Investment Advisers Act of 1940

The Investment Advisers Act of 1940 serves as the foundation for regulating investment advisers in the United States, including hedge fund managers. This law created a comprehensive system of rules that hedge funds must follow today.

The Act works together with other important financial regulations. These include 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 Securities Exchange Act of 1934 The Securities Exchange Act of 1934 is the primary U.S. legislation governing securities trading, establishing the SEC and imposing various reporting requirements on public companies and institutional investors, including certain hedge fund managers and activities. , and the Dodd-Frank Act Dodd-Frank Act The Dodd-Frank Act (Dodd-Frank Wall Street Reform and Consumer Protection Act) is comprehensive U.S. financial regulatory legislation enacted in 2010 that significantly impacted hedge funds through registration requirements, reporting obligations, trading restrictions, and enhanced compliance standards. . Together, these laws form a complete regulatory framework for the investment advisory industry.

Performance-based compensation became essential for early hedge fund managers. They gained access to these fee arrangements through exemptions from the Advisers Act registration requirements.

The regulatory environment changed significantly in 1985 when the SEC introduced Rule 205-3SEC rule that allows registered investment advisers to charge performance-based fees to qualified clients meeting specific asset thresholds.. This rule allowed registered advisers to receive performance-based compensation for the first time, but only under specific conditions.

From the industry's early years through June 2010, most hedge fund managers operated without having to register with the SEC. They qualified for an exemption that applied to investment advisers who had fewer than fifteen clients in the previous twelve months. These advisers also could not advise registered investment companiesInvestment companies registered with the SEC under the Investment Company Act of 1940, such as mutual funds. or present themselves to the public as investment advisers.

The Dodd-Frank Act dramatically changed the registration rules for hedge fund managers. Before this law passed, many hedge fund managers avoided SEC registration by using the private adviser exemptionFormer exemption that allowed investment advisers with fewer than fifteen clients to avoid SEC registration, eliminated by Dodd-Frank.. This exemption, found in former Section 203(b)(3) of the Advisers Act, allowed investment advisers with fewer than fifteen clients to skip registration requirements.

Dodd-Frank eliminated this broad exemption. As a result, many previously exempt hedge fund managers had to register as investment advisers with the SEC. The law also created new, more limited exemptions and changed how regulatory authority was divided between federal and state oversight for smaller managers.

Today, the majority of hedge fund managers must register with the SEC as investment advisers. They must also meet all the regulatory requirements that come with this registration.

Investment advisers serve as fiduciaries to their clients. This applies whether they act as agents in securities transactions or provide advisory services without making trading decisions for clients. The fiduciary relationship creates two key obligations: 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. to clients.

The U.S. Supreme Court recognized that the Advisers Act reflected Congress's understanding of the sensitive fiduciary nature of investment advisory relationships. In the important case SEC v. Capital Gains Research BureauLandmark Supreme Court case establishing the fiduciary duties of investment advisers under federal securities law., Inc., the Court established that fiduciaries have positive obligations. They must act with complete good faith, provide full and fair disclosure of all material facts, and exercise reasonable care to avoid misleading clients.

The Advisers Act establishes a comprehensive fiduciary framework with two main components: duties of care and loyalty.

The duty of care includes three fundamental obligations. First, advisers must provide advice that serves the client's best interests. Second, they must seek the best executionThe obligation to seek the most favorable terms reasonably available when executing client transactions. of transactions. Third, they must maintain continuous advisory oversight throughout the client relationship.

The duty of loyalty requires advisers to handle conflicts of interest properly. They must either eliminate these conflicts entirely or provide complete disclosure of such conflicts and obtain informed consentAgreement given by clients after full disclosure of potential conflicts of interest or other material information. from clients.

The Act places significant limits on performance-based compensation through Section 205(a)Section of the Investment Advisers Act that generally prohibits performance-based compensation arrangements.. This section generally prohibits registered advisers from receiving compensation based on capital gains or appreciation of client funds. However, the law gives the SEC authority to provide exemptions for people who do not need these protections.

The Act provides several exemptions from performance fee restrictions. These include contracts with funds exempt under Section 3(c)(7) Section 3(c)(7) Section 3(c)(7) of the Investment Company Act of 1940 exempts private funds from registration as investment companies if they limit investors exclusively to "qualified purchasers" and do not make public offerings. This allows hedge funds to accept unlimited investors who meet high wealth thresholds. of the Investment Company Act of 1940 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. , arrangements with non-U.S. persons, and relationships with qualified clients Qualified client A qualified client is a wealthy investor who can participate in performance fee arrangements. To qualify, an investor must have either $1.1 million in assets under management with the adviser or $2.2 million in net worth. These dollar amounts are adjusted roughly every five years to account for inflation. as defined under Rule 205-3.

The Act's enforcement structure centers on Section 206Anti-fraud provisions of the Investment Advisers Act that prohibit advisers from breaching fiduciary obligations to clients., which prohibits investment advisers from breaching their fiduciary obligations to clients. These anti-fraud provisionsRegulatory requirements that prohibit deceptive or misleading practices in financial communications and transactions. apply to all investment advisers as defined under the Act, whether they are registered with the SEC or not.

However, only the SEC has the authority to enforce these provisions. The Act does not allow private parties to bring lawsuits under Section 206.

Registered investment advisers must comply with all provisions of the Advisers Act. They must also implement comprehensive compliance programs. These programs must include written policies and procedures designed specifically to prevent violations of the Act and its rules by both the adviser and the people it supervises.