By Richard A. Levan

The SEC celebrated the 60th anniversary of the Investment Company Act of 1940 last month with much fanfare, regaling that bulwark of the investment world that governs the operations of America 's $7.6 trillion mutual fund industry.Barely an aside,however,was mentioned about the Investment Company Act 's poorer relation,the Investment Advisers Act of 1940.¹ That is unfortunate, because the Advisers Act, a model of concision and brevity, touches the lives of millions of U.S. investors as well as virtually every mutual fund that depends upon an investment adviser for its operations.

This article examines the Advisers Act from its passage in the wake of the financial scandals of the 1920s and 1930s through its evolution to a position of influence in the highly regulated world of international finance. The article also examines several of the pending and suggested changes to the Advisers Act and its supporting regulations, proposals ranging from cosmetic changes to a sweeping overhaul of the Act itself. Who in 1940 could have predicted such an illustrious course for the littlest act in the securities field?

The Background and History of the Investment Advisers Act

The social unrest caused by the Great Depression led to legislation of unprecedented scope. Principal among the motivations for the financial infrastructure legislation was the conviction that the conditions that led to the financial crisis of the late 1920 's both could and must be eliminated and prevented from recurring. In relatively rapid succession, Congress passed the Securities Act of 1933, 2 the Securities Exchange Act of 1934,3 the Public Utility Holding Company Act of 1935,4 the Trust Indenture Act of 1939, 5 and the Investment Company Act of 1940.6 While these statutes had individual targets and effects, they shared a common goal: to create a comprehensive system of market regulation that would "substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry."7 To achieve this goal it was necessary to regulate not only those who issued the securities and those who traded them, but also the group of individuals who sold investment advice. The need was increasingly pressing as the number of "investment advisers" had risen dramat ically since the First World War when the sale of Liberty Bonds exposed a new class of Americans to the benefits and risks of investing. Prior to 1919, investment counseling was an adjunct to the professions of law, banking, and accountancy. Paralleling the rise of small investors was growth in the number of unaffiliated "investment counselors".The majority of these advisers were law-abiding professionals, but others were shameless promoters,referred to in the House Report as "unscrupulous tipsters and touts."8

As part of its effort to protect small investors, Congress enacted the Investment Company Act of 1940, which for the first time imposed meaningful limitations on the operators of funds and the types of activities in which they could engage. Almost as an afterthought, Congress enacted the Advisers Act. Though its stated purpose was to protect the public against malpractice by persons paid for their investment advice by eliminating or exposing conflicts of interest, the initial provisions were limited to attempts to ascertain the numbers of people engaged in the advisory business and to document their associations and activities, coupled with broad proscriptions against fraud or embezzlement of client funds.9 It was from these humble beginnings that the Advisers Act was born.

As early as 1947, some recognized the inadequacy of the provisions enacted in 1940.10 For example, the Act "imposed no financial qualifications or education requirements for investment advisers and permitted verbal contract s,which could result in vague or fraudulent arrangements."11 These deficits remain. Congress has rectified other problem areas noted in 1947, including the need for a requirement that advisers maintain complete books and records, and that the SEC be allowed to examine those records whenever needed;12 extension of the Act 's anti -fraud section to cover the acts of unregistered advisers;13 and inclusion of advisers who had custody of client funds.14 Congress amended the Act in 1960 "so as to give the SEC au thority to inspect the books and records of advisers, to prescribe the books and records that should be kept, and to require reports."15 By coupling broad authority with legitimate enforcement tools, the amendments facilitated the SEC to make major advances in investment adviser regulation. Also in the 1960 amendments was a change in § 206 of the Act to make every investment adviser (rather than just 'registered 'advisers)subject to the prohibition against acts,practices,or courses of business that are fraudulent, deceptive, or manipulative.16

Another key change was in the expansion of the SEC 's power to disqualify advisers from registered status. Under the 1940 provisions, an adviser could be expelled from (or denied) registration only for certain criminal convictions, pursuant to a court injunction in connection with securities or financial fraud, or if the application for registration was materially misleading.17 The 1960 amendments expanded this provision to permit revocation for participating in or facilitating participation in: mail fraud, embezzlement, fraudulent conversion, misappropriation of funds or securities, and violation of any of the other securities acts.18 Under the original Act, the SEC could revoke an Adviser 's registration,but it had no ability to suspend it temporarily. The 1960 Amendments allowed the SEC to suspend registration for up to twelve months.19 When the Advisers Act was passed, very few states regulated advisers. The 1960 Amendments reflected the increasing regulation by states by explicitly permitting states to enact any regulations that did not conflict with federal provisions, and by permitting the SEC to share information about possible violations with state authorities.20 All of these, but especially the last, indicate an attempt to deal with a growing number of investment advisers and an increasingly complex marketplace.

