in a fund’s financial statements; and

  4. Amendments to Forms N-1A, N-3 and N-CSR to require certain disclosures regarding a fund’s securities lending activities.

Rule 18f-4: Fund’s use of derivatives and leverage

This exemptive rule is a proposed amendment to Form N-PORT. The proposal requires segregation of assets, limitations on the use of derivatives and other leveraging arrangements. Form N-PORT additions include risk metrics relating to some derivatives.

It only applies to funds that are required to adopt a DRMP (derivative risk management program) which would also include the appointment of a derivatives management officer.

Rule 22e-4: Liquidity Risk Management Programmes

Concurrently, the SEC has also adopted new Rule 22e-4 (The Liquidity Rule” and has made amendments to certain rules and forms that require registered investment companies to establish a liquidity risk management program that, among other things, classifies a fund’s investment holdings into different liquidity buckets and limits a fund’s holdings in illiquid assets to no more than 15%.

These provisions also permit those companies to use “swing pricing” under certain circumstances.

Summary of Requirements

The Liquidity Rule requires each fund to implement a written Liquidity Risk Management Program to include:


  1. The assessment, management, and periodic (at least annual) review of a fund’s liquidity risk. Also, a fund’s board must review, no less frequently than annually, a written report that describes a review of the adequacy of the fund’s liquidity risk management program.

  2. The classification of the liquidity of each fund’s portfolio investments into one of four categories below:


HIGHLY LIQUIDMODERATELY LIQUIDLESS LIQUIDILLIQUID
Convertible to cash <= 3 business daysConvertible to cash 4 to 7 business daysCan be sold or disposed within 7 days. Settlement may take longer than 7 business days7 business days

There also needs to be at least monthly review of the fund’s liquidity classifications.

  1. The establishment and periodic review of a highly liquid investment minimum for the fund—i.e., the percentage of its net assets that the fund invests in highly liquid investments;

  2. A limitation on the fund’s investment in illiquid investments that are assets to no more than 15% of the fund’s net assets; and

  3. Funds that engage in redemptions in kind must establish policies and procedures regarding how they will engage in such transactions.

Regulatory Reporting

There are a range of Regulatory Reporting requirements in respect of the above.

These are considered at Part 6.

These include that the fund’s liquidity classifications need to be filed monthly on Form N-PORT and with such information being made public quarterly.

Resources
UCITS e-Learning Hub
Investment Compliance Quick Q&A