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Investment Company
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

As defined in the Investment Company Act of 1940, any issuer that:


  1. Is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities
  2. Is engaged or proposes to engage in the business of issuing face amount certificates of the installment type, or has been engaged in such business and has any such certificates outstanding
  3. Is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40% of the value of such issuer's total assets (exclusive of government securities and cash items) on an unconsolidated basis.

Face amount certificates of the installment type are defined as obligations to pay on stated or determinable dates, more than 24 months after date of issuance, in consideration of periodic payments similarly ascertained.  "Securities," as used in the definition do not include government issues, those of employees' securities companies, or those of majority-owned subsidiaries that are not investment companies.

Money Market Funds Phenomenon.

In recent years of record and near-record short-term money rates, the rise in yields and rates of return in money market short-term instruments, occasioned by the Federal Reserve's implementation of an anti-inflation monetary policy, has provided the stimulative background for the phenomenal rise of a new type of open-end fund.  The money market fund, so-called because of its specialization in holdings of short-term money market investments, affords investors returns considerably in excess of rates paid on passbook savings accounts by thrift institutions (commercial banks' savings departments, mutual savings banks, and savings and loan associations) and also in excess of returns afforded by such thrift institutions on their savings certificates restricted as to freedom of withdrawals before specified maturity.

Besides the advantage in yields, the following are usually included among the features afforded to investors by money market funds.

  1. Lower minimum initial investment (e.g., from $1,000 to $2,500) compared to the usual minimum $10,000 initial investment in thrift institutions' savings certificates, including the six-month money market certificate.
  2. Privilege of checkwriting without checking charges, provided minimum holding is maintained (e.g., $500), with yield continuing until the check clears.  No penalties for withdrawals.
  3. No sales charges to open a money market fund account.

On the other hand, the yield on money market fund shares will fluctuate daily as money market rates vary as a function of portfolio quality and maturities, as well as expenses of the fund.

The money market account is not insured as is the savings account (passbook savings or savings certificates) in commercial banks, mutual savings banks, savings and loan associations, and credit unions.

The spectacular rise of money market funds has been the source of disintermediation (outflow of funds from intermediary thrift institutions) which has proven to be a serious problem for many such institutions, along with the internal shift of deposit funds in such Institutions from lower-paying passbook savings accounts to the higher-paying savings certificates.  Faced with such outflow of funds and higher cost of retained funds on one hand, the thrift institutions on the other hand have been restricted to interest rate ceilings that may be paid on deposits, lack of authority to invest more broadly in higher yielding earning assets (in the case of thrifts other than commercial banks), and low earning rates on mortgage portfolios.

In March, 1980, the Federal Reserve imposed a 15% reserve requirement on new asset growth of existing money market funds, which led sponsors of such funds to organize new "clones" not technically subject to the reserve requirement.  Although this restriction on growth and yields was rescinded (see FEDERAL RESERVE BOARD OF GOVERNORS a few months later in 1980, the idea of imposing a legal reserve requirement was being re-urged as of 1981, based on the checking privileges afforded by the money market funds.  Under the DEPOSITORY INSTITUTIONS DEREGULATION AND MONETARY CONTROL ACT OF 1980, interest rate ceilings will be gradually phased out.

Investment companies rank today among the largest investing institutions, and constitute a potent market factor and money pool for investment.  The following paragraphs trace the history and development of investment companies, from their early humble beginnings in the U.S., influenced by British investment company practice, to their mushroom growth in the late 1920s, subsequent shakeout caused by the great depression, subjection to federal regulation beginning in 1940, and their present important position.

British Investment Trusts.

