Investment Advisers Act of 1940

The Investment Advisers Act of 1940 is the main federal law that governs investment advisers in the United States, including hedge fund managers. Think of it as the rulebook that sets the ground rules for how these financial professionals must operate when managing other people's money.

This law creates a complete regulatory framework that hedge funds must follow. It works alongside other important regulations like state fiduciary dutyLegal obligation to act in the best interests of another party, requiring utmost good faith and loyalty. laws, the Securities Exchange Act of 1934, and the Dodd-Frank Act. Together, these laws form a comprehensive system of oversight.

The Act establishes three core requirements for investment advisory relationships: registration obligations (who must register with regulators), fiduciary standards (the duties advisers owe to their clients), and compliance protocols (the systems advisers must have in place to follow the rules). These requirements form the foundation of modern hedge fund regulation.

In the early days of hedge funds, managers found creative ways to avoid registering under the Investment Advisers Act. This was important because they wanted to maintain their distinctive fee structures, particularly the ability to charge performance-based fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. —where managers earn more when their funds perform better.

The problem was that registered investment adviser were generally prohibited from charging these performance fees. This created a conflict because performance fees were central to how hedge funds operated and attracted talent.

A major breakthrough came in 1985 with the adoption of Rule 205-3SEC rule that allows registered investment advisers to charge performance-based fees to qualified clients.. This rule allowed registered investment advisers to charge performance-based fees, but only to qualified client—essentially sophisticated investors who met certain wealth requirements. This change gave hedge fund managers much more flexibility while still maintaining regulatory oversight.

Before the Dodd-Frank Act was passed, most hedge fund managers avoided SEC registration entirely by using something called the private adviser exemption. This exemption applied to investment advisers who had fewer than fifteen clients, didn't advise registered investment companiesInvestment companies registered with the SEC under the Investment Company Act of 1940, such as mutual funds., and didn't advertise their services to the general public.

The regulatory landscape changed dramatically after the Dodd-Frank Act eliminated the private adviser exemption in 2011. This change forced many hedge fund managers to register as investment advisers with the SEC for the first time, fundamentally reshaping how the industry operates.

Today's registration requirements are based on how much money an adviser manages. Investment advisers with $100 million or more in regulatory assets under managementThe total value of client assets managed by an investment adviser for SEC registration threshold purposes. must generally register with the SEC. The law also created some limited exemptions for specific types of advisers, including those managing less than $150 million in private fund assets, venture capital fund advisers, and foreign advisers with minimal U.S. operations.

As a result of these changes, most hedge fund managers now operate as registered investment advisers. This means they must follow the comprehensive set of rules and obligations established by the Investment Advisers Act.

When investment advisers manage client money, they become "fiduciaries"—a legal term that means they must put their clients' interests first. This applies whether they manage discretionary accountA trading account where the investment manager has authority to make trading decisions without prior client approval for each transaction.—where they make investment decisions on behalf of clients—or non-discretionary accountsTrading accounts where clients retain decision-making authority and the adviser provides recommendations only. where they simply provide advice that clients act on themselves.

The importance of this fiduciary relationship was established in a landmark Supreme Court case, SEC v. Capital Gains Research BureauLandmark Supreme Court case establishing the fiduciary duties of investment advisers under federal securities law.. The Court recognized that investment advisory relationships are inherently delicate because of the trust involved and the potential for conflicts of interest.

According to the Court, fiduciaries must act with the highest level of good faith, provide complete and honest disclosure of all important facts, and use reasonable care to avoid misleading their clients. The SEC clarified these requirements in 2019, establishing that fiduciary duty has two main components: a duty of careThe fiduciary obligation to act in clients' best interests when providing investment advice and to exercise reasonable care. and a duty of loyaltyThe fiduciary obligation to eliminate conflicts of interest or provide full disclosure and obtain informed consent..

The Investment Advisers Act creates a comprehensive fiduciary framework with two fundamental requirements that work together to protect investors.

