FINRA Series 7 / 63 / 65 Investment Company Act of 1940
Last updated: May 2, 2026
Investment Company Act of 1940 questions are one of the highest-leverage areas to study for the FINRA Series 7 / 63 / 65. This guide breaks down the rule, the elements you need to recognize, the named traps that catch most students, and a memory aid that scales to test day. Read it once, then practice the same sub-topic adaptively in the app.
The rule
The Investment Company Act of 1940 (the '40 Act) regulates companies whose primary business is investing, reinvesting, or trading in securities. It defines three classifications — face-amount certificate companies, unit investment trusts (UITs), and management companies (open-end and closed-end, further subdivided into diversified and non-diversified) — and imposes structural rules on capitalization, board composition, affiliated transactions, advisory contracts, and disclosure. Funds must register with the SEC under the '40 Act, deliver a statutory prospectus, and operate within strict limits on leverage, custody, and dealings with affiliated persons under Section 17.
Elements breakdown
Three Statutory Classifications (Section 4)
The '40 Act sorts every registered investment company into one of three buckets based on legal structure.
- Face-amount certificate company issues installment certificates
- Unit investment trust holds fixed unmanaged portfolio
- Management company actively managed open-end or closed-end
Open-End vs. Closed-End Management Companies
Both are management companies but differ in capitalization, redemption, and trading mechanics.
- Open-end continuously issues redeemable shares at NAV
- Closed-end issues fixed shares trading on exchange
- Open-end priced forward at next computed NAV
- Closed-end may trade at premium or discount
Common examples:
- Open-end mutual fund computes NAV once daily at 4 p.m. ET
- Closed-end fund shares trade intraday like stock
Diversified vs. Non-Diversified (75-5-10 Rule)
To call itself diversified, a management company must satisfy the 75-5-10 test for at least 75% of its portfolio.
- 75% of assets in diversified bucket
- No more than 5% in any one issuer
- No more than 10% of issuer's voting securities
- Remaining 25% unrestricted by this test
Section 17 Affiliated Transactions
The '40 Act prohibits self-dealing between a fund and its affiliated persons absent an SEC exemptive order.
- No principal trades with affiliates
- No joint transactions with affiliates
- No borrowing from the fund by affiliates
- Affiliated person owns 5% or more of voting stock
Board and Advisory Contract Requirements (Section 15)
The '40 Act dictates the governance of fund boards and the renewal of advisory agreements.
- At least 40% of directors must be independent
- Advisory contract approved initially for two years
- Renewed annually by board or shareholder vote
- Material changes require shareholder approval
Capital Structure and Leverage (Section 18)
Limits the issuance of senior securities to protect common shareholders from excessive leverage.
- Open-end may issue only one class of common
- Open-end may borrow only from banks 300% coverage
- Closed-end may issue debt at 300% asset coverage
- Closed-end may issue preferred at 200% asset coverage
Common patterns and traps
Open-End Closed-End Swap
The wrong answer attaches an open-end characteristic (redeemable at NAV, forward pricing, continuous offering) to a closed-end fund, or vice versa. This is the most common '40 Act trap because both are 'management companies' under Section 4(3) but operate completely differently in the secondary market. Watch for stems mentioning intraday trading, premium/discount to NAV, or fixed share counts — those signal closed-end.
A choice claiming a closed-end fund 'redeems shares at the next computed NAV' or that an open-end fund's shares 'trade at a premium to NAV on the NYSE.'
75-5-10 Misstatement
The wrong answer scrambles the three numbers in the diversification test or applies them to the wrong base. Common variants: claiming the test applies to 100% of assets (it's only 75%), saying 'no more than 10% in one issuer' (it's 5%), or that the 10% refers to assets rather than the issuer's voting securities.
A choice stating 'a diversified fund may not invest more than 10% of its assets in any one issuer' (wrong — 5% of assets, 10% of issuer's voting stock).
Section 17 Loophole Bait
The wrong answer suggests an affiliated transaction is permissible because it was 'fair,' 'arm's-length,' or 'disclosed to shareholders.' Section 17(a) is a flat prohibition on principal trades and joint transactions with affiliated persons — fairness is irrelevant absent an SEC exemptive order under Section 17(b) or a rule-based exemption.
A choice that allows the adviser to sell securities to the fund 'as long as the price equals current market value' or 'with full disclosure in the next shareholder report.'
Independent Director Floor Inflation
The wrong answer overstates the independent-director requirement. The '40 Act baseline under Section 10(a) is at least 40% independent; certain Rule 12b-1 fee arrangements and exemptive rules require a majority (over 50%), but the statutory floor is 40%. Candidates often pick 'majority' as a default safe answer.
