Investment Company Act of 1940

The Investment Company Act of 1940 was enacted by Congress in response to a wave of investment company abuses documented during the 1930s, including conflicts of interest, excessive leverage, inadequate disclosure, and outright fraud. It remains one of the foundational pillars of U.S. securities regulation alongside the Securities Act of 1933 and the Securities Exchange Act of 1934. The Act is administered and enforced by the SEC.

Under the Act, any entity that holds itself out as being in the business of investing in securities and meets certain asset thresholds must register with the SEC as an investment company. The three most common types are open-end management companies (mutual funds), closed-end management companies (closed-end funds), and unit investment trusts (UITs). Exchange-traded funds were developed years after the Act was passed and operate under exemptive orders and rules that have evolved significantly since the 1990s.

The Act imposes extensive substantive requirements on registered investment companies. Directors of a fund must include independent directors — individuals with no material relationship with the fund's investment adviser or principal underwriter — who serve as a watchdog for shareholder interests. At least 40% of a fund's board must be independent, and many modern funds exceed this threshold. Independent directors must approve the advisory contract with the fund's investment manager at least annually.

Leverage restrictions under the Act limit the extent to which registered investment companies can borrow money or issue senior securities. The original 1940 rules required an asset coverage ratio of 300% for borrowings (meaning a fund could borrow up to one-third of its total assets). These restrictions were updated by the SEC's Rule 18f-4 in 2022, which replaced asset coverage tests with a more risk-based derivatives framework.

The Act also governs the pricing of fund shares. Open-end mutual funds must price their shares at net asset value (NAV), calculated at least once each business day using the current fair value of portfolio holdings. This pricing mechanism prevents the kind of dilution of existing shareholders that occurred with some historical closed-end fund structures.

Hedge funds and private equity funds typically avoid classification as investment companies by relying on exemptions under Section 3(c)(1) or 3(c)(7) of the Act, which exclude funds with fewer than 100 beneficial owners or funds whose investors are all qualified purchasers. These exemptions explain why private funds are not subject to the same disclosure and governance requirements as publicly offered mutual funds.