Mutual Funds Are Regulated by whom? SEC and FINRA overview
The Securities and Exchange Commission (SEC) is the federal agency that regulates mutual funds, investment advisors, and investment companies. The SEC was created by the Securities Act of 1933 and expanded by the Investment Advisor Act of 1940, which added the Investment Company Act of 1940. The mission of the Securities Exchange is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. In order to carry out this mission, the SEC implements rules that pertain to any security, including mutual funds.
The mission of the Financial Industry Regulatory Authority (FINRA) is to protect the public interest while maintaining fair, orderly, and efficient markets. In order to carry out this mission, FINRA implements rules that pertain to any security, including mutual funds.
As you can see, the primary regulatory oversight of mutual funds falls under the SEC and FINRA, but there are also state securities regulators that play a role. Broadly, the SEC, FINRA, and state securities regulators oversee mutual fund regulation by regulating: the initial sale of mutual fund shares, secondary market activities that involve the sale and purchase of mutual fund shares, and the professional activities of investment company representatives.
What Is The Purpose of Mutual Fund Regulation?
The purpose of mutual fund regulation is to protect investors and to prevent a wide range of market abuses.
What Types of Mutual Funds Are There?
Mutual funds are generally divided into five categories.
Landmark Mutual Fund Regulations
There was a time in the not-so-distant past when mutual funds seemed overly complex and investors were being treated unfairly. Many people compared it to the Wild West. It was a place where investors’ best interests were not being protected.
In 1975, the Securities Exchange Commission (SEC) began an overhaul of the mutual fund industry. The long-term goal was the betterment of the entire public investing community … and these reforms would lead to an environment that would benefit investors.
Today, these changes and the regulators who were the driving force behind them are credited with making mutual funds the transparent, stable, and successful investment vehicles they are today. It is a story of how government can set new standards, create good policy, and help give investors the protection they need.
The groundwork for regulation began in the late 1960s, courtesy of the U.S. Department of Labor. They announced the formation of a new committee to oversee mutual fund regulation. This happened at a time when these funds were already around for more than 30 years.
In 1970, the committee was dissolved. However, the dissolving of this group would eliminate the need for a congressional committee to oversee such regulation. An SEC Resolution in 1974 formally created a new committee to fill the void.
Securities Act of 1933
The Securities Act of 1933 is legislation that promoted full disclosure of information and practices of the investment banking firms. The Securities and Exchange Act was created to protect the public from fraudulent activities. It is overseen by the Securities and Exchange Commission. This organization was dependant on the stents and exchanges to be honest about the companies included on the stock exchange so that the investors could have no reason to be deceived by misrepresentations. The legislation limited the amount of assets that investment banking firms could hold in other companies.
Additionally, Regulation Q was established and enforced with this Act. This prohibited the offering of interest and principal on demand deposits accounts by banks to avoid a run on the bank.
Securities Exchange Act of 1934
After the 1929 market crash and the ensuing Great Depression, the government stepped in to regulate Wall Street and to prevent this type of crisis from happening again.
One historic piece of legislation was the Securities Exchange Act of 1934. This particular law laid the groundwork for the creation of the Securities and Exchange Commission (SEC), which regulates stocks, bonds, and other securities traded on the stock market. Under the Securities Exchange Act of 1934, the SEC is responsible for implementing safeguards and consumer protections that can ensure fair and effective markets.
This law also placed restrictions on trading practices. One example of these restrictions is the insider trading rule. It prohibits people who have information about a company that is considered material and who are in a position to exploit that information from trading securities of that company.
Another important piece of legislation was the Investment Company Act of 1940. Under this act, investment companies must register with the SEC, keep accurate records, and provide periodic reports. This provision was enacted to protect individual investors from fraudulent schemes, and it helps to minimize the cost of regulation through on-the-ground policing.
Investment Company Act of 1940
Since the beginning of the mutual fund, the industry has been tightly controlled by legislation. The Investment Company Act of 1940 introduced the way in which investment companies function and operate. The Act established the Mutual Funds Board of Governors, and laid down the laws and governing regulations for all investment companies. These rules were to ensure the safety of the American public.
The Mutual Funds Board of Governors is the major regulatory body that oversees the mutual fund industry. The ruling introduced rules and regulations for mutual funds to follow. The regulations include the number of shares allowed for trading, the listing of new shares, fund liquidation. Also, rules for the distribution of fees and fund assets. All these rules were introduced to ensure that neither the fund managers nor the investors benefit from the fund activities, but rather all profits are paid out to the shareholders.
