The background behind passing of the Investment Company Act of 1940 is that effective state regulation of investment companies is not viable in the interest of investors since not only these entities engage in interstate trade and commerce across different states or jurisdictions but also their share holders are widely dispersed over extensive geographical area.
Investment Company Act 1940 regulates investment companies including mutual funds engaged mainly in investing, reinvesting, trading in securities involving buying and resale thereof and even whose own securities are offered to the investing public for subscription. This law has set separate parameters for investment companies as a separate class of companies.
The Investment Company Act does not permit the US Securities and Exchange Commission to judge the merits of the investments of these companies or directly supervise their investment decisions. Instead the Act mandates such investment companies to disclose their financial condition and investment policy at the time of initial public offer of the stocks and thereafter on a regular basis. The accent is on disclosure and transparency of the investment objectives, fund position and operations of the company.
However, the Act has put certain checks and balances on the investment companies. For instance, there are certain restrictions on the activities of mutual funds like short selling of shares.
Several types of investment companies including hedge funds are exempted from the operation of the Act.