A unit investment trust, which is a type of registered investment company under the Investment Company Act of 1940 (the 1940 Act), may be used as a means of offering structured investments. This section offers some UIT basics.
The 1940 Act defines a UIT as “an investment company which: (A) is organized under a trust indenture, contract of custodianship or agency, or similar instrument, (B) does not have a board of directors, and (C) issues redeemable securities, each of which represents an undivided interest in a unit of specified securities . . . .” A UIT may be organized as a single trust, or as a series trust. Each UIT must have a fixed termination date — usually between one and 30 years, depending on its underlying portfolio. As an investment company, a UIT is required to hold “securities” as defined under the 1940 Act, which may, for example, include debt securities as well as certain derivatives that are considered “securities” under the 1940 Act. A UIT invests in a fixed portfolio of securities. The portfolio is passive — it may not be actively managed by an adviser or the sponsor (unlike a mutual fund). There is no seasoning requirement for the underlying securities; the UIT may purchase securities for deposit in the trust as part of an initial distribution.
Unlike other investment companies, a UIT must file two separate forms in order to comply with the requirements of the Securities Act of 1933, as amended (the Securities Act) and the 1940 Act. Under the 1940 Act, the UIT must file a Form N-8B-2. This form is only amended when there is a material change to the UIT affecting the content of the form. This form is subject to review by the SEC and must include: (1) a summary of the material terms of the indenture and other contracts into which the trust has entered; (2) a description of the securities offered; (3) a description of all sales loads, fees, and charges and expenses; (4) information regarding the sponsor, including its history and operations, and its officers, directors, and employees and their compensation; (5) any distribution arrangements; (6) information regarding the trustee, custodian, and any other service providers; (7) information regarding portfolio insurance, if applicable; (8) tax consequences; and (9) audited financial statements. Review by the Division of Investment Management of the SEC can take longer than review by other areas of the SEC, such as the Division of Corporation Finance.
A UIT must issue redeemable securities. The term “redeemable securities” is defined in Section 2(a)(32) of the 1940 Act as “any security other than short-term paper, under the terms of which the holder upon its presentation to the issuer (or someone designated by the issuer) is entitled (whether absolutely or out of surplus) to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.” A UIT must make redemption available on a daily basis. If units are redeemed for their cash value, the 1940 Act requires that they be redeemed at net asset value, or NAV. For these purposes, NAV would be calculated on the date the trustee receives the redemption notice.
In practice, it is typical for a sponsor to maintain a secondary market in the units. This provides investors with liquidity and avoids a depletion of the UIT’s assets due to redemptions. The SEC considers a sponsor making a market in a UIT’s securities to be the “issuer” of those securities. As such, the sponsor is required to keep current the registration statement in connection with any secondary market sales and must deliver a prospectus in connection with such sales. Sales in the secondary market will be made at NAV – the sponsor will not make a bidoffer spread on the securities.
Section 22(d) of the 1940 Act and Rule 22c-1 thereunder require that investment company redeemable securities be sold at NAV. Because of this requirement, it is not possible to list units of a UIT on a national securities exchange because the market price may not equal NAV. However, the SEC frequently grants exemptive relief to a UIT in order to list its securities on a national securities exchange.
Prohibitions on Affiliated Transactions
There are a number of prohibitions under the 1940 Act, specifically Section 17, that limit the ability of an investment company to transact with its affiliates. These sections generally are applicable to a UIT.
Prohibitions on Transactions with Broker-Dealers
Section 12(d)(3) of the 1940 Act makes it unlawful for any registered investment company (and any company or companies controlled by such company) to purchase or otherwise acquire any security issued by . . . any person who is a broker, a dealer, is engaged in the business of underwriting . . . unless: (A) such person is a corporation all the outstanding securities of which are, or after such acquisition will be, owned by one or more registered investment companies; and (B) such person is primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, or any one or more related activities, and the gross income of such person normally is derived principally from such business or related activities.
Rule 12d3-1 provides certain limited exemptions from this restriction. This rule allows a registered investment company to acquire any security issued by any person that derives more than 15% of its gross revenue from securities related activities, provided that: (1) immediately after the acquisition of any equity security, the acquiring company owns not more than 5% of the outstanding securities of that class; (2) immediately after the acquisition of any debt security, the acquiring company owns not more than 10% of the outstanding principal amount of the issuer’s debt securities; and (3) immediately after any such acquisition, the acquiring company has invested not more than 5% of the value of its total assets in the securities of the issuer. Because none of these triggers would be met, the acquisition of the Call Option by the UIT would not be prohibited by Section 12(d)(3).