In 1970, Congress again amended the Investment Advisers Act, changing the Act in five important ways. One change ended the registration exemption for advisers whose only clients were investment companies.21 Another gave the SEC expanded powers to sanction the associated persons of an adviser.22 At the same time as these changes increased the SEC 's power to regulate,a third change broadene d the SEC 's power in a different direction by giving the Commission the ability to exempt any person or transaction from the Act 's requirements.23 Fourth, the new amendments allowed an adviser to charge investment companies and certain wealthy clients a "fulcrum fee,"one set to respond to the portfolio 's gains or losses,while prohibiting the use of any other performance - based fee.24 In addition, the 1970 Amendments empowered the SEC to sanction advisers for failure to supervise employees.25

Minor changes of a technical nature were written into the Act in both 1975 and 1980,26 and in 1986 the SEC 's sanction power was extended to include persons who violated the Commodity Exchange Act and those who had been convicted or enjoined for broker-dealer activities related to government securities.27 But in 1996, Congress effected a major change in the Advisers Act. From 1980 to 1996, the number of registered advisers had increased 500 percent, to 22,500, severely straining the ability of the SEC to provide effective monitoring and enforcement.28 At the same time, an increasing number of states regulated investment adviser activity (46 in 1996), giving rise to the prospect that large firms which transacted business in several states would be subject to a maze of federal and potentially conflicting state regulations.29 In order to address both concerns, Congress reallocated the responsibility for registration, retaining the largest advisers as federally regulated (with a coordination plan to reduce overlaps and duplication between state regulations), while compelling smaller advisers to register with the states. As a result, 8,000 advisers remained under the jurisdiction of the SEC, allowing for examinations every 4-5 years and inspection of all new advisers within the first year.30

The Road From Here

While the SEC has been discussing the need for "modernization " of the Advisers Act 31 some have recommended a more thorough restructuring of the Act. One idea is to create a voluntary organization for the self-policing of investment advisers, similar to the role played by the NASD in the brokerage arena. In fact, the NASD has suggested that it would be an appropriate organization to take on advisory regulatory responsibilities, a prospect opposed by the Investment Counsel Association of America.32 In a recent SEC Roundtable, Paul F. Roye suggested that he would like to see the "laundry list " of per se prohibitions under Rule 206(4)replaced by a general antifraud standard similar to that of Rule 156 of the 1933 Act.33 Specific modernization proposals discussed at the roundtable were the following:

Electronic Registration and New Form ADV

The most far-reaching changes to the regulation of investment advisers since the Improvement Act of 1996 will take place this January when the first group of federally-registered advisers will begin filing registration documents electronically with the Commission.34 The goal of the Investment Adviser Registration Depository or "IARD " is to place the adviser community on par with t he brokerage industry where filings and updates can be accomplished electronically, thereby increasing efficiency and eliminating unnecessary paperwork. In addition, the IARD system, when fully implemented, will allow different regulators --and to some extent the general public -- to obtain ready access to advisers ' backgrounds,their business descriptions and (to some extent)their disciplinary histories.35 Part Two of the registration form filed by every federally-registered investment adviser --commonly kno wn as "Form ADV "-- is in the process of being overhauled by the SEC with input from the industry. Upon completion, every adviser registered with the SEC will have to redraft this basic disclosure document which serves to provide prospective and actual clients with a complete description of their operations, personnel, and practices. Comments on the Proposed Rules were due June 13, 2000.36 However, the SEC noted in a news release on September 12 of this year that it had "deferred action on its proposals to amend Part II of Form ADV."37 The overhaul of Part II continues to be debated and has proved to be a more daunting task than expected.38

Advertising Rules and Guidance

Much ado has been made in recent years about what constitute acceptable forms of advertising in the investment advisory field. Unlike the NASD, however, the SEC does not comment on the propriety of particular advertising pieces, except through the institution of individual enforcement proceedings and the occasional no-action letter. The SEC and the industry are in the process of working out parameters for advisers that will hopefully provide guidance for advisers without unduly restricting their need for creativity.39 In light of the increasing attention to advertising violations by the SEC in recent years, this remains a critical area for change and clarification, but one that is not susceptible to easy answers.

