Investment companies are businesses that pool money from many investors and put the combined funds into stocks, bonds, and other securities. Under the Investment Company Act of 1940, a business is legally an investment company when more than 40 percent of its total assets, excluding cash and government securities, consist of securities issued by other companies.1Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company Crossing that line, even by accident, can trigger SEC registration and the full set of federal rules that govern how these companies operate, disclose, and pay their managers.
The 40 Percent Test
The statutory definition rests on a single ratio. If a company is primarily in the business of investing in securities and its investment securities exceed 40 percent of total assets (again, setting aside cash and government paper), it fits the definition.1Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company The consequence is significant: registration with the SEC and compliance with disclosure, governance, and transaction rules that don’t apply to ordinary operating businesses.
Types of Investment Companies
Federal law sorts registered investment companies by how they issue and redeem shares.2U.S. Securities and Exchange Commission. Glossary – Section: Investment Company Each type handles pricing, liquidity, and management differently.
Open-End Funds (Mutual Funds)
Open-end funds, better known as mutual funds, continuously sell new shares and buy them back on request. Shares don’t trade on an exchange. Each day after the market closes, the fund calculates the net asset value of its holdings, and every purchase and redemption that day happens at that price. As investors move money in and out, the fund’s capital base grows or shrinks with them.
Closed-End Funds
A closed-end fund raises a fixed pool of capital through an initial public offering, then lists its shares on a stock exchange. After the IPO the fund neither issues new shares nor redeems existing ones. Investors trade with each other on the secondary market, and prices are set by supply and demand. Shares can trade above the value of the underlying holdings (a premium) or below it (a discount).
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 investment advisor making active decisions. The holdings generally stay put for the life of the trust. When the trust terminates, the securities are sold and the proceeds go to the unitholders.
Exchange-Traded Funds
ETFs combine features of open-end and closed-end structures. Large institutional participants create and redeem big blocks of shares directly with the fund, which keeps the exchange price close to net asset value. Everyone else buys and sells ETF shares on an exchange throughout the day at market prices, getting intraday liquidity along with fund-style diversification.
Business Development Companies
A business development company is a closed-end structure that elects to be regulated under specific provisions of the Investment Company Act. BDCs invest in small and mid-size private companies, and at least 70 percent of their total assets must be in qualifying private or small-cap investments.3Office of the Law Revision Counsel. 15 U.S. Code 80a-2 – Definitions, Applicability, Rulemaking Considerations They’re required to offer real management guidance to the companies they back. In return, they face fewer restrictions on leverage and affiliated transactions, and their managers can earn performance-based pay.
Registration and Ongoing Reports
A company that meets the definition registers with the SEC by filing a notification of registration, and it’s considered registered as soon as the SEC receives that filing.4Office of the Law Revision Counsel. 15 U.S. Code 80a-8 – Registration of Investment Companies A detailed registration statement follows, laying out investment policies, organizational structure, compensation, and affiliated persons.
Reporting doesn’t stop at registration. Every registered investment company with outstanding shares files an annual Form N-CEN within 75 days after its fiscal year ends.5SEC.gov. Form N-CEN Annual Report for Registered Investment Companies The SEC uses the data to track industry trends, spot risks, and support enforcement.6Federal 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 after each month ends. Those reports disclose the fund’s complete holdings along with data on investment risk, liquidity risk, counterparty risk, and leverage.7Federal Register. Form N-PORT Reporting
Private Funds That Skip Registration
Not every pooled vehicle registers with the SEC. Two exemptions let private funds, including hedge funds and private equity funds, avoid the full weight of the Investment Company Act.
The 100-Investor Exemption
A company is excluded from the definition if its securities are held by no more than 100 beneficial owners and it neither makes nor plans 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 higher cap of 250 beneficial owners. Most traditional hedge funds and smaller private equity funds rely on this exemption.
