One aim of the Investment Company Act is to protect against fund insiders, or affiliated persons, using fund assets for their own purposes to the detriment of the fund and its shareholders. For example, Section 17 of the Act prohibits or restricts a wide range of affiliated transactions, and Section 10(f) limits a fund’s acquisition of securities from an underwriting syndicate containing certain affiliates. It is the duty of the board of directors to oversee compliance with these limitations and the various exemptions to such limitations on which a fund relies.
The importance of the board of directors maintaining proper oversight of affiliated persons is underscored by the recent guidance of the SEC’s Division of Investment Management regarding the issue. Specifically, the guidance reminds series investment companies to review their compliance policies and procedures to ensure proper identification of affiliated persons with respect to each of its series to prevent unlawful transactions.
Mutual funds typically operate as “series companies,” which is a single legal entity that offers investors choices among several different funds that are all series of the single legal entity. This structure provides for operational efficiencies while supplying options to address individualized investment objectives. While the Investment Company Act does not address all of the aspects of its application to series, the SEC and its staff have generally applied its requirements to each series as if it were a separate investment company.
The position regarding the application of the Investment Company Act to series is important in the context of affiliated transaction limitations because the definition of an affiliated person of another person includes any person who owns five percent or more of the outstanding voting securities of that person. This means that the five percent or more holder of a series is an affiliated person of the series, and is thus subject to the prohibitions on affiliated transactions. For example, Section 17(a) of the Act prohibits an affiliated person of a mutual fund (or an affiliated person of that person) from selling any security or property to the fund. In the case of a series investment company, the prohibition applies when a series is a party to the transaction, and the series is also relevant in determining whether the counterparty to the transaction is an “affiliated person.”
So, the guidance advises each mutual fund to review its compliance policies and procedures for the appropriate identification of “affiliated persons” with respect to each series for the purpose of preventing prohibited affiliate transactions.
To prevent violations of the Investment Company Act, this should include processes by which to identify those owning five percent or more of the outstanding voting securities of a series (as well as the series company as a whole).