PART IX

ADMINISTRATION OF THE INVESTMENT COMPANY ACT OF 1940

Companies primarily engaged in the business of investing, reinvesting, owning, holding, or trading in securities are subject to registration and regulation under the Investment Company Act of 1940. This Act, among other things, prohibits such companies from changing the nature of their business or their investment policies without the approval of their stockholders, requires disclosure of their finances and investment policies, regulates the means of custody of the companies' assets, requires management contracts to be submitted to security holders for their approval, prohibits underwriters, investment bankers, and brokers from constituting more than a minority of the directors of such companies, and prohibits transactions between such companies and their officers, directors, and affiliates except with the approval of the Commission. The Act also regulates the issuance of senior securities and requires face-amount certificate companies to maintain reserves adequate to meet maturity payments upon their certificates.

The securities of investment companies which are offered to the public are also required to be registered under the Securities Act of 1933 and the companies must file periodic reports. Such companies are also subject to the Commission's proxy rules and closed-end companies are subject to "insider" trading rules. The Division of Corporation Finance and the Division of Corporate Regulation both assist the Commission in the administration of the statute, the former being concerned with the disclosure provisions and the latter with regulatory provisions.

COMPANIES REGISTERED UNDER THE ACT

As of June 30, 1962, there were 727 investment companies registered under the Act, including 78 small business investment companies, and the estimated aggregate market value of their assets on that date was approximately $27.3 billion. These figures represent an overall increase of 64 registered companies, but a decrease of roughly $1.7 billion in the market value of assets compared with the corresponding totals at June 30, 1961.1 The total registered companies by classification are as follows:

The decrease in asset values as of June 30, 1962 was due primarily to the May 1962 market decline.

During the fiscal year, 97 new companies, including 37 small business investment companies, registered under the Act while the registrations of 33 companies were terminated. The breakdown of these companies by classification is as follows:

GROWTH OF INVESTMENT COMPANY ASSETS

The following table illustrates the striking growth of investment company assets during the past 22 years, particularly in recent years: Number of investment companies registered under the Investment Company Act and the estimated aggregate assets at the end of each fiscal year, 1941 through 1962

1 The increase in aggregate assets reflects the sale of new securities as well as capital appreciation. By way of illustration, the Investment Company Institute reported that during the fiscal year ended June 30. 1962, its open-end investment company members, numbering 172 and representing the bulk of the industry had net sales of their securities amounting to $2.1 billion.

INSPECTION PROGRAM

In 1957 the Commission initiated a program for the periodic inspection of investment companies pursuant to the statutory authority conferred under Section 31 (b) of the Investment Company Act.

Under this program, 52 companies were inspected in fiscal 1962 in comparison with a total of 113 inspections in all prior years. While the primary responsibility for making the inspections in fiscal year 1962 rested on the field offices, teams consisting of attorneys and analysts from the Division of Corporate Regulation, as in previous years, assisted the respective field offices in a number of instances. It is expected that in the fiscal year 1963 most of the inspections will be made exclusively by personnel of the field offices, which have become increasingly familiar with the regulatory provisions applicable to investment companies.

In recognition of the importance of the inspection program, a new branch has been created in the Division of Corporate Regulation charged with the responsibility of planning and supervising the program, and reviewing the reports initially prepared by the field offices.

A majority of the inspections made during the fiscal year brought to light violations of the Investment Company Act of 1940, as well as violations of other statutes administered by the Commission. While many of the violations uncovered have been of a minor nature which, when called to the attention of the investment company, its underwriter, or adviser, have been corrected by amending the company's prospectus, filing additional documents or changing the company's operations to comply with the law, serious violations have also been disclosed. Instances were discovered in which the investment advisory contract was not renewed in accordance with the provisions of Section 15 of the Investment Company Act with the consequence that the investment adviser received money under a void contract. In one such situation, the inspection and investigation which followed resulted in an investment adviser returning a total of $250,000 in settlement of claims by two investment companies which had been making payments to the investment adviser under an invalid contract. In another instance, the inspection and investigation which followed resulted in the resignation of the investment company's officers and directors and the installation of a completely new interim management.

