What Are the U.S. Government Regulations of Mutual Funds?

By: Jane Meggitt | Reviewed by: Ashley Donohoe, MBA | Updated May 31, 2019

Millions of people save for retirement and otherwise build their financial funds via investing in mutual funds. The federal government regulates securities markets through the United States Securities and Exchange Commission, which includes mutual funds.

Mutual Fund Basics

Mutual funds consist of pooled investment vehicles offering shares to the public. Mutual funds include stock funds, bond funds, money market funds, a mix of stocks and bonds and categories specific to a certain investment class.

Such classes may include large capitalization, or large-cap funds, which invest in well-known, strong companies. Mid-cap and small-cap funds invest in companies with either mid-range or small capitalizations. Index funds track particular market indexes, such as the Standard & Poor’s 500.

Shares of mutual funds are redeemable securities, meaning that in most circumstances shareholders can redeem their shares at net asset value at any time, and the mutual funds must pay out the proceeds within seven days. In the U.S. alone, there are approximately 8,000 mutual funds with total assets exceeding $15 trillion.

Mutual Fund Regulations

Mutual fund regulation dates back decades, with many rules put forth during the administration of President Franklin D. Roosevelt after the Wall Street Crash of 1929 left the Great Depression in its wake. It was the Securities Exchange Act of 1934 that created the SEC and gave it regulatory authority over the mutual fund industry, along with the stock market and brokerage houses.

Other key mutual fund regulations include The Securities Act of 1933, which requires that investors receive specific information regarding securities offered for public sale. This legislation was also known as the “Truth in Securities Act.” The Investment Act of 1940 focuses on mutual fund regulations, as well as how investment companies are structured, operate and pursue investment objectives. This act mandates disclosure of a company’s financial health and its investment policies.

State Mutual Fund Regulations

Most states require mutual funds to file annual notices if the shares are sold in the state. The mutual funds must also pay annual fees to the state. State securities regulators may require mutual funds to file periodic reports.

Other Regulatory Bodies

The Financial Industry Regulatory Authority oversees securities firms doing business in the United States. FINRA regulations govern the way member firms market and sell mutual funds. The Commodity Futures Trading Commission regulates the U.S. options, futures and swaps markets, as well as mutual funds investing in these markets. Mutual fund advisers investing in these markets must become a commodity pool operator, as per the federal Commodity Exchange Act.

How Mutual Funds Are Authorized

The Investment Company Act of 1940 requires all mutual fund companies to register as investment companies under its regulations. The fund management must file forms N-1A and N-8A. The former requires information about the fund’s strategies, investment objectives and risks, as well as their operating expenses and fees. Form N-1A also includes information about how to purchase shares, the fund advisers and fund performance. Form N-8A is the notification of registration form.

As mutual funds go through the registration process, SEC staff reviews the fund’s registration statement and sends back comments. The company’s response to the comments is then included in amendments prior to the sale of the mutual fund’s shares to the public. Once the SEC receives the comments from the mutual fund management and determines the registration statement is satisfactory, it does one of two things: Either the registration statement is declared effective, or the fund may file an amendment that becomes effective before the sale of shares.

Every mutual fund must file Form N-1A annually, updating its fee and performance information.

Mutual Fund Marketing

Generally, mutual fund shares are marketed to the public via an SEC-registered broker/dealer distributor. Such distributors are also FINRA members and must follow its rules. These distributors purchase fund shares, and then either sell shares directly to the public or through an intermediary.

Because the distributor must adhere to FINRA regulations, they must consider the suitability of the mutual fund for individual investors. For example, the broker/dealer should not recommend very high-risk funds for elderly people seeking safe, secure investments in retirement.

Mutual funds have the right to adopt policies limiting the trading of certain investors. Some frequent, high volume traders are an example of the type of investors a mutual fund might target.

Mutual Fund Advisers

Both the Investment Company Act of 1940 and the Investment Advisers Act of 1940 govern mutual fund advisers. Mutual fund advisers must register with the SEC as investment advisers, and must adopt policies and procedures complying with all SEC regulations. Mutual fund advisers serve as fiduciaries, meaning they must act in the best interests of their clients. These advisers are required to file regular reports with the SEC and “seek the best execution” for all portfolio transactions.

It is the responsibility of mutual fund advisers to obtain shareholder and board approval of the fund’s advisory personnel. If the mutual fund adviser seeks to change certain fund investment policies, shareholder approval is also required.

Mutual Fund Custodians

All mutual funds must place assets with a qualified custodian, as per the Investment Company Act of 1940. Such custodians are either a broker/dealer or a U.S. bank meeting the necessary capital requirements. There are also situations in which a mutual fund might act as its own custodian. The Investment Company Act of 1940 allows securities depositaries, commodity clearing organizations and futures commission merchants to act as mutual fund custodians.

