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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 534-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
38.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 copies 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 412 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
the funds, the study draws attention to the potential for divided loyalties arising from these arrangements. It also comments upon the role of, and in general questions the effectiveness of, the “unaffiliated" directors of the typical fund.
The study raises questions as to the relationship or lack of relationship between the growth, size and performance of funds and sales commissions and other sales incentives, and it questions whether the apparent historical emphasis upon constantly increasing fund assets by intensive sales efforts has always been in the interest of fund investors. It also draws attention to the relationship or lack of it between growth, size and performance of funds, on the one hand, and, on the other hand, advisory fees and costs of operation of the funds and of the advisers, including fees charged by advisers to other clients. It states that, for comparable asset levels, advisory fee rates charged mutual funds tend to be substantially higher than those charged by the same advisers to the aggregate of their clients other than investment companies. The study found that the expenses involved in advising mutual funds were less than those incurred in advising other clients.
In the letter of transmittal to the Chairman of the House Committee on Interstate and Foreign Commerce, the Chairman of the Commission pointed out that many of the practices of which the Wharton School appears critical may be attributable to an industry structure which is clearly contemplated by the Investment Company Act of 1940, but that many of the comments in the study implicitly raise questions of broad policy whether some of the practices and patterns which originated in an earlier time and under different conditions and which have become conventional within the broad tolerances of the Act should be reconsidered. Accordingly, the Commission has directed its staff to undertake a detailed analysis of the Wharton School study, and on the basis of such analysis, together with consideration of material being developed in related Commission studies now in progress, to make such recommendations to the Commission regarding the provisions of the Investment Company Act and the rules and regulations thereunder as may seem appropriate. The Commission will then be in a position to determine and formulate such legislative, rule and enforcement proposals, if any, as may be desirable and thereafter to report to the Congress.
The Commission's rules promulgated under the Act require that the basic information contained in notifications of registration and in
registration statements of investment companies be kept current, through periodic and other reports, except in cases of certain inactive unit trusts and face-amount companies. The following reports and documents were filed during the 1962 fiscal year: Annual reports-----
458 Quarterly reports---Periodic reports to stockholders (containing financial statements) 1, 391 Copies of sales literature -
2, 477 The foregoing statistics do not reflect the numerous filings of revised prospectuses by open-end mutual funds and unit investment trusts making a continuous offering of their securities. These prospectuses, which must be checked for compliance with the Act, are required to show material changes which have occurred in the operations of the companies since the last effective date of the prospectuses on file. In this respect registration statements under the Securities Act of 1933 covering securities of such companies are essentially different from registration statements relating to the usual type of corporate securities.
APPLICATIONS AND PROCEEDINGS
Under Section 6(c), the Commission, by rules and regulations, upon its own motion or by order upon application, may exempt any person, security, or transaction from any provision of the Act if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act. Other Sections, such as 6(d), 9(b), 10(f), 17(b), and 23(c), contain specific provisions and standards pursuant to which the Commission may grant exemptions from particular sections of the Act or may approve certain types of transactions. Also, under certain provisions of Sections 2, 3, and 8 the Commission may determine the status of persons and companies under the Act. One of the principal activities of the Commission in its regulations of investment companies is the consideration of applications for orders under the sections referred to.
During the fiscal year, there were 221 applications under various sections of the Investment Company Act before the Commission. The sections of the Act with which these applications were concerned and their disposition are shown in the following table: