What Is the Investment Company Act of 1940?
The Investment Company Act of 1940 is an act of Congress that regulates the organization of investment companies and the activities they engage in. It sets standards for the investment company industry. A primary purpose of the Act is to protect investors by ensuring that they're aware of the risks associated with buying and owning securities.
Investment companies are required by the Act to provide investors with information about their investment objectives, investment policies, and financial condition when stock is first sold and, henceforth, at regular intervals. Investment companies must also inform investors about investment company structure and operations.
The Act was signed into law by President Franklin D. Roosevelt along with the Investment Advisers Act of 1940. Both give the U.S. Securities and Exchange Commission (SEC) power to regulate investment trusts and investment counselors.
Key Takeaways
- The Investment Company Act of 1940 is an act of Congress that regulates the formation of investment companies and their activities.
- The legislation in the Investment Company Act of 1940 is enforced and regulated by the Securities and Exchange Commission (SEC).
- Companies seeking to avoid the product obligations and requirements of the Act may be eligible for an exemption.
- The Act was signed into law by FDR who wanted to protect investors after the Stock Market Crash of 1929 and the Great Depression that followed.
- The Act has gone through many changes over the decades as financial markets have evolved and become more complex.
Understanding the Investment Company Act of 1940
The legislation in the Investment Company Act of 1940 is enforced and regulated by theSecurities and Exchange Commission (SEC). This legislation defines the responsibilities and requirements of investment companies and the requirements for any publicly traded investment product offerings, such as open-end mutual funds, closed-end mutual funds, and unit investment trusts. The Act primarily targets publicly traded retail investment products.
The Investment Company Act of 1940 was passed in order to establish and integrate a more stable financial market regulatory framework following the Stock Market Crash of 1929. It is the primary legislation governing investment companies and their investment product offerings. The Securities Act of 1933 was also passed in response to the crash, but it focused on greater transparency for investors; the Investment Company Act of 1940 is focused primarily on the regulatory framework for retail investment products.
The Act details rules and regulations that U.S. investment companies must abide by when offering and maintaining investment product securities. Provisions of the Act address requirements for filings, service charges, financial disclosures, and the fiduciary duties of investment companies.
The Act also provides regulations for transactions of certain affiliated persons and underwriters; accounting methodologies; record-keeping requirements; auditing requirements; how securities may be distributed, redeemed, and repurchased; changes to investment policies; and actions in the event of fraud or breach of fiduciary duty.
The Investment Company Act of 1940 has greatly protected the retirement savings of individuals, as mutual funds are a large component of retirement plans, such as 401(k)s, and annuities.
Further, it sets forth specific guidelines for different types of classified investment companies and includes provisions governing the rules of companies' operating products, including unit investment trusts, open-end mutual funds, closed-end mutual funds, and more.
Defining an Investment Company
The Act also defines what qualifies as an “investment company.” Companies seeking to avoid the product obligations and requirements of the Act may be eligible for an exemption. For example, hedge funds sometimes fall under the Act's definition of "investment company" but may be able to avoid the Act's requirements by requesting an exemption under sections 3(c)(1) or 3(c)7.
In accordance with the Investment Company Act of 1940, investment companies must register with the SEC before they can offer their securities in the public market. The Act also lays out the steps an investment company is required to take during this registration process.
Companies register for different classifications based on the type of product or the range of products that they wish to manage and issue to the investing public. In the U.S., there are three types of investment companies (categorized according to federal securities laws): mutual funds/open-end management investment companies; unit investment trusts (UITs); and closed-end funds/closed-end management investment companies. Requirements for investment companies are based on their classification and their product offerings.
Dodd-Frank Act and Partial Repeal
After the Great Recession, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. It is an extremely large piece of legislation that resulted in the creation of new government agencies to oversee different aspects of the act, and hence, the entire financial system in the U.S. The act impacted several areas, including "consumer protection, trading restrictions, credit ratings, financial products, corporate governance, and transparency."
Dodd-Frank impacted the Investment Advisers Act of 1940 more than it did the Investment Company Act of 1940; however, hedge funds have been impacted by Dodd-Frank.
Under the Investment Company Act, hedge funds were not required to register. This gave hedge funds a significant amount of carte blanche in their trading activities. Dodd-Frank established new rules for hedge funds and private equity funds to register with the SEC and abide by certain disclosure requirements based on their size.
Why Was the Investment Company Act of 1940 Passed?
The Investment Company Act of 1940 was established after the 1929 Stock Market Crash and the Great Depression that followed in order to protect investors and bring more stability to the financial markets in the U.S.
What Constitutes an Investment Company Under the 1940 Act?
The Act defines an investment company as "an issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire 'investment securities' having a value exceeding 40% of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis."
Which Companies Are Qualified for an Exemption?
There are a variety of companies that can qualify for exemptions based on how they are structured, their activities, as well as their size. This includes companies that only give advice about the economy but not on securities, certain subsidiaries, and companies having less than 100 investors.
How Did the Investment Company Act of 1940 Impact Financial Regulation?
The Act impacted the registration and requirements of many investment companies and made financial regulation tighter, giving the SEC more power to oversee the financial markets. It created rules that protected investors and required investment companies to disclose certain information. Financial regulation became more robust under the Act.
The Bottom Line
The Investment Company Act of 1940 was passed by FDR in the aftermath of the Great Depression after many individuals and families lost everything they had. The purpose of the Act was to provide the SEC with the power to oversee investment companies and ensure they are acting according to law and in the best interest of their investors. The purpose of the Act was to protect investors at all costs. As financial markets have evolved over the decades, so has the Investment Company Act, though at its core its purpose remains the same.