A choice stating 'the Investment Company Act requires that a majority of fund directors be independent of the adviser.'
UIT vs. Mutual Fund Confusion
The wrong answer attributes active management, a board of directors, or an investment adviser to a unit investment trust. UITs are unmanaged — they hold a fixed portfolio of securities deposited at inception, terminate on a set date, and have a trustee rather than a board.
A choice describing a UIT as 'actively managed by an investment adviser registered under the '40 Act.'
How it works
Picture Brennan-Okonkwo Equity Income Fund, a registered open-end management company. Because it is open-end, it stands ready to redeem shares within seven days at the next computed NAV — that's the forward-pricing rule from Rule 22c-1. If Brennan-Okonkwo wants to call itself 'diversified' in its prospectus, at least 75% of its assets must be spread so that no single issuer represents more than 5% of fund assets and the fund holds no more than 10% of any issuer's voting securities. The remaining 25% can be concentrated however the manager wants. The fund's investment adviser, Okonkwo Capital Management, signed a two-year initial contract; after that, the independent directors (who must make up at least 40% of the board) must reapprove it annually. And if Okonkwo Capital wants to sell a bond it owns to the fund, Section 17(a) blocks that principal transaction outright unless the SEC grants an exemptive order — the '40 Act presumes affiliated trades are tainted by conflict.
Worked examples
Which of the following statements best explains the situation to Mira under the Investment Company Act of 1940?
- A As a registered investment company, Velasquez Strategic Income Trust must redeem her shares at the next computed NAV within seven days under Section 22(e).
- B Closed-end fund shares are not redeemable; she must sell them in the secondary market, where shares often trade at a premium or discount to NAV. ✓ Correct
- C The fund must repurchase her shares at NAV because the discount exceeds 5%, triggering the mandatory tender provisions of Section 23 of the '40 Act.
- D Because the fund is a management company under Section 4(3), it must offer continuous redemption at NAV regardless of whether it is open-end or closed-end.
Why B is correct: Closed-end management companies issue a fixed number of non-redeemable shares that trade on an exchange or OTC at a market-determined price. That price is set by supply and demand and frequently diverges from NAV — a discount of 8% is common. The seven-day redemption rule and forward NAV pricing apply to open-end funds (mutual funds), not closed-end funds. Mira's only exit is to sell into the secondary market.
Why each wrong choice fails:
- A: Section 22(e)'s seven-day redemption requirement applies only to redeemable securities issued by open-end funds. Closed-end fund shares are explicitly not redeemable. (Open-End Closed-End Swap)
- C: There is no '5% discount triggers mandatory tender' rule in the '40 Act. Section 23 governs distribution and repurchase of closed-end shares but does not force redemption based on discount size.
- D: Both open-end and closed-end funds are management companies under Section 4(3), but only open-end funds offer continuous redemption at NAV. The classification alone does not impose redeemability. (Open-End Closed-End Swap)
To remain a 'diversified' company under the 75-5-10 test, what is the maximum dollar amount Tashiro Balanced Growth Fund may invest in Reyes Industrial within the diversified 75% bucket?
- A $30 million — limited to 5% of the fund's $600 million diversified bucket.
- B $40 million — limited to 5% of the fund's $800 million total assets. ✓ Correct
- C $80 million — limited to 10% of the fund's $800 million total assets.
- D $120 million — limited to 10% of Reyes Industrial's $1.2 billion voting securities.
Why B is correct: The 75-5-10 diversification test in Section 5(b)(1) is applied to total fund assets, not just the 75% diversified bucket. Within that 75% (which must satisfy the test), no single issuer position may exceed 5% of total fund assets — that's $40 million on $800 million in net assets. The fund must also stay under 10% of Reyes Industrial's voting securities ($120 million), but 5% of fund assets is the binding constraint at $40 million.
Why each wrong choice fails:
- A: The 5% per-issuer limit is measured against total fund assets ($800 million), not against the 75% diversified bucket. Applying the 5% to $600 million understates the allowable position. (75-5-10 Misstatement)
- C: The 10% figure in the 75-5-10 test refers to 10% of the issuer's outstanding voting securities, not 10% of the fund's assets. Confusing the two bases is the classic 75-5-10 trap. (75-5-10 Misstatement)
- D: Although 10% of Reyes Industrial's voting stock ($120 million) is one ceiling, the 5%-of-fund-assets test ($40 million) is the more restrictive constraint and therefore controls. (75-5-10 Misstatement)
Under Section 17 of the Investment Company Act of 1940, which statement is MOST accurate?