Although the first investment "trust" (the modern American designation for these investing institutions is "investment company") is said to have been authorized by King William of the Netherlands in Brussels in 1822, and an investment trust was started in Switzerland in 1849, the prototype that still serves as a model for modern investment companies of the general management type first assumed importance in England and Scotland.  The first was called the Foreign and Colonial Government Trust and was organized in 1865.  There were also the London Financial Association and the International Financial Society.  Many of these early investment trusts invested heavily in American securities and those of the colonies of Great Britain.  The purpose of the early British investment trust was to procure the highest yield compatible with safety through the principle of diversification and the substitution of expert investment knowledge for guesswork.  The prospectus of the Foreign and Colonial Government Trust stated:

"The object of this trust is to give the investor of moderate means the same advantage as the large capitalist in diminishing the risk of investing in foreign and colonial government stocks and reserving a portion of the extra interest as a sinking fund to pay off the original capital.  A capitalist who at any time within the last 20 or 30 years had invested, say ₤1000,000, in ten or twelve such stocks selected with ordinary prudence, would on the above plan not only have received a high rate of interest, but by this time received back his original capital by the action of the drawings and sinking fund, and held the greater part of his stocks for nothing."  (Shades of modern investment company promotional literature!)

British investment trusts went through a baptism of fire caused by the crisis generated by the Baring Brothers failure in 1893.  Out of that experience, the surviving companies emerged with sounder accounting practices, such as the crediting of turnover profits to reserves as protection against future market depreciation and losses.

The British investment trust is managed by a board of directors, or trustee-managers.  Certain limitations on complete freedom of action have been characteristic, but the trustees nevertheless are vested with wide discretionary powers.  Under the specified restrictions imposed by the articles (or memorandum) of association, the directors may, among other things:

  1. Issue and allot shares of stocks and debentures
  2. Purchase and sell securities and other investments
  3. Act as transfer agents for the registration of the company's securities
  4. Appoint and fix salaries of officers and clerks
  5. Institute, defend, compromise, or settle any legal action on behalf of the company
  6. Set aside a portion of the company's earnings as a reserve
  7. Determine the profits of the company
  8. Negotiate and effect a combination of the interests of the company with those of any other company.

There is usually some provision for limiting the expenses of administering the trust.

Over a period of about a century, British investment trust practice has become fairly well standardized and has assumed the following characteristics:  limitation of the amount of capital that may be invested in a single undertaking, which is usually from 5% to 10%; the total common stock outstanding ("trading on the equity"); payment of dividends from earnings without reference to possible impairment of the original capital, but the building up of reserves from capital gains; absence of desire to control or operate any enterprise; vesting of control in common or deferred shares, or in founders' shares.

The pattern of capitalization of British investment trusts is also fairly well defined.  There are three general classes of securities which are issued - ordinary or common shares, preference or preferred shares, and debentures.  A common provision of the declaration of trust is one limiting the issue of debentures outstanding at any one time to the aggregate amount of ordinary and preference shares.

U.S. Investment Companies.

U.S. investment companies are of comparatively recent origin, and did not become generally popular before 1923.  One of the oldest U.S. investment companies was the Railway & Light Securities Co., which dated through its predecessor, Railway & Light Securities Co., a Maine corporation, from 1904.  In the 1920s, the American concept of investment company was broadened to include not only companies or funds operating like the British (the British models being the general management type), but also certain other types of investment participation.  In this country in the era of the 1920s five types of investment companies developed, i.e., general management, specialized management, fixed or limited management, holding and financial companies, and trading corporations.  What were known as fixed and limited management investment companies in this country became popular for a time in the early 1930s, after disappointment with the results of the general management companies following the 1929 break in security prices, and generally involved the issue of certificates carrying pro rata participation in a group of specified common stocks.  The composition of each group, "block", or "unit" was prescribed in the indenture, under whose terms a trust company, acting as trustee, held the underlying securities and issued the participating certificates.  The rigidly fixed type of trust indenture provided that no changes were to be made in the units of deposited securities.  Other indentures, under which participations were sold to investors, provided for some element of management by defining a large list of eligible securities out of which the specific selection for the units could be made by the "depositor" (the sponsor selling organization creating the fixed trust by agreement with the trust company functioning as trustee under the indenture).

