Financial advisers are obligated to work in the best interests of their clients and perform fiduciary duty according to the Investment Advisers Act of 1940. It mandates that advisers must exercise client loyalty and care and disclose all material facts with utmost good faith. To comply with the Act, investment advisers need to pass a qualifying exam and register with a regulatory body.
In 1940, the United States introduced the Investment Advisers Act, a significant federal law that defines and governs the role of investment advisers. The act was partly influenced by a 1935 report to Congress prepared by the Securities and Exchange Commission (SEC), which focused on investment trusts and companies. Its purpose is to oversee those providing investment guidance to pension funds, individuals, and institutions. The law sets out criteria for qualifying as an investment adviser and mandates registration with state and federal authorities to offer such services.
The Investment Advisers Act of 1940: A Response to Financial Crises
The roots of the Investment Advisers Act of 1940 trace back to the devastating aftermath of the 1929 stock market crash and the subsequent Great Depression. In the 1930s and 1940s, several crucial financial regulations emerged in response to these calamities. Among them was the Securities Act of 1933, which aimed to bring transparency to financial statements and combat misrepresentation and fraud in the securities markets.
In 1935, the Securities and Exchange Commission issued a report to Congress highlighting the risks posed by certain investment counselors and advocating for the regulation of investment advice providers. This report led to the passing of the Public Utility Holding Act of 1935, granting the SEC the authority to examine investment trusts.
Motivated by these developments, Congress initiated the formulation of not only the Investment Advisers Act but also the Investment Company Act of 1940. The latter focused on defining the responsibilities and requirements of investment companies offering publicly traded investment products, including open-end mutual funds, closed-end mutual funds, and unit investment trusts.
Financial Advisers: Fiduciary Duty and Client Interests
Under the Investment Advisers Act of 1940, advisers are bound by a fiduciary standard and can be regulated by the SEC or state securities regulators, depending on their business's scale and scope. The act establishes a clear definition of fiduciary duty, encompassing a duty of loyalty and care. This means advisers must prioritize their clients' interests over their own. They are prohibited from engaging in front-running, where they buy securities for themselves before their clients, as well as churning, which involves making trades for higher commissions.
To ensure accuracy and completeness, consultants are required to base investment advice on reliable information through thorough analysis. Moreover, they must execute trades under a "best execution" standard, aiming for a balance of low-cost and efficient execution. To uphold fiduciary responsibilities, advisers must avoid conflicts of interest and disclose any potential conflicts to their clients, always prioritizing the clients' interests above all else.
Adviser Criteria: Under the Investment Advisers Act
In determining who qualifies as an adviser, the Investment Advisers Act utilizes three criteria: the type of advice offered, the method of compensation, and whether investment advice constitutes the primary professional function, yielding the majority of income. Furthermore, individuals presenting themselves as investment advisers in advertising or otherwise may fall under this definition.
According to the act, those providing advice or recommendations solely on securities are considered advisers, while those whose advice is incidental to their main business may not qualify. Hence, some financial planners and accountants may be considered advisers, while others may not.
Typically, advisers managing assets worth at least $100 million or advising a registered investment company are required to register with the SEC under this act.
Financial Adviser Registration: Impact of the Dodd-Frank Act
The registration process for financial advisers depends on the value of the assets they manage and whether they advise corporate clients or individuals. Before the 2010 reforms, advisers with at least $25 million in assets under management or advising investment companies registered with the SEC, while those managing smaller amounts registered with state authorities.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 revised these thresholds. Many advisers, who managed less money than the new federal rules required, could now register with state regulators instead of the SEC. However, the Dodd-Frank Act introduced registration requirements for advisers of private funds, such as hedge funds and private equity funds. Previously, these advisers were exempt from registration despite handling substantial investor funds.
The Investment Advisers Act of 1940 plays a vital role in regulating financial advisers with fiduciary duty towards their clients. It mandates transparency, accurate advice, and registration based on asset value and client scope. Originating from the aftermath of the 1929 stock market crash, the Act has evolved to ensure professionalism and client welfare. The Dodd-Frank Act introduced further reforms, altering registration requirements and including private fund advisers. Overall, these regulations have enhanced the integrity of financial advisers, promoting trust and sound financial guidance.