In another situation, the inspection program uncovered such serious violations of the Act that the Commission instituted an injunction action, alleging, among other things, gross abuse of trust on the part

of the officers and directors of that company. In addition, possible serious violations of Section 17 of the Act and possible gross abuse of trust have been uncovered in at least two inspections in which it was found that officers and directors had been causing the company with which they were associated to enter into transactions which benefitted such officers and directors or other affiliated persons. At the end of the fiscal year one of these cases was under active investigation and the other was being considered for possible injunctive action.

STUDY OF SIZE OF INVESTMENT COMPANIES

Pursuant to Section 14 (b) of the Act, the Commission engaged the Securities Research Unit of the Wharton School of Finance and Commerce of the University of Pennsylvania to conduct a fact-finding study of the problems created by the growth in size of open-end investment companies.

Data for the study were obtained by means of two comprehensive questionnaires. The first was mailed in December 1958 to all active registered open-end investment companies with gross assets of over $1 million. It covered the 53⁄44-year period from December 31, 1952 to September 30, 1958, and analyzed the growth, organization and control, investment policy, and performance of open-end investment companies; their impact on securities markets; and the extent of their control of portfolio companies. In 1960 the study was enlarged to include various aspects of the organizational, operating, and financial relationships existing among the open-end investment companies and their investment advisers and principal underwriters. This further area of study was surveyed by means of a second questionnaire, covering the year 1960, which was mailed in December 1960 to registered open-end investment companies and their investment advisers and principal underwriters.

Shortly after the close of fiscal year 1962, the Wharton School submitted its report to the Commission entitled "A Study of Mutual Funds." The report was in turn transmitted to the Committee on Interstate and Foreign Commerce, House of Representatives.

The

S.E.C. v. Midwest Technical Development Corp., D.C. Minn., No. 4-62 Civ. 142. This case is discussed in Part XI, infra, under "Civil Litigation."

See Investment Company Act Release No. 3530 (August 24, 1962). The release contains copies of the letters of transmittal from the Wharton School to the Commission and from the Chairman of the Commission to the Chairman of the House Committee on Interstate and Foreign Commerce. The study consists of approximately 600 pages, and coptes may be purchased from the Superintendent of Documents, Washington 25, D.C., at $1.50 each.

study concludes that there is little evidence that size per se of individual funds or companies is a problem at the present time, and that the more important current problems in the mutual fund industry appear to be those which involve potential conflicts of interest between fund management and shareholders, the possible absence of arm'slength bargaining between fund management and investment advisers, and the impact of fund growth and stock purchases on stock prices. It found these problems to be unrelated to company size, except to the extent that questions arise concerning the allocation between fund shareholders and investment advisers of the benefits resulting from large-scale operations.

The study found that the rates of turnover of portfolio securities were inversely related to size of fund, with the smallest funds generally having the highest turnover rates throughout the period studied and the largest funds the lowest turnover rates. It also found that, on the average, the performance of the funds did not differ appreciably from what would have been achieved by an unmanaged portfolio consisting of the same proportions of common stocks, preferred stocks, corporate bonds, government securities, and other assets as the composite portfolios of the funds. About half of the funds performed better, and half worse, than such an unmanaged portfolio. With respect to the investment policies of mutual funds, the study found that approximately 75 percent of the total net assets of the funds was held in United States common stocks, and that at December 31, 1961 such common stockholdings were equal to approximately 42 percent of the value of all stocks listed on the New York Stock Exchange.

With respect to portfolio company control, the study states that, despite the growth of large holdings of mutual funds, outright control of portfolio companies by the funds is a rarity and is confined mainly to small portfolio companies. It also concludes that the growth in the funds' net purchases of common stock which accompanied the great extension of the mutual fund industry has probably contributed significantly to the increase of stock prices over the past decade. The study stated that there is some but not strong evidence that net purchases by mutual funds significantly affect the month-tomonth movements in the stock market as a whole; and that there is stronger evidence that fund net purchases significantly affect the daily movements in the stock market, with the statistical data suggesting that this latter effect may be fairly substantial.

In commenting upon the typical management structure of the industry under which a significant part of the funds' activities are performed by affiliated organizations such as advisers, underwriters and brokers, who control or are represented on the boards of directors of