Investment Adviser Regulation

Investment Adviser Definition Under the USA

As introduced in Chapter 1, the Uniform Securities Act defines an investment adviser (IA) as any person who, for compensation, engages in the business of advising others about the value of securities or the advisability of investing in, purchasing, or selling securities. The definition also includes persons who, for compensation, issue analyses or reports concerning securities as part of a regular business.

The three-pronged "ABC test" determines whether a person meets the IA definition:

1. Advice: The person provides advice, counsel, or analyses about securities
2. Business: Providing such advice is a regular part of the person's business activities
3. Compensation: The person receives compensation for the advice (this need not be a separate advisory fee; commissions, soft dollars, or any economic benefit counts)

All three elements must be present simultaneously. If any one element is absent, the person is not an investment adviser under the USA. For example, a person who gives free investment advice to friends is not an IA (no compensation). A person who gives one-time paid advice but does not engage in an advisory business regularly is not an IA (not a business). A person who writes about general economic trends without recommending specific securities is not an IA (no securities advice).

Federal Covered Advisers

A federal covered adviser is an investment adviser that is registered with the SEC under the Investment Advisers Act of 1940 rather than with the state. Generally, an adviser qualifies as federal covered if it has assets under management (AUM) of $100 million or more (with a buffer zone between $100 million and $110 million). Federal covered advisers are exempt from state registration requirements but may be required to make a notice filing with the state and pay a fee.

Critical distinctions regarding federal covered advisers:

• States cannot require federal covered advisers to register at the state level
• States can require notice filings and fees from federal covered advisers
• States can require investment adviser representatives (IARs) of federal covered advisers to register at the state level
• States always retain anti-fraud jurisdiction over federal covered advisers operating within their borders

Exclusions from the Investment Adviser Definition

The USA excludes certain persons from the definition of investment adviser, even if they technically provide advice about securities for compensation. These exclusions are based on the principle that these persons are already regulated under other frameworks or that their advisory activities are incidental to their primary profession.

The LATE-B Exclusions

The major exclusions from the IA definition can be remembered with the acronym "LATE-B":

1. Lawyers: Attorneys whose advisory activities are incidental to the practice of law. If a lawyer provides investment advice as part of estate planning or business transactions, and this advice is incidental (not the primary service), the lawyer is excluded. However, if the lawyer holds out as providing investment advice as a separate service, the exclusion does not apply.
2. Accountants: Certified public accountants and public accountants whose advisory activities are incidental to the practice of accounting. Similar to lawyers, if the accountant provides investment advice that is incidental to tax preparation, auditing, or other accounting services, the exclusion applies. But if the accountant markets investment advice as a standalone service, they would be considered an IA.
3. Teachers: Teachers and professors whose advisory activities are incidental to their teaching duties. A finance professor at a university who discusses securities in class is not an IA. But if the professor runs a separate investment advisory business on the side, that activity is not incidental to teaching.
4. Engineers: Licensed professional engineers whose advisory activities are incidental to the practice of engineering. An engineer who evaluates the feasibility of a construction project and incidentally advises on the securities of the construction company is excluded.
5. Broker-Dealers: Broker-dealers whose advisory activities are incidental to the conduct of their business as broker-dealers and who receive no special compensation for the advisory services. This is the key exclusion for broker-dealers. If a BD's registered representative recommends securities as part of selling them and the rep receives only commissions (not a separate advisory fee), the BD is not an IA. However, if the BD charges a separate fee for investment advice (such as a wrap fee or financial planning fee), the BD may need to register as an IA.

Additional Exclusions

• Publishers of Bona Fide Newspapers, Magazines, or Financial Publications: Publishers of general circulation publications are excluded if the publication is available to the general public, is published on a regular schedule (not timed to specific market events), and does not provide personalized advice to individual subscribers. The publisher must offer the publication to anyone, not just to a targeted group. A newsletter with personalized stock picks for individual subscribers would likely NOT qualify for this exclusion.
• Federal Covered Advisers: Advisers registered with the SEC are excluded from the state-level IA definition, though they may need to file a notice filing with the state. Their IARs must still register at the state level.
• Persons Who Do Not Hold Themselves Out as IAs: Persons who do not hold themselves out publicly as investment advisers and whose advice is limited to U.S. government securities or certain other specific securities.

Investment Adviser Registration Requirements

Unless excluded or exempt, any person meeting the IA definition must register with the state Administrator before conducting advisory business. The registration process parallels that of broker-dealers in many respects.

Registration Application

The IA registration application must include:

• The name, form of organization, and address of the applicant
• The qualifications and business history of the applicant and its principals for the past 10 years
• Whether the applicant or any of its principals have been convicted of any felony or securities-related misdemeanor
• Whether the applicant or any of its principals have been subject to any regulatory action
• The applicant's financial condition and a description of its advisory business
• A consent to service of process
• The filing fee

Like broker-dealer registration, IA registration is effective for one year and must be renewed annually.

IAR Registration

Investment adviser representatives must register separately in each state where they provide advisory services. This applies to IARs of both state-registered advisers and federal covered advisers. The IAR registration typically requires passing a qualifying examination (the Series 65 or, in combination with the SIE, the Series 66).

An IAR is any individual associated with an investment adviser who:

• Makes recommendations or gives investment advice regarding securities
• Manages accounts or portfolios of clients
• Determines which investment advice should be given
• Solicits, offers, or negotiates the sale of investment advisory services
• Supervises employees who perform any of the above functions

Clerical and administrative personnel who do not perform any of these functions are NOT IARs and do not need to register.