With the deepening of the 1929-1932 depression, weaknesses in investment companies organized during the late 1920s became glaringly pronounced and were fatal to many companies, especially those that had sold large amounts of senior capital (debentures and preferred stocks) at high interest and dividend rates, thus providing for high fixed charges and leverage, and had invested the proceeds in securities at boomtime prices.  Under pressure of the collapse in security prices, abuses in management crept in; some investment companies organized by investment firms had become in effect dumping grounds for sticky underwritings; their holdings had been "churned" to generate commission business for the brokerage firm sponsors; and self-serving fees and contracts had served to milk the companies.  The financial and holding company type, which with the trading type had been popular in the late 1920s, practically disappeared, and many general management types also passed out of existence, were absorbed, or were reorganized.  Popularity of the fixed type of companies sharply waned as the list of stocks rigidly prescribed in the indenture incurred severe depreciation, suspended dividends, and loss of their original investment standing.  Many of these indentures, however, continued in existence, as they originally had prescribed 15 and 20 years or longer in term of the trust, so that although such fixed type shares were no longer offered actively, termination and liquidation of the underlying units remained to be accomplished in the future.  Beginning about 1932, the open-end (or Boston type) investment company began to rise as a solution for the disadvantages of the fixed type, and today such open-end investment companies are the most numerous and dynamic in growth.  Although the mortality rate in investment companies was high, various companies of the closed-end general management type with conservative management weathered the depression safely.

Federal Regulation.

In 1935, pursuant to the Public Utility Holding Company Act, the Securities and Exchange Commission (SEC) embarked upon an exhaustive study of investment companies in the U.S. which is the definitive work on U.S. investment company experience prior to federal regulation.  This study led to passage of the Investment Company Act of 1940, representing the first federal regulation of investment companies and marking a new stage in their history and development.  Besides being remedial in nature by aiming at abuses uncovered by the SEC study, the act is positive in character by prescribing new standards and procedures.  The act divided investment companies into three general classes.

  1. Face amount certificate companies (those engaged in issuing such participations or having any outstanding).
  2. Unit investment trusts, organized under a trust indenture or similar instrument, not having boards of directors, and issuing only redeemable securities that represent undivided interests in units of specified securities (the so-called fixed trust-type).
  3. Management companies, which are further subdivided into open-end companies and closed-end companies.  These companies are additionally subdivided into diversified and non-diversified companies.

An open-end company is one that offers for sale or has outstanding any redeemable security of which it is the issuer.  Shares are continuously offered, hence the open-end capitalization.  This is the Boston type, known semantically today as a mutual fund, the most common and most dynamically growing classification of companies.  One of the earliest was the Eaton & Howard Management Fund A-1 (now known as Eaton & Howard Balanced Fund), organized under a trust indenture March 23, 1932, felicitous timing (near the depth of the depression) for formation.  The closed-end type do not continuously offer their shares, directly or through distributor, and do not redeem their shares upon demand by the holders thereof.  A diversified company is one that has at least 75% of the value of its total assets represented by cash and receivables, government securities, and those of other investment companies, and other securities are limited for this purpose in respect to any one issuer to an amount not greater in value than 5% of the investment company's total assets, and to not more than 10% of the outstanding voting securities of the issuer.

Salient regulatory features of the act included the following.

