---
Overview
Investment companies pool money from multiple investors to purchase securities, providing diversification and professional management. The Investment Company Act of 1940 is the primary regulatory framework governing these entities. For the Series 7 exam, you must understand the structural differences between fund types, how shares are priced and sold, regulatory requirements, and tax treatment of distributions.
---
Types of Investment Companies
The Three Main Types Under the 1940 Act
| Type | Key Feature |
|---|---|
| Management Companies | Actively or passively managed; open-end or closed-end |
| Unit Investment Trusts (UITs) | Fixed, unmanaged portfolio; no board of directors |
| Face Amount Certificate Companies | Rare; investors make periodic payments for a fixed future sum |
Management Companies: Open-End vs. Closed-End
• Open-End Fund (Mutual Fund)
- Continuously issues and redeems shares
- Transactions occur directly with the fund at NAV (or POP)
- No secondary market trading; shares not listed on exchanges
- Share count fluctuates daily
• Closed-End Fund
- Issues a fixed number of shares through an IPO
- Shares trade on an exchange at market prices
- Price can trade at a premium or discount to NAV
- Subject to supply and demand like any stock
Unit Investment Trusts (UITs)
• Holds a fixed, unmanaged portfolio of securities
• Issues redeemable units to investors
• No board of directors, no active portfolio management
• Portfolio is not actively traded
• Has a defined termination date
ETFs – A Hybrid Structure
• Registered as open-end funds or UITs under the 1940 Act
• Unlike mutual funds, ETF shares trade intraday on an exchange at market prices
• Can trade at a slight premium or discount to NAV
• Generally more tax-efficient than traditional mutual funds
Diversified vs. Non-Diversified Management Companies
To be classified as diversified, a fund must satisfy the 75-5-10 rule for at least 75% of its assets:
• No more than 5% of total assets in any single issuer
• Holds no more than 10% of any one issuer's voting securities
Key Terms:
• Management Company – Investment company that actively or passively manages a portfolio
• UIT – Fixed-portfolio investment company with no active management
• Diversified – Meets the 75-5-10 test
• Non-Diversified – Does not meet the 75-5-10 test
• Premium/Discount – Closed-end fund shares trading above/below NAV
> Watch Out For: Students often confuse open-end and closed-end funds. Remember: open-end = transactions with the fund at NAV; closed-end = trades on an exchange like a stock. ETFs trade like closed-end funds but are structured like open-end funds.
---
Mutual Fund Pricing and NAV
NAV Calculation
$$\text{NAV per Share} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Total Shares Outstanding}}$$
• Calculated at least once per business day (typically at 4:00 PM ET market close)
Public Offering Price (POP)
$$\text{POP} = \frac{\text{NAV}}{1 - \text{Sales Charge \%}}$$
• POP = NAV + Sales Load
• The sales charge is always expressed as a percentage of POP, not NAV
Sales Charge Calculation Example
• NAV = $9.50 | POP = $10.00
• Sales Charge % = (POP − NAV) ÷ POP = $0.50 ÷ $10.00 = 5%
Forward Pricing
• All mutual fund orders are executed at the next calculated NAV after the order is received
• Investors never receive a previously calculated NAV
• Applies to both purchases and redemptions
Breakpoints
• Dollar thresholds at which the sales charge percentage decreases
• Reward investors who commit larger sums
• Breakpoint selling – Recommending a purchase just below a breakpoint to avoid the reduced load is prohibited
Letter of Intent (LOI)
• A non-binding agreement to invest a specified amount over 13 months
• Allows investors to receive breakpoint discounts immediately
• Can be backdated up to 90 days
• If the investor fails to reach the stated amount, the fund may recover the difference from escrowed shares
Rights of Accumulation
• Allows an investor to combine the current value of existing holdings with a new purchase to qualify for a breakpoint
• No time limit; based on total current value in the fund family
Key Terms:
• NAV – Net Asset Value per share
• POP – Public Offering Price (NAV + sales load)
• Forward Pricing – Orders executed at next calculated NAV
• Breakpoint – Investment threshold for reduced sales charges
• LOI – Letter of Intent (13 months, backdated up to 90 days)
• Rights of Accumulation – Combining existing holdings for breakpoint qualification
> Watch Out For: The sales charge percentage is always calculated using POP in the denominator, not NAV. A common mistake is dividing by NAV instead of POP. Also remember that an LOI is non-binding — the investor is not legally required to complete the investment.
