Table of Contents
SERIES 65 | FINANCIAL REGULATION COURSES
The Investment Company Act of 1940 is the primary federal statute regulating the organisation, operation, and activities of investment companies in the United States — entities whose primary business is investing, reinvesting, or trading in securities and offering their own shares to the public — establishing mandatory registration with the Securities and Exchange Commission, defining the three recognised categories of investment company, and imposing comprehensive governance, disclosure, and structural requirements designed to protect investors from the fraud, self-dealing, excessive leverage, and conflicts of interest that characterised the unregulated investment trust industry of the 1920s and 1930s.
Enacted on August 22, 1940 — the same day as the Investment Advisers Act of 1940 — the Act was the direct legislative response to the SEC's comprehensive Investment Trust Study conducted between 1938 and 1940, which documented widespread abuses in the investment trust industry including affiliate overreaching, misappropriation of assets, inadequate disclosure, and market manipulation practices that had harmed millions of investors in the years surrounding the 1929 crash.
Together with the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940, the Investment Company Act of 1940 forms the foundational four-pillar framework of federal securities regulation in the United States — a framework that governs the offer and sale of securities, the trading of securities in secondary markets, the conduct of investment advisers, and the organisation and operation of pooled investment vehicles.
The Investment Company Act of 1940 was the fourth and final pillar of the federal securities regulatory framework constructed by Congress in the decade following the Great Depression.
The Securities Act of 1933 — the first pillar — was enacted in direct response to the 1929 crash, establishing the registration and disclosure requirements governing the public offer and sale of securities. Its core principle is that investors must receive complete and accurate material information about securities offered to the public before making investment decisions. Every public securities offering — including the shares sold by registered investment companies to investors — must be registered under the Securities Act of 1933 and accompanied by a prospectus containing the required disclosures.
The Securities Exchange Act of 1934 — the second pillar — created the Securities and Exchange Commission and established the comprehensive regulatory framework governing secondary market trading, broker-dealer conduct, securities exchange operations, and the reporting obligations of publicly traded companies. The Exchange Act governs the broker-dealers who sell mutual fund shares and closed-end fund shares to retail investors, and the national securities exchanges on which closed-end fund shares and ETF shares trade. Every registered investment company whose shares are publicly traded is subject to the Exchange Act's requirements alongside those of the Investment Company Act.
The Public Utility Holding Company Act of 1935 — while not a securities regulation statute in the conventional sense — provided the legislative mandate that set the entire investment company regulatory framework in motion. Section 30 of PUHCA directed the SEC to conduct a comprehensive study of investment trusts and investment companies — a study that documented the abuses that Congress would ultimately address through the Investment Company Act of 1940 and the Investment Advisers Act of 1940.
The Investment Company Act of 1940 — the fourth pillar — completed the federal securities regulatory framework by establishing oversight of pooled investment vehicles that pool investor capital and invest it in securities on investors' behalf. Where the Securities Act of 1933 governs the offering of investment company shares to investors and the Securities Exchange Act of 1934 governs the trading of those shares in secondary markets, the Investment Company Act governs the investment company itself — its structure, governance, operations, and investment activities.
To understand why the Investment Company Act imposed such comprehensive requirements it is necessary to understand what the SEC's Investment Trust Study documented about the unregulated investment trust industry.
The study found that investment company sponsors had routinely organised affiliated companies to sell assets to the fund at inflated prices — transferring wealth from fund shareholders to controlling insiders through transactions that ordinary investors had no visibility into and no mechanism to challenge. Management fees were excessive and inadequately disclosed. Complex multi-tiered holding structures obscured conflicts of interest between fund managers and shareholders. Funds invested in highly speculative securities far beyond what was appropriate for retail investors without any disclosure of the associated risks.
In many cases fund assets were simply misappropriated for the benefit of sponsors and affiliates — treated as an extension of the sponsor's own balance sheet rather than as assets belonging to the investors who had contributed them. The study found that investment trust investors had been systematically harmed by the absence of any legal framework requiring sponsors to act in investors' interests, to disclose conflicts of interest, or to maintain the separation between fund assets and sponsor assets that basic investor protection required.
Congress responded with the Investment Company Act — a statute that in the words of its own preamble was designed to mitigate and eliminate conditions that adversely affect the national public interest and the interest of investors.
Section 3 of the Investment Company Act defines an investment company as any issuer that is or holds itself out as being primarily engaged in the business of investing, reinvesting, or trading in securities, or that is engaged or proposes to engage in the business of issuing face-amount certificates, or that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities and owns or proposes to acquire investment securities having a value exceeding forty percent of the value of the issuer's total assets on an unconsolidated basis.
The forty percent test — sometimes called the inadvertent investment company test — is particularly important because it can cause operating companies holding significant securities portfolios to unintentionally become subject to the Act's requirements. A holding company whose unconsolidated balance sheet shows that investment securities constitute more than forty percent of total assets may find itself technically subject to investment company regulation unless it qualifies for an exclusion under Section 3(b).