  1. Registration.  Every investment company with more than 100 security holders must register with the SEC.
  2. Adequacy of capital.  Section 14 of the act sets forth three conditions, compliance with one of which is a necessary prerequisite to a public offering; (AZ) net worth of the issuing company must be at least $100,000; (b) the issuer must have previously made a public offering and at the time thereof have had a similar net worth minimum; (c) provision must be made, as a condition for registration of public offerings under the Securities Act of 1933, to adequately ensure (in the SEC's opinion):  (1) that after the effective date of the registration, the company will not issue any security, or receive the proceeds of any subscription, until agreements have been made by not more than 25 responsible persons to purchase securities to be issued by the company for an amount that in addition to the net worth of the company will equal at least $100,000; (2) that the agreed payments will be made before any subscriptions are accepted from any persons in excess of 25; and (3) that arrangements will be made for refund without deduction upon demand of any proceeds paid in, should the company not realize a net worth of $100,000 within 90 days after the registration becomes effective.  These provisions are aimed to prevent unduly low "shoestring" capital.
  3. Conservatism of capital structures.  To limit "trading on the equity", closed-end companies are required to have assets of at least three times funded debt or bank loans at time of issuance, and preferred stock must be covered by at least two times by assets.  Open-end companies are limited to solely one class of security outstanding, although bank loans are permitted to a limited extent.  These requirements as to capitalization applied to capital structures after 1940, and did not disturb capitalizations built up prior thereto.
  4. Investment policies.  Each company is required to register a statement of basic investment policy, which once stated may not be changed except with approval of stockholders.
  5. Management practices and procedures.  The act prohibits self-dealing, conflicts of interest, or breaches of trust; bars persons guilty of securities frauds from serving as officers or directors; of persons not affiliated with investment bankers or with brokers; requires stockholders' approval of fundamental changes in the board of directors; calls for at least 40% of the directors to be persons who are not officers or investment advisers of the company; and requires that a majority of the directors of open-end companies be independent of the "sponsor" or sales distribution organization.  Trafficking in management contracts and contracts to supervise the company's funds is prohibited.  In addition, investment companies may not purchase over a nominal percentage of voting securities of other investment companies.

The act (Sec. 31) provides statutory authority for periodic inspection by the SEC of investment companies.  These inspections indicated in some instances noncompliance with the act in such areas as the following:

  1. Improper selling practices by salespeople who promoted the sale of mutual fund shares just prior to dividend dates without explaining that the amount of dividend to be paid was included in the purchase price of the shares on which a sales-load was paid and that receipt of the dividend would represent a return of capital on which the shareholder would be liable for income taxes
  2. Deviations from fundamental policy without approval of stockholders
  3. Improper composition of boards of directors because of the affiliations of directors
  4. Acquisition of securities during an underwriting where an affiliated relationship existed between underwriter and company
  5. Sale of securities to a company by an affiliated person acting as a principal
  6. Failure to file an appropriate fidelity bond
  7. Noncompliance with the requirements for the custody of the portfolio securities of a company under Section 17 of the act
  8. Failure to obtain approval of stockholders or the board of directors for an investment advisory contract.

In addition to noncompliance with standards and regulations under the act, such inspections revealed instances where books and records were inadequate or lacking.  Problems included failure to record the date and time of requests for redemption, thus making it impossible to determine whether the investors received their correct net asset value; failure to maintain purchase and sales journals, and failure to maintain ledger accounts for broker-dealers used by the company for its portfolio security transactions; failure to keep proper vouchers for out-of-pocket expenses; and considerable delay in the transmission to the investment companies of funds received by dealers selling the mutual fund shares.  Also found were instances where the custodian did not adhere to the terms of the custodianship agreement or the SEC's regulations on the safekeeping of portfolio securities of the company.

The vast growth of investment companies in the 1960s and the resulting changes created situations that were not anticipated in the original drafting of the Investment Company Act of 1940.  As a result of the Securities and Exchange Commission's original proposals in 1967 plus subsequent modifications, the following recommendations were presented to the 91st Session of Congress:

