Mutual Fund Basics

June 2007

Todd Cipperman, Esq.Cipperman & Company

The Players

• Sponsor: organizes and promotes the Fund; arranges service providers Investment Advisor/Manager: manage the portfolio and invest the assets– Investment Managers may retain Sub-Advisors

• Directors: > 50% independent• Administrator: accounting, NAV calculation

– May be affiliated with Advisor• Distributor: broker-dealer activities • Custodian: certain banks • Transfer Agent: keep shareholder records • Auditors: annual audit and opinion on financials • Fund Counsel: registration statement, filings, opinions,

Board meetings, advice Chief Compliance Officer: annual report to Board re compliance with securities laws

The Laws

• Investment Company Act of 1940• Investment Advisers Act of 1940• Internal Revenue Code, Subchapter M• ERISA• NASD Rules• Securities Exchange Act of 1934• SEC Interpretations, Statements, No-

Action Letters, Enforcement Actions

The Paper• Registration Statement

– Prospectus– Statement of Additional Information– Part C

• Shareholder Reports• SEC Filings• Agreements

– Investment Advisory– Distribution– Administration– Custody– Other

• Board Materials

Restrictions on Advisor• Prospectus and SAI Disclosure

– Disclose investment objective and policies– Certain policies may only be changed upon shareholder vote

• Advisory Contract– Annual Board approval includes review of investment performance, compensation,

brokerage, fund expenses• Board of Directors

– Valuation of securities – Approve distribution arrangements– Approve service providers

• Private Rights of Action (Lawsuits)– Adviser has fiduciary duty with respect to the amount of compensation received

• Affiliated Transactions– Transactions between affiliated funds– Joint transactions– Affiliated brokerage

• Investment Restrictions– Disclosure– Fund-of-funds– Diversified/Non-Diversified (e.g. no more than 5% in one security)

Advisory Contract• Approval by shareholders

– Includes material amendments• Annual approval by Board

– In-Person meeting of independent directors• Termination in the event of assignment or on 60 days’ notice• Services

– Invest pursuant to Prospectus & SAI– Place orders– Vote proxies– Report to Board– Back office work

• Fees based on AUM– Limits on performance fees– Breakpoints

Sub-Advisory Contracts

• Approval by shareholders required• Allocation of responsibilities

– Records retention

• Fees paid by Advisor or Fund• Manager-of-Managers structures

– Exemptive relief to appoint sub-advisers

Board Role in Reviewing Advisory Contract (15(c))

• 36(b): fiduciary duty on adviser not to receive excessive compensation– Includes private rights of action

• Gartenberg standard: “arm’s length”– Nature and quality of services– Comparable fees and expenses– Advisor profitability– Economies of scale– Fall-out benefits (e.g. soft-dollars)

• Shareholder reports require discussion of Board review• 15(c) report prepared by Advisor: description of business

and personnel, compensation and performance, compliance, brokerage

Investment Restrictions: Prospectus/SAI

• Fund Name: 80% test (e.g. country, region)• Investment objective• Concentration policies• Fundamental Investment policies: require shareholder vote to

change• Diversified vs. Non-diversified

– 75% of assets: no investment > 5%– IRC: no more than 25% in any one issuer– Shareholder vote to become Non-diversified

• 1940 Act– Other funds: 3/5/10 Rule– Insurance Companies– Securities-related businesses– Illiquid securities

Trading

• No purchases if an affiliate is a member of an underwriting syndicate (n.b. Rule 10f-3)

• Effecting trades through affiliated brokers (n.b. Rule 17e-1)

• Restrictions on agency cross trades (Advisers Act, ERISA

Custody

• Qualified Bank• Foreign Custody

– Foreign Sub-Custodian– Qualified Foreign Banks

• Financial strength• Ability to enforce judgments and protect assets• No exchange controls• Access to auditors

– Eligible Securities Depository– Board approval and reporting

• Custody at Futures Commission Merchant for exchange-traded futures contracts and commodity options– Segregation of assets– Sweeping of gains

Proxy Voting• Must disclose proxy voting policies and

procedures in Registration Statement– Conflicts between shareholders and adviser

• Fund must file proxy voting record• Allocate proxy voting responsibility between

adviser and sub-adviser (and third party)• Advisers Act requires proxy voting in the

best interest of clients and procedures for resolving conflicts of interest

• ERISA requirements

Conflicts of Interest

• Affiliate: investment adviser, officers, directors, partners, etc. (n.b. complex definition)

• An Affiliate may not:– Sell any security to the Fund– Purchase any security from the Fund– Borrow money from the Fund– Exception for exchange-traded securities at the current

market price (Rule 17a-7)• E.g. seeding of GOBF fund

• An affiliate may not engage in a joint enterprise with a fund (e.g. securities purchases, kickbacks from service providers, trade allocation)

• An affiliate may not act as agent for compensation in a transaction with the Fund (e.g. broker)– Rule 17e-1: permissible affiliated brokerage

