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By Mark J. Astarita, Esq.
Entities and individuals who provide investment advice to others are subject to regulation by federal and state regulators. Before providing any type of financial advise to anyone, prospective advisers must determine what the regulatory requirements are, whether registration is required, and if so, what type of registration. As noted in my other articles, Introduction to the Federal Securities Laws and Introduction to the Blue Sky Law, the regulatory system is convoluted and complicated, with serious ramifications for violation of the regulations.
Those who provide investment advice generally fall into two categories - broker-dealers and investment advisers. The former are addressed in my article defining broker-dealers, this article deals with the registration and regulation of investment advisers.
Investment adviser Registration
Section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. § 80b-2(a)(11)), which is a key federal law, defines "investment adviser" in part as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities."
Three essential elements that characterize an investment adviser are:
· Provides advice or analysis on securities either by making direct or indirect recommendations to clients or by providing research or opinions on securities or securities markets.
· Receives compensation in any form for the advice provided.
Engages in a regular business of providing advice on securities.
Each state has its own securities statute and regulations governing the operation and registration of investment advisers. It is important to note that while most states have a deminimus exemption for advisers having only a few clients in the state, some states count solicitations toward that minimum.
The IA firm holds the registration/license. The IAR is an individual who performs services on behalf of the registered/licensed IA. Some states include within the definition of an IAR a person (often called a solicitor) who regularly refers customers to an IA and who receives compensation for those referrals. Other states may have modified licensing requirements for solicitors, and may require separate registration for solicitors, or other regulatory requirements.
In recent years the registration system for Investment advisers was overhauled. Previously, Investment advisers were required to register with the SEC, and with each state in which they did business. Today Investment advisers are regulated by either the SEC or the States, but not both. Of course, both groups of regulators maintain jurisdiction over the activities of these advisers, the change has been in the registration requirements.
Simplifying the structure, firms that have less than $25 million of assets under continuous and regular management generally must register with the state or states in which they have a place of business and in which they have clients, while firms that have more than $30 million under management must register with the SEC. Between $25 and $30 million the firm is allowed to register with the SEC or applicable states. (There are other exceptions to state registration, such as for firms doing business in 30 or more states and firms doing an Internet based business.) Firms that are registered with the SEC usually have to provide a copy of their Form ADV and pay a filing fee to states in which they have clients.
The main document in the registration of an investment adviser is Form ADV The form consists of some 73 pages, and the government has estimated that it will take the average adviser 9 hours to fully complete the form. Anyone contemplating starting an investment advisory firm should review the form to gain an understanding of what is involved in not only the form, but in structuring the firm itself.
All advisers now register with the SEC and the States electronically through IARD, a secure Internet based data system. Setting Up an IARD Account is the first step in the registration process. Once an adviser establishes an IARD account, the adviser can access Form ADV (Part 1) on IARD, complete this part of Form ADV, and submit it electronically through IARD to the SEC. Part II of Form ADV is completed in paper form as discussed below.
The SEC generally has 45 days after receipt of the Form ADV to declare an applicant's registration effective. The SEC will mail an Effective Order to an adviser once an adviser's registration is declared effective. An adviser can also check on IARD under the heading "Registration Status" to see if its registration has been declared effective by the SEC. The process for State registered advisers varies from state to state, but is similar to the SEC process.
Form ADV has two parts.
Part 1 asks for information about an adviser's business, the persons who own or control the adviser, and whether the adviser or certain of its personnel have been sanctioned for violating the securities laws or other laws. Part 1 is available in electronic format and is both filed and amended through IARD. See the General Instructions to Form ADV (No. 4) for information on updating Form ADV.
Part II is a written disclosure statement (or a written brochure) that provides information about business practices, fees, and conflicts of interest the adviser may have with its clients. Part II must be completed in paper format. IARD is not prepared to accept an electronic filing of Part II at this time. You can print a blank copy of Part II from the SEC website.
Part II is a disclosure statement that an adviser must use to provide information to clients and potential clients. Read rule 204-3 under the Investment Advisers Act of 1940 regarding your legal obligations 1) to deliver a copy of Part II (or a brochure containing comparable information) to prospective clients and 2) to offer annually a copy of Part II (or a brochure containing comparable information) to all current customers. You must keep your Part II current, maintain a copy in your files, and make it available to SEC staff upon request. Do not send your Part II to the SEC. Check with state securities authorities to determine what their filing requirements are for Part II.
While the requirements for registration and maintaining the registration vary from state to state, there are some general principles which apply in all states. Each state requires that IAs who do business in their state:
· State advisers to register or become licensed.
· Federal covered advisers to make a notice filing of their Form ADV.
· A passing score on a competency examination for each individual acting as an investment adviser or investment adviser representative.
· Payment of a fee for processing the applications.
· Certain disclosures to the securities agency and/or the public.
· Registration of branch offices of the adviser.
