How the 1940 Act Stops Insiders From Trading With Their Own Funds, the Exemptions That Allow It, and What the Exam Tests

Section 17(a) of the Investment Company Act of 1940 prohibits affiliated persons of a registered fund, acting for their own account, from selling securities or other property to the fund, buying securities or other property from the fund, or borrowing money or property from the fund. It also restricts them from lending to the fund except as SEC rules allow.

These are known as principal transactions, because the affiliate is on the other side of the trade from the fund. The rule exists to stop insiders from dumping unwanted assets on a fund, buying its best assets cheaply or using its cash as their own.

This guide covers what Section 17(a) prohibits, who it applies to, the exemptions and rules that allow some transactions, how it differs from Section 17(d) and from the 1933 Act provision with the same number, worked examples, the exam traps and five practice questions. Preparing for your exam? Watch FRC’s Series 65 playlist on YouTube, with exam traps called out in every topic.

Why Congress Banned Principal Transactions

Before the Investment Company Act, some fund sponsors treated their funds as a place to unload securities they could not sell elsewhere. Others bought the funds’ most valuable holdings at below-market prices or borrowed the funds’ cash on easy terms.

Investors in those funds bore the losses, often without knowing what had happened. Congress responded in 1940 with Section 17, which targets the conflicts that arise when the people running a fund deal with it directly.

Section 17(a) is the core of that protection. Instead of relying on disclosure, it starts from a flat prohibition and allows exceptions only where the SEC is satisfied the fund is protected.

Where This Topic Appears on the Exams

Investment company regulation appears in the investment vehicles and laws sections of the Series 65. Questions test which conflicts the 1940 Act controls and how fund investors are protected.

FRC’s Series 65 Exam Preparation course covers investment companies, the 1940 Act and fund governance, and the exam requires no sponsor. The SIE Examination Preparation course introduces investment companies and the laws that shape them.

Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay. The sections of the 1940 Act are easy to mix up, so a clear picture of each is worth real marks.

What Section 17(a) Prohibits

Section 17(a) makes it unlawful for certain people, acting as principal, to do four things with a registered investment company. They cannot knowingly sell any security or other property to the fund, and they cannot knowingly buy any security or other property from the fund.

They also cannot borrow money or other property from the fund. Lending money or property to the fund is prohibited too, unless it complies with the SEC’s rules.

There are narrow carve-outs written into the section itself. For example, an affiliate may sell to the fund securities of which the affiliate is the issuer, and the fund may issue and redeem its own shares in the normal way.

Who Section 17(a) Applies To

The prohibition applies to any affiliated person, promoter or principal underwriter of the fund. It also applies to affiliated persons of those people, creating a second tier of coverage.

Under Section 2(a)(3) of the Act, affiliated persons include anyone owning 5% or more of the fund’s voting securities, any company in which the fund owns 5% or more, anyone controlling or under common control with the fund, its officers, directors and employees, and its investment adviser. The second tier pulls in the adviser’s parent company, its other funds and its broker-dealer affiliates.

That reach is deliberate. A sponsor cannot avoid the rule by routing a transaction through a sister company.

Acting as Principal vs Acting as Agent

Section 17(a) applies only when the affiliate is acting as principal, meaning it is buying or selling for its own account. If an affiliated broker-dealer simply executes a trade for the fund as agent, buying from an unrelated seller, Section 17(a) does not apply.

Agency trades are covered by a different provision, Section 17(e). It limits the compensation an affiliated broker can receive for executing fund trades to the usual and customary brokerage commission, under conditions set out in Rule 17e-1.

The trap is applying Section 17(a) to every trade involving an affiliate. The question is whether the affiliate is the counterparty or just the broker.

The Section 17(b) Exemption Process

Section 17(b) lets the SEC exempt a proposed transaction from Section 17(a) through an order. The applicant must show that the terms, including the price, are reasonable and fair and do not involve overreaching by anyone concerned.

