Published on Jun 14th, 2022 |

There continues to be new rules and regulations that impact Mutual Funds, and other Registered Funds. Recent changes like the new derivatives rule and marketing rule can impact compliance, so you need to know what strategies to implement to comply with updates. Before your business launches a mutual fund, you should understand mutual fund compliance.

LAUNCHING A MUTUAL FUN COMPLIANCE

 

MUTUAL FUND COMPLIANCE CONSIDERATIONS

Before you launch a mutual fund, it’s important to understand what makes a launch successful and compliant with regulations.

1. LEVERAGE

Borrowed money must adhere to rules regarding leverage. Funds are typically limited in how much of the overall investable portfolio they can borrow. Borrowings are subject to an asset coverage requirement, so a fund can borrow amounts that don’t exceed a certain amount of its assets. If a fund has $50 million in assets, for example, it may be able to borrow $25 million from a financial institution. The total investable assets becomes $75 million.

In derivative investments, inherent leverage doesn’t currently fall under the leverage rules. However, these investments are subject to senior security issuance rules and collateral requirements. The U.S. Securities and Exchange Commission (“SEC”) has proposed additional rules for derivatives in funds.

2. LIQUIDITY

There is a maximum amount of illiquid investments that a mutual fund can have. To avoid violating the regulatory limit, funds with illiquid investments tend to have lower internal limits. However, Rule 22e-4 under the SEC may impact liquidity and liquidity classifications. Under this rule, funds will be mandated to develop a liquidity risk management program that manages, measures and regularly evaluates liquidity risk.

Due to the new regulations, advisers will be required to regularly report and monitor the liquidity classifications of every investment within the portfolio.

3. FUND DIVERSIFICATION

For a mutual fund to be considered “diversified,” the majority of the financial assets should be represented by cash, U.S. government securities, cash equivalents, security holdings from the same issuer or other regulated investment companies (“RICs”) like ETFs.

4. IRS QUALIFICATIONS

Every mutual fund must pass qualifying tests set by the Internal Revenue Service (“IRS”). According to a RIC test, a fund must meet quarter-end diversification limits. A certain amount of the total assets in the fund must be represented by U.S. government securities, cash, cash equivalents, security holdings from the same issuer or other RICs like ETFs or mutual funds.

Excluding U.S. government securities and securities of other RICs, a fund may not own more than a certain amount of total assets in a single issuer at tax quarter-end. A fund needs to derive the majority of its gross income from investment-related activities for the tax year, such as interest, dividends and gain on the sale of securities. A RIC also must distribute to shareholders the majority of the investment company taxable income, including net capital gains and net investment income.

LAUNCHING A MUTUAL FUND COMPLIANCE

FINRA MUTUAL FUND COMPLIANCE

Though the Financial Industry Regulatory Authority (“FINRA”) does not directly regulate mutual funds, it regulates registered representatives and broker-dealers who sell mutual funds. FINRA enforces rules regarding mutual fund sales practices, advertising, the completion of mutual fund portfolio transactions and incentives provided to registered representatives.

1. ADVERTISING

Mutual fund communications between firms and the public must be fair and balanced, based on principles of good faith and fair dealing and provide a basis for evaluating the facts about any type of industry, service or security.

Broker-dealers cannot omit any qualification or material fact if the omission would cause communications to be misleading in light of the context presented by the material. Broker-dealers also cannot make exaggerated, false, misleading, promissory or unwarranted statements or claims during communication with the public, nor can they distribute, circulate or publish any communication that they know contains an untrue, false or misleading statement of a material fact.

2. COMPLEX PRODUCTS

Complex fund products can present sales practice concerns. Complex fund products include non-traditional ETFs and alternative mutual funds. A fund may be considered an alternative fund, for example, if it involves illiquid assets, non-traditional strategies or non-traditional asset classes. Rather than bundling funds under a single umbrella category, FINRA recommends firms refer to funds according to the specific strategies. FINRA has also provided guidance to firms on sales practice obligations that relate to inverse and leveraged ETFs.

3. CASH AND NON-CASH COMPENSATION

For the sale of their mutual fund shares, FINRA members and registered representatives are compensated in various ways. The disclosure that investors get varies by the compensation arrangement. In the fee table within the mutual fund prospectus, member compensation deducted from fund assets or the initial investment should be disclosed. Other types of member compensation should also be disclosed, such as payments for shelf space from a mutual fund adviser.

Cash and non-cash compensation arrangements are regulated by FINRA Rule 2341. There are also prohibitions on the receipt or payment of non-cash compensation by FINRA members in connection with the sale of securities. Non-cash compensation is awarded only if structured in accordance with a limited exception.

4. SALES CHARGES AND BREAKPOINTS

Firms are prohibited by FINRA Rule 2341(d) from selling mutual funds if sales charges are considered to be excessive. Under this rule, various limits are placed on deferred sales charges and front-end sales charges depending on whether an ongoing asset-based service fee or sales charge is imposed, along with whether the fund offers breakpoint discounts. Additionally, this rule places a limit on ongoing fund service fees.

A breakpoint discount is a volume discount that investors face when purchasing shares in Class A mutual funds. The amount of the discount will vary based on the amount invested in certain funds.

MUTUAL FUND COMPLIANCE CHECKLIST

Follow these mutual fund compliance tips to create a checklist that will help you remain compliant.