· A bond or minimum net capital.
A notice filing for a federal covered adviser is usually made by:
· Filing a complete copy of its Form ADV as filed with the US SEC.
· Filing a Form U-4 application for each investment adviser representative who will provide services on behalf of the investment adviser.
· Payment of any required notice filing fees.
The State and the SEC require electronic filing via the Investment Adviser Registration Depository (IARD). Firms must register with the IARD prior to making a filing. Complete information regarding the IARD system is available at http://www.iard.com/GetStarted.asp
Investment advisers and investment adviser representatives must renew their registration/license annually. In many states, the term is from January 1 to December 31 of a given year. However, some states have different renewal dates. Check with the state securities office in each state where you intend to do business. If an adviser becomes registered/licensed in the middle of a year, the fee is usually not prorated.
Today, the renewal process for investment advisers is handled by IARD
An adviser is required generally to maintain and keep current the records listed below. Additional recordkeeping requirements may also be set by the home state of the adviser. It will be necessary to check with the home state regulator.
Records Required of All Advisers:
· Receipts and Disbursements Journals
· General Ledger
· Order Memoranda
· Bank Records
· Bills and Statements
· Financial Statements
· Written Communications and Agreements (including electronic transmissions)
· List of Discretionary Accounts
· Personal Transactions of Representatives and Principals
· Client Records:
· Powers Granted by Clients
· Disclosure Statements
· Solicitors Disclosure Statements
· Performance Claims
· Customer Information Forms and Suitability Information
· Written Supervisory Procedures
Records Required of Advisers Who Have Custody of Client Assets:
· Journals of Securities Transactions and Movements
· Separate Client Ledgers
· Copies of Confirmations
· Record by Security Showing Each Clients Interest and Location Thereof
Records Required of Advisers That Manage Client Assets:
(These records are required to be maintained in an easily accessible place for a period of five years from the end of the fiscal year during which the last entry was made and, for the first two years, the records must be maintained in the advisers principal office.)
· Client Purchases and Sales History
· Current Client Securities Position
Most IAs do not maintain custody of their clients funds, which are typically held at a brokerage firm. If an adviser has direct or indirect access to client funds or securities, it is considered to have custody of client funds and is subject to additional scrutiny. State regulators will want to see how you handle those assets by asking the following:
· Has the adviser complied with the rules relating to safeguarding client assets in the adviser's custody?
· Does the Form ADV reflect that the adviser has custody?
· Are these assets maintained in segregated accounts?
· Does the adviser maintain the required records of client assets in its custody?
· Does the client get an itemized statement at least every three months showing the assets in the adviser's custody and the activity in the account?
· Has a surprise audit of client assets has been conducted at least annually by an independent accountant?
If the adviser has discretionary authority over the client's account, is there any evidence of excessive trading, self-dealing, preferential treatment, unsuitable recommendations, unauthorized transactions or incomplete disclosure?
The most important duty of an investment adviser is the disclosure of all information relating to the relationship between an adviser and a client. Advisers have great leeway in tailoring their client services as long as clients know up-front about such things as:
· What kinds are services are available
· Who is providing those services
· What fees and other expenses will the client be subject to and are they negotiable
· Is the adviser being compensated from other sources
· Is the adviser affiliated with another adviser, a broker-dealer or an issuer of securities
· Can you implement a financial plan anywhere or do you only get to keep the plan if you implement it through the adviser
· What other potential conflicts of interest exist that might affect the adviser's recommendations
The key document in making these disclosures is Part 2 of Form ADV and/or the adviser's brochure. This document should clearly spell out the details of the advisory relationship and other business interests of the adviser. This is the reference tool with which the client or potential client can compare advisory firms for cost of services and for compatibility with their needs. That is why investment advisory regulations require that Part 2 of Form ADV or the brochure be given to customers in advance or no later than the time of entering into a contract if rescission is permitted within a specifically allotted time.
Examiners will look for disclosure-related items not only in the disclosure document but also in any material describing any facet of the adviser's business that a client or potential client might see. This can include:
· Seminar materials
· Web sites
· Print, radio and TV ads
· Bulk mailings
· Fee schedules
· Portfolio reviews
The anti-fraud provisions of the Investment Advisers Act of 1940 and most state laws impose a duty on investment advisers to act as fiduciaries in dealings with their clients. This means the adviser must hold the client's interest above its own in all matters. Conflicts of interest should be avoided at all costs. However, there are some conflicts that will inevitably occur, such as a person being licensed as a securities agent as well as an adviser. In these instances, the adviser must take great pains to clearly and accurately describe those conflicts and how the adviser will maintain impartiality in its recommendations to clients. The SEC has said that an adviser has a duty to:
· Make reasonable investment recommendations independent of outside influences
· Select broker-dealers based on their ability to provide the best execution of trades for accounts where the adviser has authority to select the broker-dealer.
