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Mutual Fund Basics

June 2007 Todd Cipperman, Esq. Cipperman & Company

The Players
Sponsor: organizes and promotes the Fund; arranges service providers Investment Advisor/Manager: manage the portfolio and invest the assets Investment Managers may retain Sub-Advisors Directors: > 50% independent Administrator: accounting, NAV calculation May be affiliated with Advisor Distributor: broker-dealer activities Custodian: certain banks Transfer Agent: keep shareholder records Auditors: annual audit and opinion on financials Fund Counsel: registration statement, filings, opinions, Board meetings, advice Chief Compliance Officer: annual report to Board re compliance with securities laws

The Laws
Investment Company Act of 1940 Investment Advisers Act of 1940 Internal Revenue Code, Subchapter M ERISA NASD Rules Securities Exchange Act of 1934 SEC Interpretations, Statements, NoAction Letters, Enforcement Actions

The Paper
Registration Statement Prospectus Statement of Additional Information Part C Shareholder Reports SEC Filings Agreements Investment Advisory Distribution Administration Custody Other Board Materials

Restrictions on Advisor
Prospectus and SAI Disclosure Disclose investment objective and policies Certain policies may only be changed upon shareholder vote Advisory Contract Annual Board approval includes review of investment performance, compensation, brokerage, fund expenses Board of Directors Valuation of securities Approve distribution arrangements Approve service providers Private Rights of Action (Lawsuits) Adviser has fiduciary duty with respect to the amount of compensation received Affiliated Transactions Transactions between affiliated funds Joint transactions Affiliated brokerage Investment Restrictions Disclosure Fund-of-funds Diversified/Non-Diversified (e.g. no more than 5% in one security)

Advisory Contract
Approval by shareholders
Includes material amendments

Annual approval by Board In-Person meeting of independent directors Termination in the event of assignment or on 60

notice

days

Services Invest pursuant to Prospectus & SAI Place orders Vote proxies Report to Board Back office work Fees based on AUM Limits on performance fees Breakpoints

Sub-Advisory Contracts
Approval by shareholders required Allocation of responsibilities
Records retention

Fees paid by Advisor or Fund Manager-of-Managers structures


Exemptive relief to appoint subadvisers

Board Role in Reviewing Advisory Contract (15(c))


36(b): fiduciary duty on adviser not to receive excessive compensation Includes private rights of action Gartenberg standard: arms length Nature and quality of services Comparable fees and expenses Advisor profitability Economies of scale Fall-out benefits (e.g. soft-dollars) Shareholder reports require discussion of Board review 15(c) report prepared by Advisor: description of business and personnel, compensation and performance, compliance, brokerage

Investment Restrictions: Prospectus/SAI


Fund Name: 80% test (e.g. country, region) Investment objective Concentration policies Fundamental Investment policies: require shareholder vote to change Diversified vs. Non-diversified 75% of assets: no investment > 5% IRC: no more than 25% in any one issuer Shareholder vote to become Non-diversified 1940 Act Other funds: 3/5/10 Rule Insurance Companies Securities-related businesses Illiquid securities

Trading
No purchases if an affiliate is a member of an underwriting syndicate (n.b. Rule 10f-3) Effecting trades through affiliated brokers (n.b. Rule 17e-1) Restrictions on agency cross trades (Advisers Act, ERISA

Custody
Qualified Bank Foreign Custody Foreign Sub-Custodian Qualified Foreign Banks Financial strength Ability to enforce judgments and protect assets No exchange controls Access to auditors Eligible Securities Depository Board approval and reporting Custody at Futures Commission Merchant for exchangetraded futures contracts and commodity options
Segregation of assets Sweeping of gains

Proxy Voting
Must disclose proxy voting policies and procedures in Registration Statement
Conflicts between shareholders and adviser

Fund must file proxy voting record Allocate proxy voting responsibility between adviser and sub-adviser (and third party) Advisers Act requires proxy voting in the best interest of clients and procedures for resolving conflicts of interest ERISA requirements

Conflicts of Interest
Affiliate: investment adviser, officers, directors, partners, etc. (n.b. complex definition) An Affiliate may not: Sell any security to the Fund Purchase any security from the Fund Borrow money from the Fund Exception for exchange-traded securities at the current market price (Rule 17a-7) E.g. seeding of GOBF fund An affiliate may not engage in a joint enterprise with a fund (e.g. securities purchases, kickbacks from service providers, trade allocation) An affiliate may not act as agent for compensation in a transaction with the Fund (e.g. broker)
Rule 17e-1: permissible affiliated brokerage

