An investment company is a business that pools money from many investors and uses the combined funds to buy stocks, bonds, and other securities. Under the Investment Company Act of 1940, a business falls into this legal category when more than 40 percent of its total assets, excluding cash and government securities, are made up of securities issued by others.1Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company Crossing that threshold, even by accident, generally means the company has to register with the Securities and Exchange Commission and follow the federal rules built around these entities.
Congress created this framework after finding that investors were being hurt when pooled vehicles operated without transparency or were run for the benefit of insiders rather than shareholders.2Office of the Law Revision Counsel. 15 U.S.C. 80a-1 – Findings and Declaration of Policy The rules that follow, from registration to fee limits to board independence, all trace back to that concern.
The Main Types
Federal law sorts registered investment companies by how they issue and redeem their shares.3U.S. Securities and Exchange Commission. Glossary – Section: Investment Company Each structure gives investors a different mix of liquidity, pricing, and management style.
Open-End Funds (Mutual Funds)
Mutual funds sell new shares to any investor and buy them back on request. Shares don’t trade on an exchange. Instead, the fund calculates its net asset value once a day, after the market closes, and every purchase and redemption happens at that price. The fund’s total capital rises and falls as investors put money in or pull it out.
Closed-End Funds
A closed-end fund raises a fixed pool of capital through an initial public offering and then lists its shares on a stock exchange. It doesn’t issue new shares or redeem old ones after that. Investors trade with each other on the secondary market, and prices are set by supply and demand, which means shares can trade above or below the value of the underlying portfolio.
Unit Investment Trusts
A unit investment trust holds a fixed portfolio of securities until a set termination date. It issues redeemable units to the public but has no board of directors and no advisor actively managing the portfolio. When the trust reaches its end date, the assets are sold and the proceeds go to unitholders.
Exchange-Traded Funds
ETFs combine features of open-end and closed-end funds. Large institutional participants create and redeem big blocks of shares directly with the fund, which keeps the market price close to net asset value. Individual investors buy and sell ETF shares on an exchange throughout the trading day.
Business Development Companies
A business development company is a closed-end company that elects to be regulated under specific provisions of the Investment Company Act. BDCs invest in small and mid-size private companies and must keep at least 70 percent of their assets in qualifying private or small-cap investments.4Office of the Law Revision Counsel. 15 U.S. Code 80a-2 – Definitions, Applicability, Rulemaking Considerations They also have to offer meaningful management guidance to the companies they back. In exchange, they face fewer limits on leverage and affiliated transactions, and their managers can earn performance-based compensation.
Registration and Ongoing Reporting
A company that meets the legal definition of an investment company registers by filing a notification of registration with the SEC.5Office of the Law Revision Counsel. 15 U.S. Code 80a-8 – Registration of Investment Companies Registration is effective as soon as the SEC receives that notification. A more detailed registration statement follows, describing investment policies, organizational structure, compensation, and affiliated persons.
The obligations don’t end there. Every registered company with outstanding shares files an annual report on Form N-CEN within 75 days after its fiscal year ends.6SEC.gov. Form N-CEN Annual Report for Registered Investment Companies The SEC uses these filings to track industry trends, spot risks, and support enforcement.7Federal Register. Form N-PORT and Form N-CEN Reporting, Guidance on Open-End Fund Liquidity Risk Management Programs Most registered funds also file monthly portfolio reports on Form N-PORT within 45 days of month end, disclosing complete holdings along with data on investment risk, liquidity risk, counterparty risk, and leverage.8Federal Register. Form N-PORT Reporting
When a Fund Doesn’t Have to Register
Not every pooled investment vehicle is an investment company for federal registration purposes. Two exemptions carry most of the traffic, and they’re how hedge funds and private equity funds typically stay outside the Act.
The first is the 100-investor exemption. A company is excluded from the definition of an investment company if its securities are held by no more than 100 beneficial owners and it doesn’t make or propose to make a public offering.1Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company Qualifying venture capital funds with no more than $10 million in total capital get a slightly higher limit of 250 owners.
