The Regulatory Framework of Close-end Funds
A Close-end fund (CEF) is a regulated entity whether locally or abroad. In Malaysia, the establishment of a CEF falls under the purview of the Securities Commission (SC) and must comply with the SC Guidelines for Public Offerings of Securities of Closed-end Funds (CEF Guidelines). In addition, as a public listed company, a CEF needs to comply with the Companies’ Act 1965 (Act) and Bursa Malaysia listing requirements.
Under the Act, investors of a CEF are shareholders who own the company. Their rights are sealed in the Memorandum and Articles of Association (M & A) of the company. What is interesting to note here is that a Malaysian CEF cannot have a 51% controlling shareholder. Therefore, if shareholders are unhappy with the performance of the fund manager or the board of directors or any other service provider, they can call for a special meeting to vote for a change. Shareholders can even seek to liquidate the company if it is in their best interest to do so. Such a mechanism is not available for disgruntled unit trust holders.
Before a CEF is launched, it needs to be approved by the relevant regulatory bodies. The salient points of the CEF Guidelines are as follows:
i) The size of the fund and offer price
The minimum paid up capital is RM100 mln comprising ordinary share of RM1.00 each. The initial issue price shall be RM1.00. The SC may allow an offer price above RM1.00 if it is justifiable.
ii) The shareholding spread
At least 25% of the issued and paid up capital must be in the hands of the public provided that at least 10% or RM15 million, whichever is greater, is held by not less than 500 shareholders holding not less than 1,000 shares but not more than 30,000 shares each.
iii) Investment policies and objectives
The investment policies and objectives shall not be changed within the first 3 years from the date of listing. Subsequently, the CEF must inform the KLSE and the SC of any proposal to change its investment policies and objectives.
iv) M & A
The M & A must contain the following provisions :-
That any changes to the investment policies and objectives shall be
approved by the shareholders by way of special resolution;
That the CEF shall not on its own or with others take legal or effective
control of its underlying investments;
None of the shareholders can own more than 20% of the paid up capital
of the CEF, and
That the CEF shall not conduct any business other than that of a CEF
v) The directors
At least one third of the Board of Directors shall be independent directors. A director shall not be independent if he is a substantial shareholder of the CEF or if he is related in any way to the substantial shareholders of the CEF or its managers.
vi) The fund manager
The fund manager shall be a company licensed under the Capital Markets & Services Act 2007 with a minimum of three years’ track record and shall also appoint a Designated Person within its organization. The Designated Person shall be a person licensed under the Capital Markets & Services Act 2007 and shall have a minimum investment management experience of 3 years.
vii) The custodian
The custodian shall be a public limited company incorporated in Malaysia and shall be independent of the fund manager.
viii) Conflicts of interest
Conflicts of interest should be avoided and if unavoidable, reasonable steps must be taken to promptly disclose the nature of the conflict to the SC, Bursa Malaysia and the shareholders. An independent adviser shall be appointed and must comply with additional conditions imposed by the SC.
ix) Investment limits
In terms of the investment limits, the CEF must not invest more than 10% of its NAV in the security of a listed entity or more than 10% of the paid-up capital of a listed entity, whichever is lower.
It can invest up to 20% of its NAV in foreign approved stock exchange and invest up to 10% in unlisted Malaysian companies. It can borrow up to 30% of its NAV but shall not grant or guarantee any credit facility. A CEF is also not allowed to invest in other collective investment vehicles unless it is the most appropriate mechanism to invest in a particular country. Furthermore, a CEF cannot invest in derivatives without SC’s approval and can only enter into foreign exchange transactions that are incidental to the management of its investments.
A CEF also needs to comply with the relevant Income Tax Act if the CEF wants to seek “approved fund” status from the Inland Revenue. In Malaysia, the taxation for a CEF is governed by Section 60H of the Income Tax Act 1967. Under the prevailing tax laws, capital gains are exempted from income tax. Therefore, capital gains derived from disposal of CEF shares are exempted from income tax. Investors of a CEF that receive capital gains distributed by the company are also tax exempted. With regards to investment income, investment income received by the CEF is taxable under the prevailing corporation tax rate except for tax-exempt income. Tax-exempt income paid by the CEF to investors is also tax exempted at the investors’ level.
Regulations of Unit Trust Funds
The SC is the sole authority bearing the responsibility to regulate all matters relating to the unit trust industry, due to the enactment of Securities Commission (Unit Trust Scheme) Regulations 1996. Only unit trust funds (UTF) approved by the SC can be offered for sale to the public. In 1975, the industry was regulated by the Guidelines on Unit Trust Funds (GUTF). Prior to this, the Trust Companies Act 1949 was the primary regulation governing the industry. Due to the complexity of a unit trust scheme, the SC came up with additional guidelines aimed at protecting investors. Among them are Guidelines on Unit Trust Advertisements and Promotional Materials, Guidelines on Marketing and Distribution of Unit Trusts and Guidelines for Registration of Institutional Agents for Marketing and Distribution of Unit Trusts and the Disciplinary Proceedings.
i). The size of the fund and creation/cancellation of units
The objectives of the fund must be clear, specific and sufficiently detailed for investors to understand and must be stated in the prospectus. Unfortunately, if you have read any UTF prospectus, you will not have a clear idea of what you are investing in.
