What Are the Rules in Section 18 of the 1940 Act?

The Investment Company Act of 1940 is a U.S. federal law that regulates companies, including mutual funds, that engage primarily in investing and trading securities and whose own securities are offered to the public. Section 18 of this act directly addresses the capital structure of these investment funds. The objective of Section 18 is to protect investors by limiting the amount of debt and similar obligations a fund is permitted to take on.

This regulation on borrowing, a practice known as using leverage, is designed to prevent investment companies from engaging in speculative activities that could amplify losses. By setting firm boundaries on a fund’s capital structure, the act aims to ensure that funds do not become excessively risky. The rules within Section 18 vary depending on the type of investment company, creating a tailored regulatory framework for different fund models.

Defining Senior Securities and Leverage

A senior security is defined as any bond, note, or other instrument that represents indebtedness. The term also includes any class of stock, such as preferred stock, that has priority over the fund’s common stock for receiving dividend payments or being paid back if the fund is liquidated. When a fund issues these types of securities, it is using borrowed money to finance its investment activities.

This use of borrowed capital creates leverage, a financial strategy that can magnify both potential gains and losses for a fund’s common shareholders. If a fund uses leverage and its investments perform well, the returns for common shareholders are amplified. Conversely, if the fund’s investments decline, losses are also magnified because the fund must still repay its debt obligations regardless of its performance. Section 18 controls this amplified risk by limiting the issuance of senior securities.

Asset Coverage Requirements for Closed-End Funds

Registered closed-end investment companies are subject to asset coverage tests under Section 18 when they issue senior securities. These funds, which issue a fixed number of shares that trade on a stock exchange, are permitted to use more leverage than other types of funds, but only within defined limits. The regulation establishes two tiers of asset coverage requirements depending on the type of senior security being issued.

For senior securities that represent debt, such as bonds or notes, a closed-end fund must maintain an asset coverage ratio of at least 300% immediately after the issuance. This means that for every $1 of debt the fund takes on, it must have at least $3 in assets. For example, a fund with total assets of $300 million could issue a maximum of $100 million in debt.

A different requirement applies to senior securities that are a class of stock, like preferred stock. In this case, the fund must maintain an asset coverage ratio of at least 200% for that stock. This test includes all outstanding senior securities, both debt and preferred stock. For instance, if a fund with $300 million in assets already has $100 million in debt, the total value of any preferred stock it issues cannot exceed $50 million. Section 18 also restricts the issuance of warrants or rights to subscribe to or purchase a security for closed-end funds.

Restrictions on Open-End Funds

Open-end funds, more commonly known as mutual funds, face much stricter limitations under Section 18 and are generally prohibited from issuing any class of senior security. This ban is linked to the structure of an open-end fund, which stands ready to redeem its shares from investors daily at the fund’s current net asset value.

The rationale behind this prohibition is to ensure the liquidity and stability of the fund. If an open-end fund had a complex capital structure, a large volume of redemptions during a market downturn could force it to sell assets at unfavorable prices to meet its obligations, harming the remaining shareholders.

There is a limited exception to this rule. An open-end fund is permitted to borrow money from a bank, but only if it adheres to a strict condition. Immediately after any such borrowing, the fund must have asset coverage of at least 300% for all of its borrowings, the same test that applies to the debt of closed-end funds.

Special Provisions for Business Development Companies

Business Development Companies (BDCs) are a category of closed-end funds subject to special provisions within Section 18. Congress created BDCs to facilitate capital flow to small, developing, and financially troubled American companies that might not have ready access to public markets. Given this mission, the rules governing their leverage have been tailored to support their investment objectives.

Originally, BDCs were subject to the same leverage limitations as other closed-end funds, requiring a 200% asset coverage ratio for all senior securities. This effectively limited their debt-to-equity ratio to 1:1.

The Small Business Credit Availability Act (SBCAA) amended Section 18 to provide BDCs with greater flexibility. The SBCAA allows a BDC to reduce its minimum asset coverage requirement from 200% down to 150%. This change permits a BDC to increase its debt-to-equity ratio from 1:1 to 2:1, meaning it can borrow two dollars for every one dollar of equity. To take advantage of this increased leverage, a BDC must obtain approval from either its board of directors or its shareholders.

Operational Consequences of Non-Compliance

Section 18 establishes the operational consequences for a fund that fails to maintain its required asset coverage ratios. If a closed-end fund or a BDC experiences a decline in its investment portfolio value, its asset coverage can fall below the mandated thresholds. When this occurs, the Act imposes immediate restrictions on the fund’s activities.

When a fund fails to meet the asset coverage test, it is prohibited from declaring any dividends on its common stock and from repurchasing any of its common stock. These restrictions are designed to conserve the fund’s remaining assets to protect the senior security holders, who have a priority claim on the fund’s assets.

The prohibitions remain in effect until the fund restores its asset coverage to the required level. This can be achieved through an appreciation in its portfolio, by selling assets to pay down debt, or by issuing new common stock.