In addition, Rule 12d3-1 prohibits the acquisition of a security issued by, among others, the acquiring company’s promoter, principal underwriter, or any affiliated person of such promoter or principal underwriter. However, the SEC has permitted an affiliate of the primary underwriter of a registered investment company to sell to the registered investment company over-the-counter put options.6
For federal income tax purposes, a UIT may either be structured as a grantor trust or a RIC. A grantor trust is a complete pass-through entity and is not subject to tax at the entity level. Owners of a grantor trust are treated as owners of pro rata undivided beneficial interests in the trust’s assets and income. To qualify as a grantor trust for federal income tax purposes, the trust must qualify as an “investment trust” under applicable Treasury regulations.7 To qualify as an investment trust, the trust (i) must have a single class of ownership interests,8 and (ii) there must be no “power to vary the investment” of trust holders under the trust agreement.9 A violation of either requirement generally should result in the reclassification of the “trust” as a partnership for federal income tax purposes. Alternatively, the UIT may be structured as a registered investment company (a “RIC”). In order to qualify as a RIC for federal income tax purposes, the UIT would be subject to certain asset diversification requirements. In addition, to avoid an entity-level tax, a RIC also is subject to strict income distribution requirements.
Securities Act Registration Process
A UIT has two options under Section 24 of the 1940 Act for registering its securities. The UIT may register either a finite number of units or it may register an indefinite number of units initially. If the UIT registers an indefinite number of units, it must pay, within 90 days of the close of each fiscal year, the registration fee for the units sold during that year (less units redeemed or repurchased).
The UIT must file a Form S-6 with the SEC to satisfy its Securities Act filing obligations. Each series of a UIT is considered a separate registrant and must file its own registration statement on Form S-6 to register the series of the trust and the securities being offered as part of that series. Each series also must prepare its own preliminary prospectus, which is used by the underwriting syndicate to obtain indications of interest for the units. The Form S-6 generally requires disclosure, in a prospectus, of information similar to that required in the Form N-8B-2. The initial filing on Form S-6 is subject to review by the SEC and is treated as an initial public offering of the UIT. Any subsequent Form S-6 filed for a series of the UIT is not subject to full review, as discussed below, because of the implementation of Rule 487; however, the SEC may review the performance data (if any) contained in such filings.
A UIT may not avail itself of the ability to conduct continuous or delayed offerings under Rule 415; there is no “shelf registration” process for UITs (or for any registered investment company). However, if a UIT is organized as a series trust, Rule 487 provides some flexibility for conducting subsequent offers. The initial series of the trust must file a registration statement, and this registration statement is subject to review by the SEC. However, once the SEC has declared effective the registration statement, the UIT may rely on Rule 487 for future offerings. Rule 487 permits the registration statement relating to a subsequent series of a UIT to become effective automatically without affirmative action by the SEC. In order to avail itself of Rule 487, the UIT must satisfy a number of conditions. The UIT must identify one or more prior series of the trust that the SEC has declared effective. The UIT also must represent that the securities deposited in the new series being registered do not differ materially in type or in quality from those deposited in the prior series and the disclosure in the prospectus for the series being registered may not differ materially from the disclosure in the prior series’ registration statement. In addition, the UIT must deliver a preliminary prospectus in compliance with Rule 460 (delivery to underwriters). This process will have the effect of permitting frequent offers by series of the trust on an expedited basis.
Exchange Act Reporting
A UIT is subject to ongoing reporting obligations under the Exchange Act. A UIT is permitted to satisfy its periodic reporting obligations under the Exchange Act by filing a Form N-SAR, which is an annual report. Each UIT is required, under Rule 30a-1 of the 1940 Act, to file an annual report on such form within 60 days after the close of each calendar year. The sponsor would prepare the annual report on behalf of the UIT. The Form N-SAR is required to disclose information regarding, among other things, sales during the period, affiliated transactions, sales loads, and other fees. The Form N-SAR is not required to contain audited financial statements. UITs are exempt from the certification requirements of Section 302 of Sarbanes-Oxley (principally because they do not provide holders with annual reports containing financial statements). In practice, however, the trustee typically will provide an annual report to holders, detailing the activities of the trust. This report customarily contains audited financial statements and the trust’s management’s discussion of fund operations, investment results, etc.
In addition, the 1940 Act permits only a limited ability to incorporate future filings by reference, so the registration statement must be amended or supplemented in order for it to be kept current.
Ongoing Maintenance Costs
The UIT may bear the cost for certain organizational expenses, including preparing and printing the registration statement and organizing trust documents, registration of units, and the initial audit. All other expenses must be borne by the sponsor. In addition to the organizational responsibilities discussed above, a sponsor also typically performs ongoing services for the UIT. In particular, the sponsor is entitled to receive a fee for providing portfolio supervisory services, maintaining unit holder records, updating the registration statement, and audit services.