This article is adapted from the Fund Director’s Guidebook, Fifth Edition, by the American Bar Association Business Law Section’s Federal Regulation of Securities Committee.
To fulfill their responsibilities, directors or trustees (“directors”) of US investment companies registered under the Investment Company Act of 1940 (“1940 Act”) should have a solid understanding of the robust regulatory structure that the funds they oversee are subject to. The American Bar Association Business Law Section has updated its Fund Director’s Guidebook, a key resource for registered fund directors as a primer on that regulatory regime, directors’ responsibilities, and key areas of oversight. The Fund Director’s Guidebook, Fifth Edition is available for purchase from the ABA.
Many investment companies, including mutual funds, exchange-traded funds, and closed-end funds, are registered with the Securities and Exchange Commission (“SEC”) under the 1940 Act. The 1940 Act mandates compliance with extensive and comprehensive requirements that, for example, govern capital structure, prohibit certain types of investments, restrict transactions with affiliates, and regulate investment advisory and distribution arrangements. Regulation extends to such matters as composition of a fund’s board and election of directors, capital structure and derivatives risk, portfolio transactions, custodial arrangements, fidelity bonding, selection of accountants and auditing standards, compliance programs, valuation and pricing of shares, and portfolio liquidity, among others. Beyond the 1940 Act, the regulatory regime for investment companies also includes the Investment Advisers Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act, regulations of the SEC and the Commodity Futures Trading Commission (CFTC), other regulators and self-regulatory organizations, and laws of the states where the funds are organized.
The comprehensive regulatory regime applicable to registered funds—contained in the 1940 Act and the SEC’s rules thereunder in particular—contemplates an important and active role for fund directors. Because of the external management structure typical of most investment companies, the role of the directors of a fund or group of funds differs in important respects from the role of the board of directors of an operating company. The external manager of a fund necessarily operates its business in its own best interests, which may not always be congruent with the best interests of the fund’s shareholders.
For this reason, although fund management and fund shareholders have common interests in many areas, there are actual and potential conflicts of interest between the two. Under the 1940 Act regulatory framework, the directors (particularly the independent directors) are responsible for monitoring potential and existing conflicts and representing the interests of fund shareholders. Although fund directors generally work closely and cooperatively with fund management, the directors—particularly independent directors—must exercise independent judgment. Although the most obvious conflicts overseen by fund directors relate to fees and other expenses paid by, and the quality of services provided to, the fund, there are others as well. Independent directors represent the interests of fund shareholders when those interests might conflict with those of the adviser.
The Fund Director’s Guidebook serves as a convenient resource for directors of mutual funds, exchange-traded funds, and closed-end funds. It provides an overview of the functions, responsibilities, and potential liabilities of fund directors, under both the federal securities laws (including the 1940 Act) and corporate or trust law generally, as well as information about the structure and operations of the board and its relationship to the investment adviser, the distributor, and others important to the fund. The Guidebook is intended to help directors discharge their responsibilities by providing them with practical information and guidance to help them understand their duties and ask the right questions.
It is important to note that the manner and the environment in which funds operate are constantly evolving, as are the regulations governing fund and investment management activities and the industry itself. It is essential that fund directors and management stay abreast of new industry and regulatory developments affecting how business is conducted.
In an attempt to keep up with the pace of the developing industry and its regulatory environment, the Guidebook was initially published in 1996 and was subsequently updated in 2003, 2006, and 2015. The fifth edition reflects a large number of regulatory developments since 2015, covering significant completed and pending rulemakings and other initiatives by the SEC as well as industry developments, including those relating to:
- liquidity risk and cybersecurity risk management;
- exchange traded funds;
- the use by funds of derivatives;
- fair valuation;
- funds investing in other funds;
- money market fund reform;
- fund names;
- environmental (including climate), social, and governance (ESG) investing;
- LIBOR transition;
- responses to the COVID-19 pandemic; and
- a greater focus on diversity, equity, and inclusion.
The American Bar Association Business Law Section recommends that copies of the Guidebook be shared with fund directors and those that assist fund directors in carrying out their oversight function. Fund advisers, law firms with practices in this area, and other service providers to registered funds will also find the Guidebook to be a helpful resource.