Broker-Dealer Registration Exemption

A source of continuing concern to the SEC and the investment industry is the question of whether broker-dealers should be subject to regulation under the Advisers Act. Since its passage in 1940, brokers have been exempted from regulation under the Act on the theory that their rendering of investment advice was incidental to their primary service of executing trades. As the world has changed and the lines between the services provided by advisers and brokers have become increasingly blurred, the SEC has renewed its call for at least some extension of the Advisers Act to broker-dealers. The blurring of boundaries has occurred in other traditionally exempt advisory areas as well --most notably banking. In response, the SEC (with support from industry groups such as the ICAA) is shifting its regulatory focus from positional to functional. The Gramm-Leach-Bliley Act 40 reflects that shift in the financial services industry. The SEC likewise characterizes its approach to regulating broker-dealer advice as "functional."41 As an example, under the rule, the nature of the services provided, rather than the form the broker-dealer 's compensation takes, would be the primary feature distinguishing an advisory account from a brokerage account. Discretionary accounts that are charged an asset-based fee would be considered advisory accounts because they bear a strong resemblance to traditional advisory accounts, and it is highly likely that investors will perceive such accounts to be advisory accounts. Under the statute, however, discretionary accounts from which a broker-dealer does not receive special compensation, e.g., accounts that pay commissions, would still be treated as brokerage accounts not subject to the Act.42

Included in the proposed rules is a requirement that brokers disclose clearly to clients in advertisements and agreements when a broker 's services are not covered.43 The comment period on the proposed rule ended January 14, 2000. With broker-dealers vigorously opposed to being subject to regulation as advisers, it is unclear to what extent --and when --these proposed rules might be adopted.

Ban on "Pay to Play"

Of all the many initiatives under consideration by the SEC at the current time, perhaps none is more controversial than the SEC 's proposed ban or limitation on campaign contributions to politicians or candidates who possess the ability to direct the investment of government-controlled funds. Since the rule was proposed in 1999 44, the SEC and the investment community have locked horns on whether and how to limit the making of contributions to officials who control the "public coffers." The Commission has proposed a rule that would prohibit an investment adviser from "providing advisory services for compensation to a government client for two years after the adviser or any of its partners, executive officers or solicitors make a contribution to certain elected officials or candidates."45 In addition, registered advisers that have government clients would be required to maintain records of political contributions made by the "adviser or any of its partners,executive officers or solicitors."46

With billions of dollars of funds at stake, and the exercise of First Amendment rights at issue, this promises to be a major point of contention for some time to come.

Proposed Suitability Rule

In 1994, the SEC proposed a rule that would expressly require advisers to make only those investment recommendations for their clients that are suitable. The proposed rule grows directly out of the pronouncements and case law interpreting the Act and the duties of an adviser at common law. Interestingly, the rule has never been adopted and its chances for passage now seem poor.47

Other Contemplated Rule Revisions

In addition to the above, the SEC has recognized the need for clarification, guidance and, in some instances, modernization in other critical areas covered by the Act. These areas include possible changes to the client-custody rule, modernization of the books-and-records provisions of the Act, and guidance on such topics as "best execution " and "soft dollar " practices.48

Conclusion

SEC Chairman Arthur Levitt has blazed a remarkable trail of change and innovation in his six-plus years as head of the Commission. With only a few months left in his tenure, it remains to be seen exactly what changes will and will not take place to the regulatory framework encompassed by the Advisers Act. One thing, however, is certain. With the steady growth of assets under management and the demise of the company-sponsored pension, the role played by investment advisers in this new century will continue to be an integral one. As Congress responds to the blurring of roles by carving out functional regulatory powers, the rules promulgated under what is sometimes deprecatingly referred to as "the other '40 Act " will continue to exert its influence on maintaining a balance between investor protection and free enterprise.

Happy 60th birthday to you!

