Investment Advisers Act of 1940
The Investment Advisers Act of 1940 (known as the Investment Advisers Act and accessible on the SEC's Website here) is a key piece of US Legislation on the topic of Investment Management. It should not be confused with the Investment Company Act of 1940 (known colloquially as the 40 Act, which is different, albeit also a key piece of US investment management legislation, also enacted in 1940.
Both strike righteous fear into the hearts of US securities attorneys and glum resignation in the spleens of their clients. Fear, for US attorneys, of an exhilarating sort which floods the gizzard with adrenaline the way it does when you lean forward into a bungee jump. It feels a bit like bungy jumping for clients, too. Only from the perspective of the bridge.
Bungee jumping is an apt metaphor, because as soon as the 40 Act is mentioned in forensic conversation, attorneys will jump (for joy) off the client’s bridge and gleefully bounce up and down in the revenue stream drifting on below as long as they possibly can.
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Investment research and the sneaky equity brokerage exemption
Under SEC guidance to the Section 28(e) safe harbor, "commissions" may be used to purchase research on a soft dollar basis. A "commission" is a charge/fee that a broker-dealer assesses for executing a securities transaction as agent. The SEC issued an interpretation in 2001 extending the safe harbor to certain riskless principal transactions in exchange-listed securities. There is no "commission" charged to a customer on an OTC swap because it is a bilateral, principal transaction. UBS acts as counterparty rather than as agent.
Here is the relevant text of Section 28(e):
(e)(1) No person using the mails, or any means or instrumentality of interstate commerce, in the exercise of investment discretion with respect to an account shall be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law unless expressly provided to the contrary by a law enacted by the Congress or any State subsequent to the date of enactment of the Securities Acts Amendments of 1975 solely by reason of his having caused the account to pay a member of an exchange, broker, or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or dealer would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion. This subsection is exclusive and plenary insofar as conduct is covered by the foregoing, unless otherwise expressly provided by contract: Provided, however, That nothing in this subsection shall be construed to impair or limit the power of the Commission under any other provision of this title or otherwise.
Paying a broker-dealer for research outside of an execution commission creates issues under the Investment Advisers Act because an unbundled fee paid for the advice contained in research is considered "special compensation" by the SEC. The receipt of special compensation disqualifies a broker-dealer from avoiding Investment Adviser registration by reliance upon the broker-dealer exclusion (Section 202(a)(11) of the Investment Advisers Act provides a carve-out from registration for a broker-dealer providing advice that is "solely incidental" to the delivery of broker-dealer services). In practice, this means a US broker-dealer can provide research to its sales and trading clients, but avoid having to register with the SEC as an investment adviser so long as the broker-dealer avoids accepting any "special compensation" in connection with the research. A bundled trading commission is a customary and acceptable means of compensating a broker-dealer for traditional services like execution and research.
Prohibited Transactions - Section 206
The Investment Advisers Act makes it unlawful for any investment adviser acting as principal, knowingly to sell any security to or purchase any security from a client without disclosing the capacity in which he is acting and obtaining the client’s consent. Because of the practical difficulties of compliance on a trade-by-trade basis, firms tend to simply refrain from engaging in principal trading with their advisory clients.
Where advisers trade as a principal and on behalf of their clients with the same Broker-dealer, a technical issue may arise where the Broker-dealer crosses buy orders and sell orders, something it may do systematically (see systematic internalisation.
See Also
The key issue is ensuring our crossing engine can be pre-configured not to cross between certain accounts.