INVESTMENT ADVISERS ACT OF 1940



The Investment Advisers Act (IAA) was passed in 1940 in order to monitor those who, for a fee, advise people, pension funds, and institutions on investment matters. Impetus for passage of the act began with the Public Utility Holding Company Act of 1935 which authorized the Securities and Exchange Commission (SEC) to study investment trusts. The thrust of this study, which led to the passage of the Investment Company Act of 1940 and the Investment Advisers Act, was to provide a closer look at investment trusts and investment companies. The study, however, found many instances of investment adviser abuse such as unfounded "hot tips" and questionable performance fees. The IAA sought not to regulate investment advisers so much as to keep track of who was in the industry and what their methods of operation were. The IAA does not mandate qualifications for becoming an investment adviser but it does require registration for those using the mails to conduct investment counseling business.

The IAA mandated that all persons and firms receiving compensation for serving as investment advisers must register with the SEC (this requirement was altered somewhat with the passage of the Investment Advisers Supervision Coordination Act of 1996). There are, however, three general exceptions to the registration requirement: investment advisers whose clients all reside in the same state as the adviser's business office and who do not provide advice on securities listed on national exchanges; investment advisers whose clients are solely insurance companies; and investment advisers who had fewer than 15 clients in any previous 12-month period. The IAA was amended, however, in 1996 with the presidential signing of the Securities Reform Bill. Title III of this bill, known as the Investment Advisers Supervision Coordination Act (IASCA) changed the registration criteria of the IAA. The IASCA, which went into effect on July 8, 1997, basically requires the SEC to supervise and register those investment advisers managing $25 million or more in client assets. Those managing less than this amount are to be registered with and supervised by their proper state regulatory agency. If an investment adviser managing client assets of $25 million or less resides in a state that does not require registration, he or she must then register with the SEC.

A hallmark of the IAA is the required registration of virtually all investment advisers. Much verbiage, however, has gone into exactly what constitutes an investment adviser and his or her corollary—investment advice. The act defines an investment adviser as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities." The SEC further refined its definition of an adviser in its Release 1092, which stated that the "giving of advice need not constitute the principal business activity or any particular portion of the business activities in order for a person to be an investment adviser." Release 1092 went on to state that the "giving of advice need only be done on such a basis that it constitutes a business activity occurring with some regularity. The frequency of the activity is a factor, but is not determinative."

Whether or not a person is considered to be an investment adviser under the IAA generally depends on three criteria: the type of advice offered, the method of compensation, and whether or not a significant portion of the "adviser's" income comes from proffering investment advice. Related to the last criterion is the consideration of whether or not a person leads others to believe that he or she is an investment adviser, as for example through advertising.

Under the act a person is generally considered to be an investment adviser through the offering of advice or the making of recommendations on securities as opposed to other types of investments. Securities may be defined under the act as including but not necessarily limited to notes, bonds, stocks (both common and preferred), mutual funds, money market funds, and certificates of deposit. The term "securities" does not generally include commodity contracts, real estate, insurance contracts, or collectibles such as works of art or rare stamps and coins. Even those who receive finder's fees for referring potential clients to investment advisers are considered to be investment advisers themselves.

Generally excluded from coverage under the act are those professionals whose investment advice to clients is incidental to the professional relationship. The IAA excepts "any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession." "Solely incidental" is the key phrase. An accountant, for instance, who acts as an investment adviser is in fact considered to be an investment adviser under the act. If professionals are not to be considered investment advisers under the IAA: they must not present themselves to the public as investment advisers; any investment advice given must be reasonably related to their primary professional function; and fees for the "investment advice" must be based on the same criteria as fees for the primary professional function. The IAA, however, excludes from its definition of an investment adviser "any broker or dealer whose performance of such [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation thereof." Banks, publishers, and government security advisers are also excepted from the act. People who call themselves "financial planners" may under certain circumstances be considered financial advisers under the act. The difference between a financial planner and an investment adviser as it relates to the IAA is also addressed in the aforementioned Release 1092.

Under the act, investment advisers must register using Form ADV accompanied by a $150 filing fee (as of 1996). The form asks for such information as educational background, experience, exact type of business engaged in, assets, information on clients, past history of a legal and/or criminal nature, and type of investment advice to be offered. Registration under the act does not constitute an endorsement of the investment adviser nor can the person or firm advertise as such.

Registered investment advisers are required to update their ADV form annually and file operating reports with the SEC or state regulatory agency. The investment adviser must also provide to clients and prospective clients a written disclosure statement and allow inspection by the SEC or state regulatory agency of any books and records relating to investment advisory activities. Advisers generally cannot receive compensation based on the performance of their advisement, nor can they engage in excessive trading or profit from market activity resulting from their advice to clients. Investment advisers must also act in the best interest of their clients at all times and take into consideration their clients' financial positions and financial sophistication. There are also many provisions in the act dealing with fraud in terms of advertising, control of client assets, soliciting clients, and information disclosure.

[ Michael Knes ]

FURTHER READING:

Bemzwieg, Eli P. The Financial Planner's Legal Guide. New York: Prentice Hall, 1986.

Institute of Certified Financial Planners. "To Be or Not to Be: Are You an Investment Adviser Rep?" Denver: Institute of Certified Financial Planners, 1997. Available from www.icfp.org .

Kirsch, Clifford E. Investment Adviser Regulation: A Step by-Step Guide to Compliance and Law. New York: Practising Law Institute, 1996.

U.S. Securities and Exchange Commission. "Frequently Asked Questions about Changes in the Regulation of Investment Advisers." Washington: U.S. Securities and Exchange Commission, 1997. Available from www.sec.gov/rules/othern/advfaq.htm .

——. "The Great Divide: Amendments to the Investment Advisers Act and Related Commission Rulemaking." Washington: U.S. Securities and Exchange Commission, 1998. Available from www.sec.gov/rules/extra/gdiv398.htm .

Vazzana, John. "New Legislation Means Some Relief for Investment Advisers." CPA Journal 67 (June 1997): 65-66.



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