Personal Trading• No fraudulent, manipulative, deceptive practices in

connection with purchase/sale of securities by related persons

• Includes securities held by the fund during the last 15 days or had been considered for purchase during the last 15 days– Excludes Treasuries, Short-term instruments, Mutual

Funds• Fund and Adviser must adopt a Code of Ethics

– Approved by Board– Periodic reporting of violations

• Advisers Act (More restrictive Code of Ethics)– Form ADV disclosure– Broader holdings reports

Code of Ethics• Reports by Access Persons

– Holdings and Transaction reports– Must be reviewed by management or compliance– Access Person: any director, officer, general partner of adviser who, with

respect to any Fund, makes any recommendation, participates in the determination of which recommendation will be made, or whose principal function or duties relate to the determination of which recommendation will be made, or who, in connection with his or her duties, obtains any information concerning recommendations made by the investment adviser to any Fund

• Pre-approval of participation by investment personnel in IPOs and private placements

• Recordkeeping: Code, violations, certifications, access persons, holdings reports

• Disclosure about personal trading policies in prospectus

• Filing of Code of Ethics w/ SEC

Marketing Mutual Funds

• Does the material reference the Fund?• Anti-fraud (Rule 156 and 10b-5)• Is the material accompanied or preceded by the

Prospectus?• Exceptions:

– Generic advertisement: no reference to a specific fund (e.g. magazine ads)

– Rule 482

• Rules apply equally to internet advertising– Effect on marketing to non-US jurisdictions

• UK: directed communications, reasonable precautions

Rule 482 Materials

• Specific disclosures (e.g. obtaining and reading prospectus)

• Standardized presentation and calculation of performance information– Formulas for average annual total return– Must present 1, 5 and 10 year performance– Current to the most recent calendar quarter– Disclosures about past performance, risk,

loads

Other Marketing Rules

• Add disclosure about qualifications and limitations on past performance presentation– Conveying an unjustified impression– Caution with respect to future investment performance

without adequate qualification

• Balance benefits of fund structure/attributes with risks (e.g. high yield bonds, emerging markets, IPOs)

• Exaggerated claims about manager skill or process

• Misleading comparisons to other funds or indexes• Testimonials

Related Account Performance

• Permissible in marketing material if– Disclosure that it is not fund’s performance– Cannot omit fund’s performance– Explanation of purpose of related performance– Disclosure of material differences

• NASD members cannot use sales literature that includes related account information

• Note: Portfolio Holdings Policy and disclosure

NASD Regulation of Marketing

• Observe principles of fair dealing and good faith; communications must be balanced

• No false or exaggerated claims• No predicting future results• Limits on testimonials• Fair presentation of comparisons• Specific ranking guidelines• Principal must approve sales material• Must file marketing materials within 10 days of first

use– Often file before use to avoid re-printing– Pre-filing and approval if certain rankings or bond fund

volatility ratings included

Recordkeeping

• Financial records, shareholder account ledgers, agreements, board meeting minutes, brokerage reports

• All records must be maintained in easily accessible place (aka on-site) for 2 years

• Certain records must be maintained indefinitely: journal entries and ledgers, portfolio histories, corporate documents, minute books

• Other records must be maintained for 6 years• Electronic storage permissible• SEC access upon request• Third party service providers may hold records• Advisers Act requirements (generally 5 years)

Compliance• Fund must adopt and implement policies and procedures

reasonably designed to prevent violations of the securities laws– Portfolio management, trading, disclosures, recordkeeping, valuation,

privacy, market timing– Oversight of Fund service providers

• Board approval of written policies and procedures– Consider recent compliance experience– Best practices

• Annual review of adequacy and effectiveness– Includes testing– Consider changes in business, regulations, compliance– Presentation to Board

• Designate responsible Chief Compliance Officer (competent, senior, independent)

• Record-keeping

Summary

• Mutual Funds are highly regulated

• Consult your Legal or Compliance Professional

Todd Cipperman is the principal of Cipperman & Company, which provides legal services to investment managers, investment advisers, broker-dealers, mutual funds, hedge funds, and technology providers. Cipperman & Company provides a wide range of services for the industry including regulatory advice, product development, distribution arrangements, compliance programs, and client and vendor agreements.  Mr. Cipperman has more than 15 years of experience in the investment management and financial services industries. As a principal of Cipperman & Company, he has represented a wide range of investment management clients with a focus on distribution issues facing advisers and broker-dealers. He previously served as general counsel of a public mutual fund and financial technology firm, including its $65 Billion proprietary mutual fund family. He has also served as general counsel of one of the largest international equity managers. He spent several years in private practice on Wall Street representing both buy and sell side clients in investment management and capital markets transactions. He is a graduate of the University of Pennsylvania Law School and Cornell University.

Todd Cipperman, esquire

1905 General Alexander DriveMalvern, PA 19355

610.648.9449 tcipperman@cipperman.com

www.cipperman.com