Section 3(b) excludes from the definition companies primarily engaged in a non-investment business — preventing the Act from sweeping in operating companies whose securities holdings are incidental to their primary business activities.
Section 4 of the Investment Company Act classifies registered investment companies into three distinct categories — each with different structural characteristics, redemption mechanics, and regulatory requirements directly tested on the Series 65 examination.
Management Investment Companies — Open-End and Closed-End
Management investment companies are the largest and most familiar category — including mutual funds and closed-end funds — subdivided into two types based on whether they issue redeemable securities.
An open-end management investment company — the mutual fund — issues shares that are redeemable at the holder's demand at a price based on the current net asset value of the fund's portfolio. Open-end funds continuously issue new shares to investors who purchase them and continuously redeem existing shares from investors who sell — at NAV calculated once daily after the market closes. The number of shares outstanding fluctuates constantly based on investor demand.
The forward pricing rule — adopted by the SEC under the Act — requires that open-end fund shares be priced at the next calculated NAV after an order is received rather than the most recently calculated NAV. This prevents market timing abuses that would arise if investors could purchase at stale prices. Every mutual fund share is registered under the Securities Act of 1933 and must be accompanied by a prospectus disclosing all material information about the fund.
A closed-end management investment company — the closed-end fund — issues a fixed number of shares through an initial public offering registered under the Securities Act of 1933 and does not continuously issue or redeem shares thereafter. Closed-end fund shares trade on national securities exchanges — listed on the New York Stock Exchange or Nasdaq — at market-determined prices that may be above or below the fund's underlying net asset value. The premium or discount to NAV at which closed-end fund shares trade reflects investor supply and demand rather than the underlying portfolio value — creating the persistent premium and discount dynamics that distinguish closed-end funds from open-end funds and are directly tested on the Series 65 examination.
Unit Investment Trusts
A unit investment trust is an investment company that issues only redeemable units representing undivided interests in a fixed portfolio of securities — assembled at the trust's formation and not actively managed or changed during the trust's life.
Unlike a management investment company whose portfolio is actively managed, a unit investment trust holds a fixed portfolio of securities from the time it is established until it terminates. The portfolio is not changed in response to market conditions — the trust simply holds the original portfolio and passes through to unitholders the income and principal received from the underlying securities.
Unit investment trusts are typically established with a defined termination date — when the trust matures the underlying securities are liquidated and proceeds distributed to unitholders. They are used most commonly for fixed income portfolios — particularly municipal bond unit investment trusts. Exchange-traded funds were originally structured as unit investment trusts — the first ETF listed in the United States, the SPDR S&P 500 ETF launched in January 1993, was established as a unit investment trust — though most subsequently launched ETFs are now organised as open-end management investment companies under SEC Rule 6c-11.
Face-Amount Certificate Companies
Face-amount certificate companies are the third and rarest category — companies that issue certificates evidencing an obligation to repay a fixed sum at a specified maturity date in exchange for periodic instalment payments by the certificate holder. Face-amount certificate companies are effectively a historical artefact of the pre-war financial services industry. No new face-amount certificate companies have been organised in decades and the category is tested on the examination primarily for definitional completeness.
The Investment Company Act imposed comprehensive governance requirements designed to protect fund shareholders from the conflicts of interest and self-dealing documented in the Investment Trust Study.
Every registered management investment company must have a board of directors — or board of trustees — responsible for overseeing the fund's operations and approving its investment advisory and other service contracts. The board acts as the primary governance body protecting shareholder interests.
The independent director requirement mandates that at least a majority of a registered fund's board members be independent of the fund's investment adviser and principal underwriter. The SEC has consistently encouraged funds to maintain at least seventy-five percent independent directors. Independent directors must approve the investment advisory contract annually and perform numerous oversight functions specified by the Act — ensuring that fund shareholders have advocates on the board not beholden to the investment adviser whose fees they are charged with monitoring.
The shareholder approval requirement mandates that certain fundamental changes require approval by a majority of outstanding voting securities — including changes to investment objectives, changes in classification, and deviation from certain investment policies. This gives investors meaningful governance rights over the most significant decisions affecting their fund.
The Investment Company Act imposes specific investment restrictions on registered management investment companies designed to limit the risk-taking that had characterised unregulated investment trusts.
The leverage restriction limits the ability of open-end management investment companies to borrow money or issue senior securities. Registered open-end funds generally may not issue senior securities — securities whose holders have priority claims over regular shareholders — subject to limited exceptions for bank borrowings not exceeding one-third of total fund assets.
The concentration policy requirement mandates that every registered fund adopt a fundamental policy regarding industry concentration — specifying whether the fund will or will not concentrate investments in a particular industry. This fundamental policy must be disclosed in the prospectus and can only be changed by shareholder vote.
The affiliated transaction restrictions prohibit registered funds from engaging in transactions with their investment advisers, principal underwriters, officers, directors, and other affiliated persons on terms other than arm's length — preventing the affiliate overreaching that was one of the most damaging abuses in the Investment Trust Study.
Every investment company seeking to offer its securities to the public must register with the SEC under both the Securities Act of 1933 — registering the securities it sells to investors — and the Investment Company Act of 1940 — registering the company itself.