The maximum size of the fund is determined by the unit trust management company (UTMC) and has to be approved by the SC. To increase the authorized size, the UTMC must obtain the approval of the SC.
The creation price for units during the initial offer is the selling price less any sales charge on the units. The sales charge imposed during the initial offer period must be properly disclosed and it is determined by the UTMC. The cancellation price of the units during this period should equal to the creation price for units.
When a request for units/cancellation of units is received at or after a valuation point (a valuation point is calculated based on the closing prices of securities), the UTMC should instruct the trustee to create/cancel units at or before the next valuation point. The trustee must create/cancel units only for cash. The investor will pay the UTMC and the UTMC must collect and pay the trustee for the units created. The trustee should pay the UTMC for the units cancelled.
The UTMC should ensure that the margin of finance for loans in the sales of units does not exceed 67% of the amount invested.
ii). The shareholding spread
There is no requirement on shareholding spread in a UTF.
iii). Trust Deed
The trust deed is the constitutive document of a UTF. It is prepared by the UTMC and registered with the SC. The trust deed
Describes the terms & conditions governing the day-to-day operations
and management of the UTF.
Sets out the rights and liabilities of the unit holders, and
Sets out the duties and obligations of the fund manager and trustee of
iv). The UTMC
A UTF must be managed and administered by a UTMC approved by the SC under the Securities Commission Act. An UTMC must be a public company incorporated in Malaysia or a subsidiary of a company involved in the financial services industry in Malaysia or any other institution that is permitted by the SC. Unless otherwise approved by the SC, a UTMC may only be engaged in the business of managing investment portfolio, administering unit trusts, marketing and distributing UTF subject to the Guidelines for Registration of Institutional Agents for the Marketing and Distribution of Unit Trust and provide investment advisory services. It must also have a minimum shareholders’ fund of RM10 million at all times.
The UTMC may delegate any function to any party, but the delegation must be approved by the SC except for fund managers that are already licensed by the SC.
The UTMC, trustee and any service provider should avoid conflicts of interest. Cash or other liquid assets of the UTF may be placed in any current or deposit account with a party related to the UTMC if the said party is an institution licensed to accept deposits and the terms of the deposit are the best available for the UTF.
A UTMC is required to have an investment committee (and Syariah Committee) that oversees the investments of the UTF. For Islamic funds, investments have to be based on Syariah principles.
The use of any broker/dealer in dealing with the investments of the fund must obtain the prior approval of the investment committee. The dealings with broker/dealer must be on terms which are the best available for the fund. The use of any broker/dealer for the fund should not exceed 50% of the fund’s dealings in value in any one financial year. The UTMC, trustee or any service provider must not retain any rebates or commissions from brokers/dealers for dealings with the fund?s investment.
vi). Investment limits
The investment of the fund must be transferable, have a ready price or value, be traded in or under the rules of an eligible market and have proof of title or ownership to allow proper custodial arrangements to be made.
Investments of the fund may consist of foreign investments traded in or under the rules of foreign markets approved by the SC. The fund can invest up to 30% of its NAV in foreign markets, but it must register with Bank Negara Malaysia 7 days in advance the amount of its investment and must be in line with the SC guidelines. The UTMC must ensure that the proposed foreign market has satisfactory provisions relating to regulations of the foreign market.
The investment of the fund may consist of securities that are not traded in or under the rules of an eligible market but the securities must be incorporated in Malaysia and the fund must have appropriate policies and procedures for the valuation of the securities. The fund may invest in warrants and options. The fund cannot write any options.
The investments of the fund (‘investing fund’) may consist of units or shares in other collective investment schemes (‘target fund’) but the investment in the target fund must be relevant and consistent with the objectives of the investing fund.
The fund may take part in the lending of securities within the meaning of the Guidelines on Securities Borrowing and Lending and must be conducted through the holder of a dealer’s license under the Capital Markets & Services Act 2007 approved to conduct securities lending. For more, refer to the Guidelines on Securities Borrowing and Lending and Securities Industries Act.
The fund can invest according to the limits and restrictions below. The limits and restrictions must be complied with at all times based on the most up to date value of the fund. For an equity or balanced fund, the value of the fund’s holding in the capital of any single issuer must not exceed 10% of the fund’s NAV. The value of the fund?s holding in the debt securities/instruments of any single issuer must not exceed 15% of the fund’s NAV. For the other types of UTF, there is whole list of restrictions.