The second is the qualified purchaser exemption. A fund with no cap on the number of investors can still avoid registration if every owner is a “qualified purchaser.” For an individual, that means owning at least $5 million in investments. For an institution managing money on a discretionary basis, the threshold is $25 million.9Office of the Law Revision Counsel. 15 U.S.C. 80a-2 – Definitions, Applicability, Rulemaking Considerations
Either exemption removes the obligation to register as an investment company. It doesn’t remove all federal oversight. Funds using these exemptions still have to follow federal anti-fraud rules and may have filing obligations under the Securities Exchange Act of 1934.
Board Independence
Every registered investment company with a board must keep a minimum level of independence on that board. Federal law caps the share of “interested persons” — meaning people with a material business relationship with the company or its management — at 60 percent of the board.10Office of the Law Revision Counsel. 15 U.S. Code 80a-10 – Affiliations or Interest of Directors, Officers, and Employees At least 40 percent of directors must be independent. Those independent directors approve the advisory contract, monitor expenses, and check whether the fund is sticking to its stated investment objectives. Because shareholders are widely scattered and usually passive, the board carries most of the weight of protecting them.
Advisory Contracts and Fees
An investment company can’t hire an investment advisor without a written contract approved by a majority vote of shareholders. That contract has to spell out every form of compensation the advisor will receive.11Office of the Law Revision Counsel. 15 U.S. Code 80a-15 – Contracts of Advisers and Underwriters It can’t run longer than two years without renewal by either the board or shareholders. The board or shareholders can terminate it on no more than 60 days’ written notice without penalty, and if the advisor tries to transfer the contract to another entity, it ends automatically.
Management fees typically run from about 0.50 percent to 1.50 percent of fund assets per year, though index funds and ETFs are often well below that. The advisor owes a fiduciary duty regarding any compensation it receives. If fees are excessive, the SEC or any shareholder can sue to recover the overcharge, and the advisor doesn’t need to have acted in bad faith for the claim to succeed.12Office of the Law Revision Counsel. 15 U.S. Code 80a-35 – Breach of Fiduciary Duty Damages are capped at the actual excess compensation, and claims can reach back only one year before the lawsuit was filed. The fiduciary duty itself cannot be waived, though the scope of the advisor’s services is shaped by the contract.13Federal Register. Commission Interpretation Regarding Standard of Conduct for Investment Advisers
How Investment Companies Are Taxed
Most investment companies operate as “regulated investment companies” under the Internal Revenue Code, which lets them pass income through to shareholders without paying tax at the corporate level. To qualify, a company has to be registered under the Investment Company Act and derive at least 90 percent of its gross income from dividends, interest, and gains on the sale of securities or currencies. It also has to meet quarterly diversification tests: at least 50 percent of assets in cash, government securities, or shares of other RICs, and no more than 25 percent concentrated in one issuer or a controlled group of issuers.14Office of the Law Revision Counsel. 26 U.S. Code 851 – Definition of Regulated Investment Company
To keep that pass-through treatment on distributed income, the fund has to pay out at least 90 percent of its investment company taxable income to shareholders as dividends each year.15Office of the Law Revision Counsel. 26 U.S. Code 852 – Taxation of Regulated Investment Companies and Their Shareholders Anything retained above that threshold is taxed at the corporate rate. Shareholders then report the distributions on their own returns, so the income is taxed once at the individual level rather than twice.
Penalties
The Investment Company Act carries both civil and criminal penalties. Civil penalties run in three tiers based on the severity of the misconduct, ranging from a base level for straightforward violations up to $100,000 per violation for an individual (or $500,000 for a company) when fraud or reckless disregard caused substantial losses to others or produced substantial gains for the violator.16Office of the Law Revision Counsel. 15 U.S. Code 80a-9 – Ineligibility of Certain Affiliated Persons and Underwriters Fraud or reckless disregard of a regulatory requirement moves a case into the higher tiers.
Criminal prosecution is reserved for willful violations. Someone convicted of willfully violating the Act, or of making materially false statements in a required filing, faces a fine of up to $10,000, up to five years in prison, or both.17Office of the Law Revision Counsel. 15 U.S. Code 80a-48 – Penalties A defendant can avoid conviction by proving they had no actual knowledge of the rule or regulation they’re accused of violating.