Registration under the Investment Company Act requires filing a registration statement disclosing investment objectives, strategies and policies, risks, fees and expenses, management and governance arrangements, and all other material information investors need to make informed investment decisions. The registration statement and its periodic updates constitute the fund's prospectus — the primary offering document that must be delivered to investors before or at the time of purchase.
Registered investment companies must make ongoing public disclosures — filing semi-annual and annual reports with the SEC, providing financial statements audited by independent public accountants, disclosing complete portfolio holdings quarterly, and promptly reporting material events affecting investors. These ongoing disclosure requirements — required under both the Investment Company Act and the Securities Exchange Act of 1934's periodic reporting framework — give registered fund investors transparency far superior to the opacity that characterised investment trusts before federal regulation.
The Investment Company Act's definition of investment company is broad enough to encompass many private investment vehicles — including hedge funds, private equity funds, and venture capital funds — that pool investor capital and invest it in securities.
Congress recognised that it would be inappropriate to subject private investment funds serving sophisticated investors to the full regulatory requirements designed to protect retail mutual fund shareholders — and provided two primary exemptions.
Section 3(c)(1) exempts from the investment company definition any issuer whose outstanding securities are beneficially owned by not more than one hundred persons and that is not making or proposing to make a public offering. This exemption is available to smaller private funds — making it the primary exemption used by smaller hedge funds and private equity funds.
Section 3(c)(7) exempts from the investment company definition any issuer whose outstanding securities are owned exclusively by qualified purchasers — individuals or family companies owning at least five million dollars in investments, and institutions owning at least twenty-five million dollars — and that is not making a public offering. The Section 3(c)(7) exemption allows private funds to have an unlimited number of investors provided all of them are qualified purchasers — making it the primary exemption used by larger private funds that need more than one hundred investors.
The Investment Company Act's original framework did not contemplate exchange-traded funds — instruments combining the diversified portfolio of a mutual fund with the intraday exchange trading of a stock. When the first ETFs were introduced in the early 1990s each required individual exemptive orders from the SEC waiving certain Act provisions that would otherwise have prevented the ETF structure from operating.
In 2019 the SEC adopted Rule 6c-11 under the Investment Company Act — the ETF Rule — providing a standardised regulatory framework allowing most ETFs to operate without individual exemptive orders. Rule 6c-11 established standardised conditions including daily portfolio holdings disclosure, requirements for in-kind creation and redemption with authorised participants, and specific requirements for custom baskets used in creation and redemption transactions. The ETF Rule dramatically simplified the process of launching new ETFs and created a consistent regulatory framework across the industry replacing the prior system requiring each ETF sponsor to obtain its own SEC exemptive relief.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 amended the investment company regulatory framework in several significant respects — primarily addressing regulatory gaps that had allowed the private fund industry to grow substantially during the 2000s with minimal federal oversight.
Most significantly the Dodd-Frank Act eliminated the private adviser exemption under the Investment Advisers Act of 1940 that had allowed many hedge fund advisers to avoid SEC registration — requiring most large private fund advisers to register and bringing their operations under SEC examination authority for the first time. The Dodd-Frank Act also gave the Financial Stability Oversight Council authority to designate large non-bank financial companies as systemically important financial institutions subject to enhanced Federal Reserve supervision — adding a systemic risk oversight dimension to the regulation of large investment funds.
The Investment Company Act of 1940 is tested on the Series 65 examination in the context of investment company types, registration requirements, governance standards, the Section 3(c)(1) and Section 3(c)(7) exemptions for private funds, and the ETF Rule.
The key points to retain are these.
The Investment Company Act of 1940 was enacted August 22, 1940 — the same day as the Investment Advisers Act of 1940 — as the direct legislative response to the SEC's Investment Trust Study. Together with the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940 it forms the four-pillar framework of federal securities regulation. The Securities Act of 1933 governs the offer and sale of investment company shares to investors. The Securities Exchange Act of 1934 governs the secondary market trading of investment company shares and the broker-dealers who sell them. The Investment Company Act governs the investment company itself.
The three registered investment company types under Section 4 are management investment companies — subdivided into open-end funds which are mutual funds that continuously issue and redeem shares at NAV, and closed-end funds which issue a fixed number of shares that trade on exchanges at market prices that may differ from NAV — unit investment trusts which hold fixed portfolios and issue redeemable units representing undivided interests — and face-amount certificate companies which are a historical category no longer active in the modern market.
Key governance requirements include a board of directors with a majority of independent directors, annual board approval of the investment advisory contract, and shareholder approval of fundamental policy changes. The leverage restriction limits open-end fund borrowing to one-third of total assets. Section 3(c)(1) exempts private funds with one hundred or fewer investors not making public offerings. Section 3(c)(7) exempts private funds whose investors are all qualified purchasers with no limit on investor count. SEC Rule 6c-11 — the ETF Rule adopted in 2019 — provides a standardised framework allowing most ETFs to operate without individual exemptive orders, replacing the prior system requiring each ETF to obtain its own SEC exemptive relief.