The Brochure Rule

One of the most important client protection provisions applicable to investment advisers is the brochure rule. Under this rule, an investment adviser must deliver a written disclosure document (the "brochure") to each prospective client. The brochure provides essential information about the adviser's business practices, fees, disciplinary history, and potential conflicts of interest.

Content of the Brochure

The brochure (typically prepared using SEC Form ADV Part 2A or an equivalent state form) must disclose:

• A description of the adviser's business, including the types of advisory services offered
• The adviser's fee schedule, including how fees are calculated, when they are charged, and whether they are negotiable
• The types of clients served (individuals, institutions, high-net-worth individuals, etc.)
• The investment strategies and methods of analysis used
• Disciplinary information, including any legal or regulatory events that are material to a client's evaluation of the adviser
• Conflicts of interest, including any affiliations or financial industry activities that could create a conflict
• Brokerage practices, including whether the adviser has discretion over the selection of broker-dealers for executing client trades
• How client accounts are reviewed and by whom
• Client referral arrangements and compensation for client referrals
• Custody arrangements (whether the adviser has custody of client funds or securities)

When Must the Brochure Be Delivered?

The brochure must be delivered at least 48 hours before the client enters into an advisory contract with the adviser, OR at the time of entering into the contract if the client retains the right to terminate the contract without penalty within 5 business days after entering into it. This ensures the client has adequate time to review the adviser's disclosures before committing.

Additionally, the adviser must deliver an updated brochure (or a summary of material changes) annually to existing clients. If there is a material change to the brochure between annual updates, the adviser must promptly deliver the updated information to clients.

Solicitor Arrangements

An investment adviser may use third parties, known as solicitors, to refer clients to the adviser. However, because solicitor arrangements create potential conflicts of interest (the solicitor is being paid to recommend the adviser), the USA and NASAA model rules impose strict requirements on these arrangements.

Requirements for Solicitor Arrangements

• There must be a written agreement between the investment adviser and the solicitor, describing the solicitor's activities and the compensation arrangement.
• The solicitor must deliver the adviser's brochure to each prospective client at the time of the solicitation.
• The solicitor must also deliver a separate disclosure document (solicitor's disclosure) that describes the solicitor's relationship with the adviser, the terms of the compensation arrangement, and any additional cost the client will bear as a result of the solicitor's involvement.
• The adviser must receive from the client a signed acknowledgment that the client received both the brochure and the solicitor's disclosure document.
• The adviser must make a bona fide effort to determine that the solicitor has complied with all applicable requirements.

The solicitor cannot be a person who has been disqualified (e.g., convicted of a felony, subject to a securities-related regulatory order, or barred from association with a securities firm). Using a disqualified solicitor is a violation of the Act.

Custody of Client Assets

Custody refers to an investment adviser holding, directly or indirectly, client funds or securities, or having the ability to obtain possession of them. Custody creates a significant risk of misuse, theft, or misappropriation of client assets, so the USA and state regulations impose strict requirements on advisers who have custody.

When Does an IA Have Custody?

An investment adviser is deemed to have custody if:

• The adviser holds client funds or securities directly (e.g., the client writes checks to the adviser)
• The adviser has the authority to obtain possession of client assets (e.g., the adviser can direct a custodian to wire funds to any account)
• The adviser has a general power of attorney over a client's assets
• The adviser or a related person acts as trustee of a trust with client assets

An adviser who has the authority to deduct advisory fees directly from a client's account is generally considered to have a limited form of custody, but many jurisdictions treat fee deduction differently from full custody.

Custody Requirements

If an investment adviser has custody of client assets, the following requirements generally apply:

1. Qualified custodian: Client assets must be held at a "qualified custodian" (a bank, savings institution, registered broker-dealer, or other entity approved by the Administrator). The adviser cannot simply hold cash or securities in its own office.
2. Notice to clients: The adviser must notify clients promptly in writing of the qualified custodian's name and address and how the assets are held.
3. Account statements: The qualified custodian must send account statements directly to the client at least quarterly, showing all transactions and the amount of assets held.
4. Annual surprise examination: An independent public accountant must conduct a surprise examination of the adviser's custody arrangements at least once per year to verify client assets.
5. Financial statements: An adviser with custody may be required to maintain a higher net worth or post a larger surety bond than an adviser without custody.

Advisory Contract Requirements

The USA imposes specific requirements on investment advisory contracts to protect clients. These requirements ensure transparency, prevent certain conflicts of interest, and give clients important rights.

Prohibited Contract Provisions

An advisory contract may NOT contain any of the following provisions:

• Assignment without consent: The contract cannot be assigned to another adviser without the client's written consent. "Assignment" generally includes any transfer of the contract or a controlling interest in the adviser. If the adviser's ownership changes (e.g., through a merger or sale), the client must consent to the new adviser taking over the contract.
• Performance-based compensation (with exceptions): The contract generally cannot provide for compensation based on a share of capital gains or capital appreciation of the client's account (a "performance fee"). The rationale is that performance fees create an incentive for the adviser to take excessive risks with the client's money. However, there are exceptions for qualified clients (typically those with a net worth of at least $2.2 million or at least $1.1 million under management with the adviser) and for certain types of accounts (such as pooled investment vehicles).

Required Contract Provisions

Advisory contracts should include:

• A description of the services to be provided
• The term of the contract (start date and duration)
• The adviser's fee schedule and how fees will be calculated and charged
• The right to terminate the contract (typically with 30 days' notice or less)
• Whether the adviser has discretionary authority over the client's account
• The client's acknowledgment of receiving the brochure