---
Mutual Fund Share Classes and Fees
Share Class Comparison
| Feature | Class A | Class B | Class C |
|---|---|---|---|
| Front-End Load | Yes (reduced at breakpoints) | None | None or minimal |
| Back-End Load (CDSC) | None | Yes (declines over time, then zero) | Small (often 1 year only) |
| 12b-1 Fees | Low | Higher | Highest (level load) |
| Conversion | N/A | Converts to Class A after several years | Generally does not convert |
| Best For | Large, long-term investors | Long-term investors avoiding upfront cost | Short-term investors |
12b-1 Fees
• Annual fee charged to cover distribution and marketing expenses
• Maximum annual 12b-1 fee: 1.00% of average net assets
- Up to 0.75% for distribution
- Up to 0.25% for shareholder service fees
• Funds charging ≤ 0.25% in 12b-1 fees may call themselves "no-load"
Contingent Deferred Sales Charge (CDSC)
• Also called a back-end load
• Charged when investor redeems shares
• Decreases each year the shares are held
• Eventually reaches zero (rewards long-term holding)
Maximum Sales Charge (FINRA Rule)
• FINRA maximum = 8.5% of the offering price
• To charge 8.5%, the fund must offer:
- Breakpoints
- Rights of Accumulation
- Dividend reinvestment at NAV
Expense Ratio
• Annual % of average net assets covering:
- ✅ Investment advisory/management fee
- ✅ Administrative expenses
- ✅ 12b-1 fees
- ❌ Does NOT include sales loads or brokerage commissions
Key Terms:
• Class A Shares – Front-end load, lower ongoing expenses
• Class B Shares – CDSC, higher 12b-1 fees, converts to Class A
• Class C Shares – Level load, no conversion
• 12b-1 Fee – Annual distribution/marketing fee (max 1%)
• CDSC – Back-end load that declines over time
• Expense Ratio – Annual operating costs as % of assets
> Watch Out For: The FINRA maximum of 8.5% is a ceiling that requires the fund to offer breakpoints, rights of accumulation, and dividend reinvestment at NAV. If a fund doesn't offer all three, the maximum it can charge is lower than 8.5%. Also, 12b-1 fees are included in the expense ratio; sales loads are NOT.
---
Regulation and Compliance
Registration Requirements – Investment Company Act of 1940
• Must register if it has at least 100 beneficial owners (shareholders)
• Exemptions from registration:
- Fewer than 100 beneficial owners AND does not make a public offering
- Qualifies under Section 3(c)(7) with qualified purchasers
- Insurance companies, banks, and certain other entities are excluded
Board of Directors Requirements
• At least 40% of the board must be non-interested (independent) directors
• Non-interested directors have no material relationship with the fund or its adviser
• Board oversees the investment adviser's contract and fees
Prohibited Practices
| Practice | Why It's Prohibited |
|---|---|
| Breakpoint Selling | Recommending investment just below a breakpoint threshold so the investor pays a higher sales charge |
| Churning | Excessive trading to generate commissions |
| Selling Dividends | Recommending purchase just before a distribution to get the dividend |
Key Terms:
• Non-Interested Director – Independent board member with no material fund relationship
• Breakpoint Selling – Prohibited practice of recommending just below a breakpoint
• Section 3(c)(7) – Exemption for qualified purchasers
• Rights of Accumulation – Combining existing holdings with new purchases for breakpoints
> Watch Out For: Breakpoint selling is a suitability violation that harms the customer. The RR should always inform customers of available breakpoints before a transaction. "Selling dividends" is also prohibited — buying shares just before a distribution doesn't benefit the investor because the NAV drops by the distribution amount on the ex-dividend date.
