Starting a new mutual fund takes time, coordination, knowledgeable service providers, and, of course, money. In most cases, a contribution of at least $100,000 in seed capital is needed to initiate a new fund. (There are exceptions, such as if a series trust wants to add a new portfolio but has at least $100,000 in an existing portfolio.)

Closely related to the funding of seed capital is the fund’s initial Form N-1a filing and the seed audit. The process is often a tricky one because it requires the coordination of multiple service providers within a relatively tight timeframe. There also are a number of key legal, regulatory and accounting nuisances that, if not addressed during the seed audit process and the initial drafting of the fund’s prospectus and operating agreements, can cause significant problems during the fund’s first fiscal year-end audit.

Consider these five critical areas in the early stages of fund formation:

1. Clarity of Agreements
The required registration statement, Form N-1a, for a newly-formed fund describes its investment objectives and restrictions, policies, management, etc. The language in this document must be clearly-drafted, designating details such as benchmarks, disclosure of terms of significant agreements with related parties, and fundamental/non-fundamental investment restrictions. It is important for the written terms in any agreement throughout the process to be consistent with management’s actual intent, in addition to being in compliance with required SEC and state regulations.

2. Organization and Offering Expenses*
There are two types of costs to be aware of when forming a fund. Offering costs are incurred for activities to register the fund with the SEC; organization costs are incurred to establish the fund as a legal entity.

Representative offering costs can include:

• Legal fees for preparing the initial registration statement and pertaining to the fund’s shares offered for sale
• Initial agency fees of securing the rating for bonds or preferred stock issued by closed-end funds
• Licensing fees
• Initial fees paid to be listed on an exchange
• Underwriting and other similar costs
• Prospectus design and printing
• SEC and state registration fees
• Tax opinion costs related to the offering of shares

Representative organization costs can include:

• Incorporation fees
• Legal fees related to the organization and incorporation of the business, drafting bylaws, drafting agreements (administration, custody and transfer agent), performing research and consultation services in connection with the initial meeting of directors
• Audit fees related to the initial registration statement and initial seed capital audit
  

Who pays for offering and organization costs depends on the agreement formed between the investment advisor and the fund. From the advisor perspective, there are a few key questions to consider before seed capital is deposited, as all expenses will be accounted for and disclosed in the seed financial statements:

• Has the advisor already paid for fees related to organization or offering costs that are considered to be the responsibility of the fund? (e.g., Does the fund owe the advisor money?)
• If the fund has an expense waiver agreement in place, and the advisor has paid for all or a portion of the organization or offering expenses for which the fund is responsible, can the advisor recapture these fees?
• Is the treatment of organization/offering costs noted in the Investment Advisory or Expense Cap agreements?

3. Seed Capital – Cash or Securities?
There are important issues to consider regardless of whether the new fund plans to use cash or securities as seed capital. If cash is ultimately chosen, it is best to keep it in a non-interest bearing account until the fund is declared effective to offer shares to the public. If securities are used for the seed capital contribution, the issue of whether or not the contribution is taxable or non-taxable comes into play. The taxability of a securities contribution generally is based upon IRC Section 351 and on rules related to control of the fund immediately after the transfer and whether the transfers being made are part of a plan of diversification. Due to complex reporting requirements and tax consequences, it is important to speak with a tax professional prior to contributing securities.

Regardless of whether the seed capital contribution is made using cash or securities, keep in mind that there are redemption restrictions. Informal guidance has shown that the SEC’s intent is that initial seed capital should not be redeemed.

4. Choosing a Year-end
Current tax rules generally allow a corporation to pick any fiscal year end; with the exception of certain funds, which still may have limited options. The RIC Modernization Act of 2010 provides funds with greater ability to choose a non-calendar year-end and to avoid the potential pitfalls that existed prior to the Act. As a general rule, choosing a non-calendar year-end may provide expense savings, whereas choosing a calendar year-end may provide easier reporting. Declaration of tax year-end is made based on the filing of the fund’s first tax return.

5. Quarterly Fund Compliance
Each quarterly calculation throughout a fund’s first fiscal year is critical from a compliance standpoint. For example, it is imperative to be aware that the first quarter is calculated off of the fund’s intended year-end date, not the date the fund commences operations. So, a fund that selects a calendar year-end of December 31st will have its first quarter calculated as of March 31st—regardless if the fund did not commence until March 21st, for instance. Those 10 days will constitute the body of what is used for the first quarter’s diversification calculation. As it is imperative for a fund to meet IRS diversification requirements, this is important to keep in mind as the fund constructs its initial portfolio of investments.

Forming a new fund is complex, but carefully considering these five issues from the outset will help prepare for a successful launch.

To discuss launching a new fund, contact one of our professionals at 440.835.8500 or email us at inquiries@cohenfund.com.

* Source: Audit & Accounting Guide for Investment Companies, May 1, 2010.

The information is provided by Cohen Fund Audit Services and is intended for informational purposes only. Consult with legal and other advisors before taking any specific action. Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.