Investment Advisers Act of 1940: Comprehensive Guide for SIE Exam

5.1.4 Investment Advisers Act of 1940

The Investment Advisers Act of 1940 is a cornerstone of U.S. financial regulation, designed to protect investors by regulating the activities of investment advisers. As you prepare for the Securities Industry Essentials (SIE) Exam, understanding this Act is crucial for comprehending the regulatory framework governing investment advisers, their fiduciary duties, and the compliance requirements they must meet. This guide will provide you with a comprehensive overview of the Act, its key provisions, and its implications for both advisers and investors.

Purpose and Overview

The Investment Advisers Act of 1940 was enacted to regulate individuals and firms that provide investment advice for compensation. Its primary goal is to safeguard investors by ensuring that advisers act in their clients’ best interests and disclose all material information. The Act establishes a regulatory framework that defines who must register as an investment adviser, outlines fiduciary responsibilities, and sets forth rules to prevent fraudulent practices.

Definition of Investment Adviser

To determine whether an individual or entity qualifies as an investment adviser under the Act, the Three-Part Test is applied. An investment adviser is someone who:

1. Provides Advice or Analyses about Securities: This includes offering recommendations or analyses regarding securities, such as stocks, bonds, or mutual funds.

2. Is in the Business of Providing Such Services: The adviser must be engaged in the business of providing investment advice as a regular activity.

3. Receives Compensation for Those Services: Compensation can be in the form of fees, commissions, or any other economic benefit.

Registration Requirements

Investment advisers must register with either the Securities and Exchange Commission (SEC) or state securities authorities, depending on their assets under management (AUM):

• Federal Registration: Advisers with AUM exceeding $110 million are required to register with the SEC.

• State Registration: Advisers with AUM under $100 million typically register with state authorities. However, there is a buffer zone between $100 million and $110 million where advisers may choose to register with either the SEC or state regulators.

Exemptions and Exclusions

Certain individuals and entities are exempt from registration:

• Professionals Providing Incidental Advice: Lawyers, accountants, engineers, and teachers whose advisory services are incidental to their primary profession are excluded.

• Advisers to Insurance Companies: Those advising solely insurance companies may be exempt.

• Advisers to Venture Capital Funds: Advisers solely to venture capital funds are exempt from registration.

Fiduciary Duty

Investment advisers owe a fiduciary duty to their clients, which is the highest standard of care. This duty requires advisers to:

• Act in the Best Interests of Clients: Advisers must prioritize their clients’ interests above their own.

• Provide Full and Fair Disclosure: Advisers must disclose all material facts, particularly those related to conflicts of interest.

Key Provisions

Form ADV

Investment advisers must file Form ADV with the SEC or state regulators. This form provides detailed information about the adviser’s business practices, fees, and any disciplinary history. It consists of two parts:

• Part 1: Requires information about the adviser’s business, ownership, clients, employees, business practices, affiliations, and any disciplinary events.

• Part 2 (Brochure): Must be provided to clients and contains information about the adviser’s services, fees, conflicts of interest, and disciplinary history.

Brochure Rule

The Brochure Rule mandates that advisers deliver a disclosure document, known as the brochure, to clients. This document must include:

• Services Offered: A clear description of the advisory services provided.

• Fees and Compensation: Detailed information about fees and other compensation arrangements.

• Conflicts of Interest: Disclosure of any potential conflicts and how they are managed.

Recordkeeping Requirements

Advisers are required to maintain accurate books and records for a specified period. This includes:

• Client Records: Documentation of client transactions and communications.

• Financial Records: Detailed records of the adviser’s financial condition.

Advertising Rules

The Act imposes strict rules on advertising to prevent misleading claims:

• Prohibition of False Statements: Advertisements must not contain untrue or misleading statements.

• Performance Claims: Advisers must adhere to specific guidelines when advertising past performance.

Custody Rule

Advisers with custody of client assets must comply with specific requirements to protect those assets, including:

• Qualified Custodian: Client funds and securities must be held by a qualified custodian.

• Account Statements: Clients must receive account statements directly from the custodian.

Prohibited Practices

Fraudulent Activities

The Act prohibits fraudulent activities, including:

• Misrepresentation or Omission of Material Facts: Advisers must not mislead clients or omit important information.

• Deceitful Conduct: Any conduct that deceives or defrauds clients is prohibited.

Performance Fees

Generally, performance-based fees are prohibited unless the client is a “qualified client,” meeting certain financial thresholds. This is to prevent advisers from taking excessive risks to earn higher fees.

Enforcement and Penalties

The SEC is empowered to enforce the Investment Advisers Act of 1940. Enforcement actions can include:

• Sanctions and Fines: The SEC can impose fines and sanctions on advisers who violate the Act.

• Suspension or Revocation of Registration: Advisers may have their registration suspended or revoked for non-compliance.

• Civil Liability: Advisers may be held civilly liable for breaches of fiduciary duty.

Significance for the SIE Exam

Understanding the Investment Advisers Act of 1940 is crucial for the SIE Exam. Key areas to focus on include:

• Definition and Registration: Knowing who qualifies as an investment adviser and the registration requirements.

• Fiduciary Obligations: Recognizing the fiduciary duties owed to clients.

• Key Provisions and Prohibited Practices: Familiarity with Form ADV, the Brochure Rule, and prohibited practices.

Glossary

• Investment Adviser: An individual or firm that provides advice about securities for compensation.

• Fiduciary Duty: An obligation to act in the best interest of another party.

• Form ADV: The uniform form used by investment advisers to register with SEC and state securities authorities.

• Assets Under Management (AUM): The total market value of assets that an investment adviser manages on behalf of clients.

References

• SEC’s Information on Investment Advisers: SEC - Investment Advisers

• Investor Publications on Advisers: SEC - Investment Adviser Public Disclosure

• Investopedia: Investment Advisers Act of 1940

SIE Exam Practice Questions: Investment Advisers Act of 1940

This comprehensive guide to the Investment Advisers Act of 1940 will equip you with the knowledge needed to excel in the SIE Exam and understand the regulatory environment for investment advisers. By mastering these concepts, you will be well-prepared to navigate the complexities of the securities industry.