---
Fund Operations and Distributions
Ex-Dividend Date and NAV
• On the ex-dividend date, a buyer is not entitled to the upcoming distribution
• The NAV drops by the amount of the distribution per share on the ex-date
• Buying just before the ex-date to capture the dividend ("selling dividends") is prohibited and inadvisable — the investor simply receives their own money back as a taxable distribution
Regulated Investment Company (RIC) Status
• To avoid corporate-level taxation, a mutual fund must:
- Distribute at least 90% of its investment income to shareholders
- This allows pass-through taxation — investors pay tax, not the fund
- Income includes: dividends, interest, and net short-term capital gains
Taxation of Distributions
| Distribution Type | Tax Treatment to Investor |
|---|---|
| Ordinary dividends/interest | Taxed as ordinary income |
| Short-term capital gains | Taxed as ordinary income |
| Long-term capital gains | Taxed at preferential rates (0%, 15%, or 20%) regardless of how long shares were held |
| Return of capital | Not immediately taxed; reduces cost basis |
Redemption in Kind
• A fund may satisfy large redemptions by distributing portfolio securities instead of cash
• Typically used for redemptions over $250,000 or 1% of NAV
• Protects remaining shareholders from forced liquidation of holdings
• The redeeming investor receives securities and may then sell them in the market
Key Terms:
• RIC – Regulated Investment Company (must distribute ≥ 90% of income)
• Ex-Dividend Date – Date when buyer no longer entitled to upcoming distribution
• Pass-Through Taxation – Taxes paid at investor level, not fund level
• Redemption in Kind – Large redemption paid with portfolio securities
• Expense Ratio – Annual fund operating costs as % of average net assets
> Watch Out For: Long-term capital gain distributions from a fund are taxed at long-term rates regardless of how long the investor held the fund shares. This is different from selling the fund shares themselves, where the holding period does determine the rate. Also remember: the 90% distribution requirement is for income — capital gains have separate distribution requirements.
---
Quick Review Checklist
Use this list in the final days before your exam to confirm mastery:
• [ ] Name the three types of investment companies under the 1940 Act
• [ ] Explain the difference between open-end and closed-end funds (pricing, trading, share count)
• [ ] Describe how a UIT differs from a management company
• [ ] State the 75-5-10 diversification rule
• [ ] Calculate NAV per share from given assets, liabilities, and shares outstanding
• [ ] Calculate POP given NAV and sales charge percentage
• [ ] Calculate sales charge percentage given NAV and POP
• [ ] Define forward pricing and explain when it applies
• [ ] Explain breakpoints, LOI (13 months, 90-day backdate), and Rights of Accumulation
• [ ] Compare Class A, B, and C shares across load structure, 12b-1 fees, and conversion
• [ ] State the maximum 12b-1 fee (1%) and the "no-load" threshold (≤0.25%)
• [ ] State FINRA's maximum sales charge (8.5%) and its three conditions
• [ ] Identify what is and is not included in the expense ratio
• [ ] Define breakpoint selling and explain why it is prohibited
• [ ] State the 40% independent director requirement
• [ ] State the registration threshold (100 shareholders) and key exemptions
• [ ] Explain the 90% distribution requirement for RIC status
• [ ] Identify how long-term capital gain distributions are taxed (at long-term rates regardless of holding period)
• [ ] Explain what happens to NAV on the ex-dividend date
• [ ] Define redemption in kind and when it is used
---
Good luck on the Series 7 exam! Focus especially on NAV/POP calculations, share class comparisons, breakpoint rules, and the 90% distribution requirement — these are consistently high-yield topics.