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Donohue: History of the 1940 Act and Current Regulatory Challenges

In a recent address before the ALI-ABA Compliance Conference, Andrew J. Donohue, Director of the SEC's Division of Investment Management, related to the audience how the principles underpinning the Investment Company Act of 1940 remain relevant, and even vital, to the success of the industry today, "my intent is to give you a sense of how the principles embodied in the Act have truly aided investors and the investment management industry by reinforcing its understanding of the need to protect investors and instill investors' confidence in its products."  He also warned that the 1940 Act, though a flexible and dynamic regulatory scheme, has faced some challenges given the rapid growth and change of the investment company industry since 1940, noting that "[the 1940 Act is] being challenged and stretched in ways that were inconceivable when it was enacted, but which we in the Division of Investment Management are dealing with today."

Donohue provided a succinct, yet thorough, history of the 1940 Act, and highlighted a feature of the legislation that he feels is primarily responsible for its continued relevance and effectiveness: its flexibility in accommodating industry developments.

Another characteristic of the Act, and one I consider even more important to the success of the investment management industry than the Act's comprehensive regulations, is the Act's flexibility in accommodating industry developments. This flexibility is due in part to a provision contained in the Act - until recently unique to it and the Investment Advisers Act - that allows the Commission to exempt certain transactions, structures and products that would otherwise be prohibited under the Act, if and to the extent that it is necessary or appropriate in the public interest and consistent with the protection of investors and the Act itself. The Commission has used this authority to accommodate investment company innovation in certain appropriate circumstances, through individual orders and, in some circumstances, later through rules of general applicability. Money market funds, exchange-traded funds and variable annuity products - some of the most innovative financial products of the past 30 years - were made available to the investing public in this manner.

Though the 1940 Act has dealt admirably with market innovations, Donohue pointed out that the market landscape today is dramatically different than it was 70 years ago when the Act was passed.  He noted that asset-backed securities did not exist then, and a number of pooled investment vehicles and collective investment trusts that exist today would likely have been swept into the ambit of the 1940 Act if they had existed when the Act was passed, but continue to be exempt at this point.  He called on his audience to consider whether investors in these  vehicles concentrating in non-traditional areas of investment should also receive the protections of the 1940 Act.  

Donohue also stated that another area that has developed, which was not contemplated by Congress in 1940, but which the Commission staff is examining today, is funds' increasing investments in derivatives and other sophisticated financial instruments.  

Investment companies have moved from relatively modest participation in derivatives transactions limited to hedging or other risk management purposes to a broad range of strategies that rely upon derivatives as a substitute for more conventional securities. Investment companies that seek to mimic hedge fund strategies, typically involving derivative products, have become more commonplace. New categories of investment companies have emerged: absolute return funds, commodity return funds, alternative investment funds, long-short funds and leveraged and inverse index funds, among others.

The 1940 Act truly contemplated a different world. These developments present challenges in giving effect both to the literal terms of the Investment Company Act as well as two of its underlying purposes 1) to address the speculative character of shareholders' interests arising from excessive borrowing or the issuance of excessive amounts of senior securities and 2) to assure full disclosure to investors of investment strategies and risks.

Finally, Donohue discussed what he sees as another real challenge to the fund industry, private funds, some of which may be claiming exemption from regulation when, in fact, given the nature of the investors they seek to attract, they should probably fall under the 1940 Act.

We also are seeing new participants in the investment management area that did not exist in 1940 playing increasingly major roles in the markets. Most notably in this category are hedge funds, and private equity and venture capital funds. These funds traditionally have been organized in ways that avoid regulation as investment companies under the Investment Company Act, as well as avoid registration requirements of the Securities Act and the Securities Exchange Act. In addition, many hedge fund, private equity and venture capital fund managers, although they are investment advisers, avoid registration under the Investment Advisers Act of 1940 by taking advantage of an exemption from registration for small investment advisers - those with fewer than 15 clients. Private fund advisers qualify for this exemption by pooling client assets and creating limited partnerships, business trusts or corporations. Because advisers are permitted under a Commission rule to count each partnership, trust or corporation as a single client, they avoid registration while, in many cases, managing substantial amounts of assets on behalf of large numbers of investors.

The full text of Mr. Donohue's keynote ALI-ABA address is available at: