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Mutual Funds and Regulation

Other Investment Company ProductsTodd Cipperman, Esq.November 1, 2007

2Mutual Funds and Regulation Confidential Copyright 2007 FINRA

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1Other Investment Company Products


Other Investment Company Products

Closed-End Funds

Unit Investment Trusts (UITs)

Exchange Traded Funds (ETFs)

Variable Insurance Products

Section 529 Plans


Closed-End Funds

Features: Closed-Ended Funds:

– Generally a fixed number of shares is issued

– Trade on a Stock Exchange

– Shares trade based upon market price rather than net asset value (NAV) With only some relationship to Funds actual NAV Funds sold at POP (not equal to NAV – at a discount or premium to NAV)

– As of year-end 2005, total assets in Closed-End Funds was $276 billion (vs. over $8.9 trillion in Open-End Funds) 62% of all assets in Closed-End Funds are held in Debt Securities and 38%

were in Equity Funds Open-Ended Funds

– Mutual funds continuously issue shares

– Mutual funds redeem (buy back) their shares continuously

– Redeemability within 7 days (i.e. liquidity). See Section 22(e) (7 days to redeem) and Rule 22c-1 (daily pricing for redeemable securities) See Rule 23c-3 re Interval Funds and quarterly liquidity


Why Closed End Funds

“Illiquid Securities” Fund-of-Hedge Funds Emerging Market Funds CDOs etc. Bank loan funds BDCs and private equity

Less Cash Drag

Lower Costs related to cash management

Stability of fees especially performance fees


Disclosure and Regulation

Form N-2

Periodic Reporting Obligations of 1934 Act do not apply

Section 13 and 16 do apply

Repurchases generally effected through periodic tender offers

No prospectus updates unless 10b-5 issues

Importance of Annual and Semi-Annual reports Financial Statements

Registration under 1933 Act, 1940 Act, both, or neither

Rule 102 of Regulation M (limitations during distribution period) not applicable

Restrictions on multi-class structures


Registration under the Investment Company Act

Limits on investment activities Leverage limited to 33% Limits on senior securities Limits on fund-of-funds

Compliance requirements Registration Statements Board meetings Affiliate transactions Distribution Compliance Program

Cost of registration

Liability


Interval Funds (Rule 23c-3)

No more often than quarterly

No more than 25%/repurchase

Cash at NAV

Specified time periods for notice and payment

Fundamental policies in N-2

Must calculate NAV weekly

No CDSCs or 12b-1 fees

Majority of Board must be disinterested


Closed-End Fund assets: 1995 - 2006


Unit Investment Trusts

Features: Registered Investment company. Buy & Hold Strategy

– Generally buys and holds a fixed portfolio of stocks, bonds, or other securities for a very specific period of time

– Positions may be liquidated/replaced due to issuer-viability concerns Dividend income paid ‘regularly’ (quarterly or semi-annually) and interest usually

paid monthly– Dividends can be reinvested into “new” Units of UIT’s for Fixed Income UIT’s, or– Dividends can be reinvested into a similar Open-Ended Mutual Fund with the

same investment strategy Maturity dates set at issuance.

– As short as one year for equity UITs (broker-sold “Dogs of the Dow” UITs)

– As long as 30 years for bond UITs


UIT vs. Mutual Fund

Static Portfolio: no active management

Sponsor maintains secondary market

Fixed Term

Grantor Trust, rather than RIC, for tax

Single offering

Sales Charge, low fees


Why a UIT

Bond Insurance

Specific Market Sectors: “Dogs of the Dow”

Secondary Market allows for more liquidity and derivatives

Off-Shore investors

Asset Allocation

ETFs (e.g. SPDRs)

No concern about market timing, revenue sharing, etc.


Unit Investment Trusts

Advertising Issues: UITs typically cite “estimated current return” in advertisements and sales literature

– Defined as estimated net annual interest income per unit, divided by the offering price This is a measure of a trust’s current cash flow For fixed-income UITs the interest paid is usually predictable

Fixed-income UITs also may cite estimated long-term return, or estimated yield

– Uses weighted average yield to maturity, and reflects impact of sales charges


Exchange Traded Funds (ETF’s)

Listed and traded on Stock Exchanges

Continuous Trading

No discount from NAV

Started as institutional cash “equitization” product

Hedge funds and short selling

More tax efficient: manage capital gains

Very inexpensive: Compare ETF vs. Index Fund

Available to Non-US investors

Fewer regulatory limits on distribution (no revenue sharing issues)

No market timing issues



Structures and Mechanics

UITs (e.g. SPDRs, NASDAQ 100, DIAMONDS) vs. Open-End Management Company (e.g. Barclay’s I-Shares, Vanguard VIPERS) Portfolio more fixed; “sampling” of index not allowed Some tax differences Old School vs. New School

Creation Units: securities + cash = 22c-1 price “In-kind” transactions Settlement through NSCC guarantees delivery Constant arbitrage among Authorized Participants eliminates discount to