The duty of care requires advisers to act in their clients' best interests when providing investment advice. This means they must seek the best executionThe obligation to seek the most favorable terms reasonably available when executing client transactions. when making trades, monitor investments on an ongoing basis, and maintain proper oversight throughout the entire advisory relationship.

The duty of loyalty is equally important. It requires advisers to either eliminate conflicts of interest entirely or, if that's not possible, provide full disclosure of those conflicts and get informed consentAgreement given by clients after full disclosure of potential conflicts of interest or other material information. from their clients. This duty applies to any situation that might affect the adviser's ability to provide unbiased advice.

These obligations can be modified by contract to fit the specific needs of each advisory relationship, but only if there is complete and honest disclosure of any changes to the standard fiduciary requirements.

Section 206Anti-fraud provisions of the Investment Advisers Act that prohibit advisers from breaching fiduciary obligations to clients. of the Act serves as the primary enforcement tool by prohibiting investment advisers from breaching their fiduciary obligations to clients. These anti-fraud protectionsRegulatory requirements that prohibit deceptive or misleading practices in financial communications and transactions. apply to all investment advisers as defined under the Act, whether or not they are registered with the SEC.

The SEC has exclusive authority to enforce these requirements under Section 206. Unlike some other financial regulations, the Act does not allow private investors to sue advisers directly for violations. This centralized approach helps ensure that fiduciary standards are applied consistently across the entire investment advisory industry.

The Act places significant restrictions on performance-based compensation through Section 205(a)Section of the Investment Advisers Act that generally prohibits performance-based compensation arrangements., which generally prohibits registered advisers from receiving fees based on capital gains or increases in the value of client funds. Congress included this prohibition because they were concerned about the potential conflicts of interest that performance-based arrangements might create.

However, the law gives the SEC authority to provide exemptions for investors who don't need these protections. Rule 205-3 implements these exemptions, allowing performance fees for qualified clients. This includes investors who meet specific asset or net worth requirements, qualified purchaser Qualified purchaser Qualified purchasers are investors who meet specific wealth thresholds under the Investment Company Act of 1940. These investors are required for participation in Section 3(c)(7) funds. Generally, individuals must own at least $5 million in investments, while institutions must own at least $25 million in investments. under the Investment Company Act Investment Company Act of 1940 The Investment Company Act of 1940 is a U.S. law that regulates companies whose main business involves investing in securities. Hedge funds typically use special exemptions under Sections 3(c)(1) or 3(c)(7) to avoid having to register under this law, which allows them to maintain the flexibility they need for their investment strategies and fee structures. , and certain knowledgeable employeeUnder Investment Company Act Rule 3c-5(a)(4), either a senior executive or director of a private fund or its management company, or an employee who participates in investment activities for at least 12 months. of the adviser.

The rule also provides exemptions for contracts with funds that are exempt under Section 3(c)(7) of the Investment Company Act and arrangements with non-U.S. investors. These exemptions recognize that sophisticated investors are better able to evaluate and accept the risks associated with performance-based fee structures.

Registered investment advisers must establish and maintain comprehensive compliance programs designed to prevent violations of the Investment Advisers Act and its related regulations. These programs must include written policies and procedures that are specifically tailored to each adviser's particular business model and risk profile.

The compliance framework goes beyond simply creating policies on paper. It requires annual reviews to ensure the program is working effectively, designation of chief compliance officerThe person responsible for overseeing a firm's compliance with applicable laws and regulations. who are responsible for oversight, and implementation of codes of ethics that govern personal trading and manage conflicts of interest. This infrastructure helps ensure ongoing compliance with regulatory requirements while adapting to changes in business practices and new regulatory developments.

The regulatory landscape continues to evolve, with recent developments including adjustments to qualified client thresholds and modernization of internet adviser exemptionsSEC exemptions allowing investment advisers to provide online investment advice without full registration requirements.. These changes demonstrate how the Act continues to adapt to address contemporary market conditions while maintaining its core investor protection objectives.