Investment Company Act of 1940

The Investment Company Act of 1940 is the federal statute regulating companies whose business is investing in securities and whose own securities are offered to the investing public. It requires such a company to register with the SEC and then governs how it is put together and run: how its shares are priced and redeemed, who may sit on its board, what it may do with affiliates, how much it may borrow, and what it must disclose about its objectives and its finances. Mutual funds, closed-end funds and most exchange-traded funds are registered investment companies under it, which is why the industry shorthand for that wrapper is a "1940 Act fund".

Section 4 divides investment companies into three statutory classes: the face-amount certificate company, the unit investment trust, and the management company, which is everything else. That class scheme, and the reason mutual funds and closed-end funds both sit inside the third class rather than alongside it, is set out on the page about the unit investment trust.

One naming point clears up a persistent confusion. This Act and the Investment Advisers Act of 1940 are not siblings by coincidence: they are Titles I and II of a single statute enacted on August 22, 1940. Saying "the 1940 Act" without more therefore names two different laws, one about funds and one about advisers, and the reader has to work out which from context.

What brings a company under the Act is broader than "it calls itself a fund". Section 3(a)(1) reaches an issuer that is or holds itself out as being engaged primarily in "investing, reinvesting, or trading in securities"; an issuer in the face-amount certificate business; and, in the limb that catches people by surprise, an issuer engaged in investing, reinvesting, owning, holding or trading in securities that "owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis". An operating business that accumulates a large securities portfolio can trip that test without ever intending to be a fund, which is why the Act carries a long list of exclusions and why structuring around it is an industry in itself.

Registered funds are subclassified again, and the second cut produces the names people actually use. Section 5 divides management companies into open-end and closed-end companies, defining an open-end company as one "offering for sale or has outstanding any redeemable security of which it is the issuer" and a closed-end company as any management company that is not open-end. It then divides both into diversified and non-diversified companies, with the diversified test requiring that at least 75 percent of total assets be represented by cash and cash items, government securities, other investment companies' securities, and other securities limited as to any one issuer to 5 percent of total assets and 10 percent of that issuer's voting securities. So "mutual fund" is not a statutory term at all: it is an open-end management company, and the statute names it that way.

What the wrapper actually buys the holder is a set of structural constraints. Four are worth stating precisely. Section 10(a) provides that no registered investment company may have a board "more than 60 per centum of the members of which are persons who are interested persons", which is the source of the independent-director requirement funds describe in their prospectuses. Section 17(a) makes it unlawful for an affiliated person, promoter or principal underwriter of a registered fund, acting as principal, knowingly to sell property to the fund or buy property from it, with narrow exceptions, which removes the most direct route for a manager to trade against the fund it runs. Section 18(f)(1) bars an open-end company from issuing senior securities at all, except that it may borrow from a bank provided that, immediately afterwards, there is "asset coverage of at least 300 per centum for all borrowings" of the company, and requires the fund to cut its borrowings back within three days, not counting Sundays and holidays, if coverage falls below that line. And section 22(e) bars a registered fund from suspending redemptions or postponing payment "for more than seven days after the tender of such security", except during a New York Stock Exchange closure or restriction, during an emergency in which the fund cannot reasonably dispose of holdings or fairly determine the value of its net assets, or for other periods the SEC permits by order.

None of that is a judgment about the investments. The SEC's own summary is worth quoting because it is the most common misunderstanding about registered funds: "It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments." The Act's protections are about structure, valuation, custody, governance and disclosure. A registered fund can lose money in an entirely lawful way, and frequently does.

The exclusions are where private funds live. Sections 3(c)(1) and 3(c)(7) take an issuer outside the definition of an investment company, the first where its securities are beneficially owned by no more than one hundred persons, or 250 for a qualifying venture capital fund, and it is not making and does not propose to make a public offering; the second where its outstanding securities are owned exclusively by qualified purchasers and, again, there is no public offering. Those two paragraphs are the legal foundation of the private-fund industry, and the trade they express is explicit: fewer investor protections in exchange for a closed door. The practical consequences belong on the pages about hedge funds and about the qualified purchaser test.

For a fund offered to the public, the Act operates in four layers:

1. Classification. The vehicle is an investment company under section 3, is sorted into one of section 4's three classes, and, if it is a management company, is further sorted into open-end or closed-end and diversified or non-diversified.

2. Registration and disclosure. It registers with the SEC and discloses its financial condition and investment policies when its shares are first sold and on a continuing basis afterwards.

3. Structural limits. Board composition, affiliate transactions, capital structure and redemption timing are all constrained by the statute rather than by the fund's own documents.

4. Ongoing valuation. The fund's shares are priced off net asset value, and the redemption obligation is what forces that valuation to be done and honored.

A hypothetical, to make the borrowing limit concrete. Assume an open-end fund holds a portfolio worth $300,000,000 and has no other liabilities, and it borrows $150,000,000 from a bank. Immediately afterwards its total assets are $450,000,000 (the $300 million portfolio plus the $150 million of borrowed cash), and asset coverage for that borrowing is $450,000,000 divided by $150,000,000, or 3.0, which is the 300 percent floor exactly. Borrowing any more would put it below the line. Turned around, the 300 percent test means borrowings can be at most one third of total assets, or half of what the shareholders own. (Numbers hypothetical, for illustration.)

The same arithmetic explains why a registered open-end fund cannot be run the way a leveraged private fund can. The constraint is not a policy the manager chose; it is a condition of using the wrapper.

Pros

• Daily redeemability with a statutory seven-day outer limit gives an investor a legal right to their money that a private fund does not offer.
• Board composition and affiliate-transaction limits address the conflicts that arise when the manager and the fund are separate parties with the same people behind them.
• The borrowing limit caps how far a fund can amplify its own losses, which is a structural protection rather than a disclosed risk.
• Registration brings continuing disclosure of holdings, objectives and finances, so an investor can see what the fund owns and what it costs.

Cons

• The Act judges structure, not quality. A registered fund can be expensive, poorly run and lawful all at once, and nothing in the statute prevents that.
• The protections come with constraints that keep some legitimate strategies out of the registered wrapper, which is part of why private funds exist.
• The exclusions in sections 3(c)(1) and 3(c)(7) mean the investors with the most money have the easiest access to the vehicles with the fewest protections.
• Reading the Act does not tell an investor what a specific fund does. The statute sets a floor, and everything above it lives in the fund's own documents.