When it comes to foreign assets and custodians, foreign banks regulated by their governments may qualify, as do foreign securities depositories, U.S. bank subsidiaries or holding companies.

Mutual Fund Organization

For legal purposes, a mutual fund has a variety of options for its organization. These options include a corporation, business or statutory trust, a limited liability company or a limited partnership. Some states may permit other entities for mutual fund organization.

The majority of mutual fund organizations are set up as either Maryland corporations, Delaware statutory trusts or Massachusetts business trusts. One reason these particular types of organization are favored by fund managers is that annual shareholder meetings aren’t a requirement. These corporations or trusts also offer a great deal of flexibility when it comes to mutual fund governance.

Mutual Fund Investment Restrictions

Mutual funds invest in many different types of vehicles. However, the Investment Company Act of 1940 limits how much a diversified fund can invest in any single stock. Under the act, out of 75 percent of a mutual fund’s assets, 5 percent or more cannot be invested in a single stock. The fund is also prohibited from acquiring in excess of 10 percent of a single stock’s outstanding voting securities.

A mutual fund can put that other 25 percent of its investments in a single stock, so it is possible for a fund to invest up to 30 percent of its assets in one stock. Other investment restrictions include limitations for investing in businesses relating to securities, other investment companies and investments considered illiquid. If a fund invests in commodities or real estate, it must provide that information in its registration documents. Changing such investment policies requires shareholder approval.

Mutual Fund Borrowing

The SEC limits the ability of mutual funds to borrow money. Funds are not permitted to issue so-called “senior securities,” which the Investment Company Act of 1940 defines as notes, debentures, bonds or other obligations that are indebted securities. Funds are also prohibited from issuing classes of stock with asset distribution or payment priority. That doesn’t mean a mutual fund can’t borrow money from a bank, but only if it maintains a certain percentage of assets.

Mutual Fund Manager Permitted Restrictions

Mutual fund managers are allowed to place certain restrictions on their funds. Managers have the ability to close a fund to new investors or put in place minimum investment amounts. They can impose sales charges on share purchases, whether investors pay these charges upfront upon purchasing the shares, as part of an annual charge or when shares are redeemed. Managers decide which distribution channels may sell their shares.

As noted, a mutual fund manager can limit the number of trades made daily or the numbers of fund exchanges an investor may make. While mutual fund managers cannot suspend redemptions under normal conditions, they may impose redemption fees of as much as 2 percent of the value of the shares redeemed.

Mutual Fund Reporting Requirements

Some mutual fund investors may complain about all of the paperwork they receive from mutual fund companies if they haven’t switched to handling their accounts electronically, but odds are they don’t read much of the material whether it is received in the mailbox or in an attachment from the mutual fund company. Mutual fund companies are required to make these reports, which include the prospectus and any supplements to the prospectus. Other reports mutual fund clients should expect to receive include annual and semiannual reports, annual privacy notice and some forms of tax information.

Mutual funds must file other reports with the SEC. Besides the annual N-1A updates, these include any summary prospectuses; Form N-CSR, which includes annual and semiannual financial statements signed and validated by the fund’s chief executive officer and chief financial officer; Form N-Q, quarterly reports on fund holdings also requiring CEO and CFO certification; regulatory information on Form N-SAR; and Form N-PX, an annual report containing proxy voting records.

Mutual Funds and Taxes

Under the Internal Revenue Code, regulated investment companies are not subject to federal income taxes on income and capital gains, if the latter are distributed to investors in a timely manner. These investment companies are not subject to such taxes at the fund level. That is why most mutual fund companies want to qualify as regulated investment companies.

For investors, mutual fund income and short-term capital gains are taxed as ordinary income for the investor’s tax bracket. Long-term capital gains distributed by mutual funds are taxed in the same way as long-term capital gains for individual stocks and bonds.

Securities Investor Protection Corporation

As per the Securities Investor Protection Corporation website, the SIPC provides protection to the investor from the loss of securities and cash held at an SIPC-member brokerage firm. The protection limit is $250,000 for cash and $500,000 for securities. SIPC protection is available only when the brokerage firm begins liquidation. It does not cover the loss of security value resulting from trading, poor investment advice or a stockholder finding themselves with an inappropriate investment.

The SIPC protects a variety of securities, including stocks, bonds, mutual funds, money market funds, certificates of deposit and Treasury bills. It does not protect most commodity futures contracts, currency trading, limited partner investment contracts, foreign exchange trades or fixed annuity contracts, if the latter are not registered with the SEC. When a brokerage firm fails, the SIPC replaces missing securities “when it is possible to do so.”

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About the Author

A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Financial Advisor, Sapling, nj.com and The Nest.

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