· Make recommendations based on a reasonable inquiry into a client's investment objectives, financial situation and other factors
· Always place client interests ahead of its own.
When examiners review advisory books and records, they will be on the lookout for undisclosed or misrepresented conflicts of interest and prohibited practices. Some are obvious and some not so obvious. Some examples of practices that advisers should avoid are:
· Acting as an issuer or affiliate of an issuer of securities
· Recommending unregistered, non-exempt securities or the use of unlicensed broker-dealers
· Any activity that acts as a fraud or deceit on clients
· Charging unreasonable fees
· Failing to disclose to all customers the availability of fee discounts
· Using contracts which seek to limit or avoid an adviser's liability under the law
· Limiting a client's options with regard to the pursuit of a civil case or arbitration
· Borrowing money from or lending money to clients
Other situations which require disclosure of the conflict include, but are not limited to:
· The adviser or its employees are also acting as a broker-dealer and/or securities agent
· The adviser is receiving transaction-based compensation, including 12b-1 or other marketing fees, related to securities recommended to its clients
· The adviser receives any type of compensation from any source for soliciting or referring clients to another adviser or a broker-dealer.
· Hidden fees in the form of undisclosed service charges, wrap fees or expenses reimbursed by other parties.
The examiner will view perceived conflicts from the point of view of the customer; was the disclosure or lack of disclosure a factor in the client's decision to use an adviser's services or ratify an adviser's recommendations? Was the customer misled? Was the customer placed at a disadvantage or taken unfair advantage of as a result of the conflict and the adviser's compliance with disclosure requirements? The burden of proof lies with the adviser.
IA firms are subject to periodic, sometimes unannounced, audits by regulators. The purpose of an audit is to determine compliance with the regulators licensing, books and records, and anti-fraud requirements. A survey of state regulators has revealed the top five problems noted in audits:
· ADV disclosures
· Poorly maintained books and records
· Poorly maintained financial records
We are often asked if the publisher of an investment newsletter is required to be registered as an investment adviser. As noted above, Section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. § 80b-2(a)(11)), which is a key federal law, defines "investment adviser" in part as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities."
However, expressly excluded from the definition is "the publisher of bona fide newspaper, news magazine or business or financial publication of general and regular circulation."
Section 401(f) of the Uniform Securities Act, upon which the majority of state securities laws are based, similarly excludes from the definition of investment adviser "a publisher of any bona fide newspaper, news column, newsletter, news magazine, or business or financial publication or service, whether communicated in hard copy form, or by electronic means, or otherwise, that does not consist of the rendering of advice on the basis of the specific investment situation of each client."
Since a bona fide newsletter publisher is not an investment adviser, registration as such is not required. However, Section 17(b) of the Securities Act of 1933 (15 U.S.C. 77q(b)) prohibits any person from publishing, giving publicity to, or circulating any notice, circular, advertisement, newspaper, article, letter, investment service or communication which describes a security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.
An example of SEC action against a newsletter for improper "touting" of securities can be found on the SECs website at http://www.sec.gov/litigation/litreleases/lr15901.htm. States could also proceed against such a publisher under the anti-fraud provisions of their securities laws. See SEC Tips for Checking Newsletters at http://www.sec.gov/investor/pubs/cyberfraud/newsletter.htm
Other Information regarding Online Investment Newsletters can be found at http://www.sec.gov/investor/pubs/cyberfraud.htm.
Form ADV is only the beginning of the process. I hope that I have conveyed
the complexity of registration and operation of an Investment advisory
firm, since many laymen seem to believe that the process is simple and
does not require the assistance of counsel. While it is true that anyone
can complete the form, the reality is that the form is the beginning
- running a compliant operation is the goal.
Filing Form ADV is only the beginning of the process. I hope that I have conveyed the complexity of registration and operation of an Investment advisory firm, since many laymen seem to believe that the process is simple and does not require the assistance of counsel. While it is true that anyone can complete the form, the reality is that the form is the beginning - running a compliant operation is the goal.
you have any questions regarding the operation of an investment adviser,
or a broker-dealer, or wish to discuss the creation or a new entity
to provide such services, please contact Mark Astarita at
or by email at firstname.lastname@example.org
If you have any questions regarding the operation of an investment adviser, or a broker-dealer, or wish to discuss the creation or a new entity to provide such services, please contact Mark Astarita at or by email at email@example.com
Securities Law Blog
Copyright 2010. VGIS Communications LLC. All Rights Reserved. VGIS Communications, LLC - 41 Watchung Plaza, Suite 249, Montclair, New Jersey 07042 - 973-559-5566. Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial adviser before acting upon the information contained in this article. For additional information, contact Mark J. Astarita, Esq., a partner in the law firm of Beam & Astarita, LLC, who represents clients in a wide variety of finance related matters. Mr. Astarita can be contacted by email at firstname.lastname@example.org.
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