The Investment Company Act of 1940 makes companies responsible for the way they conduct investment business, giving them oversight and ensuring they operate under a series of rules.With reference to management companies the act imposes at most only limited restrictions as to the nature and types of investments management may make. In other words, the act does not in any sense make the Commission the manager of investment companies. The status and policies of a company as set forth in its registration cannot be changed without an affirmative vote of a majority of the security holders.
The act also requires that at least two-thirds of the directors of an investment company be elected by the stockholders; it restricts the period of effectiveness of management contracts to two years and requires the approval of such contracts and therefore, in effect, of the investment adviser, by the stockholder-owners. The act also requires ratification of the management's choice of the accountants of the company. Investment company proxy solicitation is subject to Commission regulation. It is further provided that all shares issued by management companies after the effective date of the act must be voting shares, and preferred shares are required to contain provisions transferring majority-voting power to the holders of such stock in the event of default in the payment of dividends.
The act restricts the amount of bonds and preferred stock, which a closed-end management investment company may issue. Generally speaking, a closed-end investment company may not issue senior securities in an amount equivalent to more than 50 percent of its assets. Only one class of bonds and one class of preferred stock may be issued. The asset coverage after issuance must be at least 300 percent for debt securities and 200 percent for preferred stocks, so that leverage at the time the senior securities are sold cannot be greater than indicated by set guidelines.
There are also limitations on the payment of dividends or purchases of the company's own outstanding stock so long as senior securities are also outstanding. The purpose is to permit a reasonable use of low-cost money in the interest of the common stock but to limit the use of leverage because of its abuse in the past.
Open-end companies are not permitted to issue any senior securities, although the same objective may be obtained because they are permitted to contract bank loans, provided a 300 percent coverage of assets for such loans is maintained at all times. New face-amount certificate companies are required to have a minimum capital of $250,000 and to maintain statutory reserves presumably adequate to redeem certificates at maturity.
Restrictions are placed on the authority of face-amount certificate companies to declare dividends where the effect of such declarations would be to impair the financial stability of such companies. Without an order of the Securities and Exchange Commission, face-amount certificate companies are not permitted to issue preferred stocks.
Investors can be thankful that there are restrictions like these in place that protec their interest in their investments and ensure that corporations keep their business practices relatively fair and above-board.