Overview of Investment Advisers Act of 1940

One of the most important set of the federal securities laws which relate to hedge fund managers is the Investment Advisers Act of 1940 (Investment Advisers Act).  The Investment Advisers Act provides the manner in which investment advisers will register with the SEC, provides the laws that must be followed as an investment advisor, and makes it illegal for both registered and unregistered investment advisors to act fraudulently toward any investors.

If a hedge fund manager is registered as an investment advisor with the SEC then the manager should make sure he understands all parts of the Investment Advisers Act. Below I’ve highlighted and discussed those provisions which are most important to a hedge fund manager.  The entire act can be found here: Investment Advisers Act of 1940.

Definition of Investment Adviser

The term investment adviser is very broad.  Section 202(a)(11) provides:

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities;

but does not include

(A) a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company, except that the term “investment adviser” includes any bank or bank holding company to the extent that such bank or bank holding company serves or acts as an investment adviser to a registered investment company, but if, in the case of a bank, such services or actions are performed through a separately identifiable department or division, the department or division, and not the bank itself, shall be deemed to be the investment adviser;

(B) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession;

(C) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore;

(D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation;

(E) any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act; or

(F) such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.

Pre-requiste for Registration

Only those managers which manage at least $25 million in assets are eligible to register with the SEC.  If a manager has less than $25 million of assets under management, then the manager will be subject only to the registration with the managers state of residence (if required).  Specifically Section 203A(a)(1)(A) provides:

No investment adviser that is regulated or required to be regulated as an investment adviser in the State in which it maintains its principal office and place of business shall register under section 203, unless the investment adviser – has assets under management of not less than $ 25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; …

Investment Adviser Registration Requirement

In general, all investment advisors must register with the SEC pursuant to Section 203(a).

Except as provided in subsection (b) and section 203A, it shall be unlawful for any investment adviser, unless registered under this section, to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.

Exemption from registration

While the definition of investment adviser is sufficiently broad to include most all hedge fund managers, there is a widely used exemption from the registration provisions.  Section 203(b)(3) provides:

The provisions of subsection (a) [the registration provisions noted above] shall not apply to … any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under title I of this Act, or a company which has elected to be a business development company pursuant to section 54 of title I of this Act and has not withdrawn its election. For purposes of determining the number of clients of an investment adviser under this paragraph, no shareholder, partner, or beneficial owner of a business development company, as defined in this title, shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner;

There are two important items to note here.  First, the investment adviser cannot have more than 15 clients over a 12 month rolling period.  A hedge fund counts as a single client for these purposes.  Second, the investment adviser

Prohibited Transactions

The act has very strong anti-fraud provisions.  Most SEC actions against investment advisers will be based on this section of the act.  Section 206, in full, provides:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly –

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

(3) acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction. The prohibitions of this paragraph (3) shall not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction;

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

Other Important Sections

There are other important sections to the act which include the following:

Section 204 – Record Keeping Requirements

Section 205 – Investment Advisory Contracts

Section 222 – State Regulation of Investment Advisers

9 thoughts on “Overview of Investment Advisers Act of 1940

  1. Pingback: Overview of Hedge Fund Investment Advisors | Hedge Fund Law Blog

  2. Pingback: How to Register as an Investment Advisor | Hedge Fund Law Blog

  3. Pingback: Hedge fund advertising - Can a hedge fund manager run a blog? | Hedge Fund Law Blog

  4. Francisco Watkins

    Do you have, or can you please tell me where to find, information on the State of California requirements for registration for independent financial advisors?
    Regards

  5. Rick Owen

    questions does forex hedge fund rules work the same way as other hedge funds? is it the responsiblity of the investor to understand the fund or is it the responsiblity of the hedge fund manager?Doesoes the hedge fund manager have to sign the agreement? is a power of att needed for trdasing forex?

    1. Hedge Fund Lawyer Post author

      Rick,

      There are a number of different ways to structure a forex trading account. Generally it can be through a hedge fund structure or through a separately managed account structure. Either way the manager will need to provide the investor with a disclosure document and some sort of legal contract. The exact documents will be different depending on the structure.

      Hope this helps.

      Regards,
      Bart Mallon

  6. Pingback: Important Hedge Fund Articles — Hedge Fund Law Blog

  7. Pingback: Hedge Fund Books and Records Requirement — Hedge Fund Law Blog

  8. Pingback: Hedge Funds and Insider Trading after Galleon — Hedge Fund Law Blog

Leave a Reply