The applicant must also show that the transaction is consistent with the fund’s stated investment policies and with the general purposes of the Act. The SEC reviews each application on its facts.

Exemptive orders are common for arrangements such as interfund lending programs, where funds in the same complex lend cash to each other at rates that benefit both sides. Without an order, lending between affiliated funds would fall within the prohibition.

Rule 17a-7: Cross Trades Between Affiliated Funds

Funds managed by the same adviser are often affiliated only because they share that adviser. Rule 17a-7 lets them trade securities with each other directly, known as cross trades, without an individual order.

The conditions are strict. The trade must be for cash only, at the security’s independent current market price, with no brokerage commission or other remuneration beyond customary transfer fees, and only in securities for which market quotations are readily available.

The fund’s board must adopt procedures to ensure compliance and review the cross trades at least quarterly. The fund must also keep written records of each transaction.

Other Exemptive Rules

The SEC has adopted several other rules that permit specific transactions within limits. Rule 17a-8 allows mergers between affiliated funds if the boards make findings that the merger is in each fund’s interest and that existing shareholders’ interests will not be diluted.

Rule 17a-10 allows funds to deal with affiliates of a subadviser that does not advise the part of the fund involved. Rule 17a-6 allows certain transactions with portfolio companies that are affiliates only because the fund holds a stake in them.

Each rule has conditions designed to remove the conflict. Transactions that fall outside them still need an order under Section 17(b).

The Rest of Section 17

Section 17 contains several other investor protections that appear on the exams. Section 17(d) and Rule 17d-1 cover joint transactions, where an affiliate and the fund invest together, and FRC’s guide to what Rule 17d-1 is covers that provision in full.

Section 17(f) sets custody rules for fund assets, usually requiring them to be held by a qualified bank or other approved custodian. Section 17(j) and Rule 17j-1 require funds and their advisers to adopt codes of ethics covering personal trading by access persons.

Together, these provisions form a complete set of conflict controls. Section 17(a) is the one that deals with direct trading between a fund and its insiders.

Do Not Confuse It With Section 17(a) of the 1933 Act

The Securities Act of 1933 also has a Section 17(a), and it is completely different. It is an antifraud provision prohibiting fraud in the offer or sale of securities.

The exam may use the label “Section 17(a)” in either context, so read the question carefully. If it mentions a fund and its affiliates, it means the Investment Company Act; if it mentions fraud in an offering, it means the Securities Act.

FRC’s guide to what Rule 10b-5 is explains how the 1933 Act’s antifraud provision compares with the SEC’s main antifraud rule.

Worked Example: A Permitted Cross Trade

Fund A and Fund B are both managed by the same adviser and are affiliated only for that reason. Fund A wants to sell 10,000 units of a listed corporate bond, and Fund B wants to buy them.

The bond’s current market price is $98.50, so the cross trade is executed at that price, for $985,000 in cash, with no brokerage commission. The trade is recorded, and the board reviews it at its next quarterly meeting.

Because it meets the conditions of Rule 17a-7, the trade is permitted without an individual order. Both funds avoid trading costs, and neither is disadvantaged.

Worked Example: A Prohibited Principal Sale

A broker-dealer affiliated with a fund’s adviser holds 20,000 shares of a thinly traded stock in its inventory. It sells them to the fund at $51 a share when the independent market price is $50.

The broker-dealer is an affiliate acting as principal, selling property to the fund. That is a principal transaction prohibited by Section 17(a), and it fails Rule 17a-7 because the price is not the independent market price and the seller is not affiliated solely through a common adviser.

The fund overpaid by $1 a share, or $20,000 in total. Regulators would treat this as a clear transfer of value from the fund’s investors to the affiliate.

Worked Example: Borrowing From the Fund

The adviser’s parent company is short of cash and proposes borrowing $5 million from one of the adviser’s mutual funds for six months. It offers to pay a market rate of interest.

Borrowing money from the fund is prohibited by Section 17(a), whatever the interest rate. The parent company is an affiliated person of an affiliated person, so it falls within the second tier of the rule.

