Understanding the Investment Advisers Act of 1940: Roles & Regulations

What Is the Investment Advisers Act of 1940?

The Investment Advisers Act of 1940 was created after the 1929 stock market crash and the Great Depression to protect investors and bring more trust to financial markets. The act helps ensure fairness and accountability, while protecting investors. The goal was to regulate investment advisors and make sure they act in their clients’ best interests. The law requires most advisors to register with the Securities and Exchange Commission (SEC) or state regulators and also sets rules on who qualifies as an investment advisor.

Historical Context and Impetus for the Investment Advisers Act of 1940

The stock market crash of 1929 and the Great Depression inspired the Investment Advisers Act of 1940 and other financial regulations. 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, an 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 on not only 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. 

Fiduciary Responsibilities of Investment Advisors

Investment advisors 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.

It requires advisors to prioritize their clients' interests over their own through a duty of loyalty and care.

Advisors cannot buy securities for themselves before their clients or make trades for higher commissions (front-running and churning). Advisors must ensure their investment advice is based on thorough, accurate information.

Additionally, the advisor 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.

Criteria for Defining Investment Advisors

The Investment Advisers Act addressed who is and who is not an advisor 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 advisor’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 advisor—by presenting themselves like that in advertising, for example—they can be considered one.

The act classifies anyone giving advice or recommendations on securities as an advisor. Individuals whose advice is merely incidental to their line of business may not be considered advisors, however. Some financial planners and accountants may be considered advisors 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.

Registration Requirements for Investment Advisors

The agency with whom advisors 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, advisors who had at least $25 million in assets under management or provided advice to investment companies were required to register with the SEC. Advisors managing smaller amounts are typically registered with state securities authorities.

The 2010 Dodd-Frank Act changed these amounts, letting many advisors switch to state registration due to lower asset levels. 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 advisors were exempt from registration, despite often managing very large sums of money for investors.

The Bottom Line

The Investment Advisers Act of 1940 was created after the 1929 stock market crash and the Great Depression to bring oversight to the financial markets. It established a fiduciary duty, so that investment advisors must always put their clients’ interests first. Advisors must pass an exam and register with regulators to legally provide advice to their clients. The Act has been updated over time, including changes under the Dodd-Frank Act, which expanded oversight to advisors managing private funds like hedge funds. It remains in place to protect investors and ensure fair practices.