Investment Company Act Of 1940

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21 Aug, 2024

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The Federal Investment Company Act of 1940, or the '40 Act, was passed by the Congress on August 22, 1940, to regulate investment companies and their investment offerings. It laid out many rules and regulations governing the incorporation and operations of investment companies in the United States.

Then U.S. President Franklin D. Roosevelt signed the Act in the backwash of the 1929 stock market crash and the Great Depression. The Act became fundamental to investment companies and was updated over the years. The most recent update is the Dodd-Frank Act of 2010.

Investment Company Act of 1940 Definition

The U.S. Investment Company Act of 1940 was passed by Congress to implement more uniform and stricter regulations on investment companies in the country.
It was one of the many measures the Franklin D. Roosevelt administration took in response to the 1929 stock market crash and the Great Depression.
The Securities and Exchange Commission became central to investment funds and other securities offered by companies to the public.
Companies should register with the SEC before they can publicly trade investments. However, there are some exemptions.

Investment Company Act of 1940 Explained

The Investment Company Act of 1940 was an important move post-Great Depression. The Act was implemented along with the Investment Advisers Act to prevent another stock markets crash like the 1929 and another economic depression.

Along with the Securities Exchange Act and the establishment of the Securities and Exchange Commission (SEC) in 1934, it was supposed to control and manage investment companies and funds and protect investors.

The 1940 Act is one of the fundamental laws especially focused on investment companies. It proposes many rules and regulations concerning the operations and management of such companies, emphasizing the securities offered.

The Dodd-Frank Act of 2010 contributed several significant provisions and amendments to the U.S. Investment Company Act of 1940. The U.S. administration drafted the Dodd-Frank Act after the financial crisis of 2008. It has strengthened the regulations on financial markets and investment companies.

Rules

Section 270 of the '40 Act laid out many rules regarding companies and investments. Let's look at some of the significant ones.

The Act defines what constitutes an investment company.
Investment companies should fully disclose all the information regarding their financials, objectives, operations, and policies frequently.
The Act confers more power and authority to the SEC to act as the protector of investors and regulator of investment firms.
Registration with SEC is mandatory before the issue of securities.

The Act also explicitly provides rules regarding the company's transactions, affiliated persons, ineligibility of affiliates, function, and activities of companies, offers of exchange, issue, redemption, repurchase of securities, reorganization, etc.

Registration

The Act mandates that companies register with the SEC before offering any investments in the market. The registration depends on the type of securities the company wants to offer. Accordingly, the Act specifies the process companies need to follow during registration. Investment companies can be registered as open-end investment companies, closed-end management investment companies, and unit investment trusts (UITs). The registration forms for each of these companies vary.

Further, investment companies should register their offerings under the Securities Act. Also, they have to pay a registration fee. After registration, these companies are subject to obligations such as minimum capital requirements, state regulation, and other reports.

Fiduciary Duty

Section 36(b) of the Act states a fiduciary duty on the part of investment companies regarding receiving compensation for services or payments. The directors, board members, investment advisers, depositors, principal underwriters, etc., are bound by their duty to investors. They should eliminate or at least expose any conflicts of interest. The company is subject to two-fold duties – duty of care and duty of loyalty, as stated by the Investment Advisers Act of 1940.

The SEC Investment Company Act of 1940 deals with actions they can take in the event of a breach of fiduciary duty. Any such cases may be taken up at proper district courts across the country, provided that the misconduct or breach of duty has occurred within five years or is about to occur. They can act against the company or any person who represents it. The court will provide adequate compensation for the damages incurred by the investor.

Exemptions

The Act exempts the following companies from its provisions:

Companies created in American territories such as the Virgin Islands, Puerto Rico, etc. The exemption will cease once the company is sold to an American resident.
Any company reorganized under court supervision since the effect of the title or five years before its effect.
The company has outstanding writing filed with the Commission. The writing expires within two years or by another stating its expiration, whichever occurs first.
A company that was a wholly-owned subsidiary before March 15, 1940, and still holds the same status.
Companies that do not issue redeemable securities.

Apart from this, companies can be exempt from certain provisions only. For example, a closed-end company that chooses to function as a business development company can be exempt from sections 1 to 53 but not from sections 59 to 65.

Frequently Asked Questions (FAQs)

Are ETFs registered under the Investment Company Act of 1940?

Yes. Exchange-traded funds should be registered under the SEC Investment Company Act of 1940 and are regulated by the SEC. ETFs, like mutual funds, fall under open-ended investment companies, according to the '40 Act.

Who does the Investment Company Act of 1940 apply to?

Like other federal laws in this regard, the federal Investment Company Act of 1940 Act, seeks to protect investors from any unlawful practices or misconducts of the company. The act applies to all investment companies that publicly offer redeemable securities. However, it comes with certain exceptions.

Who is exempt from the Investment Company Act of 1940?

The '40 Act is an extremely significant law governing investment companies and their offerings in the United States. Most importantly, the Act specifies what an investment company is. It also lays down necessary information regarding the duties of companies, registration processes, functions, etc. but certain governmental organizations, hedge funds, broker-dealers, charities, investment clubs, etc.