NAV


Regulation

Need exemptive relief Purchases by 5% holders Separate class of shares differing by redeemabilty (e.g. VIPERS) Secondary market prices rather than NAV Greater than 7-day settlement for non-US securities Prospectus delivery requirements (closed vs. open-end funds) Reimbursement of expenses to UIT sponsor Fund-of-funds

1934 Act: BD activities Regulation M: activities of affiliates during distribution Tender Offer rules Margin Rules Confirmation Rules Section 13 and 16 reporting

Conduct Rule 2830(c): sales at other than NAV


ETFs: The New Frontier

Actively Managed ETFs Need for arbitrage vs. portfolio returns See SEC Concept Release “Actively Managed Exchange Traded Funds”

(2001)

Leveraged ETFs

Alternative asset classes (e.g. gold-linked ETFs) Search for tax efficiency

401(k) plans


Variable Insurance Products

Variable Annuities, Variable Life

Insurance Features: Death Benefit, Living Benefit

A shares and B shares (See sales practices)

Ability to move money among underlying funds

Small firm 401(k) marketplace

Tax deferral benefits

Estate tax planning


Variable Product Legal Issues

Fixed grouping of funds under each contract

Different funds than offered in retail marketplace

Expenses: Loads, Admin, Mortality, Investment, Death Benefit

Sold by life insurance agents/registered reps

FINRA Conduct Rule 2821: Members' Responsibilities Regarding Deferred Variable Annuities Enhanced suitability requirements that require consideration of surrender

charges, fees, and market risks Consider exchanges within the prior 36 months Principal review and approval Procedures and training

Sales Practices


Unique Variable Insurance Features

Subchapter L requirements for Life Insurance Policies or Annuity Contracts

– Because a Trust is used to fund Insurance Contracts, each portfolio must meet certain Diversification requirements

> No more than 55% of total value of assets may be represented by one investment> No more than 70% by any two investments> No more than 80% by any three investments> No more than 90% by any four investments

No Free Lunch– Variable insurance products generally carry high internal fees

Fees cover costs of insurance features and investment management Suitability issue:

– Is it cheaper to invest and buy insurance separately? Should there be a per se rule that customer should always get lowest cost (limiting

customer choice)

Regulatory Scheme Because of dual nature of the products – subject to many levels of regulation

– SEC – regulation of offering documents and periodic reporting– FINRA – regulation of sales practices/advertising– State by State – regulation of substantive insurance law and sales practice


529 Plans

States Sponsor/Issue the Plans Plans are subject to MSRB regulation on a State-by-State basis Plans generally are managed by professional money managers

Tax Advantaged Investment Federal

– No deduction on contributions

– Earnings grow tax-deferred

– Earnings are never taxed when used for education

Flexibility Account “owners” retain control over account, not the beneficiary (no conversion

at defined age)

If beneficiary does not go to college, account can rollover to family member (includes children, nephew/nieces and 1st cousins of original beneficiary) Anyone can contribute to an account


529 Plans

College savings plans under IRS Section 529 Contributions federally taxable Many states do not tax contributions to state plans

State Plans operated by a professional investment management firm.

Earnings in a 529 Plan accumulate tax-free and can be withdrawn tax-free for the purpose of paying for certain qualifying higher education expenses – tuition, room, board, books, etc.

Underlying investments generally include mutual funds.

Regulation Municipal Securities Rulemaking Board (municipal securities) Reps must have Series 7 or 52 (or Series 6 if the only municipal securities sold are

529 Plans) and must be supervised by a Series 53 or 51, depending on the circumstances.


529 Plan Sales Practices

MSRB and FINRA jurisdiction: interest in plan and interests in funds MSRB Rule G-21:no false or misleading advertisements

–Consider state tax benefit–Performance data must comply with Rule 482

MSRB Rule G-19: broker-dealer must ensure suitability–FINRA will enforce G-19 (See Ameriprise action)

FINRA NtM 03-17: comply with 2210 and other FINRA rules (including pre-filing of marketing materials)

MSRB Notice 2007-18: Amendments to G-21: conform performance advertising to 2210 and Rule 482


529 Plans Account Features

You can have multiple accounts for one child

Many plans offer age-based or “life-cycle” investment plans that readjust over time from aggressive to conservative based on age of beneficiary Usually cannot change investment selection after initial selection You can rollover between states once per year (and therefore change investment

strategy)

You could open 2 accounts in 2 states if you wanted to blend investment styles, and change weighting going forward This is the standard current practice

Financial Aid 529 is the parents’ asset, so it has less effect than a traditional gift account when

applying for financial aid at Colleges Distributions from a 529 plan to pay a child’s expenses will show up in the child’s

tax return, and will impact financial aid eligibility in years 2-4


Summary

Closed-End Funds: portfolio liquidity

UITs: SPDRs

ETFs: low-cost indexing

Variable Insurance Products: tax deferral

Section 529 Plans: college savings


Todd Cipperman is the principal of Cipperman & Company, which provides legal consulting 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, Esq.

150 S. Warner RoadSuite 140

King of Prussia, PA [email protected]

www.cipperman.com

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