Personal Trading
No fraudulent, manipulative, deceptive practices in connection with purchase/sale of securities by related persons Includes securities held by the fund during the last 15 days or had been considered for purchase during the last 15 days Excludes Treasuries, Short-term instruments, Mutual Funds Fund and Adviser must adopt a Code of Ethics Approved by Board Periodic reporting of violations Advisers Act (More restrictive Code of Ethics) Form ADV disclosure Broader holdings reports

Code of Ethics

Reports by Access Persons


Holdings and Transaction reports Must be reviewed by management or compliance Access Person: any director, officer, general partner of adviser who, with respect to any Fund, makes any recommendation, participates in the determination of which recommendation will be made, or whose principal function or duties relate to the determination of which recommendation will be made, or who, in connection with his or her duties, obtains any information concerning recommendations made by the investment adviser to any Fund

Pre-approval of participation by investment personnel in IPOs and private placements Recordkeeping: Code, violations, certifications, access persons, holdings reports Disclosure about personal trading policies in prospectus

Marketing Mutual Funds


Does the material reference the Fund? Anti-fraud (Rule 156 and 10b-5) Is the material accompanied or preceded by the Prospectus? Exceptions:
Generic advertisement: no reference to a specific fund (e.g. magazine ads) Rule 482

Rules apply equally to internet advertising Effect on marketing to non-US jurisdictions UK: directed communications, reasonable precautions

Rule 482 Materials


Specific disclosures (e.g. obtaining and reading prospectus) Standardized presentation and calculation of performance information
Formulas for average annual total return Must present 1, 5 and 10 year performance Current to the most recent calendar quarter

Other Marketing Rules


Add disclosure about qualifications and limitations on past performance presentation
Conveying an unjustified impression Caution with respect to future investment performance without adequate qualification

Balance benefits of fund structure/attributes with risks (e.g. high yield bonds, emerging markets, IPOs) Exaggerated claims about manager skill or process Misleading comparisons to other funds

Related Account Performance


Permissible in marketing material if
Disclosure that it is not funds performance Cannot omit funds performance Explanation of purpose of related performance Disclosure of material differences

NASD members cannot use sales literature that includes related account information Note: Portfolio Holdings Policy and disclosure

NASD Regulation of Marketing


Observe principles of fair dealing and good faith; communications must be balanced No false or exaggerated claims No predicting future results Limits on testimonials Fair presentation of comparisons Specific ranking guidelines Principal must approve sales material Must file marketing materials within 10 days of first use
Often file before use to avoid re-printing Pre-filing and approval if certain rankings or bond fund volatility ratings included

Recordkeeping
Financial records, shareholder account ledgers, agreements, board meeting minutes, brokerage reports All records must be maintained in easily accessible place (aka on-site) for 2 years Certain records must be maintained indefinitely: journal entries and ledgers, portfolio histories, corporate documents, minute books Other records must be maintained for 6 years Electronic storage permissible SEC access upon request Third party service providers may hold records Advisers Act requirements (generally 5 years)

Compliance
Fund must adopt and implement policies and procedures reasonably designed to prevent violations of the securities laws
Portfolio management, trading, disclosures, recordkeeping, valuation, privacy, market timing Oversight of Fund service providers

Board approval of written policies and procedures


Consider recent compliance experience Best practices

Annual review of adequacy and effectiveness


Includes testing Consider changes in business, regulations, compliance Presentation to Board

Designate responsible Chief Compliance Officer (competent, senior, independent)

Summary
Mutual Funds are highly regulated Consult your Legal or Compliance Professional

Todd Cipperman, esquire

Todd Cipperman is the principal of Cipperman & Company, which provides legal services to investment managers, investment advisers, broker-dealers, mutual funds, hedge funds, and technology providers. Cipperman & Company provides a wide range of services for the industry including regulatory advice, product development, distribution arrangements, compliance programs, and client and vendor agreements. Mr. Cipperman has more than 15 years of experience in the investment management and financial services industries. As a principal of Cipperman & Company, he has represented a wide range of investment management clients with a focus on distribution issues facing advisers and broker-dealers. He previously served as general counsel of a public mutual fund and financial technology firm, including its $65 Billion proprietary mutual fund family. He has also served as general counsel of one of the largest international equity 1905 General Alexander Drive managers. He spent several years in private practice on Wall Street representing both buy Malvern, PA 19355 side clients in investment and sell 610.648.9449 tcipperman@cipperman.com management and capital markets transactions. He is a graduate of www.cipperman.com the University of Pennsylvania Law School and Cornell University.

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