The only route would be an SEC order under Section 17(b), which would require the terms to be fair and free of overreaching. In practice, such a loan to a sponsor’s parent would be very difficult to justify.

How the Rule Connects to the Adviser’s Fiduciary Duty

A fund’s adviser owes the fund a fiduciary duty, including a duty of loyalty. Section 17(a) turns part of that duty into a hard rule for principal trades.

Disclosure is not enough to cure a prohibited transaction. FRC’s guide to what conflicts of interest an investment adviser must disclose covers conflicts that can be handled by disclosure, but a Section 17(a) transaction needs an exemption.

Fund compliance programs under Rule 38a-1 must include procedures to prevent Section 17 violations. The chief compliance officer reports to the board on how those procedures are working.

Consequences of a Violation

The SEC can bring enforcement actions against advisers and affiliates that engage in prohibited principal transactions. Remedies can include disgorgement, civil penalties, censures and orders requiring the fund to be repaid.

Advisers that disguise such transactions can also face antifraud charges. Individuals involved can face industry bars, which appear on public disclosure records.

The Exam Traps

The first trap is confusing Section 17(a) of the 1940 Act with Section 17(a) of the 1933 Act. One covers principal transactions with funds, and the other covers fraud in securities offerings.

The second trap is confusing Section 17(a) with Section 17(d). Principal transactions, where the affiliate trades with the fund, fall under 17(a), while joint transactions, where they act together, fall under 17(d).

The third trap is assuming disclosure or a fair price makes a principal transaction lawful. It needs an exemption, such as Rule 17a-7 for qualifying cross trades or an SEC order under Section 17(b). The fourth is applying 17(a) to agency trades, which fall under Section 17(e).

For more traps like these, see FRC’s guide to Series 65 exam traps and common mistakes.

A Memory Aid

Remember “17(a) is across the table, 17(d) is side by side, 17(e) is the broker in the middle.” That separates principal, joint and agency transactions.

For cross trades, remember “cash, current price, no commission, board review.” Those are the core conditions of Rule 17a-7.

Practice Questions

Question one: an affiliate of a fund’s adviser sells securities from its own inventory to the fund. Which provision primarily applies? Section 17(a) of the Investment Company Act.

Question two: which SEC rule allows cross trades between funds affiliated only through a common adviser? Rule 17a-7.

Question three: can a fund lend money to its adviser’s parent company at a market rate without an SEC order? No, lending to an affiliate is a prohibited transaction without an exemption.

Question four: an affiliated broker-dealer executes a fund’s trade as agent with an unrelated counterparty. Which provision covers its compensation? Section 17(e) and Rule 17e-1.

Question five: Section 17(a) of the Securities Act of 1933 covers what? Fraud in the offer or sale of securities.

Related Questions

Section 17(a) protects investors in all types of registered fund. FRC’s guide to open-end vs closed-end funds explains the fund structures the 1940 Act regulates.

Get Exam-Ready

Investment company questions are among the most dependable marks on the exam once the sections of the 1940 Act are clear. The FRC Series 65 playlist linked at the top of this guide covers every exam section, with the traps to look out for in each one.

The FRC dictionary is more than a dictionary. It is a library of explainer videos, written explanations and on-page quizzes covering the FINRA and SEC rules you are tested on, so you can open any term and go deeper whenever a question catches you out.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65, the SIE or both, structured exam preparation turns topics like the 1940 Act into marks you can rely on.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply for roles, employers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

Section 17(a) of the Investment Company Act prohibits a fund’s affiliates, acting as principal, from selling to the fund, buying from it or borrowing from it, unless an exemption such as Rule 17a-7 or an SEC order under Section 17(b) applies. It is the 1940 Act’s main protection against insiders trading with their own funds.

Remember “17(a) is across the table, 17(d) is side by side, 17(e) is the broker in the middle,” and you will be ready for every version of this question the exam can ask.