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 Securities Regulation 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.

Securities Exchange Act Anatomy™ →Go uptown Section 28(e), Securities Exchange Act 1934 (view template) 28(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. Template:Anatresources-seaTemplate:Anatnavigation-sea Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

Investment research and Investment Advisers Act: a safe harbor for broker/dealers

Unless there is a safe harbor, paying a broker/dealer for investment research creates issues under the Investment Advisers Act because the SEC considers a fee for research “advice” to be “special compensation”, for which a person must be a registered investment adviser under the Investment Advisers Act of 1940.

Hey - stay with me. Stop staring out the window. This is interesting.

Typically, broker dealers are not registered investment advisers. Can be, but usually aren’t.

There is, of course, a safe harbor. It is set out in Section 28(e) of the Securities Exchange Act of 1934: to qualify for it, a broker/dealer’s advice must be “solely incidental” to its provision of “broker/dealer services”.

Under SEC guidance “commissions” may be used to purchase research on a “soft dollar” basis.

The definition of “commission” is important:

a fee that a broker/dealer levies for executing a securities transaction as agent.

Extensions and exceptions

• Riskless principal: OK: The SEC extended the safe harbor to certain riskless principal transactions in exchange-listed securities in 2001, riskless principal really being a form of quasi-agency.

• Swap: Not OK: The safe harbor doesn’t apply to swap transactions: By definition swaps are bilateral, full-principal contracts. They cannot be agency or riskless principal. The swap dealer takes a fee (as principal) that is no sense a “commission”. The swap dealer does not act as agent (or quasi-agent).

A superbly literalist, non-sensical view of the world, but there you have it. It wouldn’t be the first time, America.

So, what does this mean then?

This means a US broker-dealer can provide research to its clients without having to register with the SEC as an investment adviser so long as it doesn’t earn any “special compensation” relating to the research. A bundled trading commission is the traditional means of compensating a broker-dealer for execution and research in a way that avoids special compensation.

Sorry you asked?

Let me guess: You’re thinking, “I’m sorry I asked”. I know I’m sorry you asked.

See also

• SEC interpretative guidance

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

• riskless principal
• systematic internalisation

The key issue is ensuring our crossing engine can be pre-configured not to cross between certain accounts.

• metaphor