1. CREATE A COMPLIANCE PROGRAM

Creating a compliance program involves:

  • Appointing a chief compliance officer (“CCO”)
  • Conducting a risk assessment
  • Developing policies and procedures
  • Developing disclosures and reports
  • Conducting annual reviews
  • Recordkeeping

Conducting a risk assessment involves identifying high-risk practices or areas, using risk assessment to develop procedures and policies associated with compliance, and reviewing risk assessments regularly to incorporate new products or activities. Disclosures should be consistent with actual practices and reviewed often to ensure disclosures stay current.

2. DEVELOP WRITTEN POLICIES AND PROCEDURES

For a particular fund, compliance policies and procedures need to encompass areas that are relevant to that fund. When developing written policies and procedures for compliance, address the following areas:

  • Portfolio management: Portfolio management includes chasing returns, cherry-picking, violation of investment restrictions, unfair allocation of securities, portfolio pumping and window dressing, and use of 10f-3 and 17a-7 transactions for dumping unfavorable securities.
  • Business continuity plans: Problems with compliance can come up due to failure to protect records from destruction, failure to provide for the availability of critical systems and personnel, and failure to test and prepare for operations during emergencies.
  • Marketing advisory services: Compliance issues can arise due to failure to have written contracts with solicitors, failure to disclose payments for referrals to employees and inadequate disclosure of solicitation arrangements, or failure to disclose solicitation arrangements.
  • Trading practices and activities: This area includes interpositioning of affiliated broker-dealers, failure to obtain the best execution, failure to disclose to clients how their commission dollars are being used, and failure to systematically and periodically review execution quality.
  • Valuing assessing fees and client holdings: Compliance issues can arise due to inaccurate computation of fees, illiquid assets not valued appropriately or fees based on inaccurately valued client assets.
  • Protecting client assets from misuse or conversion: This area could include improperly disclosing client account information, unauthorized trading in client accounts, inadvertent or improper access to client assets and discrepancies between the records of the custodian and adviser.
  • Accuracy of disclosures made to regulators, clients and investors: Accuracy of disclosures includes advertisements and account statements. Compliance issues that could arise include misleading advertisements, misleading or inaccurate performance numbers, misleading statements in documents like the prospectuses, and inadequate support documentation regarding performance claims.
  • Personal trading by employees and proprietary trading of the adviser: This area involves codes of ethics violations, failure to report or untimely reports of personal securities transactions, and abusive proprietary or personal trading, such as front-running, insider trading and marketing timing.
  • Creating and safeguarding the privacy of client information and records: Compliance issues can occur due to a lack of verification that client data is accurately compiled, failure to protect the privacy of client information, lack of protection for client data from unauthorized changes and failure to notify clients about policies on protecting their information.

3. APPOINT A CHIEF COMPLIANCE OFFICER

A chief compliance officer should be designated to administer each fund’s compliance program. The CCO is responsible for developing and enforcing an appropriate compliance program for a fund, and they should be knowledgeable of applicable federal securities laws. CCOs need to be in a position of authority and seniority that compels others to comply with the program. The CCO’s annual written report may include information regarding the following:

  • Material changes made to the procedures and policies recommended due to the annual review
  • Material changes made to these procedures and policies since the last report
  • Operation of the procedures and policies and the principal service providers
  • Occurrence of material compliance matters since the last report
  • Risk assessment analysis, methods and conclusions
  • Management cooperation
  • Compliance certifications
  • Industry best practices
  • Remedial actions
  • Violations

4. CONDUCT ANNUAL REVIEWS

Under Rule 38a-1, fund boards are required to review the compliance program for the fund, along with the compliance programs for the service providers for effectiveness and adequacy each year. Some issues that may be reviewed by SEC staff during an inspection include the following:

  • COO
  • Testing
  • Risk identification
  • Policies and procedures
  • Written report to the fund board
  • Implementation of recommendations

HOW VIGILANT APPROACHES MUTUAL FUND COMPLIANCE

5. MAINTAIN RECORDS

Funds need to maintain copies of every compliance program in effect, including any annual reports from the CCO of the fund and materials provided to the board related to its approval of the service providers’ and the fund’s compliance programs. Funds must keep records documenting their annual reviews for a certain number of years following the annual review’s fiscal year. Records can be maintained electronically and provided in electronic format after receipt of an SEC request.

ETF COMPLIANCE FOR MUTUAL FUND TO ETF CONVERSIONS

Mutual funds are similar to ETFs as investment vehicles, but they differ in how they are structured. When converting mutual funds to ETFs, investors should be aware of certain considerations associated with these conversions.

You will be notified about any plans for an ETF conversion before it happens. The document you receive will contain information about the differences between the new ETF and your current mutual fund, along with the principal risks of the ETF. This document will also notify you about whether shareholder approval is needed for conversion and how you can vote to approve or reject the conversion. If your mutual fund is converting to an ETF, consider the following:

  • Taxes
  • Investment fit
  • Share classes
  • Tax efficiency
  • Lower expenses
  • Fractional shares
  • Brokerage account
  • Trading during the day
  • Invests more of its cash
  • Reinvestment of dividends and distributions
  • Premium or Discount net asset valuation (“NAV”)

 

LEARN MORE ABOUT HOW VIGILANT CAN HELP WITH MUTUAL FUND COMPLIANCE

LEARN MORE ABOUT HOW VIGILANT CAN HELP WITH MUTUAL FUND COMPLIANCE

If your business is trying to ensure financial compliance before launching a mutual fund, turn to Vigilant Compliance. Since Vigilant was established in 2004, we have offered services as both a compliance firm and an investment management solutions firm. Our compliance solutions are intended for ETFs, broker-dealers, investment advisers and mutual funds. Additionally, we offer the following services and solutions:

Contact Vigilant Compliance for more information about how we can help or with questions about compliance for mutual funds.

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