The Qualified Purchaser Exemption
A fund can have unlimited investors and 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 in investments.8Office of the Law Revision Counsel. 15 U.S.C. 80a-2 – Definitions, Applicability, Rulemaking Considerations Larger hedge funds and private equity funds typically use this route because it removes the 100-investor cap.
Either exemption removes the obligation to register as an investment company. It doesn’t remove everything else. Anti-fraud rules still apply, and other securities laws (including filing obligations under the Securities Exchange Act of 1934) may still bite.
Boards and Independence
Every registered investment company with a board of directors has to keep a minimum level of independence on it. Federal law prohibits more than 60 percent of a board from being “interested persons,” which means people with a material business relationship to the company or its management.9Office of the Law Revision Counsel. 15 U.S. Code 80a-10 – Affiliations or Interest of Directors, Officers, and Employees In practice, at least 40 percent must be independent.
The board approves the advisory contract, watches fund expenses, and checks that the company sticks to its stated investment objectives. Because shareholders are dispersed and mostly passive, the board is the working guardian of their collective interests.
Advisory Contracts and Fees
An investment company can’t hire an investment advisor without a written contract approved by a majority vote of the fund’s shareholders, and the contract must spell out every form of compensation the advisor will receive.10Office of the Law Revision Counsel. 15 U.S. Code 80a-15 – Contracts of Advisers and Underwriters The contract can’t run longer than two years without annual renewal by the board or the shareholders. Either 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, the contract automatically ends.
Management fees typically run from about 0.50 percent to 1.50 percent of fund assets per year, though index funds and ETFs often charge well below that band. On compensation, the advisor owes a fiduciary duty by statute. 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.11Office of the Law Revision Counsel. 15 U.S. Code 80a-35 – Breach of Fiduciary Duty Damages are capped at the actual excess compensation received, and a claim can reach back only one year before the suit was filed.
The advisor’s fiduciary duty also covers a duty of care (giving advice in the fund’s best interest and seeking the best available trade execution) and a duty of loyalty (not putting its own interests ahead of the fund’s). That duty can’t be waived, though the scope of services and the specific limits on the advisor’s authority are shaped by the contract itself.12Federal Register. Commission Interpretation Regarding Standard of Conduct for Investment Advisers
How Investment Companies Are Taxed
Most investment companies are structured as “regulated investment companies,” or RICs, under the Internal Revenue Code. That status lets them pass income through to shareholders without paying corporate-level tax on it. To qualify, the company has to be registered under the Investment Company Act and has to derive at least 90 percent of its gross income from dividends, interest, and gains on the sale of securities or currencies.13Office of the Law Revision Counsel. 26 U.S. Code 851 – Definition of Regulated Investment Company
RICs also have to meet asset diversification tests at the end of each quarter. At least 50 percent of total assets must be in cash, government securities, or securities of other RICs. No more than 25 percent can be concentrated in a single issuer or a group of related issuers the fund controls.13Office of the Law Revision Counsel. 26 U.S. Code 851 – Definition of Regulated Investment Company
To avoid corporate tax 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.14Office of the Law Revision Counsel. 26 U.S. Code 852 – Taxation of Regulated Investment Companies and Their Shareholders Anything the fund keeps above that threshold is taxed at the corporate rate. Shareholders then report the distributions on their own returns, so the income gets taxed once at the individual level rather than twice.
Penalties for Violations
The Investment Company Act carries both civil and criminal penalties. Civil penalties follow a three-tier structure keyed to how serious the misconduct is:15Office of the Law Revision Counsel. 15 U.S. Code 80a-9 – Ineligibility of Certain Affiliated Persons and Underwriters
- First tier: up to $5,000 per violation for an individual, or $50,000 for a company.
- Second tier: up to $50,000 per violation for an individual, or $250,000 for a company, when the violation involves fraud or reckless disregard of a regulatory requirement.
- Third tier: 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.
Criminal prosecution is reserved for willful violations. A person convicted of willfully violating the Act, or of making materially false statements in a required filing, faces a fine of up to $10,000, imprisonment for up to five years, or both.16Office 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.