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The Investment Advisers Act of 1940

Today United Atlantic Legal Service invites FinProLaw to discuss the Investment Advisers Act of 1940.

The Investment Advisers Act of 1940

The Investment Advisers Act of 1940 (the “Advisers Act”) was the last in a series of federal statutes intended to eliminate abuses in the securities industry that Congress believed contributed to the stock market crash of 1929 and the depression of the 1930s. Following these events, Congress, through an SEC report, determined that there was a significant problem in the financial industry where, either consciously or, more likely, unconsciously, there was a prejudice by advisers favoring their own financial interests.

Who is considered an “investment adviser” under the Advisers Act? Section 202(a)(11) of the Act defines an investment adviser as any person or firm that:

  • for compensation;
  • is engaged in the business of;
  • providing advice to others or issuing reports or analyses regarding securities.

Assuming these elements are met, which is not always a clear-cut analysis, then a person or firm would meet the definition of an investment adviser and generally be subject to the mandates of the Advisers Act.

What obligations do investment advisers have under the Advisers Act?

Registration. First, under section 203(a) of the Advisers Act, a person or firm that falls within the definition of an “investment adviser” (and is not eligible for one of the exclusions) must register under the Advisers Act, unless it (i) is prohibited from registering under the Act because it is a smaller firm regulated by one or more of the states, or (ii) qualifies for an exception from the Act’s registration requirement.

Although many individuals who are employed by investment advisers fall within the definition of “investment adviser,” the SEC generally does not require those individuals to register as advisers with the SEC. Instead, the advisory firm must register with the SEC. The adviser’s registration covers its employees and other persons under its control, provided that their advisory activities are undertaken on the adviser’s behalf.

It should be noted that all advisers, registered or not, are subject to the Advisers Act’s anti-fraud provisions.

Fiduciary Duties to Clients. At the heart of the Advisers Act is the investment adviser’s fiduciary obligations to its clients. “As a fiduciary, an adviser must avoid conflicts of interest with clients and is prohibited from overreaching or taking unfair advantage of a client’s trust. A fiduciary owes its clients more than mere honesty and good faith alone. A fiduciary must be sensitive to the conscious and unconscious possibility of providing less than disinterested advice, and it may be faulted even when it does not intend to injure a client and even if the client does not suffer a monetary loss.” (SEC v. Capital Gains Research Bureau, supra note 2, at 191-192).

In Meinhard v. Salmon, the Supreme Court defined the investment advisers’ fiduciary duties as:

Many forms of conduct permissible in the workaday world for those acting at arm’s length are forbidden by those bound by fiduciary ties. A fiduciary is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.

These concepts are embodied in the anti-fraud provisions of the Advisers Act. As the Supreme Court stated in SEC v. Capital Gains Research Bureau, Inc., its seminal decision on the fiduciary duties of an adviser under the Act:

The Investment Advisers Act of 1940 reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested.

The courts and the SEC have found that the following obligations flow from an investment adviser’s fiduciary obligations:

  • Full and Fair Disclosure of Material Fact – An investment adviser must, in good faith, provide full and fair disclosure of all material facts to a client regarding the client’s relationship with the adviser. This includes a duty not to mislead a client. Disclosure includes conflicts of interest (or potential conflicts of interest). Further, disclosure requirements apply to any financial matter that the investment adviser might be facing.
  • Suitable Advice – Investment advisers are required to provide only suitable advice. Note that this does not necessarily mean profitable investment advice. Investment advice should be made with consideration given to the client’s s financial situation, investment experience, and investment objectives.
  • Reasonable Basis for Recommendations – An investment adviser must have a reasonable, independent basis for its recommendations.
  • Trading Considerations – There are several areas under the trading umbrella where an investment adviser will have additional fiduciary obligations to clients. Some of these include: in best execution, interpositions, directed trades, the use of affiliated brokers, soft dollar arrangements, and proxy voting.

Substantive Requirements. The Advisers Act contains other, more specific prohibitions designed to prevent fraud. In addition, the SEC has adopted several anti-fraud rules, which apply to advisers registered with the SEC. These cover topics such as principal transactions, cross-trades, and agency cross transactions. It is important to note that the Advisers Act, under rule 206(4)-1 provides very specific guidance related to advertising (with particular attention being paid to performance advertising). Finally, there are substantive requirements under the Advisers Act relating to the custody of client assets.

Firm Brochure (Disclosure). Rule 204-3 of the Advisers Act requires the investment adviser to deliver a brochure supplement that contains information about an advisory employee, including the employee’s educational background, business experience, other business activities, and disciplinary history, to a client before or at the time the employee begins to provide investment advisory services to that client.

Other Considerations. Investment advisers, that fall under the Advisers Act, will be subjected to a myriad of other requirements, including those relating to ongoing reporting obligations, fund manager requirements, client investment management agreements, books and records requirements, etc.

About the Author

Michael Rasmussen is the founder of United Atlantic Legal Services. He is a licensed attorney in Florida and registered solicitor in the United Kingdom. Michael has acted as General Counsel and Chief Compliance Officer to several investment advisers, including private fund managers, responsible for the management of billions of dollars in client assets.  

Michael is also the founder of FinProLaw, an online learning platform where Michael has created courses designed for investment adviser compliance professionals. These courses include: 

  • Investment Adviser Compliance Essential for Chief Compliance Officers 
  • Foundations of Investment Adviser Compliance 
  • What is a “Security”? 
  • Investment Adviser Marketing Rule 
  • Regulation A – Exemption from Registration 
  • Regulation Crowdfunding – Exemption from Registration 
  • Regulation D – Exemption from Registration 

Michael can also be found on LinkedIn.

Investment adviser firms who are also clients of United Atlantic Legal Services can receive many of these courses at a significantly reduced fee or, in some cases, at no expense. Contact us today or visit the FinProLaw to learn more.