According to these laws, the mutual fund aims to maximize value for all investors, and the benefit of investors should come before that of the fund managers. Any investor is entitled to take out the funds that he or she has invested within a specified time. The minimum holding period is three years, and the client has the right to take the investment out after three years of his investment.
Investment Advisers Act of 1940
The SEC’s rules for investment advisers, specifically section 203A of the Investment Advisers Act of 1940, are intended to minimize the regulatory burden on investment advisers, and, at the same time, increase investment adviser transparency to investors. The SEC’s rules provide that an advisory contract must be in writing. Although the SEC’s rules do not require such contracts to be registered with the SEC, investment advisers must retain their advisory contracts for a period of not less than five years.
The Investment Advisers Act of 1940, as amended (the “Advisers Act”), was originally enacted as a stop-gap measure to prevent fraudulent activities by investment advisers while the SEC was preparing or “formulating” for the regulation of investment advisers. The Advisers Act is a bit like a sales tax; it was a temporary, quick fix that became permanent.
Congress chose to leave control of the investment adviser industry under state regulation and did not subject investment advisers to federal regulation until enactment of the provisions of the Exchange Act in 1934. Essentially, the purpose of the Investment Advisers Act of 1940 was to remind investment advisers that they were subject to state regulations and to regulate the sale of securities by investment advisers in a limited way.
Sarbanes-Oxley Act of 2002
When the Securities and Exchange Commission (SEC) reported that accounting fraud was being committed on a widespread basis by corporations whose finances involved complex financial holdings.
This was a shocking revelation!
So shocking, that Congress passed the Sarbanes-Oxley Act in 2002. This Act set new requirements in place for corporations with more than 500 employees.
The purpose of the Act was to improve corporate responsibility and accountability.
The Act was also designed to protect investors & shareholders in publicly held companies, and to protect the national economy from future meltdowns.
Requirements of the Act included:
Section 302: Disclosure of Executive Compensation. This section requires that all executive compensation packages be disclosed to the shareholders. It also prohibits the backdating of executive compensation.
Section 404: Audit committees. This section requires that audit committees be established and the composition of committees is clearly outlined. Also, audit committee members are required to be financially literate and this is determined by the company’s board of directors. The committee must oversee all aspects of an audit process, including the hiring, firing, and compensation of the auditor.
Section 406: Changes in Corporate Control. This section requires that a company notify the shareholders, and the SEC of any change in ownership of more than 5% of the outstanding shares of common stock.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was signed into law in July 2010, and the U.S. Securities and Exchange Commission (SEC) was tasked with implementing some of the legislation. This proved difficult, as there was a lot of misunderstanding regarding the regulations and how they would affect mutual fund regulation.
Essentially, Dodd-Frank requires that mutual funds and other financial products offer a standardized portfolio disclosure document to investors. This document must disclose all material information about the fund and its holdings and activities.
In addition, any transaction between a fiduciary investment advisor and a fund must be fair and equal, and should benefit the investor rather than the advisor or anyone else.
Dodd-Frank also calls for a review of the fund's securities in alignment with the sponsor's business models (owner, employee) and continuity of investment in the principal investment strategies.
The purpose of all of these changes is to make it easier for investors to understand exactly what they're purchasing and to eliminate any conflicts of interest.
State Regulations and Other Rules
As investors, we all know there is one set of federal mutual fund regulations in place to protect us. But we also know that regulations are state-based, as well as sector specific and even fund specific.
Let's take a look at the two major types of state-based mutual fund regulations: prospectus and performance-related.
Invest in Mutual Funds With Your Eyes Wide Open
Investing in mutual funds can be great. You can expect regular returns on your investment over a period of time which could be anything up to five decades. The highest returns in mutual funds are no doubt generated when you invest in mutual funds in the initial stages. This is because mutual fund companies pay commissions to their partner brokers to bring them new business. Hence the brokers will send these new clients to mutual fund companies who offer higher commissions to them. That is why it is quite common for new investors to make the mistake of investing in mutual funds right from the start.
Since the new investor will not know much about mutual funds and their investment strategy, they will end up making their investments based on the money they are being offered. However they must remember that the rate of return on the investment is not always proportional to the amount of money being paid to the brokers or to the mutual fund itself.
The reason for this is that many mutual fund companies pay brokers a percentage of funds that go into your account. Now it is quite common for broker to have their clients to invest a higher amount and make a large number of transactions. This helps them earn a larger commission from the mutual fund companies. While this would be beneficial for the brokers, it is not so good for the clients.