  1. Compensation received by investment advisers and other persons affiliated with investment companies should be "reasonable" and there should be opportunity for judicial enforcement of this standard.
  2. Contracts that base any part of the adviser's fee on a specified percentage of the company's capital appreciation should be prohibited, but fees that increase and decrease proportionately on the basis of investment performance measured against an appropriate index of securities prices or other appropriate measure of performance would be permissible.
  3. The so-called front-end load on periodic payment plus certificate plans (i.e. certificates issued in connection with contractual plans for the accumulation of fund shares on an installment basis) should be abolished or restricted.
  4. The National Association of Securities Dealers should be given authority to make rules to prevent excessive sales charges, subject to the Securities and Exchange Commission's oversight.
  5. Exclusion from the act of those oil and gas funds that issue redeemable securities or sell their securities on the installment plan should be terminated; however, oil and gas funds in which investors make only a single payment and do not receive a redeemable security would still be excluded from the definition of an investment company.
  6. The imposition of surrender charges should be abolished.

In late 1970, the 91st Congress passed the Mutual Fund Bill (P.L. 91-547), pursuant to which the NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. (NASD) submitted its proposed "full service" maximum sales load rule to the SEC.  As proposed, the rule, which was designed to prevent excessive sales loads, taking into account all related circumstances, permitted mutual funds or single payment contractual plans to charge a maximum sales load of 8.5% (declining to 6.25% for larger purchases), but conditioned the right to charge the maximum on the fund's offering of dividend reinvestment at net asset value, rights of accumulation, and volume discounts, as defined in the rule.  The rule was adopted by NASD's board of governors on January 28, 1975, and was subsequently approved by the NASD membership for SEC approval.

The section of the law that regulates contractual plans allows the sponsors of such plans to operate under two alternatives.  The first alternative retains the 50% maximum first-year sales load and the 9% overall sales charge provisions previously in effect.  If a periodic plan certificate is sold with such a load, the following refund provisions apply. the holder may surrender the certificate at any time within the first 18 months after issuance and receive the value of his account plus the excess of any sales load above 15% of his total payments.  The registered investment company issuing the certificate, or any depositor of an underwriter for such company, must give written notice of these redemption rights.  This notification must be made to each certificate holder who has missed three payments or more within 30 days following the expiration of 15 months after the issuance of the certificate.  A second alternative allows not more than 20% of any one payment to be deducted for sales load, and provides that the entire deduction during the first four years may not exceed 64% of the total payments.  Again, the total sales charge may not exceed 9% of the total investment over the life of the plan.  Under this alternative a seller is entitled to deduct a 16% sales load each year for the four-year period of 20% in each of the first three years and $4 in the fourth year.

The law also gives a specific fiduciary duty to a fund's investment adviser, which would allow either the Securities and Exchange Commission or a shareholder to sue an investment adviser for a breach of fiduciary duty, particularly regarding compensation for his services.

In 1970, the Securities and Exchange Commission issued an official policy statement on the acquisition and holding of restricted securities by investment companies.  These securities, sometimes referred to as "letter stock," are securities that are acquired in private placements or that for some other reason require registration under the Securities Act of 1933 before they may be resold to the public.  The commission set a 10% limitation in terms of net assets on such restricted securities by open-end investment companies, so as to avoid possible liquidity problems.

Pros and cons of the load charge on open-end shares are as follows.  The load is necessary to compensate the distributor for its sales promotion efforts, important for growth of the company, and the dealers selling to investors.  The load is only on purchases by the investor, most companies making no or only a nominal charge on redemptions of shares.  The following are the cons of the load charge.  The load frequently may be more than the dividends plus appreciation, if any, of the first year of holding.  There is no point in paying a load for open-end shares when just as reputable and suitable open-end companies charge no load, and when reputable and suitable closed-end company shares are available in the market either at asset values, or reasonable premiums, or even discounts below current asset values; closed-end companies do not redeem shares, but many have their shares listed on stock exchanges and traded actively in the over-the-counter market that loads are profitable is indicated by the usually strong demand for shares of distributor organizations, some of which first made their shares publicly available in recent years.

Tax Status.

