What is the Investment Company Act of 1940?

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Mutual Fund Education

What is the Investment Company Act of 1940?

Aaron Levitt Sep 03, 2014

While you can argue for and against more government intervention on Wall Street, there have been some net-positive pieces of regulation for retail investors. One of the strongest is the Investment Company Act of 1940. It was this piece of regulation that helped set forth the modern mutual fund, hedge fund, and exchange traded fund (ETF) industries.

Be sure to also see the 7 Questions to Ask When Buying a Mutual Fund

A Bit of Background

In response to these two major economic events, Congress wrote into law the Securities Act of 1933 and the Securities Exchange Act of 1934 in order to regulate the securities industry in the interest of the general public. That gave birth to the SEC and now commonplace items, such as quarterly filings and prospectuses.

However, there were still some issues that needed to be addressed further.

Investment companies (closed-end funds and regular open-end mutual funds) were still a relative novelty at the time. In order to get the general investing public interested in these vehicles, Congress wrote up the Investment Company Act of 1940 and gave power to the SEC to enforce its attributes. It was here that the modern mutual fund industry really took shape.

The Nuts and Bolts of the Act

The act also specifically defined what a mutual fund was – something that hadn’t actually been done prior to 1940. Ultimately, the bill was designed "to mitigate and eliminate the conditions which adversely affect the national public interest and the interest of investors.” It does this in several ways.

First, all investment companies must register with the SEC. This provides necessary oversight. Secondly, each investment company must have a board of directors, and 75% of those board members must be independent or not affiliated with the fund’s activities. Again, this is designed to protect investors and provide impartial oversight of the fund.

In terms of actually operating the fund, the Investment Company Act of 1940 requires that funds limit the use of leverage and must include a cash buffer—in the case of mutual funds—for those investors wishing to redeem their shares at any time. In addition, funds under the act must disclose their structure, financial condition, investment policies and other objectives to investors via quarterly reports and updates. The N-SAR form—which holds all of this information as well as expense ratios and other operating facts—can be accessed free of charge through the SEC’s online EDGAR database.

All in all, the Act’s rules and regulations are intended to make sure that funds are acting in their investors’ best interests in order to minimize conflicts. However, the SEC does not make the distinction between “good” and “bad” investments. Picking the wrong mutual fund could still result in major losses.

Furthermore, not every investment trading on the market is classified under the Investment Company Act of 1940. Many hedge funds are able to skirt the rules by using what’s called a 3©1 or 3©7 exemption. Those rules require that funds have either less than 100 or less than 499 investors who meet certain standards. This allows hedge funds to use leverage and make exotic bets. Secondly, many commodity pools—like the iShares S&P GSCI Commodity-Indexed Trust (GSG)—are not regulated under the Act. The same goes for various managed futures funds, special purpose vehicles (SPVs), and other foreign investment funds.

Updated by Dodd-Frank

Shaping the Mutual Fund Industry

While mutual funds continue to evolve, the Act still provides a legal framework for protecting the average investor from fraud. That makes the Investment Company Act of 1940 one of the most important pieces of legislature in Wall Street’s history.

The Bottom Line

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