- A The transaction is permissible because it will be executed at fair market value and disclosed to shareholders after the fact.
- B The transaction is permissible if a majority of the fund's independent directors approve the price in advance.
- C Section 17(a) prohibits this principal transaction between the fund and its affiliated adviser absent an SEC exemptive order under Section 17(b) or a specific rule exemption. ✓ Correct
- D The transaction is permissible because Okonkwo Capital is acting as an unaffiliated counterparty when trading from its proprietary account.
Why C is correct: Section 17(a) of the '40 Act flatly prohibits an affiliated person of a registered investment company — which includes its investment adviser — from selling securities to the fund as principal. Fairness, market-value pricing, and after-the-fact disclosure do not cure the prohibition. The only path forward is an exemptive order from the SEC under Section 17(b) or reliance on a specific rule-based exemption (such as Rule 17a-7 for cross-trades between affiliated funds, which has its own conditions).
Why each wrong choice fails:
- A: Section 17(a) is a categorical ban on affiliated principal transactions; it cannot be cured by 'fair pricing' or post-trade disclosure. The prohibition exists precisely because fairness is hard to police in self-dealing situations. (Section 17 Loophole Bait)
- B: Independent-director approval does not substitute for SEC exemptive relief under Section 17(b). The board cannot wave through a flatly prohibited principal trade. (Section 17 Loophole Bait)
- D: Okonkwo Capital is the fund's investment adviser and therefore an 'affiliated person' under Section 2(a)(3) regardless of which proprietary account the bonds come from. The affiliation, not the account label, triggers Section 17. (Section 17 Loophole Bait)
Memory aid
Three classifications: 'FUM' — Face-amount, UIT, Management. For diversification: '75-5-10' — 75% of assets, 5% per issuer, 10% of issuer's votes.
Key distinction
Open-end funds redeem shares at NAV (forward-priced) and continuously offer new shares; closed-end funds issue a fixed number of shares that trade on an exchange at a market price that may diverge from NAV.
Summary
The Investment Company Act of 1940 classifies funds into three structural buckets and imposes governance, diversification, leverage, and anti-self-dealing rules — most exam items turn on classification mechanics, the 75-5-10 test, or Section 17 affiliated-transaction prohibitions.
Practice investment company act of 1940 adaptively
Reading the rule is the start. Working FINRA Series 7 / 63 / 65-format questions on this sub-topic with adaptive selection, watching your mastery score climb in real time, and seeing the items you missed return on a spaced-repetition schedule — that's where score lift actually happens. Free for seven days. No credit card required.
Start your free 7-day trialFrequently asked questions
What is investment company act of 1940 on the FINRA Series 7 / 63 / 65?
The Investment Company Act of 1940 (the '40 Act) regulates companies whose primary business is investing, reinvesting, or trading in securities. It defines three classifications — face-amount certificate companies, unit investment trusts (UITs), and management companies (open-end and closed-end, further subdivided into diversified and non-diversified) — and imposes structural rules on capitalization, board composition, affiliated transactions, advisory contracts, and disclosure. Funds must register with the SEC under the '40 Act, deliver a statutory prospectus, and operate within strict limits on leverage, custody, and dealings with affiliated persons under Section 17.
How do I practice investment company act of 1940 questions?
The fastest way to improve on investment company act of 1940 is targeted, adaptive practice — working questions that focus on your specific weak spots within this sub-topic, getting immediate feedback, and revisiting items you missed on a spaced-repetition schedule. Neureto's adaptive engine does this automatically across the FINRA Series 7 / 63 / 65; start a free 7-day trial to see your sub-topic mastery climb in real time.
What's the most important distinction to remember for investment company act of 1940?
Open-end funds redeem shares at NAV (forward-priced) and continuously offer new shares; closed-end funds issue a fixed number of shares that trade on an exchange at a market price that may diverge from NAV.
Is there a memory aid for investment company act of 1940 questions?
Three classifications: 'FUM' — Face-amount, UIT, Management. For diversification: '75-5-10' — 75% of assets, 5% per issuer, 10% of issuer's votes.
What's a common trap on investment company act of 1940 questions?
Confusing open-end (redeemable, NAV) with closed-end (exchange-traded, market price)
What's a common trap on investment company act of 1940 questions?
Mixing up the 75-5-10 diversification test with concentration policies
Ready to drill these patterns?
Take a free FINRA Series 7 / 63 / 65 assessment — about 25 minutes and Neureto will route more investment company act of 1940 questions your way until your sub-topic mastery score reflects real improvement, not luck. Free for seven days. No credit card required.
Start your free 7-day trial