The Investment Company Act of 1940 (the “Investment Company Act”) is what gives structure to the hedge fund industry.  The Investment Company Act provides very strict regulations for entities which are “investment companies” such as mutual funds. While hedge funds do fall within the definition of “investment company” they will seek an exemption from the registration provisions because such restrictions are onerous. This article provides an overview of certain aspects of the Investment Company Act including the reason hedge funds seek exemption from the registration provisions and the definition of “investment company”.  In depth discussion of the exemptions for hedge funds under the Investment Company Act can be found elsewhere on this website.

Reason to seek exemption – Onerous Regulation

While the advantage for a mutual fund is that they can publicly advertise investments in their shares, there are many regulations which the mutual fund must follow.  These include:

• Mutual funds must register their securities under the Securities Act and Investment Company Act, this is a long and very costly process.
• Mutual funds must have a Board of Directors and 75% of the Board must be independent.  The Board must approve and vote on various items related to the mutual fund, include 12b-1 fees.
• Mutual funds have certain investment restrictions.  Form example, mutual funds use of leverage is limited; there are percentage restrictions on investment into other mutual funds and hedge funds
• Mutual funds have daily net asset value (NAV) calculations and daily redemptions.  Because of the possibility of daily redemption the mutual fund must keep a certain amount of cash available at all times.
• Mutual funds can only be advised by a registered investment advisor.

Definition of Investment Company

Section 3(a)(1) of the Investment company act as follows:

When used in this title, “investment company” means any issuer which (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (C) 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 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Exemption from registration under Section 3(c)(1)

Please see Section 3(c)(1) Hedge Funds

Exemption from registration under Section 3(c)(7)

Please see Section 3(c)(7) Hedge Funds

In addition to the above sections, below is the SEC’s description of the Investment Company Act of 1940 and its important provisions.  This description can also be found here.

Investment Company Act of 1940

This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments. The full text of this Act is available at: http://uscode.house.gov/download/pls/15C2D.txt (Subchapter I). (Please check the Classification Tables maintained by the US House of Representatives Office of the Law Revision Counsel for updates to any of the laws.)