Both open-end and closed-end investment companies may elect to qualify irrevocably as "regulated investment companies" for tax purposes under the Internal Revenue Code.  Practically all have so elected because of the tremendous tax advantages obtained, i.e., in effect making them largely tax-free, thus reducing extra multiple taxation (taxation still is multiple - issuers of securities pay income taxes, and individual holders of investment company shares pay personal income taxes).  To be eligible for the tax-regulated category, investment companies must be registered under the Investment Company Act of 1940; must qualify as to minimum diversification under the code (readily met by reason of the Investment Company Act's own requirements); and must distribute at least 90% of net investment income as taxable dividends (no requirement that capital gains be distributed).  Such a regulated investment company pays federal income taxes solely on any part, up to 10%, of investment income retained, and on retained capital gains.  Since 1956, moreover, the tax paid by the regulated investment company on retained capital gains is for the account of the shareholders, i.e., the individual shareholder reports and gets credit on his tax return for such tax paid by the investment company in his behalf, and writes up the cost of his investment company shares by the amount of the capital gains tax paid by the company.  At the end of the year, each shareholder of an investment company receives therefrom a notification of the taxable basis for dividends received, ordinary dividend income, depletion dividends (return of capital), and dividends from capital gains, so that the shareholder may appropriately report such respective portions in his tax return.  Capital gains tax paid on retained capital gains by the investment company is also reported to the shareholder.

Uses for Investment Company Shares.

Individual investors find in investment company shares a medium for the practice of diversification for any amount invested.  The diversification will be in accordance with the registered investing policy.  Thus the individual can select that investing policy consistent with his own objectives.  Classified as to investing policy, open-end companies include the common stock or equity companies, investing in diversified holdings of common stocks; the balanced funds, investing in bonds, preferred stocks, and common stocks in appropriate ratios of "defensive" and "aggressive" selections from such media; and the speciality funds, with portfolios specializing intensively in particular classes and qualities of securities, e.g., investing solely in high-grade bonds; medium-grade bonds; speculative bonds; high- and medium-grade preferred stocks; high-grade, medium-grade, and speculative common stocks; or stocks of companies in particular industries such as steel stocks, chemical stocks, etc., without diversification outside the industry selected.

Dual Funds, which first appeared in 1967, are closed-end companies with a specified duration (usually 15 years), which afford two types of leveraged shares:  income shares, which contribute half the original capital but are entitled to all of the investment income, including a specified current minimum if earned dividend and dividend arrears if any, and capital shares, which also contribute half of the original capital but are entitled to all of the capital gains presumably accumulated when the fund is eventually liquidated, after allowing for original capital investment of the income shares and any of their dividend arrears.  The capital shares therefore receive no dividends during the duration of the fund and depend upon the residual upon eventual liquidation for long-term capital gains.

Hedge funds (in fact, nonpublic limited partnerships, run by general partners) engage in both margin buying and short selling to realize capital gains.  Swap funds, which first appeared in 1960, are exchange funds accorded tax-free status (Sec. 351 of the Internal Revenue Code) for the securities of participants originally accepted in setting up the fund, who thus postpone capital gains tax that would have to be paid if their holdings were first sold and the net proceeds used to participate in the fund.  Such funds are "one-short" formations, no continuous offering of shares being permitted pursuant to the code.

No-load funds are simply mutual funds that sell their shares to the public without the sales charge (load) above asset value.  They can be readily identified in the list of quoted mutual fund shares by the fact that offered prices are exactly the same as bid prices (asset values).

Investment company shares are suitable for DOLLAR AVERAGING with automatic diversification provided by the portfolio of the company pursuant to its investing policy; for execution of FORMULA PLANS, defensive investment company shares being bought as well as aggressive investment company shares in the desired ratios and thereafter adjusted pursuant to the formula followed; for investment and in general for investors who do not have either the time or skill to select and administer their own direct selections.


DONOGHUR'S Money Fund Report.

WISENBERGER SERVICES, INC.  Investment Companies.  Annual.

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