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Abstract

More than 100 million Americans invest $25 trillion in mutual funds and exchange-traded funds (collectively, “funds”) regulated by the Investment Company Act of 1940 (the “Act”), making funds the predominant investment vehicle in the United States. Everyday investors rely on funds to save for retirement, pay for college, and seek financial security. In this way, funds demonstrate how “Wall Street” can connect with “Main Street” to improve people’s lives.

By way of background, funds are created by investment advisers (“advisers”) that provide investment advisory (e.g., stock selection) and other services to their funds in exchange for a fee. Investors purchase shares of a fund, which represent a pro-rata interest in the fund’s net assets—essentially, the securities chosen by the adviser—with the hope that the value of those assets, and in turn, the value of the fund, will appreciate. Although managing a fund is expensive, pooling investments from the public allows an adviser to spread its costs over an entire fund, which allows professional money management to be affordable for all.

Prior to the Act, the unique structural aspects of funds, coupled with a lack of regulation, enabled rogue advisers to put their own interests ahead of those of fund shareholders. These structural aspects include that a fund typically relies on its adviser, which seeks to make a profit, to manage its day-to-day operations. Before 1940, adviser personnel also dominated the boards of directors of funds, which are responsible for overseeing the adviser and negotiating its compensation. This made funds susceptible to rogue advisers that were more interested in managing funds to benefit themselves and their “affiliates” (i.e., their employees and related businesses), as opposed to increasing the value of their funds.

Recognizing the vital role that funds play for both the overall economy and the citizen of “small means,” the Securities and Exchange Commission (SEC) and the fund industry worked together to draft the Act, which Congress passed unanimously. The incredible growth of funds over the past 80 years is often attributed to the oversight and direction provided by the Act, which regulates all facets of fund operations and is arguably the most complex of our nation’s securities laws.

Understanding the policy concerns that led to the Act helps to cut through that complexity and make sense of the Act’s provisions. As a result, this article focuses on those concerns, which can be thought of as guiding “Principles,” to demonstrate how the Act seeks to: (1) prevent insiders from taking advantage of funds they manage; (2) require effective disclosure; and (3) ensure the equitable treatment of shareholders.

The Principles make the Act easier to apply by serving as shoal markers for conduct to avoid. But, just as a buoy indicates dangerous areas to avoid, the Principles also help guide conduct that steers clear of them. The Principles are thus a useful lens for interpreting the Act, particularly when considering novel situations or whether, per the “rubber” built into the Act, exemptive or other relief is appropriate. In these instances, harnessing the history and purpose of the Act can help advisers, fund directors, practitioners, and regulators apply the Act and ensure that funds remain a driver of national and, most importantly, investor gain.

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