What Is the Investment Advisers Act of 1940?
The Investment Advisers Act of 1940 is a U.S. federal law that regulates and defines the role and responsibilities of an investment adviser.
Prompted in part by a 1935 report to Congress on investment trusts and investment companies prepared by the Securities and Exchange Commission (SEC), the act provides the legal groundwork for monitoring those who advise pension funds, individuals, and institutions on matters of investing. It specifies what qualifies as investment advice and stipulates who must register with state and federal regulators in order to dispense it.
- Financial advisers must adhere to the Investment Advisers Act of 1940, which calls on them to perform fiduciary duty and act primarily on behalf of their clients.
- The Act imposes upon the adviser the “affirmative duty of ‘utmost good faith’ and full and fair disclosure of material facts” as part of their duty to exercise client loyalty and care.
- Investment advisers are required to pass a qualifying exam and register with a regulatory body as part of the Act.
Understanding the Investment Advisers Act of 1940
The original impetus of the Investment Advisers Act of 1940, as with several other landmark financial regulations of the 1930s and 1940s, was the stock market crash of 1929 and its disastrous aftermath, the Great Depression. Those calamities inspired the Securities Act of 1933, which succeeded in introducing more transparency in financial statements and establishing laws against misrepresentation and fraudulent activities in the securities markets.
In 1935, a SEC report to Congress warned of the dangers posed by certain investment counselors and advocated the regulation of those who provided investment advice. The same year as the report, the Public Utility Holding Act of 1935 passed, allowing the SEC to examine investment trusts.
Those developments prompted Congress to begin work not only on the Investment Advisers Act but also the Investment Company Act of 1940. This related bill clearly defined the responsibilities and requirements of investment companies when offering publicly traded investment products, including open-end mutual funds, closed-end mutual funds, and unit investment trusts.
Financial Advisers and Fiduciary Duty
Investment advisers are bound to a fiduciary standard that was established as part of the Investment Advisers Act of 1940 and can be regulated either by the SEC or state securities regulators, depending on the scale and scope of their business activities.
The act is very specific in defining what a fiduciary means. It stipulates a duty of loyalty and duty of care, which means that the adviser must put their client's interests above their own.
For example, the adviser cannot buy securities for their account prior to buying them for a client (front-running) and is prohibited from making trades that may result in higher commissions for the adviser or their investment firm (churning). It also means that the adviser must do their best to make sure investment advice is made using accurate and complete information—basically, that the analysis is thorough and as accurate as possible.
Additionally, the adviser needs to place trades under a "best execution" standard, meaning that they must strive to trade securities with the best combination of low-cost and efficient execution.
Avoiding conflicts of interest are important when acting as a fiduciary. An adviser must disclose any potential conflicts and always put their client's interests first.
Establishing Adviser Criteria
The Investment Advisers Act addressed who is and who is not an adviser by applying three criteria: what kind of advice is offered, how the individual is paid for their advice or method of compensation, and whether or not the lion's share of the adviser's income is generated by providing investment advice (the primary professional function). Also, if an individual leads a client to believe they are an investment adviser—by presenting themselves like that in advertising, for example—they can be considered one.
The act stipulates that anyone providing advice or making a recommendation on securities (as opposed to another type of investment) is considered an adviser. Individuals whose advice is merely incidental to their line of business may not be considered an adviser, however. Some financial planners and accountants may be considered advisers while some may not, for example.
The detailed guidelines for the Investment Advisers Act of 1940 can be found in Title 15 of the United States Code.
Generally, only advisers who have at least $100 million of assets under management or advise a registered investment company are required to register with the SEC under the Investment Advisers Act of 1940.
Registration as a Financial Adviser
The agency with whom advisers need to register depends mostly on the value of the assets they manage, along with whether they advise corporate clients or only individuals. Before the 2010 reforms, advisers who had at least $25 million in assets under management or provided advice to investment companies were required to register with the SEC. Advisers managing smaller amounts typically registered with state securities authorities.
Those amounts were amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which allowed many advisers who previously registered with the SEC to now do so with their state regulators because they managed less money than the new federal rules required. However, the Dodd-Frank Act also initiated registration requirements for those who advise private funds, such as hedge funds and private equity funds. Previously, such advisers were exempt from registration, despite often managing very large sums of money for investors.