1. At the end of a Keynote Address by Paul Roye, Director, Division of Investment Management, United States Securities and Exchange Commission, Before the American La w Institute and American Bar Association on June 15,2000,Mr.Roye said,"Finally, while this conference primarily focuses on Investment Company Act issues,it also touches on the other '40 Act,the Investment Advisers Act." Speech available at http://www.sec.gov/news/ speeches/spch382.htm.

2. 15 U.S.C.S. §§ 77a - 77aa (2000).

3. 15 U.S.C.S. §§ 78a - 78mm (2000).

4. 15 U.S.C.S. §§ 79 - 79z-6 (2000).

5. 15 U.S.C.S. §§ 77aaa - 77bbbb (2000).

6. 15 U.S.C.S. §§ 80a-1 - 80a-64 (2000).

7. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963).

8. House Report on the Advisers Act, in Thomas P. Lemke and Gerald T. Lins, Regulation of Investment Advisers, Appendix D2 at D2-1 (2000).

9. History of the Advisers Act, in Thomas P. Lemke and Gerald T. Lins, Regulation of Investment Advisers, Appendix D1 at D1-7 (2000).

10. Tamar Frankel and Clifford E. Kirsch, Investment Management Regulation 61 (1998).

11. Id.

12. Id.

13. Id.

14. Id.

15. 5 A.L. R. Fed. 246, 250 (2000).

16. Id.

17. History of the Advisers Act, in Thomas P. Lemke and Gerald T. Lins, Regulation of Investment Advisers, Appendix D1 at D1-12 (2000).

18. Id. Violations of the Investment Company Act were not included in the 1960 Amendments, but were in the 1970 Amendments. See id. at D1-16.

19. Id.

20. Id. at D1-14 (citing S. Rep. No. 184, 86th Cong., 2d Sess. 9 (1960)).

21. Id. at D1-15.

22. Id. at D1-16 (citing Section 203(a), (f) [15 U.S.C. § 80b-3(b)(2)]).

23. Id. (citing Section 206A [15 U.S.C. § 80b-3(b)(2)]).

24. Id.

25. Id.

26. For a brief discussion of the amendments in those years, see id.

27. Id.

28. Statement of David C. Tittsworth, Executive Director, ICAA, in connection with the SEC Roundtable on Investment Adviser Regulatory Issues, May 23, 2000, at 9. Available at http://www.icaa.org/ html/comments___statements.html. Mr. Tittsworth notes that the resources were so strained that smaller advisers could be inspected only once every 44 years. Id.

29. Statement of David C. Tittsworth, at 10.

30. Id. at 13-14.

31. Keynote Address by Paul Roye, Director, Division of Investment Management, United States Securities and Exchange Commission, Before the American Law Institute and American Bar Association on June 15, 2000, available at http://www.sec.gov/news/speeches/spch382.htm.

32. Statement of David C. Tittsworth, at 7 and nn. 25-27.

33. Paul F.Roye,Speech,"2000 and Beyond,SEC Priorities for the Investment Adviser Profession ",before the Investment Counsel Association of America, April 6, 2000, at http://www.sec.gov/news/speeches/spch361.htm

34. Codified at 17 CFR Parts 200, 275, and 279, Effective October 10, 2000. See http://www.sec.gov/rules/final/ia-1897.htm and www.sec.gov/iard for more information.

35. Paul F. Roye, Speech, April 6, 2000.

36. See http://www.sec.gov/rules/proposed/34-42620.htm.

37. See http://www.sec.gov/news/digests/09-12/txt.

38. As a point of comparison, when the Mutual Fund Registration (Form N-1A) was modified in 1998, the revised form and the implementing rules ran over 100 pages. See http://www.sec.gov/rules/final/33-7512r.htm and http://www.sec.gov/rules /final/33-7512f. htm.

39. See, for example, Letter from the Office of Compliance Inspections and Examinations to Registered Investment Advisers, on Areas Reviewed and Violations Found During Inspections, May 1, 2000, at http://www.sec.gov/offices/ocie/advltr.htm

40. P.L. 106-102, November 12, 1999.

41. Speech of Paul Roye, April 6, 2000.

42. http://www.sec.gov/rules/proposed/34-42099.htm.

43. Id.

44. http://www.sec.gov/rules/proposed/ia-1812.htm; comments were to be received by November 1, 1999.

45. Id.

46. Id.

47. Speech by Paul Roye, April 26, 2000.

48. Id.

Copyright 2006. Richard A. Levan. All rights reserved