7 ALI-ABA Course of Study Investment Company Regulation and Compliance June 3-4, 2010 Washington, D.C. Legal Considerations in Forming a Mutual Fund By Boston, Massachusetts
8 2
9 I. Introduction LEGAL CONSIDERATIONS IN FORMING A MUTUAL FUND * The process of forming a mutual fund requires consideration of a variety of issues and options. Among other things, it is necessary to consider which form and jurisdiction of organization to select, whether to organize as a series company, whether to establish multiple classes of shares, and whether to organize the fund in a traditional stand-alone structure or master-feeder structure. Each of these matters must be considered in light of the objectives of maximizing procedural flexibility, minimizing personal liability, maintaining a reasonable cost structure, accommodating potentially different marketing initiatives and achieving pass-through tax treatment for the fund. II. Selecting the Appropriate Form and Jurisdiction of Organization A. Overview of the Options 1. Business Trusts and Corporations. The preferred forms of organization for an investment company today are the business trust and the corporation. Each of these forms has certain distinct advantages and disadvantages, as described in greater detail below. Most investment companies that are organized as business trusts are established under the business trust laws of Massachusetts or the statutory trust laws of Delaware. Most investment companies that are organized as corporations are established under the corporation statute of Maryland, which contains numerous provisions specifically designed to accommodate the special needs of registered investment companies. In general, a business trust provides greater flexibility with respect to procedural matters and a corporation provides greater certainty with respect to limitation of personal liability. In either case, it is possible to qualify for pass-through tax treatment under Subchapter M of the Internal Revenue Code of 1986, as amended (the Code ), and to establish multiple series and classes of shares. A comparative summary of the major distinctions among Massachusetts business trusts, Delaware statutory trusts and Maryland corporations is included as Appendix A to this outline. 2. Limited Partnerships. Prior to 1988, it was sometimes advantageous for an investment company to be organized as a limited partnership if it appeared that the fund might not be able to satisfy all conditions for qualifying as a regulated investment company under Subchapter M of the Code. As a limited partnership, the fund would be able to avoid a * This outline includes materials previously included in outlines prepared by Robert E. Carlson for use in prior ALI-ABA programs.
10 corporate level of taxation and thereby maintain a competitive yield for investors. In 1987, however, Congress amended the Code to provide that all publicly traded partnerships (including open-end registered investment companies) will be treated as corporations for tax purposes and, therefore, will be subject to the corporate level of taxation. See Section 7704 of the Code. For this reason, it is no longer practical for a publicly marketed investment company to organize as a limited partnership. B. Comparing Business Trusts and Corporations on Procedural Issues 1. Governing Law. A corporation is governed by state corporation statutes, which may only be amended by an act of the legislature. A business trust is governed primarily by its trust instrument, which may be amended by the trustees if the trust instrument so provides. Because of this difference in governing law, the trust instrument of a business trust may, and often does, contain provisions that would not be permitted by the applicable corporation statute. As mutual fund products have become more diverse and complex, the flexibility of the business trust has become increasingly important. Essentially, the business trust eliminates a layer of regulation, i.e., the state corporation statute. The state of Maryland, however, has enacted changes to its corporation statute to eliminate some of the disadvantages of organizing a registered investment company as a corporation. 2. Annual Shareholders Meetings. The corporation statutes of most states require a corporation to hold annual shareholder meetings. The process of holding an annual shareholder meeting is both costly and time consuming. Under the Maryland corporation statute, a registered investment company organized as a Maryland corporation (a Maryland Company ) is not required to hold an annual shareholders meeting, except in a year in which the election of directors is required by the Investment Company Act of 1940, as amended (the 1940 Act ). A business trust may provide in its trust instrument that an annual shareholders meeting is not required. 3. Authorized Shares. A corporation must specify an authorized capital in its charter and pay a fee, usually based upon the number of shares the corporation is authorized to issue. Once the authorized capital is depleted (i.e., shares are issued equaling the number of authorized shares), a corporation must increase its authorized capital, which typically requires shareholder approval and a costly proxy solicitation. The Maryland corporation statute allows the board of a Maryland Company to increase the number of authorized shares without shareholder approval. Although the board of directors of a Maryland Company may increase the authorized capital stock of the corporation without shareholder approval, the board may not authorize an unlimited number of shares. Accordingly, the corporation must monitor the number of authorized and unissued shares continuously to ensure that all shares being sold are validly issued. 2
11 Shares issued in excess of the number authorized are voidable by the shareholder until such time as the corporation files articles supplementary increasing the number of authorized shares. A business trust may authorize the issuance of an unlimited number of shares and, therefore, will never have to amend its trust instrument to increase its authorized capital. This feature is especially attractive for a money market fund, which may sell a large number of shares during a short time period. 4. Creation of Additional Series. Many state corporation statutes require shareholders to vote upon the creation of additional series of shares. A Maryland Company may, without shareholder approval, create a new series and allocate authorized shares among several series by action of the board of directors. If its trust instrument so provides, a business trust may, without shareholder approval, add additional series upon the vote of its board of trustees. 5. Elimination of Stock Certificates. Most state corporation statutes provide that each shareholder is entitled to a stock certificate representing the shareholder s interests in the corporation. Under the Maryland corporation statute, a Maryland Company may issue shares in uncertificated form. A business trust may provide in its trust instrument that stock certificates will not be issued. 6. Liquidation Without Shareholder Approval. Virtually all state corporation statutes require shareholder approval to liquidate. A business trust may provide in its trust instrument that any series may, without shareholder approval, be liquidated by vote of the trustees. Although a Maryland corporation may not liquidate without shareholder approval, a Maryland corporation registered as an open-end investment company may dispose of all or substantially all of its assets without shareholder approval and, subject to any limitations in its charter, redeem all of its shares for cash without shareholder approval, thereby effecting the equivalent of a liquidation without shareholder approval. 7. Reorganization. Many state corporation statutes require shareholders to vote on a proposed reorganization. A Maryland Company may not merge with another entity without shareholder approval. However, a Maryland Company registered as an open-end investment company may transfer substantially all its assets to another entity without shareholder approval. A business trust may provide in its trust instrument that the trust may reorganize, without a shareholder vote, by a vote of the trustees. 8. Indemnification. Most state corporation statutes impose substantive and procedural limitations on the power of a corporation to indemnify its officers and directors. If its trust instrument so provides, a business trust may provide for indemnification to the full extent permitted by the 1940 Act. 3